Rolfe Winkler

Writing my Hotel California column earlier this week, I came across the following interesting tidbit in Goldman’s 10-K (page 206):

The amount deposited by the firm’s depository institution subsidiaries held at the Federal Reserve Bank was approximately $27.43 billion and $94 million as of December 2009 and November 2008, respectively, which exceeded required reserve amounts by $25.86 billion and $6 million as of December 2009 and November 2008, respectively.

This seems a good indicator of the lack of lending opportunities in the economy. But I’m curious: Goldman is probably losing a lot of money parking customer deposits on reserve at the Fed. Why do it?

But first let me try to explain what’s happening here…

Goldman has a bank subsidiary — GS Bank USA — which collects deposits via brokerage accounts. It doesn’t have any bank branches anywhere. And Goldman has grown these deposits a fair bit, from an average of $13 billion in 2007 to $35 billion in 2009.

This is odd for two reasons.

First, Goldman doesn’t have much use for deposits that I can see. They can’t be used to fund investment banking activities.

And clearly they don’t see many good lending opportunities for these deposits. If they did, they wouldn’t park such a big proportion at the Fed, where they lose money.

[Aside: a common misconception is that holding reserves at the Fed is profitable for banks since the Fed now pays interest on reserves. But this ignores the other side of the balance sheet. Banks, after all, have to pay for the deposits that they then put on reserve at the Fed. Math in next paragraph]

Excess reserves held on deposit at the Fed pay 0.25%. But the average interest rate Goldman paid on U.S. deposits in 2009 was 1.06%, implying a negative net interest margin of 0.81%.

Multiply -0.81% by total excess reserves of $25.9 billion held at December 2009, and you get an implied annualized loss of $210 million. That’s a decent chunk of change.*

Another reason these deposits might not make good loans is old-fashioned asset-liability maturity mismatch. Brokerage deposits aren’t sticky like retail deposits. They chase the highest return in the market. Short duration (“hot money”) deposits tied up in longer-duration illiquid loans is a recipe for bank failure.

Now, certain folks might use this as an excuse to bash Goldman (“why aren’t they lending to the real economy!”), but that’s wrongheaded. Don’t get me wrong: I’m no fan of Goldman Sachs. But the problem isn’t that banks are lending too little today, it’s that they lent way too much yesterday. The chief lesson of the financial crisis is that irresponsible lending has dire consequences for the economy. Better that banks err on the side of safety and soundness….better that they lose money parking reserves at the Fed than chase risk making dodgy loans.

But the original question still stands. If Goldman can’t find anything profitable to do with deposits, why keep collecting them?

——————–

*A couple caveats here. The rate Goldman is paying on deposits could be lower today than the average in 2009. Also, to lose $210 million, Goldman would have to hold this balance at the Fed — at a NIM of -.81% — for a full year.

(ht frog)

Reader note: off on vacation the next few days so posting will be light. But LOTS of great links today….2 days of reading here!

Must Read – Volcker’s rules: DOA (Pethokoukis, Reuters) It appears the administration was never seriously considering a big push to get the “Volcker Rules” limiting bank size and proprietary trading added to financial reform legislation. My colleague Jimmy P. has a pithy, incisive analysis of what’s happening.

Must Read — How JP Morgan treats its clients, scandalously and in bad faith (Felix) Great find from Felix. Judge Rakoff is at it again, this time ruling against JP Morgan, which Rakoff says acted in bad faith. “The gist is that JP Morgan took one of its longest-standing clients in Mexico — Grupo Televisa — and tried to hand all of its secrets over to its biggest rival, Carlos Slim. And the way it tried to do that was by selling Slim a loan larded up with covenants which would essentially force Televisa to reveal any and all information to the holder of the debt.”

China sells Treasurys….or did they? (EconompicData) Great post. The WSJ follows their lead today.

Stripping away the disguise of derivatives (Das, FT) Explaining how derivatives can be used to mask debt. Not a long piece, but read slowly if you’re not familiar with the terms.

Treasury Secretary would lead new systemic risk council (Chan, NYT) The idea that a systemic risk council will help avert crises is foolish when you think about it. None of the regulators that will be on the council has done a very good job “leaning against the wind” in the past.  Yet together they are going to be able to not only reach consensus about systemically risk firms, but actually take corrective action?

