Tavakoli Structured Finance LLC

The Financial Report

By Janet Tavakoli

Hidden Bank Risks Drive Investors to Productive Assets, U.S. Treasuries, and Gold

JPMorgan’s “London Whale” episode exploded the myth that managers of too-big-to-fail banks have risk under control. The London-based Chief Investment Office that unexpectedly lost $6 billion in 2012 due to oversized credit derivatives trades reported directly to CEO Jamie Dimon.

As traders increased their losing position, Dimon courted Congress and preened for the media to thwart the Volcker Rule that would limit this sort of proprietary trading. The losses wiped out years of earnings for the huge banking unit within the bank behemoth.

Dimon later explained: “In hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored.” Dimon understated the situation. JPMorgan broke securities laws. Revelations of JPMorgan’s worst-practices in risk management and misleading disclosures resulted in an admission of wrongdoing and a $920 million SEC fine. JPMorgan shifted blame to “rogue” traders, but the systemic problem seems to be rogue management.

Dimon is now spending billions on an army of accountants and other “risk professionals” to examine JPMorgan. Yet this flurry of activity will not improve the bank’s core risk knowledge, because the global banking system has enormous systemic hidden risk. Dimon’s debacle is not an isolated case.

“The AIG of the World Is Back”

Kyle Bass, founder of Hayman Capital Management, announced during his March 2013 talk to the Chicago Booth’s Global Markets Initiative that he is bearish on Japan and has engaged in trades that will pay off in an extreme scenario:

“I have 27 year-old kids selling me one year jump risk in Japan for less than one basis point. Five billion dollars’ worth at a time.”

Mr. Bass said his aggregate position grew to $500 billion, or one-half trillion dollars. He could potentially lose his estimated $50 million investment, but his downside is limited, and his potential upside is enormous. He did not provide details of the trades or provide the formula for calculating his potential payout. Based on his presentation, the tail risk trades may pay off if there is sudden and dramatic weakening of the yen or a spike in Japan’s interest rates. The trades may not work out for him this year, but Bass observed: “The AIG of the world is back”.

Shortly after Bass put on his trade, bank traders asked the hedge fund manager to close out his position. They explained they ran a new model with better stress tests, and the trades were riskier than they first thought. Bass declined, even though he could have made a quick profit. He’d rather harpoon a whale.

Bass isn’t the only speculator to put on huge risky transactions with banks. But unlike the others, he spoke about it publicly and ridiculed the folly of his bank counterparties. (Bass comments on the trades after 52:47 minutes in this clip.)

AIG stock price after 1:20 reverse stock splitThe AIG Financial Products debacle was a contributing factor to the September 2008 financial crisis. AIG’s multifaceted taxpayer-funded bailout—and subsequent support programs from the Federal Reserve and U.S. Treasury—mounted to over $180 billion. Among other problems, AIG owed tens of billions to bank counterparties, after it wrote credit default swap protection on suspect collateralized debt obligations for mere single digit basis points.

In August 2007, I challenged AIG’s accounting in a Wall Street Journal article written by David Reilly. AIG failed to show material losses for these trades. Instead, AIG wrote down nothing at all, claiming it would never experience a loss. By February 2008, AIG was cited for material weakness in accounting for mark-to-market losses. By September 2008, AIG was in dire need of cash.

At the end of 2012, Treasury claimed U.S. taxpayers made $5 billion on the massive AIG bailout. But there was another material weakness in accounting for taxpayers’ so-called profit. The Federal Reserve had gifted Treasury more than 500 million shares of AIG, and AIG also received valuable preferential tax treatment. Taxpayers put capital at risk, and received not merely a negative risk-adjusted return, but an absolute negative return. Taken as a whole, taxpayers lost money.

Banks House Invisible Hedge Funds with Inadequate Capital

The enormous bank exposures in past years to so-called super senior, “AAA,” “investment-grade asset-backed securities,” and derivatives were all allowed due to a banking system blind spot, a phenomenon that has been written about for decades, including in my 1997 book, Credit Derivatives. Enormous exposures that do not require large amounts of regulatory and economic capital—because they are deemed to be “low risk” or “tail risk”—are simply ignored.

Citigroup was the largest financial institution in the world. As I mentioned in an earlier commentary: “Citigroup received the most bailout money of any U.S. bank. Between TARP, the FDIC, and the Federal Reserve, Citigroup got a total of $476.2 billion in cash and guarantees.” No one has been held accountable for material omissions in its pre-crisis disclosures. Citigroup’s share price is less than 10% of its pre-crisis share price. This former finance titan would trade at a little over $5 per share as of the December 13, 2013 close, if we hadn’t done a 1:10 reverse stock split. It was just too depressing to see the former U.S. flagship trading at a single digit price, so it is now trading above $50 per share, because we multiplied the price by ten.

