No Recession In 2008

No Recession In 2008, Study Says
A UCLA Report Predicts The Nation And State Will Be Saved, Saying Some Of The Economy's Worst Bumps Are Past.

By Peter Y. Hong, LA Times | 6 December 2007

LEFT: The economy hits home; click to enlarge

California and the nation will escape a recession in 2008 despite rising oil prices, sinking housing prices and a turbulent stock market, a UCLA study released today predicts. "Be calm my friends. Be calm," wrote UCLA Anderson Forecast director Edward Leamer in the latest quarterly report from the group. A recession— negative economic growth for two consecutive quarters— probably will be averted next year, the forecast says, noting that the economy has already taken some of its hardest hits.

Nationwide, unemployment would have to climb to 6% from the current 4.6% to cause a recession, the forecast said. Such an increase would require the loss of 2 million more jobs. Cuts on that scale won't be possible, the Anderson report said, because job growth was weak throughout the current economic expansion.

Job losses in California will be numerous in the construction and financial sectors but total unemployment will peak by the end of next year at a 6.1% rate, the study reported. Meanwhile, real personal income will rise 1% to 2%.

"How can we lose jobs that were never found?" the report said.

• The loss of 3 million manufacturing jobs early this decade means there is little room to cut more positions.


• Most of the damage to the economy from the housing slump will be over by the end of next year.


• The weak dollar will help U.S. exports, aiding manufacturers in Southern California.


• Consumer spending will drop, but much of the effect will be shouldered by other countries as U.S. imports of their products decline.

The Federal Reserve [met] Tuesday and … cut its benchmark interest rate for a third time to help avoid a recession. That reduction— and more next year— will be needed to ward off a recession, the forecast said.

"Should the Fed fail to ease significantly, we believe our 'no recession' forecast would be at significant risk," the study said.

UCLA economists also predicted that stock prices would rise 10% to 12% next year amid calming credit markets and modest economic growth. In California, the economy will be hit hard by the weak real estate market, falling government revenue, and the Hollywood writers' strike. But like the nation, the Anderson Forecast projected that recession would be averted.

"It gets pretty ugly, but still no recession," the report said. State government will face a budget shortfall of $8 billion over the next two fiscal years because of weaker than previously expected income, sales and corporate tax collections, the study said. That shortfall would be greater than the state's spending on the University of California and California State University systems combined, the report said.

If the Writers Guild of America strike lasts as long as the 153-day action of 1988, it would lower personal income growth in Los Angeles by 0.25%, the forecast said. So the strike's effect on the overall economy will be slight but "can be very substantial and difficult for the people involved," the study said.

Ryan Ratcliff, a coauthor of the California portion of the forecast, said areas such as white-collar businesses, education, healthcare and tourism remain healthy, softening the blow of the real estate downturn. "It's not so much that there is one [paticular] sector doing so well it is offsetting real estate doing so badly," Ratcliff said, "we are seeing slow growth everywhere outside of real estate."

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Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

We Got The Oversold Rally, But Now What?

By normxxx | 26 December 2007

For the most part, the broad equity indices haven't done anything wrong since the November low— in fact, the price pattern has played out in classic fashion.

By mid-December, stocks had sold off hard. So hard, in fact, that a slew of price-based oversold signals were triggered. I spent a couple of days going over some of them, and all of those "oversold in December" stats argued for higher prices ahead... if we were willing to hold through the first couple of sessions of the new year at the latest.

We didn't have to wait long, though, as stocks quickly turned around and have gone up strongly since then. That's good confirmation of what I saw in the indicators at the time, but it has also begun to trigger a lot of short-term signs of excessive optimism. Typically, when we get those types of readings, even during seasonally positive periods, stocks have trouble holding on to much additional upside.

As for the more intermediate-term indicators, they are mostly neutral. I saw an overwhelming number of historically extreme "excessive pessimism" readings in November, which consistently precede gains of 5% - 10% over a one- to three-month period when they've occurred in the past. We've already satisfied those goals, and sentiment has understandably become more bullish because of it.

Looking at the sentiment conditions as they stand now, it's hard to make a strong case either way. The 'Smart Money Confidence' index is still relatively high, poking around 60%, but the 'Dumb Money' is also relatively high and it won't take much more to push it also over 60%. I'm going to go to 25% Long here, simply based on the idea that the models, indicators and studies I follow no longer provide as strong a bullish edge as earlier in this 'positive season.' But, this still is much more positive than the neutral position I had planned to end the year on.

Coming into this week, we had a number of short-term measures that were pointing to the idea that it was unlikely we'd see more sustained upside until the indices took a breather. ST overbought conditions, on the heels of an options expiration, have tended to precede weakness much more often than not.

The one big wildcard was (and is) seasonality, which is unmistakably positive as we all know at this time of year. Nevertheless, looking at past occurrences of the current kinds of setups heading into the end of the year, I see as much weakness as strength.

That kind of battle is not one I want to fight. It seems I can make a valid argument for being long, and an equally valid one for being short, and that's not the type of situation in which I want to risk capital, so I'm staying mostly neutral (as per plan) for trading positions here.

My thought heading into the week was that we'd have one more opportunity to trade the "oversold in December" phenomenon. The longer we go without pausing, though, the less likely it's going to present itself, simply because the clock is ticking ever closer to year-end.

The Nasdaq 100, in particular, has a very nasty habit of correcting at least 5% within a 10-day window during January, so if I'm to be tempted further to the long side, then we need to see the setup fairly quickly. The past couple of years, the index shot higher to begin the new year, but that was after weak endings to the previous December.

The bottom line is that I'm doing very little here trading-wise. I'd like to see another opportunity for a low-risk long trade heading into the first couple sessions of the new year, but if we just hang around in overbought territory, then my focus will likely shift to the short side after the end of the year.
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Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Cape Coral, Florida

This Is The Sound Of A Bubble Bursting

By Peter S. Goodman | 26 December 2007

Published Sunday, December 23, 2007

A model home in Cape Coral, Fla. In the wake of the real estate bust, the area is facing falling home values, foreclosures, municipal cutbacks and the loss of jobs. •  •   Phillippe Diederich for The New York Times

Cape Coral, Florida

Two years ago, when Eric Feichthaler was elected mayor of this palm-fringed, middle-class city, he figured on spending a lot of time at ribbon-cuttings. Tens of thousands of people had moved here in recent years, turning musty flatlands into a grid of ranch homes painted in vibrant Sun Belt hues: lime green, apricot and canary yellow. Mr. Feichthaler was keen to build a new high school. He hoped to widen roads and extend the reach of the sewage system, limiting pollution from leaky septic tanks. He wanted to add parks.

Now, most of his visions have shrunk. The real estate frenzy that once filled public coffers with property taxes has given way to a devastating bust over the last two years. Rather than christening new facilities, the mayor finds himself picking through the wreckage of speculative excess and broken dreams.

Last month, the city eliminated 18 building inspector jobs and 20 other positions within its Department of Community Development. They were no longer needed because construction has all but ceased. The city recently hired a landscaping company to cut overgrown lawns surrounding hundreds of abandoned homes.

"People are underwater on their houses, and they have just left," Mr. Feichthaler says. "That road widening may have to wait. It will be difficult to construct the high school. We know there are needs, but we are going to have to wait a little bit."

Waiting, scrimping, taking stock: This is the vernacular of the moment for a nation reckoning with the leftovers of a real estate boom gone sour. From the dense suburbs of northern Virginia to communities arrayed across former farmland in California, these are the days of pullback: with real estate values falling, local governments are cutting services, eliminating staff and shelving projects.

Families seemingly disconnected from real estate bust are finding themselves sucked into its orbit, as neighbors lose their homes and the economy absorbs the strains of so much paper wealth wiped out so swiftly.

Southwestern Florida is in the midst of this gathering storm. It was here that housing prices multiplied first and most exuberantly, and here that the deterioration has unfolded most rapidly. As troubles spill from real estate and construction into other areas of life, this region offers what may be a foretaste of the economic pain awaiting other parts of the country.

Cape Coral is in Lee County, across the Caloosahatchee River from Fort Myers. In the county, a tidal wave of foreclosures is turning some neighborhoods into veritable ghost towns. The county school district recently scrapped plans to build seven new schools over the next two years. Real estate agents and construction workers are scrambling for other lines of work, and abandoning the area. As houses are relinquished to red ink and the elements, break-ins are skyrocketing, yet law enforcement is resigned to making do with existing staff.

"We’re all going to have to tighten the belt somehow," says Robert Petrovich, Cape Coral’s chief of police.

Florida real estate has long been synonymous with boom and bust, but the recent cycle has packed an unusual intensity. The Internet made it possible for people ensconced in snowy Minnesota to type "cheap waterfront property" into search engines and scroll through hundreds of ads for properties here. Cape Coral beckoned speculators, retirees and snowbirds with thousands of lots, all beyond winter’s reach.

Creative finance lubricated the developing boom, making it easy for buyers to take on more mortgage debt than they could otherwise handle, driving prices skyward. Each upward burst brought more investors— some from as far as California and Europe, real estate agents say.

Joe Carey was part of the speculative influx. An owner of rental property in Ohio, he visited Cape Coral in 2002 and found that he could buy undeveloped quarter-acre lots for as little as $10,000. Nearby, there were beaches, golf courses and access to the Caloosahatchee River, which empties into the Gulf of Mexico.

Builders were happy to arrange construction loans, then erect houses in as little as six months. Real estate agents promised to find buyers before the houses were even finished.

"All you needed was a pulse," Mr. Carey said. "The price of dirt was going up. We took that leap of faith and put down $10,000."

Backed by easily acquired construction loans, Mr. Carey’s investment allowed him to buy three lots and top off each with a new home. He flipped them immediately for about $175,000 each, he recalls. Then he bought more lots, confident that Cape Coral and Fort Myers— the county seat across the river— would continue to blossom. From 2000 to 2003, the population of the Cape Coral-Fort Myers metropolitan area grew to nearly 500,000 from 444,000, according to Moody’s Economy.com.

"Jobs were very plentiful," Mr. Carey said. "The construction trade was up, stores were opening up, and doctors were coming in. It kind of built its own economy."

In 2003, Mr. Carey became a real estate agent. The next year, he opened a title company. Then he teamed up with seven others to open a local office for Keller Williams Realty, the national realty chain. They hired 40 agents.

By 2004, the median house price in Cape Coral and Fort Myers had shot up to $192,100, according to the Florida Association of Realtors— a jump of 70 percent from $112,300 just four years earlier. In 2005, the median price climbed an additional 45 percent, to more than $278,000.

Lots that Mr. Carey once bought for $10,000 were now going for 10 times that. During the best times back in Ohio, he once earned about $100,000 in a year. At the height of the Florida boom, in 2005, he says he raked in $800,000. "If you just got up and went to work," he says, "pretty much anybody could become an overnight millionaire."

National home builders poured in, along with construction workers, roofers and electricians. But as a kingdom of real estate materialized, growth ultimately exceeded demand: investors were selling to one another, inflating prices. When the market figured this out in late 2005, it retreated with punishing speed. "It was as if someone turned off the faucet," Mr. Carey said. "It just came to a screeching halt. When it stopped, people started dumping property."

By October this year, the median house price was down to $239,000, some 14 percent below the peak. That same month, he and his partners shuttered his real estate office. In November, he closed the title company. On a recent afternoon, he went to his old office in a now-quiet strip mall to take home the remaining furniture. He was preparing to move to the suburbs of Atlanta.

While speculators may find it easy enough to pack up and move on, they are leaving behind a landscape of vacant houses that will not be easily sold. More than 19,000 single-family homes and condos are now listed on the market in Lee County. Fewer than 500 sold in November, meaning that at the current rate it would take three years for the market to absorb all the houses. "Confusion abounds because nobody knows where the bottom is," says Gerard Marino, a commercial Realtor at the Re/Max Realty Group in Fort Myers. Commercial builders are unloading properties at sharply reduced prices, sometimes even below construction costs, which further adds to the glut.

"It’s our goal to clear out the inventory," James P. Dietz, the chief financial officer of WCI Communities, a Florida-based home builder, said in an interview two weeks ago. "We have to generate cash to make payroll." Last week, Mr. Dietz announced he would leave WCI at the end of this year to pursue a career in the vacation resort business. AT Pelican Preserve, a gated community set around a 27-hole golf course in Fort Myers, WCI has halted building, leaving some residents staring at mounds of earth where they expected to see manicured lawns. Half-built condos sit isolated in a patch of dirt, cut off from the road.

"It bugs the hell out of my wife," says Paul Bliss, 61, whose three-bedroom town house is next to a half-built home site. "She looks out and sees that concrete slab." But the builder makes no apologies. "There was such a falloff in demand that it made no sense to build new units," says Mr. Dietz, adding that the pause in construction "doesn’t in any way detract from the property."

Throughout Lee County, a sense of desperation has seized the market as speculators try to unload property or lure renters. On many lawns, a fierce battle is under way for the attention of passers-by, with "for rent" signs narrowly edging out "for sale." In Cape Coral, foreclosure filings in the first 10 months of the year reached 4,874, more than a fourfold increase over the same period the previous year, according to RealtyTrac, an online provider of foreclosure information.

Elaine Pellegrino and her daughter, Charlene, see no way to avoid joining that list. Seven years ago, Ms. Pellegrino and her husband bought their three-bedroom house in northwestern Cape Coral for $97,000, without having to make a down payment. The land was mostly empty then. But as construction crews descended and a thicket of new homes took shape, values more than doubled. The Pellegrinos’ mailbox brimmed with offers to convert that good fortune into cash by refinancing their mortgage. They bit, borrowing against the inflated value of their home to buy two businesses: an auto repair shop and a lawn service. "We were thinking we were on the way up," Ms. Pellegrino says. But last December, Ms. Pellegrino’s husband died unexpectedly, leaving her with the two businesses, both deeply in debt, and $207,000 she owed against her home, which is now worth about $130,000, she says.

Disabled and 53 years old, Ms. Pellegrino does not work. She says she lives on a $1,259 monthly Social Security check. Her daughter, a college student, receives $325 a month for child support for one child. Charlene Pellegrino has been looking on the Web for office work for months, but with so many people being laid off, she has come up empty, she says. They have not paid their mortgage in four months. "What can we do?" Charlene Pellegrino asks, as dusk nears and her driveway lights glow into a void. The rest of the block lies in shadows, with little light emanating from surrounding homes. "We’re probably going to lose the house," she says.

But not anytime soon. The Pellegrinos have joined a new cohort offered up by the real estate unraveling: they are among those waiting in their own homes for the seemingly inevitable. The courts are so stuffed with foreclosures that they assume they can stay for a while. "We figure we have at least six months," Elaine Pellegrino says. "We haven’t heard a thing from the bank for a long time."

As construction and real estate spiral downward, the unemployment rate in Lee County has jumped to 5.3 percent from 2.8 percent in the last year. With more than one-fourth of all homes vacant, residential burglaries throughout the county have surged by more than one-third. "People that might not normally resort to crime see no other option," says Mike Scott, the county sheriff. "People have to have money to feed their families." Darkened homes exert a magnetic pull. "When you have a house that’s vacant, that’s out in the middle of nowhere, that’s a place where vagrants, transients, dopers break a back window and come in," the sheriff adds.

The county’s Department of Human Services has seen a substantial increase in applications for a program that helps pay rent and utility bills for those in need. Half the applicants say they have lost jobs or have seen their work hours reduced, said Kim Hustad, program manager. At Grace United Methodist Church in Cape Coral, Pastor Jorge Acevedo normally starts aid drives this time of year for health clinics in places like India and Africa. This year, the church is buying Christmas presents for about 50 children in the congregation, many who are are in families suffering through job losses.

At Selling Paradise Realty, a sign seeks customers with a free list of properties facing foreclosure and "short sales," meaning the price is less than the owner owes the bank. Inside, Eileen Rodriguez, the receptionist, said the firm could no longer hand out the list. "We can’t print it anymore," she says. "It’s too long." In late November, more than 2,600 of the 5,500 properties for sale in Cape Coral were short sales, says Bobby Mahan, the firm’s owner and broker. Most people who bought in 2004 and 2005 owe more than they paid, he says. "Greed and speculation created the monster."

As much as anything, the short sales are responsible for the market logjam. To complete a deal, the lender holding the mortgage must be persuaded to share in the loss and write off some of what is due. "A short sale is a long and arduous process," Mr. Mahan says. "Battling the banks is horrendous." Kevin Jarrett is stuck in that quagmire. In 1995, freshly arrived from Illinois, he put down $1,000 to buy a house in Lehigh Acres, in eastern Lee County. Three years later, Mr. Jarrett left his mental health-counseling job and began selling real estate. He bought progressively nicer homes, keeping the older ones to rent, while borrowing against the rising value of one to finance the next.

Mr. Jarrett acquired a taste for $100 dinners. He bought a powerboat and a yellow Corvette convertible. (In a photograph on his business card, Mr. Jarrett sits behind the wheel, the top down, offering a friendly wave.) Last summer, he paid $730,000 for a 2,500-square-foot home in Cape Coral with a pool and picture windows looking out on a canal. But Mr. Jarrett hasn’t closed a deal in three months. He is on track to earn about $50,000 for the year, he said. Yet he needs $17,000 a month just to pay the mortgages, insurance, taxes and utility bills on his four properties— all worth less than half what he owes. Rental income brings in only about $3,500 a month.

Mr. Jarrett has not paid the mortgage on two of his properties in six months and is behind on the others as well, he says. His goal is to sell everything, move into a rental and start over. He is supplementing his income by selling MonaVie, a nutritional juice that retails for $45 a bottle. He recently dropped health insurance for his family, saving about $680 a month. He is applying for a state-subsidized health plan that would cover his 9-year-old daughter. "I’m in survival mode," he says.

Many others are in similar straits, and the situation has had a ripple effect on the local economy. Scanlon Auto Group, a luxury car dealer, says it has seen its sales dip significantly— the first time that’s happened in 25 years. Rumrunners, a popular Cape Coral restaurant with tables gazing out on a marina, says its business is down by a third, compared with last year. Furniture dealers are folding. Hardware stores are suffering. At Taco Ardiente in Lehigh Acres, business is down by more than three-fourths, complains the owner, Hugo Lopez. His tables were once full of the Hispanic immigrants who filled the ranks of the construction trade. The work is gone, and so are the workers.

At the state level, Florida’s sales tax receipts have slipped by nearly one-tenth this year, and by 14 percent in Lee County. That is a clear sign of a broad economic slowdown, said Ray T. Kest, a business professor at Hodges University in Fort Myers. "It started with housing, the loss of construction jobs, mortgage companies, title companies, but now it’s spread through the entire economy," Mr. Kest says as he walks a strip of mostly empty condo towers on the riverside in downtown Fort Myers. "It now has permeated everything."

In recent years, Bishop Verot Catholic High School in Fort Myers had raised as much as $200,000 by selling goods at a dinner auction. Michael Pfaff, a Cape Coral mortgage broker, used to donate a weekend cruise on his 40-foot catamaran. But Mr. Pfaff’s business has all but disappeared, and he recently sold the boat. This year, the school canceled the auction and is deferring building maintenance.

The county school district’s decision to cancel construction of new public schools reflects a broader diminishing of resources. Developers have to pay so-called impact fees to the district to help fund new facilities. Two years ago, the district took in $56 million in such fees. Next year, it expects only $25 million. New schools are no longer needed anyway, says the schools superintendent, James W. Browder. Many families connected to construction and real estate have moved away, so school enrollments are growing more slowly than expected. This could generate a snowball effect all its own: the new schools were to cost as much as $60 million each to build, so canceling them could mean further job cuts for the already reeling local building industry.

Mr. Browder points out an upside of the housing downturn: Hiring people has become easy. In recent years, the school system struggled to find bus drivers, given the abundance of jobs at twice the pay driving dump trucks in home construction. "Now, we get 14 applicants for every job," he says. The county government depends on property taxes for a third of its general funding. Since taxes are assessed based on the previous year’s real estate values, it has yet to feel a dent. But agencies are under significant pressure to pare back in anticipation of a dip in next year’s funds.

Tax-cutting advocates cheer this prospect. Governments have gotten fat on the boom, they say. A constitutional amendment facing Florida voters in January would expand tax caps for many residences statewide. "All the local governments were drunk with money," says Mr. Kest, the finance professor. "Now, they’re going to have to cut back and learn how to manage."

But local officials counter that they are already being forced to contemplate significant changes that could affect everyday life. The county’s public safety division, which operates ambulance services, says it could be obliged to cut staff. The county’s Natural Resources Department recently delayed a $2.1 million project to filter polluted runoff spilling into the Lakes Regional Park— a former quarry turned into a waterway dotted by islands and frequented by native waterfowl.

People who were priced out of the earlier boom here could wind up the winners. "We had an affordable-housing crisis," says Tammy Hall, a Lee County commissioner. "The people who were here for a fast buck are gone. You’re going to see normal people go back into that housing." When Andrea Drewyor, 24, moved to Cape Coral from Ohio this year to take a teaching job, she found a brand-new two-bedroom waterfront duplex in a gated community with a fitness center, a swimming pool and a Jacuzzi— all for $875 a month in rent.

At night, most of the units around her are dark. The developer can moan. Not Ms. Drewyor.

"I like not having a lot of people living here," she said. "This place is awesome."
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Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Crosscurrents

Home Of "Pictures Of A Stock Market Mania"

By Alan M. Newman, Editor, Crosscurrents | 26 December 2007

These excerpts from the December 17th issue have been posted to coincide with receipt by snail-mail subscribers.

Derivative Uncertainties

To further solidify our analysis of a derivative crisis in progress, Bloomberg's David Evans recently reported (see http://tinyurl.com/2f4ypm) that Florida local governments and school districts had pulled $8 billion out of a state run investment pool, representing 30% of the pool's assets, after realizing one of their money market investments contained more than $700 million of defaulted debt. Of the $42 billion in short term assets managed by the State Board of Administration, almost 6%, or $2.4 billion consists of defaulted commercial paper. The State Board also manages the state's $137 billion pension fund. We are concerned that if speculation about pensions threatened by deteriorating derivative contracts does not abate quickly, there is a distinct possibility of a run on assets of every kind and description, not just in Florida but in many other locales. The Bloomberg article goes on to quote John Coffee, a securities law professor at Columbia Law School in New York, predicting investment pools will likely file lawsuits to recover losses.

Most of the now defaulted asset-backed commercial paper was sold to Florida by Lehman Bros. The company declined to comment on the matter but Coffee is on record saying that since the risks were hidden, "I'd expect the pool is going to sue the people who sold them the commercial paper." We would expect that the Florida situation has the potential to be played out literally thousands of times over across the nation as school, fire, water and other local districts find that supposedly safe short term investments were in reality, tainted derivatives. Clearly, as we have shown in these pages since late summer, the chart patterns of many major banks and brokers were (and still are) evidence of a rapidly deteriorating environment for structured finance. In the process, those who have been first in line to liquidate holdings of the pools have gotten out intact. The others behind them have been and still are at risk. Joseph Mason, a professor of finance at Drexel University who has studied the history of bank failures, says, "Since nobody wants to be at the end, you get a run on the pool."

While we would love to shove these ugly developments under a rug or find a way to stress only positive aspects (there are none), we cannot ignore the growing refrain of concern, uncertainty and even fear voiced by observers. In a span measuring only a few minutes on Tuesday, December 4th, we found stories claiming a "Dire Credit Market" (see http://tinyurl.com/2xjbba), "Could Citadel's valuation of E*Trade's CDOs wipe out capital at three big banks?" (see http://tinyurl.com/25glbu), and "Dangerously Close to a Money Panic" (see http://tinyurl.com/3cvb2q). The pattern of waning confidence is already having an extremely negative impact.

As startling a development as any may turn out to be the refusal of auditors to verify the results of the major banks when they are due to report results in January. As related by the NY Post's John Crudele (see http://tinyurl.com/2zf5qj) more than a month ago, under a rule enacted in early 2006, banks can no longer indemnify auditors for mistakes. Given the recent mess and uncertainty over derivatives, auditors may simply step back, which would only serve to heighten apprehensions further.

Add to the mix potential problems with structured finance covering consumer credit card loans and auto loans and you have the potential for a mess unlike any seen since the Roaring Twenties ended with a whimper. Since the market for derivatives is so opaque, there is no completely accurate method to gauge counter-party risks or even to judge precisely who may be on hook to whom for how much if defaults and writedowns continue at their now frenetic pace.

Now, toss in the administration's plan that hopes to freeze mortgage rates for five years and you have the makings of an even uglier mess. The "plan" really changes nothing at all, but ironically, will likely make it even more difficult to structure or value mortgage derivatives. Therein lies the crux of the issue. Last week, our colleague Jim Bianco, one of the savviest minds on Wall Street, commented, "The real problem is investors in structured securities have lost confidence in the securities they own. They are too complicated to understand and they have stopped buying new ones. Consequently, existing structured securities are losing value as bids and offers are non-existent." Bianco goes on to cite the 20,000 ratings downgrades of ‘structures’ and in our view, correctly states that "Delinquencies and defaults are not a problem if you understand what you own. Defaults and delinquencies create a panic when operating in the dark— which is what has been happening in the credit markets this year."

The most gut-wrenching uncertainty that has surfaced may be that quite a few participants are rooting for a worsening environment by shorting the ABX indexes, which were recently pricing in a replay of the Great Depression. If Goldman Sachs did not game the index (see http://tinyurl.com/yq9eo3), they clearly gave the impression of a horrific conflict of interest. Financial engineering has created a brave new world, one that was tested quite severely in 1987 and 1998. And now in 2007, structured finance has again laid out a very uncertain future.

Rationales & Targets

In the last issue, although we were confident the risk/reward ratio favored the downside, the "Current Forecast" assumed a "brief rally" was probable over the "short term." It would have been unrealistic to expect to forecast the extremes exactly as they played out but we believe our take was accurate and timely. The Dow actually bottomed the following day and then rallied strongly into December 10th before finally turning down again last week. Sentiment presents a very mixed bag. Option indicators could support additional brief rally attempts but longer term sentiments imply the bears are giving up and walking away from any possibility that a protracted downside might be in store. To wit: total assets in Rydex Bear Index funds has plunged to its lowest level since the October 2002 bottom! While we must grant that assets in Rydex Bull and Sector funds has gone mostly sideways for four years, the contraction in pessimism is one of the most surprising developments, given the Dow Theory bear market signal and the ongoing corrective mode. We interpret this as an extremely negative long term development and remain in bear mode.

Market Indicators

The perspective below has correctly called all meaningful tops over the last few years. We ran the chart and placed it on the front page of the November 6th issue, only four days after Nasdaq’s high. Propitious, to say the least. In theory, when Nasdaq volume picks up substantially relative to everything non-Nasdaq, we have entered a speculative phase and risk looms large. What now? We note the prior four circled reversals resulted in worse corrections than now. The first instance from the end of January to mid-August ’04 encompassed 18.6% on the downside. The second correction was 12.6% from the end of December ’04 to the end of April ’05. The third was 14.8% from mid-April to late July ’06. The 11.1% recent drawdown seems way too tame given the run in "Speculative Intensity." Our long held 15% downside target is still quite viable and equates to 7.7% below Friday’s close.

ߧ
Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

1929: A 'Walk In The Park'

Crisis May Make 1929 Look A 'Walk In The Park'

By Ambrose Evans-Pritchard | 23 December 2007

As central banks continue to splash their cash over the system, so far to little effect, things are rapidly spiralling out of their control.

Twenty billion dollars here, $20bn there, and a lush half-trillion from the European Central Bank at give-away rates for Christmas. Buckets of liquidity are being splashed over the North Atlantic banking system, so far with meagre or fleeting effects.

As the credit paralysis stretches through its fifth month, a chorus of economists has begun to warn that the world's central banks are fighting the wrong war, and perhaps risk a policy error of epochal proportions.


Click Here, or on the image, to see a larger, undistorted image.
Faces of power: The Fed’s Ben Bernanke, the BoE’s Mervyn King, the ECB’s Jean-Claude Trichet

"Liquidity doesn't do anything in this situation," says Anna Schwartz, the doyenne of US monetarism and life-time student (with Milton Friedman) of the Great Depression. "It cannot deal with the underlying fear that lots of firms are going bankrupt. The banks and the hedge funds have not fully acknowledged who is in trouble. That is the critical issue," she adds.

Lenders are hoarding cash, shunning peers as if all were sub-prime lepers. Spreads on three-month Euribor and Libor— the interbank rates used to price contracts and Club Med mortgages— are stuck at 80 basis points even after the latest blitz. The monetary screw has tightened by default.

York professor Peter Spencer, chief economist for the ITEM Club, says the global authorities have just weeks to get this right, or trigger disaster. "The central banks are rapidly losing control. By not cutting interest rates nearly far enough or fast enough, they are allowing the money markets to dictate policy. We are long past worrying about moral hazard," he says. "They still have another couple of months before this starts imploding. Things are very unstable and can move incredibly fast. I don't think the central banks are going to make a major policy error, but if they do, this could make 1929 look like a walk in the park," he adds.

The Bank of England knows the risk. Markets director Paul Tucker says the crisis has moved beyond the collapse of mortgage securities, and is now eating into the bedrock of banking capital. "We must try to avoid the vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply, and slower aggregate demand— all feed back on each other," he says.

New York's Federal Reserve chief Tim Geithner echoed the words, warning of an "adverse self-reinforcing dynamic", banker-speak for a downward spiral. The Fed has broken decades of practice by inviting all US depositary banks to its lending window, bringing dodgy mortgage securities as collateral.

Quietly, insiders are perusing an obscure paper by Fed staffers David Small and Jim Clouse. It explores what can be done under the Federal Reserve Act when all else fails.

Section 13 (3) allows the Fed to take emergency action when banks become "unwilling or very reluctant to provide credit". A vote by five governors can— in "exigent circumstances"— authorise the bank to lend money to anybody, and take upon itself the credit risk. This clause has not been evoked since the Slump.

Yet still the central banks shrink from seriously grasping the rate-cut nettle. Understandably so. They are caught between the Scylla of the debt crunch and the Charybdis of inflation. It is not yet certain which is the more powerful force.

America's headline CPI screamed to 4.3 per cent in November. This may be a rogue figure, the tail effects of an oil, commodity, and food price spike. If so, the Fed missed its chance months ago to prepare the markets for such a case. It is now stymied.

