The US Banking Sector’s Dependence on Bernanke’s QEs

Is the US banking sector having a déjà vu of 2008?

The Economist suggests so (bold emphasis mine)

Wild gyrations in stockmarkets; banks' share prices falling like stones; politicians stepping in to back-stop lenders for fear of collapse. The echoes of 2008 are alarming. Morgan Stanley is one of the big casualties: fears apparently caused by its exposure to European assets led its share price to fall by 17% over the past two days of trading. You have to go back to December 3rd 2008 to find the last time the bank's stock closed at the same price as it did yesterday, even if it still sits 36% above its 2008 nadir. A French bank, Société Générale, has already breached its 2009 low, hitting €15.31 in late September, although it has bounced back by 24% since then. Bank stocks may now be approaching levels seen in the depths of the financial crisis but broader stockmarket indices still have a long way to go to reach that mark. That won't last if the banks get into real difficulties.

Bank stocks have not been only suffering from depressed share prices but have likewise seen their default risks surging.

According to Bespoke Invest (chart above from Bespoke)

“a gain in CDS prices is a bad thing, as it means that default risk has gone up. And it has gone up significantly for financial companies once again this year. For the majority of financials, CDS prices are still not as high as they were during the financial crisis, but they're starting to get close. And interestingly, while the European banking system is the one that is supposedly in trouble, two US financials are up the most this year -- Morgan Stanley and Goldman Sachs.”

I’d further add that banking sector looks highly dependent on Bernanke's Quantitative Easing (QEs) programs.

I previously noted of the timeline for the previous QEs,

The timeline for QE 1.0 is officially from March 2009 to March 2010, and QE 2.0 from November 2010 to June 2011

The Philadelphia Bank Index exhibits that since the closure of the previous two quantitative easing programs by the US Federal Reserve, shown by the green ellipses, the banking index either wobbled (as in post QE 1.0) or has been in decline (post QE 2.0).

What this implies is that despite the trillions thrown by the US Federal Reserve, the balance sheets predicaments of the banking system have not gone away. Think of all the resources wasted just to save the Bernanke's most preferred sector.

To add, the still foundering property sector continues to weigh on the banking sector’s balance sheets.

Such dynamic seems no different with the Dow Jones Financial Index.

This means that interventions had only masked the problems, which resurfaces everytime such government support ended.

Also given that US banks have substantial exposures to European banks, it isn't farfetched to perceive a potential contagion from any further deterioration in the latter's banking sector.

So either we see the team Bernanke redeploying the modified version of the 'helicopter option' through QE 3.0, to bolster the flagging US banking and financial sector soon, or we will see many bankruptcies and mass liquidations that would exacerbate the current pressures on the global financial markets.

My guess is Ben Bernanke won’t like to have his hands bloodied and would rather resort to the “kick the can" option.

BIS: The Difference of Great Depression and the 2008 Crisis is Central Bank Inflationism

What’s the fundamental difference between the crisis of the Great Depression in 1931 and that of the US Mortgage crisis of 2008?

The Bank of International Settlement (BIS) gives an answer: central banking inflationism

Here’s the concluding remarks of William A Allen and Richhild Moessner from their recently published paper:

We have suggested a number of ways in which the financial crisis of 2008 was propagated internationally. We argue that the collateral squeeze in the United States, which became intense after the failure of Lehman Brothers created doubts about the stability of other financial companies in the United States, was an important propagator. The provision of large-scale swap lines by the Federal Reserve relieved many of the financial stresses in other countries that had followed Lehman Brothers’ failure. The unwinding of carry trades, particularly yen carry trades, is also likely to have transmitted market volatility to the countries that had been the destination of the carry trades when they were first put in place. It seems likely that, at the time of writing, there is still a large quantity of yen carry trades to be unwound.

