I call them the “zombies,” the institutions being propped up by government bailouts. Companies like Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC), General Motors Corp., Chrysler LLC, etc. On an operating level, these walking dead are sucking the life out of the recovery.

Unlike in previous downturns, huge resources have been devoted to propping up entities that should have been taken out of the picture.

Of course, it’s easy to avoid zombies directly. No one is going to force you to take a position in GM. But if you really want to know where to look for the bargains – for companies that have the greatest potential for serious growth in real numbers and real markets – you need to look for what I call “zombie-free zones.”

Unfortunately, the United States and the United Kingdom are not “zombie-free” zones – and thus offer the worst hunting ground available right now.

If you’re looking for something solid, there are only three places to aim your portfolio. In fact, my top three picks are…

Germany, Korea, and Canada.  All have an abundance of companies you can invest in with at least a good chance of not being forced to compete with the undead.

The Problem with Zombies

You see, the problem with zombie banks and companies is that they soak up resources that should be devoted to living banks and companies, while providing unfair competition that makes their competitors unsound.

It’s difficult to see this effect at the moment, because the U.S. Federal Reserve is propping up the banking sector. It’s much clearer in the automobile sector, where the zombies GM and Chrysler make it more difficult for Ford Motor Co. (NYSE: F) to compete. There’s no question that the continued existence of Chrysler after its first non-bankruptcy in 1979 drastically weakened Ford in the 1980s and 1990s.

There’s the effect on wages too. The United Auto Workers (UAW) union is a huge supporter of the GM and Chrysler rescues, partly because they keep UAW members employed at above-market wage rates. One certainly can sympathize with the great many American autoworkers that have lost their jobs, but by keeping the sector over-employed, the government is driving up wages and hurting businesses – particularly Ford, the only member of Detroit’s “Big Three” to not ask for a bailout.

The same effect can be seen in the banking sector. The bonus pool at JPMorgan Chase & Co. (NYSE: JPM) is partly inflated by the continued employment of all the Citibankers who should have lost their jobs. Since banking pay scales got over-inflated during the bubble, it is reasonable now for them to come back down to earth, but that’s not going to happen while banks are in their current undead state.

Turning to the international market, it is immediately clear that Britain has the same problem as the United States, only on a larger scale. Royal Bank of Scotland Group PLC (NYSE ADR: RBS) and Lloyds Banking Group PLC (NYSE: LYG), two of Britain’s largest banks have been kept open by the government. (Though, to be fair, Lloyds only got in trouble because the government made it acquire another failing bank, HBOS.)

Financial services is a huge part of Britain’s economy, which needs to diversify, but it won’t be able to diversify if so much of its talent is locked up in banking, and its best graduates are sucked into the high-paying dealing rooms of the City of London.

Japan has the same problem. Here the zombies are really ancient, cobwebbed skeletons left over from the 1990 collapse of Japan’s bubble. Some of them were put out of their misery by Junichiro Koizumi, the reformist prime minister, in 2003. Yet just this week we learned that many Japanese retailers face losses because of competition from The Daiei Inc. and Ito-Yokado Co. Ltd., gigantic retailing companies that were effectively bankrupt in 1993 but have been propped up by Japan’s banks. If you’re afraid of zombies, Japan is really creepy!

Historically, Europe is the continent where investors have suffered most from zombies propped up by governments. Certainly some countries, notably Italy, are attractive only for investment necrophiliacs.

Where to Find “Zombie-Free Zones”

There are some exceptions. Germany has only a few relatively small zombies. Both Sachsen LB and IKB Deutsche Industriebank AG, the banks that got in trouble buying U.S. subprime mortgage-backed bonds, have been sold to other buyers – Sachsen to a larger Landesbank and IKB to the private equity group Lone Star Funds. Whatever their subsequent fate, those banks are currently being managed on a profit-maximizing basis.

There is a large older zombie, Hypo Real Estate Holding AG, the former Bayerische Hypothekenbank, which got in trouble in the late 1990s lending to real estate in the former East Germany, but that appears an isolated example. Industrially, Germany has been admirably rigorous in cleaning up its dead companies, and with its new pro-market government looks attractive for zombie-fearing money.

In Asia, South Korea is probably your best bet. The country had a big zombie problem ten years ago, but that problem has been cleared up with the bankruptcy and reorganization of several conglomerates and much of the banking system. This time around, there have been few major casualties and so the economy looks relatively zombie-free.

Finally, there is our northern neighbor, Canada. Canadian housing never became as over-extended as U.S. housing, and the Canadian bank bailout was correspondingly smaller, with none of the banks facing bankruptcy. Canada had a bad zombie problem fifteen years ago from decaying heavy industry, but today those zombies are long gone and the Canadian economy is resilient. The most recent bankruptcy, Nortel Networks Corp. (OTC: NRTLQ) in Jan. 2009, is being handled in a thoroughly market-oriented fashion, with its assets being sold off piecemeal. So your money is safe in Canada – lots of snow, but no zombies!

