Betting on Government Relief Stocks: A Real Bad Idea

Established on January 5, 2009, the NASDAQ OMX government relief index that tracks companies that are participating in the US government's financial relief plan (symbol: QGRI) is down 36% since inception. The US Treasury is in the process of becoming the proud owner of some 36% of Citigroup's common stock, after pouring some $45 billion into the company. Analysts say the U.S. government’s third attempt to help rescue Citigroup Inc. won’t stanch the company’s losses, which will continue to swell and may lead the bank to require more money in coming months. Investors that have stuck with Citigroup on the hope that government intervention would turn around the company have lost some 97% of their investment since the peak in the stock in 2007. How about a double short on the NASDAQ OMX government relief index?

The pattern for AIG is the same. CNN, in an article called "The Bailout that Won't Quit" pointed out that AIG has already blown through the $152.2 billion bailout it already received from the government, and it is likely the US government will take an even bigger stake to wield more control over the world's largest insurer. AIG and the government know that the current plan is not viable. The speculation now is that the US government will put together a Citigroup-like package for AIG, or the insurer may turn over some of its divisions to the government as payment on the loans, or the government may also opt to pump more cash into the insurer--doubtless with the same result. Too big to fail is becoming a black hole of government support.

No wonder that Paul Kedrosky of the Infectious Greed blog and others openly wonder if the financial markets might not be openly against the Obama Administration. Fred Barnes on Fox News has also observed that the first reaction to President Obama's speeches is to fall. US stock prices dropped 800 points since Barak Obama became president, and more like 2,200 points since he was elected. To some, that is a financial market vote of no confidence on his economic policies.

Or, it could be that the problem (which has long ago since gone global) is simply too big for any one government to make a short-term dent in. The New York Times (as well as Bloomberg) estimates that the US government has committed $8.8 trillion (some 68% of the US GDP) and has already spent some $2 trillion on the problem. Yet economists like James Gailbraith and Nouriel Roubini claim that much more is needed. Our question to Mssrs Gailbraith and Roubini is, before you insist that more government money is needed, come up with a suggestion as to how in the world the US will be able to pay for this.

AIG: The Bailout that Won't Quit
Government Relief Index Not Looking Good
Do the Markets Hate Obama?
Total Bailout Tab

From Global Powerhouse to Ward of the State

The US Treasury is moving to convert up to $25 billion of preferred stock it holds in Citigroup to common stock, while its remaining investment in Citigroup would be converted to a trust preferred security of greater structural seniority that would carry the same 8% cash dividend rate. The conversion of preferred to common would raise the US government's ownership of Citigroup from 8% to 36%, and the US Treasury is to receive the most favorable terms and price offered to any other preferred holder, even though other government sovereign wealth funds such as Singapore's Government Investment Corporation and Saudi Arabian Prince Alwaleed Bin Talal have also apparently agreed to convert their Citigroup preferred into common. In an apparent exchange for the government support, Citigroup will be altering its Board of Directors so that a majority of the Board will be comprised of independent directors.

In other words, what was once a global financial powerhouse and the epitomy of US capitalism has become a government-sponsored entity (GSE), or more bluntly, a ward of the state, like Fannie Mae, Freddie Mac and AIG.

The only difference between this and nationalization is that, a) Citigroup was not "seized" but became a ward of the state willingly and b) government takeover in and of itself did not wipe out Citi's shareholders. They were already effectively wiped out with the stock price hit $1.50/share, some 97% below its 2007 high.

Jettisoning Global Operations

Citigroup's more financial viable competitors are arguing that Citigroup, as a ward of the state, should not be allowed to operate freely in overseas markets. In restructuring plans announced last month, Citigroup already designated its Nikko Cordial Securities and Nikko Asset Management operations as "noncore" operations, i.e., on the block for sale, even though Citigroup has stated that the transaction with the US Treasury does not change its business strategy. Citigroup spent roughly JPY1.5 trillion for Nikko Cordial, but interested Japanese megabank groups are prepared to bid only up to JPY500 billion yen or so. However, US Treasury ownership would hamper a discounted sale in defernce to potential losses to US taxpayers.
Citigroup has already began accepting applications from firms interested in acquiring the brokerage, including Mitsubishi UFJ Financial Group Inc. (8306), Mizuho Financial Group Inc. (8411) and Sumitomo Mitsui Financial Group Inc. (8316).

