More Failures to Come

Reggie Middleton has not been one to drink the Kool Aid, but he believes there are many out there who still are. Once upon a time, the kool aid they were drinking was that leverage was a one-way street to profits, that the music would keep playing, etc etc. Now, its a new flavour of kool aid being drunk, which is that government can save the day. In Another Big Bank Failure: More Likely Than Not to Occur (hat tip: naked capitalism), Middleton argues that deleveraging has actually increased the concentration of the crap that banks have hidden behind the scenes (Level 3 assets keep going up), meaning a day of reckoning is inevitable.

Countrywide was forced into a fire sale vs. bankruptcy situation. It was totally insolvent and reeked of non-performing, illiquid and depreciating assets.

Merrill Lynch (MER) was forced into a fire sale vs bankruptcy situation. It was totally insolvent and reeked of non-performing, illiquid and depreciating assets.

Bank of America (BAC) bought both of these companies. Hmmmm. Look at its share price and balance sheet. Where do we think all of those reeking assets ended up?

Bear Stearns was forced into a fire sale vs. bankruptcy situation. It was totally insolvent and reeked of non-performing, illiquid and depreciating assets.

Washington Mutual was forced into a fire sale vs bankruptcy situation. It was totally insolvent and reeked of non-performing, illiquid and depreciating assets.

JP Morgan (JPM) bought both of these companies. Hmmmm. Look at its share price and balance sheet. Where do we think all of those reeking assets ended up?

The government virtually nationalizes Citibank (C), one of (use to be, anyway) the world's largest banks.

Goldman (GS) falls in price by ~75%, Morgan Stanley (MS) likewise. They are both forced to become commercial banks. Morgan decides to play the retail banking game, but Goldman appears to remain obstinate. I think they are still punch drunk from drinking their own (we're the best on the Street) Kool Aid.

I stated in the past, they have a very high share price correlation to their brethren (most of which no longer exist) and they still have some of the most illiquid and dangerous assets on their books. Yes, they have delevered significantly over the last few quarters, but a forensic glance shows that this delivering was achieved by selling the more liquid and marketable stuff, thus actually increasing the concentrations of the stuff that made them need to delever in the first place.

Now, this is a judgment call by management, and I will not argue with it. I am sure they are loathe to sell depreciating assets in a down market when they probably feel the market will turn in the near to medium term.

I look at it this way though. They wrote leveraged products on overvalued underlyings at the top of one of the most effervescent bubbles in modern history. Now the bubble has popped, and reality is hastily approaching. Many companies from the previous year would have been much better off (actually, would still be in business), if they bit the bullet and sold at a loss today in lieu of waiting tomorrow when their assets for sale are definitively worth less than the aggregate debt used to finance them. That is the danger of 30x leverage, and that is the danger with what's left with these banks.

We don't know what the leverage ratio is for these banks. Although many (example Goldman and Citi) have taken their leverage down considerably - we really don't know from what level it is truly coming from. Almost all of the off balance sheet vehicle, specifically the SIV's, use significant leverage. The reporting on them is murky at best, non-existent for the most part. Make no mistake, there is exposure to economic risk from these entities. Thus, as Goldman delevers by selling few things that it probably should keep, it amasses greater concentrations of the things most likely to kill it.

Think of a woman that sheds lots of water (marketable assets) to lose weight to impress beauty judges (short sighted shareholders, shorter sighted regulators, and the sell side game), thereby building up dangerous levels of toxicity within her system. Now, the woman looks a lot better from the outside, and may even win a trophy, but the poisons within are now undiluted and potentially killing her. The pretty woman that walks down the aisle very well may collapse (like so many of her sisters from last year), and I get the feeling that if she does, everyone will act surprised.

"Won't the government help us?"

Many of my lesser aware associates are still of the mindset that the government will pull us out of this one. I am put in mind of those who blindly follow religion without bothering to once wonder exactly how all of those miracles may actually work. I believe it is a lot easier for government to allow us to go down the path to recession than it is to work our way out of it. Recession is natural and normal anyway, and needs to happen. The kicker is that we had a wildly voracious up-cycle that ridiculed both the fundamentals and fiscal prudence - this lasted for about six and a half years.

We have seen roughly one and half years of carnage. Methinks that we have roughly three to six years more of this to go, or 12 to 18 months of a hyper accelerated, extremely destructive downward plunge - one that would have 2008 something the optimists would end up wishing for. The only variable is the velocity of the descent. It is guaranteed, a given, that mother equilibrium will insist upon returning to her pre-bubble ways, and potentially then some.

I rant ad nauseum because I find myself returning back to the big money center banks mentioned above.

As you all know, I shorted all of the names mentioned above heavily backed by some rather comprehensive fundamental and forensic research, and am still short most of those that are still in business. The trades were roughly six months to a year in duration, and although proved to be very, very profitable (several scoring more than 100 point hits) had a significant amount of volatility introduced that produced some nasty drawdowns. These drawdowns came from bear market rallies that were sparked by the "Won't the government help us?" mentality.

As stated earlier, recession is a natural and inevitable occurrence that needs to happen, just as much so as economic boom times. The dead banks will have to die. It's just a matter of whether we get it over quickly and allow the Phoenix to rise from its ashes to start anew, or we drag this out in a form of macro-economic water torture.

Remember, mortgage banks were dropping like flies. Bear Stearns collapsed over the weekend. The Fed backstopped investment banks by allowing unprecedented borrowing from the Fed discount window, accepting as collateral practically anything, stocks, private labeled MBS, baseball cards, manure and fertilizer (Okay, I was joking about the baseball cards). This allowed the market to rally from the March lows that was put in by the Bear Stearns collapse. After all, the government has unlimited resources and they have pretty much stated that they will not allow a large investment bank to fail.

Six months later, a large investment banks fails in the form of Lehman Brothers. What happened? The government said it wasn't their fault. They had no viable buyer. What happened to the government sanctioned liquidity? What did Lehman and Bear have on their books that the other ex-I banks don't? The short answer is nothing. They had higher concentrations of mortgage related assets.

That may sound bad given the occurrences of the past year, but it trust me, it sounds worse than it is. This was not a real estate or mortgage crisis, but an asset securitization crisis born from the punch drunk giddiness to be had when lenders and their cronies have access to nigh unlimited balance sheets and liquidity, and very limited recourse and responsibility for their actions. Thus, any asset that was normally lent against, was most likely abusively lent against under this scenario. Real assets and mortgages were simply the first to pop, starting with subprime, and as we have already seen, definitely not ending there.

As a matter of opinion, it is quite probable that the other asset classes that have bore witness to the lending abuses very well may be hit harder than real estate and mortgages - if not on an individual basis, then definitely on an aggregate basis. This is where Goldman, Morgan, HSBC (HBC), et. al. will see real pain. This is why Goldman's level 3 assets are actually increasing as they delever. Think private equity, think, leveraged loans, think venture capital. Just think...

Do you really think the government can prevent another big bank failure? It will happen sooner or later, but looking at the current condition and prospects, it appears to be more likely to happen than not.