IMF to sell 191 tons of gold on open market (Pardomuan/Wroughton, Reuters) It sold 400 tons not long ago, half of which was scooped up by India. Gold still makes sense in the long-run as insurance against a dollar crisis, but with the dollar likely to get stronger in the short run on the back of continued debt problems in Europe, it may be possible to add to gold positions below $1,000…

Ackman may make $170 million on grand-slam General Growth bet (Taub/Burton, Bloomberg) And he could make much more if Simon ups its bid or another bidder emerges at a price higher than Simon’s offer of $9. The market expects a higher price in the end, what with the shares trading near $13. Ackman bought his for 46¢! He’s said the shares are worth at least $24, but with the cash component of Simon’s offer just $6, it would make sense to take some profits…

Goldman’s Rococo PR prince (Abelson, NY Observer)

States sink in benefits hole (Merrick, WSJ) As of June 30, 2008 the 50 states collectively faced a $1 trillion funding deficit between what they’ve promised to public sector retirees and the funds they’ve actually set aside. And the data were collected before the bottom fell out of the market, so the gap is likely worse. Keep this in mind when liberal economists try to explain away the federal debt as manageable. If banks got bailouts, you can bet public sector employees will, so consider these funding gaps as obligations of the federal government…

Muni threat: Cities weigh Chapter 9 (Dugan/Maher, WSJ) It isn’t just states facing budget trouble.

Feather starfish swimming (Youtube) Wow.

Gadget Noir…

New flower for North Korea may be succession ploy (Lim, Bloomberg)

Greece’s Goldman Sachs swaps spawn EU dispute on disclosure (Martinuzzi/Finch, Bloomberg) Greece was rebuked as early as 2004 by the EU for “deficit inaccuracies,” and again last month for under-reporting deficit figures for the past decade. The latest disclosure about swaps used to hide debt may make a bailout more distasteful, but won’t stop it. Too much is at stake.

The Greek derivatives aren’t Goldman’s fault (Felix, Reuters) Risk magazine was talking about this long before the NYT…

Why Greece should default (Kemp, Reuters)

Investors recruit terminally ill to outwit insurance cos on annuities (Maremont/Scism, WSJ) An underhanded variant of the life settlement business…

Japan eclipses China as top holder of Treasurys (AFP) China’s holdings dropped while Japan’s grew.

Leaving Ireland (Capell, BusinessWeek) Unemployment is driving a generation away.

Roger Ebert: The essential man (Jones, Esquire) “It has been nearly four years since Roger Ebert lost his lower jaw and his ability to speak. Now television’s most famous movie critic is rarely seen and never heard, but his words have never stopped.”

Tortoise vs. cat (pogpog)

Rubik’s cube solver (built entirely from “Lego elements”)

Wall St. helped Greece to mask debt, fueling Europe’s crisis (Story/Thomas Jr./Schwartz) When an addict is hooked on a drugs, whose fault is it? The guy selling him the junk? Or his own for getting hooked in the first place? It’s convenient (and not entirely wrong) to blame bankers, mortgage brokers, real estate agents and others who sell us debt to finance more lavish lifestyles than we can afford. They do so to generate income via transaction fees. But at the end of the day, the Greek government knew what it was doing. As do most folks piling on leverage…

For some firms, a case of “Quadrophobia” (Thrum, WSJ) Public companies fear the digit “4.” Earnings per share, when calculated down to tenths of a cent, suggest companies use accounting gimmickry to make sure they can round UP to the nearest cent.

Pirate boss to make web pay (BBC) I’m skeptical. A micropayments product that relies on the generosity of users will be about as successful as a PBS funding drive. But I’ll support anyone who wants to help users pay directly for good content creation. Personally, I think the future of micropayments could be via cellphone. Carriers already have a billing relationship with everyone, all that’s needed is someone to facilitate the flow of payments from buyers to sellers via your phone. (Full disclosure: I previously worked for a company, Fotolog, whose parent company was also in this business)

Edwards: Collapse of euro “inevitable” (Fleming/Shipman, Mail) SocGen’s Albert Edwards as bearish as ever.

Magic Johnson in talks to buy publisher of Ebony/Jet (Pulley, Bloomberg)

How Christian were the Founders? (Shorto, NYT) Long, but worth reading to the end.

Dubai CDS spreads jump (Connaghan/Brown, WSJ) The cost of insuring Dubai debt against default is back near levels from December, before Abu Dhabi offered assistance.

