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Will The Collapse Of FDIC Insured Banks Cause Another Stock Market Crash?

Stock-Markets / Financial Crash Sep 08, 2009 - 09:01 AM GMT

By: Andrew_Butter

Stock-Markets

Diamond Rated - Best Financial Markets Analysis ArticleThe problem with Banks these days is that it's hard to understand if they are solvent or not. Sometimes I suspect that the people running them don't even know, or if they do they are in denial, or lying.

Presumably, in July 2008, before Hank Paulson stood up and announced to the world "The US Banking System Is Safe And Sound One", he or his people, had looked at the audited accounts, talked to the regulators, perhaps the SEC, perhaps the rating agencies too; I mean presumably he wasn't deliberately telling a big fat lie? 


Yet that statement marked the start of the most comprehensive collapse of any banking system, any time, anywhere, in history. And at some point in the next three months the penny dropped.

At a conference in London about three months ago I managed to have the extraordinary honor to get a few seconds with the head of Moody's EMEA and also with the head of the recently formed Financial Stability Unit of the Bank of International Settlements.

I asked them both (separately) a question, "don't you think it would be a good idea to do the valuations of the assets properly, like work out how much they will be worth the moment liabilities come due, so you have an idea how much you will be able to get for them at the point of time that you might need to sell them?"

I thought that was a perfectly reasonable question, I mean banking isn't complicated, (1) you lend people money (2) they put up collateral (3) at some point in the future some of the people don't pay the money back, so (3) you sell the collateral, also at some time in the future (4) if the money you get from that is less than what you lent, you go broke.

They both looked at me like I was a lunatic.

Their response if I understood it correctly was (a) it's impossible to predict the future (b) it's much more complicated than that.

I don't think I am a lunatic; and I don't think impossible to predict the future, I do it all the time, that's what a valuation is. And in any case all you need to do is to work out what is a reasonable minimum estimate for what you will be able to sell something for at some time in the future, that's easy, the question that I get asked a lot is "what's the maximum"?  That's a lot harder.

And if you don't know, and you are honest, you can simply say, "I don't know", that's a perfectly reasonable answer.

Someone walks into a bank and asks to borrow a trillion dollars; you say, "Great, have we got a deal for you! So what collateral are you offering?" He opens up his bag and reveals that he has a miniature monkey in there, so you ask the person who does the valuations, "How much can I be reasonably sure to sell this miniature monkey for at some unspecified time in the future", and he (or she) says (quite reasonably), "I haven't got a clue".

This is Test:  What would be the most prudent thing to do in those circumstances?

If you said "Oh we will check his credit rating, and we will do a multivariate regression analysis of our database to work out his "score"...so much if he owns a dog, a bit less if he owns a monkey, so much if he is quarter Hispanic, half White and quarter Cherokee Indian, and so much if one leg is shorter than the other, and then we will assign a standard error to each variable and run a Monte Carlo analysis and work out the probability of default, and if he passes that test we will hand over the money...see...it's complicated!!!"

Well sadly, that's the wrong answer; it's the miniature pet monkey that matters in the end, just focus on the monkey; it's really not complicated.

Sure it is harder (and often more expensive), to figure that out than finding out what you might have been able to sell the monkey to someone dumber than you, yesterday, (mark to market), or what the guy who stuck you with it bought it for (face), or even what you can persuade some moron at the SEC or the Treasury what it's worth (mark to fantasy), but if you don't ask that question, specifically, that exact question, well you can be pretty much guaranteed you won't get the answer.

Granted if you ask that question, you might get the wrong answer sometimes, but the chances of getting the right answer are a lot better if you ask the question, than if you don't ask the question at all.

And working that out is not hard; let me give an example, which is relevant to this article.

On 26th February 2009 I wrote an article: "Time to Jump Into US Stock Markets...when DJIA hits 6600 and when S&P 500 hits 675". (http://www.marketoracle.co.uk/Article9131.html).

On 5th March the DJIA pierced 6600 for about two hours; on 9th March the S&P 500 pierced 675 for about thirty minutes, thereafter over the next six months they both went up by 55%. March 6th was a good time to jump into the DJIA; March 10th was a good time to jump into the S&P 500.

It won't explain how I did that, except simply to say that was not a prediction, that was a valuation done strictly in accordance with International Valuation Standards by someone who knows how to do valuations; specifically (in this case) of the minimum price that you could expect to sell stocks indexed to the New York Stock Exchange at some unspecified time in the future.

I do valuations, but I'm not the only person in the world who knows how to do valuations, for example; I recall recently watching Warren Buffet being interviewed and he was asked, "So Warren how do you know the companies you buy are good", to which he testily replied, "I know how to do valuations".

