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WHAT THE “SUBPRIME” MESS IS REALLY ABOUT
It is about the international fiat monetary regime’s denouement, and the Ron Paul presidential campaign. Even the popular name of this “crisis” – implying that the whole problem is “subprime” borrowers with sketchy credit histories – is really just more disinformation. Shaky American borrowers defaulting on their home loans are indeed a danger, but in the same way that a free press is a danger to despotic government. It is the danger of exposure. It is the end of plausible deniability. If the “markets” of the world perceive – finally – that the emperor has no clothes, the nearly century old game may be over.
First, a little background. Forgive all the quotation marks, but it is important to maintain a healthy skepticism when considering this subject. When a “lender” (usually a bank) makes a “loan” to a “borrower”, the borrower executes a legal instrument known as a “note”, sometimes also called a “bond”. The “note” or “bond” is the borrower’s promise to repay the “loan” at such and such an interest rate, over such and such a period of time, consisting of monthly payments in such and such an amount.
There’s a lot more to explain here, but first, before we go there, pull out your wallet and take a look at any currency you have in there. You will notice that the currency is also called a “note”. Just like the “note” the “borrower” executes to the “lender”, the currency is a promise to pay, but in the case of currency it is minus the interest rate or period of time. Currency notes are “payable to the bearer on demand,” also called “bearer paper” and “demand notes”.
But if one kind of note functions as currency – money, really – why can’t another? Why indeed. No reason at all. In fact, since in the absence of a gold standard currency “notes” are ultimately unredeemable promises, other kinds of notes are arguably better than currency. Particularly if they are “backed” by something of “tangible” value – like, say, real estate – which is something government currency cannot claim.
This reasoning – and it is valid reasoning – led to a state of affairs in which home mortgage loan paper (the “notes”), primarily from the U.S., began to “circulate”, just as currency circulates among individuals. This paper, and derivatives of it like CDOs, mortgage-backed securities, CLOs, and SIVs, have by now gone all over the world and for all intents and purposes function as “money” in the world’s banking systems, constituting financial “assets” on their books. The nominal aggregate value of all this American mortgage loan paper is many, many trillions of dollars. This actually – and somewhat ironically – dwarfs the nominal value of all official but unbacked U.S. government paper currency in circulation.
Notice I say “nominal” value. This is important. Because while the essence of the international fiat monetary regime is that nothing can have a fixed, permanent or finally determined value, everything must have a “nominal” value, otherwise buying and selling – trade and economic activity itself – would be impossible.
Yet the “market”, i.e., the human beings who comprise it, craves precisely assets of a fixed, permanent and finally determined value. This is the basis of the great financial asset game of the 20th century just past: The hoi polloi chasing and acquiring assets they believe to be of permanent value, and the rulers – sometimes slowly, sometimes abruptly – then destroying the value of those assets, in part because not to do so would undercut the regime itself. The regime is a jealous god.
So the home loans of the hoi polloi, and the homes themselves “backing” the loans, were eventually transformed into “financial assets” like everything else, then sold and marketed all over the world at their nominal value. The current “crisis”" is the result of this nominal value being called into question and tested at its very foundation, through the only true “mark-to-market” events that can ever apply to such assets – default, foreclosure and auction of the “collateral” – the homes of the “borrowers”.
The problem is, if there is one thing we have learned in the world of financial assets over the last 20 years or so, it is that the process of questioning and testing their value invariably reveals a cesspool of scandal and fraud. Mortgage-backed paper is no different.
In truth, lenders have been systematically concealing the market value of this paper through a fairly simple and universal manipulation of the foreclosure process. When a property is foreclosed and “publicly” auctioned, the lender itself bids in the amount it claims to be owed at the auction, thus insuring that there is never a loss on the loan itself, since the loan is always “paid in full” at the auction. When it is the successful bidder – as it almost always is – the lender then winds up owning the property. When the property is finally sold by the lender, there is normally a loss. But technically, that is not a loss on the loan itself. That does not damage the value of the original “paper”. In this way mortgage paper and its many derivatives can be and have been marketed as very “safe” investments, providing a “good return” with “no risk of loss.” But of course there is a risk of loss. It has just been hidden.
Now that risk is materializing. As defaults and foreclosures increase, the lenders have to pay out more and more to hide the losses. But the lenders can only make this up by making more loans, because this is how they increase their cash flow. And now it is clear they can make more loans only by simultaneously increasing their losses, since their “loans” are proving to be losers. So no one wants their “paper” anymore. It is the financial equivalent of toxic waste.
The “subprime” stuff is just the first surge. The tidal wave is close behind. Because all of it, the subprime, the prime, the AAA and everything in between, is the product of a previously hidden, but now obvious, Ponzi scheme. A Ponzi scheme that is in the process of unraveling, as all Ponzi schemes eventually do. And what person wants to be the last idiot to buy into a Ponzi scheme?
So now the lenders are squeezed on all sides. They have defaults bubbling up from underneath. They cannot access credit on their now questionable paper. And it appears their whole business is structurally geared to lose money. One by one they begin firing their CEO’s, warning their investors (closing the barn door after the horses are gone, but what else is new?), being investigated, probed, etc. We all know the drill. Some very big names are already involved.
This is all supposedly “very scary”. The credit markets are “seizing up”. The Federal Reserve is doing this and that, but even they cannot fix problems in the tens of trillions of dollars. Oh sure, they can goose the stock market, but only temporarily. They put the money in but it all comes back out within a few days. The whole idea is just to get the lemmings to jump in after them. But it only takes what – $40 billion max? – to pull that stunt. The mortgage backed paper problem is many, many times bigger, and cannot be solved in a few days of goosing.
Now. Why is all this a threat to the international monetary regime?
It is really very simple. This whole debacle is showing emphatically that debt cannot be money. But the regime is built entirely on the principle that debt is money. It is an elegant deception. In the world of accounting, my debt is an “asset” on the books of my creditor. There is nothing really wrong with looking at it this way, and indeed it is a useful fiction to “account” for economic relationships. But we cannot lose sight of the fact that it is a fiction. A “receivable” based upon someone’s promise to pay is not the equivalent of a hard asset that does not depend upon someone’s promise. A “promise to pay” cannot be “payment” – by definition.
But because the regime says otherwise a worldwide home mortgage paper market with a nominal value in the tens of trillions of dollars – all debt – exists, though it appears not for much longer. And compared with that market the Federal Reserve System itself, with all of its regional branches, its Board of Governors, its “congressional mandate”, its annual reports and so on, is a mere trifle. We could so easily be rid of it.
And that brings us to Ron Paul. Talk about being in the right place at the right time.Link here.
FED TRANSPARENCY AND OTHER ILLUSIONS
On November 14, Ben Bernanke delivered a speech to the Cato Institute’s 25th annual monetary conference. Cato is a well-known Washington Beltway “free market” think tank. I find it fascinating that Cato invited the Chairman of the Board of Governors of the organization that is by far the most powerful government-created monopoly on earth – the antithesis of the free market – to deliver the keynote address. I suppose it is good to hear what your mortal enemy has to say, but to provide a forum for him to say it is, in my view, bizarre. It is as if a 1962 anti-Communist rally invited Nikita Khrushchev to deliver the keynote address.
Bernanke began his lecture with a quotation from a 1923 Fed document.
The more fully the public understands what the function of the Federal Reserve System is, and on what grounds its policies and actions are based, the simpler and easier will be the problems of credit administration in the U.S. (Federal Reserve Board, Annual Report, 1923, p. 95.)
This is the equivalent of saying, “I’m from the government, and I’m here to help you ... and it won’t cost you a penny.”
Here is a privately owned organization that has been granted a monopoly by the U.S. government over the nation’s money supply, but we are expected to believe that it wants the public to understand its operations.
The 1910 meeting which drew up the plans for the Fed was held in secret on a Georgia sea coast island at a social club whose members included banker J. Pierpont Morgan and William Rockefeller, brother of John D., Sr., at which every participant used only his first name, just in case he was ever placed under oath by a government investigatory agency. But it wants greater transparency.
Here is a central bank whose organizers refused to use the word “bank” in its title because millions of voters opposed the idea a central bank. Here is a licensed monopoly that received its charter in the last hour of Congress on the final day before the Christmas recess in 1913, where a quorum was barely present in the Senate, a bill which President Wilson signed into law before the day was over – the ultimate fast track. But it wants greater transparency.
Quoting mid-1950’s comedian George Goebel, “Suuuuuuure it does.”
If it wanted transparency, why did it not provide this, beginning no later than 1923?
Here is my contribution to the discussion, Dr. Bernanke. I offer these steps in transparency, which are nothing compared with SEC requirements for every publicly traded company.
How is that for a start? Reasonable? Is there anything unreasonable here?
Consider the timing of this speech. The speaker represents a government-created monopoly whose policies have created a gigantic real estate bubble, which is now unraveling. The fall-out so far this month has led to the firing of the head of Merrill Lynch, the nation’s largest brokerage firm, and Citigroup, the nation’s largest bank.
He ended with this affirmation: “The communications strategy of the Federal Reserve is a work in progress.” Translation: “This organization has been shrouded in secrecy ever since 1914, and if it had ever been serious about transparency, its communications strategy would long since have been a work completed.”
The more things change, the more they stay the same. The song and dance, shuck and jive, bait and switch operation known as the Fed rolls on, undeterred by Congress or any other government control agency. The whole thing rests on a sham. Bernanke referred to it. “As I have emphasized today, the Federal Reserve is legally accountable to the Congress. ...”
