No End in Sight for the Credit Crisis

Posted by Louis Navellier on 8/4/08 11:49 am

On Friday, the Federal Deposit Insurance Corporation (FDIC) announced the eighth bank failure of the year, and the fourth in less than a month.  The latest casualty was a Florida bank.  Also on Friday, the FDIC revealed that it had issued warnings to four other banks that lacked sufficient reserves to cover potential loan losses.  The cease-and-desist orders issued by the FDIC in June said the four banks needed to raise more capital, expand their loss allowances, and better oversee and diversify their loan portfolios. 

Obviously, financial stocks are not out of the woods yet, as rising defaults, especially on mortgage loans, continue to sink the banking industry.

Credit card securitizations are in troubled waters, too.

On Wednesday, the Fed announced that it is continuing to implement several steps designed to enhance its emergency lending program for banks and primary dealers.  For banks, the Fed said it would lengthen some of the credit it extends to 84 days.  Previously, the loans the Fed has made to banks were for 28 days.  For broker dealers that serve as primary dealers of Treasury debt, the Fed said it would introduce auctions of options on $50 billion loans.  These options could be exercised if needed in periods of elevated stress in the months to come, like at the end of a quarter.  The Fed also said it’s extending its primary dealer loan program to the end of January from mid-September.

The Financial Accounting Standard Board (FASB) last week gave banks a one-year reprieve from having to realize up to $5 trillion of offshore debt on their balance sheets.  Yikes!  It was already bad enough that Structure Investment Vehicles (SIVs), which were essentially a leverage arbitrage bet based on yield curve differentials that were packaged in offshore commercial paper, ended up in institutional money market funds.  Obviously, from a disclosure point of view, financial institutions have more to hide.  FASB’s chairman, Robert Herz, said that the FASB’s decision was made reluctantly after a staff recommendation for a delay because there might not be enough time for all companies to adjust to the upheaval of having to realize their off balance sheet instruments.  Specifically, Gerz said that “It does pain me to allow something that has been abused by certain folks, to let that go on for another year.” Clearly, some major financial companies have offshore surprises that even FASB is having a hard time gauging.

Last week, the Securities and Exchange Commission (SEC) extended their order to prevent “naked” short selling for an additional two weeks in the stocks of major financial companies, including Freddie Mac and Fannie Mae.  The SEC acknowledged that short selling, when done legitimately, is “essential to efficient, highly liquid markets.” However, abusive naked short selling has drawn blame from some quarters for the abrupt declines in share prices of major financial stocks this year.  The SEC’s temporary rules on naked shorting apply to shares of financial institutions that have been granted additional access to the Fed’s credit facilities as part of coordinated efforts to work through the credit crisis without more failures.

Obviously, the Fed, FASB and the SEC are all working together to resolve the credit crisis that is threatening to sink more major financial stocks.  However, in the end, credit markets will remain in shambles, so the efforts from the Fed, FASB, and the SEC may merely postpone the inevitable.  According to former Fed Chairman Alan Greenspan, the U.S. is potentially in the worst credit crisis in 100 years.  Considering the Great Depression was less than a 100 years ago, Greenspan’s comments are very eerie.

One-year into the credit crisis, a potential “smoking gun” was revealed.  The SEC released information from an S&P analytical staffer who e-mailed another colleague saying that a mortgage or structured-finance deal was “ridiculous” and that “we should not be rating it.” The other S&P staffer replied “We rate every deal…it could be structured by cows and we would rate it.” An analytical manager in the collateralized debt obligations (CDO) group at S&P told a senior analytical manager in a separate email that “rating agencies continue to create” an “even bigger monster … the CDO market.  Lets hope we are all wealthy and retired by the time this house of cards falters.” Yikes!

I think that explains a major factor behind the credit crisis.  S&P and Moody’s were providing favorable ratings on highly questionable CDOs in exchange for booming revenues and were clearly not being objective.  For example, at S&P, revenue from rating the mortgage-laden bond portfolios grew more than 800% from 2002 to 2006, so S&P (and Moody’s) prospered by rating the rocketing market for mortgages and CDOs, and clearly had an immense conflict of interest since as soon as they downgraded these instruments, their windfall revenues could fizzle.  Obviously, Wall Street messed up big time by creating financial instruments with no valid resale market, as President Bush recently pointed out.

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