Shadow Banks, Shadow Government

Here at Financial Jenga, we don't often comment directly on politics - being much more inclined towards economics. We are also equally skeptical of both groupthink and conspiracy theories - which tend to be opposite sides of the same psychological coin. However, the sheer scale of the current crisis and many of the proposed solutions make this problem inherently political. It would also appear that many of the "fixes" being bandied about won't actually fix anything but WILL benefit certain politically-connected parties.

There is considerable evidence that the proposed $700 billion bailout of Wall Street will do little to fix the credit problems. One of the key arguements used by supporters is that banks don't have enough money to keep lending. This is simply a lie. The latest Fed H.3 report shows that excess reserves in the banking system were $68.8 billion as of 9/24/08. This is 1400% above any other datapoint for the past year and more than 2000% higher than the average for that time. In other words, the Fed has FLOODED the banking system with borrowed money (the excess reserves) and the banks STILL won't lend.

In the real world, you cannot conduct fully-controlled experiments to validate an economic theory. But to the extent that it can be, we have already tested the thesis that giving banks more money will cause them to lend more and found it to be flawed. The most likely outcome of the bailout appears to be many banks saved at taxpayer expense but we get a credit crash and recession-depression anyway and Main Street has even less money to struggle through it since it will have been given away to Wall Street. Basically, it redistributes the losses for past transgressions from the guilty to the innocent and does little to help the future. We therefore oppose the bailout on both economic and moral grounds.

Hitting the Panic Button
According to various media reports, the supposed experts threatened Congress with all sorts of terrible repercussions if the bailout was not passed immediately and without strings. From their public statements, our representatives have been told that failure to do so would result in an immediate end of credit, a stock market crash, massive layoffs and likely a new Great Depression. As regular readers here know, many of these consequences ARE likely but they do NOT stem from the lack of a bailout for Wall Street. They are the DIRECT result of the orgy of foolish lending that preceeded the bailout request. Paulson and Bernanke are using their control of information and the ignorance of the politicians to run a bluff. We are being threatened with consequences that are likely to come in any event and the bailout won't change that.

In many ways, the financial authorities are taking active measures to make the crisis worse. The Fed has been withdrawing liquidity from the financial system for over a week. According to the Slosh Report, system liquidity topped at $190 billion on 9/18 and fell to $110, $110, $90, $65, $63 and $59 billion on subsequent days. With the Fed deliberately cutting prior support, it's no wonder the short-term stress has become overwhelming. One result has been the largest bank failure in history (Washington Mutual) followed within days by a shotgun marriage to prevent an even larger one (Wachovia). The WaMu failure itself is quite interesting. The FDIC ALWAYS buries failed banks on a Friday, in order to give themselves time to sort the mess out over the weekend. We've gone back and checked and it's been true for many years. Yet the WaMu failure was announced on a Thursday, the day after the President unveiled the bailout proposal. The FDIC's timing on WaMu looks suspiciously like an attempt to rachet up the pressure on Congress - as does the Fed's withdrawal of liqidity support from the system.

In many ways this power-grab resembles the cynical use of religion in primitive societies. It is well documented that the priesthood in many cases studied the heavens with great care. One benefit would be the ability to predict solar eclipses - one of the most terrifying astronomical events to our ancestors. In some cases, the religious leaders used that terror to wring offerings, greater control and even political power from a frightened populace. The events in Washington today are quite similar but even worse. The crisis is already pre-determined. But the current financial leaders helped to create the disaster and now demand power to end it. In contrast the shamans and witch doctors were merely opportunists. The crisis centered in the Shadow Banks is now being used to create a Shadow Government.

Reserves, Profits and Multiples

One of the key problems with valuation in the stock market today is the difficulty of determining actual profits are trying to compare the numbers that are reported to previous years where different standards were used. Many bulls have tried to tell me that I should buy because the S&P 500 is selling at a P/E of only 16x 2008 earnings. Well, there are a ton of problems with that statement so let's just cover the fatal flaws.

First, I don't know what 2008 earnings are going to be and neither do they. They are using a guess as the denominator to get that multiple. The number we do have is the historical reported numbers and based on that the multiple is 18x, significantly higher.

Second, 18x is very expensive and even 16x is far from cheap. 16x would be a normal peak multiple over the business cycle. 18x would be extreme territory normally. During the 20th century, the P/E for the S&P 500 has exceeded 18x on a sustained basis 3 times: the late 1920s, the mid 1960s and the late 1990s. Each of them was followed by epic bear markets. Not a good set of precedents.

Each of those periods also featured prolonged (multi-year) periods of high earnings growth. We had the same thing this time in 2004-05 but EPS growth has fallen from 18% to 0% while equity indexes make new highs. Dangerous? You bet! In the past stocks rolled over shortly after earnings growth started to slow down. This time they refuse to roll over even when the slowdown is about to go to negative growth.

Then there is the quality of the profits themselves. The financial sector and banks in particular are quite problematic. The NY Times has done excellent coverage on the severe depletion of loss reserves at the big banks.

Some investors seem to think that banks’ current share prices reflect whatever grim earnings news remains ahead for the sector. But anyone who thinks that we have hit bottom in the increasingly scary lending world is paying little mind to the remarkably low levels of reserves that the big banks have set aside for loan losses. Indeed, loss provisions as a percentage of total loans held for investment plummeted to a historic low in the second quarter of 2007, the most recent period for which comprehensive figures are available.

Yep, we're heading into a major default crisis and banks have the lowest reserves ever. That's not a problem or anything that the Fed and Treasury want us to worry about. But the weak reserves have allowed financials to over-report profits for the last several years. Time to correct that and the price will be weak profits and for some, losses instead for the forseeable future. And I'm supposed to be interested in paying extreme peak multiples for inflated financial sector profits? No thanks.