Nikko Asset is one of Japan's largest asset managers, with around JPY10 trillion yen in assets under management, and had recently been ramping up purchases of Japanese equities after taking over management of Japanese equity investment by Citi's other asset manager, Clearbridge. Citigroup's earnings results already included a $560 million valuation loss for Nikko Asset shares, and having already booked these, the sale of the asset management company could well begin taking shape as well.

Citibank Japan's banking operations, which rank on par with leading regional banks in Japan with 38 branches in Japan and total deposits of JPY5.9 trillion, are at present not up for sale. But if Citigroup's competitors succeed in pressuring the US government to downside Citigroup's overseas assets, Citibank Japan may also have to consolidate.

Note: Japanese banking laws protect customer assets at Citi's Japanese units, including stocks and investment trusts as well as yen deposits.

Japan's January Trade Numbers Even Worse than December's

Japan posted a record trade deficit in January, as exports plunged 45.7% versus a "shocking" 35% YoY plunge in December. The December number was worst reading on record and the largest drop in at least 28 years. Exports to the U.S. tumbled an unprecedented 52.9% from a year earlier. Shipments to Europe slid 47.4% YoY and even xports to China fell 45.1%, while those to Asia dropped 46.7%. In 2008, Japan's balance of trade fell 80% as exports for the year fell for the first time in seven years. Last year, the media was reporting that Japan recorded "a rare" trade deficit in August, but the trade deficit has now persisted for six months because of plunging exports.

The collapse is likely to force Japanese companies to keep firing workers and closing factories, worsening an economy that shrank the most in 34 years last quarter, as the Bloomberg survey of consensus forecasts for January production show a 30% YoY decline. Japan may shrink a record 4% in the year starting April 1, according to economists surveyed by Bloomberg. The worst contraction to date was fiscal a 1.5% drop in 1998.

Japan's economy is in deep trouble, as its politicians continue to fiddle with a JPY70 trillion-plus stimulus package while the economy is flaming out. As we have pointed out before, the horrible economic numbers mean the yen is rapidly losing its luster as a haven currency. The yen’s 23% percent gain against the dollar in 2008 was based on massive yen carry trade unwinding, not economic fundamentals. The yen was trading 96.49 per dollar after the January trade report, and the currency is near the lowest level against the dollar in three months.

US Banking Crisis Still In Phase 2, While the Real Hard Part Comes in Phase 3

It is widely perceived that Japan’s banking crisis was made worse by the fact that the Japanese government took so long to take decisive action for a clean-up. Successive actions were taken in Japan, but the government and regulators consistently underestimated the depth and breadth of the problem.

Stock prices collapsed first in 1990, followed by a collapse in property prices in 1991, while official land prices did not begin falling until 1992. The Basil Capital Accord dictating minimal capital requirements for banks was implemented in March 1993. This included two tiers of allowable capital, Tier 1 and Tier 2. As the Japanese banks were allowed to count 45% of the market value of their stock holdings as Tier 2, they appeared to have a comfortable capital cushion as well as a significant amount of unrealized gains on marketable securities as well as property holdings.

Like the US, the crisis first began in the non-bank financial sector and in property loans gone sour, with seven housing loan corporations (nicknamed Jusen) that had been financed to a large extent by credit cooperatives on implicit credit guarantees from formal banks.

Phase 1—Collapse of a Shadow Banking System

Until 1995 (five years after the crash in stock prices and real estate), Japan’s financial crisis appeared to be largely within a “shadow banking system” that had been outside the Bank of Japan and financial regulators’ control, and mainly centered on real estate lending, similar to the US experience in 2006~early 2007.

After 1995, however, it became clear that the bank’s problems had considerably worsened beyond the Jusen and the credit cooperatives. Japanese regulators however hesitated to take strong action because of fear of triggering a public panic, because of political resistance by the banks, and because of strong public sentiment against using public funds to help the banks.

