Unlike Dorothy in “The Wizard of Oz,” the brutalized U.S. banking system will never again return to that comfortable, cozy, and cushy capital place it once happily referred to as “home.” But its “Wicked Witch” was its own greed. The curtain has finally been pulled back on the machinery, and the hot air used to pump up the U.S. banking system’s version of the Emerald City in the Land of Oz.

For decades, American banks operated on a simple – and nicely profitable – business model: They took in deposits and lent out money.

In the simplest model, a bank might take in deposits of a million dollars and lend out a million dollars. In a perfect world, such a “matched book” is established if they know that the deposit will be left in the bank for a year and the loan they made has a maturity of one year. If the bank pays the depositor 3% and charges the loan borrower 5%, it can assume a profit for the year of 2% (the difference between the 5% loan rate and the 3% payout to depositors).

It Takes Money to Make Money – Disappear

In order to make more money, banks need more money to lend. In addition to taking in deposits, banks borrow money to make more loans, to buy assets to keep on their balance sheets, and to trade in the markets. They get this money by offering products such as certificates of deposits (CDs) to entice depositors to bank with them, they borrow overnight in the Feds Funds market (from other banks), they sell commercial paper backed by their balance sheets to investors, they get capital from profitable trades and investments, and they generate fees for their banking services.

The problem is that banks don’t just take in money in order to lend it out; they take in money to make more money with it by investing and, yes, speculating.

On the deposit-and-loan side of the equation, banks don’t even bother trying to run a matched book anymore. They borrow short and lend long. This works well if their short-term borrowing costs are substantially lower than their long-term lending rates.  But if short-term rates start to rise, banking profits in the borrow-and-lend game start to get squeezed. And if short-term rates shift so much that they’re actually higher than the interest rates the banks are charging on their long-term loans, banks actually start to lose money.

Banking-system executives are fully aware of these interest-rate dynamics. Indeed, they knowingly speculate on interest-rate movements by not running matched books, and trying to increase their spread profits by borrowing as short as they can and lending for as long as they can. The bottom line: Banks actually are speculating on interest-rate movements.

Speculating on the Health of the U.S. Banking System

If you didn’t already know that banks speculate, you’re about to be really surprised. All the money that is not lent out to borrowers floats around in what’s known as the bank’s “treasury.” The job of the people who work in the treasury is to make money with the cash that’s sitting around. To a banker, idle cash is no better than idle hands – both are regarded as the devil’s playthings.

There’s some merit to that argument. After all, no one actually makes money with idle cash: It has to be put to work, lent out, used as investment capital or, of course, used as trading capital in speculative deals.

Banks lend treasury funds overnight – and for short periods – to other banks, and to such non-banking institutions as insurance companies, corporate clients, securities broker-dealers, and investment banks (investment banks do not take in deposits and are therefore not the same as commercial banks, nor are they regulated by the same supervisory bodies that oversee commercial banking operations).

For banks, the problem in making these loans is one of “counterparty risk” – will the borrower be able to pay the funds back? Banks have become very wary of counterparty risk and have drastically cut back their lending to many traditional types of borrowers.

Instead, banks invest in assets, including government bonds, corporate bonds, mortgage bonds, currencies and derivatives. Some investments actually end up on banks’ books because they have deals to hold assets they are not able to syndicate (sell pieces of to other bank partners). And sometimes banks hold assets so that they can profit as these holdings appreciate in value. (Of course, stating that a bank is “holding assets as investments” is actually just a polite way of saying that it is speculating).

The Bottom Isn’t Yet Within Sight

Lately, banks have been holding mortgage bonds and similar financial instruments in so-called “off-balance-sheet” entities. By doing this, the bank essentially takes assets off its books (which are visible to investors and regulators) and places them inside a special holding company, where they now will be out of sight.

Why would a bank do this? Simple. Banks are hiding risky assets so that their “books” and balance sheets look better. Truth be told, there’s no reason for off-balance-sheet entities. Period. They’re nothing more than a means for a fraudulent conveyance.

Banks trade – a lot. They buy and sell government bonds, currencies, derivatives and whatever else their charter allows them to trade. Banks trade billions and billions of dollars every day. They are speculating.

Particularly in the U.S. banking system, what has happened is that banks have over-speculated across the board. And the losses that have resulted have severely reduced their available capital. This means that they have less money to lend and will be much more strict with prospective borrowers, exacting tougher loan terms and demanding higher creditworthiness before agreeing to make any loans.

As banks lose money – something I expect will continue for perhaps the next several quarters – their stock prices will continue to fall, reducing their equity capital (which is what regulators look at to determine their stability).

Banks keep raising capital via investments from sovereign wealth funds and through preferred and common rights offerings. And still their losses continue. They have to keep going back to the well. Sooner or later, this capital-markets well will have to run dry. There are going to be bank failures and we will see the doctrine of “too big to fail” tested yet again, as a major bank sinks into the abyss (the failure of The Bear Stearns Cos. Inc. (BSC) was a test and the subsequent central-bank-led bailout seems to have proved that it was too big to fail).

To understand this crisis is to first understand what’s wrong with banks. We cannot come out of this credit crisis if we do not repair the damage to the commercial lenders in the U.S. banking system. And by “repair,” I’m talking about fixing their credibility and integrity just as much as I am referring to the need to restore their capital base.

This country is the capitalist behemoth that it is because of our banking system. Where are the regulators? Where is Congress? Where are the outraged stockholders and borrowers? Will it take a banking-system collapse and a run by depositors to get these problems addressed and fixed?

Until the banks are fixed, avoid all financials – especially commercial banks and investment banks. Stay short on the dollar. Short the major stock indexes. If you have to remain long in equities, sell calls on a rolling basis.

The next stop on the Dow Jones Industrial Average is likely a test of 10,000.

[Editor’s Note: Contributing Editor R. Shah Gilani - and his column, "Inside Wall Street" - are brand-new additions to the Money Morning lineup. Gilani brings readers the ultimate insider’s view: He’s toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. His self-professed goal is to take readers on a journey through the "shadowy back alleys" of the U.S. capital markets - and past the "velvet rope" that typically keeps the average investor from learning the secrets that sit beyond, just out of reach.]

