In light of worsening economic conditions, the Federal Reserve Board should continue to conduct stress tests of the nation’s largest bailed-out banks, a congressional panel said.

The Congressional Oversight Panel, while complimentary of the stress tests conducted earlier this year on 19 major banks, said that an unexpected increase in unemployment meant that the tests were already outdated.

The original stress tests projected the health of those banks under various levels of future economic distress. In the worst-case scenario, the tests assumed a 2009 unemployment rate of 8.9 percent. In May, however, the yearly average reached 8.5 percent, and if current trends continue, it will exceed previous assumptions.

Nine of the banks that underwent stress tests were found to hold sufficient capital. Ten of the banks were order to raise additional capital, and many have moved aggressively to do so by initiating stock offerings.

To better understand the stress tests, the panel hired two financial risk management experts to review the Treasury’s methodology.

The researchers, Professor Eric Talley and Professor Johan Walden, both of the University of California at Berkeley, found that “the Federal Reserve used a conservative and reasonable model to test the banks, and that the model provides helpful information about the possible risks” the banks face moving forward.

Professors Taley and Walden noted, however, that it was not possible to replicate the stress tests. The Federal Reserve has not disclosed whether it made different assumptions for different banks, and there is no way to check the reliability of the self-reported data that the banks provided to the government in advance of the tests.

“Without this information, it is not possible for anyone to replicate the tests to determine how robust they are or to vary the assumptions to see whether different projections might yield very different results,” the report says. “It may fail to capture substantial risks further out on the horizon.”

Moving forward, the oversight panel suggested that the Federal Reserve continue to conduct stress tests on a regular basis. It also said that banks should conduct their own stress tests and provide the results to regulators, and that regulators should have the ability to order stress tests whenever “they believe that doing so would help to promote a healthy banking system.”  

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When the “Stress Tests” were announced, which not coincidentally was a big part of what led to the bank stock (and broad market) rally, I said at the time:

Once again, America, you’ve been whitewashed by a bunch of insiders who have infested our government and then between the executives and government have conned you.

Indeed, Ken Lewis was on CNBC this morning and all-but-admitted that “the rules didn’t apply”, a fairly strong implication (if not an admission) that the law was simply ignored when it was inconvenient.

What makes you think its being followed now?

Further, Lewis also said that if unemployment continues to ramp neither he or any other bank will find it reasonably possible to make money due to default rates on consumer loans, especially unsecured paper such as credit cards and that the government will find that “politically unacceptable.”

Well? 

We’re about to get an unemployment number that will be within a point of the worst case scenario in these “stress tests”, and the true internal unemployment number (U-6), which represents the number of people not working far better than ignoring anyone inconvenient to count is several points higher than the “worst case” - and its only May!

American Idol is almost over; I recommend exercising your rights and responsibilities of citizenship and raising hell over this faux piece of garbage that was sold to America as “hope”.

Well, here we go again: I told you so!

But, the panel added, the Fed’s worst-case scenario does not go far enough. For example, the “stress tests” conducted by the Fed were based on the 2009 unemployment rate average of 8.9 percent. Unemployment in May climbed to 9.4 percent.

“While no one should gainsay the potentially positive results of the tests, it would be equally unwise to think that those results reflect a diagnosis of all of the potential weaknesses or create a necessarily sufficient buffer against future reverses for the banking system,” the panel wrote.

No kidding?

Folks, I keep coming up with this stuff, but before you prepare to lionize me for being some sort of “soothsayer” please understand that nothing more complicated than sixth grade math is required to understand this crap, and the facts are being intentionally hidden from you, the public.

It gets better.  Geithner has the balls to press Europe for “tougher” stress tests – on their banks:

The Obama administration wants Europeans to put their banks through more rigorous public stress tests to help ensure that the institutions survive if the economy slips from bad to worse.

Treasury Secretary Timothy Geithner will likely discuss the issue in Italy later this week during closed-door meetings with finance ministers from the Group of Eight leading nations.

