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Written: July 18, 2008

Dear Investor,

Not so very long ago, I published here a photo of an honest-to-goodness bank run in England, as depositors tapped politely at the door of Northern Rock Bank in the hopes of receiving their money back.

As you know, the British government charitably stepped forward and, dipping into taxpayers’ pockets, made depositors whole.

Here is another photo of a bank run, this time in the U.S. from earlier this week, as depositors sit comfortably under an awning on chairs thoughtfully provided by the management of IndyMac.





Now, you have to ask yourself a question or two.

Are these two bank failures members of the species of “black swans” you hear so much of these days? You know, outliers that come from nowhere and are expected by no one until they splash down next to you… and bite your face?

Or are they the first wave in an evolutionary process that will soon darken the skies with flocks of the breed?

The answer to this question is of no small importance.

You see, while the great unwashed of investor-world – those that get their investment ideas from watching Jim Cramer’s Mad Money -- can handle a couple of bank failures, even a modest-sized number of same will, almost more than anything else, trigger real panic.

And in times of panic, people run for cover… increasing savings and holding off on discretionary spending… just the sort of thing that can turn a faltering economy into one for the history books.

It is worth noting that, while everyone tends to focus on the stock market crash of Black Monday, 1929, the worst of the bank failures didn’t occur until late in 1930 through 1933, with the Roosevelts’ euphemistically labeled “bank holiday” coming only on March 5, 1933.

With the rally in the U.S. stock markets this week, the financial talkies were abuzz with much speculation that the worst might now be over… and that the skies were bright blue and clear of anything other than swans of the white variety, handsomely offset by a puffy cloud here and there.

It’s a classic bear market trap.

The problems facing the banks are still miles away from being resolved… with the $5.3 trillion commercial real estate market now hanging by its fingertips over the same abyss that residential real estate has already tumbled into, the Fed clinging on its back like a powerless version of Gandalf.

Then there is the darkening picture on credit card delinquencies, which you can see in the graph below.





It is thus clearly in the interest of the banks, desperate as they now are to replace their evaporated capital, that investors not look too closely lest they discover the degenerated conditions and bleak prospects of many of the institutions.

And so this week the banks were pulling out all stops with “news” that could be spun into tidy sound bites such as these…

Citigroup Gains After Posting Smaller-Than-Estimated Loss of $2.5 Billion Citigroup Inc. rose in New York trading after reporting a smaller-than-estimated loss on fewer mortgage-bond writedowns, lower borrowing costs and job cuts.

Citigroup, the biggest U.S. bank by assets, said its second-quarter net loss was $2.5 billion, or 54 cents a share, because of $12 billion in writedowns and increased bad-loan reserves. Analysts estimated the New York-based bank's loss at $3.67 billion. The shares rose as much as 14 percent.

And this…

JPMorgan posted earnings of 54 cents, vs. $1.20 a year ago, and revenue fell 2.7%. However, Wall Street was expecting earnings about 10 cents per share lower. The bank took a $540 million hit related to its acquisition of Bear Stearns.

The JPMorgan report isn't the only evidence that some financial firms are avoiding the full impact of the financial crisis. Also Thursday, PNC Financial Services (PNC), the largest bank in Pennsylvania, said its second-quarter profits rose 19%. Earnings of $1.45 per share beat analysts estimates by 29 cents. On Wednesday, Wells Fargo (WFC) sparked a stock market rally when it raised its dividend and its second-quarter profits impressed investors.

Just as I was preparing to let out a long bottled-up Hip! Hip! and all that, a couple of items came across my desk. The first was an article out of Bloomberg…

July 14 (Bloomberg) -- At an investor presentation in May, Citigroup Inc. Chief Executive Officer Vikram Pandit said shrinking the bank's $2.2 trillion balance sheet, the biggest in the U.S., was a cornerstone of his turnaround plan.

Nowhere mentioned in the accompanying 66-page handout were the additional $1.1 trillion of assets that New York-based Citigroup keeps off its books: trusts to sell mortgage-backed securities, financing vehicles to issue short-term debt and collateralized debt obligations, or CDOs, to repackage bonds.

Hey, what’s $1.1 trillion between friends.

Then Steve H., a regular correspondent and fellow skeptic dropped me an email with the following off of www.minyanville.com.

Two Plus Two Equals Four

Financial companies are desperate for capital, but their stock prices are so low that any issuance would be dilution death for the companies. The government is desperately trying to keep the financial system together. Add that up and you get the possibility of a great manipulation.

How would the government engineer a rally in financial stocks so that these companies can sell stock to raise capital at a reasonable or at least palatable dilution level?

It might go something like this. Since financial stocks are in such trouble, they have heavy short interest; this is natural and well known and can be used to their advantage. A clever “berry” might think to introduce confusing rules that raise the cost of borrowing short stock and temporarily confuse shorts into covering and not shorting more. And this is precisely what the SEC did.

It seems innocuous to most folks, but it put stock loan desks and dealers in complete disarray. New short sellers could find no stock to borrow and many existing short sellers were forced to cover as the technical rules forced allocation of loans at much higher costs.

For example, the rebate rate on Fannie Mae (FNM) the day before the SEC announcement was 1%; the day after it was -5%. Many who were short the stock were forced to cover, thus driving the stock price up.

