The latest Federal Reserve survey of senior loan officers finds very few shoots of green in that garden. According to the survey, “A significant majority of banks reported that credit quality for all types of loans is likely to deteriorate over the year.” And this assumes the economy won’t get any worse than it already is now! Here are some specifics (hat tip, Real Time Economics)

Commercial and industrial loans: Of 52 banks responding, none said they expect improving quality, but seven said they expect delinquencies and charge offs to stabilize at current levels.

Commercial real-estate loans: Only 1 of 51 banks (the other doesn’t make such loans) sees improving quality, and three see quality stabilizing at current levels. Of the 47 who see a worsening picture, 13 expected a substantial deterioration in 2009.

Prime residential mortgages: Only 1 of 50 banks sees improving quality, and seven see quality stabilizing at current levels.

Subprime mortgages: No bank sees improving quality, and only two see quality stabilizing at current levels.

Home equity lines: No bank sees improving quality, though nine expect quality to stabilize around current levels.

Credit card loans: None of the 31 banks who make such loans expects improvement, and three expect stabilization.

Other consumer loans: Only one of 50 banks expects improvement, though 12 see loan quality stabilizing around current levels.

The Federal Home Loan Bank system, a government sponsored enterprise like Fannie Mae (FNM) and Freddie Mac (FRE), has been called a shadow Fed, and is another part of the”shadow financial system” that’s been a central player in the ongoing financial mess we’re continuing to battle.

With several of the 12 Federal Home Loan Banks now losing money, their impaired ability to lend to their member banks or pay dividends may increase financial-system stress and insolvency. That has the Fed and the FDIC very worried.

And with good reason.

The FHLB system allows member banks to borrow cheaply, to use proceeds for purposes other than originally intended, to mask regulatory capital inadequacy, and ultimately to leverage U.S. taxpayers by adding to the burdens of central bank and the FDIC.

Questions regarding government backing, moral hazard, conflicts of interest and whether the Home Loan Banks inadvertently abetted the banking crisis need to be addressed immediately.

The Blueprint of the Home Loan Banking System

The Federal Home Loan Bank system, established by Congress in 1932, is a wholesale cooperative of 12 regional banks with locations in Atlanta, Boston, Chicago, Cincinnati, Dallas, Des Moines, Indianapolis, New York, Pittsburgh, San Francisco, Seattle and Topeka. It was designed to address several specific problems.

In 1932, for instance, there was no secondary market for residential mortgages, thrifts originating mortgages had to hold them until maturity. If a thrift was “loaned up,” meaning there was no more depositor funding available for mortgage lending, potential borrowers were turned away. The Home Loan Banks were chartered to make loans, known as “advances,” to member banks, after taking in their existing mortgages as collateral.

Originally, only thrifts, savings-and-loan associations, savings banks and insurance companies were allowed to be members of the Home Loan Bank system. The Financial Institutions Recovery Act of 1989 opened the FHLB system to commercial banks, credit unions and other depository institutions with involvement in the mortgage business. In 1999, the Gramm-Leach-Bliley Act increased membership reach by loosening participation criteria and lifting the cap on the amount of other real estate assets – such as commercial real estate loans – that members could post as collateral.

As of September 2008, according to the latest figures available on the FHLB’s Web site, the system has 8,154 member institutions, $1.429 trillion in assets, and has extended $1.012 trillion in advances – which has resulted in $88 billion in mortgage loans. The fact that the FHLB hasn’t updated its assets and advances to reflect activity through the end of the year may be more a failure to be timely than it is a hint that there are problems afoot. Still, given that we’re in the midst of the worst financial crisis in modern history, updated data on membership, assets, advances and mortgage creation, should have been a priority.

The Hidden Costs of Cheap Money

The problem begins with the FHLB’s easy ability to raise the money it lends to members.

The FHLB funds itself by issuing debt instruments across the world’s capital markets. But because the FHLB is a government-sponsored enterprise (GSE), the debt it raises is not only a joint obligation of the regional Home Loan Banks, it is also considered an obligation of the United States government. The de facto government backing means an investment grade AAA rating from all the major rating agencies. And that means that the FHLB can borrow at a very narrow spread over Treasuries – in other words, cheaply.