This has eerie echoes of Japan in late-1990, when inflation rose to 4 per cent on a mini price-surge across Asia. As the Bank of Japan fretted about an inflation scare, the country's financial system tipped into the abyss. In theory, Japan had ample ammo to fight a bust. Interest rates were 6 per cent in February 1990. In reality, the country was engulfed by the tsunami of debt deflation quicker than the bank dared to cut rates. In the end, rates fell to zero. Yet, still it was not enough.

When a credit system implodes, it can feed on itself with lightning speed. Current rates in America (4.25 per cent), Britain (5.5 per cent), and the eurozone (4 per cent) have scope to fall a long way, but this may prove less of a panacea than often assumed. The risk is a Japanese denouement across the Anglo-Saxon world and half Europe.

Bernard Connolly, global strategist at Banque AIG, said the Fed and allies had scripted a Greek tragedy by under-pricing credit long ago and seem paralysed as post-bubble chickens now come home to roost. "The central banks are trying to dissociate financial problems from the real economy. They are pushing the world nearer and nearer to the edge of depression. We hope they will eventually be dragged kicking and screaming to do enough, but time is running out," he said.

Glance at the more or less healthy stock markets in New York, London, and Frankfurt, and you might never know that this debate is raging. Hopes that Middle Eastern and Asian wealth funds will plug every hole lifts spirits. Glance at the debt markets and you hear a different tale. Not a single junk bond has been issued in Europe since August. Every attempt failed. Europe's corporate bond issuance fell 66% in the third quarter to $396bn (BIS data). Emerging market bonds plummeted 75%.

"The kind of upheaval observed in the international money markets over the past few months has never been witnessed in history," says Thomas Jordan, a Swiss central bank governor. "The sub-prime mortgage crisis hit a vital nerve of the international financial system," he says.

The market for asset-backed commercial paper— where Europe's lenders from IKB to the German Doctors and Dentists borrowed through Irish-based "conduits" to play US housing debt— has shrunk for 18 weeks in a row. It has shed $404bn or 36%. As lenders refuse to roll over credit, banks must take these wrecks back on their books. There lies the rub.

Professor Spencer says capital ratios have fallen far below the 8 per cent minimum under Basel rules. "If they can't raise capital, they will have to shrink balance sheets," he said. Tim Congdon, a banking historian at the London School of Economics, said the rot had seeped throughout the foundations of British lending. Average equity capital has fallen to 3.2 per cent (nearer 2.5 per cent sans "goodwill" [[of which there is hardly any left!: normxxx]]), compared with 5 per cent seven years ago. "How on earth did the Financial Services Authority let this happen?" he asks. Worse, changes pushed through by Gordon Brown in 1998 have caused the de facto cash and liquid assets ratio to collapse from post-war levels above 30 per cent to near zero. "Brown hadn't got a clue what he was doing," he says.

The risk for Britain— as property buckles— is a twin banking and fiscal squeeze. The UK budget deficit is already 3 per cent of GDP at the peak of the economic cycle, shockingly out of line with its peers. America looks frugal by comparison. Maastricht rules may force the Government to raise taxes or slash spending into a recession. This way lies crucifixion. The UK current account deficit was 5.7 per cent of GDP in the second quarter, the highest in half a century. Gordon Brown has disarmed us on every front.

In Europe, the ECB has its own distinct headache. Inflation is 3.1 per cent, the highest since monetary union. This is already enough to set off a political storm in Germany. A Dresdner poll found that 71 per cent of German women want the Deutschmark restored.

With Brünhilde fuming about Brot prices, the ECB has to watch its step. Frankfurt cannot easily cut rates to cushion the blow as housing bubbles pop across southern Europe. It must resort to tricks instead. Hence the half trillion gush last week at rates of 70bp below Euribor, a camouflaged move to help Spain.

The ECB's little secret is that it must never allow a Northern Rock failure in the eurozone because this would expose the reality that there is no EU treasury and no EU lender of last resort behind the system. Would German taxpayers foot the bill for a Spanish bail-out in the way that Kentish men and maids must foot the bill for Newcastle's Rock? Nobody knows. This is where eurozone solidarity stretches to snapping point. It is why the ECB has showered the system with liquidity from day one of this crisis.

Citigroup, Merrill Lynch, UBS, HSBC and others have stepped forward to reveal their losses. At some point, enough of the dirty linen will be on the line to let markets discern the shape of the debacle. We are not there yet [[indeed, far from it!: normxxx]].

Goldman Sachs caused shock last month when it predicted that total crunch losses would reach $500bn, leading to a $2 trillion contraction in lending as bank multiples kick into reverse. This already seems humdrum.

"Our counterparties are telling us that losses may reach $700bn," says Rob McAdie, head of credit at Barclays Capital. Where will it end? The big banks face a further $200bn of defaults in commercial property. On it goes.

Meanwhile, the International Monetary Fund still predicts blistering global growth of 5 per cent next year. If so, markets should roar back to life in January, as though the crunch were but a nightmare. Then again, the credit soufflé may be hard to raise a second time.

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Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Chrysler: We're 'Bankrupt'

Chrysler Ceo: We're 'Operationally' Bankrupt
Automaker Scrambling To Sell Assets Just Months After Private Equity Buyout As Credit Crunch Deepens

By CNN.Money.com | 25 December 2007

NEW YORK (CNNMoney.com)— Chrysler Corp., the troubled automaker bought by private equity just four months ago, is scrambling to sell assets amid indications of huge losses, as access to cash becomes increasingly scarce, according to a published report Friday.

"Someone asked me, 'Are we bankrupt?'" the Wall Street Journal quoted Chrysler boss Robert Nardelli telling employees at a meeting earlier this month. "Technically, no. Operationally, yes. The only thing that keeps us from going into bankruptcy is the $10 billion investors entrusted us with." To raise money, Chrysler is looking to sell over $1 billion in land, old factories, and other holdings, even if it has to let those properties go for under book value, the Journal said.

In an interview with the Journal, Nardelli confirmed the comments and declined to give a financial forecast for 2008, saying only that Chrysler "will make a pretty significant improvement" over the $1.6 billion the company is set to lose this year. The Journal said Nardelli originally hoped to turn a profit in 2008. The rush to raise capital comes amid constricting access to money as more banks and other lenders face heavy losses related to subprime mortgages.

Chrysler's owner, Cerberus Capital Management, is now facing serious subprime-related losses from GMAC Financial Services, which it bought from General Motors (GM, Fortune 500) for $12 billion, and is also trying to walk away from a now pricey deal to buy United Rentals Inc., (URI) the Journal said.

Cerberus bought Chrysler from German automaker Daimler in a deal that closed in August.

In the arrangement, Daimler (DAI) essentially paid Cerberus to take the automaker, which fell to No. 4 in U.S. sales behind Toyota Motor (TM) in 2006, in an effort to get out from under a $1.5 billion loss from last year, along with continued obligations to union members and retirees.

ߧ
Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Blindly Into The Bubble

Blindly Into The Bubble

By Paul Krugman, NYT | 21 December 2007

When announcing Japan's surrender in 1945, Emperor Hirohito famously explained his decision as follows: "The war situation has developed not necessarily to Japan's advantage." There was a definite Hirohito feel to the explanation Ben Bernanke, the Federal Reserve chairman, gave this week for the Fed's locking-the-barn-door-after-the-horse-is-gone decision to modestly strengthen regulation of the mortgage industry: "Market discipline has in some cases broken down, and the incentives to follow prudent lending procedures have, at times, eroded."

That's quite an understatement. In fact, the explosion of "innovative" home lending that took place in the middle years of this decade was an unmitigated disaster.

But maybe Mr. Bernanke was afraid to be blunt about just how badly things went wrong. After all, straight talk would have amounted to a direct rebuke of his predecessor, Alan Greenspan, who ignored pleas to lock the barn door while the horse was still inside— that is, to regulate lending while it was booming, rather than after it had already collapsed.

I use the words "unmitigated disaster" advisedly.

Apologists for the mortgage industry claim, as Mr. Greenspan does in his new book, that "the benefits of broadened home ownership" justified the risks of unregulated lending.

But homeownership didn't broaden. The great bulk of dubious subprime lending took place from 2004 to 2006— yet homeownership rates are already back down to mid-2003 levels. With millions more foreclosures likely, it's a good bet that homeownership will be lower at the Bush administration's end than it was at the start.

Meanwhile, during the bubble years, the mortgage industry lured millions of people into borrowing more than they could afford, and simultaneously duped investors into investing vast sums in risky assets wrongly labeled 'AAA.' Reasonable estimates suggest that more than 10 million American families will end up owing more than their homes are worth, and investors will suffer $400 billion or more in losses.

So where were the regulators as one of the greatest financial disasters since the Great Depression unfolded? They were blinded by ideology.

"Fed shrugged as subprime crisis spread," was the headline on a New York Times report on the failure of regulators to regulate. This may have been a discreet dig at Mr. Greenspan's history as a disciple of Ayn Rand, the high priestess of unfettered capitalism known for her novel "Atlas Shrugged."

In a 1963 essay for Ms. Rand's newsletter, Mr. Greenspan dismissed as a "collectivist" myth the idea that businessmen, left to their own devices, "would attempt to sell unsafe food and drugs, fraudulent securities, and shoddy buildings." On the contrary, he declared, "it is in the self-interest of every businessman to have a reputation for honest dealings and a quality product."

It's no wonder, then, that he brushed off warnings about deceptive lending practices, including those of Edward M. Gramlich, a member of the Federal Reserve board. In Mr. Greenspan's world, predatory lending— like attempts to sell consumers poison toys and tainted seafood— just doesn't happen.

But Mr. Greenspan wasn't the only top official who put ideology above public protection. Consider the press conference held on June 3, 2003— just about the time subprime lending was starting to go wild— to announce a new initiative aimed at reducing the regulatory burden on banks. Representatives of four of the five government agencies responsible for financial supervision used tree shears to attack a stack of paper representing bank regulations. The fifth representative, James Gilleran of the Office of Thrift Supervision, wielded a chainsaw.

Also in attendance were representatives of financial industry trade associations, which had been lobbying for deregulation. As far as I can tell from press reports, there were no representatives of consumer interests on the scene.

Two months after that event the Office of the Comptroller of the Currency, one of the tree-shears-wielding agencies, moved to exempt national banks from state regulations that protect consumers against predatory lending. If, say, New York State wanted to protect its own residents— well, sorry, that wasn't allowed.

Of course, now that it has all gone bad, people with ties to the financial industry are rethinking their belief in the perfection of free markets. Mr. Greenspan has come out in favor of, yes, a government bailout. "Cash is available," he says— meaning taxpayer money— "and we should use that in larger amounts, as is necessary, to solve the problems of the stress of this."

[ Normxxx Here:  Of course, since the profits made from all of this wheeling and dealing are long gone into the pockets of that "top 1% - 5%" whose taxes were so conveniently reduced in time to collect that largesse!  ]

Given the role of conservative ideology in the mortgage disaster, it's puzzling that Democrats haven't been more aggressive about making the disaster an issue for the 2008 election. They should be: It's hard to imagine a more graphic demonstration of what's wrong with their opponents' economic beliefs.

ߧ
Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Economic and Market Considerations

Considerations Of Our Current Economic And Market Climates

Questions by [BoltonCT]; Answers largely by normxxx | 16 December 2007

[BoltonCT]: Norm, Al and others... what do you think we need to do to get the economy back on track? We hear contradictory analysis. The FED says they are increasing liquidity. Others say the facts show they are not. They are only maintaining current liquidity.

The question of what the Fed is doing was answered above. But I will begin by expanding on my comment, "Note that neither John nor Gary seems to be considering the non-bank money centers, which have been the Principal source of money for mortgages, etc."

Consider first the invention of mortgage backed securities, which has since morphed into asset backed securities of every stripe. In 1968, Congress established the Government National Mortgage Association, commonly known as Ginnie Mae, as a government-owned corporation within the Department of Housing and Urban Development (HUD). Even today, Ginnie Mae securities are the only mortgage-backed securities (MBSs) that offer the full faith and credit guaranty of the United States government. These MBSs were created to solve a problem: a lack of available, consistently priced capital, which put a ceiling on the number of new mortgages that Ginnie Mae could issue, since the mortgages generally don't return much of the principal until they are near due— for perhaps 20 years or so.

Ginnie Mae solved this problem and revolutionized the American housing industry in 1970 by pioneering the issuance of mortgage-backed securities. Today, 'intermediate lenders' (such as Fannie Mae and Freddie Mac) pool packages of 'qualifying' FHA, VA, RHS or PIH mortgages and convert them into securities (the lesser mortages are packaged by the banks and other 'private' creators of MBSs and CDOs), which are then resold to the final lenders (pension funds and the like). Ginnie Mae guarantees investors the timely payment of principal and interest on these securities (the 'private' packagers may use 'private' insurers).

In a single step, the issuance of mortgage-backed securities converted individual mortgages into liquid securities for investors around the world. It would not be a large leap for others to do the same with mortgages and other forms of debt. All manner of debt had become fungible! For what happened next, see We're heading toward financial chaos

By immediately selling off their mortgages (or other loans) as packages of MBSs/ABSs to others, including "off-the-books" Funds (such as SIVs and similar) set up by the banks themselves explicitly for that purpose, the banks were immediately able to relend the same money over and over again to other mortgagees. What did the banks gain in such a transaction? Fees. These became so profitable, as the money turnover sped up, that even the really "prime" mortgages, which the banks had retained simply to collect the "safe" interest on, were eventually sold to regain funds with which to turn over other mortgages and loans. Banks had become mortgage and loan "originators" only— and no longer figured very prominently in a loan once it was sold.

The description of how the "fractional reserve" money and banking system works is well described by Gary and John for as far as it goes. But it neglects this direct access of the commercial money markets by banks and others in order to gain funds to support highly risky ventures. These funds were never loaned out under the auspices of the "fractional reserve" money system, since the money was used either simply to replace funds that were part of the system— by the reserve banks— or was just directly re-lent by non-[reserve]bank 'money centers', e.g., F&F, Countrywide, etc. who were never part of the system. All of this was outside of the "fractional reserve" money and banking system!

In the diagram below, start with the bank and follow the arrows around to gain some idea of how this "off-the-books" process worked— until it didn't. The picture is the similar for the non-bank money centers such as F&F, and the so-called "mortgage brokers" (e.g., Countrywide), which act a bit like banks and a bit like the Funds set up by the banks, except that they cannot call on a parent bank or the CB when there is a run on their assets— so they go bankrupt! (Though I seriously don't think that F&F will go BK.)


Click Here, or on the image, to see a larger, undistorted image.

The source of low cost short-term funding for all of these extra-bank and non-bank money center lending was the commercial paper market, until it largely imploded. The SIVs fell back on funds from their parent or other banks; the smaller non-bank money centers have largely gone bankrupt; the rest are hanging on by a thread.

So the banks (the newly created "loan originators") neatly bypassed/circumvented the Fed/bank money system so carefully described by Gary and John. And F&F and the many lesser non-bank money centers (such as Countrywide) were never part of that banking system, but still originated loans and lent out money— until they suddenly could not sell any more MBSs or CDOs, to anybody.

See Conduits, SIVs, cash-hoarding, commercial paper restructuring and such for a handle on how the banks' sponsored funds are doing currently.

[BoltonCT]: Premise 1 There is a worldwide imbalance and polarization between saving (East) and investment (West).

Only partly true. In the past, even the most supposedly "risk free" investments in third world countries carried plenty of risk, so it was fairly common for the rich folk in those countries and in the developed countries to send their funds to supposedly "safe havens"— such as the U.S. and other Western countries. These funds were then mostly locally relent (in the developed world, that is). I doubt if that trend will survive this credit collapse. See Citibank SIVs Hit Norway Townships— Several Norway townships are caught up in the international credit crisis.

[BoltonCT]: Premise 2 There is now a reported worldwide credit crunch.

So far, it has been mostly contained to MBSs in the commercial paper market; but even bank "paper" and other so-called "safe" funds are rapidly drying up or are being subjected to far greater scrutiny and suspicion. The CP market has become a shadow of what it was just a year or so ago. See Calculated Risk: Discount Rate Spread Increases, FT.com:What America’s shrinking asset-backed market tells us…., Market looks to Fed as commercial paper falls and The Great Commercial Paper Meltdown of 2007

[BoltonCT]: Premise 3 Greenspan is right in saying the sub-prime collapse is the trigger not the cause of the crunch and that the crunch was an accident waiting to happen. The credit markets melted down in August because "risk had become increasingly under priced as market euphoria, fostered by an unprecedented global growth rate, gained cumulative traction."

Yes, but "Easy Al" still was a large proximate cause of the present collapse. It is amazing how wild "financiers" can get with 'almost free' money! Al's artificially easy money (at 1%) was the immediate cause of the "risk [becoming] increasingly under priced as market euphoria gained cumulative traction." The overall risk has been growing for over 20 years (gee; just about as long as Al was Fed Head!) and was the reason that I predicted TEOTWAWKI in 2009 during the last market meltdown, which I rightly averred was not IT (aka, "the BIG one")!

[BoltonCT]: Premise 4 The FED and world banks are trying to ease credit.

Well, they're trying to ease the "credit crunch." But, it is unclear how they can do that. The problem is not so much a loss of direct bank liquidity as that investors (and even other banks!) have lost trust in the system! When "AAA" rated securities can drop by half of face value, or even default, whom or what can you trust[!?!]

[BoltonCT]: Premise 5 Dr. Hussman concludes that no new money is actually flowing to ease the credit crunch.

That's largely true. The problem with this credit crunch, however, is that it is largely due to major investors holding back funds from the credit markets (better safe than sorry). And this lending is many times what the banks can lend.

[BoltonCT]: Therefore QED: Conclusion 1, This is a similar situation to the Great Depression where the FED/Banks push on a string and nothing happens. Reducing interest rates have no effect when risk gets too high. The crunch may be a lack of demand and not lack of supply for solid investments. When risk is too high only the credit unworthy still want credit. Logic-Why buy a house now when prices will be lower in 2 years?

There is a certain truth to what you say. But, today, the problem is not a lack of demand, but the lack of a way to close the gap between the investors with the money and those who need it, that the investors can trust! However, the Great Depression also saw deflation, and deflation causes real interest rates to rise (even as nominal interest rates go to zero), so it is easier/safer just to hold on to your money. That is not yet true today.

[BoltonCT]: Conclusion 2, Risk is now either properly priced or over priced and lowering the discount rate cannot ease the crunch or help the stock market any more. It can only weaken the dollar.

The only purpose to lowering the discount rate is to increase the spread between short term and long term rates (a common panacea when the banks get into trouble), so the banks can earn more money with which to pay off their liabilities. In any event, risk is still way underpriced, which is why we have a "credit crunch." At seriously higher long rates, there would be enough lenders; but how many ARM mortgagees, credit card holders, and marginal businesses set up during the 'easy money' era could afford those much higher rates? This is known as a vicious circle!

[BoltonCT]: Conclusion 3, Fiscal (Keynesian) policy (deficit spending) can no longer stimulate spending and investment because of the risk overhang of bubbles ready to burst. The financial mine field practically guarantees a loss on future investments.

I am not sure I understand the gist of this conclusion. But the problem as I see it is that income for those below the top 5% - 1% has stagnated since about 2000. So there is no way that current mortgagees can afford the houses they are now living in if they bought in the last several years or so (or if they foolishly tapped it as a source of funds to spend on 'free' living— pun intended). Moreover, now that we can no longer tap our houses for loans, or our credit cards, etc., we may just have to live within that stagnated income. But that sounds like a repeat of the '30s in the current economy; we have lived for too many years on the savings of foreigners— that well is now dry.

Just printing money will no longer work because we are at the point where inflation would rise as fast as (or faster than) the increase in money supply.

For a theory of endless bubbles, see iTulip's Ka-Poom Theory. (The 2006 update is shown at the bottom, with a long description of the theory here: "Ka-Poom Is A Rhyme Not A Repeat Of History". See "Dollar’s Last Lap As The Only Anchor Currency" for the most recent comments on the theory.)

[BoltonCT]: Conclusion 4, The U.S. currency will likely come under attack as the East-West balance is resolved as long as America continues to lower interest rates and maintain deficits. Current policies are making the situation worse causing inflation.

It depends on which calamity you are considering. The fascinating dilemas of the end-game are such that addressing one invariably makes another— equally dire— get worse. The usual approach (à la Alan Greenspan) was/is to leave inflation as the last thing to address, since "it is something we know how to control"[!?!] Unfortunately, while that may have been true for Paul Volcker, it was never true for AG. All of the paper currencies are inflating, just at different rates. Invest in physical assets, but be prepared for wild swings as we reverbrate from boom to bust and then finally reach some sort of equilibrium. For a beautiful explanation of hyperinflation, deflation, and how they are related, see Hyperinflation: Creating Repulsive Money by Paul Tustain.

[BoltonCT]: Conclusion 5, Bailouts place America in the Japanese conundrum. They postpone reckoning so they never put risk behind them. They just face perpetual economic risk. Bailouts are how governments create a legacy of corrupt and ineffective polices as can be seen throughout much of the world.

While that is largely true, if we get to deflation, then the Fed (or other CB, such as the BoJ) has lost control, and we have a repeat of our 'never ending '30s' in the U.S. or Japan's 17 year off-again on-again off-again economy. That was why AG was so terrified of deflation (even a hint got him to drop rates to 1% and seemingly hold them there forever.) The Fed is most comfortable with an inflation rate between 1% and 2%, and gets mightily nervous if it drops below 1% or rises above 2%. However, the "doctored" inflation rate of recent years is running around 4% to 6% higher than the "historical" (pre-Clinton) rates. See How do You Spell Stagflation? by John Mauldin. The pre-Clinton rates probably were/are somewhat high— as long as we can out-source to Asia and others at below domestic costs— but now I believe we have overcompensated in the other direction.

[BoltonCT]: Potential solutions: Potential Solution 1: "There are also, I should admit, forces which one might fairly well call automatic which operate under any normal monetary system in the direction of restoring a long-run equilibrium between saving and investment[[1]]. The point which I cast into doubt— though the contrary is generally believed— is whether these `automatic' forces will... tend to bring about not only an equilibrium between saving and investment but also an optimum level of production.[[2]]" (John Maynard Keynes, Collected Writings, Vol. 13, 1973: p.395) This probably will not help, for while America under-saves, China, Japan, and Germany balance it out globally. In the high-risk environment it is better not to have anything worth losing individually. But America has a lot to lose corporately. America is becoming more vulnerable to China and others buying our corporate natural resources and suppliers with cheap dollars under current FED policies. The danger is inflation.

[[1]] You have largely answered this first assertion: under "globalization" of trade, the economy has gone global. But as the wages and costs in the second and third world countries rise (and the credit they extend to us falls), the costs of those imports to Americans will rise— so, we are net-net no longer importing deflation, but exporting inflation!

[[2]] Keynes was concerned with overproduction due to limited demand. Incomes in the '30s among the vast numbers of consumers, just as now in the U.S. (with the cut-off of credit), had gotten too low— it took WWII to raise wages and pent up demand so that the economy was able to take off and never look back from the late '40s on.

Currently, we are again (temporarily?) suffering from overproduction in the second and third world countries.

However, as the 'boomers' in Europe, the U.S., and Japan retire, demand in these countries will swell— more than enough to keep the second and third world countries— with their huge under 30 populations— producing happily. But what thing of value do we give them in exchange for their production?

[BoltonCT]: Potential Solution 2: [[1]] Let it go and get the correction behind us. Fear of high and increasing economic and social risks from other meltdowns is the probable cause of the credit crunch that results in little demand for new investments. Who wants to invest in a house now when in two years a 25% decline can wipe out the owner's entire equity? Yes new money is drying up but who wants to invest it in a guaranteed loss as the stock market and other bubbles pop. Ultimately a recession is necessary to clear out the waste and corruption. The recession in 2001 was mild and corrected the market distortions and popped all the bubbles. [[2]] Raise the FED rate and let the stock market bubbles pop around the world. The EU is maintaining their rate, as we should be doing. China's bubble is the biggest and the threat of them controlling world resources would pop just as Japan's threat popped 17 years ago. Unlike Japan we should put our economic cleansing behind us and virtually eliminate risk in the USA as we have done in the past. Then unlike Japan our economy will grow rapidly again. Much of the Old World cannot part with the legacy of fears and hatreds they harbor from their past.

[[1]] This is a question that I have raised before:how do you let go of "the tail of the tiger" without risk of being eaten before you can make good an escape[!?!] I think you misread the temper of the average American today; conditions such as the '30s would surely incite a revolution (as they very nearly did in the early '30s). You can argue that if FDR had "toughed it out," the depression would have been over with probably no later than '35 or '36. But would there still have been a U.S. by then? Japan and the Japanese may be 'suffering'— but you'd hardly notice it. Between the natural acceptance of things as they are by the Japanese (and the abhorrence of any sort of radical protest) and their 'social welfare' programs, things never got/get so bad that there is much protest. Much the same is true in the EU, which is why they can tolerate unemployment of around 10% for years and years. Our social catastrophe nets are full of holes!

[BoltonCT]: Who wants to invest in a house now when in two years a 25% decline can wipe out the owner's entire equity?

Despite what you may think; there is no lack of demand; only a lack of the wherewithal. And, I don't think we will once again try to put people into homes with mortgages they cannot afford (once the teaser rates run out) on the insane assumption that house prices can only rise, and so the increased value of the home will allow them to refinance on more favorable terms. But you are right in the sense that the lenders will no longer lend to someone "in a house now when in two years a 25% decline can wipe out" a good chunk of the lender's "equity?" So, you'd better have a hefty downpayment and golden credit, especially if you are looking for a Jumbo mortgage loan.

[BoltonCT]: The recession in 2001 was mild and corrected the market distortions and popped all the bubbles.

Well, it was the popping of the dot.com bubble that brought on the puny recession of 2001; but beyond that it was not deep enough nor long enough to clear out many (if any) market distortions. Just look how eager and quickly "investers" were once again to jump into the stock market once the housing market really took off! If there had been a serious correction, it would have taken about a half to a full generation (10 to 20 years) to get the stock market going again!

[BoltonCT]: [[2]] Raise the FED rate and let the stock market bubbles pop around the world[!?!]

[[2]] Disabuse yourself of the notion that the Fed is looking out for the housing or stock markets, or even the economy; there is only one thing the Fed concerns itself with: the health of the banks of which it is made up. (Remember that famous 'old' saying [only slightly altered] "What's good for the banks is good for the USA") Remember, also, the only government official in the Fed (outside of the worker peons) is the Fed Head. All of the other members are heads of private banks.

As I noted above in answer to a previous point, "The only purpose to lowering the discount rate is to increase the spread between short term and long term rates (a common panacea when the banks get into trouble), so the banks can earn more money with which to pay off their liabilities."

But, aside from that, how long do you think Congress and/or the President would sit still if the Fed were seen to raise rates during a recession? Volcker got away with it, because (1) everyone was suffering from the runaway inflation, (2) Volcker only raised rates to an extreme for a very brief period (shock therapy), and (3) President Reagan (the man of iron convictions) was willing to go along and back him! (But the howls were still ferocious, and Reagan lost his Republican Senate!)

[BoltonCT]: The USA prospers because we have the most transparent and uncorrupted political and economic systems in the world. The Japanese laughed at us in the early 90's and said we had "Cowboy Economics" when we started downsizing as the building and banking bubbles were popping. It is time for this cowboy to pull in the belt again and start another fresh uncorrupted economic expansion.

I am uncomfortable with "the most ... uncorrupted political and economic systems in the world." Would you settle for least corrupted "political and economic systems in the world"?

My money on why we have prospered so (above and beyond what a cornucopia of natural resources have bought us) is that no other region in the world promotes, rewards, and treasures its innovators like the U.S.— From those who "made do" on the frontiers, to Eli Whitney, to Thomas A. Edison, to the computer innovators, to the internet and dot.com innovators, to the banking and other financial innovators who gave us our present alphabet soup of financial products (yes, even if they did overdo it— 'originators' operate without brakes— which is why we need government or somebody to slow things down when they get too heated)! Moreover, our society is attuned to novelty (possibly too much so) and change. And, yes, as a country we were never worried much about "saving face" when it came to cleaning up after financial or other disasters (such as slavery or Jim Crow).

Keep Your Eyes On Bernanke

Keep Your Eyes On Bernanke's Shoes

By Gary North | 23 December 2007

The humor scenes of Robin Williams' movie, Patch Adams, were quite good. Two of them remind me of Bernanke's present assignment. One was Adams' attempt to cheer up a morose dying patient. His strategy was to dress as an angel and come up with phrases synonymous with death. The dying man finally enters into the spirit of the challenge. Basically, it was "go out with a smile." (Doesn't sound funny? I guess you had to be there.) Second was the scene in a ward full of pre-teen cancer patients. Williams grabs some available implements and turns them into a clown's wardrobe. He cuts a red rubber syringe and sticks it onto his nose. He grabs a pair of bedpans and uses them as shoes. Every time I think of Ben Bernanke, I think of a guy with a bright red nose and bedpan shoes. But I merge the two scenes. He is trying to get us to laugh by coming up with clever euphemisms for financial death. (To the image, I add a beard.)

Walking The Tightrope

Think of a combined circus act: a tightrope walker who is a clown. He dons a pair of bedpan shoes and steps out onto the rope. He uses a safety net. But he uses it in a peculiar way. It isn't under him; it's over his shoulder.

This is Bernanke's assignment. He is the man in charge of the economy's safety net. It isn't much of a net. It is the legal authority to create money. This money is then used to buy mostly U.S. Treasury debt. To this has been added collateral held by commercial banks. This may not seem like much of a net. Basically, it's a license to print money. How does that provide safety for the tightrope walker himself?

Bernanke is a very special performer. He must provide a sense of command. He must persuade the rest of us that he is the preserver of the safety net. That net is supposed to protect all the rest of us in our death-defying walks across the high wire. But it's not attached to anything except the equivalent of a printing press. Bernanke holds that device in his hands. The device has two long bars, each extending out from one side. It's a kind of balance pole. At the end of each bar is a sign. One says "deflationary depression." The other says "inflationary crack-up boom."

At the center of the two bars is the mini-printing press. It's voice-activated. A whisper gets it going. It then spews out money toward the "crack-up boom" side of the bar whenever it looks as though the economy is tilting toward deflationary depression. Then, when the bar tilts too far toward "crack-up boom," he whispers to stop printing money. He then leans toward the deflationary depression side. All the while, he keeps up a line of patter. When it looks as though he and the economy will topple off the tightrope toward recession or even depression, he starts talking up liquidity. He's got it down pat.

