Increase In Bank Sub-investment Grade Derivatives Reveal A Need For Gold Insurance

The financial crisis started with banks getting burned in the derivatives market. Then TARP was manipulated to help banks get cash. Next came the Federal Accounting Standards Board (FASB) allowing banks to mark to model (fantasy) their real estate assets (cheat). And now we have come full circle once again as banks own more sub-investment grade derivatives today than at the height of the 2008 financial crisis.

Does History Repeat Itself?

In 1929-1933 it wasn’t inflation that caused people to run to the banks and exchange their Federal Reserve Notes for gold coins, but as a result of a run to “real wealth” versus “illusions of wealth.” People in that era knew the value of gold. They knew its history and its ability to maintain purchasing power. This run to real wealth was as a result of the “roaring” 20’s and loose money policy by the Fed.

The following excerpt from A History of Money and Banking in the United States by Murray N. Rothbard describes what he called the “last stand of the laissez-faire, sound-money liquidationists;”

“Professor H. Parker Willis, a tireless critic of the Fed’s inflationism and credit expansion, attacked the current easy money policy of the Fed in an editorial in the New York Journal of Commerce. Willis pointed out that the Fed’s easy-money policy was actually bringing about the rash of bank failures, because of the banks’ “inability to liquidate” their unsound loans and assets. Willis noted that the country was suffering from frozen wasteful malinvestment sin plants, buildings and other capital, and maintained that the depression could only be cured when these unsound credit positions were allowed to liquidate.”

Does this ring true to what is occurring in the U.S. today?

Rothbard goes on to say; “On February 3, 1932, Hoover established a new Citizens’ Reconstruction Organization (CRO) headed by Colonel Frank Knox of Chicago. The cry went up from the CRO that the hoarder is unpatriotic because he restricts and destroys credit (That is, by trying to redeem their own property and by trying to get the banks to redeem their false and misleading promises, the hoarders were exposing the unsound nature of the bank credit system).”

Leave it to the government to blame the People for wanting what is rightfully theirs; their own property. 17,000 banks had failed in 1931 according to Rothbard. Something had to be done to stop this right?

Today we are still feeling the effects of the credit expansion that led up to the 2008 financial crisis. This contraction is only buoyed by Quantitative Easing (QE) by Bernanke and the Fed. But how long can they keep doing this? How long can banks hold out?

The Office of the Comptroller Can Lead A Bank To Safety, But They Can’t Make The Banks Drink From the Safety Well

After the financial crisis of 2008 that lingered on into the beginning of 2009, the Office of the Comptroller of the Currency (OCC) sent out the following bulletin; Investment Securities: Risk Management and Lessons Learned written May 22, 2009 to all  “Chief Executive Officers of All National Banks, Department and Division Heads, and All Examining Personnel;”

Background And Purpose

The ongoing credit crisis and weak economic environment have given rise to numerous difficulties in managing bank investment portfolios. Relaxed underwriting standards in the residential loan sector, a weak economy, and the downturn in real estate markets have introduced greater credit risk into classes of investment securities that traditionally have little actual or perceived credit risk. In many cases, the initial prices and yields on these securities did not fully reflect their elevated credit risk. As market and underlying credit conditions have deteriorated, credit and liquidity spreads have widened, giving way to valuation declines and, in many cases, significant credit rating downgrades by nationally recognized statistical rating organizations (NRSRO).

The key lessons learned via the bulletin were;

  • Undue Reliance on Credit Ratings
  • Limited Investment Portfolio Liquidity
  • Inadequate Valuation of Structured Products
  • Investment Portfolio Risk Management
  • Classification of Investment Securities
  • Risk-based Capital Considerations

Under the category “Investment Portfolio Risk Management” above, they make reference to the previously issued bulletin (circa 2002); OCC 2002-19 “Unsafe and Unsound Investment Portfolio Practices.” In other words, they are telling the banks in 2009 what they have already been told in 2002. But the banks ignored that bulletin, which is in part what led to the 2008 financial crisis with the banks taking unnecessary risk in the derivatives market.

