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The Credit Crisis and Cycle Proof Regulation1

1 Remarks delivered by Raghuram G. Rajan, Eric Gleacher Distinguished Service Professor of Finance at the Homer Jones Lecture organized by the Federal Reserve Bank of St Louis in St Louis on April 15, 2009. I thank Luigi Zingales for very useful discussion including some of the ideas in this talk. All errors are mine.

The 2009 Homer Jones Lecture
by Raghuram Rajan
Eric J . Gleacher Distinguished Service Professor of Finance,
University of Chicago Booth School of Business

Federal Reserve Bank of St. Louis
April 15, 2009

We are currently engaged in a search for the causes of the current financial disaster. But in
pinning the disaster on specific agents, we could miss the cause that links them al. I will argue that this common cause is cyclical euphoria, and unless we recognize this, our regulatory efforts are likely to fall far short of preventing the next crisis.

But let me start at the beginning. There is some consensus that the proximate causes of the crisis are: (i) the U.S. financial sector misallocated resources to real estate, financed through the issuance of exotic new financial instruments; (ii) a significant portion of these instruments found their way, directly or indirectly, into commercial and investment bank balance sheets; (iii) these investments were largely financed with short-term debt. (iv) The mix was potent, and imploded starting in 2007. On these, there is broad agreement. But let us dig a little deeper.

This is a crisis born in some ways from previous financial crises. A wave of crises swept
through the emerging markets in the late 1990’s: East Asian economies collapsed, Russia
defaulted, and Argentina, Brazil, and Turkey faced severe stress.

In response to these problems, emerging markets became far more circumspect about borrowing from abroad to finance domestic demand. Instead, their corporations, governments, and households cut back on investment and reduced consumption.

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Here is our latest comment FYI.  Barry is wandering the wilds of Michigan and will be back soon with lots of channel observations.  Chris

The Institutional Risk Analyst

April 23, 2009
“What’s right about America is that although we have a mess of problems, we have great capacity – intellect and resources – to do some thing about them.”Henry Ford II

(1917 – 1987)
First, next Thursday, April 30, 2009, we will be participating in an important event in Philadelphia, “The Financial System, Banks & Economy: After the Storm…Where Are We Now?” The morning program includes Barry Ritholtz of Fusion IQ, David Kotok and Bob Eisenbeis of Cumberland Advisers, William Poole of CATO Institute and Diane Swonk of Mesirow Financial. For more information or to register, please click here: http://www.interdependence.org/Event-04-30-09.php
Next, we wish to thank the FDIC for the quick response to our last comment (“Can Citigroup Be Restructured Without an FDIC Resolution?”), where we suggested that the public record of the US banking industry is incomplete. We revised same to reflect their views. Bottom line is that the FDIC is presenting the bank unit data gathered from insured depository institutions correctly and consistent with GAAP.

Trouble is, while the current methodology may be precisely correct in a compliance and GAAP sense as it applies to federally insured legal entities, in our view and from a portfolio perspective, the FDIC dataset still is missing significant historic loss data, not just in 2008 but in previous years. Part of this situation stems from the “survivor bias” in the data. More, the impact of the timing of certain transactions and the use of GAAP purchase accounting has created some seemingly significant anomalies in both the historic record of the industry’s loss experience and in how GAAP accounting creates hidden reserves for acquirers, reserves that largely are invisible to retail investors but seemingly create distortions in reported earnings.

One reason that we took the risk of pissing off our friends at the FDIC by persisting with questions about the accounting treatment of the purchase of Wachovia Bank by Wells Fargo (NYSE:WFC), for example, is not only because the Q4 2008 industry data does not, in fact, include the charge-offs from Wachovia, realized losses that total into the tens of billions dollars. No, we were also interested in understanding how WFC got a little side benefit – a “cookie jar” in earnings terms – that is an effective subsidy for WFC to help absorb the cost of remediating the Wachovia portfolio.

