Debt Rattle, June 7 2008: Waking up to a new reality

Dorothea Lange, late 1930s. Edison, Kern County, California.
Children of young migratory parents, originally from Texas.

The Complacency that the Worst Was Behind Us in Financial Markets is Rapidly Fading Away

The complacency that took hold of financial markets (equity and partly credit) - after the bailout of the Bear Stearns’ creditor and the extension of the lender of last resort support of the Fed to systemically important broker dealers (those that are primary dealers) – is rapidly fading away as financial markets and financial institutions are again under severe stress.

Let us detail how…

Independent analysts of the banking system and of other financial intermediaries have clearly pointed out that the massive writedowns and losses of financial institutions will continue as the credit losses will spread from subprime to near prime and prime mortgages; to commercial real estate loans that had similarly poor underwriting standards; to unsecured consumer credit (credit cards under stress given the balance sheets of households, auto loans that are in big trouble with auto sales plunging, student loans whose market is now frozen); to leveraged loans and bridge loans that financed reckless LBOs that should have never happened in the first place; to muni bonds now that distressed municipalities – see Vallejo in California as the canary in the mine - will experience an onslaught of muni bonds defaults; to monoline insurers battered by a double whammy of muni bonds under stress on top of the trouble of toxic MBS and CDO that were wrapped into monoline guarantees; to industrial and commercial loans as many debt burdened firms are in trouble; to corporate bonds as hundreds of billions of dollars of junk bonds were issued in the last four years by heavily indebted and poorly performing corporations; to the CDS market where $62 trillion of nominal protections – that was sold by a small group of broker dealers, hedge funds and monoline insurers – is sitting on top of an outstanding stock of only $6 trillion of corporate bonds; with the ensuing risk that the losses among the sellers of protection will lead to some of them going belly up and thus show to the buyers of protection that there was no hedge as counterparty risk rears its ugly head.

These delinquencies, defaults and bankruptcies have only started to rise outside subprime mortgages but they are now mounting in a tsunami of rising losses as the subprime disaster was only the tip of an iceberg of a credit bubble that run amok across the economy and across many and different credit markets.

No wonder that now heads just started to roll at the top of Wachovia and WaMu; that Lehman – even with the protection of the Fed liquidity blanket – is in trouble again; that Countrywide is on the verge of bankruptcy once BofA pulls out of a loser acquisition of the biggest and most insolvent mortgage lender; that the troubles among mortgage lenders are now spreading to the UK where the housing bubble was as big – if not bigger – than in the US; that S&P has finally downgraded major financial institutions; and now that more financial trouble lurks ahead for major US banks and smaller US banks (small banks that will go into bankruptcy by the hundreds as the housing recession deepens, home prices collapse and the economic recession deepens and persist longer than expected by the market consensus). So after a brief period of complacency – if not delusional optimism that the worst was behind us – a painful reality check is setting in. Fed Funds easing and new liquidity facilities (TAF, TSLF, PDCF, Swap lines) of the Fed cannot resolve insolvency and credit problems that go well beyond illiquidity.

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Wall Street Hits the Panic Button

A frightened Wall Street flooded the stock market with sell orders June 6, sending major indexes plunging 3% and giving investors plenty to ponder over a warm summer weekend.

The big question: Is this a temporary mood swing for a nervous market? If so, fear may dissipate, and the market has a chance to quickly bounce back when better news headlines come along next week.

Or, did something fundamental change on June 6, a day when oil prices spiked $11 per gallon and a jobs report showed the unemployment rate jumping from 5% to 5.5%, the largest rise in 22 years?

Many market observers believe it is the latter: The stock market is catching on to a new, scary reality....

....Rising commodity prices also add to inflation worries. Inflation, in turn, could prompt the Federal Reserve to quickly raise interest rates later this year. "That will shock the market," Genter says.

One hope for the stock market is that oil's runup is a "blowoff rally." That is Morgan Keegan Chief Technical Strategist John Wilson's term for one last rally before oil prices quickly collapse and speculators flee the market all at once. "I think crude could drop $20 or $30 in a heartbeat," Wilson says.

Another hope for stock investors is that the market is simply overreacting. "I don't think the world changed today," says John Merrill of Tanglewood Capital Management. Oil's surge may be temporary, and plenty of other economic data suggests the economy is holding up O.K., he says.

Investors must hope that the market is focusing far too much on a couple of nasty news headlines—news that will be soon forgotten. But the fear is that those headlines are merely a harbinger of worse things to come.

