Astonishingly, at a time when the public is crying out for greater regulation to limit excessive risk-taking by financial institutions, the banks are trying to get Congress to agree that the next time there’s a big downturn, they should have the ability to alter their accounting standards — essentially, fudge the numbers — so that the public and investors won’t be able to tell how insolvent they really are. By ignoring their declining asset values, they can avoid the standard requirement of raising more capital.

The mechanism is contained in an amendment set to be introduced in mid-November by Rep. Ed Perlmutter (D-Colo.) that would move final authority over the Financial Accounting Standards Board (FASB) from the Securities and Exchange Commission to a new body, a so-called “oversight” board, that would include the officials charged with managing systemic risks to the financial markets.

Accountants are apoplectic. Even the Chamber of Commerce is fighting this, on behalf of their non-bank membership, co-signing a letter with the Center for Audit Quality and the Council of Institutional Investors:

By placing the FASB under the jurisdiction of a structure charged with managing systemic risks to the financial markets, accounting rules will be viewed though the narrow lens of a few large companies from specific industries, rather than considerate of the applicability of financial reporting policies to over 15,000 public companies. Such a narrow focus can skew standards such that it makes understanding of transactions that businesses engage in on a daily basis more difficult and undermine the confidence of investors. We believe that the SEC has been and continues to be best suited to provide the oversight of the FASB for such a broad and diverse economy.

As such, we strongly support an independent standards-setting process, subject to public scrutiny and free of undue pressures.

Another helpful bit of the article explains how it isn’t Wall Street driving this, it’s smaller community banks.

It bothers me how small banks have been able to set themselves up as David to the Wall St. Goliath. No, they don’t benefit from TBTF guarantees so, yes, they are at a disadvantage relative to Wall St.

But that’s not a reason to bend the rules in their favor. No they didn’t get involved in more exotic products that blew up Wall St., but many got caught in the CRE mania. If they are insolvent, they need to be shut down. Otherwise they’ll continue to absorb capital that should go to solvent banks and borrowers.

But congressmen tend to like little guy storis (also they like campaign contributions from community banks) so many are happy to sponsor this race to the bottom.

(By the way….it’s interesting that Kanjorski is against this. Recall that it was his subcommittee that browbeat FASB into overriding fair value rules earlier this year.)

#116

• Failed bank: United Security Bank, Sparta GA
• Acquiring bank: Ameris Bank, Moultrie GA
• Vitals: as of 9/14/09, assets of $157m, deposits of $150m
• DIF damage: $58 million

Ameris Bank also bought American United two weeks ago.

#117

• Failed bank: Home Federal Savings Bank, Detroit MI
• Acquiring bank: Liberty Bank and Trust, New Orleans LA
• Vitals: as of 9/24/09, assets of $14.9m, deposits of $12.8m
• DIF damage: $5.4 million

#118

• Failed bank: Prosperan bank, Oakdale MN
• Acquiring bank: Alerus Financial NA, Grand Forks ND
• Vitals: as of 8/30/09, assets of $199.5m, deposits of $175.6m
• DIF damage: $60.1 million

#119

• Failed bank: Gateway Bank of St. Louis, St. Louis MO
• Acquiring bank: Central Bank of Kansas City, KC MO
• Vitals: as of 9/25/09, assets of $27.7m, deposits of $27.9m
• DIF damage: $9.2 million

#120

• Failed bank: United Commercial Bank, SF CA
• Acquiring bank: East West Bank, Pasadena CA
• Vitals: as of 10/23/09, assets of $11.2 billion, deposits of $7.5 billion
• DIF damage: $1.4 billion

The LA Times notes that United Commercial got $299 million of TARP money, which is now gone.

Fannie owed $15.8 billion by Lehman (Fannie 10-q) see page 103.

With tax break, a bigger carbon footprint (Glaeser, Boston Globe) “The real problem with the [home buyer tax] credit is that it continues the long-standing federal push toward far-flung McMansions and away from dense, apartment living.” It’s not just about carbon consumption. It’s about encouraging the expansion of a footprint that our incomes can no longer support.

Goodbye to reforms of 2002 (Norris, NYT) Floyd chimes in on Sarbox.

Pre-retirees in denial on savings (CalculatedRisk) Future generations (including mine) will look back in wonder at the 20-year retirements that were typical through the 80s/90s/00s.

950th time is the charm for learner driver (Couzens, Sky News, ht Troy M) Is this multiple choice? Surely a monkey filling ovals at random would have managed the necessary 60% at some point. Nevermind that the questions can’t change all that often. A regular should figure out the right answers by a simple process of elimination…

Student stuns Iran by criticizing Ayatollah Khamenei to his face (Faramarzi, AP)

Anne Frank offends Hezbollah (Yazbeck, AFP) “Anne Frank’s diary has been censored out of a school textbook in Lebanon following a campaign by the militant group Hezbollah claiming the classic work promotes Zionism.”