Jonathan Weil of Bloomberg News wrote a very good analysis of WFC that puts the size of the cookie jar at $7.5 billion: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a6sv0hG.nW7g

For those not familiar with the cookie jar concept, we turn back the pages of the proverbial comic book to pre-2004, when Sanford I. Weill was the King of the Citi and the folks at the SEC were sound asleep when it came to hidden reserves. During Sandy’s shopping spree to build the great financial bodega now know as Citigroup, Weill accumulated a number of acquisitions and, thanks to the benefits of good legal advice and purchase accounting, was able to amass a considerable, undisclosed reserve position.

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Good Evening: After spending most of Earth Day solidly and appropriately in the green, stocks returned to Terra Firma late in the session. Various earnings reports and some conflicting stories about the current state of U.S. home prices all contributed to the crosscurrents that ruled Wednesday’s trading. It’s still too soon to say if “countertrend Tuesday” correctly pointed to a resumption of widespread risk aversion, but today’s action hinted that such an outcome is more than possible.

U.S. stock index futures were indicating a lower open this morning after a very disappointing loss announced by Morgan Stanley (see below). Analysts and investors alike bemoaned the write-downs taken and the trading opportunities missed by MS in Q1. With Goldman and JP Morgan using their balance sheets to rake in fixed income profits in the first three months of ‘09, Morgan Stanley decided to hunker down. That MS’s leverage ratio of assets to equity is now closer to 10 than last year’s 30 looks wise to me in this environment, but investors obviously disagreed with this view.

Market participants did their level best to portray the MS results as company specific in the early going, and stocks were soon higher after opening losses of nearly 1%. Positive surprises from AT&T, JC Penney, and Sybase contributed to the comeback in equities, as did one of the stories about housing you see below. The Federal Housing and Finance Agency (where did they come from?) put out a report this morning that tried to claim that U.S. home prices actually ROSE in February. What’s more, this report apparently also stated that inventories of unsold homes are declining. CNBC touted the story, of course, though I think the last story you see below is a more accurate picture of housing. In addition, please see BAC-MER’s take on the mortgage applications data out this morning (see below). In it, David Rosenberg and crew note that while refinancing activity has perked up of late, the number of applications by folks actually looking to buy a house has been falling. They think the April home sales figures are at risk, and I agree that housing is far from being out of the woods.

The major averages couldn’t be bothered with the details, however, and they sauntered their way to gains north of 2% with 40 minutes to go. Whether it was late day profit-taking or more concerns about the upcoming stress test results, I don’t know, but equities had the rug pulled from beneath them as the closing bell approached. Gains in the Dow and S&P 500 turned into losses, while the other indexes finished mixed. The Dow Industrials (-1%) fared the worst and the Dow Transports (+1.6%) held up the best. Treasury prices were on the weak side all day after fixed income investors were reminded just how much debt Uncle Sam will have to issue in 2009 (see below). This figure could total almost $2 trillion, a daunting sum that gave investors pause when they realized that all the sovereign wealth funds combined don’t have that much spare cash to lend us. Yields rose only 2 to 6 bps today, but the curve did steepen as a harbinger of what may lie ahead. The dollar dropped 0.5% and the CRB index was unruffled in gaining a tiny 0.15%.

On the original Earth Day back in 1970, this writer was in a music class with his third grade contemporaries when our teacher put up the following 5 note scale: E G B D F. To mark Earth Day and learn these notes, she introduced us to the concept of the pneumonic device by asking us to come up with a green phrase that matched the letters in the scale. Predictably, we came up with something appropriately simple for 9 year olds: Earth Garbage Brings Death Fast.