In both crises, deposit outflows were not the only important sources of liquidity pressure on banks: in 1931, the central European acceptances of the London merchant banks were a serious problem, as, in 2008, were the liquidity commitments that commercial banks had provided to shadow banks. And in both crises, the behaviour of creditors towards debtors and the valuation of assets by creditors, were all very important. Flight to liquidity and safety was an important common feature of the crises of 1931 and 2008. In both episodes, the management of central banks’ international reserves appears to have had pro-cyclical effects.

However, there was a crucial difference, in that the supply of assets that were regarded as liquid and safe in 1931 was inelastic and became narrower with the passage of time, whereas in 2008, it could be, and was, expanded quickly in such as way as to contain the effects of the crisis. The understanding that the role of governments and central banks in a crisis is to enable such assets to be supplied was perhaps the most important lesson of 1931, and the experience of 2008 showed that it had been learned.

The difference has been Central Bank's asset-purchasing program or termed as credit easing policies a.k.a Quantitative Easing.

The BIS gets it.

The deflation camp based on premises of “aggregate demand” does not.

Perhaps a little more elaboration from the great Murray N. Rothbard who presciently wrote (What has Government Done To Our Money), [emphasis added]

But the central Bank, by pumping reserves into all the banks, can make sure that they can all expand together, and at a uniform rate. If all banks are expanding, then there is no redemption problem of one bank upon another, and each bank finds bank expansion of one bank upon another, and each bank finds that its clientele is really the whole country. In short, the limits on bank expansion are immeasurably widened, from the clientele of each bank to that of the whole banking system. Of course, this means that no bank can expand further than the Central Bank desires. Thus, the government has finally achieved the power to control and direct the inflation of the banking system.

In addition to removing the checks on inflation, the act of establishing a Central Bank has a direct inflationary impact. Before the Central Bank began, banks kept their reserves in gold; now gold flows into the Central Bank in exchange for deposits with the Bank, which are now reserves for the commercial banks. But the Bank itself keeps only a fractional reserve of gold to its own liabilities! Therefore, the act of establishing a Central Bank greatly multiplies the inflationary potential of the country.

The essence is, an inflationary or deflationary outcome depends largely on central bank directives.

Inflation expands the power of central banks, deflation does not. Guess which route central bankers are likely to chose? (Of course, this assumes that the market can still bear with the effects of central bank policies)

Putting The TED Spread Into Perspective

Here is how to spook people...

TED spread are rising fast, so run for the hills!

Chart of the 6 month TED Spread courtesy of Bloomberg

The TED spread, according to wikipedia.org, is the difference between the interest rates on interbank loans and short-term U.S. government debt ("T-bills"). TED is an acronym formed from T-Bill and ED, the ticker symbol for the Eurodollar futures contract.

More from wikipedia.org

``Initially, the TED spread was the difference between the interest rates for three-month U.S. Treasuries contracts and the three-month Eurodollars contract as represented by the London Interbank Offered Rate (LIBOR). However, since the Chicago Mercantile Exchange dropped T-bill futures, the TED spread is now calculated as the difference between the three-month T-bill interest rate and three-month LIBOR...

``A rising TED spread often presages a downturn in the U.S. stock market, as it indicates that liquidity is being withdrawn."


Yet seen from a 5-year period, the perspective dramatically changes.

Thus, it has not been established yet whether the TED spread will reach a panic mode or hit extraordinary levels seen in 2008.

At present, rising TED spreads remain at pre-2008 Bear Sterns-Lehman levels (blue horizontal line) and have not encroached into panic territory.

Besides, there was much volatility during the pre-2008 as evidenced by the undulations. However, much of these gyrations had been muted until the unraveling of the concealed impairments seen in major US investment banks.

In addition, there are stark differences in 2008 and current conditions. For instance, then, policymakers dithered on how to intervene, today, they are quick to resolve any signs of volatility with a "shock and awe" 'throw money at the problem' approach. Example, today, Bank of Japan declared a new lending window to the tune of 3 trillion yen ($32.8 billion).