From the bulletin; Unsafe and Unsound Investment Portfolio Practices Securities Rated Below Investment Grade (emphasis added)

The OCC has also observed problems when banks have used their legal lending authority to acquire securities rated below investment grade but have failed to perform the credit analysis necessary to satisfy safety and soundness standards. 4 It is not unsafe or unsound for banks to acquire investment assets using the bank’s legal lending authority; the OCC has issued several precedent letters permitting such transactions. Banks typically use their lending authority to acquire securities when the securities do not conform to either the quality (i.e., investment grade rating) or marketability requirements of 12 CFR 1. However, banks that use their lending authority to acquire securities must apply the same standards of credit analysis, underwriting, and approval as they would normally apply to large corporate loans. In addition, banks must make the decision to use their legal lending authority to acquire securities before purchase, not after. It is unacceptable to buy securities that do not meet the quality or marketability requirements of 12 CFR 1 and then call them “loans” in an attempt to avoid a violation of the investment regulation. Examiners will review all securities a bank acquires with its lending authority to assess the bank’s credit due diligence procedures.

Examiners will review the assets for classification purposes as loans and will require appropriate corrective action when banks fail to acquire these credit exposures in a prudent manner. Securities that a bank acquires pursuant to its lending authority are subject to the accounting requirements of Statement of Financial Accounting Standards No. 115 (Accounting for Certain Investments in Debt and Equity Securities). Therefore, banks must designate them as held-to-maturity, available-for-sale, or trading. Examiners will generally consider depreciation on defaulted securities to be “other than temporary” and require banks to take losses against current period earnings. The use of the lending authority to acquire securities does not eliminate the need to measure, manage and control the investment risks of the securities. It is an unsafe and unsound practice to overlook the risks of investment assets simply because a bank has acquired them under its lending authority.

National banks must understand and prudently limit the price sensitivity and credit exposures of securities acquired via their legal lending authority. As part of their ongoing limits and controls, banks should also periodically obtain current prices for these securities and consistently follow the required accounting standards, including recognizing losses where appropriate. Complex Security Structures. An additional credit issue involves the proliferation of new and complex asset-backed security structures. Two securities with identical credit ratings (e.g., Baa3/BBB-) can trade at significantly different yields depending upon the collateral backing the security and the structure of the securities.

Some banks seeking to generate high yields have begun to purchase securities backed by subprime consumer paper, trust preferred stocks and corporate bonds. As the default rate for some of these asset classes has increased, the securities have depreciated rapidly and many now have “other than temporary” impairment. It is not an unsafe or unsound practice to purchase securities that have high yields simply because of the type of collateral or structural complexity. However, it is unsafe and unsound to do so without an understanding of the security structure and a scenario analysis that shows that the bank has evaluated how the security will perform in different default environments.

The Nations Top Banks: A Trail Of Bailouts, Cheating and Ignoring The OCC

Banks were given TARP funds not too long after Secretary Paulson was running around like Chicken Little to Congress, begging for money. The banks were in dire need of cash, but they didn’t use the money for loans to individuals and businesses so they could help grow the economy. They used the funds to shore up their rapidly dwindling balance sheets that were decimated by the unfolding financial crisis. Banks were then scolded in March of 2009 by the Office of the Controller of the Currency, after ignoring previous written requests to police themselves. They were reminded that they need to not overlook the risks of investment assets and are required to “measure, manage and control the investment risk of the securities” they buy. The nations top 5 banks sub-investment grade derivatives amounted to a total of $4.65 trillion as seen in the following table dated 3/30/2009, just before the Comptroller of the Currency’s “key lessons learned” memo to the banking industry. Just over $3 trillion of those sub-investment grade derivatives were to mature within 5 years.


What About Banks Today? Have They Learned Their Lesson?

Flash Forward To 12/31/2010 and have the banks listened to the OCC, or have they ignored them like they did leading up to the 2008 financial crisis? The answer is they ignored the OCC requests as sub-investment grade derivatives have grown to more than they were at the height of the crisis with over $5.70 trillion, $3.77 trillion of which will be maturing in the next 5 years. This means that total sub-investment derivatives have grown by over $1 trillion in just 21 months since the OCC reminder and sub-investment grade derivatives maturing in less than 5 years have grown by over 700 billion. Are the banks listening? Why not?



Banks Know They Will Be Rescued As They Consider Themselves “Too Big To Fail”

Do banks do what they do because they know they’ll be bailed out, in particular, the largest banks who play these games? Maybe they do, but Moody’s just announced June 2nd that they may cut BofA, Citi and Wells Fargo’s ratings. Evidently J.P. Morgan is untouchable. No mention of the issues with sub-investment grade derivatives in the article. I did see some tough talk though, allegedly stemming from the Dodd-Frank financial oversight law passed by congress last year. You know…the law that gave the Federal Reserve more powers without ever having to audit them….except for a one time audit. The article stated; “The FDIC is working to sketch out how this “orderly liquidation authority” will work. It hopes the fleshed-out plan will convince markets that policymakers are serious about not bailing out financial giants in the future.” I’ll believe it when I see it. Perhaps someone other than the $8 billion in the hole FDIC should be in charge. But maybe that’s why FDIC chairman Shelia Bair is crying to raise the debt ceiling. Why do I flash back to the “Mo Money, Mo Money, Mo Money” segments of In  Living Color right now?