News and Related Story Links:

• Money Morning Special Investment Report:
  Outlook 2008: Three Ways to Profit From Sovereign Wealth Funds – the “Next Wall Street”

• Wikipedia:
  “The Wizard of Oz.”

• Investopedia:
  Counterparty Risk.

• Investopedia:
  Off-Balance-Sheet Entities: The Good, The Bad And The Ugly.

• Wikipedia:
  Fraudulent Conveyance.

By Martin Hutchinson
Contributing Editor

Imagine that you’re the investment director for one of the new sovereign wealth funds (SWFs). A very important guy – you get to invest several hundred billion dollars, with far fewer committees and shareholder interest groups harassing you than if you the head
of U.S. institutions such as CalPERS or TIAA-CREF.

Last winter, you had delegations from all the big banks in New York explaining that they’d just had this teensy weensy hiccup in subprime mortgages and so were giving you an unparalleled opportunity to buy shares – or convertible bonds – at a modest discount to the market price. You bit and you bought – a few billion dollars in each of two or three of them maybe, a fleabite in terms of your overall funds to invest but real money for ordinary mortals.

Now you open The Wall Street Journal handed you by a flunky to see how your investment is doing….

And find it’s down an average of 15%. And that’s in dollars, which themselves appear to be turning into some kind of peso.

The Politburo will not be happy (if yours is the Chinese fund). You may even find yourself minus a hand (if it’s one of the Middle East funds). Worst of all, if you’re from Singapore’s Temasek Holdings, you may have to explain your poor investment decision to the razor-sharp intellect of the 84-year-old island patriarch Lee Kuan-Yew!

The reality is that according to a Financial Times calculation the sovereign wealth funds, institutions and other investors that have poured $65 billion into cash-starved U.S. financial services companies since last October have lost $9.7 billion, or 15% of their initial investment. In some cases, like the monoline insurers, investors have lost 65% to 70% of their money in less than six months. Yes, that’s a small number compared to the cost of the War in Iraq or Barack Obama’s health plan, but if you’re running a large fund that made several of these investments, it could play merry hell with your job security.

So, when the financial services companies discover their next set of disasters, which they will, and come round for another emergency injection of equity capital, where are they going to find the buyers?

Make no mistake, there will be more disasters – we’re nowhere near through the woods yet. Lehman Brothers Holdings Inc. (LEH), which had previously avoided writeoffs, just declared a $2.8 billion second-quarter loss and is now fighting desperately for survival. American International Group Inc. (AIG), the insurance and finance giant, has written off more than $20 billion and fired its top management, but nobody thinks they’ve found all the problems hidden in their books yet. 

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Even Goldman Sachs Group Inc. (GS), which has so far been snootily superior about its lack of major write-offs and quarterly losses, now has $96 billion in “Level ” assets, three times its capital. “Level ” assets, for those who haven’t been following the bizarre accounting sub-plot to this saga, are those for which no meaningful market price can be found, so instead they are valued by in-house mathematical models. I hate to be cynical, but if I had borrowed twice my net worth and invested it all in assets for which there was no market price, I might be just a tad worried in a financial storm as big as this one.

There are two forces that make me believe Wall Street investment houses will report another round of unexpected losses.

The first is the continuing decline in house prices. The $300 billion that has been written off Wall Street balance sheets so far represents the worst paper – subprime mortgages that weren’t justified in the first place. Almost certainly that $300 billion figure is still too low, but there might be the hope of an end to the losses if not for the continuing decline of house prices, at a rate of about 2% per month nationwide.

Those declines are exposing huge new tranches of mortgages that were previously in good standing. If the principal amount of even a prime mortgage becomes substantially above the value of the home, and the borrower gets into difficulties, the odds of default increase. The large bumps in property taxes that municipalities are beginning to levy, to cover unexpected gaps in their tax receipts, exacerbate the problem.  Future mortgage losses will probably greatly exceed those already written off financial sector balance sheets.

The second force causing further write-downs on Wall Street is all the other lending the banks did during the boom years that is now also turning out to be rubbish. To the extent mortgages default, credit card loans cannot be far behind, and indeed we are already seeing a sharp rise in credit card delinquency ratios, which particularly affects the regional banking sector. Then there are the acquisition loans, and lending in general to overleveraged companies that are turning out not to have the cash flow they had projected.

Finally, there is the new and terrifying area of credit default swaps, now with a total volume of an extraordinary $62 trillion, ten times the size of the U.S. corporate bond market. Theoretically, for every loser on a credit default swap there is a winner. But in practice, many of the losers will turn out to be hedge funds and other non-creditworthy riff-raff, and the financial system will be left holding the bag.

The losses investors have suffered on past equity investment in U.S. financial institutions are now probably sufficient enough to deter further investment in such institutions. Thus the market may well be shut out from raising future capital. We are already seeing this problem in Britain, where a $600 million rights issue for the home mortgage lender Bradford & Bingley PLC (PINK: BDBYF) was withdrawn, even after it had been underwritten, an extraordinary event that did not happen, for example, during the crash of 1987.

Sovereign wealth funds may be stupid, but they’re not THAT stupid. And nor is the equity market as a whole.

For the financial system, this is likely to bring further bankruptcies or emergency bailouts – except that the Federal Reserve may not be able to find banks to conduct a bailout, as JPMorgan Chase & Co. (JPM) did for Bear Stearns Cos. Inc. (BSC) When JPMorgan Chairman James Dimon says, as he did last week, that he believes the financial crisis is almost over, he may be indulging in desperate wish-fulfillment rather than cold hard analysis – Bear Stearns seems likely to cost Morgan even more money than previously feared.

So if your broker comes to you with a great deal for a U.S. financial institution, I would advise you to hang up. Don’t be lured by the promise of big dividends – soon the banks will be too cash poor to pay. We’ve already seen dividend cuts from the likes of Citigroup Inc. (C) and Washington Mutual Inc. (WM). More cuts are on the way.

What can investors do about it? Simple – avoid fashionable companies involved in “symbol manipulation” and look for makers of actual PRODUCTS – things you can drop on your foot (possibly crushing it, if we’re talking about Deere & Co.’s (DE) John Deere 3510 sugar cane harvester). Just make sure the companies you invest in won’t need to go to their banks for extra money anytime soon, because the banks won’t have any to give.