Women’s college soccer? Or UFC? (ESPN) How did this girl not get red carded?

You know you’re a redneck when …. (imgur) Click to zoom in.

It’s very refreshing that John Reed, an architect of Citigroup — the biggest, most disastrous financial supermarket of them all — now says the merger was a mistake and banks should be broken up.

From Bob Ivry, Bloomberg:

Congress’ overhaul of U.S. financial regulations should include ordering banks to hold more capital, ensuring executives’ compensation is aligned with long-term profitability and banning firms that take deposits from also engaging in equities and fixed-income trading, Reed said.

“I would compartmentalize the industry for the same reason you compartmentalize ships,” Reed said in the interview in his office on Park Avenue in New York. “If you have a leak, the leak doesn’t spread and sink the whole vessel. So generally speaking you’d have consumer banking separate from trading bonds and equity.”

Lawmakers were wrong to repeal the Depression-era Glass- Steagall Act in 1999, Reed said. At the time, he supported overturn of the law, which required the separation of institutions that engaged in traditional customer banking services from those involved in capital markets.

“We learn from our mistakes,” said Reed, who wrote an Oct. 21 letter to the editor of the New York Times endorsing a division of banking activities. “When you’re running a company, you do what you think is right for the stockholders. Right now I’m looking at this as a citizen.”

Again, this is just half the battle. Getting dangerous activities outside of insured banks doesn’t mean the activities themselves, which in many cases still pose systemic risks, won’t continue to benefit from an implicit government guarantee.

As long as investment banks remain highly complex, systemically dangerous institutions, they’ll always have a government lifeline. (”No more Lehmans!”)

I’m a fan of gold as insurance, especially for high net worth individuals who want some of their wealth “out of the system.” It protects against violent deflationary or inflationary episodes, both of which can wipe out the value of paper wealth very quickly. That said, the premiums to buy that insurance are getting pretty expensive…

Personally, I don’t see how we escape this crisis without a dramatic decline in paper wealth. Credit can’t expand forever, much as the Fed and Treasury would like for that to happen. Eventually the cycle goes into reverse because the government no longer has the balance sheet capacity to absorb more of the private sector’s liabilities. When that happens, asset values crater. The economy is so over-levered in my estimation, its equity value is probably negative. There’s a reason the Dow declined 90% a few years into the Depression. (Stocks have some option value, so they aren’t going to zero.)

The government is aware of how violent deflation can be…ergo, the stupendous show of monetary and fiscal support over the past year. But seems to me all we’re doing is re-inflating the bubble, using the public balance sheet for financing instead of private balance sheets.

Some would argue that so long as there is an “output gap” this won’t be inflationary. I disagree. I think runaway stimulus means the U.S. will eventually face a “sudden stop” situation á la Argentina or Ireland when credit markets lose confidence in U.S. paper. They’ll see the only way they will be paid back is via direct monetization. When that happens, the bid for dollar-denominated assets could disappear more quickly than folks might be willing to admit.

But these dynamics could literally take years to play out. We still print the currency in which our debt is payable. Some consider this a huge advantage. To me, we just have more rope to hang ourselves with.

And I’m not saying this is going to happen. It’s entirely possible we get our act together and let the economy deflate gradually, using stimulus to support a gradual de-levering of the economy. But politically that may not be possible, and so the correction may be forced on us. To hedge that risk, it’s not a bad idea to diversify out of paper wealth into tangible wealth.

BTW, I don’t think you make money on gold in the long run. I think, at best, you protect the purchasing power of the dollars you already have.

From Marketwatch:

Gold futures rose to a new record high of $1,100 an ounce Friday after data showed the U.S. unemployment rate topped 10% in October, raising the metal’s appeal as a safe asset. Gold for November delivery gained 1% to $1,100 an ounce on the Comex division of the New York Mercantile Exchange, the highest level for a front-month contract. The more actively traded December contract rose to $1,101.90 an ounce.

FHA delays release of financial audit (ElBoghdady, WaPo) The dog ate my homework…

Wells Fargo defers reckoning on troubled mortgage balances (Eckblad, DJ) Wells’ book of option ARMs threatens to blow up in the next few years as the loans recast, forcing borrowers to start paying down principal, not just making a minimum payment as they might on a credit card. Turning them into 6-10 year interst only loans pushes back the pain for the borrower…extend and pretend. The example used in the article notes that as part of the modification, this borrower gets a $100k reduction in principal owed. That’s not nothing. Writing down principal reduces the borrowers leverage, and it means the bank is taking a loss on part of the loan balance. Call it a silver lining.