So let me see if I get this right: We put forward a rigged test that is proved to be inadequately rigorous before its even run, we then “certify” the capital adequacy of our banks based on a known-bad test (after all, unemployment is already above the test levels!) and then we have the unmitigated gall to demand that Europe run more stringent stress tests?

This is some kind of joke, right?  No, in fact it is an outright scam, with all levels of our government involved, including The Fed:

The Federal Reserve said Monday that plans submitted by those banks, if implemented, would be enough to help them survive a deeper recession.

The Fed (and Treasury) lied. 

Again.

Period.

Oh, and while we’re at it, how about if The Fed discloses the mark-to-market losses on their portfolio of garbage securities?

Anyone care to take the “over/under” on $100 billion?

That’s what I thought.

Disclosure: Short Bernanke, Congress and The American People for putting up with this crap coming out of Washington DC.  Long Merkel – if she displays an atomic bird in Geithner’s direction.

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” The federal government should repeat its stress tests of the nation’s largest banks if its assumptions about the severity of the economic downturn prove too rosy, according to a congressional oversight report to be released today.”

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he Federal Reserve significantly scaled back the size of the capital hole facing some of the nation’s biggest banks shortly before concluding its stress tests, following two weeks of intense bargaining.

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Most news outlets seem anxious to join the Treasury’s PR campaign in pronouncing the banks essentially healthy based on the stress test results. There is of course enormous uncertainty around the course of the economy over the next few years, and the results of these stress tests may well prove to be an accurate assessment of the banks’ health, but there are some reasons for believing that the stress tests are likely to prove too lenient.

1) Fraud in mortgage issuance — we know that many of the loans issued in this period involved fraud, more often on the lenders’ side than the borrowers. In these cases, for example where the mortgage application grossly overstates the buyers income or the appraisal hugely overstates the market price of the house, default rates will be far higher than would be expected even in bad economic times. Also, recovery rates will be far lower if the original appraisal price was inflated.

2) Unemployment — in their negative scenario, the stress tests assumed a year-round average unemployment rate of 8.9 percent for the 2009 and 10.3 percent for 2010. The economy is on track to have a much higher unemployment rate, as it is likely to hit 9.0 percent in April. My best guess for a year-round average would be 9.4 percent for 2009 and probably around 10.5 percent for 2010. (These numbers assume no second stimulus, but of course Congress will not sit back and just let the unemployment rate go through the roof.)

3) House prices — the negative scenario assumes that house prices, as measured by the Case-Shiller 10-City index fall 22.0 percent in 2009. Prices in this index have been falling at a 24 percent annual rate in recent months. Given the massive inventory of unsold homes, It is reasonable to expect that this rate of price decline could continue at least through 2009.

What difference would harsher assumptions make? The projected loss rate on first mortgages increases by 45 percent between the baseline scenario and the negative scenarios in the stress tests. The baseline scenario assumes an 8.4 percent unemployment rate for 2009 and 8.8 percent for 2010 (some serious stimulus here), compared to the 8.9 and 10.3 rates in the negative scenario. The rate of house price decline in the baseline scenario was 14 percent in 2009 and 4 percent in 2010, compared to 22 percent and 7 percent in the negative scenario.

So, if my somewhat more negative numbers prove accurate let’s assume that it increases losses by about 20 percent. That comes to an additional $120 billion in losses. That would mean that instead of having to raise $75 billion, these banks would have to raise $195 billion. That’s a qualitatively different picture.

So, are the stress tests worthless? They did provide a much clearer picture of the position of individual banks than we had previously. It is worth noting that this is a 180 degree shift from the original course pursued by Treasury Secretary Henry Paulson last fall. Paulson tried to conceal the situation of individual banks, putting a cloud over all of them. Treasury also should be credited for disclosing many of the specifics of the stress tests so it is possible to do a quick (or more in depth) analysis of its assumptions and explore the implications of alternative assumptions.

Still, it is hard not to conclude that these stress tests and certainly the PR campaign around them, were intended to paint as positive a picture as possible of the banks’ financial condition. If this picture proves to be wrong, then it means that we will have unnecessarily delayed the clean-up of the financial system. It will also be bad political news for the administration (Geithner and Summers will presumably be joining the ranks of the unemployed).

