CIT On the Brink, Yet Again

Everybody's favorite commercial lender, CIT, was once again teetering on the brink of a bankruptcy filing. The company is preparing a debt exchange offer that would eliminate 30%-40% of its more than $30 billion in debt outstanding. New bondholders would be secured by CIT's assets, as well as nearly all the equity in the restructured firm. If enough bondholders don't fall for this latest effort to keep the firm alive, CIT plans to resolve its issues in court via a Chapter 11 bankruptcy filing. It is always nice to leave your mark in the business history record books, but going down as the fifth-largest bankruptcy filing in US history during Bailout Fest 2008-2009 is perhaps a bit disappointing. Speaking of bailouts, the government, in its far more generous days, did lend CIT $2.3 billion through TARP, most of which it is likely to lose if CIT winds up in Chapter 11.

On one hand, a restructuring is exactly what the debt-laden lender needs and it's good to see nature finally taking its course. On the other, the lender would be forced to shrink itself into a smaller company, which bodes ill for the thousands of small companies that rely on CIT for financing to conduct their daily operations. Where are those companies going to turn? Our nation's banks? They are too busy using their available capital to trade stocks and bonds. They have no excess capacity to lend to pipsqueak borrowers.

The debt exchange is set to last 20 business days. One way or another, we'll have some closure to the "Is CIT going to make it?" situation.

Some Data and More Musings From FDIC and SEC

• In happy economic headlines, S&P's Case Shiller index on housing prices posted a small uptick from the prior month. Only Las Vegas and Seattle showed declines. Year-over-year, prices are still down across the board, with the worst performer, Las Vegas, posting a drop of 31.4%, and the best performer, Cleveland, posting a 1.3% decline.
• Meanwhile, the index of consumer confidence dipped to 53.1 from 54.5 putting an end to the stock market's rally this morning. I suppose economists who predicted a continued rise in consumer confidence were shocked that consumers somehow care about silly things like a 10% unemployment rate, rising credit card fees, and negative home equity.
• Desperate to raise money without having to tap the Treasury, the FDIC is now expected to propose that the bulk of the banking industry prepay three years' worth of fees to replenish the dwindling deposit insurance fund. The FDIC anticipates collecting between $36 billion and $54 billion through this new money-making scheme. I suspect this fee will be met with more than a wee bit of resistance from the banking industry. Certainly all banks have been underpaying for the past several years since it only took us a year or so to blow through the insurance fund, but still, it's never fun paying for the clean-up.
• The SEC is weighing new regulations for that mysterious and "opaque market" called securities lending. I know we need to regulate everything to look like we're actually doing something after last year's clustersuck, but still, this is getting ridiculous. There is nothing opaque or complex about securities lending that needs regulating. The securities lenders lost buckets of money last year out of sheer stupidity not because the industry needs more regulation. They took a very simple business model of lending out securities to shorts and reinvesting into liquid assets earnings higher rates and screwed it up by investing in highly illiquid toxic securities that lost money. Besides, if the SEC finally does succeed in making short-selling so difficult that nobody wants to do it anymore, securities lending won't be necessary.

Regulators in Hilarious Move to Halt Reliance on Short-Term Funds

The credit crisis in its infancy was merely a funding crisis. In mid-2007, the normally highly liquid money markets began experiencing a pullback in lenders' eagerness to take certain forms of collateral. So Wall Street's greatest friend, the Fed, began creating a slew of new financing vehicles which offered near-unlimited funds for banks so that they could continue, if not increase, their reliance on short-term funding. Then Bear Stearns imploded, followed by Lehman, not to mention a slew of other leveraged vehicles (who have no access to the Fed) that were cut off from short-term funding when the money markets seized.

After spending a few years completely propping up the money markets, regulators now think they it's a good idea to halt banks' reliance on short-term funds. Hilarious! If regulators wanted to halt reliance on short-term funds, they maybe should've had a chat with the Fed and not allowed them to become the short-term lender of not only last resort but ONLY resort. Furthermore, borrowing short and lending long IS how banks make money. When the yield curve is steep, they print cash, when it inverts they lose money. If you take away their ability to play the yield curve, they will just raise their fees on deposits. So I suspect this plan to regulate will be met with resistance and wind up being so watered down that it becomes irrelevant.

The way to combat banks' reliance on short-term funding is to get the Fed out of the business of propping up the banking sector with super cheap funding. Make it clear that the financing vehicles they created in the past two years are being wound down and aren't coming back, and then have a plan in place to liquidate failed institutions. Spoken to Lehman or Bear lately? Funny, they don't seem to have any funding problems anymore.

"Shadow Banks" Lousy Underwriters

The FT reports that the US financial sector's losses on large loans exploded over the past year, exceeding the combined losses since 2001. Regulators' annual review of "shared national credits" - loans larger than $20 million shared by three or more federally regulated institutions - reveal that one in three dollars lent by non-bank institutions (i.e hedge funds, securitization vehicles and pension funds) went sour compared with 11.5% for US banks. Furthermore, non-bank institutions were responsible for 47% of problem loans in spite of only accounting for 21.2% of the total loan pool.

