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XMFSinchiruna (26.54)

An eye-opening article on the state of the financial sector...



November 20, 2008 – Comments (4)

I offer up this article not as a treatise of actions I believe the govermnent or the sector should pursue, but rather simply for the insights the piece provides into the scale of the problem. Paul Miller, of Friedman, Billings, Ramsey points out that the TARP program does not address the problem (which I agree with), since what is needed is tangible common equity as opposed to long-term debt financing. He believes $1 trillion - $1.2 trillion is needed to restore confidence, though I personally doubt that even that would suffice. But here's the really interestiong tidbit:

Talking about 8 of the most influential companies on Wall Street, Miller indicated that: "Combined, these eight companies have roughly $12.2 trillion of assets and only $406 billion of tangible common capital, or just 3.4 percent, the analyst said in his note to clients."

Food for Foolish thought: since the Treasury and fed have been attempting to recapitalize the industry instead of permitting the natural delevereging process from taking place, the sector retains a scary 30:1 leverage ratio even as the Dow has been chopped nearly in half! The question becomes, what happens to the Dow and other benchmarks when the inevitable deleveraging process does commence in earnest?

Suddenly, my suspicion that the Dow may one day trade at parity with an ounce of gold does not seem so far-fetched. Even a Dow/gold ratio of 3:1 would represent a disaster for the USD, and unfortunately I think that's precisely what we have in store.

(Reuters) - The U.S. financial system still needs at least $1 trillion to $1.2 trillion of tangible common equity to restore confidence and improve liquidity in the credit markets, Friedman Billings Ramsey analyst Paul Miller said.

However, veteran banking analyst Richard Bove contradicted the idea of raising tangible common equity as a measure to improve liquidity.

"There seems to be no discernable reason why tangible common equity is a relevant indicator of anything other than market participants think it should be," Bove said in a note to clients.

"If a bank is to be liquidated and its businesses sold off, those businesses associated with the intangibles are likely to bring a much higher price than the businesses backed by tangible assets," he wrote in a note on Thursday.

"In sum, the whole furor of tangible common equity makes no sense to me."

However, FBR's Miller said in his note dated November 19 that the only solution for the global crisis was injections of true tangible common equity. "Debt or TARP capital is not true capital. Long-term debt financing is not the solution."

Eight financial companies -- Citigroup Inc (C.N: Quote, Profile, Research, Stock Buzz), Morgan Stanley (MS.N: Quote, Profile, Research, Stock Buzz), Goldman Sachs Group Inc (GS.N: Quote, Profile, Research, Stock Buzz), Wells Fargo & Co (WFC.N: Quote, Profile, Research, Stock Buzz), JPMorgan Chase & Co (JPM.N: Quote, Profile, Research, Stock Buzz), American International Group Inc (AIG.N: Quote, Profile, Research, Stock Buzz), Bank of America Corp (BAC.N: Quote, Profile, Research, Stock Buzz) and GE Financial -- are in greatest need of capital, Miller said.

Combined, these eight companies have roughly $12.2 trillion of assets and only $406 billion of tangible common capital, or just 3.4 percent, the analyst said in his note to clients.

Miller said these institutions need somewhere between $1 trillion and $1.2trillion of capital to put their balance sheets back on solid ground and begin to extend credit again, given their dependence on short-term funding and the illiquid nature of their asset bases.

Since the summer of 2007, Wall Street has been hammered by a sharp pullback in debt markets, which began with mortgage woes and escalated into a credit crisis, slowing economic activity around the world.

Currently, the U.S. financial system has $37 trillion of debt outstanding, Miller noted.


The bulk of the capital will have to come from the U.S. government, Miller said. The government needs to take the initial steps to begin the process, and private capital and earnings can finish the job.

"The quicker the government acts, the sooner the financial system can work through its current problems and begin to supply credit again to the economy," he said.

The U.S. government must declare a bank-dividend holiday and convert the TARP funding into pure tangible common equity to get the credit markets functioning.

Also, the government should support a centralized CDS clearinghouse that backstops all transactions and eliminates the cross-default problem, the analyst said.

Top U.S. financial regulators said on Friday they were working on developing a centralized clearinghouse for credit default swaps, the exotic instruments that have exacerbated the financial crisis of recent months.

The weakened economy and global credit crisis had pushed the U.S. government into bailing out companies including insurer AIG, investment bank Bear Stearns, and mortgage companies Fannie Mae (FNM.N: Quote, Profile, Research, Stock Buzz) and Freddie Mac (FRE.N: Quote, Profile, Research, Stock Buzz).

Regulators have also shown a willingness this year to intervene when banks appeared to struggle. They pushed Wachovia Corp (WB.N: Quote, Profile, Research, Stock Buzz) into finding a buyer and arranged for JPMorgan to buy Washington Mutual Inc's (WAMUQ.PK: Quote, Profile, Research, Stock Buzz) banking assets after worried customers began to yank deposits.

Miller, however, said it could take three to five years for the financial system to fix itself completely, with adequate capital and appropriately priced interest rate and credit risk.



4 Comments – Post Your Own

#1) On November 20, 2008 at 6:46 PM, Option1307 (30.59) wrote:

Ouch, scary thoughts. Interesting article, thanks.

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#2) On November 20, 2008 at 7:14 PM, jgseattle (26.24) wrote:

great post!!!!!!!!!

Makes you wonder where the low is and not worry about inflation for a long time!!!!!


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#3) On November 20, 2008 at 7:21 PM, XMFSinchiruna (26.54) wrote:


I certainly disagree with your latter interpretation, since systemic deleveraging and rampant hyperinflation can indeed take place in concert. We are presently in an anamolous stage of deflation preceding the mother of all hyperinflationary environments... which is precise why the Peter Schiffs of the world see the Dow reaching parity with an ounce of gold. Take a look at my post of Jim Rogers videos for more on impending inflation and the resulting solid fundamentals of commodities.

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#4) On November 28, 2008 at 1:10 PM, FreeTradingQuiz (< 20) wrote:

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