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When Bubbles Collide

I have been pondering for a few weeks about whether the long-only commodity index funds are really affecting the markets. Basically, these funds have become a huge part of the commodities market. It is clear that enough buying and in size will affect any market, but these funds do not take delivery. They "roll" their exposure as they get close to expiration, so they are not involved in the spot price. In theory, the spot price should be a function of immediate supply and demand.

But, it is not that simple, as Louis Gave reminded me. Looking at recent CFTC data, investors known as "commercials" were long 827 million barrels of oil. In the early part of the decade it was 3-400 million barrels. Commercials are supposed to be those who are hedging their production of oil. But large oil companies rarely hedge, and smaller producers only hedge a portion of their oil (see more below). Has supply increased over 100%? I think not.

Where is the increase in commercial interest coming from? The clear answer is long-only commodity index funds and ETFs. They simply buy baskets of commodities at whatever the price is, speculating on the rise in the price of the overall commodity market. It is a one-way trade. Jim Rogers is probably the most famous exponent of such trades, but there are scores of funds which mimic what he does. But there are limits to how much exposure speculators can buy, because the CFTC will allow a speculator to only buy so much of any given market, to keep large players from getting a corner on the market and driving up prices, a la the Hunt brothers and silver in 1980. These limits are known as "position limits."

There are no position limits for commercials who are hedging. They are in theory hedging their physical exposure to a given commodity they are selling or buying. Think of a farmer and General Mills. Both want to lock in the price of wheat so they can plan for the future. Speculators are useful in that they provide liquidity to the markets. In fact, they are essential to a properly functioning market.

The CFTC created a loophole when they allowed investment banks to be classified as commercial investors. So, when a long-only commodity index fund wants to buy a million barrels of oil, they can go to the investment bank, who will sell them a "swap" on the price of oil, and then immediately hedge their exposure in the futures market.

To be sure, the long-only index fund can now create positions far in excess of the position limits that are enforced upon normal speculators. These funds can grow to be huge - multi-tens of billions of dollars. Even though they are speculators, they are not included in the data as speculators. Because they get their exposure from an investment bank, they are ultimately listed as a commercial. In total, they represent an enormous part of the commodities markets. But they are providing liquidity, so what's the problem? They are not actually hoarding the commodities. The price is still set at the spot price. But.

But that is not the whole story. They are making it difficult, if not dangerous, to short the market. When massive buying comes into the market, it moves the market and sends the signal to the market that prices are rising. Momentum players move in, and prices rise some more.

In fact, as the price of oil has risen from $90 to $100 and higher, normal speculative open interest has declined, as who can afford to fight the tape? At the least, I expect the CFTC to require those "commercials" that are really long-only index funds to provide transparency. Politicians are demanding that something be done. It is entirely possible that they will impose position limits on the long-only funds. As I said last week, when the elephants are dancing, the mice should leave the floor. And Congress and the regulators are very serious elephants indeed. Let's hope they do whatever they are going to do quickly.

I think smaller investors should take the profits they have made over the last few years in these funds and move to the sidelines until it becomes clear what the rules are going to be. Let me also make it very clear that I am only talking about long-only commodity index funds. Funds that are managed by commodity trading advisors which can go both long and short have the potential to profit from volatility (and of course, they can also lose). In these types of markets, I like funds which are "long vol." (To be long volatility means you have the potential to benefit from volatile markets.)

Now, let's look at how the credit crisis is contributing to the problem. Let's say you are a small oil producer or grain company. You go to the futures market and hedge your oil production or the grain in your silos; and if the price goes up, you don't care, because you are going to deliver the grain at a cost you already know. But there is the matter of that margin call, and you need to borrow from your local bank to meet that call.

You are hedged. Your profits are locked in at some point in the future. But the margin clerk is calling today. And your bank is having a small problem with its capital base. What is the cover story in the Wall Street Journal today? "Real Estate Woes of Banks Mount." Banks, mostly smaller ones, may have to write off as much as $165 billion in bad real estate loans made to developers and commercial builders. Regulators are "encouraging" banks to raise capital and increase their lending standards.

So banks have less capital to lend. Your banker looks at you when you ask for more money to meet those margin calls, and says, "There are two types of problems. Mine, and not mine. Yours is of the latter variety." And you have to cover your hedges. Enter the margin clerk (the person who calls you and tells you to come up with more money or they will sell out your position at whatever the market price is.)