Overall, the US financial sector's losses on loans in early 2009 reached a record of $53 billion, almost triple the previous high in 2002, and nearly 15% of the $2.9 trillion in the SNC portfolio was classified as "substandard." The review is conducted each year by the Fed, FDIC, OCC and OTS. They made the astonishing discovery that underwriting standards had improved last year, but that the loans originated before mid-2007 had continued to drag down the portfolio's performance. Could it be that underwriting standards have improved because many of the non-bank lenders have since gone bust and all financial institutions virtually ceased lending after the credit crisis hit? Nice to know our regulators are discovering such ground-breaking information three years after it actually matters.

If you were wondering what on earth the OCC and OTS actually did with their time, the answer is here: run reviews of loan portfolios made during a credit boom that they slept through and say things like "wow! you guys really originated a bunch of crappy loans!" If there's a silver lining in any of this, it's that the non-bank institutions made our banking institutions look like prudent lenders. Even in the business of lending, everything is relative.

Financial Headlines 9/24/2009

• The Fed left interest rates unchanged yesterday, and said it would slow down and extend its MBS purchase program until March of next year. Since the Fed has purchased 80% of all MBS issued by Fannie and Freddie in the past year, I'll let you guess what direction mortgage interest rates are headed when its buying binge comes to an end.
• In some slightly encouraging news for the job market, initial claims for jobless benefits fell 21,000 to 530,000 for the week ended Sept. 19. Continuing claims fell by 123,000 to 6,138,000 from the preceding week's revised level of 6,261,000. Still, claims are high, indicating it'll be awhile before we start adding jobs.
• The SEC is actually going after someone for insider trading in the options market. This comes as a complete surprise to me, a former options market maker, as it seemed like suspicious insider trading happened all the time ahead of merger news without arousing any action from regulators. In this case, the SEC has filed a civil lawsuit against an employee of Parkcentral Capital and accused him of making $8.6 million in profits from buying Perot Systems options ahead of Dell's announcement that it would purchase the company. The man accused has worked for various Perot entities and allegedly spoke to a director from the firm about the impending deal. Nice to know that the SEC is getting off its duff and finally taking insider trading in the options market seriously.

Financial Headlines 9/23/2009

• Yet another meaningless article about the Fed increasing scrutiny over bank bonuses, this time in the FT. Regulators are asking to look more closely at banks trading positions to see how much of bonuses are based on "real" profits and how much on unrealized gains. The article is asking for a "breakdown of their balance sheets with particular attention to trading books." It's a bit scary that they don't already have a breakdown of the balance sheet, given that they just conducted stress tests and proclaimed our banks to be well capitalized.
• Funny article in the WSJ about how day traders are mostly responsible for the recent incredible volatility in AIG's stock. They haven't had this much fun since 1999.
• Very unfunny article in the WSJ about how delays in foreclosures are merely prolonging the crisis by pushing the inevitable into the future. According to one analyst, three to four million foreclosed homes will be put up for sale in the next few years.
• The FDIC is hoping to dispose of the assets of the failed Corus Bank, one of the largest bank failures this year, which include condo loans and other property. The loans are expected to fetch between 30 cents and 80 cents depending on whether they are performing or not. The FDIC will partner with the winning bidder, owning a 60% stake and providing the financing. About 10 bidders are expected to participate and bids are due Friday.
• The Cioffi/Tannin Bear Stearns hedge fund trial just gets better and better and it hasn't even started yet. Prosecutors are now asking that Ralph Cioffi's bail be reviewed after he traveled to Florida to get documents related to a condo investment project that went awry. Apparently, Mr. Cioffi pledged his $5.7 million investment in the Bear hedge fund he managed as collateral for an investment in a Sarasota, Fla condo project. More leverage on top of his leveraged hedge fund. I'm starting to think this guy was too stupid to have knowingly deceived his investors. He allegedly went to a bank storage facility and requested that documents be copied and sent to him without being sent to his lawyers. In related news, Mr. Cioffi's lawyers are still attempting to keep evidence related to the mysterious disappearance of his computers and his lifestyle from being submitted as evidence in the case. By lifestyle, I'm referring to the three Ferraris, a $12 million Southampton pad, a $3.5 million house in New Jersey, a $3.25 million house in Vermont and two Florida properties worth $7.1 million and $1.25 million.

Is AIG Stabilizing?

According to the WSJ, which has an article entitled "AIG is Showing Signs of Stabilizing," AIG is stabilizing. Certainly yesterday's extraordinary leap in its stock price (21%) would indicate that the fortunes have finally turned for the insurance giant that was mostly responsible for wrecking our economy and is now being propped up by government support. And yet, the Government Accountability Office's report released yesterday, didn't seem to say much of anything. "AIG's recovery will depend not only of the long-term health of the company but also on market conditions and other factors." Obviously, but has the company showed any real improvement?