News and Related Story Links:

• Money Morning:
  Why Mark-to-Market is Bad News for Shareholders

• Money Morning:
  Credit Default Swaps: A $50 Trillion Problem

• Fortune:
  More big bank dividend cuts lie ahead

Oppenheimer & Co. (OPY) analyst Meredith Whitney’s reputation has soared like a skyrocket since she made her bearish – but highly prescient – call on the banking sector, including Citigroup Inc. (C), as Money Morning reported last fall.

Now she’s back. And her outlook for the financial sector is actually worse. Whitney is now predicting that the banking-sector’s financial crisis will extend well into next year. If not beyond.

And that’s not even the bad news.

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Whitney now says the worst may be yet to come. The banking-sector financial crisis will last at least until the end of next year, and may actually stretch well past that. And that could lead to a major U.S. downturn.

"We believe the credit crisis is far from over," Whitney wrote in a research report last week. "In fact, we believe what lies ahead will be worse than what is behind us."

The so-called "first wave" of the credit crisis hit banks’ trading books. But the second lightning strike will hit lenders where it hurts the most – right in their lending businesses. If she’s right, the impact on the economy will be devastating.

Here’s why. The banking system’s "originate-to-distribute" model changed the rules of the game. No longer did banks make loans that were based on very careful risk-of-loss analyses. Under the new system, banks make loans – such as subprime mortgages – which are then "securitized," or packaged together, into debt instruments that the trading operations of banks, investment banks or institutional investors might then purchase, believing it was a way of achieving higher returns.

Initially, this led to higher profits. Which induced banks to boost lending so that they could boost securitizations. But here’s the problem. First, since the banks were no longer going to keep the loans, they relaxed lending standards. In fact, they actually had to since, second, they wanted to boost those volumes.

When the underlying loans unraveled as the subprime-mortgage crisis spiraled deeper and deeper out of control, companies such as The Bear Stearns Cos. Inc. (BSC) took losses that just kept growing. Bear Stearns is now being taken over by JPMorgan Chase & Co. (JPM), with the help of the U.S. Federal Reserve.

The sins weren’t limited to banks, however. Consumers stoked this credit inferno – and, in doing so, unknowingly created their own funeral pyre.
Consumers grew accustomed to the "rolling loan gathers no loss" mindset, Whitney says. Housing values were soaring, and as long as those values continued to rise, homeowners could continue to roll over their loans into new borrowings – often packing in a lot of ancillary consumer debt from credit cards or car payments long the way.

When the housing market collapsed, however, homes were no longer a real-estate-version of an automated teller machine (ATM) that consumers could turn to each time they needed to eradicate debt from car loans, home loans or even credit-card debt.

When banks stopped lending, consumers had nowhere to turn to roll over their loans. Making matters worse were two other factors:

• First, many of their loans had so-called "re-set" provisions that permitted the loans to reset at much higher interest rates – a fact that caused the overall monthly mortgage payments to increase, sometimes by as much as 40% or more. And since their incomes weren’t rising in kind, many consumers could no longer make these payments, and defaulted on their mortgages.
• Second, the downturn in the housing market sent home prices into a severe tailspin, in some cases leaving homeowners with mortgage balances that were much larger than the new (lower) market value of their home. And if the mortgage loan also reset, that homeowner was hit with a double-whammy blow – a boosted mortgage payment on a house whose value had plunged.

Those resets have caused foreclosures to soar, the news is going to get lots worse, real estate data firm RealtyTrac Inc. said last month. Indeed, U.S. home foreclosures likely won’t peak until the fourth quarter, Money Morning reported last month.

"What we’re really looking at is ongoing fallout from people overextending themselves to buy homes they couldn’t afford and using highly toxic loan products to get into the houses in the first place," Rick Sharga, RealtyTrac’s vice president of marketing, told The Associated Press. "We’re going to see quite possibly a record amount of foreclosure activity in the third or fourth quarter," reflecting the spike in monthly payments because of the re-sets on adjustable-rate subprime mortgages that will take place in May and June.

And that brings us back to Whitney.

The banking sector’s lending pullback will fuel these losses and foreclosures, for many of the reasons we’ve detailed here. Already, banks will likely have to set aside an additional $170 billion in reserves through the end of 2008 – just to keep up with mounting loan losses.

To do that, banks will have to further rein in lending – to the tune of about $2 trillion worth of available credit lines, BusinessWeek.com reported.
For some context, the annual gross domestic product (GDP) of the entire U.S. economy is approaching $14 trillion. Two-thirds of that is driven by consumer spending.

That’s why the lending pullback is going to have a massive contractionary effect on the U.S. economy.

"New and unforeseen strains on consumer liquidity will push more consumers into precarious credit positions and cause consumer credit losses to be far worse than what is currently estimated, even by the most-draconian of investors," Whitney wrote.

News and Related Story Links:

• Forbes.com:
  Whitney: Credit Crisis Will Run Into 2009.

• BusinessWeek.com:
  Meredith Whitney Scares Us all – Again. 

• BusinessWeek.com:
  The Analyst Who Rocked Citi.

• Money Morning News:
  Investors Bolt From Citigroup in Light of Suggested Dividend Cut or Asset Sale.

• Money Morning News Analysis:
  With More Pain to Come, Don’t Be Fooled by Yesterday’s Banking Sector Gains.

• Money Morning News:
  JPMorgan Raises Bear Stearns Bid

• Money Morning News Analysis:
  With Record Mortgage "Re-sets" Still to Come, U.S. Home Foreclosures Likely Won’t Peak Until the Fourth Quarter of This Year, Expert Says.

Those who were blindsided by the recent financial meltdown are now loudly blaming the "free market" for its failure to police its own excesses, and are calling for greater regulation to prevent future disasters.  But for those who clearly observed the problems developing [no doubt in high definition slow motion], the blame can be directed squarely at the policies of the Greenspan/Bernanke Federal Reserve regimes.  As has been the case countless times throughout history, the free market will now pay the price for government incompetence.