Harrisburg moves a step closer to default (Hurdle, Reuters) Pennsylvania’s capital city excludes debt payments in its 2010 budget. It has a scheduled interest payment of $2.1 million on March 1.

“4-foot-nothing mother goose” … epic voice mail.

VIDEO: “Hurt Locker” in Cambodia (YouTube) Guy clears land mines in Cambodia with stick and pocket knife. FF to 0:50 mark.

Bing Maps are cool….(but it appears that there’s no support for Firefox…)

Homeownership rate falls to 2000 level (CR) At 67.2% it’s still way overstated. Home “ownership” is a misnomer in cases when the owner has withdrawn mortgage equity or when the price of the home has fallen below the principal value of the mortgage. A better measure of homeownership, I think, is just to look at total owner’s equity as a % of household real estate. The most recent Fed Flow of Funds report (page 104, line 50) puts the figure at just 37.6%…

U.S. could extend bank fee beyond 10 years, Geithner says (Di Leo/Crittenden, WSJ) The proposed tax on non-deposit liabilities should be permanent, and should target ALL liabilities, including repos. Deposits are guaranteed via FDIC. While that insurance is dramatically underpriced (witness the cash-strapped state of the DIF) at least banks pay something for it. Non-deposit liabilities are also effectively guaranteed, for the biggest banks anyway, via the promise that none which is too big will be allowed to fail. To counter moral hazard, this implicit guarantee must be taxed in order to offset any benefit derived from lower funding costs.

Must-Read: What’s a college degree really worth? (Pilon, WSJ) A lot less than you think, as argued here before. This piece is well-written with lots of good data!

AIG derivatives staff said to forgo $20 million in retention bonuses (Katz/Son, Bloomberg) They’re still well-paid, but this is better than nothing I suppose.

Deficits as a national security issue — Sanger NYT & Seib WSJ — Good to see prominent columnists picking up the thread. A refresher on the Suez Crisis of 1956 offers helpful background.

Rising FHA default rate foreshadows foreclosure crush (ElBoghdady/Keating, WaPo) Key line: “the FHA projects that it will pay out claims to lenders on one out of every four loans made in 2007 — the worst rate in at least three decades. The claim rate should be nearly the same on the vastly larger volume of loans made in 2008.”

Goldman spokesman’s most withering rebuttals (Daily Intel) Methinks he doth protest too much…

North Korea propaganda, with translations (nikopop)

VIDEO — Reporter filing report on the blindfold half court shot, makes own impossible shot (fox4)

Trader caught taking a break…

President’s budget (gpoaccess.gov)

Barney Frank: The poor should rent, not own (Indiviglio, Atlantic)

Citigroup said to plan sale of private equity unit (Keoun/Keehner, Bloomberg) Citi cites raising cash to pay down debt as the reason to sell this unit. Of course this would also get Pandit some brownie points with Paul Volcker, who wants commercial banks out of private equity, hedge funds and proprietary trading…

HCA owners get $1.75 billion payout (Lattam, WSJ) Speaking of private equity…a nice payout for investors in one of the biggest LBOs in history.

All those little Stuy towns (Morgenson, NYT) Bullying as a business model…

Goldman Sachs and the $100 million question (Times UK) This is a thinly sourced article that claims Lloyd Blankfein will get a blowout $100m bonus for 2009. If true, talk about giving the finger to, well, pretty much everyone.

Five myths about America’s credit card debt (Manning, WaPo)

Happy palindrome day! (imgur)

Barefoot running: How humans ran comfortably, and safely, before the invention of shoes (Science Daily)

Accidental time capsule…

Tim Geithner’s appearance in front of Congress today was another embarrassment, perhaps more for the people’s representatives than the Treasury Secretary. Still, Geithner offered a clumsy defense for paying out 100¢ on the dollar to AIG’s counterparties, which included more than Goldman Sachs.

What they lacked in knowledge and nuance, Congress made up for in volume and OUTRAGE. The worst moment I saw was the utterly bogus comparison by Rep. Stephen Lynch between AIG’s payout to Goldman (100¢ on the dollar!) and the bailout offer for Bear Stearns shareholders (only $2 per share). 100 is a bigger number than 2, you see.

Geithner was lucky to be doing battle with such an unprepared, unimpressive group.

