The End Of The FIRE Economy

The End Of The FIRE* Economy

*Financial, Insurance, and Real Estate.

Here Comes Another Set Of Dodgy U.S. Bank Loans
The Next Big Financial Meltdown: Insurance!?!

By John Browne | 2009

Several weeks ago Citigroup shocked Wall Street by announcing that the company would be profitable in the current quarter. And, since the FASB has now allowed banks to 'refrain' from having to mark their assets to market, many more banks have reported the same. At the same time, the Obama Administration indicated that it would be unlikely to nationalize American banks, preferring to provide low cost funding to encourage the private sector to buy distressed assets from the banks. The two developments has sparked a vigorous rally in financial stocks, which previously had been drifting downward for weeks, caught in what appeared to be an unending death spiral. But have the good times really returned?

On the surface at least, there are some promising points. Based on current income, and an upward trending yield curve (that will allow banks to borrow at nearly no cost from the Fed and lend to borrowers at a good profit) the banks should generate strong cash flow. But that is hardly the full story.

Continued gradual write-downs in the value of toxic assets already held on bank's balance sheets will explode like miniature time bombs, rendering banks a poor source of earnings for years to come. For many of our largest banks, these debts are probably too large to be overcome by a positive cash flow fueled by cheap access to short-term funding— at least within a single year. Hence, these banks are 'technically' insolvent from a capital balance sheet point of view. This is the underlying problem that America and much of the world face with their banks: banks can be trading with positive cash flow but from a technically insolvent capital position— which is illegal. [[And the International Accounting Standards Board (IASB) has so noted, with a scathing disapproval of the FASB action.: normxxx]]

Some argue that toxic assets make up only a very small part of the total assets of the banking system. That may be so, but the real issue is the enormous size of the toxic assets in relation to both the capital of the banks and the funding ability of the government. According to the Bank of International Settlements, the world's total of derivatives investments, including the poorly understood credit default swap (CDS) market reached some $700 trillion at its height, or more than 20 times the world's total annual production! The American portion was about $419 trillion, or some 40 times America's annual production.

The essential problem is that these inherently risky securities were used as collateral for loans. The fall in their value resulted in massive deleveraging. Of course, not all derivatives are yet flawed, or toxic. So, it can be assumed that, in the absence of a total financial collapse, only a limited number will default.

However, if a conservative assumption were made that only some two percent of derivatives fail, it would still amount to some $14 trillion. The American share would be about $8 trillion, or almost one year of GDP once that figure declines to a sustainable level. The estimated total capitalization of all U.S. banks is some $1.6 trillion. But, this amounts to only 20 percent of the potential American liability.

So far, American citizens have been forced to provide financial institutions with nearly $2-3 trillion in additional bailouts. This brings the total of current U.S. banking capital to some $3.6 trillion, still less than half of the potential problem, leaving a massive $4.4 trillion shortfall. In light of this, even noted bearish economist Nouriel Roubini's estimate of a $3.6 trillion shortfall appears to be too optimistic.

Of course, not all American banks are in trouble. There are a number of local and regional banks whose managements did not participate in gambling away America's financial future. [[But see the next article below!: normxxx]] Nevertheless, investors should ask themselves some hard questions. What if the government is forced to face the fact that the U.S. banking system, as a whole, is already fundamentally insolvent? What if the Administration is therefore forced, despite its expressed disinclination, to nationalize the problem banks?

Most importantly, after the 'good' banks have been separated from the 'bad' in the FDIC's 'corral,' what will happen to those 'bad' banks? Worse still, what will happen to all of those 'bad' international banks— especially those European banks which cannot avail themselves of the accounting relief permitted by FASB? What will happen to consumer confidence and the price of gold?

Citigroup says that it is profitable. At the same time, most banks are in dire straits. Until Citigroup is able to put its capital where its mouth is, investors in U.S. financials should remain very, very cautious. [[But it looks like its delaying tactics in marking down its assets really has paid off for Goldman Sachs. Do you think they had any advance notice of what FASB was planning?: normxxx]]

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Here Comes Another Set Of Dodgy U.S. Bank Loans!

