May 12 2009 2: And you think you know what's next

Rembrandt van Rijn Aristotle contemplating a bust of Homer 1653

Ilargi: Bought by the Metropolitan Museum of Art in 1961 for the then-record sum of $2,300,000. Figured very prominently in Joseph Heller's brilliant 1988 book "Picture This".

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"Rembrandt had one foreign patron, a Sicilian nobleman, who asked him to paint a philosopher. The request came at a time when Rembrandt had become embroiled in serious financial trouble, and this commission seems to have sparked off some deep inner response. The combination of his personal anxieties and the idea of philosophy drew from Rembrandt one of his greatest masterpieces, in which he contrasts two ways of being a genius.

"He ponders visually the importance in life of material success, fame, and power, compared with being true to art. He does so by confronting the greatest Greek philosopher, Aristotle, with the greatest Greek poet, Homer. In the 4th century B.C., philosophy included the whole of science, and Aristotle understood it, integrated and systemized it. He was dazzlingly successful. We see his rich, wide, silken sleeves - those of a man who does not need to work - and, above all, his thick gold chain. The chain was a gift from Aristotle's most prestigious pupil, Alexander the Great, who had left Aristotle an enormous fortune, but whom the philosopher had failed to influence spiritually.

"Rembrandt imagines Aristotle in all his fame and wealth, looking at a bust of the great blind poet Homer. From the meagerness of the bust, we can see that Homer was poor. He wandered around Greece with his harp, playing at evening parties, and earning a pittance. Homer was true to his genius: he made no money from his art, and he did not care. With the medallion, representing both his great material success and his great teaching failure, swinging between them, Aristotle ponders - and Rembrandt with him: What matters most? How can one be certain that one is not selling out? Of course, I can say nothing about Aristotle, but I am certain that Rembrandt never sold out. Perhaps it was precisely these moments of profound self-questioning that kept him pure.

Text from "Sister Wendy's American Masterpieces"

Ilargi: Picture this: you get the feeling that you're hanging, no place special, weightless and suspended in mid-air, and something tells you this may last quite a while. For all intents and purposes, you should be falling, and gaining speed while you do. But it doesn't happen, and you're not Wile E. either. What's more, you’re incessantly being promised that you’ll never fall as long as you keep moving your arms and legs. And though you wonder what fate will have in store once you get too tired of swimming, you try very hard to believe that the breaststroke and the butterfly, when executed properly, nullify gravity, because you think you know what's next if you don't. Nothing to do but to keep swimming and tell yourself you have faith. Mind over matter and all that.

Yeah, and whatever you do, don't look down, or so they say, but that's easier said then done. You peeked, you couldn't help yourself, who do they think they're fooling, after all it's your life too, and more than it's theirs, and you see "they" are losing over a third in their life blood tax income, while they rake up debt as if it's cotton candy, the kind that you can feel is being spun out of your living tissue, and you're afraid that might start hurting something bad sometime soon. And if that would happen, you now realize that no medicare is all too bleeding very likely to pay for your medical bills, and the insurance that came with your job is sure to leave with it too, and one out of every 6 of your neighbors is out of work already and once it's one out of every five you're pretty darn sure it'll be your turn too.

And you might get up and shout, and vent your doubts and anger, or so you think, and so you keep repeating in your head, if only you were sure you would not have to be alone. What, you ask, is bound to become of the one who is the first to lose the belief? Is that one destined to fall into the bottomless pit reserved for ye of little faith and none at all, or will it be a ritual tearing off of life and limbs by the hands of the truer followers? What are the chances that the first head to stick out above the evenly waving fields of grain will be hailed as a liberator, and not cut off at the neck in order to let what everybody knows their place is to go on and on and on?

For now you see no other way, no choice or option, than to believe that believing will keep you from falling, like everyone else around you tells you they do, and you do feel somewhat comforted by the notion that ever since the days of old, those who live in their faith have pledged they will take care of their own. But mostly, if you're open and lucid and honest, you're just simply scared out of your wits. And what you're most afraid of above all is that somewhere high above the waving fields of grain, your very fear will freeze you, no place special, in mid-air, suspended and weightless and unable to keep on moving your arms and legs. And you think you know what's next.

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U.S. Government Receipts Collapse

Black swan: as every American knows, April is tax time in the U.S. of A, and accordingly April receipts normally vastly exceeds outlays. Not this year, for the first time in living memory, receipts are lower than outlays in April, a whooping 34% lower than last year. The accumulated deficit for the first seven months of the [fiscal] year is almost double the entire total for last year.