The NPLs in the Jusen continued to deteriorate, and the Ministry of Finance (MOF) and credits agreed to dissolve the seven Jusen in August 1995. At the same time, local governments were moving to close down financially troubled credit cooperatives that had become defacto full range banks heavily lending to real estate. By Q3 2005, the MOF also began closing down essentially insolvent regional banks. In order to facilitate this, a Housing Loan Administration Corp. was established in July 1996 to assume the assets/liabilities of the Jusen, with shortfalls to be covered by parent/creditor banks of the Jusen. This resulted in total NPL write-offs of some JPY3.5 trillion to JPY1.7 trillion. At the same time, a Resolution Collection Bank was also established in 1996 to cope with the liquidation/asset recovery of failed Jusen as well as credit cooperatives, and the Deposit Insurance Corporation was strengthened

But Japanese banks were not realizing all of the NPL losses due to loan forebearance and restructuring, and were still able to tap into significant unrealized gains in bonds, stocks and real estate holdings to offset loan losses. Japan still did not have an adequate deposit insurance scheme or a legal framework for bank restructuring, and still did not have a clear measure of the extent of the NPL problem. The regulatory authorities were intervening only after distressed banks became insolvent, and were often taking action once they had no other choice.

Phase 2—Near Collapse of the Formal Banking System

By 1997, however several large and high profile financial institutions in Japan went into effective bankruptcy, aided by a continued deterioration in property as well as stock prices. In April 2007, the MOF shut down Nissan Life Insurance, in November, Sanyo Securities triggered a near melt-down in the money markets by defaulting on call market borrowings. The MOF also shut down Hokkaido Takushoku Bank—all of these actions led to a renewed sell-off in the stock market.

In 1997, the “Law to Ensure the Soundness of Financial Institutions”, or Prompt Corrective Action (PCA) framework was introduced in Japan, but not effective until April 1998. The program,

1) Required to banks to make a self-assessment of their assets on a prudent and realistic basis under well-defined guidelines. The banks’ own findings were subject to review by external audiors and inspections as well as monitoring by bank examiners.

2) Set specific capital ratio thresholds under which regulators could order banks to take remedial action, including liquidation in the case of insolvency.

In 1997, it became clear that even big Japanese financial institutions were not too big to fail, even though the authorities repeatedly insisted in public that no such banks would be allowed to do so. But the severity of the problems and the need to use public funds to restructure the system was not recognized by the public and politicians until 1998, or eight years after the bubble first burst.

Phase 3—Proactive Measures to Clean Up the Banking System

In February 1998, the Japanese Diet passed two laws to amend the Deposit Insurance Law and establish emergency measures for stabilizing the financial system. Some JPY30 trillion was set aside to bail out banks and protect depositors. Yet many banks had difficulty meeting capital requirements in March 1998. As a result, all major banks applied for public capital injection, but all received essentially the same amount, ostensibly because differing amounts would lead to fears that one bank was in worse shape than the other. This is similar to the $250 billion injected into the major US banks by Hank Paulson under the first phase of TARP.

To further help the banks strengthen their capital positions, the Japanese government relaxed accounting rules, allowing banks to count 45% of their revalued real estate holdings as Tier 2 capital. They also suspended lower of cost or market accounting and let banks report the historical cost of their stock holdings. This is exactly what many are calling for now in the US, i.e., abandon mark-to-market accounting.

The Financial Supervision Agency (FSA) was established in June 1998 to take over bank supervision. The FSA was granted considerable operational autonomy and independence to allow supervisors to operate more effectively. In October 1998, the Diet passed the Financial Revitalization Law and the Financial Early Strengthening Law, in addition to amending the Deposit Insurance Law, to provide a broad framework for resolving the banking crisis.

The new laws augmented available procedures for dealing with bank failures by introducing management by financial resolution administrators and temporary nationalization as well as special public management. The new laws merged the Resolution and Collection Bank and the Housing Loan Administration Corp. into the Resolution and Collection Corp. (RCC), allowing it to purchase NPL not only from failed banks but also solvent institutions.

By March 1999, a second round of capital was injected into the banks to the amount of JPY7.5 trillion, or 4X as much as the first round in 1998. Capital was injected by purchases of preferred shares by the DIC or subordinated debt issues by the banks. Vis-a-vis the initial TARP capital injections, a 4X increase in capital injections for US banks would mean over $1 trillion, which many are now saying is the kind of scale of capital infusions now needed for US banks.

