Given how mortgage-backed securities turned out (and those securities were regulated, unlike derivatives), I believe that most, if not all major banks in this country are insolvent or would be recognized as such if you marked the assets on their balance sheets at anything resembling market values.

By James Kwak

A reader pointed out a quick analysis done by Dean Baker and Travis McArthur of the Center for Economic Policy and Research back in September. They estimate the value of being “too big to fail” by looking at the spread between the cost of funds for banks above $100 billion in assets and banks below that level. The spread averaged 0.29 percentage points from 2000 through 2007, but rose to 0.78 percentage points from Q4 2008 through Q2 2009, an increase of 0.49 percentage points. Alternatively, the spread peaked at 0.69 percentage points from Q4 2001 through Q2 2002 at the end of the last recession; by comparison, the spread this time around was only 0.09 percentage points higher. Using 0.09 and 0.49 percentage points as their low and high estimates, Baker and McArthur come up with an estimate of the aggregate value of being TBTF that ranges from $6.3 billion to $34.2 billion per year.

Last week's auctions caused prices on the long end of the curve to rally, but that did not help the U.S. dollar as investors continue to invest in foreign currencies. I think that bubbles exist in foreign currencies, equities, high yield bonds and some high grade bonds. Joining me in the camp is Bill Gross of PIMCO. Bill believes that those markets are over done and U.S. treasuries are the place to be. It is difficult for me to say this as a long-time corporate bond trader, but the credit markets are overdone here. Spreads between 10-year industrials, such as Wal-Mart (WMT) are well under 100 basis points. Verizon (VZ) and AT&T (T) paper are in the 100 basis point area. Only in the bank and finance arena does some value exist. That is because there could still be some bad news (but not fatal news) ahead. The more retail participation, the more overvalued the asset class at this time. This goes double for floating rate notes.

At the end of each trading week, Hillbent scans the equity market for potential anomalies which exhibit extremely oversold and overbought conditions. Past observations have revealed that such candidates may experience reversal corrections to the upside or downside once the market reconfirms that their fundamentals remain solidly intact or relatively poor. From a contrarian perspective, these lists may also serve as a precursor to changes in institutional sentiment and underlying fundamentals.

(The purpose of this report is not to provide specific recommendations, but instead serve as a time-saving reference tool and starting point for investment ideas as the upcoming trading week unfolds. Of course, the results generated are not always perfect and users are strongly encouraged to perform their own due diligence on these names. Note that overbought and oversold conditions are based upon proprietary algorithms and quantitative models instead of conventional technical analysis indicators. As a supplement to this report, please refer to our ETF Market Trends™ Report to determine if market direction trends support a bullish or bearish investment bias over short-term, intermediate, and long-term timeframes.)

The Jamie Dimon piece in Friday’s Washington Post is a must-read. Dimon, head of behemoth JPMorgan Chase (JPM) makes the best case for not breaking up large too-big-to-fail financial institutions. His idea: set up a robust resolution process and let reckless lenders fail regardless of size.

Now, back in September, I attended a meeting at the Clinton Global Initiative where both Americans Sheila Bair and Jamie Dimon and British bank executive Peter Sands gave their ideas on the too big to fail idea. They all agreed that too big to fail must end. But, while Bair was arguing for shifting the balance of power toward smaller, community banks, Dimon was arguing, as he does in the Post, to keep large organizations intact.

According to SEC filings by Paulson & Co. on Friday, billionaire hedge fund manager John Paulson has increased his position in Citigroup (C) to $1.4 billion dollars, roughly 300 million shares. Paulson's firm has an average cost of $4.84/sh on the holding. Citigroup made a positive move in after hours trading on Friday after the filing had been reported. Shares traded up 2.75% to $4.16/sh.

These recent hedge fund positions are based on the 13F filed by Paulson & Co. on 11/13/09 (which includes positions held as of 9/30/09). According to the report, the hedge fund also reduced positions in Bank of America (BAC), Goldman Sachs (GS), and JP Morgan Chase (JPM).

The Wall Street Journal’s “Tinkering Makes Comeback Amid Crisis” stirred my thoughts on the limits of America’s dependence on a knowledge-based economy. The article focused on engineering students at prestige universities wanting to actually create physical things. Students are migrating from the virtual world of software science to hobby-ing with computer controlled milling machines in their dorm rooms, school workshops and membership machine shop clubs.

The Journal’s “Obama to Warn Asia Against Relying on U.S. Consumers” reports that the President is reiterating his call for the US to get back to making things for itself and the rest of the world. In “Larry Summers and Jeff Immelt Preparing for Post-Consumer Economy” and "US Needs to Convert from a Consumer to an Industrial Economy", I highlighted that companies such as Eaton (ETN), Ingersoll-Rand (IR), Parker Hannifin (PH) and Rockwell Automation (ROK) could be the beneficiaries. Now it appears that both the President and these companies are developing a young following.

