## Saturday, February 28, 2009

### Bank of America's tangible common equity ratio is roughly 0.7% using mark-to-market accounting

Tangible common equity is one important ratio the Treasury is believed to be using in it's "stress test" of banks. Citigroup's low tangible common equity ratio is believed to be the reason common shareholders are having their stakes massively diluted.

The formula for the tangible common equity ratio is:
tangible common equity ratio = (common shareholder's equity – goodwill – intangible assets) ÷ (total assets – goodwill – intangible assets)
Bank of America recently reported a tangible common equity ratio of 2.6%. However, things are much worse if you use mark-to-market accounting for the loans on their books.

Loans held to maturity are not subject to mark-to-market accounting, but banks do have to report the mark-to-market value once per year. Bank of America just released that number yesterday. According to Bloomberg, the mark-to-market value of their loans is \$44.6 billion less than what the balance sheet says. So, by looking at their balance sheet and doing a little math, we can figure out Bank of America's mark-to-market tangible common equity ratio.

First let's figure out the tangible assets. A month ago they reported total assets as \$2,485.2 billion. Goodwill was \$87.3 billion and intangible assets were \$14.3 billion. That gives us tangible assets worth \$2,383.6 billion.

Second, let's calculate tangible common equity. Bank of America didn't list their common equity separately from their preferred equity, but we can easily figure out their tangible common equity by multiplying their tangible assets by 2.6%. That gives us \$62 billion in tangible common equity.

Third, to figure out the mark-to-market tangible common equity ratio, we need to subtract \$44.6 billion from both tangible assets and tangible common equity. That gives us \$2,339 billion and \$17.4 billion, respectively.

Finally, divide \$17.4 billion by \$2,339 billion to get 0.7%. Yikes!

For Bank of America's sake, let's hope a temporarily high risk premium (market fear) is causing the mark-to-market value of the loans to be unreasonably undervalued.

## Friday, February 27, 2009

The intra-day low on the S&P 500 so far today was 734.52. That's lower than the intra-day low (742.61) on December 5, 1996—the day Alan Greenspan gave his famous irrational exuberance speech. The closing price that day was 744.38. If it doesn't happen today, we will likely close below that level within the next week or so.

Update: The S&P 500 ended the day at 735.09, lower than when Alan Greenspan warned of a possible stock market bubble over 12 years ago.

### Doh!

The Treasury Department's "stress test" of large banks looks at how they would do under two economic scenarios, a "baseline" scenario and an "adverse" scenario. The baseline scenario assumes a 2.0% GDP decline this year, while the adverse scenario assumes a 3.3% GDP decline this year. With the adverse scenario in mind, today's GDP news is a bit disheartening:
GDP fell at a 6.2% seasonally adjusted annualized pace in the final three months of 2008, revised from the initial estimate of a 3.8% drop, the Commerce Department reported. It was the worst decline in GDP since a 6.4% decrease in the first quarter of 1982.
Doh!

By the way, the adverse scenario assumes a 22% decline in housing prices this year, followed by a 7% decline next year.

## Wednesday, February 25, 2009

### The recession's worst may be past

Economist Irwin Kellner says the economy's decline may be slowing:
Although you wouldn't know it from the behavior of the stock market, the economic outlook is turning just a bit less gloomy.

Prosperity may not be just around the corner, but statistical evidence is mounting to suggest that the worst of this recession may soon be past.

And before you inundate me with email alleging that I am out of touch with the real world, let me say right at the top that I am not for one moment saying that the economy has stopped sliding. I am only suggesting that it appears to be contracting at a slower pace.

Clearly, this has nothing whatsoever to do with the stimulus package that the president signed into law last week. ...

If you want a policy to credit, it's monetary policy. The combination of liquidity that the Federal Reserve has pumped into the economy, along with its special lending programs and capital injections into the banks, is largely responsible.
For the full list of reasons why Kellner thinks the worst is past us, read it here.