AIG's insurance operations are showing signs of improvement. The $26 billion gap between withdrawals and deposits in the life and retirement-services unit has shrunk to $3 billion in the second quarter. The GAO also noted that the cost of purchasing protection against default on AIG's unsecured debt has fallen. Um, yeah. I suppose the premiums on my CDS would fall too if I had the government's unconditional financial support. I think that indicator is meaningless. In other super bullish signs, AIG also reported pretax operating income of $1.3 billion, compared with an $8.8 billion loss in the year-earlier quarter. Also fairly insignificant in light of the $100 billion in losses the company took last year. The GAO concluded that the recent improvement in AIG's financial condition is mostly attributable to government support. Perhaps the understatement of the year.

Meanwhile in bitter ex-CEO land, Hank Greenberg presented a proposal to the Chairman of the House oversight committee that would include cutting the government's stake in AIG to about 20% from 80%. The proposal also calls for cutting the interest rates that AIG is paying on its government loans and extending loan terms so that AIG wouldn't be forced into a fire sale to pay off the debt. No word yet on whether Mr. Greenberg's proposal is expected to fly. The market seems to think it will, given the recent leniency the government has shown towards our financial institutions (please see Bank of America's paltry $425 million fee to weasel out of the government's guaranteeing of $118 billion in assets.)

If we let AIG off the hook this easily, then the market really should rally back to 14,000 in a day. Since we STILL don't have a plan in place to liquidate systemically important financial institutions if they go bankrupt, we can assume that the government is just going to prop up our financial sector forever and companies should just keep piling on the risk, without any regard for how they plan to manage the downside. AIG lost over $100 billion dollars and wiped out all of its shareholders equity because it single-handedly decided it could manage the risk of insuring every single crappy MBS structured in the past few years. Why they deserve a second chance on more lenient terms from the government is beyond me. Unwind the company, sell its assets, and pay back the government loan. It's the only right thing to do.

Tax Cheats Get Extension

The IRS will extend the deadline to voluntarily come forward and admit that you've been hiding taxable assets from the US government. The extension was granted after a slew of accountants begged for more time to help clients get their filings together. More than 3,000 taxpayers have already come forward, compared with 88 for all of last year and 1,300 in 2003, the last time the IRS offered cheats a chance to come forward, admit their sins, and sleep better at night.

Apparently, it is not guilt that is making a hoard of tax evaders come forward just now. After the Swiss government settled with the US and agreed to identify at least 4,450 UBS account holders and possibly more from other banks, UBS sent a round of letters to account holders informing them that their information was about to be revealed. Some customers had hoped that they could escape scrutiny because their account was too small, but there appears to be no discernible pattern as to which customers were selected, with accountants claiming that several clients with "plain vanilla accounts well under $1 million have received these letters."

I find it interesting that so many folks chose to evade taxes during the Bush years. It seems hard to believe that the tax code in the US was ever going to be more friendly to capital than it was during the past eight years. 15% long term capital gains? 15% on dividends? Seriously, is it really that bad to suck it up and pay your 15% so you can have a police force and maybe some decent roads? Now your choices are to either confess and pay back taxes, penalties, attorney's fees, accounting fees and a special penalty that will work out to 40% to 60% of the account balance or face the very real prospect of criminal prosecution.

Financial Headlines 9/18/2009

A bunch of non-news news in the headlines today:

• The FHA's reserves are set to drop below the minimum level of 2% set by Congress. Is this really news? Default rates on FHA-backed mortgage loans have been sky-rocketing. It's what happens when you allow borrowers with only 3.5% of a downpayment to purchase homes, not all of these folks will be reliable credits. But fear not, the FHA will get its bailout, just like every other housing-related agency.
• Officials are warning that option ARM mortgages are set to explode. Option ARMs were designed to explode. So why are we reporting this as news? The first time I read about an option ARM in 2005, I thought "Geez, these things will explode in a few years when borrowers have to repay principal plus all of that extra interest that's been accruing." I guess the news here is officials have finally taken notice, which means its going to happen tomorrow and it's too late to do anything about it.
• The WSJ reports that bankers are facing "sweeping curbs on pay." The article follows up with a very vague description of how the Fed is going to be able to reject any compensation policies it believes encourages bank employees to take excessive risk. Mind you, the Fed's recent ridiculously easy money policies were designed so that a monkey could make money this past year if it worked at a bank, at the expense of our entire nation, so you can imagine they're really going to crack down on comp. The article should've been entitled "Bankers facing yet more bonuses, and nobody is going to do anything about it."
• Vikram Pandit thinks $100 million might be a bit much to pay to any one employee. But he's probably just bitter because he's only working for $1 this year.
• Speaking of comp, the WSJ has a very interesting article about how the nation's really smart graduates, engineers from MIT and the like, are steering away from finance to find more fulfilling work. The article shows how much the pay incentives on Wall Street led to a misallocation of our nation's smartest minds away from lower paying jobs like engineering and medicine, into careers trading and selling derivatives. The trend is apparently moving in the opposite direction now.