Importantly, the TED Spread isn't the only 'magical' indicator that determines conditions of the credit markets aside from the supposed spillover effects to the stock markets.

Therefore, I'd be leery of any analysis using the TED Spread to "spread gloom". That's because such insight seem to be misrepresenting the facts for a desired (biased) outlook. I call this "cart before the horse" reasoning.

Jim Chanos: 10 Lessons From The Financial Crisis That Investors Have Already Forgotten

Here is the presentation recently given by Hedge Fund wizard Jim Chanos at the University of Virginia's Value Investing Conference and the Yale School of Management's Leadership Forum.
09/10/22 Chanos Virginia Value Investing Conference Presentation

Decoupling In Foreign Direct Investments?

In the crest of the 2008 crisis, decoupling, for the mainstream, resonated as a fantasy or myth.

Well, for us the synchronization or "recoupling" then signified more of shock or an anomaly than of a secular trend.

Again we see another sign where emerging markets appear to be diverging from advanced economies in terms of Foreign Direct Investments.

According to the Economist, ``FOREIGN direct investment inflows will barely reach $1 trillion in 2009, a decline of more than half since 2007, predicts the Economist Intelligence Unit, a sister company to The Economist. And for the first time emerging economies will attract more than half of the global total. Flows to poorer economies, especially Asian ones, are proving more resilient than flows to rich economies which are suffering the worst recession in several decades." (bold emphasis mine)

In short, secular trends appear to be overpowering interim 'crisis based' dynamics.

Iceland's Devaluation Toll: McDonald's

Recently we dealt with The Evils Of Devaluation. And Iceland should be a good example.

Last year's meltdown heavily devastated Iceland, an erstwhile prosperous nation but whose banking system recklessly engaged in intensive leveraged based speculation [see last year's post Iceland, the Next Zimbabwe? A “Riches To Rags” Tale? ]

The consequent losses in the banking system prompted Iceland's government to intervene and provide support even when there had not been enough resources to do so. This eventually took toll on its currency, the Krona.

The Krona has devalued or collapsed from 60 to around 140 (chart courtesy of ino.com).

This fueled domestic inflation even amidst a spike in unemployment.

chart courtesy of tradingeconomics.com

Nevertheless Iceland's crisis has prompted one of the world's most prolific fast food chain, McDonald's (NYSE: MCD), to withdraw.

This from Financial Times

``Iceland edged further towards the margins of the global economy on Monday when McDonald's announced the closure of its three restaurants in the crisis-hit country and said that it had no plans to return.

``The move will see Iceland, one of the world's wealthiest nations per capita until the collapse of its banking sector last year, join Albania, Armenia and Bosnia and Herzegovina in a small band of European countries without a McDonald's.

``The loss of the Golden Arches highlights the extent of Iceland's economic demise since the pre-crisis boom years when its "Viking Raider" entrepreneurs turned Reykjavik into an international finance centre and launched a buying spree of high-profile European assets."

The reason...

``McDonald's blamed the closures on the "very challenging economic climate" and the "unique operational complexity" of doing business in an island nation of just 300,000 people on the edge of the Arctic Circle.

``Most ingredients used by McDonald's in Iceland are imported from Germany - leading to a doubling in costs as the krona has collapsed while the euro has strengthened.

``Magnus Ogmundsson, managing director of Lyst, the McDonald's franchise holder in Iceland, said that price rises of at least 20 per cent were needed to produce an acceptable profit. That would have pushed the price of a Big Mac burger well above the $5.75 it costs to buy one in Switzerland, home to the world's most expensive McDonald's, according to the Big Mac index."

Of course somebody's else problem could serve as another person's solution:

It could be argued that this should be healthy as there would be less junk foods.

Or that Iceland will have to rely more on their own.

Again the FT, ``Mr Ogmundsson admitted that some customers were alarmed by the symbolism of such a recognisable brand abandoning Iceland but others have reacted positively. "People are pleased that we will be sourcing more goods locally," he says.

