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.

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.

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It’s the end of the “American Dream.” It’s the story of how the inevitable bailout of insolvent housing giants Fannie Mae (FNM) and Freddie Mac (FRE) – with the Federal Housing Administration soon to follow – will ultimately lead to such sorrowful sequels as “TheDeath of the Dollar,” “The Downgrading of U.S. Government Debt” and, yes, “The Depression.”

Let’s be very clear on one point, however: There’s no question about it – Freddie and Fannie have to be supported. If the doctrine of “too big to fail” didn’t already exist, it would have to be invented – immediately. Although many are arguing against a “bailout,” those “experts” never seem to address the fallout that would emanate from such a strategy. Nor do they ever discuss the sad series of events that brought us to this financial brink. On that latter point, the truth is so ugly and the failure of governance and its resulting greed so disgusting that to not understand it will guarantee the loss of the American Dream for generations.

Fannie Mae and Freddie Mac: From Dream to Drama

Because it was designed to foster capital creation – and directly promote the American Dream of home ownership, as well as a vibrant economy – the creation of Fannie Mae and Freddie Mac involved some of the best and brightest legislation ever enacted.

That brings us to the most obvious question of all: What went wrong?

First and foremost, both Fannie and Freddie should long ago have been phased out as “government sponsored enterprises,” or GSEs. The implicit (now explicit) guarantee of U.S. government backing allowed the firms to borrow cheaply in the capital markets. If fixed-income (debt) investors – and equity investors as well, for that matter – believe their investments are guaranteed, they will likely invest more and with greater comfort.

The result: These enterprises are able to borrow more cheaply than their rivals – namely banks, investment banks, mortgage companies and other non-bank lenders.

Since Fannie and Freddie were able to borrow more for less, they were also able to post fatter profit margins and dwarfed all potential competitors. The federal government should have gradually unshackled itself from this implicit backing by simply declaring a timetable over which future debt issuance would be explicitly exempt from any government guarantees. This graduated phaseout would have resulted in existing debt being guaranteed up to its maturity, while any new debt would have to be raised competitively, and not at preferential rates. This would have fostered competition, reduced the swelling balance sheets of both enterprises, and kept U.S taxpayers from having to be on the hook for both institutions.

How simple that would have been.

Secondly, and manifestly because of their ability to cheaply fund their balance sheets, both enterprises diverged from their mandates and began to buy and hold the securities they were supposed to create and sell to investors. They bought their own products. The more they created, the more they bought. Ultimately, both enterprises were making more on an operating basis – by fattening their own balance sheets with trillions of dollars of their own securities – than they were making in fees from originating, guaranteeing and selling mortgage debt.

Both enterprises began to borrow aggressively and fund their purchases by borrowing shorter. Their “protected” status enabled them to tap the market whenever they wished.

After recognizing they were creating the classic dilemma of borrowing short and lending long, Fannie and Freddie decided to mitigate their interest rate exposure by hedging with swaps and derivatives. They also bought insurance from the monoline insurers, expecting that their investments would be further protected by these insurers whose own capital was so inadequate that they could never pay 1/100th of their contingent liability exposure.

So, just how big did the balance sheets of Fannie Mae and Freddie Mac actually get? Together, the two housing giants currently guarantee or hold approximately $6 trillion of mortgage-related securities.

Those Missed Opportunities

The capital base underlying their bloated balance sheets was never adequate.

Never.

But again – because of their importance in the grand scheme of capital formation and the implicit government guarantee – investors didn’t focus on their equity or capital base. Just like what happened with technology stocks in the late 1990s, housing prices just kept moving higher.

Both companies saw their share prices escalate as the investments they held made money. Everyone’s eyes were diverted. People were getting rich – debt and equity investors, and especially management.

All hell should have broken loose when, in 2003 and 2004, Fannie Mae suffered from massive accounting scandals. Its top three executives pocketed over $115 million. They were cooking the books. After billions of dollars of the company’s money was spent to “fix” the accounting problems and $400 million of fines were paid by the company, no one went to jail.

Yes, you heard that correctly.

Where were the regulators? Where was the congressional outrage? Where were the analysts and ratings agencies?

There are myriad technical aspects to the workings and investments of both Fannie and Freddie. And there are many questions as to how they were allowed to grow and expose taxpayers to their massive liabilities, and how they are able to manipulate and coddle regulators when it comes to their accounting and specifically their capital adequacy.

The day of reckoning has finally arrived.

