Money Sage (archive)

Well folks, this morning we are treated to the news that four of the most important banks in the United States are offering discounts of up to 10% in order to "clear" a $231 billion "backlog" of high-yield bonds and loans.

The greatest miracle in the world, according to financial world folklore, is "the miracle of compound interest." It is said that Albert Einstein himself coined this phrase in recognition of the astonishing growth of nominal capital hoards thanks to the multiplicative power -- over time -- of compound interest. Today's news brings Einstein's apothegm to mind. Let us phrase it as tactfully as we can insofar as it clearly applies to banks: "Compound stupidity produces the most egregious of losses." If there is smart money and dumb money, as their surely is, there can be no question about where the banks stand. We do not think it is much of an overstatement to say that banks rank high as the dumbest of the dumb money. The opposite side of the coin is the smart money, as epitomized by some of the buyout shops and other private equity players. The banks, it turns out, reap what the private equity shops have sown. Unfortunately, it is the shareholder and, more significantly, the average citizen and taxpayer who are likely to have to reap what bank stupidity and greed have sown.

Specifically, we have reference here to debt wracked up by private equity and leveraged buyout shops (LBOs). The latter are cunning fellows indeed: they are skilled mightily at getting others to shoulder the bulk of the risk while they enjoy the vast bulk of the rewards of their financial engineering. These "others" are the banks, commercial and investment. Of course, this merry game of financial musical chairs must inevitably come to an end. When it does, the banks find -- for the umpteenth time -- that they are the prime patsies. Of course, the banks themselves have laid off as much of their risk as possible upon the ultimate patsies -- the greed-driven, ever wishful-thinking crowd of "investors" who eagerly buy the banks' spiel as well as the bonds they are hawking. The stupidity of the banks is measured by the poor-quality debt they are caught holding when the music stops and the savvier players have already secured all the chairs. They do not, you see, have time to lay off all the garbage they have accumulated as a consequence of their own short-sighted greed, itself the father of the illusion that they can ALWAYS unload this stuff on the unwary retail investment consumer.

The banks are happy as clams as long as the tide is rising. They reap huge deal fees and then promptly pass on the dubious "assets" to their customers. The problem comes when the music stops. It is here that the greed of banks -- which grows like topsy as the money machine keeps grinding out ever-more lucrative fees -- does them in. Their greed-created illusionary thinking is that they can always unload on the suckers. What they are content to blind themselves to is their past experience that while, in the immortal words of P.T. Barnum, "there is one born every minute," there is NOT one born every second. Burn a customer badly enough and he wises up. The banks have been down this road before, but, like the Bourbon, "they learn nothing and they forget nothing." Or, to put it a tad more accurately, they manifest the classic symptoms of deliberate ignorance: "there are none so blind as those who will not see."

Today, if news accounts are correct, four banks are offering 10% discounts on $231 billion of high-yield bonds and loans. If our third grade arithmetic will serve, this amounts to a LOSS of some $23 billion. A nice, tidy sum. Not exactly chump change for 4 banks. The implications for the state of bank capital, and the contraction of lendable capital to sustain reliable borrowers are pretty clear, we think. Of course, we do not know how much more of this "inventory" there may be left for clearance, assuming the $231 billion can be unloaded. The more we learn about the state and extent of depreciating junk bonds and junk loans held by the great banks, the more questionable the survival of the banks appears, absent a government-sponsored and ultimately taxpayer-financed bailout.

What we find truly astounding about the lack of bank prudence is the INSTANTLY ACCESSIBLE KNOWLEDGE about the historical parameters of the yield patterns of "high-yield" (i.e., junk) debt. As we pointed out in an earlier post, a simple line chart of the historical spread between Treasuries and high yield debt over the past 20 years could be comprehended readily by any junior high school student with an IQ above 100. What does the chart show? It shows that the bull cycle for high yield debt crests in the 3-point spread area. On each of the prior occasions when the spread between Treasuries and junk have narrowed to this degree, a severe bear market in junk began. How severe? The bottom on each occasion was not reached until the spread EXCEEDED 10-points. Today, the spread is UNDER 6-points. We hardly need be a financial wizard to infer that the BEAR MARKET IN JUNK has a LOT FURTHER TO GO. Why would anyone whose IQ placed him above the clinical IDIOT level buy now? And, more to the point, how was it that the supposedly sophisticated banks BOUGHT hundreds of billions of this stuff when the yield was at the uttermost low spread -- and even narrower -- signalling that high yield debt was deeper than ever before into the crash area??

Perhaps the suckers can be lured back, employing a combination of "investor" greed and the media blaring about all the discounts and deals to be had. Indeed, we have been experiencing this dangerous rubbish since this summer, when the financial media and many on Wall Street started trumpeting the appeal of "cheap" "undervalued" bank and real estate stocks, which were supposedly attracting so many savvy buyers. Hard-pressed sellers, desperate to dump, could hardly have paid Madison Avenue for a more effective ad campaign.

We suspect that enough "investors" have been burned badly enough, recently enough, for them to have wised up. If so, the four banks' losses will far exceed the $23 billion in question today. These bonds and loans are the financial equivalent to lead-poisoned toys from China.

The issue, as we see it, goes far beyond the requirement of prudence which should inform all bank-decision-making. It is a question, ultimately, of an ability to judge the market and avoid buying (i.e., financing deals) when the historically reliable klaxons are sounding at the highest decibel level. The failure of the regulators to regulate, of the legislators to legislate, and of the banks to adhere to the minimal canons of their profession impose a very serious risk to the economy. This will occur again in the future, after the current debacle is cleared up courtesy of the taxpayer, unless there are stringent structural and regulatory reforms. The FEDERAL RESERVE needs to cease act as lobbyist for the banks and start acting as the guardian of the soundness of the financial system, for starters. Sackcloth and ashes, rather than arrogance and stupidity, are in order, we think, for out central bankers.