Moody’s may claim they might cut these banks ratings, but I highly doubt they will.

I’ve written a few articles on the bank derivatives issue and had included the beginnings of this analysis in Chapter 4 of my book, “Buy Gold and Silver Safely.”

The Banking Crisis is Far From Over

The Banking Crisis Is Far From Over Revisited – FDIC Troubles and Bank Shenanigans

We know banks aren’t making money the way they used to, by fractional reserve lending. Those who even can qualify for loans today aren’t taking any extra debt burdens at this point in time. Because of the stricter FICO score requirements not too many other people are borrowing, but rather trying to pay down the debt they have, or simply walk away if they are eventually kicked out of the home they have been living in for an average of two years rent free.

I personally know of friends who have been sitting in a house for over 2 years, not paying a dime. Perhaps you do too. The bank has finally caught up to them. But instead of foreclosing, the bank has given them the option to do a short sale. This allows the bank more time because guess what? The bank can say “no” to the price offered. Banks set the price and in my friends case, they set it at $130,000 over what the market value is. The loan is for $1.4 million, the bank sets the price of the home at $730,000 and the value of the home is around $600,000. A foreclosure would have went to auction and the house immediately sold and my friends possibly kicked to the street. What choice do you think my friends took since the bank gave them the option?  This is what banks are doing when they don’t have to mark to market the assets they own. It’s actually cheaper for them to pay the property taxes each year than to take a loss on the loan. But what they are really doing is avoiding the FDIC from knocking on their door because their balance sheets show problems. Believe me, there are more problems than anyone thinks with the banks that have the sub-investment grade derivatives.

Even with record low interest rates, no one is borrowing and banks aren’t lending. The banks have to figure out a different way to make money. They have to be trying to create some sort of income since much of what they used to make via loans, they are no longer receiving. Since the large banks have been failing miserably at the derivatives game. as more of their bets fall into the sub-investment category with a higher degree of default, it might be speculated that they found a way to stop foreclosing altogether, led by who else; Bank of America and J.P. Morgan. You’ll see there names in the sub-investment grade derivative tables above. While this is pure speculation on my behalf, the timing couldn’t have been better for these large banks. Can we trust these banks to not come up with plans to keep them from revealing the truth? Of course they will. If anyone knew the real truth, they would rush to the banks immediately and withdraw their funds just like they did in 1929-1933. Lets take a look at the 1929-1933 era a little closer and see where there might be similarities to today.

Correlations To 1929-1933

During the deflationary credit contraction of 1929-1933, banks were failing at an alarming rate. People were rushing to the banks and exchanging their Federal Reserve Notes for gold coin. That’s because Federal Reserve Notes at the time were actually redeemable in gold coin (silver too). Something needed to be done to stop this conversion. A bank holiday was called and FDR put out an Executive Order asking the People to turn in their gold for Federal Reserve Notes or risk fine and/or imprisonment. Subsequently, the price of gold was raised thus devaluing the Federal Reserve Notes just given to the holders of gold the year prior. Bernanke, in his 2002 speech, Deflation; Making Sure It Doesn’t Happen Here, had this to say about what FDR did;

“Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it’s worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.17 The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt’s devaluation.”

Let me change two sentences in Bernanke’s speech;

“A striking example from U.S. history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases confiscation and domestic money creation.”

“If nothing else, the episode illustrates that monetary actions gold confiscation can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt’s devaluation.”

Now that reveals the truth of what really happened to “save the Fed” back in 1929-1933. Who will save the Fed today? Note: I am not in any fear of gold confiscation today. They would have to knock on everyone’s doors like census takers, asking; “Do you have any gold?” It’s much easier, in times of economic distress mind you, for the government to confiscate or nationalize, 401ks, IRA’s and other pension plans. I’m not saying they will do this, but this is something they control and have easy access to, without fear of the 2nd amendment being used on them.

