Thursday, March 27, 2008

They are worth zero. Zero.

Please don't miss today's Debt Rattle, March 27 2008

Ilargi: Our friend Karl Denninger at is on a roll these days, he's sharp as a tack, writing really good articles. I may not share Karl's political views, but I very much think his financial insights deserve to be read by everyone. And if I can help getting him a wider audience, I will. Here's Karl:

AA^2? Mayyyybe! Oh, And CDS Explosion, Part 2

Oh boy, the tape bombs are good.

Let's start with an explosive allegation - that KPMG may have pulled an AA with New Century!

"New Century 'engaged in a number of significant improper and imprudent practices related to its loan originations, operations, accounting and financial reporting processes,' Missal wrote in the report. He said 'KPMG contributed to certain of these accounting and financial reporting deficiencies by enabling them to persist' and in some cases 'precipitating' a departure from 'applicable accounting standards.'


The examiner said several people he interviewed for the report claimed KPMG recommended the improper changes to the reserve calculation, and KPMG denied doing so. Work papers show KPMG 'evaluated and approved the change,' Missal said."

That might leave a mark (to market); the money quote is that they found work papers. Oops.

Bankruptcy auditors have a nose for this sort of crap.....

Speaking of "mark to market", it appears that we're about to have the world wake up to the reality that all these "credit default swaps" that have been "protecting" their portfolios are in fact worthless. I've been saying this for quite some time, but now we have active attempts to avoid payment, first in the suit that Merrill filed and now this:

" FGIC Corp. said it's walking away from an agreement to provide $1.9 billion in guarantees on mortgage-linked securities because Credit Agricole SA and IKB Deutsche Industriebank didn't live up to their side of the deal."

Of course the claim here is that the folks who bought this "protection" misrepresented various things, like, for instance, what was inside and their financial condition. Uh, no kidding folks! Or, to put it in one word: DUH!

While the numbers so far are small ($1.9 billion thus far on this one, and $3.1 billion in the case of Merrill) if this gets any sort of legs, and you can bet it will, it means that the underlying credit quality (or lack thereof) will instantly "appear" back on the bank's balance sheets!

As I've said for a long time the underlying problem here is one of capitalization.

NONE of the firms writing this crap have the capital behind them to survive any significant phalanx of claims. They can't because the fiction that underlay this entire business model was that you could buy insurance against default for less than the actual risk premium over risk-free return. In short, the model was predicated on the ability to find a "free lunch."

Now, however, the claims are coming fast and furious and the truth is coming out - the capital simply is not there, and the insurance these people bought is in fact worthless!

What's worse is that now FGIC has admitted reality - they have exceeded legal risk limits. That is, they are now in violation of New York State Insurance Law!
"FGIC also said in a statement that it had a substantially reduced capital and surplus position through Dec. 31. As a result, insured exposures exceeded risk limits required by New York State insurance law, the company, which is based in New York, said."

The upshot of this, of course, is that NY State could decertify them as an insurer at any time, which instantaneously vaporizes all of their credit insurance products' value!

This will cause capital problems for those who bought these swaps. Maybe serious, or even critical ones. No, not on a couple of billion, but what if the number is $10, or $20 billion? Or more? And what if, as frequently happens, the reserve requirements in that instance double or even triple? Is the capital there to absorb that without causing severe, perhaps even extreme, stress?

Oh, and in the "we'll downgrade them after they blow to bits" Fitch dropped ratings on all three of XL Capital, SCA and FGIC today - all to "junk", or below investment grade. All three are now considered "junk" or "high risk" debt - which should, in theory at least, mean that all the swaps they wrote now have the same "BB" or worse ratings.

IF, and I stress IF, there are honest accountants at the buyers of swaps from these folks, they will all be removing the value of those hedges this morning. This should result in an immediate reserve requirement increase.

The paradox is that those who argue that "bailing out" Bear Stearns was necessary claim that the purpose of that bailout was for this precise purpose - that is, avoiding these reserve increase requirements!



The credit default swaps written to "protect" the ratings on the CDOs and other complex instruments out there are WORTHLESS.



