B of A, Citigroup "In A Year, Gone!"

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Those were the words this week from Don Straszheim of Straszheim Global Advisors. He was speaking at the annual forecast dinner for the CFA Society of San Diego. “Gone?” I asked him in disbelief. “You mean, like no more Bank of America Versateller ATM for me?” Well, no, he told me. “Just gone as in no shareholder equity left. I don’t see how B of A or Citi can be worth anything.”

Straszheim gave an impassioned speech to the crowd of finance professionals. He was joined by Liz Ann Sonders, Schwab’s Chief Investment Strategist. I moderated the event, taking notes furiously.

Forecasting is always a perilous endeavor, but here are the highlights of what these two pros see looking ahead, based, in part, on looking back. . . .

Maybe Christian leaders could encourage Christians to pray for world leaders of economics and politics that they may be successful in both acting in cooperative fashion to avert economic catastrophe and being courageous and effective politically. If your church allows it, maybe you could voice a petition along these lines at your Mass or worship.

I pulled my money from BOA a few months back. It is now in a Credit Union.

We need to break up the big banks to the way it use to be.

I am inclined to side with those who think B of A and Citi really are “too big to fail”, in the sense that no other bank is big enough or solvent enough to take them over. The government itself is incapable of either running them or liquidating them. It is precisely the inability of anyone to determine the value of the strange assets and operations some of the giant banks have, that led to Paulsen switching the focus of TARP I from purchase of “toxic assets” to direct capital investment in banks. Taking those banks over and running off the management will not make it any clearer and really would result in the government trying to find a market for assets that nobody wants and the government itself does not understand.

There is a big difference between the capital infusions of TARP I into the “too big to fails” and smaller banks. Those funds did not go into the small and regional banks that looked like they were going under (though some might anyway). But they did go to insolvent B of A and Citi with TARP funds. They went to the smaller banks because the Fed knows full well that there are going to have to be some survivor banks with enough capital to take over failed banks. So they boosted their capital. Those banks are on the FDIC’s “call list” for the takeover of failing banks.

But, again, with the giants, it’s different. They will likely keep going to the government for capital infusions. And the government will probably keep infusing capital. It’s probably the least expensive thing the government can do.

Chapter 7. The price for bad business.

The trouble is, the accountholders of City and B of A will be paid 100%, by the government. That’s about 1.5 trillion. In addition, they owe other banks about a half trillion in fed funds and, if I’m not greatly mistaken, the government has backed those in order to ensure liquidity and to prevent other banks from refusing to provide it. It’s much cheaper to recapitalize them than to do that. Assuming they have no net worth at all (and I don’t know if they do) recapitalizing would cost about 150 billion, with a chance to recoup. In addition, their assets would be “fire saled” with a corresponding reduction in value of the assets of other banks all over the country which, I fear, would cause a cascade of failures. I, personally, don’t like those banking giants. But there really does come a point where shutting them down is scarier to me than recapitalizing them.

Assuming that the debts cannot be discharged, injecting capital only delays the inevitable. Fractional banking is fraudulent and at any moment the bank can become insolvent if people simply ask for the return of assets that they own. By definition, your recapitalization will not return the banks to solvency because, as you advertise, the recapitalization amount is less than the outstanding liabilities.

Further, the fire sale of assets is not really a bad thing when the assets’ ongoing concern value is zero. And let us drop this pretense about “illiquid” assets. There’s a difference between illiquid and worthless. Houses are illiquid because they have market value but cannot be sold very quickly. Questionable financial instruments are worthless because the market doesn’t want them.

I’m not sure I understand what you are saying. If, by “fractional banking” you mean the situation where a bank loans out more than its net worth, then ALL banking is fractional and therefore, in your view, fraudulent.

Undoubtedly, some of the big banks’ assets are worthless in the sense that they can never be realized upon. An unsecured note from a bankrupt borrower would be an example. If all of B of A or Citi’s assets are like that, then there really is nothing for the government to do but pay off the account holders and call it quits. However, that possibility is so remote as to invite total disbelief. There are all kinds of “questionable financial instruments”. A house nobody will buy right now is not necessarily worthless for that reason alone, because at some other time someone may buy it. A “questionable financial instrument” may or may not be worthless even though no one wants to buy it right now. An ARM on a house that it doubtfully worth the amount of the debt is not something people want to buy, because the realizable value is presently unknown. It is unknown because the market for the collateral is unstable and uncertain. But ultimately there is some value to it even if the borrower goes bankrupt, because the collateral will ultimately sell for some amount or other. It is my impression that some of the derivatives that are essentially unmarketable at present, are collateralized, whereas some are not. In more normal times, even uncollateralized obligations have some value in the aggregate, because some are collectible notwithstanding that some are not. There are, for example, companies that buy up past due medical bills; perhaps the most questionable obligations there are. Maybe they buy them for ten cents on the dollar or even less. But they do collect some, and therefore the package of debts does have value. Undoubtedly in bad economic times where no one knows where the “bottom” is, those investors think differently. Maybe five cents on the dollar will give them a comfort level. But then, notwithstanding that some will be collected, maybe the number can no longer be calculated, and the company will no longer buy them at all. But that does not mean no one ever will.

