The first time around, the three-headed federal serpent – the Bush administration, the Treasury Department and the U.S. Federal Reserve – used Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) to “legitimize” trillions of dollars worth of toxic financial waste known as subprime mortgages.

The result was the worst financial crisis since the Great Depression – a mess that was global in nature.

And we’re now headed for a repeat performance.

Some of the players may have changed since the first subprime-mortgage crisis, but the game apparently remains the same. With banks currently unwilling to lend, the new federal triumvirate of the Obama administration, the Treasury and the Fed are trying to inflate the moribund U.S. housing market. This time around, however, the FHA is the weapon of choice.

Obama & Co. are making an all-or-nothing bet that the U.S. economy will recover and bail out the housing market before the final bill for this ill-advised gambit comes due.

When this bubble bursts – and it will – U.S. taxpayers will be on the hook for more than $1 trillion in government-guaranteed debt.

Ginnie Mae: Fannie and Freddie’s Once-Quiet Cousin

As a direct result of the real-estate meltdown, U.S. banks have become reluctant lenders. And they’ve raised their loan standards considerably. Federal officials knew they had to keep the mortgage spigot open, especially to suspect borrowers, so they turned to their new “secret weapon” – the FHA.

The FHA has been cranking out new government-insured subprime loans, which it packages into government guaranteed securities for sale to banks. This frightening reflation of the subprime bubble is being engineered for two key reasons:

• To put a floor under falling house prices.
• And to let banks swap toxic Fannie and Freddie securities for new toxic debt that is 100% guaranteed by U.S. taxpayers.

The almost inevitable insolvency of the FHA could rapidly undermine the fragile recovery of the U.S. economy. And it could plunge stock prices and bank viability to new lows.

Why the FHA?

That’s simple. In an era of increasingly stringent lending standards, the FHA’s standards are laughably lax.

Created by the National Housing Act of 1934, the FHA insures private mortgage lenders against borrower default on residential real estate loans. But its current allure is that it opens the door to prospective homebuyers who almost certainly wouldn’t qualify for a conventional home mortgage. These are buyers with no credit history, a history of credit problems, or not enough cash to cover the down payment and closing costs.

The FHA has quadrupled its insurance guarantees on mortgages in just the last three years, with the bulk of that growth coming in the past two years. Currently, the FHA insures $560 billion of mortgages.

Loans that are FHA-insured are pooled and packaged into mortgage-backed securities (MBS) by the Government National Mortgage Association, more commonly known as Ginnie Mae. Ginnie Mae insures the actual MBS pools composed of FHA loans. Ginnie Mae securities are the only mortgage-backed securities backed by the full faith and credit of the U.S. government.

Two weeks ago, Ginnie Mae proudly announced that it had issued a monthly record $43 billion in FHA mortgage-backed securities, and through the end of July held guaranteed securities with a value of $680 billion. It is on track to exceed $1 trillion worth of guaranteed securities by the end of calendar year 2010.

Ginnie Mae is a cousin of its better-known siblings Fannie Mae and Freddie Mac. Those two mortgage giants are technically insolvent, and were forced into government conservatorship at the height of the financial crisis – ostensibly due to concerns that foreign central banks in China, Japan, Europe, the Middle East and Russia might stop buying our bonds. As “government-sponsored enterprises,” or GSEs, Fannie and Freddie were only supposed to have the “implicit” backing of the U.S. government. But recent events have shown these to be fully backed by taxpayers.

The implosion of Fannie and Freddie severely threatened the mortgage market. It essentially shut down the two giant repositories that bought the loans banks and mortgage originators didn’t want to hold as assets on their own balance sheets.

The FHA and its mortgage-backed securities “factory” – Ginnie Mae – have taken up where Fannie and Freddie left off, and are now the dumping ground for toxic mortgages. Using the FHA is the core strategy in the administration’s misguided effort to prop up mortgage origination and modifications, real estate prices and insolvent banks.

Warning Signals?

Administration officials might want to take heed of some eerie parallels between the current situation and the one involving Fannie and Freddie. They could serve as an early warning system.

First and foremost, the FHA has already started to acknowledge systemic fraud in its business. In the earlier subprime crisis, similar circumstances led to the revelation of massive fraud in the issuance, packaging, ratings and sale of subprime toxic mortgage-backed securities.

On Aug. 4, the FHA suspended Taylor, Bean & Whitaker Mortgage Corp., one of its largest approved independent mortgage originators, from making anymore FHA-backed loans. The suspension came one day after federal investigators raided Taylor Bean’s Ocala, Fla., headquarters.

Since 2007, the value of FHA-backed loan originations underwritten by Taylor, Bean had soared 117%. By contrast, the origination of conventional loans by the firm dropped 34% over the same period. Taylor, Bean subsequently filed for bankruptcy.

Earlier this summer, the U.S. Department of Housing and Urban Development (HUD), which oversees the FHA, raised concerns about FHA practices. On June 18, HUD released an internal inspector general’s report that revealed that the FHA’s default rate exceeded 7% and that more than 13% of its insured loans were delinquent by more than 30 days.

In a “Review and Outlook” piece, The Wall Street Journal reported that the FHA’s reserve fund dropped from 6.4% in 2007 to about 3% today, putting it dangerously close to its mandated 2% minimum. That translates to a “33-to-one leverage ratio, which is into Bear Stearns territory,” the newspaper report stated, referring to the now-failed investment bank that had been a central player in the original subprime mortgage crisis.

Bear Stearns is now owned by JPMorgan Chase & Co. (NYSE: JPM).

The HUD inspector general’s report stated that the agency’s growth makes it “vulnerable to exploitation by fraud schemes” and that it may need “Congressional appropriation intervention.”

In a recent article – “FHA Disputes Whispers of Capital Reserve Problems” – on the Mortgage News Daily Web site, HUD Secretary Shaun Donovan said in June that “there’s a better than even chance that we will stay above the two percent reserve threshold. That suggests, not just for the 2010 business, but overall for the portfolio, that we’ll more than likely to stay out of a broader need for any taxpayer funding.”

It may be more than a little disheartening to know that in a very uncertain economic environment, precisely due to fraud in mortgage lending and increasing borrower defaults, that our government is stretching a 50/50 wager on the backs of taxpayers.

That’s only part I of the FHA dilemma story.

Part II is even more frightening.

A Look Ahead

Banks are dumping Fannie and Freddie-backed securities onto the Fed’s balance sheet and replacing them on their own balance sheets with FHA-insured loans packaged into government-insured securities issued by Ginnie Mae. Banks aren’t reducing their net assets, they are aggressively swapping acknowledged toxic securities that no-one wants for a new variety that no one will want in the future. Why?

It’s not just that Ginnie Maes are fully backed by the U.S. taxpayers and Fannie and Freddie’s securities are only implicitly backed. All of them will be covered by taxpayers.

The devil is in the details.

Because Fannie and Freddie securities are only implicitly guaranteed, banks that hold these securities as assets on their balance sheets must “haircut,” or set aside reserves, based on a 20% risk-weighting assigned to the value of those holdings.

Because Ginnie Maes are explicitly 100% guaranteed, they are considered “risk free,” and on par with U.S. Treasury bonds, notes and bills. There is no reserve requirement, or haircut, on Ginnie Mae securities.