Fed Scrutinizing Banks' Commercial Property Exposure

According to the FT, the Fed has decided to "review" banks' exposure to commercial real estate. If there is any sign that the Fed is ill-equipped to be the master systemic regulator responsible for ensuring that banks aren't piling on too much risk, this is it. You see, TODAY is not the day to begin to review commercial real estate exposure. It's about a year or two too late for that. The commercial real estate market has come to a complete halt and there is little anyone can do to stop the avalanche of defaults and distressed sales that are certain to happen because of soured commercial real estate deals.

Nevertheless, the Fed will look at a cross-section of banks to build a picture of how resilient institutions are to the troubled market. They aren't calling this a "stress test." No, this is different. The article doesn't say how or why, or what the Fed is even planning to do after its "review." Apparently, a "cross-disciplinary team will look at a variety of commercial real estate assets on banks' balance sheets, encompassing loans and CMBS." So, don't worry. They're on the case. The commercial real estate crisis is contained.

Bear Stearns Fund Manager Trial Gets Interesting Before It Begins

We're still about a month away from the start of the Cioffi/Tannin trial. For those who don't recall, the collapse of two Bear Stearns hedge funds in 2007, run by Ralph Cioffi and Matthew Tannin, marked the official beginning of the credit crisis. Mr. Cioffi and Mr. Tannin are facing charges of conspiracy, securities fraud and wire fraud in a nine-count indictment in a criminal case that cost investors more than $1 billion. In retrospect, what's $1 billion after everything that's happened since? But given the lack of criminal charges brought against wrong-doing since the crisis began two years ago, at least somebody's going to trial.

The defendants have asked the federal judge to keep from introducing evidence during their trial next month that Mr. Tanin's computer and trading notebook disappeared. Apparently, the defendants believe that it might look as if the computer and trading notebook were purposefully disposed of to keep damning evidence from surfacing, when really it was just an innocent mistake. I mean, really, I lose notebooks and computers every single day and I'm not being criminally prosecuted for anything. So, I can totally understand how Mr. Tannin, after finding out that prosecutors were investigating him, might have accidentally bludgeoned his laptop with a hammer, before trying to flush it, before driving to a remote location to bury it.

Mr. Cioffi has a more general request of the judge. He would like the court to preclude the government from discussing settlements between Bear Stearns and investors and to exclude evidence concerning Mr. Cioffi's lifestyle, including discussions of furniture, antiques, automobiles and real estate. I suppose Mr. Cioffi is worried about being considered guilty-as- charged once the jury hears tales of the lavish lifestyle that he lived at the expense of his investors, and ultimately, the American taxpayer. Maybe he threw a $2 million party in Sardinia that was videotaped and we'll get to watch it on CNBC over and over again, like Dennis Kozlowski of Tyco fame? Mr. Kozlowski is doing 25 years after being found guilty of siphoning millions from Tyco's coffers, owing mostly to that video tape that I'm sure the jury had a hard time forgetting. Regardless, Mr. Cioffi seems to understand that a "jury of his peers" might not include a bunch of hedge fund managers who live similar lifestyles, but instead a bunch of angry populists bearing pitch forks. I, for one, look forward to reading about this trial

Retail Sales Rebound and Other News

Retail sales perked up and rose 2.7% from the previous month as folks rushed out to take advantage of the cash for clunkers program. I guess that's what happens when you hand out checks for $4,500. Consumers will spend it. It's the American way. Subtracting out the effects of the clunkers program and gas, other sales rose a less impressive 0.6%. Still, better higher than lower. However, July retail sales were revised lower to a decline of 0.2% from 0.1% and total sales for June through August 2009 were still down 7.6% from the same period a year ago. So while sales appear to have hit bottom, we're operating at low levels. Calculated Risk has good graphs which you can see here. It will be interesting to see what happens after the clunkers program expires. The really good news is that if retail sales fall off a cliff again, we can always give everyone a check for $4,500 to buy a new refrigerator, or washer/dryer, or, well, just fill in the blank and write your congressman.