Of course, the big second stimulus package that Congress will pass this summer, will save both the banks and the administration.

–Dean Baker

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First up, let’s talk about the stress tests. Personally I could just as easily forget about them, because as I’ve said over and over again, the government wasn’t going to “spook” the markets with “true results.” This whole “exercise” is a just another effort to make us all “feel good.”

OK, the rumor mill has finally been shut down, and the facts, as the government would let us know them to be, are out… Let’s take a gander at the results!

The Wall Street Journal reported it like this: 10 of the 19 largest U.S. Financial Institutions will be required to raise a combined $75 billion in new capital.

The Washington Post reported it like this: Nine of the 19 banks do not need any new capital at all.

It’s all in the way you word it… Both of them are correct… The WSJ tells it like I think most people would want to hear it, while the WP, is for the “Pollyannas” of the world!

When it’s all said and done… This feel good circus is now over, and we can get back to dealing with the financial meltdown, deficit spending, China, and other things that are easier for us to deal with, like the story that came across the screens yesterday regarding credit card charge offs, than a feel good circus! Yes, the credit card charge offs are up 44% versu last year… Now, isn’t that one of those things that makes you go, oooooooohhhhhh nooooooooo!

The currencies drifted most of the day yesterday waiting for the stress tests results, and then rallied at the end of the day with the euro (EUR) pushing past 1.34 once again. The euro has fallen back below that figure again this morning, but remains close to the 1.34 figure.

Yesterday, the European Central Bank (ECB) did what I said would be the prudent thing to do, if you “had” to do it, and cut rates only 25 BPS, instead of the 50 BPS the markets were expecting. The euro had to deal with the dolts that think larger rate cuts are what values a currency… But, as I said before, the ECB wants to be able to come back to the rate cut table, if needed, and cut rates again.

Unfortunately for the euro going forward, ECB President Trichet finally gave in to the “weak links” in the European Union, and announced that the ECB would begin buying bonds to support the credit markets. This move was fiercely opposed by Germany’s Central Bank, the Bundesbank and it’s President, Axel Weber. I’m with the Bundesbank on this one… To bad Trichet “gave in.” This move now throws the European Union on the roster of nations employing quantitative easing… And you know where I stand with that!

Well… Today is the Jobs Jamboree for April… Yesterday, the Initial Jobless Claims fell from 635K the previous week, to 601K… And, just like I said they would… The media was all over this move, pointing out that this is most likely an indication that the recession is coming to an end. Well… Today’s Jobs Jamboree is expected to show a fall in jobs lost too… I guess they haven’t polled Chrysler and GM workers… But anyway, the “experts” believe April’s figure will be right at 600,000, down from last month’s 663,000. That’s quite a ride down the slippery slope don’t you think? I’m going to say that 600,000 is too “pie in the sky” and that the actual number will be disappointing compared to 600K. But again, if it shows a figure below last month’s 663K, then we’ll hear about how all is right on the night, and happy days are here again…

That should boost risk assets… Should…

This article originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a “uniquely refreshing” perspective on the global economy, investing, and today’s markets.

Stress Tests Finally Print

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Good day… And a Tub Thumpin’ Thursday to you! We’re stuck in a rainy pattern here in St. Louis. I just have to hope the rain stops long enough to get in the day game at Busch Stadium!

Well… The stress tests get their public showing today… The rumors continue to be something strange. Strange in that one day Bank of America (BOA) needs to raise $10 billion, the next day it’s $35 billion, and then later in the same day, BOA doesn’t need to raise any capital! Talk about wild swings of emotion! WOW!

The rumor going around this morning is that the banks are all right on the night, and not in major deep dookie any longer. Hmmmm… Didn’t I tell you over a week ago that this was going to be the case? I said it because… I just don’t believe the government is going to “spook” the markets right now and release the “real results”… Of course, I don’t know that to be a fact, it’s just my hunch. I could be all wet… But at least I got the first part correct, if in fact the results print as rumored.