I share this vignette because the Earth Day circa 2009 brings to my mind a financially oriented set of words to commemorate the occasion. Given what happened today to Morgan Stanley, various bank stocks, many REITS, and financing entities like CIT Group, let’s try Earnings Ground Banks, Developers, and Financiers on for size. Though this phrase won’t enhance anyone’s musical IQ, it is simple enough to fit right in with the third grade mentality many investors have displayed while chasing financial stocks these past six or seven weeks. The downside reversal today in the major averages in general and the financial stocks in particular may or may not portend an imminent shrinkage of risk appetites. Investors might even find Apple’s earnings news tonight delicious enough to make them hunger for shares of all types tomorrow. But if it really does come down to housing, the health of our banks, and earnings reports that seem to need accounting tricks to make them palatable, then perhaps the rally off the March lows has indeed run its course. Even a third grade investor-to-be might understand that stocks unable to stay in the green on Earth Day may soon be polluting portfolios that are left untended.

– Jack McHugh

U.S. Markets Wrap: Stocks Drop Following Late-Day Bank Slump

Morgan Stanley Posts Bigger-Than Estimated Loss

Soaring U.S. Budget Deficit Will Mean Billions in Bond Sales

Home Prices Gain 0.7% in February From January

California, Florida Metropolitan Areas Lead in Foreclosures

Lower rates lift mortgage refi.pdf

Gary Weiss of Portfolio has just published a profile of Treasury Secretary Tim Geithner:

http://www.portfolio.com/executives/2009/04/22/Treasury-Chief-Tim-Geithner-Profile

He recalls my first experience with Geithner at an NYU conference on risk management hosted by the Stern School several years ago.  Even though Geithner admitted yesterday in his congressional testimony that he has no actual financial markets experience whatsoever, you would think that an economist and bureacrat focused on financial policy would have some passing acquiantance with Basel II, especially as the President of the FRBNY.

The more I see and hear Secretary Geithner speak on financial services policy, the more I am convinced that this man has not a clue what he is doing and must therefore be acting at the instruction of others — Bob Rubin, Larry Summers and the folks at GS — IMHO.

Best,

Chris

Testimony Before the Joint Economic Committee
United States Congress
Thomas M. Hoenig
President and Chief Executive Officer
Federal Reserve Bank of Kansas City

Washington, D.C.
April 21, 2009 2

Madam Chair Maloney, Vice Chair Schumer, ranking members Brady and Brownback, and members of the committee. Thank you for the opportunity to testify at this hearing.

The United States currently faces economic turmoil related directly to a loss of confidence in our largest financial institutions because policymakers accepted the idea that some firms are just “too big to fail.” I do not.

Despite record levels of expenditures, we have not seen the return of confidence and transparency to financial markets, leaving lenders and investors wary of making new commitments. Until confidence is restored, a full economic recovery cannot be achieved. When the crisis began to unfold last year, and its full depth was not yet clear, substantial liquidity was provided to the financial system. With the crisis continuing and hundreds of thousands of Americans losing their jobs every month, it remains tempting to pour additional funds into large firms in hopes of a turnaround.

However, actions that strive to protect our largest institutions from failure risk prolonging the crisis and increasing its cost. Of particular concern to me is the fact that the financial support provided to firms considered “too big to fail” provides them a competitive advantage over other firms and subsidizes their growth and profit with taxpayer funds.

Yes, these institutions are systemically important, but we all know that in a market system, insolvent firms must be allowed to fail regardless of their size, market position or the complexity of operations. In the rush to find stability, no clear process was used to allocate TARP funds among the largest firms. This created further uncertainty and is impeding recovery.

We have options that could provide a more successful outcome, but there are several hard steps to be taken. Here are two:

First, we must “triage” systemically important financial firms based on their current condition. For those that are well-capitalized, we move on. Those that are viable but need more capital either raise it privately or seek government assistance, with the taxpayer put in the senior position and the government determining the circumstances of the senior managers and directors. Second, nonviable institutions must be allowed to fail and could be put into a negotiated conservatorship, as was done in 1984 with the holding company Continental Illinois.

Such actions serve to ensure that when public funds are used, and they may well be needed, management and shareholders bear the full cost of their actions before taxpayer funds are committed. It would give the public confidence in the process and mitigate the need for the government to micromanage institutions.