U.S. Financial Institutions are interconnected – as the fall of Lehman demonstrated, they are tied together and interwoven in a complex web of obligations which can rip, run or unravel with unexpected consequences. As such, they may be regarded, for analytical purposes, as having one balance sheet. Double entry bookkeeping, which underlies all GAAP accounting, suggests that assets should equal liabilities for this giant composite balance sheet. I doubt that it does. The purpose of the article is to raise questions on two areas that do not seem to add up, and suggest that exploring these relationships would be a good task for the systemic regulator.

Derivative Assets and Liabilities – Five large banks together constitute the bulk of the U.S. Derivative market. The nature of the derivative transaction is such that each position has two sides, an asset and a liability, which will be on the books of the counter-parties. While numerous hedge funds and other bit players add complexity to the picture, it is evident that collectively derivative assets should equal liabilities for the banks involved, since a majority of the trades eventually make their way back to the largest players.

As I have repeatedly written (see this and this), the new derivatives legislation is so bad that it probably increases - rather than decreases - the risk to the financial system.

William Greider has a great piece in The Nation pointing out:

By James Kwak

Gillian Tett has an article criticizing the idea that CoCos — contingent convertible bonds — will solve the “too big to fail” problem. (And yes, she calls it “too big to fail,” even though Gillian Tett of all people understands what interconnectedness means.)

If there's any good news about the economy, it's the startling surge in corporate earnings. In the most recent quarter, about 80 percent of S&P 500 firms reported profits greater than Wall Street analysts expected, according to Thomson Reuters. That's the highest proportion of upside surprises since Thomson Reuters started tracking the data in 1994.

[Slide Show: 10 Companies Missing the Earnings Boom.]

• H-P grabs 3Com, takes on Cisco. Hewlett-Packard (HPQ) agreed to acquire networking-equipment maker 3Com (COMS) for $2.7B, or $7.90/share - a 39% premium to Wednesday's close. With 3Com, H-P - the world's largest PC maker - gains a networking business that competes directly with Cisco's (CSCO) core business of routing and switching, and a strong foothold in China, which accounts for half of 3Com's revenue. Analysts were largely enthusiastic about the deal, saying 3Com was one of the biggest values in the networking space, second only to Cisco in the breadth of its enterprise portfolio. Cisco responded swiftly, saying on its blog that networking acquisitions "only validate the fact that networking is becoming the platform for all forms of communications and (information technology)." H-P also preannounced Q4 EPS of $1.14 vs. consensus of $1.12, and revenue of $30.8B vs. $29.8B. After hours, HPQ was -0.6%, and COMS was +35%.
• UTech buys GE Security for $1.8B. GE (GE) agreed to sell its fire alarm and security systems unit to United Technologies (UTX) for $1.82B in cash, as had been widely speculated. UTX said its customers "will see increased breadth and depth of product offerings" as a result of the deal. The unit includes Edwards Systems Technology, which GE bought for $1.4B from SPX Corp. (SPW) in 2005. The business offers building management systems that help control commercial structures during fires, earthquakes and other emergencies, and would take United "beyond just perimeter and access security," one analyst said.
• Benmosche stays put. AIG (AIG) CEO Robert Benmosche told employees Wednesday in an internal memo he remains "totally committed to leading AIG through its challenges" despite his frustrations with government curbs on compensation at the company. The reassurance came after reports Benmosche might bail after just three months at the helm, saying strict compensation rules made it almost impossible to retain talent. In the memo, he called the pay curbs a "barrier" that "stand in the way of restoring AIG's value" and repaying its debt.
• World banks prop up dollar. Central banks say they've been snapping up dollars this week in an effort to stem its slide and hold down the value of their currencies. While Geithner continues to pay lip service to maintaining a strong dollar, Washington has yet to take any concrete steps to stop the bleeding, which is beneficial to U.S. exports and tourism.
• TARP repayments reduce gov't borrowing. The U.S. will borrow "substantially less" than initially anticipated, with banks already repaying rescue funds and more "significant repayments" ahead, Treasury's Geithner says. Reduced borrowing, a narrowing of the current account deficit, and signs that Americans are saving more all contribute to global confidence that the U.S. can rein in its deficit, he said today in Singapore.
• High oil prices could derail recovery. The IEA revised its 2010 world oil demand forecast slightly higher, but warned that rising crude prices could smother the fragile economic recovery. IEA now expects global oil demand to rise to 86.2M barrels a day, up 140K from October. Rising stock markets, a weak U.S. dollar, and rebounding world economies have driven crude prices up almost 80% this year, despite a persistent overhang in oil inventory which now stands at 60 days of forward cover.
• Foreclosures fall, but for how long? Foreclosures slowed for a third straight month, but remain sharply higher than a year ago. The number of homeowners who received foreclosure notices fell 3% month-on-month to 333K, up 18.9% from the same month in 2008. Rick Sharga of RealtyTrac, which released the report, cautioned the improvement was likely temporary: “It’s good to see that foreclosures have slowed down marginally, but we don’t really think it’s a trend." The firm predicts 3.2-3.4M properties will go into foreclosure in 2009, up from 2.3M in 2008.
• Art auction smokes projections. A very positive art auction at Sotheby's (BID) has some thinking the art-market recession may be on the mend. Sotheby's brought in $134.4M at an auction of post-war and contemporary art Wednesday night in Manhattan, including a smoky sheet of dollar bills by Andy Warhol that went for $43.7M. Total proceeds blew away Sotheby's' internal estimate of $67.9-$97.7M, and also outdid its $125M sale of a year ago. 52 of the 54 works offered found buyers.
• Microsoft strikes back at modders. Microsoft (MSFT) booted as many as 1M players from its Xbox Live gaming service on suspicions they modified their consoles to play illegally downloaded games. The move comes amid this week's release of "Call of Duty: Modern Warfare 2" (ATVI), the most highly-anticipated Xbox game of the year. "All consumers should know that piracy is illegal and that modifying their Xbox 360 console to play pirated discs violates the Xbox Live terms of use, will void their warranty, and result in a ban from Xbox Live," Microsoft said in a statement. It's not clear how Microsoft detected the Xbox rigging.
• Turkeyless Thanksgiving for BofA? Bank of America (BAC) may miss its internal deadline of naming a new CEO by Thanksgiving, due in part to its inability to zero in on a clear frontrunner, and amid worries that the process must be approved by the Fed.
• Mortgage apps rise. Mortgage applications rose 3.2% from a week ago, led by a 11.3% gain in refinancing, which now accounts for 71.5% of all applications, up from 66% last week. MBA said the average 30-year mortgage rate fell to 4.9% from 4.97% in last week's survey. Freddie Mac's weekly survey of mortgage rates comes out at 10:00.

