Deus ex machina

Voltron says: The "Deus ex machina" of the '87 crash was portfolio insurance . . . basically "put" options. Most people think Credit Default Swaps will be the cause of the next crash. That may be, but then the crash after that will be caused by short ETFs such as SDS and SRS which make money when the market goes down. Unlike options, ETFs don't expire. Unlike a short position, you have limited downside risk. It's a less scary way to make money in a declining market. Right now the average investor is sitting like a deer in headlights - crippled by fear and lulled into complacency by Cramer on CNBC. Someday they'll look at what trades do well in a crash and they will start piling into short ETFs. That can create a bubble in reverse and cause the market to basically consume itself.

Grey Monday

Voltron says:

After Sunday's Fed hosted poker game, Bank of America bought Merrill Lynch and Lehman Brothers went bankrupt. Dow opened down around 300 points then bounced off of 11,100 a few times until plunging over 500 points for the day - the largest one day decline in six years.

Washington Mutual, the nations largest thrift, bonds are cut to junk (link) Possibility exists for a run of the bank. FDIC cannot cover all the deposits without raiding the US Treasury.

AIG, the nations largest insurance company, also had it's ratings cut and has received permission from New York State to raid $20 billion of it's own reserves. (link)

Meredith Whitney from Oppenheimer pulls out her crystal ball on CNBC (video) (summary)

Merrill Lynch downgraded several New York real estate investment trusts (link) Good news for SRS, but this is just the beginning.

The Federal Reserve is losing control of short term interest rates (link) an omen that preceded the crash of 1987. (link)

Financial entities are blowing up faster than I had expected and the situation is clearly beyond anyone's control but market prices still do not indicate capitulation. translation: we're not at the bottom yet.

Asia trading

Voltron says: It's looking ugly in Asia . . . Dow futures down 250 and the dollar down 2% versus the yen. Treasuries are rallying even though that's the last place you'd want to put your money. Gold is up 2.25%. It's quite possible gold will go down in the short term and the dollar will rise as people unwind their positions and raise cash. Don't bite off on the head fake. The big question that no one in the media is asking is WHAT DID LEHMAN HAVE ON THEIR BOOKS. Liquidation of these positions may be what moves the market in the short run. I have no idea what is on their books. I guess we'll find out on Monday.

WSJ: Bank of America may buy Merrill Lynch

Voltron says: I'm glad I did not short Merrill Lynch. Bank of America may buy Merrill for $29 per share, almost double Friday's close of $17.

from the Wall Street Journal:

Imagine you are John Thain, CEO of Merrill Lynch. Unlike [Lehman CEO] Dick Fuld, who has held tight, in July you sold collateralized debt obligations with a face value of $31 billion at 22 cents on the dollar. But you still are capital constrained.

And now you are asked by Treasury Secretary Hank Paulson, the man who didn’t make you CEO of Goldman Sachs, to put up billions of dollars to save Lehman? So that Barclays or Bank of America can pick up Lehman on the cheap to compete with you? It is humiliating enough that you may soon need one of those banks to bail you out. Indeed, the Wall Street Journal reports that BofA and Merrill are in merger talks.

Heads they win, tails we lose

CNBC: negotions on Lehman Brothers are breaking down

http://www.cnbc.com/id/26681709/site/14081545

$4 trillion

Voltron says: Now that our prudent government bureaucrats have taken control of prodigal sons, Fannie Mae and Freddie Mac they will surely end their profligate ways and quickly return to prudent lending standards. WRONG! Four senators have asked that they put a moratorium on foreclosures for 90 days. Hmmmmm, what’s happening within 90 days . . . hmmmmm . . . why would they want to prevent price discovery and market transparency during that time? Awww shucks, I can’t figure it out. They are also authorized to expand Fannie and Freddie’s loan portfolio until 2010. Also, the FDIC is refinancing IndyMac’s subprime loans at rates as low as 3 percent for terms as long as 40 years! They are also halting foreclosures until all the workouts can be done. OK, let’s engage in a thought experiment: Suppose the government refinances all mortgages at 3 percent for 30 years. If the mortgages are still “upside down” (i.e, the house is worth less than the mortgage), the borrower should still default. If the government offered mortgages at 3 percent for 30 years to NEW home buyers as well, then the house prices would rise so that the existing mortgages would not be upside down. OK, how much would that cost? Well, the 30 year t-bill rate is 4.5% so if the government refinanced the $10 trillion in outstanding mortgages at a cost of (4.5% minus 3%) it would cost about $4 trillion. Good thing Congress gave the Treasury secretary a blank check!