Mirabile Dictu! Goldman lost money one day last quarter (Yves Smith) In its quarterly filing with regulators, Goldman published a “frequency distribution” for daily profits. That’s a fancy way of describing the average amount of money it made each day last quarter. Out of 65 trading days, only once did it lose money. And a pittance at that. (Alphaville published the chart yesterday.)

FDIC reduces risk-weight to 0% on TLGP-backed debt (FDIC) Yuck, that sounds complicated. Say you’re a bank, and you hold GMAC bonds that were sold with an FDIC guarantee. Normally when you have a bond on your balance sheet (an asset) you have to carry capital against it just in case the bond’s value declines. But for regulatory capital purposes, FDIC-backed debt is now the functional equivalent of Treasuries. “Risk-free” as it were. This will allow banks to hold more TLGP-backed debt on their balance sheet.

Goldman benefits from debt gold mine (Eavis, WSJ) Speaking of cheap funding, the average interest rate on Goldman’s long-term debt is down to 0.92% from 3.53% a year ago. Eavis notes this is due to clever hedging. Pretty easy to make money as a bank when your cost of funds is close to zero. Helps to have the implicit backing of the government.

Bald bears baffle zookeepers (Daily Mail) This must be what Cerberus looks like…with two more heads I guess.

Dutch smoke less pot than other Europeans (The Australian) Who’d a thunk it.

Squirrel deterrent (photobucket)

African Gothic…

We are hearing that discussion of breaking up large financial institutions that pose systemic risk to the market is gaining traction on the Hill. At this point, discussions are in the early stages, but we understand that an amendment addressing breaking up institutions deemed “too big to fail” could be introduced in the House over the next few days. How does one define “too big to fail” and how would the divestiture process work - these are good questions that Congress will have to address as the discussion moves forward. To our understanding, any amendment that could be introduced in the coming week would likely be vague and would give the regulators discretion to determine which institutions qualify as “too big” and how to address the risk they pose to the system.

[UPDATE: It appears this legislation may be coming from PA's Paul Kanjorski]

Hmmm. A “vague” amendment directing regulators to look into breaking up TBTF banks might not lead to much, not when regulators have made clear they have no interest in breaking up big banks.

[After she gave a speech complaining about TBTF at the Economist's Buttonwood Conference, I asked Sheila Bair if she would favor policies to proactively shrink/break up big banks. She said "no, I don't know how we would do that."]

And breaking up banks is only half the battle. While it’s very important to get commercial banks out of the trading business, if derivative books don’t shrink dramatically systemic risk won’t have gone away.

Neither Bear nor Lehman had a commercial bank. But the size, opacity and interconnectedness of their trading books posed huge risks for the system.

Speaking of the systemic risk posed by derivative books, there’s a very interesting and relevant tidbit in Andrew Ross Sorkin’s new book titled “Too Big to Fail.”

Not long before AIG collapsed, CEO Bob Willumstad went to Tim Geithner — then head of the NY Fed — and asked that AIG be made a “primary dealer,” giving it access to the Fed as its lender of last resort….

He left Geithner with two documents. One was a fact sheet that listed all the attributes of AIG FP [the division run by Joe Cassano that blew the company up] and argued why it should be given status as a primary dealer. The other–a bombshell that Willumstad was confident would draw Geithner’s attention–was a report on AIG’s counterparty exposure around the world, which included “2.7 trillion of notional derivative exposures, with 12,000 individual contracts.” About halfway down the page, in bold, was the detail that Willumstad hoped would strike Geithner as startling: “$1 trillion of exposures concentrated with 12 major financial institutions.”

You will bail me out or I’ll bring the whole system down with me.

Until they neuter the derivatives business by putting all contracts on exchanges, enhanced “resolution authority” will probably be meaningless. Regulators still won’t be able to shutter the largest financials because doing so would cause the systemic event they’re trying to avoid in the first place.

Sarbox was passed in the wake of scandals at Enron, WorldCom and others to protect investors. Sections 404(a) and 404(b) are important provisions.

The first requires executives to sign off on the integrity of internal controls. Can employees walk off with inventory? Are two people signing checks? Is accounting in order? Basic stuff to reduce the risk of misstatements and fraud.

The second requires an outside audit of the above. And that costs money.

At the time, companies with market caps below $75 million successfully lobbied to delay compliance, arguing that the costs were too big relative to their size.

Apparently, a delay is no longer enough. Representative John Adler, a New Jersey Democrat, pushed through the House Financial Services Committee today an amendment that would permanently exempt companies below $75 million from 404(b). And it would direct the Securities and Exchange Commission to “study” how to ease rules for companies with market caps of under $250 million. The amendment has the support of the Obama administration.

“This is an insult to investors given what we’ve experienced over the past year,” says Kurt Schacht of the CFA Centre for Financial Market Integrity. “Small companies have had plenty of time to plan for this.”