By replacing their asset mix and holding Ginnie Maes, banks don’t have to set aside reserves. They can use the money they otherwise would have to set aside to actually leverage-up their balance sheets. And guess what they’re buying?

More Ginnie Maes, naturally.

The effect of the asset swap – basically one toxic pool for a replacement that’s not much better – creates the illusion that banks have healthier balance sheets and that they are meeting their reserve requirements. It’s such a good deal for the banks and actively promoted by the Fed and Treasury, that banks are using Troubled Assets Relief Program (TARP) money to buy Ginnie Maes.

But it’s all a façade.

Capital ratios are being manipulated and insolvent banks are being propped up.

The danger of relying on the FHA to prop up the shaky housing market by facilitating mortgage origination, modifications and refinancing to less-than-stellar borrowers will only result in more subprime loans being stockpiled on the Federal Reserve balance sheet.

Eventually, defaults will overwhelm the FHA. And the hoped-for floor in residential real estate pricing will be pulled out from under us all. The next down-round in real-estate values will expose bank balance sheets for what they really are: Over-leveraged and over-stuffed with junk. Already on the ropes, banks will lose capital and will have to tighten the credit screws on consumer borrowers even more.

We may be headed for another bruising round of real-estate and MBS-related depreciation. Even a mild financial-markets setback could put the economy and the stock market onto the canvas for a 10-count. Further pummelling of shaky consumer confidence accompanied by a couple of major bank failures could easily send the U.S. market down for the financial-system equivalent of a TKO.

Taxpayers, always the lowly cornermen holding the spit buckets, are already in place with the safety nets. We will catch the FHA loans because we insure private lenders against subprime borrowers with no skin in the game. We then will have to catch the buyers of Ginnie Maes, because we guarantee those MBS securities. And we will be forced to catch the falling banks, because we already insure depositors through the Federal Deposit Insurance Corp. (FDIC).

Perhaps our ultimate fate is that of the permanently punchdrunk veteran boxer, who rues his decision to stay in the game, realizing that he fought “one bout too many.” If that’s the case, that “one bout too many” could be Subprime Crisis II, arranged by the very market referees whose job it was to protect us from such beatings.

Source: How the Government is Setting Us Up for a Second Subprime Crisis

Everyone also knows that some of the key culprits behind this financial mess were the credit-rating firms like Standard & Poor’s and Moody’s Investors Service, which assigned top-tier “AAA” ratings to investments that were actually backed by subprime mortgages and other toxic debt.

Whether it was collusion or incompetence almost didn’t matter: The firms claimed that the credit ratings they issued were constitutionally protected free speech. With this First Amendment shield, S&P, Moody’s and others said they were protected from lawsuits or other liabilities.

But that’s about to change.

A federal court judge in New York last week stripped the ratings firms of that defense, a decision that could expose the companies to billions of dollars worth of liabilities from investors who were burned by the faulty ratings.

Let’s legal case involved three specific firms – two firms that rated collateralized debt securities, and an investment bank that sold the debt. Those three companies were:

• Standard & Poor’s, which is owned by The McGraw-Hill Cos. Inc. (NYSE: MHP).
• The Moody’s Investor’s Service unit of Moody’s Corp. (NYSE: MCO), which is 19% owned by Warren Buffett’s Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B).
• And Morgan Stanley (NYSE: MS).

This particular case had been brought against Moody’s and S&P by Abu Dhabi Commercial Bank PJSC and Washington State’s King County. The case involved losses suffered from an investment in a structured investment vehicle (SIV) called Cheyne Finance. Although the debt securities Cheyne issued were backed in part by subprime mortgages, they received ratings as high as “AAA.”

In return for the high rating, the companies received higher-than-normal fees.

The $5.86 billion Cheyne Finance SIV went bankrupt in August 2007. The plaintiffs claimed fraud. The suit is seeking class-action status on behalf of investors who were burned when Cheyne was forced to dump securities it had issued between October 2004 and October 2007.

Since lawyers for the plaintiffs say the ruling could be applied to any deal involving SIVs, it could have a substantive impact. Before the financial crisis caused the value of these asset pools to plummet, experts estimate there were $350 billion to $400 billion worth of SIVs in existence.

“There certainly will be other cases filed – that’s the future impact of this decision,” San Diego attorney Patrick Daniels told The Wall Street Journal.

Moody’s and S&P had sought a dismissal, citing their First Amendment protections. But U.S. District Court Judge Shira Scheindlin ruled on Sept. 2 that securities ratings that were distributed to a small group of investors don’t warrant the same First Amendment protections that are afforded to the widely circulated ratings of corporate bonds.

Judge Scheindlin acknowledged that ratings constituting “matters of public concern” are typically protected from liability. That’s especially true when the ratings are distributed to the general public. But it wasn’t the case here.

“Where a ratings agency has disseminated their ratings to a select group of investors rather than to the public at large, the ratings agency is not afforded the same protection,” Judge Scheindlin ruled.

The ruling will likely be appealed. And it could end up in front of the U.S. Supreme Court.

The case spotlights the biggest problem with the business of rating securities: The ratings firms are paid by the issuers to rate them.

When you get right down to it, ratings firms are in business not to rate but to make money for themselves by rating issuers and their securities. The surprise isn’t that the obvious lack of objectivity fostered abuses in the credit-rating process – it’s that the problem took so long to come to a head. The complexity of mortgage-backed securities (MBS), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs) only exacerbated the investor risk.

The decision received widespread media attention. But it’s only half the story.

And the media missed the other half.

In an ironic twist that transforms the credit-rating firms into legal sacrificial lambs, the U.S. Securities and Exchange Commission (SEC) has in recent weeks acknowledged its own failure to protect the public from the same ratings firms that the federal agency mandates that investors rely upon.

This admission – combined with the legal assault on the constitutional protections ratings firms are used to hiding behind – could threaten the ratings firms’ very existence. It not only will further fuel investor ire, it could also provide litigants with additional needed legal ammunition. The ratings involve tens of billions – if not hundreds of billions – of dollars of failed securities.

A series of internal reviews by the SEC – one reaching back to last year – has highlighted some of the abuses.

About a year ago – in July 2008, to be exact – the SEC concluded a 10-month examination of the ratings industry that uncovered “poor disclosure practices and procedures guiding the analysis of mortgage-related debt and insufficient attention paid to managing conflicts of interest.”

According to the report, there was an obvious degree of knowledge and complicity in playing the ratings game.

E-mail exchanges between analysts at “unnamed” ratings firms back this up. In one, an analyst said the firm’s ratings model didn’t capture “half” of the deal’s risk, but said that the security “could be structured by cows and we would rate it.” In a Dec. 15, 2006 missive, a manager wrote that the ratings industry was creating “[an] even bigger monster – the CDO market.”

Confided the manager: “Let’s hope we are all wealthy and retired by the time this house of cards falters.”

In July of this year, in testimony to Congress, SEC Chairwoman Mary Shapiro said she supported proposals to impose liability standards that would make it easier for investors to sue credit ratings firms. That’s a bit ironic given that the SEC is charged with supervising the ratings firms.

According to the internal investigation conducted by the Office of Inspector General, the SEC failed to exercise its duties as the nation’s watchdog of the same credit ratings firms that many large investors are forced to trust.