By James Saft | 2009

LONDON (Reuters)— Banks in the U.S. face a new source of write-downs and failures this year and next as loans made to developers to finance residential and commercial property development rapidly go bad. And as these loans are old-fashioned and concentrated in smaller banks, their fate is particularly interesting as it indicates that issues with the banking system go far deeper than the so-called "toxic assets" belonging to the largest lenders that have thus far gotten most of the attention and government aid.

They are also a great illustration of the difficulties of stopping a housing and deleveraging crash. Called Acquisition, Construction and Development (ADC) loans, they total 8.4 percent of all bank loans, just below a 30 year peak, and are used by developers to buy land, put in infrastructure, and construct housing or commercial and office space. And because they are dependent on a reasonably healthy real estate market— someone who is willing to buy or rent the properties— when projects are completed, they are now in deep trouble.

"Everyone in the media is focused on consumer foreclosures. What they're not focused on is the builder developer foreclosures which are only in the early innings and which will continue to wreak havoc as these assets are liquidated at depressed prices. Until they are cleared there can't be a stabilization in home prices," said Ivy Zelman, a longtime housing analyst at Zelman & Associates, who thinks the pressure will cause "hundreds of banks" to be closed and liquidated.

"The Federal Deposit Insurance Corporation doesn't have the funds to deal with all this. They don't have the scalability to deal with all these problem banks. They can't examine the smaller banks fast enough," she said.

Zelman estimates that U.S. banks risk having to charge off an additional $84 billion of ADC loans between now and 2013, equal to a hit of nine percent of Tier 1 capital. That is damage banks can ill afford just about now, given the rising trend in delinquencies on consumer and home purchase loans, not to mention a deteriorating outlook for general commercial loans.

Non-performing ADC loans hit 8.5 percent at the end of the year, up from just 3.2 percent the year before. Loans delinquent between 30-89 days are also up, by 25 percent in the quarter to 2.9 percent. And developers, struggling to try to survive without reliable cash flow from sales, are drawing down on commitments from banks that are not secured. The percentage of unsecured construction loans drawn down hit 73 percent, already above the peak seen during the 1990s real estate slump and a crucial sign of builder distress.

FDIC Funding Crunch

Of particular concern is the way in which ADC loans are concentrated in smaller and community banks, which tend to have long and deep relationships with local developers. ADC loans account for 47 percent of non-performing loans at small banks as against 14 percent at larger banks.

And you can't blame mark-to-market or toxic securitizations for these losses. They are considered held-to-maturity and are not typically included in any complex securities. Chris Whalen of Institutional Risk Analytics, which specializes in bank risk analysis, sees ADC loans as part of the difficulties banks face with commercial real estate, and believes that regulators will be forced to get tough with banks in forcing them to write down exposure to struggling firms and deals.

"It will be subject to an impairment test and then they will have to start charging it off. The regulators are already beginning to force the community banks," he said. And while smaller banks being closed by the FDIC may not get the attention of a bailout of a big bank like Citigroup, every failure depletes resources and hurts credit availability.

The FDIC fund fell by almost half in the fourth quarter alone, touching $18.9 billion as it set aside a large portion of money for actual and expected bank failures. The FDIC has said it needs a bigger cushion but moves to impose special fees on healthy banks will inevitably hit profitability and credit availability. Democratic Senator Christopher Dodd, chairman of the Senate Banking Committee, is moving to introduce legislation that would more than triple— to $100 billion— the FDIC's line of credit with the Treasury Department.

But even beyond bank failures, ADC loan woes point to the intractable problems of a real estate bust. Banks, while trying to reduce their overall exposure to these loans, have been reluctant to pull the rugs from under borrowers because, as with a house foreclosure, they end up owning a hard-to-sell underlying asset. But more foreclosures are coming, and with them fire sales as banks compete with those developers who still are in business, and with homeowners, and with home foreclosure sales to liquidate inventory.

That will drive land and real estate prices down further and suck others into what amounts to a negative self-reinforcing cycle. That's true for housing, true for banking, and true for the economy.

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The Next Big Financial Meltdown: Insurance!?!