In a phone interview, Adler told me that 404(b) is problematic for several reasons. First, it has reduced the number of IPOs. To support his point he compares the 1990s with this decade, conveniently forgetting that the number of offerings last decade was dramatically inflated by the dot.com bubble.

Second, he says, small American companies are either moving their headquarters overseas or listing shares in London to dodge Sarbox compliance. Asked for examples, he cited Princeton Review and Peet’s Coffee & Tea. Actually, Princeton Review is based in Massachusetts, Peet’s in California. And both are listed on Nasdaq.

Are small foreign companies listing less frequently in the United States because of Sarbox? Yes, according to a 2008 paper by Suraj Srinivasan of Harvard and Joseph Piotroski of Stanford.

So shed a tear or two for banks, which may lose underwriting fees, and for small foreign companies, which may get locked out, but American investors are protected as a result because our markets have more integrity.

This benefits larger foreign firms that do comply with Sarbox, Srinivasan notes, because compliance gives their managements more credibility.

The legitimate argument against compliance is that it costs money. Those are dollars that small firms can’t invest in their business. But cost estimates vary widely. Adler points to a 2006 SEC study that put the average cost for small firms at $900,000. Jeff Mahoney of the Council of Institutional Investors, however, cites other studies that suggest the cost is lower.

Because of concerns over cost, regulators have already issued guidance instructing auditors to go easy. So if small companies — which have a much higher rate of accounting misstatements than their larger brethren, by the way — don’t want to comply with Sarbox, that’s fine. But they should issue stock privately.

The race to the regulatory bottom continues. With no natural constituency fighting in favor of tough market rules, those subject to them steadily chip away.

The non-response to last year’s financial crisis — toothless reform for derivatives, “resolution authority” that codifies too-big-to-fail — suggests that it will take a total market collapse before we get real reform.

Glass-Steagall, for example, was a great piece of legislation that protected us from the worst excesses of banking. But it took a Depression to deliver it.

Congress agrees to keep homebuyer tax credit (NYT)

Fitch downgrades Ireland (Kennedy, Marketwatch)

Berkshire may lose AAA rating from S&P on Burlington deal (Frye, Bloomberg)

The deferred tax asset disaster (Tracy Alloway, Alphaville) A very helpful reminder from Tracy about DTAs. Banks still count these as capital (and yes, it’s included in TCE) even though, in a stressed situation, they don’t provide any cushion whatsoever to absorb losses.

In Somalia, cheap mobile calls help more young couples elope (Skeikh, Retuers) Stick with the article to the second page in order to get the gist.

Zimbabwe plane veers off runway after colliding with warthog (David Smith, BBC)

Film-makers want government money (Schweizer, Bloomberg)

The viper logo upside down is daffy duck (imgur)

Hilarious….the “action” shots in the middle are the best

The 135,913 consumer bankruptcy filings in October represented a 27.9 percent increase over last October’s monthly total of 106,266, according to the American Bankruptcy Institute (ABI), relying on data from the National Bankruptcy Research Center (NBKRC). The October 2009 consumer filings represented an 8.9 percent increase from the September 2009 total of 124,790. Chapter 13 filings constituted 28.5 percent of all consumer cases in October, a slight increase from the September rate.

“The nearly 9 percent increase in consumer bankruptcy filings in October, together with a 7 percent jump reported in business cases, demonstrates the sustained stress on the U.S. economy,” said ABI Executive Director Samuel J. Gerdano. ABI forecasts that total bankruptcies this year will exceed 1.4 million, the highest number since 2005.

Filings in 2005 were inflated by the passage of a new bankruptcy law that made it harder to file.

Buffett splits “B” shares 50:1 (Jonathan Stempel/Lilla Zuill, Reuters) This will put shares in reach of regular folks. Look for index funds to load up. Oh and by the way, this should make it easier to short Buffett too…

Santelli vs. Liesman (CNBC) Santelli has a penchant for getting worked up, but how can you blame him when he’s talking to Liesman, who seems so worried about losing access to top policy-makers, he never takes a contrary position?

Here comes the “second stimulus” (Pimm Foxx/Mark Drajen, Bloomberg) It won’t be the last. Economists of all stripes are convinced that we have to stimulate as long as unemployment is high. But none of their models account for debt, so this will all end badly…

Economists reach for new paradigm (WSJ) Speaking of not accounting for debt in their models…Good article…but no mention of Minsky? There were plenty who read him years ago and were appropriately positioned to avoid the crash…)

Cell phone users miss the obvious, like a unicycling clown (Kie Relyea, Bellingham Herald)

Kitty doing math (Reddit)

How come the monkey gets top billing? (The coolest part is just past the three minute mark)

The International Monetary Fund has sold 200 tonnes of gold to the Reserve Bank of India for $6.7 billion, quietly executing half of a long-planned bullion sale that has threatened to slow gold’s ascent….

