Here are my talking points for my Fox Business News interview.

Watch my interview.

1. Why should all the bailout money be focused on financial institutions? It is seems a matter of fact but no one has really challenged the logic.
2. We must act now to prevent the second wave of the credit crisis. The first wave was partially caused by people with jobs buying houses well beyond their means. The second wave will be people with prime mortgages who have lost their jobs. They are paying out of savings right now (and that accounts for the lull) — but savings will run out.
3. Fed stress test had unrealistic 2-4% assumption for loan losses in prime mortgages.
4. Prime is by far the biggest market. Close to $9T. Hence, every percent mistake in the Fed assumption is worth $90B. So a small error in prime loan losses could make many financial institutions insolvent.
5. We can’t afford any more spending – hence, we should redirect some funds.
6. Will be moral hazard problem (people want to be bailed out that don’t need to be bailed out). But not a valid critique of mortgage loan restructuing. The current policy has an even more extreme moral hazard problem. Financial institutions faced with coin flips where “head I win., tails you lose” — you being the American tax payer.
7. Target: 1) responsible borrowers – those that put at least 25% down on their houses; 2) simple means test based on 2008 tax filing + investment portfolio information; 3) priority in the process to recently unemployed. Reckless borrowers should be foreclosed.
8. Restructuring should be handled by bank or service provider — not the government or the courts. Not much has happened because little capital has been directed to the individual mortgages.
9. Proactive action to head off second wave. All of this could have been done two years ago and muted the impact of the sub-prime problem.

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Most of the reporting on the stress test focused on the number of banks passing the test and the doable amount of capital the failing banks needed to raise. The tough question was not asked: if the stress test wasn’t really that stressful, why did a majority of the banks fail?

The Good News

1. This is a move towards being more transparent. This is a good start.
2. I was very concerned about the assumptions of the stress test. The news that leaked out before the release suggested the loss impairment assumptions were far from realistic. However, it turns out that all of the loss assumptions are for only a two year horizon. This is an important point. For instance, suppose you think that the total impairment over a four year horizon is 8%. You read in the WSJ that the government is using 4%. You think that is way too low. However, it is not as low if the horizon is only two years.
3. The fact this is in the news is serves an educational function. People are getting a forced lesson in risk management. Whether they like it or not, this learning should decrease the chance of a systemic episode in the future. More people know the right questions to ask.

The Bad News

1. As I have said before, the economic assumptions are problematic. The adverse scenario has 8.9% unemployment in 2009 (average). Today we learned that the unemployment rate rose to 8.9% in April. The adverse scenario has a rate of 10.3% in 2010. It is likely we will reach that rate by the end of the summer of 2009.
2. The two year horizon essentially assumes that good times return by 2011. That is not obvious to me. We have not seen unemployment like this since 1948 and I project that we will blow by 1948 (adjusting for the size of the workforce) by the end of the summer. Employment lags the business cycle. This means there will be loan losses in 2011 and 2012. So rather than $599.2, given the assumptions on loss rates but simply extending out to 2012, a more realistic number is $1 trillion.
3. I think the assumption on Prime mortgage losses is particularly problematic. The more adverse scenario assumes Prime losses of 3-4%. First lien mortgage category includes three components: Prime, Alt-A, and Subprime. Putting all these together the adverse scenario only assumes an 8.8% loss over two years. This includes 9.5-13% losses on Alt-A and 21-28% losses on Subprime. I focus on the Prime assumption because the market is so big. In the overall economy (not the 19 banks), we are talking about $6 trillion. So, for every extra 1.5% in losses we drop $100 billion in value.
4. What about the other 8,000 banks? The two-year losses for the 19 are projected to be $599.2 billion in the stress test. These 19 have 2/3s of the assets and half of the loans.
5. I reject the idea that nobody should fail. When anyone takes on risk, you reflect on the upside and the downside. You temper amount of risk you take because of the downside. But if you are always bailed out, there is no downside and you will (continue to) take excessive risk. In addition, it creates a double standard: financial institutions are bailed out but other industries or individuals are not (yes, there are some exceptions like the autos). There is also another double standard based on size: if you are big you are bailed out but if you are small you are allowed to fail. The only word to describe this is "unfair" This bailout mentality did not happen with the Savings and Loan Crisis in the early 1980s.

Resources

The Fed white paper on the stress test results is worth a read.

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See below my monthly employment graph that standardizes the job losses (based on the sized of the labor force) across different recessions.

Obama scorecard

President Obama means well and is doing a great job in many areas. However, I fear that we are perpetuating the same policies of the previous administration when it comes to the financial sector. It is simply not fair that each of the 19 big banks are bailed out. If you take risk, then there must be some consequence. Right now it is a blanket insurance policy that will lead to similar problems down the road.

See video.

Stress testing the banks

The so-called stress test is a sham. They delayed the release of the test because it is really hard to explain why so many of the banks (including the very largest ones) are offside when the adverse scenario is looking like an optimistic scenario. Note the adverse scenario has 8.9% unemployment in 2009. We could be there next week. It has 10.3% in 2010 and we could be there by the end of the summer. The whole idea of a stress test is to see what happens in a scenario that is worse that what we expect. The test fails on that dimension. It is misleading, increases uncertainty, and decreases confidence.

