Debt Rattle, February 24 2008

Ilargi: And here's for your quiet Sunday disaster reading, starting with the longest sentence we've ever had, which summons it all up pretty well.


Things Are Beginning to Look Grim

Apparently, things are looking grim these days as the debt crisis that was initially contained to subprime mortgages, and then contained to investors in assets collateralized by subprime mortgages, and then to all residential-backed mortgage securities, and then to structured investment vehicles filled with collateralized debt obligations, and then to the money center banks that sponsored these structured investment vehicles, and then to short-term enhanced money market funds, and then to the bond insurers that may have underestimated the risk of the bonds they were insuring, and then to short-term auction rate securities, and then to corporations, institutions, schools and municipalities that may have assets in short-term auction rate securities that no one wants to buy or sell, and then to the corporate bond market, and then to the municipal bond market, spreads to Main Street.


Meanwhile, as the Debt Crisis becomes more apparent to Main Street, government officials, including most notably President George W. Bush and Treasury Secretary Henry Paulson, who insist "no government bailout" is in the works, are busy working diligently to maintain the ongoing government bailout using public institutions such as the Federal Housing Administration and Federal Home Loan Bank system while simultaneously shaking the bushes to draw out even more exotic bailout proposals.

Among the proposals being considered are broad "rescue bills" that would enable the government to purchase outright some troubled mortgages and even a plan offered up a few days ago by the Office of Thrift Supervision that would create a system allowing borrowers to refinance into government-insured loans that cover the current value of their homes while the refinancing package would pay part of what's owed to the original lender with the remainder of the balance that isn't covered issued to the lender as a "negative equity certificate." The lender could then redeem the certificate if the home is eventually sold at a higher price.

This is nothing new. As the Debt Crisis continues its inexorable march from Wall Street to Main Street the call for government intervention will grow louder, the pressure more intense.

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The Bonfire of Capital

Last week the noose tightened around auction-rate securities, a little-known part of the market that requires short-term funding to set rates for long-term municipal bonds. The $330 billion ARS market has dried up overnight pushing up rates as high as 20 per cent on some bonds -- a new benchmark for short term debt. Auction-rate securities are now headed for extinction just like the other previously-vital parts of the structured finance paradigm.

The $2 trillion market for collateralized debt obligations (CDOs), the multi-trillion dollar mortgage-backed securities market (MBSs) and the $1.3 asset-backed commercial paper (ABCP) market have all shut down draining a small ocean of capital from the financial system and pushing many of the banks and hedge funds closer to default.

The price of insuring corporate bonds has skyrocketed in the last few weeks, making it more difficult for businesses to get the funding they need to expand or continue present operations. Much of this has to do with the growing uncertainty about the reliability of credit default swaps, a $45 trillion dollar market which remains virtually unregulated.

It all sounds more complicated than it really is. Imagine a 200 ft. conveyor belt with two burly workers and a mountain-sized pile of money on one end, and a towering bonfire on the other. Every time a home goes into foreclosure; the two workers stack the money that was lost on the transaction, plus all of the cash that was leveraged on the home via "securitization" and derivatives, onto the conveyor-belt where it is fed into the fire.

That is precisely what is happening right now and the amount of capital that is being consumed by the flames far exceeds the Fed's paltry increases to the money supply or Bush's projected $168 billion "surplus package". Capital is being sucked out of the system faster than it can be replaced which is apparent by the sudden cramping in the financial system and a more generalized slowdown in consumer spending.

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All The Kings Horses

Here's the theme of a best seller, another in our series of the Best of Capitalstool.com. "All the Kings' men and all the Kings' Horses cannot put the A-A-A rating back together again! How many times have we been told about the bail-out of the bond insurers?

First we had the Federal government bailout discussion. Did not happen and can't happen, but that's another story. Then we had Wil Ross on Crapvision in January and saying he is looking at the bond insurers. Did not happen. And mind you, all these stories caused the market to rise for a day. Then we had Warren Buffet's pitch. Did not happen. Then we had the state bail out discussion. Now we have the bag holders, rather the banks, looking to buy an AAA rating.