Perhaps if FHLB members just used borrowed capital to facilitate mortgage lending in their respective regions, the fallout would’ve been localized. But in a 2007 U.S. Federal Reserve report, “Federal Home Loan Advances and Commercial Bank Portfolio Composition,” authors W. Scott Frame, Diana Hancock and S. Wayne Passmore determined that the banks were, relatively speaking, no longer fulfilling their primary purpose. The authors concluded that:

• Capital advanced by the Home Loan banks is “just as likely to fund other types of bank credit as to fund single-family mortgages.”
• Unexpected changes “in all types of bank lending are accommodated using FHLB advances.”
• Some banks “appear to have used FHLB advances to reduce variability in commercial and industrial lending in response to macroeconomic shocks.”

There are two problems with members borrowing cheaply and easily from the system:

The first issue is one of moral hazard. Not having to rely on core deposit growth or pay higher fees to attract deposit capital through CDs, member banks, able to borrow freely, are less constrained in their efforts to grow. The lack of any “risk premium” imposed by the FHLB on members doesn’t differentiate good borrowing members from suspect borrowers and actually may incentivize some banks to take greater portfolio risks.

The second problem is that many banks may actually be using these loans to mask capital inadequacy. There have already been some egregious examples of FHLB advances propping up sick institutions.

From the end of 2004 to the end of last year, IndyMac Bancorp Inc. (OTC: IDMCQ) increased its borrowings from the San Francisco Home Loan Bank to more than $10 billion, an increase of 500%. At the time IndyMac failed, that money accounted for a third of IndyMac’s liabilities. In November, when asked why the Home Loan Bank helped keep IndyMac afloat, FHLB spokesperson Amy Stewart told MSNBC.com that “it’s not our role to cause a liquidity problem for a member institution.”

Not one to be denied a place at the FHLB trough, Countrywide Financial Corp., as it was reeling from mortgage losses in 2007, borrowed $51 billion from the Atlanta Home Loan Bank branch, which U.S. Sen. Charles E. Schumer, D-N.Y. accused CEO Angelo Mozilo of using like a “personal ATM.” But the winner, so far, has been Washington Mutual Inc., which the FDIC says tripled its FHLB advances to $58.4 billion – or almost 20% of its assets – before it collapsed.

Problems Looming?

At a time when global financial leaders are working hard to end the banking crisis and restore confidence in the still-functioning institutions, insolvent banks that are actually being propped up by FHLB advances pose a devastating possible threat to these objectives. Potentially insolvent banks pose an overwhelming threat to the FDIC, and virtually none to other member banks that may inadvertently be abetting insolvency.

The FHLB has never suffered a loss on any advance. Because advances are “collateralized claims,” they have a senior position under U.S. bankruptcy law. FHLB claims are repaid before other claims, including those of the FDIC.

In its November cover story, “Banks on the Edge,” Bloomberg Markets magazine quotes Tim Yeager, a former Fed economist who is now a finance professor at the University of Arkansas at Fayetteville, as saying: “The Federal Home Loan Banks cannot effectively control or monitor the risks that are in these institutions.”

That’s not a problem for the FHLB, according to John von Seggern, president of the Council of Federal Home Loan Banks, a lobbying group for the FHLB.

“We’re not the regulator, our role is to be the liquidity provider,” he told the magazine.

But liquidity loans are a big problem for the FDIC. According to that same Bloomberg article, FDIC Chairman Sheila C. Blair said “we really get a double whammy. We have a beef with excessive reliance on Federal Home Loan Bank advances.”

It stands to reason that if FHLB advances spell trouble for the FDIC, they spell even more trouble for the Fed and the U.S. Treasury Department, which will inherit the problem and be forced to bail out the FDIC when its dwindling deposit-insurance fund is exhausted.

In fact, the government is not only worried about funding the FDIC, it is so worried about the potential solvency of Federal Home Loan Banks that on Sept. 7 – the day after then-U.S. Treasury Secretary Henry M. “Hank” Paulson Jr. announced the bailout of Fannie Mae and Freddie Mac – he quietly extended a secured line of credit to the FHLBs – “if needed.”

The time of “need” may be nearing. At the end of February, the Federal Home Loan banks of San Francisco, Pittsburgh, Boston and Chicago reported write-downs on heavy losses on mortgage securities, and some banks had net losses. The Pittsburgh bank reported a loss of $187.9 million for the fourth quarter; the Boston bank reported a loss of $73.2 million; and the San Francisco bank reported a loss of $103 million for the quarter – a major swing from the net profit of $231 reported in the comparable quarter the year before.