Overall, Icelanders would have lesser choice and diminished privileges from today's modern society. In short, Iceland's living standard has retrogressed.

Wal-Mart: The Only Crisis Proof Stock During The 2008 Crash

Interesting observation from Bloomberg's Chart of the Day

Bloomberg notes that discount retail behemoth Wal-mart had been the only stock to remain in positive grounds among the the S & P 500 index constituents throughout the recession period.


From Bloomberg, ``Wal-Mart Stores Inc. is the only Standard & Poor’s 500 Index company that has rallied during the entire 22-month recession.

``The CHART OF THE DAY shows that shares of Walmart, the world’s biggest retailer, were up at the end of each week while the S&P 500 posted losses throughout most of the worst contraction since the 1930s. Walmart closed at $45.72 in New York Stock Exchange composite trading on Jan. 4, 2008, and has finished above that level every week since.

``Walmart is a great example of a recession-proof company,” said MarK Bronzo, a money manager at Security Global Investors, which oversees $21 billion in Irvington, New York. “People believe that when you go there you’re getting consumer staples or necessities, like food, at the best price available. So, in an environment where people were very conscious of what they were spending, Walmart was able to deliver.”

``Walmart, based in Bentonville, Arkansas, peaked at $62.41 on Sept. 12, 2008, three days before Lehman Brothers Holdings Inc. filed for the world’s largest bankruptcy and triggered the worst stock market rout since the Great Depression."

I'd say that this is an exceptional feat, considering that 499 issues from the S & P 500 suffered losses during the crisis/recession.

Walmart's lone outperformance appear to also validate the Edwin Lefevre (Jesse Livermore) aphorism ``In a bear market all stocks go down and in a bull market they go up..I speak in a general sense. But the average man doesn't wish to be told that it is a bull or a bear market. What he desires is to be told specifically which particular stock to buy or sell."

How Asia's Richest Fared In 2008

Some interesting charts and commentaries on the wealth conditions of Asia's Richest in 2008 from Capgemini's Asian Wealth Report 2009.

Here are the highlights (bold highlights mine)


``Asia-Pacific’s population of high net worth individuals (HNWIs1 ) shrank 14.2% in 2008 to 2.4 million, while their wealth dropped 22.3% to US$7.4 trillion.



``The HNWI population and its wealth were even more concentrated by the end of 2008 than they had been a year earlier. Japan and China together accounted for 71.9% of the Asia-Pacific HNWI population and 65.8% of its wealth, up from 68.8% and 62.4% respectively.


``Asia-Pacific’s Ultra-HNWIs2 suffered greater losses of wealth than Ultra-HNWIs in other regions and their population also diminished by more. At the end of 2008, Asia-Pacific’s Ultra-HNWI population was down 29.6% from a year earlier, compared with the global decline of 24.6%, and their wealth was down 35.1% vs. 24.0% globally."

Additional observation:

The chart below decomposes on the financial assets held by the High net worth individuals.


A noteworthy observation is that except for India, South Korea and Australia, the cash component of the financial assets of High Net Worth Individuals in the region have the largest share in terms distribution.

India on the other hand has equity exposure as the largest, while South Korea and Australia are substantially into real estate.

It would be interesting to see how these huge share of cash holdings would respond to "inflationary setting", which we expect would likely boost property and or stock markets.


Importantly, the Capgemini report highlights on the regulatory conditions and how it impacts on the general business environment.

The report cites some strategic disadvantages in select Asian economies as the Philippines, Vietnam and Japan.

Again Capgemini (all bold highlights mine)

``Tough’ markets (Japan, Vietnam and Philippines) have the tightest regulations in the region and are difficult to penetrate. Japan, for instance, has historically been a very tough market for Western banks as the market is dominated by local players. Foreign banks can emphasize their global reach and product expertise, but lack the branch networks and local resources of their Japanese rivals. The local wealth management segment has always been short of expert capabilities, products and services, but foreign players are still unable to win the complete trust and confi dence of Japanese clients. Foreign banks did get somewhat of a respite recently when the Financial Services Agency (FSA) eased regulations regarding how banks can interact with their securities arms. Previously, banks had been barred even from recommending services among sister divisions. The new regulation presents a major boost to foreign banks, which had been most disadvantaged by the regulation, as they lacked the same holding company structure as local banks.