…Although the IMF’s plan to sell a share of its gold holdings in order to increase low-cost lending to poor countries had been flagged for a year before it was formally approved in September, the speed, scale and identity of the buyer were a surprise….

….The market’s focus has now shifted to China, which has reportedly been in talks with the IMF about buying some of the fund’s bullion as Beijing seeks to shift some of its more than $2 trillion in foreign exchange reserves away from the U.S. dollar….

Already the world’s top producer of gold and rivaling India as a consumer, China revealed this year that it had quietly lifted its own government holdings of gold stocks to 1,054 tonnes from 600 tonnes when it last reported its holdings in 2003.

200 tons is decent chunk. I’ve seen varying estimates, but according to Peter Bernstein, the total supply of gold is 125,000 tons. That puts this single purchase at about two-tenths of one percent of the total.

Valuation (based on share prices of $100 for Burlington, $59 for Union Pacific, and $48 for Norfolk Southern):

• Enterprise Value to 2010 unlevered free cash flow (think of this as a better alternative to P/E ratios):
  • BNI = 29x
  • UNP = 24x
  • NSC = 18x

• Return on capital employed (based on 2010 operating income and year-end ‘10 balance sheet estimates.
  • BNI = 11%
  • UNP = 10%
  • NSC = 10%

(I’m using Stifel Nicolaus estimates for 2010)

The cash flow characteristics of the business aren’t very good. From 1999 to 2009, BNI poured 68% of operating cash flow back into capital expenditures. That’s cash flow that doesn’t go to shareholders.

Nor are the returns fantastic. Because operating a railroad requires so capital, the return on capital employed is only mediocre.

And the business is not without risk. High fixed costs mean railroads generate increasing returns during upswings, but decreasing returns during downturns.

As an asset, railroads do seem well-positioned. And Burlington Northern particulary so.

1. Increasing fuel costs hit truckers harder than railroads, so that works in their favor.

2. As my Reuters colleague John Kemp points out: “Burlington’s track and rights of way are perfectly positioned to benefit from a massive expansion of the country’s coal-fired output in the next 20 years, coupled with ‘carbon capture and store’ technology to curb the carbon-dioxide emissions.”

He’s talking about Burlington’s track near the Powder-River Basin in Wyoming and Montana. PRB coal has lower sulfur content than Appalachian coal. To the extent we increase coal-fired power generation in the U.S., we’re likely to do it on a “clean” basis, giving PRB coal (and those who ship it) a competitive advantage.

3. Most important: Pricing. As volumes have increased the last few years, railroads have been able to increase their prices. Buffett is betting this will continue.

But again, given the high price he’s paying, Buffett needs a lot of things to go right for this deal to generate meaningful returns for shareholders.

More than anything, I bet he’s anxious about sitting on $25 billion worth of cash. Yields on short-term investments are at rock-bottom rates thanks to the Fed, and Buffett has gone on record that he’s worried about inflation.

Senate health bill won’t reduce health costs as % of the economy (PGPF)

Can Citigroup carry its own weight? (Martin/Morgenson, NYT) “Over the past 80 years, the United States government has engineered not one, not two, not three, but at least four rescues of the institution now known as Citigroup.”

Aussie dollar channeling Yuan shows increased trading in China (Zachariah/Goodman, Bloomberg) The Aussie currency is in good shape thanks to strong demand for the country’s national resources. Look for another rate increase there today.

PA judge accepted millions in kickbacks to send juveniles to private jails (AP)

Banking regulators seized nine related community lenders in California, Illinois, Arizona and Texas, representing the collapse of one of the nation’s largest privately held bank holding companies that grew through a string of acquisitions dating back to the savings-and-loan crisis of the 1990s.

The nine small banks represented the holdings of FBOP Corp., based in Oak Park, Ill., and owned by a banker who had plowed into real-estate lending around the country.

#107-#115

• Failed banks: Bank USA, Phoenix AZ; California National Bank, LA CA; San Diego National Bank, SD CA; Pacific National Bank, SF CA; Park National Bank, Chicago IL; Community Bank of Lemont, Lemont IL; North Houston Bank, Houston TX; Madisonville State Bank, Madisonville TX; Citizens National Bank, Teague TX.
• Acquiring bank: US Bank, Minneapolis MN
• Vitals: as of 9/30, $19.4 billion of assets, $15.4 billion of deposits
• DIF damage: $2.5 billion

US Bank has been highly acquisitive during this failure cycle. They also picked up Downey Savings and Loan and PFF Bank and Trust last November. Those two had $12.4 billion and $3.7 billion of assets when they failed.

Barney Frank, chairman of the U.S. House Financial Services Committee, reversed course and will support requiring financial firms to prepay into a fund the government will use to unwind large firms after they fail.