## Tuesday, February 24, 2009

### A lost decade for stocks

Graph: The S&P 500 from the day Alan Greenspan made his famous "irrational exuberance" speech (December 5, 1996), through yesterday:

You would have done better with short-term U.S. Treasury bonds. Of course, you should not make future investment decisions by looking in the rear-view mirror.

## Monday, February 23, 2009

### President Obama to cut deficit in half by 2013? I say B.S.

President Obama is now repeating one of President Bush's false promises.

From the Financial Times:
Barack Obama will this week set the goal of halving the budget deficit he inherited by the end of his first term, while pushing ahead aggressively on healthcare reform, climate change and education.

His first budget, released on Thursday, will show the deficit falling to \$533bn (€415bn, £369bn) by fiscal year 2013, compared with an inherited deficit aides estimate at \$1,300bn.
From President Bush's 2004 State of the Union speech:
And we should limit the burden of government on this economy by acting as good stewards of taxpayer dollars. In two weeks, I will send you a budget that funds the war, protects the homeland, and meets important domestic needs, while limiting the growth in discretionary spending to less than 4 percent. This will require that Congress focus on priorities, cut wasteful spending, and be wise with the people's money. By doing so, we can cut the deficit in half over the next five years.
Keep in mind that cutting the deficit in half is far different than cutting the national debt in half. Cutting the deficit in half means that government spending will still be contributing to the national debt. In order to reduce the national debt, we need to have a budget surplus, not a deficit.

The \$533 billion deficit that Obama hopes for would rank among one of the worst deficits experienced under George W. Bush. In other words, it would be no great accomplishment. Even so, I think Obama is unlikely to achieve it.

## Saturday, February 21, 2009

### Is the stock market undervalued?

Here is Morningstar's stock valuation graph:

## Friday, February 20, 2009

### Fed President Lockhart: Bank nationalization unlikely

Atlanta Fed President Dennis Lockhard doesn't expect the U.S. to nationalize banks:
Nationalizing banks is "substantially" off the table, Federal Reserve Bank of Atlanta President Dennis Lockhart said following a speech in Alabama.

Speaking to reporters after his speech, Lockhart said he was "unaware" of any serious consideration of bank nationalization. ...

Lockhart said correctly valuing assets is a central challenge to fixing banks and that the Treasury is not ruling out guarantees of toxic assets.
Fed Chairman Ben Bernanke also opposes nationalization, but does see it as a possible temporary option:
Ben Bernanke, the chairman of the Federal Reserve, expressed skepticism Wednesday about the prospect of nationalizing troubled banks and suggested that President Obama’s administration would much prefer to keep financial institutions in private hands.

His comments, at a luncheon at the National Press Club, came shortly after his predecessor, Alan Greenspan, told The Financial Times that temporary nationalization of some banks might be the “least bad solution” to the current banking crisis. Many were surprised that Mr. Greenspan, long a fan of self-regulation in the financial sphere, would even suggest such a move.

“As a general rule, it’s very challenging for governments to manage banks for a protracted period,” Mr. Bernanke said Wednesday after being asked about Mr. Greenspan’s comments, The Charlotte Observer reported.

Later, he added: “Whatever action would need to be taken at one point or another, there’s a very strong commitment on the part of the administration to keep banks private and return them to private hands as quickly as possible.”
A temporary nationalization would be as bad for shareholders as a semi-permanent nationalization. For the economy as a whole, semi-permanent nationalization would be far worse. Treasury Secretary Tim Geithner is also known to oppose nationalization. My guess is even temporary nationalization is off the table as long as a bank is solvent. If a bank becomes insolvent, then something needs to be done.

## Thursday, February 19, 2009

Finally, some good news for the economy:
Economic weakness will continue through this year, though the recession's intensity could ease over the next few months, the Conference Board said Thursday.

For the second consecutive month, the index of leading economic indicators rose, gaining 0.4% in January, following a downwardly revised 0.2% in December.