When it comes to accountability, the Fed is ahead of the Cosa Nostra but behind Congress – way, way behind Congress.Link here.
Financial Times (Gillian Tett): “Another week, another memorable encounter with a nervous financial beast. This time, however, the animal in question is Royal Bank of Scotland ... Last week, RBS raised eyebrows when it was widely reported that one of its highly respected credit analysts had predicted that subprime losses could eventually rise to between $250 billion and $500 billion – or twice previous estimates ... behind the scenes – and occasionally in public view – the credit analyst community remains distinctly divided about just how big the final hit might be ... Thus while some observers project a $100 billion hit, others talk about $500 billion ... A decade ago, I covered the Japanese bank crisis and became embroiled in a bad-loan guessing game that continued for many years. The tally of Japanese bad loans was estimated to be about $100 million at the start of the 1990s, but by 1999 had risen to 1,000 times that size. I am told that a similar game occurred during the Latin American debt crisis in the 1980s and the Savings and Loans crisis – or indeed in almost every other recent banking shock.”
Bloomberg (Kabir Chibber): “The slump in global credit markets will force banks, brokerages and hedge funds to cut lending by $2 trillion, triggering the risk of a ‘substantial recession’ in the U.S., according to Goldman Sachs Group Inc. Losses related to record U.S. home foreclosures using a ‘back-of-the-envelope’ calculation may be as high as $400 billion for financial companies, Jan Hatzius, chief economist at Goldman ... wrote ... The effects may be amplified 10-fold as companies that borrowed to finance their investments scale back lending, the report said. ‘The likely mortgage credit losses pose a significantly bigger macroeconomic risk than generally recognized,’ Hatzius wrote. ‘It is easy to see how such a shock could produce a substantial recession’ or ‘a long period of very sluggish growth,’ he wrote.”
I commend Mr. Hatzius for his informed and forthright analysis, and certainly appreciate Ms. Tett’s insight. The adept and well-informed are coming to recognize the gravity of the situation. Meanwhile, most analysts and economists remain steadfast in the “economic fundamentals are sound and the risk of recession low” camp. Goldman’s Hatzius recognizes both the fundamental role that credit plays in economic development, and that we are in the midst of an extraordinary credit crunch.
Mr. Hatzius throws out a $2.0 trillion number in an attempt to quantify the scope of curtailed lending. He goes on to suggest that a “substantial recession” is in order if this crunch unfolds quickly, or a period of protracted stagnation if it materializes over time. My observations and analysis make it patently clear that this historic credit crunch has passed the point of no return and will now escalate hastily.
The general economy has reacted only moderately thus far. Most analysts mistake this as further indication of the resiliency of the U.S. economy and additional confirmation of “sound” underpinnings. I take exceptions on both counts, and see the general economy’s fortitude in an altogether different light.
Central to the bull case today is the financial strength of the U.S. business sector. Granted, the non-financial corporate balance sheet is today heavier on cash and lighter on short-term debt (perhaps significantly) than would typically have been the case at this stage of the cycle. In stark contrast to the technology sector’s (“Ponzi”) vulnerability to the abrupt change in financial conditions back in 2000, much of our (non-financial) corporate sector can these days contemplate credit market tumult with assured poise and, practically, indifference. Outside of housing, few face an immediate cash-crunch that would necessitate terminating projects and firing workers. I believe this general invulnerability to short-term market liquidity issues helps to explain today’s complacency in the face of a momentous deterioration in financial conditions. I believe this complacency is not only unjustified, but also creates the “hook” that has corporate managements and stock market bulls alike confidently staying the course in the face of terribly ominous developments.
Importantly, the other side of the ostensibly robust non-financial corporate balance sheet is the troubled financial sector’s. Keep in mind that since the beginning of 2001, financial sector borrowings have inflated 83% to $14.9 trillion. Moreover, during this 6 1/2 year period total mortgage debt jumped 106% to $14.0 trillion. It was, after all, the massive expansion of household and financial balance sheets (and, in particular, their liabilities) that created the “cash-flows” that accumulated in unusual quantities in the non-financial corporate sector. The bulls are wont to fixate on the wherewithal of corporate America, yet the source of this seeming financial well-being is in reality at the root of acute systemic fragilities.
Bloomberg (Bryan Keogh and Shannon D. Harrington): “For the first time in at least a decade, the world’s biggest financial institutions are paying more to borrow in the corporate bond market than the average company.” The widening spread differential between the financial and industrial sectors is telling and it is not speaking bullishly. Residential Capital LLC (“Rescap”), the residential lending arm of GMAC, saw pricing its credit risk widen an astounding 2,800 basis points this week 4,500. The market is now pricing Rescap credit insurance for likely default. Its bonds are trading at 55 cents on the dollar. A Rescap default would have far-reaching ramifications and would certainly be a major blow for mortgage finance overall. Rescap has been a leading subprime lender. It is owned jointly by GM and Cerberus Capital Management, and the markets now fear that the parent companies will be forced to choose bankruptcy over funding a festering financial black hole. GMAC (1-year) Credit Default Swap prices widened about 240 bps this week to 975 basis points. GM and Ford CDSs widened notably as well.
Clearly, a Rescap default would be a major event for the troubled CDS marketplace. Whether it would prove catastrophic, I simply just do not know. But I will assume that Rescap, GMAC, GM and related risk exposures are a meaningful component in a multitude of structured products, including synthetic collateralized debt obligations (CDOs of CDSs). Those on the wrong side of these rapidly widening spreads face acute market illiquidity and few avenues to hedge exposures. This is precisely the backdrop conducive to panic and market accidents.
Between the CDS market and heightened GSE angst, it was another rough week for “structured finance”. Expect it to deteriorate further. Freddie tightened lending standards this week, and with a tidal wave of credit losses building, I do not see how the GSEs do not implement meaningfully tighter lending standards throughout the “conventional” mortgage arena. And with major lenders such as Wells Fargo, Countrywide, and Rescap moving to tighter lending, it appears we are at the brink of only worsening credit availability and resulting housing market pressure.
And in regard to mortgage credit tightening, it is worth noting recent operational data from Countrywide. October Purchase Fundings were down 55% from July’s levels. Other categories were even worse. Countrywide’s ARM fundings were down 75% in three months. Home Equity Fundings were down 64%. Subprime Fundings were down 98% to $42 million. We are only a few months into the general mortgage credit crunch – and credit is about to get even tighter.
Housing markets, especially in California, are at the brink of some very serious trouble. Moreover, a severe credit crunch is just now taking hold in commercial real estate, a sector notorious for punishing boom and bust cycles. While not commonly appreciated, commercial real estate is today acutely vulnerable to the downside of “Ponzi Finance” dynamics.
With the securitization market severely impaired and Wall Street reeling, the banking sector balance sheet has now ballooned $550 billion (21% annualized) over the past 16 weeks. How can this not be a disaster? How can it be sustainable?
The bottom line is that we have now entered a financial environment prone to serious accidents. The financial sector generally is under heightened strain, and I expect this predicament to increasingly feed into the rest of the (finance-driven) real economy. For one, expect huge finance-related job cuts over the coming weeks and months. Second, expect more broad-based tightening of credit and financial conditions. Third, expect the severity of the unfolding housing bust to negatively impact holiday spending and consumer confidence more generally. In short, expect intensifying recessionary forces. And, importantly, expect all of the above to worsen markedly when the stock market bubble succumbs.Link here (scroll down).
Fog and fear obscure the reality behind subprime losses.
What could make the 2007 subprime shock a little unusual, I suspect, is the way the rot is coming to light. Back in the 1990s, Japanese banks were able to sit on their problems for years, because they were a clubby bunch – and corporate loans have very long shelf lives. Similarly, in the Latin American debt crisis, American banks effectively colluded to conceal the rot as they restructured loans.
However, these days, Wall Street bankers have little appetite – or ability – for collaboration. Whereas the bank controllers used to discuss with each other how to value illiquid derivatives instruments in the 1990s, this crisis is unfolding with minimal interaction between banks.
Worse still, the losses are emerging with unusual speed. That is partly because instruments such as CDOs tend to have a shelf life of three years or so, which means that losses crystallise faster than on, say, a Japanese corporate loan. Moreover, accounting reforms are forcing many institutions to mark their assets to market, however difficult this might be. Investors end up with just enough knowledge about the losses to feel scared but not enough information to think the worst is past.
Of course, eventually this fog and fear will clear. After all, even Japan produced clarity in the end (and, for the record, though the losses there were more than $100 million, they were also less than the gloomy $1 trillion-odd projections.) But until such clarity emerges, major banks face a truly pernicious set of challenges. And the only real winners from the numerical fog (aside from some savvy hedge funds) are likely to be a massing army of American lawyers.
After all, if you take a situation of partial opacity, then stir in some serious investor losses and finally add a mixed bag of accounting regimes and pricing techniques, you have the perfect recipe for everybody to sue everyone else. One sequel of this summer’s credit shock, in other words, is a long looming winter of litigation.Link here.
LIBOR soars as credit crunch returns.
The credit crunch is returning in a virulent form to money markets, experts warned, after City of London banks raised their wholesale lending rates to the highest level in two months. Morgan Stanley said that the recent jump in the benchmark London Interbank Offered Rate, which on Monday rose to just under 6.45%, was not merely a seasonal blip but a major warning sign of pain ahead.
