“Currently, the vast majority of banks have more capital than they need to be considered well capitalized by their regulators,” Geithner said in testimony to a congressional oversight panel on the government’s financial rescue program.

One of these banks, Bank of America (BAC), the world’s second largest in terms of market capitalization, booked a first-quarter net income of $4.247 billion – 6% more than it made in all of 2008.

So is this the turnaround Geithner et al. have been willing to beggar our nation’s future for?

Before calling your broker and placing a big order for bank stocks based on all this “good” news, it might be prudent to answer a couple questions first.

For starters, just where did all this income come from? And has credit quality really improved?

The answers to both can be found buried in a company press release bearing the encouraging title “Bank of America Earns $4.2 Billion in First Quarter.”

I’d like to draw your attention to the four most telling excerpts from this release.
1. “Equity investment income includes a $1.9 billion pretax gain on the sale of China Construction Bank (CCB) shares.”
2. “Noninterest income included $2.2 billion in gains related to mark-to-market adjustments on certain Merrill Lynch structured notes as a result of credit spreads widening.”
3. “Credit quality deteriorated further across all lines of business as housing prices continued to fall and the economic environment weakened.”
4. Nonperforming assets were $25.7 billion compared with $18.2 billion at December 31, 2008 and $7.8 billion at March 31, 2008, reflecting the continued deterioration in portfolios tied to housing.”
Now we see that out of its $4.2 billion in profits, a total of $4.1 billion came from a one-time sale of CCB stock and marking up Merrill’s book of mortgages. If you subtract these one-time gains from net income and include preferred dividends, Bank of America actually lost $1.286 billion.

As far as credit quality goes, I think number 3 above makes the situation as clear as can be.

Importantly, Bank of America is not the only big bank engaged in accounting sleight of hand.

As The New York Times article “Bank Profits Appear Out of Thin Air” by Andrew Ross Sorkin points out:
With Goldman Sachs, the disappearing month of December didn’t quite disappear (it changed its reporting calendar, effectively erasing the impact of a $1.5 billion loss that month); JP Morgan Chase reported a dazzling profit partly because the price of its bonds dropped (theoretically, they could retire them and buy them back at a cheaper price; that’s sort of like saying you’re richer because the value of your home has dropped); Citigroup pulled the same trick.

So what’s the takeaway?

When the Treasury secretary tells you banks are well capitalized and you read in the press that financial institutions have turned a corner, don’t buy it. And don’t buy the stocks of these companies either.

These days, smart investors are well advised to carefully watch the investment as well as the political landscape… because Washington’s movers and shakers’ influence on the markets has never been greater. The Casey Report investigates and analyzes those influences and trends – to find the best investing opportunities with maximum gains. You can try it completely risk-free – check out our 3-month trial with 100% money-back guarantee. Click here to learn more.

Source: Are Banks Going Bankrupt? “NO!”, say Banks

This from Martin:

If you’re an emerging-markets investor, and you happened to peruse the study that the Institute for International Finance released this week, you must’ve experienced alarm – if not panic. The IIF expects the inflow of private funds into these markets to plunge to only $165 billion this year – an amount that’s just 18% of the $929 billion that flowed into these very same markets in 2007.

For investors, the message is clear: We’d better concentrate on those emerging markets whose inhabitants have hefty piggybanks of their own.

The details of the investment slowdown are as alarming as the headline. Bank loans to emerging markets will decline from an inflow of $165 billion to a net outflow of $61 billion. Private non-bank debt investment will decline from $125 billion to $31 billion, and even official flows will decline from $41 billion to $29 billion.

Net portfolio equity investment will remain negative, though the outflow will be only $3 billion compared to 2008’s $89 billion. Only direct foreign investment will increase, rising 12% from 2008 to $195 billion.

In terms of regions, emerging Europe will suffer worst, with inflows plummeting from 13% of regional gross domestic product (GDP) in 2007 to just 1% in 2009. Latin America will also suffer, with inflows dropping from 11% of regional GDP to 3%.

Overall, inflows to emerging markets will drop by 5.8% of emerging market GDP between 2007 and 2009 – almost double the declines of the late 1990s crisis (3.7% of emerging market GDP) and early 1980s (3.2%). Emerging market cash flows will also be affected by the need to repay $223 billion of private market debt this year.

This will cause a reordering of the economic pecking order in the emerging markets.

From 2003 to 2007, the availability of natural resources and/or cheap labor was more important than high foreign reserves or a big domestic savings base, so Argentina (natural resources) and emerging Europe (cheap labor, relative to the EU average) did well.

