bizzXceleration: Performance, Value and Profit

Bank Earnings in Context

Taylor Says Bernanke Gets Rate Rule Right While Goldman Doesn't Understand  Economists from Goldman Sachs Group Inc., Macroeconomic Advisers LLC, Deutsche Bank Securities Inc. and even the San Francisco Federal Reserve Bank argue the Taylor Rule, a pointer for finding the correct level for interest rates, suggests the Fed should be doing a lot more to stimulate the economy. Taylor said his measure shows just the opposite: that Fed policy is appropriate, that central bankers are right to be considering how to withdraw their unprecedented monetary stimulus and that critics who say otherwise are misinterpreting his rule. The formula is designed to show the best rate for spurring growth without stoking inflation. Those figures suggest the federal funds rate target should actually be negative 0.955 percent. Since the Fed can’t lower rates to less than zero, the Taylor rule means the central bank has to pump money into the economy through other methods, such as purchases of Treasuries, mortgage securities and agency bonds. That’s exactly what the Fed under Bernanke has been doing, more than doubling assets on its balance sheet to $2 trillion. The debate among economists is whether they’ve done enough to meet the Taylor formula. Macroeconomic Advisers said its growth and inflation forecasts for the coming year show the Fed should be aiming for the equivalent of a negative 4 percent federal funds rate under the Taylor rule. “What’s been done so far is not enough to get the economy back to any reasonable growth rate,” said Laurence Meyer, 65, a former Fed governor who is vice chairman of Macroeconomic Advisers. “You need to use your balance-sheet policies sufficiently aggressively to replicate the effect you would have had if you pushed the funds rate down to negative numbers.”

Bankers Bet Jobs on a Roaring V-Shaped Recovery The country’s biggest banks are doubling down on a bet that the economy will improve in the latter half of the year. If they’re wrong, and borrowers don’t pull out of a tailspin, bankers and their investors will take a beating. That’s because banks will have to rebuild diminishing reserves that they set aside for soured loans, which results in charges that lower profit. Signs that big banks are hoping to draw the equivalent of an inside straight on an economic rebound emerged in second- quarter results. Figures from the country’s seven largest commercial banks by assets, including banks like Wells Fargo & Co. and Bank of America Corp., show they went easy on increasing loan-loss reserves in the quarter. That followed a similarly light buildup in the first quarter. Such moves help bolster bank profits. If loan losses slow during the next six months because, say unemployment levels off and housing stabilizes, banks will win big with this bet. They will have pumped up profit today while allocating sufficient reserves for the rest of the year. At some point in every economic cycle, wagers like these pay off for banks as loan losses peak and provision charges ebb. Timing is everything, though, and there are reasons to worry banks are making their recovery play too early. Plus, commercial real estate loans are a growing threat. U.S. commercial property prices have declined 35 percent since their peak, Moody’s Investors Service said in a recent report, while Federal Reserve Chairman Ben Bernanke warned Congress this week that defaults in this sector may pose a “difficult” challenge for the economy. Meanwhile, banks’ credit losses aren’t showing signs of slowing. Wells isn’t alone in dragging its feet on bulking up reserves. Of the seven biggest banks by total assets, all but Citigroup Inc. saw the growth of nonperforming assets -- mostly loans likely to result in a loss -- grow at a quicker pace than the increase in the bank’s loan-loss reserve, according to my calculations. Additionally, all the banks except Citigroup saw reserves as a percentage of assets fall in the second quarter. Citigroup’s reserves increased to 128 percent of nonperforming assets compared with 119 percent in the first quarter.

Accountants Gain Courage to Stand Up to Bankers Turns out America’s accounting poobahs have some fight in them after all.Call them crazy, or maybe just brave. The Financial Accounting Standards Board is girding for another brawl with the banking industry over mark-to-market accounting. And this time, it’s the FASB that has come out swinging. It was only last April that the FASB caved to congressional pressure by passing emergency rule changes so that banks and insurance companies could keep long-term losses from crummy debt securities off their income statements. Now the FASB says it may expand the use of fair-market values on corporate income statements and balance sheets in ways it never has before. Even loans would have to be carried on the balance sheet at fair value, under a preliminary decision reached July 15. The board might decide whether to issue a formal proposal on the matter as soon as next month. The scope of the FASB’s initiative, which has received almost no attention in the press, is massive. All financial assets would have to be recorded at fair value on the balance sheet each quarter, under the board’s tentative plan. This would mean an end to asset classifications such as held for investment, held to maturity and held for sale, along with their differing balance-sheet treatments. Most loans, for example, probably would be presented on the balance sheet at cost, with a line item below showing accumulated change in fair value, and then a net fair-value figure below that. For lenders, rule changes could mean faster recognition of loan losses, resulting in lower earnings and book values. The board said financial instruments on the liabilities side of the balance sheet also would have to be recorded at fair-market values, though there could be exceptions for a company’s own debt or a bank’s customer deposits.