It came amid further jitters in the banking sector, where many smaller, more indebted banks are struggling to find lenders to keep them afloat. LIBOR rates, which indicate how willing banks are to lend to each other, have risen sharply during the past week, after spending almost two months close to the 6.3% level – a worrying sign since it was LIBOR’s increase in August that signaled the initial impact of the credit crunch.
Borrowing rates have also risen in the U.S. and the eurozone, though sterling’s levels have jumped in particular because the Northern Rock experience has left traders feeling wary about UK banks.Link here.
AS BANK PROFITS GREW, WARNING SIGNS WENT UNHEEDED
We should have known something was strange. The banks were doing a lot better than they should have been doing.
When the history of the financial excesses of this decade is written, that will be a verdict of financial historians. There were signs that banks were either lying about their results or were taking large risks that were not fully disclosed, but investors were oblivious.
What signs? Consider how banks make money. They pay low rates on short-term deposits and charge higher rates on long-term loans. So they love what are known as positively-sloped yield curves. And they like to see big credit spreads, where risky borrowers are charged much more than safe ones. Put them together, and banks should clean up.
By that light, nothing was going right in 2006 and early this year. The yield curve was inverted, or at best flat. And credit spreads were at historic lows. Risky loans, whether to subprime mortgage borrowers or junk-rated corporations, were readily available at rates that seemed to assume there was only the slightest risk of default. And yet the bank stocks were buoyant, and so were reported profits.
“We should have been suspicious from the get-go,” said Robert A. Barbera, the chief economist of ITG. “There was financial alchemy at work.”
Instead of being suspicious, many analysts believed that banks had found a new way to prosper. Making a loan and keeping it on the balance sheet until it was repaid was so old-fashioned. It was far better to collect fees for arranging transactions and passing on the risk to others. We did not ask why passing on risks should be so profitable to the risk-passers. In reality, it was not.
In recent weeks, we have learned of many risks the banks kept. Not only did we not understand them, but there is every indication that senior managements did not either.
Consider “liquidity puts”. In a fascinating article in Fortune, Carol Loomis quotes Robert E. Rubin, now the chairman of Citigroup, as saying he had never heard of them until this summer. What were they? Banks put together collateralized debt obligations, or C.D.O.’s, many of which held subprime mortgage loans as assets. The C.D.O.’s were financed by issuing their own securities, and the risk of mortgage defaults seemed to pass to the people who bought the securities.
But we now learn that some banks also handed out liquidity puts, giving buyers of C.D.O. securities the right to sell them back to the bank if there was no other market for them. That risk may have seemed slight when the securitization market was booming. But now the banks are being forced to buy back securities for more than they are worth.
How could the banks get the original loans off their balance sheets? How could they claim they had sold something if they could be forced to buy it back? It will be interesting to see if the S.E.C. challenges the accounting.
But even if the accounting was completely proper, it was not very informative. It does not appear that any banks chose to mention the puts to investors before this month. Citigroup had billions of dollars of them, and in the new quarterly report from Bank of America, we learn that it had $2.1 billion of such puts on its books at the end of 2006, a figure that rose to $10 billion by the end of September.
In other words, as the subprime market was starting to falter early this year, the bank stepped up the issuance of such puts. Presumably, that was necessary to “sell” the paper. This week Bank of America announced a $3 billion write-off. A large part of it came from those puts.
There were many other funny ways to bolster profits, like specialized investment vehicles, or SIVs. These creatures bought those C.D.O. securities, paying for them with money borrowed in the commercial paper market. Just like banks, the SIVs borrowed short and lent long. The spreads might be thin, but they could employ leverage to make narrow margins go a long way. The SIVs did not have much capital, but so long as everyone believed in C.D.O.’s, they did not need it. The banks that set up the vehicles swore they had no continuing interest in them, and so they also vanished from any balance sheet that investors could see. Now they are costing banks money to prop them up.
Jamie Dimon, the chief executive of JPMorgan Chase, told investors this week that “SIVs don’t have a business purpose” and “will go the way of the dinosaur.” Will they take the securitization system with them? The answer to that question may be crucial in determining how soon the financial system recovers.
The most important duty of the Federal Reserve is to preserve the health of the banking system. In the early 1990s, after the last big crisis, it engineered a steep yield curve for years, helping banks to recover. When the smoke clears, the Fed will try to do that again, even if it means significantly higher long-term interest rates.
Higher long-term rates are not what either debt-laden consumers or the depressed housing market really need, of course. But such trade-offs are what come when big risks are taken, and ignored, for too long.Link here.
Financial insiders bullish on their companies’ shares in a volatile market.
Insiders have reacted to the most recent Wall Street turmoil by snapping up more shares of their companies’ stock, continuing a bullish trend that began in the summer. A report from Web site InsiderScore.com, which tracks insider deals, said despite the uptick, insider buying levels still remain below August’s multiyear highs. Analysts look to the buying and selling trends of insiders, who are typically long-term investors, for clues to the broader market outlook.
In August, when the subprime mortgage market meltdown last battered Wall Street, insiders drove buying volumes to their highest monthly levels since 1990 [a major low in bank shares, after which followed a 15-odd year bull market], according to Thomson Financial. According to the InsiderScore.com report, buying activity remained moderately bullish in September and October, and then ratcheted up again in recent weeks as continued credit market weakness and worries about consumer spending spurred another bout of market volatility.Link here.
A CHAIN REACTION IN SHAKY DEBT?
As exotic CDOs topple, the impact could ripple through debt markets and wallop more funds and banks.
The fate of one exotic security may signal more trouble ahead for the credit markets. In early November, a collateralized debt obligation called Carina CDO apparently started liquidating its $450 million portfolio filled with bonds backed by subprime mortgages and pieces of other CDOs. These sales prompted credit rating agency Standard & Poor’s to downgrade Carina’s bonds from AAA to junk in a day.
The fear is that more dramatic downgrades could follow, perhaps setting off a chain reaction that might trigger further fire sales, extend the credit meltdown, and threaten the economy. “Systemic risk is sky high,” says Morgan Stanley strategist Gregory J. Peters.
The complexity of such structured finance deals as Carina, which piled one esoteric bond upon another, have amplified threats in the credit market. In the housing-market heyday, investment firms packaged subprime and other risky loans into investment pools that issued bonds. Those securities were then grouped together into CDOs, whose own bonds were sometimes sold to other CDOs. Credit-rating agencies graded securities all along the chain.
But when home prices started to sink and troubled borrowers stopped making payments on their loans, the pyramid began to crumble. First the ratings on mortgage-backed securities took a hit. Moody’s Investors Service, e.g., has downgraded $56 billion of such bonds, creating problems for the CDOs that own them. In turn, Moody’s has cut the ratings on 338 CDO-related bonds this year and has another 734 under review for downgrade.
Such rating changes create a particularly dire situation for some CDOs. The rules governing Carina and many others dictate that certain events can put a CDO into technical default. In the case of Carina and at least 13 other CDOs, technical default occurred because the ratings on underlying holdings dropped too far. With more securities under review by the rating agencies, dozens of additional CDOs may be headed for the same fate, according to research by Citigroup strategist Ratul Roy.
More defaults would have serious implications for the already troubled credit markets. When a CDO falls into technical default, investors in the top tier of bonds usually get additional rights. They can collect all the interest payments for themselves, leaving other investors with nothing. So investors in the lower part of the food chain, including hedge funds, investment banks, and other CDOs, take a big financial loss.
In the worst-case scenario, the top-level bondholders can force the CDO managers to dump assets. Only investors in Carina’s bonds are believed to have done that so far. If more do, additional fire sales could depress prices further and create more panic in the markets.
Making matters worse, another wave of mortgage delinquencies might be on the way. Some $362 billion worth of subprime loans are due to reset to higher interest rates in 2008, according to Banc of America Securities. Rating agencies are also looking at another segment of troubled bonds, those backed by Alt-A mortgage loans. Some $675 billion of Alt-A bonds were issued in 2005 and 2006. They are considered less risky than subprime ones, but the underlying mortgages often came with teaser rates that will jump higher soon. On November 9, S&P put $2.1 billion of bonds backed by Alt-A mortgages on watch for downgrades.
If such downgrades occur, billions worth of CDOs holding the bonds could get hit. That would keep the vicious cycle going, making it harder for borrowers to find loans and threatening all manner of mortgage-related investments.Link here.
Ambac investors sweat a little more.
The shock waves from Swiss Re’s announcement that it would take a write-down on losses on mortgage-backed securities were felt across the Atlantic on Wall Street, where shares of Ambac, MBIA and other bond insurers sank amid renewed fears that the bloodbath in the mortgage markets may be far from over.
Swiss Re said it was taking a hit of $900 million due to the fall in value of a single client’s portfolio of mortgage-backed securities and asset-backed collateralized debt obligations, because of “unprecedented and severe ratings downgrades undertaken by the rating agencies in October.” Swiss Re said that the value of the client’s portfolio, which it was insuring, had fallen to zero. Shares of Ambac fell 7.0%, while MBIA dropped 7.3% and Radian Group sank 8.0%. The day’s fall left Ambac Financial down a total of 63.8% since October 11.
According to Friedman, Billings, Ramsey analyst Steve Stelmach, the issue for Ambac over the past few weeks has been whether the New York City-based bond insurer is appropriately valuing its CDO portfolio as credit ratings on the securities have plummeted. As a financial guarantor, Ambac writes insurance policies and other contracts protecting lenders from defaults. CDOs are securities backed by a pool of bonds, loans or other assests, where investors buy slices classified by varying levels of debt or credit risk. “The debate is whether mark-to-market is a reflection of credit losses, or whether from lack of liquidity in the secondary market,” Stelmach said, “and that’s not a debate that’s going to be settled soon.”