By law, certain investors must rely on the ratings of a handful of companies, known as  “Nationally Recognized Statistical Rating Organizations,” or NRSROs. In many cases, the NRSROs determine what are “eligible” or “appropriate” investments. And it’s the SEC that determines who is, or who can be, an NRSRO.

For instance, most state insurance regulators say that insurance companies can only invest in assets that carry one of the top four credit ratings. And it’s the NRSROs that certify those ratings.

Similarly, money-market funds can only invest in the highest NRSRO-rated securities.

Countless institutions – public and private, domestic and international – rely on rules that determine what assets are acceptable investments. And that acceptability is determined by financial due diligence and the resulting credit ratings – as determined by SEC-certified rating agencies.

It’s not clear that any of this is really protecting investors, according to a Feb. 15, 2008 “Review & Outlook” piece in The Journal. Drexel University Finance Prof. Joseph Mason took a look at CDOs that were “Baa” (an investment grade rating) by Moody’s. His finding: They were 10 times more likely to default than equivalently rated corporate bonds.

In that same article, an S&P spokesperson was asked if they actually examined the mortgage debt that made up the investment pools that make up a CDO.

The spokesperson’s answer was not confidence-inspiring: “We are not auditors; we are not accounting firms.”

Source: The Credit Rating Firms Are Running Scared – It’s About Time

Everyone also knows that some of the key culprits behind this financial mess were the credit-rating firms like Standard & Poor’s and Moody’s Investors Service, which assigned top-tier “AAA” ratings to investments that were actually backed by subprime mortgages and other toxic debt.

Whether it was collusion or incompetence almost didn’t matter: The firms claimed that the credit ratings they issued were constitutionally protected free speech. With this First Amendment shield, S&P, Moody’s and others said they were protected from lawsuits or other liabilities.

But that’s about to change.

A federal court judge in New York last week stripped the ratings firms of that defense, a decision that could expose the companies to billions of dollars worth of liabilities from investors who were burned by the faulty ratings.

Let’s legal case involved three specific firms – two firms that rated collateralized debt securities, and an investment bank that sold the debt. Those three companies were:

• Standard & Poor’s, which is owned by The McGraw-Hill Cos. Inc. (NYSE: MHP).
• The Moody’s Investor’s Service unit of Moody’s Corp. (NYSE:MCO), which is 19% owned by Warren Buffett’s Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B).
• And Morgan Stanley (NYSE: MS).

This particular case had been brought against Moody’s and S&P by Abu Dhabi Commercial Bank PJSC and Washington State’s King County. The case involved losses suffered from an investment in a structured investment vehicle (SIV) called Cheyne Finance. Although the debt securities Cheyne issued were backed in part by subprime mortgages, they received ratings as high as “AAA.”

In return for the high rating, the companies received higher-than-normal fees.

The $5.86 billion Cheyne Finance SIV went bankrupt in August 2007. The plaintiffs claimed fraud. The suit is seeking class-action status on behalf of investors who were burned when Cheyne was forced to dump securities it had issued between October 2004 and October 2007.

Since lawyers for the plaintiffs say the ruling could be applied to any deal involving SIVs, it could have a substantive impact. Before the financial crisis caused the value of these asset pools to plummet, experts estimate there were $350 billion to $400 billion worth of SIVs in existence.

“There certainly will be other cases filed – that’s the future impact of this decision,” San Diego attorney Patrick Daniels told The Wall Street Journal.

Moody’s and S&P had sought a dismissal, citing their First Amendment protections. But U.S. District Court Judge Shira Scheindlin ruled on Sept. 2 that securities ratings that were distributed to a small group of investors don’t warrant the same First Amendment protections that are afforded to the widely circulated ratings of corporate bonds.

Judge Scheindlin acknowledged that ratings constituting “matters of public concern” are typically protected from liability. That’s especially true when the ratings are distributed to the general public. But it wasn’t the case here.

“Where a ratings agency has disseminated their ratings to a select group of investors rather than to the public at large, the ratings agency is not afforded the same protection,” Judge Scheindlin ruled.

The ruling will likely be appealed. And it could end up in front of the U.S. Supreme Court.

The case spotlights the biggest problem with the business of rating securities: The ratings firms are paid by the issuers to rate them.

When you get right down to it, ratings firms are in business not to rate but to make money for themselves by rating issuers and their securities. The surprise isn’t that the obvious lack of objectivity fostered abuses in the credit-rating process – it’s that the problem took so long to come to a head. The complexity of mortgage-backed securities (MBS),collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs) only exacerbated the investor risk.

The decision received widespread media attention. But it’s only half the story.

And the media missed the other half.

In an ironic twist that transforms the credit-rating firms into legal sacrificial lambs, the U.S. Securities and Exchange Commission (SEC) has in recent weeks acknowledged its own failure to protect the public from the same ratings firms that the federal agency mandates that investors rely upon.

This admission – combined with the legal assault on the constitutional protections ratings firms are used to hiding behind – could threaten the ratings firms’ very existence. It not only will further fuel investor ire, it could also provide litigants with additional needed legal ammunition. The ratings involve tens of billions – if not hundreds of billions – of dollars of failed securities.

A series of internal reviews by the SEC – one reaching back to last year – has highlighted some of the abuses.

About a year ago – in July 2008, to be exact – the SEC concluded a 10-month examination of the ratings industry that uncovered “poor disclosure practices and procedures guiding the analysis of mortgage-related debt and insufficient attention paid to managing conflicts of interest.”

According to the report, there was an obvious degree of knowledge and complicity in playing the ratings game.

E-mail exchanges between analysts at “unnamed” ratings firms back this up. In one, an analyst said the firm’s ratings model didn’t capture “half” of the deal’s risk, but said that the security “could be structured by cows and we would rate it.” In a Dec. 15, 2006 missive, a manager wrote that the ratings industry was creating “[an] even bigger monster – the CDO market.”

Confided the manager: “Let’s hope we are all wealthy and retired by the time this house of cards falters.”

In July of this year, in testimony to Congress, SEC Chairwoman Mary Shapiro said she supported proposals to impose liability standards that would make it easier for investors to sue credit ratings firms. That’s a bit ironic given that the SEC is charged with supervising the ratings firms.

According to the internal investigation conducted by the Office of Inspector General, the SEC failed to exercise its duties as the nation’s watchdog of the same credit ratings firms that many large investors are forced to trust.

By law, certain investors must rely on the ratings of a handful of companies, known as  “Nationally Recognized Statistical Rating Organizations,” or NRSROs. In many cases, the NRSROs determine what are “eligible” or “appropriate” investments. And it’s the SEC that determines who is, or who can be, an NRSRO.

For instance, most state insurance regulators say that insurance companies can only invest in assets that carry one of the top four credit ratings. And it’s the NRSROs that certify those ratings.

Similarly, money-market funds can only invest in the highest NRSRO-rated securities.

Countless institutions – public and private, domestic and international – rely on rules that determine what assets are acceptable investments. And that acceptability is determined by financial due diligence and the resulting credit ratings – as determined by SEC-certified rating agencies.

It’s not clear that any of this is really protecting investors, according to a Feb. 15, 2008 “Review & Outlook” piece in The Journal. Drexel University Finance Prof. Joseph Mason took a look at CDOs that were “Baa” (an investment grade rating) by Moody’s. His finding: They were 10 times more likely to default than equivalently rated corporate bonds.