Bank profits not as impressive as they seem The big banks are making big money again, but they won't be back to health as long as they have to deal with a recession and customers defaulting on mortgages and credit cards. The impressive numbers included a $3 billion second-quarter profit announced Friday by Citigroup and $2.4 billion for Bank of America. They followed similarly robust earnings for Goldman Sachs and JPMorgan Chase. That the banks managed to turn a profit at all is remarkable. Just 10 months ago, many of them looked to be on the verge of collapse. The stock market staged a huge rally this week, driven by the signs of health in banking. But Bank of America CEO Ken Lewis had some sobering words during a conference call with Wall Street analysts after his company's results were released Friday: "Profitability in the second half of the year will be much tougher than the first half." Bank of America Corp., JPMorgan Chase & Co. and Goldman Sachs Group Inc. earned profits this spring largely on investment banking and trading -- not traditional banking businesses, which still look shaky. Citi benefited from selling its majority stake in the Smith Barney brokerage. Strip away those money-makers, and the banks have to rely on customers who are losing their jobs or earning less money. The banks will suffer as long as their customers do.

• Citigroup, BofA Results Shine Light on Failings BofA and Citi posted second-quarter profits that were reliant on hefty onetime gains, exposing weaknesses in some operations amid rising credit losses.

GS as Exemplar

What Is Goldman Sachs? Recall that in Q4 2008 brokerage firms (Goldman Sachs, Morgan Stanley) and finance companies (CIT, GMAC) were given permission to convert into commercial banks. They did this to get access to better sources of funding during the dark days last fall. Now that Goldman Sachs is a commercial bank comes a new set of public reporting requirements. One of these public reports is linked above, and below is a series of charts and tables from this report. The first chart shows total credit exposure to risk-based capital for the five largest commercial banks. Below the chart is a table showing the the underlying data. Goldman Sachs is among the five largest commercial banks. Regarding their credit exposure to capital relative to their peers, we believe the technical term is “wow!” The next chart shows quarterly trading revenue at the top five banks. Notice the blue bar under Goldman Sachs, it is their Q1 2009 results. Trading revenue accounted for 69% of gross revenue. No other large bank is even close to having trading be this large a part of their gross revenue. Combined with the charts above and we can see that Goldman’s revenues primarily come from credit trading. What happened to investment banking? The charts note two different dates. The first is February 8, 2007, the date we believe the credit crisis began [11] (the date HSBC, or “patient zero”, restated 2006 earnings because of subprime losses). The second date is September 5, 2008. This was the day Fannie Mae and Freddie Mac were placed in conservatorship and a week before Lehman Brothers failed. Since February 7, 2008 both Goldman’s stock and the bank index has been highly correlated to credit. Neither was highly correlated before this date. Since September 5, 2008 Goldman’s relationship to credit held, but the bank index’ relationship has begun to diverge. So, in answering the question, “do stock traders understand that Goldman is essentially a large credit protfolio”, these charts suggest the answer is “yes.”

• Goldman execs sell $700 million in stock: report
• With Big Profit, Goldman Sees Big Payday Ahead
• Behind Goldman Sachs’ second quarter profit
• Bank of America Posts a Profit on Trading Gains, BofA, Citigroup Battle Credit Losses
• Finance Woes Sink GE Net

Shining Results Aren't Solid Gold Only months after the government rescued Wall Street, risk is back in fashion. Or at least it is on Broad Street, home to Goldman Sachs Group. As investors expected, the firm Tuesday reported blowout second-quarter profits. The secret? Putting risk capital to work as markets revived. Goldman reported net income of $2.7 billion on record net revenue of $13.8 billion. The stellar results raise two big questions: Are they sustainable for Goldman? And do they suggest the broader financial system is on the mend? On the first, Goldman recognized early that sentiment was changing. It didn't shrink from using its balance sheet to make markets for clients stampeding back into recovering markets. And Goldman appears to have booked solid proprietary-trading profits alongside increased client activity. Full marks for timing. More-cautious rivals may have lost out on a possibly fleeting period of hefty profits. But Goldman swung for the fences to post these second-quarter numbers, judging by its value-at-risk -- an industry risk measure that estimates the one-day loss on trading positions in certain adverse conditions. Granted, VaR is an imperfect and narrow measure. It gave no warning of the huge recent losses at banks. It is hard to reconcile across firms. And Goldman has higher capital buffers today to absorb potential losses. Even so, the big gap between Goldman's latest VaR and first-quarter numbers from other firms is raising eyebrows. In the second quarter, Goldman's VaR climbed to $245 million, its highest quarterly level since the firm went public in 1999. At Morgan Stanley, VaR was $142 million in the first quarter, while J.P. Morgan Chase's trading VaR was $190 million. Goldman's first-quarter figure also was higher at $240 million. Embracing risk could keep working for Goldman if market conditions continue to improve or, at least, stabilize. However, Goldman increased VaR the most in equities. And stock markets have weakened so far this quarter, notes Michael Hecht at JMP Securities. In addition, credit markets could easily swoon again, especially if massive government programs aimed at shoring up bond prices lose their impact.

