Scene 1 — The bank and an insurance product are in a dark hallway where they can’t be seen. They’re about to embrace, but the insurance product stops short.

Bank: Please don’t. I can’t live without you anymore.

Insurance: But you know we can’t. What if someone sees us?

Bank: Who? The Insurance Brokers Association of Canada?

Insurance: Well, yes. The insurance industry is mighty powerful and I don’t want to be turned into some lowly mutual fund product.

Bank: Forget them! If we’re going to compete with the really big banks one day, the government will have to  let us sell insurance, not to mention merge with other banks. So it’s no use to resist.

Insurance: I want to, but I can’t.

Banks: Fine. I’ll just build an insurance office under a different name, right next to my regular branch and then I’ll show your industry who’s boss. Don’t come crawling back to me when you have a change of heart!

End scene.

Oh the glorious drama. OK, so it’s hard to make banks and insurance sexy, but, for those who are into this sort of thing, the ongoing battle between the two financial sectors is as gripping as any episode of The Young and The Restless.

Right now the government won’t allow banks to sell insurance products. Of course, the big five want to sell insurance as it is a multi-billion dollar industry. Because the industry makes so much dough, they’ve got a lot of pull in Ottawa, which means banks won’t be selling insurance any time soon.

But you can’t stop a financial institution from doing what it wants, so, instead of waiting until the rules change, some banks have found a loophole in the law — they’ve set up insurance offices, under a subsidiary, right next to their regular branches.

The latest outfit to do this is Scotiabank. Under the new ScotiaLife Financial moniker, which was revealed yesterday, the bank is able to sell home, auto, life and health insurance products. RBC has also gone this route, and it’s been very successful — its insurance business rose by 53% last quarter and the bank is planning to build about 100  insurance offices next to existing branches.

Seems strange, huh? Why the no-insurance rule for banks, when it’s not illegal to sell products through a subsidiary? To make things a bit more confusing, banks are allowed to use the Internet to market and sell insurance products. In June, financial regulators ruled that websites aren’t the same thing as a branch, and therefore the ban on banks from selling insurance doesn’t apply. So now Canadians can purchase insurance from their bank’s website. (And this might be what really hurts the insurance industry. The Canadian Bankers Association reports that 445.7 million transactions were made online last year, up from 13.2% in 2007. ABM transactions dropped 3.8% to 954.7 million. The web could soon — and already is for many people — becoming the banking method of choice.)

Clearly, the banks are making a mockery out of this rule, and in turn the Canadian government. Can they sell insurance or can’t they? (Obviously it’s the latter, even though they’re technically not supposed to.)

It’s time the Conservatives change the regulations and allow banks to sell insurance through their branches. This would give consumers even more choice and allow the banks to compete globally. In fact, it’s really only a matter of time until the rules change, because if they don’t there’s a risk that Canada’s banking sector will fall behind.  Banks are getting bigger, even as many crumble in the U.S., and if our financial institutions can’t merge or sell insurance outright they won’t be able to compete on the world’s stage.

The Conservatives have said they won’t loosen the restrictions, so until that happens (and if the Cons don’t do it, who will?) the banks will be forced to get more creative, ultimately making an even greater farce out of this now out-of-date rule.

Calgary is no longer leading the trend downward. That honour now belongs to Vancouver, which dropped 9.6%. Next came Calgary (−8.4%), Toronto (−6.9%) and Halifax (−0.8%). Just two cities managed to stay in positive territory: Montreal (2.9%) and Ottawa (1.0%).

All cities in the index are down from their peak levels. Calgary, Vancouver and Toronto are off their peaks by more than 10%.  This is beginning to look like a U.S.-style retrenchment — only with a lag of 12 to 18 months. For more detail, see the charts ( from housepriceindex.ca) below.

Much has been made of the resiliency of Canadian banks in the midst of the global financial meltdown. But was it, in part, based on a delayed tumble in house prices? Now that the Canadian market is beginning to resemble the U.S. market, will Canadian banks be able to keep a stiff upper lip?