So, what happens? Bernanke talks the dollar up and commodities and oil go down. Two days later a French president of the ECB gets inflation religion and the markets react swiftly. Commodity prices rise and more money comes into the market. Traders start covering their shorts as quickly as possible.

Then this morning, the margin clerks of the world go to work and oil spikes as the pits smell blood. Morgan Stanley issues a call for $150 oil in July. The euro rises to $1.5778! Interest rates drop. The stock market falls large at the open.

And rumors of an attack on Iran? An Israeli politician says that Israel would need to bomb Iran to keep them from getting a nuclear weapon, just as it becomes clear Obama might be the next president and would not act to prevent such a problem?

Who can aggressively short in this environment? In a conversation with Dennis Gartman this afternoon, he commented that it felt like the NASDAQ. But is it 1999 or 2000? The oil market will continue to go up until it doesn't, and no one knows when that is. It will continue to rise until all the shorts that are not strong hands have been covered. The margin clerks are in control, and they will have their way. Was it all over today? I rather doubt it.

I wonder if some of the majors aren't tempted to sell some of their production at $138? I mean, really. If you don't think that is a reasonable price, and they tell us they don't, then why doesn't Exxon just go in and start taking all the bids they can? They and the other majors would be the ultimate strong hand. But then, what do I know?

Central banks, short covering, a respected analyst issuing a near-term call for a $20 rise in oil, conspiracy theories and Iran, long-only funds buying, everyone scared to short, margin calls, and a credit crisis all give us the perfect storm.

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ASX chief warns of 'third phase' in credit crisis

The head of the Australian Securities Exchange, Robert Elstone, has warned investors to expect much more pain on world share markets as the fallout from the US sub-prime crisis hits the real economy.

Mr Elstone said the world economy was now entering a "third phase" of market turmoil -- driven by the spillover of the financial crisis into the real economy -- that would take much longer to play out than the first two market falls of August last year and in January this year.

In an interview with The Weekend Australian, Mr Elstone predicted that there would be big differences in the performance of different market sectors -- from resources to retail and property-orientated companies -- over the coming year. "Life is going to get a lot more complicated," said Mr Elstone, who has been under pressure for his administration of the ASX in the wake of controversies over the settlement problems of broker Tricom in January, the collapse of broker Opes Prime and questions over disclosure of margin lending, short selling and the power of hedge funds.

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Behind the falsification of US economic data

In recent years, it has become increasingly clear to those who follow US economic statistics that there is something dubious about the numbers released by official government agencies and used to guide many aspects of social and public policy.

The details and chronology of the corruption of economic data are presented in a new book by Kevin Phillips, the political commentator and former Republican Party adviser who has become something of a muckraking critic of the “excesses” that he helped set in motion. The book is entitled, Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism Phillips summarizes some of his main conclusions in an article in the current issue of Harper’s Magazine.

The article focuses primarily on three measures: the monthly Consumer Price Index (CPI), the quarterly Gross Domestic Product (GDP), and the monthly figure for the unemployment rate. Phillips convincingly demonstrates that the real unemployment rate in the United States is between 9 and 12 percent, not the 5 percent or less that is officially claimed. The real rate of inflation is not 2 or 3 percent, but instead, between 7 and 10 percent. And real economic growth has been about 1 percent, not the 3-4 percent officially claimed during the most recent Wall Street and housing bubble that has burst.

Phillips’s background makes his statements all the more significant. He was a prime strategist for Nixon’s 1968 presidential campaign and one of the main architects of the notorious “Southern strategy,” through which the old Republican Party of Wall Street and Main Street refashioned itself with a right-wing populist appeal, stoking racial antagonisms while above all capitalizing on the bankruptcy of American liberalism to shift the political spectrum sharply to the right.

The corruption of official statistics is not the work of one administration, and Phillips traces it back nearly 50 years.

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Real GDP - Part III: Let The Games Begin

After receiving his marching orders from Emperor Debitus, Calculus walked slowly down Palatine Hill, heading towards the Forum and his official chambers at the Treasury basilica. He was in deep, troubled thought.

On the one hand he felt professional rage at being ordered to manipulate the Imperial books to accommodate Flavius' boondogle. Up to now he was always scrupulous in his accounting, down to the last copper as that crossed his books. Given its size and nature, the overhaul required by Debitus would entail smoke and mirrors on a grand scale, with a similar-sized reduction in his own integrity as a public servant. Old, stammering Emperor Claudius would be horrified. But then again, he was long dead and safely ensconced in Elysium, along with the rest of his god-like kin. What care had gods of earthly matters?