For the full Treasury department report (PDF) go here

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Medicare Insolvent In 8 Years

We're officially past the point where Social Security and Medicare insolvency are far-off problems that we can ignore. Medicare is going bust sooner than we expected. And this isn't some crazy, partisan rambling. This is coming straight from the government, which just updated their numbers based on new tax data. Here's what Tim Geithner said in a statement:

"The Medicare Trustees Report makes clear today there is no more important long-term fiscal policy measure than gaining control of the growth of Medicare costs by delivering health care services more efficiently. These savings can only be achieved in the context of a larger effort to control health care costs and improve quality more generally.  The most effective entitlement reform measure will be a major health reform that helps bring down the growth rate of national health care spending. The Administration is committed to working with Congress to find ways to control runaway growth in both public and private health care expenditures while helping to ensure that all Americans receive the high quality, affordable health care they deserve. The recent commitment of major health stakeholders to help lower the annual growth rate in costs by 1.5% represents a crucial step in that direction.

The Trustees Reports come to the following conclusions. 

• The Medicare program's financial challenges are larger and more imminent than those of Social Security.  Medicare faces demographic challenges, rapidly growing health care costs and the short-term outlook has been hurt by the recession.  Medicare's annual costs were 3.2 percent of GDP in 2008, or nearly three-quarters of Social Security's, but are projected to surpass Social Security expenditures in 2028 and to reach 11.4 percent of GDP in 2083, compared with 5.9 percent for Social Security.
  
• Medicare's Hospital Insurance Trust Fund is projected to become insolvent in 2017, two years earlier than projected in last year's report.   
  
• The cost of Medicare's Supplementary Medical Insurance (SMI) to the federal government is projected to increase rapidly.  General revenue financing for SMI is expected to increase from about 1.3 percent of GDP in 2008 to over 4.7 percent in 2083, with continued increases beyond 75 years.

As you can see, Geithner takes a measured tone in his writing, but this really is an extremely urgent crisis. That being said, there is good news, when you take a step back. Big picture, it's not about funding Medicare or Social Security (which had its lifespan clipped by four years) it's about taking care of old people. That's not necessarily or the same thing. Medicare and Social Security may not be sustainable, but a rich society should be able to care for aged retirees.

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Insolvency Is Seen Closer for Social Security and Medicare

The financial outlook for Medicare and Social Security has significantly worsened, as the bad economy and mounting job losses have pushed both programs years closer to insolvency, according to a grim report issued Tuesday by the Obama administration. The new projection, in an annual report from the programs’ trustees, says that Medicare’s hospital insurance trust fund will be exhausted in 2017, just a year after President Obama would leave office if re-elected to a second term. Last year the trustees said they expected the fund to last until 2019.

The trustees also said that Social Security’s reserves now face depletion in 2037, four years sooner than the previous projection of 2041. The projections assume that there are no changes in current benefits, policies and tax rates. The two programs, which serve more than 50 million people, are caught in a difficult dynamic linked largely to the recession: Millions fewer people are working and paying the taxes that support the programs; yet health care costs are continuing to soar, millions of baby boomers have begun receiving Social Security retirement benefits, and Americans are living longer.

Medicare expenses are now expected to surpass Social Security’s in 2028. The report comes a day after President Obama embraced a pledge from health-care providers to slow the increase in their costs over the coming decade. The new projections will add to the urgency of controlling those costs. The Treasury secretary, Timothy F. Geithner, said in a statement on Tuesday that the new projections underscored the need for a bipartisan approach to shoring up the two programs, through what he said would be "difficult but achievable changes."

"That is why even as this president has focused on pulling our nation out of economic recession, he has made clear his commitment to working in a bipartisan way to address the long-term health of Medicare and Social Security" and, he added, "not simply pass on our debts." The shorter deadline for Social Security insolvency does not mean that future retirees would receive nothing after that date. The trustees noted that even when the Social Security trust fund is exhausted in 2037, tax revenues will presumably continue to come in. But benefits would be limited to the amount paid in that year, and would probably continue at only 75 percent of their promised level — 3 percentage points less than was projected in last year’s report.

The darker picture facing the two programs will complicate the president’s spending plans and policy ambitions; just Monday, the administration raised its estimate of the federal budget deficit this year to $1.84 trillion, the largest on record. The House majority leader, Steny H. Hoyer of Maryland, called last week for a bipartisan effort to fix Social Security’s long-term finances. Other Democratic leaders have been loath to take up the politically difficult issue now. But it is the looming shortfall in the Medicare hospital insurance trust fund that the report calls "an urgent concern."

"Correcting the financial imbalance for the H.I. Trust Fund — even in the short-range alone — will require substantial changes to program income and/or expenditures," it says. The trustees project adequate funding for a separate Medicare trust fund that pays doctors’ bills and other outpatient expenses, known as Part B. But it cautions that about one-fourth of Part B enrollees face "unusually large" premium increases in the next two years. The standard Part B premium has already increased by 64 percent in the last five years.