The Painful Payoff of the Fannie/Freddie Debacle

Because of the precipitous drop in both companies’ share prices, the resulting erasure of their capital, and the fact that Freddie Mac was yesterday (Monday) scheduled to auction off $3 billion worth of 3-month and 6-month notes (they reportedly sold), the rescue was inevitable.

In a classic attempt to calm the markets Sunday, U.S. Treasury Secretary Henry Paulson said the Treasury Department and the Federal Reserve will provide a “liquidity backstop” by offering a line of credit that is “to be determined.” Furthermore, “if needed,” it will supply “temporary authority to purchase equity” in the enterprises.

The Treasury Department and the Fed also will strengthen regulatory measures.

Now, I’m relieved!

The bailout has begun. The $6 trillion burden will be shouldered by U.S. taxpayers. U.S. debt will double to the equivalent of our gross domestic product (GDP). Borrowing costs will rise for homebuyers, further depressing the housing market and leading to hundreds of billions of additional bank write-offs, hedge-fund losses and failures of financial institutions and enterprises ranging from banks to hedge funds.

The Fed has no concern about inflation relative to the demise of the economy, and will have to keep interest rates low for critical liquidity demands and to stave off a deep recession. The building inflationary pressures in the face of the Fed’s efforts to provide liquidity and keep interest rates low will crush the dollar.

We are facing the prospect of a depression and the end of the American Dream. What can be done? Will the housing legislation on the table be the rescue plan we desperately need?

Absolutely not.

This crisis can’t wait. I’ll address the legislation, why it will fail and what should be done later this week.

Don’t be fooled by any bounce in the markets. Every bounce is an opportunity to sell and add to shorts. This is no time to be picking bottoms. The trend is your friend – and that trend is clearly down.

News and Related Story Notes:

• Money Morning News Analysis:
  MBIA on the Hook for $7.4 Billion After Moody’s Downgrade.
• MSNBC:
  Report: Fannie Mae Manipulated Accounting.
• RebelTraders:
  Updates on Market, Washington Mutual, Freddie Mac Bond Sale.
• Money Morning Special Investors Research Report:
  Nine Ways to Profit From the Diving Dollar.
• Money Morning Weekly Forecasting Commentary:
  Subprime Crisis Again in the Spotlight as the Meltdowns of Fannie Mae and Freddie Mac Fuel Fears of a Deeper Downturn.

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The fundamentals of economic strife based on the disastrous collapse of the U.S. housing market will not get better any time soon. In fact, what’s being pushed through both houses of Congress, even as you read this, is so dangerous that it should be immediately abandoned and revealed for what it is – a ticking time bomb labeled with the initials FHA.

In the past few days alone, the Bernanke Bomb Squad – also known as the U.S. Federal Reserve – was able to defuse two ticking time bombs – Fannie Mae (FNM) and Freddie Mac (FRE) – before the full force of their explosive power could be felt. Fannie and Freddie are now being propped up and will eventually have to be taken over or put into receivership, meaning there ultimately will be damage to deal with.

So, why do I still hear a ticking sound? Because there’s another bomb out there, and it’s getting closer and closer to its point of ignition. Most folks aren’t aware of it, and others who should know better are ignoring it.

The upshot: Most investors are completely oblivious to the danger it poses.

When FHA is Pronounced as “TNT”

This latest threat we’re referring to, of course, is the

Federal Housing Administration, more generally known as the FHA.

Congress believes that the FHA is the institution it can count on as the salve that covers the housing gash, and heals it – thereby delivering us from a New Millennium version of the Great Depression. But in reality, the FHA is not only an additional ticking time bomb – it’s one that Congress is packing with additional gunpowder.

The Federal Housing Administration was created as part of the National Housing Act of 1934; in 1965 it became part of the Department of Housing and Urban Development (HUD). In a nutshell, FHA provides insurance – paid for by borrowers – that insures lenders, making certain that interest and principal will be paid on the mortgages that lenders grant to borrowers. FHA insurance and FHA-predicated loans facilitate home buying by low- to middle-income borrowers. When there were eager subprime-mortgage lenders and a plethora of similar lenders bending over backwards to provide mortgages (usually with teaser rates), FHA loans were not in the spotlight.

Legislative Shortfalls Certain to Surface

Within short order, perhaps as soon as next week, the Senate and House versions of their respective housing-recovery-legislation efforts will cross each other and be reconciled. In this politically charged election year, both U.S. political parties and both houses of Congress want to appear both proactive and decisive. The result will be a housing-relief package whose centerpieces are based on Fannie, Freddie and the FHA.