Source: Why You Need to Look at these Three ‘Zombie-Free Zones’

U.S. Federal Reserve Chairman Ben S. Bernanke and Congress agreed Friday that the financial system – not the American taxpayer – should bear the costs of bank bailouts. Sheila Bair, head of the Federal Deposit Insurance Corp. (FDIC), wants the banks to ante up $45 billion – three years’ worth of deposit-insurance premiums – to bail out the fund that insures bank deposits.

When it comes to bank stocks, we all know that there were a number of Money Morning readers shrewd enough to buy Citigroup Inc. (NYSE: C) shares when the foundering giant’s stock price was below $1 a share.

If you’re one of those investors, good for you: With Citi’s shares now trading at nearly $4.70 a share, that shrewdness – or courage – has been amply rewarded.

But the question we have to ask at this point is: Why would anyone buy banks stocks right now?

Bailouts Revisited

When the Bush administration bailed out the banks last autumn, I opposed the bailout. But I understood the rationale for it. The Lehman Brothers Holdings Inc. (OTC: LEHMQ) bankruptcy had clearly done a lot of damage to market confidence. Thus, a series of high-profile failures – however well merited – could push the market into a behavioral funk that might take years to emerge from.

After all, as we were incessantly reminded, the banks were all intimately inter-connected – not in the least by the diabolical credit-default-swap market. So a big failure could trigger a mass-market meltdown.

That justified the immediate bailout back then. But it did not justify the continued existence of those banks and other financial institutions – especially Citi, Bank of America Corp. (NYSE: BAC) and insurance giant American International Group Inc. (NYSE: AIG) – a year after the bailout.

Even if there was an argument for preventing the immediate meltdown of those companies – to prevent panic – there was no good argument for allowing them to continue in business as zombies, distorting the market forever after. An orderly liquidation was what was really needed.

But if the plans called for these three bad actors to be liquidated, it should surely be happening by now. Two of the three have even kept their top management for the intervening year. The exception has been BofA, where Chief Executive Officer Ken Lewis is now being shoved – kicking and screaming – toward the exit. (However, I have no doubt he’ll end up being well rewarded for the indignity).

Japan’s ‘Lost Decade’

Economically, keeping banks and other companies alive after they should be dead is the mistake Japan made back in the 1990s. After Japan’s massive stock market meltdown, most of the banks were technically insolvent. A decline in the value of the stocks the banks held had gnawed away their capital, while their assets were shredded by the collapse in the value of their real-estate loans.

Despite this, Japan opted to prop up many insolvent companies, which kept the country’s entire banking system on life support until 1998 – hence the “Lost Decade” of financial legend. And a true resolution of the problem did not come until it was forced by Prime Minister Junichiro Koizumi in 2003. The result was more than a decade of economic stagnation and a mountain of public debt that actually exceeded 200% of gross domestic product (GDP).

For the banks themselves, the fallout can be even worse.

An ‘Artificial’ Market

At first blush, the profits of the last few months look pretty good. And the record bonuses being threatened on Wall Street suggest that all is fine. However, there are two problems. First, bank earnings have been propped up by an extraordinarily bank-friendly monetary policy, keeping short-term interest rates at close to zero and buying up more than $1.5 trillion of bad bank loans from the markets.

That simply can’t last. If it does, we’ll end up with a bad case of hyperinflation.

As for the bonuses, does anybody think that if Citi had gone bust, and ex-Citibankers were now selling apples on the street corners of New York, bonuses would be zooming so high?

If the market for overpaid bankers had been allowed to clear properly, they would no longer be overpaid.

If the Japan’s Nomura Securities (NYSE ADR: NMR) wanted to double its U.S. staff, as it announced Monday (an extraordinarily shareholder-hostile decision, given Nomura’s lousy U.S. track record), it could just lean out of its office and whistle, and a parade of ex-Citibankers, ex-AIG executives and ex-BofA execs would rush in, begging for scraps.

It appears that the concerns that Soros expressed are well justified.

A Grim Reaping For Bank Investors

Since there are more competitors in the market than there should be, once the Fed’s over-generous monetary policy is corrected, there will be too much competition, so bank profits will be squeezed. Conversely, there will be too many jobs in the industry, so banker pay scales will be artificially propped up.

If that’s a recipe for good shareholder returns, I’m a Dutchman.

There’s more. The populist fury against the banking system doesn’t look like it’s doing much about banker pay. However, it will almost certainly result in special extra taxes being levied on surviving banks, to pay for the bailouts.

The costs of those taxes will be passed through to shareholders, because competition from all the zombies that are still in business will prevent banker pay from being squeezed much. The extra levies that Bair, the FDIC chief, is employing to keep the deposit-insurance fund solvent also will fall on banks, although in this case it will be the small and medium-sized that will suffer the worst.