The story on Crapvision just demonstrates that you can't make a Triple AAA rating out of junk, nor can you buy a AAA rating. But this is what the pig men have been doing. Their thinking is bankrupt and so is their system. But more importantly, the article really tells you how desperate things really are. This latest bail out story will have the opposite effect.

On Monday, if a deal is announced the banks stocks will be sold again. Just like they were sold after the government SIV deal fell apart forcing the banks to bring back that bad debt onto their balance sheet. When will folks realize they can't fix this mess?

Next Best Seller: Bond Rating School for Dummy's entitled: ‘How to get Triple A Ratings on Junk.’ Of course this best seller has already been written. All these "in-process" blow-ups have to be the best "Who-Dun-It" stories of all time. What a pathetic mess.

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Fannie and Freddie Losses To Offer Gauge on Defaults

When Fannie Mae and Freddie Mac report fourth-quarter results in the coming week, shareholders will be nervously surveying the damage from rising defaults on home mortgages owned or guaranteed by the two companies. Both are expected to post big losses, as they did in the prior quarter. Merrill Lynch downgraded their shares to "sell" Friday. With housing in a deep slump, the financial health of these government-sponsored behemoths matters to Americans in general, not just their long-suffering shareholders.

Fannie and Freddie acquire home loans and hold them as investments or bundle them into securities held by other investors. They collect fees for guaranteeing payments on those so-called securitized loans -- and take a hit when lots of homeowners default. Though Fannie and Freddie are owned by private shareholders, the companies were created by Congress to help ensure a steady flow of money into housing. Investors assume the government would bail them out in a crisis.

The huge role Fannie and Freddie play in the mortgage market has grown even bigger since mid-2007, when other investors took fright and virtually stopped buying home loans other than those guaranteed by Fannie and Freddie or insured by the Federal Housing Administration. Meanwhile, another set of government-sponsored institutions -- the 12 regional Federal Home Loan Banks -- have stepped up their lending to mortgage companies cut off from other sources of funds.

The mortgage market is now so reliant on funds from government-related entities that it has been "effectively nationalized," says Richard Iley, an economist at BNP Paribas. These institutions have kept the credit spigots open for home mortgages, but "potentially there are very large liabilities for the taxpayer," Mr. Iley says.

Freddie, which is scheduled to report results Thursday, is forecast to post a loss of about $1.6 billion, or $2.54 a share, according to the mean analyst estimate compiled by Thomson Financial. The mean forecast for Fannie -- whose results are due in the coming week, though the day hasn't been announced -- calls for a loss of about $1.1 billion, or $1.13 a share, Thomson says. Those forecasts are only a rough guide because analysts find it hard to predict how the results will be affected by such things as swings in the value of loan-guarantee obligations.

Heavy losses in the third quarter forced Fannie and Freddie to raise a combined $13 billion through the sale of preferred shares late last year to shore up their capital. But David Hochstim, an analyst at Bear Stearns, says another trip to the capital trough isn't likely in the near term. He says that Fannie and Freddie have been able to raise the fees they charge lenders, and he expects their regulator eventually to remove a "surcharge" that for now requires the companies to hold 30% more capital than their normal statutory minimum.

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Pushers, Lenders and Debt Junkies

Is the analogy that lenders and banks are essentially pushers and Americans are debt junkies over the top? Perhaps not.

Let's start with a pernicious truth about credit: if you don't have any, then you'll never be able to obtain a home mortgage. Like any good pusher, the lending industry must first create a need, and then be the only source to fill it. In this case, the "need" is a high credit rating, for without a good credit rating, you will be unable to qualify for a conventional (low interest rate) mortgage.