In 2009, access to capital will be more critical than either of those other strengths. Countries without a large domestic savings base, or with substantial balance-of-payments deficits, or with low foreign exchange reserves, are likely to suffer badly.

Many emerging Europe countries have balance of payments deficits exceeding 10% of GDP so will suffer badly. Within that region, the Baltic states – fairly uncorrupt and friendly to foreign investment – will do much better than Romania and Bulgaria, which are both corrupt and xenophobic.

In Latin America, Brazil has an excellent domestic savings base, which it has been nurtured by policies that keep interest rates much higher than the rate of inflation. It is also quite friendly to foreign direct investment. Hence, in spite of its high foreign debt, Brazil should do fine.

Conversely, Mexico has a lower domestic savings base, relies heavily on remittances from Mexicans in the United States (which have declined sharply) and is quite hostile to foreign investment, particularly in the energy sector. Hence it is likely to have a tough year.

In Asia, China – with huge domestic savings, $1.95 trillion in foreign exchange reserves, and low foreign borrowing – will do fine. Conversely, India’s high domestic savings are offset by a profligate government, which runs a wasteful deficit of more than 10% of GDP. Hence India is quite reliant on foreign borrowing, and is likely to have problems.

Which ETFs the Pros are Buying

For investors, the message is clear. Our emerging markets investments must be concentrated in countries that will not be badly affected by the decline in foreign capital inflows, preferably where domestic savers have piggybanks that are large enough to fund expansion locally.

In particular, without delving into particular stocks, the following country-specific exchange traded funds (ETFs) are worth looking at:

• The iShares MSCI Brazil Index (EWZ) has net assets of $3.4 billion, a Price/Earnings (P/E) ratio of 7.0, and a dividend yield of 6%. Money Morning Contributing Editor Horacio Marquez recently recommended this Brazilian ETF in this weekly “Buy, Sell or Hold” series.
• The iShares MSCI Chile investable Index (ECH) has net assets of only $112 million and a P/E of 13. However, Chile is interesting because it built up a reserve fund of $21 billion (12% of GDP) during the years when copper prices were high – it is thus not dependent on foreign-fund inflows.
• The iShares FTSE/Xinhua China 25 Index (FXI) invests in the 25 largest Chinese companies. Net assets are $5.9 billion, its P/E ratio 10, and its yield 2.7%.
• The iShares MSCI Taiwan Index (EWT) has net assets of $1.3 billion, a P/E of 9 and a yield of 8%. Taiwan is highly liquid, with large reserves, a high savings rate and almost no foreign debt
• The iShares MSCI Singapore Index (EWS) has net assets of $800 million, a P/E of 9 and a yield of 8%. Like Taiwan, Singapore is highly liquid, with large foreign exchange reserves and little debt. Taiwanese and Singapore companies may indeed benefit from the liquidity crunch by finding attractive investment opportunities in regional cash-short emerging markets with high growth potential, such as Vietnam.

Source: The Five Most Promising Emerging Market ETFs for 2009

Private equity is an asset class consisting of equity securities in operating companies that are not publicly traded.  The name “private equity”is the rechristened, kinder and more gentile label for what used to be known as leveraged buyouts, or LBOs. But make no mistake about it, while leverage may not be part of the name any more, it remains a big part of every private equity deal.

LBO firms, or “franchises”, as Henry Kravis, co-founder of Kohlberg Kravis Roberts & Co. (KKR), likes to call his shop, acquire publicly traded operating companies. Then they streamline management and operations to increase profitability and hope to cash out through a merger, an outright sale of the company, or by taking the company public again through an initial public offering, or IPO.

Private equity firms are the debutante sisters of hedge funds. They raise huge pools of capital from pension funds, endowment funds, sovereign wealth funds, institutional investors and wealthy entrepreneurs. But while hedge funds buy and sell the stocks of companies they hope to profit from, private equity shops buy whole companies.

Generally, once a target is identified, an offer is made to buy a majority, or all of the stock of the company. The trick of the deal is to pay for the target by using as little equity capital as possible, and raising the remainder by actually having the target company borrow the required funds. Except for the private equity firm’s initial equity investment, the target company is essentially buying itself.

And if that isn’t enough of a trick, very often when the target is privatized, their new masters have the company borrow even more money so they can then pay themselves a dividend as a bonus for the good job they did in leveraging the company to the hilt so they can streamline it.

The leveraged buyout business has been around for a long time and it has worked very well for investors and the private investment bankers who make an extravagant living with other people’s money. In fact, the business was so successful it eventually led to its now very problematic fork in the road. The problem facing private equity is that their leveraged deals were at one time in such great demand that it became too easy to borrow too much money.