The Federal Reserve also took a number of supplemental actions, such as cutting the fee charged for lending Treasury securities. The purpose of the discount window actions was to assure depositories of the ready availability of a backstop source of liquidity. Even if banks find that borrowing from the discount window is not immediately necessary, the knowledge that liquidity is available should help alleviate concerns about funding that might otherwise constrain depositories from extending credit or making markets. The Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets. (Aug. 31, 2007) At the height of the recent financial turmoil, the Federal Reserve took a number of steps to help markets return to more orderly functioning. The Fed increased liquidity in short-term money markets in early August through larger-than-normal open market operations. And on August 17, the Federal Reserve Board cut the discount rate— the rate at which it lends directly to banks— 50 basis points, or 1/2 percentage point— and subsequently took several additional measures. These efforts to provide liquidity appear to have been helpful on the whole, but the functioning of a number of important markets remained impaired. (Nov. 8, 2007)

Then, when it looks as though the economy might be facing rising prices and the instability associated with rising prices, he starts his famous anti-inflation patter.

More fundamentally, experience suggests that high and persistent inflation undermines public confidence in the economy and in the management of economic policy generally, with potentially adverse effects on risk-taking, investment, and other productive activities that are sensitive to the public's assessments of the prospects for future economic stability. In the long term, low inflation promotes growth, efficiency, and stability— which, all else being equal, support maximum sustainable employment, the other leg of the mandate given to the Federal Reserve by the Congress. (July 10, 2007) Moreover, if inflation were to move higher for an extended period and that increase became embedded in longer-term inflation expectations, the re-establishment of price stability would become more difficult and costly to achieve. With the level of resource utilization relatively high and with a sustained moderation in inflation pressures yet to be convincingly demonstrated, the FOMC has consistently stated that upside risks to inflation are its predominant policy concern. (July 18, 2007)

The thing that catches my attention is the dating of these routines. The first two, designed to take our minds off the threat of depression, were both given after mid-August, 2007, that is, after the subprime mortgage crisis first raised its ugly head. The second two, designed to take our minds off the threat of rising prices, were delivered prior to August.

If chronology means anything, the balance bar was leaning toward anti-inflation before August. Then, in late July, he shifted the balance bar's weight by leaning toward anti-depression. He turned on the money machine in a rather loud whisper.

But then he whispered it back off in mid-August through mid-September. Then back on. Then off. On-off, on-off: it's a sight to behold!

There he is, high above the ground, with a bright red nose, a beard, and a pair of shiny bedpan shoes. He is out there in front of us. We dutifully listen to his words of encouragement. We watch him lean left, then lean right, all the time insisting that the net will save us, probably, all things considered, but not to trust in moral hazard, where the net saves any group's investments. It will save all our investments, more or less, give or take 20% - 30% at the worst [[if only we invest 'prudently': normxxx]].

But he's carrying the net. It's supposed to be down there under us, isn't it? But it isn't. It's over his shoulder.

I keep looking at his shoes. Just one slip. . . .

At The Edge

Because of the vast increase in the size of the leveraged futures markets called derivatives, now in the range of $11 trillion in contracted liabilities and $500 trillion in dollar amounts or their currency equivalent traded annually, the world's central banks' task has become highly complex. The size of the derivatives market is vastly beyond the assets of any central bank. The Federal Reserve, which is the largest central bank, has about $1.2 trillion in its portfolio, mostly in the form of U.S. Treasury debt.

Then there are all the other debt liabilities, worldwide, especially real estate debt. The participants— creditors and borrowers— have trustingly operated on the assumption that over a hundred legally independent central banks somehow manage the upkeep of a single safety net for the interdependent world economy.

The public assumes that committees of [[relatively modestly paid: normxxx]] salaried bureaucrats can handle the unforeseen outworkings of hundreds of millions of private transactions [[engineered by some of the best talent churned out by our top schools, all competing for commissions often rising into the tens, if not hundreds, of millions of dollars: normxxx]] in regulated and unregulated capital markets. These committees [are supposed to be able to] do this while walking the other tightrope, which links central banks' assertion of independence from government control and incumbent politicians who don't want an economic downturn on their watch, but above all [NOT] in election years.

If we wanted to make this analogy accurate, a central banker has one foot on the depression/crack-up boom tightrope and the other foot on the independence/incumbent politicians tightrope. The ropes don't always swing together.

The complexity of modern capital markets grows greater every day, yet the central banks' tools of evaluation, let alone control, remain basically stagnant. Franklin Sanders has summarized these tools: "inflation and blarney." Sometimes the blarney is incoherent: Greenspan's Fedspeak. Sometimes it is footnoted: Bernanke's speeches. But it remains blarney. It is patter from a very high wire without an independent safety net.

We need a safety net. We used to have one. It was called the international gold standard. It was a gold coin standard. It controlled central banks and their governments. How? By putting commercial banks at the mercy of holders of IOUs to gold coins. The same system governed the issue of government IOUs: bonds. Some of these IOU holders were other central banks. Most were little people who held legally redeemable paper money rather than gold coins.

All this ended in the late summer of 1914, when commercial banks ceased redeeming IOUs for gold coins, central banks confiscated the gold in commercial banks' accounts, and governments passed laws legalizing both steps. The justification for this confiscation was World War I. With respect to the confiscation of gold in the United States in 1933, it was the Great Depression. It was upheld by the Supreme Court by a vote of 5 to 4.

[ Normxxx Here:  For a contrasting view of this "wonderful gold standard," see my comments in "Study History, Mr. Epstein."  ]

That series of events placed the world's central bankers on their individual yet interconnected tightropes.

They all have bedpan shoes.

Swinging That Rope

The financial tightrope has begun to swing back and forth most violently. The winds of financial change are blowing more wildly. The ability of central bankers to walk the line has been reduced.

Beginning in August, the subprime mortgage crisis revealed itself in America's capital markets. Millions of borrowers— home owners— had signed loan agreements that allowed creditors to hike their interest rates. The creditors were in fact borrowers. The initial issuers of mortgages were no longer long-term holders of the mortgages. They had sold the contracts to pools of investors within days of the signing of the papers.

To keep the process going full blast, the creditors decided to become borrowers. They borrowed money short-term in order to issue more mortgages. The mortgages were of two varieties: long term and short term. Long-term mortgages were issued to reliable borrowers who were expected to remain in their homes and making monthly payments for decades. Short-term mortgages were issued to home buyers who did not have credit ratings to obtain long-term mortgages. The lenders assumed these people would remain in their homes even after rates climbed to match rates in short-term credit markets [[since it was assumed that house prices could only grow in value, and thus give these latter owners a comfortable premium on the value of their homes with which to negotiate new loans.: normxxx]]. This assumption blew up in August.

At that point, the money for leverage— short-term loans to long-term lenders— dried up. The mortgage lenders had been going out of business since December, 2006. Now the bankruptcy rate increased, as large lenders went belly-up.

This leaves the local mortgage markets without large pools of short-term loans disguised as long-term loans. This reduces liquidity locally. Home sellers cannot find buyers at pre-August prices. But [[as yet: normxxx]] they refuse to admit that this lack of liquidity will force them to lower their asking prices. The inventory of unsold homes rises. Sellers are holding on when they can.

Sometime in 2008, millions of them will no longer be able to hold out any longer. A recession will force their hands. They will have to move, either leaving homes vacant or forcing them to rent their homes to strangers. At that point, the decline in housing prices will accelerate.

This means that everyone's home equity will shrink. For recent buyers (2005 or later), it may disappear. It may even go negative: more money owed than the homes are worth after commissions and discounts.

If people own their homes free and clear, this does not affect them immediately unless it's time to sell. If they move out— to a retirement facility, for example— they can rent their homes to strangers if they want to retain ownership. The same applies to people who have been building equity for a decade. But equity builds rapidly only after about half the mortgage period is over. Most Americans move every five years. So, equity as a percentage of home prices is usually reduced because sellers buy larger, more expensive homes. Then they borrow against this equity.

This is another way of saying "increased leverage." This is the nightmare of central banking. The more leverage there is, the more wildly the tightrope swings in the wind.

The whole world has imitated central banking: increased leverage. There is no industry more wealthy with less equity than central banking. The equity is in the form of a government-granted monopoly: the legal right to say how fast commercial bankers can create fiat money.

Conclusion

The central bankers can inflate. They usually limit this inflation to the purchase of very short-term assets: promises to repay. This, plus blarney, is all they have to keep the economy from toppling into either recession or inflation.

When you think "central banker," think "bedpan shoes."

The more equity you have, the stronger your safety net. The Federal Reserve can buy equity by issuing more fiat money. When it does, the nominal equity of the economy increases. The actual equity shrinks. Equity is more and more defined as IOUs: promises to pay.

Don't bet your future on promises to pay.
ߧ
Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Mark To Value Or Liquidity During Crises?

Mark To Value Versus Mark To Liquidity During Market Crises

By Rick Bookstaber | 23 December 2007

There is the song lyric "the darkest hour is just before dawn" which probably was not speaking about liquidity crises, but it could have been. I have written a lot about liquidity crises, both in past blog posts and in my book,

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation"
by Richard Bookstaber

In a nutshell, the issue with a liquidity crisis is that there is a market shock that forces investors who are highly leveraged to liquidate. Their liquidation drops prices further— remember the market already had some sort of a shock, so it doesn’t take much to move prices down more— and this causes even more forced selling. You end up with a downward spiral in prices. This is helped along because some of the people who might be natural buyers run for the sidelines. They see the market is in disarray and watch a lot of apparently smart people hanging on by their fingernails, and they don’t want to take the risk. Or they want to take the risk, but their bosses, who are further removed from the scene, will think they are imprudent gamblers if they do.

The end result of this cycle is that prices are determined by liquidity issues, not by value. The value players have by and large been scared away. Once the dust settles and the highly leveraged players are done bailing, everything moves back to normal, where "normal" means that prices are determined more by value again. Granted, on the margin liquidity will still affect the price. If there is a pension fund that has a large position to move, prices will adjust for that in order to find the other side of the market. But in most markets, that sort of thing will move prices a few percent here and there, if that much.

Things are deservedly considered to be bad right now. There are major institutions that have gotten themselves into terrible positions. This is a crisis that has a risk of having systemic repercussions both because of its depth and because of the types of markets that are involved. So my intent is not to be sounding an "all clear" siren. But I wonder if some people are confusing the liquidity-driven marks with the value-based marks, and in doing so are making things look even worse than they are. This already was on my mind when I watched the level of write-downs of positions, but the most recent event that really makes this a question to pose is the sale of assets by E-Trade for pennies on the dollar. Is that really a representation of where value is? What is the implied default rate that would make that fair value?

I have seen a number of sources extrapolate the E-Trade transaction, asking what would happen if all the Level 3 positions of banks and investment banks were to be remarked based on this transaction! This seems to be a variation on the game that started a month or so ago of assessing the prospects of a bank staying in business based on the ratio of Level 3 assets to capital. I think this is an exercise that is [maximally] alarmist. Level 3 positions are not all sub-prime or even all CDO. There may be Level 3 positions that are good as gold, but simply do not have comparables or models that can provide adequate marking. And it is no surprise that these institutions are highly leveraged— they typically might have a balance sheet that is twenty times their capital. So with that sort of leverage, and with the sorts of businesses they are in (remember, they tend to make markets in things that you can’t just run out and buy on an exchange), it is not surprising to me that they will have Level 3 assets that are greater than their capital. But again, "Level 3" does not mean "worthless".

Granted, if you are in a position where you may be forced to liquidate, then mark to liquidity is what you are concerned about, and for E-Trade apparently that was the case. But if you have the ability to weather the storm, what will finally matter is the mark to value.

ߧ
Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Is The Slump Over Yet?

Is The Slump Over Yet?
Challenging Housing Markets Continue Into 2008

By Amy Hoak, Marketwatch | 20 December 2007

CHICAGO (MarketWatch)— After a year of falling house prices in numerous parts of the country and a meltdown in the mortgage market that affected borrowers regardless of their ZIP code, many hope that housing markets will finally start to get better next year.

But if there's any improvement in 2008, it may be relatively modest. It's difficult to get a consensus on exactly when housing will turn the corner. Local markets will certainly vary, but at the least it's likely that some of the same problems that plagued 2007 will carry over into next year.

At best, market conditions could start to stabilize, with home sales regaining strength. If more buyers get back into the market, some of the huge inventories of new and existing homes for sale can begin to be worked off.

"The only reason why demand is finding a bottom is because sellers are cutting their prices," said Mark Zandi, chief economist of Moody's Economy.com. "There was a sense that the market would cool— I don't think there was a sense it would crash. And it crashed."

The National Association of Realtors predicts a slight increase in existing-home sales next year but a decline in new-home sales. After the median price for existing homes dropped 1.9% in 2007 to a projected $217,600, NAR forecast that the median price would rise 0.3% to $218,300 in 2008. Others aren't as optimistic, including the Mortgage Bankers Association, which is predicting that sales won't pick up until 2009. And, the MBA is expecting prices of existing homes to decrease 2.93% in 2007 and 2.04% in 2008; new-home prices should decrease 2.72% in 2007 and 1.96% in 2008.

A recent Economy.com report, "Aftershock: Housing in the Wake of the Mortgage Meltdown," predicts home sales will hit bottom in early 2008, with housing starts hitting bottom mid-2008. But prices will continue to drop, and by early 2009 home prices will have fallen about 13% nationally from their peaks, according to the report. Prices will have fallen more than 15% if nonprice discounts to buyers are taken into account.

Housing's Ills

Housing's most fundamental problem, according to the Economy.com report, is the excess of unsold inventory lingering in many of the country's local markets. The supply of homes for sale hit its highest level in 22 years in October, according to NAR.

Overbuilding is a culprit in many markets, and investors who are unloading units bought during the boom are adding to the massive supply, the National Association of Home Builders pointed out in a recent forecast. In December, the group reported that single-family housing starts were down by about 50% from a record high at the beginning of 2006.

"Once we hit bottom ... we're going to stay there for awhile," at least in terms of new construction, predicted Richard F. Moody, chief economist of Mission Residential. Adding to the already elevated inventories are foreclosures hitting the market. According to the MBA, 1.69% of first-lien mortgages were in the foreclosure process in the third quarter. The percentage was the highest in the survey's history, and the group expects high numbers of foreclosures to continue into next year.

Areas where overall economic conditions were weak, including Michigan and Ohio, drove up the national foreclosure numbers, as did areas where there was much investor speculation, including California, Nevada and Florida. Defaults on adjustable-rate loans— especially subprime loans made to borrowers with weaker credit histories— caused a lot of the strain; when the mortgage's teaser period was up, homeowners couldn't keep up with payments.

The mortgage meltdown this summer made it tougher for borrowers to get a loan, another stumbling block in this housing market. In particular, nonconforming loans [[e.g., Jumbos: normxxx]], which can't be bought by government-sponsored mortgage agencies Freddie Mac or Fannie Mae, were harder or more expensive to come by.

Many borrowers with good credit and a decent down payment were fine, but subprime loans, intended for borrowers with poor credit histories, became a thing of the past. Alt-A loans, which required little or no documentation, became a rarity. And rates on jumbo loans went through the roof, making it tougher for home buyers in expensive markets.

Some borrowers who could qualify for a Federal Housing Administration insured loan turned to those, and proposed FHA modernization may help some borrowers even more. But in the second half of the year, the credit disruptions slowed down an already sluggish market.

Waiting For The Rebound

Rick Loughlin thought the Boston market appeared to be "really coming alive" this summer. "Then we had the mortgage crisis," said Loughlin, chairman of the Greater Boston Real Estate Board and president of Coldwell Banker Residential Brokerage New England. The borrowing ability of many individuals took a hit, reducing the number of buyers able to enter the market and stranding homeowners looking to trade up.

The lending landscape isn't likely to change much in the near term, with no-documentation and low-down payment loans remaining harder to come by, Moody said. Perhaps the only bright spot in the mortgage arena this year was low interest rates on conforming loans. The average rate on the 30-year fixed-rate mortgage fell below 6% at one point in December; NAR expects the 30-year to rise to about 6.4% by the end of 2008.

The low rates "should have provided a lift to home sales, but it has not," said Lawrence Yun, NAR's chief economist. That indicates to him that the elevated cost of jumbo loans is still taking a toll. If conforming loan limits were raised to accommodate expensive markets, it could have a greater impact on housing than the current low conforming rates have, he said.

Sitting On The Sidelines

The home price drops encouraged a number of people to put home buying decisions on hold. In some of the most sluggish markets, sellers who don't absolutely need to sell aren't attempting to do so; those who do are offering price cuts and concessions to make the deal.

"A lot of buyers and investors are sitting on the sidelines. They feel unsure what is happening in the marketplace," said Devin Reiss, president of the Greater Las Vegas Association of Realtors. Some mistakenly think that it's impossible for anyone to get a mortgage nowadays, even with good credit, he said. Often, however, fears revolve around the undesirable scenario of buying a home only to watch it decrease in value a short time later. His advice for bargain hunters: Don't wait too long. "If we start to see demand go up and supply go down, prices will go (up) with it," he said.

But probably the best advice is to know your market before making any kind of move. "A hallmark of the downturn is how broad it is across the country," said Economy.com's Zandi. But even in poor-performing markets there could be good neighborhoods, he said, adding that housing conditions vary "block to block."

NAR reported that 93 out of 150 metropolitan areas showed increases in median existing single-family home prices during the third quarter of 2007, compared with 2006, even though price drops in other areas brought down the national median price. Still, Bob McNamera, a real-estate agent with Pasquesi Realty in Chicago, said that some people are staying out of the market based on what they hear about general trends. "They hear it's a bad market, and don't do any more homework," he said. First-time buyers, however, with a down payment and decent credit, could find bargains, he added.

Even in Stockton, Calif., an area hard-hit by foreclosures, Renee Becker, a Realtor and vice president of Beck Realtors, has hope for next year. The deals in the foreclosure inventory might bring back more investors and help fuel a slow and gradual recovery, she said.

ߧ

Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

S&P's 50-Day Cross of 200-Day

S&P 500's 50-Day Cross of the 200-Day

By Bespoke Investment Group | 22 December 2007

The S&P 500's 50-day moving average crossed below its 200-day moving average today, which is a big no-no for technicians. Earlier this week, we highlighted that the index has typically performed poorly in the month and quarter following a similar 50/200-day cross. Click here to view our prior post. While the market did okay after the last time it happened in July 2006, the average returns following this 50/200-day negative cross aren't pretty.

A 50-day cross below the S&P 500's 200-day has happened 36 times since 1940. The average change of the S&P 500 in the month following this cross has been -0.76%, while the average change over the next 3 months has been -0.01%. These numbers are very negative when taking into account that the average 1-month change during any period since 1940 has been +0.66% and the average 3-month change during any period has been +2%.

ߧ
Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Study History, Mr. Epstein

Economic Beat: Study History, Mr. Greenspan

By Gene Epstein, Barron's | 22 December 2007

Can former federal reserve chairman Alan Greenspan be blamed for the current crisis in mortgage debt? The question is like asking whether the recently departed Mafia lord in charge of pushing drugs might be responsible for the fact that a lot of folks got addicted, and eventually overdosed. Now suppose this same Mafia lord also manages the major methadone clinics and rehab facilities. This is good for his organization, which wants to sell to users whose habits are kept under control. It all makes for a system that runs like a well-oiled machine.

The "drug" in question is money and credit, which the central bank dispenses. And it's the ready availability of money and credit that lures the irrationally exuberant [[bankers and 'semi-prudent' businessmen?: normxxx]] into committing finance capital to unsustainable projects that eventually bring on the sort of crisis we're now in.

These points are worth making not because we share Greenspan's concern about the way history will remember him. (See his self-exculpatory article in The Wall Street Journal, Dec. 12.) Rather, they help us gain perspective on the current debate about fundamental causes: And as usual, it's the debate about whether government regulators should have been aware of the problem sooner, or whether the former Fed chairman, "the maestro," should have moderated the tempo sooner.

In this umpteenth variation on the credit crisis that periodically strikes the world's economies, the cause that is truly fundamental is rarely addressed. That cause is the very regime that makes the expansion of money and credit possible. The existence of that regime is bound to make the economists happy. Being an adviser to presidents can undoubtedly be exciting, as both Greenspan and current Fed chairman Ben S. Bernanke can probably attest, since both once served as Chairman of the President's Council of Economic Advisers. But what can be more glorious than running a virtual fifth estate, in the form of today's central bank?

The human susceptibility to "Potomac fever" helps explain why Alan Greenspan so conveniently forgets that he himself once saw the alternative to the modern Fed. "A fully free banking system and fully consistent gold standard have not as yet been achieved," he wrote hopefully in his 1966 essay "Gold and Economic Freedom." And: "under the gold standard, a free banking system stands as the protector of an economy's stability and balanced growth."

[ Normxxx Here:  And, the bankers who would "stand… as the protector of [the] economy…"— are they the same one's who got us into this mess, who went to town with Mr. Greenspan's nearly free money!?! The same ones who gave us the various panics of the 19th century, culminating in the Panics of 1870, which lasted, off and on, for over twenty years, and the horrendous 'bankers' panic of 1907? ]

It was seen that a central bank had to be (contradictorily) decentralized somehow, or it would be attacked by local politicians and bankers as had the First and Second Banks of the United States. The solution was a regional system. Numerous small revisions were made, such as headquartering a region in the financial backwaters of Richmond, Virginia. President Woodrow Wilson added the provision that the new regional banks be controlled by a central board appointed by the president. Wilson also came up with a compromise plan that pleased bankers and the opposition alike. The opposition were happy that Federal Reserve currency became liabilities of the government rather than of private banks— a symbolic change— and by provisions for federal loans to farmers. The demand to prohibit interlocking directorates did not pass. Wilson convinced the anti-bank Congressmen that because Federal Reserve notes were obligations of the government, the plan fit their demands. Southerners and westerners learned from Wilson that the system was decentralized into 12 districts and and thus assured that this design would weaken New York City's Wall Street influence and strengthen the hinterlands. After much debate and many amendments Congress passed the Federal Reserve Act or Glass-Owen Act, as it was sometimes called at the time, in late 1913. President Wilson signed the Act into law on December 23, 1913.

[[This is one case where I am sure the best solution is to ammend the system, not go back to a system that was tried— and failed wantonly.: normxxx]]


How quickly we forget!

In today's environment, anyone who even raises these issues risks being branded as a heretic and crank. One common rejoinder is that credit crises predated the creation of the Federal Reserve. Of course; but the Fed didn't invent money-and-credit expansion, either. The creation of the Federal Reserve in 1913 only made the practice more respectable and systematic, while not incidentally giving the economists a seat at the tables of power.

For example, in his Dec. 12 article Greenspan refers to the "South Sea Bubble of the 18th century." But he does not mention, as economist Jesus Huerta de Soto does in his 2006 book Money, Bank Credit, and Economic Cycles, the role played by credit expansion in the South Sea Bubble via the Bank of England. De Soto's comprehensive work would make for indispensable reading by Greenspan, Bernanke and anyone else wishing to know the way out of our current predicament.

[ Normxxx Here:  And perhaps Gene Epstein should reread the history of money and banking since about 1800. Note, however, I am no Greenspan or Bernanke fan, but trivializing solutions to what has become almost as complex as rocket science, is not helpful.  ]

ߧ

Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
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Marketwatch:MacroProblemsPowerGoldRush

Gold's odd price move
Commentary: Australia's Privateer Says Macro Problems Power Bull Rush

By Peter Brimelow, Marketwatch | 19 December 2007

NEW YORK (MarketWatch)— A poor week for gold. But the gold bugs are grimly determined (again). Well, it wasn't really bad— the metal was only down $1.10 from Friday to Friday. But it did lose over $20 from Wednesday's high. The sensitive Amex Gold Bugs Index (HUI: 379.59, -2.52, -0.7%) lost over 7% in the week.

More alarming, The Privateer's U.S. Gold 5x3 Point and Figure chart turned down on Friday. It now displays an ominous pennant. See chart As The Privateer dryly notes: "The BIG distribution zone is coming to a point. The price will have to break out of it soon. The only question is, in which direction?"

What was striking about this was that it happened in the teeth of an abundance of gold-friendly news. Thursday's inflation news was horrific, as Privateer noted: "The biggest monthly rise since August NINETEEN SEVENTY-THREE! Yep, that's a little over 34 years ago at the dawn of the global fiat currency era."

And financial structure stress news is the worst since the early 1970s (I know: I was there). The Bush administration's nationalizing of the mortgage crisis has disillusioned even solid loyalists such as The Gartman Letter, which this past week formally abandoned support of the White House. What happened? Bill Murphy of the manipulation-minded Le Metropole Cafe had an answer, in fact two:
Thursday headline: "Shoot the Messenger."
Friday headline: "They shot the Messenger yet again." See Website
No one should dismiss this point of view without reading Le Metropole's powerful Friday article from a source called Deepcaster: "... important new data releases from the BIS (Bank of International Settlements The Central Bankers' Bank]) the U.S. Bureau of Labor Statistics, and the U.S. Federal Reserve are quite astounding. They reflect a considerable acceleration of market intervention ... these developments dramatically increase systemic risk ..."

I've discussed Le Metropole's argument that the authorities are manipulating markets before. See Oct. 18 column

But what is the underlying problem?

For this purpose, I think The Privateer is exceptional. I have never met or corresponded with the proprietor, William Buckler, who, I am reliably informed, operates from a slightly inland rural setting half way up the right hand side of Australia.

But who cannot pay attention to this, from his bulletin published this Sunday? "On Dec. 6, President Bush and Treasury Secretary Paulson announced an agreement with lenders that will fix rates on some mortgage loans for five years ... Of course, what has been totally pushed aside, for now, is the simple fact that this action has breached contracts all over the world ... the precedent has been set. Now, extend it to the global debts of the U.S. Treasury. Nearly two-thirds of the U.S. Treasury's debt (notes, bills, etc.) is short-term it matures within one to three years. If interest rates on this short-term official U.S. debt paper start climbing early next year, so would the cost to the U.S. Treasury of servicing its massive foreign debts. What happens if Bush and Paulson act on the earlier "precedent" and unilaterally alter the U.S. Treasury's one— and three-month notes, changing them all to five-year notes for example?

"Total U.S. credit market debt has now exploded 20% in two years. Since the beginning of 2003, total debt has surged 50%, rising from 298% of GDP to 343%. This is the biggest credit inflation in human history ..."

More From The Privateer

GoldMoney's James Turk this past published his FreeMarket Gold & Money Report's 2008 predictions: "Gold will see $1,500, and close the year at $1,200— $1,300."

We can laugh, but the gold bugs have been winning the argument since gold made its low early in the decade.

Bankers Try Firebreak

World Bankers Resort To Firebreak

By Ambrose Evans-Pritchard, Telegraph.UK | 17 December 2007

Never before have the central banks of North America, Europe, and Britain, acted together as such a unified phalanx, but never before have transatlantic credit markets seized up with such violent effect. Desperate times call for drastic action, but in a double-edged battle, liquidity lubrication has its limit.

"This is a drastic action. The central banks want to place a fire-break to stop credit tensions spilling over into the broader markets and becoming the catalyst for a global economic crunch," said Ian Stannard, an economist at BNP Paribas.

While yesterday's joint move was sketched at the G20 a month ago, and fine-tuned in encrypted telephoned calls over the past month, the final trigger seems to have been the spike in the crucial three-month money rates that lubricate finance. Dollar and sterling Libor spreads have vaulted in recent days. Euribor spreads reached an all-time high of 99 yesterday morning.

"A co-ordinated move like this has the 'wow factor'," said Paul Mackel, currency strategist at HSBC. "But there's a lot of scepticism over whether this will be enough medicine to end the credit crisis. Is it already too late?"

Ben Bernanke, chairman of the US Federal Reserve, made his academic name studying the "credit channel" causes of depressions. He must have watched with growing alarm as the debt markets limped from one mini-crisis to another, failing to recover from their August heart attack despite three emergency rate cuts.

The asset-backed commercial paper market in the US has now shrunk for 17 weeks in a row, shedding almost $400bn (£196bn). Lenders are refusing to roll over short-term loans as they fall due, leaving borrowers desperately searching for other sources of money.

The crucial elements in the Fed's move yesterday is not so much the sum of money on offer— $20bn next week, $20bn the week after— but that all depository banks in America can draw from the tap anonymously, without the risk of being found out.

"People looked at what happened to Northern Rock in Britain and said we're not going to risk that, so hardly anybody has been using the Fed facilities," said Bernard Connolly, global strategist at Banque AIG.

The Fed is now spreading the net wider by allowing all US banks to use the Term Auction Facility, which offers secrecy and allows them to hand in a much wider set of investments as collateral to raise money, including mortgage securities. Perhaps some credit will at last reach those in urgent need.

The Bank of England's £20bn injection over the next two months has a different flavour. It fires a double-barrelled dose of liquidity: priced by auction at far below the penal rate of 6.5pc, and eligible to any lender with half-decent collateral and— crucially— securities backed by housing and credit card debt. Northern Rock might have escaped a deposit run if all this had been on offer in the summer.

Officials denied the worldwide action was orchestrated to pressure the Bank of England to open its credit spigot, giving Threadneedle Street global "cover" for what amounts to a major volte-face. The Fed vice chairman, Donald Kohn, said two weeks ago that "strong bids by foreign banks in the dollar-funding markets" had complicated efforts by the US authorities to manage the liquidity problems. It is unclear whether British lenders were the culprits.

In Frankfurt, officials are seething at the enormous scale of borrowing by British banks at the European Central Bank's window, calling much of it "central bank arbitrage". There is irritation the British are trying to have their cake and eat it, dipping in and out of the eurozone when it pleases them. The bad blood has undoubtedly strengthened the push by EU insiders for more EU-wide financial rules.

The ECB ($20bn) and the Swiss National Bank ($4bn) are playing a support-role in the latest joint action, backing the US move by offering dollar liquidity to European banks caught in the sub-prime mess. Part of the problem in August was that the Fed and ECB lacked swap arrangements, causing a mad scramble by European banks to obtain dollars. "The Europeans are acting simply as agents of the Fed," said Neil MacKinnon, a strategist at the ECU hedge fund group.

"There's a real danger that this may not work. Both the Fed and the ECB have injected a lot of liquidity before, but the banks are hoarding it. We're still seeing all the signs of stress with Libor and the VIX [fear gauge] at very elevated levels. The reason is that people still don't know where the bodies are buried," he said. "This may be a Made-in-America credit crisis but the Americans have cleverly exported their sub-prime cancer to pension funds all over the world. The risk now is a recession on both sides of the Atlantic," he said.