During Senate hearings last week, all parties involved completely ignored the Fed’s own culpability in igniting the speculative fever that caused the current conflagration.  It’s as if a senior prom had turned into a wild bacchanalia, and angry parents are now asking why the chaperones failed to notice the disrobing or why the DJ played provocative music, even as they ignored the bearded gentleman pouring grain alcohol into the punch bowl.

The Inflationary Shuffle

A perfect illustration of the Fed’s failure to take responsibility can be found in central bank Chairman Ben S. Bernanke’s explanations regarding inflation, which he solely attributes to the effects of the rapid increase in global commodity prices.  He failed to mention that commodity prices are rising as a direct consequence of his monetary policy, which is debasing not just the U.S. dollar, but currencies around the world. 

Rather than accepting the blame for creating inflation, Bernanke is shifting the blame to the free market.  Senators seemed happy to let him get away with the subterfuge, since it provides more evidence to support the "need " for more government to save the economy from the disastrous effects of unbridled capitalism.

When asked how we got into this mess, Bernanke replied that our problems resulted from an excessive credit bubble characterized by aggressive leverage, reckless lending, and extreme risk taking.  Absent from his laundry list of catalysts was the Fed’s role in irresponsibly setting interest rates below market levels, which mispriced risk, got the party started and kept it raging into the wee hours of the morning. After drinking that potent punch, it’s little wonder that Wall Street investment banks were stripped financially.

For much of this decade, the objective of the Fed has been – and continues to be – to encourage and facilitate borrowing and lending.

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Defending a Bailout

During his testimony, Bernanke continued to claim that The Bear Steams Cos. (BSC) was not bailed out. His reasoning: Shareholders only received about $10 per share.  Of course, $10 is better than zero, which is what they surely would have received if the Fed hadn’t thrown taxpayer money around.  What about Bear’s creditors though? 

Although the collapse of Bear Stearns would have cost bond holders dearly, the bailout essentially makes them whole.  Here again, the Fed creates an even greater moral hazard by encouraging excessive risk taking.  By bailing out lenders who extend excessive credit, the Fed simply invites more of that behavior.  The free market must be allowed to properly price risk.  Lenders need to know that when they lend money, whether to highly leveraged investment banks and hedge funds, or to over-stretched homebuyers or credit-card users, they run the risk of not getting paid back.  By interfering with this process, the Fed simply guarantees more losses and even bigger bailouts in the future.

Also, leveraged speculators need to know that it is not "heads they win, tails the taxpayers lose."  Wall Street executives amassed fortunes by making extremely risky bets.  Now that those bets have soured, why is it that the taxpayers have to eat the losses?  Wall Street billionaires earned their bucks on the backs of the middle class, who made little on the way up, but are now forced to foot the entire tab for this mess on the way down.

While Bernanke talked about the underlying strength of our economy, he cried "necessity" in deciding to save Bear Stearns from bankruptcy, claiming the failure would have brought down our entire financial system.  How sound can our economy be if the failure of one investment bank can cause it to topple?  Does this now mean that no more major banks or brokerage firms will be allowed to fail?  Since we routinely accused Japan of practicing "crony capitalism," what do you suppose we should call our own version?

Not to be outdone in rewarding reckless behavior, Congress earlier last week passed $15 billion in tax breaks for homebuilders, who had made their fortunes overbuilding during the bubble and unloading their shares to a gullible public.  By threatening to hold back on their political contributions, these same homebuilders are awarded still more billions.  The last ones we should be subsidizing are homebuilders.  After all, the last thing we need right now is more homes.

The legislation also contained a provision that offers generous tax credits to individuals who buy homes out of foreclosure.  While this is billed as a benefit to homebuyers, it is just another handout to lenders, since the prospective buyers qualifying for the tax breaks will simply pay more at auctions as the tax breaks subsidize higher bids.  The real winners are the creditors who will now get more in foreclosure than they would have had buyers not been counting on having their bids subsidized by the government.

Of course, for all the talk about taxpayer bailouts, none of the Senators bothered to mention that – for the moment – no tax increases actually are on the table.  Instead, the bailouts are being financed by savers, pensioners, wage earners, investors and the elderly on fixed incomes, who all suffer staggering increases in their costs of living, as the Fed uses inflation to rob Main Street to pay off Wall Street.

[Editor's Note: Money Morning Guest Columnist Peter D. Schiff is the president of Euro Pacific Capital Inc., a Darien, Conn.-based broker/dealer known for its foreign-markets expertise. A well-known financial author and commentator, Schiff is a regular Money Morning contributor, and has most recently written about the ineffectiveness of the U.S. Federal Reserve, the fiction of the Bush Administration's professed "strong dollar policy", the futility of "juicing" the economy and soaring gold prices. In mid-August, when analysts were touting beaten-down financial shares, Schiff said the stocks were "toxic," were destined "to get hit hard," and advised investors to "stay away." Investors who heeded that advice, and avoided such shares as Merrill Lynch, also avoided some stressful, subprime-induced losses. Check out Schiff's first book, "Crash Proof: How to Profit from the Coming Economic Collapse," which was published by Wiley & Sons last February.]

News and Related Story Links:

• BusinessWeek:
  Bernanke Defends Bear Stearns Rescue.

• Money Morning Market News:
  Midday Market Update: Markets Swing on Bernanke’s Testimony.

Wall Street firms borrowed on average more than $30 billion a day from the U.S. Federal Reserve discount window in the past week.

It has only been two weeks since non-commercial banks, known as primary dealers, were first granted access to the discount window when the Fed made an emergency change to standard procedures in light of The Bear Stearns Cos. Inc. (BSC). [For a complete list of primary dealers, please see the chart below.]

The daily average of $32.92 billion in funds borrowed demonstrates the continued liquidity crunch in the short-term lending markets.

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In an effort to boost liquidity in the financial markets and restore lending confidence, the Fed is making loans to primary dealers through its clearing banks for the first time.

The discount window is normally reserved for commercial banks, which are subject to much stricter banking regulations and oversight than investment banks. The Fed’s decision to allow access to troubled Wall Street firms has led to cries for more intense scrutiny for investment banks.

But U.S. Treasury Secretary Henry M. Paulson, Jr. recently called for restraint, saying that granting access to primary dealers is a temporary measure. 