Drill that into your head until it sticks, because IT IS A FACT. They are worth ZERO because the people who wrote them DO NOT HAVE THE MONEY TO PAY AND THEY HAVE NO PRAYER IN HELL OF BEING ABLE TO EARN IT BEFORE THE PAYMENTS MUST BE MADE.

The model of EVER INCREASING LEVERAGE is and ALWAYS WAS bankrupt.

It was a FICTION.

Ever-increasing leverage as the foundation of a financial spiral is trivially easy to prove as mathematically impossible. Charles Ponzi created the "original" scheme of this sort in American Jurisprudence but he was not the last one to try it, and the latest incantation of CHARLES PONZI'S WORK is now found in these "credit default swaps"!

These swaps NEVER HAD ANY CHANCE OF PERFORMING UNDER STRESS because eventually the ever-increasing spiral of geometrically-increasing amount of new business that underlay this model MUST RUN TO EXHAUSTION, and when it does THEY ALL BLOW UP, just as Charles Ponzi's scheme did.


I have gone over this REPEATEDLY and yet people continue to argue that the financial equivalent of PERPETUAL MOTION and VIOLATIONS OF THE LAWS OF THERMODYNAMICS can and will hold up.

These laws are called LAWS in the physical world for a reason. You cannot get a patent on a "machine" that violates the laws of physics because the Patent Office understands that you are attempting to run a SCAM.

Why we continue to have financial regulators who REFUSE to put forward one simple test - is it mathematically possible for this piece of financial engineering to perform on a perpetual basis, and then prosecute those who put forward schemes that fail this simple test of mathematics, is beyond me.

Yet this very simple reality is in fact why we keep having blowups in our markets and financial sphere. It was responsible for the Tech Blowup and now the Subprime Blowup. It was responsible for The Great Depression and the two Depressions (that nobody talks about before the 1930s) prior to that.

The Fed is not the reason we have had these economic dislocations but they are partially responsible for refusing to stop the root cause before the dislocations happen, because Ben Bernanke and all the other Fed Governors did, in fact, pass high school mathematics, and that is all you need to know that these schemes CANNOT POSSIBLY WORK.

This basical mathematical reality is why the dislocation is not over and why there are many more firms that will FAIL. For the list of those firms you need only look towards those who are reliant on the premise that home prices will increase at a rate that exceeds growth in incomes in the financial "products" they currently have on their balance sheet. All of those firms that have insufficient capital (and are unable to raise sufficient additional capital) to withstand the drawdown that a price correction in the housing stock to no more than 3x average incomes, which is an average national home price decline on a constant dollar basis of 33%, will go under.

This is a mathematical certainty; those who argue otherwise are arguing with the laws of mathematics, not with my or anyone else's opinion.


The Clear Channel "buyers" are suing the banks and apparently, this morning, got a TRO. Seems they don't like the idea of the banks walking off. Awwwwww.... such poor pump monkeys! (snicker)

And to those who say that there's "limited" impact on the economy from the house price adjustment, don't talk to these people:

" Miami-area homeowner Richard Welch is spending $70 less on groceries a week after his house lost $145,000 in value. Rita Roland cut off 11 inches of hair to save on salon trips, and Victor Parris stopped drinking his favorite brands of dark ale."
Yeah, ok. Falling home prices don't influence consumer spending eh? Tell it to the mouse!

Guess the truth sucks when you're a pump monkey eh?

Now, back to Bear and friends...

This morning we saw The Brits decide to release "more liquidity" (read: loans) into the banking system, which moved the Euro markets higher and spiked our futures somewhat. The result here was somewhat mild but certainly present, and out the pump monkeys come - again - crooning about this and that.

What we need to examine as investors, however, is the macro economic picture - oh sure, we can sell rallies and buy dips, but at the end of the day the bottom line is whether the environment in which we live and invest has changed.


More to the point, over the last four years (until last August) we have lived in an extraordinarily low-volatility environment and, from 2002-2004, in a period of extremely low "official" interest rates. This has led people to gear up more and more in an attempt to earn a "good" return, where "good" is "enough to buy my new Ferrari" (if you're an investment banker or Hedge Fund.)