By Michael Brush, MSN Money | 2009

The mortgage and credit sickness that brought banks and brokers to their knees has now infected the companies that insure our lives and protect our families. The life insurance companies that millions of Americans entrust to help protect their families or pay the bills in their golden years are caught in a downward spiral eerily similar to the one that has brought down banks and brokers. Like Bear Stearns and Lehman Bros., life insurers Hartford Financial Services (HIG), Principal Financial Group (PFG), Lincoln National (LNC) and many others all have significant exposure to mortgage-backed securities and other risky debt instruments.

They're reporting huge losses that— if they continued— could trigger a meltdown.

That could wipe out shareholders, who already have suffered declines of 20% to 50% since the meltdown began. Customers with annuities or insurance policies might have to turn to state insurance backstop funds and settle for only a portion of the money they were expecting. Health, auto and property insurers are better off. But based on how far life insurance stocks have fallen, investors are worried many won't survive at all.

What are the chances this doomsday scenario will play out?

"To know that, you have to gauge how bad this market will get over the next six months, which none of us know," responds Jim Ryan, an analyst with Morningstar (MORN). It all comes down to how much worse things could get for the economy and for the debt instruments and stocks that life insurance companies hold. "We're telling people to be more careful, particularly if you are going into longer-range products that involve significant upfront funding like annuities," says Bob Hunter, the director of insurance for the Consumer Federation of America. "You want to make sure that the company is actually around when you want to get the money out. I'd say there's a good likelihood some of them will go under."

Death Spiral

It's easy to imagine a spiral that takes many insurers out or at least has them begging for help from the federal government. It starts with those serious market losses. Life insurance companies rely on investments in bonds and stocks to meet cash-flow needs years from now. But because of exposure to dubious debt securities backed by shaky subprime and commercial real-estate loans, they're now piling up investment losses big time.

In early February, for example, Hartford Financial reported a loss of $806 million, or $2.71 per share for the previous quarter, including a $610 million realized loss on investments. Lincoln National reported a $1.98-per-share loss, including a realized loss on investments of $238 million after taxes. This isn't the end of it. Analysts at Morgan Stanley (MS), for example, estimate Lincoln National is sitting on $7.6 billion more in unrealized losses in its $58 billion investment portfolio. Many other companies have significant unrealized losses, too.

These big losses create two problems for life insurance companies. First, they have to reserve more capital against payments they promise by selling annuities and life insurance policies. More importantly, the erosion of their capital bases has ratings agencies downgrading their debt. If that continues, big corporate customers and individuals might consider them too risky and pull business— sparking a "run on the bank" at insurers.

"Over the course of 2009, we expect signs of a flight to quality on the part of annuity buyers," Wachovia analyst John Hall wrote in a recent research note. He thinks that's already playing out at Lincoln National. All of this, then, brings another cycle of downgrades in credit ratings— a kind of vote on how likely a company is to pay back its debt. Taken to extremes, investment losses that spark ratings downgrades— combined with stock price declines— would make it virtually impossible for insurers to raise capital. It would also be tough to roll over debt coming due over the next two years.

Poof. There would go your life insurance companies.

This scenario inched closer to reality in recent weeks as insurers announced big fourth-quarter losses. The news had debt-rating agencies such as Fitch Ratings, Moody's Investors Service and Standard & Poor's Ratings Services cutting their ratings for Hartford, Principal Financial, Prudential Financial (PRU) and Genworth Financial (GNW), citing "surging investment losses and weakening earnings capacity."

Some Help From Regulators

As a sign that the problems for insurers are getting more serious, regulators are loosening accounting standards to try to help them out. In the past few weeks, insurance regulators in Connecticut, Iowa and Ohio have eased accounting standards for life insurers like Hartford and Allstate (ALL) in an effort to help them meet standards for capital on hand.

State regulators are allowing insurers to count future tax refunds as capital on hand. They are also permitting insurers to reserve less cash against promised annuity payments. Again, this seems disconcerting, since you might expect regulators to ask for more reserves at a time when investment assets are falling.

"They are trying to grasp for other forms of capital," says Donald Thomas, an accounting analyst with Gradient Analytics. "This is a sign of stress among these companies." The Consumer Federation of America likens the practice to doling out "lollipops at a barbershop."