So how do you establish good credit? By taking on debt. There is no other way. It's a pretty sweet setup: if you ever want to buy a house via a mortgage, then you have to open and use credit accounts--the more the better in terms of establishing a high credit score. Having one revolving credit account (say, a Sears charge card) isn't going to do much for your creditworthiness; better to have a half-dozen credit accounts which you pay on time like clockwork. That establishes you can handle debt responsibly.

You know what lowers your credit rating? A bunch of unpaid loans, to be sure, but having no credit cards or other loans (consumer debt, auto, etc.) also marks you as a credit risk. No credit history? You're a risk. Thus paying in cash one's entire life will insure that mortgage lenders will cast a gimlet eye on your application.

The "pusher" -the lending industry- now has an unbeatable sales pitch: if you ever want to own a piece of the American Dream, come open a bunch of credit accounts.

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Splitting headaches

“We were not designed or structured to be the most important company in the entire financial system,” said Jay Brown on February 19th as he returned to MBIA, charged with steadying the company he had run from 1999 to 2004. You may think otherwise, given the markets' fevered concern over the “monoline” bond insurers. 

Thanks to unwise forays into mortgage-backed securities, an industry that a year ago was basking in profitable obscurity now stands accused of endangering large chunks of the financial system, including Wall Street banks and the huge market for municipal bonds. With rating agencies preparing to downgrade them to levels that could destroy their business, and regulators pushing for bail-outs or break-ups, the monolines' moment of truth has arrived. For anyone linked to the $2.4 trillion of securities they have guaranteed, it is nail-biting stuff.

The sense of urgency has increased since Eric Dinallo, the insurance regulator for New York state, stepped up pressure on banks to offer help. At a congressional hearing on February 14th, Eliot Spitzer, New York's governor, gave the insurers a few days to strike rescue deals or face government intervention—meaning, probably, forced break-up into good books (the original “monoline” business of backing municipal bonds) and bad ones (collateralised-debt obligations and the like).

Auction-rate bonds may never recover. That would not be catastrophic. They are extra gears, engineered by over-achieving bankers, rather than essential market cogs. May the same be true of bond insurance? The crisis shows it is only as good as its underwriters, and they have proved inept. Moreover, muni bonds are rated using tougher criteria than corporate bonds. If they were not, most would be almost AAA, reducing the need for insurance.

The more pressing question is whether the government should intervene in any other way than encouraging talks. There are grounds for scepticism. As painful as the disruption in municipal markets is, it looks temporary. Rates fell this week, and high-quality issuers were able to raise finance in municipal-bond markets.

Moreover, there is no supply crisis in the monoline business: Warren Buffett has entered the market (even offering to take on rivals' municipal businesses) and some less-troubled monolines, such as FSA, are grabbing market share. The monolines' woes are already largely priced in. There is scant evidence that leaving their fate to market forces, though it may be painful, would bring down Wall Street banks. If the banks see the danger growing, they will have even more incentive to find the money to help.

On top of which, a state-mandated break-up could trigger a wave of lawsuits, further eroding trust in the system. Eager as they are to be seen doing the right thing, Messrs Dinallo and Spitzer should wait to see graver danger than this before they meddle in private contracts.

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Euro May Get Boost From 'Abrupt Shift' by State Funds

An "abrupt shift" by state investment funds into euro-denominated assets could fuel gains in the currency, according to a draft European Commission paper. "While an increased international use of the euro would definitely bring benefits, an abrupt shift towards the European currency" by sovereign wealth funds "could put unwelcome upward pressure on the euro and should be avoided," according to the draft paper obtained by Bloomberg News. The final paper will be presented to European finance ministers next month.

Against the currencies of the euro region's 24 biggest trading partners, the euro has strengthened 5.8 percent in the past year, hurting the competitiveness of the exports that drove economic growth since 2006. Europe posted its first trade deficit in more than a year in December as the euro's gains and slowing global growth curbed shipments abroad. Governments, which use sovereign wealth funds to invest windfall revenues in foreign equities and other assets, have increased their holdings of the euro recently.