National level

Francis Chou, manager of Toronto-based Chou Funds, has in the past not been a fan of financial stocks. During a previous rally, he warned unitholders to stay away from them because of the DROP principle (D is for dribbling out the bad news slowly, R is for raising money, and OP is for dishing out the most optimistic projections). “Once the money has been raised from investors, these companies will announce a few months later ‘the big drop’ – that is, to take a big writedown,” he wrote.

Chou is not as negative on the current rally in bank stocks. When he coined the DROP principle during a previous rally, he “was trying to alert unitholders to the dangers of toxic assets in the balance sheets of financial companies. They were not written down and the financial companies may try to raise capital before they had to declare the true extent of their losses in toxic assets ….That is not applicable now because of the cataclysmic losses they reported in 2008.”

He adds: “Banks that have not been affected by the financial crisis will do quite well in the future. With the governments driving the treasuries to yield nearly 0%, the spread between what the banks are paying for deposits and borrowings in the market (like FDIC insured), and what they can lend at is enormous. For the first time in many years, banks are being paid handsomely for the risks they are taking.”

Which banks have come through the crisis relatively unscathed? Royal Bank of Canada and other Canadian banks have. In the U.S., big banks that got through the crisis without government funds were (according to an IMF chart in this document):

JP Morgan Chase (JPM)
Wells Fargo (WFC)
US Bancorp (USB)

When you are not too big to fail, you are … well, allowed to fail. The Federal Deposit Insurance Corp. closes your doors. So the list of failed regional banks keeps growing. According to the FDIC, there were three banks shuttered in 2007, another 25 in 2008, and 32 more in just the first 18 weeks of 2009.

As the list gets longer, warns the May 20 issue of Standard and Poor’s The Outlook, it could have negative consequences for investors in smaller banks — specifically, holders of exchange-traded funds such as the iShares Dow Jones US Regional Banks (IAT) and SPDR KBW Regional Banking (KRE).

iShares Dow Jones US Financial Sector (IYF) 71%
Financial Select Sector SPDR (XLF) 99%
Regional Bank HOLDRs (RKH) 128%
Rydex 2x S&P Select Sector Financial (RFL) 238%
Direxion Financial Bull 3X Shares (FAS) 325%

The U.S. financial sector could add to these gains but longer term it’s not obvious to me it is a sector to which one would want to give a lot of weight in their portfolio. There are two main reasons why.

First, those business models that gushed earnings during the boom era seem somewhat busted now. It’s difficult to see many of their tainted product lines, such as asset-backed securities, regaining the popularity they once enjoyed. Moreover, legislators will likely bring in regulations to tame financial innovation and temper other aggressive practices. And regulators will probably be a lot less tolerant of non-compliance. Finally, the Federal Reserve has learned that it needs to keep not only consumer prices under control but also asset prices — so once the economy has climbed out of its current hole, monetary policy should be run more conservatively (which means less credit creation for the banks).

Second, even if the above analysis ended up wrong, I still would not want to have anything to do with the big financial conglomerates in their present form. Another argument for avoiding them is one that believers in socially responsible investing (SRI) may be able to identify with. SRI abstains from investing in companies that harm society, the classic example being tobacco companies. I would add to that list many of the big financial conglomerates.

They unleashed a severe financial crisis and recession on the world. What immense harm they have caused — and could do again if they are allowed again to operate unfettered. Not only that, but look at the trillions of dollars taxpayers had to give to them. They have socialized the losses and privatized the gains.  I personally would find it repugnant to invest in their shares.

The sustainability of the U.S economy requires a halt to the relentless climb in indebtedness, if not a lengthy period of deleveraging. Investing in the big financials would only lend support to unhealthy trends. The pusher has to stop selling his drugs to the addicts.

The first sentence goes: “Most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized.” Really? Maybe someone can help me here. I got the impression from an April 21 piece in the LEX column of the Financial Times of London that there was a bit of a shortfall. It says:

“McKinsey estimates that US banks still hold about $2,000bn in impaired assets. By comparison, the Federal Deposit Insurance Corporation estimated that US banks had tier one capital at year-end of just $1,296bn. That $700bn gap is simply too big to be breached by earnings power.”