But then, Bloomberg printed a story last night that showed a handful of banks needing between $34 billion and $2 billion in additional capital… So… Let’s see which set of books the government reveals, eh?

OK… So the currencies all sold off on the news yesterday morning that the banks would need more capital, and then came back overnight on the latest rumor. As I said yesterday, the markets are all about the stress tests right now… Actually, I’m surprised the government didn’t delay them one more day so that the focus would be on the stress tests tomorrow, instead of the Jobs Jamboree!

Speaking of the Jobs Jamboree that will take place tomorrow… The ADP Challenger report printed yesterday and indicated that tomorrow’s Jobs data will show less jobs lost, and a number below 600K for the first time in five months! ADP says the jobs lost were 491K… And believe me now and hear me later on this, the media will eat this up, and be all ecstatic about the fall from 600K to 491K… As if 491K is a “good number”! Well, yes, it’s better than 600K… But the reporting should all be balanced… Like… “Is this the turning point in job losses? Yes, their still almost 500,000 for the month, but that’s a fall of over 100,000. While one monthly report does not make a trend, just like one swallow doesn’t make a summer, this is good news, and we’ll be watching for signs of further improvement in May.”

I’m watching the Big Dog, euro (EUR), rally right now, from an overnight low of 1.3250, to its current level of 1.3330, as German Manufacturing Orders surprised this morning with a rise of 3.3% in March. The European Central Bank (ECB) is meeting right now, and is expected to cut rates 25 BPS to 1.25%. I read a couple of stories yesterday regarding the ECB… The writers were saying how the Eurozone economy is in shambles and needs a larger than 25 BPS rate cut… But, I argue with that. The ECB wants to keep some rate cut arrows in their quiver, in case they need more rate cut stimulus in the coming months… They shouldn’t shoot them all now! That’s what the Fed did, and we know what that led to… Quantitative easing!

But the Big Winner of yesterday and last night is the Aussie dollar (AUD)… It’s on a moon shot, since the Reserve Bank of Australia (RBA) left rates unchanged the night before, and issued a balanced statement afterward, with emphasis on waiting to see the affects of the previous rate cuts. The Aussie dollar got an additional boost this morning when it was reported that the unemployment rate in Australia fell for the first time in eight months! The Aussie dollar is 75-cents and change this morning, heading to 76-cents… A seven-month high!

Some commodities have been rising in price recently… I’ve chronicled the rise in the oil price, but here’s one you don’t hear about every day, except of course if you listen to our friend, Jim Rogers, every day! I can hear Jim Rogers talking about sugar as if he’s sitting right here next to me… Sugar is heading to a 28-year high, as the crop in India fell short of expectations… And wheat had gained three consecutive days now, on low yield estimates for the U.S. crop… I hear you, Jim!

I would think that if the bank stress tests “somehow” show no insolvency risk, that risk taking will be back on the table, BIG TIME! So… I would think that if risk taking is back on the table, gold, currencies and other commodities would be singing a different tune.

Yesterday, I told you about how the Indian currency (INR) was rallying, and how my Currency Capitalist colleague, Ashish Advani, gave the currency the thumbs up in last month’s letter, and how Standard Chartered Plc was now bullish on rupees… Well, now add Society General (SOCGEN) to the list of rupee flag wavers! SOCGEN believes the rate cuts in India are a thing of the past, and it will be all seashells and balloons for the rupee going forward.

And while I’m talking about an Asian currency… I might as well head over to China and talk about how their stimulus continues to hit the nail on the head, and help to bring China’s economy out of their slowdown and doldrums. The Peoples Bank of China (PBOC) issued a report yesterday saying that the economy performed “better than expected” in the first quarter. This improved performance is helping the “managed currency” (renminbi) to gain ground versus the dollar once more.

I had a reporter follow up with me yesterday on my thoughts toward what China had on their minds The reported asked me if I thought the Chinese would be under more pressure to allow the renminbi (CNY) to float, if they are really pursuing a “wider use of the renminbi.” I said… I thought the Chinese would receive pressure to allow the renminbi to float, but no more than what they received in the past from the combo of Paulson, Schumer and Graham… (The United States!)