http://www.nytimes.com/2008/09/13/business/13fannie.html

Subprime Mortgage Crisis Blues

Last Gasp of a Doomed Currency

By Peter Schiff – Europacific Capital

 

Voltron says: this is why DKA, DBN and DBU are down.  Take advantage of this “head fake” and buy more.

 

In the latest example of financial market madness, the recent government “bailout” of Freddie Mac and Fannie Mae has perversely resulted in a sharp rise in the value of the U.S. dollar. If the markets were functioning rationally, the transference of staggering new liabilities to the U.S. Treasury would have been immediately seen as catastrophic for the dollar. Instead the markets have ignored the obviously negative long-term implications and have remained fixated on the more immediate effects. However, rather than solving the problems, the government’s actions merely confirm my worst fears, and increase the chances for a hyper-inflationary outcome.

 

By transforming $5.5 trillion of suspect mortgage-backed securities into seemingly bullet-proof Treasury bonds, the move has sparked a relief rally in the dollar as foreign investors no longer have to worry about defaults or markdowns. In fact, to holders of Fannie and Freddie debt, it no longer matters what happens to the housing market. Home prices can drop another 50%, every single homeowner can default on their mortgage, and bond holders will not lose one dime. This has emboldened foreign investors, and temporarily increased demand for both dollars and Freddie and Fannie debt.

 

Had the government done the right thing and not guaranteed Freddie and Fannie debt, I believe we would now be experiencing an outright financial crisis. The dollar would be falling sharply along with real estate prices, gold would be soaring and the recession would be deepening. However, by nationalizing Freddie and Fannie, the government has merely delayed the crisis. The borrowed time will cost us dearly, as the day of reckoning will now likely involve much steeper losses for our currency.

 

The Freddie and Fannie takeover does nothing to address the underlying problems that forced the companies into bankruptcy in the first place. All of the bad mortgage debt still exists. In fact, based on this bailout, there will be trillions more in bad mortgages insured over the next few years. The only thing that has changed is how the losses will be distributed. Instead of falling solely on bond holders, who had chosen to invest in mortgage debt, they will now be dispersed among U.S. taxpayers and all holders of U.S. dollars, who made no such choices.

 

Over the next year or two, my prediction is that several trillion dollars of existing mortgages, not currently insured by Freddie or Fannie, will be transferred to the pile. Going forward the vast majority of new mortgages made to Americans will be bought by Fannie or Freddie. Therefore in a few short years the $5.5 trillion of initially transferred liabilities could grow to more than $10 trillion of new obligations for the U.S. Treasury.

 

The defenders of the bailout claim that Fannie and Freddie debt does not represent true obligations because they are fully collateralized by homes. But anyone with a casual interest in the current real estate market knows that homes are now only worth a fraction of outstanding mortgage debt. And that fraction gets smaller every day. My guess is that $10 trillion of federally insured mortgages could result in $2 trillion of losses, which amounts to more than $25,000 per American family.

 

Also, there is no reason to believe that the bailout merry-go-round will end with Fannie and Freddie. Faltering investment bank Lehman Bros. is now positioned to receive the kind of Federal backstop that smoothed the purchase of Bear Stearns back in March. Bailouts of automotive and airline companies can’t be long in coming. Once the market perceives a Federal magic wand, it becomes politically impossible to stop waving it.