Squeezed profits, expensive staff, extra taxes and special FDIC levies – it doesn’t look to me as if there will be much left for bank shareholders.

Expect 2010 to be a grim year for them.

Source: Hidden Traps Make Bank Stocks a Bad Deal

On one hand, the $130 billion he spent on acquisitions – FleetBoston Financial Corp., MBNA Corp., LaSalle Bank Corp., Countrywide Financial Corp., Charles Schwab Corp.’s (Nasdaq: SCHW) U.S. Trust private banking unit and Merrill Lynch – that more than tripled the size of Bank of America, making it the largest U.S. lender both by assets and deposits.

On the other, his open-wallet policy and the example it set forth almost perfectly encapsulates the boom, bust and nascent rebound of the U.S. housing and banking crisis – which later became the financial plague that devastated markets all over the world.

In the second half of 2007, the extent of the U.S. housing crisis began to crystallize when Countrywide’s freewheeling subprime-lending policy irreversibly sank the nation’s largest home lender. Lewis moved in and acquired the troubled lender for $4 billion the following January, and in doing so, he put Bank of America on the hook for Countrywide $1.5 trillion loan portfolio.

In the second half of 2008, the extent of the how much havoc the destruction of investment banks and brokerage firms would wreak upon the world became clear. The vortex of it was Sept. 15, the day the Lehman Brothers Holdings Inc. (OTC: LEHMQ) declared bankruptcy and Bank of America agreed to pay $29 billion for world’s largest brokerage firm, Merrill Lynch, which probably would have failed had it not found a partner.

Lewis’ spending got Bank of America into this mess. The question now is whether continued  spending – using the $45 billion bailout courtesy of the U.S. Treasury’s Troubled Asset Relief Program (TARP) – will get BofA out of it.

And Lewis seems to acknowledge both in the news release announcing his voluntary departure.

“Bank of America is well positioned to meet the continuing challenges of the economy and markets,” Lewis said. “We are in position to begin to repay the federal government’s TARP investments. For these reasons, I decided now is the time to begin to transition to the next generation of leadership at Bank of America.”

Lewis naturally defends his actions just as much as critics chide him for them.

“Their loan portfolio is horrible looking and it’s not going to be easy for them,” Mike Williams, research director at Gradient Analytics in Scottsdale, Arizona, said in a Bloomberg News interview before Lewis announced his departure. “They would have been better off without the Merrill and Countrywide acquisitions over the next few years.”

Money Morning Contributing Editor Martin Hutchinson, a leading banking expert, says that Bank of America has a very difficult journey ahead of it.

“Lewis followed [predecessor CEO Hugh] McColl’s strategy of expanding BofA by acquisition,” he said. “The trouble is that his last 2 deals were both lousy. Countrywide was at the epicenter of all that was bad about housing finance, and that was obvious in January 2008, when he bought it. Just a terrible deal.”

In fact, Hutchinson believes there’s only one viable option for Bank of America.

“BofA will have to be broken up, but may need to be sorted out by a liquidator/ the government,” he said.

Spinning Merrill

The Merrill merger was perhaps the defining moment in Lewis’ tenure, and he Lewis has played the victim and hero of the saga.

Lewis testified that U.S. Federal Reserve Chairman Ben S. Bernanke and former U.S. Treasury Secretary Henry M. “Hank” Paulson Jr. pressured him not only to move ahead with a merger with Merrill Lynch despite reservations, but also to stay quiet about the mounting losses at the crumbling investment bank.

And in a note to employees announcing his departure, he took credit for the fact that Merrill has contributed 24% to the Bank of America’s first-half profit, boosted trading and investment-banking revenue, Bloomberg reported.

“I am gratified that even some of the critics of our acquisition of Merrill Lynch have come to acknowledge how well the deal is working out for our clients,” Lewis wrote. “This journey has been a rocky one and not for the faint of heart, but perseverance is paying off.”

But to the rest of the world, Lewis was most often seen sitting under the hot light of probes by Congress, the U.S. Securities and Exchange Commission (SEC) and New York’s attorney general all trying to determine if Lewis misled investors about Merrill’s losses and bonuses.

And even if shareholders agreed with Lewis’ decisions, they didn’t prefer him to be the company’s face. In April, shareholders voted 50.34% in favor of stripping Lewis of his chairman title.

Changing of the Guard

When Lewis steps down from his post Dec. 31, he joins the ranks of fellow financial firm executives – James Cayne of The Bear Stearns Cos., Charles Prince of Citigroup Inc. (NYSE: C), Stanley O’Neal of Merrill, Kennedy Thompson of Wachovia and Richard Fuld of Lehman Brothers, John Thain of  Merrill Lynch – that resigned, many in disgrace, either during or in the aftermath of the global financial crisis.

Among the survivors, Lloyd Blankfein, CEO of Goldman Sachs Group Inc. (NYSE: GS), and Jamie Dimon, CEO of JPMorgan Chase & Co. (NYSE: JPM).