His defense, such as it was, amounted to the following:

Had the Fed imposed haircuts on AIG counterparties, it would have led to AIG’s credit rating being downgraded and the company (and consequently the economy) would have collapsed.

But AIG had already been downgraded, that’s why the government stepped in with a bailout. At that point the firm’s liabilities were taxpayer backed, so it strains credulity to say that extinguishing certain CDS it had written would cause systemic fallout in and of itself. Essentially what was happening here was unused insurance contracts were being extinguished. (Imagine a pro-rata refund from your insurer for a homeowner’s policy it wants to cancel…)

And there was precedent for this kind of negotiation. Eric Dinallo, former Commissioner of the NYS Dept. of Insurance and current candidate for Eliot Spitzer’s old job, had previously negotiated haircuts on CDS written by the monoline bond insurers. They were never forced into a taxpayer bailout. Did anyone at the Fed pick up the phone to consult Dinallo? Why not?

At the hearing, Geithner said he took “great pride” in his judgment to pay out 100¢ on the dollar to AIG counterparties because, he claims, it saved us from economic catastrophe.

No doubt the system was on the verge of collapse. But the biggest threat was undercapitalized banks. The payout to AIG counterparties was just a backdoor bailout for them. As Dan Alpert of Westwood Capital points out:

Every dollar of [haircut] would…amount to a dollar less of capital on bank balance sheets today (actually more, because in the interim the affected banks made money with that capital). If the discount was more than a little, some of the institutions would have required “front door” bailouts, or would have failed.

That’s why everyone is still so angry about this, and Goldman’s ridiculous claims that it would have been fine even absent the $12.9 billion it received from taxpayers via AIG. Sure, they’ve paid back TARP. But here’s another $12.9 billion of your money that’s helping to fund their bonus pool.

Jim Rickards offers a good closing thought on the matter:

What was actually done [in the AIG bailout] shows a breathtaking lack of imagination and legal skill on the part of the people involved.  The Fed and Treasury do have an obligation to save the system, but they have no obligation to save each and every member of the system.  That’s a big difference.  You may need to build a firewall but it’s important to build it in the right place.  Makes sense to protect the little guy but where was the national security interest in protecting Goldman? This is why I am just speechless when I hear Geithner testify that though he was utterly surrounded by ex-Goldman people they somehow had NO IMPACT on his judgment to save Goldman.  How blind and unaware can you be?

Not so blind that you can’t be Treasury Secretary…

—-Not to beat a dead-horse here, but I thought I’d blog one last interesting thing on Goldman. This from today’s conference call. (Transcript via Thomson Street Events, no link)—-

Guarantees for certain liabilities aren’t the only way Goldman has benefited from government largesse. They’ve also made money handling trading volume that is driven by the Fed…

Meredith Whitney, Analyst: I have a few questions. The government purchase program was supposed to end this quarter. They’ve extended it to next quarter. How much of that us a driver of velocity of flows? And how are you positioned when they exit, if they exit, for any type of principal risk? And what do you think that impact is going to be in the larger market? That is my first question. Start off with an easy one.

Is MW on to something here? Perhaps: Note the non-answer answer.

David Viniar – Goldman Sachs Group, Inc. – EVP, CFO: Not a problem. Look, I think, as you know and I think the Fed knows this, exiting their support of various markets is a very tricky thing. I think that they are going to do it carefully. They are going to do it slowly and over time. I think they are signaling the market. I think they are doing a very good job of letting people know they are going to continue for a while, but they aren’t not going to continue forever. As far as our positioning, I don’t think it really matters at all. As you know, as I said, most of what has happened has been the velocity, not the positioning. And I think that they are going to slowly extricate themselves for that as the markets get healthier and can pick up slack.

MW: Okay, but in terms of the flow volume, right — so you have been the greatest beneficiary of increased flow volumes. How are the flow volumes going to be influenced as they exit?

DV: I think that they will try to time their exits for the market being healthy enough to pick up that flow. And so I think the flow will continue.

Another non-answer. But MW persists…

MW: And then who would you imagine would be the substitute buyers?

DV: The various market participants. I think it will be the various financial institutions, funds. I think the whole variety of buyers. And there is a lot of cash out there to buy.

MW: Okay. And then just a last one. I was teasing when I said it’s the easiest one. But it was easy for you. The last one, of the principal revenues, almost $1 billion, how much of that was cash sales, and how much were markups?

DV: Oh, I would say that it was much more markups than sales…I don’t have the exact number, but it would be much more markups than sales.