 

In addition to adding new sources of debt in the form of mortgage backed securities, the government is also piling on debt the old fashioned way…through budget deficits. Recent projections put the 2008 deficit at $410 billion, not counting the Iraq war or any costs related to financial bailouts. It is my guess that the annual Federal budget deficit will soon approach, and then exceed, $1 trillion, and that the national debt, including actual bonds and guaranteed mortgages, will soon exceed $20 trillion. When these untenable obligations force Treasury and agency investors to shift focus from default risk to inflation risk, a mass exodus from both Treasuries and mortgage-backed securities (now Treasuries in disguise) will ensue. The stampede will trample the dollar.

 

When the dust settles, the Federal government will be left with staggering liabilities that will be impossible to repay with legitimate means (taxation or borrowing). To make good, they must rely on the printing press to create money out of thin air. The rapid expansion in money supply will push the dollar down mercilessly.

 

Right now every asset on the planet is being sold except the U.S. dollar. To me this rally looks like the last gasp of a dying currency. Just like a toy rocket ship, once the dollar runs out of fuel it will crash back down to Earth.

Moral Hazard

Rescue Risks Setting Stage For New Woes

 

By MARK GONGLOFF, Wall Street Journal

 

The government's rescue of Fannie Mae and Freddie Mac may have averted a financial meltdown, but it could create other unintended problems.

 

In the short term, auto makers and other troubled industries might use the move to argue that they, too, deserve a taxpayer lifeline. Some foreign governments will use Uncle Sam's generous backstop as justification for market controls that may not be quite so constructive. And the move might further fan the election-year populism that already has free-market advocates gnashing their teeth.

 

The potential longer-term consequences may be more troubling. For one thing, unlike equity holders, debt holders in financial companies once again have been protected, as they were with Bear Stearns and others. That may lead these lenders to examine those companies less carefully, putting more burden on regulators to sniff out problems, warns Gerard Caprio, economics professor at Williams College and a former World Bank official.

 

What's more, lawmakers and regulators will eventually have to figure out how to shrink Fannie and Freddie, redistribute their portfolios and refine oversight of the U.S. mortgage business. Missteps could create loopholes that savvy investors can exploit, warns Anil Kashyap, a business professor at the University of Chicago and student of past financial crises.

 

In such regulatory soups new opportunities and risks are born. The Resolution Trust Corporation that ended the savings-and-loan crisis in the late 1980s led to a booming mortgage-securitization market that dumped buckets of cash on Wall Street. It also planted the seeds of the mess the government this weekend stepped in to solve.

Paulson's Quick Draw

By Peter Schiff – President, EuroPacific Capital

 

Treasury Secretary Henry Paulson, the man who said that subprime was contained and that the Bazooka in his pocket would never be used, now assures us that the bailout of Fannie Mae and Freddie Mac will be costless to taxpayers. Despite the near euphoria that the plan has sparked on Wall Street, the move will go down in history as the biggest policy blunder of all time, and will be credited as a pivotal point in the financial collapse of the American economy. The ultimate cost to Unites States citizens will be in the range of hundreds of billions of dollars, perhaps more.

 

The original idea that gave birth to Freddie and Fannie, which is to make housing more affordable to average Americans, should now be seen as farcical. Their new goal is to keep housing prices high. Absent Freddie and Fannie, housing prices would fall sharply and the mortgage market would stabilize. Americans would once again be able to buy affordable houses with mortgages they could actually repay –just like their grandparents did. Instead they will keep overpaying for houses, burdening themselves with excessive payments in the process, and ultimately sticking taxpayers with the bills when they default.

 

In contrast to Paulson’s continuous misreading of the market, I have consistently predicted the failure of Freddie and Fannie. I did so in my book Crash Proof, and in numerous speeches, commentaries and television appearances. I also was quick to point out that Paulson’s Bazooka would not remain holstered for long.

 

There is absolutely no substance to Paulson’s insistence that based on the government’s first claim on the future profits of Fannie and Freddie, the plan offers protection for taxpayers. There will be no future profits, just more heavy losses. Americans will now have unlimited ability to continue to overpay for houses and commit to mortgages they can’t afford. In fact, the plan insures that eventual public sector losses will vastly exceed those that would have befallen the private sector in a free-market resolution.