Contrary to 1998, the amount injected varied by Japanese bank and reflected individual financial conditions. In return for the capital injection, the FSA required each bank to submit a restructuring plan which would be subject to review on a quarterly basis. The FSA also had the option of converting their preferred shares into common equity if restructuring conditions were not met. All of this was done after full-scale special on-site examinations of all major banks were conducted in the fall of 1998.

Closures and suspension of banks continued during 1998. The Long-Term Credit Bank of Japan was temporarily nationalized in October 1998 as ws the Nippon Credit Bank. At the same time, the FSA was pressuring the banks for “voluntary” mergers. This wave of mergers resulted in what had originally been some 20 major banks consolidating into what essentially have become four megabank groups.

US Crisis Still in Phase 2

In our view, the US banking crisis is still in Phase 2 “near collapse of the formal banking system”. The shadow banking system has undergone a major consolidation and the mortgage bank system (similar to Japan’s Jusen) has effectively collapsed. There has also been a major credit event in September 2008 (i.e., the failure of Lehman Brothers) that triggered a near collapse of the formal banking system, as occurred with the failure of Sanyo Securities in Japan in November 1997.

But after two years of continued deterioration and a near global financial meltdown, the US still does not have a comprehensive framework for restructuring the financial sector, nor a clear measure of the extent of the problem. The TARP, TALP and other acronyms being used by the US government and Federal Reserve are merely reactionary ad-hoc measures to prop up a dysfunctional financial system.

Treasury Secretary Timothy Geithner has promised a comprehensive bank reform package, and has announced the initiation of “stress tests” for every US bank with over $100 billion in assets, but this puts the US where Japan was in February 1998, i.e., still five years away in Japan's case from the eventual perceived end of Japan’s financial crisis in Q2 2003.

With the stress tests, the US regulators will ostensibly establish capital ratio thresholds under which regulators can order banks to take remedial action, including liquidation in the case of insolvency. The question then is, what will they do with this information?

Like Japan in 1997, it is becoming clear by plunging bank stock prices that even big US financial institutions are not too big to fail, despite repeated insistence by the regulators that no such banks will be allowed to do so. While it has taken the US crisis two instead of seven years to reach this point, there is still no public and political consensus on the need to use public funds to restructure the system, which emerged in Japan in 1998.

Nor is there a financial services agency in the US whose specific writ is bank supervision, and who has sufficient operational autonomy and independence to allow supervisors to effectively operate. As a result, the capital infusions under TARP to date have occurred without any effort to prevent moral hazard. Unlike Japan’s second round of capital infusions there is no implicit threat that bank management take responsibility for their failure if the government is forced to convert their preferred shares into common stock or to temporarily nationalize the bank.

As with Japan, a second, formal round of capital infusions is probably inevitable, as is being seen now with AIG and Citigroup. While the bank guarantees are implicit, the US government is now committed to converting convertible preferred shares with dividends but for nothing in return from bank management, unlike the restructuring plans that were required Japan's FSA in lieu of additional capital injections.

Moreover, the US is likely to end up temporarily nationalizing some of its largest banks despite a comprehensive program to restructure the banks and protect depositors. Despite all of their proactive capital infusions and stringent requirements to write-off and/or write-down NPL losses, Japan in the end ended up temporarily nationalizing three banks, i.e., Long-Term Credit Bank of Japan (now a private bank named Shinsei Bank), Nippon Credit Bank (now a private bank named Aozora Bank) and a consolidated, restructured bank called Resona Holdings (itself a merger of several regional banks. As was seen with Resona, consolidation of weak banks without addressing the underlying problem is like two drunks holding each other up, or one sober person trying to hold up a drunk, which is more applicable in the case of Bank of America's takeover of Merrill Lynch.

More Stock Market Pain Lies Ahead

By 1998 and the time Japan serious started to address its banking problem, the Nikkei 225 had fallen some 55% from its December 1989 high. However, the bear market was far from over, and over the next 5 years and until the banking crisis was largely solved, the Nikkei 225 declined another 56% from 1998 levels to an eventual low around 7,600 in April 2003, representing an 80% peak-to-trough decline from December 1989.

