Big banks learn K1 hedge fund returns were unbelievable

Who could lose money on performance like this?

This just in: Barclays, JPMorgan and BNP Paribas are swallowing $400 million in losses after making loans to German-based hedge fund firm K1 Group– now under criminal investigation, Bloomberg reports.

The returns were unbelievable: The K1 Global Fund claims to have steadily risen more than 900% since 1996. The Dow Jones Industrial Average gained about 90% in that same time frame. But the banks apparently weren’t concerned about K1 which invested in a variety of hedge funds. Here’s possibly one reason, according to an expert quoted by Bloomberg:

Lending to firms that invest in a variety of hedge funds is considered safer because risks are spread among a variety of managers, said Michael Statz, founder of Fiducia Capital in Munich, a hedge-fund consultant. Banks typically use the fund stakes as collateral. If one of those funds loses money, banks can force the sale of other stakes to avoid losses on their own books.

Why does this sound so familiar?

Graphic via FT Alphaville blog

Banks prefer Uncle Sam at arm's length

Chocolate-coated bank sale

Banks are stressed out. Not about their capital base or loan loss reserves. They’re stressed out about an uninvited guest sitting in their boardroom. Timmy, you’re mother is calling you.

The feds have determined that our biggest financial institutions need about $75 billion in equity to shore up their capital bases. If the banks can’t raise the money, the folks over at Treasury have a plan that could eventually give it a substantial stake in the banking system. As far as they’re concerned, banks think Geithner& co are swine flu carriers. No, thank you. Take a look at Citicorp or GM or Freddie Mac and you’ll understand why: Government ownership is no fun. Freddie Mac’s CEO quit earlier this year after just a few months on the job, reportedly because he couldn’t stand clearing every decision through the regulators. And banks with bailout money are not happy to hear from taxpayers yelping about their outsized paydays.

So the banking giants are on the prowl in the capital markets.

Wells Fargo has already announced plans to raise $6 billion in stock; the stress test results reveals that it needs a total of $13.7 billion. Morgan Stanley, which needs a mere $1.8 billion, says it will raise $2 billion. Bank of America, in search of nearly $34 billion, plans on raising $17 billion through stock sales and conversions of preferred shares to common. It will raise the remaining $17 billion through asset sales. BoA has had a singularly testy relationship with the Feds and is pushing back hard to get them out of its hair: CEO Ken Lewis is saying no thank-you to a loss-sharing deal with Treasury to backstop losses on up to $118 billion in assets. Now that’s confidence.

To be fair, Treasury is not all that anxious to become a shareholder in Wells Fargo or any of the other companies that came up short in the Supervisory Capital Assessment Program. The terms of engagement are not nearly as attractive as other government programs that hand out money in exchange for different types of assets at reduced rates. It’s geared to get banks out of their hair. And the paperwork on the capital plan, which would allow banks to exchange the TARP preferred for something called mandatory convertible preferred shares, is much more complex.

Amazingly, the stock market is loving the results of the stress test. Geithner and Federal Reserve Chairman Ben Bernanke have convinced everyone that the banking system is perfectly solvent, just a little bruised. And without any real peek inside the bank portfolios, investors are accepting the say-so of the dynamic duo. The report gives a sense of some weak spots but doesn’t lift the veil on the toxic assets — originally considered the vortex of the problem.

But after a quick run through the numbers, I can tell you the banks all have weak spots and the stress test was not so stressful. In the worse cast scenario, it assumes GDP declines by 3.3% in 2009 and edges up 0.5% in 2010; unemployment would rise to 8.9% in 2009 and 10.3% in 2010.

Even JPMorgan Chase, the golden boy of the bunch, has some real weak spots. According to the stress test, in the so-called “more adverse than expected” circumstance, JPM would need to write off $21.2 billion in credit card loans, or 22.4% of its portfolios. But lucky Jamie Dimon: His capital cushion can absorb the onslaught, the regulators declared

Citicorp would need to write off $19.9 billion or 23% from its credit card portfolio in the more adverse scenario. It is still short $5.5 billion in capital. And that’s after $87 billion in government support and preferred share conversions. The bank that never sleeps probably should have caught a few Zs before okaying second lien mortgages. Expected losses: $12.2 billion, or 19.5% of the portfolio.

It will be wondrous to track Morgan Stanley, Wells Fargo and Bank of America as they test the appetite of investors for new bank shares. Their stock has tripled in value this year, so somebody sure must like them. And if all else fails, before these too-big-to-fail giants faint into the arms of the taxpayer, they could try one last thing, a suggestion from @insomniacdee on Twitter: A massive bake sale.