Julian Jessop, chief economist at Capital Economics, said the move was stop-gap measure. "These measures should tide the markets through the potentially awkward New Year period but do not and cannot address the underlying imbalances threatening the world economy. Risk premiums are likely to remain permanently higher after the excesses of the last few years, and it will still be harder to obtain credit," he said.

For now, investors and hedge funds are scrambling to buy risky assets again, renewing bets on the yen "carry trade", piling back into equities and pushing up commodity futures. Gold jumped $12 to $814 an ounce. They forget that central banks are having to fight two battles at once: against the credit crunch and against inflation.
ߧ
Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Lessons Learned

"8 Lessons I Learned From The Cheapest Family
In The Nation" By Silicon Valley Blogger

How a family of seven is able to live on $35,000 a year after taxes.
Click Here, or on the image, to see a full explanation and image.

2008…“Deeper, Darker, Scarier.”

2008…“Deeper, Darker, Scarier.”

By Joe Average | 10 December 2007


"The (spreading sub-prime) mortgage hole is worse than anyone saw. It is deeper, darker, scarier… (banks) are now looking at new reserves …my sense…is they don’t have a clear picture of how this will play out …confidence is low."
(Tony James, Blackstone Group.) Robert Guy/Peter Wells, Financial Review, November 14, 2007.

This glum assessment made by the man at the helm of Blackstone Group, the world’s biggest private equity company, makes it clear that the sub-prime problem is not going away anytime soon. James’ opinion is backed up by Geoff Wilson (chairman Wilson Asset Management): "Bad news is a lagging indicator, not a leading indicator…For the next six to twelve months, we’re going to see the impact that (the credit crunch) had on various people. It takes time to work through the system. There’s always a knock-on effect…And when there’s such an adjustment in pricing in any market, or the bursting of a bubble or a crash, then it does take time for the impacts of those sudden movements to present themselves."

New York Deutsche Bank securities analyst Michael Mayo believes "these events tend to become deeper and play out longer than most people initially expect…This is one of the slowest-moving train wrecks we’ve seen." Tyndall’s Mal Whitten (portfolio manager) laments "there’s more and more negative news coming out of the U.S. so you can’t ignore that…Quite clearly there’s much more damage in the system than anyone thought."

The Worst Yet to Come.

Other forecasters are warning that the resulting housing slump won’t bottom for at least another year, will most probably wipe up to 1.5 per cent from GDP, and will result in at least a half a million jobs being lost. The losses being touted from the sub-prime mess are estimated up to $500 billion and rising, with up to $4 trillion being sucked out of credit markets. Credit Suisse Group estimates that problems with resetting home mortgages will continue to rise through to 2010 until over 1.5 million homes are in default. Some analysts are less sanguine and think this estimate is way too conservative.

A recent Goldman Sachs report is factoring in a future 15 per cent fall in house prices, assuming the economy and the powers that be (Wall Street, the Plunge Protection Team, and Central Banks) can skirt around an all out recession. Under a recession scenario a property crash of anywhere from 20 per cent to 40 per cent or more becomes a chilling possibility. With the number of foreclosures increasing and looking to skyrocket another problem has cropped up for investors in securitized loans. Many of these loans have been sliced and diced into complex, exotic instuments so that the question of who actually owns the mortgage note has become obscure. Recent court rulings have hampered creditors’ efforts to foreclose on delinquent borrowers because courts were not satisfied with the "proof of ownership" presented. Last month a federal judge (Christopher Boyco) in Cleveland dismissed 14 foreclosure applications filed by Deutsche Bank (as trustee for securitisation funds) citing that Deutsche had failed to prove ownership by producing the actual mortgages or notes.

This development is certain to cause a lot of angst among many other European, Asian and Middle Eastern investors who have their funds tied up in similar U.S. financial instruments. They too may find it very difficult to take back possession of homes in the event of property owners defaulting on their mortgages and may find their funds frozen and not easily retrievable. To make matters worse, concerns are being raised about the asset base of some Bond Insurers and whether they have the reserves to actually cover the trillions of dollars of debt they have guaranteed against default. The share price of bond insurers Ambac Financial Group and MBIA have plummeted over 50 per cent this year. Morgan Stanley head of credit strategy Greg Peters warns "there is a huge domino effect on the financial system" and should bond insurers have their ratings revised downwards then the investors in the insured securities will also be punished as their values decline.

Meanwhile, stresses keep building in the financial system with Freddie Mac fessing up to a $2 billion loss and looking for ways to raise more capital.

Jim Sinclair (http://www.jsmineset.com) puts the magnitude of the problem into perspective when he tells us: "The size of the mountain of over the counter derivatives is above $450 trillion dollars. The size of the world economy is slightly above $145 trillion. What do you think the risk factor is on $450 trillion worth of garbage paper, from CDOs, CBOs and now CLOs? Is it $2 trillion like the London Financial Times said yesterday, is it $20 trillion or maybe even $200 trillion?"

Dow Theory Sell Signal?

Technical analysis devotees like Tim Wood and Robert Prechter have been watching the Dow’s recent gyrations carefully and are now warning that the "fat lady may have sung" ( a euphemism for a stock market crash in the making).

They have also been rejoined by the venerable Richard Russell (who had recently deserted the bear-camp and turned bullish: "true I did continue to ‘hope’". In his news letter, which has been going out to subscribers for more than 50 years, Russell now is also warning1 "It was a noble battle, it was a battle that seemed almost endless. But today the great battle ended. Today the D-J Industrial Average closed below its August 16 low of 12845.78, thereby confirming the prior violation of the Transportation Average. In doing so, the stock market and the Dow Theory have spoken— they have confirmed the existence of a primary bear market. The Transports broke under their August 16 low of 4672.35 back on November 7."

The Next Big Thing...Cash?

"European banks are facing a new wave of financing troubles as the markets they borrow money from take a turn for the worse… ‘There’s a genuine fear here of bank failure’" (strategist at Barclays Capital Tim Bond)… ‘Liquidity, specifically cash, is king right now…if you do not have it, and need to access the capital markets, you are likely to have to pay dearly in the current environment’ (Lehman Brothers Holdings Report).
Carrick Mollenkamp/Mark Whitehouse, 27 Nov 2007, The Australian.

"Anything below 12,500 (in the Dow) could trigger program-trading and crash the market. The global credit crisis has hit Asia with a vengeance for the first time, triggering a massive flight to safety…Yields on three-month deposits in China and Korea have plummeted to near 1pc…caused by panic withdrawals from money market funds and credit derivatives…On Tuesday Chinese government officials ordered a complete halt to bank lending."
Mike Whitney, 25 November 2007 pacificfreepress.com

"I now see the risk of a severe and worsening liquidity and credit crunch leading to a generalized meltdown of the financial system."
Professor Nouriel Roubini, Stern School of Business NY.

"CRASH IS COMING, WARNS TOP INVESTOR…The man responsible for investing $41 billion of the (Australian) State’s money (chief investment officer…Victorian Funds Management, Leo de Bever) has warned mum-and-dad investors to prepare for a massive sharemarket crash…repercussions of the $300 billion subprime lending crisis in the US."
Jason Dowling/Peter Weekes, Nov 4, 2007, THE AGE.


"The global banking system now faces the risk of a general flight towards cash and liquid level one assets (refer new US FAS 157 accounting standard) on a scale that has not been seen since the early 1930’s. Already British banks are showing signs of near panic."
William Rees-Mogg, Nov 12, 2007, http://www.timesonline.co.uk

The message seems clear. There are a lot of nervous investors around the globe and more than a few are moving to the safety of cash. But even these investors need to be careful where they park their cash because as Professor Roubini warns, in an extreme financial crisis we may see a run on weaker banks as frightened customers scramble to withdraw their savings.

Some banks may be forced to close their doors, while others may respond by putting a limit on the amount that may be withdrawn by customers. In an article entitled "Transfer Limits Have Potential To Block Run On Bank" (http://www.jsmineset.com November 17,2007) Jim Sinclair alerts us to the fact that some banks appear to be altering account agreements to "put in place a tool to prevent an electronic run on an institution such as the one which recently occurred in Great Britain. If you have $1,000,000 in such an account …it would take you 100 months to withdraw the funds."

The Times They Are a Changing.

On November 24th Australian Prime Minister John Howard’s Liberal Party was crushed at the ballot box. The devastating political defeat was all the more remarkable because only three years prior Howard had won the previous election with such a huge majority that pundits declared it was "a massive, two term (ensuring) victory".

The Australian nation has just experienced a decade where many Aussies have more than doubled their wealth (thanks to a massive credit-fuelled real estate boom) and a China-driven commodities boom; during this time unemployment has fallen to record lows below 4 per cent. So what went wrong?

It seems there were four main issues that brought about Howard’s downfall.

1. Housing affordability is the lowest it’s been for some thirty years. During this purple economic decade the rich certainly got very much richer. However, further down-market (and despite their new debt-fuelled affluence) many new home owners are now struggling with rising mortgage repayments and cost-of-living expenses. Meanwhile, disenfranchised first home buyers who can’t afford to buy a home are not at all happy and have turned from being disillusioned to angry.

2. Many workers feel the low unemployment figures have been achieved through an Industrial Relations policy that had also decreased job security and increased pressure on salaries in some sectors. Post election, even some employers now admit that the Howard government may have pressed too hard for workplace reforms which were seen by many workers as being "unfair".

3. Howard’s refusal to ratify Kyoto and his casual approach to global warming did not sit well with much of the electorate.

4. As Iraq continues to spiral into chaos, many Australians began to question Howard’s judgement (What1no weapons of mass destruction?) especially as he seemed in no hurry to plan an exit strategy. Unlike former British Prime Minister Tony Blair, who saw the writing on the wall and had the sense to retire before he was pushed, Howard stayed on too long. He just couldn’t see that "the times they are a changing".

All the best, Joe.

http://www.lifetoday.com.au

ߧ
Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Subprime Bailout Bonanza

The Subprime Bailout Bonanza

By David Gaffen | 8 December 2007

And so it begins. The bailout to end all bailouts, the drive to reroute traffic around this Big Dig-style snarl that’s engulfed the economy kicks off with President Bush’s speech outlining the plan. With further detail a better picture should emerge of the extent of government involvement in the markets on a level not seen since the resolution of the S&L crisis, and just what type of moral hazard is created for the future borrower, and what type of additional premium investors will ask for in exchange for the knowledge that such a wholesale restructuring of mortgage contracts could emerge as a result. Many cling to the assumption that the invisible hand that represents the markets is best served being left alone, but that was until the invisible hand started throttling the invisible neck of the economy. Be it a combination of government initiative, creative mortgage financing, too much easy money, bad Federal Reserve policy and predatory lending, here we are, and the invisible neck is gagging. After all, Lehman Brothers expects about 2.8 million subprime mortgages to reset in 2008 and 2009 about 30% higher.

[Left] Subprime delinquencies have soared, and upcoming resets mean more are expected (Source: Lehman Brothers).

The question that remains is whether intervention in these markets will produce a solution that will enhance the value of the vast supply of mortgages that are set to reset in coming years through loan modification. Nouriel Roubini of RGE Inc. supports the general plan, saying that investors in mortgage-backed securities, CDOs and other investments backed by this paper will see more return on their investment due to assistance provided to borrowers who can afford those teaser rates (not those set to default due to income problems or other inability to even pay the lower teaser rates).

"If you don’t do this scheme those investors are going to lose much more," he says. "The losses you’re going to have on CDOs and MBSs are going to be massive… the argument is just flawed. It’s the same thing as if you force a firm into bankruptcy liquidation— the value is going to be lower for creditors; the value is better when maintaining rather than destroying it."

But opponents of the plan argue that the default rates on many of these modified mortgages are extremely high— estimating in the range of 40% to 60%— and in an environment where the borrowers in question have little home equity (and therefore little incentive to hold onto the house) in properties where asset values are falling, the cost of postponing an eventual foreclosure and default is potentially greater to the holders of the loans.

"If home prices continue to decline [investors] may not really be getting more later," says Josh Rosner, managing director at Graham-Fisher, a housing and mortgage research consultancy. "Modified borrowers default at alarming rates."

The Calculated Risk blog suggests that concentrating the assistance to those with low FICO scores (around 660 or so) would limit the losses taken by investors. Rates wouldn’t adjust up to, say 10% or so, but investors would still get the 7.7% rate— as opposed to taking substantially lower rates if those with stronger credit were involved, and their mortgages were altered.

"The cost of this is, actually, going to be absorbed by investors in mortgage-backed securities," they write. "This is why ‘good credit’ borrowers are not going to be ‘rewarded’— because investors cannot be brought to forgo that much interest."

But some believe having mortgage investors bear that cost could result in an increase in mortgage rates in the years to come, as investors will need to factor in the possibility of another such occurrence.

"The lenders are getting a bad deal— if you keep these ARMs at the teaser rate, the overall return on the body of loans is going to be very inferior," says Christopher Whalen, president of Institutional Risk Analytics.

However, at least so far, the ABX indexes— which track a basket of subprime mortgages— haven’t budged all that much. The double-A rated ABX was traded at 39.8 cents on the dollar this morning, as investors still see very little value being recovered from those loans. "At the end of the day, the plan won’t have a huge impact," Derrick Wulf at Dwight Asset Management, told Dow Jones Newswires.
ߧ
Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Debt Be Not Proud

Debt Be Not Proud
The Subprime Mess Is Just The Beginning Of The Credit Crunch.

By Daniel Gross | 8 December 2007

President George W. Bush (left) and Treasury Secretary Henry M. Paulson
[[Why does Paulson looked like he can't believe what Bush is saying!?!: normxxx]]

The stock market rallied last Thursday after President Bush announced a deal under which mortgage lenders would cut subprime borrowers some slack and freeze [some] rates. As such, it represents the latest effort by the financial-industrial complex to draw a bottom line under the spreading credit woes. With this action, the market seems to have concluded, the negative effects of the subprime mess may finally be contained.

I hate to be the bearer of bad news, but the subprime flood— which has been declared contained over and over again— isn't contained yet. Newsweek's Daniel McGinn ably explains why the rate freeze is far from a panacea for all [[but a few: normxxx]] subprime borrowers. And a flood of new data indicate that the subprime woes may be a symptom— rather than a cause— of a broader economic malady. That awful smell in Midtown isn't from the horse-drawn carriages carrying tourists around. It's the distinctive odor of debt going bad.

We've just ended a bubble in housing, in housing-related credit, and in all other types of credit. Low interest rates, competition for market share, the continual pooh-poohing of inflation, and the widespread use of securitization spurred banks and mortgage companies to lend with abandon. Any risk associated with lending could be ironed out by slicing and dicing debt and selling it to investors, who could in turn hedge their exposure to the debt through derivatives. Any remaining risk would be wiped out by growth, perpetually rising asset prices, and a willingness of other lenders to refinance existing debt on favorable terms. And so credit was available on easy terms to people in all walks of life: home buyers and real estate developers, car buyers and college students, consumers and private equity firms.

Thursday, however, the assumptions holding up the latticework of credit are coming apart, one by one. Even as the economy continues to expand, more and more borrowers are having difficulty remaining current on their debt. Which isn't surprising, given that median household income hasn't budged since 1999 (see Figure 1 on Page 4 of this Census report) [[and the convoluted terms of many of these ARM mortgages, which seem almost guaranteed to force mortgagees to default, eventually: normxxx]]. What's more, in a natural reaction to reckless lending, mortgage companies and banks are now in money-hoarding mode and thus unable or unwilling to help Americans refinance existing debt.

The Mortgage Bankers Association, Thursday, came out with its "national delinquency survey," which has nothing to do with high-school kids sniffing glue. "The delinquency rate for mortgage loans on one-to-four-unit residential properties stood at 5.59 percent of all loans outstanding in the third quarter of 2007," up from 4.61 percent a year ago. This figure, which doesn't include loans in the process of foreclosure, is "the highest in the MBA survey since 1986." While the pain was concentrated in subprime (16.31 percent of subprime loans were delinquent in the third quarter), the seasonally adjusted delinquency rate for prime loans rose to 3.12 percent from 2.73 percent in the second quarter.
@@
As the volume and price of new home sales continues to fall (PDF), home builders are suffering, as well. The Wall Street Journal reported (subscription required) last Wednesday that delinquencies on loans extended to condominium developers have risen sharply in the past year. In the third quarter, 5.9 percent of such loans were delinquent, up from 4.1 percent in the second quarter, according to Foresight Analytics. The delinquency rate for builders putting up single-family homes rose from 3 percent in the second quarter to 4.3 percent in the third quarter.

Other types of consumer debt, which have nothing to do with housing and nothing to do with subprime, are going bad, too. The Wall Street Journal reported that "about 4.5% of auto loans made in 2006 to top-rated borrowers were at least 30 days delinquent as of the end of September, up from 2.9% the previous month, according to a Lehman Brothers survey of companies servicing these loans." In October, Fortune's Peter Gumble warned that a similar plague may soon afflict credit-card companies. In October, credit-card giant Capital One Financial reported that the delinquency rate on credit cards for the third quarter of 2007 was 4.46 percent, up from 3.53 percent in the third quarter of 2006. "Given current loan growth and delinquency trends," Capital One reported, it "expects the U.S. Card charge-off rate to be around 5.25 percent in the fourth quarter."

The stock of First Marblehead, which has enjoyed explosive growth making private (i.e., not federally guaranteed) student loans, has been hammered in recent days because Moody's, the ratings agency, concluded that loans it had made "appear to be defaulting at a significantly higher rate compared to loans originated through school financial aid offices." The Wall Street Journal reported that "seventeen months after First Marblehead arranged one 2005 package of student loans, 2% had defaulted, according to the company's monthly reports to note holders. But last month, a comparable 2006 package— also 17 months after issue— had a default rate of 3.98%."

And so it goes. The next arena likely to see a spike in delinquencies and then defaults? Corporate bonds. In September, ratings agency Standard & Poor's warned of a potential wave of defaults.

Investors may have thought that Bush and Treasury Secretary Henry Paulson stuck their fingers in a hole in the dyke, thus forestalling disaster. But given the rising tide of bad debt across the economy, last Thursday's actions are more like throwing a sandbag into a rising Mississippi River.

[ Normxxx Here:  Like withdrawal from any addiction, the withdrawal pains from 'easy credit' is bound to be torturous. I still expect it to lead to TEOTWAWKI by 2009. Batten your hatches: distribute your wealth widely, both geographically and among financial instruments.  ]

ߧ
Normxxx    
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Lenders 'Must Prepare For Worst'

Lenders 'Must Prepare For Worst'

By BBC News, UK | 9 December 2007

UK mortgage lenders have to prepare for the "very real prospect" of the global credit crunch getting much worse. The Financial Services Authority (FSA), said a tougher global financial situation could affect the whole UK mortgage market, boosting defaults.

Access to cash could become more difficult [[FWIW, that's DEflationary: normxxx]]— a problem that caused the run on Northern Rock earlier this year. Lenders needed contingency plans to guard against the "worst outcomes", the City watchdog said. The FSA also told lenders that despite the liquidity and credit risks it was important that lenders maintained their focus on treating customers fairly, including their treatment of customers in arrears. The FSA is also to look at how those in mortgage arrears are treated.

Changing World

Already there were signs that the market might be changing, the FSA said. The watchdog warned that arrears and repossessions have increased significantly, albeit from a very low base and concentrated in specific sectors of the market.

"There is a very real prospect that conditions will worsen further into next year, in terms of both liquidity and credit risks," Clive Briault, the FSA's retail managing director, told the Council of Mortgage Lenders' annual conference. He said that firms should be assessing their funding and liquidity positions, and testing whether or not their business models could withstand severe market problems and volatility. They should also review and assess their medium and longer-term strategies and the options open to them, as well as considering contingency plans against the worst outcomes.

"We want there to be a competitive and thriving mortgage market in the UK which clearly meets the needs of consumers," he continued. "Lenders should have tested business plans that take account of the changing world, with viable funding models." Mr Briault added that firms needed boards and senior management that understood and knew how to operate in the best interests of their customers in a variety of market conditions.

Difficult Refinancing

The FSA estimates that more than 1.4 million borrowers on fixed-rate, short-term mortgages are due to come off their favourable terms next year, which were fixed when the Bank of England's main interest rate was lower. Many of them will either have to pay higher interest rates as a result, or will go back to the market to find new deals. Should they not find them, the resulting higher repayments could see them rein in consumer spending sharply. In some of the worst cases, this may even lead to a repossession of the property that has fallen into arrears.

Mr Briault explained that many of the borrowers were on relatively high loan-to-value ratios or income multiples and would find it difficult, if not impossible, to refinance their mortgage on favourable terms. At the bottom end of market, the so-called sub-prime sector that focused on people with poor or non-existent credit histories, many borrowers "may not have access to the market at any price".
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Normxxx    
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Financial Chaos?

We're heading toward financial chaos

By Steven Pearlstein | 10 December 2007

It was 19th-century Scottish journalist Charles Mackay who observed that men go mad in herds but only come to their senses one by one.

We are only at the beginning of the financial world coming to its senses after the bursting of the biggest credit bubble the world has seen. Everyone seems to acknowledge now that there will be lots of mortgage foreclosures and that house prices will fall nationally for the first time since the Great Depression. Some lenders and hedge funds have failed, and some banks have taken painful write-offs and fired executives. There's even a growing recognition that a recession is over the horizon. But let me assure you, you ain't seen nothin' yet.

What's important to understand is that contrary to what you heard from President Bush last week, this isn't just a mortgage or housing crisis.

The financial giants that originated, packaged, rated and insured all those subprime mortgages were the same ones, run by the same executives, with the same fee incentives, using the same financial technologies and risk-management systems, who originated, packaged, rated and insured home-equity loans, commercial real estate loans, credit card loans and loans to finance corporate buyouts. It is highly unlikely that these organizations did a significantly better job with those other lines of business than they did with mortgages. But the extent of those misjudgments will be revealed only once the economy has slowed, as it surely will. At the center of this still-unfolding disaster is the collateralized debt obligation, or CDO. CDOs are not new; they were at the center of a boom and bust in manufactured housing loans in the early 2000s. But in the past several years the CDO market has exploded, fueling not only a mortgage boom but also an expansion of all manner of credit. By one estimate, the face value of outstanding CDOs is nearly $2 trillion.

But let's begin with the mortgage-backed CDO.

By now almost everyone knows that most mortgages are no longer held by banks until they are paid off. They are packaged with other mortgages and sold to investors much like a bond.

In the simple version, each investor owned a small percentage of the entire package and got the same yield as all the other investors. Then someone figured out that you could do a bigger business by selling them off in portions corresponding to different levels of credit risk. Under this arrangement, if any of the mortgages in the pool defaulted, the riskiest portion would absorb all the losses until its entire investment was wiped out, followed by the next riskiest and the next.

With these portions, or tranches, mortgage debt could be divided among classes of investors. The riskiest tranches, those with the lowest credit ratings, were sold to hedge funds and junk bond funds whose investors wanted the higher yields that went with the higher risk [[and these are the guys that will shortly be baled out by 'Paulson's Plan': normxxx]].

The safest ones, offering lower yields and Treasury-like AAA ratings, were snapped up by risk-averse pension funds and money market funds. The least sought-after tranches were those in the middle, the "mezzanine" tranches, which offered middling yields for supposedly moderate risks.

It is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same "tranching" process, they could use these mezzanine-rated assets to create a new set of securities, some of them junk, some mezzanine, but the bulk of them with the "AAA" ratings more investors desired.

It was a marvelous piece of financial alchemy, one that made Wall Street banks and the ratings agencies billions of dollars in fees. And because so much borrowed money was used, the whole thing was so highly leveraged that the returns, at least on paper, were very attractive. What we know now, of course, is that the investment banks and ratings agencies underestimated the risk that mortgage defaults would rise so dramatically that even the "AAA" investments could lose their value.

One analysis, by Eidesis Capital, a fund specializing in CDOs, estimates that of the CDOs issued during the peak years of 2006 and 2007, investors in all but the AAA tranches will lose all their money, and even those in AAAs will suffer losses of 6 percent to 31 percent.

And looking across the sector, J.P. Morgan's CDO analysts estimate that there will be at least $300 billion in eventual credit losses, the bulk of which is still hidden from public view. That includes at least $30 billion in additional writedowns at major banks and investment houses, and much more at hedge funds that, for the most part, remain in a state of denial.

As part of the unwinding process, the rating agencies are in the midst of a massive and embarrassing downgrading process that will force many banks, pension funds and money market funds to sell their CDO holdings into a market so bereft of buyers that, in one recent transaction, E-Trade was able to get only 27 cents on the dollar for its highly rated portfolio.

Meanwhile, banks that are forced to hold on to their CDO assets will be required to set aside much more of their own capital as a financial cushion. That will sharply reduce the money they have available for making new loans.

If all this sounds like a financial house of cards, that's because it is. And it is about to come crashing down, with serious consequences not only for banks and investors but for the economy as a whole.

That's not just my opinion. It's why banks are husbanding their cash and why the outstanding stock of bank loans and commercial paper is shrinking dramatically. And it is why Treasury officials are working overtime on plans to stem the tide of mortgage foreclosures and provide a new vehicle to buy up CDO assets.


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Normxxx    
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Interview:R.Younes, JuliusBaerInt'n't'lEquityFund

A Contrarian's Take on the World
Interview With Rudolph-Riad Younes, Co-manager, Julius Baer International Equity Fund

By Sandra Ward | 13 December 2007

Russia is the place to be. Take that hot tip to the bank, since it comes straight from the lips of one of the most successful international stockpickers, Rudolph-Riad Younes. He and his colleague, Richard Pell, consistently have outperformed the broad market averages and their international benchmarks by a wide margin, by being contrarian and opportunistic. More remarkable, they have continued to do so even as the collective assets for which they are responsible have mushroomed to $63 billion. This year, their fund is up a smart 18.4%, compared with 6.6% for the S&P 500 and 13.4% for its peer group. In the past five years, the Julius Baer International Equity Fund has advanced 25.6% a year on average, versus 11.6% for the S&P 500 and 21.3% for the MSCI EAFE index. Riad recently sat down with us at Julius Baer's Manhattan headquarters to share his thoughts.

Barron's: Are you more sanguine about the markets now that some of the calamity you expected has occurred?

Younes: We are in an age of decadence, as I have said in the past, and the trick is understanding whether we are going to stay in that age or enter an age of renaissance. There are no Mother Teresas among us, from top to bottom, from the government and the Federal Reserve to the intermediaries to accounting firms and credit-rating agencies, down to CEOs, financial investors and regular citizens. If there is one panacea, it is fixing the inflation index. At the Fed we need more courage and less politics, and we need to reverse many of the changes that were made in the early 1980s to the inflation index, beginning with the decision to remove house prices from it and replace them with equivalent rents.

What is the problem?

Under this revision, inflation rates consistently have been below those of the past. For example, under the old method, inflation in the past 10 years would have ranged between 8% and 10%. Under the new method it has ranged between 2% and 4%. Had the inflation method been kept intact, inflation readings would have been 4% to 6% higher and, in response, interest rates would have been much higher. We would have grown more slowly during the boom, but avoided the bubbles and the ensuing bust. The inflation index, to use an analogy, reminds me of a parent who invents Santa Claus for his children and then begins to believe the fantasy himself. The government invented Santa Claus in order to cheer up the children— pensioners and laborers— who were worried about their parents' ability to pay for their entitlements. The children were happy with the yearly gift added to their benefits; the parents were satisfied the children were buying the fairy tale, and spending was reined in.

But inflation is well under control, say a lot of people.

Look where the dollar is. Look at commodity prices. Look at your bills. Besides bond managers and insurance companies, I don't know anybody who wants to own government bonds. There is no debate.

"The inflation index reminds me of a parent who invents Santa Claus and then believes the fantasy."
— Rudolph-Riad Younes


Foreign governments still own our bonds.

That may change. Sovereign wealth funds are waking up, and slowly but surely will buy fewer bonds and more real assets, equities and maybe foreign bonds. The biggest losers will be U.S. bonds; we are going to see much higher yields in the next five years. The bigger winners will be equities and real assets. The dollar will be a small loser.

What's your overall outlook?

The subprime issue is deeper than people thought. We started talking about $50 billion in losses and now we're talking about $500 billion in potential losses. Most likely, the government and the Federal Reserve will do a lot of maneuvering to minimize that. The financial markets are betting the U.S. decouples from Asia and emerging economies.

What are you betting?

We're going to extend this growth and delay the day of reckoning. We're going to cut rates aggressively, which may buy us time, but it will create another bubble along the way. The market is expecting a 25-basis-point cut when the Fed meets Dec. 11. The Fed may even go to 50 basis points [half a percentage point] or include some other measures along with 25 basis points to ease the liquidity crunch. If you look at Libor [London interbank offered rate, a key benchmark], rates continue to rise despite the Fed cuts. There is definitely stress in the system.

And this, with the backdrop of inflation?

Easing monetary policy is going to reignite inflation. Every time we have a problem, the currency we choose to pay with is inflation instead of creating a temporary recession.

How do you think the emerging markets as a safe-haven theme will play out?

You are asking the wrong person because we have been very pragmatic. We have added some exposure to Southeast Asia, but we're not big advocates. There will be a delayed coupling as opposed to a decoupling. There will be a lot of spending in China ahead of the August '08 Olympics, and it may take awhile before the weakness in the U.S. trickles down to Asia. We have exposure to emerging markets more from a risk-management perspective as opposed to any conviction on the region. But our favorite market in the world for next year is Russia. With oil around $90 a barrel, it doesn't make sense that Russia is one of the worst-performing emerging markets this year. The country has one of the most aggressive tax systems— crude export duty is about 89 cents on the dollar for oil over $25 a barrel.

Isn't there concern about contract law?

Russia is not a big market for our multinational corporations compared with, say, China. U.S. multinationals are basically helping the Chinese government catch its dissidents. In Russia, where [President Vladimir] Putin has an 80% approval rating, we are pestering him. We are being hypocritical. There has been some backpedalling on reforms, but sometimes you have to take one step backward to take two steps forward. For me, the politics is a non-issue.

How are you investing in Russia? Oil plays?

Oil plays are relatively cheap. Though they are being punished by a very aggressive tax regime, ultimately there will be a different tax regime because the cost of exploration has gone up dramatically and these companies need compensation. That's why we don't see a lot of new development today in Russia. In order to see new fields and development there needs to be a better tax regime. That's a hidden catalyst in the future. The consumer and domestic-oriented sectors will be in the sweet spot for the next few years as the country is awash with money and foreign reserves. The government has announced it is going to spend about a trillion dollars in the next five years. I am interested in the broad Russian index. I don't have specific companies.