The Bank of England (BOE) is also meeting this morning to discuss rates… I would think it is almost inevitable that the BOE would leave rates unchanged. This has been the prevalent thought in the markets for a week now, and has led to the pound sterling (GBP) making a very auspicious rally to 1.5170! What I think the BOE needs to do now is to sit down with the markets and tell them what direction their quantitative easing (QE) is going. Will they limit the purchases, or increase them, etc… Not that any QE is good, but to be honest and transparent with the markets would be a step in the right direction for a central bank!

Yesterday, Norway’s Norges Bank lowered their internal rate 50 BPS to and internal rate of 1.5%. I was hoping they would only cut 25 BPS, but… This has all the makings of “the last rate cut”… You know, one big blow out to end the summer… Or… A star burns brightest right before it burns out… But, I now believe this will be the last cut in Norway…

Recall many moons ago I called this a “race to zero” regarding central banks around the world cutting interest rates? Well… It certainly has panned out that way, eh?

Have you ever heard of the book, The Black Swan? The author Nassim Nicholas Taleb describes his theory of “Black Swan” as a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations. Obviously we’ve had a few “Black Swans” in the past two years, eh? Anyway, the thing I’m going for here is that Mr. Taleb was speaking at a conference yesterday, and had this to say about commodities and gold… “The global economy is heading into a big deflation though the risks of inflation are increasing as governments print more money. Gold and copper may rally massively as a result.”

Speaking of gold… It has rallied the past two days, but could be just waiting in the wings for confirmation of two things… 1. The bank stress tests don’t show major problems… And 2. The Jobs Jamboree does show falling job losses. Silver has really gotten on the rally tracks too, outperforming gold the past two days! Silver is back above $14… And that’s good news. That is unless you’ve dilly-dallied your days away, and not taken advantage of the cheaper prices that have been available for some time now!

No word from the BOE or ECB, so I’ll just head to the Big Finish now… No wait! The BOE’s decision just flashed across the screens… Let’s see here… Oh, the BOE left rates unchanged (as expected, see above), and they announced that they will increase the size of their asset purchase program (quantitative easing) by 50 billion sterling to 125 billion sterling. Well… Let’s see here, the pound sterling is taking on some water after this announcement, as it should! Too bad for the sterling rally… But increasing QE is not healthy for a currency!

The ECB decision will come in about 45 minutes… I’ll be well on my way to figuring out my currency positions and trades needed by then… So, I’ll just go to the Big Finish now, for real this time!

Currencies today 5/7/09: A$ .7565, kiwi .5935, C$ .8575, euro 1.3330, sterling 1.5085, Swiss .88, rand 8.3440, krone 6.4875, SEK 7.8525, forint 208.75, zloty 3.2325, koruna 19.9250, yen 99.20, sing 1.4675, HKD 7.75, INR 49.27, China 6.8215, pesos 13, BRL 2.1130, dollar index 84, Oil $57.91, Silver $14.11, and Gold… $921.30

That’s it for today… How about that! They found that three-year old boy that’s been missing here in Missouri! YAHOO! I see where the Somali pirates have seized another ship… This time it’s a Dutch ship. We’re all fans of “old school pirates” on the desk here, but NOT these new pirates! My little buddy Alex had a late game last night, but the game was suspended in the third inning because of fog. Sometimes living near a river has its good points, as I was able to get to bed at a decent hour! Of course, those “good times” get wiped out when the river floods, as it looks like it’s getting ready to do, after all the rain we’ve received, and will receive in the next week… UGH! I’m glad that we’re not going to do the multi-city FX tour this year. That was just a tad taxing on me. Tomorrow’s the jobs Jamboree, so start getting ready for that! OK… I’ve got to get this out of here, and get to work; I’m going to the day game today! Of course, you didn’t think I would miss a day game would you? I hope your Thursday is Tub Thumpin’!

This article originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a “uniquely refreshing” perspective on the global economy, investing, and today’s markets.