Such a resolution process is equitable across all firms, has worked in the past, and favors taxpayers. Past experience also suggests this approach is much less costly than the alternative of not recognizing losses and allowing forbearance, as Japan initially did with its problem banks during the “lost decade” and as the United States initially did with thrifts in the 1980s.

As we look to the future, we will turn to the matter of regulatory reform. It is critical that we correctly diagnose the cause of this crisis. The structure of our regulatory system is neither the cause nor the solution. These “too big to fail” institutions are not only too big, they are too complex and too politically influential to supervise on a sustained basis without a clear set of rules constraining their actions. When the recession ends, old habits will reemerge.

Thus, we should focus on defining the supervisory framework and operational rules that over the decades have provided the best outcomes no matter the complexities and dynamics of the market. For example, history has shown that strong limits on leverage ratios work.

Finally, the structure of the Federal Reserve System also is not the problem, as has been
recently suggested. It would be a sad irony if the outcome of a crisis initiated on Wall Street was to result in Wall Street gaining power at the expense of the other parts of the country. The 12 regional Federal Reserve Banks that make up the Federal Reserve System were established by Congress specifically to address the populist outcry against concentrated power on Wall Street.

Its structure reflects the system of checks and balances that serves us well at all levels of government, and it is the reason I am here today able to express an alternative view.

I look forward to your questions.

Good Evening: While many investors felt stressed yesterday about the upcoming release of our government’s attempts to test bank balance sheets under various economic scenarios, today appeared to be an official attempt to mollify those worries. And it worked — somewhat. Treasury Secretary Geithner and Fed Vice Chair Kohn offered enough soothing words that our capital markets took back between 10% and 50% of yesterday’s moves. Watching each market retrace portions of Monday’s gyrations in almost lockstep fashion looked very much like the “countertrend Tuesday” moves I first learned about more than 20 years ago.

While the economic calendar was free of actionable data today, there were plenty of earnings reports for market participants to sift through. CAT, MRK, BK, TXN, and IBM were the headline grabbers overnight and this morning, and the general theme was one of disappointment. The subplot, however, called for all these names to open lower and then recover some or all of those early downticks (except for TXN, which did the exact opposite). The rest of the tape responded in kind. After a lower open, equities spent most of the day grinding higher.

Also providing a tailwind, at least to the financial stocks, were a couple of speeches made by Timothy Geithner and Donald Kohn. Testifying before a congressional oversight panel this morning, our Treasury Secretary sought to placate investors that were yesterday chewing their nails about the now infamous bank “stress tests”:

“In a prepared statement for the hearing in Washington, Geithner said ‘the vast majority of banks have more capital than they need to be considered well capitalized by their regulators.’” (source: Bloomberg article below).

Though his successor offered an eerily similar endorsement for both Freddie and Fannie just prior to when the GSEs became wards of the State, most market participants took Mr. Geithner’s statement as a vote of confidence in our banking system. But I see this whole exercise as one morphing from a well intentioned peek under the hood of the banking system into one that resembles little more than CYA politics. Highly regarded bank analyst, Meredith Whitney, echoed similar sentiments on Bloomberg T.V.(see below). She feels the stress test will be far harder on the regional banks than on the money center institutions everyone is fretting about. The timing and methodologies (about which you can read below) have changed so often that this “test” is likely to show whatever Treasury deems most expedient. Benjamin Disraeli once quipped, “There are three kind of lies: lies, damned lies, and statistics”. I’m guessing we’ll safely be able to add the results of Treasury’s stress test to the former British Prime Minister’s famous list.

If Mr. Geithner’s testimony wasn’t enough to talk folks off of the ledge they wandered on to yesterday, Fed Vice Chairman, Don Kohn, chipped in with some federally sponsored advice of his own during a speech today. Mr. Kohn surmised that our economy was on the verge of a stabilization that could lead to an economic recovery in the second half of this year. Mr. Kohn’s forecasts have been wrong just as often as were those of his mentor, Alan Greenspan, but some investors actually tried to take him at his word and displayed some hope today.