"The second half of 2009 may see a period of anemic growth," said Ken Goldstein, economist at the Conference Board. "In fact, a return to robust growth may not occur until well into 2010, even if the long climb starts a few months from now."

The recent gains are due, in part, to the Federal Reserve's huge injections of cash into the money supply. Despite the rise in January, widespread weakness remains as the troubled job and housing markets continue to take their toll.

Some of the index's estimates may be too optimistic, and could be downwardly revised, wrote Ian Shepherdson, chief U.S. economist with High Frequency Economics, in a research note.

"In short, we see no real improvement here despite the rise in the headline," Shepherdson wrote.
The way I see it, a weak recovery is ideal. The economy as a whole stops tanking, but the economy is weak enough that housing prices are likely to continue declining.

## Monday, February 16, 2009

### The worst case scenerio for the big banks

From The New York Times' DealBook blog:
CreditSights ran the numbers, and found that according to its “severe” case situation, all the major banks and brokerages — Citigroup, Bank of America, Wells Fargo, JPMorgan Chase, Goldman Sachs and Morgan Stanley — might require further capital injections from the government.

CreditSights’ projections were driven by its own forecast for future credit losses based on how badly the market could perform over the next two years. Under these assumptions, the losses from mortgage-related products would be significantly higher than the amount the banks have set aside already. It also envisions an unemployment rate of 10 percent.

The future losses for some banks are staggering by CreditSights’ estimates: Wells Fargo, \$119 billion; BofA, \$99 billion; JPMorgan, \$124 billion; Citi, \$101 billion; Goldman Sachs, \$47 billion; Morgan Stanley, \$34 billion.

## Sunday, February 15, 2009

### This recession's chain of events

Click on the image to see it full size.

Here is a little diagram I drew to point out the chain of events that is occurring in our current recession. I marked "falling housing prices" as being caused by the free market to emphasize that it is the natural result of high housing prices. However, in reality every item along the chain is being caused by the free market. The actions in red represent the federal government's attempts to weaken the link between falling housing prices and rising unemployment.

Many people may be tempted to try to prop up high housing prices, and that is what the economic stimulus package's \$8000 tax credit is attempting to do. However, last year's \$7500 tax credit failed to have a noticeable effect. At best, attempting to prop up high housing prices in the near term will only make the decline last longer, which in turn will make the recession last longer. President Obama should realize that it is in his own interest to let housing prices correct as fast as possible, so prices are no longer falling when he runs for re-election in 2012.

## Tuesday, February 10, 2009

### Government deserves much of the blame for the economic crisis

Stanford University economics professor John Taylor says the government bears a lot of responsibility for the housing bubble and the resulting financial crisis.
My research shows that government actions and interventions — not any inherent failure or instability of the private economy — caused, prolonged and dramatically worsened the crisis.

The classic explanation of financial crises is that they are caused by excesses — frequently monetary excesses — which lead to a boom and an inevitable bust. This crisis was no different: A housing boom followed by a bust led to defaults, the implosion of mortgages and mortgage-related securities at financial institutions, and resulting financial turmoil.
Regarding the housing bubble:
Monetary excesses were the main cause of the boom. The Fed held its target interest rate, especially in 2003-2005, well below known monetary guidelines that say what good policy should be based on historical experience. Keeping interest rates on the track that worked well in the past two decades, rather than keeping rates so low, would have prevented the boom and the bust. Researchers at the Organization for Economic Cooperation and Development have provided corroborating evidence from other countries: The greater the degree of monetary excess in a country, the larger was the housing boom.

The effects of the boom and bust were amplified by several complicating factors including the use of subprime and adjustable-rate mortgages, which led to excessive risk taking. There is also evidence the excessive risk taking was encouraged by the excessively low interest rates. ...