Bank of America said it will find a replacement by Lewis’ last day, and media outlets have already began making lists of possible successors.

Among the names frequently mentioned:

• Brian Moynihan, head of Bank of America’s consumer and small business banking unit.
• Sallie Krawcheck, former Citigroup Inc. (NYSE: C) CFO and president of Bank of America’s global wealth and investment management unit.
• Tom Montag, former Merrill executive and head of Bank of America’s corporate and investment banking unit.

An outsider might well be the best choice, says Money Morning’s Hutchinson.

Lewis is “leaving a company that no human being could manage, with vast problems, and far too broad a franchise,” Hutchinson said. “North Carolina retail bankers haven’t a clue how to run a top international investment bank like Merrill and vice versa. There’s nobody available to succeed him that can do the job.”

Source: Boom, Bust and Rebuild: Bank of America and the Kenneth Lewis Legacy

Now likely less than $10 billion strong and with more bank failures sure to come, the FDIC faces two choices: Raise their taxes on banks to bolster the fund or tap the Treasury. Given the health of the U.S. banking system and the tendencies of our government over the last decade, you can probably guess which Bair will chose. Here’s another hint… Barney Frank, leader of the House Financial Services Committee, has already publicly opined on what Bair should do.

The FDIC has the authority to borrow as much as $500 billion through 2010.

“Stock market bulls aren’t concerned about the inevitable acceleration in bank failures — at least for now,” Dan Amoss told his Strategic Short Report readers just before Irwin’s failure. “Even though deposits will be insured against loss, the loss of local banks will still have a depressing effect on hundreds of small communities. These communities are going to lose their only access to business credit when their local zombie banks — loaded with toxic construction or commercial real estate loans — are liquidated or merged into other weak banks.

“Meanwhile, the latest monthly figures show that commercial bank balance sheets are shrinking at a fairly rapid rate, due to a combination of several factors: loan charge-offs, older loans being paid back at a faster rate than new loans are being made and regulators pressuring banks to build larger capital buffers.

“So credit-fueled growth in consumption or investment is not occurring. Combine this with stagnant or declining wages and corporate profit margins and it becomes hard to imagine how GDP will rebound on a sustainable basis.”

Source: The Next Big-Gov Bailout

Commercial property values in the U.S. have plummeted 36% since peaking in 2007, and the commercial real estate market is unlikely to recover before 2012, according to the quarterly PricewaterhouseCoopers Korpacz Real Estate Investor Survey, released yesterday (Tuesday).

Office rents in New York and San Francisco may drop 20% through next year, the survey found.

“The biggest problem is that commercial real estate lags what happens in the economy,” Susan Smith, who is the director of PricewaterhouseCoopers’ real estate advisory practice and editor-in-chief of the survey, told Bloomberg News. “Companies are looking for ways to cut costs, many are continuing to reduce workers and are continuing to reduce their space needs.”

That means many of the banks that made commercial real estate have only realized a fraction of their losses. And as those losses continue to mount, we’re likely to see more and more bank failures.

Roughly $530 billion in mortgage-backed securities are due for refinancing between now and 2011, according to property researcher Foresight Analytics LLC. Foresight estimates that the U.S. banking sector could incur as much as $250 billion in commercial real estate losses, enough to cause a as many as 700 banks to fail, in that time.

The FDIC’s “problem list,” or banks that run a higher risk of failure, grew to 416 in the second quarter, up from 305 in the first quarter. That’s the highest number since the second quarter of 1994, when there were 434 banks on the list.

San Francisco-based Wells Fargo & Co. (NYSE: WFC) has the largest share of the $3.1 trillion commercial debt market with 16.5% of its $821 billion loan portfolio invested. JPMorgan Chase & Co. (NYSE: JPM) is a distant second with 5.4% of its portfolio invested in commercial loans, followed by Citigroup Inc. (NYSE: C) with 3.4%.

However, smaller banks – 92 of which have already folded this year compared to 25 last year – are even more at risk because they will likely have a harder time accessing the crucial capital to offset rising defaults, according to the TARP-inspired Congressional Oversight Panel’s August Oversight Report.

“Unlike large banks that can sustain a certain number of defaults, even of large commercial loans, smaller banks may have far more difficulty in absorbing more than a few large loan losses,” the panel said. “The FDIC’s statement that ‘banks have been able to raise capital without having to sell bad assets through the LLP’ may not reflect the reality for these banks.”

Indeed, the number of smaller banks expected to seized by the FDIC (Federal Deposit Insurance Corporation) is forecast to accelerate by economists. More than 150 publicly traded U.S. banks have nonperforming loans that account for 5% of their assets, according to the report.

The panel said rising commercial real estate loan defaults may prompt the need for $12 billion to $14 billion more in TARP funds as well as well as stress tests for smaller banks.

The early 1990s saw a devastating crash of the real estate market, but this coming time around the result could be far worse. The $3.1 trillion that makes up the commercial real estate debt market is three times the size it was during the early 1990s – meaning the potential for losses is steeper than ever before.