We are now year three from the peak in the US housing bubble, and year two from the peak in the US stock market. Even though it has taken the US essentially two years instead of eight years to reach Phase 2, and the S&P 500 is now down nearly 50% from 2007 highs, we are probably still a couple years and another 50% on the S&P 500 away from the end of the US financial crisis.

Japan Government Studying Measures to Support the Stock Market

Japan's new finance minister Kaoru Yosano is making no secret of the fact that the Japanese government is studying ways to prop up Japan's stock market, whose benchmark indices, the Nikkei 225 and Topix, are at 25-year plus lows.

Mr. Yosano says he has instructed government officials to study past stock support programs in Japan, ostensibly out of worry that stock valuation losses are harming the financial viability of the nation's banks, where valuation losses on stock holdings eat into regulatory capital

The Bank of Japan is already committed to buying up to JPY1 trillion of stocks held by the banks, a scheme previously used between 2002~2004, when the Nikkei 225 rallied smartly off a Q2 2003 secular low. A bill is also under consideration by the Diet for a JPY20 trillion package to buy shares held by the banks, but passage has been held up by political gridlock.

JPY1 trillion of buying by the BOJ could soon be overtaken by foreign investor selling, but JPY20 trillion of buying would not. Purchases of JPY20 of Japanese stock would represent about 8% of total market capitalization of JPY243 trillion at current prices, and about one-third of the 25%-plus of market capitalization that is owned by foreign investors.
CNBC

Investor Confidence Improves, But Economic Outlook Has Never Been Worse

State Street's Investor Confidence Index for February shows two months of improvement from late 2008 lows, mainly on an improvement in North American investor confidence. In Europe and Asia, however, investor confidence is still slipping.

Meanwhile, the economic outlook has never been worse, according to the Info Institute's survey of world economic conditions. Does this mean that investors fully discounted the deterioration in economic fundamentals with the global stock market lows last year? We don't think so, as global stock market indices are again testing last year's lows. The DJIA and DJ transports have broken through these lows, as have the S&P Sector SPDR financials (XLF), utilities (XLU), consumer staples (XLP) and industrials (XLI), as well as the European Top 100 stock index, the French CAC 40, and the German DAX Composite.

The indices still above last year's lows are; the S&P 500, the NASDAQ Composite, the S&P Sector SPDR materials (XLB), health care (XLV) and technology (XLK) as well as Japan's Nikkei 225 and the UK's FTSE100 indices. It could only be a matter of time before these indices break down to new bear market lows as well.

Japan's Production in January 2009 Could Have Plunged 30% YoY

Industrial production in Japan has been literally falling off a cliff due to plunging exports and ballooning inventories, particularly in automobiles and electronic products.

Industrial production turned minus YoY in October 2007, and has rapidly deteriorated since. The January numbers, if a Bloomberg survey of economists' estimates are accurate, could show when announced on February 27 that the decline was still accelerating.

Japan's GDP already declined a record 12.7% annualized in Q4 calendar 2008 mainly on this plunge, and could see another two-digit annualized decline in Q1 2009. While this decline is probably already in stock prices to some extent, it backs up the conjecture that ordinary profits in Japan's manufacturing sector in the final quarter of FY08 (Jan-Mar 2009) were in deficit by a massive JPY4 trillion.

Asian Investors Refuse to Buy Fannie and Freddie Debt Without Explicit Guarantees

Bloomberg is reporting that Asian investors won’t buy debt and mortgage-backed securities from Fannie Mae and Freddie Mac until they carry explicit U.S. guarantees, similar to those given on bonds issued by Bank of America Corp. or Citigroup Inc. This even after President Barack Obama vowed on Feb. 18 to sink as much as $400 billion of capital into Fannie Mae and Freddie Mac, double the original commitment.

Foreign investors sold $170 billion of agency debt and securities in the second half of 2008, the largest amount since the Treasury began tracking sales in 1977, according to the most recent data. Asians, the biggest non-U.S. block of owners in the category, unloaded $70 billion worth from July through December, after scooping up $55 billion in the second quarter and being net buyers during much of the last decade. “The U.S. government is worried about the agency market, and market participants feel the same way,” said Kei Katayama, head of the foreign fixed-income group in Tokyo at Daiwa SB Investments Ltd.