Stocks opened down less than stock index futures had suggested they might. Churning around the unchanged mark until Mr. Geithner’s testimony hit the tape, equities spent the rest of the day in an uneven climb. By day’s end, the major averages had recouped almost exactly half of yesterday’s losses, with the Dow (+1.6%) lagging, and the Russell 2000 (+3.9%) leading the way. Even the bank stock index (BKX) followed the script by rising 8% in the wake of Monday’s 15% tumble. Treasurys also reversed course by dropping this afternoon. Yields rose 2 to 6 basis points as the coupon curve steepened. The dollar joined in, though it only edged lower, while commodities made it a clean sweep of reversals by rising today. Both the grain and energy complexes recorded gains, and the precious metals kept up their end of the bargain with a late day sinking spell. The CRB index rose 0.6%

I learned many things while working with CNBC’s Rick Santelli at the Chicago Board of Trade in the 1980s. He used technical analysis to help guide his views back then, and he was an early devotee of both Gann and Fibonacci. Constantly in search of patterns, he was the first to point out to me the concept of “countertrend Tuesday”. Though I don’t know if Rick invented the concept or not, he did notice that markets tended to forcefully trade in the direction of the underlying trend on Monday’s and Fridays. Wednesdays and Thursdays were less strongly correlated with the main directional trend, in his opinion, but Tuesdays were different. Tuesdays seemed to trade in the opposite direction of the main trend, and often with less force and less volume.

Santelli dubbed them, “countertrend Tuesdays” and I’ve rarely seen a better example of his theory at work than what the markets served up today. Each asset class on Tuesday moved in the opposite direction of the strong action posted Monday, as both magnitude (percentage move in price) and force (volume) backed off as they should. Since all these markets don’t always move in such perfect harmony, to which of them (stocks, bonds, currencies, commodities) do we turn to when trying to spy the main trend? It’s a bit of trick question, since it’s really risk appetites that are the driving force in our capital markets.

The urge to take on risky assets, ever more prevalent between 2003 and 2007, has been in a downtrend for 18 months now. Until Monday, those risk appetites were starting to grow after reaching the point of near starvation six weeks ago. The question before investors this evening is whether or not today’s “countertrend Tuesday” action is a tip off that the main trend to flee risk has resumed. It looks to me like risk aversion is about to reassert itself, but the next few days should give us more clues as to whether Monday or Tuesday was the real head fake.

– Jack McHugh

U.S. Stocks Advance as Geithner Says Banks Have Enough Cash

Fed’s Kohn Says Economy May Stabilize, Start Recovery This Year

U.S. Regulators Put Emphasis on Loan Quality in Tests

Whitney Says Stress Tests Will Be Harder for Regional Banks

Kevin Lane is one of the founding partners of Fusion Analytics, and is the firm’s director of Quantitative Research. He is the main architect for developing their proprietary stock selection models and trading algorithms. Prior to joining Fusion Analytics, Mr. Lane enjoyed success as the Chief Market Strategist for several sell side institutional brokerage firms. In those capacities he oversaw the firms’ research departments. He produced a broad range of widely followed institutional research publications ranging from industry specific notes to quantitative/fundamental reports on individual stocks. His buy side clientele consisted of many of the nations top money managers and hedge fund managers. Mr. Lane is a member of the Market Technicians Association.

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S&P500 Failing at Resistance

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As seen in the above S&P 500 research note the index stalled at resistance and then subsequently broke its’ minor uptrend line on expanding volume. Directional volume is important as it suggests the conviction behind the move and as much as it was bullish not far off the lows, yesterday’s action while not equally negative was ugly. The skew of decliners on the S&P was torrential with 479 of 500 issues scoring price losses for the session.