Don't Worry, Be Happy

Though industry supporters acknowledge there could be serious trouble if the economy and the markets sink low enough, they cite several reasons a doomsday scenario isn't realistic:

First, life insurers typically have very little money invested in stocks or risky mortgage-backed securities. Most of it is in bonds— and in a broadly diversified portfolio of high-grade corporate or government bonds at that, maintains Steven Weisbart, the chief economist at the Insurance Information Institute. "There may be one portion of their portfolios where they are experiencing investment losses, but you have to look at their overall business and how they are managing that business," Ohio Insurance Director Mary Jo Hudson told me. "Based on the analysis that we do here in Ohio, the insurance companies are safe and sound."

Next, outright bankruptcies are unlikely, says Sterne Agee analyst John Nadel, because life insurance companies have agreed to make payouts over the long term— typically several decades from now. They can survive near-term market weakness because they aren't required to make paybacks right away. Nadel also doubts a run on the insurance companies will occur, because they charge hefty fees for cashing out accounts. Uncle Sam hits policyholders with penalties for cashing out early, too.

And, unlike Bear Stearns and Lehman Bros., insurers did not borrow huge amounts of money to make investments, Connecticut Insurance Commissioner Thomas Sullivan says. Despite recent downgrades to its debt rating, Principal Financial says its capital position actually doubled in the fourth quarter to about $800 million and that it still has relatively strong debt ratings and a strong capital base. The company also says it won't have to pay out on many of its annuities and policies for a long time, so it can wait out near-term unrealized losses on investments. It also says that its wealth management divisions could continue to operate well even if the company got lower ratings.

Last Friday, Hartford chief Ramani Ayer told investors: "We entered 2009 well-capitalized and with ample liquidity. The Hartford remains well-prepared to meet our commitments to our customers, as we have for the past 200 years." And as for relaxed accounting rules, two state insurance commissioners I spoke with defended the practice.

Allowing insurers to take credit for deferred tax assets makes sense because insurance companies typically overpay taxes on life insurance premiums. The taxes get paid back to the companies over time, says Hudson, Ohio's chief insurance regulator. So allowing companies to recognize 15% of the deferred tax asset— up from 10%— is no big deal.

Next, insurers already reserve more than required for variable annuities. An easing of the standards has been approved by the National Association of Insurance Commissioners for 2010. Regulators are only speeding up that change, Connecticut's Sullivan says.

It's also important to keep in mind that health, auto and property insurance companies make fewer long-term investments, because their policies and payouts stretch out over much shorter periods. They invest in more-liquid short-term securities and may not face the same level of portfolio losses as life insurers. As for those life insurers, the points above may be reasons to feel more secure. But if the economy and the markets continue to tumble hard, the companies won't be safe.

The number of companies with quality debt that is on the verge of slipping into junk territory hit an 18-year high in January, according to Standard & Poor's. That's the supposedly safe debt the insurers are invested in. Nouriel Roubini of RGE Monitor thinks continuing economic damage will ultimately push their credit losses to $3.6 trillion, up from recent levels of around $1.6 trillion.

(You can check S&P ratings of insurers at Insure.com and ratings from A.M. Best here. Keep in mind, the ratings may not reflect the latest gyrations of the market.)

Government Guarantees

If your insurance company does go bust, you'll get a hand from "guarantee funds" run by states. Once the assets of a bankrupt insurer were exhausted, policyholders could file claims against these state funds for insurance losses or lost annuities. One drawback is that these funds limit claims to a few hundred thousand dollars. "If you have a million-dollar life insurance policy, you're going to get a haircut," says Hunter, of the Consumer Federation of America.

And a lot of these state guarantee funds don't actually have any money. Instead, they assess surviving insurance companies for the money they need to satisfy claims. In a real disaster scenario that took out a lot of insurance companies, it might be hard for states to raise enough money to satisfy claims. At that point, some states would dip into their general funds[!?!]

Ultimately— in the meltdown scenario— it might be Uncle Sam that would be asked, once again, to save the day. Last month, federal banking regulators approved applications from Hartford and Lincoln National to acquire existing savings and loans and become 'thrift' holding companies. That move makes an insurer eligible for federal government bailout funds.

Voilà. Problem solved— assuming taxpayers will stomach more bailouts at that point. [[But, since there is no sign that taxpayers are now or ever will have to fund any of this, who cares!?!: normxxx]]

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Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.



Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.