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The Ken Rogoff Study That Tim Geithner Refuses To Read

Niels C. Jensen of Absolute Return Partners isn't buying the green shoots thing.  He's also thinks the huge market move is just a suckers' rally.  In ARP's May letter, he notes that 1929-1932 saw four massive rallies of 20%+ and that such rallies are the hallmark of bear markets.

But Niels' real problem is with debt.  Specifically, the amount of debt the world is going to have to take on during the recovery from this crisis.  This mountain of debt, Niels says, is likely to be vastly larger than the IMF, the US government, or anyone else is expecting.

Before we go to Niels, here's a quote from the Ken Rogoff and Carmen Reinhart study of financial crises that inspires some of Niels' analysis.  This study was widely cited after it appeared a few months ago.

Broadly speaking, financial crises are protracted affairs. More often than not, the aftermath of severe financial crises share three characteristics. 

First, asset market collapses are deep and prolonged.  Real housing price declines average 35 percent stretched out over six years, while equity price collapses average 55 percent over a downturn of about three and a half years.

Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment. 

Third, the real value of government debt tends to explode, rising an average of 86 percent in the major post–World War II episodes.  Interestingly, the main cause of debt explosions is not the widely cited costs of bailing out and recapitalizing the banking system.  Admittedly, bailout costs are difficult to measure, and there is considerable divergence among estimates from competing studies.  But even upper-bound estimates pale next to actual measured rises in public debt.   In fact, the big drivers of debt increases are the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions, as well as often ambitious countercyclical fiscal policies aimed at mitigating the downturn.

And now here's Niels, as excerpted in John Mauldin's Outside The Box.

Banking Crises Run and Run

Reinhart and Rogoff studied every banking crisis of the past generation and made some startling observations. One in particular caught my attention. It has to do with the subsequent rise in government debt which, according to Reinhart and Rogoff, has been "... a defining characteristic of the aftermath of banking crises for over a century". According to the authors, governments inevitably underestimate the ultimate cost of a banking crisis, because the indirect costs (such as falling tax revenue in subsequent years) end up much higher than predicted.

The IMF estimates that the cost of the current crisis to the United States will eventually reach 34% of GDP or close to $5 trillion. However, the Obama administration, through its various implicit and explicit guarantees, is already using a number close to $9 trillion⁴. And Reinhart and Rogoff's historical average of 86% of GDP implies an ultimate cost of over $12 trillion!

The IMF is too optimistic

I have a lot of respect for all the good work being produced by the people at the IMF; however, they are sometimes too politically correct for my taste; maybe too afraid of stepping on someone's toes. So when they go public, as they did recently, with an estimate of how much the current crisis would ultimately cost, their projection will more than likely prove hopelessly inadequate.

The true cost is important, because it has to be financed through new bond issuance, and it is my thesis that the sheer size of this tsunami will eventually overwhelm the world's bond markets. As you can see from chart 7, using the official IMF estimates, the twelve most industrialised of the world's G20 countries (in my book known as the Dirty Dozen) will have to issue about $10 trillion worth of new bonds to cover the cost of the current crisis.

The final cost will be enormous

However, if you (like me) believe that IMF underestimates the true cost of this crisis, Reinhart and Rogoff offer a more realistic approach (see chart 8). Using their least costly case study (Malaysia 1997) as our best case scenario, the true cost comes to $15 trillion. If one uses the average of 86% instead, the cost jumps to a whopping $33 trillion. I didn't even bother to produce a worst case scenario - it all got too depressing!

I need to put the $33 trillion into perspective, because it is so big that it is almost incomprehensible. According to Wikipedia (see chart 9), total private wealth across the world today is about $37 trillion less the losses incurred in 2007-09, so the real number is probably closer to $30 trillion now. Total global savings (loosely adjusted for the big losses in 2008) are probably somewhere in the region of $100 trillion. In other words, financing this crisis could absorb one-third of total global savings. No wonder Gordon Brown looks tired!

Where do we find the money?

Obviously, governments may buy a portion of these bonds themselves, but they cannot afford more than a fraction of the total unless they want to challenge Mugabe as the ultimate master of illusion. Neither should investors hold out for sovereign wealth funds to do the dirty work. As is clear from chart 9, the total amount of wealth accumulated in these funds is pocket money when compared to the projected bond issuance over the next few years.

Hence it comes down to the price at which governments can attract sufficient demand from people like you and me. One of two things may happen. Either this crisis will ignite such a bout of deflation that investors will happily own government bonds yielding 2-3% or the deflation scare goes away ultimately, the global economy recovers and bond investors demand much higher yields for taking sovereign risk. I am not yet sure which scenario will prevail, but I do know that both are quite bad for equities longer term. Take your profits!