In that same article, an S&P spokesperson was asked if they actually examined the mortgage debt that made up the investment pools that make up a CDO.

The spokesperson’s answer was not confidence-inspiring: “We are not auditors; we are not accounting firms.”

Source: The Credit Rating Firms Are Running Scared – It’s About Time

The FDIC currently insures bank depositors up to $250,000 – up from $100,000 prior to the financial crisis. So far this year, 81 banks have failed, costing the FDIC an estimated $21.5 billion.

And the situation is almost certainly going to get worse.

A Growing List of Troubled Banks

The FDIC reported yesterday (Thursday) that the number of distressed banks rose to the highest level in 15 years during the second quarter, thanks to an economic malaise that’s saddling banks with a growing level of bad loans.

The number of troubled banks rose to 416 at the end of June from 305 at the end of March. The FDIC hasn’t had that many banks on its “problem list” since June 1994, when there were 434, the agency said. Assets at these troubled institutions totaled $299.8 billion – the worst level since the end of 1993, according to the FDIC.

The FDIC’s insurance fund, as of March 31, was down to its last $13.5 billion. Bank failures in the second quarter cost the insurance fund an estimated $9.1 billion. These hits were mostly offset by an emergency special assessment of $6.2 billion and an additional $2.6 billion raised as part of the regular quarterly assessment on FDIC-insured banks.

The FDIC just took another hit due to the recent failure of Colonial Bank, which cost the fund an estimated $2.8 billion, and the failure last week of Guaranty Bank, which cost an estimated $3 billion. FDIC Chairman Sheila C. Bair is determined to not have an insolvent FDIC turn to the U.S. Treasury Department to draw on a $500 billion line of credit set up for just this purpose, although that move is clearly inevitable.

In a fatalistic twist of irony, however, the FDIC’s demand for another special assessment in the fourth quarter and another expected special assessment in the first quarter of 2010 may tip several more banks into failure.

Although there seems to be a desperate need for private equity capital to come running to the rescue, the reality unfortunately isn’t that simple.

A Disappointing Decision

As most all consumers and investors know, the FDIC only covers insured deposits. However, the ongoing cost of a busted bank becomes higher for the FDIC if the agency cannot merge that failed institution with a healthy player, or can’t sell it outright. When The FDIC can’t find a willing partner or buyer, the agency must instead manage the “unwinding” of every failed bank’s stockpile of illiquid and toxic assets. With so many more banks in trouble and so many fewer banks willing to acquire additional suspect assets, private equity firms have offered to step up and buy failed banks these professional investors believe can be turned around.

On July 9, the FDIC published and sought comments on its “Proposed Statement of Policy on Qualifications for Failed Bank Acquisitions.” The controversial proposed policy statement suggested tough terms and conditions under which the federal agency would be willing to sell failed banks to non-traditional buyers – specifically, private equity firms.

A total of 61 comments were filed during the 30-day comment period – most of them from private-equity firms, their lawyers, financial-services trade associations and lobbyists. There were also comments from academics, four U.S. senators and six individuals. The FDIC also received 3,190 form-letter comments in support of the controversial proposal.

The FDIC issued its final decision on the matter on Wednesday. The new version was much weaker, once again underscoring the federal government’s proclivity for weakening banking regulations – a willingness we’ve repeatedly warned will have dire consequences for the U.S. financial system, as well as for the broader economy.

These alterations are setting the stage for an escalation in bank failures. The real losers will once again be the U.S. taxpayers, who will end up footing the bill for the FDIC’s failure to take a tough stand.

How much weaker were the new regulations, when compared with the earlier proposals? In one instance, instead of the initially proposed requirement that new investors maintain a 15% Tier 1 common equity capital ratio – three times what traditional bank holding companies are required to maintain – the new entry hurdle is only a 10% ratio.

Private equity firms will be spared the requirement of other bank holding companies and will not be called upon as a “source of strength,” should their investment in a bank need shoring up.

Bank holding companies have to make their resources available if their banking operation requires support. But private equity companies don’t want to expose their vast pools of capital to any one investment. Just as Cerberus Capital Management LP refused to put any more money into its failed Chrysler LLC investment – leaving taxpayers to bail it out – firms are loathe to be put into a position to support a bank holding with anything more than what was deemed as a suitable capital investment at the outset.

The FDIC granted other compromises granted in favor of private equity buyers. For instance, the agency spared them from having to cross-guarantee their portfolio-bank investments – unless they owned at least 80% of two or more banks.

Getting “Real” About Private Equity

Private equity interests certainly didn’t get everything they wanted. For one thing, the final policy statement prohibits “insider” and “affiliated” loan transactions and strips firms of using a controversial “silo” structure to obfuscate ownership and control positions.

The final policy statement reads like the painful enunciation of a split decision in a controversial heavyweight title fight. The valiant efforts Bair, the FDIC chairman, to keep the howling wolves of private equity at the door and out of the banking henhouse were ultimately undermined by the rapidly dwindling coffers of the Deposit Insurance Fund, which brought the FDIC to its knees. The compromises in the final policy statement grant the private-equity crowd a lot of what it was lobbying for while only momentarily sparing the FDIC the embarrassment of being knocked out.

But make no mistake. That day of reckoning is on its way. And not even the entrepreneurially gifted private-equity set will be able to keep that from happening.

Let’s be clear: We’re not saying that the private-equity sector is made up of angels (angel investors, yes, but outright angels, no way). Indeed, as we’ve demonstrated in past columns, the private-equity set is actually a group of uber-capitalists who are hell-bent on turning their gargantuan ambitions into extraordinary wealth – and who aren’t above shopping for regulators or hardballing Congress to get what they want.

Private-equity players demanded – and got – the FDIC to agree to share whatever losses they might incur, whereby the government (meaning taxpayers) must bear the brunt of the losses incurred when risky loan pools are acquired.

In all fairness to private equity firms, acquiring banks also have loss-sharing agreements with the FDIC. But they are regulated entities and private equity firms are not. Nor will private equity firms willingly become regulated in order to buy banks.

And there are actually some advantages in having private equity investors acquire failed banks – including a host of issues that critics describe as “self-serving,” grousing that the private-equity benefits come only at a cost to taxpayers.

Given the new set of rules, private equity firms can swoop in and pick up failed banks by banding together and dividing the equity commitment and investment liability assumed upon purchase. If there is no recourse against other private equity firm assets or even any cross-guarantees against other acquired banks, unless they are 80% owned, the consortiums cannot be called upon and certainly not relied upon to be a “source of strength” for their depository, taxpayer-backed portfolio banks.

Regardless of any rules on self-dealing, as sure as “bank” is a four letter word, private equity firms will find a legal way to lend from their taxpayer-backed banks to leverage their other portfolio companies and extract their usual exorbitant fees. If they don’t lend to their own portfolio companies, they will surely lend to other private equity firms’ portfolio companies in a modified version of the “club deals” that bind them together. These firms have a mutual interest in generating deal fees and in controlling their lucrative franchises.

A Glimpse of What’s to Come

The problem with banks is that they became too leveraged. When they couldn’t amass assets on their books, against which they had to set aside “reserves,” they established “off-balance-sheet” vehicles to acquire leveraged pools of assets. They were leveraged inside and out.

