The Fed’s Employment-Taper Myth, Big Six Bank Stocks, and Downgrades

There is a prevailing, politically expedient myth that the Fed’s bond purchase programs are somehow akin to job fairs; as if there’s an economic umbilical cord stretching from a mortgage-backed security lying on the Fed’s books to a decent job becoming available in the heart of America. Yet, since the Fed began its unprecedented zero-interest rate and multi-trillion dollar bond-buying policies - the real beneficiaries have been the Big Six banks (that hold more than $500 billion of assets): JPM Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley.

The Big Six banks’ stock prices have outperformed the Dow’s rise by more than double, since early 2009. Moreover, low to zero percent interest rates on citizens’ savings accounts have catalyzed depositors, pensions, and mutual funds to buy more stocks to make up for low returns on bonds and money market instruments, further buoying the stock market.

Quantitative Easing ‘QE’ entails buying bonds, not creating jobs

No matter how many articles and politicians claim the Fed is buying Treasury and mortgage-backed securities (MBS) to help the a) economy or b)  unemployed, it isn’t true.

According to the Economic Policy Institute “the unemployment rate is vastly understating weakness in today’s labor market.” True, the official unemployment rate  (called ‘U-3’ on the Bureau of Labor Statistics reports) has inched downward from a high of 10% in early 2009 to 7%. But, that’s because people have dropped out of the hunt for jobs. The number of these ‘ workers’ as EPI calls them, has risen with the stock market’s rise; that’s not a sign of a healthier employment situation.

If those workers were still ‘participating’ in the employment-seeking crowd, the adjusted U-3 unemployment rate would have hovered between 10 and 11.8% since early 2009. It is currently at 10.3%. In other words, it’s still pretty damn high.

And that’s a more conservative estimate of unemployment than places like John Williams’ Shadowstats computes, which pegs the unemployment rate at Great Depression levels of just below 23%.

(The BLS’s estimate of the U-6 unemployment rate, which includes people who have briefly stopped looking (short-term discouraged or marginally attached workers) or found part-time rather than full time jobs, is at 13.2%. It has declined along with the official U-3 estimate, but does not account for the “missing” 5.7 million workers, either. Plus, the BLS long-term jobless figures have remained steady around 4 million people.)

Happy Hundredth Birthday Fed! (Bank to the bankers, not the people)

As I explore in greater detail in my upcoming book, All the Presidents’ Bankers, the Fed wasn’t created in the wake of the Panic of 1907 to help people find jobs. It was created to provide bankers a backstop to the pitfalls of risky bets gone wrong, and propel the US to a financial superpower position competitive with major European banks via supporting the US dollar.

As per its official summary in the Federal Reserve Act of 1913 (approaching its century anniversary on December 23, 2013), the Federal Reserve was formed to “provide for the establishment of Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.”

Besides, if the Fed really wanted to make a dent in unemployment today, it could have spent the nearly $1.4 trillion it used to buy MBS to create 14 million jobs paying $100K or 28 million jobs paying $50k, or funded the small businesses that the big banks are not. Equating QE with employment illogically equates offering the biggest banks a  dumping ground for their securities with middle and lower class prosperity.

QE is ongoing because the Big Six still hold crappy mortgages and like trading

According to the latest New York Fed's quarterly trends report; the Big Six banks’ annualized trading income, as a percentage of trading assets, is higher than pre-crisis levels, whereas non-trading non-interest income as a percentage of total assets is lower. That means banks are making more money out of trading post-crisis than pre-crisis relative to other businesses.

In addition, total non-performing loans, as a percent of total loans, is 4.75% (from a 2009 high of 7.25%) for the Big Six. This figure remains more than double pre-crisis levels, and more than double that of the rest of the industry (i.e. the smaller banks).

Nearly 10% of the residential mortgage loans of the Big Six banks are non-performing. This is not very different from the 11% highs in 2009 (compared to smaller banks whose ratios are 3.5% vs. 6% in 2009). In other words, the Big Six banks still hold near record high levels of bad mortgages, and in higher concentrations than smaller banks. That’s why the Fed isn’t tapering, not because it’s waiting for a magic unemployment rate.

QE Propels Big Six Bank Stock Prices

Since the financial crisis, the Fed has amassed a $3.88 trillion book of securities, or quintupled the size of its pre-crisis book. As of December 2013, the Fed owns $1.44 trillion MBS, many purchased from its largest member banks, the ones engaged in settlements and litigations over the integrity of similar securities and loans within them.