The dollar's share of global foreign-exchange reserves fell to a record low in the third quarter as demand for U.S. assets waned after the collapse of the country's subprime-mortgage market. The dollar accounted for 63.8 percent of reserves at the end of September, down from 65 percent three months earlier, according to International Monetary Fund data. The euro's share rose to 26.4 percent from 25.5 percent. IMF quarterly figures go back to 1999, the year the euro was introduced.

Sovereign wealth funds, or SWFs, will quadruple in size to $7.9 trillion by 2011 from $1.9 trillion last year, according to Merrill Lynch & Co. In an October report, Merrill said the flood of cash may put pressure on the dollar as central banks diversify their reserves into other currencies.

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It's looking bleak, experts tell Darling

Alistair Darling is facing a major deterioration in the public finances in the coming years, despite having raked in a record month's tax receipts in January, experts warned.

The Chancellor was buoyed yesterday by news of a record budget surplus, but analysts warned that the public finances remain in a poor state ahead of Mr Darling's first Budget on March 12. The public finances generated £14.1bn more than was spent in January, according to the Office for National Statistics. It is the highest monthly surplus since records began in 1993, and was bigger than most economists had forecast.

It was driven by a larger-than-expected leap in income tax receipts, as households filling in self-assessment forms submitted their tax payments for last year. The increase will help the Chancellor near his £38bn forecast for borrowing in the Budget next month. But while the Institute for Fiscal Studies and the Ernst & Young Item Club said Mr Darling may just hit his target, which was set in last Autumn's Pre-Budget Report, they added that with the economy set to slow down in the coming months the outlook for next year was far less positive.

The Item Club's Peter Spencer said: "Looking ahead, the position looks bleak for the Chancellor. The Treasury has been running a current deficit - borrowing to finance current spending - while the economy has been booming. Now it's a different story. The slowdown in the economy will hit the revenue side hard, making it more difficult for the Chancellor to attain forecasts."

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Sandler faces Northern Rock funding quandary

The nationalisation of Northern Rock will not include the £50bn off-balance sheet vehicle called Granite which funds half of the Newcastle-based lender's mortgages. If Granite were to go under, the state-owned Northern Rock would be at the bottom of the queue of creditors, meaning taxpayers could face a £5.5bn loss. The Government yesterday confirmed that Granite, which is a Jersey-based trust, would not be covered by the nationalisation legislation.

The Conservatives warned the revelation meant the move was risky for the taxpayer. Northern Rock set up Granite to fund about half its mortgage book. It owns an 11.5pc stake worth about £5.5bn. As the bank is set to pass into public hands as early as Friday, that liability will pass to the taxpayer, the Conservatives pointed out. 

Granite is unlikely to collapse but its existence puts Northern Rock's incoming executive chairman, Ron Sandler, in a difficult position. He has to strike a balance between shrinking the bank fast so assets can be freed up to repay the Government's £25bn loan, and keeping Granite funded. Investors in Granite have bought bonds which mature at certain points and are invested in mortgage assets. 

Mortgages which get paid off or moved to a rival company have to be replaced in a process known as "feeding the beast". Granite's bonds range in quality from triple A through to below B, but most of the vehicle is invested in high quality mortgages. Therefore, as mortgages in Granite are paid off, Northern Rock must either replace them with the good mortgages from the rest of its portfolio, or go out into the market to win new customers with a low risk profile.

Alternatively, Mr Sandler could decide to liquidate Granite. Sandy Chen, an analyst at Panmure, said the move might make sense. "It would shrink the size of the book and if you are bearish about the UK mortgage market, it might make sense to sell now rather than later." Liquidation would only work if Northern Rock thought it could make enough money to repay all the bondholders and cover its own shareholding.

Separately, Northern Rock will scrap its Together mortgage, the 125pc loan it used to ramp-up its new lending in 2006 and the first half of 2007. Meanwhile, Northern Rock has yet to publish its 2007 results.