But now the originators of the leveraged-buyout business model want to control taxpayer-backed banks, to apply another round of leverage to already crippled banks in order to squeeze out all the profits possible. Although this comes at a cost to duped and already drained taxpayers, regulators, legislators and the American public would be foolish to expect anything else from the private equity crowd. If the FDIC thinks it has a problem now, wait until the next implosion of leveraged banks happens.

In a comment letter to the FDIC on the original policy proposal, the Private Equity Council, an industry advocacy group, without recognizing the irony of its comment, suggested that mandating higher capital ratios for private equity buyers of failed banks would actually increase the risk at those banks because their owners would essentially have to employ more leverage to generate sufficient returns to meet the higher capital standards – while still generating returns high enough to satisfy the investors in their private-equity funds.

If that’s not an advance look at the next round of financial-sector problems we could be facing, we are deluding ourselves.

Private equity should be allowed to buy banks, but should also be held to a higher standard. They have a proven record of success at leveraging companies when they have access to cheap funding, and they also have a record of spectacular failures that resulted from their leverage. The last thing that American banks need – especially right now – is a hyper-aggressive management that leverages them to the hilt in order to generate “acceptable” rates of return for a select group of private investors.

Unfortunately, we’ve once again placed ourselves in a position where the viable solutions to the problems that were created will end up causing an entirely new set of problems – problems that always seem to provide a benefit to the old crony network while leaving the battered U.S. taxpayer as the ultimate victim.

We have no one to blame but ourselves.

More town hall meetings and more vocal opposition to being duped and used by Wall Street would be a good place to start.

Source: Desperate for Capital, the FDIC Backs Away From Tougher Rules Governing Private Equity Purchases of Failed U.S. Banks

The administration’s 88-page “white paper,” released last Wednesday (June 17), goes a long way in identifying most of the weak links in the regulatory chain that was supposed to protect America from a financial freefall. But, as always, the devil is in the details.

In 85 of those 88 pages, extensive fixes are put forth in an attempt to create additional financial institution transparency, to bolster consumer protections and to enhance supervisory oversight. But, in fewer than four of those pages, without any detail, the white paper calls for a  “regime” to “provide for the ability to stabilize a failing institution by providing loans, purchasing assets from the firm, guaranteeing the liabilities of the firm, or making equity investments in the firm.”

The blind spot in the need to create such a “regime” if it isn’t intentional – is the missed assumption that all of the reforms supposed to constitute “A New Foundation” will still not be enough to arrest the failure of systemically important firms. The black spot on the administration and legislators’ records may ultimately be their complicity in not breaking up so-called “too-big-to-fail” institutions, Instead, the current and past administrations and elected officials coddled these firms and allowed them to continue to grow in both size and influence, to the point that they became large enough and important enough – as well as frail enough – to end up as assets in an American-style, taxpayer-funded sovereign wealth fund.

A Threat to the Economy’s Free-Market Foundation

Democratic capitalism – the foundation of our economic system – has two inherent characteristics that, if left unimpeded by government interference, result in almost-certain economic success. The first is the ideal of free markets and the other is the notion, popularized by Austrian economist Joseph Schumpeter, of creative destruction. Building from the foundation is a straightforward process: Free markets will themselves engender creative destruction, maximizing the ability of innovative entrepreneurs to destroy the hegemony of existing companies by creating and delivering new and better products and services to a free-to-choose public. Government coddling or the takeover of failing institutions destroys both of these foundational principles.

Keeping our eyes on the prize necessitates not impeding free markets or the process of creative destruction. And while prudent regulation is absolutely necessary to check and arrest the ever-present bad seeds from choking our field of dreams, allowing the pendulum to swing too far in the direction of government control subjects the democratic capitalist model to attack by socialist influences. And that assault is already underway.

In the face of financial devastation in America and throughout the world, government intervention has been a welcome intrusion meant to lessen the pain of lost savings, foreclosed homes, violated security, broken dreams and the horrendous fear that many of us will never rise out of the hole created by the implosion of trusted systems we rely upon for our way of life.

The danger now is that welcoming the seeming suave of government intervention may embolden some misguided politicians and the vested-interest big-government/big-money crowd to permanently corrupt our once free markets. Government intervention has the potential of destroying the creative processes by undermining entrepreneurs and small businesses to protect an emerging and quickly growing portfolio of government-controlled assets.

If it’s not intentional, why does the administration’s regulatory reform package lead us directly down this path?  By leaving in place discredited supervisory bodies and the failed regime of ineffective regulatory officers and soldiers, does the assured future failure of protected and coddled firms signal a policy paradigm shift towards more government intervention, control and ownership of giant, systemically important firms? Are we headed towards a more socialist economic model?

I brought these concerns to Bill Singer of BrokeAnd Broker.com, a partner at powerhouse law firm Stark & Stark, a veteran regulatory lawyer, staunch advocate for the rights of smaller broker-dealer firms, registered persons and defrauded investors, and a regular commentator on television and Forbes.com panelist.

“Look, I’d love to rail against creeping socialism and state capitalism, and you may well be right – that may be the sad legacy,” Singer said. “While it would be expedient to say that I don’t like it (and, frankly, I truly don’t), I like the concept that someone, somewhere has a cord to pull in the event of an emergency – the problem is whether there is anything at the end of that line when it’s pulled, or whether it merely sets off a series of contingency steps that will only reach some final stage long after the harm is done.”

When Too-Big-To-Fail Becomes Too-Big-To-Succeed

Whether it is an intentional shift towards a more socialist economic model, or the drift from the fallout of well-intended government assistance to save jobs, firms or industries, there’s an easier, more familiar and well-proven path that should be cleared and undertaken. Start by looking backwards. If too-big-to-fail firms constitute systemic threats, don’t allow firms to get too big. It really is that simple. There is no need and no place for socialist tendencies in this country if we already know that free markets create a level playing field for all willing participants and then take steps to make sure that they are not crowed out by vested interests that are backed and protected by the government.

Regulatory reforms must ensure that free markets remain free. Part of what’s necessary is to reform the tendencies of firms to overdo the concept of economies of scale. Bigger isn’t always better if it crowds out the processes of creative destruction, the drain in the tub that can overflow and undermine the floor and foundation of democratic capitalism.

It was big banks, big super-regional banks, big investment banks and big mortgage originators that deposited us into the economic sinkhole in which we’re presently mired. Community banks and small loan originators didn’t conceive of the weapons of mass destruction, but they were forced to compete with the big brothers of business by engaging in many of the same practices and investments as a way to remain competitive or be destroyed by the sprawl of bigger, bolder, and badder brethren. Why not disallow firms to get so big they swallow or destroy all competition?

To those that argue that larger and better-capitalized foreign firms will command the high ground, I say nonsense. If we want to compete with outsized international firms, we already have a mechanism to do that. For example, banks already syndicate large loans. By having even more banks participate in syndicated loans, it spreads the credit risk across a wider array of institutions. And maybe if our automotive industry hadn’t been allowed to get so large and cumbersome, we’d have more auto firms offering more innovative products and supporting a more robust industry of manufacturers, dealers and suppliers.

There’s a Way, But is There the Will?