And thus, on the other hand Calculus pondered how to best accomplish the task set before him. The emperor was menacingly clear: cook the books or get ready for an immediate trip to Hades - a very unpleasant choice....

....Obviously, those who ran the show would reap huge profits. Not only would they charge an arm and a leg to construct and finance the arena, they would also provide the gladiators and beasts at a markup, hold the food and slave concessions and control the bookies taking all the bets. It would quickly result in a vast transfer of wealth from the public at large to a select few bloodsuckers - fat Flavius and his unscrupulous gang. Calculus could easily predict that in just a few decades the lower patrician classes [Ed. today's middle class] would have to go into debt in order to survive and, once stripped of all assets, ultimately be forced into indentured slavery in lieu of their debts.

And yet, Calculus had to somehow find a way to portray this constant ruination as a net economic benefit, year after year! [Ed. in today's terms, show real annual GDP growth].

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Thomas Palley: "Defending the Bernanke Fed" (We Beg to Differ)

More broadly, what bothers me about Palley's argument is that combating what he calls a demand shock is neither realistic nor desirable. First, labeling it a demand shock is overly dramatic; until today, a large number of economists felt this downturn could be short and shallow because jobs and consumer spending appeared to be holding up well.

I've been in the pessimistic camp because the current level of consumption to GDP (71-72%) is high and unsustainable. It has been achieved only via increasing debt to GDP to unprecedented levels (hence our credit crisis).

Thus "preventing demand shock" is tantamount to "keeping current levels of demand going" which per above, was accomplished via rising debt levels. We simply cannot keep doing that. The longer we go on, the worse the day of reckoning.

Similarly, the flip side of "consumption is too high" is "savings are too low", and insufficient savings result in capital influxes which are accompanied by current account deficits. You can debate how the causality runs, but that's how the math works.

Even with the fall in the dollar, our current account deficit to GDP ratio is over 5%, down from over 6%. That's all well and good, except a level over 4% leads to a depreciating currency. So again, if you want to defend the dollar, that means more savings (and reducing debt is a form of savings) and less consumption. Thus, lower demand NEEDS to happen; the question isn't preventing a demand decline (i.e. a recession or prolonged low growth period) but whether and how much the powers that be should intervene to alleviate the pain.

But that sort of reasoning doesn't go over very well in an America where everyone likes to have their cake and eats it too.

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Judge approves ABCP deal

An Ontario judge has approved the plan to restructure $32-billion of asset-backed commercial paper, moving individual and corporate investors closer to recovering troubled investments that have been frozen since last August.

Mr. Justice Colin Campbell of the Superior Court of Ontario issued reasons for his decision to approve a plan that was challenged by a number of individual and corporate investors.

The plan grants a sweeping immunity to every bank, rating agency and other major funds that helped nurture the market. The immunity will shield the ABCP players from future lawsuits related to the investment crisis. Not protected from this immunity are brokerages or dealers that may have fraudulently sold the troubled notes to investors.

A number of investors have challenged the legal release, but architects of the restructuring said it was necessary to win bank and other backers' financial support and concessions that are central to the plan.

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Safety deposit box raids yield £1bn of drugs, cash and guns

Police have seized a potential £1 billion “treasure trove” of cash, drugs and guns in an unprecedented raid on concrete vaults holding 7,000 safety deposit boxes.

Scotland Yard believe the operation may unlock clues to every layer of serious crime in Britain - including murders, shootings, drug trafficking, fraud and paedophile gangs.

Metropolitan Police Assistant Commissioner John Yates said: “Each box will be treated as a crime scene in its own right.”

More than 300 officers and staff were involved in simultaneous raids at three depots in London’s Park Lane, Hampstead and Edgware. Officers have secured the concrete and steel vaults and will take several weeks to remove each box, using angle grinders, to a secret location where they will be prized open with diamond-tipped drills....

....“In the past safety deposit boxes have been searched on an individual basis often resulting in the recovery of guns, drugs and cash. We believe that this operation has the potential to impact upon many layers of serious crime.”

The investigation - codenamed Operation Rize - has been running for two years and included intensive work with lawyers to ensure they were able to seize all of the boxes.

Members of the public who have innocently and legally stored their valuables were “inevitably” going to get swept up in the disruption, it was predicted.

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Not-So-Safe-Deposit Boxes: States Seize Citizens' Property to Balance Their Budgets

The 50 U.S. states are holding more than $32 billion worth of unclaimed property that they're supposed to safeguard for their citizens. But a "Good Morning America" investigation found some states aggressively seize property that isn't really unclaimed and then use the money -- your money -- to balance their budgets.