In 1993, less than 2% of U.S. banks and thrifts had an exposure to commercial real estate that was more than five times their Tier I capital. By the end of last year, that ratio had spiked to 12%, involving about 800 banks and thrifts.

And this time around – compared to the early 1990s – banks left themselves no margin of safety in the form of “Tier I Capital” – a measure of how well a lender can navigate serious levels of losses. The higher the ratio, the less likely a lender will be able to work its way through a stretch when loans start going bad.

Source: Bank Failures Could Surge as Commercial Real Estate Losses Continue to Mount

Guaranty Bank in Texas became the 81st U.S. bank to fail this year. It was the 11th largest bank failure in U.S. history. This kind of thing is becoming so regular it is hardly news when it happens.

But what’s interesting to point out about this one is that the FDIC sold Guaranty to Banco Bilbao Vizcaya Argentaria of Spain. This is the first time regulators have sold a failed bank to a foreign lender. Such a turn of events would have been unthinkable only a decade ago.

So the world turns. When it comes to the question of who has the money, it’s often a non-U.S. buyer these days.

Speaking of foreign buyers, there is probably no group of buyers more watched and coveted than Chinese consumers. Recently, the Financial Times had a piece that highlights things the Chinese like to buy.

This is important because the Chinese are becoming increasingly affluent in large numbers. Total consumer spending was $1.7 trillion in 2007, compared to $12 trillion in the U.S. But that number is growing rapidly. The FT focused on the new rich. China now boasts more millionaires than the U.K. The rapid growth of this group has companies all over the world spending more money and time figuring out ways to get in their pockets.

So what do the affluent Chinese like? Outside of ordinary things like flashy cars and booze and quirky things like ivory and dried seahorses, one thing was mentioned in the FT piece that caught my eye: The Chinese love gold.

“China loves gold in all its forms,” the FT reports, “as a reserve currency, jewelry, an investment.” I’ve mentioned in the past about how the Chinese central bank doubled its holdings of gold this year, but it’s more widespread than that.

The rising middle class in China also buys a lot of gold. Since 2007, Chinese consumers have been the second largest purchasers of gold jewelry in the world, behind only India. The FT points out those gold sales were up 28% year over year in May. Total gold demand for the year was up 21%, to 400 million tonnes. There are not too many sales of any kind going up that much in this financial crisis, but there it is.

The financial crisis and weak stock market have helped gold as people look for a place to park some money. I think gold will remain a good place to be for some time yet. And gold stocks have the stars lined up for them. Many are reporting falling cash costs, yet the price of gold is staying up here in the $900s — and is likely headed much higher. That means gold stocks are reporting good increases in cash flow, among the few sectors to do so.

The Growth Is Overseas

As to the larger picture, I think trends in overseas markets should continue to be a focus, and I will keep on an eye on them. The U.S consumer is pretty well tapped out, finally. The growth is overseas.

Over the weekend, Barron’s featured a worthwhile interview with Chris Wood, the Hong Kong-based strategist for CLSA’s Asia-Pacific group. He’s been on top of some of the bigger-picture developments in Asia for years — sniffing out trouble in Thailand before the Asian crisis in 1997, for instance, and, more recently, giving early warning calls on the global troubles that would emerge after the U.S. mortgage market imploded.

What’s Wood’s take today? “The financial crisis in the Western world will lead to a long period of anemic growth,” he says. “From a global investor’s standpoint, Asia and the emerging markets stand out as a place to invest.”

When you look at some of the data rolling in, it is hard not to see it. For instance, earlier this year, oil consumption in the developing countries passed the top 30 (OECD) countries for the first time. There are now more cars sold on a monthly basis in the top 16 emerging markets than there are in the U.S., Japan and the EU combined.

More opportunities will emerge, as many of these markets are only in the early innings of the most commodity-intensive part of their development. As a result, we’ll see a lot more power plants, water treatment plants and the like built over time. Then there are the agricultural needs, not only to support population growth, but to support the boost in biofuels.

Biofuel Boom

Steven Johnston at AgCapita, a firm dedicated to investing in agriculture, put together a worthwhile newsletter. In the latest update, the group shows how biofuel production is on the rise:

This trend will surely continue, as most of the oil-producing countries have in place biofuel targets whereby they mandate that a certain amount of fuel must be biofuel. AgCapita’s own research indicated that the biofuel targets in the U.S., the EU, Canada, Japan, Brazil, India and China alone could require the use of over 400 million acres of arable land, or over 10% of the world’s total. This is in direct competition with food production and should have a significant effect on crop prices.

What a lot of people overlook is just how fertilizer-, water- and energy-intensive these biofuels are. So agriculture remains another attractive market to invest in right now in what otherwise looks like a time of tepid growth. That means opportunities in fertilizer stocks, grain handlers, farm equipment and farmland.