Because of the already-existing burdens of Freddie and Fannie, it’s obvious that further encumbering them with loans from banks – or mortgage companies such as Countrywide Financial Corp. (CFC) – is flat out a bad idea. These are loans, after all, that no one else wants. Ultimately, Freddie and Fannie would take these newly acquired loans, would repackage them as securities, and would end up selling them to themselves, since no one else will buy them.

The centerpiece of the legislation provides $300 billion to the FHA to insure new mortgages for borrowers who are in danger of being foreclosed. This inane and stillborn idea is predicated on a reality

that just doesn’t exist.

What will happen is that the legislation will shoehorn borrowers into mortgages that they have no real incentive to repay. In the end, when those dead-end mortgages are abandoned, we the taxpayers will pay to bail out the FHA.

Here’s why the legislation won’t work.

The Top Two Reasons Congress Can’t Win

First, troubled borrowers will have to get lenders to forgive existing loans and take the write-off so that borrowers can refinance with an FHA loan. The trouble here is that lenders just can’t unilaterally decide to forgive the loan. Most of these borrowers have second loans and equity credit lines – usually with more than one lender – and many of these lenders have no incentive to forgive the loans. After all, if the lenders forgive the indebtedness, what will they get?

Exactly nothing – nothing at all.

Another major impediment to this approach is that most of these loans were packaged into “trusts” that issued securities (collateralized mortgage bonds) based on the collective mortgages. The “servicers” of these trusts do not speak for the original lenders, and furthermore have absolutely no incentive to allow individual mortgage holders to opt-out.

If individual mortgage-holders opted out because they could refinance, that would shrink the size of the mortgage pool. Since trust-servicers are compensated based on total size of the pool, where’s their incentive even if they could negotiate on behalf of the underlying lender? Another idea that was tragically stillborn.

But it’s the second problem that’s the most worrisome. If borrowers could refinance based on the reduced appraised value of their homes (there’s another issue right there: what appraisals?), they would have to agree to share any appreciation with the federal government.

I’m trying very hard not to laugh. Because it’s really not funny. And here’s why: Because all these folks need help and because the FHA requires down-payments of only 3%, those who can refinance actually might do so instead of just walking away – particularly since the FHA allows the down-payment to be borrowed, gifted or provided by charitable organizations. (Builders and developers can actually constitute themselves as charitable organizations, believe it or not).

So, banks will hold onto those loans that have decent recovery prospects. More than likely, anything valued at less than 80 cents on the dollar they have already written off – or will, soon – and will then dump those borrowers on the FHA. The FHA will end up with subprime and junk mortgages where the borrowers have “no skin in the game,” and no upside incentive. And, as a last laugh, new legislation, already in place, allows the FHA to raise the amount of a loan they can insure from the previous level of $362,790 to a new total of $729,750.

(Special note to lawmakers: Hey folks, it was the extension of credit to borrowers who were unable to afford homes in the first place that got us into this mess).

The FHA is supposed to be revenue neutral, last year it lost $4.6 billion. Can you see where this is going?

The bottom line: This plan is not a panacea. It is a sea of pain – for the taxpayers, and for the housing market.

Market Notes From “Inside Wall Street:” Don’t Get “Faked Out”

Don’t be fooled by the “head-fake” rally. The truth is that the congressional efforts being pushed along at breakneck speed to “fix” the U.S. housing disaster are short-sighted and inept, and serve to hide the massive FHA time bomb that’s destined to blow up in our collective face.

Color me unimpressed.

Wednesday’s stock-market rally – and the follow-up advance yesterday (Thursday) – do not portend a sea change in momentum and no previous sell-offs would constitute a “capitulation” bottom.

To the contrary, it was what we professional traders call a

“dead cat bounce.” It was a technical rally based not on fundamentals, but on technicals. Shorts ran for cover, thanks chiefly to newly proposed Securities and Exchange Commission rules that would force short-sellers to actually “locate” shares of stock before they can sell that stock short.

There are massive shorts out there and from time to time such squeezes will result in “head-fake” rallies. The fundamentals have not changed. Keep your eyes on the prize.

News and Related Story Links:

• Money Morning Financial Commentary:
  Inside Wall Street: The Fannie Mae/Freddie Mac Bailout is Necessary – But Don’t Expect a Happy Ending.
• Money Morning Special Investment Report:
  The Lost Decade: How the U.S. Financial Crisis Resembles Japan’s Ten Years of Misery – And How to Play it (Part I of II Parts).
• Money Morning News Analysis:
  As Treasury’s Paulson Prescribes Bailout for Fannie Mae and Freddie Mac, Guru Jim Rogers Predicts an “Unmitigated Disaster.”
• Wikipedia:
  Dead Cat Bounce.
• Bloomberg News:
  U.S. Stocks Advance as JPMorgan Leads Two-Day Financial Rally.