Bernanke’s solutions from that speech is to do what the Fed did not do (print money) in 1929-1933 to fight deflation. Or at least not enough of it. That’s why we have Bernake and company today giving us QE1 and QE2 and you can bet there will be more QE in the future. As a matter of fact, you can bank on it! Or maybe they will come up with another fancy name for what they do since the QE term is so mainstream now. Have to keep people guessing what they are up to right? Perhaps they can call it ‘Financial Undertaking Collaborating Knowledge Yielding Opportunity Unilaterally” I’ll leave it up to the reader to figure out what the acronym is for it. But instead of “opportunity,” in reality all they do is bring “oppression” and potentially depression.

Bernanke doesn’t understand how the Japanese government has been spending like crazy during their deflationary episode and it has done nothing to stimulate the economy. The real estate market is still down 75% and the Nikkei down about the same. 15 years of throwing money at things has only done one thing for Japan; it’s made it the leader in the world with the highest debt to GDP ratio of over 220% (some say it’s actually higher, and after this most recent double disaster of earthquake and tsunami, and with the radioactive disaster from the nuclear plants to last for years, this percentage will do nothing but move higher).

The only difference between Japan’s situation and that of the U.S., is they are a net exporter and hold $750 billion of U.S. treasuries. The U.S., which it is clear Bernanke is choosing the same path as Japan as their debt to GDP ratio rises accordingly, is a net exporter and OWES $4.6 trillion to other countries, mostly China and Japan. With an unemployment rate that is not improving, and a manufacturing base that has dwindled over the years, we can’t all be making iPhone, iPads and work for Google. While there are some companies that are prospering (many with government contracts given to them by lobbying Congress, but that’s a whole different discussion), the overall economy is and has been in a recession for years. The only thing we are seeing now is the propping up of certain industries, including banks, ethanol, green technology, Universities, Big Pharma, etc. through government programs or bailouts. I didn’t include GM, because the government can’t let them fail. They may need them for the war machine at some point.

So What Will Bernanke Do?

Will Bernanke come after your 401ks, IRA’s and pension plans? How about those annuities just sitting there with the insurance companies? How easy would that be to nationalize? While I do think this is far fetched, like the confiscation of gold in 1933, it actually is a solution to the Fed’s problems. But the Fed doesn’t deserve to be bailed out. The Fed IS the problem, along with the banks they don’t allow to fail. All we want in America is a sound monetary system and to keep pace with inflation if there is some. We want to go about our lives in a normal fashion and not have to worry about our money in the bank. Stop letting the big banks do what they do and potentially destroying the entire system!

Unfortunately, Congress always sides with the banks….”to save the system.”  But at what cost to future generations?

Gold As Insurance

I have said it before, and I will keep saying it until Congress gets their act together. You insure you home from fire and theft. You insure you life from premature demise. You insure you car from any potential damage. You more than likely will never collect on any of these insurances (remember, you can’t collect on your own life insurance, ha). Gold and silver are insurance not just against potential/likely inflation down the road, but against the very real possibility that these sub-investment grade bank derivatives have no counterparty to them but the Fed. It’s either that or default. Either way, expect more bailouts or whatever they’ll be called and expect a higher price for gold and silver.

Some may claim I am biased in what I write because I sell gold and silver. They can claim all they wish, but can’t refute the facts. There is not one anti-gold person out there that can refute these facts about the banking situation. Even Moody’s is raising the caution flag. All these naysayers can do is claim that you can’t go to the grocery store and buy food with gold or silver. Really? That’s amazing news….But answer me this…will I be able to sell my gold and silver at some point in the future at much higher prices once these banks start imploding and buy the grocery store?

Note: We are just entering the summer slow season for gold and silver. This lasts June, July and August. It’s a good time to dollar cost average into a position. I expect that silver could test its 200 day moving average of just under $30 during this time. It’s a 40 year pattern that is quite consistent. While there are multiple reasons to own gold and silver at present, and potential problems can arise at any moment, just know that the dollar could get stronger in the months ahead and there may be some pressure on gold and silver during this summer season. However, we are setting up for the buy of a lifetime. We will eventually look back at these prices and be glad we got in on any pullback.

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About Doug Eberhardt

Doug Eberhardt is a 28 year financial services veteran and precious metals broker selling gold and silver at 1% over wholesale cost. Doug has written a book to help investors understand how gold and silver fit into a diversified portfolio, how to buy gold and silver, and what metals to buy. The book; “Buy Gold and Silver Safely” is available by clicking here Contact phone number for Buy Gold and Silver Safely is 888-604-6534


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