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The Overstretched American Empire

O! Bama! Whither takest thou us? There are two broad theories concerning the great men of history. One says that history is made by great men. The other says great men are made by history. But here at The Daily Reckoning we think they're both wrong. In our book, great men don't really exist. They are merely invented by the historians. History needs heroes. Sometimes tragic heroes... sometimes comic... the historians take what they've got to work with and set them spinning. But if you look at their leading characters closely, they look little different from the rest of us... just fellow passengers on the big bus.

Poor Obama. He seems like such a likable fellow. He would probably make a good college president. Or a good butcher. You'd enjoy going into his shop to buy cutlets. But now the poor man finds himself in what has to be one of the tightest spots in history. At least in economic history. The crash of '08-'09 clipped stock market investors for half their nominal wealth. The bear market in property has put one out of every four homeowners underwater. And now the recession/depression threatens to knock the stuffing out of the rest of the economy.

How can he get us out of this jam? He hasn't a clue. So, he turns to his advisors... his hacks... his pollsters and his hangers-on... ..and what do they come up with? "U.S. deficit four times last year's record," comes the press report. "Federal government will borrow almost 50 cents of every dollar it spends this year." This news would have taken our breath away. If we had any breath left. But after so many wonders, each one more breathtaking than the last, our lungs are all squeezed out. We can't even give an audible sigh. Hold a mirror up to our nose and you would think we were dead.

You'll recall that President Obama announced that he had found budget savings of $17 billion. We were exhaling on that for a moment until we realized that it represented less than 36 hours' worth of federal spending. Then came news a week later that instead of cutting the budget, the latest estimates showed it going up by some $89 billion. Let's face it, at this point $89 billion is chicken feed. Here at The Daily Reckoning we carry that much in our wallet. We pass it out to subway bums and use it to tip cab drivers. So, we're not about to get excited about such a trivial amount. But coming on top of a budget deficit already estimated at four times the record deficit set last year...and we begin to think of straws and camels.

The idea of spending twice as much as you earn should take even a camel's breath away. An ordinary man...hearing that fact...would feel like breaking the glass and pulling the alarm. "You can't do that...you'll go broke," he would say. Basic arithmetic reveals the trap. In one year, you've built up debt equal to all of next year's revenue. In two years, you've got debt of 200% of annual revenues. In 10 years, you've got debts equal to 1,000% of your annual receipts. Let's see...say you only pay 5% interest...then, the interest alone takes up HALF your revenues. What creditor would lend you money? The feds have their own projections, of course. According to them, they won't continue this hell-for-leather spending much longer. Their estimates show the deficits declining in future years. Ten years out, they show a fairly modest total of $7.1 trillion in accumulated deficits.

It is a measure of how breathtaking the financial news has been that $7.1 trillion can in any way be regarded as modest. It is half America's total GDP. It is also a measure of how out-to-lunch the federal estimators are. Their projections imagine a "worst of worlds" that would be a "best of worlds" to most people. In the Great Depression, national output went down by some 30%...and continued for a decade (depending on how you figure it). In Japan, the on-again, off- again slump has gone on for 19 years. Yet, the official guess is that this downturn in the US will take output down by only 1.2% and that it will be over in a few months...with a return to growth of 3.2% in 2010.

No one knows how bad it will become. The last report showed GDP declining at a 6% rate. And our friend Nassim Nicholas Taleb says it will be "vastly worse" than the '30s. But give a man enough education and he's ready to believe anything. He can even convince himself that such reckless spending is a "stimulus" effort...that it merely "replaces" spending that would have been done by the private sector (if the private sector were stark raving mad)...and that it will bring about a "recovery" in the entire economy. You could even glance at the latest financial news and say: "Look...it's working!" The Dow lost 155 points yesterday. A minor setback in what has been an agreeable interlude. Oil, the dollar, and gold stayed about where they were yesterday.

Our thoughts return to Mr. Obama. He is surely the man of the hour. He is the fellow historians will take for the leading man. Will he be a tragic hero? A comic hero? One of America's greatest presidents? A black Lincoln? A Roosevelt with two good legs? Like Lincoln and Roosevelt, he is a man with no apparent convictions that will stand in his way. Perhaps he is just the man the U.S. of A. needs - a man capable of bankrupting the nation with a smile. Yes, Dear Reader, the 'great man' always seems to come along when you need him. Longtime Daily Reckoning readers will recall our theory:

After the Berlin Wall came down... America had no enemies worthy of the name. She had a monopoly franchise on the world's money - the dollar was the undisputed queen of the planet's reserves. And she had a monopoly on military power too - the undisputed king of the hill, with a Pentagon budget nearly as large as all other nations' military spending put together. But nature abhors a vacuum and detests a monopoly. Lacking a suitable challenger, America had to become her own worst enemy. Lacking a rival who could destroy her, she had to destroy herself. And so, when Americans went to the polls in November of 2000, they elected a president who was up to the job: George W. Bush. Eight years later, the Clinton surpluses had turned into the biggest deficits ever...an immense bubble had impoverished the middle class...and the country was engaged in two unwinnable, unnecessary, and hugely expensive wars.