Just last Wednesday, according to The Seattle Times, the Federal Home Loan Bank of Seattle announced it took a fourth-quarter net loss of $241.2 million, and said it took a $304.2 million charge for impaired securities on its balance sheet. In addition to its statement that full-year results will be posted by March 31, the bank said it failed to meet a regulatory capital requirement at the end of last month and that because of its capital deficiency it is disallowed from paying a dividend or repurchasing its capital stock from members. Members rely on dividends and their ability to sell back capital stock to their district banks to additionally bolster their own balance- sheet capital. The F ederal H ome L oan banks of Atlanta, Pittsburgh and Indianapolis have already suspended or delayed dividends, the newspaper reported.

No one really knows what might happen if all of the system’s financial dirty laundry is aired, given how many banks are being propped up by FHLB advances. For the member banks reliant on that capital, the graver concern is what might happen if FHLB funding dries up. If that’s the next shoe to drop in this ongoing financial crisis, the worry is that an entire leg – the banking system – comes with it.

New and stronger regulations – and absolute transparency – are necessary to wean banks off these “easy-money loans” from the Federal Home Loan Banks and “hot money” from brokered deposits, the FHLB’s other evil twin.

Like a flash-fire in an untouched part of the woods, just as fire crews have finally gotten a series of deadly wild fires under control after months of battling, a crisis and scandal in a heretofore untouched portion of the U.S. financial sector could have a demoralizing and devastatingly damaging impact on the long battle to subdue the financial crisis – just as it seems some gains have been made.

With the opportunity to act before this fire really gets started, let’s not waste weeks or months in debate. The time to act is now. We need to “Just Do It.”

Source: “Shadow Fed” Casts a Shadow Over the Solvency of the U.S. Banking System

There’s always a bull market somewhere, the cliche goes. Today — and so far in 2009 — Shanghai’s been a surprisingly good spot to place your bets.

The Shanghai Composite climbed another 6% yesterday. Rumor has it the Chinese government is considering doubling its own economic “stimulus” package, from around $580 billion to $1 trillion… maybe more.

There are a couple data points being published lately that have traders excited. The Chinese purchasing managers’ index, for example, rose to 49 in February, just a hair short of the contraction/growth score of 50 and an improvement from November’s record-low score of 38.

The Chinese sovereign wealth fund has been pumping money into its biggest banks, too. And with the fall of financial giants here in the U.S., those Chinese banks are becoming, umn, relevant. Middle-class demand for goods and housing, while slowed, is still growing.

A record 20% of all U.S. residential mortgages were “underwater” in December. That means more than 8.3 million mortgages carried more debt than the value of the home they were borrowed against. The “sand states” — California, Nevada, Arizona and Florida — have it worst. For example, 50% of all Nevada mortgages were underwater in the last month of the year.

“The accelerating share of negative equity, combined with deteriorating economic conditions, means that mortgage risk will continue to increase until home prices and the economy begin to stabilize,” said Mark Fleming, chief economist of First American CoreLogic, which published the survey. No word on what happens if they don’t.

Private American companies shed 697,000 jobs in February, ADP claims today. The payroll management company’s gauge of monthly employment registered 83,000 more schlubs kicked to the curb than the Street expected… and marks the 14th straight month of decline.

The Bureau of Labor Statistics (BLS) is expected to announce 650,000 job losses in February. If ADP’s report is any indicator (and that’s a big “if”), Friday’s BLS report will be worse than expected as well.

Regardless of the accuracy of either report, you can get a pretty fair look at the employment scene by charting both. Look very closely and you might spot a trend.

Even we’re getting bummed out by these numbers.

Doing its part, the U.S. auto industry had its worst month in 27 years during February. Sales crashed 41% year over year, to an annual pace of “just” 9.1 million. That’s the slowest pace since 1981… amazing, especially considering there were around 75 million fewer Americans back then.

A year ago, yearly sales exceeded 15 million cars and trucks.

Tired of driving their own hybrids to Washington, GM execs are now pleading with European governments for bailout bucks over the phone. The degenerates’ case: Without a multibillion-dollar boost, up to 300,000 Europeans will lose their jobs when GM’s EU plants run out of money. Hmmn… that sounds familiar, doesn’t it?