Could one reason for the discrepancy be due to different approaches to valuing loan portfolios — with SCAP using the banks’ convention of carrying them at amortized cost instead of mark-to-market? As the white paper states:

“Loans held in portfolio subject to accrual accounting are carried at amortized cost, net of an allowance for loan losses. The use of accrual accounting for these assets is based on BHCs’ intent and ability to hold these loans to maturity, which reflects, in part, a combination of more stable deposit funding and information advantages about the quality of the loans they underwrite. The economic value of loans in the accrual book is reduced through the loan loss reserving process when repayment becomes doubtful, but is not reduced for fluctuations in market prices ….”

Oh, wait a minute. Reading down further, the white paper does admit the banks do need capital after all. It’s needed because the economy is going to get worse and present capital bases may not be able to cope with the expected loan losses:

“Given the heightened uncertainty around the future course of the U.S. economy and potential losses in the banking system, supervisors believe it prudent for large bank holding companies (BHCs) to hold additional capital to provide a buffer against higher losses than generally expected, and still remain sufficiently capitalized at over the next two years and able to lend to creditworthy borrowers should such loses materialize.”

The government stands ready to help out:

“The United States Treasury has committed to make capital available to eligible BHCs through the Capital Assistance Program as described in the Term Sheet released on February 25. In addition, BHCs can also apply to Treasury to exchange their existing Capital Purchase Program preferred stock to help meet their buffer requirement.”

On page 4 we are given some detail on how the data for the estimates were collected:

“The BHCs (bank holding companies) were asked to estimate their potential losses on loans, securities, and trading positions, as well as pre-provision net revenue (PPNR) and the resources available from the allowance for loan and lease losses (ALLL) under two alternative macroeconomic scenarios.”

I must admit my initial reaction was similar to Professor Robert Salmon’s. In his words:

“So if I understand this correctly, the Treasury is relying on banks to provide them with an assessment of their current troubles. This is like asking an alcoholic if he thinks he has a problem.”

We also get detail on the parameters used in the baseline and adverse scenarios projected for 2009 and 2010. These are already well known and many observers have commented that developments in the economy now suggest the adverse scenario would have been more fitting to use as the baseline scenario.

The stock market’s reaction was interesting. It seemed a little uncertain how to interpret the report. There was an initial dip on the news, followed by a rally. Then near the close, there was a rather sharp drop — but not enough to wipe out the day’s gain. Bad omen that last bout of selling? Last Friday, as I recall, there was a similar finish to the trading day and Monday ended decidedly down.

To see the Federal Reserve white paper, click here.

But what a wall or worry it is this time. Did those buying really do their due diligence and check the fundamentals carefully? Or are they simply letting Mr. Market tell them it’s the time for climbing the wall of worry? Or worse, are they caught up in a buyer’s panic and motivated by the fear of being left behind?

These were the questions that came to mind when I found some more time to resume the mash-up of highlights from the stream of data/commentary on the current/future state of the economy and financial markets. When you step back a bit and listen to some other voices besides Mr. Market’s, there seems to be a rather wide disconnect between the two.

What follows pertains to just the financial sector, which has been mainly responsible for the stock-market rally in the U.S. I hope to cover other aspects in subsequent posts.

Highlights from the data/comments flow

Green shoots are appearing and we will be watching for more signals that will herald the economic recovery. For now, it is not self-sustaining economic growth yet. Stability in the financial sector, with clean balance sheets of banks and a working credit machine, will be necessary for self-sustaining economic growth. Northern Trust economists.

Some of the largest mortgage companies are stepping up foreclosures … [they] had stopped foreclosing on borrowers as they waited for details of the Obama administration’s housing-rescue plan [and for other reasons] … now, they have begun to determine which troubled borrowers … to move through the foreclosure process …. The resulting increase in the supply of foreclosed homes could further depress home prices and put additional pressure on bank earnings as troubled loans are written off. Wall Street Journal.

U.S. foreclosure activity was up 46 percent in March from a year earlier, hitting a record high as programs stunting the torrid pace of failing mortgages expired. RealtyTrac.

More than 2.1 million homes will be foreclosed in 2009, up from about 1.7 million in 2008.Economy.com.

Credit offered by the 21 largest banks receiving TARP funds fell 2.2% in February compared with the prior month. U.S. Treasury Department.