It’s All About the Stress Tests

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The wait is over.
Stress test results reveal nine of the nation’s 19 largest banks successfully endured the government’s testing and will not require any additional capital, while the other 10 banks must boost capital levels by a collective total of $74.6bn, in order to comply with government standards, said the Federal Reserve this afternoon.
Bank [...]

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It’s a train.

The “rumor” floated over the weekend and this morning was that some of the banks might need $10 billion under the “stress” scenarios.

That they might be able to raise, and it has been part and parcel of fueling the rally.

Not so fast, grasshopper.

S&P yesterday afternoon stuck virtually the entire sector on Credit Watch Negative and that was just the start.

There are now some independent analysts out there with their own numbers on “required capital”, and they’re ugly.

Friedman Billing Ramsey came out and said they believed that Bank of America needs $60 billion all on its own, while Egan-Jones piped up and said the number was $100 billion!

SNL Financial, a research firm, thinks the number is $50 billion each for Citi and Bank of America – minimum – and might be closer to $70 billion for Bank of America.

Nor does it end there. Wells is projected to need $66 billion and JP Morgan needs $33b, according to these folks.

But if you think those numbers are a horror show, the real ugliness isn’t found there.  It is in fact found in all the foreclosed-but-unsold and not-yet-foreclosed “but will be” housing stock.  Through the nation I am getting reports, some hard and some anecdotal, that lenders are sending out NODs  (default notices) and then sitting on the process intentionally.

Why would they be doing that?

Simple: Most lenders who have these notes either in a security or as “whole loans” they were unable to pawn off on someone when the securitization market collapsed are holding them at “par” – the total amount outstanding.

If they sell they are forced to realize the loss; so long as they have a “reasonable belief” it will perform or be bought out (e.g. a government-sponsored and funded refinance) they can carry it this way if it is held to maturity.  This of course makes their books look much better than they really are when you’ve got $500,000 in cash out against collateral that the market values at $150,000!

Then there is the Option ARM inventory and, most troublesome, the HELOC’s (mostly seconds used for purchase and cash-out transactions) behind them. 

There have been opinions floated that the “ARM” decimation is mostly a nothing, since short-term rates are so low and will remain that way for a reasonable amount of time. 

This is true but misleading – with Option ARMs the nuclear destruction does not come from a reset of the interest rate but rather the recast when the loan ages or reaches (typically) 110% of the original principal value.

At that point what was either an interest-only (or even not a full interest) payment is forced to a fully-amortizing payment on the balance of the original time.  For many of these loans this is set to happen at either three or five years post-issue, which means we’re just starting to see the loans written in 2006 turn into many-headed hydra about now.

The importance of this event is that the increase in payment is absolutely insane – it is not at all unusual for payments to double, and there are few if any of these loans where the jump will not be at least 50%.

The IMF says there’s roughly double the embedded loss in the system compared to what has been recognized and written down.  I think they’re conservative – my original estimate for housing market losses was somewhere around $2.5-3 trillion for residential alone.

So far the tally is up in the high hundreds of billions, meaning that there are a lot more cockroaches still to be found in the banking system – and they’re doing their best to hide from the light.

Can that succeed?  Not a prayer in Hell.

Those Option ARMs and any seconds behind them are doomed.  There is no possible way to refinance them as most are over $100,000 underwater.  The seconds written on top to get around conforming limits or avoid PMI are in fact worth nothing as the first has priority in a foreclosure action and there’s not enough there to even satisfy the first!

To put this in perspective there are condos out in Las Vegas that sold for $500,000 that now can be had for $50k or so.  You’d think that’s a great deal.  You’d be wrong, because half the complex is foreclosed, the association is on the verge of bankruptcy and as a consequence the special assessments will be rolling in soon – and they won’t be small!

Now add to this the basic business model in the consumer credit sector – jack up everyone’s credit card interest rates.  This is effectively an attempt to cost-shift those who cannot pay and are defaulting onto those who (still) can.  It is doomed to fail because those who can pay off the card will immediately do so and close the line, while those who can’t default under the increased burden.  This looks good for a little while but the math is never wrong, and this sort of path forward either collapses under its own weight or eventually will draw a strong government regulatory response.

