This is part of my continuing diatribe on the state of the US and global banking system. As a backgrounder, and to get caught up on where I am coming from, see:

• Banks, Brokers, & Bullsh1+ part 1
• Banks, Brokers, & Bullsh1+ part 2
• Banks, Brokers & Bullsh!t part 3 - Shenanigans at Morgan and Lehman
• I know who's holding the $119 billion dollar bag!
• Is this the Breaking of the Bear?
• The worst is behind us, unless massive bank failure is considered a bad thing
• Reggie Middleton on the Street's Riskiest Bank - Update

In my most recent post, I admitted to being disappointed in myself for allowing volatility to drop my personal investment results below my internal 110% annualized return goal. This volatility stemmed from financials and the broad market rallying due to the "alleged and percieved mollification of systemic financial system failure". Now, I never believed we were at risk of systemic failure. That was just the fodder of tabloidal media outlets. Asset securitization and OTC counterparty credit risk management is on the verge of systemic failure, though, and these are significant portions of our financial system. I don't think these failures will bring the whole financial system down, just the portions that need it. We were, and still are, at risk of a correction where the excesses of the past will be shaken out and weaknesses in our system will break and then be eliminated, bringing down the players that were overly reliant on those weaknesses. Examples of these weak points are:

• the lack of propert due diligence and credit risk management in the credit default swap markets,
• the monoline cum multiline industry,
• excessively leveraged structured products written on top of a real asset bubble,
• poorly underwritten, covenant none leveraged and high yield loans,
• poorly underwritten consumer debt,
• the peak passing and return to the trough of the most recent business profit cycle (banks and financial institutions in particular),
• the return to mean of real asset prices.

A quick perusal of this weeks news and analysis pretty much reveals what I thought to be the case - this bear market sucker's rally will probably end in a deep downturn and entrance (continuation of) a prolonged bear market. These wide swings are the cause and source of the volatility that has now forced me to implement return robbing dampeners to quell these wide swings. I am also in a quandary. Should I allow the volatility to persist, for the aggregate risk adjusted return is still way above most other's efforts and alpha is being generated over both broad market and hedge fund indices, or should I spend the time and money to dampen both volatility and return to make everything look pretty and ease my own stomach? The answer really relies on who sees my returns and what kind of observers they happen to be. I think that too many investors are trying to mimic the steady fixed income-like and large cap returns that are the bread and butter of many institutions. The problem with that is that it actually reduces returns over the long run and introduces risk. I don't have time to get into this now, but it will definitely be on the table for a future blog posting.

Now, back to this week's events:

Credit risk as measured in CDS markets recedes significantly after Fed bail-out of Bear Stearns and introduction of discount window and long-term swap facilities by central banks in UK, EMU, and U.S. Some analysts see this as evidence for receding systemic risk and the beginning of the end of the credit crisis. Since I never saw the risk as "the end of the world", but more as "the end of the world as we know it" (not catastrophic, but both systemic and necessary), I won't get into this debate here and now. Just realize the risk is truly significant, and has yet to be purged. As I have always alleged, this is a solvency issue, not a liquidity issue and the Fed is trying to extend the banks lifelines in the form of liquidity to allow them to earn their way out of the solvency hole. The problem is that the hole is so big, more than Bear Stearns is likely to fall into it - AND - this is the end of the high profit portion of the Wall Street business cycle and we are trendind downwards. They will not be able to earn their way out of it in a down business cycle. As a matter of fact, after forenscically reviewing the latest earnings reports of Lehman and Morgan Stanley (the Street's Riskiest Bank), you will find more public relations, marketing, one time non-cash gains and shenanigans than actual cash earnings - see Shenanigans at Morgan and Lehman. Commercial and regional banks are sitting on the fastest growing pile of NPAs and the thinnest capital ratios since the S&L crisis, which we are most likely doomed to repeat - The worst is behind us, unless massive bank failure is considered a bad thing.

In "Why this Crisis is Far from Finished", Mohamed El-Erian chimes in agreement with me, which shows just how smart he is.