But leverage - gearing - is your undoing when the worm turns. The reason is quite simple - while you can make more using leverage, when things go bad you can lose more than you started with.

This is of course the mantra of those who think "short selling" is inherently suicidal - that stocks "can go to the moooon" and wipe you out.

Of course the truth is something different - I've seen more stocks go to zero than go to infinity, eh?

But in good times everyone forgets the bad side of leverage. We now have "Investment Banks" that are geared at 20, 30, or even higher ratios. When you are geared at 20:1 a 5% decline in your positions net-on-net wipes you out!

Now how many of us haven't had a 5% decline in our stock portfolios at some point in our life? Did we die and go to Investment Hell? No, because we're strictly limited in our gearing; if you're not using margin then you have no gearing, 1:1, while if you do have "maximum margin" you're only geared at 2:1.

Yes, there are ways to blow your head off as a retail investor, with the key one being the futures market - there, tight stops and discipline are absolutely essential lest you find a big smoking hole where your account once was.

So yeah, these guys are "The Smartest Playas In The Room" but in point of fact we're all human, we all make mistakes, and when you are geared like this and volatility spikes, you die.

This is the underpinning of our financial system?

Here's the truth, although you won't hear this on Bubble TV -

There is no way that a financial system geared at 20 or 30:1 is stable or sustainable. Regulators need to step in here and now to FORCE that crap to stop by whatever means are necessary.

This means, at minimum:
  • No more "off-balance sheet" games. I've been hollering about this for a year now, and my viewpoint has not changed one iota. These vehicles are an explicit and obvious attempt to circumvent the rules on leverage and margin that are imposed on various financial institutions and hide that gearing from the investing public and regulators. This needs to be treated as what I believe it is - organized fraud, that is, Racketeering, and the organizations involved in it need to be given no more than one quarter to consolidate all this back onto their balance sheets or face prosecution.
  • Gearing ratios must be set by reserve levels and strictly enforced. Since we live in a world of fractional reserve banking the inherent gearing of 8:1 or thereabouts that is involved in such a world must be the cap for all financial institutions including banks, brokerages, and others who we, the people, will provide any sort of protection against market failure. This regulation must be strictly enforced via nightly mark-to-market with capital shortfalls generating immediate "margin calls" by the regulators. This also means that all instruments must trade on an exchange where we have public price discovery, so that nightly mark can be enforced.
  • Any financial product or model that relies on ever-increasing business or earnings beyond the long-term historical level of GDP growth must be banned. It is mathematically impossible for such a model, scheme, or system to work. This is trivially easy to prove using nothing more than elementary-school mathematics; if you can do four-function math on a piece of paper you can easily prove that an expansion of financial results beyond that in GDP, over long periods of time, must blow up, sticking the investors in same with huge losses. It is therefore fraudulent to claim that such a model is "sound".
  • We have PROOF that market participants will cheat if there is any way for them to do so. This has been proven over and over again, from the crash of 1929 to the '87 "portfolio insurance" blowup to LTCM and 00-03 Tech Wreck. The story is never different - without the jackboot of the government on the neck everyone in the financial sphere cheats in an attempt to post "better numbers" than their competitors! As such regulation must be consistent, it must be impossible to cheat, and it must assign a net present value of ZERO to any "non-publicly-verifiable" asset. If people want to carry around such "assets" that's fine but they cannot use them as part of their capital base nor use them as the foundation for their leverage.

There will be people who claim that this makes the business model of investment banks "inherently broken."

Guess what - at the recent prices these institutions have sold in the market, they are unsustainable - that is, the business model IS broken.

You cannot have a sustainable marketplace based upon nothing more than debt-financed LBOs, yet that has been the premise and base of the last three years in the equity markets, whether we're looking at "private equity" or debt-financed stock buybacks!

This sort of blatant pumping, enabled and fueled by "Bubble Television" is no more than a modern-day version of Tulip Mania and these sorts of manias always end badly, bankrupting most participants who stay too long at the dance.