Mission accomplished! But it's not over. The millstones of history may grind slowly...but they grind exceedingly fine... The American empire is clearly overstretched and over-indebted. If it is to save itself, it should scale back immediately...cutting the Pentagon budget in half, for example, and eliminating all unnecessary expenses (which is most of them). Instead of spending $3 trillion, it should spend...say...$1 trillion, and run a surplus. What about the depression, you might be wondering. Isn't this the time to increase government spending, rather than decrease it? Ah...if you are even asking the question, you are the victim of a dead economist. Keynes' theory was that the state should run contra-cyclical surpluses and deficits - to offset the ups and downs of the business cycle. But that is too soggy a bog for us to trod in today. Instead, we will skirt it with another of our dicta:

People come to believe what they must believe when they must believe it. When an empire is new and fresh and growing...people believe in saving, hard work, and small frugality. When an empire is old and decaying...they think the government should spend "whatever it takes" to take care of them. This attitude helps destroy the empire...thus making room for the next one. But if America really wanted to protect its wealth, its power, and its position in the world, it should fight the depression in an entirely different way. Instead of bailing out failed businesses it should let them go bust. Instead of coddling the executives who mismanaged their companies, it should turn them loose. Instead of shoring up reckless banks, it should help knock them down.

And instead of spending money on stimulus programs...it should give money back to the taxpayers so they can stimulate the economy, or not, as they choose. Taxes should be cut in line with government spending. This would boost savings, reduce debt, and... gradually...increase investment and consumer spending too. But that is not the road Americans have chosen. Instead, they found a president willing to go along with history. Instead of scaling down, he is scaling up. Instead of reducing America's indebtedness, he is increasing it. Instead of going for safety, he's going for broke. No one knows how this will turn out, of course. None of us get to read the history books before they are written. But our guess is Mr. Obama will emerge from the tomes as another 'great man.' Doing history's dirty work...he is continuing the destruction of America's monopoly position on money and power.

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Ilargi: Darn! And only this morning we had those great stories that despite plunging Chinese exports and imports, domestic investment was up 30%. Strike that too, I guess.

China cuts lending amid asset bubble fears

Chinese bank lending slowed dramatically in April because of fears that loan growth in the first quarter had been excessive and could pave the way for loans of deteriorating quality, so possibly creating a new round of asset bubbles. China’s state-dominated banks gave out Rmb591.8bn ($85.2bn, €62.5bn, £56.3bn) in new loans last month, less than a third of the Rmb1,891bn in new loans extended in March, but still well above the monthly levels of recent years. In the first quarter, Chinese lenders answered the government’s call to open the credit taps and get the economy moving again, extending more than Rmb4,600bn in new loans – more than the entire amount of new lending in 2007.

That led to fears among regulators that money was being funnelled illegally into the stock market and handed out to state-sponsored stimulus projects of dubious commercial value that could become non-performing assets.
Some regulators also worried about the potential for rampant inflation. Those fears were somewhat eased by price measurements released on Monday showing China remained in deflationary territory in April for the third consecutive month. The consumer price index fell 1.5 per cent from a year earlier in April, compared with a fall of 1.2 per cent in March, while the producer price index fell 6.6 per cent after falling 6.0 per cent in March.

Chinese bank lending is usually strongest in the first quarter and moderates as the year goes on. However, the abnormally steep April drop raises some concerns that China’s nascent economic recovery could flounder without the injection of huge volumes of new loans. Nonetheless, many analysts were sanguine that reduced loan levels would still buoy growth. Wang Tao, economist at UBS, said: “April new lending is much more sustainable than that in Q1 and especially that in March, and the natural tapering off does not mean that growth will slow down. We continue to think that there will be enough liquidity to support an economic recovery (estimated at 7.5 per cent gross domestic product growth) for 2009.”

Most of the loans in the first quarter were to government-backed infrastructure projects. Many smaller private enterprises have complained that they are still unable to access credit from the banks, in spite of the flood of new lending. Ben Simpfendorfer, an economist with RBS in Hong Kong, said: “The central bank noted in its quarterly monetary report that private investment sentiment remains weak and warned that slower profit and wage growth might yet be a drag on consumption.” This is a worry for Beijing, which is trying to shift the economy away from relying on exports and more towards domestic consumption.

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The Truth Behind the Stress Tests

TForecasting loan losses at banks is inherently speculative. Forecasting future cash flow from existing loans is also speculative. Both estimates lie at the core of this week's leaked (and eventually announced) stress test. Isn't it ironic how creatively regulators were interpreting Reg FD laws with all of this week's leaks to the press? The leaks may not be very relevant, but they are yet another sign that this stress test was designed for public consumption. It was intended to bolster public confidence in the banking system, and I'm shocked at the lack of skepticism among the professional investment community.