``Regulations in Vietnam and the Philippines are also stringent, making these markets tough to enter. Vietnam recently revised its credit law, and has put tough restrictions on credit and bank-equity ownership. Foreign banks are concerned this law could hamper their future growth plans in Vietnam. The Philippines also puts substantial limits on the local operations of foreign wealth management firms, so many are largely operating from offshore locations."

Again overregulation has again served as a major deterrent or a significant barrier to investment flows.

You can read a summary of the report from Finance Asia here or read the entire report from Capgemini here (registration required)

The Myths of Deregulation and Lack of Regulation As Causal Factors To The Financial Crisis

Professor Arnold Kling, former economist on the staff of the board of governors of the Federal Reserve System and also a former senior economist at Freddie Mac and presently a co-host of the popular EconoLog has an eloquent and impressive article refuting the popular myths peddled by liberal-progressives at the American.com, entitled Regulation and the Financial Crisis: Myths and Realities

His intro: (italics mine)

``The role of regulatory policy in the financial crisis is sometimes presented in simplistic and misleading ways. This essay will address the following myths and misconceptions

Myth 1: Banking regulators were in the dark as new financial instruments reshaped the financial industry.

Myth 2: Deregulation allowed the market to adopt risky practices, such as using agency ratings of mortgage securities.

Myth 3: Policy makers relied too much on market discipline to regulate financial risk taking

Myth 4: The financial crisis was primarily a short-term panic.

Myth 5: The only way to prevent this crisis would have been to have more vigorous regulation.

``The rest of this essay spells out these misconceptions. In each case, there is a contrast between the myth and reality."

In short, such misplaced arguments attempt to deflect on the culpability of the role of policymakers and their interventionists policies in shaping the financial crisis and instead pin the blame on "market failure" as justification for more government intervention.

Read the rest here

Professor Kling's conclusion:

``The biggest myth is that regulation is a one-dimensional problem, in which the choice is either “more” or “less.” From this myth, the only reasonable inference following the financial crisis is that we need to move the dial from “less” to “more.”

``The reality is that financial regulation is a complex problem. Indeed, many regulatory policies were major contributors to the crisis. To proceed ahead without examining or questioning past policies, particularly in the areas of housing and bank capital regulation, would preclude learning the lessons of history."

Yes, oversimplification of highly complex problems can lead to more prospective troubles than function as preventive or cure to the disease, especially when myopic prescriptions ignore the human behavior dynamics in the face of regulatory circumstances.

As David Altig, senior vice president and research director at the Atlanta Fed wrote in Markets work, even when they don’t, ``Markets are, everywhere and always, one step (or more) ahead of regulators"

India Boots Out Communists, Sensex Scores Largest One Day Gain Ever!

After a landslide victory for the Party of Prime Minister Manmohan Singh, India's stock markets went into a bacchanalia with a fantastic record breaking one day run!

According to Forbes, ``Talk about a post-election party. Indian stocks rose so fast on Monday that trading had to be halted.

``The market was euphoric over the Congress party's unexpectedly strong showing in India's national elections. Congress' unexpectedly strong majority means the party will not have to compromise by forming another coalition with leftist parties, which the business community blames for slowing down India's much-needed economic reforms." (highlight mine)

Bespoke Invest observes, ``the next biggest one-day gain came in March 1992 when the index rallied 13.14%. From its peak in January 2008 to its recent low, the Sensex dropped 60.91%. From its low, however, the index has now rallied 75.04% in just over two months. Even after this 75% gain, India needs to rally another 46.13% to reach its old highs."

Both Charts from Bespoke.