Like the other US banks that reported first-quarter earnings this week, Citigroup was desperate to appear as healthy as possible ahead of the Treasury’s stress test results, which are now just weeks away …. But Citi will have $80B of tangible equity versus assets of $2,000B … that is still worryingly geared. LEX, Financial Times of London.

It does not help that many banks have not set aside enough reserves for credit losses –Wells Fargo holds an array of assets at rose-tinted values and may need another $25 billion in capital on top of the $25 billion it has already taken from the Treasury. Few banks hold their commercial-property portfolios anywhere close to 50-60 cents on the dollar. Economist magazine.

The banks will face more pressure because their legacy loans have not been marked to market …losses on the banks’ loan portfolio are likely to rise to 3.5% by the end of 2010, which would exceed Depression Era losses … the banks aren’t factoring those losses in yet. Mike Mayo banking analyst for Calyon Securities.

The banks will not see profits after the first quarter … home prices will fall another 30%. banking analyst Meredith Whitney

Home prices will fall 22% to 27% from their January levels. Ronald Temple, a director of research at Lazard Asset Management.

The negative dynamics between the real and financial sides of the economy have created severe downside risks … [financial markets remain highly stressed, making them an impediment to recovery] …While we’ve seen some tentative signs of improvement in the economic data very recently, it’s still impossible to know how deep the contraction will ultimately be. Janet Yellen, president of the San Francisco Federal Reserve.

My latest estimates are $3.6-trillion in losses for loans and securities issued by U.S. institutions …. It is said that the International Monetary Fund will announce a new estimate of $3.1-trillion for U.S. assets … By this standard, many U.S. and foreign banks are effectively insolvent …. Nouriel Roubini, Professor of economics at the Stern School of Business.

The Obama plan to fix the banking system is destined to fail … The people who designed the plans are either in the pocket of the banks or they’re incompetent …. TARP isn’t large enough to recapitalize the banking system … weaker banks should be put through a receivership where the shareholders of the banks are wiped out and the bondholders become the shareholders. Nobel prize economist Joseph Sitglitz

More representative of the state of the banking system arguably is Capital One Financial, which reported late Wednesday a surge in credit-card losses in March, to 9.33% from 8.06% just a month earlier. Randall W. Forsyth in Barron’s

Financial stocks leading this rally have run 26% above their 50-day averages — the widest gap in almost two decades. Kopin Tan in Barron’s

More blows are coming. Banks worldwide have written down their assets by $1.1 trillion. The final tally is expected to be double that, or more. The pain is only now starting to spread through commercial property and commercial loans. As a result, the first-quarter reprieve will turn out to be a “head fake”, says Chris Whalen of Institutional Risk Analytics. Economist magazine.

First, AIG International Group recently handed out more than $200 million in bonuses to executives even though it has received a $170-billion bailout from the U.S. Government and previously had a run-in with regulators over bonuses. The U.S. Senate wants to claw back AIG’s latest bonus extravaganza through taxation. But this doesn’t go far enough, in my opinion. Bonuses are a systemic problem that keeps popping up, again and again. Politicians and regulators should really be thinking about clawing back bonuses for all firms that contributed to the financial crisis and retroactively to 2007 at least — for reasons laid out in my Sept. 11 2008 column, Claw back the bankers’ bonuses.

Second, while bonus-driven bank executives were laying the groundwork for today’s financial implosion, legions of bank lawyers and accountants were busy exploiting loopholes to cut tax bills for the banks and their high net-worth clients. So while taxpayers are now being asked to pay for a trillion-dollar bailout of the banks, they also got the short end of the stick when times were good.

This week, a whistleblower released internal memos from Barclays Bank revealing “the process involved in structuring extremely complex and artificial tax avoidance schemes,” to quote the editor of the Guardian newspaper (which had posted the documents on its website until a court ordered them to be removed). One scheme, wrote Hugo Dixon in breakingviews.com, “aimed to save tax by shunting over $16bn of loans from a series of companies and partnerships in the Cayman Islands and Luxemburg.”

Last month, tax avoidance by other financial institutions made the headlines. Swiss bank UBS AG, which was under investigation for allegedly helping 17,000 American citizens to evade taxes, agreed on Feb. 18 (thanks to an order from Swiss regulators) to provide the U.S. government with the identities of over 200 American clients and to pay $780 million in fines and restitution.