Once it was announced that bank executives were pushing back on regulators about their forecasted losses, the stress tests instantly lost a great deal of their credibility. What kind of test in school allowed you to argue with your teacher about the correct answer? Just like a student either knows their subject or does not, a bank's capital will be sufficient to weather this crisis without obscene levels of government subsidies, or it will not. If it is not, the FDIC should resolve it at a measured pace to minimize taxpayer losses. With Bear Stearns more than a year in the rearview mirror, there's no excuse for top regulators to not have a mechanism for unwinding complex bank/brokerage institutions - in which losses would be borne by shareholders and bond holders - rather than taxpayers.

Instead, the authorities are trashing the value of the U.S. dollar and blowing up the deficit to potentially unmanageable levels. Independent regulators - not bank executives - should be the sole judges of capital adequacy under a stress scenario. We all know what kind of biases bank executives tend to hold about their own loan books. We have probably not seen the end of the stress test process. If the future data flow on loan delinquencies comes in higher than the current "stress" scenario, then we may see a scenario where a major bank (or three) gets massively diluted. For a model of what night happen to shareholders at the most toxic of the megabanks, consider the proposed exchange offer for GM bondholders, which would leave current GM shareholders with a 1% equity stake in the "new" GM.

Why any professional can justify investing client capital in such megabank stocks is beyond my understanding. The market's reaction to the stress test - in the form of soaring bank stocks - tells me that the consensus is treating this stress test as if it has the ability to magically predict yearend 2010 capital levels with pinpoint accuracy. Most of us do not have magic predictive powers - only the ability to make judgments based on knowledge and experience. In my judgment, the stress test was not stressful enough. For instance, it is not really accounting for borrower behavior in a scenario where they are underwater on their mortgage and under- or unemployed.

The stress test's estimated losses on second-lien mortgages in particular seem very low. In foreclosure, these are often total losses. With another big wave of Alt-A resets and foreclosures in the pipeline, the performance data on second lien mortgages should worsen. Several state-imposed and bank-imposed foreclosure moratoriums are ending. The bulk of housing activity right now consists in foreclosure auctions and short sales. How much are second mortgage liens worth under this scenario? Not much. Most big banks already have low levels of tangible capital relative to towering trillions in risky assets. The cash flow from their existing and new loans must exceed their loan losses in order to simply maintain existing capital levels (let alone increase capital). Here's the illustration I used in the March 27 Strategic Short Report alert:

"Think of this situation as a bathtub. Bank capital is the amount of water in the bathtub, and the faucet pours new water into it (that's cash flow from existing, paying loans and securities, plus new capital infusions) and the drain sucks it out (these are the loan losses). Pessimists claim that the drain of losses is sucking water out so fast that it will empty the bathtub within a year or two, depending on the bank. They tend to ignore or downplay the new water coming in. Optimists claim that if regulators allow the water level to fall to a very low level during this crisis (regulatory forbearance), in time, the water level will eventually rise back to normal levels.

There's a risk that if the optimists are wrong about the amount of new water coming in, we'll be stuck with a Japanese-style "zombie bank" situation. After this week, I think the risk of the zombie bank scenario is much higher. We'll probably see this manifested in continued tight credit conditions. The banks under the most intense scrutiny will tend to reinvest cash flows into less risky assets like Treasuries and agency mortgage-back securities (another form of government guaranteed debt) - rather than write new commercial or consumer loans.

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European Banks Take Stress Hit

The U.S. government's stress tests are fueling concerns that European banks could be falling behind in their efforts to bolster their own finances. Unlike in the U.S., there has been no major policy initiative to force banks in Europe to increase capital cushions, and governments have intervened only on a piecemeal basis. Meanwhile, as U.S. banks pile in with efforts to raise capital from investors, European banks aren't taking advantage of a stock rally to do the same. "Compared to the U.S., the European banking system is rapidly being left behind," said Philip Finch, bank analyst at UBS AG. "If anything, the rally that has taken place has allowed complacency to come back at the bank level and at the policy level."

European banks have raised only about 40% of the $1 trillion they need to cover losses since the beginning of the financial crisis and maintain healthy capital levels, according to the latest estimates from the International Monetary Fund. By contrast, U.S. banks have raised or announced plans to raise about two-thirds of the $666 billion the IMF believes they need. The divergence partly reflects a different attitude toward how to scrutinize battered banks. The U.K., one of a handful of European countries to stress-test its banks, never disclosed the parameters or detailed results. A spokeswoman for the Committee of European Bank Supervisors said national authorities are carrying out stress tests of their domestic banking systems, with results due by September. The examinations are aimed at assessing the European financial system's resilience to shocks, not the capital needs of individual banks. The findings and methodology won't be disclosed publicly.