You can guess what side of the debate Ambac is on. Management has recently been making its case to the public as to why the situation is not as bad as it seems. In his report, Morgan Stanley analyst Ken Zerbe wrote, “as the credit market continues to weaken, our confidence that the guarantors will survive the credit meltdown is waning, prompting us to take a more conservative view of the financial guarantors.”
At a recent conference, Bob Genader, Ambac’s chief executive, said the “significant and painful drop in the last few weeks that has been caused by a number of misperceptions about the industry in general and misperceptions about Ambac specifically.” Much of the concern on Wall Street has focused on credit rating reviews undertaken by Moody’s, Standard and Poor’s and Fitch Ratings.
The collapse of the subprime mortgage market in recent months has created a domino effect in which investments like CDOs have lost much of their value, and subsequently the companies that hold them have had to incorporate those declines onto their books. Ambac’s fellow gurantor MBIA has fallen 39.8% over the past month, and Radian Group has dropped 40.2% over the past three months.Link here.
IN REVERSAL, SAFE IS RISKY, RISKY IS SAFE (SO FAR)
For a long time, if there was a problem on Wall Street, Credit Suisse was not far away. From its high-flying mortgage desk that blew up in 1998 to its superstar technology team that promoted Internet stocks in the late 1990s, Credit Suisse could be counted on as an example of problems on Wall Street.
UBS, its crosstown rival in Zurich, has typically taken a more conservative approach, avoiding seemingly risky markets like leveraged lending while relying instead on its huge wealth management unit.
But when the markets fell apart this summer, it was UBS, not Credit Suisse, holding the bag. Some of the Street’s safest institutions – or those that hoped to be perceived as safe – turned out not to be, while some perceived as risky are so far sailing through. And it was not the giant loans to buyout clients that so many Wall Street players had warned of that brought the party to an end. It was the subterranean world of mortgage-related debt – securities that were backed by the American dream of homeownership – that laid bare inadequate risk controls.
Conventional wisdom, it turns out, has not been very reliable in the topsy-turvy world that has emerged from the credit market meltdown. Just as some investors were starting to believe that Wall Street could produce more consistent growth in profit, the banks there delivered a stark reminder of why they tend to trade on such low earnings multiples.
Among the American firms, investors might have expected Merrill Lynch to weather the storm as a result of its huge and stable brokerage business. Citigroup, meanwhile, has a large retail bank and sufficient global diversification that could have provided a buffer. Instead, they have both buckled under a business – mortgages – that accounted for a relatively small portion of profits. The two managed to write down an astonishing $20 billion or so, with the vast majority coming from mortgage-related products. Lehman Brothers, which investors might have expected to suffer because of its huge mortgage business, has so far taken one of the smallest losses on the Street.
While the agony has been concentrated among those who built and sold the financial fairy tale of structured credit products (creating low-risk investments from high-risk securities), virtually all the banks’ shares have suffered.
Warren Buffett said it best: “One of the lessons that investors seem to have to learn over and over again, and will again in the future, is that not only can you not turn a toad into a prince by kissing it, but you cannot turn a toad into a prince by repackaging it.”
The eye-popping write-downs prove what the skeptics have always said, that the attractive profits made by Wall Street’s opaque trading businesses are unpredictable and worth much less when it comes to assigning price-earnings multiples at the investment banks.
Goldman Sachs today trades at almost nine times trailing 12-month earnings. But shares of traditional asset managers like T. Rowe Price, which are less likely to risk billions of dollars to build expertise in an area riddled with acronyms, trade at more than 20 times earnings.
That means that even though some firms have so far shown that they are good risk managers, others on the Street proved once again that you can never count too heavily on sophisticated systems, armies of Ph.D.’s or confident managers who have it all under control (and appear to play a lot of bridge or golf). The failure of many means that none, not even the market leader, will be given the benefit of the doubt.Link here.
OOPS, THEY’RE ON TO YOU
In the 1993 movie Mad Dog and Glory, Robert De Niro plays a police photographer who saves the life of a small time organized crime figure. The crime boss (Bill Murray) tries to return the favor by loaning De Niro the character played by Uma Therman. While loaning out Ms. Therman is a grand gesture, De Niro is understandably uncomfortable with the arrangement. In a minor subplot, De Niro realizes that his kind-hearted neighbor is being abused by another member of the police force, but is afraid to confront the guy. One night De Niro checks on a disturbance only to have the boyfriend slam the door in his face. Feeling helpless about the whole thing, De Niro, shouts through the door, “I’m on to you!”
Eventually De Niro gets another cop to beat up the loser boyfriend, and save the neighbor from further torment. Incredibly, Caruso does the job without a single CSI Miami-style close-up. The Uma Problem, however, takes the rest of the movie to work out.
Fed Chairman Bernanke recently testified to Congress that economic growth should slow in the fourth quarter and that the number crunchers at the FOMC expect GDP growth to remain on the weak side early next year. But the Fed expects this housing thing to be behind us in no time, and the economy should pick up thereafter. The chairman also testified that while inflation has been kicking up some dust lately, the bottom line is that overall and core inflation should be “consistent with price stability next year.” If regular Americans had the chance to testify before Congress, many might say something like this: “Mr. Bernanke, we’re on to you!”
Here is why: Syndicated columnist Bob Herbert opined that if Mr. Bernanke would just “open his eyes” he would see what so many Americans are already see, and that is tough sledding. What does Herbert see? “Flimflammery.” That he calls the government’s statistics on a variety of topics. In other words, even a New York Times political columnist understands that the official stats do not mesh with the real world. As Herbert sees it, the real world is the opposite of the statistical world which tells us: “job growth good, inflation low.”
The management of Sara Lee and Black & Decker probably see things with Herbert’s eyes, at least when looking at recent financial statements. Both the maker of frozen cakes and the purveyor of must-have power tools complained that rising inputs have crimped profit margins.
Herbert is onto Bernanke, but he is not alone. Thousands of people who are not NYT columnists do not buy that we are not already in a recession. What other conclusion can a reasonable human draw from the hoards of people willing to pay good money to hear a man tell them what they already know: “Spend less, save more.” That is what radio host and anti-debt guru David Ramsey preaches to the masses as he tours the allegedly recession-free USA. At long last, is “frugality” the new “new kitchen”?
Could be judging from Paul Kasriel’s chart of Mortgage Equity Withdrawal. That is chart #9 way down the page of his latest Economic Outlook (PDF). The chart shows the huge amounts of money that have been sucked out of home equity over the past few years. Recent withdrawals total twice the levels of 2000. But today, thanks to tighter credit, the home ATM is missing the “fast cash” option. That means that this source of funding (or any source?) will be smaller over the next seven years. As an indication of tighter mortgage credit generally, Countrywide reported that its October mortgage loan fundings fell by almost half year-over-year, with subprime lending insignificant.
Consumers are already spending a record amount of what they are earning. Kasriel’s chart 5 tracks the ratio of real personal consumption expenditures to real disposable personal income. By this measure, we are spending like the war is already over. World War II, that is, back personal when balance sheets were sound and kitchen counters were devoid of espresso machines.
David Ramsey might sum up this disjointed column: Tighten the belt. Pay off debt. Aggressively save. Watch out for inflation. But if enough people take his advice, it will take a lot more flimflammery to avoid a recession.Link here.
THE HOUSING BUBBLE – 2007 UPDATE
This analysis updates and expands our October, 2006 analysis of the “bubble” in residential structure investment. Our analysis still indicates that the housing investment “bubble” has surpassed even the housing boom of the 1920s and that it is now fading away into a very difficult housing market over a period that will probably extend into 2011.
Based on Q3 2007 GDP information, the rate of housing investment has declined over 25% compared to 2005. Since we expect that Q4 housing investment will be worse, the rate of housing investment will likely have fallen at least 30% from 2005.
In our 2006 calculations, we estimated that it would take up to 5 years of investment levels at 80% of trend (40% to 50% below 2005) in order to significantly diminish the accumulated housing over-investment. We believe that estimate was, and remains, good. Our 2007 analysis segmented housing investment into new housing construction and into renovation and repair construction. As of 2007, both segments are thoroughly over-invested.
2008 should be a residential investment disaster from a macro-economic perspective. Residential investment is about 2 years over-invested on the basis of housing units and renovations and repairs are about 9 months over-invested. In spite of lower interest levels, mortgage debt service levels during 2007 as a percent of income are the highest ever recorded. Finally, the motive to produce new units has disappeared as builder profits have evaporated.
Micro-economics drives individual purchase decisions. In 2008, the financing loss associated with obtaining a new mortgage at a higher rate than an existing mortgage should slow purchases and renovations. Home price appreciation now causes an additional financing loss as price gains no longer exceed mortgage rates. The frictional cost of trading properties creates additional costs when sellers must provide incentives to buyers.
In 2006, we were correct that the housing boom would be over as we entered 2007. We now have a better answer to the question “How far down is down?” We expect that 2008 and 2009 will be a residential investment crater with the average residential investment 35% or more below 2005. 2008 and 2009 could be substantially worse if interest rates increase faster than we expect.