 

Paulson claims that his goal is to stabilize the mortgage market. But the best way to do so would be to allow housing prices to fall to a market clearing level. As long as home prices remain artificially high, the risks of mortgage lending will keep credit tight, and the high costs of mortgage payments will keep potential buyers on the side-lines. With private lenders justly cautious, the government intends to hold open the lending spigots, without the pesky concerns over losses or financial risk. The hope is that the new lending will prevent home prices from falling further. It won’t work. The government “solution” will simply delay the fall of artificially high home valuations and temporarily preserve the illusion of prosperity.  (Until the election/inauguration –Voltron)

 

In order to preserve current home prices, the government will be forced to maintain the lax lending standards that got us into this mess in the first place. Since all the losses will now be borne by taxpayers, those lax standards will be much more problematic. The moral hazard that existed prior to this bailout has become that much more hazardous. Every mortgage now insured by Fannie and Freddie is the equivalent of a U.S. Treasury bond. This allows anyone to borrow on the full faith and credit of the U.S. government so long has the money is used to buy a house. In addition, mortgage lending will now be a government function, run with Post Office-like efficiency.

 

Of course the biggest collateral damage caused by Paulson’s bazooka is the large hole ripped through the already tattered U.S. Constitution. If the government can do this, does anyone believe there is anything it can not do? In effect the Federal government now has absolute power to corrupt absolutely.

 

For a more in depth analysis of our financial problems and the inherent dangers they pose for the U.S. economy and U.S. dollar denominated investments, read my new book “Crash Proof: How to Profit from the Coming Economic Collapse.”

Out of Lehman

Voltron says: Lehman finally cracked $12 today.  Then $11, then $10, then $9 and is now trading with an 8 handle.  I’ve covered my short position.

 

http://biz.yahoo.com/zacks/080909/14625.html

Treasuries down

From the July 17th issue of “The Economist

 

“Nationalization . . . would bring the whole of Fannie’s and Freddie’s debt onto the federal government’s balance sheet. In terms of book-keeping this would almost double the public debt, but that is rather misleading. It would hardly be like issuing $5.2 trillion of new Treasury bonds, because Fannie’s and Freddie’s debt is backed by real assets. Nevertheless, the fear [is] that the taxpayer may have to absorb the GSEs’ debt . . . . That suggests yet another irony; the debt of the GSEs has been trading as if it were guaranteed by the American government, but the debt of the government was not trading as if Uncle Sam had guaranteed that of the GSEs.”

 

Voltron says: This irony (or paradox) has been resolved:  the GSE debt was priced correctly and government debt was priced incorrectly.  The government’s intent in bailing out the GSEs was to raise the value of GSE debt (decrease borrowing costs) but since that proves that government debt was mispriced; it is government debt prices that will adjust.  In fact, this has started happening already.  The Treasury’s actions will do nothing to fix the housing bust.  It will just make the budget deficit worse.  It will collapse the dollar and cause inflation.  It will drive banks holding GSE equity into the arms of the woefully undercapitalized FDIC.  If fannie and Freddie couldn’t make money with all of their “implicit guarantees” and tax advantages and everything else . . . how are regular banks supposedly profitable?  Of course there’s optimism in the market that the Fed and Treasury Dept are taking decisive action, but the fact that they are doing it now is evidence that the problem is much much worse than they were previously willing to admit.  The government is bent on doubling down again and again until the election/inauguration.

 

More background and analysis here.

CDS supernova coming

 

Voltron says:  it’s official: credit default swaps on Fannie and Freddie are being triggered (link)

 

What next?

Voltron says: The collapse and bailout of Fannie and Freddie is possibly bigger than then Enron and every other accounting scandal combined. So what does this mean to my forecast? Well, we now have a very large, important and irrational player in the game – the government. There is a fascinating power struggle between Washington and Wall Street. Politicians get big donations from Wall Street (including Fannie and Freddie to the tune of $186 million), but politicians are resentful of Wall Street’s conspicuous wealth and the power it can buy. Now Wall Street has finally overleveraged and painted themselves into a corner. They are calling in all of their favors, but they are so beaten up this time that Washington can pull the rug from under them. Bill Gross, PIMCO’s top bond fund manager has bet heavily on a Fannie/Freddie bailout (link) and on Friday he said that if he doesn’t get one, he’ll take his ball and go home (link). The government can do anything from nothing, to a complete - throw moral hazard to the wind - socialize the losses bailout of everyone at taxpayer expense, to total nationalization of the banking system. I’m not sure which way they are going to go, but in any case it’s not good for the US dollar.