Goldman Sachs has done it again, deftly navigating markets to maximize its own returns and leave others nursing losses.

The deal in question is a loan Goldman made to the troubled lender CIT. The loan was dressed up as a derivative, which means Goldman can extract payments it is owed outside of the normal bankruptcy process.

Nothing wrong with that; Goldman has made another great trade. But is the exemption it exploited worth closing?

At issue is the integrity of the bankruptcy process.

By calling a time-out on creditors, bankruptcy offers the opportunity to reorganize and rehabilitate troubled companies, which is often in creditors’ best interest. A debtor’s assets often have more value if they keep generating cash flow, if the company in question continues as a going concern.

But if certain creditors get to pick off assets when a time-out is called, bankruptcy itself may be undermined. Such is the luxury of holding derivatives, which thanks to a 2005 bankruptcy reform, are exempt from the automatic stay that prevents creditors fleeing with their cash. Derivative holders also enjoy netting and close-out privileges that aren’t available to other creditors. And as we learned in the Lehman bankruptcy, derivative traders may make off with cash that isn’t rightfully theirs, forcing other creditors to chase them down.

Because Goldman’s loan to CIT was structured as a derivative — specifically, a “total return swap” — Goldman’s claim won’t be stayed along with others’ if CIT files for Chapter 11. The filing would trigger a $1 billion payment to Goldman.

Spying an opportunity to arbitrage regulation, smart lenders are doing the same as Goldman, structuring loans as “swaps, currency exchanges or securities deals,” according to bankruptcy lawyer Harvey Miller of Weil, Gotshal & Manges. Many are doing whatever they can to “put transactions beyond the control of bankruptcy courts.”

Why exempt derivatives from bankruptcy rules? A chief reason, according to proponents, is systemic risk. Derivative markets are just too volatile. You can’t force traders to sit on their positions through a lengthy bankruptcy process without breaking the daisy chain that connects counterparties.

First off, according to a paper by Robert Bliss and George Kaufman, it’s possible that the protections afforded derivatives actually increase systemic risk.

But for the sake of argument, let’s assume they’re necessary. Then we have another case of the tail wagging the dog, of reorganizing our financial markets around the needs of derivatives traders.

For what? The increased “liquidity” that derivative traders are so fond of reminding us they provide? CIT might not have been able to secure extra financing a year ago had Goldman not been able to structure its deal as a derivative. But maybe that would have been a good thing. If a company can’t secure financing via conventional lending sources, that’s probably a great sign the balance sheet needs to be restructured.

And I wonder: has total liquidity, in fact, increased? If conventional lenders see that their claims are increasingly superseded by derivative deals, will they be less inclined to offer financing?

In the end we could end up with another race to the bottom as bad financing options chase away good ones. Borrowers may sacrifice the protection of bankruptcy tomorrow for cash needed to survive today.

The CIT loan illustrates the need for change. To be sure it would be too disruptive to roll back the bankruptcy exemption for derivatives all at once. Still, it’s yet another reason we must shrink the derivatives market dramatically. Increasing capital requirements and migrating trades to exchanges would be a good place to start.

When I was 14, Warren Buffett wrote me a letter.

It was a response to one I’d sent him, pitching an investment idea.  For a kid interested in learning stocks, Buffett was a great role model.  His investing style — diligent security analysis, finding competent management, patience — was immediately appealing.

Buffett was kind enough to respond to my letter, thanking me for it and inviting me to his company’s annual meeting.  I was hooked.  Today, Buffett remains famous for investing The Right Way.  He even has a television cartoon in the works, which will groom the next generation of acolytes.

But it turns out much of the story is fiction.  A good chunk of his fortune is dependent on taxpayer largess. Were it not for government bailouts, for which Buffett lobbied hard, many of his company’s stock holdings would have been wiped out.

Berkshire Hathaway, in which Buffett owns 27 percent, according to a recent proxy filing, has more than $26 billion invested in eight financial companies that have received bailout money.  The TARP at one point had nearly $100 billion invested in these companies and, according to new data released by Thomson Reuters, FDIC backs more than $130 billion of their debt.

To put that in perspective, 75 percent of the debt these companies have issued since late November has come with a federal guarantee. (Click chart to enlarge in new window)

Without FDIC’s debt guarantee program, even impregnable Goldman would have collapsed.