Commercial Banks Step to Fed Window: U.S. commercial banks this week increased their use of the Federal Reserve's discount window while investment banks cut their use of a direct-lending program, a sign that the focus of credit strains may be shifting from brokers to depository institutions. Like clockwork, as I comment on and short the regional and commercial lenders, there issues come out to the forefront.

Here's the take from Insitutional Risk Analytics :

In particular, in the two decades of Greenspan's tenure, the Fed's Washington staff, other regulators and the Congress allowed and enabled Wall Street to migrate more and more of the investment world off exchange and into the opaque world of over-the-counter derivative instruments and structured assets. This change is described by people like Greenspan and Treasury Secretary Hank Paulson as "innovation," but our old friend Martin Mayer rightly calls it "retrograde."

In a market comprised primarily of exchange traded instruments, there is little or no counterparty risk. OTC trades which reference exchange traded benchmarks are likewise far more stable. By replacing exchange traded securities with ersatz OTC instruments, Greenspan and the quant economists who dominate the Fed's Washington staff have created vast systemic risk that need not exist at all and that now threatens our entire financial system.

BSC failed not because it had too little capital or too little liquidity, but because the thousands upon thousands of OTC trades which flow through the firm's books are bilateral rather than exchange traded. It was the understandable fear of counterparty risk, not a lack of capital or liquidity, which killed BSC. The irony is that the "financial innovation" of OTC derivatives and structured assets takes us backward in time to the chaotic situation that existed in the US prior to the crash of 1929.

Would that the Congress and the Fed had the courage to confront Paulson and the other banksters who have turned America's financial markets into an increasingly unstable, derivative house of cards. If all federally insured commercial banks, mutual and pension funds were required by law to invest only in SEC registered, exchange-traded instruments, the threat of further systemic risk could be eliminated tomorrow. What a shame that neither Chairman Bernanke nor FRBNY President Timothy Geithner said that last week when they appeared before the Senate Banking Committee...

...

The IRA: So what is the Rosner view of the world? The party line in Washington and on Wall Street is that everything's fine and we'll return to normal growth in the second half of 2008.

Rosner: I see troubles radiating outward. What I mean specifically is that there is no functional change in the problems in the mortgage markets. What is really making us feel OK, at the moment, is the fact that banks are destroying shareholder capital and that they are raising new money. That's all well and good, but we still have not changed the underlying reality, namely that most of the losses taken so far are due to mark to market issues. We have not yet really seen the bulk of the underlying credit losses.

The IRA: Ditto. We have been talking about this for six months, but there seems to be a refusal on the part of many observers to accept that the losses reported to date have been primary trading book write downs vs. actual charge offs of loan losses. Citigroup (NYSE:C), for example, did just 120bp in aggregate charge offs in 2007.

Rosner: There is a lack of appreciation or maybe a lack of understanding between these two issues, mark to market losses and actual credit losses, and we need to distinguish between these two issues. I continue to believe that we are going to see further downward pressure on home prices -- regardless of what the Congress believes or intends or manipulates. Unless we actually nationalize the housing industry, there is not much we can do to avoid the downward correction in home values....

I've been beating this drum since I started this blog. You cannot lever up at the top of an asset bubble, allow that bubble to pop, and expect to delever and wait for asset values to return to bubble top prices. It they ever return to those prices, it will probably be a long ways off. The best way to explain this is with a visualization. We are now at the top of that big spike you see at the right of the graph. There is no way in hell we are going back there any time soon, and if you borrowed 8 to 30x your equity to buy stuff at that peak, you're done - plain and simple. Look back 115 years. For over a decade, and since the remnants of the US gold rush, we have never seen a spike off of costs on a nominal or real basis as we have seen over the last 7 years. Mark to market losses will be real credit losses in just a few more quarters - believe it. The Ambac, MBIA AAA fallacy is just that - a fallacy and those mark to market losses are already becoming actual operating losses at a much quicker pace than nearly all but a small handful of us believed - Ambac does it again. Who are the biggest counterparties to these guys? See Banks, Brokers, & Bullsh1+ part 2 and I know who's holding the $119 billion dollar bag!

Alas, I digress, and back to the interview with IRA:

Rosner: We are starting to see an acceleration of the delinquencies and loss rates moving from subprime through alt-a through the prime market. GSEs like Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) are in no position frankly to do much to save themselves let along save the market.