Earnings: Before Open

• AECOM Tech (ACM): FQ4 EPS of $0.48 beats by $0.02. Revenue of $1.63B (-0.2%) in-line. Sees 2010 EPS of $1.90-2.00 vs. $2.03. (PR)
• EnCana (ECA): Q3 EPS of $1.03 misses by $0.14. Revenue of $3.88B (-64.2%) vs. $3.08B. (PR)
• Kohl's (KSS): Q3 EPS of $0.63 beats by $0.02. Revenue of $4.05B (+6.5%) in-line. Sees Q4 EPS of $1.14-1.24 vs. $1.25. (PR)
• Urban Outfitters (URBN): Q3 EPS of $0.36 beats by $0.01. Revenue of $506M (+6%) in-line. Operating margin 19% vs. 17.1% in Q2. (PR)
• Wal-Mart (WMT): Q3 EPS of $0.84 beats by $0.03. Revenue of $98.66B vs. $99.88B. Sees Q4 EPS of $1.08-1.12 vs. $1.12 consensus. "The sales environment continued to be difficult this quarter, but customer traffic is up throughout the company." (PR)

Earnings: Wed. After Close

• Advance Auto Parts (AAP): Q3 EPS of $0.69 beats by $0.03. Revenue of $1.3B (+6%) in-line. Third-quarter same-store sales increased 4.7%. Shares -3.7% AH. (PR)
• Applied Materials (AMAT): FQ4 EPS of $0.13 beats by $0.10. Revenue of $1.5B (-25%) vs. $1.3B. Expects revenue growth of more than 30% in fiscal 2010. Reports "increased net sales and profitability in our semiconductor equipment business, with improved demand and financial performance in all of our segments." Shares +0.7% AH. (PR)
• Computer Sciences (CSC): FQ2 EPS of $1.40 beats by $0.05. Revenue of $4B (-5%) in-line. Shares -2.9% AH. (PR)
• Ctrip.com (CTRP): Q3 EPS of $0.44 (RMB3.03) beats by $0.12. Revenue of $80M (+47%) vs. $72M. Sees Q4 revenue of $100M-104M vs. $75M. Shares +10.5% AH. (PR)
• Green Mountain Coffee Roasters (GMCR): FQ4 EPS of $0.34 beats by $0.01. Revenue of $222M (+65%) vs. $217M. Shares -9.1% AH. (PR)

Today's Markets

Asia markets headed lower Thursday. Europe stocks are flat at midday, and futures are under some selling pressure.

Toll Brothers (TOL), Bank of America (BAC), Wells Fargo (WFC), Ormat Technologies (ORA), Kimberly Clark (KMB)

Citigroup (C) has been losing tens of billions of dollars over the past two years as the financial crisis has unfolded. If one considers the government capital that Citi has not paid back, the bank is clearly the weakest of the four largest legacy banking behemoths in the U.S. Earnings results this year demonstrate that its raw earnings power is no match for the likes of JPMorgan Chase (JPM) or Wells Fargo (WFC). Moreover, its capital base has been impaired, causing the bank to have to sell assets, reducing its earnings power further still.

Unless something miraculous happens over the next few years, Citigroup is not going back to the glory days of $20 billion yearly net income. That’s why its mountainous $38 billion deferred tax asset is a problem.