Another step toward reining in the financial sector is to address tax avoidance. Cleaning up the mess they left behind is going to cost a lot and every source of revenue needs to be tapped. Why should the banks be allowed to conitnue dodging taxes for themselves and their clients when trillions of dollars are needed to stabilize the system?

So close the tax loopholes. Make it unlawful for the banks to have subsidiaries or affiliates in tax havens. And, as Dixon said, adopt globally the U.S. doctrine of “economic substance,” under which transactions need to have some genuine purpose other than to avoid taxes.

Lastly, as Dixon also suggested, recruit better tax inspectors. So far, they have been no match for executives motivated by million-dollar bonuses. What, then, if we give the tax inspectors bonuses too? Make the reward a percentage of the taxes recovered. That’ll work for sure.

• Canadians are now more indebted than Americans. The debt-to-disposable-income ratio in Canada currently stands at 132%, higher than the U.S ratio of 122%, according to Bank of Canada data cited by Deloitte. Canada has pulled ahead because U.S. indebtedness has fallen against disposable income since mid-2007 while Canada’s continues to rise.

• Many Canadian credit-card issuers loosened standards in recent years. Their credit card balances have increased almost 40% since 2004.

• Deloitte’s survey of credit-card executives in Canada revealed a 5% to 10% jump in delinquencies beginning last fall – which translates into annualized industry losses of more than $800 million (at the upper end).

• Credit-card companies in Canada “have traditionally seen loss rates of less than 4% – a figure much lower than that of their American counterparts (6% and growing),” but with Canadian consumers increasing their debt-to-disposable-income ratios to more than 130%, “Canadian issuers could see losses similar to those of their U.S. counterparts,” warns the Deloitte study

• Financial institutions see credit-card losses as the “canary in the coal mine.” In Canada “customers will likely default first on cards rather than on mortgages or car payments. This is converse to what has been happening in the U.S. where fairly lax mortgage default legislation has meant that people have been walking away from their houses before they have missed payments on their credit cards.”

These include nationalizing the sickest banks (e.g. Royal Bank of Scotland in UK), setting up “an aggregator bank” to swallow toxic assets, and injecting government money into the banks through huge equity stakes. The measures seem to imply substantial dilution of existing equity holders. So the latter shoveled out positions onto the market yesterday, dragging the S&P Financials index down by over 16% and the S&P 500 over 5%. Investors in many institutions were worried, to put it another way, that the U.S. will follow the example of the UK and introduce a rescue package that wipes them out. That’s not quite the source for the sell-off expected, but it will do.

Interestingly, though, the S&P 500 is still up about 7 per cent since the November 20 low while the financials are down more than 13% since. The market seems to be betting the more radical policies on the way will draw a line under the debacle. Bank investors may suffer but investors outside the sector could be okay since their companies should be better assured of having access to credit. In Canada (as an aside), I still remain a little worried about the chartered banks being able to avoid further drops in share prices, with the world around them in flames (it shouldn’t be a decline anywhere as bad as elsewhere, though).

A dissonant note was the sell-off in U.S. government bonds. The flight to safety lost out to concerns that the requirement for greater government assistance will finally result in too many bonds being issued. That development is a little disconcerting because it hints the capacity of the U.S. and Europe to bail out its banks is near its limit.

When added to existing debt and commitments, the debt burden will be so huge that it could mean it’s not possible to finance it in a non-inflationary way. This may not be entirely evident in the near term with deflationary forces still strong, but if the world economy is to keep climbing out the hole without unnerving interruptions, central banks may feel compelled down the road to allow more inflation than what their targets allow. We shall see; a clearer picture will emerge in months ahead. Anyway, shorting government bonds still seems to be one way to ride out the crisis.

Up to now, shareholders have consoled themselves with the thesis that the Canadian banks were prudent lenders and didn’t have a housing bust to pull them down. But house prices are falling all the same, with the Canadian Real Estate Association reporting a decrease of 4.5% over the year to November, according to its new methodology. And TD Bank (TD) and Bank of Montreal (BMO) have about a quarter of their loan portfolio at subsidiaries in the U.S.