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Given that the U.S. Federal Reserve is the master of “Three-Card Monte,” can you tell what’s in the cards for short-term interest rates?

Three-Card Monte is a confidence game in which manipulation and misdirection are employed as the “mark” tries to guess where the “money card” is among the three facedown choices.

The Federal Reserve’s job is to masterfully manipulate the public’s perception of where interest rates are headed. And it runs this larger-than-life game with three specific face cards:

• Inflation.
• The U.S. dollar.
• And the actual “money card,” which is interest rates.

For the Fed, the end game is public confidence itself. The central bank actually intended to gain and keep our confidence in its ability to stem inflation and strengthen the greenback. And it pursues these two objectives by simultaneously managing the direction of interest rates and working to keep the economy from dropping into a recession, or worse, a depression.

The Fed and the Global Game of Dealer’s Choice

First, ladies and gentlemen, please take a good look at the inflation card. What we have here is the Jack of Spades, the rising inflation card, and a devilish villain whose prospects instill fear in all the world’s central bankers – not to mention the public at large. But remember that real inflation is initially trumped by inflationary expectations. Here’s what that means: No matter how bad inflation gets when it rears up, this tsunami of swirling prices doesn’t really reach shore and inflict damage until there is a pervasive expectation of its arrival.

It’s here that the perception about the potential impact actually begins to take hold and starts changing our behavior.

If a loaf of bread costs $2.00 today and $2.50 tomorrow, is that a problem? Let’s assume that prices for some other things are rising, too. That may or may not be a problem; it depends on what you are buying. But if you look at the increase in those items that have risen in price, you can raise the specter of impending inflation. The question to ask is this: Is it affecting you?

Prices rise and fall based not only on the supply and demand for our loaf of bread, but also on the same catalysts for the underlying ingredients and labor that go into that bread loaf.

If increases in those costs are passed along in the form of higher prices for the finished product, then we will pay more. But we may no longer have a need to purchase that loaf of bread, or we may have substitution possibilities that are not as costly. Inflation is only a problem if there are a lot of goods and services for which there are no substitutes, meaning that we have to pay those passed-along higher prices for such “essentials.”

It is therefore the expectation of inflation across a wide spectrum of mostly essential goods and services that begets real inflation. And as we’ll see shortly, it’s a viciously virulent circle. If prices rise and we cannot afford the goods and services we demand, we will seek higher wages to be able to finance this newfound higher cost-of-living. If we achieve higher wages to pay for the higher cost-of-living, our employers’ profit margins are crimped and they have to charge more for the goods and services we produce for them so that they can pay us.

Finally we have a “real” problem – “real” inflation. And it’s quite a hand to be dealt.

But beware of the trickery being played upon us. Let’s take a look to see what I mean.

Watch for the Fed’s One Hellacious Hole Card

The first card of the three to be played is the Jack of Spades – the card the Fed shows us when it acknowledges its own inflationary worries. Central Bank Chairman Ben S. Bernanke & Co. show us that card because it’s meant to tell us: “We have to raise interest rates to stamp out your expectation that inflation is taking root.”

That’s an important part of the central bank’s hand. But here’s a secret those of you who aren’t yet initiated in this confidence game probably aren’t aware of: The Fed doesn’t really have to actually raise interest rates, since the mere expectation the central bank is going to act is enough to change individual behaviors and alter market trends.

Second, ladies and gentlemen, we have the Jack of Clubs – the falling-dollar card, another devilish villain. Take a good look, folks: The prospect of a falling dollar means that – relative to other currencies and other economies (Europe, China, India, Japan and South America, to name just a few), America’s worth is declining.

The falling-dollar card also points to increased inflation. Why? Because the more the greenback declines, the more it costs us to buy the goods and services we get from all of our trading partners.

Additionally – and much more insidiously in nature – the value of all the dollars that our trading partners hold is falling, meaning that the buying power of their dollar reserves are in decline, as well. That’s a problem for many reasons, not the least of which is that their stronger currencies allow them to buy U.S. assets at bargain-basement prices. Indeed, it’s already happening, as we see from all the foreign takeovers of U.S. companies, and from Dubai’s recent buyout of New York’s Chrysler Building.

Moreover, since most of the world’s commodities – especially oil – are priced in dollars, it takes more and more dollars to pay for those commodities. And with oil, the producers are loath to see their petro-gusher revenue decline. So with every downward click in the dollar, there’s a corresponding upward click in the per-barrel price.

If that doesn’t represent inflation, nothing does.