Japanese institutions like Fukoku Mutual Life Insurance Co., once big buyers of US agency securities, spent last year trimming “risky assets,” and sold all agency holdings in the third quarter, said Satoshi Okumoto, general manager at the company in Tokyo, apparently because agency securities are now considered "risky assets".

Bloomberg

Fixing a Disintegrated Financial System Requires Political Consensus and Transparency

According to George Soros, “We witnessed the collapse of the financial system." "The bankruptcy of Lehman Brothers in September marked a turning point in the functioning of the market system. (The financial system was then) "…placed on life support, and it's still on life support. There's no sign that we are anywhere near a bottom." According to US President Obama "The credit crisis is real, and it's not over,"

The debate about nationalizing major US banks has already hit a fevered pitch, and if the first quarter is going to bring another series of multi-billion losses, institutions including Citigroup (C )and Bank of America (BAC) may simply not have the balance sheet resources to remain independent. Having the government seize one or two major banks is increasingly seen as the ultimate key to their survival.

The "snake in the box" however is the concern is that, if the public loses confidence in the rest of the independent banks, brokers, and money managers in the country, (nationalization) could trigger a series of bank runs not seen since the Great Depression. While there may not be a great deal of logic to the prospect of heightened fear about the future of banks if the government ends up owning a few of them, the psychological effects on consumers could be devastating.

Treasury Secretary Timothy Geither has proposed bank balance sheet “stress tests” in his financial stability plan, which will naturally lead to nationalization if these tests reveal that a bank is insolvent. Once the government faces the truth that major banks are effectively insolvent, there really isn’t much left to do but nationalize, apparently aka the Nordic model (as examined by two recent papers on the Nordic bank rescues by the Federal Reserve Bank of Saint Lewis and the Federal Reserve Bank of Cleveland)—i.e., a temporary takeover, cleanup and then resale of these banks. But the longer nationalization is delayed, the longer the solvency of the entire banking system will be in question. Thus, more good banks will get dragged down into the mud with the bad.

The worry of course is that the Obama Administration is running out of time and options.

Government bank balance sheet stress tests are expected to begin next week, and will be required for any bank with more than $100 billion in deposits. The banks in question of course are dead set against being nationalized and are pressuring the Obama Administration to bolster flagging confidence in the US financial system.

The Key Components are Political Consensus and Transparency

According to the Federal Reserve Bank of Saint Lewis’ analysis (Resolving a Banking Crisis, the Nordic Way), the key components of the apparent success that the Nordic countries had in cleaning up their banking cisis were:

１）Political Consensus. A key step to solving a banking crisis is the building of bipartisan political consensus to support the actions needed to maintain confidence in the banking system. In the Nordic case, this involved establishing a financially and politically independent crisis resolution agency to handle both communication with the public and bank restructuring.

２）Transparency is crucial. Regulators need to refrain from concealing both the extent and the nature of the problem. They need to require open accounting for all expected losses and write-downs for all banks as early as possible. They also need to be very transparent about support actions through a highly visible public government guarantee for the obligations of the banks, including deposits and borrowings.

３）Seek private sector solutions whenever possible. Regulators need to continue seek private sector solutions wherever possible, including mergers and acquisitions, and need to avoid liquidations.

What the Obama Administration has so far failed to achieve is;

a) A bipartisan political consensus about what needs to be done. There is much less resistance to nationalization in Europe (such as in France or the UK), while the myth that the US is a bastion of capitalism and the free market runs very deep. Nationalization has to be seen by the political majority (Democrat and Republican) in Washington, the banking regulators (Treasury and the Fed) as well as the voting public that this is the only remaining viable alternative. One of the major reasons it took Japan so long to address its banking crisis was the simple lack of political will.

b) Transparency. The extent and the nature of the problem bank by bank is still unknown, i.e., there is no transparency. With no transparency, traders and investors will continue to make their own assumptions about the viability of each institution.

Resolving a Banking Crisis the Nordic Way
Effective Practices in Crisis Resolution and the Case of Sweden