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Death by Slow-Motion Asphyxiation

Just reading through the various mainstream media stories and articles one can sense that faith in the Wizard of Oz is really waning. Typical is this one by Jon Markham on why the prop jobs are failing. He points to the two reasons long expressed on this blog: 1. the fictitious pricing of securities and capital and the wounding of the Riskloves. and 2. a complete lack of confidence in the character and ethics of Pig Men financial institutions. He says on the later:

To breathe a meaningful amount of new oxygen into the financial system, and thus effect a lasting reversal in the fortunes of major banks and stocks, experts now believe will require hundreds of billions of dollars just as a baseline. Plus we'll need to see a restoration of confidence in dishonored regulatory bodies, bank execs and ratings agencies, and quite possibly wholesale changes in the way financial companies are governed and managed worldwide. For all that, add the most precious commodity of all: time. Until U.S., European and Asian central banks, investors and governments can coordinate a solution on an unprecedented scale, all interim white knights are doomed to fail.

The highlighted portion is absolutely correct. Of course few have been tracking "progress" on this front more so than this blogger and his readers. And the verdict on transparency and credibility is clear so far, it's only gotten worse. And reform of financial institutions, hardly, as so far we've seem some modest write offs, no doubt forced by accountants covering their own tawdry rear ends. We have seen a merry-go-round of sleazy characters going out with huge golden parachutes only to be replaced with Winston Wolfe types. Winston Wolfe was the clean up guy played by Harvey Keitel in Pulp Fiction you may recall. He was brought in to clean up the brain tissue on a botched hit. Does that restore dishonored institutions in a positive way?

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Bernanke's State of the Economy speech: "You are all dead ducks"

Even veteran Fed watchers were caught off-guard by Chairman Bernanke's performance before the Senate Banking Committee last Thursday. Bernanke was expected to make routine comments on the state of the economy but, instead, delivered a 45-minute sermon detailing the afflictions of the foundering financial system. The Senate chamber was stone-silent throughout. The gravity of the situation is finally beginning to sink in. For the most part, the pedantic Bernanke looked uneasy; alternately biting his lower lip or staring ahead blankly like a man who just watched his poodle get run over by a Mack truck.

As it turns out, Bernanke has plenty to worry about, too. Consumer confidence has dropped to levels not seen since the 1970s recession, real estate has gone off a cliff, credit brushfires are breaking out everywhere, and the stock market continues to gyrate erratically. No wonder the Fed chief looked more like a deckhand on the Lusitania than the monetary czar of the most powerful country on earth. Bernanke's prepared remarks were delivered with the solemnity of a priest performing Vespers. But he was clear, unlike his predecessor, Greenspan, who loved speaking abstrusely. Bernanke:

As you know, financial markets in the United States and in a number of other industrialized countries have been under considerable strain since late last summer. Heightened investor concerns about the credit quality of mortgages, especially subprime mortgages with adjustable interest rates, triggered the financial turmoil. However, other factors, including a broader retrenchment in the willingness of investors to bear risk, difficulties in valuing complex or illiquid financial products, uncertainties about the exposures of major financial institutions to credit losses, and concerns about the weaker outlook for the economy, have also roiled the financial markets in recent months."

Yes, of course. The banks are ailing from their subprime investments while Europe is sinking fast from $500 billion in unsalable asset-backed garbage. The whole system is clogged with crappy paper and deteriorating collateral. Now there are problems popping up in auction rate sales and the normally safe municipal bonds. The whole financial Tower of Babel is cracking at the foundation. Bernanke continues:

Money center banks and other large financial institutions have come under significant pressure to take onto their own balance sheets the assets of some of the off-balance-sheet investment vehicles that they had sponsored. Bank balance sheets have swollen further as a consequence of the sharp reduction in investor willingness to buy securitized credits, which has forced banks to retain a substantially higher share of previously committed and new loans in their own portfolios. Banks have also reported large losses, reflecting marked declines in the market prices of mortgages and other assets that they hold. Recently, deterioration in the financial condition of some bond insurers has led some commercial and investment banks to take further markdowns and has added to strains in the financial markets.