Just yesterday, I was discussing the situation with a man who is characteristically a “bottom feeder” investor. He risks his capital to buy terribly distressed assets, but will only do so if the discount to presumed value is deep. A person like him will do all the work it takes to recognize value other don’t see, and realize on such assets, and he’s very good at it. He remarked on the very “fire sale” phenomenon you’re talking about, and gave this analogy. He also invests in cattle. Right now, cattle prices are moderately depressed, but cattle are also difficult to buy because of the slow-motion liquidation of herds that is going on. That liquidation is taking place because ranchers are having a hard time making it, and have no place to go to stay afloat other than to liquidate herds. But they don’t want to completely liquidate, because then they would be out of business. At some point, cattle prices will go up, because not only the available supply, but the possible numbers in the “pipeline” will be reduced. But if everyone panicked and took most of his cattle to market on the very same day, in numbers many times the “normal” numbers but not known relative to the total possible supply, most of the cattle would be “worthless” at that point, because the market will not even come close to absorbing them, and the phenomenon itself would cause all “normal” calculations of buyers to become invalid. They would simply stop buying no matter how good the deals might ultimately be. The vast majority of the cattle, then, would end up starving to death for miles on the highway leading to the stockyards. “Fire saleing” enormous bank assets would be like that, even if some unknown portion of the bank assets would indisputably be collected some time or other.

I agree with you that the value of paper assets is very uncertain right now. But then, the whole economy, which is always based on expectations rather than indisputably certain values, is uncertain. Is the top 10% of the presumed market value of a house “worthless”? Or is it the top 30%? Or 40%? What is the “real” value of a 30 year government bond? No values of any asset are intrisic and immutable. Not even that of gold.

The fractional reserve system is that by which banks lend more than their total deposits, keeping on hand only the reserve requirement set by the Federal Reserve. This is fraudulent because at any given time, more than one person can have legal claim to the same dollar of savings.

Undoubtedly, some of the big banks’ assets are worthless in the sense that they can never be realized upon. An unsecured note from a bankrupt borrower would be an example. If all of B of A or Citi’s assets are like that, then there really is nothing for the government to do but pay off the account holders and call it quits. However, that possibility is so remote as to invite total disbelief. There are all kinds of “questionable financial instruments”. A house nobody will buy right now is not necessarily worthless for that reason alone, because at some other time someone may buy it. A “questionable financial instrument” may or may not be worthless even though no one wants to buy it right now. An ARM on a house that it doubtfully worth the amount of the debt is not something people want to buy, because the realizable value is presently unknown. It is unknown because the market for the collateral is unstable and uncertain. But ultimately there is some value to it even if the borrower goes bankrupt, because the collateral will ultimately sell for some amount or other. It is my impression that some of the derivatives that are essentially unmarketable at present, are collateralized, whereas some are not. In more normal times, even uncollateralized obligations have some value in the aggregate, because some are collectible notwithstanding that some are not. There are, for example, companies that buy up past due medical bills; perhaps the most questionable obligations there are. Maybe they buy them for ten cents on the dollar or even less. But they do collect some, and therefore the package of debts does have value. Undoubtedly in bad economic times where no one knows where the “bottom” is, those investors think differently. Maybe five cents on the dollar will give them a comfort level. But then, notwithstanding that some will be collected, maybe the number can no longer be calculated, and the company will no longer buy them at all. But that does not mean no one ever will.

I agree that the assets are not “worthless” in terms of “will never be collected”. That would be a ludicrous assumption. But as you say below, there is no intrinsic value to an asset. The value is assigned only based on what agents believe that it is worth.

Suppose that out of Citi’s “illiquid” assets, x dollars will be collected. Is the asset worth x? No, because of risk and time value of money. It is worth some fraction of x. But exactly what fraction? Well no one gets to make that call. The value is decided by the market. If a firm is bankrupt, its assets should be liquidated to the market and that value is the fire sale value. But this fire sale value, far from being a ripoff, is the market’s best guess at the actual value. And that’s how much it should be sold at.

Yes, the government has made some big mistakes by guaranteeing deposits. This problem won’t be solved by buying time using bailouts. Instead, all parties (banks and the government) need to pay their liabilities.

I agree with you that the value of paper assets is very uncertain right now. But then, the whole economy, which is always based on expectations rather than indisputably certain values, is uncertain. Is the top 10% of the presumed market value of a house “worthless”? Or is it the top 30%? Or 40%? What is the “real” value of a 30 year government bond? No values of any asset are intrisic and immutable. Not even that of gold.