"Recent market conditions are an exception from the norm," Paulson said in a speech at the U.S. Chamber of Commerce of the United States, The New York Times reported. "The Federal Reserve’s recent action should be viewed as a precedent only for unusual periods of turmoil."

Also, for the first time, the Fed has expanded the types of loan collateral permissible to include certain mortgage-backed securities.

As a further consideration of the current liquidity crisis, the Fed has extended the term of discount window loans twice. In Sept. 2007, as the subprime crisis first began to unfold, the Fed first extended loan terms from the traditional term of overnight to as much as 30 days.

With the emergency rules put in place on March 16, the Fed extended terms to up to 90 days.

News and Related Story Links:

• Reuters:
  Dealers double pace of discount window borrowing

• Seeking Alpha:
  I-Banks Can’t Have their Cake and their Discount Window Too

• The Wall Street Journal:
  Wall Street Taps Fed’s New Loan Program

• Money Morning:
  Jim Rogers: "Nowhere does it say you’re supposed to bail out investment banks"

• Money Morning:
  Surprise Rate Cut And Bear Stearns Buyout Inspires Investor Skepticism, Not Calm

Contrary to what Wall Street would have you believe, this appalling sloppiness that created the subprime mortgage scandal has not been a feature of every housing boom for the last half century. It’s actually quite new, the result of the misdirected incentives caused by the mortgage-securitization business.

Traditionally, mortgage loans were made by small local institutions that took the credit risk themselves and who knew the borrowers personally. You can see how it worked in the 1946 classic movie, "It’s a Wonderful Life."  Actor Jimmy Stewart plays George Bailey, heir to a local building-and-loan company, who battles the evil local capitalist Henry F. Potter to change the character of his hometown, Bedford Falls, by offering affordable housing loans to the poor but upwardly mobile.

It is an appealing model, with only one real flaw; if a local savings and loan is in financial difficulty [as was Jimmy Stewart's in 1932] it will not be able to attract deposits, and no mortgage loans will be made in that locality. With the rise of interstate banking, that problem would have been soluble – mortgage loans would be more expensive in an area if a large national bank was their only potential source, but they would still be available.

The Sad Emergence of Securitization

But Jimmy Stewart and his peers were forced out of business by the 1974-82 inflationary surge, which caused short-term interest rates to rise sharply, while long-term returns on the lender’s mortgage loans remained fixed. By 1982, the great majority of mortgage lenders in the United States were insolvent, in that their capital had been lost. It took nearly another decade for them finally to go out of business, but the damage had been done.

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Securitization was thus Wall Street’s response to a genuine problem: the savings-and-loan sector’s shrinking capital base and its limited ability to lend. There were other possible solutions to the problem, notably a federally financed S&L bailout that did not force them to disappear.

Another solution could have made use of another new Wall Street product: The interest rate swap, under which S&Ls could have locked in a fixed rate on their deposit funding, thus securing their business against fluctuations in interest rates. Through securitization, however, Wall Street was able to take control of the enormous pool of mortgage loans, which showed obvious opportunities for massive profits.

Under securitization, instead of making mortgage loans directly, mortgage bankers only "originated" the housing loans – doing whatever paperwork was thought necessary – before selling them to a Wall Street broker. The broker combined all the loans it was purchasing into a shell company, which enabled it to repackage the debt and sell the resultant products to bond investors.

Fannie, Freddie and Mac

The government gave a huge assist to Wall Street in its efforts to take over the market by establishing Fannie Mae (FAN) and Freddie Mac (FRE). Without these two government-sponsored entities (GSE), the credit risk of each mortgage would be different, so it would have been very difficult to do the first bond issues. However, with Fannie Mae and Freddie Mac guaranteeing most mortgages, the mortgage packages became quite standardized so that investors no longer needed to worry about the mortgages themselves.

In bull markets, like the one that ran from 2000 to 2007, investors would buy mortgages even without the Fannie/Freddie guarantee – especially the so-called "jumbo" mortgages for large amounts that Freddie and Fannie could not legally provide a guarantee for.

However, without Freddie and Fannie, the securitization market might never have arisen. But it did arise, and with it came a big problem. As is now quite painfully clear, the central problem with securitization is that nobody is really responsible for the credit risk:

• Instead of taking loans onto their own balance sheet, and losing money if they default, mortgage companies merely sell the loans they originate to Wall Street, pocketing a fee.

• Wall Street, in turn, retains very little of the resulting mortgage packages; it turns around and sells them to investors, who can hardly expect Wall Street to be responsible for each individual mortgage.

In fact, it’s almost as if everyone connected with the mortgage has turned into a salesman.  Since it’s no longer necessary to have a balance sheet to originate mortgages, mortgage brokers became pure sales operations.  The sales business being what it is, the more unscrupulous and aggressive the sales operation, the more business it did. To keep getting more aggressive, new products like "liar loans" were invented. [Originally known as "low-documentation" or "no-documentation" mortgages in which the prospective borrower is permitted to list such key items as income and assets on the loan application - without having to provide the documentation that's usually an essential part of the mortgage process. Since the assertions were accepted as fact, meaning the applicant could write down almost anything they chose, they gained the derisive nickname, "liar loans"].

You would expect that in a free market, the move to a new product such as securitization would have led to cheaper mortgages.

But it hasn’t been so.

The Sad Reality of Securitization

Back in the 1971-1976 time frame – the period before securitization really took hold – the average differential between Treasury bond yields and 30-year mortgage yields was just over 1%.

In 2000-06, before the housing finance crash made mortgages even more expensive than they had been, the average differential was more than 1.5%. In other words, securitization has boosted mortgage costs by half a percentage point compared with the Jimmy Stewart days, something free-market theory says shouldn’t happen.

But in reality, you can see just how it happened: It was driven by aggressive salesmanship.

In the days of the old "Bailey Bros. Building & Loan," thrifts weren’t very profitable. Many were unable to survive anything but optimum market conditions and failed, meaning not much new capital moved their way.

In more recent times, specialized mortgage brokers and Wall Street securitizers made huge amounts of money for the aggressive sales types and quants who peopled them. Naturally, the hard sell beat out the traditional provider, at considerable expense to homeowners. As capital flowed their way, they got increasingly greedier and also more aggressive – creating such new products as the "low-documentation" loans we now refer to as "liar loans."