Banks house invisible hedge funds. Sometimes enormous risks lurk behind potential trigger events, such as currency knock-in options. It is the job of bank managers to expose and even prevent these risks, but most bank managers seem to lack the will or the competence to uncover them. Perhaps the long-time habit of giving bailouts to banks has made bank managers lose their edge.

Why Banks Fail at Risk Management: Game Theory Shows Payoffs Pervert Incentives

It’s one thing for speculators to engage in huge volatile bets, but should global banks be pricing tail risk trades for less than a basis point, when they have the potential for eye-popping losses?

If a bank’s mispriced tail-risk trades go wrong, the bank will be stuck with massive losses. But the payoff is different for a bank’s trader and his managers. His downside is he’ll probably be fired only to be rehired by another bank or a hedge fund. The trader’s upside is a fat bonus and a new Maserati.

After every new debacle, bank managers claim they have plugged the holes in their shoddy management practices. Yet, even with billions spent on risk management, huge systemic risks remain.

Banks, including U.S. banks, write huge “low probability” risk for chump change when the trades have low regulatory capital requirements. This is the same mistake made by AIG, Ambac, MBIA, FGIC, Citibank and others before the last crisis.

Banks currently engage in regulatory capital trades: total return swaps on CDOs with off balance sheet vehicles. The sole purpose of these trades is to create a cosmetic appearance of less risk and make capital ratios appear better.

Game theory suggests bank traders have a rich incentive to expose banks to perverse risk. That’s also true of any other bank employee paid on the basis of trading revenues. Bank managers reap undeserved kudos and bonuses in good years. In really bad years, they get a taxpayer funded bailout followed by the added bonus of near zero cost borrowing from the Federal Reserve.

Sovereign Debt: More Bank Blind Spots

European sovereign debt is trading at artificially low rates. If rates climb, the value of the debt will drop. Spain, Italy, and Portugal have loaded up on their own sovereign debt. For example, Italian banks are undercapitalized and own around 267 billion euros ($366 billion) of Italy’s sovereign debt. Italy cannot afford to recapitalize its banks, and the greater Eurozone doesn’t want to do it. Default risk has been shifted to European taxpayers.

The European stock market is up, but nothing has been fixed in the European banking system.

Greece provides an object lesson in what happens when debt service is high but investment in the economy is insufficient to ramp up productivity. The Wall Street Journal, reported: “Parliament member Panagiotis Kouroumplis…supported the first bailout, but, he says, ‘every single euro we got went for debt. We haven’t spent a single euro on development.’”

Sovereign Debt Bailouts and the IMF’s T.I.N.A. Myth

The International Monetary Fund not only presented the first bailout of Greece and subsequent bailouts as if there is no other alternative (T.I.N.A.), it lied about the likely impact on the Greek economy and bent its own lending rule. The Wall Street Journal reported on a “strictly confidential” IMF document that showed the 2010 so-called bailout benefited the wider Eurozone instead of Greece. The IMF released the document only after the press leaked the embarrassing facts.

International bank bailouts, including the bailouts in the U.S. may have been necessary. Taxpayers aren’t objecting to saving the economy, but bailouts without consequences were more designed to save entitled bankers first, and international economies languish.

Simon Johnson, a former Chief Economist at the IMF and currently a professor at the MIT Sloane School of Management, explained there were alternatives to the way U.S. bank bailouts were done in his May 2009 article in The Atlantic: “The Quiet Coup.” The U.S. bailouts were a departure from IMF protocols.

The U.S. did not enforce existing securities laws, so no one should have confidence that new Dodd-Frank rules will have any meaningful impact. The U.S. banking system seems to have captured its regulators, Congress and the Treasury. Previously I mentioned there are alternatives to the Treasury bailouts that do not violate the spirit of democracy. Perhaps we’ll keep this in mind next time.

Why Foreign Borrowing Is a Clear and Present Danger for the United States

The Fed has become a huge buyer of U.S. Treasuries. Foreign investors including Japan and China own U.S. debt, and that poses a clear and present danger.

The U.S. debt ceiling fight made foreign investors in U.S. debt nervous. Treasury department data as of July 31, 2013, show China holds $1.28 trillion in U.S. Treasury bonds and Japan holds $1.14 trillion. If foreigners sell debt, they can cause a run on the dollar.

The dollar is still the world’s reserve currency, but that advantage is weaker than a few years ago. After the 2008 financial crisis, China argued that the U.S.’s reserve currency status and Triffin’s dilemma contributed to the crisis. If the U.S. doesn’t continue to run balance of payment deficits, foreign central banks lose their chief source of reserves, and the resulting illiquidity could cause the global economy to contract. But if the U.S. continues to run deficits, it can shake confidence in the value of the US dollar, damage its status as the reserve currency, and land the globe in the same liquidity crisis as not running the deficit.