• Deal Journal: One-Quarter Wonder?
• Goldman Firing on (Almost) All Cylinders
• Keeping up with the Goldmans Goldman Sachs's record profits owe more to lack of competition than market recovery.
• Can Wall Street Catch Up to Goldman Sachs?

A Tale of Two Bailouts Goldman will surely deny that its risk-taking is subsidized by the taxpayer -- but then so did Fannie Mae and Freddie Mac, right up to the bitter end. An implicit government guarantee is only free until it's not, and when the bill comes due it tends to be huge. So for the moment, Goldman Sachs -- or should we say Goldie Mac? -- enjoys the best of both worlds: outsize profits for its traders and shareholders and a taxpayer backstop should anything go wrong. We like profits as much as the next capitalist. But when those profits are supported by government guarantees or insured deposits, taxpayers have a special interest in how the companies conduct their business. Ideally we would shed those implicit guarantees altogether, along with the very notion of too big to fail. But that is all but impossible now and for the foreseeable future. Even if the Obama Administration and Fed were to declare with one voice that banks such as Goldman were on their own, no one would believe it.

• What Wall Street Owes You Tavakoli discusses how GS blowout was based on government guarantees, subsidies, artificially low interest rates, transfers (e.g. AIG) and a massive decline in competition.
• WSJ Editorial Page Favors “Bailout Tax” on Large Financial Institutions

Industry Futures

Two Giants Emerge From Wall Street Ruins A new order is emerging on Wall Street after the worst crisis since the Great Depression — one in which just a couple of victors are starting to tower over the handful of financial titans that used to dominate the industry. On Thursday, JPMorgan Chase became the latest big bank to announce stellar second-quarter earnings. Its $2.7 billion profit, after record gains for Goldman Sachs, underscores how the government’s effort to halt a collapse has also set the stage for a narrowing concentration of financial power. “One theme here is that Goldman Sachs and JPMorgan really have emerged as the winners, as the last of the survivors,” said Robert Reich, a professor at the University of California, Berkeley, who was secretary of labor in the Clinton administration. Both banks now stand astride post-bailout Wall Street, having benefited from billions of dollars in taxpayer support and cheap government financing to climb over banks that continue to struggle. They are capitalizing on the turmoil in financial markets and their rivals’ weakness to pull in billions in trading profits. For the most part, the worst of the financial crisis seems to be over. Yet other large banks, including Citigroup and Bank of America, are still struggling to return to health. Both are expected to report a more profitable quarter on Friday, but a spate of management changes and looming losses from credit cards and commercial real estate have thwarted a stronger recovery. And then there are the legions of regional and small banks that are falling in greater numbers across the country. While many have racked up large losses, they stand to bleed more red ink if the recession wears on. Fifty-three have failed this year, and the Federal Deposit Insurance Corporation is girding for scores to follow. Uncertainties over the economy mean that Goldman and JPMorgan may be enjoying a fragile dominance, industry experts said. JPMorgan reported big declines in its consumer business on Thursday, and it has set aside more than $30 billion to cover future losses from surging credit card charge-offs and mortgage and home equity losses. “Nobody is through this until unemployment turns around,” said Moshe Orenbuch, a Credit Suisse banking analyst. And if regulation being considered in Washington is passed, banks would face new limits on the amount of their own capital they may trade. That could limit the profits that banks like Goldman and JPMorgan make from their trading businesses, and level the playing field, experts say.

