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End of the EU? Probably not.... End of the Euro? Probably

Ambrose Pritchard has another smashing piece that really gives a lot of credence to those dollar bulls.

From The Telegraph:

Ex-Bundesbank chief Karl Otto Pohl has just said that Ireland and Greece are in danger of defaulting on their sovereign debts and/or may be forced out of the Euro, for those who may not be aware of his Sky interview by my colleague Jeff Randall.

"I think there are countries considering the possibility. It would be very expensive," he said. "The exchange rate would go down, 50 or 60% and then interest rates would go sky high because the markets would lose all confidence."

Professor Pohl said Germany's political class is afraid their country will ultimately have to pay for the EMU mess. His view is that the burden should be shifted to the IMF (ie. the US, Canada, Japan, Britain). Thanks a lot Karl Otto. You broke it, you fix it.

It is a great read especially the part on Italy really being in a mess.

AIG: Let me try and understand this

From Bloomberg:

March 5 (Bloomberg) -- American International Group Inc., the insurer that got four bailouts from the federal government, has been the subject of complaints from rivals who say the firm is underpricing commercial coverage, a regulator said.

Competitors have said AIG was able to charge lower rates after getting government help, said New York Insurance Superintendent Eric Dinallo in an interview with Bloomberg Television today.

So basically AIG takes billions of taxpayers money and then turns around and undercuts the good insurers who actually take part in non-risky underwriting. This screams of moral hazard. What makes it worse is that AIG is failing to realize that under no actuarial situations are these rates any good if there are claims longer term.

“We worry just as much about low pricing as high pricing,” because the industry needs to have enough capital to pay claims that may emerge years after policies are sold, Dinallo said

Government help “allows unhealthy insurers to grab more market share in the short term at levels that are unsustainable in the long term,” said David Sampson, head of the Property Casualty Insurers Association of America, an industry group, in a statement last week.

I mean its blatantly obvious that these type of situations will occur when the government is giving out free money and it sickens me that AIG is out causing more harm to their healthy counterpart.

An Excellent Analogy

an excellent analogy explaining why banks don't need more money they just need more time. (From Accrued Interest Blog)

Han will get that shield down...

First, let me start with an analogy.


I have a good friend, also in the finance business, who bought a condo about 2 1/2 years ago. It was part of an apartment building rehab, but is located in a very sought-after zip code in suburban Baltimore. And its a beautiful place. When my wife and I first went there she jokingly said we should sell our place and buy his.

Unfortunately for him, not only did he buy at the top of the housing market, but the builder doing the rehab went under and sold the project. The new owners are going to continue the rehab, but leave it as rentals, not convert to condos. So that's absolutely destroyed the value of his place. I'd guess in the -50% area or some such.

Now this guy is relatively young, and while I don't know much about his personal finances, I know he doesn't have huge amounts of liquid assets. So I can safely say that he owes more on his house than his entire net worth.

And yet he's earning a good income, as does his wife. In fact, he told me that he is well under the debt-to-income number that Obama's foreclosure relief plan is targeting. So I have no reason to believe he's going to default on his loan. Still, based on a simple assets vs. liabilities calculation, the dude is insolvent.

Obviously the bank would be incredibly stupid to foreclose on him now, even if the bank had that right. Allowing my friend to remain a "going concern" makes much more sense. Granted, the risk my friend poses has gone way up, as there is no longer any equity cushion. But if the bank were to foreclose now they'd be looking at a 50ish percent loss. Whereas if they look the other way and let the cash flows play out, my friend is very likely to pay off his loan.

Now stepping back, there are a lot of financial institutions in this same boat. They have gigantic paper losses, yet little in cash flow interruption. This brings us to the GE Capital discussion of the last couple days. I've mentioned a fundamental problem the finance sector is currently dealing with. This is essentially the source of my kobayashi maru title from the other day.

• Financials have made many investments (be it in loans, properties, securities etc.) that they wouldn't make today, at least not at the original terms.
• However, some of these investments will eventually work out alright from a cash flow perspective. Some won't.
• It stands to reason then that some financial firms will own more "good" investments and some will own more "bad" stuff. Only with time will we really know who is which.
• Unfortunately, the market isn't giving firms much time. The door for raising new equity money is now pretty much closed for any financial, and wild trading in CDS is stoking more fear.