Other government actions were at play: The government-sponsored enterprises Fannie Mae and Freddie Mac were encouraged to expand and buy mortgage-backed securities, including those formed with the risky subprime mortgages.
Regarding the financial crisis:
A third policy response was the very sharp reduction in the target federal-funds rate to 2% in April 2008 from 5.25% in August 2007. This was sharper than monetary guidelines such as my own Taylor Rule would prescribe. The most noticeable effect of this rate cut was a sharp depreciation of the dollar and a large increase in oil prices. After the start of the crisis, oil prices doubled to over \$140 in July 2008, before plummeting back down as expectations of world economic growth declined. But by then the damage of the high oil prices had been done.

After a year of such mistaken prescriptions, the crisis suddenly worsened in September and October 2008. We experienced a serious credit crunch, seriously weakening an economy already suffering from the lingering impact of the oil price hike and housing bust.

Many have argued that the reason for this bad turn was the government's decision not to prevent the bankruptcy of Lehman Brothers over the weekend of Sept. 13 and 14. A study of this event suggests that the answer is more complicated and lay elsewhere.

While interest rate spreads increased slightly on Monday, Sept. 15, they stayed in the range observed during the previous year, and remained in that range through the rest of the week. On Friday, Sept. 19, the Treasury announced a rescue package, though not its size or the details. Over the weekend the package was put together, and on Tuesday, Sept. 23, Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson testified before the Senate Banking Committee. They introduced the Troubled Asset Relief Program (TARP), saying that it would be \$700 billion in size. A short draft of legislation was provided, with no mention of oversight and few restrictions on the use of the funds.

The two men were questioned intensely and the reaction was quite negative, judging by the large volume of critical mail received by many members of Congress. It was following this testimony that one really begins to see the crisis deepening and interest rate spreads widening.

The realization by the public that the government's intervention plan had not been fully thought through, and the official story that the economy was tanking, likely led to the panic seen in the next few weeks. And this was likely amplified by the ad hoc decisions to support some financial institutions and not others and unclear, seemingly fear-based explanations of programs to address the crisis.
His conclusion:
It did not have to be this way. To prevent misguided actions in the future, it is urgent that we return to sound principles of monetary policy, basing government interventions on clearly stated diagnoses and predictable frameworks for government actions.

Massive responses with little explanation will probably make things worse. That is the lesson from this crisis so far.
One problem with this narrative is that we were already well into the housing bubble by 2003. Many economists say that the housing bubble was initially caused by excessive savings in China and the Middle East, which resulted in ultra-low interest rates in the U.S. Rather than creating the housing bubble, it is much more likely that the Federal Reserve poured gas on an already burning fire.

John Taylor has a new book about the financial crisis coming out soon.

## Sunday, February 8, 2009

### Japan as an example of Keynesian fiscal stimulus

From The New York Times:
Japan’s rural areas have been paved over and filled in with roads, dams and other big infrastructure projects, the legacy of trillions of dollars spent to lift the economy from a severe downturn caused by the bursting of a real estate bubble in the late 1980s. During those nearly two decades, Japan accumulated the largest public debt in the developed world — totaling 180 percent of its \$5.5 trillion economy — while failing to generate a convincing recovery.

Now, as the Obama administration embarks on a similar path, proposing to spend more than \$820 billion to stimulate the sagging American economy, many economists are taking a fresh look at Japan’s troubled experience. ...

It matters what gets built: Japan spent too much on increasingly wasteful roads and bridges, and not enough in areas like education and social services, which studies show deliver more bang for the buck than infrastructure spending.

“It is not enough just to hire workers to dig holes and then fill them in again,” said Toshihiro Ihori, an economics professor at the University of Tokyo. “One lesson from Japan is that public works get the best results when they create something useful for the future.” ...

In the end, say economists, it was not public works but an expensive cleanup of the debt-ridden banking system, combined with growing exports to China and the United States, that brought a close to Japan’s Lost Decade. This has led many to conclude that spending did little more than sink Japan deeply into debt, leaving an enormous tax burden for future generations.