So each time you write out your monthly mortgage check, just remember that half a percentage point on your home-loan rate has no economic purpose at all – and is nothing more than a reward to the hard-sell artists and lordly titans of Wall Street.

With the mess the subprime crisis has made of the mortgage sector, perhaps this will change. But it will be painful. Fannie and Freddie are currently aggressively buying up more loans. Since they have far too little capital, it’s possible they’ll be forced into a rescue situation by taxpayers. If that happens, and Congress is on the ball, it can close them down, forcing mortgage loans to be held or sold on their own merits, without the extra government guarantee.

At that point, given the problems that have occurred, securitization will become very difficult — there will be few investors interested in securitized mortgage bonds, which will make these once-popular securities relatively unprofitable and uninteresting for Wall Street to sell. If we are lucky, that will allow the re-emergence of local mortgage lenders, who will once again nurture relationships with their local customers and who will also hold the mortgage loans on their balance sheets.

When that happens, we’ll tell George Bailey that we have a great job opening for him.

And this time around, we won’t let the Henry Potters, or the greedy salesmen of Wall Street, force that neighborhood thrift into bankruptcy.

[Editor's Note: Money Morning Contributing Editor Martin Hutchinson, an expert on the international-banking and global-bond markets, has been covering the subprime-lending crisis since it broke last year. His most recent reports have been highlighting key trouble spots in the debt markets. In his most recent articles, Hutchinson has explained how Wall Street helped create the credit crisis and how U.S. investors can profit from the dollar's decline - before it rebounds.]

News and Related Story Links:

• Wikipedia:
  Securitization.

• Money Morning Financial:
  How Wall Street Bankers Helped Create the Current Credit Crisis.

• Money Morning Financial Analysis:
  Three Ways to Play the Dollar’s Current Spiral.

• Wikipedia:
  It’s a Wonderful Life.

Prior to the beginning of the current financial crisis last August, many of you had probably never even heard of collateralized debt obligations (CDOs).

So how did these obscure, tottering towers of debt precipitate a crisis that has since prompted the U.S. Federal Reserve to take such drastic action and brought down long-standing Bear Stearns Cos. Inc. (BSC)?

Under a CDO, a group of long-term loans, mortgages or bonds is assembled and then sold to a shell company [called the Special Purpose Vehicle, or SPV], with only modest capital. The resulting SPV then issues short-term commercial paper, which it pays from income generated on the longer-term debt it holds. If everything goes according to plan, profits are made because the SPV is earning a higher rate of interest on its long-term credits than it is paying on its short-term debts.

Why would banks do this?

Under modern regulations, banks are forced to maintain certain capital ratios. If a bank can remove $1 billion of assets from its own balance sheet, that frees up about $80 million of capital that had secured those assets and use it for other purposes.

The bank has to use some of that $80 million to initially capitalize the SPV, but since the SPV is not held to the same standard of capital requirements, the bank can do so with only $20 million to $25 million. The remaining $55 million to $60 million can then be used to secure more loans or buy more assets, increasing profits.

Story Continues Below…

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Thus, CDOs enable banks to increase their business – as well as their profits – with the same amount of capital.

Investors buy the commercial paper issued by the SPVs because they offer an attractive yield. And the SPV is left with a profit, since it makes a higher return on its long-term assets than it pays out on its short-term liabilities.

It sounds simple. So, why doesn’t it work?

When Things Don’t Go as Planned

The most fundamental reason is the SPV’s huge liquidity mismatch. 

Its long-term assets have terms of 20 to 30 years, whereas the short-term assets it’s selling turn over every 90 days, and sometimes as often as 30 days. If the SPV can’t find a market for its short-term commercial paper at a yield it can afford with the income from its long-term assets, the SPV has to find money from another source – or declare bankruptcy.

The only reliably available source for money the SPV has is the bank that originally sponsored it. If the credit markets freeze up the way they have of late, the bank has to lend money to the SPV to keep it afloat. If the liquidity crisis persists, the bank might face this choice: Either bring the assets back on its own balance sheet, or allow SPV to go under.

And that’s just one problem scenario. But trust me, there are others.

Commercial paper debt is rated by agencies such as Moody’s Corp. (MCO), Standard & Poor’s and Fitch Ratings Inc. A pool of long-term debt secures the SPV’s short-term debt, and it was assumed that since those assets comprised a wide variety of borrowers, only a few would default at any one time. That would mean that commercial paper secured on, say, the top 50% of the assets would be very low risk, and it was typically granted a "AAA" rating.

However, as we’ve now learned, in most cases those long-term assets were subprime mortgages. And many of those subprime and Alt-A loans that were securing the commercial paper held by the SPVs were made to borrowers by banks that never bothered to verify income or determine the borrower’s true financial position. If you don’t check the borrower’s income, you know nothing about his ability to repay the loan.

The downturn in the housing market dramatically increased the default rate, which in turn affected the income stream the SPVs were able to realize from their long-term debt. The "AAA" rating of the commercial paper was worthless due to the riskier assets securing it.  No amount of clever analysis will give you an accurate credit rating on loans where the borrower has been allowed lie about his finances.

The Future of CDOs

I think CDOs will disappear. If banks have to lend to the SPV in difficult markets, there is no justification in taking the SPV’s assets off the bank’s balance sheet. Several banks, such as Citigroup Inc. (C) have had to move assets back onto their own balance sheet. And it no longer makes sense for a short-term investor to buy commercial paper from an SPV now that the true risk of such an investment has been exposed.

With the two main rationales for CDOs removed, it seems unlikely they will survive, except in small niches of the market where special circumstances make them desirable.

CDOs were always an unsound idea, and now they have contributed to the current financial crisis by forcing banks to bail them out, tying up money that the banks need for other purposes. But it could have been only a moderate problem – especially with the Fed pumping liquidity into the markets with hundreds of billions in short term loan facilities – if not for other factors, such as truly lousy credit quality in the home mortgage market, which made the credit crisis fallout that much worse.

Here’s a warning to investors. There’s a new term you’re going to hear a lot about in the coming weeks: "Frontier Markets."

Regard the term – and the investment strategy behind it – with substantial caution.

Here’s why.