In a remarkably sane move, a federal judge threw out the SEC's $33 million proposed settlement with Bank of America over its disclosure (or lack thereof) of bonuses paid to Merrill Lynch. US District Judge Jed Rakoff pointed out that the SEC fine levied on B of A "does not comport with the most elementary notions of justice and morality" because the company's shareholders - the victims of the alleged misconduct - are the same people being asked to pay the fine. Well, that and taxpayers, who also happen to fund the SEC's payroll, which made the whole settlement even more preposterous. Judge Rakoff has set a court date of February 1st so we all get to hear the juicy details of how the SEC conducts its investigations. It's nice to know that somebody is taking a stand against all of the recent government kowtowing to Wall Street. I happen to think that the $3.6 billion in bonuses paid to Merrill Lynch employees after the firm lost $20 some odd billion dollars and required an additional $20 billion from the government to close the merger with Bank of America is one of the the most egregious and distasteful actions I have ever seen a Wall Street firm take. And I don't think a silly $33 million fine even begins to cover it. I'd really like to know how the move was ever justified and who was involved in making those decisions. Nothing better than a trial to get everything out into the open.

In yet another remarkably sane move, Wells Fargo fired the employee who was throwing parties at a beachfront Malibu pad that had been seized from Madoff investors. Apparently, Wells Fargo frowns on that sort of behavior. It's too bad she didn't work for Merrill Lynch, because she probably would've gotten a promotion and another bonus. At any rate, no more wild and crazy parties, which is a major bummer because I was hoping to get an invite to the next one.

Lehman Brothers Revisited

Markets, regulators, and commentators have had a year to reflect on the repercussions from the failure of Lehman Brothers. Because of the devastation caused by the collapse of the once scrappy and proud investment bank, many have come to the conclusion that it was a big mistake to allow Lehman to go down. The consensus seems to believe that it cost us more to let Lehman fail than it would've to bailout the firm. I completely disagree.

The theory seems to be that Lehman's failure caused a domino affect whereby other liquidity strained institutions also failed because of Lehman. What's become more clear a year later is that some financial firms were insolvent and some only had liquidity problems. While the line between the two became blurred during the heyday of the crisis, the distinction is important. The insolvent firms would've failed regardless of whether Lehman was bailed out. AIG would not have survived. Citi would've gone down. Bank of America, because of its horrible Merrill purchase would've failed as well. The government-assisted sale of Bear Stearns to JP Morgan and the preemptive seizures of Fannie and Freddie, which were all meant to stabilize the market and keep liquidity flowing, did not keep Lehman from failing. The insolvent institutions were doomed; it was only a matter of time. Lehman's failure only sped up the process.

While it is nearly impossible to calculate how much the domino effect of Lehman's failure actually cost the economy, it is indisputable that Lehman's secured creditors received less than 10 cents on the dollar. The firm had an $100 billion hole in its balance sheet, and possibly more. A bailout of Lehman would've only cost our government an additional $100 billion dollars that was simply unrecoverable. So frankly, I'm glad Paulson drew a line in the sand and I wish he'd have kept it there instead of reverting to more bailouts.

The most important thing that happened when Lehman failed was that it reintroduced the idea of risk into investing. Markets from stocks, to emerging markets, to money market funds were slapped across the face with a giant RISK! Credit markets move in cycles and often in the good times, investors forget that they are actually taking risk with their money when they invest and then remember when they lose money in the down cycles. During this last boom, it was as if risk no longer mattered, and investors just made up numbers and plowed headlong into every stupid investment peddled to them. The Fed's decision to take $26 billion in Bear's crappy assets onto its balance sheet and assist the sale to JP Morgan in the early days of the credit crisis introduced the idea that the government would never let a systemically important institution fail. This is precisely why the market ripped for two months following that move. Yippee! The government is going to support every institution that's in trouble, so investing is risk free again. No worries. But as defaults began to rise and losses started piling up, risk reared its ugly head again.

Sadly, the government's intervention through the introduction of a variety of new mechanisms, liquidity injections and direct capital support, has removed the idea of risk taking from investing again. Now everyone is just focused on how much money they can make by taking advantage of the government's largesse. The government has taken away a key function of the market, which is the obligation to make the determination between those institutions that would've survived the crisis and those who should've failed due to too much risk-taking. For example, JP Morgan and Goldman Sachs likely would've survived. They may have been forced to raise very expensive capital from alternative sources, but they probably would've scraped by. By offering government guarantees for their debt and cheap financing for their collateral through the Fed, the government took money from investors and handed it directly to JP and GS. Without these guarantees, we wouldn't be having any discussions about bonuses, because the banks would be hoarding capital to stay alive. While the short-term benefits have been great for the market, the long-term effects are murky, and frankly scare me. If you introduce the idea of risk-free investing for everyone, banks are just going to throw money at stupid investments again expecting a bailout later. Heads I win, tails the taxpayer loses.

The government had six months after Bear caved to come up with a solution for letting financial institutions fail without cratering the market. They failed to do so. It's been a year since Lehman failed and we still don't have a viable plan on the table. This sends a signal to the market that the government is going to support our financial institutions indefinitely. Make no mistake, we will pay for this later.

Why Buy a House in Malibu When You Can Squat?