See video.

Professor Harvey interviews Len Blum of Westport Capital

See video.

Westport Capital conducted a stress test based on leaked information. They estimate a further impairment of $200 billion. I question why they would use the government rosey assumptions. I specifically ask for their assumptions on the prime mortgage impairment. It is rumored that the U.S. Treasury is using an assumption of 5% impairment which, in my opinion, is way too low given the surging unemployment.

Are we seeing the end of the recession

While the stock market is up and consumer confidence is up, it is hard to see any economic fundamentals that point to a trough. In particular, the surging unemployment will likely cause a second wave of mortgage defaults. We don’t see the defaults right now because people are drawing down their savings. We will see it soon.

See video.

Image courtesy of AllPosters.com/J. Thompson

Each of the three programs announced by the Secretary of the Treasury today has the same theme: the private investor has a limited downside and a huge upside – the American taxpayer bears almost all the downside and gets shafted on the upside.

Read my preliminary analysis of the three programs.

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Image courtesy of flickr/John Wardell

AIG disclosed some of the firms that benefited from the government bailout. Essentially, the government money was largely used to pay off other firms. I have a few comments.

1. AIG’s customers were either using AIG for hedging positions or speculative positions. This was mainly done through Credit Default Swaps. These CDS essentially “insure” risky corporate debt – if the CDS is used along with a position in corporate debt. For example, you could buy Ford bonds and simultaneously protect against a default by purchasing CDS from someone like AIG. You are hedged but (and this is a big but) only fully hedged if AIG stays in business.

2. For the hedgers, they failed to properly take the risk of the insurer into account. Parties on the other side of these contracts need to share some of the responsibility. Goldman, for example, was not doing business with the U.S. government – they were doing business with a corporation. This is not the same thing as Goldman having a savings account where the FDIC is covering $250,000 – yet that is how we are treating it. The U.S. taxpayer should not be obligated to make whole all these counterparties who miscalculated the risk of AIG. We are bailing out bad risk management and it is not fair to the American taxpayer. As for the speculators, why should they be bailed out? It’s like bailing out someone who lost at the craps table.

3. It is not surprising that many of the counterparties are foreign. I don’t think the foreign firms should be treated differently. Domestic firms, foreign firms, municipalities, all failed in their risk management. They all should bear some of the cost.

4. From the AIG press release:

American International Group, Inc. (AIG) recognizes the importance of upholding a high degree of transparency with respect to the use of public funds. As a result, after close consultation with the Federal Reserve, AIG is disclosing information identifying certain credit default swap counterparties, municipal counterparties and securities lending counterparties.

What does “certain” mean? Does it mean “a select number”? Does it mean “”all”? If it was “all”, why didn’t they say “all”. How can they call this a “high degree of transparency”?

5. The real story here is for someone to figure out how much more the American taxpayer is potentially on the hook for. AIG has been to the trough four times and now has $180 billion of our money, roughly $1,200 for every working (and seeking work) American. It seems like there was little or no due diligence done on the original government dole out. Transparency to me implies a level of disclosure such that we can figure out the future obligations. How much more will they likely need? $50b, $100b, $300b? We have no way of determining this. This type of forward looking analysis needs to be done as a prerequisite for any future taxpayer money.

6. The other sub-story here is size. AIG has many good business units. However, because they were a conglomerate, the good businesses are being punished for the incompetence of a small number of their business units. With smaller specialized units, we would not be in this situation. AIG could not make the “systemic risk” AKA “too big to fail” argument (as they do on their website).

7. The final sub-story is the following. The U.S. taxpayer is “the” stakeholder in AIG. It is not clear to me that the corporate governance in AIG has shifted from maximize shareholder value to ‘do what’s best for the American economy’. For example, full transparency is necessary. Uncertainty about the future health of AIG and the size of future government obligations, works against the recovery of the U.S. economy.

Read the AIG release here.

The losses are staggering. If the pace of January and February continued through the year, we would lose 8.4 million jobs in 2009.

That is unlikely, but it will be ugly. Consider the following facts.

The percentage job losses have now exceeded the deep 1981 recession. Since December 2007, we have lost 3.17% of nonfarm jobs. In 1981, we lost 3.07%. But we are not done yet.

The recent survey by Duke University and CFO Magazine had CFOs cutting 5.7% of their workforce in 2009. Further, they see the recession lasting another 14 months.

Let’s do some calculations. There are 111 million private sector jobs. 5.7% layoffs means 6.3 million jobs lost in the private sector.

Currently, the labor force is 154 million and there are 12.5 million unemployed, implying an unemployment rate of 8.1%.

Now suppose the CFOs are correct and we lose another 6.3 million jobs and the unemployed rise to 18.8 million (12.5+6.3). That implies an unemployment rate of 12.2%.

So you think the CFOs are pessimistic? Well, maybe they are. But we are forgetting something. We are measuring “planned” workforce reductions. This number does not include the layoffs that result from firms going out of business. Hence, there is reason to believe the number could be greater than 6.3 million.