Have a good week, and I’ll write you again soon.

Regards,
Chris Mayer

Source: What Chinese Money Buys: Gold Goes Green

“Banks recover to their levels before the fall of Lehman,” is a headline in this Monday’s El Pais from Madrid.

“Public assistance enables the world’s largest 15 financial firms to return to the capitalization they had in September 2008,” the article continues. The largest of the largest, HSBC, is now judged to be worth $186 billion, according to the stock market. China’s ICBC is on its heels, with a market cap of $178 billion. BNP Paribas is 7th at $87 billion.

We will overlook the compromising detail that banks actually lost money in the last quarter – more than $3 billion. And let’s forget that China’s major banks are sitting on mega-losses from more than eight years ago (to say nothing of the more recent losses). Western banks, too, still have billions in assets whose real worth is an open question…and subject to quick reconsideration…

El Pais goes on to report something intriguing: “The two big Spanish banks leave the crisis stronger.”

Ah. What doesn’t kill you makes you stronger. The world economy is recovering, or so people believe. Stocks are going up – led by the banks. But are the undead of the banking world really stronger?

Ha ha…don’t make us laugh.

But the world seems to believe it. The Wall Street Journal reports that just five big financial stocks are behind the stock market’s rally. Fannie Mae (NYSE:FNM), Citigroup (NYSE:C), Freddie Mac (NYSE:FRE), Bank of America (NYSE:BAC) and AIG account for nearly a third of market’s daily turnover. Seems everyone is speculating on the banks…and moving them higher.

You will recall, dear reader, the banks made a fortune during the bubble years. You may also recall that they made so much money that when the bubble years came to a close, that they were almost all broke. Without hasty action from the feds, it would have been the end of the road for every major bank on Wall Street. As it was, even with government help, none of them survived intact. They all either went bankrupt, were sold off, or got bailouts with strings attached.

What busted the banks was too much of a bad thing. They made their money by peddling debt. In order to move the stuff, they convinced clients that their products were good safe investments – even leveraged derivatives backed by subprime mortgages! Such good salesmen were they that they even convinced themselves. When the crisis came, they realized that they had been buyers of the debt…as well as sellers of it. What could they do with it…except sell it to the feds?

But the whole financial industry is coming back to life. According to El Pais, it’s back…and it’s better than ever.

But wait? How could that be? Hasn’t the world entered the worst recession since the great depression? How could lending money be such a good business? People don’t borrow in a recession.

Strategic Short Report’s Dan Amoss is just as skeptical. “The banking system has no experience managing through the current ‘negative home equity’ environment,” he tells us. “This is an environment in which mortgage rates are already about as low as they can get and consumer balance sheets are as stressed as ever. Due to the nonrecourse nature of mortgages, most borrowers have no financial incentive to keep paying. Many are choosing to mail the keys back to the lender.

“This problem will cap the upside of bank stocks for years to come, so the sector will offer lots of short selling opportunities.”

Borrowing by households has fallen off a cliff. Instead of borrowing, they’re paying back debt at the fastest rate since the ’50s. No money to be made there.

How about commercial and business loans? Are you kidding? Businesses are cutting back too. Businesses borrow to expand…and there is no expansion going on. This is a contraction. Credit is contracting along with everything else.

Then, how could the banks make money? Let’s refer to that news item again. Oh…there are the magic words: “Public assistance enables…”

The banks are making money the same way Detroit is making money…dishonestly and temporarily. Instead of doing honest deals with willing and able counterparties, the banks are pulling a fast one. Their money comes, ultimately, from the poor taxpayer…the poor sap who funds all the government’s giveaways. The private sector lived far beyond its means during the bubble years. People wasted their money they didn’t have on things they didn’t need. Now, they try to save their money. But now the government wastes their money for them.

Speaking of which…a quick note on the Cash for Clunkers program. Numbers to be released today are expected to show a peak in sales in August caused by the feds’ incentives. President Obama calls the program a showcase, proving how effective government can be at getting the economy back on the road.

But let’s go back to basics. It’s a sham when people waste their own money. It’s a crime when they waste other peoples’ money. Prosperity comes from accumulating (saving) capital…and using it to increase productive capacity. The formula is pretty simple: Save your money. Invest it in productive business. The Clunkers program encouraged people to do the opposite – consume capital, other peoples’ capital.

’Nuff said.

We were going to let Ted Kennedy go to his grave without mention here at The Daily Reckoning. The newspapers, television and radio shows have mentioned it enough. Even the foreign press has taken note of the event.

We might have let it go, but we have taken an oath: whenever we see a bubble we must pop it. And there is a bubble in Kennedy worship so big it threatens to blot out the sun. Today, we approach with a needle.

No writer has failed to mention that Mr. Kennedy was not the first of the clan die. The press cannot resist hero worship – especially when its heroes die young.