And this excludes the emergency, opaque lending facilities from the Federal Reserve that also helped rescue the big banks. Without all these bailouts, the financial system would have been forced to recapitalize itself.

Banks that couldn’t finance their balance sheets would have sold toxic assets at market prices, and the losses would have wiped out their shareholder’s equity.  With $7 billion at stake, Buffett is one of the biggest of these shareholders.

He even traded the bailout, seeking morally hazardous profits in preferred stock and warrants of Goldman and GE because he had “confidence in Congress to do the right thing” — to rescue shareholders in too-big-to-fail financials from the losses that were rightfully theirs to absorb.

Keeping this in mind, I was struck by Buffett’s letter to Berkshire shareholders this year:

“Funders that have access to any sort of government guarantee — banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government’s umbrella — have money costs that are minimal,” he wrote.

“Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that … are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be.”

It takes remarkable chutzpah to lobby for bailouts, make trades seeking to profit from them, and then complain that those doing so put you at a disadvantage.

Elsewhere in his letter he laments “atrocious sales practices” in the financial industry, holding up Berkshire subsidiary Clayton Homes as a model of lending rectitude.

Conveniently, he neglects to mention Wells Fargo’s toxic book of home equity loans, American Express’ exploding charge-offs, GE Capital’s awful balance sheet, Bank of America’s disastrous acquisitions of Countrywide and Merrill Lynch, and Goldman Sachs’ reckless trading practices.

And what of Moody’s, the credit-rating agency that enabled lending excesses Buffett criticizes, and in which he’s held a major stake for years?  Recently Berkshire cut its stake to 16 percent from 20 percent.  Publicly, however, the Oracle of Omaha has been silent.

This is remarkably incongruous for the world’s most famous financial straight-shooter. Few have called him on it, though one notable exception was a good article by Charles Piller in the Sacramento Bee earlier this year.

Buffett didn’t respond to my email seeking a comment.

What saddens me is that Buffett is uniquely positioned to lobby for better public policy, but he’s chosen to spend his considerable political capital protecting his own holdings.

If we learn one lesson from this episode, it’s that banks should carry substantially more capital than may be necessary.  You would think Buffett would agree. He has always emphasized investing with a “margin of safety” — so why shouldn’t banks lend with one?

Yet he mocked Tim Geithner’s stress tests, which forced banks to replenish their capital. Why? Is it because his banks are drastically undercapitalized?  The more capital they’re forced to raise, the more his stake is diluted.

He points to Wells Fargo’s deposit funding model being more robust than investment banks’, but that’s no excuse for letting tangible equity dwindle to three percent of assets.  At that low level, the capital structure would have collapsed were it not for bailouts.

And by the way, the strength of Wells’ funding model is a result of FDIC insurance, among the government subsidies Buffett complains about in this year’s letter.

To me this feels like a betrayal.  There’s a reason he’s Warren Buffett and not, say, Carl Icahn.

As Roger Lowenstein wrote in his 1995 biography of Buffett, “Wall Street’s modern financiers got rich by exploiting their control of the public’s money … Buffett shunned this game … In effect, he rediscovered the art of pure capitalism — a cold-blooded sport, but a fair one.”

But there’s nothing fair about Buffett getting a bailout, about exploiting the taxpaying public for his own gain.  The naïve 14-year-olds among us thought he was better than this.

What would Ben Graham say?

It was a surreal moment two weeks ago when analysts on Goldman Sachs’ earnings conference call pressed CFO David Viniar to jack up leverage. They seem to think that the worst of the credit crisis is behind us, so Goldman should goose its risk profile to increase returns. This is remarkably short-sighted.

Yes, leverage is down, but only relative to the obscene levels reached a year ago.  Measured by tangible common equity, the biggest banks are still levered over 20 to 1. If banks learn nothing else from the financial crisis, it’s that they should err on the side of prudence, carrying substantially more capital than appears necessary.

(Click table to enlarge in new window)

Tangible common equity remains the crucial measure of bank capital because it’s the primary cushion to absorb losses. When that cushion gets low, creditors panic. Bank runs ensue and the financial system ceases to function.

(more…)

UPDATED 3:25PM

NEW YORK, July 22 (Reuters) – Tim Geithner deserves a pat on the back, Hank Paulson a kick in the rear.