For the Fed, then, the Jack of Clubs is the card the central bank is now waving to say: “We have let the greenback fall far enough and we are ready to support our dollar and strengthen it.”

At this point, the only real way to strengthen the dollar is to raise interest rates.

So, my good friends, just where is that third card, the Queen of Hearts, the interest rate card? In which direction are rates going?

The Queen of Hearts is nowhere in sight.

The confidence game now demands that the Fed take action against inflation and strengthen the dollar. The two Jacks are the cards central bank policymakers are energetically and enthusiastically waving in our faces. But it’s misdirection – that’s the game.

By waving those two cards, the Fed implies that interest rates must rise to stem inflation and support the dollar.

But rates cannot rise. The game is fixed. And most investors don’t even realize it.

The Fix Is In

The Fed is not really worried about inflation (on a relative basis). It’s true that inflation has reared its ugly head, and is inflicting both damage and pain on the U.S. economy. But the collective expectation for inflation and its resulting pressures are not here yet. The Fed knows that as we are falling deeper into recession, jobs will be lost, wages will not rise, consumers will not be buying. There’s no real need to raise rates. The central bank just needs to show us that it has that card; it’s part of the game. It’s about giving us confidence in its resolve to do battle with the evil forces of inflation.

The same is true of the Fed and the dollar. It’s only been in the past couple of weeks that the current “Bush-league” administration and the Fed have even acknowledged the dollar’s big swoon. Why the delay? Because they knew consumers were tapped out and that the only growth (which they point to as part of their confidence-building shell game) is being generated by exports. The dollar has fallen so far that our U.S.-made goods and services are essentially “on sale” when compared to wares made in countries whose currencies have zoomed to record highs against the greenback.

I hope I’m not confusing you. But if you are a bit bewildered, let me provide the “spoiler” here by telling you precisely why the “money card” stays face down: Interest rates cannot go higher.

The credit crisis has blown our banking system apart, and the fallout from that explosion has smashed our entire capital formation/borrowing & lending infrastructure. And the capital that formally emanated from that sophisticated system is what makes the merry go round.

Rates now have to stay low in order to jump-start these crucial liquidity flows and re-ignite demand. While it’s true that maintaining low interest rates will further fuel inflation, the Fed really has no choice. Or perhaps it’s a Hobson’s choice. You see, if the central bank actually raises rates to combat inflation, adjustable rates on mortgages will rise, setting in motion a whole new round of housing defaults, which will lead to an escalation of bank write-downs, which will torpedo stock prices, which will force institutional investors to liquidate holdings to raise capital. The same will happen out in the marketplace, where companies with debt coming due will find it impossible to refinance, touching off still another avenue of defaults, losses, and write-downs.

Better to keep rates low now – and believe that it can throttle back inflation later on.

Beware of the proverbial dead-cat bounce. Keep your eyes on the prize. There will be a market bottom. It’s not clear how long that will take. But keep this in mind: It won’t be a buying opportunity until the “shills” have been shaken out and “the game” the Fed is playing is no longer a confidence game, but instead is the kind of transparent, well-supervised marketplace that’s the hallmark of capitalism.

News and Related Story Links:

• Money Morning Special Report:
  Special Report: Are We Now Running With the Bulls, or Just Following More Bear Tracks?
• Wikipedia:
  Three-Card Monte.
• TopNewsIn:
  Dubai buys New York’s landmark Chrysler Building.
• Wikipedia:
  Shill.
• Money Morning Financial Commentary:
  Inside Wall Street: That Ticking Sound You Hear Out in the Mortgage Market is the FHA.
• Wikipedia:
  Hobson’s choice.
• Wikipedia:
  Dead-cat Bounce.

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I once asked my friend – world-famous magician Lance Burton – if he could show me how he did a particular trick.

“Can you keep a secret?” he asked.

“Of course,” I replied.

“So can I,” he said.

The point is that the U.S. Federal Reserve, the U.S. Treasury Department and federal regulators are keeping secret the true precariousness of the capital markets credit crisis and the banking system’s close-to-the-precipice predicament. They need to give banks and investment banks room to maneuver their balance sheets by whatever “hocus-pocus accounting” methods they can utilize – without being outright fraudulent.  It’s a matter of putting on a good show to give the banks time to repair their balance sheets and build up capital, however long that takes and with whatever magic can be mustered.

No End in Sight

Contrary to once-prevalent expectations – including the early prognostications from the Fed and Treasury – the capital markets credit crisis is not abating. And as long as sleight-of-hand, hocus-pocus accounting is prevalent, transparency will be thin, liabilities will be buried, losses will surprise investors, and capital will be both inadequate and expensive.