The IRA: Agreed. Cap or no, we can't see how either FNM or FRE can lever up to take more risk. Are we missing something?

Rosner: Yup. The GSEs have come up with yet another bright idea to add to their financial woes. Haven't you heard? What FNM is doing, which goes back to the accounting shenanigans, is actually using most of the capital relief granted by OFHEO for their "Home Saver Advance." Most people outside the real estate industry are not following this at all. FNM has now crept out of their secondary market role and into the primary market. We have heard nothing from HUD, OFHEO or the FM Watch folks about this.

The IRA: We are shocked. Go ahead.

Rosner: FNM has announced that they will give a $15,000 loan to borrowers with negative equity so that they can pay down some of their principal balance and therefore refinance into a new mortgage. First of all, this loan is not secured by the property but rather by the personal guarantee of the borrower.

The IRA: So FNM is getting into the consumer lending business? Looks like more mission creep.

Rosner: Basically, yes. It is unsecured debt. So FNM is no longer just operating in the secondary mortgage market but in the primary consumer lending market. Second, what they are really doing is paying that $15,000 because it is cheaper than having to buy defaulted loans out of mortgage pools guaranteed by FNM and cover arrears.

The IRA: Kind of, sort of looks like modification? Or not?

Rosner: No, the GSEs have been doing modification. This is something worse than that. With a bank that modifies loan, someone has to take the loss when the loan re-defaults. Here, FNM and FRE are modifying but without the increased security of the underlying asset. They're actually taking an unsecured exposure.

The IRA: Yup, which they will end up eating. The loss given default on these "homeowner saver loans" will be 100%.

Rosner: Yup. And given that re-default rates on modified loans were north of 20% in good times, it will be interesting to see how bad it gets this time around. The GSEs are trying to outrun problems that are faster than they are...

...

The IRA: You've been speaking to a lot of bankers and government officials outside the US. What is your perspective on the housing credit situation outside the US?

Rosner: Let me circle around to that. The credit problems are spreading into the prime market. They are already visible in the home equity line of credit market. The HELOCs are typically committed lines and frankly people often forget that in some respects, at least in this cycle, the consumer lenders, revolving lenders, credit card lenders, are in a better place that the HELOC lenders. The revolving and credit card lenders can change your available lines overnight and change your rate terms with the same speed. The HELOC lenders cannot.

The IRA: The latest line out of the banks is that they see a growth opportunity in small business credit card lending. The mail solicitations from lenders like C and Advanta that we've reviewed feature terms that encumber the small business as well as the individual, and then kick the rate up to 31% APR the first time you are late. What does a 31% penalty rate say about the probability of default on that portfolio?

Rosner: Yes, except for the fact that it is a terminal probability. What I mean by that is that the last asset which a borrowed defaults on is the primary mortgage...

The IRA: At least it used to be. The FT reported a while back that the 2006 production was the reverse, with borrowers defaulting on mortgages before credit cards or auto loans.

Rosner: No, the mortgage still is the last thing to go into default. The borrowers we've see default already are those with no other resources. Where I think we see the next leg and what I am watching carefully now is that we are seeing the drawdown of committed but undrawn lines of credit by distressed borrowers who are taking cash out of the line to pay first their primary mortgage and then revolving lines of credit. At some point we reach a terminal period where they default on their credit card and then their primary mortgage. I'm not sure it does not go in the other order, but we'll see. That is the reason, I believe, that we've seen a little bit of a slowdown, a respite from a massive spike in defaults, because the borrower who is Alt-A and prime largely, even with the decline in home values, still has access to credit. Consumers do not give up spending of their own volition. They do so only after they have exhausted all other options.

The IRA: Suggesting that we could be headed to a huge uptick in default experience in unsecured and mortgage loans in the not too distant future?

Rosner: Yes, we will see the drawdown of HELOCs until they are exhausted, resulting in an eventual upsurge in defaults on mortgage-related and revolving credit.

The IRA: It is funny you raise this issue because we have been watching the slow decline in Exposure at Default which we calculate for all US banks using The IRA Bank Monitor. There are only two reasons for such a broad, secular trend; either people are using available lines or banks are reducing exposure by cutting unused lines.