That said for the time being (until proven otherwise) we have to assume the sellers are back in control as the skew of decliners to advancers suggested they overwhelmed buyers yesterday. We did suggest several days back that after a big rally that buyers were becoming more discriminating at what price they would pay for stocks. So part of the action yesterday was profit taking and also buyers being more selective now the question is where, when and if the buyers make a stand. For the record we believe this to be a classic retesting sequence, however what we believe and what may happen are not always in sync.

For now the market is on the defensive and it’s better to wait for reinforcements (buyers coming back in mass) before getting aggressive on the buy side.

Now not being at the front of the line may mean you miss the early part of the turn (if and when it materializes), however the odds of a successful turn once the front line has made its’ stand is far greater.

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Contact Peter Greene for more information about institutional research & trading:

Trading/Institutional Contact

The ‘Green Shoots’ of recovery that has been the favorite two words of many of late has been mostly predicated on the dramatic drop seen in inventories over the past few months and the subsequent inventory replenishment process that may help to stabilize the economy. The CEO of TXN in last nights earnings press release sums up this scenario well with a necessary caveat, “demand for our products has begun to stabilize after sharp drops in the past 2 q’s. Many customers have increased orders for TI products as they have begun to slow down their inventory reductions. However, we remain sensitive to continuing weakness in the global economy, and we have yet to see signs of a broad based recovery in our business.” With the results and release of the ‘stress test’ just two weeks away, the man leading the process, Mr. Geithner, testifies at 10am in front of the Congressional Oversight Panel. German ZEW rose to the highest since July ’07.

Has stock market rally run its course?

I highlighted the short-term overbought nature of the stock market in my “Words from the Wise” review two days ago, saying:

“From a technical perspective, a primary bear market still exists as long as the major indices remain below the January highs and the 200-day moving averages. Many of the rally’s leaders (indices and sectors) seem to be running into major resistance at these levels and look susceptible to retrace at least a portion of the gains since the March low. Further evidence of a short-term top in the making comes from a chart showing the percentage of S&P 500 stocks [90%] trading above their 50-day moving averages.”

Not surprisingly, investors’ lingering worries about the financial sector resurfaced yesterday, pulling the S&P 500 Index down by 4.3% and the Dow Jones Industrial Average by 3.6% – the worst losses since early March and in all likelihood a so-called 90% down-day.

While the short-term movements play themselves out, it is important to remember that the longer-term charts have not yet signalled a secular uptrend. Using monthly data, the graph below shows the multi-year trend of the S&P 500 Index (green line) together with a simple 12-month rate of change (or momentum) indicator (red line). Although monthly indicators are of little help when it comes to market timing, they do come in handy for defining the primary trend. An ROC line below zero depicts bear trends as experienced in 1990, 1994, 2000 to 2003, and again since December 2007. Having said that, the level of the indicator is grossly oversold, as confirmed by the RSI indicator (blue line).

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Good Evening;   In what could described as a less than fairly tale ending, the six week rally in both financial shares and the U.S. stock market came to a halt today.  Another dose of economic reality didn’t help, but it seemed that the proximate causes were some so-called “earnings” from Bank of America and a less than flattering appraisal of Citigroup’s recent report.  It’s also quite possible that the rally since March 6 was simply in need of a breather, but today’s 15% drop in the KBW bank index reminded me of the boy who shouted, “But he has nothing on!” while viewing his Emperor’s invisible new clothes.

Other than some typical, post-expiration blahs, I didn’t see any early news that put our stock index futures on the defensive this morning.  Soon afterward, however, Bank of America announced it had tripled its earnings in Q1 versus those it had reported a year ago (see below).  Poorly performing loans rose sharply, and since the numbers were laced with one time gains, including $2.2 billion for a drop in the value of some Merrill debt, analysts and investors alike were unimpressed.  Nancy Bush put it thusly:  “It was a quarter with extremely low quality earnings and climbing credit costs,” said Nancy Bush, an independent bank analyst. “It’s not a healthy picture.” (source: Bloomberg article below).  BAC dropped 25% in today’s trading, finishing on its low tick.