Goldman Sachs has announced the redemption of its TARP warrants for $1.1 billion. Including dividends, taxpayers will have made a 23 percent annualized return on their TARP investment in the firm. That’s not bad considering the great terms Goldman received when Paulson issued the warrants in the first place.

Compare the terms to those Warren Buffett received when Berkshire Hathaway made a similar preferred investment in Goldman. We got a 5 percent dividend yield. Buffett got 10 percent. We were able to redeem our preferred shares for only 100 percent of their par value. Buffet can redeem his for 110 percent.  The strike price on Buffett’s warrants is $115, the strike price on ours is $122.90.

In the end we made a 23 percent annualized return while, according to Linus Wilson, assistant professor of finance at the University of Louisiana at Lafayette, Buffett’s annualized return through July 13 was 105 percent.

Despite the poor terms, we actually did OK. According to Wilson, the deal for Goldman warrants “is the best one taxpayers have gotten to date.”  Previous warrant redemptions haven’t been very favorable for taxpayers. Here we at least got fair market value.

While it’s good news that Goldman has paid back TARP, taxpayers shouldn’t be fooled into believing that the bank is operating free of public support.

The bank has borrowed $28 billion at below-market interest rates courtesy of FDIC’s debt guarantee program; it received $13 billion directly from taxpayers to make good on AIG investment guarantees; and then there’s the various emergency lending facilities provided by the Federal Reserve to which Goldman still has access.

And these are just the explicit forms of support that Goldman gets. As a “too-big-to-fail” bank, all of its private obligations carry an implicit taxpayer guarantee.

Because taxpayers continue to insure Goldman’s liabilities, we need a greater degree of control over the firm’s assets. Hopefully regulators exercise this control and exorcise the bank’s high-risk trading business.

If Goldman guys want to keep running their hedge fund, they should do it somewhere else — not within a federally insured institution.

As predicted, Goldman reported blow-out earnings.  The market had been expecting as much, which is why the stock has been flat today.

The good news is that Goldman’s leverage fell again this quarter.  Total tangible assets were $885 billion; tangible common equity was $50.9 billion.  That implies leverage of 17x, or a TCE ratio of 6%.

Last quarter leverage was 22x, implying a TCE ratio of 4.5%.

Before we go giving Goldman too much credit for shrinking its balance sheet, it would be nice to understand all its off balance sheet liabilities, a distinctly difficult exercise since Goldman doesn’t disclose the necessary data (more on poor disclosure from CreditSights below)

Moreover, their balance sheet is still far from pristine.  Level 3 “mark to myth” assets still equal $54 billion, which is higher than the bank’s TCE.  And they didn’t provide any disclosure of Level 2, “mark to model” assets.  I’ll provide an update here when they publish the data in their 10-Q.

CreditSights made the following, very interesting points in their report today (no link)

Nominally a bank, still thinking like a broker

After two full quarters as a bank holding company, we note that Goldman Sachs has not yet converted to reporting its earnings in a bank-like fashion.  For instance, the company does not provide a full balance sheet with its press release, or provide detailed break downs of revenue and valuation marks.  In general, our sense is that Goldman’s switch to bank holding company status was basically a security blanket in the worst of last fall’s troubles, and the company would be happier today if it could let it go.  We also sense that Goldman Sachs may not yet have the same level of regulatory scrutiny that many banks routinely live with.  We note that the company still reports a Basel II Tier 1 ratio which was used by the SEC under its oversight, whereas banking regulators have always been focused on Tier 1 under Basel 1.

Our view is that because Goldman Sachs passed the SCAP stress test with flying colors and repaid its $10 billion in TARP preferred stock, the company has basically been given a green light to continue operating in a “business as usual” fashion.  Bank regulators have their hands full with other deteriorating bank situations and for the time being, seem content to let Goldman do what it’s always done.  Over the longer term, we wonder if Goldman’s business profile, which relies heavily on trading and principal investments, will sit well with bank regulatory authorities.  our understanding base on current reform proposals under Obama is that certain companies deemed as “Tier 2″ — of which Goldman will certainly be one — will face higher capital and liquidity requirements, as well as potentially tougher scrutiny that peers.

Goldman shouldn’t get a green light for paying back TARP preferred.  There’s also the matter of AIG collateral payments and FDIC debt guarantees as I blogged yesterday.  Until Goldman is out from under those rescue blankets as well, and subject to far more stringent capital requirements, government officials shouldn’t be discussing “green lights.”