Of course, without being overly protectionist, prudent legislation and regulation could easily control the sprawl of overly ambitious monster foreign interests. As politicians look at the power and potential of sovereign wealth funds, there may well be an inclination to compete with them by facilitating America’s own version of such a fund. Without enunciated exit plans from the asset control and ownership now enjoyed by the U.S. government, we’re going to move in that direction. A U.S. sovereign wealth fund can carry another name – state capitalism.

By keeping the old guard on duty and only giving them new binoculars, we may well see the next set of failures on the horizon – but will be powerless to stop them. Whether intended or unintended, the result will be the destruction of free markets and entrepreneurship.

We would do well to express our outrage at the prospects of such an outcome long before the debate goes behind closed doors and we end up with an oligopoly run by a cadre of self-serving officers.

Or, as best put by Singer, the veteran regulatory attorney: “Unless we are prepared to clean house – to purge ourselves of the majority of politicians now in power and to substantively overhaul the boards of directors of most public companies into meaningful, hands-on overseers, then we’re just deluding ourselves,” he said. “This isn’t merely a battle to re-start American capitalism; it is a battle for the heart and soul of our way of life.  While it would be popular to suggest that we still have a fighting chance, I think we also need to wonder whether we have the political will to implement the wholesale changes that are necessary.”

Source: Is the Obama Administration’s Financial System Overhaul Pushing Us Toward State Capitalism?

The outcome could well determine how quickly and completely this country’s financial system rebounds from the ongoing crisis. And that outcome will also likely determine whether or not we’ll ever have to face something as dangerous and damaging as this again.

By unveiling its proposals for revamping the U.S. regulatory architecture that houses the agencies and watchdogs responsible for safeguarding the financial system that supports our way of life, President Obama is touching off a bruising battle – but one that probably has an unfortunate, and predictable, outcome. Unlike the more-aggressive overhaul proposals Money Morning previously outlined for both the regulatory system and the U.S. banking system, the reality here is that the current set of regulators will survive.

The $64 trillion dollar question was whether or not the existing limp and dysfunctional alphabet soup of regulators that were supposed to be the watchdogs of our way of life will actually be reconstituted into a new stew with the same ingredients – or whether a new kitchen crew would be empowered to stop Wall Street from force-feeding the public its same old toxic menu.

Thanks to details that have already been leaked to the public, the answer is already clear.

Front running its own public offering of a regulatory makeover, the Obama administration has been systematically leaking the guts of the “white paper” it plans to deliver tomorrow. The reason for the soft opening is that President Obama wanted to avoid a knee-jerk reaction in the financial markets. Plus, there’s a history of political backlash and negative public opinion when it comes to any balancing act regulating the powerful cabal of bankers and brokers.

The crazy patchwork quilt of regulators overseeing our banks, bankers, brokers, investment products and markets is an inventory of acronyms that includes:

• The Federal Reserve Board (FRB).
• The Office of the Comptroller of the Currency (OCC).
• The Office of Thrift Supervision (OTS).
• The Federal Deposit Insurance Corporation (FDIC).
• The National Credit Union Administration (NCUA).
• And the U.S. Securities and Exchange Commission (SEC).

But that’s not the end of it. Operating under the SEC are certain “self regulatory organizations” (SROs), including the Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board (MSRB), which police their own registered and licensed persons, the products they sell and trade and the public who they deal with.

Then there’s also the Commodity Futures Trading Commission (CFTC), and a slew of state regulators who also act to ensure the integrity of financial intermediaries, products, and markets.

The question on everyone’s mind is this: “Where were any of these kitchen hands when all the burners on the financial stove were turned all the way up and every pot on the stove was boiling over?”

Citing the myriad signals and obvious cracks that regulators missed or egregiously overlooked would easily fill a few volumes. And while it is instructive and incumbent upon us to not forget our history – lest we repeat it – there is enough still fresh in our minds to avoid dwelling on the past in favor of taking steps to make sure something this potentially ruinous never happen again.

With such a mindset, it’s natural to conclude that our failed regulatory architecture needs a serious overhaul.

In his inaugural speech, President Obama directly addressed the need for more effective and protective regulation of Wall Street. Echoing the president’s public position, Treasury Secretary Geithner recently said to the Independent Community Bankers of America (ICBA) trade group, “I think the president believes we need to have a much more simplified, consolidated oversight structure.”

But sadly, true to the inviolate nature of politics and the power of entrenched and vested money interests, this once-in-a-lifetime opportunity to actually tear down the failed structures that guarantee another economic collapse and to replace them once and for all with a substantive regulatory structure that can stave off future financial tsunamis isn’t likely to happen.

It seems that the Obama administration’s sensitivity to potentially jeopardizing what some are pointing to as signs of recovery by not calling for radical regulatory surgery has resulted in signals that the approach will instead be to empower existing regulators with more patches and some needles and thread. In a clear about-face, the administration is quietly soft-selling its upcoming agenda for regulatory reform by making the case that the overlap of multiple agencies actually prevents any one agency from being subjected to undue political or commercial interests or influence.

What the administration is billing as a “sweeping reorganization” of financial supervision actually results in few major changes – and does nothing to address the turf wars and political power of the congressional fiefdoms that serve the greater interests of their lobbying masters.

To say this is unfortunate is an understatement with no rivals.

There is nothing in the offering plate that addresses the failed doctrine of “Too Big to Fail.” While there are proposals to rein in leverage and to toughen capital and liquidity standards there are no proposed limits on curbing the monster machines of finance that will only get larger and larger and will eventually figure out how to break out of any paper cage they’re put in, meaning at some point they’ll be at large and able to threaten the world again.

There is nothing that directly reins in over-the-counter derivative products, or the sales and trading of these highly speculative (make that “gambling”) devices. Lately, we’ve been joined in our concerns by George Soros – king of speculators in his own right – calling for the complete abolishment of certain derivatives. But that’s not going to happen, because too many banks make too much money off these “instruments” of economic destruction.

As we’ve noted previously, there is nothing to stop clever players from shopping the regulatory smorgasbord of supervision servicers to find a friendly hall monitor who will accept their made-up class cutting and test-avoidance excuses.

There is nothing to rein in the U.S. Federal Reserve’s independent power as omnipotent God wagging the tail of the U.S. Treasury Department as it sees fit. In fact, the Fed will be offered more power and more control over the nation’s largest financial institutions. That makes the too-big-to-be-controlled Fed a vested partner in the drive to make the system too big to do anything but fail.

There is nothing to address who really will have the newly proposed power to unwind institutions deemed to be a systemic threat. The idea is to empower a “council” to determine just who those systemic threats actually are. Will the council’s power be absolute, or will that power go to the Fed, the Treasury, the FDIC, or all three to fight about? Although it’s unlikely that special interests would ever try to lean on any of the competing supervisors charged with threatening the life of a major corporation making many insiders very rich, it conceivably could happen. Let’s be honest – it already has.

What’s supposedly new is the idea of a consumer-protection regulator. But here’s the problem: Weren’t all the regulators supposed to be consumer advocates all along?

The inclination to retain the failed patchwork of a regulatory-quilt-in-tatters would be a major victory for Wall Street. Unless the American public wants to subject itself to more and deeper financial catastrophes, it must weigh in on the battle against the Wall Street machine.