In the United States, it has also led to calls in Congress, particularly by Republicans, not to repeat the errors of Japan’s failed economic stimulus. ...

Economists tend to divide into two camps on the question of Japan’s infrastructure spending: those, many of them Americans like Mr. Geithner, who think it did not go far enough; and those, many of them Japanese, who think it was a colossal waste. ...

Most Japanese economists have tended to take a bleaker view of their nation’s track record, saying that Japan spent more than enough money, but wasted too much of it on roads to nowhere and other unneeded projects.

## Saturday, February 7, 2009

### Warren Buffett's and Robert Shiller's stock valuation metrics agree

Carol Loomis of Fortune has a new article out saying that Warren Buffett's valuation metric says it's time to buy stocks. I decided to compare Warren Buffett's stock valuation metric with Robert Shiller's. They both compare nicely.

Warren Buffett's stock valuation metric: Total stock market value as a percent of GNP.

Yale economist Robert Shiller's stock valuation metric, based on Benjamin Graham's advice in Security Analysis: S&P 500 10-year price/earnings ratios.

Robert Shiller doesn't compare the S&P 500 only to its current year earnings. Instead, he compares it to the average of the past ten years, adjusted for inflation. This way, he avoids getting fooled when single-year corporate earnings rise and fall with the business cycle.

Although Warren Buffett's and Robert Shiller's valuation methods are entirely different, they both seem to track each other fairly nicely. Knowing what happened in 1929, however, it looks like Robert Shiller's valuation method is slightly better than Warren Buffett's.

## Friday, February 6, 2009

### Economic history lessons for today's financial crisis

From Carmen Reinhart and Kenneth Rogoff:
Until now, the U.S. economy has been driving straight down the tracks of past severe financial crises, at least according to a variety of standard macroeconomic indicators we evaluated in a study for the National Bureau of Economic Research (NBER) last December.

In particular, when one compares the U.S. crisis to serious financial crises in developed countries (e.g., Spain 1977, Norway 1987, Finland 1991, Sweden 1991, and Japan 1992), or even to banking crises in major emerging-market economies, the parallels are nothing short of stunning.

Let's start with the good news. Financial crises, even very deep ones, do not last forever. Really. In fact, negative growth episodes typically subside in just under two years. If one accepts the NBER's judgment that the recession began in December 2007, then the U.S. economy should stop contracting toward the end of 2009. Of course, if one dates the start of the real recession from September 2008, as many on Wall Street do, the case for an end in 2009 is less compelling.

On other fronts the news is similarly grim, although perhaps not out of bounds of market expectations. In the typical severe financial crisis, the real (inflation-adjusted) price of housing tends to decline 36%, with the duration of peak to trough lasting five to six years. Given that U.S. housing prices peaked at the end of 2005, this means that the bottom won't come before the end of 2010, with real housing prices falling perhaps another 8%-10% from current levels.

Equity prices tend to bottom out somewhat more quickly, taking only three and a half years from peak to trough — dropping an average of 55% in real terms, a mark the S&P has already touched. However, given that most stock indices peaked only around mid-2007, equity prices could still take a couple more years for a sustained rebound, at least by historical benchmarks.

Turning to unemployment, where the new administration is concentrating its focus, pain seems likely to worsen for a minimum of two more years. Over past crises, the duration of the period of rising unemployment averaged nearly five years, with a mean increase in the unemployment rate of seven percentage points, which would bring the U.S. to double digits. ...

Perhaps the most stunning message from crisis history is the simply staggering rise in government debt most countries experience. Central government debt tends to rise over 85% in real terms during the first three years after a banking crisis. This would mean another \$8 trillion or \$9 trillion in the case of the U.S.

Interestingly, the main reason why debt explodes is not the much ballyhooed cost of bailing out the financial system, painful as that may be. Instead, the real culprit is the inevitable collapse of tax revenues that comes as countries sink into deep and prolonged recession. Aggressive countercyclical fiscal policies also play a role, as we are about to witness in spades here in the U.S. with the passage of a more than \$800 billion stimulus bill.