• Goldman Gains on Rivals' Pain

The real price of Goldman’s giganto-profits So what’s wrong with Goldman posting $3.44 billion in second-quarter profits, what’s wrong with the company so far earmarking $11.4 billion in compensation for its employees? What’s wrong is that this is not free-market earnings but an almost pure state subsidy. Last year, when Hank Paulson told us all that the planet would explode if we didn’t fork over a gazillion dollars to Wall Street immediately, the entire rationale not only for TARP but for the whole galaxy of lesser-known state crutches and safety nets quietly ushered in later on was that Wall Street, once rescued, would pump money back into the economy, create jobs, and initiate a widespread recovery. This, we were told, was the reason we needed to pilfer massive amounts of middle-class tax revenue and hand it over to the same guys who had just blown up the financial world. We’d save their asses, they’d save ours. That was the deal. It turned out not to happen that way. We constructed this massive bailout infrastructure, and instead of pumping that free money back into the economy, the banks instead simply hoarded it and ate it on the spot, converting it into bonuses. So what does this Goldman profit number mean? This is the final evidence that the bailouts were a political decision to use the power of the state to redirect society’s resources upward, on a grand scale. It was a selective rescue of a small group of chortling jerks who must be laughing all the way to the Hamptons every weekend about how they fleeced all of us at the very moment the game should have been up for all of them. Now, the counter to this charge is, well, hey, they made that money fair and square, legally, how can you blame them? They’re just really smart!Bullshit. One of the most hilarious lies that has been spread about Goldman of late is that, since it repaid its TARP money, it’s now free and clear of any obligation to the government - as if that was the only handout Goldman got in the last year. Goldman last year made your average AFDC mom on food stamps look like an entrepreneur. Here’s a brief list of all the state aid that is hiding behind that $3.44 billion number they announced the other day. In no particular order: Taken altogether, what all of this means is that Goldman’s profit announcement is a giant “fuck you” to the rest of the country. It is a statement of supreme privilege, an announcement that it feels no shame in taking subsidies and funneling them directly into their pockets, and moreover feels no fear of any public response. It knows that it’s untouchable and it’s not going to change its behavior for anyone. And it doesn’t matter who knows it. There are going to be some people who say that some of this stuff isn’t government subsidy so much as ordinary government contracting. After all, do we criticize Boeing for making airplanes or Electric Boat for making submarines during a war? If we don’t do that, then why should we be pissed about Goldman making a profit underwriting TARP repayment stock issuances, or Treasuries?The difference is that Boeing and Electric Boat didn’t start the war. But these guys on Wall Street causesd this crisis, and now they’re raking in money on the infrastructure their buddies in government have devised to bail them out. It’s a self-fulfilling cycle — beautiful, in a way, but at the same time sort of uniquely disgusting. That they’re going to get away with it is bad enough — that they’re getting praised for it, for being such smart guys, is damn near intolerable.

• Goldman Sachs vs. Rolling Stone: A Wall Street Smackdown
• Goldman's Sudden Boom Could Be a Bust for Obama

Tenacious G The interest of the Street, dominated by Goldman Sachs, has been to have markets that are opaque, inefficient, and unregulated,� says Peter Solomon, chairman and founder of the investment bank Peter J. Solomon Company. �And that’s been the policy for twenty years. That’s what the world is reacting to.� In the aftermath of AIG, the firm’s government connections have come to look like a conspiracy of outrageous self-interest�the ultimate hedge protecting their investments. As one Wall Street executive at a competing bank puts it, � �What about Goldman?’�that’s their natural default position. Lost in the haze of Goldman’s recent record profits is the fact that the firm nearly went under even after the AIG bailout last fall. As the market continued to plunge and Goldman’s stock price nose-dived, people inside the firm �were freaking out,� says a former Goldman executive who maintains close ties to the company. Many of the partners had borrowed against their Goldman stock in order to afford Park Avenue apartments, Hamptons vacation homes, and other accoutrements of the Goldman lifestyle. Margin calls were hitting staffers up and down the offices. The panic was so intense that when the stock dipped to $47 in intraday trading, Blankfein and Gary Cohn, the chief operating officer, came out of the executive suite to hover over traders on the floor, shocking people who’d rarely seen them there. They didn’t want staffers cashing out of their stock holdings and further destroying the share price. (Even so, many did, with $700 million in employee stock liquidated in the first nine months of the crisis.) Meanwhile, there were huge losses for Goldman’s clients in souring investments, many of which Goldman executives and their network of alumni were also vested in. Salvation came on November 25, a few days after Goldman’s stock price plunged to $52 a share, down from the year’s high of $200 and the lowest price the company had seen since it went public. Again, the white knight was the government. It turned out that Goldman’s conversion to a garden-variety bank-holding company offered an amazing advantage: Goldman now had access to incredibly cheap money. Exploiting its new status, Goldman became the first financial institution to sell $5 billion in government-backed bonds through the Federal Deposit Insurance Corporation, which allowed Goldman to start doing deals when the markets were at a near standstill. �Goldman was desperate for it,� says a prominent Goldman alumnus. �Everybody knows it. Those FDIC notes they got were lifesaving because they couldn’t issue any debt. If it had gone on another week or two, Goldman would have failed, they would have gone the way of Lehman, and you’d be talking about Lloyd the way you talk about [Lehman CEO] Dick Fuld.