GM is asking Germany for $4 billion in exchange for partial ownership of European operations. The FT says the automaker is also in talks with the U.K., Spain and Poland. Just what the global economy needs, eh? A global shakedown.

The stock markets opened decidedly higher this morning. After stumbling to a small loss yesterday, the Dow popped up 100 points at the opening bell today… for… umm… no real reason at all. Other than this curious sound bite:

“What you’re now seeing is profit and earning ratios starting to get to the point where buying stocks is a potentially good deal,” newly elected president turned financial adviser Barack Obama said yesterday, “if you’ve got a long-term perspective on it.”

Here’s a question: How many of the retiring baby boomers with gutted portfolios and bitch-slapped pension plans have a long-term perspective “on it”? Solid, like Barack.

“We are quite confident,” added Fed head Ben Bernanke yesterday before Congress, “that we can raise interest rates, reduce the money supply and do that all in a timely way to avoid any inflationary consequences.”

The chairman marched to Capitol Hill yesterday to defend his multitrillion-dollar campaign to save us from ourselves. He insisted that he “had no choice” but to bailout AIG, and soothed lawmakers with assurances like this: “If there’s a single episode in this entire 18 months that has made me more angry, I can’t think of one other than AIG.”

Grr…

And as the Fed chairman massaged Congress with one hand, the other quietly orchestrated the first day of the Term Asset-Backed Securities Loan Facility (TALF). (That sounds dirty, doesn’t it?)

Between his printed dollars and taxpayer dough lent from the Treasury, the program to rekindle student, auto, credit card and eventually mortgage loans will have a war chest exceeding $1 trillion.

“The question facing every investor today,” writes Eric Fry, “and the one that could wield a very large influence over one’s investment fortunes — is whether deflation or inflation will hold sway during the next couple of years.

“To preview our conclusions: We’re betting on inflation.

“No one knows, least of all Ben Bernanke or Timothy Geithner, if the Fed will conjure up one dollar too many. And no one knows if the Fed could ever coax its magical deflation-fighting dollars back into the cauldron, once their services were no longer needed.

“At least, in theory, no one knows…

“In reality, everyone knows: The excess dollars will never return to the cauldron. They will escape into the economy at large, where they will run rampant, and cause the price of eggs to increase to $10 a dozen…or $20…or maybe even $100…

“And what if inflation arrives much sooner than expected? What if the widely anticipated deflation never materializes? The holders of long-dated Treasuries would fare very, very poorly. And the nonbuyers of gold would be very chagrined, at best. So consider this two-part question:

“1) Is the 2.89% yield of a 10-year Treasury so thoroughly compelling that it justifies risking an enormous capital loss (if inflation appears sooner than expected)?

“2) Are commodity plays at their current depressed quotes so thoroughly risky investors should continue to shun them, no matter the price?”

Oil has snapped back $3, to $44 a barrel. Most of the buying support today comes from the Far East, as the latest momentum from China gives traders hope that the world’s second biggest user of the gooey black stuff is still guzzling away.

But gold isn’t getting any love today. The spot price fell another couple bucks overnight, now at $910 an ounce.

“The monetary and banking problems driving gold higher for months have not disappeared,” James Turk assures us. “They will remain for the foreseeable future because the imprudent lending by banks will take years to unravel, highlighting the essential need for a safe haven for one’s money.

“Gold is the safest of safe havens because it does not have counterparty risk. Gold also preserves purchasing power, which is an attribute that will become increasingly important in the months ahead as all the new money being printed by central banks around the world takes its inflationary toll.

“Gold has not yet made a new record high in U.S. dollars, but I expect one soon.”

After hitting a fresh three-year high yesterday, the dollar index is still holding strong today. It scores just under 89.

“I get asked all the time,” notes EverBank’s Chuck Butler, “how long will this dollar strength last. I said some time ago that I believed that by late summer/early spring, the credit markets might be showing signs of unlocking, and that could bring the risk takers back out from under their respective rocks, and that a return to the fundamentals would bring about an end to the dollar strength. The end of July marks one year of dollar strength, when the you-know-what hit the fan with subprime loans and this whole lockdown of credit and liquidity caused a huge deleveraging in the markets.

“While I still believe this thought has merit, I also have to figure in the fact that the previous stimulus plans didn’t work, the money was wasted on Wall Street buddies and cronies… And now we need another one, but only this new one is centered on the wrong things. So I’ll be watching for signs. If none appears, then I’ll have to go back to the drawing board.