But this alone would only drive stock prices up so much. The clever berry needs a catalyst, one that would force panic buying into now truncated supply.

It just so happened that the new SEC rules came conveniently the day before many of these financial companies were to report earnings. If just somehow these earnings were really good, the match would be lit on the kindling.
So far banks have miraculously come through on their end of things. Wells Fargo (WFC) and JPMorgan (JPM) reported better-than-expected beaten-down earnings. Things must be getting better just as the companies need capital.

What a coincidence.

But if you look at how the banks “beat” their earnings, the coincidence becomes clear. WFC took the unprecedented step of extending charge-off acknowledgment from 120 days to 160 days. This allowed the bank to move less capital to loan loss reserves and report better-than-expected horrible earnings. And JPM was even more aggressive. It actually lowered its loan loss reserves quarter to quarter.

The list of financial companies where shorting regulations are being enforced/enhanced is precisely the banks and dealers (and FNM/Freddie Mac (FRE)) that have access to the Fed's balance sheet (dealers through the PDCF and FNM/FRE through the recently allowed access to the discount window). So we can speculate on the nature of the ''coincidence'': Perhaps the Fed is getting worried about the value of all that collateral these dealers have posted to the Fed balance sheet and must boost the capital of these companies to protect that value.

And now on cue FRE, a $5 billion market capitalization company wants/needs to issue $10 billion in new stock? Doesn’t that sound a little crazy? Well, get ready for others to do the same because the banking system needs capital desperately and the government is there to help.

But help at the expense of whom?

And the Minyanville contributors are not the only ones noticing what’s going on… just today The Economist published the following commentary that (accurately) paints the SEC in a less-than-favorable light.

America’s SEC fights dirty

BEAR markets often involve bare-knuckle fights, but it is still a shock when the referee starts punching below the belt. The Securities and Exchange Commission (SEC) has intervened in the epic struggle between financial companies and the hedge funds that are short-selling their shares.

Desperate to prevent more collapses, the main stock market regulator has slapped a ban for up to one month on “naked shorting” of the shares of 17 investment banks, and of Fannie Mae and Freddie Mac, the two mortgage giants. Some argue that such trades, in which investors sell shares they do not yet possess, make it easier to manipulate prices. The SEC has also reportedly issued over 50 subpoenas to banks and hedge funds as part of its investigation into possibly abusive trading of shares of Bear Stearns and Lehman Brothers.

The SEC’s moves deserve scrutiny. Investment banks must have a dizzying influence over the regulator to win special protection from short-selling, particularly as they act as prime brokers for almost all short-sellers. There is as yet no evidence that market abuse has driven down financial firms’ share prices—and plenty that their trashed balance-sheets and credibility have. London’s financial-services regulator has as yet failed to provide evidence to justify its decision to tighten the disclosure rules on short-selling of some bank shares.

The SEC’s initiatives are asymmetric. It has not investigated whether bullish investors and executives talked bank share prices up in the good times. Application is also inconsistent. The S&P 500 companies with the biggest rises in short positions relative to their free floats in recent weeks include Sears, a retailer, and General Motors, a carmaker. Like the Treasury and the Federal Reserve, the SEC is improvising in order to try to protect banks. But when the dust settles, the incoherence of taking a wild swing may become clear for all to see.

In past musings, I have wondered aloud what measures the government will use in its attempt to maintain the status quo… or at least the status quo that used to be the status quo until the new status quo grabbed the global economy by the neck last year.

At this point we are, in my opinion, still in the early rounds of the crisis, and the reaction of the “authorities” to the crisis. And the low blows to investors foolish enough to remain in the same ring as the regulators and their cronies are just beginning.

As one frantic, clumsy or heavy-handed regulatory attempt to patch things up fails, things will grow steadily worse, leading, I continue to be convinced, to an announcement by the newly sworn-in President Obama of a new deal whose net result will be to knock the excesses out of the economy with an “ambitious” new body of legislation.

That things will roll out this way is due to the quaint tradition in our modern democracy that the new resident of the White House will do “whatever it takes,” no matter what the effect on the economy, to try and eliminate any long-term negative consequences of the mess left by the prior president. The trick is to “git ‘er dun” early in the new presidency, while the memory of the previous administration’s role in creating the mess is still fresh in the public mind.

The problem is that getting her done this time around would require an approach that is literally foreign to either of the leading aspirants of the highest office of the land… not to mention 99% of officialdom, elected and otherwise.

Of course, I arrogantly assume that I know the solution… to let the failed banks fail, to end the fiat monetary system, to cut the size of government in half… for starters… etc. An anarchist/libertarian utopian dream, to be sure. But before writing it off, take a close look around and then tell me how well you think the current Frankenstein model that is just one tick away from communism is working out?

Because I am, once again, massively time-stressed, I will have to leave it there… but as it is a given that Obama will approach his new deal using more traditional – which is to say “statist” – methods, I would love to hear your best bets on what sorts of “tough love” measures the newly elected president will take in an attempt to right the listing economy. Correctly anticipating his moves could lead to a serious money-making opportunity for properly positioned investors.

Drop me your thoughts at david@caseyresearch.com and I’ll run the more cogent thoughts in an upcoming edition.