Chris Whalen On The Upcoming "Worst Economic Contraction Since WWI (Forget WWII)"

From Chris Whalen at Institutional Risk Analytics

Exposure at Default: Does Bank American Have Any Alternatives for Countrywide?

The erosion of the profitability of the U.S. banking industry over the past two years under the glorious Summers-Geithner-Bernanke rescue scheme is the proverbial fly in the ointment for both major political parties. Democrats and republicans alike are going to be fed into the meat grinder over the next several years as the banking sector deals with literally hundreds of billions of dollars in direct and indirect expenses from the deflation of the mortgage bubble. For the economy, this slow process of muddle along championed by Summers and Geithner will ensure that Barack Obama becomes the Herbert Hoover of the Democratic Party.

The economic carnage that will causes these losses, as we described in a recent post in Reuters, "Double Dip or Global Deflation?," is going to represent the worst economic contraction since WWI. Forget WWII. Think "shrinkage" to use the Gilded Age description for economic deflation. And frankly nothing that either the Fed or Treasury does in the near-term can change this basic economic fact of restructuring. Banks such as Ally, which is the owner of the ResCap legacy portfolio as we all know, can impose moratoriums and issue press releases, but the losses remain. It is only a question of when they are recognized.

Thus we turn the pages back to August of 2008, when we were just returning from our annual Maine fishing trip with David Kotok of Cumberland Advisors. In our comment “Is Countrywide Financial Headed for Bankruptcy?,” we described the lawsuit by Bank of New York Mellon (Q2 2010 BSI Rating: "A+") to force Bank of America (JPM/Q2 2010 BSI Rating: “C”) to formally take responsibility for the debt of Countrywide Financial. BAC management had made statements to investors during conference calls that Countrywide was being kept “bankruptcy remote” from the BAC parent.

Since then, most talk of a bankruptcy by Countrywide has been squelched because of the legal and practical obstacles involved. We’ll be going into these issues in detail for subscribers to the IRA Advisory Service later this week. Suffice to say that while the legal situation may seem clear and mitigate against a bankruptcy filing by Countrywide to limit legacy claims, both liquidated and unliquidated, the economic situation at BAC and among all of the legacy zombie banks continues to worsen. No amount of bullshit from Washington changes the fundamental economic situation inside the largest U.S. lenders.

In earlier comments, 'An Involuntary Transaction: Why BAC + CFC May Never Close', May 6, 2008 and 'Update: Are Countrywide Financial Bond Holders Bankruptcy Remote?', May 1, 2008, we had further described the shenanigans by BAC management with respect to the Countrywide acquisition in that year. And as we wrote then and we remind one and all now, the decision by former Treasury Secretary Hank Paulson, Fed Chairman Ben Bernanke and OCC Head John Dugan to slam Countrywide and Merrill Lynch into BAC, Wachovia Bank into Wells Fargo & Co (WFC/Q2 2010 BSI Rating: “B") and Bear Stearns into JPMorgan (JPM/Q2 2010 BSI Rating: “C”) was a fundamental error -- and one that is only creating the precursors for the next systemic crisis.

The difference between the Lehman Brothers bankruptcy and the JPM acquisition of Bear Stearns is that the unliquidated claims against the former firm for securitization and other exposures are all being managed by the U.S. Bankruptcy Court for the Southern District of New York. Jamie Dimon and his shareholders are on the hook for all of the claims against the legacy Bear Stearns securitization business, but Dimon is fortunate compared to his counterparts at WFC and BAC. The claims against Washington Mutual, for example, are sitting in the U.S. Bankruptcy Court in Wilmington -- except, of course, for the covered bonds issued by WaMu and conveyed to JPM via the FDIC receivership. Wonder if our friend Meredith Whitney has noticed this issue yet...

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