Either way what the banks are doing can’t work; 36% interest charged against someone who is paying zero because they defaulted is still zero, but all your customers who can pay it off and leave will do so to avoid being bent over the table.

The continued refusal by our government to put these financial institutions where they belong – in front of a bankruptcy judge where priority is honored, the capital structure is crammed down and the assets sold off for whatever the market will bear – is leading us inexorably toward economic Depression.  Both President Bush and now Obama are proceeding under the (false) hope that if they can hold things together for a little while the economy will turn and it will all be ok. 

The “green shoot” people are all predicting positive GDP in the 3rd and 4th quarter.  What they’re not talking about is what the real number was for the 1st Quarter – there was a trade balance shift credit in there worth nearly 3%; take that back out and we weren’t -6% annualized, we were -9%!

The bad news is that the trade balance shift is actually bad for the economy and signifies extreme weakness yet it shows up as a positive contributor to GDP due to how the math works.  Nice eh?

But that was likely a one-time change, which means the second quarter could get real interesting.

Here is the reality folks:

1. Until continuing claims start to come back into a reasonable range and the U-6 “frustrated” employees find work, the consumer credit picture cannot materially improve in terms of default rates on all sorts of credit.  The consumer is 70% of the economy. 
2. When that happens we will still be left with an economy that is missing the “pulled forward” demand represented by home equity extraction and rabid, unsustainable granting of all forms of credit.  This is likely in the 3-4% of GDP range, and that adjustment will be permanent!
3. The excess debt in the system not only hasn’t been flushed it has to a large degree been hidden and/or shifted to The Federal Government!  Defaulting it there doesn’t do anyone a damn bit of good – in fact, it spreads the damage to everyone instead of keeping with the people who made the bad bets on both sides (borrower and lender.)  This is pure insanity, but it is what our government has done because we “the sheeple” keep believing we can have something for nothing.
4. There is no way to “fix” the bank balance sheets without massive dilution.  Either you convert preferred to common, you issue new common, or you sell performing (cash-flowing) assets.  The first two dramatically dilute everyone holding the common stock and the latter takes a pole-axe to the earnings side of the balance sheet, having the same effect on shareholders as the first two.  The recent runup in bank stock prices, doubles in many cases or more, is not only unsustainable it is something right out of The Three Stooges.

To those who think that the banks will “all be ok” and “we will muddle through and have economic recovery in 2010″ I politely suggest that you’re smoking something legal only in California.

Bluntly, the excessive debt must be flushed from the system, and since we can’t pay it down the only option is to default it through bankruptcy, as I’ve said since this mess began.

Until that happens any “recovery” will be fleeting at best – and a false hope.

Disclosure: No position in any stock named; considering several shorts.

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Here we go again. Australia’s Federal budget-revealing glorious new deficit, is coming is coming next week. But this week will be all about tomorrow’s Reserve Bank meeting and today’s house price data from the Australian Bureau of Statistics.

Oh wait. We forgot about the ‘stress tests.’ Remember that’s the official government report of how the 19 largest U.S. banks would hold up under further loan losses or asset write downs. It’s designed to give investor (and the banks) a transparent picture of how much capital the banks need to be unequivocally healthy.

Actually, it’s not designed to do that at all. The ‘stress tests’ are a white-wash. There’s no way the government would release a report to the market that said the banks were in horrible shape (insolvent) and needed billions more in capital to make up for billions of losses in residential and commercial real estate.

That means either the ‘stress tests’ were a bogus exercise in deception. Or, to the extent they uncovered anything legitimate, it will be leaked in the press and priced into the relevant banks shares before the tests ever hit the public. Besides, the ‘stress test’ began in 2007. The market’s already told us what it thinks of the banks.

One more quick note on commercial real estate. Is it still ‘the other shoe to drop’ on the banks this year? Maybe it already dropped! The Guardian reports that, “Global sales of investment grade real estate plunged 73% to $47 million in the first quarter from a year ago, or just one-sixth of the level two years ago, according to real estate research firm Real Capital Analytics on Friday.”