When it comes to Wall Street, the worse the markets around the world behave, the more you’re going to hear about potential "alternatives."

Travel back about 10 years and it was the so-called "emerging markets," including Hong Kong, Singapore, Taiwan and Malaysia. Then came the "BRICs" – Brazil, Russia, India and China.

Now the "alternative markets" du jour are the frontier markets.

These are places like Namibia, Bangladesh, Pakistan, Romania, Vietnam, Morocco, Cyprus and Nigeria, for example. These markets aren’t exactly paragons of geopolitical stability anymore than they’re economic security.

Even so, the Big Boys read that to mean Wall Street’s insiders are starting to talk them up as having BRIC like potential.

And with good reason. The Standard & Poor’s Frontier Markets Index reflects an annualized return of 37% over the last five years, which is better than the Morgan Stanley Capital International Global Emerging Markets Index (MSCI GEM) and a whole lot better than the Standard & Poor’s 500 Index, especially lately.

Sound appetizing?

Think again. You’ve heard this song before.

Despite the fact that Standard and Poor’s, Morgan Stanley (MS) and, most recently, Merrill Lynch & Co. Inc. (MER) all have created frontier indices of their own, investing in them is largely limited to institutional investors. Save for one tiny (and expensive) frontier fund from T. Rowe Price Group Inc. (TROW), there is no easy way in for individuals. But that won’t stop the Wall Streeters from telling you all about it – especially as U.S. market conditions continue to worsen.

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Why? Because it’s in their interest to keep you interested. They generate fees – lots of fees – by holding onto your assets, meaning they have a lot of "skin" in the game here.
                    
Callous?

You bet. But it’s true, nonetheless.

By the time somebody creates an exchange traded fund (ETF) and makes it available to individual investors who want to get their feet wet in the frontier markets, the institutions that are enjoying everything the talking heads will tout in their glowing reports will unload those holdings and rebalance their portfolios using the flood of money from individual investors to do so.

This will once again potentially leave the little guys like you and me on the hook in unstable, untested and uncorrelated markets. There’s a relative lack of regulation and corruption rampant in these markets. So are the risks related to political instability, currency devaluation and a near complete lack of research data on the companies, or the markets.

If you ask me, this sounds a lot more like a recipe for indigestion than a strategy for market-beating investment returns.

So what’s an individual investor to do? Here are three simple rules that will keep you on the investment-profit pathway:

• Don’t Chase Performance: You will hear a lot about these markets in the near future and the numbers you’ll hear will make it very tempting to make a play. But don’t do it.

• Play Stability: Stick with the established global companies that are actively doing business in these markets, rather than investing "in country" yourself. Not only are top-tier global managers more capable of cutting deals in – and wringing profits out of – the emerging markets, but they provide a built in safety-brake and diversification play that can actually lower your risk while potentially increasing your returns at the same time. Companies focusing on infrastructure, energy and agriculture are good solid choices, for instance.

• Keep it Sane: If you can’t resist buying in, we don’t blame you. But at least make sure that your exposure to the "frontier markets" is kept within reason. That way you won’t get burned too badly when these volatile markets retrench – as they will. That’s when we’ll be buying in, because by that time we’ll be able to base our decision on stability, and not speculation.

In conclusion, it’s important to remember that even though going global is an absolute necessity in today’s markets, it’s not a license to be reckless – no matter what Wall Street claims about past performance.

It’s the future that matters.

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Stocks were pummeled last week, as the U.S. stock market got off to its worst start memory. Pressured by major recessionary fears, each of the three major indices suffered losses in the first three days of trading in the New Year.

The blue-chip Dow Jones Industrial Average Index closed the week at 12,800.18, a drop of 3.50%, marking its worst start since 1904.  The tech-laden Nasdaq Composite Index lost 5.57% to close at 2,504.65, the worst start since the index’s inception in 1971. And the broader Standard & Poor’s 500 Index lost 3.86% to end the week at 1,411.63, the index’s lowest level in the past five months.

"There’s a lot of blood. It has not been pretty," Chief Investment Officer Joseph Keating, who managers $3 billion in assets at Alabama-based First American Asset Management, told Bloomberg. "How slow is the economy going to be and what does it mean for earnings? That for me is the big issue."

According to the "January Effect" theory, the first five trading days of the year determine trading patterns for the entire year. Since 1970, in 31 out of 37 years – or 84% of the time – the S&P 500 Index has enjoyed positive annual returns when the index increased during those early days. That means that investors will be under severe pressure to send stocks higher on Monday and Tuesday sincne the first three trading days resulted in deep, negative returns.

Friday’s trading was particularly rough, with ten declining shares for every gainer across all 24 sectors of the S&P 500.  News of an increase in unemployment to 5% for December 2007, which was released on Friday, helped to batter prices that were already dropping after Wednesday’s report of a manufacturing slowdown.

The Dow Jones Wilshire 5000 Composite Index fell 2.58% on Friday, closing at 14,210.85. Based on the decline of the broadest index of U.S. shares, the value of the market decreased by $471.3 billion in one day, Bloomberg reported.

The losses in the U.S. markets only underscore Money Morning’s position that global investing is the appropriate course during these turbulent financial times.  On the same day (Friday) that U.S. shares took a tumble, the China-based Hang Seng Index posted a 2.35% gain, while Singapore’s Straits Times Index also rose 1.20% on Friday.

News and Related Story Links:

• Bloomberg:
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• Bloomberg:
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• Money Morning:
  Outlook 2008: The January Effect, the Presidential Election and Other Indicators Bode Well for U.S. Stock Prices.

• EarthTimes.org:
  U.S. Stocks Plunge to Worst Opening Week in Recent Memory.

Last week, investors worldwide were hoping for a holiday respite from the financial-market uncertainty and geopolitical turmoil that was the hallmark of 2007. They wanted to forget about the imploded U.S. housing market, the subprime-mortgage debacle, the ongoing credit crisis, escalating oil prices, the yearly "gloom-and-doom" forecasts issued by retailers every year at this time.

 They wanted to focus on time with family and friends, and to enjoy holiday cheer – and to escape the uncertainty and nervousness of the U.S. economy and U.S. stock markets.

But it didn’t happen.

Nor will there be an easy escape in 2008.