Needless to say, a near doubling of the U.S. national debt suggests that the endgame to this crisis is going to eventually bring much higher interest rates and a collapse in today's bond-market bubble. The legacy of high government debt is yet another reason why the current crisis could mean stunted U.S. growth for at least five to seven more years.

### The Republicans' stupid mortgage plan

Republican economist Ed Glaeser says Republicans have a stupid mortgage plan:
It is particularly disappointing to see Senate Minority Leader Mitch McConnell embrace "providing government-backed, 4% fixed mortgages to any credit-worthy borrower" as his alternative to the Barack Obama/Nancy Pelosi stimulus package. ...

Since lenders have recovered their sanity and are once again requiring appropriate down payments, buyers are more constrained by the need to come up with 20% of the purchase price than they are by interest rates. Today's down-payment requirements and low interest rates suggests that mortgage markets are working well and have little need for governmental "help." ...

Subsidizing mortgages is an idea from the New Deal, not the Republican playbook. Fannie Mae and the Federal Housing Administration were set up by liberal Democrats to encourage borrowing. Subsidizing interest rates appealed to big-government interventionists because the expense is kept off federal balance sheets, at least for a while. The true costs of Fannie and Freddie were long shrouded, despite the efforts of some Republican senators. Likewise, the full costs of subsidizing 4% mortgages will appear only over time, as the government is put on the hook for default after default. ...

We are in the ruins of a housing market made worse by subsidized lending. The government has no business egging people on to borrow as much as possible to bet on housing prices. There is plenty of room to criticize the current stimulus plan, but Republicans need to adopt Ronald Reagan or Dwight D. Eisenhower, not Harold Ickes, as their intellectual role model.

## Thursday, February 5, 2009

From Princeton University economist Paul Krugman:
Consumers are pulling back because they’ve realized that they’re too far in debt. The economy is shrinking in large part because consumers are pulling back. And the result, almost surely, is to leave household balance sheets worse than ever. I can’t do this accurately until the Federal Reserve’s flow of funds data have been updated, but almost without question the ratio of household debt to personal income has been rising, not falling, as consumers try to save more.

## Wednesday, February 4, 2009

### Where the foreclosures are

Click on the map to see a larger image.

### Senator Chris Dodd is still a crook

U.S. Senate Banking Committee Chairman Christopher Dodd got a special deal on mortgages from Countrywide Financial in 2003. Now he's playing games with reporters regarding the issue. From The Wall Street Journal:
Connecticut Senator Chris Dodd has finally, sort of, kind of, ended 193 days of stonewalling about his sweetheart loans from former Countrywide CEO Angelo Mozilo. At least he did if you were a fast reader and were one of the few reporters he invited to his Hartford office yesterday to review — but not copy or take — more than 100 pages of documents related to his 2003 mortgage financings through Countrywide's "Friends of Angelo" program.

These are the files that Mr. Dodd pledged to make public after the news broke last summer that the Chairman of the Senate Banking Committee had received preferential treatment from Countrywide. At first, Mr. Dodd denied everything. Later, he conceded that he'd been given special treatment but thought it was "more of a courtesy."

Heck, we'd all love the kind of courtesy that would have saved Mr. Dodd \$75,000 over the life of the two loans he refinanced to the tune of \$800,000, according to an analysis by Portfolio magazine. The savings came from rock-bottom interest rates and a free "float-down" — the right to borrow at a lower rate if interest rates fall before you've closed on the loan.

On Monday, with interest rates — even for non-VIPs — near historic lows, Mr. Dodd announced that he would refinance the sweetheart loans with another lender. ...

We don't know whether the documents Mr. Dodd briefly showed yesterday illuminate this mystery or not, because he didn't release them to us, or to the public or his constituents.