Accounting is not supposed to be that complicated. There shouldn’t be any magic, trickery, or sleight-of-hand. The ugly truth is that, until housing prices bottom out, no amount of hocus-pocus accounting will fix the problems that fed into the capital markets credit crisis. Hiding problems only delays the day of reckoning. In short, given our present set of circumstances, ugly is not just skin deep. And there is no rabbit to be pulled from the hat.

Attendant to the magic of hocus-pocus accounting are numerous sideshows that further mask mortgage-related liabilities. One easy-to-spot trick is the lengthening of the measure under which banks consider loans to be troubled, or categorized as non-performing assets. The sleight-of-hand occurs when a bank redefines troubled loans to be non-performing when the borrower is three payments behind versus two payments, or when it moves the target for “anticipation of borrower default” out to 180 days from 120 days.

Pick a target: If you’re afraid they’ll hit it, just move the target.

The Basel Boondoggle

It’s not enough that subjective Financial Accounting Standards Board (FASB) asset-classification standards and subjective fair value accounting methodologies provide the dagger in the heart of transparency; there are additional knives and swords available and widely employed with which to slice and dice asset values in order to cloak capital inadequacy and actual losses.

Besides deferringlosses, banks and investment banks manipulate critical measures of capital adequacy in order to remain, in the eyes of regulators and the public, adequately capitalized and solvent. Tier 1 capital, the principal measure of adequate equity capital, consists of shareholder equity, irredeemable preferred stock and retained earnings. The more Tier 1 capital a bank has, supposedly, the safer it is.

The calculation of Tier 1 was established by the Basel Accord of 1988 under the auspices of the Bank of International Settlements (BIS). The 1988 Accord, known as Basel I, was updated in 2004. The modified accord is known as Basel II.

A bank’s Tier 1 capital ratio is the ratio of the bank’s equity capital to its risk-weighted assets. The ratio is important because it serves as a window into leverage and risk. The problem with the capital-ratio measure is the potential for manipulation in the calculation of “risk-weighting.”

How banks weight the riskiness of assets is too often a result of bank’s managing their capital. In other words, it’s a bottom-up process: Determine what capital is required and then manage the books to meet that measure. 

The classification of assets as available-for-sale is a perfect example of burying liabilities to meet capital requirements. “Available-for-sale” gives management the option to account for assets as if they might be saleable now and priced concurrently or whether, maybe, they will be held to maturity and not have to be priced according to their present fair value. 

What’s even better for banks when they use this magic trick is that losses, no matter how large, reside in the netherland of accumulated other comprehensive income, the accounting line on the balance sheet that available-for-sale assets flow down to. And those losses are not included in Tier 1 calculations!

There are other problems with implementation of the Basel Accords. Commercial banks, overseen by the Fed, follow Basel I guidelines for Tier 1 ratios. Investment banks, overseen by the U.S. Securities and Exchange Commission, calculate Tier 1 ratios based on Basel II guidelines.

Investment banks are deemed to have it easier because Basel II allows greater management flexibility in weighting risk and allows the incorporation of ratings and internal modeling into that process. It’s enough to know that manipulation is manifest. That much is clear, especially with all the pain that trumped-up – and downright corrupt – ratings have already caused in the massive subsequent downgrading of credit instruments. Federal Deposit Insurance Corp. Chairman Sheila C. Bair has actually stated that Basel II essentially lets “banks set their own capital requirements.”

One fine point of the Basel I Accord differentiated between banks holding mortgages on their books and those holding mortgage-backed securities, in terms of the capital to be held against these different assets. Holding mortgages required more capital since, technically speaking, mortgages are technically less liquid than tradable security instruments. The result was a wholesale exit from holding individual mortgages and a rush into mortgage-backed securities.

Now You See it …

Having to hold capital against assets as a cushion against future losses ties up otherwise productive capital. Anywhere those capital requirements can be reduced frees up that released capital to be employed elsewhere in leveraging the balance sheet. The ultimate device to free up capital was not merely accounting sleight-of-hand to pare back capital-reserve requirements, it became the ultimate magic trick – the disappearing act.

In order for banks and investment banks to make their capital-reserve-holding requirements disappear, they would have to make the assets against which capital needed to be held disappear. And, with a wave of the wand and the magic words hocus-pocus, they did. Welcome to the world of “now you see it, now you don’t” – better known as “structured investment vehicles” (SIVs) and conduits.