Bernanke sounds more like a New Testament prophet reading passages from the Book of Revelation than a central banker. But what he says is true. even without the hair shirt. The humongous losses at the investment banks have forced them to go trolling for capital in Asia and the Middle East just to stay afloat. And, when they succeed, they're forced to pay excessively high rates of interest. The true cost of capital is skyrocketing.

That's why the banks are protecting their liquidity and cutting back on new loans. Most of the banks have also tightened lending standards which are slowing down the issuance of credit and threatens to push the economy into a deep recession. When banks cramp-up, the overall economy shrinks. It's just that simple, no credit, no growth. Credit is the lubricant that keeps the capitalist locomotive chugging-along. When it dwindles, the system screeches to a halt.

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The Muddle Through Fed

"The Federal Reserve Board notes that savings rates for three groups: The first is that of homeowner's who have no line of home equity credit; the 2nd is the entire US population, and the 3rd is that of homeowners with home-equity lines of credit. Rounding the averages off to the nearest percentage point, the data shows that back in 1991, all three groups had savings rates very near to 10%. The differences between the three were effectively nothing.

"Nine years later, all three groups had had their savings rates turn negative, but the differences between the three had become quite large. Those without a home-equity line of credit had a savings rate of approximately -3%; the population at large had a savings rate that was marginally worse, but only barely so.



"However, those with a home equity line of credit allowed their savings rate to deteriorate to approximately -9%. By '05, the 'spread' had become even worse, as the first group had a 0% savings rate; the 2nd group had a rate of approximately -2%, and the 3rd group had allowed its fiscal circumstances to deteriorate to such a degree that its savings rate had fallen to -13%!

"Last year, the 1st group had returned to a small positive number, with a savings rate of 1%; the population at large had a savings rate of 0%, while the 3rd group was either trying to move in the proper direction or was being forced to do so, for although it still had a negative rate of savings, it had moved from the disastrous -13% to a somewhat less disastrous -7%. To paraphrase Shakespeare, 'some are borne to savings; some achieve savings, and some have savings thrust upon them.'"

This is indicative of something I have been writing about for some time: the collapse of the housing market and a recession is going to be a wake up call for consumers, and especially those approaching retirement. The thought that "You better be careful what you wish for, you might just get it good and hard" comes to mind when people bemoan the low savings rate in the US.

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Antarctic glaciers surge to ocean

UK scientists working in Antarctica have found some of the clearest evidence yet of instabilities in the ice of part of West Antarctica. If the trend continues, they say, it could lead to a significant rise in global sea level. The new evidence comes from a group of glaciers covering an area the size of Texas, in a remote and seldom visited part of West Antarctica. The "rivers of ice" have surged sharply in speed towards the ocean.

David Vaughan, of the British Antarctic Survey, explained: "It has been called the weak underbelly of the West Antarctic Ice Sheet, and the reason for that is that this is the area where the bed beneath the ice sheet dips down steepest towards the interior. "If there is a feedback mechanism to make the ice sheet unstable, it will be most unstable in this region."

There is good reason to be concerned. Satellite measurements have shown that three huge glaciers here have been speeding up for more than a decade. The biggest of the glaciers, the Pine Island Glacier, is causing the most concern.[..]

Throughout the 1990s, according to satellite measurements, the glacier was accelerating by around 1% a year. Julian Scott's sensational finding this season is that it now seems to have accelerated by 7% in a single season, sending more and more ice into the ocean. "The measurements from last season seem to show an incredible acceleration, a rate of up to 7%. That is far greater than the accelerations they were getting excited about in the 1990s."

The reason does not seem to be warming in the surrounding air. One possible culprit could be a deep ocean current that is channelled onto the continental shelf close to the mouth of the glacier. There is not much sea ice to protect it from the warm water, which seems to be undercutting the ice and lubricating its flow.

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