What else besides Russia?

We still like Central and Eastern Europe. There is no immediate gratification or catalyst but we would use weakness or a correction to add and build positions.

How about some companies?

FLSmidth [ticker: FLS.Denmark], a Danish company, is a play on commodities. It's a great way to bet on the increase in consumption of commodities and increased infrastructure spending. This is the world's largest supplier of cement plants. They have about a 29% market share and are a major provider of equipment and services to the minerals industry. Spending on new mines is growing. The CRB Index may be ahead of itself and see a correction, but the demand for commodities is going higher. This is one way to play it without worrying about commodities prices.

Is it reasonably valued?

Yes. The company's sales are 46% in the developed world and 54% in emerging markets, 49% in the cement sector and 45% in the mineral sector. The remaining 6% is in roofing, which I think they will sell. For the next two to three years there is a record backlog and strong order intake. Recently the company had a big breakthrough by winning its first Russian order. Russia, because of its oil plants and high infrastructure spending, will be a great new market for them. The company is integrating some of its recent acquisitions in the mineral sector. It is a very fragmented sector and they will continue to make acquisitions.

Valuation?

On a 2008 basis the price/earnings multiple is roughly 13, and enterprise value [stock-market value plus net debt] is about 7.8 times EBITDA [earnings before interest, taxes, depreciation and amortization]. This is very high growth for very good value.

How about another name?

OTP Bank [OTP.Hungary], a Hungarian bank. I first mentioned it in Barron's years ago [Feb. 14, 2000]. It has done well. This is a great time to bring it back. It is an excellent franchise, high growth potential and great management at a bargain valuation. OTP is a leading bank in Hungary with 32% market share in retail deposits. About 76% of their earnings come from Hungary. The bank is focused on regional expansion into Ukraine and Russia, Southeast Europe and the Balkans. They're targeting 50% of their income from those regions by 2010. While they have a dominant position in Hungary, Bulgaria and Montenegro, in other countries they are forming niche strategies. In Russia they are building a regional retail bank. In Croatia they are focusing on the lucrative coastal areas, and in Romania they are focusing on the wealthy Hungarian regions.

Let's look at the valuation.

The P/E is 8.7 times 2008 earnings estimates. Price to book value is about 1.9. The company is going through a digestive period because it did a lot of acquisitions outside of Hungary. In Romania its costs are going higher as it tries to gain economies of scale and market share. In Serbia it is integrating three acquisitions. Management's goal is to double earnings before taxes to €2 billion by 2010. If it succeeds, you're talking about a P/E of 5 by 2010. OTP is the last remaining independent bank in the region, but management believes it is too early to sell. They believe they can grow earnings by 30% a year at least for the next three to five years.

Next up?

Credito Emiliano [CE.Italy] is a bank with an old-fashioned business model, fully funded by depositors, unlike many banks that rely on the commercial-paper market for much of their lending. It's a solid franchise that pays attention to credit quality and redeploys excess capital for growth through new branch openings and acquisitions. It is the 13th largest bank in Italy, focusing on the Emilia-Romagna region and Lombardy. We expect annual profits to grow at least 10% in the next few years, driven by loan growth and a falling cost-to-income ratio. Credito Emiliano would also be a prized asset for both domestic and foreign banks. One of its greatest attractions is a high and growing dividend. You're buying a 5.3% dividend yield, a P/E of 9.5 times on 2008 estimates and a price-to-book of 1.6.

How about another pick?

Siemens [SI], in Germany, is a major restructuring story. Poor profitability and bribery scandals forced a genuine attempt to change. The portfolio is being repositioned; divestitures are being announced. They will reduce SG&A [selling, general and administrative] expenses by 10% to 20% and do a €10 billion share buyback. New investments will be made only in high-margin areas like energy, environment, automation and health care. The stock is trading at 15.4 times fiscal '08 earnings. As costs go down and margins increase, it will be a good performer.

Thank you, Riad.
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Normxxx    
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GS Sits Out Rally

Goldman Sachs (NYSE: GS) Sits Out The Rally

By Dr Joe Duarte | 11 December 2007

Goldman Sachs (NYSE: GS) has yet to deliver significant gains during the market's recent bounce.


Click Here, or on the image, to see a larger, undistorted image.
Chart Courtesy of StockCharts.com

Few things are constant in the markets, but one factor has remained very consistent for the last 12 months, Goldman Sachs shares have been outstanding performers, regardless of the overall market trend. Yet, over the last couple of weeks, as the market has recovered, Goldman has mostly moved sideways. Yes, the shares are above the support level provided by the 200-day moving average. And clearly, the stock has outperformed the brokerage sector. But, the lack of pop over the last few raises questions about the potential for a nasty surprise that may lie ahead. A quick look at insider activity shows no major sales since late October where Gregory K Palm General Counsel & Executive Vice President and David A Viniar Chief Financial Officer & Executive Vice President sold 17,900 shares between the two of them in the open market. Whether that is significant or not remains to be seen, but is nowhere near what was evident in shares of Countrywide Financial prior to its crash.

Thus, for now, Goldman's flat performance remains enigmatic.
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Normxxx    
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  M O R E. . .

Normxxx    
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Russia: Natural Gas Woes.

Russia: Natural Gas Field Woes.

By Dr Joe Duarte | 11 December 2007

Not Measuring Up

The next geopolitical surprise might not be related to Islamic militants but to a significant energy dispute between Russia and China. And the implications of such a dispute are difficult to assess, yet could play a critical role in the world and the financial markets.

Russia has leveraged its energy resources into reclaiming a significant position in the geopolitical arena. Yet, despite its successes, signs point to dwindling resources and bad policy as a significant trouble spot for the future.

According to Stratfor.com: "Gazprom's Yuzhno-Russkoye oil and natural gas field will come on line Dec. 18. However, even this 805 billion cubic meter field will not stem the overall decline in Gazprom's natural gas production, highlighting the seriousness of the supply crunch in the near future." The intelligence service concludes that this latest Russian project, although "considerable," as it contains "proven reserves of 805 billion cubic meters (bcm) of natural gas and 5.7 million tons (42 million barrels) of oil," it is "incapable of stemming the slow decline of Gazprom's natural gas supply."

In other words, Stratfor is predicting a serious "supply crunch in the near future."

To be sure, Stratfor is quite alone in this viewpoint, seeing as natural gas prices are hovering near their 52 week lows, as they have been for months, due to the plentiful supply, especially in the U.S. where the Barnett Shale find continues to flood the marketplace, and the lack of sustained frigid weather is dampening demand.

Yet, Stratfor has some interesting thoughts that are worth exloring.

First, Stratfor suggests that the easy natural gas, "the low hanging fruit" has already been found by Gazprom, while no new sizeable projects have been brought on line, except for Yuzhno-Russkoye and the Zapolyarnoye "superfield" since 1991. Second, "The other three major fields in Western Siberia— Urengoy, Yamburg and Medvezhye— with reserves of 16 trillion cubic meters of natural gas among them, already account for 70 percent of Gazprom's natural gas production. The fields already online are also past peak output." Third, and most important is this. According to Stratfor, Gazprom has both foreign and domestic commitments. The foreign commitments are more profitable, since Gazprom has to sell gas at a huge discount to its domestic markets. Adding to Gazprom's problems are some regional complexities as "The dwindling natural gas supply might not be able to support all of Gazprom's commitments. Gazprom currently is relying on the Central Asian states, particularly Turkmenistan and Kazakhstan, to pick up the slack in production. However, those countries' ability to increase production in part depends on Gazprom's commitment to investing in transportation infrastructure linking Russia to Central Asia— not exactly a high priority for the Russian natural gas giant."

Making matters worse for the gas giant is the fact that both Turkmenistan and Kazakhstan are looking for alternative export routes, that do not include Russia.

Among these alternatives is a 2000 line pipeline project that would connect "China to Kazakhstan's sector of the Caspian Sea. Once the line is completed, China will be able to tap multiple oil-producing regions throughout Kazakhstan, and ultimately ship 1.0 million barrels per day into western China." Yet another Chinese project "would link Turkmenistan to China via a natural gas line. This project has been under discussion for some time, but the Chinese have always been coy in public about the deal's prospects. Now their interest is public and firm. Beijing also has explicitly said it wants the line to transit Uzbekistan, which would link Tashkent's energy and political desires into China's policy." In other words "China's plans do not foresee exploiting many fresh sources of natural gas in the region, but simply diverting output from routes Russian to routes Chinese. This development, which could be in place as soon as 2009, would greatly interfere with Russia's strategic policies in a very real, sudden and broad sense."

Conclusion

If Stratfor is correct, Russia's natural gas monopoly, Gazprom, is headed for some trouble, due to both internal and external issues. The former being its status as a monopoly, and the feeling of security engendered by the circumstance. The latter deals with the constant risk of competition from China.

China, due to its extraordinary and ongoing growth is constantly scavenging the planet for natural resources. Its lack of a major navy, and its prospects of not having such a navy for decades forces the Chinese to look for land bound resources whenever possible. Thus, ties to Central Asia are more sensible, despite the potential for a significant set of difficulties with Russia. As Stratfor puts it: "Given Gazprom's technical limitations, without Central Asian natural gas, Gazprom can meet its export requirements for Europe or it can meet domestic demand— not both. And considering that cheap energy acts as a panacea for social disruption at home and is a critical arm of strategic policy abroad, the Chinese decision to grab the ring will muck with Russian geostrategy in Europe, Central Asia and even at home. "

What it means is that the combination of Russia and Gazprom's plodding ways, and China's constant search for resources will likely be a major geopolitical development over the next few years, with the potential for armed or at least very tense political clashes between the two countries.

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Normxxx    
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Uk Recession?

Bank Woes May Tip Uk Into Recession

By Roger Bootle, Telegraph.UK | 11 December 2007

Will the Bank of England (BoE) do enough to avoid recession? A week is a long time in economics. At the start of last week it looked unlikely that interest rates would be cut but by Thursday the reduction of 0.25pc was no surprise at all. So how did things change so quickly?

By Thursday morning the pressure on the Bank had become intense. First, two distinguished previous Monetary Policy Committee (MPC) members urged the Committee to act. Professor Willem Buiter said that if the MPC did not cut rates it would be "wimpish". Meanwhile, Dr Sushil Wadhwani said that leaving rates on hold would mean that the MPC was in danger of returning to the "bad old days" of backward-looking monetary policy.

Second, the liquidity problem in the banking system was intensifying.

Third, the Bank of England was under pressure from the actions of other central banks. The US Federal Reserve had already slashed rates by 0.75pc, with another 0.25pc likely this week. And last Tuesday the Bank of Canada cut interest rates by 0.25pc.

Finally, the weaker run of economic data, and the strident tone of most newspaper commentaries, meant that come the day of the big decision the markets were more or less fully expecting a cut. If the Bank had not acted there would have been consternation.

After the intense criticism over its handling of the Northern Rock affair, both here at home and abroad, the Bank was in a weak position to resist such pressure. In particular, because of Northern Rock, the Governor, Mervyn King, has seen his own personal position weaken considerably. It will be fascinating to see, when the minutes are released on 19th December, whether the Governor voted for this cut or not. I suspect that he did.

So the Bank is open to the criticism that it has merely buckled under pressure. But I don't think that this charge will stick. A rate reduction last week was justified, not least by the consistently weak tone of recent economic news. In particular, Halifax reported that in November house prices fell by 1.1pc, the third successive fall, meaning that prices have already fallen by 2.4pc since the end of August. This compares with the total fall in prices of only 0.7pc in the 2004/05 housing market slowdown.

And there was also evidence of a weakening in the wider economy. The headline balance of the CIPS/RBS survey on the services sector fell to a four-year-low in November.

Furthermore, conditions in financial markets have become very worrying, with interbank rates remaining almost 1pc above bank rate, thereby resulting in an unintended extra tightening of monetary conditions. Last week's cut will still leave three-month interbank interest rates well above the levels seen immediately after the last rate hike in July.

So where do we go from here? There are good reasons to think that more action will be needed, including the precarious state of the housing market and the threat of a much weaker international environment.

But won't substantial interest rate cuts risk setting off inflationary pressures? Of course, there are such risks and if they look like becoming more serious then the MPC will not be able to cut rates so vigorously. Much depends upon the strength of the forces pulling towards an economic slowdown. A weaker economy should tend to reduce inflation. Moreover, if, as seems likely, this weakness is mirrored internationally, then there is a good chance that oil and food prices, which have heightened inflation fears, would subside.

Could all this be too dramatic? Yes, is the answer. The economy could prove stronger than I am forecasting. Liquidity may return and confidence recover. The housing market may respond favourably to this interest rate cut and another couple to come next year. Lower oil prices could inject spending power into western economies and simultaneously reduce inflation. All of this could mean that we experience only a mild and short-lived slowdown which does not require drastic interest rate action from the Bank.

But although this is perfectly plausible I do not think that it is likely. What worries me most is what is happening in the banking sector. We have grown complacent about financial sector upsets because previous versions involved big drops in equity prices. By contrast this one involves heavy pressure on the banks and the drying up of credit. I cannot recall when we in Britain last experienced a credit crunch. Examples from abroad offer no encouragement. Japan is the most striking case where the bursting of an asset bubble left the banking system weighed down by bad debts and collapsed asset values and thereby enfeebled in its ability to make new lending.

Our situation is not as serious as Japan's was then but there are some worrying parallels. This is not just a UK problem. The exuberance of Anglo-Saxon financial systems has sustained not just the Anglo-Saxon economies themselves but the world as a whole. Credit has been what has kept us afloat. So the current difficulties strike at the very heart of our economy.

Why are banks so reluctant to lend to each other? This could be simply an unjustified panic and a self-fulfilling prophecy where, because each fears that liquidity has dried up, each is not prepared to put money in the markets, thereby creating collectively the very thing which each individual bank fears.

But it is also possible that the banks' reluctance to lend reflects a rational fear that bank losses are already, and will be in the future, much bigger than the manageable estimates of losses from sub-prime mortgages suggest. I think this is probably closer to the mark. Over and above the sub-prime losses, there will be losses from prime mortgages and from lending to commercial property, and from heaven knows what else— in both the UK and in the US. There are the makings here of a nasty interaction between weak asset prices, bank losses and a weak economy.

So why will recession be avoided? It may not be. But the contrast with the conditions which led to previous UK recessions is significant. In the recession of the mid 1970s, late 1970s and early 1990s, inflation was a serious problem— on a scale which knocks today's worries into a cocked hat. And in 1990-92, the key difference to today is that we were then in the ERM so that when the economy started to weaken and inflation looked to be under control we still could not cut interest rates [[The coming world recession (2009) will be a severe test for the EU.: normxxx]].

This time, by contrast, the MPC will be able to cut vigorously if the need arises— as I suspect it will. I now expect UK interest rates to fall to around 4.5pc by the end of next year. What's more, if the economy remains weak in 2009, then interest rates could fall further to 4pc.
ߧ
Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Foreclosure Avoidance

Foreclosure Avoidance: A Society that is Psychologically Bent On Avoiding the Brutal Facts.

By Doctor Housing Bubble | 11 December 2007

Most will agree that as a society, we cannot spend our way into prosperity. In fact, many of even the most ardent bulls will acknowledge that we have some serious issues to address in our current economy. From preliminary reports, this rate freeze will have a very minimal impact on the overall housing market. Keep in mind that we have yet to see the plan in action since the first rate resets to take effect will not occur until 1/1/2008. The proposal at best is an avenue for a cathartic release from the housing doldrums and gives those in the industry a respite to scream "let us gasp for air!" It seems to have worked. Housing related stocks are up and with the prospect of further rate cuts, all seems well until you start facing the brutal reality of what is occurring.

Jim Collins in his book Good to Great examines the successful traits of prosperous companies. His focus wasn’t on high flying companies that made a torrent of money and suddenly crashed. He looked at the attributes of sustainable and successful companies. He offers various characteristics of these companies such as choosing the right people from the beginning, focusing on your core strengths, and also having the ability to confront the brutal facts. The last point seems rather harsh and down right pessimistic. Yet the essence of facing the brutal facts is optimistic because you cannot move on to greater and better things until you first address the underlying issues/problems. In psychology 101 we learn that a prerequisite to having a healthy mental state is being able to confront our demons not with fear but with courage. Once we face up to what is at the root of the problem we can start to progress and live a healthier life.

So what does this have to do with the mortgage crises? It actually has a lot to do with it. We currently live in a society that is repressed on economic issues. Instead of being attacked at the root (which would require enduring some pain now in order to gain future benefits), some nostrums and palliatives are being prescribed for the impending credit crises to make the current pain more bearable. Even the term "rate freeze" provides the perception that all is well for the moment and we’ll deal with the problem at a later date. Yet this perception avoids the true difficulty: that we are in a historical credit bubble that can only be solved by a substantial correction. As a society we have not come to terms that without credit, we have a very hard time functioning. That is why even the mere hint of a rate cut makes the financial markets slap happy, since it postpones the inevitable for one more day. But is this really a healthy long term approach?

A Culture of Avoidance

This isn’t only seen in the economics of our consumerist society but also the psychology of other parts of our nation. Think of the avoidance of old age. Plastic surgery and cosmetics play into this desire of the forever young and give the perception that the fountain of youth has been discovered. But again, how appropriate to have plastic cover up the real you. Is this not what is occurring by funneling yet more credit into a market that clearly needs a massive 90210 makeover? There is no drug or surgery that is going to make this market look beautiful. Think of it as a Hollywood wild west stage. All looks real and strong but when you walk behind the saloon, you realize it is held up by a two-by-four.

Take a look at the public debt:


Click Here, or on the image, to see a larger, undistorted image.

Follow this by taking a look at mortgage debt:


Click Here, or on the image, to see a larger, undistorted image.

Mortgage debt is at a whopping $13.3 trillion. Couple this with stagnant wages and you realize that people are subsidizing their current lifestyle via credit; mortgaging tomorrow to the hilt (pun intended!).

Delaying the Inevitable

As I’ve been reporting at least here in Southern California, short sales [[of houses. i.e., houses whose mortgage exceeds their value: normxxx]] have been increasing for the past 22 consecutive weeks. We are now over 12,000 short sales in the Southern California area and this doesn’t show signs of stopping. There was an interesting note that inventory did fall a bit, but looking at actual sales numbers we realize that people are simply pulling their homes off the market. Is this not a way of avoiding the main issue? There was a case on the A&E show Intervention of this woman who was $130,000 in credit card debt and had filed bankruptcy two times. We all realize that this person has some serious issues and the show of course brought this to light. Yet I am astounded that no blame was being assigned to the credit card companies. This is a person that has already demonstrated financial imprudence with not only one bankruptcy, but two and she was still able to spend. Does the 'lender' not have some sort of responsibility ? [[If that were alcohol or drugs, we would call them the 'enabler' or 'pusher'! : normxxx]] It is a co-dependent relationship and many in our society seem so addicted to this cornucopia of credit, that the thought of delayed gratification has become a foreign concept.

This imbalance is clearly seen when we look at our trade deficit:


Click Here, or on the image, to see a larger, undistorted image.

Just to offer you a direct example, in the month of October we had 323,131 20-foot containers coming into the port of Long Beach and 144,839 shipping out. A large potion of the items being shipped out are raw materials while we are bringing in boat loads of manufactured goods [[just like any other 'banana' republic: normxxx]]. Clearly this can not go on forever and these trade deficits will have to be faced. The argument may be that we are wealthier than we were in the past— yet a higher and higher proportion of 'disposable' income is going to servicing debt.


Click Here, or on the image, to see a larger, undistorted image.

Broken Window Theory of Mortgages

Some of you are already familiar with the broken window theory. Here’s a good explanation of the theory:

"Consider a building with a few broken windows. If the windows are not repaired, the tendency is for vandals to break a few more windows. Eventually, they may even break into the building, and if it’s unoccupied, perhaps become squatters or light fires inside. Or consider a sidewalk. Some litter accumulates. Soon, more litter accumulates. Eventually, people even start leaving bags of trash from take-out restaurants there or breaking into cars."

How does this apply to the mortgage and credit crises we are facing? It won’t explain the economic reason in numbers but will help to paint the picture of the psychology of what got us to where we are. The problem should have been addressed when a few "broken windows" were appearing in the mortgage industry. The first 'stated income' [[aka, 'liar': normxxx]] loans. The early stages of fraud. Rampant speculation. An industry with no barriers to entry [[the mortgage broker industry; I believe the number went up by several hundred percent: normxxx]]. Wall Street greed. These things didn’t suddenly appear with the current market, but were certainly greatly exacerbated by the current climate and the credit addiction mentality [[how does that go? Wine, women, and song today, and the devil take tomorrow: normxxx]].

Think of the superstars who crash and burn with their multiple addictions. When you have money [[or, seemingly unlimited credit: normxxx]], it magnifies your good attributes (donating to worldly causes) or highlights your demons (drugs and partying every night). Think of the broken window theory and why it occurs. You see someone driving a leased BMW, taking on a $500,000 mortgage, and having 10 different department store credit cards. This is the rule rather than the exception in your neighborhood. So instead of littering, you can go for easy credit. It is easier to dive into debt when those around you follow suit. This is an observable phenomenon in sociology and goes back to the 1920s and "keeping up with the Joneses." We can even go further back with the Holland Tulip Bubble and South Sea Bubble so this is something that goes well back time and is seemingly inherent in human nature. But now that reality needs to be faced, instead of tightening our belts as a society, we are simply lowering the credit bar and trying to run on credit fumes [[at least until the next President's term: normxxx]].

I’m not sure what will actually happen in an election year, but the only solution which does not risk making the problem worse is getting our financial house in order; for example, with cram downs and the stopping of the credit addiction cold turkey. Isn’t it ironic that the perpetrators of the housing bubble are the same ones coming up with solutions? This is like asking a drug dealer for solutions to a drug addiction. It seems that modern politics isn’t about what makes the most economic sense over the long run, but what pleases the most voters now.


Hope Now Alliance: Press 1 for Subprime, Press 2 for Spanish.
Looking at a Hypothetical Case.

There has been a torrent of information shrouding the new Hope Now Alliance proposal that was offered up this past week. We’ve heard outraged battle cries of "no government bailout" and we’ve also heard the argument that this plan does not go far enough to help those facing foreclosure. Aside from the philosophical debate, how many people does this plan really help in its current format? Now that we have a few more details of the plan, it is apparent as it stands that this proposal will only offer support to a small portion of the 1.2 million subprime borrowers facing trouble next year.

Let us give you a quick recap of what we know so far:

This will only apply to owner occupied properties with at least a 36 month ARM reset period or less.

1. Loans must be originated between 1/1/2005 and 7/31/07. These loans must have reset dates between 1/1/08 and 7/31/10.


2. The loan must be current.


3. LTV must be greater than 97 percent


4. The borrower must have a FICO score less than 660


5. The borrower’s FICO score cannot be higher than 10% since the loan's origination date.


6. Each servicer must determine the owner cannot afford higher payments.

Should you fall within this if-then statement of complexity, you will qualify for the 5-year rate freeze. So instead of a 2/28 mortgage we now have a 7/23 mortgage. In this post we will analyze our hypothetical case study of Johnny Subprime who meets all the above contingencies and has a scheduled rate reset on 1/1/2008.

Just to show my due diligence in this, I decided to call up the Hope Now Alliance program. I called at a late hour as everyone was hitting their slumber since I know they are extremely busy. After a brief summary of what they are about, I am led to the omnipresent "press 1 for English, press 2 for Spanish." From what it appears, they are being an advocate and are running a quick triage report to see if you even qualify. Early estimates from various sources state that this plan will currently help anywhere from 125,000 to 240,000 people.

This plan doesn’t even begin to address the potentially more dangerous mortgage bubble of Option ARM mortgages that are set to hit in 2010 through 2011. According to Fitch Ratings, 80 percent of Option ARM borrowers only make the minimum payment [[currently: normxxx]]. What this means is these folks are going negative amortization in a time where across the country every large metro area is seeing real estate depreciation. This is a guaranteed recipe for being underwater at a time when analyst are predicting the bottom of the housing market will be hit [[based on the current subprime fiasco: normxxx]]. It [[the ARMs fiasco: normxxx]] is literally the second tidal wave of this housing credit explosion.

But let us deal with one thing at a time. Let us run some assumptions just to show how this Hope Now Alliance will play out for Johnny Subprime:

Mortgage Type: 2/28 Mortgage

Origination Data: 1/1/2006

Home Purchase Price: $250,000

Mortgage Amount: $250,000

Mortgage Rate: 7 percent with expected rate at reset of 10

Current Principal and Interest: $1,663

Expected Principal and Interest at Reset: $2,173 *2/28

Taxes and Insurance: $260

Yearly Income: $50,000

Monthly Net Take Home Pay: $3,080

Car Payment: $300

Car Insurance: $100

Auto Fuel: $120

Food: $400

We’ll leave out other factors like cell phones, healthcare, utilities, and credit cards which many borrowers have. With the current payment Johnny Subprime has disposable monthly income of $237. After talking with a counselor on the phone, Johnny hasn’t missed a payment and falls within the guidelines and demonstrates that a rate reset will suddenly put his $237 monthly surplus into a monthly deficit of $273. Since most subprime borrowers already start out at a higher rate, it is very common to see a starting rate of 7 percent especially if the note originated in 2005 or 2006 when rates were very low and the secondary market was buying them up like hotcakes. So instead of his rate resetting in 1/1/2008 it will now reset in 1/1/2013. Without the rate freeze the rate payoff curve looks as follows:



For simplicity, we will only assume that there is a rate cap of 10 percentthat doesn’t go higher— which latter has a very high probability, given the current economic circumstances and the structure of many subprime loans. Interest rates cannot remain at multi decade lows forever. So the freeze is on and Johnny lives to fight another day. Does this freeze really help long-term? Johnny goes on living his life, paying his bills, and doing the things of daily life. Let us assume that Johnny has received a 4 percent pay raise each year and now we are in 1/1/2013. How does our scenario variables change?

Current Principal and Interest: $1,663

Expected Principal and Interest at Reset: $2,112 *7/23

Taxes and Insurance: $260

Yearly Income: $60,800

Monthly Net Take Home Pay: $3,597



You’ll notice that the difference between the 2/28 reset payment and the 7/23 reset payment is only off by $61. So how is Johnny Subprime now doing in 2013? With the new rate reset he is now with a monthly surplus of $305. On the surface, it looks like the rate freeze has saved Mr. Subprime from losing his home. But there are many assumptions that we are assuming here.

Three Assumptions of the Hope Now Alliance

This seems all well and good for our hypothetical case. But as you can see from the tiny payment difference, all we are doing here is buying extra time in hope of a few things. First, there is no reason for Johnny Subprime’s salary to go up in the next 5 years. In fact, wages have recently been stagnating. If and when the economy goes into recession, there is even less of a reason to assume wages will increase as the economy contracts. This puts one major dent into this freeze plan.

The second assumption is that housing prices will stabilize over this timeframe. Who is to say prices will stay the same? In fact, we have another major mortgage debacle awaiting us in 2010 and 2011 just when this one is getting cleansed from the system. We are already seeing that yes, real estate does go down and in fact can go down on a national scale. Estimates abound that home prices can fall anywhere from 10 to 30 percent depending on the area. Many analysts predict the bottom somewhere in 2010 but of course the dormant giant of Option ARMs hasn’t even been tackled. So assuming Johnny Subprime’s property falls by 10 percent nominally, he will still owe $227,868 on the new 7/23 mortgage and the property will be worth $225,000. He will have zero appreciation and will lock himself into a place for 7 years. As you can see, sometimes renting is better than buying. After all, having a roof over your head and building up no equity is the simplistic definition of renting.

The final assumption here is that Johnny will in fact want to stay in his home. We’ve heard countless times from the industry how no one ever stays in one place anymore. Well in this case, Johnny will not have much of a choice in the first few years since he doesn’t have the equity to sell, especially in a declining market. What if he gets a new job somewhere else and needs to move? Is he going to be compelled enough to stay in the place? What if he realizes that the only true winner here is the lender and he in fact may be coming out with no equity in the end? Will he want to continue making payments to keep the lenders afloat?

[ Normxxx Here:  But, that seems to have been the purpose for which this 'bailout' was designed—and to keep lenders from suing the banks en masse for fraud  ]

You can see that it is much too early to determine how this thing will go. Will people in foreclosure that don’t qualify for this plan call for equality? Why should they be punished because they didn’t fall within the given timeline of the current proposal? What about prime borrowers that are underwater? Why shouldn’t they be able to freeze their rates as well? Again these are philosophical questions more than economic but I assure you they will come up in the coming years. Even though this isn’t a bailout per se, it does open the door slightly for more government meddling. We already know that Paulson said this isn’t a "Federal bailout" but the wording giving tax-exempt status to states should be watched. Another major thing that would be a bailout is what Angelo Mozilo, CEO of Countrywide mortgage is pushing. He is calling for caps to be raised to $625,000 so the FHA, Freddie Mac, and Fannie Mae can purchase larger mortgages. Mozilo had actually called for raises of as much as $850,000. Since Countrywide and WaMu have nearly 45 to 50 percent of their mortgages in California, I wonder why he is pushing this so hard?

What are your thoughts? Is this a bailout or is this something more benign?
ߧ
Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Carnage On Wall Street

Carnage On Wall Street As Loans Go Bad

By Steve Schifferes, BBC News, US | 9 December 2007

The scale of the losses that will hit Wall Street banks could approach half a trillion dollars as large numbers of sub-prime home loans go bad [[They're still in denial; best estimate I've seen so far puts the total at a cool $1 trillion— and that doesn't count the several trillions lost by all of those investors in MBSs and CDOs. : normxxx]]. And the carnage in the financial markets could cause a credit squeeze that will dampen economic growth for years to come.

The US sub-prime crisis is leading to a wave of reposessions across the US that is having a devastating effect on the US housing market, and is likely to lead to the halving of the US economic growth rate in the next six months. At the root of the problem is the breakdown of the new model of mortgage lending, when instead of giving mortgages directly to their customers, banks borrowed money from credit markets to fund a growing volume of mortgages. But its biggest impact is likely to be on the financial sector, which made billions of dollars in profits in the past few years by betting heavily on the sub-prime market.

Already the big Wall Street banks have revealed losses totalling $50bn (£24bn), and the head of the biggest bank— Chuck Prince of Citigroup— and the biggest investment firm— Stan O'Neill of Merrill Lynch— have departed.