Keep an eye on Lehman

Voltron says: Lehman is trying to split into a “good bank” and a “bad bank” (link). If that sounds a bit fishy, that’s because it is. It’s fraudulent conveyance and it’s illegal. Of course, that won’t stop Lehman from doing it because after all their CEO is on the board of the Federal Reserve Bank of New York. If that happens the shareholders will be issued share is in the good bank and the bad bank. Most people will dump the shares of the bad bank and the stock will plummet. Shares in the good bank will most likely rise. If that happens and you are short Lehman (like me) you will be short shares of good Lehman and bad Lehman. If you cover both, you may initially take a loss because after all, Lehman is doing this to increase the overall value (hoping the whole is worth less than the sum of its parts). The trick is to cover the bad Lehman when it plummets and stay short the “good Lehman” until people figure out the scam and it goes down too.

Also the rats have been jumping ship (link, link) which makes selling off parts of the firm less likely.

Fannie and Freddie bailout official

Voltron says:  According to the New York Times (article linked from my previous post) Fannie and Freddie were Phoney and Fraudy.  What the government hired forensic auditors and bankers have uncovered so far is that they were keeping tax losses on their books as “assets” even though there was no reasonable expectation of taxable income to use them to offset in the near future and while most banks start writing off a mortgage if it’s 90 days late, F&F WAITED TWO YEARS!  And they need to refinance $223 billion is short term debt in the next few weeks.

 

Here’s what we know: http://www.forbes.com/2008/09/07/fannie-freddie-bailout-biz-cx_lm_0907mortgage.html

 

Commercial Banks hold preferred stocks in F&F because the FDIC considers it as good as cash and there are tax advantages.  It is unclear if the deferred dividend payments on the preferred stocks will send commercial banks into the arms of the undercapitalized FDIC (link).  It is also unclear if it will trigger an apocalyptic chain reaction of credit default swaps (link) like what nearly brought down the financial system when Bear Stearns went under.

 

Here’s some indignation courtesy of the colorful Mr. Mortgage: http://mrmortgage.ml-implode.com/2008/09/07/fanniefreddie-massive-fraud-breakdown/

NYT: Why fannie and freddie are getting bailed out NOW

http://www.nytimes.com/2008/09/07/business/07fannie.html?_r=1&pagewanted=print

Fannie and Freddie Bailout

Voltron says: There is some kind of bailout of Fannie Mae and Freddie Mac that will be announced on Sunday. Rumors abound. At question is to what extent the stock holders, the preferred stock holders and bond holders will take a loss. Fannie and Freddie financed $5 trillion in mortgages. That's half of the mortgages in the U.S. and comparable in size to the national debt. F&F are not government agencies, but the people treated them as if they were. As a result they were able to borrow money very cheaply, and people were willing to lend to them because they got paid a little bit more than if they loaned money to the government. As private profit seeking companies accountable only to the shareholders, they acted rationally; they made as many stupidly risky loans as they could as quickly as they could to make as much money as possible in the shortest amount of time. They were also embroiled in accounting scandals and their accounting is still a mess and nobody knows what lurks in their $5 trillion portfolios of exotic financial instruments. When I say nobody I mean NOBODY, including themselves. They eventually became "too big to fail." Much of that debt is owned by foreign governments which whom we have a trade deficit, such as China and Japan. They (wrongly) view the debt as U.S. government debt and it would be a diplomatic disaster if F&F defaulted. Many banks own the preferred stock because the dividends has special tax treatment (thanks again, government). There are also trillions of dollars in credit default swaps - i.e., insurance on F&F debt that will trigger a massive cascade of bankruptcies if F&F ever defaults. So here we are. I'll post the details and my analysis when they are announced. In the meantime, enjoy Treasury Secretary Paulson getting schooled by Sen Jim Bunning (R-Kentucky) when he asked congress for a blank check to defend F&F.