SIVs are generally offshore entities set up to warehouse assets that would otherwise be subject to bank capital reserve requirements. A conduit is the generic name for an SIV; it is a conduit because it is a reciprocating channel for buying back asset-backed securities (ABS) previously sold into the capital markets by the banks. Banks fund SIVs with short- term commercial paper issuance, massively leverage their borrowed capital, and buy huge amounts of ABS instruments.

They don’t need to waste capital on reserve requirements because SIVs are not banks, and are therefore not subject to capital-reserve requirements. They are virtual banks without the regulatory hassles.

Doesn’t anybody out there remember what happened when the now-defunct Enron Corp. employed these vehicles and manipulated their earnings?

The problem with this ultimate accounting fraud is that banks are potentially going to have to take their SIV assets back onto their books, haircut capital for reserves and eat the losses that have been hidden by accounting gimmickry at the SIV level. It’s massive. But, because it is so massive and dangerous for banks’ liquidity and a potentially devastating blow to their capital adequacy, regulators, including the Fed and Treasury, have yielded to delaying until 2010 the requirement that banks take these off-balance sheet assets, or more correctly, liabilities, back on to their books. Citi alone is estimated to have some $600 billion to $700 billion of SIV assets.

Once banks repatriate their SIV assets back onto their balance sheets, they will employ the full magic of accounting sleight-of-hand to bury liabilities in their efforts to struggle to maintain capital adequacy. Understanding some of the hocus-pocus accounting ticks – which I shall unmask in my follow-up piece tomorrow (Thursday) – will help investors look behind the curtain as they attempt to measure the worth of banks and investment banks and gauge the true duration of the capital markets credit crisis.

[Editor’s Note: Contributing Editor R. Shah Gilani has 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. In his new column, “Inside Wall Street,” Gilani promises to take readers on a journey through the “shadowy back alleys” of the U.S. capital markets - and to conduct us past the “velvet rope” that guards Wall Street’s most-valuable secrets - in an ongoing search for the investment ideas with the biggest profit potential. In Part II of his commentary on “hocus-pocus accounting” tomorrow (Thursday), Gilani will “unmask” three of the actual accounting maneuvers that fed into the capital markets credit crisis.]

News and Related Story Links:

• Bank of International Settlements:
  Basel Accord of 1988.
• Money Morning News Analysis:
  FDIC Quandary Could Stick U.S. Taxpayers With the Tab for the U.S. Credit Crisis.
• Wikipedia:
  Mortgage-backed security.
• Wikipedia:
  Asset-backed securities.
• Wikipedia:
  Enron Corp.
• Wikipedia:
  Structured Investment Vehicles (SIVs).

Who says accounting can’t be fun? When it comes to determining capital adequacy and the solvency of banks and investment banks gutted by this historic capital markets credit crisis, accounting cards are magically being shuffled to manifest the illusion of repaired balance sheets – and sometimes even profits.

On the dark side, these few seemingly simple tricks are actually masking the thick red ink of buried losses.

The props in this “hocus-pocus accounting show” determine how assets are accounted for. In fact, there are three “accounting boxes” into which assets are placed. Let’s take a close look at each of the three:

• The first accounting box is labeled “Held-to-Maturity:”Assets that are held-to-maturity are accounted for on the balance sheet at cost. That’s good and bad, but at least it’s transparent. If an asset has appreciated, it doesn’t show, nor does its depreciation change the balance sheet or hit the profit-and-loss (P&L) statement. The generally good news is that longer-term, fixed-type assets appreciate over time. The caveat to continuing to hold an asset at cost is that it should be accounted for differently if changes in value are considered either “more permanent” or “other than temporary.” Hocus-pocus accounting is possible here simply by virtue of manipulation of the definition of the terms more permanent and other than temporary.

• The second accounting box is labeled “Held-for-Trading.” In this box, assets are marked-to-market on a quarterly basis (quarterly for reporting purposes, however, they are usually marked internally on a daily, if not hourly, basis). And their fair value – relative to the last time they were marked-to-market – reflects a profit or loss that is accounted for on the institution’s balance sheet and in its quarterly earnings. Marked-to-market means that the asset is priced based on the last sale price on the day it is being accounted for. For example, if you wanted to mark-to-market the shares of International Business Machines Corp. (IBM), you would use the closing price for the stock on the day you want to value it. The difficulty, which includes transparency issues and the potential for manipulation, is valuing assets that do not trade frequently, or may be priced based on internal mathematical models. These hard-to-value assets are classified as Level 3 assets. There’s plenty of room here for hocus-pocus accounting. Valuing Level 3 assets is a magic act all by itself.