Your question is very strange. The market value of a house is, in a free market, its value. It makes no sense to say that part of the market value is “worthless”. Still, if a house is in such poor shape that no one wants it, then its fire sale value (probably the value of the materials composing the house) is its market value.

Unless you are onto something about which I am ignorant (a distinct possibility) banks are unable to loan out more money than they have deposits EXCEPT their own net worth and money borrowed from others. They really don’t loan the same money out twice. Of course, loans are magnified if one bank lends money to another and the second loans it to another, who loans it to consumers, etc. But that happens inevitably, because banks don’t borrow money unless they use it for something, and that somthing is usually lending.

I have seen enough FDIC liquidations to know that they do not realize full value. There are a number of reasons for that. Because they do not sell for full value, they depress the market for everybody else. Their desire to reduce everything to cash is often imprudent, in my opinion. But what the h–l, it’s only government money. Speculators often buy up the assets that are distressed by FDIC ownership, and thus the taxpayer ends up subsidizing the speculators. I will say, however, that FDIC is less imprudent than FNMA, FHLMC, SBA, FSA, FHA in reducing mortgages to cash. Wildly guessing, I am going to speculate that the government is going to lose more money on those agencies’ guarantees than they are ever going to lose with the banks, unless they just start shooting the latter in the head and throwing their assets at speculators.

On the other hand, some banks have excellent “workout teams” that often realize the “book value” and more of failed loans’ underlying collateral. Some banks, though, employ “liquidation companies” and usually lose their backsides in doing it. I could name names, but had better not. Whether B of A and Citi have good workout teams is unknown to me.

The realizable value of something depends on a lot of factors, including the skill of the “workout team”, Real estate is not a fungible item like corn. Nor does it have an organized market. Consequently, its “value” is not determined by what buyers of last resort will pay, particularly when one depresses the market by throwing a lot of assets at it. Thus, a lot of value is lost when liquidations occur.

Yes, I meant that fractional reserve results in a credit structure which results in banks lending more than is deposited. Each individual bank, as I mentioned, keeps a reserve requirement set by the Fed. I might not have been thinking very clearly when I typed that bit, because I notice now that the wording was horrible.

It’s the act of lending money that has been deposited into accounts like checking that I consider fraudulent. In essence, the person who made the deposit has an immediate claim on the money and so does the person who has borrowed the money.

I have seen enough FDIC liquidations to know that they do not realize full value. There are a number of reasons for that. Because they do not sell for full value, they depress the market for everybody else. Their desire to reduce everything to cash is often imprudent, in my opinion. But what the h–l, it’s only government money. Speculators often buy up the assets that are distressed by FDIC ownership, and thus the taxpayer ends up subsidizing the speculators. I will say, however, that FDIC is less imprudent than FNMA, FHLMC, SBA, FSA, FHA in reducing mortgages to cash. Wildly guessing, I am going to speculate that the government is going to lose more money on those agencies’ guarantees than they are ever going to lose with the banks, unless they just start shooting the latter in the head and throwing their assets at speculators.

On the other hand, some banks have excellent “workout teams” that often realize the “book value” and more of failed loans’ underlying collateral. Some banks, though, employ “liquidation companies” and usually lose their backsides in doing it. I could name names, but had better not. Whether B of A and Citi have good workout teams is unknown to me.

The realizable value of something depends on a lot of factors, including the skill of the “workout team”, Real estate is not a fungible item like corn. Nor does it have an organized market. Consequently, its “value” is not determined by what buyers of last resort will pay, particularly when one depresses the market by throwing a lot of assets at it. Thus, a lot of value is lost when liquidations occur.

The value isn’t really lost, it’s just gained by whoever bought the asset at undervalued prices. The losing side, as it appears to me, is the banks’ shareholders, who deserve it after terrible decisions, and the government, which made some irresponsible guarantees.

Again, I dont care a thing about B of A or Citi, personally. But I do have major concern about the consequences of liquidation, which may be worse than bolstering them until the economy recovers. Liquidating them would only make this recession worse, as near as I can tell. That’s particularly true if their place is then taken by foreign banks that HAVE had a lot of government support.

That’s the first time I’ve heard the protectionist argument applied to banks. I suppose that’s a topic for another day.

About your first point, the alternative to fractional reserve banking isn’t carrying gold around. Bank notes, issued for gold, was the replacement for carrying gold around. Fractional reserve, loaning out money that people already have claims to, is not the same thing.

The difference between them is simple. Issuing notes for gold, to be redeemed at a later date, is non-inflationary. Fractional reserve is inflationary because it gives two or more people claims to the same deposit.