Rosner: Right, it is pretty hard for a lot of the banks to reduce consumer lines, both from a contractual perspective and from an operations management perspective. I would be very wary of institutions that have HELOC exposure. For the time being, I would be less concerned with the credit card companies. And then there is the situation in commercial real estate, where the wheels are starting to shake and even fall off the wagon...

...

The IRA: So let's go overseas for a second. We know you have to get packed and head back to the airport.

Rosner: In the UK, we have already seen a 10% decline in commercial real estate values. And my contacts in that market expect to see a further 10% decline from there. In that context, when you hear reports of further new build in the US commercial market, that only confirms my belief that we will see our market fall as well. For the large international Basel II institutions, none of this is good news. The same global banks with exposure to the US residential and commercial markets also have exposure to the burgeoning problems in the Spanish real estate market, Irish housing problems, UK housing problems, and Italian housing problems.

The IRA: So do we detect the first signs of interest rate ease in the EU?

Rosner: Definitely. I think we are at the front end of the day when you want to be long the dollar and short the Euro. The Spanish mortgage market funds in the repo market, not via deposits. I think that at some point there is going to be significant tension in Europe because the Germans and the French are not going to want to finance Spanish mortgage collateral. This could be the catalyst for a crisis in Europe. Do I think that it will spell the end of the Euro? No. Do I think that it will create a period of uncertainty? Yes.

The IRA: You mean that German and French banks will no longer want to finance Spanish real estate speculation for the benefit of UK retirees?

Rosner: Yes, especially if you remember that the Germans are already going to be licking a lot of wounds. The good news is that the German Landesbanks have no more than 25% of their float to the public. The bad news is that the German federal government is going to have to bail out the state governments.

The IRA: Some of our sources say that the Landesbanks are something like 5x the problems at UBS (NYSE:UBS).

Rosner: Correct. My understanding is that there is one institution with about $50-60 billion in exposure and another has $80 billion. So there is no way that the German government will have sufficient bandwidth to help support the Spanish banks.

The IRA: Maybe Spain becomes the next Iceland?

Rosner: We should differentiate between Northern Europe and the rest of Europe. Where the rest of Europe moves west to get their exposures, Northern Europe mostly moved east. While they have significant exposures to problematic mortgage markets, they don't have the type of exposures to structured assets and so their exposures are not leveraged...

...

Rosner: The housing market woes in the US will not be over before 2010, regardless of what legislative initiatives come out of Washington. The fundamental reason why we are having these problems in the US is that real wages and incomes have not kept pace with home prices since the 1960s and that's what drove demand for these affordability products. Unless the Congress wakes up and let's home prices correct so that we restore some balance between wages and affordability, this problem will remain for years to come.

The IRA: That implies a 40-50% cut in home prices from peak levels and an insolvent US banking system.

Rosner: Yes, long term trends in home prices suggest that we will revert to the peak levels of the previous cycle. That implies that we are going back to the pre-1991 peak home price levels.

The IRA: Yikes. Then you agree with our view that the US government may be forced to take over some of the largest banks?

Rosner: Yes, well, we won't call it nationalization, but in economic terms that is the substance of the situation. One of the striking comments I hear in Europe is that at least with Northern Rock, the Financial Services Authority in the UK screwed up the first time, but then admitted the mistake and publicly nationalized the bank. With Bear, Stearns, the US has nationalized the bank and appointed JPMorgan as conservator, but then US regulators tell the public and the Congress that it was not nationalization.

The IRA: The Fed seems to be incapable of admitting that they screwed up, whether on structured assets or Bear Stearns. I've never heard anyone at the Fed admit, for example, that their active push to allow banks to migrate more and more business over the counter and off exchange has vastly increased systemic risk.

Rosner: The difference between Fed's prior to the Greenspan and the Bernanke Fed is that the former did not see themselves as part of the President's Cabinet

The IRA: Exactly, Bernanke seems completely co-opted by Paulson and the Goldman Sachs mafia that runs the Treasury. Both Bernanke and Geithner seem so weak and lacking in market experience that is almost sad to watch them testify next to banksters like Steel and Paulson.

Rosner: Correct and that is a very dangerous path for the United States.