Moreover, Canada did have a commodity boom and it is now unwinding. Plus, there is recession elsewhere, notably in auto manufacturing. The Canadian industry is concentrated in Ontario, where the banks have half their loan portfolios.

The recent round of equity issues from Canadian banks is reminiscent of what occurred before the U.S. meltdown. It’s not a comforting sign when equity is issued after a 40% decline in prices and when dividend yields are in the unheard of range of 5% to 8% (earnings will be reduced by the dividends to be paid on the new shares).

Dividend payout ratios are rising too. TD has climbed from 36% last year to just below 50%. The worse case, BMO, is currently at 75%. With its dividend yield now over 8%, speculation seems to growing that BMO will be the first to slash its payout.

Will this turn out to be the “DOPE-DUD” phase? Francis Chou called it the DROP phase when he applied it to US banks in early 2008 but I like the DOPE-DUD nomenclature, which stands for: Dribbling the bad news out slowly with the most Optimistic Projections while raising as much money as possible from Every investor (DOPE), followed by Divulging all the Unpleasant news and Dousing (DUD) investors with a big bath.

But with the tsunami of a global commodity bust and severe U.S. recession headed their way, Canadian bank stocks might get knocked down even deeper into bargain territory. Cheaper share prices and richer yields may be the likely consequence of higher loan-loss provisions, slower growth in loan volumes, and declines in market-sensitive business.

An Oct. 31 update on the banking sector by eResearch projects loan-loss provisions for fiscal 2009 of $9.6 billion, double the estimated level for fiscal 2008 (versus a previously projected 30% increase by eResearch). Business-loan losses will contribute nearly half of the jump, while consumer and credit-card loan losses will contribute the other half.

Loan volume growth in Canada was revised down to 2% to 5% for fiscal 2009, compared to “three year annual growth rates of 10% for mortgage and consumer loans and 15% for credit card loans.” The report is also factoring in a 15% decline in revenues from the “market-sensitive” business lines of investment banking, retail brokerage, and trading commissions (which have risen from 19% of total revenues in 2002 to 25% in 2008).

So are the dividends safe? “Yes!” exclaims the eResearch report. Dividend payout ratios currently average 45.8%. The declines in earnings per share projected to fiscal 2009 should raise the average payout ratio to 52%.

While there likely will not be any dividend cuts, there likely won’t be any dividend hikes either in 2009. The average payout ratio of 52% for fiscal 2008 is slightly above the upper boundary for the banks’ payout targets. Royal Bank and TD will still be inside their target range, and so may still have room to increase dividends. Bank of Montreal, with a projected payout ratio of 67% in fiscal 2009, is least likely.

The decline in the Canadian dollar will help offset some of the impact of the commodity bust and U.S. recession, especially for Royal Bank, TD Bank, and Bank of Nova Scotia (because of their foreign operations). Canadian banks also appear to be benefiting from the financial crisis by winning deposits and accounts as clients flee U.S. banks.

The investor’s strategy may be to establish or raise a position in stages, looking for opportunities to buy on the dips when bad news hits share prices. There is a good chance by the end of 2009 that an investor could have four or five of the banks in their portfolio with an average dividend yield geater than 6% – and poised to resume growth at the banks’ historic average rate of 5% to 7% per year.

Bank dividend yields (Oct. 31) 

Royal Bank 4.3%

TD Bank 4.1%

Bank of Nova Scotia 4.8%

Bank of Montreal 6.5%

CIBC 6.3%

Specifically, it would not be too surprising to see the whole hedge-fund industry to go into an indefinite lockdown period to keep withdrawals from fuelling waves of forced selling in financial markets. Similarly, “holidays” could surface elsewhere too, like in the money market mutual fund industry, or even the entire mutual fund industry.

What’s a bit surprising is the number. There were 124 “systemic banking crises” spread across dozens of countries between 1970 and 2007 (see appendix).

A downer is the average fiscal cost (cost of government bailouts) of the crises. “Fiscal costs, net of recoveries, associated with crisis management can be substantial, averaging about 13.3 percent of GDP, and can be as high as 55.1 percent of GDP,” note the authors. The $1 trillion (U.S.) estimate bandied about for the U.S. financial crisis seems gargantuan but is still far below 13.3 per cent of U.S. GDP. Could the final cost end up being even more monumental?