The opportunity to recreate the walls and bridges that once were in place and have been dismantled – and to build a new and better fortification to protect the country from the greed and avarice of a few too many – is right in front of us.

And we may not have this opportunity again.

To that end, we should not be lulled into a sense of false security by believing that the existing regulatory architecture can be fixed. What’s being rolled out tomorrow is more about rolling over and pretending everything is now okay than it is about engineering real, substantive change.

It is now or never.

By electing President Obama, the majority of Americans voted for change. Whether or not we actually get that change is now largely up to each of us, and promises to be a function of whether or not we actually demand that change loudly enough.

[Editor's Note: Is it a new bull market, or just a bear-market rally that's going to separate investors from the last of their cash? For the shrewdest investors, it may not matter. A new offerfrom Money Morning is a two-way win for investors: Noted commentator Peter D. Schiff's new book - "The Little Book of Bull Moves in Bear Markets" - shows investors how to profit no matter which way the market moves, while our monthly newsletter, The Money Map Report, provides ongoing analysis of the global financial markets and some of the best profit plays you'll find anywhere - including such markets as Taiwan and China. To find out how to get both, check out our newest offer.

To read a related story on how the long-term dismantling of U.S. banking regulations set the stage for the U.S. financial crisis, please click here. That story, which appears elsewhere in today's issue of Money Morning, is available free of charge.]

Source: Wall Street vs. Main Street: The Regulatory Battle Begins Tomorrow

The truth is that U.S. regulators believed the American public couldn’t handle the truth that what had been allowed to happen, on their watch, was actually happening.

Unfortunately, we now face the same situation with credit default swaps, a derivative security that has the ability to destroy otherwise healthy companies with the virulence of a full-blown plague.

Until the American public understands this, and forces the government to take action, the odds of a repeat performance of what we refer to as the global financial crisis remain very high.

This is not an “Origin of the Species” seminal epic. Rather, it is a short story about the failure of evolutionists to recognize that, while creationism actually starts somewhere, it is actually the failure of regulators to evolve as institutions and markets change that makes monkeys of us all.

Let’s start by looking at the Federal Housing Finance Authority (FHFA), the current regulator of Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE), two players who were central to the start of the U.S. housing crisis, which became the contagion that grew into a full-blown global crisis.

It’s bad enough that the regulators who came before the FHFA were inept, but what is happening now under the FHFA is far worse, and actually has the potential to exacerbate a crisis that most taxpayers believe is being resolved.

For more than six months, the U.S. Justice Department and the Securities and Exchange Commission (SEC) have been investigating the accounting practices of the two mortgage behemoths. And now the FBI has gotten into the act. It seems that, not long ago, the FHFA hired renowned investigative firm Kroll Inc. [One of the powerful, one-named, spook-like firms – not unlike Blackwater Security Consulting – Kroll is a unit of New York-based insurance powerhouse and “risk advisor” Marsh & McLennan Cos. Inc. (NYSE: MMC)].

Kroll’s confidential report to the FHFA concluded that “inappropriate application” of accounting rules “enabled Freddie to defer billions of dollars of losses incurred from 2001 through 2004.” The source of those losses, according to a Wall Street Journal article, was derivative contracts based on interest-rate swaps.

What’s the big deal you ask? While it’s no surprise that Freddie used an inappropriate set of rules – known as “hedge accounting” – to stretch out losses over several years, rather than just take immediate hits to its profit-and-loss statement, what is frightening is that the FHFA, after hiring Kroll and uncovering the accounting inaccuracies, said it had decided “not to take issue with the accounting,” the Journal reported.

The FHFA labeled it as a “disagreement among the experts.” Call it what you want, but I call it fraud.

Here’s the problem. Fannie and Freddie are incredibly “fragile” right now (the correct financial term is probably “insolvent”). That means that the very two institutions being used by government to halt the catastrophic slide of the U.S. housing industry are so crucial to the bailout of the mortgage industry that to force these two institutions to write off more losses would only spook the financial markets even further.

As large as Freddie and Fannie are in the U.S. housing and mortgage markets, even their combined portfolio value – estimated at about $13 trillion – is dwarfed by an exponentially larger and even more insidious monster running over regulators like they’re not there. I’m talking about the $40 trillion stranglehold that the credit default swap market has on corporations all around the world.

Credit default swaps brought insurance giant American International Group Inc. (NYSE: AIG) to its knees. It was also one of the key catalysts that helped transform a housing bubble into a full-blown global financial crisis.

But here’s the rub: After all that, credit default swaps still aren’t regulated.

Of course that doesn’t mean that regulators don’t try and insert a hand here and there, it just means that the hand they insert has been feeding the monster rather than taming it. But, just recently, a good faith public relations effort was made to show the new interest the revitalized SEC has in reining in the monster from Hades.

In what amounts to a minor case with major worldwide implications, the SEC has brought insider trading allegations against a credit default swap trader and his source of inside information. It is alleged that Renato Negrin, formerly a trader at hedge fund Millennium Partners LP, received inside information from Jon-Paul Rorech, a salesman at Deutsche Bank AG (NYSE: DB). Supposedly, Rorech provided inside information to Negrin about the potential value of certain credits of VNU NV, a Dutch holding company that owns Nielsen Media and other media businesses

It doesn’t matter that Negrin no longer works at Millennium, or that both men say they are innocent, or that the alleged ill-begotten gain was a measly $1.2 million, or that the two men’s lawyers say the SEC has no jurisdiction over derivative contracts, period – let alone derivative contracts tied to European bonds.

What matters is that the SEC has finally put its toe into the muck. According to ABC News, it’s the first insider-trading case involving credit default swaps

Nothing may come of it. But I, for one, will be watching.

It strikes me as tragically ironic that after the credit-default-swap market has been allowed to grow from a few wispy hairs into the tail that wags the dog, the SEC is just now trying to be more than a flea on the tail of this monster.

The real reason we are not hearing more about the catastrophic systemic danger unleashed by credit default swaps is that even the regulators who would like to be overseeing this huge market – if for no other reason than for the regulatory-driven fee income these securities could generate – are afraid to admit this market is still poised to unleash a capitalist plague unlike any that’s ever been seen.

Just as we saw with the role Fannie and Freddie played in the housing market, the credit default swap market has gotten so large and out of control that to admit there is a problem is to admit that the problem is so big and will be so difficult to unwind that the threat can’t be thwarted anytime soon.

But until the public recognizes that credit default swaps can be used to manipulate the credit characteristics, ratings and creditworthiness of corporate borrowers – and also be used to intentionally push down stock prices in a way that destroys good companies, this derivative security will continue to hang over Corporate America and the U.S. stock market like a capitalist sword of Damocles.

It happened with AIG. And it can easily happen again.

The tarnish dulling the prospects of America’s recovery needs to be wiped clean and in its place clear transparency into the workings of the U.S. financial markets needs to be implemented. It’s bad enough that we are in this mess and afraid to admit how deep the hole is. But one thing is for sure, if we don’t create a level playing field, if we don’t expose fraud, if we don’t rein in swashbuckling traders slicing and dicing up America’s corporate backbone, we will discover that this particular hole is bottomless.

But if we’re honest about the problems we still face – as well as what needs to be done – we will find that everyone can see a clear path to steer, and will navigate our way back to economic high ground.