In my opinion anyone who is seeking to either do investments on behalf of others, or to advise on the proper conduct and reporting standards of banks; who doesn't know how to do a valuation, is a dangerous and unscrupulous lunatic.

Perhaps instead of all the rambling verbiage that is being produced by the people who are happy to sell the grandchildren of ordinary Americans (and Brits), into a slavery of perpetual debt to make amends for the incompetence of people who couldn't figure out that it was all about the monkey; perhaps they should first be required to do a simple test?

How about this one: "What's the minimum price that you can reasonably expect the S&P 500 to be in the next six months"? 

If they can't answer that correctly within 5%, (I can do 0.1%, but there again I had practice (doing valuations) so one wouldn't want to set the bar too high), then they shouldn't be allowed to "practice" on something as important as the banking system, and instead they should be advised to seek a more suitable employment doing something a bit less "complicated", like flipping hamburgers or stacking shelves in Wal-Mart?

And please don't say, "Oh that's not fair, perhaps they don't know anything about the stock market". I don't know anything about stock markets either, that "prediction" was the first time I ever thought about the stock markets in my life for more than ten minutes; but I do know how to do a valuation.

By the way, if ever you want a valuation of a miniature pet monkey, like the slightly hard sort, i.e. the minimum you can reasonably expect to sell it for at any time over the next five years, just drop me a line. I know absolutely nothing about miniature pet monkeys (except that they bite), but I can probably figure it out, and if in the end I'm not sure, I'll tell you, "I don't know".

How will I do that? Simple, International Valuation Standards, it's like a cookbook, the Dummies Guide to Valuation, even I can understand it.

Are all the FDIC insured banks bankrupt?
I did an article recently on foreclosures (http://www.marketoracle.co.uk/Article13143.html); I was trying to figure out how much money the FDIC insured banks stood to loose.

Perhaps I am indeed a lunatic, but the way it looked to me from the information that was in the public domain, the amount of money they stand to lose over the next two years, could well be more than the amount they have in their Reserve for Losses" ($211 billion) plus their $1.422 trillion Equity Capital (total $1.633 trillion).

Of course I could be wrong, I don't have the advantage of being able to ask hard questions, but I didn't notice Sheila Bair standing up and declaring "The FDIC insured Banks are Safe And Sound!"

Although perhaps given the experience of the reaction when Hank Paulson made his little speech that might be like waving a red flag at a bull?

So what if they are bankrupt?
This is a valuation of the S&P 500 that I did, that's average monthly end of day closing data month by month, I downloaded it from Yahoo (thank you Yahoo, very nice site).

The red line is the valuation; that is my estimate of what the price of the index ought to be if the market was not what George Soros calls "mispriced" or what International Valuation Standards calls "in disequilibrium". That line is what's called the "other than market value" under International Valuation Standards (the other sort of valuation (there are only two - (really it's not complicated)), is called market value, that's the value when (a) there is a functioning transparent market with plenty of well-informed buyers and sellers who have all the information they need to make rational and well informed decisions (i.e. not the AXA exchange), and (b) the market is not in disequilibrium).

So what's disequilibrium? Well markets are like a flock of penguins, they all go "quack-quack" in one direction; then they get a fright and then they all go "quack-quack" in the opposite direction. And When Hank Paulson stands up to make a speech, they all go "quack-quack-quack" in all sorts of random directions - that's called disequilibrium.

 I'm not going to explain how I did that, I sort of had an attempt explaining it before, but you would probably say that I am a lunatic; suffice to say that you need that red line to be able to say, in advance (like 13 days before), "The time to jump into the S&P 500 is when it hits 675", with a "tolerance" of 0.1%. You also need to understand bubbles; (http://seekingalpha.com/article/149741-the-seven-immutable-laws-of-bubbles).

The interesting thing about that chart is that the "crash" of September/October and the mini-V-crash of March; was not caused (directly) by the bursting of a bubble, which is the normal reason that you get a crash in a market.

Up to about July 2008, and since the popping of the Dot.com bubble, the market had been performing relatively predictably.

There was a bubble (the market got mispriced "UP", then there was a bust and the period of time the market got mispriced "DOWN" was more or less predictable (both in terms of amplitude and periodicity) from the dynamics of the preceding bubble. Nothing complicated there.

I say relatively because I think that the valiant efforts of Allan Greenspan to save people from the unpleasant side effects of creating a bubble (which is that a lot of people lose a lot of money), distorted the market, and in the event, finally made things worse for everybody, even people who were not involved in creating the bubble in the first place.