In 2008, there will probably be no place for housing investment to hide. The macroeconomic factors are all negative for demand and supply. We have not seen anything remotely like this since 1990. The primary microeconomic factors influencing individual housing investment choices should also work against housing. With no unfilled need, no reason to buy, and no reason to build, 2008 should be the worst residential investment year since 1991.Link here.
Freddie Mac posts loss, warns of a possible dividend cut and the need to raise capital; shares plunge.
Freddie Mac fell 29%, the biggest decline since it went public in 1988, as the 2nd-largest U.S. mortgage-finance company posted a record loss, warning of a possible dividend cut and the need to raise capital. The worst housing slump in 16 years caused “significant deterioration” in the 3rd quarter that will continue through year-end, Freddie Mac said in a statement. The net loss was $2.02 billion, or $3.29 a share, three times what some analysts estimated.
“It is as bad as it possibly could be,” said Howard Shapiro, an analyst at Fox-Pitt Kelton in New York. Shapiro recommended investors sell Freddie Mac shares, reversing his opinion to hold more of the stock than is contained in benchmark indexes.
Freddie Mac and the larger Fannie Mae, created by Congress to foster American home ownership, profit by holding mortgages and mortgage bonds as investments and by charging a fee to guarantee and package loans as securities. They record losses when defaults rise. The companies have lost $41 billion in market value this year as mortgage defaults and foreclosures rose to record levels. The companies, which own or guarantee 40% of the $11.5 trillion U.S. home loan market, will have less money available for new mortgages.
“There is nothing we see right now to be more optimistic,” Chief Financial Officer Anthony Piszel said in an interview. He told analysts on a conference call that Q4 “is not going to be pretty.”
“These companies have lots of problems yet to come, I don’t think they really know,” how bad the losses will get, well-known investor Jim Rogers, said in an interview. “I’m still short those companies.”
A slump in the value of mortgages reduced core capital by 2/3 to $600 million more than Freddie Mac’s regulatory requirements, prompting the company to seek more money. Freddie Mac’s required capital level is 30% larger than typical as the company recovers from accounting mistakes revealed in 2003.
Wells Fargo CEO John Stumpf last week said the housing market was the worst since the Great Depression. Banks and securities firms worldwide have already reported about $50 billion in losses from subprime mortgages, loans given to borrowers with weak credit, that have been defaulting at a record pace. The total damage may reach $400 billion, Deutsche Bank analysts said last week. Freddie Mac’s $713.1 billion portfolio as of September included $105 billion of securities backed by subprime mortgages. “Even the strong credit managers with the best assets are not immune,” said Jim Vogel, head of agency debt research at FTN Financial in Memphis, Tennessee.
Fannie Mae and Freddie Mac have been constrained from buying mortgages because of regulatory restrictions imposed last year. OFHEO in September loosened some limits in an effort to ease a housing slump that has caused other mortgage investors to retreat. Senator Charles Schumer of New York and other Democrats have called on OFHEO to relax restraints barring Fannie Mae and Freddie Mac from buying loans exceeding $417,000 and from expanding their assets. The senator introduced legislation in September to let the companies temporarily increase their portfolios by 10%.
“Freddie’s earnings announcement provides confirmation that the foreclosure crisis has officially spilled over into the prime market,” Schumer said. “Today’s news does nothing to lessen the critical role that the GSEs must play in providing much-needed liquidity to a struggling market. The whole reason Fannie and Freddie exist is to help in times like these.”Link here.
Freddie, Fannie seek a few billion.
Freddie Mac and Fannie Mae can only make it through a prolonged credit crisis if they raise billions of dollars of new capital. That, in a nutshell, is what the plunging stock prices of both mortgage buyers are saying this week. Freddie stock tanked 29% Tuesday, and Fannie’s was down 26%. Both have lost more than half their value since the end of September.
Freddie accounted for a sharply higher batch of bad loans in its Q3 earnings, a little more than a week after Fannie did the same thing. But Freddie said that it would move quickly to raise more capital through a large issue of preferred shares. It added that it was seriously considering cutting its dividend – another capital preserving action.
When asked on a conference call if Freddie would have to raise as much as $4 billion by issuing shares, Chief Financial Officer Buddy Piszel declined to quantify the issue’s size. “It will be a large transaction,” Piszel said. Last week, Fannie raised capital in issuing $500 million of preferred shares, but the company will almost certainly have to raise more capital because its bad loan problem is at least as serious as Freddie’s.
The Office of Federal Housing Enterprise Oversight, which regulates Fannie and Freddie, is not worried about existing shareholders. Its job is to make sure both companies are strong enough to get through this housing meltdown. “Freddie Mac’s announcement of the steps it intends to take reflects prudential actions for the company that are appropriate in light of current market conditions,” said OFHEO director James Lockhart.
Fannie and Freddie are seen to be an important source of demand for mortgages, so any problems at these companies could end up reducing the amount of mortgage lending that gets done by the banks that sell mortgages to Fannie and Freddie. Because of their integral role, it would be no surprise if OFHEO, as well as other financial regulators like the Federal Reserve, were keen to see a ramp up in capital at both companies. Such capital increases will have to be very large. Neither Fannie nor Freddie is close to having sufficient capital to weather a full-blown recession.
As government sponsored entities operating under a congressional charter, investors have perceived both companies to have an implied government guarantee on their debt. Over time, that has lulled investors into becoming comfortable with thin capital cushions. In addition, because Fannie and Freddie’s mortgages were mostly loans to people with good credit, losses were not expected to be high on them.
But it has been clear since late 1990s that real and large losses could occur on the financial instruments that both companies use to insure against adverse movements in interest rates. And then Fannie and Freddie started to become exposed to mortgages to people with incomplete or poor credit histories. Losses have started to come in on those.
OFHEO recently penalized Fannie and Freddie for misleading accounting and poor oversight. As part of its measures against the companies, OFHEO has demanded that they hold 30% extra regulatory capital. But for Freddie that higher capital number – $34.6 billion – is still equivalent to only 4.4% of assets.
Yup, that capital increase is going to have to be very large indeed.Link here.
Block loses $1 billion, sacks bosses.
H&R Block, the USA’s biggest tax preparation firm, which has incurred more than $1 billion of losses on its sub-prime mortgage subsidiary, Option One, and has replaced Chairman Mark Ernst with Richard Breeden, a former head of the SEC. The new temporary CEO will be Alan M Bennett, who retired this year as CFO of Aetna Inc. The company said it had formed a search committee to recruit a new permanent CEO.
Richard Breeden, who served as Chairman of the S.E.C. from 1989 to 1993, and controls nearly 2% of Block’s shares, won a seat on the board in September after a proxy fight and has waged a campaign to force Block to stem the losses at Option One. Block had arranged a deal with Cerberus Capital last March which has fallen apart due to the problems in the sub-prime mortgage market.
“For more than 50 years H&R Block has successfully served the tax-related needs of millions of Americans and thousands of businesses, as well as helped clients meet their financial objectives. Our actions today reflect a determination to focus on those activities where H&R Block can generate significant shareholder value,” said Mr. Breeden. “By refocusing on our core strengths and market-leading capabilities, we will work to generate strong growth in shareholder value.”
Block is the world’s largest tax services provider, having prepared more than 400 million tax returns since 1955. The company and its subsidiaries reported revenues of $4.0 billion and net income from continuing operations of $374.3 million in fiscal year 2007. The company moved into sectors unrelated to its main business, such as consumer banking, in an attempt to make better year-round use of staff and facilities that were grossly under-used except during the peak tax preparation period each year.Link here.
Moi ? Greenspan and the housing bubble.
THere was an interesting interview with Alan Greenspan on Fox Business Network about housing, gold, and the lack of need for a central bank. It appears that Greenspan has plenty of reasons for why the housing bubbles worldwide ever started and are now bursting. This appears to be Greenspan’s new MO. He has been traveling all over the country promoting his book, criticizing his successor, and pointing the finger at everyone but himself. ...Link here.
AMERICA, A NATION OF SUBPRIME CONSUMERS
When home prices skyrocketed in the early part of this decade, everyone seemed to forget that the subprime borrowers were high risk by definition. Now that losses are snowballing, lenders are belatedly rethinking the “wisdom” of making such loans in the first place. Similar conclusions will soon be reached by foreign nations that have supplied American consumers with goods that they can not afford. In reality, America is a nation of subprime consumers.
For most of recorded history, nations have paid for their imports with exports. When a nation runs a trade deficit, and instead pays for imports with its own currency, it in effect issues an IOU to the seller to buy an exported good at a future date. After all, the currency of the nation running the deficit is only legal tender in the country of issue, and is therefore useless to other nations unless it can be exchanged for goods in the issuing country or exchanged for other currencies. However, no matter how many times the currency is passed around, at some point the final holder must spend the money on something in the issuing country.
By providing goods in exchange for IOUs, foreign nations are in essence engaged in vendor financing. This concept came to mass attention during the dot-com boom, when many telecommunications equipment companies sold their goods to cash poor start-ups in exchange for credit or stock positions (in effect, IOUs). When the dot-coms went bust, the equipment providers were forced to restate earnings as losses.
As the world surveys the landscape of the American economy, it will notice an industrial base too hollow to produce sufficient quantities of exportable consumer goods necessary to make good on our outstanding IOUs (U.S. dollars). As those dollars continue to lose value, the losses will suddenly become increasingly apparent. Just as lenders eventually figured out that loaning money to borrowers who could not pay them back was a bad idea, nations will discover that selling products to Americans who can not afford to pay for them is just as foolish.