Indeed, the watchword of 2008 will be "decoupling." Increasingly, we’re going to see how the U.S. market is no longer the catalyst for the remainder of the global economy.

For instance, as of the end of last week, the Dow Jones Industrial Average had returned 7.19% for 2007. The tech-laden NASDAQ Composite Index had returned 10.83%, while the broader Standard & Poor’s 500 Index returned 4.09%.

But many indexes overseas – especially those in Asia – did much better. China’s Shanghai Composite Index returned 96.7%. Jakarta’s JSX Index returned 52.1%. South Korea and Malaysia both advanced by about a third in 2007.

[For a Money Morning Special Investment Research Report on the outlook for U.S. stocks in the New Year, please click here. The report is free of charge].

The Week in Review

Last week, instead were reminded that the world still is a very dangerous place and that geopolitical developments can be even more devastating than fraudulent mortgages or earnings warnings.  Former Pakistani Prime Minister and current opposition leader, Benazir Bhutto, was shot and killed last Thursday and suddenly that already volatile region was thrust into even greater turmoil.  Pakistan sits right next to Afghanistan and, as a recipient of billions in government assistance, the country is considered among the most crucial U.S. "partners" in the war on terror.  The Pakistan economy, and its markets, were performing incredibly well as of late and offered some stability to a very frightening part of the world.  Pakistan’s gross domestic product (GDP) growth had averaged almost 7% over the past five years, and its benchmark KSE-100 was up 40% this year – even after plunging 4.7% on Monday.

Oil prices climbed above $96 a barrel on the news of her death and concerns about new regional (rather global) instability.  Earlier last week, skirmishes between Turkey and the Kurds prompted added uncertainty about future supply issues.  To exacerbate matters, inventories of crude and heating oil declined last week by larger-than-expected percentages, and oil prices suddenly were again on the rise and talks about that dreaded $100 mark were back on the front burner.

The $8 billion in expected mortgage write-downs that Citigroup Inc. (C) investors were fretting about earlier in the year are now looking like bargains.  These days, analysts believe that $18 billion may be a more accurate estimate [what's an extra $10 billion between friends, after all?], and the bank is rumored to be trimming its dividend by about 40%, a trend that may become quite common during 2008. Even so, Citi has gained the financial support of a sovereign wealth fund – to the tune of $7.5 billion – and  may well represent a bargain-basement investment [For a Money Morning investment research report on Citigroup, please click here. The report is free of charge].

Recently UBS AG (UBS) issued a stock dividend instead of a cash dividend, a move designed to bolster its liquidity position.  And, in another recent report, Merrill Lynch & Co. Inc. (MER) went even more global by shoring up its balance sheet through a sovereign-wealth-fund private placement – thanks to Singapore’s Temasek Holdings Pte. Ltd.

Investors were hoping that the prior Friday’s strong equity market performance would lead to a year-end Santa Claus Rally [see below].  Instead the devastating news out of Pakistan put a damper on the holiday season and brought renewed caution and uncertainty.  With many traders and investors taking the week off, volume was far lighter than usual, a phenomenon that often leads to increased volatility and exaggerated price swings.

Economically Speaking…     

*  Reflects changes in interest rates over various time frames. 

Weekly Economic Calendar

Just a week ago, stock-market bargain hunters seemed to be on the prowl, hoping to get a jumpstart on the January Effect, a theory that stocks rise during the first five trading days of the New Year.  In general, many investors take some end-of-year profits, harvest some "unfortunate" losses [which may mean fewer taxes], and raise some much needed cash to pay for those expensive holiday gifts.

These market moves have little-to-nothing to do with the overall U.S. economy or with corporate fundamentals. So when January then rolls around, investors put their dollars back to work and the markets tend to trade higher, at least, during those first few days.  The Santa Claus Rally implied that the "brightest of the bright" anticipate the January Effect and buy just a few days earlier.  That notion appeared to be right in line this year…until the afore-mentioned untimely death of Bhutto.

Though few folks were probably watching last week, housing continued to struggle with a report that home prices plunged more than 6% in 20 major domestic cities, according to the Standard & Poor’s Corp.’s Case-Shiller Home Price Index.  Additionally, new home sales in November dropped to the lowest level in more than 12 years.

The holiday season remained worrisome with discount giant Target Corp. (TGT) warning that December sales will come in well below prior expectations.  Durable goods orders increased by a slight 0.1%, although economists had been calling for a more-substantial increase.

And a greater number of workers [technically, now ex-workers] filed for unemployment benefits in the prior week. [On a positive note...thankfully, few were paying attention].

Here’s to a Happy New Year, one of peace on earth, and greater stability in the economy and in the stock markets, both here in the United States and in markets overseas.

And please know this: We’ll be here for you throughout 2008. May good fortune be yours.

News and Related Story Links:

• Money Morning Special Investment Report:
  Outlook 2008: How to Profit When Oil Bubbles Up Above the $100 Level.

• Money Morning Special Investment Report:
  Outlook 2008: The January Effect, the Presidential Election and Other Indicators Bode Well for U.S. Stock Prices.

• Money Morning Investment Research Report:
  Citigroup: Why This Turnaround Play Has Legs – Big Ones.

• Wikipedia:
  The Santa Claus Rally.

• Money Morning Investment Analysis:
  Why Some of the World’s Savviest Investors Are Buying – Gasp! – Citigroup.

• The Seattle Times:
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• Money Morning News:
  Wall Street Boosts Compensation – 14% Average in 2007.

• Wikipedia:
  The January Effect.

• NewsDaily:
  Turkey Hit Kurd Rebels Hard.

• Wikipedia:
  Benazir Bhutto.

• Wikipedia:
  The Assassination of Benazir Bhutto.

• Wikipedia:
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• Money Morning Special Investment Report:
  Outlook 2008: Eight Ways to Pocket Profits From China, While Dodging the Biggest Risks.

• Business Week:
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• Money Morning News:
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• Wikipedia:
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• Answers.com:
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• Money Morning Commentary:
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• Answers.com:
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• Money Morning Investment Research Report:
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• Science News Online:
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• Answers.com:
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• Answers.com:
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• Stock Trader’s Almanac.

• Money Morning News:
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