“Where’s The Money??….!!”

(bumped up by Susan from Sunday night late)

I hope that all our loyal readers and listeners have been able to enjoy a wee bit of rest and relaxation with friends and family during this holiday stretch. In the midst of connecting with friends, doing a little more reading and research, and watching a few movies, I pondered what may be an appropriate topic for a year end piece.

I thought about providing an outlook for 2009. I considered offering further opinions on Obama’s economic plans. Perhaps a review of the Bush economic program would be well received. Then, yesterday the lead editorial in my local newspaper asked “Where did the bailout money go?” I had my answer. In previous pieces I have touched upon why I thought there was a very good chance why this money would not flow through the system. I hesitate to continue to refer back to my piece published on November 12th (The Wall St. Model is Broken…and Won’t Soon be Fixed).

but for new readers and followers I do firmly believe it is as good as anything I have read or seen in any publication in explaining how we find ourselves in our current position.

Please allow me to digress for a second. I will admit that I am not a movie buff but I do enjoy films that focus on the success of underdogs, have a measure of financial intrigue, or perhaps a combination of the two. Not surprisingly a few of my favorite movies are, “Rocky”, “Jerry MaGuire”, and “The Sting”.

Early on Rocky, in the role of legbreaker, intimidates a longshoreman and in a very threatening fashion demands, “where’s the money.” Rod Tidwell implores Jerry Maguire to “show me the money!”. At the climax of “The Sting”, Doyle Lonnegan totally enraged rushes the window in the racing parlor and demands to know, “where’s my money”. If only our current economy were merely a movie. That said, still so many in our country after disapproving of a $700 billion rescue package want to know “where’s the money?”

In large measure our mainstream media has done an exceedingly poor job as to highlighting the dynamics at work in the banking system. I will utilize a tape from a high profile financial show to reveal how the media is largely pandering to the public on this topic. Prior to doing that, though, let me get very detailed in answering the question as to “where’s the money?”

The business of banks is to lend money and in so doing they provide the liquidity to keep our economy moving. The banks lend money in a number of sectors but they can be summarized as follows: credit cards, residential mortgages, commercial mortgages, corporate loans. In addition to their lending role, most banks maintain a separate investment portfolio to further augment their revenue.

We have maintained that as a result of these investment activities banks retained a wide array of what are now qualified as “toxic mortgage assets”. While globally banks and investment banks have taken $1 trillion in write-downs on these assets, by my estimation and confirmed by independent research and analytics there are likely at least another $750 billion in write-downs yet to take on these assets.

If those write-downs were all we had to worry about we would probably be doing all right. Let’s get more detailed in regard to the consumer and corporate lending and why banks are hoarding cash.

Credit Cards: at end of 2007, banks were experiencing chargeoffs against delinquent cards of app 4.5%. At this point in time chargeoffs are app 7% (a full 50% increase year over year) and projections for 2009 have chargeoffs moving toward 10%.

Commercial Mortgages: this sector has benefitted from a lack of speculative development and as a result has only experienced a default rate of app 1%. However, with expectations of potentially 20% of retailers filing bankruptcy, space in many retail malls will definitely be increasingly vacant. Additionally there will be increased vacancy rates in many office buildings with increased unemployment. There are also app $500 billion if not higher in commercial loans due in the next three years. It is almost certain that there will be an increased number of these loans that will not be refinanced forcing defaults. Overall default rates in this sector could easily triple.

Residential Mortgages: there are 11 months worth of homes currently on the market. There has been a 40% increase in foreclosures year over year, and with an increase in unemployment in 2009 there will be more foreclosures in 2009. More pain.

Corporate Lending: independent research from a variety of firms is indicating that corporate credit defaults will double to app 5% and will triple to app 10% for the most speculative credits.

The ratio of total debt/GDP has increased by app 40% over the last ten years from app 250% to 340%.

How does our banking system respond to a rapidly rising level of defaults and write-downs? They dramatically increase their level of reserves, they increase the cost of credit, and they allocate future credit much more sparingly.

If it were merely these asset classes listed above perhaps our system would be able to recover in a relatively rapid fashion. However, the massive development of the CDS (credit derivatives market) market is the 800 pound gorilla that truly has the banking system and the regulators spooked. The CDS market was developed as a means of insuring credit and thus managing risk. However, the CDS market has grown so far beyond the size of the underlying markets that they were intended to insure that it has gone from managing risk to creating risk. (To further clarify as an example if GE had $1 billion in outstanding debt, it may seem prudent that there only be $ 1 billion in CDS on GE debt. However there are multiples of that as market players have taken to using CDS not only for hedging but for speculating).

The CDS market is app $50 trillion in size and with expected defaults across sectors to move into the 5-10% range there will be an expected transfer of payments between counterparties of $2.5 trillion to $5 trillion. Granted there will be some netting in some of these payments but the real concern is that some entities that will be net payers will not be able to perform thus causing further losses and risks to the overall financial system. This scenario is exactly what is occurring with AIG.

Add the risk of default in payments from CDS on top of the losses expected in the other asset classes and thus, “banks are hoarding cash” and trying to add capital by finding cheap deposits (thus the use of money for bank mergers PNC buying National City, JPM buying Washington Mutual, Wells Fargo buying Wachovia) to protect themselves.

Thus, “where’s the money?” It has already been lent and increasingly won’t be returned. Thus reserves are being built against these current and expected losses. Sorry to be the bearer of bad news but them’s the facts. You will not hear this on your favorite cable shows or or in your local papers.

In fact while Congress and many others in the public eye will scream at the banks, the banking regulators (FDIC and Office of Comptroller of the Currency) are telling the banks to grow their reserves. There have been 25 banks that have closed to date and there are another 200 that are on watch.

If you care to be pandered to please check out the attached video with Mike Barnicle and Jim Cramer from one of the high profile financial channels filling air time but not truly addressing the question of “where’s the money?”

In Joe Friday fashion, if you just want the facts, then check in with LD here at NQ. Please join us tonight to discuss these topics and so much more on LD’s Dollars and Sense at 8pm.