Think about this. Currently, foreign tour operators are organizing shopping tours, where foreign citizens fly to America for the specific purpose of buying goods cheaper here than they can buy the same goods in their own countries. Of course, most of the goods they are buying, such as clothing, electronics, jewelry, etc., were not made in America in the first place. How absurd is it for Italians to come to New York to buy Italian made shoes cheaper than they can find them in Milan? Does it make sense for foreign producers to offer products to Americans for less than their own citizens? Of course not. In short order the free market will correct this by raising prices here in America and lowering them in the rest of the world.
Many naively believe that this scenario is unlikely as foreigners will indefinitely prop up the U.S. economy in order to preserve their “best” export market. Well, based on the outsize fees generated by subprime lending products, risky borrowers were clearly the mortgage industry’s “best” customers. Given their profitability, why did lenders not simply extend subprime borrowers even more credit to preserve the market? The obvious answer is that at some point lenders discovered that the market was not worth preserving. Any short-term profits came at the expense of far greater future losses.
The same revelations are about to be made around the world as other nations realize that selling consumer goods to Americans is a losing proposition, as the profits they believe they are earning today will simply evaporate tomorrow. When that happens, just as subprime borrowers are losing access to mortgage credit, America’s subprime consumers will find far fewer bargain basement imported products at their local Wal-Mart.
For a more in depth analysis of the tenuous position of the Americana economy and U.S. dollar denominated investments, read my new book Crash Proof: How to Profit from the Coming Economic Collapse.Link here.
THE DISAPPEARING MIDDLE CLASS
It is already clear that one of the great election issues of 2008 will be the relative impoverishment of the American middle class, defined in the American rather than the British sense to include well-established blue collar workers with families and mortgages. Republicans who ignore this problem will find themselves talking only to the winners, the top 1% in the income scale – laughably inadequate as an electoral base. Democrats who propound the usual socialist nostrums to cure it will find themselves ardent proponents of an economics that does not work. A new intellectual paradigm is required.
The declining share of low and moderate income workers in the American pie is undeniable. The relative share of such workers peaked as long ago as 1973. For those with only high school qualifications or less, their absolute earnings peaked in 1973 and have declined substantially since then. From 1973 to 1995, this appeared to be a simply a case of the rewards for skills increasing, with low skilled workers suffering increasingly in terms of earnings and job losses compared to those with a bachelor’s degree or better. Since 2000, however, the paradigm has changed, with all sectors of the workforce losing ground in absolute terms, except for the top 1% who have gained essentially all of the modest gains in employee incomes under the George W. Bush administration.
Blue collar workers lost bargaining power catastrophically following the peak of the 1973 cycle, and since 2000 their failure has been accompanied by a more generalized loss of bargaining power by white collar workers and all toilers below the level of top management. Employers no longer feel compelled to offer their workforce either a decent wage or the most basic of healthcare benefits – benefits which were considered sacrosanct in the social contract of 1945-73. The American dream, in which hard work can propel ordinary people into a comfortable, even affluent, lifestyle, is becoming ever more distant for all but a small fraction of the population.
There appear to have been a number of causes of this. One is technological change, that old chestnut, which has not made production line workers obsolete, as had been thought would happen, but instead has compelled their children to get jobs in the service sector of the economy, generally lower paid, since fewer of the employee’s skills are used. In the service sector itself, technology has de-skilled a number of routine tasks such as retail-level credit analysis, so that respectably paid lower level bank officers have been replaced with casual-labor clerks.
A second cause is the increasing ease of world trade, and the new possibilities the Internet has brought of outsourcing to Third World countries where labor costs are a small fraction of those in the U.S. This has brought new wealth to a number of poor countries. Equally important it has demonstrated to poor countries with large populations that the way to new wealth is not through socialism or religious-driven hostility to the outside world but through openness to world trade and investment, in order that their surplus labor can be used to best effect in an increasingly integrated world economy.
Naturally, the increased access to the U.S. economy of a much larger workforce with lower pay scales has had a depressing effect on U.S. wage rates, particularly at the lower skill levels,. The doctrine of comparative advantage, beloved by free trading economists as a rationale for opening borders, works much less well when the poorer country through opening to world trade can work itself up the value chain and expand its comparative advantage to an increasing proportion of the richer country’s business.
Another cause of middle class immiseration is unquestionably high immigration. Business lobbies want high immigration to reduce the bargaining power of their workforce. This puts pressure on workforce remuneration, particularly at the lower skill levels.
Finally, and most relevant to the increased post-2000 inequality, which has been of a different type to that of 1973-95, there is the interest rate policy of the Federal Reserve, which since 1995 has been persistently far too loose. This has allowed the benefits of the deflation that has naturally occurred due to the Internet to flow not to the living standards of the average U.S. worker, but to asset values, concentrated at the top end of the income scale and the boom in which has provided jobs largely for the upper middle class.
The lack of an adequate process of “creative destruction” on Wall Street has allowed housing finance, for example, to be routed through a securitization mechanism that provides ample livings for Wall Street and the hyper-energized salesmen known as mortgage bankers, but as revealed in this column a few weeks ago has actually increased the relative cost of home mortgages to the consumer compared to the old savings and loans.
The standard centrist and conservative response to inequality, that increased investment in education will solve the problem, is mostly tosh. There is however a need for investment in mid-career education, as well as in adjustment of those mechanisms of finance and social cohesion that make it difficult for people to retrain in midlife.
A second essential is to reduce the pace of change, not of cutting-edge technological change, which in any case occurs relatively slowly most of the time, but of Schumpeteran “creative destruction” which destroys jobs and, more important, destroys the employee security brought by decades of experience in a particular function. In general, low interest rates accelerate destruction, as does a labor market open to immigrants from countries with much lower wage levels. A world in which money is tight, new projects are undertaken only when they clearly provide a clearly superior avenue to reward and labor is secure against competition based solely on price is a world in which careers can be built, seniority attained and workers at 55 can feel relatively secure that they will not be thrown onto the industrial scrapheap. There is no need whatever for additional government spending to achieve this. It simply requires tight control of the money supply and immigration.
Protectionism itself is not the answer. For one thing, as U.S. and E.U. agriculture subsidies have amply demonstrated, it merely enables the lobbying rich to entrench themselves still further from their less affluent countrymen.
A world of tight money, tight immigration controls and greater stability is unattractive to Wall Street, if only because it will tend to reduce the share of corporate profits in GDP and the opportunities for creative (albeit in the long run destructive) financial juggling. However corporate profits and the stock market are not an end in themselves, they are only a means to an end, by which investment is adequately remunerated and labor is permitted to improve its living standards over time with adequate protection from excessive turnover.
A world in which few if any have security in their livelihood is not conservative, it is anarchist. It is also deeply repugnant to the average voter. That will ensure that, if the noise and struggle of the free market is allowed to become too destructive, it will be replaced by the eternal silence of the socialist tomb.Link here.
SAUDI MINISTER WARNS OF DOLLAR COLLAPSE
The dollar could collapse if OPEC officially admits considering changing the pricing of oil into alternative currencies such as the euro, the Saudi Arabian foreign minister has warned. Prince Saud Al-Faisal was overheard ruling out a proposal from Iran and Venezuela to discuss pricing crude in a private meeting at the oil cartel’s conference.
In an embarrassing blunder at the meeting in Riyadh, ministers’ microphones were not cut off during a key closed meeting, and Prince Al-Faisal was heard saying, “My feeling is that the mere mention that the OPEC countries are studying the issue of the dollar is itself going to have an impact that endangers the interests of the countries. There will be journalists who will seize on this point and we don't want the dollar to collapse instead of doing something good for OPEC.”
After around 40 minutes press officials cut off the feed, which had been accidentally broadcast to the press room. Prince Al-Faisal added, “This is not new. We have done this in the past: decide to study something without putting down on paper that we are going to study it so that we avoid any implication that will bring adverse effects on our countries’ finances.”
Iran and Venezuela have argued that the meeting’s final communique should voice concern about the level of the dollar, which has recently fallen to new record lows against the euro. They are pushing for oil to be denominated against a basket of currencies.
Nigerian finance minister Shamsuddeen Usman said that Opec could declare in the communique that, “While underlining our concern for the continued depreciation of the dollar and its adverse impact on our revenues, we instruct our finance ministers to study the issue exhaustively and advise us on ways to safeguard the purchasing power of our revenues, of our members’ revenues.”Link here.
WHEAT FUTURES: IS THIS MARKET FINALLY WAKING UP?
After weeks of selling and, more recently, sideways movement, wheat futures finally began to show some life this week, advancing to their highest level in seven trading days on November 20. For traders eager to go long wheat futures, it was a case of “finally!” After all, this commodity had already retreated more than 200 points since surpassing the 950 mark in late September.
And while the 11-20 rally was not enough to garner television news headlines, it certainly grabbed the attention of the financial news community. Analysts around the world began to weigh in with their speculations on why wheat finally broke from its long slumber. According to one story, bad weather in the U.S. plains, combined with added export orders from Pakistan, was the reason for wheat’s awakening.
On the face of it, that would seem to make sense. After all, the U.S. Midwest, like much of the nation, is experiencing a drought that could hamper wheat growth. And, according to supply-and-demand theory, lower wheat supply should equal higher market prices. Unfortunately, if you have watched the news and the markets’ reactions long enough, you know that supply-and-demand theory can provide frustratingly short-lived answers. Whether or not it will be the case here remains to be seen, but there is a forecasting method that can tell you today, right now – and with a lot more objectivity – what is likely in store for Wheat from here.