That's a sort of Socialization of the pain; spreading it around the whole country rather than letting the morons who made the mistake, take the fall. But that's another subject, and I suppose it's easy to be critical after the event, and anyway the current strategy appears to be to reward the morons and let the rest of the country pay for their mistakes, which is not Socialism, that's Crony Capitalism, which is even worse.

I'll leave the rights and wrongs of all that to people who are not generally considered to be lunatics; thankfully there are plenty of economists around to debate that and now that they all agree that they had no clue there was going to be a credit crunch; at least they all agree on something for a change. All that needs to happen next is that they need to all agree WHY it was that all of them were so clueless.

Anyway, the interesting thing is that the direction of the line from about the moment Hank Paulson declared "The US Banking System Is A Safe And Sound One"; is almost at right angles to the trend line, which is a kind of disturbing turn of events, those penguins certainly got spooked this time!

I wonder what can be concluded from that?

Well for a start I think it would be a good idea for someone to suggest to Sheila Bair that she does NOT stand up any-time soon and declare that, "The FDIC Insured Banking System Is A Safe And Sound One", just as sort of precautionary measure.

One interesting thing is that "theoretically" the stock market is selling now for a little over half of what it "ought" to be selling for, if there wasn't all this uncertainty about the financial system.

And even if nominal GDP (I only talk about nominal, my views on the way that the CPI and inflation numbers are gamed and manipulated are unprintable, and my thoughts on "inflation targeting" without properly measuring what inflation actually is, are worse than unprintable), anyway, even if nominal GDP flat-lines (i.e. zero nominal economic growth for the next eighteen months), and even if the yield on a 30-Year Treasury goes up to 5% (I can't imagine it will go more than that in the foreseeable future), then once the "angst" about the financial system is dissipated the market "ought" to be selling at least at 1,300 (Option B on the Chart).

My suggestion which I was trying to offer to in my ten second audiences with the Great and Powerful, who obviously had much more important things to do, was that what needs to happen to the financial system is that people who want to either invest in it, or who are counter-parties, need to be able to have the full information made available to them, so that they can decide in a rational and coherent way, whether the entity they are dealing with is in fact bankrupt or not? Optimally as a matter of Law.

And OK if the penguins don't want to use that information and chose to blindly believe the nonsense that the "experts" put out well it's their barbeque.

By the same token, since ordinary Americans (and Brits) are actually paying to support the extravagant lifestyles of the morons who created this mess, shouldn't that be public domain? What's happened and what's happening at the moment is that some suppliers of information that markets need to make the right decisions, have created monopolies for their own benefit, that's not free-markets, that like I said, is Crony Capitalism.

Specifically since the "industry" evidently (evidence the recent experiences of the past), either doesn't know how to do valuations properly, or if they do, they just don't want to, shouldn't the stakeholders in those rotten banks and so on, be provided with sufficient information to allow them to do the valuations themselves, and make up their own minds?

Clearly having people from Moody's, Fich, S&P, The Big Four auditors, the SEC, the Treasury, FASB, IFRS, FSA, The Fed, The Bank of England, BIS, all standing up like a row of penguins and singing in perfect harmony "The Banking System Is A Safe And Sound One", just doesn't do the trick anymore.

So what Next?
One of the more friendly comments I got back from my adoring long-suffering dear readers, was "well if you are so smart, what's going to happen next". 

The way I see it, it's quite simple, either there will be another banking crisis, or there won't, if there isn't, give the current situation time to calm down and the S&P 500 should be easily up to 1,500 by Christmas 2010 (Option C on the Chart).

If there is another crisis, and my suspicion is that it's the FDIC insured banks that are most likely to blow up, well, will it be worse than the last one?

I mean it's only a trillion or so to be flushed down the toilet, that's chump-change these days. And the nice thing is everyone has had some practice, plus if you want to be safe, have a look at how stuff did over the past crisis, and that will give some clues about what's safe and what's not. So my guess if that happens is the "shock and awe" of finding out the full degree of incompetence of the banking sector will be less than last time (Option A).

One possibility I suppose is that a new trend line has been established, that will be parallel to the traditional one (Option D), that sounds unlikely, unless the demise of so many things, has mean that nominal GDP is now being grossly over-estimated. That's perhaps something worth thinking about, it surprises me how the loss of the great generator of "value added" i.e. the financial services sector, didn't dent GDP more, particularly since the damage to there sectors of the economy look dire.

Will they Crash and Burn?
As far as predicting if the FDIC Banks will blow up, don't ask me, I just do valuations, and if you asked me what is the value of those banks, I'd have to say, "I don't have a clue", there isn't enough information to be able to do that valuation.

But if you like, I'll do you a miniature pet monkey!

By Andrew Butter

Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( hbutter@eim.ae ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.

© 2009 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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