Some bankers prefer the discreet approach. The U.S. strategy was "not the way to instill confidence in the process," Stephen Green, chairman of HSBC Holdings PLC, said in an interview Monday, noting the haggling between banks and regulators. But that openness boosted the credibility of the U.S. stress tests -- and last week's results -- in the eyes of some analysts and investors. One reason European banks are behind those in the U.S. in raising capital: The economic downturn took as much as a year to ripple across the Atlantic Ocean. That delayed the pain for most banks, except a small number of European financial institutions that invested in shaky U.S. assets or U.K. banks hurt by a decline in real-estate values. European banks now face potential losses from risk-taking that U.S. banks largely avoided, such as investments in Eastern Europe, which is suffering from a severe recession. Banks in Europe also are more vulnerable to skittish wholesale money markets because of their higher ratios of loans to deposits.

Weakened banks in Europe have a potentially bigger economic impact than U.S. financial institutions do, since some 80% of lending to companies in Europe is through banks, compared with only one-fifth in the U.S. If replenishing capital levels causes European banks to pull back on lending, it could slow economic recovery. Of the $600 billion in additional capital still needed by European banks, financial institutions in the 16-nation euro zone need $375 billion, followed by $125 billion in the U.K. and $100 billion elsewhere on the Continent, according to the IMF. The IMF's figures are larger than other estimates, partly because they include all banks. In Germany, many of the so-called Landesbanks owned by individual German states are seen as needing more capital. The U.K. has injected £80 billion ($121.88 billion) of new capital into its banks and is insuring some £562 billion of bank assets under a government program aimed at putting a lid on losses.

Analysts at investment firm Keefe, Bruyette & Woods Ltd. who attempted to replicate the U.S. stress tests for European banks came up with what they called a "broadly positive" result. Six banks with widely traded shares, including Commerzbank AG and Danske Bank AS, would need to raise a total of only about €8 billion ($10.9 billion) in capital to meet the 4% equity Tier 1 capital ratio used in the U.S. tests. In reality, the European banks probably would want to raise a lot more capital -- as much as €60 billion -- to maintain investor and customer confidence under a bad scenario similar to one used by the U.S. government, said Andrew Stimpson, a KBW analyst. Tonny Thierry Andersen, finance chief at Danske Bank, said the Danish bank raised about 26 billion kronor ($4.76 billion) in early May, making it the best-capitalized bank in the Nordic region. A representative for Commerzbank said the German bank is "capitalized adequately."

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EU Bank Regulators Plan Stress Tests to Examine Risks

European Union bank regulators will conduct confidential stress tests by September, stepping up scrutiny of risks after lenders absorbed more than $1 trillion of losses and writedowns in the global financial crisis. Regulators in the 27 EU countries will report overall data, not results for individual banks, to finance ministers and the EU’s executive arm, said Efstathia Bouli, a spokeswoman for the Committee of European Banking Supervisors in London. They don’t plan to publish the results.

The program, the second such review run by CEBS, examines sources of risks across financial markets, after EU states have pumped almost 300 billion euros ($411 billion) of capital into lenders and offered 2.5 trillion euros in guarantees to help weather the crisis. The tests won’t assess banks’ capital needs, in contrast to the U.S. program completed last week. "They don’t want to spook people by reporting big holes in the banking system, if that’s what they find," Dominic Bryant, an economist at BNP Paribas in London, said in a telephone interview. Any such finding would "put pressure on banks to shore up their finances and be less risky in the future."

After the crisis rippled through U.S. and U.K. banks, lenders in continental Europe, such as in Spain, are likely to make losses this year as their domestic economies contract, according to Bryant. Among EU banks, losses and writedowns from the crisis have hit hardest in Britain, led by HSBC Holdings Plc and Royal Bank of Scotland Group Plc, according to Bloomberg data. U.S. regulators found that 10 financial companies led by Bank of America Corp. need to raise a total of $74.6 billion of capital, in results made public on May 8. Releasing the findings helped calm investors, said U.S. Comptroller of the Currency John Dugan, who oversees national banks, said today at a conference in Washington.

The tests are "an assessment of the European financial system, to test its resilience to shocks and to contribute to best practices," Bouli at the CEBS said in a telephone interview. They are part of a "regular risk assessment" mandated by the EU’s executive arm, the European Commission. The CEBS designed a "common scenario," which won’t be disclosed, to see how banks would perform in such an environment, according to Bouli. Kirsty Clay, a spokeswoman for the U.K.’s regulator, the Financial Services Authority, declined to comment immediately. Policy makers in Europe "need to subject financial institutions to rigorous stress tests," Marek Belka, director of the International Monetary Fund’s European department, told journalists in Paris today. "Impaired assets need to be isolated from the rest of the financial sector."