China positions its advocacy of a stronger more international renminbi as a means to alleviate the problems posed by Triffin’s dilemma, by strengthening the position of the renminbi as an alternate reserve currency, enhancing global liquidity, and allowing the U.S. to reduce the balance of payment deficit. China recently initiated agreements with the Eurozone and Japan to swap renminbi directly for Euros and yen. This eliminates the intermediate step of first converting to dollars. Hong Kong’s Chinese Gold & Silver Exchange Society now offers gold quoted in renminbi. Ai Baojun, the vice mayor of Shanghai, told a forum of the Chicago Council on Global Affairs that he wants the renminbi to take a greater role in international trade.

Debt and Maxed-Out Growth Engines

The growth of the U.S.’s bigger and broader productive economy has been stunted by bad policies and bank bailouts benefiting rent-seeking financiers siphoning off an outsized percentage of the nation’s gross domestic product (GDP). Rent-seeking companies lobby Congress for subsidies for activities that do not benefit society. Moreover, beneficiaries of Congressional largesse damaged society by engaging in control fraud, wherein parasites damage their own financial firm from within while earning huge bonuses. William K. Black coined the term “control fraud.” As a regulator during the 1980’s S&L crisis, he helped initiate over 1,000 felony indictments. Yet the much larger 2008 crisis produced zero felony indictments.

The financial services industry has grown like an algae bloom with the help of taxpayer bailouts and ongoing subsidies, all of which increase our debt. According to a study by Harvard professors David Scharfstein and Robin Greenwood, in 1950 the financial industry accounted for only 2.8% of GDP; in 1980 it accounted for 4.8% of GDP; and in 2007, it accounted for 7.9% of GDP. In 2011, the Commerce Department reported the financial sector accounted for 8.4% of GDP, and represented 30% of corporate profits.

If proceeds of U.S. debt had been invested for roads, high speed railroads, new industries, cheap energy, airports, and to fund scientific research, the debt would self-liquidate. But the bailouts came with a huge component of dead-end financing designed to let bankers suck rents from the financial system. The Fed monetizes debt through asset purchases and has been filling gaping holes in bank balance sheets.

What will be the driving force for growth in the United States and Europe?

In both Europe and the United States, taxpayers are stuck with the banks’ bills, and capital investment suffers. Deficit spending is maxed out. Interest rate lowering is maxed out. Yet both the U.S. and Europe have a priority for little or no inflation.

Germany’s answer is to liberalize trade with the U.S. and other markets. But that’s China’s answer, too, and the U.S. would like to decrease its trade deficit.

Temporary Liquid Stores of Value: Gold and T-Bills

Warren Buffett, CEO of Berkshire Hathaway and one of the most successful investors in world history, riffed gold in his 2012 shareholder letter. Yet he acknowledged: “the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time.” Buffett didn’t mention that most of the weakness in the dollar occurred after Nixon took the dollar off the gold standard in 1971.

Buffett claimed that for most people, gold is only a fear trade and that people afraid of every other asset run to gold and hope the “ranks of the fearful will grow.” Based on my observations, Buffett’s notion does not represent diversified investors.

Buffett may or may not be right about gold, but he has a reason to be biased. He’s the beneficiary of massive post-crisis bailouts and the Fed’s hyperaggressive monetary policy the past five years. If U.S. taxpayers hadn’t bailed out many of the stocks in his portfolio (US Bancorp, Bank of America, American Express, Goldman Sachs, Wells Fargo), his performance would have suffered, and he wasn’t alone.

Shares of Lehman were worthless. Bear Stearns’ shares (now part of JPMorgan Chase) and Merrill Lynch’s (now part of Bank of America) plummeted along with the shares of Freddie Mac, Fannie Mae, Citigroup, MBIA, Ambac, AIG, and many more.

Savvy investors like Buffett are ever mindful that the financial system hasn’t dealt with its problems. Investors are looking for diversified temporary stores of values—and that may include gold and U.S. Treasuries.

Buffett claimed gold, a non-productive asset, is in a bubble. Perhaps both gold and U.S. Treasuries are in a bubble, and they are both non-productive assets, but they both have financial utility. Buffett keeps his powder dry by investing a working level of $20 billion in U.S. Treasuries—and never less than $10 billion—for liquidity. The same aggressive zero interest rate policy (ZIRP) that has destroyed safe savings and encouraged investors to buy riskier assets (thus benefiting Buffett’s stock portfolio) has resulted in a negative real return for U.S. Treasuries. But Buffett invests in treasuries for the same reason other diversified investors invest in some gold: because he believes it is a prudent strategy.