The Kennedy brothers could have lived comfortably all their lives on their father’s liquor money. Instead, they took up the banner of ‘public service’ and wrapped themselves in it so tightly it suffocated them all. The oldest of the band was killed in WWII. Ted Kennedy’s grave lies only 100 feet from his brother, Robert, killed in 1968 while running for president. And only another 100 feet from another brother who was shot down five years earlier. With that kind of curse on a family, you’d think the younger bro would have gone back into the liquor business. Instead, the younger held his head up…headed for glory…and drove off a bridge. The bridge probably saved him. Had he made it beyond the primaries, some nutcase would have certainly taken a shot at him.

The bridge incident would have sunk a lesser man – that is, one who lacked the name, family connections, lawyers, and money of Ted Kennedy. It probably would have sunk a more reflective, more sensitive man too. A man with a sharper conscience might have seen the girl’s face in his dreams and have been driven to drink…eventually drowning himself in his own guilt, like a character from a Russian novel. But Kennedy had the ability to rise above shame and put scandal behind him, with some helpful amnesia from the press. Chappaquiddick is reported in today’s press as though it were a personal triumph. A lesser man would have gone to jail for manslaughter; Kennedy went on to become the ‘lion of the Senate.’ He merely gave up his presidential aspirations and buckled down to the life of a Senate hack. The eulogies tell us that driving off the bridge, drunk, made him what he was: “the greatest legislator of all time,” as the President put it.

No, we never shared the conservatives’ loathing for the man. We never met him. Had we known him personally, we probably would have found him as agreeable a drinking companion as anyone else. But we come neither to bury Ted Kennedy, nor to praise him…we merely poke fun at the world that idolizes him.

The fact that the Kennedys committed themselves to ‘public service’ seemed to make them part of the furniture of public life. Everywhere you looked, there they were. The newspapers loved them. Everyone knew what they looked like. Hairdressers knew their private lives. Taxi drivers suffered their personal tragedies as if they were one of the family.

But the Kennedys were more than just furniture. First, because they were not particularly useful…you couldn’t sit on them or dine on them. More importantly, when it came to decorating the republic, they were the ones who wanted to arrange the furniture.

All the obituaries hammered this point as if they were hardening steel: “He devote his life to public causes…” says one. “He fought for the poor and the downtrodden…” says another.

He said so himself. In a letter to Pope Benedict XVI, Kennedy seemed to write his own obituary. He allowed as how he had “done his best to champion the rights of the poor and to open doors of economic opportunity. I’ve worked to welcome the immigrant, fight discrimination and expand access to health care and education…”

USA Today provides a typical illustration of the Senator’s magnanimity and generosity.

A woman with an autistic son asked the government for help. “The Haitian immigrant wrote to her senator, ‘the only one who can understand what it takes to raise a child with disabilities.’” (Kennedy’s son lost a leg and his sister, Rosemary, was mentally disabled. This, according to USA Today, gave him “a connection with the public’s private pain.”)

“Within three weeks,” the news item continues, “they secured vocational and life skills training [for the son]…that allowed his mother to finally earn a college degree last year at age 58.

“I have my life back and my son is no longer under by my care 24 hours a day…”

No…now he’s under someone else’s care! Kennedy redecorated. He moved the cost of caring for the poor fellow on to someone else.

And what does the mother do with her free time? She’s now a “community organizer.” You can bet she’s organizing more transfers…of money from the people who earned it to the people who didn’t.

“He was always reaching out,” said Democratic strategist Donna Brazile. Yes, he was always re-arranging the furniture. And USA Today told us that he inspired a whole race of redecorators – people infected by a desire for ‘public service.’

“Hundreds of lesser-known former Kennedy staffers and campaign volunteers…followed him into public service…The alumni of his office pepper the government…”

But what is the consequence of all this meddling? Is the nation better off for it? None of the obituaries we saw even raised the question. How do you know if something is genuinely a public service? Is it a public service when you take money from one person and give it to another? The press seems to think so. Is it a public service when you load up the nation with hundreds of billions worth of programs and pet projects?

Kennedy was a prolific proposer…a serial legislator…a Tom Friedman with a Senate seat. Surely some conservative think tank has totted up the cost of all his legislation. And surely it is in the hundreds of billions of dollars. Where did the money come from? It had to come from somewhere. It has to come from people who had ideas and plans of their own…people who had put the couch under the window and the TV in front of the easy chair, just the way they wanted it. Were they really any better off when Kennedy moved things around? Was the republic stronger, healthier, more prosperous and more honest after the Kennedy brothers got through with it?

We leave you with the question.

As for Ted Kennedy, the man was a scalawag. But he was God’s scalawag; and all His creatures deserve our respect. And now that he’s in the dirt, God will do with him as He chooses. RIP.

Until tomorrow,

Bill Bonner

Source: The Undead of the Banking World

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

More consumers are turning to their checking accounts for purchases, and this could make for a significant boost in overdraft fees. Charges related to overdrawn accounts this year may add up to $38.5 billion following last year’s $36.7 billion, according to data from research firm Moebs Services Inc.