Our leaders might be surprised, if they would only accept one basic fact: We can handle the truth – if we know what it is.

Source: How Credit Default Swaps Could Reverse the Economic Recovery

[Editor’s Note: Uncertainty will continue to be the watchword in the months to come. R. Shah Gilani – a retired hedge fund manager and a nationally known expert on the U.S. credit crisis – has predicted five key financial crisis “aftershocks” that he says will create substantial profit opportunities for investors who know just what these aftershocks are, and how to play them. In the Trigger Event Strategist , trigger events,” as gateways to massive profits. To find out all about these five financial-crisis aftershocks, and about the trigger-event profit strategy they feed into, The Trigger Event Strategist check out our latest offer.]

]]> http://www.contrarianprofits.com/articles/how-credit-default-swaps-could-reverse-the-economic-recovery/16741/feed 0 http://www.contrarianprofits.com/articles/is-goldman%e2%80%99s-share-offering-an-attempt-to-further-ensnare-the-government/15615 http://www.contrarianprofits.com/articles/is-goldman%e2%80%99s-share-offering-an-attempt-to-further-ensnare-the-government/15615#comments Wed, 15 Apr 2009 14:40:44 +0000 Shah Gilani http://www.contrarianprofits.com/?p=15615 Not a fan of socialism? Me either. But, if the federal government has to backstop free market excesses with taxpayer dollars, how will it eventually unravel the veil, or tarp of intervention? Or should it? The answers are about to unfold before our eyes.

In the case of the government and Goldman Sachs Group Inc. (GS), a decision on whether Goldman can repay government bailout money and be freed to pay its employees whatever it wants, may determine the winners and losers coming out of this financial collapse, and what kind of government Americans will end up with.

In her extraordinary 1999 book, “Goldman Sachs the Culture of Success,” Lisa Endlich vividly chronicles the “history, mystique and remarkable success of the…

In the face of gloom-and-doom predictions, rapidly rising unemployment, and an imploding economy, the market’s strong rally clearly anticipates a recovery in late 2009.

Is this just a bunch of bull?

While everyone seems focused on the economy hemmoraging red ink from the gash in the real-estate market, the broken bones of consumer demand and the unconscious state of banking and credit markets, only the stock market, and yours truly, seems to realize that the patient is being effectively triaged.

No, I haven’t lost my senses; I’ve simply regained a sense of optimism. I never drank the poisoned Kool-Aid of markets past and am on record calling in February 2008 for investors to not only “sell everything,” but to “short everything, buy short-dated Treasuries and hold cash, not cash equivalents.” And just because I was right then doesn’t mean that I’m right now; however, like back then, the traffic lights are flashing.

This time, however, they’re green, and not bright red.

There’s no doubt in my mind that the economy has farther to fall. Unemployment will hit double digits. Yesterday, the Labor Department announced that 5.6 million Americans are out of work, and that doesn’t count those who’ve given up looking for work. On top of that it was reported that based on fourth-quarter numbers, gross domestic product (GDP) actually shrank at an annualized rate of 6.3%.

So, what are rallying markets telling us?

First of all, the U.S. Treasury Department may not actually have to spend the approximately $13 trillion in rescue programs teed-up to drive the economy. If investor perception that the U.S. Federal Reserve and Treasury plans might actually work, whatever the details end up being, then traders and risk takers will lead the investing crowd by getting in early before the herd follows suit.

That is exactly what we’re seeing now.

Second, by some estimates, there is more than $9 trillion of cash sitting on the sidelines. I haven’t heard a single market commentator – or so-called expert – illuminate the new market reality, which is that there are far fewer shares available to buyers than anyone realizes.

Since the Tech Wreck of 2000, we haven’t seen any significant issuance of corporate equity. Since late 2007, for instance, the initial public offering (IPO) pipeline flow has been virtually at a standstill.

What hasn’t been at a standstill since 2002 are leveraged buyouts. Low interest rates drove the leveraged buyout (LBO) business, which now goes by the more genteel name of private equity. Giant and once-thriving private equity shops such as KKR & Co. LLP, TPG Capital, Cerberus Capital Management LP, The Blackstone Group LP (BX), The Carlyle Group LP, Bain & Co. Inc., and a host of other multi-billion-dollar buying machines took hundreds of public companies private by purchasing their outstanding stock with leveraged debt.

What will happen to most of these debt-laden “private” companies is another story, but the word “bankruptcy” will be featured prominently in the epitaph-like final chapter of most of their stories. The point, however, is that there are fewer companies and fewer shares for equity buyers to purchase. Add into the equation a share-drop in share prices to levels not seen in decades, and “Presto:” When institutional money and eventually retail buying comes back into the market, those trillions of dollars will be chasing fewer shares at low, low prices. It doesn’t take a Wall Street rocket scientist to figure out that robust demand for cheap assets will fuel a rapid run-up in prices.

As the perception that this dead-cat bounce or bear-market rally has real legs takes hold, more committed buyers will come out of the woodwork, not wanting to miss the opportunity to average down or pick up top-notch household names at bargain-basement prices. [For additional insights on the recent run-up in U.S. stock prices, please click here to check out a news-analysis story that appears elsewhere in today’s issue of Money Morning.]

Increasingly positive market breadth and momentum technicals aside, what’s fueling my optimism is that we’re finally seeing a real effort to constitute meaningful regulatory reforms. Recent statements from President Barack Obama and Treasury Secretary Timothy F. Geithner echo my clarion calls for regulation of derivatives, market-moving hedge funds and run-amok private equity firms. This week, Geithner said he was pushing “not modest repairs at the margin, but new rules of the game.”

In addition to reigning in freewheeling leveraged wrecking machines, I see unequivocal echoes of my calls for a systemic regulator to monitor all players with the potential to single-handedly corrupt the markets, tightened and more universal accounting standards and a systemic watchdog to monitor threats to markets and the general economic health of the country.

Equally encouraging are statements that signal interest in adopting the “Spanish model” of requiring banks to set aside more capital in good times to cushion their equity and support regulatory reserve and capital ratios in bad times. Also, in a wink and a nod to stemming the moral-hazard implication of charging all banks the same Federal Deposit Insurance Corp. (FDIC) deposit insurance premiums, smaller and better run banks may not have to pony up premiums on an equal basis with insanely large and egregious and incompetently run money center universal banks.

The upcoming G20 meeting on April 2 will spotlight whether America will take charge in orchestrating a better international regulatory order by demonstrating its commitment to meaningful wholesale changes in it own feeble domestic regulatory apparatus. Clearly, President Obama had Treasury Secretary Geithner float several trial balloons this week, and clearly in the face of terrible economic data, the markets found a reason for increasing confidence.

It’s just not possible to say enough about what effects appropriate, protective, and dynamic regulations can do for investor confidence in banks, markets and the safety of committed investment capital.

Unfortunately, as far as the economy, unemployment, embattled homeowners, businesses and devastated investors are concerned, the pain may not be over. On the other hand, if the tide of investor perception flows towards the potential for a safer investing climate and roots itself in anticipation of a stampeding bull run, all boats may rise with the tide a lot sooner than the gloom-and-doomers would have us believe.

I’m looking to the future.

Are you?

Source: Stock Markets Move Past Gloom and Doom in Anticipation of the U.S. Economy’s Recovery

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