Since the Fed announced QE3, a $40 billion extension asset purchases per month (over the then-prevailing limit of $45 billion) on September 13, 2012,

the Dow has jumped 19%. BUT meanwhile - the Big Six bank stocks are up on average 53.5% (JPM Chase is up 43%, Bank of America 74%, Goldman 42%, Citigroup 57%, Morgan Stanley 77% and Wells Fargo 27%.)

Since its March 2009 lows, the Dow is up 142%. BUT - the Big Six bank stocks are up on average 324% or more than twice the level of the Dow. (JPM Chase is up 258%, BofA 396%, Goldman 122%, Citigroup 499% (accounting for its 10 to 1 reverse stock split in March 2011 - it was trading close to a buck on March 6, 2009) Morgan Stanley 80%, and Wells 408%.) Yes, they were near death, but you can’t argue the Fed’s policy helped the broad economy as opposed to mega-disproportionally helping the banks. These numbers don’t lie. And help from the Fed won’t stop with a new Chair.

Yellen to the (bank) rescue?

In her statement to Obama on October 9, 2013, Janet Yellen said “thank you for giving me this opportunity to continue serving the Federal Reserve and carrying out its important work on behalf of the American people.”

A month later, she told the Senate Banking Committee, “It could be costly to fail to provide accommodation [to the market],” underscoring her support for quantitative easing and zero-interest rate monetary policy (and Big Six bank stock prices).

In its latest FOMC meeting release, the Fed reiterated, “the Committee decided to await more evidence that progress [in the economy] will be sustained before adjusting the pace of its purchases.” It says the same thing every month, with slightly different wording. Every time the market wobbles on ‘taper’ fears, it jumps back, because professionals know the Fed will keep on buying bonds, because that’s what the Big Six banks need it to do. To analyze taper-time, look at the banks’ mortgage book, not the unemployment rate.

Resolution Plans and Downgrading for the Wrong Reasons

On November 14, Moody’s downgraded 3 of the Big Six banks - Goldman, JPM Chase, and Morgan Stanley - and also Bank of New York a notch each because “there’s less likelihood in the future that these banks will be helped by the government” in a financial emergency. Moody’s has the downgrade right, but for the wrong reasons.

The big banks had to present ‘living wills” as the media calls them, or Dodd-Frank Title II required resolution strategies. They amount to the big banks selling whatever crap they own in an emergency and dumping whatever remains of their firms on the FDIC. 

I examined the plans submitted to the Fed on October 30.  They aren’t long. The ones for JPM Chase and Goldman Sachs, for instance, tally 31 pages each, of which 30 pages discuss their businesses and just one page - resolution strategy.

The FDIC basically would get the toxic stuff unsellable by the ‘troubled’ bank and place it in a newly established ‘bridge bank’ before the ‘troubled’ bank finds another buyer or declares bankruptcy. Which is exactly what happened with IndyMac and other banks that were ‘taken over’ by the FDIC and then resold to private equity and other firms.

If all else fails, each firm would undergo bankruptcy proceedings, in an “orderly” manner and “with minimum systemic disruption” and “without losses to taxpayers.”  Or so the process is characterized by JPM Chase and the others.

Goldman Sachs also waited until page 31 of 31 to present its main resolution idea, consisting of  “recapitalizing our two major broker-dealers, one in the U.S. and one in the U.K., and several other material entities, through the forgiveness of intercompany indebtedness...” This amounts to massaging inter-company numbers if things go haywire.

But banks oozing eloquences like “orderly market” or ‘minimum-disruption” bankruptcy and the reality being so, are two different things. Lehman Brothers tried most of these methods and still catalyzed a widespread economic meltdown. Bear Stearns didn’t declare bankruptcy, but the Fed and Treasury still conspired to guarantee its assets in a sale to JPM Chase. Technically, politicians and bankers argued no taxpayer money was used in that scenario because the guarantee wasn’t part of the TARP funds, but it was a government guarantee all the same so the distinctions amounts to splitting political hairs.

There is simply NOTHING NEW in these plans, no safety shield for the world. The problem remains that the FDIC can’t handle a systemic banking collapse, which is a threat that the Big Six banks, in all their insured-deposit-holding-glory still pose.