Many reasonable diversified investors, including Ray Dalio of Bridgewater, the largest money management firm in the world, own a portion of their diversified holdings in gold. Gold doesn’t pose credit or counterparty risk, and unlike many U.S. stocks, it has never been worth zero. Gold isn’t viewed as an alternative to productive assets; rather investment in gold is another way to diversify.

The recent drama over a possible technical default of U.S. debt, cast doubt on the liquidity of T-Bills, and reignited concern about the dollar’s reserve currency status. The most shocking development was this: “HKFE Clearing Corporation, part of Hong Kong Exchanges and Clearing, increased the haircut on US Treasury bills from 1% to 3% for maturities of less than one year.” The Commodity Futures Trading Commission is considering a regulation that could double liquidity facility costs; clearinghouses may have to back Treasuries pledged as collateral with bank credit lines. The CFTC claims that in a crisis, it may take too long, up to a day, to liquidate Treasuries. Yet Congress foolishly refuses to rule out the future possibility of a technical default. Perhaps Warren Buffett should diversify Berkshire Hathaway’s liquid investments even more.

Central Banks: Global Printing Destroyed Money Standards

There is no longer a stable currency benchmark for the largest economies in the world: the United States, the Eurozone, China, Japan, or any other country. Relative value is a rapidly moving target. No one can adequately track it.

Central banks still use gold as a form of money. Dr. Mario Draghi, President of the European Central Bank, is the former governor of the Bank of Italy, the fourth largest owner of gold in the world. Draghi stated:

“I never thought it wise to sell it, because for central banks this is a reserve of safety; it’s viewed by the country as such. In the case of non-dollar countries, it gives you a fairly good protection against fluctuations of the dollar. So there are several reasons, risk diversification, and so on…the experience of some central banks that have liquidated the whole stock of gold about ten years ago, was not considered to be terribly successful from a purely money viewpoint.”

Dr. Draghi suggests some gold ownership is a prudent strategy at a time when global currencies have become unmoored.

Trouble is Opportunity

The world population is approaching 7 billion. Every day we wake up hungry, and we all have needs. We will have trouble. Liars, thieves, and bullies will always be with us. But so will productive people and productive assets to supply growing needs. There will always be opportunities for sound investments.

It is in everyone’s interest to keep the production-to-corruption ratio as high as possible. Our leaders failed us, but the human will for survival may result in a push to rebalance the scales.

Those of us who have lived through tremendous upheaval know that people don’t want cash, gold, or other liquid assets for their own sake. These are simply a means of storing value so that you can invest in productive assets at a reasonable price.

What Is a Reasonable Price?

The late John Templeton (1912-2008) was one of the greatest investors of all time. He used guidelines that suggest many global stocks are currently overpriced by historic measures and are located in countries with high debt to GDP ratios. They are a “Templeton sell.” Before he evaluated country risk, however, he looked at individual companies. He looked for companies with low debt and growth in net earnings per share.Opinions of stock value

Templeton sought profits after deducting expenses and taxes. He also looked for a good price as indicated by relatively low price-to-earnings (P/E) ratios, relatively low price-to-earnings-growth (PEG) ratios, strong dividends, and relatively low price-to-book values.

When stocks became overvalued in his estimation, he sold them. He remarked that he never bought a stock at its lows and never sold at the highs. He was one of the earliest western investors in Japan and sold when he believed the Japanese stock market was overvalued. The Japanese stock market became a bubble that continued to expand until it exploded.

Templeton didn’t get out at the highs, because he didn’t want to stay invested in a stock bubble. He was happy to hold cash as a temporary liquid store of value, if he couldn’t find an investment 50% better than what he was selling. This wasn’t his only strategy, but it was one of his several successful strategies.

Bubbles versus Reasonably Priced Productive Assets

Most global stocks appear overvalued. Many stocks in the S&P 500 (Standard and Poor’s) look like a “Templeton sell,” and the index overall has a trailing 12-month P/E ratio of 18.4 according to the Wall Street Journal’s market data center.

The S&P 500 recently added Facebook to the index. The stock has a P/E ratio of 127 and a PEG ratio of 4 as of December 13, 2013. Index investors should take note of Standard & Poor’s penchant for serial incompetence.

When Buffett wrote his comments on gold, he noted that “over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices.”

Standard & Poor’s explanation is that Facebook has “staying power,” but that isn’t the same as saying that it is well-priced.

This is why John Templeton avoided indexes and performed his own analysis. One defense against bubbles is to selectively invest in productive assets when they can be purchased at reasonable prices. When assets are overpriced, investors can choose a store of value.

This is part four of a four part series. See also:

Structured Finance: Price Manipulation Includes Silver and Gold” (Part One)

Who Says Gold Is Money?” (Part Two)

Structured Finance: Sovereign Debt, Banks, and Gold” (Part Three)

How to Corner the Gold Market

Currency Manipulation and Derivatives

More finance articles by Janet Tavakoli

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