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French Find Safety Nets Multiplying in Pastures

The French, known for their mistrust of banks, are not just stuffing money into mattresses in these anxious days of recession and minuscule interest rates. They are also putting their cash into cows. For Pierre Marguerit, 60, cows make a safe, secure investment, allowing for long-term growth from a renewable resource. The cow contracts are hardly new, but go back to Richard the Lionheart; the French word for livestock, "cheptel," is the root for "capital." These are not exactly cash cows. But investment in Mr. Marguerit’s Holsteins will bring a 4 to 5 percent return a year after taxes, he said, based on "natural growth" — the sale of their offspring. That compares to an interest rate now of 0.75 percent on the basic French bank account.

Last year, his business went up by 40 percent, and so far this year, it has "practically doubled ," said Mr. Marguerit, the managing director of Élevage et Patrimoine, a cattle investment firm in this part of eastern France, near the Alps, and president of Gestel, which works with farmers and investors. "People have saved money and don’t want to waste it," he said. "Stocks have fallen a lot, and people see it. We need somewhere to put our money for a long-term investment, something more stable." At the moment, there are about 37,000 cows under contract in France at some 880 farms, according to the French Association for Investment in Cattle. But the potential market is huge, Mr. Marguerit insists, perhaps as many as one million head in France and six million in Europe as a whole.

A typical couple will buy 10 to 20 dairy cows for about $1,700 each and can decide to sell the offspring each year or keep them as additional "capital." "At this difficult time, it’s a much better investment than real estate and much more tangible than the stock market," Mr. Marguerit said. He then proceeded to praise the new interest "in natural, organic and lasting things" among the French, who have always romanticized the countryside and imagined themselves shrewd peasants at heart. "This is part of the patrimony," he said. In the steep financial crash, "we’re having a moment of realization — we’re landing hard and people are asking real questions." Diversify into cows? Why not?

For Richard Durand, the arrangement frees up capital for improvements to his small dairy farm here, 500 acres deep in the countryside about 35 miles southeast of Lyon. He provides his 100 Holsteins with the best of everything, including a view of the mountains and the grassy fields where they spend the summer months. Even better, they can have a massage — a large round brush they rub against whenever the urge hits them. He calls his property "The Farm of the Happy Cows," and so they seem, so far as one can tell. Mr. Durand "rents" 37 of his 100 cows, all of whom he knows by name and not just by the numbered tags punched through both ears, like big plastic earrings. He seems especially fond of Tartine, a brown and white Holstein who likes her head rubbed.

Mr. Durand, 48, has come up in the world. "I smelled of cows until I was 42," he said, describing how he had to clean their hooves with his fingers and showing off the automated sledge that runs on a track down the middle of his modern barn, sweeping away the excrement and soiled straw of all those happy cows. Now he confines himself to making cheese, while others deal with the straw and the twice-a-day milking. He sells his excellent fromage blanc, butter and yogurts to local markets that feature artisanal products, while most of his 200,000 gallons of milk a year are sold to the local cooperative.

Raising cows owned by others gives him more tax deductions and frees as much as 17 percent of his capital for improvements or investments, said Mr. Durand, whose three children have moved away, wanting nothing more to do with cows. The animals are good natured but, he admits, boring. "They spend eight hours eating, eight hours sleeping and eight hours ruminating," he said. As for him, the day runs from 5:30 a.m. till 7 p.m. In a little shop attached to his barn, Mr. Durand has a list of French expressions using the cow. He points to one: "le temps des vaches maigres," a time of skinny cows — a period of belt-tightening.

There are many other signs of coping in this area of France, where industry is also being hit hard by the recession. Business is brisk at traditional consignment shops, where people bring used or unwanted items. Stores are having floating sales, outside the traditionally rigid sale periods, possible under a new law. Web sites bring together "neighbors in solidarity," who help one another with chores or repairs and buy basic commodities in common; on swap sites, people can work out exchanges for things from clothes to household equipment. Sites put consumers in touch with farmers, to buy fruits and vegetables in bulk; another site, Le-Dindon.fr, facilitates the donation of unwanted items, instead of their disposal.

In Lyon, Jérémie Romand, 28, has come up with his own clever idea: an Internet company that puts together people who want rides with those who have empty seats, at a guaranteed fare that is transferred to the driver only after a customer arrives safely. His company, EnVoitureSimone.com — a French phrase roughly equivalent to "Let’s hit the road, Jack" — is doubling its customers every month, he said. On average, he said, cars carry only 1.2 passengers every trip. "We want to capture the potential of these millions of empty seats in a way that is safe, secure and organized," he said. "Transport is the second-largest household expense in France, after housing and before food." The crisis has helped his company and been a wake-up call to everyone, Mr. Romand said. "The French now want to know how to save money in every aspect of life."

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