  Sub-Prime Losses So Far 
   
  Citigroup:        $11.0bn
  Merrill Lynch:      8.0   
  Morgan Stanley:     3.7  
  Bear Stearns:       3.2
  UBS:                3.4
  Deutsche Bank:      3.2
  Credit Suisse:      1.0
  Wachovia:           1.1
  IKB:                1.0 
  Source: Company reports

Show And Tell

But experts estimate that the total losses facing the financial sector could amount to between $150bn and $450bn, and that many of the banks have hidden losses that have been concealed in off-balance sheet instruments like "structured investment vehicles (SIVs)." The big Wall Street banks and investment houses who are most exposed could find their profits, and much of their capital base, wiped out. To restore their profits, and indeed in some cases to remain solvent, they will be forced to sell off many assets and lay off many workers, as well as cutting the bonuses of their remaining staff [[shed a tear for those 'innocent victims': normxxx]] and limiting their future lending.

The size of the financial sector in the US economy— with banks making up 30% of the profits of all US companies last year— means that the effects will be felt both in the real economy and on the stock market. And with $2.8 trillion in distressed mortgage bonds, including $1.3 trillion in sub-prime bonds, there is enough distress to go around. Dick Syron, the head of Freddie Mac, a government-sponsored agency that also trades mortgage-backed securities, reckons he has never seen circumstances so bad, and that the credit crunch is having a "dramatic effect" on the US housing market.

Investors Strike

But even that impact could be dwarfed by the effects of the credit squeeze spreading beyond sub-prime loans to other sectors of the bond market. The non-government mortgage backed securities market has grown rapidly in recent years, and mortgages are now the largest part of the $27bn bond market. But since 9 August, bondholders have effectively gone on strike, refusing to buy some $2.8 trillion worth of sub-prime, Alt-A, and other types of securities not guaranteed by government-sponsored agencies.

Meanwhile, the value of sub-prime mortgage-backed bonds has plummeted since the beginning of the year. The fear is that the whole of the bond market, which funds everything from government debt to company borrowing to credit cards and car loans, will begin to dry up as investors worry about undisclosed problems. According to US Federal Reserve chairman Ben Bernanke, "although it was the problems with sub-prime mortgages that initiated the financial turmoil, credit concerns quickly spread into a number of other areas".

"In the short term, these events do imply a greater measure of financial restraint on economic growth as credit becomes more expensive and difficult to obtain." Already there are signs that it is getting harder to sell bonds linked to credit cards and car loans, and there are worries that spreads on corporate bonds are deteriorating.

"These events do imply a greater measure of financial restraint on economic growth as credit becomes more expensive and difficult to obtain," said Ben Bernanke, chairman, Federal Reserve. The tightening of credit will hurt economic growth because in the US consumers have borrowed heavily to fund their consumption. The latest figures indicate that consumer and business confidence is slumping both in the US and Europe as worries about the effects of the credit crunch grow.

How Big Are The Potential Losses?

The credit markets are frozen because of uncertainty and lack of information. No one knows how much mortgage-backed securities are now worth, and no one wants to sell them to find out. Also, no one knows where these losses are hidden among the banks and other financial institutions. The gargantuan scale of potential losses is terrifying investors in banking stocks— which have fallen by 30%— as well as mortgage-bond investors.

There are three ways to estimate the size of the possible losses from the sub-prime crisis.

• Estimate how many sub-prime mortgages will eventually end in foreclosure


• Look at the current market valuation of sub-prime mortgage bonds


• Look at the books of the major banks and estimate the size of their potential liabilities and the proportion of those which will turn into losses

The first method should give the best estimate of the long-term cost of the crisis.

The range of plausible estimates goes from $150bn (US Federal Reserve) to $450bn (Moodys.com worst-case scenario).

  Potential Sub-Prime Losses
   
  Sub-prime mortgages:               $1.3 trillion
  Distressed sub-prime mortgages:       $625 billion
  Foreclosed sub-prime mortgages:  $220-$450 billion
  Percent sub-prime foreclosed:          15%-25%
  Current market value 
of sub-prime mortgages:            $300-$900 billion
  Sources: Federal Reserve, Moodys.com

According to Mark Zandi of Moody's, there are $1.3 trillion-worth of sub-prime and other distressed mortgages that were issued in 2005, 2006 and the first half of 2007 that will see their terms change for the worse in the next two years. He estimates that about half of these, $625bn, are likely to go into arrears leading to court action, and that after reschedulings and foreclosures, about $220bn is likely to be lost, net of the auction sales of such properties. Other organisations, such as the Center for Responsible Lending, also estimate that about 20% of sub-prime mortgages will go into foreclosure.

But, as Mr Zandi points out, both his estimate and the Fed's are very sensitive to changes in house prices. If house prices were to fall by 20% rather than 12% as Mr Zandi's model currently estimates, he says that the total losses could double to $450bn. And if the US goes into recession, or if the Fed raises interest rates to combat inflation, then the losses would also increase dramatically. Meanwhile, fear has led the bond markets— through derivative trading— to cut the value of sub-prime mortgage bonds by an even larger amount.

Since the beginning of the year, sub-prime mortgage bonds issued in early 2007 have dropped in value by between 20% and 80%, depending on their bond rating. Using an arithmetic average, and assuming that other mortgage bonds are equally distressed, this implies they have lost at least half their value, or $625bn.

Truth or consequences

Measuring the likely losses faced by individual banks is an even more difficult task. But what is clear is that most financial institutions have not begun to reveal the full scale of their potential losses. "The reality is that most financial institutions have barely started to recognise the lower 'fair value' of their impaired securities," says Professor Nouriel Roubini of New York University. "The credit crunch is getting much worse and its financial and real fallout will be severe."

Some estimates suggest that banks may have vastly under-estimated their potential liability, especially in connection with off-balance sheet activities. One look at Citigroup, using SEC data, suggested that their potential liability could be $343bn rather than the $55bn they declared.

Another issue is how much of the potential liabilities may eventually have to be written off. In recent announcements, Citigroup wrote off 20% of its admitted $55bn liability, while other banks have written off between 10% and 40%. Another key measure of the stress on banks is the amount of so-called "tier 3" capital they are carrying on their books.

These are risky loans that cannot be valued except by an economic model because there is no market for them.

By that measure, the big investment banks like Goldman Sachs and Morgan Stanley are much more exposed, relative to their total capital, than Citigroup or Merrill Lynch.

Hidden Losses

Changes in US accounting rules which came into force on 15 November, known as FASB 157, may force the big Wall Street banks to come clean on the scale of their losses— especially when accountants have to sign off their annual accounts in January. In particular, it may force them to reveal some of the hidden losses which they have concealed through the use of off-balance-sheet funds (such as structured investment vehicles, or SIVs).

These are bank-sponsored financial funds which buy up mortgages— using money borrowed from the short-term commercial paper markets— bundle them up and then sell them to the bond markets. Thus the banks charge two fees— one at each side of the transaction— and officially have no risk, as they never owned the mortgages. But in practice, when these funds go bad, the banks are liable either to continue to fund them, or to repurchase the underlying mortgages.

Currently the banks have an estimated $340bn in such SIVs, and since the market in short-term asset-backed commercial paper (ABCP) has dried up completely, they are forced to put up the short-term funding themselves. Citigroup, JP Morgan Chase, and Bank of America are the most exposed by this measure.

Rescue Fund

The big banks are hoping that they can rescue about $75bn of this debt, which they say is perfectly sound, by putting it in a special super-SIV, a plan endorsed by US Treasury Secretary Hank Paulson in the hope that it will calm the credit markets and help restart their normal functioning. But even Mr Paulson now admits that the fund will do only a little to reassure investors about the broader mortgage-backed securities market. And others are clear that the only thing that will restore confidence in the markets is the full disclosure of all the potential losses.

Dick Syron, the chairman of Freddie Mac, says he has experienced many financial crises during his work at the Federal Reserve. "You don't begin to get resolution of these questions until you get price discovery," he says. "The problem in the market is not just liquidity. The problem in the market is lack of certainty and lack of information."

Why did the financial sector get it so wrong? And why did it take so long for the banks and the mortgage bond market to realise the scale of the problem that sub-prime lending would cause? The main reason was that the new system broke the link between the lender and the borrower. The institutions who now own the loans— the people who bought bonds— had too little information about how dangerous they were. They relied on the ratings agencies to reassure them that the complex mortgage bonds they were buying were indeed investment-grade.

But those ratings agencies did not understand how, under conditions of "stress," i.e., falling house prices, those bonds would fall in value. And since most pension funds are managed by several different fund managers who all compete with each other to get the best quarterly rate of return, there was a strong incentive to buy as much as they could of these supposedly safe yet high-yielding bonds. According to David Pitt-Watson, who manages the pension fund business at Hermes, the pension funds failed to exercise their rights to find out enough about what they were buying— or question the way the banks were run. And he says the system did not give the right financial incentives to encourage lenders to be careful.

Wrong Incentives

The system created challenges at the other end as well. "Gone are the days when a homebuyer only went to the corner bank to take out a mortgage," says US Treasury Secretary Hank Paulson. "Today the mortgage system is disaggregated and less personal... a homeowner having trouble making payments does not know who to turn to for assistance." In addition, the new system of mortgage finance did not give the right financial incentives to ensure that proper checks were made on the individuals who applied for sub-prime mortgages.

The banks who offered mortgages and sold them on did not care as much whether the loans went into foreclosure. They were paid a fee for selling the mortgage on, and another fee for servicing (collecting the loan payments), and even got additional fees if they had to foreclose. As the banks who sold on these mortgages were not putting up their own money as collateral, they no longer used their own in-house bank managers to assess the income of their borrowers and check the real value of the house they were giving a mortgage on.

Instead, they increasingly turned to mortgage brokers to sell them even more mortgages. And there is evidence that the poorly-regulated mortgage brokers— whose job it was to check the income of potential mortgagees— and the home appraisers, who had to value the property— began to exaggerate both the income of their clients and the value of the homes, thus getting higher fees themselves. "The sub-prime mortgage market in recent years was also accompanied by a deterioration in underwriting standards," says Fed governor Randall Kroszner.

"In some cases, abusive or fraudulent lending practices resulted in homeowners taking on mortgage obligations they could not afford, with terms they may not have fully understood." It is now up to the regulators and policy makers in Washington to correct the broken mortgage system— before the damage to home owners, banks and the US economy becomes too great.

But whatever is done, it is bound to be painful.

"We can't make all the pain go away," says Mr Syron. "We can ameliorate it and most importantly we can try and prevent it happening again but we can't eliminate all of it."

ߧ
Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

The Coming China Crash

The Coming China Crash

By Martin Hutchinson | 7 December 2007

While the Chinese stock market, as measured by the China Securities Index 300, is down 18% since October 16, that follows a period of almost two years during which the CSI 300 had soared 535% since January 1, 2006. Chinese economic growth is currently running at over 11% and the big money is convinced that it will continue, while the country’s foreign exchange reserves are $1.4 trillion, the largest in the world. A crash would appear to be imminent!

Bears on China have been common for the last decade, and their track record has not been good. To take just one unfair example, Henry Blodget, the former Internet genius, wrote in Slate in April 2005 "You’ve probably been daydreaming about the fortune to be made in Chinese stocks. Well, keep dreaming….you’ll eventually conclude that you could have done better selling insurance in Toledo." That was about six months before the Chinese market took off,and if anybody has made 500% on their investment by selling insurance in Toledo during that period, I haven’t met him.

To see why a crash may be coming, it is worth examining the behavior of the China Investment Corporation, the $200 billion sovereign wealth fund set up by the Chinese government in September. Now $200 billion is a fair chunk of cash; you could almost buy all but three US corporations with that (at today’s prices, ExxonMobil, General Electric, Microsoft— there are 4 - 5 others including Google that barely top the bar.) Six weeks ago, the power of sovereign wealth funds was celebrated and China Investment’s moves into the market were awaited with bated breath.

Well, so much for that. A third of China Investment’s portfolio is to be invested in Central Huijin Investment Company, a purchaser of bad loans from the Chinese banks, and another third will recapitalize China Agricultural Bank and China Development Bank, to shape them up for privatization. $3 billion of the fund was invested in the private equity manager Blackstone in May— that may have bought China useful political contacts, but it is now worth $2 billion. And the remainder is being invested very carefully, primarily in US Treasury securities— which are also losing money steadily in yuan terms.

The lackluster investment strategy of China Investment exposes a central flaw in the Chinese economy, its lack of a rational system of capital allocation. For more than a decade, Chinese state-owned companies have made losses, and have been propped up by the banking system. Since 2004, loss-making state owned companies have been joined by overbuilding municipalities, erecting white-elephant office blocks in attempts to turn themselves into the next Shanghai. None of these losses have resulted in bankruptcy; instead the cash flow deficits have been covered by the Chinese banks. As a result, the Chinese banks have an enormous volume of bad loans— $911 billion at May 2006, according to a later-withdrawn estimate by Ernst and Young, which must surely have ballooned to $1.2-1.3 trillion now.

That explains why China Investment is somewhat un-aggressive in its international investment strategy. China’s $1.4 trillion of reserves are in fact almost all required to prop up the banking system, when the inevitable liquidity crisis occurs. If the banks are to survive, China Investment will have to be followed by six more sovereign wealth funds of equal size, each of which will have to abandon attempts to take over Exxon or Google and pour money down domestic rat-holes.

A $1 trillion problem in subprime mortgages has caused even the US money market to seize up and has required frequent applications of sal volatile by the Fed. Since China’s economy is around one fifth the size of the United States’ the Chinese banking system’s bad debt problem is in real terms about five times that of the United States, about 40% of its Gross Domestic Product.

We have seen this movie before; the Japanese banking system’s bad debts after 1990 totaled around $1 trillion, about 30% of Japan’s GDP. The result was the bursting of the 1980s bubble and a period of little or no economic growth that lasted well over a decade. Admittedly the Japanese authorities made matters worse, by refusing to face up to their bad debt problem and issuing more government bonds to fund witless Keynesian public spending schemes.

Nevertheless, we can have very little confidence that the Chinese authorities, once the same problem stares them in the face, would do any better. After all, at least one of the alternative policy mixes, that tried by Herbert Hoover and the Federal Reserve in 1930-32, proved very much worse. Per Capita US Gross Domestic Product was no higher in 1940 than it had been in 1929, as in the Japanese case, but in the interval it had declined by a horrifying 28% and had recovered very slowly. If China faces the choice between a decade of stagnation, as in Japan from 1990-2003 and a decade of economic collapse, as in the United States from 1929-1940, it will rightly prefer the Japanese alternative.

It may not however have the choice. One of the factors that kept Japan out of real trouble in the 1990s was continued strong growth in the US and world economies; thus its magnificent export industries were able to continue growing, albeit at a slow rate, and provide a certain amount of traction for the economy as a whole. However, China will find it difficult to do the same, since the next decade does not seem likely to be a period of robust world growth, far from it. The United States seems fated to endure at least a few years of very sluggish growth due to its housing market crash, and Britain appears to be in a similar mess, so even relatively robust growth in the resurgent economies of Germany and Japan may not be sufficient to keep Chinese exports growing.

At that point, China will have two alternatives. It can allow the banks to work their way out of their bad loans, condemning the domestic economy to probably a decade of little growth and extremely tight credit (high Chinese savings would alleviate this problem, but they will be trapped in the Chinese banks because the authorities foolishly do not allow Chinese citizens to invest abroad.) Alternatively, it can inject more or less its entire foreign exchange reserves into the domestic banking system in order to recover its bad debts, which would allow the Chinese economy to continue expanding, but at a cost of devastatingly high inflation from the additional money pumped into the system (the $100 billion plus of Chinese bank initial public offerings carried out in 2006-07, pumped into the domestic economy, already appears to be worsening Chinese inflation and China Investment’s $130 billion will doubtless worsen the problem.)

We have seen societies with low economic growth, very high inequality (as China has now) and persistently high inflation; they are collectively known as Latin America. Since China also has much of the corruption that bedevils Latin America and its government lacks any genuine understanding of the free market and is increasingly dominated by special interests, it may indeed be fated to follow a Latin American growth path for the next few decades, with a tiny entrenched elite enriching itself at the expense of the disfranchised masses. That would be the worst possible outcome for the Chinese people, but it is not by any means impossible.

Many observers of the current US financial market downturn comfort themselves with the thought that the world now has more than one growth engine, and that China, with four times the US population, can because of its very high growth pull the world economy along sufficiently even when the US stalls. However, if China is about to incur the inevitable backlash from its recent debt and equity bubbles, during which practices have flourished that have no place in a well functioning free market, then we may be entering a world in which the two main growth engines of the last decade are both broken. Growth in such a world will be truly sluggish and inflation high, as the world struggles to cope with the effects of an excess of cheap money now grown toxic.

The problem with major recessions is that they tend to produce foolish political reactions. In the United States, it seems likely that a major recession, if we have one, will produce resurgent protectionism and an aversion to world trade, which to the voting public will appear to have been responsible for the loss of millions of good US jobs without any corresponding gains to the living standards of the majority. Japan, bless it, remained admirably politically stable during its sluggish decade, and eventually found a leader in Junichiro Koizumi who was able to lead it back into renewed growth.

In China, there can be no assurance whatever that a populace whose living standards have suddenly stopped improving will not turn to violent nationalism and/or counterproductive economics. Since the country is not a democracy and not likely to become one, the authorities are likely to react to hardship as did Vladimir Putin to the chaos of late 1990s Russia, imposing even more draconian repression and seeking a military adventure abroad to occupy the masses of disaffected youth and distract the public from its new poverty. That too would produce a future in the West far worse than would be cased by a mere domestic recession.

Bears who weary of observing the chaos in the US financial markets can cheer themselves up by looking at China. There will be more than one source of the oncoming world downturn!
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Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Consumers Pulling Back?

Evidence Grows That Consumers Are Pulling Back
Latest Industry to Feel Pinch: Plastic Surgery; Debating a Recession

By Rhonda L. Rundle And Kelly Evans, WSJ | 9 December 2007

The latest sign that growth in consumer spending, the mainstay of the U.S. economy, is slowing? A nip and tuck in spending on cosmetic surgery. The slowdown was a hot topic at the meeting of the American Society of Plastic Surgeons in Baltimore this fall. One breast-implant maker sees hints of a slowdown in demand. The number of vision-correction surgeries appears to be falling as well.

"This whole mortgage credit crisis is making people think twice," said J. Peter Rubin, a Pittsburgh plastic surgeon. "It's something I've noticed and some colleagues have noticed as well."

While anecdotal, the industry chatter is the latest worrying hint of a broader slowdown in consumer spending, which accounts for 70% of the U.S. economy— and fodder for a broader debate on how deep such a slowdown might bite. The big question is whether the triple whammy of falling home prices, still-high energy prices and a credit crunch will crimp consumer spending so much that the nation slides into recession.

Consumers spend more on housing, health care, education, travel, restaurants and other services— $4.6 trillion last year— than they do on food, gasoline, clothing, electronics, cars and other goods— $3.6 trillion. Spending on services such as education and housing tends to be less sensitive to economic swings. But discretionary spending, such as elective medical procedures or airline tickets, is susceptible to cyclical pressures.

Consumers sound pessimistic. On Friday, the Reuters/University of Michigan's index of consumer sentiment reported a decline in early December to a level lower than any month since 1992— except for the month following Hurricane Katrina. Gloom among lower-income households more than offset gains in better-off households. The Conference Board's survey is similarly weak.

Besides rising mortgages delinquencies and home foreclosures, delinquencies in the auto-loan market are ticking up to the highest level in several years, and lenders are tightening terms. Student loans are weakening too. After Moody's Corp. cited rising default rates in student loans as reason to consider downgrading notes created by First Marblehead Corp., the student-loan packager on Friday halved its dividend and said it wouldn't do another offering of bonds backed by student loans this quarter. (See related article.)

Also Friday, Federal Reserve data suggested credit-card spending has slowed. Consumer credit increased at an annual rate of 2.3% in October, faster than September's 1.6%. But that was less than half the pace of earlier in the year, and the acceleration in the growth of credit-card debt offset a second month of declines in the category that includes auto loans. Credit-card issuers have been pulling back, with approval rates across the industry dropping to 33% from 41% a year ago, said Robert Hammer, chief executive of R.K. Hammer, a bank-card advisory firm. Many are raising fees and interest rates.

Brad Tober of Buffalo, N.Y., recently got a notice that Capital One Financial Corp. was replacing the 9.9% fixed rate on his credit card with a variable rate of about 19%. The 21-year-old college student said he hadn't paid a bill late or done anything that he anticipated would lead to a higher rate. A spokeswoman for Capital One attributed the change to "business and economic" factors.

The broadest measure of consumer spending, one which includes food, energy and all other goods services, grew at a 2.7% annual pace in the robust third-quarter. Still, forecasters expect a substantial slowing in the current quarter, an important one to retailers depending on holiday sales. Economists at Macroeconomic Advisers, a St. Louis forecasting firm, expect consumer spending to grow a mere 1.1% seasonally adjusted pace in the current quarter.

To be sure, some economists expect the economy to keep rolling, despite what consumer-confidence surveys show. "The surveys are useful for telling you the mood of consumers...but they're not that useful for forecasting how much consumers are going to spend," said Dean Croushore, a University of Richmond economist whose research suggests declines in confidence don't regularly foreshadow downturns in spending. "Pay attention to what people do, not what people say. As long as people's incomes are doing fine and they have money to spend, they'll spend it."

The labor market has held up, a good sign since most Americans' incomes come from their jobs. The government said yesterday that employers added 94,000 jobs in November, roughly the average for the past six months. The unemployment rate held steady at 4.7%.

But even here there are some signs of weakening. Initial claims for unemployment benefits are running at a four-week moving average of 340,000, the highest since October 2005. Fed policymakers' latest forecast shows the jobless rate rising to between 4.8% and 4.9% next year, and the outlook has darkened since those projections were made in late October.

The Christmas season will fill in some blanks. Consumer purchases of big-ticket items, such as cars and furniture, are far more volatile than purchases of services. When times get tough, spending that can be deferred often is.

That's where plastic surgery comes in. Last year, Americans spent an estimated $11.4 billion on plastic surgeon fees and probably close to $4 billion more when facility fees and anesthesia are included, according to the American Society of Plastic Surgeons.

Breast jobs and tummy tucks aren't covered by insurance, so patients need a chunk of cash— or a healthy credit line. So far, the slowdown in some plastic surgeons' offices appears to be affecting big-ticket surgeries rather than less costly procedures such as anti-wrinkle facial injections.

Some surgeons say business didn't pick up this fall as much as usual. Others say they have been busy but have lighter bookings for next year. Patients typically go under the knife in January and February to allow time to recuperate before bathing-suit weather arrives.

Breast-implant maker Mentor Corp. in Santa Barbara, Calif., says the surgeons who are its customers have noticed a drop in patient interest. Since last November when the Food and Drug Administration returned silicone implants to the cosmetic market after a 14-year partial ban, Mentor's sales have been strong. But the company detected some disturbing signs at the end of the quarter ended Sept. 30. In a conference call with analysts, Mentor Chief Executive Joshua Levine, sounded a cautionary note. Some plastic surgeons, he said, are seeing a drop-off in patient consultations, which is "usually a little bit of a precursor to lighter surgical calendars maybe 45 to 60 days out." He said he wasn't sure if a significant slowdown was on the way, but warned, "If we're going to have a real problem in the broader economy, we won't escape that."

Investors treated his remarks as an inflection point. The impact was heightened because it followed laser maker Cutera Inc.'s announcement that it would discontinue giving financial guidance to investors. Cutera, of Brisbane, Calif., said that "a number of factors, including recent signs of a slowing market growth rate, have made it more difficult to accurately predict our future financial performance." Cutera lasers as used for hair removal and skin rejuvenation among other aesthetic therapies.

Companies that lend money to consumers for such procedures say the business has been growing so quickly that it's nearly impossible to detect cyclical swings. "We haven't noticed a change in cosmetic surgery," said Mike Testa, president of General Electric Co.'s Care Credit unit, which specializes in consumer loans for dental and medical procedures. But people generally commit to cosmetic surgery and take out a loan months later, so it may be too early to see a trend, he said.

Care Credit has, however, noticed a downturn in another popular procedure— laser vision-correction surgery. Volume dropped 10% in October, the sharpest decline the firm has ever seen in such procedures, Mr. Testa said.

Over the past five years or so, the volume of such surgeries has closely tracked the Conference Board's consumer confidence index, said Dave Harmon, president of Market Scope LLC, a market-research firm in Manchester, Mo. Last month, Mr. Harmon cut his 2007 estimate of vision-correction surgeries by 2.6% to 1.38 million. In recent years, he says, 80% of the change of volume in such surgeries can be explained by changes in consumer confidence.
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Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Worsening Credit Crisis

Worsening Credit Crisis Leading to Meltdown of Financial System and Severe US Recession

By Mike_Whitney | 26 November 2007

The increased volatility suggests that we are watching a "real time" meltdown. International Business editor for the UK Telegraph, Ambrose Evans Pritchard, summed up yesterday's action in the Asian markets:<

"The global credit crisis has hit Asia with a vengeance for the first time, triggering a massive flight to safety as investors across the region pull out of risky assets. Yields on three-month deposits in China and Korea have plummeted to near 1% in a spectacular fall over recent days, caused by panic withdrawals from money market funds and credit derivatives. "“'This' is a severe warning sign,” said Hans Redeker, currency chief at BNP Paribas. “Asia ignored the credit crunch in August but now we're seeing the poison beginning to paralyze the whole global economy.”" (Credit 'Heart attack' engulfs China and Korea, Ambrose Evans Pritchard,UK Telegraph)

The credit storm that began in the United States with subprime mortgages has spread to markets across the globe. In fact, the train has already crashed. What we're seeing now are the boxcars piling up on top of each other.

On Tuesday Chinese government officials ordered a complete halt to bank lending to slow the speculative frenzy that has created an enormous equity bubble in the stock market. According to the Wall Street Journal:

"Chinese authorities are slamming the brakes on bank lending, in their latest attempt to curb the runaway investment threatening to overheat what is soon to be the world's third-largest economy. In recent weeks, regulators have quietly ordered China's commercial banks to freeze lending through the end of the year, according to bankers in several cities. The bankers say that to comply, they are canceling loans and credit lines with businesses and individuals." ("China freezes lending to Curb Investing Frenzy" Wall Street Journal)

The move illustrates how concerned the Chinese are that a slowdown in US consumer spending will trigger a crash on the Shanghai stock market. It also shows that the Chinese are having difficulty dealing with the inflation generated by the hundreds of billions of US dollars absorbed via the trade imbalance with the US. China is awash in USDs and that surplus is causing a steady rise in food and energy costs. This could be mitigated by allowing their currency to "float" freely. But a sudden, steep increase in the Chinese yuan's value could also send the world headlong into a global recession. For now, the lending freeze and price fixing appear to be the way out.

Another sign that the markets have reached a "tipping point" appeared in a Reuters article on Wednesday; "Interbank Covered Bond Trading Halted on Volatility":

"Renewed credit turmoil and volatility led the European Covered Bond Council (ECBC) on Wednesday to suspend inter-bank market-making in covered bonds until Monday, Nov. 26. The move is a sign of the stress in the covered bond market, which is dominated by German institutions that have almost a trillion euros of covered bonds outstanding. Covered bonds— backed by pools of assets that remain on the borrower's balance sheet— are usually highly liquid and typically rated triple-A by ratings agencies. The ECBC's recommendation is aimed at relieving the pressure on market makers who are forced to quote prices at a fixed bid-offer spread. "In light of the current market situation and in order to avoid undue over-acceleration in the widening of spreads, the 8-to-8 Market-Makers & Issuers Committee recommends that inter-bank market-making be suspended," the ECBC said in a release."

Note: This isn't mortgage-backed junk that's being sold, but highly liquid bonds that are usually easy to cash in [[virtually the equivalent of cash: normxxx]]. The ECBC's action is a sign of pure desperation and indicates that credit paralysis has infected the entire euro banking system.

Reuters: "Due to general market conditions and the specific mechanics of the inter-dealer market making it even seems possible that inter-dealer market making will not be resumed this year."

That's bad. The whole mechanism for converting covered bonds [[and what other securities?: normxxx]] into cash has broken down.

The dollar took another pasting on Wednesday, sliding to $1.49 on the euro; another new record [[it closed below $75, today, at $74.82: normxxx]]. Gold shot up to $814 per ounce. Oil continues to flirt with the $100 per barrel mark, and the yen rose to 107 per dollar forcing a further sell-off of hedge fund assets levered through the carry trade [[which puts further pressure on the dollar: normxxx]].

Jon Basile, economist at Credit Suisse, summed it up like this: "There's a heck of a lot of bad news out there." Indeed.

In California Governor Arnold Schwarzenegger has joined with four mortgage lenders to freeze adjustable interest rates (ARMs) for some of the state's highest-risk borrowers; another unprecedented move. The Governor hopes to avoid a collapse of the California real estate market which has gone into a tailspin. Home sales have plummeted more than 40 per cent for the last two months. Prices have dropped sharply— roughly 12 per cent statewide. New construction has slowed to a crawl. Layoffs are steadily rising. Jumbo loans (mortgages over $417,000) have been put on the "Endangered Species" list. Even qualified borrowers can't get mortgages. Nothing is selling. California housing is "off the cliff".

Schwarzenegger's plan to keep over-extended subprime mortgage-holders in their homes faces an uncertain future. What incentive is there for homeowners to continue paying exorbitant monthly rates when their payments are not applied to the principle? The homeowners would be better off bailing out, accepting foreclosure, and starting over with a clean slate.

It's unrealistic to think that Schwarzenegger can stop the tidal wave of foreclosures that are sweeping across the state. An estimated 3 million homeowners will lose their homes nationwide. If you want to blame someone; blame Alan Greenspan. He's the one who created this mess.

According to the economist Mike Shedlock:

"The Fed caused the credit crunch by slashing interest rates to 1 per cent to bail out its banking buddies in the wake of a dotcom bubble collapse. All the Fed did was create a bigger bubble. This bubble is so big in fact that it cannot even be bailed out. It's the end of the line for a serially bubble blowing Fed. "So not only was this the biggest credit bubble in history, this was also the biggest transfer of wealth from the poor and middle class to the already enormously wealthy. That is the real travesty of justice regardless of whether or not the price tag is $1 trillion, $2 trillion, or $10 trillion." (Mike Shedlock, "Mish's Global Economic Trend Analysis")

The problem has gotten so serious that even Secretary of the Treasury, Henry Paulson, is putting up red flags. Last week, Paulson ignited a sell-off on Wall Street when he made this statement:

"The nature of the problem will be significantly bigger next year because 2006 [mortgages] had lower underwriting standards, no amortization, and no down payments....We're never going to be able to process the number of workouts and modifications (to mortgages) that are going to be necessary doing it just sort of one-off. I've talked to enough people now to know that there's no way that's going to work."