Image via Flickr

Banks need more capital but credit crunch may be easing

The much talked about  federal stress test of the nation’s largest banks shows ten of 19 institutions will need more capital, but are unlikely to dig into TARP funds, the Wall Street Journal reports. That signals further thawing in the markets as investors remain in glass-is-half-full mode. Rather than hurting bank stocks, the leaked results are boosting confidence, creating a self-fulfilling prophecy which could help get the economy unstuck and ease the credit crunch. For the most part, investors don’t even seem concerned about the integrity of the stress tests.

Administration officials believe many banks will be able to raise capital without tapping the Troubled Asset Relief Program’s remaining $109.6 billion. They’re optimistic the bulk of the money will come from private investors made more confident by the glut of information provided by the tests. Banks could sell assets and stakes in their companies, a move that could accomplish another government goal of shrinking some of the country’s largest banks.

Officials say banks that can’t tap private markets will be able to raise capital by agreeing to convert some of the government’s existing preferred shares into common equity, a move that would leave the government owning chunks of the nation’s largest banks.

via More Banks Will Need Capital – WSJ.com.

Bank stocks have helped lead a monster rally this spring. The S&P500, now at 907.24, is up 34% from its 12-year low posted in March and has erased its 2009 losses. (The index, of course, is still down 42% from its all-time 2007 high.) Banks are lower for the year, but have tripled since March.

There’s more good news: Some credit markets are easing, which is always a critical ingredient in stock market rallies. Through mid-April, corporations sold $975 billion in new issues globally, a record, according to Dealogic. On Monday, the WSJ reports that companies sold $10 billion of bonds through another government program, the Federal Reserve Term Asset-Backed Securities Loan Facility. Initially, interest in the program was tepid, a bad sign for the credit crunch. Unlike TARP, TALF’s sole purpose is to get more cash into banks so they can lend. The weak response was worrisome.

That changed Monday. A small group of investors asked J.P. Morgan Chase to put together a bond offering backed by credit-card loans that is eligible for the program. The $5 billion deal is the largest yet of the TALF-eligible offerings, according to Barclays.

The J.P. Morgan deal sold at 1.55 percentage points over the one-month London interbank offered rate.

Banks sold $8.2 billion of securities under the plan in March and $2.57 billion in April.

Throughout the crisis, banks have been hesitant to lend — and rightly so. Their health and the health of many borrowers have been questionable. The most recent Federal Reserve survey of senior lending officers reveals that bankers in April are still tightening lending standards — but not as intensively as they did in January. Things are easing up a bit for businesses, but are still pretty tough for mortgage borrowers. Does anyone (besides ACORN) really want looser lending standards?

Taxpayers have been hoping that TARP money would pry open the wallets of its recipients. But other programs are better suited to achieving that goal, like the FDIC guarantee of debt issued by financial institutions. More than $100 billion in FDIC-guaranteed securities have been sold this year — including by Goldman Sachs, an unlikely candidate to lend to retail consumers. (That’s another story for another day.)

Treasury has consistently misled on TARP — initially established as a buyout fund for toxic assets. Turned out Treasury couldn’t figure out how to execute that plan; the markets were in too much turmoil to price the troubled assets. Treasury changed course and said the money would be used to get banks lending again. Bert Ely, a banking consultant, says TARP should really be used to bolster the capital base of the banking system so that it can regain its footing and then resume lending. Most recently, he cautioned against banks being forced to lend before they are ready. Besides, he notes, in 2008 lending actually rose 5.63% at commercial banks, but they account for about only one-fifth of lending.  The rest comes from the securities markets and other types of financial intermediaries, like insurance companies. Ely sees the state of lending quite differently form the mainstream press: “The economy is in recession and working off the consequences of a housing bubble fed by excessive mortgage credit. Given that loan demand typically falls during a recession, it’s amazing that bank lending increased as much as it did last year. It was essentially flat during the 2001 recession.”

In sum, the market response to the stress test suggests that banks will be able to raise money to shore its capital; investors are ready to invest in asset-backed securities, which should supply more cash to lenders to do what they are in the business of doing: lending. And that is really the only safe route to ease the credit crunch. The next question: Are the stress tests real? Will the markets get a rude surprise Thursday and decide banks are in much worse shape than currently believed? Nouriel Roubini, aka Dr. Doom, published an OpEd piece in the WSJ today that challenges the credibility of the stress tests and calls for greater oversight of government funds. He notes that data from the International Monetary Fund point to extensive insolvency in the banking system. But the markets aren’t interested  in the doom-and-gloom scenario.

The banks still face plenty of challenges and the bailout has plenty of leaky holes in it. Roubini outlines a list of outrageous behavior that persists in the sector. And homeowners are still suffering. But the banks and government may be getting smart, leaking news of the stress tests in a way that manages market response. It will be interesting to see if the details released Thursday match the snippets of information leaked over the past few days. Stay tuned.