Ideally we'd like to give financial institutions time to sort out who is who here, but private investors aren't going to accommodate. I mean, as a bond manager, I wouldn't be waiting around for three or four years to see if GE Capital can work through their problems. Investors as group, we made that mistake with Bear Stearns and Lehman and AIG and Merrill Lynch and WaMu and Wachovia and GSE preferreds and Citigroup etc. etc. etc. etc. etc. Most pros got stung or nearly stung with one or more of these disasters. We aren't waiting around any more.

This should be the focus of government programs to cleanse the financial system. Creating time. Otherwise, as Keynes said, we're all dead.

Dissing Decoupling

A great little nugget from Ambrose Evans-Pritchard discussing the long lauded idea of decoupling in Europe and abroad. (For those of you who don't know what decoupling is, its the idea that even though the U.S. is heading towards a recession, everywhere outside of the us will continue to grow). A very sobering review of the current situation:

http://blogs.telegraph.co.uk/business/ambrosevanspritchard/april2008/thisbeargrowlson.htm

Level 3 Profits! Hooray For Creative Accounting!

Courtesy of Bloomberg and Johnathan Weil:

April 23 (Bloomberg) -- Here's Rule No. 1 from Wall Street's public-relations
playbook: If the company you run has big losses on hard-to-value assets, scream
your head off about the accounting rules.
And what if the squishy values
result in huge gains instead, as they have in the not-so-distant past? Rule No.
2: Stay mum about it for as long as the rules allow.

There you have it folks. A cliff notes version of how to run a Wall Street firm, when you make bad decsions complain about the accounting rules that force you to admit your mistakes. Then make sure you take all that crap sitting on your balance sheet that has no market and claim that you profited immensely from it:

There has been no commensurate outrage about fuzzy mark-to- market
accounting that lets companies post unrealized gains on illiquid balance-sheet
items. Yet if it weren't for large non- cash profits on hard-to-value holdings, Goldman Sachs Group
Inc. wouldn't have had much profit last quarter. Lehman Brothers Holdings
Inc. would have had significantly less. And Morgan Stanley wouldn't
have had any.
You wouldn't have known those things from the earnings press
releases the three investment banks issued in mid-March. Investors had to wait
until a few weeks later to find out. That's when the banks filed their quarterly
financial statements, including footnotes showing changes in their so-called
Level 3 assets and liabilities.
The rules allow such delays. What's amazing
is that the banks' investors aren't demanding to get this information sooner.

So lets try and get everyone to understand the hierarchy of Level 1, 2, and 3 assets.

1. Level 1: Mark-To-Market Go look up any stock, bond, option, mutual fund on your investment brokerage account. Very easy to value and all gains and losses are reported each quarter on your earnings.
2. Level 2: Mark-To-Model Prices don't exist, so you create a computer program to create a synthenic value for your illiquid product based on price inputs observable in a liquid market.
3. Level 3: Mark-To-Make Believe Essentially a level 2 asset however one of your inputs doesn't have an observable liquid market so you make your own assumptions about its pricing, essentially imagining a market for this input.

Weil Continues:

There isn't anything necessarily wrong with Level 3 measurements. By
definition, though, they are less certain and more prone to bias. There's
nothing new about Level 3 gains and losses either. They just weren't called
Level 3 before FAS 157, which the major investment banks adopted last year, and
didn't have to be disclosed.
Break Down
Here's how the numbers break
down. For the quarter ended Feb. 29, Morgan Stanley reported $4.24 billion of
net unrealized gains on Level 3 assets and liabilities. That was almost twice
the company's $2.21 billion of pretax income.
Those figures included $8.39
billion of net gains on Level 3 derivative contracts, driven in large part by
adjustments on credit-default swaps, which Morgan Stanley used to buy protection
against declines in the creditworthiness of various holdings.
Morgan Stanley
included the $8.39 billion on its income statement as part of trading revenue,
which was $3.39 billion last quarter. So, without those items, Morgan Stanley's
trading revenue would have been negative $5 billion. (Yes, negative.)
At
Goldman, net unrealized Level 3 gains were $2.07 billion for the quarter ended
Feb. 29, equivalent to 96 percent of the company's $2.14 billion of pretax
income.

Please read the rest of his piece here:
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a0ZGtAQHLpiA

More Inflation Shenanigans

It just amazes me that Regan and Clinton had the foresight to understand the mess that social security would become and thereby created new methods of calculating inflation so as to tame the exponential growth of social security. I mean why actually try an address a problem when you can mathematically brush it under the rug? Must really be hard for those old folks whose standard of living has dropped precipitously over the last decade or so as their real cost of living has run up while their social security cheques have meagerly risen.