If Frank’s legislation passes, there will be an explicit taxpayer guarantee backing the high risk activities of the big banks.

Why? Because there’s no way banks could fund the cost of even one systemic resolution. How much has AIG set back taxpayers? $182 billion so far. And we’ve promised $200 billion each for Fannie and Freddie. Banks complained about the $5.6 billion special assessment on FDIC. We expect them to pre-fund sufficient scarol to fund the next AIG?

David Reilly made this point very cogently a couple days ago.

Will creditors and shareholders actually have to absorb meaningful losses? As reader Ralph DG points out the creditors and counterparties of the banks are … other banks and insurance companies, systemically-important themselves.

Losses can’t be forced on them without causing the kind of systemic “domino effect” this whole scheme is trying to prevent.

Bottom line: when the bill comes due, taxpayers will pay it.

In the meantime, banks will benefit from their new protected status.

(Click table to enlarge in new window)

Measured by tangible common equity, the biggest banks are levered 20 to 1, a solid improvement from last quarter’s 24 to 1 and a giant leap from 30 to 1 in the third quarter a year ago. (These figures exclude off-balance sheet assets, which will increase leverage when they are consolidated beginning next year).

Tangible common equity is the crucial measure of bank capital because it is the primary cushion banks have to absorb losses. When it gets too low, creditors panic and bank runs ensue. From a systemic risk perspective, it’s great that banks are rebuilding this cushion.

The crucial question is how they’ll fare in a less favorable monetary environment. While consumer prices show little sign of inflating, asset prices are another story. Interest rates near zero have encouraged investors to chase risky assets. If that trend continues, the Fed may have to unwind its balance sheet and raise rates sooner than it would like, putting banks in a tough position.

FBR Capital Markets points out in a recent note to clients that many banks have poured excess liquidity into their securities portfolios, “which could present significant interest rate risk” when the Fed reverses course.

Compared with last year, the top 10 commercial banks have increased the size of their securities portfolios nearly 40 percent, with JPMorgan Chase’s rising over 150 percent.

And while securities prices are more immediately sensitive to monetary policy, loan portfolios would be impacted as well. Early next year, after the Fed turns off its printing press and after the home-buyer tax credit expires, real estate prices could resume falling. This will put more owners upside down on their loans, keeping default rates high.

Banks are extending loans, pretending that asset prices will recover past peaks, an unlikely prospect if the Fed does its job.

Now it’s up to regulators to deliver higher capital requirements so that banks can withstand the end of government support. After all, 20 to 1 leverage is still very high. It only looks prudent against the insane levels reached last year.

Ken Silverstein is on the case and he says it’s “an object lesson in governmental failure.” Turns out Johnson was asked to testify at the last minute and wasn’t able to submit testimony at the hearing. Later when he tried to get it posted to the Committee’s website, at first they dithered and then they refused.

But I’ll let Ken tell the story. He’s a great writer.

As for Johnson’s full testimony, you can read it here. Print it out. Keep it on file. Explains in great detail why, in Johnson’s words, the derivative reforms legislation is “too tepid, too weak, too late…Very industry influenced. We had a crisis and they are pandering to the perpetrators.”

(ht Walker T.)

Goldman sends back some collateral to AIG (Liam Pleven) Interesting. Recall that AIG served as a slush fund through which the Fed sent money to banks that had been AIG’s counterparties. Goldman was the biggest recipient of this cash with $13 billion (though as Barry Ritholtz would be quick to point out, they got additional collateral before the government takeover). With asset prices climbing, some of the collateral has returned to AIG.

A three-way split is most logical (John Gapper) A very good column adding color to the argument that banks need to split according to their various functions: commercial banking, investment banking (and trading), asset management. Also insurance should be separated probably.

San Francisco Fed sees FHA reviving subprime (Diana Golobay, ht ML)

Motor Vehicles add 1.66% to Q3’s 3.5% growth (EconompicData) A very interesting chart…

Mutual funds getting in on TALF party (Miles Weiss) Like the PPIP program sponsored by FDIC (which never really got off the ground), TALF provides non-recourse debt to investors that want to buy toxic assets. Investors can put up a sliver of equity and take a flier on some busted assets. If it doesn’t work out, the Fed is left holding the bag. As of 9/30, the Fed had lent $43 billion under the program.

And then there were none… (NY Fed) After today’s purchase of $1.9 billion, the Fed has completed its program to buy $300 billion worth of Treasuries. Quantitative easing isn’t done, however. There’s still plenty of agency MBS and agency debt left to buy.

The $10 phone bill (Scott Woolley) Fighting to deflate your cell phone bill.