Wait, we have forgotton the “stimulus” plan. In the most optimistic (and unrealistic) projection, 3 million jobs are created. This means (only) 15.8 million unemployed and a rate of 10.2%. In my opinion, it is more realistic to think that 1.5 million new jobs are created by the plan. This leaves us with 11.2% unemployment.

There is a serious disconnect here.

The Obama economic team’s analysis of the stimulus plan had unemployment capping out at 8% (with the plan). We have already blown through 8%.

More seriously, the so called “stress test” assumes a worst case scenario of average 8.9% unemployment in 2009. That is not a worst case. That is not even a realistic projection. We could hit 8.9% in the next two months! Oddly, the “baseline” scenario, also has 8.9% unemployment in 2009. What kind of scenario analysis has identical projections for “baseline” and “severe”?

Unfortunately, the news gets worse. Unemployment lags the business cycle. This means that even if there is a recovery in the economy in 2010 unemployment will likely continue to increase. The stress test worst case had unemployment increasing 1.4 points in 2010.

The recent data suggest: (1) the situation is much more severe than our policy makers are letting on and (2) the stress test exercise for our financial institutions will have little value because of the unrealistic assumptions about the economy in 2009.

Given the trillions that we are shelling out, I think we deserve transparency and straight talk. It is better to tell us how bad it really is than to sugar-coat some economic projections that will surely lead to future disappointments — and decreased confidence.

Image courtesy of flickr/David Wild

AIG is back to the trough for another $30 billion. We already gave them $150 billion.

AIG — supposedly a firm in the insurance business — got into trouble taking an astounding $450B unhedged bet in the Credit Default Swap (CDS) markets. They insured the holders of mortgages and other asset backed securities.

I have no idea how you can consider yourself an insurance company and take the largest unhedged bet in the history of business.

Folklore suggests that the original $150B deal was made quickly over the telephone with former Treasury Secretary Paulson. A default by AIG would sent many firms instantly into bankruptcy — including UBS and Goldman Sachs (need I say more?). These banks were technically hedged – but their hedges assumed no counterparty risk (i.e. their hedges would only work if AIG was solvent). FYI, a hedge with counterparty risk is not a real hedge. So these banks share some blame too. In addition, our regulators were asleep at the wheel. Essentially, there was no oversight – even though the taxpayer is covering the downside.

At the time, the deal seemed like a good one. The taxpayer (in contrast to a number of other deals) got equity worth 79.9% of the firm. We had the upside!

However, we now know that there was no attempt to value the firm. If the most basic valuation was done, it would be evident that the firm had a huge negative net worth – probably -$250B!

Valuation? –You gotta be kidding. Knowing the value of what you are buying? — Not required! This is the legacy of our government’s actions during the financial crisis.

For each working American, we have written a check to AIG for $1,200 because of the reckless bets they took.

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Image courtesy of flickr/Stuart Crawford

We finally got the information on the stress tests.

The government will consider two scenarios: baseline and worst case.

The goal of the stress test is to see if banks have the capital to weather a darker storm.

However, and incredibly, the worst case scenario is not really a worst case.

The government’s idea of the worst case is a GDP decrease of 3.3% this year and growth of 0.5% in 2010; 8.9 unemployment rate in 2009 and 10.3% in 2010.

That is not the worst case! That is what I call the “baseline”. We are probably at 8% unemployment in February.

As a result, the stress test is a sham. It yields very little information. The government’s rosey worst-case scenario perpetuates the incompetent risk management that got us into this mess.

See my comments on this topic on BNN.

Here are three new video blogs.

1) Bank CEOs Testify before Congress

Eight bank CEOs appeared before Congress on February 11, 2009 to explain how their institutions used the TARP funds they received in 2008. I comment on their testimony and the American taxpayer’s role as primary stakeholder of many of these firms.

Watch on YouTube

Watch streaming video from Duke University.

2) The Positive Aspects of the Treasury’s New Plan

On February 10, 2009, Treasury Secretary Geithner delivered a speech and released a 7-page fact sheet describing the government’s new moves to address the financial crisis. I detail what I believe are the strengths of the plan.

Watch on YouTube

Watch streaming video from Duke University.

3) The Negative Aspects of the Treasury’s New Plan

Unfortunately, the new plan has many flaws. I outline a few of the many problems.

Watch on YouTube

Watch streaming video from Duke University.

The international banking system is at great risk in the current environment.

This week Fortis shareholders rejected a takeover offer. This puts the whole country of Beligium at risk. Fortis’ assets are more than 200% of the GDP of Beligium.

I know that Iceland gets a lot of press — but that country is tiny.

If you combine UBS and CS, they represent 700% of Swiss GDP. RBS assets are about 140% of U.K. GDP.

Fortunately, the U.S. is no where near as exposed. The largest banks assets, like Bank of America and Citigroup, each represent less than 20% of U.S. GDP.

My BNN interview explores these issues in more detail. I argue that no bank is safe in today’s environment. Previously thought of safe assets are not necessarily safe.

Watch BNN Interview.