So while emerging markets seem to be embracing globalization, even in the face of the present crisis, developed markets appear run on the opposite route.

Needless to say, decoupling dynamics seem to be surfacing even in terms of political trends!

Negative Chain Effects from Regulatory Arbitrage: The AIG experience

In the Freakonomics blog, Daniel Hamermesh commented on a review of Kat Long’s The Forbidden Apple where he notes of how prohibitions have triggered unintended consequences.

Mr. Hamermesh wrote, ``The review describes a number of incidents where efforts to ban or restrict transactions in one market spilled over with negative consequences into a related market.

``To eliminate drinking on Sundays, New York City restricted it to hotels. In response, bars created makeshift hotel rooms, separated by dividers, which in turn created a burgeoning prostitution business. To avoid having men buy a drink in a bar in order to use the only publicly available restroom, the city opened public restrooms. But this created places where gay sex could proliferate.

``Both of these examples illustrate the law of unintended consequences: actions that restrict quantity or price in one market will affect them in related markets. Indeed, they may even create markets that nobody had heretofore imagined. No doubt there are many other, equally prurient examples.” (bold highlight mine)

Mr. Hamermesh’s remarks reminds us of how the “restrictions” based regulatory arbitrages in the financial sector spawned “related markets” in derivatives, the shadow banking system and other “structured finance” instruments.

As Paul Farrell wrote in the marketwatch.com in 2008, `` The fact is, derivatives have become the world's biggest "black market," exceeding the illicit traffic in stuff like arms, drugs, alcohol, gambling, cigarettes, stolen art and pirated movies. Why? Because like all black markets, derivatives are a perfect way of getting rich while avoiding taxes and government regulations. And in today's slowdown, plus a volatile global market, Wall Street knows derivatives remain a lucrative business.” (bold highlight mine)

These innovative vehicles ultimately served as the principal financing conduits or the “black markets” which fueled the colossal real estate bubble that subsequently shaped today’s crisis.

Essentially the banking system which sought for higher yields took advantage of legal loopholes to assume more risks by leveraging up. Hedge instruments became speculative and Ponzi financed.

Although the actions of the "bailout cultured" banking system had been partially typical of an arbitrageur, which as Michael Mauboussin of Legg Mason says is driven by “The idea is simple and intuitive: a smart subset of investors cruise markets seeking discrepancies between price and value and make small profits closing those aberrant gaps.”

Chart from Michael Mauboussin of Legg Mason

Nonetheless Chris Whalen of Institutional Risk Analytics gives an example of how AIG morphed from an insurance and reinsurance business model to a Ponzi by virtue of “regulatory arbitrage” or “may even create markets that nobody had heretofore imagined” (Daniel Hamermesh)…

``One of the first things we learned about the insurance world is that the concept of "shifting risk" for a variety of business and regulatory reasons has been ongoing in the insurance world for decades. Finite insurance and other scams have been at least visible to the investment community for years and have been documented in the media, but what is less understood is that firms like AIG took the risk shifting shell game to a whole new level long before the firm's entry into the CDS market….

``One of the most widespread means of risk shifting is reinsurance, the act of paying an insurer to offset the risk on the books of a second insurer. This may sound pretty routine and plain vanilla, but what most people don't know is that often times when insurers would write reinsurance contracts with one another, they would enter into "side letters" whereby the parties would agree that the reinsurance contract was essentially a canard, a form of window dressing to make a company, bank or another insurer look better on paper, but where the seller of protection had no intention of ever paying out on the contract…

``It is important to understand that a side letter is a secret agreement, a document that is often hidden from internal and external auditors, regulators and even senior management of insurers and reinsurers….

``It appears to us that, seeing the heightened attention from regulators and federal law enforcement agencies such as the FBI on side letters, AIG began to move its shell game to the CDS markets, where it could continue to falsify the balance sheets and income statements of non-insurers all over the world, including banks and other financial institutions.

Read the rest here