The result was that they chased too many deals, paid too much for targets, paid themselves too many dividends and fees, and now their portfolio companies are straining and collapsing under the weight of too much debt.

Act I: The Two Big Mistakes that Made Leveraging Possible

There are two elements that made massive borrowing possible.

The first was a ready supply of capital courtesy of the U.S. Federal Reserve’s easy money policy and low interest rates. The second was the ability of banks that lend money to acquired companies to pool those loans into securities called  collateralized loan obligations, or CLOs, and sell them off to investors. Banks and investors refer to this asset class as “leveraged loans.”

Since banks were able to sell off their leverage loans to investors they had plenty of recycled money to lend out again and again. Competition to lend out all that money put borrowers in an advantageous position, which they exploited.

Banks and non-bank lenders attach covenants to the loans they make. Typically, covenants dictate to borrowers what specific balance sheet requirements must be met and include debt-to-cash flow leverage ratios, limitations on the total amount of debt a company can carry, minimum equity provisions and other dictates that serve to secure collateral that is relied upon by lenders.

But, banks were so flush with money and so eager to lend that privately acquired companies, driven by their new private equity masters, proposed that the money they borrowed should not be encumbered by the protective covenants lenders are used to demanding. Hence the birth of “covenant-lite” loans.

Covenant-lite loans included insane “reverse covenants” that benefited the borrowers not the lenders.

Among other things, some borrowers demanded and got rights to:

• Increase debt-to-EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization) levels to 10:1.
• Freely substitute collateral.
• Have collateral “released” outright.
• Issue unsecured debt equal to the total amount of existing debt (if they hedged or effected swaps.
• Employ PIK (payment-in-kind) options, where instead of paying interest in cash they could substitute more debt.
• Employ PIK toggles, sometimes called “extendibles.”

PIK toggles (think of a toggle switch which is used to turn something on or off) let the borrower can roll interest payments into principal and extend the maturity, instead of making twice yearly cash payments. If that sounds like an option ARM mortgage, where borrowers can choose whether to pay the interest due, some part of it, or none of it, and roll unpaid interest into principal, it’s because it is the exact same borrower covenant.

It’s like déjà vu all over again.

Act II: With No Leverage Private Equity Deals Fall Apart

Junk, junk and more junk. When the music stopped and the credit crisis began last August, money and credit evaporated. Only then did it bother leveraged loan investors that the private equity guys were leveraging their private companies to pay themselves huge dividends – enough in many cases to repay the entire initial cash equity investment used to underpin the leveraged buyout of their targets. And only then did they realize that all the debt heaped onto these companies was going to drag many of them into bankruptcy.

At that point, investors simply stopped buying leveraged loans. And the net result is that banks may be sitting on over $150 billion of junk leveraged loans that they can’t place. They are taking hits to their balance sheets as they have to mark down these loans which were securitized and subject to mark-to-market accounting. And they are terrified that the recession will drive more of these leveraged companies into bankruptcy.

Thomson Reuters recently reported that 40 private equity companies have sought bankruptcy this year. According to Standard & Poor’s, of 86 S&P rated companies that defaulted this year, 53 of them were private equity related transactions. Linens ‘n Things which was taken private by Apollo Group Inc. went bankrupt. Sharper Image, Wickes Furniture and catalogue company Lillian Vernon, were all taken private by Sun Capital Partners Inc., all of them are bankrupt. Mervyn’s which was taken private by Sun Capital and Cerberus Capital Management LP. is bankrupt.

Also in the clutches of the three-headed-dog from Hades, Cerberus, is Chrysler LLC; Chrysler Financial, GMAC LLC (General Motors Acceptance Corporation) (GMA) – 51% owned by Cerberus – and Residential Capital LLC, a GMAC company. By most accounting standards, all of these companies are, if not already, close to insolvent.

GateHouse Media Inc. (OTC: GHS), 40% owned by Fortress Investment Group LLC (FIG), is at risk of debt default and may likely be headed for bankruptcy. Former Lazard Ltd. (LAZ) deputy chairman and  media honcho Steve Rattner’s Quadrangle Capital Partners may lose control of American Media Inc., publisher of The National Enquirer and Star magazine, as he battles with bondholders and may also lose portfolio company Alpha Media Group Inc., publisher of Maxim magazine. These few examples of failures are just the tip of the iceberg.