A Wells Fargo executive who heads up the commercial real estate foreclosure division has been using one of the properties seized from Madoff victims for weekend jaunts to the beach. Personally, when I squat in empty multi-million dollar beach front properties, I play it sort of low key. I definitely don't throw any loud parties because it's probably not a good idea to piss off the neighbors when you're doing something that is so preposterous that it may wind up in the pages of the LA Times, not to mention get you fired. Nevertheless, Cheronda Guyton, was caught red handed during the weekends boozing it up with friends in the $12 million Malibu home. Perhaps this is some sort of marketing scheme in this tough economic environment? Not according to angry real estate agents, who wanted to show the property to interested clients but claim that Wells Fargo wouldn't allow it. However, the bank claims that an employee's use of property that has been surrendered to satisfy debts is a violation of its ethics code. I'll take their word for it. And I suspect that Ms. Guyton will have much more free time on her hands and will be spending it in her own, less lavish, accommodations.

Mack's Exodus Surprises Some

In a surprise move, Morgan Stanley's CEO John Mack is stepping down. Mr. Mack leaves after four very rocky years at the helm of the formerly esteemed investment bank which almost bit the dust a few times in the last year. It seems like a lifetime ago that Mr. Mack was brought in to run MS by a few high profile investors who instigated a coup to oust the more conservative, former Dean Witter broker, Phil Purcell. Vikram Pandit famously walked off the trading floor to a round of applause and quit in protest, when Mr. Purcell promoted a woman (EGADS!) over him. Nobody should have to stay at their job after that sort of indignity. Mr. Mack was brought in to straighten up the place and keep all of those talented revenue producers from leaving. The firm ratcheted up its risk and went on to lose buckets of money in CDOs, CMBS, RMBS, you name it. Mr. Pandit started his own hedge fund that never made a dime but was bought by Citigroup anyway for $800 million at the peak. He now has the distinct pleasure of running the disaster that is Citi. And Morgan Stanley will now be run by a conservative former broker (they call it wealth management now.) This is what people mean when they call investment banking cyclical.

Mortgage Mods Moving Like Molasses

According to a Treasury report released Wednesday, only 12% of eligible borrowers have started trial loan modifications under the $75 billion mortgage foreclosure prevention plan. Under the program, eligible borrowers who are behind on payments or are at risk of imminent default can get their payments reduced for a trial period. If they stay current for three months, then their loans will ultimately be reworked. Doubts are growing about how many of those trial periods turn into a successful modified mortgage. So far, of the four million borrowers that appear to be eligible, 570,000 trial modifications have been offered and 360,000 are under way since the program was introduced in February. Skeptics of the program believe that only 50% of trial mods will lead to real modifications.

According to the MBA, nearly one in 12 borrowers are at least 90 days past due or in foreclosure. Among the largest servicers, Wells Fargo has begun trial mods for 11% of eligible borrowers, with Bank of America initiating for 7%, JP Morgan for 25% and Citigroup for 23%. In an interview Wednesday, Assistant Treasury Secretary Michael Barr called the program "highly effective" and predicted it will meet its goals. If a program that has been under way for six months and is still only running at 12% capacity is Mr. Barr's definition of "highly effective," well, I'd hate to see how some of our other policies he is in charge of are performing. Still the program is battling against some tough economic forces. In many cases, many borrowers are just better off walking away then struggling to pay off a mortgage they never could afford to begin with.

Consumer Credit Contracts At Record Pace

Yesterday's release by the Federal Reserve of consumer credit numbers was not particularly pretty. The report showed consumer credit contracting for the sixth month in a row by a record $21.6 billion. Total borrowing, which includes most consumer loans except real estate, decreased at a seasonally adjusted rate in July to $2.47 trillion. This follows on the heels of a 7.4% annual rate of decline in June. I happen to think that a contraction of credit is very healthy for our economy in the long run, as I just don't think we can operate as a society that is leveraged out the yin yang any longer. Consumers must cut back back on spending, pay down debt, or just plain default and start over if they are to repair their balance sheets. However, this is one of the many reasons why I don't believe our economy can recover from this recession at a rapid clip. 70% of GDP is consumer spending. If consumers aren't spending, the odds of a quick bounce back to old GDP levels aren't looking too hot.