Now, regarding 401K plans, you can’t seriously think that taxpayers should take on risk for investors. Ok, so someone’s 401K plan does poorly and now the government should help him out. What if his plan did well? Was he going to share his rewards with the taxpayers, donating a fraction to the government? Probably not. That’s the thing about personal responsibility. If the rewards are going to be used as you wish, then the risks are also yours to bear.

It’s easy to think that the investor bears no responsibility for this, but he selected his employer and agreed to a plan which would leave some of his assets in bank stock. If he didn’t want to, he could have selected a defined benefit plan.

Issuing notes for gold may be inflationary or deflationary, depending on the supply of gold and the government’s desire to issue notes based on it. There is no particular relationship between the supply of gold and the needs of an economy for currency. Gold has no more inherent value than a cow does; less really. Its use as a measure of value is essentially a convention, made widespread because gold doesn’t rust or rot.

But in any event, your model assumes that no one will ever loan anything to anyone else. No matter what the medium is, a loan always multiplies the money. Therefore, am I to assume you do not believe in allowing lending at all?

The 401k owner had nothing to do with the sins of the management of B of A. You asserted that stockholders were paying for their own folly, when that’s rarely true. That was my point, not that anyone’s 401k ought to be protected by the government. But it’s also a fact that few people really know what all is in their 401k plans. And what is in it today might not be in it tomorrow, and the owner rarely knows when those changes take place or what they are.

Rarely does any employer give an employee a choice between having a defined benefit or a defined contribution program. Defined benefit, by the way, is on its way out, and rightly so, because future returns on assets (assuming they really are asset backed) are extremely difficult to predict 20 or 30 years out.

I will grant the conventional notion that the big bankers engaged in greed when they, and wall street, devised all of the various derivatives, swaps and so on. What they evidently did was seriously misjudge, and therefore underprice, the risk. But I am not persuaded that the proper remedy for the economy is to exacerbate and expand the risks by further devaluing the assets of those who had nothing to do with it, when there may be no good reason to do it other than to satisfy one’s sense of outrage.

But I will likewise say that government blame is just as deserved as is blaming the bankers. Those who voted for those who forced imprudent lending and securitization, and those who benefited from it, are as blameworthy as are the people with the 401ks. More so, really. Anytime government artificially increases demand for something like housing by forcing imprudent lending, and when the public generally got a short-term benefit from the resulting inflation in housing, there’s plenty of blame to go around.

Bankruptcy seems to be coming… I hope that people dont loose all their money to this.

I think we are understanding notes in a different way. What I meant by non-inflationary notes are notes which are issued for a particular amount of gold. That is, the bank can only issue a note for a particular weight of gold that it currently has in deposit. This cannot be inflationary because the definition of the note corresponds with the amount of gold that can be redeemed. This style of note is used when the country is on a standard, such as the gold standard.

But in any event, your model assumes that no one will ever loan anything to anyone else. No matter what the medium is, a loan always multiplies the money. Therefore, am I to assume you do not believe in allowing lending at all?

Again, I am opposed to lending money that someone else has an immediate claim to. If a depositor makes an agreement to deposit an amount of money for 10 years, of course the bank can lend that at interest. This is not fraudulent, because only one party (the bank or the debtor) has a claim to the money. The original depositor has relinquished it for 10 years. I am against loaning money to which the depositor has immediate claims, because such lending is inflationary and fraudulent.

The 401k owner had nothing to do with the sins of the management of B of A. You asserted that stockholders were paying for their own folly, when that’s rarely true. That was my point, not that anyone’s 401k ought to be protected by the government. But it’s also a fact that few people really know what all is in their 401k plans. And what is in it today might not be in it tomorrow, and the owner rarely knows when those changes take place or what they are.

Okay, I will agree that there is an asymmetry of information. Nonetheless, the investor is just as likely to have good luck and make extraordinary returns as to have bad luck and make poor returns, if we are to believe in market efficiency.

I will grant the conventional notion that the big bankers engaged in greed when they, and wall street, devised all of the various derivatives, swaps and so on. What they evidently did was seriously misjudge, and therefore underprice, the risk. But I am not persuaded that the proper remedy for the economy is to exacerbate and expand the risks by further devaluing the assets of those who had nothing to do with it, when there may be no good reason to do it other than to satisfy one’s sense of outrage.

There is a certain sense of outrage, perhaps. Can you clarify whose assets are being devalued who have nothing to do with this? You’ve agreed that the bankers and government are both responsible. The investors less so, but nonetheless they assumed risk willingly. The borrowers got loans without any means to pay them back, so they are culpable also. So who are these innocents whose assets will be devalued?

Those people who had nothing to do with it?

Other banks and the people who own them, who had no part in it. Ordinary citizens who did not go drunk on credit, but whose assets will be devalued by the liquidation of the big banks. The taxpayers who will get handed a bill for yet another two trillion, perhaps more as other institutions go down if these banks go down.

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