SPEs: The Next Financial Crisis Buzz Word

by: Thomas Wagner

In early October 2008 I wrote an article for Seeking Alpha titled Inflation, Deflation and the US-Chinese Relationship.

Written shortly after the TARP program was introduced, I attempted to explain that the "financial crisis" was really more of a "credit crisis" and a by product of years of global trade imbalances, not a liquidity crisis.

I also stated that such a crisis would not be solved by the Fed or the Treasury throwing money at the problem.

I also clearly stated that the banking system would not re-loan money it received under the TARP, as they were focused on trying to remove bad loans from their balance sheets. More specifically, transferring them to the public balance sheet maintained via the Federal Reserve and Treasury.

I also took the controversial position that China would fare much better by focusing on internal consumption and that sooner or later they too would begin to question the wisdom of loaning money to a country that consumes more than it produces. The later statement was, to put it politely, not received well by some readers.

So where do we stand several months later? As I suggested, the banks are still not lending but instead are still trying to find a patsy to unload there bad loans on. Whether it will be the public, the Fed or Treasury that seeks to bring in private investors has yet to be decided. On the other hand, China woke up, decided that internal consumption was there only option, introduced a financial stimulus program that works and has been reducing there US holdings steadily and quietly.

So why are US banks not lending despite the countless billions of Fed and Treasury money being spent on various programs? The reason is simple: banks understand that real estate prices are still falling, and that no amount of Fed or Treasury money will stop the slide.

In China, loan growth has exploded, primarily because of the iron grip the government has on the banks. While I do have serious question about the quality of these loans and the long term effect they will have, so far it has been effective in compensating for the slowdown in exports.

So am I fortune teller? Of course not. But anyone who has a basic understanding of economics and equilibrium theory will tell you that you can't pay a Michigan GM worker $70.00/hr and a Shanghai GM worker $7.00/hr to do the same job. The resulting imbalances of such a relationship will soon or later show up in the global financial balance sheet.

We are now one day away from the release of another Treasury and Fed program labeled "The Stress Test". What is this program? Good question. What it appears to be is a government attempt to get in front of the downward spiral in bank equity caused by the continued speculation about how bad the economy will get and what future effect the economy will have on the banks in a "fair value" world. Obama & Co. have dressed this "test" up with all the bells and whistles stating that it will incorporate fair economic assumptions and will be fully transparent. They even sent Bernanke out yesterday to declare that "the real estate market has bottomed and that we can all expect a late 2009 recovery".

So what's the problem? US equities have rallied 30%, emerging markets are up almost 50%. The crisis over right --- well, hold on boys and girls. Am I the only one wondering what happened to FASB? You remember FASB, the Financial Accounting Standards Board. The folks that brought you fair value accounting back in 2006 and the resulting bank run in 2007. After being beat up by several congressmen about three months ago, they were sent to their room like an unruly child and told to rewrite FASB 157 in such a way that allowed for more rational than fair value. Despite the decision in early 2008 to delay FASB 140 implementation for banks until 4th quarter 2009.

You remember FASB 140, don't you? This was originally brought forth by FASB back in 2003 in an effort to eliminate the use of SPEs, or special purpose entities, AKA variable interest entities under the European vernacular. As far as I know, it's still on track to be implemented in early 2010, isn't it? Ever since Congress scolded the FASB they have gotten very quiet on the subject.

But some are suggesting that the reintroduction of FASB 140 and FIN 46 (R) may be just in time for a double dip recession. Is a double dip possible? Certainly. Whether it is probable is hard to tell, but it is not an unreasonable assumption given the continued deterioration of the commercial real estate market and the unemployment numbers that we are seeing.

What are SPEs or "special purpose entities"? To oversimplify, this is when a bank takes a bunch of loans that probably should not have made in the first place, packages them and spins them off into a separate company or entity, but remain financially responsible for them. The benefit, if it's done right, is that there is no need to account for them on your balance sheet or under 157 Fair Value Accounting. Problem solved, boys and girls. As the old adage goes, out of sight, out of mind.

So here I am, going out on a limb again, one day before another major program announcement by the Fed with another prediction. When the results of this stress test are released. we may, I repeat, just may, hear more of FASB 140 and the elimination of special purpose entities. What effect will this have in late 2009, early 2010 is hard to say, since almost everything that was spun off into these vehicles has not been accounted for quite some time.

But consider this. How good could a bunch of auto, credit card and other non secured loans that were taken out by consumers be now that most consumers personal wealth has been cut by 50%? Most of these loans were taken out by home owners with the assumption that an increase in home equity would pay for it sooner or later.

The question is whether the Fed will address this next shoe when it drops, and it will eventually drop. The Fed's solution for China not buying long Treasuries? No problem, we'll just run the printing presses and buy them ourselves. Please refer back to my prior article and its implication for a hyper-inflationary scenario.

How will the Fed and Treasury deal with the hundreds of billions of dollars of new bad loans? How will Congress, the American people and investor react to the mounting debt required to bail out this new set of liabilities? More importantly, how will it damage our credibility and the willingness of our financial counterparties to accept the credit rating of our national debt and value of our currency?

Once again, I will go out on a limb and state that until the conditions that caused the financial crisis change, this crisis will not end. I suspect that we will continue to see an erosion on US purchasing power and credibility in the financial markets. This as well as several of the issues should make for another good article in about a month or two, maybe less. Enjoy your summer.

Disclosures: Author is short US equities, US dollar, US Government Bonds, commercial real estate ETFs. Author is long Gold, Silver and select Chinese equities.