The desperation is palpable. Like Schwarzenegger, Paulson is trying to get mortgage-lenders to provide a safety net for struggling borrowers who are defaulting on their loans.

[ Normxxx Here:  Ah, but most of those "mortgage-lenders" are European, Chinese, Japanese, and other Asiatic and ME funds and banks! Good luck on getting them to bail-out "those American crooks!"  ]

Paulson is calling for emergency legislation that will allow the Federal Housing Administration to play a greater role in the relief effort. The FHA has already expanded its traditional role by taking on hundreds of billions in extra debt just to keep a few "private" mortgage lenders and banks from going bankrupt. Of course, when Paulson's plan goes kaput and the debts pile up; it'll be the taxpayer that foots the bill.

"Paulson also called the Senate's failure to pass legislation overhauling mortgage giants Fannie Mae and Freddie Mac frustrating," saying that the two government-sponsored entities need to be playing a bigger role in the housing market. "If we ever need them it's during times like today, and they're most valuable when there is distress in the mortgage market," he said. "I'd like to see them playing an even bigger role."(Wall Street Journal)

Fannie and Freddie, have already posted enormous quarterly losses and don't have the capital reserves to add millions of subprime mortgage-holders under their "government-sponsored" umbrella. Paulson is just grasping at straws.

Similar troubles are brewing in the broader market where late-payments and defaults have spread to credit card debt and new car loans. Every area of "securitized" debt has suddenly veered off the road and into the ditch. Last week the Fed injected more credit into the teetering banking system than anytime since 9-11.

No one has predicted the downward-spiral in the market more accurately than Nouriel Roubini. Roubini is a Professor at the Stern School of Business at New York University. His analysis appears regularly on his blogsite, Global EconoMonitor. Last week's prediction was particularly dire and is worth reprinting here:

"It is increasingly clear by now that a severe U.S. recession is inevitable in next few months...I now see the risk of a severe and worsening liquidity and credit crunch leading to a generalized meltdown of the financial system of a severity and magnitude such as we have never observed before. In this extreme scenario whose likelihood is increasing we could see a generalized run on some banks; and runs on several of the weaker (non-bank) broker dealers, that may go bankrupt, with severe and systemic ripple effects on a mass of highly [integrated and interdependent] leveraged derivative instruments that will lead to a seizure of the derivatives markets... massive losses on money market funds with a run on both those sponsored by banks and those not sponsored by banks; ..ever growing defaults and losses ($500 billion plus) in subprime, near prime and prime mortgages with severe knock-on effect on the RMBS and CDOs market; massive losses in consumer credit (auto loans, credit cards); severe problems and losses in commercial real estate...; the drying up of liquidity and credit in a variety of asset backed securities, putting the entire model of securitization at risk; runs on hedge funds and other financial institutions that do not have access to the Fed's lender of last resort support; a sharp increase in corporate defaults and credit spreads; and a massive process of re-intermediation into the banking system of activities that were until now altogether securitized." (Nouriel Roubini's Global EconoMonitor)

"A generalized meltdown of the financial system".

Looks like Chicken Little might have gotten it right this time; "The sky IS falling."


Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Spirals of Death

The Bear’s Lair: Spirals of Death

By Martin Hutchinson | 8 December 2007

Close observers of the US housing finance disaster in recent months will have noted a curious phenomenon. Companies such as Countrywide that were in late August regarded as rock solid have recently passed clearly into the danger zone while those like Fannie Mae and Freddie Mac that were regarded as potential market saviors have come under a cloud. In Britain Northern Rock, whose September bailout was said to be modest, involving little risk to the taxpayer has now turned into an immense 25 billion pound ($51 billion) potential black hole— real money even in the US economy let alone in the much smaller British one. This illustrates a deeply troubling quality of the largest downturns: the tendency for the free market to turn into a death spiral, in which even sound well-run institutions are engulfed.

Death spirals are fairly rare in financial history. The Wall Street Crash of 1929 was perhaps the most virulent example. After the first downturn, the market recovered for several months. Then the collapse of the Bank of the United States in December 1930, together with the further economic damage from the Smoot-Hawley Tariff caused a further collapse in confidence and activity that was concentrated in the banking sector, as relatively solid institutions followed the Bank of the United States into bankruptcy. The Federal Reserve failed to correct for the money supply contraction caused by the bank bankruptcies, leading the US economy further into the pit. The additional shove given by President Herbert Hoover’s 1932 tax increase was almost unnecessary; only the confidence brought by a new president (albeit with equally counterproductive economic policies) brought recovery from 1933. By the time the spiral was over, more than one fourth of the banks in the United States had gone bankrupt and the stock market had bottomed out at one tenth of its peak.

A second death spiral, with somewhat less dire economic consequences, occurred in Britain in 1973-74. Edward Heath’s government had removed the quantitative controls on bank lending in 1971, which resulted in an orgy of high risk lending against real estate, very similar to the recent episode in the US except that most of the loans were made against commercial real estate rather than housing. When the first major real estate lender, London and County Bank, collapsed in November 1973 another more conservative house, First National Finance (FNFC), was used as the epicenter of the "lifeboat" rescue organized by the Bank of England. However, the decline in confidence and real estate values quickly sucked FNFC into the maelstrom.

The lifeboat rescue fund grew larger and larger for more than a year as the stock market declined to record low levels, 70% below its 1972 high. Homebuilders such as Northern Developments, in no way involved in the original crash but dependent on bank lending, were dragged down. So were the two most important entrepreneurial finance houses, both internationally diversified and neither significantly involved in commercial real estate lending— Jessel Securities, founded by Oliver Jessel and Slater Walker, founded by Jim Slater.

Neither Jessel nor Slater had been aggressively run— indeed Jim Slater had begun de-leveraging a year before the crash, as he saw trouble coming— and no wrongdoing was proved against the head of either organization, yet by the end of 1975 both very substantial companies had gone bankrupt and neither founder played a significant further role in the British financial sector. This was a great pity: in losing Jessel and Slater Britain had lost not only their very able founders but the most aggressive entrepreneurial teams in the City of London, who might have been best able to compete against the foreign invasion when Britain deregulated the financial services sector in 1986.

The British experience of 1973-74 seems more like the current position in the United States. National policy is currently reasonably neutral, so far avoiding the twin dangers of protectionism and tax increases which caused the medium sized downturn of 1929-30 to turn into the Great Depression. The problem is concentrated in the property sector. However there are already worrying signs that the magic alchemy of modern finance, through such mechanisms as securitization vehicles whose funding falls apart and complex derivative securities that prove to be unsalable in a crisis, is causing the problem to metastasize. In the consumer sector, GMAC has reported problems with its automobile loan portfolio, while it appears that credit card debt quality is rapidly deteriorating. In the corporate loan sector, loans to aggressive leveraged buyouts have got in trouble, and loans to hedge funds and private equity funds have been sharply cut back. (The latter effect can be seen in the movement of the yen/dollar exchange rate from 120 to 108, as the hedge funds’ ”carry trade” positions have been de-leveraged.)

The "death spiral" characteristics of the current market are pretty clear. If Fed Chairman Ben Bernanke’s original estimate of subprime loan losses of $50-100 billion had been anywhere close to accurate, there would have been no problem. The market deals with difficulties of that size all the time, without significant effect on surrounding sectors. A few fringe operators go bankrupt, a few large houses show unexpected losses, and the overall market continues without a tremor. The collapse of the Amaranth hedge fund in September 2006 or that of Refco a year earlier were substantial events, causing losses to a number of those institutions’ business partners, but there was no question of any general market disturbance.

When the subprime problem first emerged in February, it appeared that it would also be limited. A number of subprime lenders, relatively insignificant institutions, were forced to shut down. However the general market appeared unaffected; its view appeared to be that the problem was localized and should have no effect on the real economy, nor even any great effect on the broader housing finance market.

August’s widening in Libor spreads, at which banks lend money to each other, should have told us that this problem would be different, and altogether more important. If leading banks were unable to assess each other’s credit quality for short term transactions then something much more serious was wrong than the collapse of a modest fringe sector of the housing finance market. The Fed’s chosen solution, dropping interest rates and pumping more money into the system, did not address the real problem and was thus useless, as it has since proved. It has only postponed the denouement for a few months and stored up further trouble with inflation.

Two factors are at play here. The first is sheer size. If as now appears likely the eventual losses in the home mortgage market do not total only $100 billion, but a figure much closer to $1 trillion, then the subprime debacle becomes something much more than a localized meltdown. $1 trillion of losses is 7% of US Gross Domestic Product. The market cannot absorb losses of that size without some major institutional bankruptcies or a lengthy recession. The closest equivalent problem is the savings and loan collapse of 1989-92; that caused a major housing downturn but only a minor recession. However its cost (mostly borne by the US taxpayer) of $176 billion was about 3% of 1990 US GDP, only half the size of the likely current losses on mortgage loans.

The second is lack of transparency, and the blow to confidence that comes from the dawning suspicion that a large portion of the derivatives and securitization mechanisms designed in the last quarter century are faulty. The unluckily timed implementation for years beginning after November 15 of FAS Rule 157, requiring banks to divide their assets into three levels according to their degree of marketability, has thrown an unwelcome spotlight on the problem. If Level 3 assets can be valued only by reference to an 'internal' valuation model, and have been allowed to accrue value in banks’ financial statements for a decade or more (enabling hefty bonuses to their progenitors), then how do we know they are really worth anything close to what the model says, and how do we go about realizing their value, in a market where confidence has vanished?

To ask those questions is to answer them. Since every incentive led bank mathematicians to devise models that maximized the reported value of the bank’s holdings, and since little or no market existed by which those values could be checked, it is likely that today those assets’ book values are highly overstated. Moreover, even in banks where the mathematicians and their bosses were scrupulously, even impossibly disinterested and intelligent, there still remains the problem that those assets are worth far less in a downturn, because their illiquidity makes them intrinsically unattractive in a market where liquidity has become once more important. Anyone who has attempted to sell venture capital positions in a bear market can attest to how rapidly and completely the value of such assets can disappear. It is thus perfectly possible that the true realizable value of "Level 3" holdings in a bear market is no more than 10% of their book value[[ if that: normxxx]].

This immediately demonstrates the problem. Goldman Sachs, generally regarded as insulated from the subprime mortgage problem, has $72 billion of Level 3 assets; its capital is only $36 billion. If anything like 90% of the Level 3 assets’ value has to be written off, Goldman Sachs is insolvent. They do not have the option of acting like Nomura Securities did recently, selling everything possible and writing the remainder down to zero, because they would be without capital. Instead they are likely to be dragged kicking and screaming, quarter by quarter, to a gradual writedown and sale of their Level 3 assets, with their true position remaining undisclosed and obfuscated by meaninglessly optimistic statements by top management. Only the bonuses will survive, paid in cash and draining liquidity from the struggling company.

That’s what a death spiral looks like. The US survived the Great Depression, eventually, and Britain survived the 1973-74 debacle. However the market recovered only after it had plumbed depths previously thought impossible, at which even the soundest investments were trading far below their true value. After normality returned, the financial services landscape was very different, with many large and apparently solid houses having disappeared, a generation of participants reduced to driving taxis or selling apples and a generation of investors scarred by their losses and unwilling to return to the market. Emergency infusions of money, from the Fed or the taxpayers, generally do no good, only postponing the denouement and delaying the arrival of truly bargain price levels.

Such spirals of death represent the final definitive triumph of the Bears.
ߧ
Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

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Stagflation?

How do You Spell Stagflation?

By John Mauldin | 27 November 2007

Cooking the Inflation Books

Just for the record, I want to state that I know as does nearly everyone else who pays attention to the CPI statistics that they are bogus. They do not reflect the real world that you and I, gentle reader, live in. So, while it may look like I take them at face value, I do so only because the Fed pays attention to the number, (nod, nod, wink, wink) and makes policy based upon it. So, let's look at how the calculation of the CPI has been politicized and how much of a difference it makes, and then go on to the expectation for statistical inflation in the near future.

John Williams writes an excellent monthly letter on all types of government statistics called the Shadow Government Statistics. One of the things he points out that during the Clinton administration, the way the BLS calculates inflation was changed. He calculates his own inflation number using the old pre-Clinton inflation model. Using that methodology suggests that inflation is at 7%. And if you use other methods, inflation might even be substantially higher. Look at the chart below.


Click Here, or on the image, to see a larger, undistorted image.

Since the CPI is used to calculate the increase in Social Security payments and a host of other items, calculating inflation is important. In the early 1990s the arguments in the press was that inflation was over-stated. Michael Boskin, chief economist in the first Bush administration and Alan Greenspan were among the chief proponents for a new methodology of accounting for inflation.

Quoting Williams:

"Up until the Boskin/Greenspan agendum surfaced, the CPI was measured using the costs of a fixed basket of goods, a fairly simple and straightforward concept. The identical basket of goods would be priced at prevailing market costs for each period, and the period-to-period change in the cost of that market basket represented the rate of inflation in terms of maintaining a constant standard of living. "The Boskin/Greenspan argument was that when steak got too expensive, the consumer would substitute hamburger for the steak, and that the inflation measure should reflect the costs tied to buying hamburger versus steak, instead of steak versus steak. Of course, replacing hamburger for steak in the calculations would reduce the inflation rate, but it represented the rate of inflation in terms of maintaining a declining standard of living. Cost of living was being replaced by the cost of survival. The old system told you how much you had to increase your income in order to keep buying steak. The new system promised you hamburger, and then dog food, perhaps, after that. "The Boskin/Greenspan concept violated the intent and common usage of the inflation index. The CPI was considered sacrosanct within the Department of Labor, given the number of contractual relationships that were anchored to it. The CPI was one number that never was to be revised, given its widespread usage. "Shortly after Clinton took control of the White House, however, attitudes changed. The BLS initially did not institute a new CPI measurement using a variable-basket of goods that allowed substitution of hamburger for steak, but rather tried to approximate the effect by changing the weighting of goods in the CPI fixed basket. Over a period of several years, straight arithmetic weighting of the CPI components was shifted to a geometric weighting. The Boskin/Greenspan benefit of a geometric weighting was that it automatically gave a lower weighting to CPI components that were rising in price, and a higher weighting to those items dropping in price. "Once the system had been shifted fully to geometric weighting, the net effect was to reduce reported CPI on an annual, or year-over-year basis, by 2.7% from what it would have been based on the traditional weighting methodology. The results have been dramatic. The compounding effect since the early-1990s has reduced annual cost of living adjustments in social security by more than a third."

Then to confuse the process even more, the BLS uses something called hedonics, from the root word hedonism. Essentially, the adjust the price of an item based on the "pleasure" or increased value you get. Thus, they don't price automobiles based on the sticker price, but on what you get for your money. If the manufacturers load in more items like new electronics or anti-locking brakes that were not standard the year before that means you are getting more value for your dollar, so therefore the price in terms of inflation goes down even though you may be paying the same or even more to get out of the car show room.

The same is true for computers. We clearly get more power every year, so for the BLS the price of computers are going down, although it seems to me that the price I pay for a top of the line computer is about the same as it was five or ten years ago.

If the government mandates an additive to gasoline that costs 10 cents more, that is not included in the inflation numbers, because we get a new, improved gasoline that pollutes less. Supposedly the pleasure of breathing cleaner air reduces the costs to our pocket book, or something like that.

My health insurance costs have tripled over the last ten years, and I know that is the experience of many of my readers. Yet, the BLS has medical costs rising by less than 50% for the last ten years. Their data suggest the cost of housing has risen by about 30% over the last ten years. Again, that is not the experience of many of my readers.

Social Security expenses are $657 billion per year. If Williams is right (and I think he is) that under the old methodology expenses would have risen by a third, then that means SS is paying $200 billion a year less than it 'should'. Add $200 billion to the deficit. And then watch politicians panic.

I am not one to suggest conspiracy, but if the CPI reflected the real world, the US government would be spending far more money on Social Security and a host of other pension programs. The crisis we will be experiencing in about 8 years would have already hit us. Thus, there was an incentive for 'leaders' to find economists who could argue for new, more "progressive" methods for calculating inflation. Notice that this was done by the BLS without any protest from Congress.

None of this was done behind closed doors. The BLS, to its credit, is extremely open about how it calculates CPI, and you can get an enormous amount of detail on their web site about prices of things like tomatoes in very part of the country going back for decades.

But the way we calculate the CPI is not going to change back. No administration will want to go back and add in an extra 4-5% a year to Social Security and other government pension programs. So, let's return to the prospects for a rise in the CPI in the near future, which will have policy implications for the Fed.

Gaming the Producer Price Index

After the above notes on the CPI, it will probably not come as a surprise that there may be some problems with the Producer Price Index. The PPI rather oddly has the price of energy going down in October. PPI is important, as it is an indication of the trend of inflation in consumer prices in the future.

As friend Bill King notes:

"Since June, BLS has energy prices declining in all three PPI stages: finished, intermediate and crude. For June finished energy goods the index is 160.9, for October 159.5; the intermediate prices are 179.9 vs. 178; for crude it's 238 vs. 232.9. BLS has energy prices DOWN 3.64% since July!! "Oil has rallied from ~$75 to the mid-90s since July 9. Over the same period, gasoline has rallied from $1.95 to $2.35; heating oil has rallied from $2.15 to $2.55; natural gas has fallen from $8.50 to $8.25."

That means that inflation in the PPI numbers may be less than the table below, which is bad enough. Notice the increase in the change of year over year inflation in the index over the last 8 months.


Click Here, or on the image, to see a larger, undistorted image.

Another table shows "core" PPI, without energy and food, and you find that core PPI is flat. Again, we are seeing almost all of the real inflation in food and energy. But with a falling dollar, do we expect food and energy prices in the US to fall as well, since much of the price of food and energy is determined on international markets?

Consumer Spending is Up, but then Again, It May Be Down

Headline consumer spending came in up 5.2% year over year, which suggests a very respectable growing economy. But retail sales were only up 0.2% in October, which is below inflation. In other words, retail sales fell in October in real terms. But digging deeper into the numbers, we find a problem. Remember food and energy. As Greg Weldon points out, it is unlikely that US consumers bought 16% more gasoline than they did last year. The increase in spending for gasoline was all related to price. Ditto for food.

John Williams says the same analysts who want to use core inflation should also use core retail sales. And if you take out food and energy from retail sales, you find consumer spending to be flat in October. There were multiple categories like home furniture, music, electronic games, etc that were in outright declines. Most interestingly, online sales actually dropped in October. Annual sales growth dropped to its lowest number in years.

FedEx warned today that its earnings would be down due to fewer shipments and higher energy costs. The number of containers coming into the US is down. Retailers are expecting a very modest Christmas season.

So, we come to the question: Is the economy slowing and thus the Fed will cut, or is inflation rising which will force the Fed to sit tight?

A Two Dimensional Problem

I recently spent some time with the very brilliant Columbia Professor Graciella Chichilnisky (the economist whose work created the carbon credit markets, among other things). We got to talking about the problems the Fed is facing, and she gave me a very interesting insight from a paper she had written a few years back. I am going to try and re-create it, though I am sure I will take some of the potency away in trying to put it in my simple terms.

Assume that you have an individual living in a two dimensional world. For them there is only length and width, but no height. Then let's draw a line between two exactly opposite points above and below that two dimensional world and connect them with a line. At the precise point where the lines meet in the two dimensional world, to the individual in that world, it appears that both points are exactly the same. Two things which would clearly be opposite to anyone living in a three dimensional world would be equal in a two dimensional world.

The Fed faces a problem something like that. They are living in a two dimensional world, working with two dimensional tools (they can cut rates or raise them) but the problems they face are multi-dimensional.

If they cut rates, the dollar will fall and import prices rise, and it will also likely have negative effects on food and energy prices. If they do not cut rates, the markets will simply throw up as it will interpret that as a Fed which is not concerned about a slowing economy. Not cutting rates risks an economy that could easily slip into recession due to a growing risk of a credit crisis turning into a credit crunch. Usually, that means that inflation will fall. Usually, but not always. The Fed is faced with a problem I predicted four years ago in this letter and in Bull's Eye Investing, as the Fed dramatically eased monetary conditions in an effort to fight deflation. In a word, stagflation. That terrible moment in time when an economy slows (is stagnant) yet inflation is high, limiting the monetary authority's ability to act.

With a clearly slowing economy, a credit crisis, and rising inflation, they have no good and clear choices. Whatever they do is likely to create problems in a multi-dimensional real world. I still think they cut, as core inflation is still close to their comfort zone. But if core inflation starts to rise, they will have to act. Or at least should.


Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Battle Lines Over Mortgage Plan

Battle Lines Form Over Mortgage Plan

By Michael M. Phillips, Serena Ng And John D. Mckinnon, WSJ | 7 December 2007

WASHINGTON—

In unveiling a plan to help more than one million struggling homeowners, the Bush administration and the mortgage industry have embarked on a controversial project: picking winners and losers from the rubble of the subprime-mortgage meltdown. Under the deal, formally released yesterday, the industry would 'voluntarily' help as many as 1.2 million homeowners who are heading for trouble paying their subprime mortgages but aren't yet lost causes. For some homeowners, loan-servicing companies will agree to freeze mortgages at their low introductory rates. In other cases, credit counselors or loan servicers will walk mortgage holders through refinancing processes. The deal won't provide relief to many subprime-mortgage holders: These include borrowers who are now in foreclosure, have already refinanced their homes or are more than 60 days delinquent on more than one payment over the past year. In some cases, people with good credit scores will be excluded. Also left out are those deemed able to afford the higher interest rates scheduled to replace their introductory rates over the next two years.

The initiative could help stabilize falling home prices and rising foreclosure rates, buoy the mortgage market and provide a modicum of comfort to investors watching the housing crisis bleed into the broader economy.

But it also sets what promises to become a battle line as the subprime crisis plays out over the coming election year. Some critics, especially Democrats, say the plan doesn't go far enough to protect vulnerable homeowners against foreclosure. Others, including some homeowners, as well as those who have watched from the sidelines as home prices have soared in recent years, charge that the plan amounts to a bailout for financially reckless borrowers.

The agreement covers homeowners who have taken out subprime mortgages, those offered typically to high-risk borrowers [[in other words, just the junk that the banks (mostly) got rid of— that's mostly owned by hedge funds, we hope: normxxx]]. About 1.8 million subprime loans are adjustable-rate mortgages, or ARMs, that carry low introductory rates that are set to expire in the next two years and adjust upward. These ballooning mortgage payments would threaten to produce a wave of foreclosures and a spiral of lower home prices and tightening credit.

The housing crisis is spreading beyond this relatively small subprime universe, causing turmoil on Wall Street and raising the specter of an economic slowdown [[or far worse, if this type of bailout goes much further— I wonder what BB had to say, or even if he was consulted: normxxx]]. In the third quarter, home foreclosures hit their highest rate since at least 1972, according to the Mortgage Bankers Association. Prime adjustable-rate loans— not covered in the industry's rescue plan— accounted for 18.7% of mortgages starting foreclosure, the second-highest proportion behind subprime adjustable-rate loans. The overall delinquency rate is the highest since 1986, with some 2.64 million borrowers nationwide behind on payments for their first-lien mortgages for residences.

Nouriel Roubini, an economist at New York University and chairman of research firm Roubini Global Economics, calls the plan "a step in the right direction." But Mr. Roubini says the plan won't turn things around. "Over the next three years, we're still going to see a housing recession that leads to defaults and foreclosures," he predicts. "Anything we do now is on the margins."

The agreement, which was hammered out with investors[!?!] and mortgage companies under the auspices of the Treasury Department, is the centerpiece of the Bush administration's free-market approach to the mortgage crisis and may be as far as it is willing to go in the direction of a full bailout. But pressure is likely to increase as housing and the economy move to the top of the presidential-election agenda. Candidates such as Hillary Clinton, Barack Obama and John Edwards have come out with their own plans, all of which go further than the White House is willing to go so far.

Rep. Barney Frank, a Massachusetts Democrat and chairman of the House Financial Services Committee, said he is concerned that the plan sends the wrong message by not helping borrowers who have maintained good credit scores. These scores can run from 300 (bad) to 850 (ideal). According to the plan, homeowners scoring 660 or above will be considered fit to pay their mortgages. Such a rule would punish people who have tried to avoid taking on debt they couldn't handle, Mr. Frank said. He called the decision a "grave error."

Under the new plan, Humberto Goncalves would be on the cusp. The electrician took out an adjustable-rate mortgage when he bought a home in Cranston, R.I., in 2005. He is current on his mortgage and thinks his credit score is about 660. Mr. Goncalves says he is already paying about $2,000 a month. "Anything to keep it from going up would be very helpful," he says. "There's no room for it to go higher."

Gladys and Robert Edmonds believe they should be offered a lifeline as well. The retirees in Tiverton, R.I., aren't eligible for government help because they don't have a subprime loan. Instead, the Edmondses, who live on a fixed income, say they refinanced their home in 2005 by taking out an option ARM, which lets borrowers pay small amounts early but that risks sharp payment increases later.

The couple has run up credit cards trying to keep current on their home payments, which have climbed from $1,480 to about $1,800 and will rise again to more than $2,000 in January. They say they were approached to refinance by a telephone solicitor and that the loan's terms weren't properly explained. "We're not the kind of people to neglect our debts," says Ms. Edmonds.

At its most basic level, the Bush-supported proposal is aimed at stopping and reversing the real-estate market's spreading turmoil. As foreclosures have increased, they have added to the number of houses for sale, depressing prices. Falling prices encourage more people to stop paying their mortgages and go into default, because their homes are worth less than their loans. More homes go into foreclosure. The program aims to assist borrowers able to keep up with payments at their introductory rates but who will likely fall behind and face foreclosure if their rates go up as scheduled. According to the plan, homeowners would contact credit counselors or their loan-servicing companies, who would sort them by their credit and payment history and ability to pay. Those 60 days behind on more than one mortgage payment over the past year would most likely receive no assistance, other than credit counseling to talk them through the loss of their homes. In the triage of the mortgage industry, they are considered largely beyond help.

"If the sheriff is at your door hauling out your furniture, and that's the first time you call your lenders, then you're probably too late," said Steve Bartlett, president of the Financial Services Roundtable, a trade association of the country's 100 largest banks, mortgage servicers, insurance companies and mutual-fund companies. Treasury Secretary Henry Paulson asked the group to coordinate the industry negotiations, in a forum called the Hope Now Alliance.

The alliance estimates that 600,000 of the subprime borrowers whose rates will reset in the next two years fall into this category. They are likely to lose their homes, or, in Mr. Paulson's words, "become renters."

The 1.2 million borrowers relatively current in their mortgages will be considered for the government-endorsed program. They will pass through the next set of screening to determine whether they can refinance at more-favorable mortgage rates. Some 600,000 borrowers are expected to qualify. These borrowers are expected to be offered counseling and a fast track to secure refinanced mortgages.

The remaining 600,000 won't qualify to refinance their existing mortgage, the alliance estimates. Such borrowers' loan servicers or counselors would determine whether they can afford to pay the higher interest rates once their introductory rates expire. The servicers will assume that those with better credit scores and more equity can afford to pay when their existing loans adjust upward. They would receive no special assistance.

A middle group, who may or may not struggle with the increased interest rates, will have to negotiate individually with their loan-servicing companies to secure a rate freeze, repayment holiday or other relief.

[ Normxxx Here:  In other words, make sure you have enough debt! Go out and buy yourself that yacht you always wanted.  ]

Those who can't afford the higher payments, and who have credit scores below 660 and less than 3% equity in their homes, will get the biggest break from the lenders. They receive a five-year extension on their introductory interest rates, with the possibility that the grace period will be extended. Such a rate freeze would be available only to people who live in the mortgaged properties.

Mortgage-industry officials say they aren't sure how many subprime borrowers will ultimately see their rates frozen.

Mr. Bush, speaking in front of a White House fireplace mantel festooned with greenery and gold ornaments, sought mainly [[vainly?: normxxx]] to calm homeowners. "The holidays are fast approaching, and unfortunately, this will be a time of anxiety for Americans worried about their mortgages and their homes," he said.

He said the initiative was focused squarely on borrowers, not on investors. "We should not bail out lenders, real-estate speculators or those who made the reckless decision to buy a home they knew they could never afford," Mr. Bush said. "Yet there are some responsible homeowners who could avoid foreclosure with some assistance."

Treasury Secretary Paulson addressed some of the criticism about the plan's scope. "The approach announced today is not a silver bullet," he told reporters yesterday. "We face a difficult problem for which there is no perfect solution."

The program will be closely watched in markets around the world, where subprime defaults have triggered steep write-downs and constrictions in credit markets. Many foreign banks and investment funds invested in complex US securities backed by subprime mortgages, which promised high returns but are now battered and difficult to value.

The rescue package suggests that most investors[!?!] [[they were consulted? HOW?: normxxx]] prefer to give up some interest revenue rather than carry out expensive foreclosures of thousands of homes. But the plan won't reduce their losses by much. Analysts at Barclays Capital Research said in a report that the Treasury's plan could reduce cumulative losses from subprime loans by 0.6 to 1 percentage point, "which is not much relief when losses could reach 13% to 15%."

Investors who hold mortgages, meanwhile, would still bear the risk of the loans under the plan, said Doug Dachille, chief executive of First Principles Capital Management in New York, which invests in some mortgage-backed securities. Creditors would also bear the pain of forgone income from mortgages that under normal market conditions would have brought higher interest income.

"There ought to be costs to both the borrowers and lenders, but right now you're just giving a freebie to homeowners," he says. "They still get to live in their house and benefit from any appreciation in the value of the house over the next few years."

Milton Ezrati, market strategist with money-management firm Lord Abbett & Co., says the plan could undermine the market for mortgage-backed securities. Investors may say, "if you can interrupt my cash flow today, you can do it tomorrow," says Mr. Ezrati.

Another question concerns mortgage servicers, the companies that collect payments on behalf of the eventual debt holder: Can they change the terms of mortgages without being sued by the investors who purchased them?