He got what he asked for.

Down the Rabbit Hole

Voltron says: Genius is the ability to hold two contradictory thoughts in your mind at the same time.

By Peter Schiff - EuroPacific Captial

In recent months, investors have been unjustly chastised for their lack of consistency. In truth, they have an unblemished record of drawing the wrong conclusions. Last week’s 2nd quarter GDP report provides the freshest evidence of market cluelessness.

In its report, the Commerce Department stunned economy watchers by showing a 3.3% annualized increase in 2nd Quarter GDP. The robust growth apparently wrong-footed those expecting further recessionary signals, lent further strength to the current dollar rally, and encouraged previously cautious investors to take another look at U.S. stocks. The strong number also bolstered claims by the Bush administration and the McCain campaign that a recession is primarily a psychological phenomenon. These conclusions would be at least quasi-logical if they were not based on a complete misreading of the report.

Without raising an eyebrow on Wall Street or in the press, the GDP deflator, used in the report to downwardly adjust GDP to account for inflation, was shown at just 1.2% annualized.... the lowest deflator in ten years. In other words, to arrive at a 3.3% growth rate, the government assumed that inflation is running at a ten-year low! In contrast, the latest reading on consumer prices (CPI) in the second quarter shows year-on-year inflation running at a 5.6% rate, a seventeen-year high! In fact, for the second quarter, the same time period measured by the GDP deflator, prices actually rose at an even faster pace of 8.0% annualized. How can it be that inflation is simultaneously running at a seventeen-year high and a ten-year low? Welcome to the Alice in Wonderland world of government statistics.

You would think that this statistical bombshell would raise the hackles of the press. Think again. Not only did the hawk-eyed media completely miss the story last week, they have totally ignored our subsequent attempts to show them the light (with the exception of the N.Y. Post’s John Crudele – who has long suspected a ruse). Although none of the reporters we spoke with could explain why inflation could run at a 10 year low and a 17 year high at the same time, they did not deem the anomaly sufficiently noteworthy. Having been ignored by reporters, I then tried the opinion pages. Unfortunately the piece that we prepared on the subject was rejected this week by all the leading national newspapers.

Reporter Michael Mandel did note the head scratcher on a Businessweek blog posting last Friday. As a partial explanation he pointed out the CPI measures the prices of what we buy, and the GDP deflator measures the prices of what we make. Although this certainly sheds some light, it offers no real explanation. Excluding imports and exports, both measures are determined by the same forces, and should move in relative harmony. If anything, the costs of what we make should be outpacing the costs of what we buy. Producer prices are now rising faster than consumer prices (the latest annual reading of the Producer Price Index ‘PPI’ being 13.2% annualized from the 2nd quarter), which helps explain why corporate profits have fallen drastically. In addition, from July 2007 through July 2008 (the latest data available) import and export prices have risen 21.6% and 10.2% respectively. In other words, no matter what numbers you use, the 1.2% GDP deflator simply doesn’t add up.

I have often argued that government statics are dubious, particularly those related to inflation. But here is an example where they are not even consistent! If we simply use second quarter CPI to adjust nominal second quarter GDP for inflation, the number would have registered a 3.5% annualized decline.

Such horrific GDP numbers are much more consistent with the anecdotal recession evidence that Wall Street and Washington want us to ignore (confirmed by today’s weak jobs report which included the unemployment rate spiking to 6.1%, a five-year high). However, with Orwellian propaganda, our government fabricates GDP growth out of thin air without the smoke and mirrors traditionally required for such an elaborate illusion. All that is required is to put out ludicrous statistics and hope no one notices. Given that this strategy appears to be working, expect future government numbers to get even more outrageous. After all, if they can get away with this, they can likely get away with anything.

Investors relying on this data and reacting to the global economic slowdown by buying dollars and other U.S. based assets while selling gold, commodities, and foreign assets, are jumping out of the frying pan right into the fire. My guess is that it will not be much longer before they feel the heat.