It may be BYOB as fewer firms plan holiday parties (Ian Sherr)

How basketball star blew $100 million (Shira Springer) “Bankrupted Boston Celtics player kept entourage of 70, spent wildly on cars, watches, gambling, mansions.”

From Alison Vekshin at Bloomberg:

Federal Deposit Insurance Corp. Chairman Sheila Bair, breaking with the Obama administration, said U.S. financial companies should prepay into a fund the government would use to unwind large failed firms.

Congress should set up a Financial Company Resolution Fund and force institutions with more than $10 billion of assets to pay before a firm collapses, Bair said in testimony prepared for a House Financial Services Committee hearing today. Investors in failed companies also should take losses, she said.

As I noted in my column yesterday, Barney Frank’s legislation would have taxpayers front money for systemic bailouts while large financial firms would be on the hook to pay the money back.

Of course that would never happen. Banks would never pay. Look how hard it’s been to get banks to replenish the Deposit Insurance Fund. Anyway, Sheila agrees that ex-post funding is a bad idea.

But pre-funding is an equally terrible idea. If there’s a fund somewhere that’s supposed to protect the system, that will codify TBTF and reinforce moral hazard. Not only will investors know some firms are TBTF, they’ll see there’s a pile of cash to protect them. This would put TBTF firms at an advantage in the marketplace.

Now, some would argue that it would penalize the firms because they’d have to pay capital into the fund. Perhaps in the short-term. But soon enough everyone will be content that the system is “safe,” people will be making money and Congress will tell the regulators to lay off.

This is not just a hypothetical. Look at our experience with the Deposit Insurance Fund. From 1996-2006, FDIC was prevented by statute from collecting insurance premiums. Congress, in its infinite wisdom, had determined the DIF didn’t need any more money because the system was firing on all cylinders.

The S&L crisis–which cost $150 billion to resolve–taught us the moral hazards of government insurance funds for bank creditors. Because their money iss guaranteed, depositors don’t care what kind of risky activities their bank are engaged in. They just go to the bank that offers the highest interest rate.

We’re reminded of this fact by GMAC today, whose subsidiary Ally Bank is able to attract billions in deposits by offering high interest rates. And read the Puget Sound Biz Journal’s article on WaMu. They were so desperate for funding amid a bank run last fall that they started offering 1-yr CDs at 5%.

And think about what’s being insured here. Trading. In derivatives, stocks, bonds, forex, commodities …. all of it with leverage. Trading + leverage = high risk!

Despite the moral hazards of deposit insurance, we insure commercial banks because the functions they provide (managing the payment system, turning savings into loans) are important to society. In the fullness of time, I have my doubts that even this makes sense. But arguments supporting it are at least defensible.

This new scheme that Bair is proposing would insure investment banks, and all the risky trading activities they engage in.

Again, we’re acting to protect the needs of TBTF banks rather than protecting the needs of society. What we should be doing is getting trading activities out of the banks to begin with.

The repeal of Glass Steagall essentially put the Wall Street Bull inside the China Shop we call the commercial banking system. We’re surprised when he trashes the place every few years?

But instead of kicking him to the curb, we’re expending all this effort putting the China in bubble wrap…..which in the long-run is no match for the Bull….

[On a related note: Have you ever wondered why WaMu's failure -- $307 billion of assets, $188 billion of deposits -- never cost the Deposit Insurance Fund a dime? One reason was that FDIC moved relatively quickly. More importantly, losses on assets were forced onto shareholders and creditors. Common and preferred equity was wiped out, as were subordinated debtholders. Reader Andrew points out in the comments that there was a large buffer of capital (debt and equity) to absorb losses ahead of depositors.  (More on that from Kevin LaCroix)]

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Grind also includes this interesting tidbit:

Each day, Brinks Security trucks pulled up to replenish WaMu ATMs across the country. Before the crisis, the trucks delivered about $30 million in cash a day nationwide, Freilinger said. During the September bank run, they delivered as much as $250 million a day.

WaMu was certainly seeing larger deposit outflows than most, but plenty of folks in “healthy” banks were pulling money out to stuff in their mattress. I wonder how much cash was being delivered to ATMs and bank branches nationwide last September and October…

General Motors Acceptance Corp on Wednesday sold $2.9 billion in three-year government-guaranteed notes, according to a market source familiar with the sale. The 1.75 percent notes were priced at 99.991 to yield 1.753 percent, or 31.6 basis points over comparable U.S. Treasuries.

The notes are guaranteed under the Federal Deposit Insurance Corp’s temporary liquidity guarantee program.

GMAC has permission to sell up to $7.4 billion of FDIC-backed debt, in addition to the $12.5 billion of TARP money already received and the $2.8-$5.6 billion of additional TARP cash they’re negotiating for.

In exchange for upping GMAC’s TLGP allowance, Sheila Bair supposedly extracted concessions on the interest rates GMAC will be able to advertise for deposits.