Jordan Schwartz, a structured-finance partner at law firm Cadwalader, Wickersham & Taft LLP, says agreements that govern mortgage securities generally give servicers discretion to modify loans if they consider it to be in the best interest of investors who hold the securities. But any plan that emerges from Washington "won't have the force of law," he says.

George P. Miller, executive director of the American Securitization Forum, a trade association of investors, servicers and other securitization players, said servicers won't receive a guarantee against being sued. But because the plan was created by major industry players, including his group, and was endorsed by the Treasury Department, it offers a substantial shield against lawsuits.

Alan Gulick, a spokesman for Washington Mutual Inc., Seattle, the sixth-largest subprime servicer, according to Inside Mortgage Finance, said the bank is "supportive of the proposal." Mike Heid, co-president of home mortgages at Wells Fargo & Co., the eighth-largest servicer, said his bank played a key role in developing the plan to help consumers who have managed their mortgages well but are "caught in the current whirlwind of market forces."
ߧ
Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Consumers Gloomy

Jobs Added But Consumers Gloomy

By Glenn Somerville | 7 December 2007

WASHINGTON (Reuters)—

Employers added 94,000 jobs in November, the Labor Department said on Friday in a report showing a slowdown in job creation in recent months that raises chances for a modest cut in interest rates next week. Analysts said continued gains in hiring showed the economy was not at immediate risk of crumbling onto recession despite strains from a weak housing sector and credit tightness. But a later report showed consumers' moods grew darker in December.

"Current employment gains are not robust, but sufficient to keep the consumer out of serious trouble," said Stephen Gallagher, chief U.S. economist for Societe Generale in New York, though they are battling with slumping home prices and soaring energy costs.

Stock prices were little changed in early trading. But U.S. Treasury debt prices fell as investors bet the jobs numbers meant Federal Reserve policy-makers were more likely to cut interest rates by a quarter than by a half percentage point when they meet next Tuesday.

The Labor Department said the national unemployment rate was unchanged at 4.7 percent in November, but it substantially revised its estimates for job growth in the two prior months to show a less vigorous pace of hiring. The department said 170,000 jobs were added in October instead of 166,000 it reported a month ago and slashed its estimate for September new jobs to 44,000 from 96,000— a net decrease of 48,000 over the two months.

A report issued at mid-morning by Reuters/University of Michigan showed its index of confidence fell to 74.5 so far this month, slightly below analyst forecasts and down from 76.1 in November. Excluding a reading in October 2005, shortly after Hurricane Katrina devastated the gulf coast region, it was the worst level in 15 years. It was a third straight monthly fall in confidence and analysts said it contained worrying signs that consumers fear gasoline and other costs are going to keep rising. [ Normxxx Here:  Note too, that consumer confidence is a highly accurate leading barometer of the job situation (at least it was, before the BLS began massaging the heck out of the numbers with their infamous "Birth/Death" models which are about as accurate as those models that their far more learned brothers on Wall Street used to 'predict' risk in the mortgage market). I would tend to put more credence in consumer confidence, especially as the numbers have changed materially, than in the BLS's lagging (and possibly 'doctored') indicators of the job situation.  ] "The Fed is going to keep cutting rates to save the economy, but inflation still remains an issue, at least for the consumer," said Peter Boockvar, an equity strategist with Miller Tabak & Co. in New York, who said conditions were becoming "stagflationary"[[that dreaded "S" word: normxxx]]— with growth slowing and prices rising.

The revised September job-creation figure was the weakest monthly gain in more than 3-1/2 years, since 31,000 jobs were added in February 2004, department officials said. Nonetheless, the November new jobs total came in slightly ahead of forecasts by Wall Street economists for 90,000 jobs.

"Not too hot, not too cold," said Hank Smith, chief investment officer for equity management with Haverford Investment in Radnor, Pennsylvania.

"This assures a rate cut for next week," Smith added, but it may be aimed less at stimulating economic activity and more at breathing confidence into battered credit markets.

The jobs report showed a loss of 33,000 jobs in goods-producing industries during November while 127,000 jobs were created in service-providing businesses. Manufacturing industries continued to shed employees, cutting 11,000 jobs last month on top of the 15,000 that were dropped in October. The average workweek was unchanged at 33.8 hours and overtime hours were steady in both October and November at 4.1 hours.

ߧ
Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Popeye-Paulson Needs More...

Popeye-Paulson Needs More Than Plain Spinach

By Brady Willett and Todd Alway, FALLStreet.com | 7 December 2007

Treasury Secretary Henry Paulson was trying to strong-arm the supposedly free markets again last week, this time catching headlines for his fronting of the government’s proposal to temporarily freeze interest rates on some troubled subprime mortgages. You have to give Mr. Paulson credit for having the bluster to constantly make media appearances— first to dispel contagion fears, then to announce that he was helping banks set-up an SIV bailout, and now to provide an update on his subprime bailout plans. At the same time, you have to give the media very little credit* for questioning both his tactics and his apparent lack of results. Of course juggling two Treasury coordinated bailouts at the same time is no simple task. Most immediately there are the tactical concerns associated with directing Citigroup representatives to the right conference room— we can only imagine the reception desk querying new arrivals as if they were diners at a low-end stake-house: "are you here for the SIV or subprime bailout?"

Needless to say, the appropriateness of his entire interventionist mentality bears scrutiny. Longer-term neither of the planned Paulson-led bailouts are likely to provide the cure for financial market sea-sickness. Instead, recall that while the bailout of LTCM may have momentarily averted disaster, it also permitted the embers of uncertainty to smolder. Nothing Mr. Paulson or anyone else is discussing begins to even remotely deal with financial markets that are ridiculously overleveraged, under-regulated, and in desperate need of increased transparency. At best, Paulson’s plans— a la LTCM— to quarantine the carnage and give financial market participants [[definitely NOT the 'great unwashed': normxxx]] a feeling of false hope. This is something to think about when Paulson next meets with the applicably coined ‘Hope Now alliance’.

Paulson Has Been Eating His Spinach

Paulson entered the month of November pressuring the White House to help out the mortgage industry and trying to put the final touches on the SIV superfund. Incidentally, the argument has been made that Paulson was/is concerned that many 'average' Americans [[those making— can you imagine how they must feed themselves— a million per: normxxx]] are losing their homes (something that has been happening all-year!). However, that Paulson’s bailout timetable shortens only as his Wall Street buddies start to come under more pressure gives the impression of more than coincidence.

Regardless of his objectives, Bloomberg noted in late October, ‘Paulson has used contacts from three decades on Wall Street to prod the nation's largest banks to avoid a fire-sale of $320 billion in assets held by SIVs.’ Seemingly a junkie for pressure, Paulson contended shortly thereafter that "It will be more valuable if it's [the SIV fund] up and running sooner. It will take a while, but it should be done by the end of the year." With these extremely timely expectations in place, the sheer amount of issues Paulson took the time to touch on in the month November was mind-boggling— almost superhuman. Below is a brief recap of his high energy high jinks.

November 8: Paulson fields the question of a slumping dollar with: "the U.S. has a very competitive, strong economy that's proven itself over many years."

November 9: Paulson finds more time to talk about the dollar: "The dollar has been the world's reserve currency since World War II and there's a reason. I put the U.S. economy up against any in the world in terms of competitiveness…a strong dollar is in our nation's interest."

November 9: During remarks at the China Institute in New York Paulson said "We [the U.S.] do not fear an economically stronger and more competitive China…" This statement was made in an attempt to dull Paulson’s October 20 call for the IMF to look more closely at the intentions of sovereign wealth funds (SWF). Paulson concluded with the party line: China’s exchange rate is "viewed by many countries as a source of unfair competition" and that "China needs more flexible prices, including a much more flexible, market-driven exchange rate."

November 10: During a meeting with reporters Paulson reiterated that the SIV rescue fund should be in operation by year’s end, adding that "The market forces are working."

November 13: Paulson goes to Africa for G-20.

November 16: With dollar decline recently accelerating, Paulson tells reporters, "I believe that we are going to continue to grow and that our economy is going to continue to grow. Its fundamental, long-term strengths will be reflected in currency markets." During a South African radio interview (picked-up by Dow Jones), Paulson adds "We have very much a strong dollar policy; that's in our nation's interests"[!?!] Finally, when pressed by reporters on the dollar, an irritated Paulson responded with "What I said yesterday was a strong dollar is in our nation's interest…You heard the part about being reflected in currency markets, right?...I think I have been very, very consistent on a strong dollar and I'll leave it at that".

November 19-20: After a tour of Thandi Wines, Paulson releases a long statement before preparing to Tour the Ghana Stock Exchange Trading Floor and ring the opening bell. The statement vaguely highlighted his dual bailout affront: "…we are working to avoid preventable foreclosures and promote orderly markets." Paulson’s 6-day trip to Africa is book-ended by yet another "strong dollar is in our nation's interest and our economy like any other has its ups and downs".

November 21: Talking with the Wall Street Journal about the issue of subprime Paulson says, "The nature of the problem [foreclosures] will be significantly bigger next year because 2006 (mortgages) had lower underwriting standards, no amortization and no down payments."

November 29/30: Paulson and other government officials meet with mortgage industry officials to try and outline the details of the mortgage bailout program. Paulson’s "optimism" stokes speculation that a deal may be finalized within a week. Paulson notes that "This is not a government subsidy that we're talking about here. This is something that the industry will do where it makes sense."

But Is The Spinach Missing An Ingredient?

Mr. Paulson severely underestimated how serious the subprime/credit crunch would be earlier this year, and his actions since coming to grips with the ominous realities of growing foreclosures, global bank runs, Wall Street blow-ups, and widening credit market tightness have been disjointed, to say the least. To be completely frank, all Mr. Paulson has established is that he likes doing interviews! During these interviews Paulson relishes discussing SIV bailouts, subprime bailouts, the non-death of USD hegemony, and the potentially "political" actions of SWEs. However, what he doesn’t do, at least not yet, is sail his optimistic platforms into practical policy vehicles. The word "adrift" comes to mind.

Our suggestion is to slow it down Popeye-Paulson! In order for this to be accomplished perhaps someone needs to spike Paulson’s spinach with Ritalin. This would help Paulson focus on the issue that is most pressing and/or a problem that can be temporarily fixed. Remember that the ultimate goal in bailout land, ala Greenspan**, is to act decisively, rinse, and repeat, not to hype multiple bailout initiatives before they come to pass like Paulson has been doing.

Will Popeye-Paulson arrive in time to save the day? Perhaps. Perhaps also it is worth remembering that Popeye, while extremely powerful, was essentially a rowdy love struck sailor [[and not one given to false modesty: normxxx]].

^* Bloomberg is one notable outlet that has questioned Paulson’s actions/motives in recent weeks. Unfortunately the chatty Paulson does not comment on his employment record at Goldman Sachs.

^** Of course we are not suggesting that any of Greenspan’s policies as Fed boss improved the long-term health of the U.S. markets (they didn’t!), only that his record of bailing the markets out of trouble was 'uncanny' and 'superhero like'.
ߧ
Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

The "Other" Credit Market

The "Other" Credit Market
Click here for a link to complete article:

By The ContraryInvestor.com | 2 December 2007

The "Other" Credit Market... For readers of our commentaries over the years, you already know that credit market analysis and observations have held quite the prominent place in our discussions for many a moon. In recent years, we have suggested that if macro financial market turmoil were to finally rear its ugly head at any point in time, its origin would most likely be the credit markets. Well whaddya know, that conceptual ship has finally pulled into port. For now a key issue in our minds as we look ahead is just how much influence Fed monetary policy will have on non-bank US financial system trajectory and fundamentals ahead, this being ground zero for macro credit market largesse over the last decade-plus and the locus of current market turmoil. Luckily, we're already in the midst of being presented an answer to this question. Unfortunately, and at least as of now, three discount rate cuts and two Fed Funds rate cuts have done little to nothing in terms of influencing the literally uninterrupted bleeding in asset backed commercial paper markets, the blowout of LIBOR spreads, swap spreads, and credit market spreads of all types.

Maybe too simplistically, as we see it, the basic credit market problem of the moment is not liquidity, it's solvency and ongoing deterioration of collateral values underpinning mountains of in place leverage originally built on faulty forward collateral value growth assumptions. So will Funds rate cut numero tres most likely to be handed down this month be the silver bullet to change current credit market circumstances? Or will yet another rate cut ultimately prove as truly ineffective as the last two, heightening in investor perceptions the thought that the Fed is burning through precious monetary ammunition while completely missing the target? Either way, we're all going to find out in relatively short order.

Although we continue to believe that the credit markets are the key to financial market and real economic outcomes ahead, we want to have a quick look at the "other" credit market— margin debt— for potentially important messages that appear to us to be being overlooked at the moment. It has been one heck of a long time since we've had a peek at the history and current complexion of NYSE margin debt outstanding. We believe it's now very important in our current circumstances to do so. Wasting zero time, let's get right to it. The following chart is the history of nominal dollar NYSE margin debt outstanding going back to 1990. Of course, overlaid on this data is the like period price history of the S&P 500. Notice anything?


Click Here, or on the image, to see a larger, undistorted image.

Of course you do. First, and very simplistically, directional change in both margin debt balances and the S&P itself has been highly correlated over time. No massive surprise. Second, and admittedly set against the relative short-term financial market history of the last eighteen years, noticeable spikes in margin debt have been associated with meaningful tops in the major equity averages. The coincidental spike into the final top in early 2000 is simply classic experience and absolutely obvious in hindsight. So as we sit here today and look at our most recent circumstances, are we looking at a spike top replay in both margin debt balances and equity index price? The spike up in margin debt balances since last summer corresponds exactly with the big run in the equity averages summer 2006 to summer 2007. But much as was the experience in 2000, the current spike up in margin debt looks unsustainable. So too equity prices? We're about to find out. Moreover, could it be that we are witnessing a cyclical peaking in margin debt outstanding right alongside a potential peak in total credit market acceleration that has been so important to US economic outcomes for so long? Maybe not so much the coincidence.

Let's look at this same data from another angle that indeed heightens our sense of near term risk awareness. Rather than nominal dollar margin debt balances, let's look at margin debt growth on a very simple year over year rate of change basis. Again, we've overlaid the like period S&P 500 price experience for perspective. Although we only show data going back a decade in this next chart, the year over year rate of change in NYSE margin debt outstanding has exceeded 60% on only five relatively short lived occasions over the last half century. The first was in late 1972, in front of an almost 50% decline in the S&P over the following two years. The next came about in mid 1983. Although the equity bull market was still early in secular lift odd mode at that time, following that margin debt rate of change spike, the S&P was 7% lower one year after the margin debt number elevated above 60%. Following on, we fast-forward to January of 1993 to again find the annual margin debt rate of change number climb above 60%. Although there really was no equity market downturn to follow, the S&P fourteen months later had not even advanced 2%. The final two examples over the last quarter century of the year over year rate of change in margin debt outstanding exceeding 60% lie in the chart directly below.


Click Here, or on the image, to see a larger, undistorted image.

The 60% year over year rate of change demarcation line for NYSE margin debt growth was crossed literally inDecember of 1999. Although ahead of the final price top in the S&P, this nominal dollar margin debt peak coincided with the top in the monthly Dow at that time literally on the nose. The subsequent rate of change peak in nominal dollar margin debt occurred in March of 2000. Quite the tell at the time. In 2007, the 60% rate of change level was breached in June. So too, June was the nominal dollar peak in margin debt for now. Although certainly anything can happen ahead, the history of margin debt relative to equity market price movement over the last half-century is suggesting to us we're at a high risk juncture right here. This is exactly why we wanted to bring up this subject and give you a bit of historical perspective right now. In fact, given equity market character as of late, we're quite sorry we've overlooked this circumstance until now.

Very quickly, the following chart chronicles the long-term year over year change in NYSE margin debt. You can clearly see the five periods of rate of change spike highs in margin debt, the aftermaths of each we described above. Of course the aftermath of the current instance is yet to be written in the financial market history books. Have no worries, you'll know firsthand how it all turns out as you'll get to live through it.


Click Here, or on the image, to see a larger, undistorted image.

Maybe more for drill than not, the following table documents equity index price performance in the 3,6,9 and 12 month periods following NYSE margin debt achieving a 60% year over year rate of change. Will this be helpful in our current experience? We're just going to have to see, but history is telling us to be quite mindful of risk.

History of NYSE Margin Debt Achieving A 60% Yr/Yr Growth Rate And Subsequent S&P Price Performance
Month of 60% Y/Y Margin Debt Growth	S&P 3 Mos. Later	S&P 6 Mos. Later	S&P 9 Mos. Later	S&P 12 Mos. Later
8/72	5.0%	0.5%	(5.5)%	(6.1)%
7/83	0.6	0.5	(1.5)	(7.3)
1/93	0.3	2.1	6.6	9.7
12/99	2.0	(1.0)	(2.2)	(10.1)
6/07	1.6	?	?	?

Although we did not mention this above, in late 1992 the NYSE changed the methodology for calculating margin debt outstanding. What that caused in the data was a bit of discontinuity. And it's this discontinuity that resulted in the 1/93 annual rate of change spike in margin debt. Should we throw out this observation of the 60% year over year margin debt acceleration based on change in NYSE methodological calculations? We certainly could make the case for that, but we left it in this discussion in the spirit of complete coverage of all of the available data. If the Jan '93 experience is taken out of the admittedly small data sample of experience due to that data calculation change, then the S&P was lower in all nine and twelve month periods following year over year margin debt acceleration of at least 60%. It's a message we believe is important.

Incredibly enough, we don't hear anyone talking about these dynamics in the "other" credit market, the world of margin debt character. We'll see what happens ahead, but at the moment the rhythm of NYSE nominal dollar margin debt relative to equity market action is raising a few warning flags from multiple viewpoints, both rate of change in margin debt and the spike in nominal dollar margin balances over the past year that accompanied the summer '06 to summer '07 rally. As always, the most important financial market change can occur at the margin— pun definitely intended this go around.

My Logic Has Drowned In A Sea Of Emotion... It's always tough in a market like this to maintain composure and emotional stability, but indeed those are two of the most important personal characteristics of successful investors. In order to try to maintain our own sense of balance, in periods like this we believe it's absolutely critical to remember that risk management is necessarily the first and foremost focus of our activities at all times. We'll leave trying to pick pro forma short term trading bottoms to those courageously willing to test their fortunes and their will. Although the character of margin debt circumstances of the moment is indeed a warning flag in our eyes, we need to remember that this is but one indicator of emotion. In the spirit of continuing to watch our backs while trying to "see" what lies ahead, a number of technical tools have also helped us in the past in terms of macro risk management.

If the margin debt circumstances of the here and now appear to be truly warning of the potential for an important top, then identifying additional corroboration points of such becomes the order of the day as we move ahead. In relatively simple fashion, we try to look back and develop a sense of technical risk points that have fit our market environment of recent years and at least respect those points until they perhaps ultimately show us they are no longer valid. Given that the financial markets are ever changing beasts, nothing works forever. Nothing. So we respect what has worked until it doesn't. At least since 2003, one such corroboration point, if you will, has really been "staying alive at 75" that has been a big help in terms of the macro. And by that we're talking about the 75 week moving average of the S&P 500, as is seen below.

The SPX crossed the 75 week MA for the first time to the upside in the current bull sequence during May of 2003, clearly in hindsight heralding the sustainable up move that was to come. Since that time it has acted as consistent downside resistance at most important market lows, breached on very few intra week occasions. It just so happens that again in recent weeks the 75 week MA has again been tested, and at least for now has held. One macro risk management warning flag lies below the 75 week MA for the S&P. If we close sustainably below the 75 week MA for the SPX, we need to start thinking defense.


Click Here, or on the image, to see a larger, undistorted image.

Certainly this is but one of many risk management tools in the greater analytical tool box, as is margin debt analysis. As we look ahead into the new year, one big question for investors is whether the equity markets will undergo meaningful trend change given the ongoing difficulty in credit markets and clear and present speed bumps facing US consumers. The answer to the question of market trend will ultimately be found in the corroboration of the directional messages among the many risk management indicators.

Our very best wishes to you and your families for a wonderful holiday season ahead.

  M O R E. . .

Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Dead Men Walking

Surreality Check... Dead Men Walking

By Eric Sprott and Sasha Solunac | 26 November 2007

Although it is our job to understand markets, we must confess that we are having a difficult time understanding the behaviour of the stock markets over the past few months. This isn’t necessarily a bad thing. After all, if we are proven to be ultimately correct in our assessment that the markets are behaving irrationally, then we and our investors should do quite nicely in the end. But in the short run it can nonetheless be frustrating to watch illogic take hold when, for anyone who is able to connect the dots, the financial markets are currently in as bad a shape as they’ve ever been. Ever? Yes, ever. Or at least, worse than most of us have experienced in our lifetimes— and many of us have been around long enough to have experienced some pretty nasty markets. Yes, we are alarmists, and we believe justifiably so. After all, it only stands to reason that things can get pretty ugly after the party that was arguably the biggest global credit bubble in history comes to an end. There is now a lot of trash lying strewn about in the dance hall. Trash that until recently was considered to be highly valuable and in great demand, but that is now worthless toxic paper that needs to be cleaned up and thrown into the trash bin.

Make no mistake. The credit markets are clearly and unambiguously saying that the game is over. The music has stopped playing and anybody who is still dancing will undoubtedly slip on the trash and fall flat on their face. There is nary a safe place to hide in the credit markets as all paper that symbolizes debt and leverage is getting trashed. Save for ‘risk-free’ government debt, almost all bonds are taking it on the chin as the perceived risk of default has exploded at all levels— not least of all for the reason that supposed credit insurance and default swaps and guarantees aren’t likely to be worth the paper they’re written on.

Furthermore, the housing market, the chief beneficiary of the credit bubble, is still crashing in the US as mortgage lending has dried up. How bad is it? In an investment conference last week, the CEO of Wells Fargo went as far as to say that the US housing market is in the worst shape it’s been since the Great Depression of the 1930’s. Anecdotally, in Florida some houses are being sold for half the price they were selling for during the peak of the housing bubble two years ago. For banks and mortgage lenders, that’s scary stuff that is sending shock waves throughout the financial system. Yet stock markets have yet to clue in… it’s surreal. While government treasury bonds have increased in price as flight to safety has once again taken hold and the prospect of further rate cuts drives yields down, the same is not true for other debt instruments.

Recently making headlines: the municipal bond markets, traditionally viewed as safe tax-free investments, are experiencing rising yields and falling prices in spite of falling treasury bond yields. Muni bond issuances are being pulled due to the market’s perception of higher risk of default.¹ In particular the financial health of the various guarantors of these bonds is being put into question (more on this later). Private equity and their leveraged deals are now long dead. Problems at money market funds are once again making headlines.² And banks are once again reticent to lend to each other, and for good reason, as evidenced by the rising spreads on interbank lending rates. LIBOR is once again soaring to distress-signaling levels, and the US two-year swap spread is the highest its been since 1989.

It has become clear that the desired liquidity injections being generously applied by central banks are losing their effect. Since the Fed began cutting rates again, the cost of borrowing for everything except government bonds is now higher. Both the US Federal Reserve and the Bank of Canada were in money printing mode again last week, but is anybody else getting a case of déjà vu? When the subprime crisis first reared its head in February, the printing presses of the world’s central banks went to work and for the time being seemed to quell the market panic. But then the crisis re-emerged in August— in expanded form— as the contagion spread beyond the subprime market to the credit 'commercial paper' market.

The printing presses went to work again and the hit seemed to temporarily relieve the markets. Now here we are, once more, in November and it’s déjà vu all over again. Credit and leverage is like a drug addiction. In each case, rescue requires a larger and larger dose, and in each case the effects of euphoria don’t last as long as they did before. And like a drug addiction, it doesn’t get solved by increasing the patient's dose. Analogously, the problem that was created in the financial system by too much paper can’t be solved by printing even more. Such a simple solution would defy logic [[and also history: normxxx]]. The imbalances won’t go away. We believe the crisis will continue to resurface again and again regardless of what steps are taken to paper it over.

Yet, if one were to believe the stock markets, one would hardly think that we are arguably in the midst of one of the worst financial crises [[if not the worst, as I believe, however it is resolved: normxxx]] the credit markets have ever seen. According to the stock markets everything is ok. Perhaps not great, but certainly not bad, and definitely ok. In spite of volatility, both the Dow and the S&P remain firmly up for the year. What financial crisis? There’s a surreal haze shielding the equity markets from reality and allowing it to remain basking in a false sense of optimism. We think it’s high time to slice through this haze with a surreality check. Let’s start with General Motors. In spite of recent beatings, the markets continue to believe that this stock is worth $27 per share— a market cap of $15 billion. Yet, after the latest write-down in the third quarter, the book value of GM now stands at an eye-popping minus $74 per share!

This means that GM will need to pay off $74 in net liabilities per share before they can even begin to have positive equity. It also means GM will have to earn $100 per share (present value no less) before they can justify their stock price. Compounding the issue, the prospects for the North American auto industry are looking rather grim on a go forward basis. Still not convinced? As overshadowed as GM’s assets are by its liabilities, its assets are STILL overstated because GM still owns 50% of GMAC. GMAC is GM’s financial services arm, which happens to own Residential Capital, or ResCap. ResCap was one of the big players in the US subprime mortgage market— almost two thirds of its $60 billion loan book consists of subprime loans.

Another example is Fannie Mae. Fannie Mae is a Government Sponsored Enterprise (GSE) that is in the business of selling mortgage guarantees to mortgage issuers. These mortgages are then packaged and sold into the credit markets as mortgage-backed securities with Fannie Mae as the guarantor, i.e. the absorber of credit risk in case of delinquency or default. In many cases Fannie is even required to purchase delinquent loans from lenders. Needless to say, the number of delinquent loans are not only ballooning, but are also often well above the current market values of the houses being used as collateral. In Fannie’s own words, the situation seems to be getting worse. During the housing bubble, Fannie Mae’s book of business expanded exponentially at double-digit annual rates, doubling in size since 2001. They now own or guarantee $2.7 trillion of mortgages, roughly a quarter of all US residential mortgages [[with an almost equal amount held by Freddie Mac, who is in like straights: normxxx]]. At least $100 billion of these mortgages are in the subprime/alt-A category, and much of the rest is also at risk of impairment due to the weakening housing market.

[ Normxxx Here:  And we haven't even entered into a general recession yet!  ]

How much equity is backing up these mortgage assets and guarantees? A relatively paltry $40 billion.

Which means that if only 1.5% of Fannie’s assets end up overvalued then their equity is gone. Is Fannie Mae’s balance sheet in a position to withstand the worst housing market since the Great Depression? Although Fannie has attempted to divert some of the risk to other mortgage insurers, we believe these insurers are in no better position to honour mortgage guarantees than is Fannie. MGIC, the largest mortgage guarantor, has insurance coverage on $200 billion of mortgages backed by equity that has a market value of $1.6 billion, or 125:1. PMI Group, another large mortgage insurer, has guarantees on $120 billion of mortgages backed by equity that has a current market value of $1 billion, or 120:1.

Others are in an even more precarious position. ACA Capital, the company we mentioned a few articles ago that is owned by investment banks and insures over $60 billion of Credit Default Obligations, or CDO’s, has a market cap that is now $50 million. That equates to leverage that is greater than 1000:1 It should go without saying that being in the business of insuring any type of default risk is not a good business to be in right now, especially when what is backing up the guarantees is a tiny sliver of equity. We suspect that many, if not most, of these guarantors will fade into surrealism themselves before the credit crisis has fully played itself out, with dire ramifications to those who rely on them to save their overleveraged balance sheets.

This just in: Freddie Mac, another GSE in a similar business to Fannie Mae, just announced a third quarter loss and the likelihood of needing to raise capital in order to conform with statutory capital guidelines. Good luck raising equity in this market! The stock is down 30% as we speak. Perhaps the market is finally starting to wake up from its blissful surreal dream state, albeit belatedly. But the big mess will come from the big banks. In varying degrees, all the major banks are knee deep in subprime and other toxic assets on their balance sheets. Level 3 assets for many of the main financial players are now in the order of 200% of equity. As we mentioned in our last article, "The Financial System Is A Farce", Level 3 assets are the ones that are "marked-to-myth" and are based merely on management’s own best guesstimates.

Although the new accounting rules are likely to result in $100 billion of write-downs at the major banks (for now), when all is said and done it is estimated that $250 to $500 billion of losses could be incurred.³ To put this in perspective, Citigroup, the largest bank in the US, currently has a total market cap of $150 billion. Furthermore, if one were to use the ABX Index as an indication of what subprime debt is being valued at in the markets (20 cents or less on the dollar for anything below A, and 68 cents on the dollar for some of this year’s AAA [[currently, and it's dropping even as we write: normxxx]]), then we believe many banks and investment banks would be shown to be severely undercapitalized [[or actually insolvent— this is a replay of the Japanese crisis of the '90s: normxxx]]. But of course, the liquidation of these assets in any quantity is impossible. Like a hot potato, nobody actually wants it.

That’s why the super SIV solution is dead in the water. Ultimately there can only be a market solution, regardless of how painful and ruthless it may be [[well, the Japanese managed to limp their way through— but the current crisis is much worse and wider in scope: normxxx]]. Some would argue that the sheer size of the GSE’s, the major banks, and most of the investment banks make them too big to fail. The government would likely have no choice but to bail them out. Perhaps so. But what would be the impact on the economy and the banks in that scenario? But the banks may well survive more or less intact; after all, when central banks open the money coffers, it is the banks that are first beneath the helicopters. But, once again one must question the logic of trying to solve a problem created by too much easy money by throwing at it even more easy money. It’s a nonstarter— a cure that is worse than the disease.

The already badly bruised dollar could become a pariah currency. So what’s keeping stock markets up? Although the credit markets are saying that leverage is now anathema, everybody is still knee deep in it, trying desperately to escape. In a world where the value of any debt is being put into question, what does that say about the value of equities, which are at the very bottom of the financial pecking order? The stock markets need a surreality check. Connect the dots and the evidence is overwhelming that the equity of many companies is at risk of being wiped out. They are dead men walking. And, like all dead men walking, their only hope is to wait for a government reprieve… a stay of execution… or in this case, a Fed bailout.

[ Normxxx Here:  Of course, in Japan, in the like situation, the proffered bailout was inadequate. And interest rates are still below 1%, with the economy seemingly headed into another recession and still deflating.  ]

NOTES:

¹ "Credit Pressure Filters Down To Muni Market", Wall Street Journal, November 16, 2007.
² "More Money-Market Funds Hit Trouble", Wall Street Journal, November 16, 2007.
³ "Banks Face $100