EWI’s Daily Futures Junctures editor Jeffrey Kennedy, relying on the Elliott Wave Principle, has been looking for a move up in wheat for some time. In the 11-20 evening issue he noted, “When the selloff in Wheat began in early October, we were looking for prices to decline to 775 1/2 - 758 1/2,” as this chart illustrates.
Moreover, based on the wave patterns within Wheat’s sell-off from the late-September high, Jeffrey knew that wheat was ripe for a turn: Wave 1 sell-off looks completed and a wave 2 advance has been in the cards.Link here.
FINALLY PUTTING THE OTCBB DOUBTERS TO REST
Most investors are weary about the Over the Counter Bulletin Board (OTCBB). That is understandable, considering the number of bankruptcies, shell companies and delistings that occur in over-the-counter markets. But there is a very large misconception that is widely shared among investors – that no OTC company has to report current financial information. That is the case with the Pink Sheets, but not so with the OTCBB.
Before 1990 the OTC securities market was a Wild West show. Not complete lawlessness, but close to it. So that year, the S.E.C. started the OTCBB as part of the Penny Stock Reform Act. The OTCBB’s main purpose was to bring more quotation and last-sale information. By 1999, the OTCBB had evolved to the point where every company had to report regular financial information. This sets it apart from others, specifically the Pink Sheets, which do not have reporting requirements.
We have discussed the Pink Sheets extensively here at Penny Sleuth. (If you want a detailed analysis of the Pink Sheets, have a look at this free report we cooked up.) There are absolutely no requirements for Pink Sheet companies. They do not have to file regular and current financial information (although a recent classification system is slowly changing that), they do not have a strict minimum market capitalization requirement, and they certainly do not have to pay the couple hundred thousand dollars just to be traded on a major exchange.
OTCBB companies, on the other hand, have to keep up with regular financial reporting. This truly makes all the difference in the world. Here is an example:
Company A is traded through the Pink Sheets, and Company B is on the OTCBB. Both companies issue press releases claiming to be “transitioning their businesses.” Company A really just withdraws into a shell company state, because no one has to know what is actually going on, whereas Company B has to file regular quarterly earnings. If it does not, the OTCBB will add the letter “E” to the end of the company’s ticker, which immediately tells investors that the company is behind on its disclosure. This can make or break that investment. People invested in Company A are out of luck. Company B investors can get out before the going gets too tough.
But why are OTC companies are even worth investing in? Two reasons. The main reason most OTCBB investors keep trading these securities is the profit potential. A $300 billion Blue Chip cannot double in size too easily. That does not give investors too much to work with. A $3 million company can double in size overnight without flinching.
The second reason is that overall general market attitude has a very small effect on these tiny companies. There are almost never any big institutional investors or large mutual fund managers pulling money in and out of these companies. These two groups of investors are more interested in macro market sentiments than what individual companies are doing. So, in bear markets, it is still quite possible to have a bunch of these OTCBB companies take off.
In a 2001 study published in the Journal of Alternative Investments, a 4-year period of OTCBB trading was studied for the purpose of discerning a risk-to-return ratio. The interesting conclusion they came up with was that OTCBB stocks did not reflect what the general market was doing at that time. There were some years of extreme bullish overall sentiment, which engendered a solid return on the S&P, where the overall OTCBB market lost a lot of money. On the flip side, years of extreme bearishness in the S&P, along with the major exchanges, showed positive returns for many OTCBB companies.
So whether you are a safe-bet kind of investor or a fly-by-the-seat-of-your-pants type, there is still a place for you, just off the major exchanges.Link here.
ETF INVESTORS WEIGH HEADING FOR THE EXITS
With many of the year’s most popular ETFs starting to look shaky, it is a good time to look at exit strategies. IShares FTSE/Xinhua FXI, PowerShares Golden Dragon Halter, USX China Portfolio PGJ, Claymore ETF EEB, and iShares MSCI Brazil EWZ are in the top five performers over the past 12 months.
But that does not mean they will stay that way, says Tom Lydon, president of Global Trends Investments.
iShares FTSE/Xinhua, for example, returned 153.4% over the last year, but the share price was 177.40 on Tuesday, November 21 – vs. its 218.51 peak on October 31. PowerShares Golden Dragon also peaked on 10-31, at 38.72, and closed Tuesday at 31.86, after returning 113.9% last year. Claymore peaked 57.90 and closed Tuesday at 51.55, with a 113.9% return. iShares MSCI Brazil hit 86.15 on 11-8 and dropped to 81.38 on Tuesday, still returning 108%.
The Brazil ETF, Lydon says, would be on his firm’s watch list to sell. Investors should get out if an ETF loses between 5% and 8%, he says. A disciplined sell strategy is essential, he says, because too often investors are impressed by trailing returns. But eye-popping returns can blind investors to the fact that when an ETF is on a losing streak, it is sometimes harder to make up ground.
For example, many who understand that emerging markets are volatile will shrug off a 20% loss as temporary. Lydon says they are right to a point, but when declines reach 50% an investment has to double in value just to break even.
Lydon also watches an ETF’s 200-day average to see if the price declines are temporary or if they show a long-term trend by breaking below a key support level. A sustained fall below the average often means there is a more fundamental problem. iShares FTSE/Xinhua, e.g., has not dipped below the 200-day average, but it has dropped more than 8% off its high, so it would be a sell. The firm buys when an ETF stays above the 50-day average and is rising. iShares MSCI Brazil has dropped about 5.5%, but it has not dropped below the 50-day average yet. That puts it on the watch list, Lydon says.
Global Trends Investments, with $70 million under management, has model portfolios, primarily focused on ETFs. The firm’s model growth portfolio has gone to about 55% cash over the past several weeks. Over the trailing 12 months through October 31 the portfolio has returned 24.8%, against 12.8% for the S&P 500.
The portfolio’s heaviest weight is in WisdomTree Pacific Ex-Japan Dividend DND. It hit a new high of 94.17 on 10-31.Link here.
HEADS WE WIN, TAILS YOU LOSE
As internal debates in the Gulf and Asian nations intensify over the need to continue propping up the U.S. economy, dangerous signals this past week from the Fed, Freddie Mac, and Wall Street may be pushing them to finally let go of the lifelines that have kept America afloat.
Despite clear signs of surging prices in the U.S., the Fed took a major step in undermining its own credibility with its most recent forecast that inflation would remain below 2% for the next three years. As the forecast clearly paved the way for additional Fed rate cuts, Wall Street ignored its absurdity and heralded the announcement as legitimate good news. The celebration is likely infuriating foreign governments, who must be dumbstruck that the Fed can claim contained inflation at home while the declining dollar is fueling massive inflation problems around the world.
In order to maintain their pegs to the dollar, foreign central banks have been forced to print their own currencies to buy all the dollars accumulated by their exporters. This has resulted in upward pressure on consumer prices in their respective nations, with annual increases now reaching alarming rates. Bernanke’s message of benign neglect means U.S. exported inflation will likely increase substantially in the years ahead, exacerbating the inflation problems for those nations now supporting the dollar.
In December, OPEC nations will convene to discuss continuing their dollar pegs. If they were looking for a reason to drop them, the Fed may have just provided it.
Also this week, Freddie Mac announced billions in losses and indicated additional capital will be required to avoid insolvency. As shares of both Freddie and Fannie plunged, it must be increasing obvious to all that the mortgage crisis now affects the totality of U.S. mortgage-backed securities, many of which are owned by these very foreign central banks. As bankruptcy for these two quasi-government agencies becomes a serious threat, the implied U.S. government guarantee will certainly be called into question. If the government were to honor it, how many more dollars would be printed, and how much will those dollars be worth? Either way, contemplating the inflationary implications of these bankruptcies will weigh heavily on the minds of foreign central bankers with dollar pegged currencies.
Perhaps the icing on this “let them eat cake” mentality was provided by Wall Street itself. In a year with record losses, Wall Street firms announced that they would also be paying record bonuses to their employees. The rationale for this PR fiasco was that since the losses were not the fault of the employees (really?), they should not be made to suffer. So rather than sharing the pain being endured by their firms’ shareholders (clearly even less culpable then themselves), Wall Street’s fat cats will rub salt in their owners’ wounds by compounding their losses with the additional expense of lavish bonuses. Following the outlandish pay packages already given to ousted CEO’s who clearly were responsible for the losses, Wall Street’s “heads we win, tails you lose” attitude will not go over well abroad.
In many nations now supporting our currency, the only thing similarly disgraced CEOs would have taken would have been their own lives. If Wall Street firms care so little about their own shareholders, what confidence will customers have that their interests will be respected? Such disgraceful compensation in the wake of such horrendous losses, especially following the lousy advice given to clients to buy these toxic mortgage-backed securities in the first place, proves that the only wallets Wall Street executives watch are their own.
For a more in depth analysis of the tenuous position of the Americana economy and U.S. dollar denominated investments, read my new book Crash Proof: How to Profit from the Coming Economic Collapse.Link here.
A CRISIS TO SHATTER THE WHOLE WORLD
“He that diggeth a pit shall fall into it.” ~~ Ecclesiastes 10:8
The French president, Nicolas Sarkozy, was in Washington earlier this month, speaking to Congress en Français and telling the U.S. to stop dumping dollars and risking a global financial crisis. Ooh la la! Sounds just like old times.