If all of the banks implode on the back of still existing co-dependent chains of derivatives or toxic assets or whatever the next calamity delivers, even if the Treasury Department doesn’t get Congress to pony up funds to purchase preferred shares in the big banks, and even if the FDIC creates bridge banks to take over trillions of dollars of bad assets - which it can’t afford to do, the Fed would simply enter QE-Turbo Mode.

It doesn’t matter if bankers and politicians don’t consider this a ‘taxpayer-backed’ bailout as per the lofty aspirations of a tepid Dodd-Frank Act. Because whatever subsidies are offered in that case, we will all still be screwed, and we will all pay in some manner. The Fed’s balance sheet and Treasury debt would bloat further. The cycle would continue.

Jon Corzine, MF Global, and Unaccountability

In April 2007, former New Jersey governor, 'honorable', Jon Corzine had an altercation with a Garden State Parkway guardrail. A year later, he addressed a bevy of reporters at the swanky Drumthwacket mansion and expressed appreciation for “family, friends, and the fragility of life.” During his recovery period, he advocated seatbelt safety, before returning to New Jersey's budget, extracting $500 million in austerity measures from farmers, educators, and environmentalists, and hiking tolls on New Jersey roadways.

On the one-year anniversary of his accident, his chief-of-staff, Bradley I. Abelow declared,  “Corzine has returned to his former self as a thorough and exacting boss.” (Italics mine.)

Fast forward to the current MF Global flameout. Abelow shifted to Corzine’s Chief Operating Officer. And not only did Corzine ratchet up the ante on ways to really piss off farmers, but after several days of engaging in verbal dodge ball with Congress, this ‘thorough and exacting boss’ maintained his Forest Gump type cloak of secrecy regarding the stolen $1.2 billion of his customers’ segregated money.

After days of political-reality TV, we knew nothing more about its evaporation. Corzine and his stewards, Abelow and Chief Financial Officer, Henri Steenkamp, executed a perfect chorus of  ‘I don’t recalls’, ‘I didn’t intends’ and ‘the butler did its’.

For the most part, testimony from the various regulators didn’t shed additional light on the ‘missing’ funds either (everyone’s extremely sorry and deep in search mode) but they did reveal extreme, pass-the-blame incompetence, in the spirit of AIG.

Acronym alert. SEC director, Robert Cook testified that MF Global Holding Company (like AIG) had no official consolidated supervisor regulating it; one of its subsidiaries, MF Global UK Limited, fell under the UK Financial Services Authority (FSA.) The other one, MF Global Inc. (MFGI) was registered under the Commodity Futures Trade Commission (CFTC) as a FCM (futures commission merchant) and also, under the SEC as a broker-dealer. It was the Chicago Board of Options Exchange (CBOE) supposedly overseeing MFGI’s broker-dealer activities, while its futures activities fell under the CFTC, National Futures Association and the Chicago Mercantile Exchange (CME). Somewhere in the mix lurked the private self-regulatory body, the Financial Industry Regulatory Authority (FINRA). Really, how many inept regulatory bodies does it take to screw customers out of $1.2 billion?

But, here’s how we know Corzine was lying – besides the nervous body movements.

During the summer of 2011, the CBOE and FINRA told MF Global Inc. that it didn’t have enough capital behind its repo-to-maturity (RTM) positions in European sovereign bonds – the positions Corzine put on. By mid-August, the SEC got involved and met with Corzine and other MF Globalites. They then had to file a net capital deficiency notice on August 25^th for $150 million.

During  the week of October, 17^th – MF Global Holding had to increase capital again at MFGI - for the same positions. The next week, on October 25^th, it released abysmal quarterly earnings, and got downgraded to almost junk status. The stock plummeted and customers were heading for the hills, the fastest ones getting their money out, others getting locked out. The SEC set up camp at MF Global headquarters in Manhattan on October 27^th to “monitor the situation” and “engage with senior management regarding the steps that were being taken by the firm” regarding possibilities like selling the firm, selling the customer business, or selling the RTM positions.

On Sunday afternoon, October 30, a perspective buyer for MFGI’s customer business emerged: Interactive Brokers (whose judgment I question, so watch out for them). In the wee hours of Monday morning, October 31, – the ‘missing’ funds were detected.  Interactive Brokers balked. Bankruptcy proceedings begun at  9 AM.