Fanning these early flames among financial names was a report from Goldman Sachs about the equally alarming rise in credit losses at Citigroup.  Citi reported $1.6 billion in “earnings”, but according to Goldman Sachs analyst, Richard Ramsden, C actually suffered an underlying loss of 38 cents per share when the report is stripped bare.  Trading north of $4 on Friday, Citigroup finished Monday with a 2 handle.  With these two financial giants exposed, market participants ran for cover.  Leading indicators, at -0.3%, were a tenth worse than had been hoped, and a rise in the dollar sent energy and materials names to the dungeon.  Just like that — last week’s voracious risk appetites were suddenly sated.

Opening 2% lower, the major averages never once mounted a rally worthy of the name.  Slipping more with each passing hour, most of them closed right on their session lows.   BAC-MER economist, David Rosenberg, makes a fundamental case why the rally into last Friday may have gone too far (see below).  And, after today, the technical picture isn’t exactly a bright one, either.  The 4.3% loss in the S&P 500 was bracketed by a 3.6% drop in the Dow and a 5.6% shellacking in the Russell 2000.  As one might expect during a day when risk is shunned, Treasurys performed quite well.  Yields dropped between 6 and 12 bps across a flattening yield curve.  As mentioned above, the dollar was also sought; it rose nearly 1% against the other fiat currencies.  The currency no central bank can print (gold) also benefited from today’s return to risk aversion, but the rest of the commodity complex fell out of their collective chairs.  A 9% plunge in crude oil was a headline-grabbing factor in today’s 4% fall in the CRB index.

One of Hans Christian Andersen’s more beloved fairy tales is “The Emperor’s New Clothes”.  For those who only remember that “no” could be substituted for “new” in the story, here’s a refresher from the latest Wikipedia entry:

“An emperor of a prosperous city who cares more about clothes than military pursuits or entertainment hires two swindlers who promise him the finest suit of clothes from the most beautiful cloth. This cloth, they tell him, is invisible to anyone who was either stupid or unfit for his position. The Emperor cannot see the (non-existent) cloth, but pretends that he can for fear of appearing stupid; his ministers do the same. When the swindlers report that the suit is finished, they dress him in mime. The Emperor then goes on a procession through the capital showing off his new “clothes”. During the course of the procession, a small child cries out, “But he has nothing on!” The crowd realizes the child is telling the truth. The Emperor, however, holds his head high and continues the procession.” (source: Wikipedia)

This timeless tale comes to mind when viewing the many financial stocks that had until this morning been parading around, hoping not to be seen as similarly draped in fictitious finery.  Each outfitted with the best TARP your taxes can buy, and stitched together with the thread of all but invisible mark-to-fantasy accounting, our nation’s banks have been prancing about to rave reviews ever since the early March memo proclaiming Citigroup’s “profitability” during the first two months of 2009.  Phase one of the resulting liftoff in bank shares was further fueled when other institutions came out and claimed their companies were also profitable using what I then called ”EBITDAW” accounting — Earnings Before Interest Taxes Depreciation Amortization and Write-downs. 
The KBW bank index then entered the booster phase of this rally on April 9 when Wells Fargo “pre-announced” stunningly positive earnings.  It helped usher the KBW Bank index to a level that just more than doubled the March 6 nadir.  Now that Citigroup and Bank of America have finally reported, the rally in financial names has ended where it began, with C and BAC.  The actual results are seeing the light of day, and analysts and investors are seeing less to like with each new accounting disclosure.  Whether the sell off we saw during Monday’s session is just some quick profit taking or the start of something more sinister, only time will tell.  Today just happened to be the day someone at Goldman Sachs finally shouted, “hey, these banks really aren’t making any money!”.

– Jack McHugh

U.S. Stocks Tumble as Financials, Commodity Shares Retreat

Oracle to Buy Sun for $7.4 Billion as IBM Talks End

Bank of America Shares Decline on More Bad Loans

Citigroup Credit Losses Rising Rapidly, Goldman Says

Reversible rally or reflexive rebound?