The pernicious part of this is that the mentality espoused and promoted through that "Bubble TV" has in fact imbued itself into the "meme" in consumer behavior and the financial television folks are the part and parcel of drilling this into your heads!

"Flip This House", for example, is an attempt to enlist Joe Six Pack - the ordinary person - into the leveraged financial mania! It was fueled, promoted, and stuffed into the nation's eyeballs via the media and the financial "lever pullers." It worked - for a while.

But all leverage-driven manias will and must bust.

They must bust because prices cannot rise on a sustainable basis faster than actual productive gains in the common man's earnings power, that is, wages.

There is no free lunch kids.

There never has been and never will be.

Not now, not ever.

Oh, and guess what popped up today from Barak Obama? An interesting attempt to get my vote. While there are things in there I don't particularly care for, including a raw lack of acknowledgement that the solution to housing cannot be found until prices fall to roughly 3x incomes on an average basis, many of the other issues he hits on are items I can identify with.

Next one - another note from Mish - you have to read it to believe it.

Citibank is apparently trying to refinance people from their ARMs to Fixed Rate mortgages as they are about to reset. Good for customers, right? Uh, one small problem - the ARM resets are to a lower rate, not a higher one. Yes, Mish says he has proof.......

The TSLF's first results are out, and while oversubscribed, it appears the banks attempted to lowball The Fed. Now there are people who claim this is "bullish", but there's another way to look at it - they don't have anything else elegible for collateral, even under the new, "expanded" criteria. Which is it? Hmmmm.... tough to know eh? Yep. Such is our "newer, more transparent Fed".

Pull the other one Ben.

Psst - you know those comments about Fannie buying crap paper? Here's an example. This is a VA loan, and thus "insured", but it is an example of the sort of garbage that gets through the system - even today. There is absolutely no way this loan is affordable. Not a snowball's chance in Hell.

Do I need to underline why I think the GSEs may well be zeros?


Anonymous said...

Were we flies on the wall at the various brokerages I wonder what the true state of affairs is...or at Treasury.Paulson knows that this is going to blowup on his watch,but his comments have been those of someone almost disinterested in the eventual outcome of the disaster he is riding herd on.My brother,robotics engineer,and very careful Forex trader is of the opine that it has been decided to destroy the dollar as a currency,thus destroying the debt ,{and setting a "new"system in place for Social Security....One called "work till you die"}
Do you think this may be the case..That some traitors "in the system" have decided to destroy the system because they cant change it within the law?And I am being very careful with that word...because these are the actions of someone who is out to harm my country for their Ideology....that fits the word as I see it

scandia said...

I was wondering how a 20-30% decline means system collapse. I would be pressed to find a better example of " tipping point " than this from Derringer- "...When you are geared 20:1 a 5% decline in your positions net-on-net wipes you out!"
We've reached a tipping point!

Ilargi said...


That is precisely what I wrote in the intro to the March 27 Debt Rattle. I got emails from people saying that they didn't see a collapse, but it is.

Look at the different parties involved, lenders, builders, homeowners etc. None have the resilience to deal with numbers falling as fast and deep as this.

Existing home sales: down 23.8%. New home sales: down 29.8%.

There is no realistic other way to interpret this. It doesn't matter what the media try to make you believe. Every single party in the real estate food chain is leveraged to the hilt, from borrowers to lenders to securitizers to investors. There is no resilience in the system, and certainly not for 25%-30% plunges within one year.

Anonymous said...

We've got $750T in derivatives, $75T in real estate, and $50T in global GDP. That first number just doesn't look very nice next to the other two, neither individually, nor if they are added together.

The dollar is done, or the banking system implodes, or a little of both. We get away with the devaluation and/or implosion thanks to some other numbers ...

... 11 aircraft carriers, 10 amphibious assault ships, 22 Aegis cruisers, 51 Aegis destroyers, 30 frigates, 54 attack subs, 18 ballistic missile subs, and a host of support vessels. We can't win a ground war right now, but we can interdict shipping and cause trouble anywhere we choose.

The big question is how the unwinding is handled - my guess is another layer of blubber for the fat cats and gristle, bone, and suffering for the rest of us.