Also on the depressing side are the output losses due to systemic banking crises. The IMF document says they have “averaged about 20 per cent of GDP during the first four years of the crisis, and range from zero per cent to a high of 98 per cent of GDP.”

Interestingly, “there appears to be a negative correlation between output losses and fiscal costs, suggesting that the cost of a crisis is paid either through fiscal costs or larger output losses. Furthermore … even in the absence of significant government intervention, fiscal losses may be large due to tax revenues forgone because of higher output losses.”

Appendix: Canada was one of the few countries not to appear on the IMF list. An oligopolistic industry does have its advantages, it seems. Could lower levels of competition mean less pressure to lower credit standards?

It was once thought the U.S. had banished financial panics and great depressions thanks to measures put in place after the 1930s. Of note, deposit insurance for bank customers would ensure no repeats of the disastrous runs on banks that caused a one-third contraction in the money supply during the Great Depression.

But in recent decades, a second, unregulated financial system was allowed to develop alongside the regular banking system. It consisted of investment banks, hedge funds, mortgage-finance companies and other entities that operated with a decided lack of transparency and disregard for risk in the pursuit of profits.

Investment dealers leveraged their capital 30 times or more compared to the 10 times or so permitted regulated banks. Financial engineering produced ever more esoteric and complex instruments. Off-balance-sheet assets were common. And the expansion occurred without the safety net of a deposit insurance program — opening the door to a run on the unregulated sector should it ever stumble. Now the stumble is here and one wonders if it could yet have the same effect of contracting the money supply as the banking crisis of the 1930s did.

The Federal Deposit Insurance Commission (FDIC) currently has reserves of $53 billion (U.S.) to compensate bank customers for lost deposits in the event of a bank failure. About ten percent of these reserves will be needed to pay off depositors at failed Indymac, leaving at best no more than $50 billion in the FDIC kitty, remarks Narayanan.

According to FDIC estimates, total insured deposits in the U.S. banking system were $4.43 trillion at the end of the first quarter. “Thus the FDIC is operating with a cushion of no more than $50 billion to insure $4.43 trillion in deposits” at a time when dozens of regional and other banks are expected to go under. There is a risk depositors may become fearful for their deposits and start lining up to get their money out.

Moreover, another $2.42 trillion of bank deposits are uninsured by FDIC. These deposits are at even greater risk of fleeing the banking system, Narayanan believes.

Narayanan goes on. “Fannie Mae and Freddie Mac … are technically bankrupt when their assets are marked to market ….” Thanks to leverage ratios (total assets/equity) of anywhere from 20 to more than 80 times (depending on how one chooses to look at their off-balance sheet risks), their equity has been wiped out by asset impairments. They both have negative equity positions of more than $5 billion each, which could be disconcerting considering they jointly guarantee over S$4.7 trillion of mortgage securities, notes Narayanan in his monthly report.

The forced selling is prolonging the underperformance of the value investing approach — which has been quite extensive lately. Research published on the U.S. market by Joseph Mezrich, head of quantitative research at Nomura Securities, shows a model portfolio of momentum stocks gained more than 70% year-over-year while a model portfolio of value stocks fell about 50%. Value stocks haven’t been this cheap in 35 years.

Historically, when value stocks get beaten up to this extent, they usually go on to do very well. However, this time round, they are cheap mainly because of the financial sector, which is facing ahistoric problems. Some say the business models in the financial sector are busted, just like dot-com business models were busted in the early 2000s.

On the other hand, some would say monetary policy in the U.S. is based on central banks feeding the commercial and investment banks enough liquidity to keep them lending and dealing liberally. So the business models of the financial institutions will survive and flourish because they are a necessary adjunct of the central banks’ modus operandi for managing economic fluctuations.

“Dividends are an important measure of financial strength. They’re an indication that a company is financially sound and is looking ahead with a positive view to the future,” notes the report. If so many are raising their dividends, are things all that bad – at least in Canada (where AIC Fund is based)?