A 73% cliff dive is as good as a crash in our book. But that figure only refers to new sales. There is a lot of existing debt that has to be refinanced. “Making things worse,” the Guardian adds, “the number of properties that need to refinance or need capital infusions is soaring. New reports of defaulted mortgages and failed commercial property companies surpassed $55 billion in the first quarter, bringing the total known distressed commercial properties to $153 billion.”

This is one reason to remain suspicious of property and financial stocks this year. In fact, you can pretty much bank on the idea that these stocks will never lead the market again in the way did over the last five years. The sector that leads the market up in a credit boom never really fully recovers as the best-performing sector (think tech stocks).

One thing to watch for? The financial sector and state governments using the Federal wholesaled funding guarantee to trash the country’s international credit rating. Macquarie Group used the Fed guarantee to raise $14 billion on international debt markets at the end of the financial year. The company has already set aside $200 million to pay the Feds for the use of the guarantee this year (think about that for a second, this government is ‘selling’ its credit rating for $200 million).

Macquarie is raising capital this way, “Mainly because Macquarie could actually save money on its deals because it did not have to rely on its lower (and therefore higher risk-rated) single “A” credit rating. Analysts have estimated Macquarie’s benefit at $580 million for every $10 billion of new debt raised,” reports Danny John in today’s Age.

To be fair, Macquarie is also raising money from equity investors too. After announcing write downs that slashed its full year-profit in half, the company told the ASX it had sold $540 million in new equity to institutions. So here’s the question…what is the bank loading up for?

By ‘loading up’ we mean that it’s essentially re-arming itself to get back in the market…and do what? “Macquarie is already aiming to build a global stock-broking business centred on Asia, London and New York and to become significantly bigger in energy trading, specifically in oil and gas. It plans to buy new businesses and increase its existing operations with capital injections on the other side of its balance sheet.”

Hmm, oil, energy, and Asia? That sounds like a strategy based on decoupling. Remember that? It was the idea that the credit crisis would hurt the U.S. and Europe but not so much the emerging market countries. But it depends on what you mean by ‘hurt.’

Equity investors everywhere were ‘hurt’ in the last 18 months. Nowhere was safe. Nothing was decoupled. So now the question is which economies will recover first: the high-saving emerging markets with growing populations and rising incomes, or the highly-indebted industrial economies that are going even deeper into debt to bail out financial institutions (this is not a trick question.)

By the way, Western governments have been so fixated bailing out their banks they haven’t noticed how Chinese banks and companies are providing critical capital to world-class mining projects. China picked up another valuable pebble when China Non-Ferrous Metal Mining Company picked up a controlling stake in the world’s largest non-Chinese rare-earths producer for the paltry stake of $505 million on Friday. We’ll have more on the sad strategic case of Lynas Corporation tomorrow and whether there is good news buried in the story of Aussie resource investors.

Is it fair to blame the government for leaving strategic assets hung out to dry? That’s debatable, and the Treasurer still has to sign off on this deal. But obviously the government has other problems on its mind. On Friday, Treasurer Wayne Swan said government ‘revenues’ would be about $100 billion less than he expected with last May’s budget.

What does all this lead to? We reckon the combined burden of Federal, State, and government-guaranteed bank borrowing is going to put a lot of pressure on the Aussie dollar and lead to higher interest rates. State governments are already under pressure. “Victoria may lose its prized triple-A credit rating as the State Government pushes the state deep into debt to fund new roads, railway lines, hospitals, schools and water projects, one of the big four banks has warned,” today’s Age reports.

The Wall Street Journal (and international investors) are on to the story too. The Journal reports that, “Australia’s major states are all expected to post in the next six weeks a significant deterioration in their fiscal positions, strengthening expectations of a surge in state government bond issuance. A dramatic erosion in traditional revenues from land taxes and mining royalties will be a common theme for all states.”

Dan Denning
for The Daily Reckoning Australia

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