On BankRate, they’re still listed as #3 for 1-yr CDs.

While we’re on the subject of auto bailouts, John Stoll and Sharon Terlep of WSJ are reporting that GM dipped into its bailout fund from Treasury to help rescue supplier Delphi:

General Motors Co. by the end of the week will outline plans to draw down more U.S. government money it will use to aid Delphi Automotive LLP and also give an update on a closely watched escrow account of its bailout funds, according to several people familiar with the matter.

GM’s additional borrowing will mostly be limited to Delphi’s funding needs and is expected to be north of $2.5 billion, based on prior announcements.

According to the article, the U.S. has committed $50 billion to the GM bailout, $30.1 billion of which was committed when the company filed for bankruptcy. Much of that amount went into an escrow account GM can tap as needed.

Stressful jobs that pay badly (CNN, ht Rej) #2 has a funny anecdote.

Goldman’s lies of omission (Janet Tavikoli, ht Jesse)

Couple alive after car pins them to bed for almost an hour (CNN)

Extension of homebuyer tax credit not a done deal (CR)

A drop in the wrong bucket (David Leonhardt) Pandering to seniors.

Cell size and scale (Utah.edu) Ultracool. Zoom in slowly by scrolling to the right.

Schwarzenegger vetoes bill, sends message to Cali legislature (imgur)

Jaws (Telegraph) A larger predatory fish?? Wow.

Frank should go back to the drawing board. Per the recommendation of Bank of England Governor Mervyn King, he should split banks in half, sending trading operations off into the wilderness so banks can get back to basics.

The need for resolution authority stems from regulators’ arguments that they didn’t have the tools to shutter big firms last year. They knew losses properly belonged to shareholders and creditors. They just didn’t have the power to execute such a plan.

Color me skeptical.

Just as likely, they were terrified that shuttering a systemically important financial institution would cause financial markets to panic, that the daisy chain of derivative counterparties would break, collapsing the system.

If it’s so difficult to wind down large bank holding companies that it requires new, complex resolution authority, common sense tells us such institutions shouldn’t exist in the first place.

The goal should be to prevent banks from getting into danger, to get them out of risky activities that pose systemic risks. Bank regulators already have broad powers to do this, yet they’ve shown little willingness to use them.

Some argue they were stymied by regulatory shopping, so this legislation would give more power to the Fed. But will the Fed use it?

Last week, it installed as its top regulator Patrick Parkinson, long an advocate of a hands-off approach to derivatives: “Counterparties typically are quite adept at managing credit risks,” he testified in 1999. Whoops.

In any case, codifying institutions as too big to fail is likely to backfire by signaling to the market that such banks are the safest place for capital.

Advocates of this legislation say that won’t happen, that “Tier 1 Financial Holding Companies” will face capital and leverage requirements that put them at a disadvantage. But that’s not in this legislation; those new rules are to be written and enforced by regulators who have shown a remarkable lack of fortitude to date.

Advocates also say the legislation puts bank investors in line to absorb losses. But aren’t they already? The reason too-big-to-fail is a problem is that the capital structure is so big and complex that forcing losses onto investors causes a systemic event.

Naturally, then, taxpayers will front the money to fund a good chunk of these resolutions. Supposedly banks with more than $10 billion of assets will pay taxpayers back. If you believe that, I’ve got a bridge in Brooklyn I’d like to sell you.

Just look how hard it has been to replenish the Deposit Insurance Fund. Banks threw a tantrum about a special assessment that raised all of $5.6 billion. Sheila Bair, the FDIC chairman, was forced to resort to accounting gimmickry to squeeze more cash out of them.

We could make banks tithe their profits for years and we would recover a fraction of the total cost of recent bailouts.

New resolution authority is nice to have, but it won’t resolve the problem. What we need to do is shrink and simplify banks so they don’t pose a systemic risk in the first place.

Mervyn King and Paul Volcker have both put ideas forward to do that. We’d be better served if Frank and his staff fleshed those out.

The following chart shows how the US 10yr yield has disconnected from the price of commodities. We believe yields are not reflecting the future risk of inflation, and the fiscal situation of many sovereign issuers. However, there are no limits to what governments may do to support their debt. In the UK, a recent ruling was announced by the FSA forcing banks to increase their holdings of government bonds. In India a similar initiative has just been announced. In Japan, already over 50% of outstanding JGBs are owned by public sector institutions. In the US, only 0.9% of commercial banks’ assets are treasuries; in 1994 it was as high as 8.7%, so there’s great scope for it to increase. Mandated purchases of government bonds by banks and other financial institutions – crypto-quantitative easing – could persist long after official QE comes to an end, keeping bond markets supported for longer than many think.

Nevertheless, we think longer-term yields will move higher. Sell rallies.