• The third accounting box is labeled “Available-for-Sale.” This box is the magician’s version of a “black hole.” In here assets could be sold, but are likely to be held. Gains and losses on assets in this box are not accounted for on the balance sheet in terms of profit or loss, and instead are accounted for under equity. And they don’t show up on the P&L (corporate income statement) – unless, of course, any change in value is determined to be not temporary. I’ll come back to “not temporary” value changes shortly, but please realize it’s important to know where these gains and losses are floating, and to understand the circumstances under which they’ll affect earnings.

Instead of hitting earnings when changes occur in the value of assets in the available-for-sale box, the changes are parked on the balance sheet under shareholders’ equity, and from there, under accumulated other comprehensive income (AOCI). It is in this floating netherworld that gains or losses are neatly stashed, potentially for years, until they are released into net income when desirable. Another term for active use of this trick is “managed earnings.”

The hocus-pocus accounting is in the determination of temporary, or when these losses should be extracted from the darkness of the netherworld and accounted for in the light of day. Generally, they should be accounted for in earnings when they are impaired, as defined under International Accounting Standard (IAS) 39, paragraph 58.

The important exposure of this trick is in understanding that losses held under AOCI do not count in calculating either Tier1 capital or capital ratios. If these rules were to be changed, only God could help the banks meet capital adequacy and solvency tests.

All this prestidigitation, or sleight-of-hand, is revealed by understanding what you can’t see. The problem is “intent-based” accounting. If assets can be accounted for in multiple ways – and the determining factor is the intent of management – there isn’t much room for transparency, and there’s even less for the comparative analysis of balance sheets, earnings, capital and capital ratios.

According to Stephen Ryan, an accounting professor with New York University’s Stern School of Business, “all forms of intent-based accounting are problematic, as intent does not change the risk or value of a position while you hold it.” Add to that insight the comments of Bloomberg Markets columnist Jonathan Weil, who recently noted that the Financial Accounting Standards Board’s recently issued Statement 159 further obfuscates appropriate comparisons and transparency. FASB Statement 159 allows companies to pick and choose when to apply recurring fair-value reporting – as well as which assets to apply it to.

While the illusion that banks and investment banks are nearly finished writing off their accumulated losses suggests the potential for bottom-fishing, there’s a key point to understand: Without the appropriate transparency, the actual critical measures of capital and solvency will remain cloaked in secrecy.

The U.S. Federal Reserve, the U.S. Treasury Department and federal regulators are in no mood, and in no position, to tighten up accounting rules at this stage of the game. Any further deterioration in capital measures will only force the Fed to keep its liquidity window open indefinitely – and rates artificially low. The Treasury will continue to backstop the Federal Deposit Insurance Corp. (FDIC), while the FDIC continues to bulk up reserves for the inevitable cascade of failing commercial banks.

Unfortunately, the only magic that will settle the capital markets credit crisis is the bottoming out of home prices and the de-leveraging of inflated balance sheets. Once that’s done, the accounting tricks that mask transparent comparisons need to be eliminated.

The next trick will be to pull the U.S. consumer out of the deep debt hat in an ugly environment of skittish banks whose cost of capital will crimp margins and profits for years to come.

In finance – as in life – perhaps it’s sometimes just better to believe in magic and not ask how the trick is done.

[Editor's Note: Contributing Editor R. Shah Gilani has 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. In his new column, "Inside Wall Street," Gilani promises to take readers on a journey through the "shadowy back alleys" of the U.S. capital markets - and to conduct us past the "velvet rope" that guards Wall Street's most-valuable secrets - in an ongoing search for the investment ideas with the biggest profit potential. In Part I of his commentary on "hocus-pocus accounting," which ran yesterday (Wednesday), Gilani detailed just how these accounting maneuvers created the foundation for the capital markets credit crisis.]

News and Related Story Links:

• Money Morning Market Analysis and Commentary:
  Inside Wall Street: Why Hocus-Pocus Accounting Will Perpetuate the Capital Markets Credit Crisis. 
• Investorwords.com:
  Held to Maturity. 
• Investorwords.com:
  Profit-and-Loss Statement. 
• FDIC.gov:
  Accounting News: Other-Than-Temporary Impairment of Investment Securities. 
• Investorwords.com:
  Mark-to-Market. 
• Money Morning Financial Commentary:
  Why Mark-to-Market is Bad News for Shareholders. 
• Money Morning Market Analysis:
  Rising Tide of Level 3 Assets a “Disaster Waiting to Happen” 
• Wikipedia:
  Black Hole. 
• Wikipedia:
  Ownership Equity. 
• NYU Stern School of Business:
  Accounting Professor Stephen Ryan.

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