“The dollar cannot remain solely the problem of others,” said Sarkozy before a joint session of Congress on November 7, riffing on the (infamous) joke made by John Connally, treasury secretary to Richard Nixon in the early ‘70s. Connally said the dollar was America’s currency, “but your problem.”
Au contraire, replied monsieur le president this week. “If we are not careful,” he went on – apparently using “we” to mean both himself and the U.S. Congress – “monetary disarray could morph into economic war. We would all be its victims.” Ooh la la again! Did Sarkozy need to take liquid courage before speaking his mind?
“What the U.S. owes to foreign countries it pays – at least in part – with dollars that it can simply issue if it chooses to,” barked French president Charles de Gaulle in a landmark press conference in February 1965. “This unilateral facility contributes to the gradual disappearance of the idea that the dollar is an impartial and international trade medium, whereas it is, in fact, a credit instrument reserved for one state only.”
De Gaulle did more than simply grumble and gripe, however. Unlike Nicolas Sarkozy, he still had the chance to exchange his dollars for a real, tangible asset – physical gold bullion. Gold “does not change in nature,” de Gaulle announced in that 1965 speech, as if he were telling the world something it did not already know. “[Gold] ... has no nationality [and] is considered, in all places and at all times, the immutable and fiduciary value par excellence.”
How to collect this paragon of assets? Back in the 1950s and 1960s, world governments could simply tip up at the Fed, tap on the “gold window”, and swap their unwanted dollars for gold. So that is what de Gaulle did. Starting in 1958, he ordered the Banque de France to increase the rate at which it converted new dollar reserves into bullion. In 1965 alone, he sent the French navy across the Atlantic to pick up $150 million worth of gold. Come 1967, the proportion of French national reserves held in gold had risen from 71.4% to 91.9%. The European average stood at a mere 78.1% at the time.
“The international monetary system is functioning poorly,” said Georges Pompidou, the French prime minister, that year, “because it gives advantages to countries with a reserve currency. These countries can afford inflation without paying for it.”
By 1968, de Gaulle pulled out of the London “gold pool” – the government-run cartel that actively worked to suppress the gold price, capping it in line with the official $35 per ounce ordained by the U.S. government. Three years later, and with gold being air-lifted from Fort Knox to New York to meet foreign demands for payment in gold, Richard Nixon put a stop to de Gaulle’s game. He stopped paying gold altogether.
De Gaulle called the dollar “America’s exorbitant privilege.” This privilege gave the U.S. exclusive rights to print the dollar, the world’s “reserve currency” and force it on everyone else in payment of debt. Under the Bretton Woods agreement of 1944, the dollar could not be refused. Indeed, alongside gold – with which the dollar was utterly interchangeable until 1971 – the U.S. currency was real money, ready cash, the very thing itself. Everything else paled next to the imperial dollar. Everything except gold.
“Printing a $100 bill is almost costless to the U.S. government,” as Thomas Palley, a Washington-based economist wrote last year, “but foreigners must give more than $100 of resources to get the bill. That’s a tidy profit for U.S. taxpayers.”
This profit – paid in oil from Arabia, children’s toys from China, and vacations in Europe’s crumbling capital cities – has surged since the U.S. closed that “gold window” at the Fed and ceased paying anything in return for its dollars.
Now the world must accept the dollar and nothing else. So far, so good, but the scam will work only up until the moment that it no longer does.
“The U.S. trade deficit unexpectedly narrowed in September,” reported Bloomberg on November 9, as “Customers abroad snapped up American products from cotton to semiconductors, offsetting the deepening housing recession that is eroding consumer confidence.” But Bloomberg missed the surge in U.S. import prices right alongside. They rose 9.2% year-on-year in October, up from the 5.2% rate of import inflation seen a month earlier.
Yes, the surge in oil price must account for a big chunk of that rise – and the surge in world oil prices may do more than reflect dollar weakness alone. The Peak Oil theory is starting to make headlines here in London. Not since the Club of Rome forecast a crisis in the global economy in 1972 have fears of an energy crunch become so widespread.
“At the end of 2006, China’s foreign exchange reserves were $1,066 billion, or 40% of China’s GDP,” notes Edwin Truman in a new paper for the Peterson Institute. “In 1992, reserves were $19.4 billion, 4% of GDP. They crossed the $100 billion line in 1996, the $200 billion line in 2001, and the $500 billion line in 2004.”
What to do with all those dollars? “If all countries holding dollars came to request, sooner or later, conversion into gold,” warned Charles de Gaulle in 1965, “even though such a widespread move may never come to pass...[it] would probably shatter the whole world. We have every reason to wish that every step be taken in due time to avoid it.” But the step chosen by Washington – rescinding the right of all other nation-states to exchange their dollars for gold – only allowed the flood of dollars to push higher.
Nixon’s quick-fix brought such a crisis of confidence by the end of the 1970s, gold prices shot above $800 per ounce – and it took double-digit interest rates to prop up the greenback and restore the world’s faith in America’s paper promises. The real crisis, however, the crisis built into the very system that allows the U.S. to print money that no one else can refuse in payment – was it merely delayed and deferred? Are we now facing the final endgame in America’s postwar monetary dominance?
If these sovereign wealth funds – owned by national governments, remember – cannot tip up at the Fed and swap their greenbacks for gold, they can still exchange them for other assets. BCA Research in Montreal thinks that “sovereign wealth funds” owned by Asian and Arabian governments will control some $13 trillion by 2017 – “An amount equivalent to the current market value of the S&P 500 companies.”
And if China does not want to buy the S&P 500 – and if Congress will not allow Arab companies to buy up domestic U.S. assets, such as port facilities – then the sovereign wealth funds will simply swap their dollars for African copper mines, Latin American oil supplies, Australian wheat – anything with real intrinsic value. They might just choose to buy gold as well. After all, it is “in all places and at all times ... the immutable and fiduciary value par excellence,” as a French president once put it.
Charles de Gaulle also warned that the crisis brought about by a rush for the exits – out of the dollar – might just “shatter the world.” It came close in January 1980. Are we getting even closer today?Link here.
MUCH TO BE THANKFUL FOR
In this season of reflection, a bucket of thankfulness should be reserved for Gretchen Morgenson of the New York Times. Her story last week reminded us how lucky we are that not that every management team is as creative as NovaStar Financial. NovaStar is (was) the highflying mortgage originator structured as a REIT. Its stock price, now below $2, was around $40 as recently as June.
A “nova” as regular visitors of the “Ask an Astrophysicist” website already know, is a sudden brightening of a star. This sort of thing can happen if two stars get too close together. Like two kids in the back seat of a Hyundai, one begins taking stuff from the other and things just build from there. If the bad behavior continues, nuclear fusion breaks out, making the instigator brighten, just like Dad’s face behind the wheel.
According to the astrophysicist, before the advent of telescopes, the sudden brightening would make a star seem to appear out of nowhere. Hence the name “nova” – which is Latin for reckless mortgage lending.
But NovaStar management was not just aggressive when it came to doling out hundreds of thousands of dollars to credit-challenged customers. They also doled out hundreds of thousands to themselves. Check that ... after careful consideration, the board’s compensation committee decided to reward management with a fair and balanced compensation plan. That is, they paid them lavishly. And yes, they got stock options. But thanks to a flash of innovation brighter than the sun, NovaStar execs received dividends on their stock options – just as if they owned the stock, even though they owned only the options, which are contracts and not securities, and which do not pay dividends. Unless your are a NovaStar exec. Brilliant!
This is where it may be appropriate to take a moment and say, “We are grateful for our bounty, the good health of our families, and the inability of so many other managements to be as creative as NovaStar.”
Although Ms. Morgenson no doubt has dozens of contacts in the investment community, she found the above information the same place investors large and small could have discovered it – in the company’s annual reports. The 2006 version explained that the clever incentive program delivered about $6 million to management over two years.
Now, there are not enough hours in the day to watch Cramer, download new trading software, and leaf through a bunch of annual reports. That is why you would think that at least one of the big players in the individual investor information industry (IIII) would have come up with some dandy corporate governance ratings. For example, is there any reason Morningstar cannot assign a “Five Pig” ranking for unusually high executive pay, or a “Four Cookie Jar” mark for suspect earnings quality?
It is not like no one is looking at corporate governance. In the institutional world, corporate governance is big business, particularly in respect to proxy voting. In fact, Pension & Investments recently pointed out that corporate governance firm, The Corporate Library, labeled Countrywide a “very high concern” way back in 2005 because of its governance risk. It was CFC’s executive compensation policies that made TLC skittish. But somehow, “earnings beats” got all the attention until they didn’t.
Maybe Value Line will come up with something. They have got “timing” and “safety” rankings. Why not a rating on company management? Since Value Line is big on numbers, they could score them 1-5 with, 5 being the most egregious offenders. Maybe something like:
Rating 1: The money the company spends on share buybacks merely soaks up dilution from stock options. Otherwise, management appears tolerable.
Rating 2: Earnings glitches are hidden by acquisition spree. Otherwise management appears tolerable.
Rating 3: Management compensation is higher than industry average. Retiring executives are guaranteed an island in Dubai shaped like Brazilian model Gisele.
Rating 4: Management makes more money than Alex Rodriguez. Thinks coal plants are the wave of the future. Company directors attend compensation seminar hosted by NovaStar.
Rating 5: Dick Cheney joins board.
Happy Thanksgiving.Link here.
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