Fellow SA contributor Pendulum's recent article "Euro Rallies As Draghi Reassures: Is It Time To Go Long Europe?" poses an interesting question we think is mulling in the minds of many investors today: How long can the central banks and the "too big to fail and jail" money center operatives prop up our equity markets? This all comes front and center after the disappointing jobs report last Friday. A recent headline tells a lot:
March 2013 job report is bleak
Only 88,000 new jobs were added to the economy last month, a significant drop from February's numbers.
With Portugal following Cyprus and the underlying strength in the U.S. economy now in question, where do equity investors turn for confidence? "Why, the central banks of the world of course" answer is starting to look a little "long in the tooth". Hedge fund manager Jim Chanos and former FDIC Chair Sheila Bair describe the weak foundation underlying our financial system in recent articles highlighting the behavioral problems in our largest financial institutions and the regulators overseeing them.
Here are some excerpts from Chanos' interview with Lynn Parramore in naked capitalism:
The problem is that financial crimes, unlike crimes of passion and crimes of opportunity, come with their alibis already built in. You build a veneer of legitimacy about what you're doing. You get accountants to sign off on what you've done. ...We teach this legal concept called "willful blindness," and that is, in some cases senior executives are cut out intentionally from controversial things because they don't want to be able to say, well, I approved that or I saw that. ...We've had the stunning admission by the Justice Department in the past month that they put into their calculus as to whether or not to prosecute crimes in the financial arena as to the systemic effect of that. My head is still reeling from that admission. Most people would agree that that's not the Justice Department's role. And I think it's caused a really reasonable, serious, continued undermining of trust in our markets. ...but it's something I think that policy makers should keep in mind, because again, the people taking the biggest risks and taking the biggest paychecks and bonuses - if they had been hedge fund managers, they would have been wiped out, and that's that. End of game. But because they were doing it in too-big-to-fail institutions, they got to keep playing. In a weird way it is the antithesis of the free market. The free market would have taken these people out a long time ago. But, in fact, the subsidized market that we have, where the taxpayer stands behind all these bad decisions and the bad accounting, continues to exacerbate the income inequality issues. ...It raises an interesting point, doesn't it? Because if now, as the senior member of a bank, or the board of a bank, I know that there are no criminal penalties for breaking the rules, don't I have a fiduciary responsibility to my shareholders to actually play fast and loose? Because if I get caught, that's just the cost of doing business? I know it's a frightening thought, but if carried to its logical extreme-if truly people believe that because of their size, they can't be prosecuted, it actually brings forth a new issue of moral hazard extreme: illegal behavior.
As we have written before, JPMorgan (JPM) and HSBC (HBC) have started to come clean with regulators and paid for their sins and others such as Santander (SAN) are still defying justice and not parting ways with their law breaking managers as this CNBC article highlighting SAN's Chairman defending CEO Saenz at SAN's annual meeting points out. It seems our Fed is condoning this behavior by continuing to loan SAN billions of dollars at low to no interest charges as we pointed out in our previous article as well. We believe the cloud will continue to hang on institutions like SAN as long as they give the cold shoulder to justice. Here is a chart of SAN's share price:
(Click to enlarge)
Of particular note in the chart above is the price action in SAN since February when Senator Merkley announced that he had been awarded the chairmanship of a subcommittee of the Senate Banking Committee, the Subcommittee on Economic Policy. Is it a coincidence? We don't think so as Senator Merkley seems serious about cleaning up the big banks of their foul behavior.
Take a look at SAN's chart compared to JPM and HBC who are making efforts to deal with their regulatory issues:
Moreover, it's not just the short sellers who are crying foul about the "too big to fail and jail" banks. A former head of the FDIC who insures U.S. bank depositors also has started to call to attention to this despicable banking behavior. Here are some excerpts from her recent WSJ article as republished at bipartisanalliance.com :
"The recent Senate report on the J.P. Morgan Chase "London Whale" trading debacle revealed emails, telephone conversations and other evidence of how Chase managers manipulated their internal risk models to boost the bank's regulatory capital ratios. …On average, the three big universal banking companies (J.P. Morgan Chase, Bank of America and Citigroup) risk-weight their assets at only 55% of their total assets. For every trillion dollars in accounting assets, these megabanks calculate their capital ratio as if the assets represented only $550 billion of risk. …The ease with which models can be manipulated results in wildly divergent risk-weightings among banks with similar portfolios. Ironically, the government permits a bank to use its own internal models to help determine the riskiness of assets, such as securities and derivatives, which are held for trading-but not to determine the riskiness of good old-fashioned loans. The risk weights of loans are determined by regulation and generally subject to tougher capital treatment. As a result, financial institutions with large trading books can have less capital and still report higher capital ratios than traditional banks whose portfolios consist primarily of loans. …In the U.S. and most other countries, banks can also load up on their own country's government-backed debt and treat it as having zero risk. Many banks in distressed European nations have aggressively purchased their country's government debt to enhance their risk-based capital ratios. …In addition, if a bank buys the debt of another bank, it only needs to include 20% of the accounting value of those holdings for determining its capital requirements-but it must include 100% of the value of bonds of a commercial issuer. The rules governing capital ratios treat Citibank's debt as having one-fifth the risk of IBM's. In a financial system that is already far too interconnected, it defies reason that regulators give banks such strong capital incentives to invest in each other."
As we see it, Ms. Bair has just pinpointed the real cause of the malaise in our economy: Because of the risk weighting bank capital regulations, banks can't afford to lend money - it's capital inefficient. As long as banks don't lend to small business, our economy will be at the behest of large companies who seem very adept at increasing efficiency doing more with less people and squeezing out more profits from less stagnant revenues.