The CME’s testimony stated that just past mid-night on October 31,^st Christine Serwinski, the chief financial officer of MF Global's North American division, and Edith O’Brien, a treasurer, told Mike Procajlo, an exchange auditor that about $700 million in customer money was transferred on October 27th, 28th and possibly October 26 from the broker-dealer side of the business to ‘meeting liquidity issues.’ The CME hadn’t noticed this while reviewing the firm’s books prior to bankruptcy. Another $175  million was used by MF Global UK.

The CFTC disclosed that MF Global’s general counsel, Laurie Ferber notified them Monday evening, October 31st about “a significant shortfall in its segregated funds account”.  Neither the SEC, nor the CME had picked up on this beforehand.

As a broker-dealer registered with the SEC, MFGI was not just subject to CFTC rules, but also to the SEC's customer protection rule that prohibits use of customer funds or securities to support proprietary trading or expenses. It also prohibits customer funds or assets from being pledged as collateral for the firm’s own trades or to raise funds, plus requires a reserve account  be maintained that is bigger than their holdings – just in case.

The CFTC has a more lax rule, called Reg 1.25, weakened courtesy of MF Global, JPM Chase, and others that enables segregated customer funds to be used for investing in foreign sovereign bonds (investing – not posting as margin or acting as collateral). But as Janet Tavakoli pointed out in her excellent MF Global analysis; the ‘missing’ customer funds were not in the currency of the foreign sovereign bonds, as per the rule’s stipulation. Plus, none of the required replacement assets were held against those funds. Indeed, there is no element of Reg 1.25, the reg cited as a potential legal loophole by various media, that allows segregated customer funds to be used for risky purposes – like saving a firm from destruction long enough to sell it. Translation – the ‘missing’ funds were stolen against rules, from their rightful segregated customer accounts. Corzine claimed no knowledge of this.

But the reality is - the clock ran out on Corzine’s big bet and customer funds were the only way to keep it ticking until a potential sale of the firm could be confirmed. If the funds hadn’t been switched, the firms seeking margins would have taken losses. The motive was to optically alter the appearance of MF Global and exit, leaving the bag with someone else. You can’t have that clear a motive and no idea of how to achieve it. It’s implausible.

Let me put $1.2 billion into a perspective that the House committees didn’t. According to its second quarter SEC filing, MF Global had $3.7 billion of available liquidity.  The funds were equivalent to a third of that liquidity. That’s not a tiny figure. If you’re running a firm buckling under the weight of the bets you’re losing, you’re damn well aware of your liquidity lines – they are your life raft.

Besides that, MF Global’s net revenue for the second quarter was $206 million and for the six months ending September 30, 2011, it was $520 million. The ‘missing’ customer money was more than twice the firm’s net for the first half of their year.

To recap. Corzine was obsessed with the European sovereign bet. So, he fired his risk officer, Michael Roseman for questioning it,  and replaced him with a yes-man, Michael Stockman whose job description appeared to have included stroking Corzine's – er – ego, and to remain quiet about any trade concerns. He rides the trade through a succession of flailing earnings and intense market volatility, while meeting with regulators questioning its sustainability. He knows he’s got to pony up a chunk of capital in the summer to appease them and stick with it. And when finally, MF Global’s ratings were downgraded on October 25th, a bunch of calls transpire between him and NY Fed head and former Goldmanite, William Dudley before the firm goes bankrupt a week later, with nearly $1.2 billion in customer money ‘missing.’ 

We’re supposed to believe this ‘thorough and exacting’ man knew nothing about where it went? Or that his sense of entitlement and bravado was so big, he didn’t think it was wrong to take that money? Or that he wasn’t aware it was available? At all?

No. Not possible. And yet, over half a dozen regulatory bodies were oblivious to the fund heist. Finding Corzine guilty of a crime would be like asking them to indict themselves. The CFTC Enforcement division can refer criminal matters to the Department of Justice for prosecution. But the DOJ has punted on every Wall Street crime related to the 2008 subprime crisis. So what will probably happen –  is that Corzine may get a little fine from the Washington regulators. Legislators will move on to figuring out how to incorporate MF Global into stump speeches. Those that had their money stolen will battle it out in civil suits for years. And again, no lessons will be learned. No practices altered. No heads will roll.