“Investors have lumped all financials – both good and poor performers – together under the same category, and have generally stayed away,” adds the commentary. “During this time, it’s important to remember that each financial company is different and should be evaluated individually on its own merits.

“Solid core financials entering times of market or economic crisis often emerge stronger in the end, obtaining increased market share from weaker performers who fall by the wayside.” AIC Fund’s list of dividend-raising financials might then be a screen of sorts for the latter kind of companies, so let’s offer it here.

Dividends were raised at: Bank of New York Mellon Corp., Bank of Nova Scotia, HSBC Holdings, JPMorgan Chase & Co., Lloyds TSB Group, National Bank of Canada, Royal Bank of Canada, Toronto Dominion Bank, American International Group, AGF Management Ltd., CNP/NPM, IGM Financial Inc., Invesco Limited, Investor AB, Power Corporation of Canada, Great-West Lifeco Inc., Manulife Financial Corporation, Power Financial Corp., Sun Life Financial Inc.

Those holding the line on dividends were: CI Financial, Barclays PLC, Royal Bank of Scotland Group plc, Dundee Corporation, Merrill Lynch & Co. Inc. One company cut: The Wharf (Holdings) Limited.

So suggests BMO Nesbit Burns strategist Michael Herring in a recent publication. The banks can borrow the cheap funds and buy higher-yielding Treasury and agency bonds, pocketing the spread in yields to replenish their balance sheets over time.

This “carry trade” is what happened after the savings and loan crisis nearly 20 years ago. “The Federal Reserve held the Fed Funds rate at 3% for almost a year and a half so the banks could borrow cheap and buy U.S. government bonds to rebuild their balance sheets,” writes Herring.

Citigroup is the archetypical, supermarket-style financial firm, made possible by regulatory changes. The Glass Steagall Act of 1933 created deposit insurance in the U.S. and to limit risk prohibited mergers between banks and brokerages, insurance companies and other financial firms. But Fed Chairman Alan Greenspan endorsed the merger of Citicorp and Travelers in September, 1998, to give birth to Citigroup. The Clinton administration, with Robert Rubin as Treasury Secretary, then pushed for a repeal of provisions in the Glass Steagall Act to give Citigroup more scope to operate. In the fall of 1999, the Act was repealed and days afterward, Robert Rubin joined Citigroup.

The new Citigroup, with chief executive Sanford Weill in charge, was “riddled with internal conflicts of interest” and had a culture where “profits were given undue importance,” says Narayanan. For example, Jack Grubman, Citigroup’s star telecommunications analyst, was reportedly influenced by Weill to upgrade his rating on AT&T Corp. because the latter’s chief executive was on the Citigroup board and Weill needed his vote in a boardroom showdown with another board member.

Also, Citigroup “was a key player in the Enron scandal where it averaged one deal a month with the firm from 1997 till bankruptcy,” and was found by the bankruptcy examiner to have helped Enron produce misleading statements. Yet another example of pushing the limits was the directive from Japan’s stock-market regulator in 2004 to close Citigroup’s Japanese private-banking operations because of “unscrupulous violations” of rules and regulations.

In the mid-2000s, Weill passed the reins to Chuck Prince, while Weill’s team, including Rubin, stayed on. Narayanan believes “Rubin pushed the bank to increase its activity in high-growth areas like structured credit” – just as things were peaking. Rubin may have also assisted with the $800-million (U.S.) purchase in 2007 of the Old Lane Partners hedge fund, which was months before formed by a team led by Vikram Pandit. Just over a year later, the fund had to be written off.

Now Rubin is in charge of Citigroup following Prince’s resignation and has hired Pandit (from the failed hedge fund) to be chief executive. Yet, “Mr. Pandit has no prior experience to speak of in classic banking, let alone with one as large as Citi,” states Narayanan.

What Citigroup’s example shows is that “regulators and investors exercised little to no oversight of the bank and allowed it to operate unchecked.” It also shows that original participants in events leading up to the financial messes are still at the helm. “If an investor of sound mind were presented with Citigroup today it all its glory with its complex balance sheet and rivers of red ink, how could he possibly feel comfortable about investing in the firm to shore up its capital base …,” wonders Narayanan.