The WSJ has a great chart depicting outstanding consumer credit since 2004. I am including it because it paints a fairly obvious picture of what much of our economic growth was based upon in the years leading up to the credit crisis: excessive borrowing by consumers. As a reminder, this does not include mortgage debt. We're talking flat-screen TVs, dvd players and the like here. Way back in 2004, when the economy had already recovered from the last recession, consumer credit was $2.1 trillion. It hit a peak just shy of $2.6 trillion in mid-2008. It has now fallen to $2.47 trillion. We are currently $270 billion away from 2004 levels. Tuesday's report showed that 35% of banks tightened credit with no banks easing. Nearly half the banks surveyed also said they had decreased the size of credit card lines for existing customers with only 3% increasing them. So the trend is for a continued tightening despite the Fed's best efforts to flood the market with liquidity. Here's the chart:

SEC Failures Highlighted in 477 Page Madoff Report

I have yet to peruse the 477-page report released by the SEC's internal watchdog that described in painful detail what a bunch of bumbling idiots work at the SEC. But the FT has a nice summary of how, after being tipped off on numerous occasions over the course of nearly 20 years, the SEC failed to uncover the giant Madoff Ponzi scheme. I'm not talking about one or two emails from respected investors and analysts that said "hey, you guys should give Bernie Madoff a call, something's not quite right over there." The SEC received numerous tips from many folks that said outright "I think it's a ponzi scheme." Or "Their options trades might not exist." No less than the esteemed Renaissance Technologies became uncomfortable with Madoff in 2003 and withdrew money from the funds when it couldn't understand or replicate Madoff's strategy. The firm suspected something was amiss and wanted to get out before Eliot Spitzer got wind of it. According to the report, on numerous occasions, SEC officials thought it was sufficient to call Mr. Madoff, ask him questions, and then take his word as evidence without asking for any supporting documents. Can we forget Harry Markopolis's pleas for a thorough investigation of Bernie Madoff that were repeatedly ignored despite the painstakingly detailed information he provided to investigators?

Interesting then that the new budget calls for an increase in funding for the SEC by more than 13% from its 2008 budget of $906 million. 2008 was sort of a banner year for the SEC wouldn't you say? It would've been a fantastic opportunity for the SEC to do something productive with its nearly $1 billion budget. Although the SEC was directly responsible for regulating the broker dealer community, it failed to police them during the market run up and sat idly by while the entire sector melted down last year. The SEC neglected to uncover loads of fraud and/or ponzi schemes until they unraveled by themselves due to investors calls for redemptions. Furthermore, the SEC's single action during the entire crisis during 2008 was to blame short sellers for the failure of financial firms and then institute a short sale ban that merely exacerbated the volatility in the markets. It didn't stop the insolvent firms from going bust. That's what $1 billion of our money bought. So I say cut the SEC's budget instead of raising it. To zero. What is the point of having an organization that shuffles papers and provides the illusion that someone is actually policing the market when they aren't? Anyone who can point to anything useful that the organization did in the past few years to protect investors is welcome to share their opposing views.

Nonfarm Payrolls Better Than Expected? Um, No

August nonfarm payrolls came in at minus 216,000, compared to expectations of a loss of around 233,000. Everybody can celebrate now that job losses are moderating and losses were "better than expected," except for that minor pesky detail of both June and July being revised lower by a combined 50,000. Does anyone else notice that payrolls come in better than expected and then often mysteriously get revised lower the next month? I'm not into government conspiracies but this has been bugging me recently. Oh, and the part about the unemployment rate hitting 9.7%? That's not so good either. How about the economy losing 7.4 million jobs since December 2007? Sort of bleak, wouldn't you say? But no worries, all the economists say that the recession is over. So the nearly 10% of our population that is actively looking for work but is having no luck, can always bring up that point at dinner parties to make themselves look better, right before stuffing an extra couple of canapes into their bags while nobody is looking.

Cerberus to Bar Withdrawals From Two Funds

The FT reports that Cerberus, the three-headed dog-like fund vehicle that loves to buy auto companies right before they go bankrupt, will introduce a three-year lock-up on two new hedge funds that it plans to raise later this year. The funny thing is that the only difference between the new funds and Cerberus' old funds is that this time investors actually know about the lock-up restrictions beforehand. You see, last December investors were denied access to their funds when Cerberus halted redemptions in response to a frenzy of requests for withdrawals from their clients. No doubt investors, who were entitled to withdraw funds based on a previously agreed to redemption schedule, were pissed off when their withdrawal requests were denied so that Cerberus could avoid having to liquidate assets at fire-sale (aka "market") prices. The fund has since relented and will allow investors controlling $4.77 billion, or 60% of the fund's total assets to have their money back, sort of. The funds will be placed in a wind-down vehicle and money will be returned over several years. I believe this is what is called an involuntary lock-up.

According to the FT article, Cerberus abhors the limelight and is really distressed over all the publicity, mostly negative, it has received in the past couple of years and has vowed to avoid high profile deals going forward. COO Mark Neporent states that "We were naive in thinking that buying Chrysler would not have been high profile. But we have always tried to avoid publicity. We are happy making money for our investors and leaving the headlines to others." As if the problem with its investments was that they were high profile, instead of just really dumb money-losing investments. Because piling tons of debt onto both an auto company and an auto finance company with uncompetitive cost structures, in the most cyclical of industries, at the peak of a credit cycle wasn't incredibly stupid? It was just too high profile. Right. If Cerberus manages to raise multiple billions later this year for its new hedge funds, I'll be shocked. Why anyone would give these clowns their money to manage is a mystery.