Then, of course, there’s the pure genius of PE firms coming to the rescue of troubled banks. But, TPG Capital (formerly Texas Pacific Group) doesn’t look so genius with its $7 billion investment in Washington Mutual Inc. (OTC: WAMUQ) which was wiped out in a matter of five months.

It’s understandable that bankrupt target companies are suing. Mervyn’s, for example, filed a 57 page suit against its lead dog master Cerberus, alleging fraud among other charges. But what is not as easily understandable is that some other lawsuits have the potential to turn the game viciously against the private equity firms and all the major bank lenders. I’m not talking about the deals that got done; I’m talking about the deals that didn’t get done because private equity firms walked away or otherwise tried to dissolve pending deals.

Apollo Management asked a Delaware Court of Chancery to kill a transaction it had entered into to have one of its portfolio companies, Hexion Specialty Chemicals Inc., buy NYSE listed Huntsman Corp.(HUN) for $6.5 billion. Huntsman sued and won. The judge issued a ruling that Hexion “knowingly and intentionally” breached parts of the merger agreement and ordered the company to complete the deal. Not only is Apollo being forced to go through with the deal, the ruling allows Huntsman to seek damages from Apollo. Apollo is now suing the banks it had lined up to provide debt financing for the deal.

There are hundreds of billions of dollars of abandoned deals that may now be re-visited in courts around the country. The implication for private equity firms and banks is potentially staggering.

Here are a few of the larger failed deals that resulted from a lack of debt investor interest:

• Cerberus’ failed  deal for United Rentals Inc. (URI).
• The Blackstone Group LP’s (BX) failed deal for Alliance Data Systems Corp. (ADS).
• J.C. Flowers’ failed deal for SLM Corp. (SLM), also known as Sallie Mae.
• And Appaloosa Management in conjunction with Harbinger Capital Partners, Merrill Lynch & Co. Inc. (MER), Goldman Sachs Group Inc. (GS), and UBS Securities LLC’s failed financing of Delphi Corp. (OTC: DPHIQ) to take it out of bankruptcy, for which they are being sued for fraud and conspiracy to “derail” the bankruptcy plan; a serious situation because interfering with a bankruptcy is a federal crime.

The amount of leverage involved in private equity deals is a problem if banks aren’t eager, or able, to supply needed loans. But that alone isn’t scary. What is scary is the effort private equity firms are making to actually get into the banking business themselves.

Act III: Private Equity Seeks to Corrupt Banking System

There’s a lot of pressure on banks to raise capital and there’s a lot of pressure being exerted by the private equity guys to lean on the Fed and U.S. Treasury to bend the rules to let them play in that sandbox. Pushing hard from the private equity camp are Randall Quarles, Managing Director of Carlyle Group Ltd. and a former senior Treasury official and none other than the former Treasury Secretary himself, Chairman of Cerberus Capital Management, John Snow.

What the private equity guys want is the ability to buy into banks and control them. If they get their hands on the low cost deposit-based capital at commercial banks, they’ll be unstoppable. How about having the piggy-bank, backed by taxpayers to leverage at will?

The prospect is frightening.

Right now there’s a limitation imposed on investors in Federal Deposit Insurance Company insured commercial banks. Once an investment exceeds 9.9% there must be an agreement with regulators to not “control or influence” management. If an investment exceeds 24.9% the investing entity must register as a Bank Holding Company, and subject itself to all necessary transparencies called for by regulators and the Fed. In addition, the holding company is forced to serve as a “source of strength”, meaning its capital will be called upon to support its bank.

Private equity guys do not want any part of either of those restrictions. They don’t want their business looked through nor do they want their capital encumbered. The private equity firms are sitting on hundreds of billions of dollars of fresh money raised recently. While it may seem reasonable and expedient to allow private equity capital to be infused into ailing banks, any compromise of existing regulations would result in the creation of the mother of all moral hazard enablers.

There’s no doubt that if the recession is as deep and as long as feared,, the continuing failure and bankruptcy of leveraged private equity portfolio companies will result in far greater unemployment, and in and of itself, has the potential to deepen the recession on an inordinate scale.

There’s too much greed and far too much power in the form of private equity firms. Their greed has encumbered American banks with significant CLO and leveraged loan exposure and encumbered American companies with too much debt. Now, they threaten to undermine sound banking (wait a minute, that’s already been done by the banks themselves) by investing capital into them in order to control them.

Until concrete underpinnings replace the glue and duct tape that’s holding together the banking system, and until leverage is wrung out of companies, investment vehicles and households, banks and private equity firms will both be on a slippery slope.

Source: Overly Leveraged Private Equity Deals Add to Unemployment and Deepen Recession