The shift from credit to debit cards means banks still have another avenue to collect lucrative fees despite legislation signed in May by U.S. President Barack Obama that protects consumers from excessive fees and last-minute contract changes such as interest rate hikes.

“Fee abuse hasn’t disappeared in banking with the credit- card legislation,” Tony Plath, a finance professor at the University of North Carolina Charlotte told Bloomberg News. “It’s just migrated to checking accounts.”

If President Obama gets his way, a new consumer protection agency would be formed and have the power to ban “unfair, deceptive and abusive practices.” This puts the Obama administration at odds with the U.S. Federal Reserve, the agency that is currently tasked with regulating such practices.

Overdraft fees, which account for more than 75% of all bank fees, could make or break some banks. Without the fees, 45% of the banks and credit unions would have been unprofitable, according to Moebs.

“Banks are returning to a fee-driven model and overdraft fees are the mother lode,” Mike Moebs, founder of Moebs Services, said in an interview with the Financial Times.

The largest banks charged the largest overdraft fees: The median fee among banks worth $50 billion or more, including Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC), JPMorgan Chase (NYSE: JPM) and Wells Fargo & Co. (NYSE: WFC), is set at $33.  The median fee among all banks is $25 to $26.

Fees for overdrawing an account can be astonishingly high when calculated as an annual interest rate. For example, a consumer who overdraws an account by $20, repays the bank in two weeks and pays a $27 fee, would be charge the equivalent of a 3,520% annual interest rate according to a study conducted last year by the Federal Deposit Insurance Corp.

Higher fees at bigger banks are appropriate because they do not know their customers as well as smaller local banks, and need to be compensated for the higher risk, Nessa Feddis, general counsel at the American Bankers’ Association told The FT. Consumer advocacy groups reject this, saying that overdrafts are the least risky form of credit, and the most expensive for consumers.

“The banks own your paycheck before you do, so the only way you can default on your overdraft is if you choose to open another account and deposit your income elsewhere,” said Eric Halperin, director of the Center for Responsible Lending.

Source: Hefty Overdraft Fees Raise Banks’ Profits and Consumers’ Eyebrows

And I’m going to give you a chance to join them.

If you think Canada escaped the downward trend in U.S. banking, think again. While the country may not have plunged headfirst into subprime mortgages, it did dip heavily into risky derivatives. The leverage it took on generated impressive returns on equity in good times, but that same leverage is set to wipe out equity today.

Shareholders in one “safe” Canadian bank will have to rethink their loyalty. Its looming solvency crisis practically guarantees a dividend cut. And that’s our catalyst for this month’s short play action – offering us a chance for 200% profit potential.

Accounting secrets have not yet obliterated Canadian bank earnings – like those of U.S. banks – because the Canadians have not yet accounted for the coming tsunami of mortgage, consumer loan, and corporate loan losses.

Here’s how they loaded those loan books with hidden risk.

The Basics of Bank Accounting

Bank shareholders leverage their capital by borrowing short-term money, primarily from depositors. Your bank account is an asset for you, but it’s a liability for your bank. For every dollar of capital, bank shareholders borrow 15, 20, or even 30 dollars from senior creditors – otherwise, they could not afford to own their huge portfolios of loans and securities. Here’s the core problem: Bank shareholders and their agents (bank executives) are lending other people’s money. So bankers are looser with lending than if they were lending their own savings.

The accounting process to determine commercial bank profits is inherently speculative, as well. Banks book an upfront profit on every new loan they make, minus a small “provision” for loan losses – just in case some loans wind up going bad. These upfront profits have the habit of disappearing when loans “season,” and banks discover how many deadbeats owe them money. In case you’ve been wondering what has wiped out the majority of the S&P 500’s trailing earnings, here’s your answer: Banks and brokerages reversing most of the profits they booked on loans made and securities bought at the peak of the bubble.

Banks claimed to make good money loans to every borrower. But somebody sure was lying, since they’re taking charges against these older vintage loans and securities left and right. And the industrywide provision for loan losses, which is the single most important – and unpredictable – cost in a bank’s income statement, has been soaring. Once these provision expenses soared on the backs of delinquent loans, the banking sector’s earnings plunged deep into negative territory.

Throw in a few more explosive ingredients like deposit insurance, central bank lending facilities, loan syndication, and securitization and we’re left with a system for which sales volume – not risk management – is priority No. 1.

Those who claim the banking system is well capitalized – including those who designed the unstressful “stress test” – hold rosy assumptions about how many loans will go bad and how much banks will earn from existing loans to have a shot at outrunning their credit losses.

Lots of bank stocks remain in a fragile state. This month, we’re going to buy puts on the Canadian bank most ready to fall. And now’s your chance to join us. If you want the name of my latest play, just click here to learn more about Strategic Short Report.

Regards,
Dan Amoss

Source: Don’t Bet on Canada’s Banks