Snippets of Data

Not much in the headlines worthy of a longer discussion, but here are some interesting data points to ponder:

• ADP reports 298,000 job cuts in August. More cuts, more bad news for employment numbers.
• An upscale luxury hotel in Stockton is offered at $19 million, just a third of the $58 million in debt, liens and unpaid taxes owed on the property. The hotel opened in late 2007 and was delinquent on its loans by July 2008. But with all 42 condo units unfinished and unsold and an occupancy rate of 25%, it's amazing the place operated for that long. This must be a complete shock to all of those many travelers who demanded an upscale hotel/condo development in Stockton.
• Speaking of hotels, let's talk about one that is in a location where upscale travelers actually want to go. The Maui Prince Hotel is facing foreclosure. The Morgan Stanley real-estate fund and local developers bought the hotel for $575 million two years ago (aka "the high".) The owners failed to pay the resort's $192.5 million mortgage when it came due in July so the mortgage-holders sued to foreclose. The foreclosure threatens to wipe out the $227.5 million in mezzanine debt held by a UBS fund and the $250 million in equity that MS and its partners put into the property. To add insult to injury, the resort's manager will stop managing the property on September 16th due to a shortage of funds for pesky unimportant things like payroll. So if you hold a reservation after September 16th, you might want to cancel, unless you don't mind washing your own linens.
• A vacant parcel of land in Miami has sold for $39 million, down from the original price of $88 million in 2006. The deal, which was struck between seller Africa Israel and buyer Falcone Group got tied up by legal issues due to what appears to be a case of buyer's remorse. Sometimes lawyers really do come in handy because the delay bought Falcone enough time to put the screws to Africa Israel, now facing major liquidity problems, who agreed to the draconian price cut. Should you care about a silly $39 million land deal? Not really. But the total value of sales of vacant land through July of this year fell to $636 million, down from $5.5 billion last year. In aggregate, those numbers start to look ugly.

Market Update

It appears as if the market joined K10 in a vacation last week. I hope it had as much fun as I did. Very little happened while I was gone, the indexes were virtually unchanged, and no new economic discoveries were made. Perhaps the most surprising news is that AIG's stock somehow managed to trade at the preposterous price of $55, before falling back to a merely ridiculous $42. Traders and investors continue the great debate over whether the economic recovery is for real or if we've just experienced a quick bounce due to the record amounts of government stimulus. A Bloomberg article pits Goldman Sachs' ever-bullish Abbey Joseph Cohen against a slew of bearish hedge fund managers. Meanwhile, Calculated Risk highlights a few articles on August auto-sales and posits the important question of whether cash for clunkers was a real boost to auto sales, or if it merely cannibalized regular sales during the typically strong month of August, before falling back to abysmal levels. Meanwhile, Bank of America is wheeling and dealing with the government, to try to pay back roughly $20 billion of the $45 billion it has borrowed from TARP. Also, the bank hopes to pony up $500 million to shelve the government profit-sharing-I mean loss-sharing agreement on certain assets. If the bank can make these arrangements then it is no longer considered a special needs patient and can go about its business promising to pay its bankers egregious sums of money without any clue as to whether it can afford to or not. Speaking of loss-sharing agreements, the WSJ reported yesterday that the FDIC had agreed to absorb up to $80 billion in losses on many of the deals it had struck with acquirers of failed institutions. The FDIC has estimated that it will have to cover $14 billion in future losses on these deals. How close are these estimates to reality? Let's see, last year the FDIC had $42.5 billion in its insurance fund coffers. It now has $10 billion as of the last quarter-end. Thankfully, it can borrow $100 billion from the Treasury without having to ask for permission, and another $400 billion if it says "please." So far 84 banks have failed this year and 416 are on the FDIC's problem list. So I'm not all that comfortable with the FDIC's estimating abilities. The regulator is just hoping that spreading the losses out over time will reduce the pain? Perhaps the economy will just recover and will make the losses easier to absorb? Wouldn't that be convenient?

Regular readers of Mock the Market know that I must side with those who believe that the recent enthusiasm about the prospects for a robust economic recovery is overdone. The problem is that we went through a period of enormously easy fiscal and monetary policy in response to the tech bust, September 11 and the accounting scandals of the early 2000's. The most basic economics course will teach you that this is a recipe for inflation. Since the Fed based its monetary policy decisions on the CPI (which doesn't take housing prices into its calculations), instead of things like the quintupling of home prices in Arizona, Florida and California, it failed to notice the asset price bubble that was inflating. As assets went up in value, consumers used them as collateral to borrow more. But you can't solve the problem of an entire society that lived beyond its means by borrowing against assets that have now lost significant value by offering them zero percent financing. The reality is that we will be operating at much lower rates of economic growth until the debt overhang is resolved. It's just going to take some time.