• The Man Who Crashed the World Almost a year after A.I.G.’s collapse, despite a tidal wave of outrage, there still has been no clear explanation of what toppled the insurance giant. The author decides to ask the people involved—the silent, shell-shocked traders of the A.I.G. Financial Products unit—and finds that the story may have a villain, whose reign of terror over 400 employees brought the company, the U.S. economy, and the global financial system to their knees.

Looking Back in Anger at the Crisis To the congressmen at the hearings, something nefarious must have taken place during those negotiations. But what exactly? Dennis Kucinich, a Democrat from Ohio, told me that Mr. Lewis’s failure to inform shareholders was a “potential violation of securities law.” He felt that Mr. Lewis had gamed the banks’ regulators to get more money. Mr. Towns, for his part, seemed to think that Mr. Paulson and Mr. Bernanke should have fired Mr. Lewis as a condition of more bailout money — that the government had been too nice to an incompetent management. Republicans, meanwhile, felt that Mr. Paulson and Mr. Bernanke had overreached, using intimidation and threats to force through a private transaction. And they all cited e-mail from the Fed that expressed skepticism at Mr. Lewis’s motives, and emphasized the need to keep things quiet for as long as possible. I had watched the first two hearings with a growing sense of bewilderment. It always seemed obvious to me that if the Bank of America-Merrill deal hadn’t gone through, Merrill Lynch would have been in a horrible position, akin to Lehman Brothers or the American International Group. The government very likely would have had to spend an awful lot more than $20 billion to save it. Surely, the end result was worth whatever arm-twisting and additional government aid was required. So why the anger? Why the suggestions of “cover-up” and “lies”? On Thursday, as I watched Mr. Paulson being castigated, it dawned on me. Seven months later, with the palpable fear of a financial collapse largely subsided, it really all boils down to how you view what happened last year. Was it, as Mr. Towns believes, a bailout of a handful of unworthy but too-big-to-fail institutions? Or was it, in the eyes of Mr. Paulson, a rescue of a teetering financial system? My vote is for the latter. We’ll never know what would have happened if Bank of America had canceled the Merrill deal. What we do know is that the system didn’t melt down last December, and it seems reasonable to assume that the decision by Mr. Paulson and Mr. Bernanke to hold Mr. Lewis’s feet to the fire was the right one. “They were making it up as they were going along last year,” said Ms. Bush. “There was no precedent.” By all rights, Congress ought to pat them on the back for saving the deal. Instead, it wants to pummel them. But there is also something else going on here. There was a point during Thursday’s hearing when the questions turned from the particulars of the Bank of America-Merrill deal to the larger questions surrounding the events of last year. The questioners seethed with anger. Hadn’t Mr. Paulson lied to Congress about the original purpose of the TARP money? Hadn’t his former company, Goldman Sachs, been the recipient of billions of dollars in government money that was funneled through A.I.G.? Why weren’t any of the heads of the financial firms — A.I.G. excepted — forced out of their jobs, given the calamity they helped create? One congresswoman practically accused Mr. Paulson of creating the crisis himself. In retrospect, Congress felt bullied by Mr. Paulson last year. Many of them fervently believed they should not prop up the banks that had led us to this crisis — yet they were pushed by Mr. Paulson and Mr. Bernanke into passing the $700 billion TARP, which was then used to bail out those very banks. Like Mr. Lewis, they took one for the team. Now that the crisis has subsided, it is payback time. As they watch Goldman Sachs and JPMorgan and — yes — Citigroup and Bank of America report billions in profits once again, they feel taken. Their constituents are out of work, home foreclosures are on the rise, yet Goldman, for instance, is planning to pay billions in bonuses for this year. The “investigation” into the Bank of America-Merrill deal is simply a convenient vehicle to express that fury. Maybe, if we’re lucky, the score is settled now. But I doubt it. If the Bank of America hearings show anything, it is that Congress is taking away all the wrong lessons from the crisis. In all likelihood, if the crisis erupts again, Congress won’t let itself be pushed around by Treasury, the way it was last time. Then we’ll really be in trouble.