“So in an environment when ‘bad news’ rewards the dollar… and the bad news just keeps coming along, that’s not a good sign for a reversal of dollar strength right now. When what used to be called 100-year events now happen almost weekly.”

“The reader commenting that the best thing for China, et al., to do,” writes our first reader today, “would be to cut Americans off from funding and provide tough love may be missing a big implication. If an unreformed alcoholic is TOLD to stop drinking and his bottle is forcibly removed, do they graciously thank you or come up swinging?

“I believe that if America had its funding removed, we would be fighting World War III within weeks. Ever better to maintain the facade BUT take advantage of opportunities within the charade.”

“If I have time to read only one of the many, many e-letters that I get daily,” writes another reader, ”The 5 is that one. Keep up the great work!”

“Many thanks for continuing the best daily read around anywhere,” says a third.

And a fourth: “You guys are the best…love your timely and wisdom-filled 5 Min. letter.”

“Thank you!” writes a fifth. “Your ongoing thoughts on the markets are ALL excellent, even the ones I don’t agree with. Your thoughts make me think, and sometimes differently to my original thoughts.”

The 5: Thank you! You’ve always been gracious to The 5, but lately, we’ve been getting an awful lot of one-line thank you notes. We’re starting to get suspicious. How about some criticism? If there’s anything you think we’ve been missing or would like to see more of in our daily digest, by all means… let us have it: 5minforecast@agorafinancial.com

And seriously, thanks for reading. It’s our pleasure.

China Bucks the Trend, GM Goes to Europe, Inflation Prediction, Jobs and More!

The second quarter has seen lower client-related trading volumes, little banking activity, losses related to ineffective hedging and reversals of gains on fair valuing liabilities, [Citigroup analyst] Prashant Bhatia wrote in a note dated May 16.

He expects significant asset sales related to leveraged loan inventory, and commercial and residential mortgages as a result of a greater degree of liquidity in the marketplace.

“While the environment seems to have improved considerably in May, it will not offset the considerable weakness in March and April,” he added.

Meanwhile, consumer sentiment is getting “extremely grumpy”, according to a report by Jennifer Yousfi on Money Morning.

Mirroring the stagflation of the early 1980s, consumer sentiment hit its lowest level since that time period this month as short-term inflation continues to ramp up.

The Reuters/University of Michigan preliminary index of consumer sentiment dropped to 59.5 in May from 62.6 in April. The index is at its lowest level since June 1980. Consumer confidence was at 85.6 as recently as 2007.

“The consumer is getting extremely grumpy,” Brian Bethune, director of financial economics at Global Insight Inc., who had forecast a decline in the confidence index to 59.6, told Bloomberg News. “The economy is flirting with a recession. The only thing keeping it out is this huge amount of pump-priming going on,” including aggressive interest-rate reductions by the U.S. Federal Reserve, the government’s stimulus package and deep discounting by retailers.

Lower-income households are feeling the rising prices at the pump and grocery store most acutely, the survey showed, as such households were the main cause for the index’s fourth consecutive monthly decline.

The buck declined despite some upbeat news from the Institute for Supply Management. The ISM said nonmanufacturing sectors of the U.S. economy expanded during April after three months of contraction. Its services index rose to 52.0% from 49.6% in March. That handily beat economists’ projections for a decline to 49.4%.

Analysts believe traders were locking in their gains from last week’s rally, which was based on signals from the Federal Reserve that it is near the end of its interest-rate cuts. The dollar index, which charts the greenback against a basket of currencies, rose 2.5% last week.

Currency strategists at Brown Brothers Harriman are of the opinion that the “pieces of the puzzle we believe will contribute to a U.S. dollar uptrend this year are beginning to fall into place, but more pieces are needed for a more significant U.S. dollar rally.”

But the good feelings were diluted considerably by a report from the Federal Reserve on the credit crunch, which continues.

More than half of the banks surveyed by the Fed said they had tightened commercial and industrial loans, commercial real estate loans, residential mortgages, and home-equity lines of credit. Almost no banks eased credit terms for any type of loan, the Fed said in its quarterly senior loan officer survey.

“The significant tightening of standards for consumer loans is probably the ugliest news of this report,” wrote Harm Bandholz, of UniCredit Markets. “Investment will continue to shrink, while private consumption growth will come to a halt or even turn negative” in the second quarter.