Unclaimed property consists of things like forgotten apartment security deposits, uncashed dividend checks and safe-deposit boxes abandoned when an elderly relative dies.

Banks and other businesses are required to turn that property over to the state for safekeeping. The problem is that the states return less than a quarter of unclaimed property to the rightful owners.

Not-So-Safe-Deposit Boxes

San Francisco resident Carla Ruff's safe-deposit box was drilled, seized, and turned over to the state of California, marked "owner unknown."

"I was appalled," Ruff said. "I felt violated."

Unknown? Carla's name was right on documents in the box at the Noe Valley Bank of America location. So was her address -- a house about six blocks from the bank. Carla had a checking account at the bank, too -- still does -- and receives regular statements. Plus, she has receipts showing she's the kind of person who paid her box rental fee. And yet, she says nobody ever notified her.

"They are zealously uncovering accounts that are not unclaimed," Ruff said.

To make matters worse, Ruff discovered the loss when she went to her box to retrieve important paperwork she needed because her husband was dying. Those papers had been shredded.

And that's not all. Her great-grandmother's precious natural pearls and other jewelry had been auctioned off. They were sold for just $1,800, even though they were appraised for $82,500.

"These things were things that she gave to me," Ruff said. "I valued them because I loved her."

Bank of America told ABC News it deeply regrets the situation and appreciates the difficulty of what Mrs. Ruff was going through.

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Israel May Mull Iran Attack on Atomic Work, Mofaz Tells Yediot

Israel will have to attack Iran if it doesn't abandon its nuclear-development program, Shaul Mofaz, Israel's transportation minister and a contender for the post of prime minister, told the Yediot Ahronot daily.

International sanctions aimed at stopping Iranian nuclear research haven't been effective and the ``window of opportunity'' to stop what Israel says is the country's plan to develop atomic weapons is closing, Mofaz said in an interview with the newspaper published today.

Any operation against Iran would be taken with the consent of the U.S., Mofaz, who is also the minister responsible for strategic relations with the U.S., told Yediot.

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Israel attack on Iran 'unavoidable'-Olmert deputy

An Israeli attack on Iranian nuclear sites looks "unavoidable" given the apparent failure of sanctions to deny Tehran technology with bomb-making potential, one of Prime Minister Ehud Olmert's deputies said on Friday.

"If Iran continues with its programme for developing nuclear weapons, we will attack it. The sanctions are ineffective," Transport Minister Shaul Mofaz told the mass-circulation Yedioth Ahronoth newspaper.

"Attacking Iran, in order to stop its nuclear plans, will be unavoidable," said the former army chief who has also been defence minister.

It was the most explicit threat yet against Iran from a member of Olmert's government, which, like the Bush administration, has preferred to hint at force as a last resort should U.N. Security Council sanctions be deemed a dead end.

Iran, which denies seeking nuclear weapons, has defied Western pressure to abandon its uranium enrichment projects. The leadership in Tehran has also threatened to retaliate against Israel -- believed to have the Middle East's only atomic arsenal -- and U.S. targets in the Gulf for any attack on Iranian turf.

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Joschka Fischer: As things look, Israel may well attack Iran soon

As a result of misguided American policy, the threat of another military confrontation hangs like a dark cloud over the Middle East. The United States' enemies have been strengthened, and Iran - despite being branded as a member of the so-called "axis of evil" - has been catapulted into regional hegemony. Iran could never have achieved this on its own, certainly not in such a short time.

A hitherto latent rivalry between Iran and Israel thus has been transformed into an open struggle for dominance in the Middle East. The result has been the emergence of some surprising, if not bizarre, alliances: Iran, Syria, Hizbullah, Hamas and the American-backed, Shiite-dominated Iraq are facing Israel, Saudi Arabia, and most of the other Sunni Arab states, all of which feel existentially threatened by Iran's ascendance.

The danger of a major confrontation has been heightened further by a series of factors: persistently high oil prices, which have created new financial and political opportunities for Iran; the possible defeat of the West and its regional allies in proxy wars in Gaza and Lebanon; and the United Nations Security Council's failure to induce Iran to accept even a temporary freeze of its nuclear program.

Iran's nuclear program is the decisive factor in this equation, for it threatens irreversibly the region's strategic balance. That Iran - a country whose president never tires of calling for Israel's annihilation and that threatens Israel's northern and southern borders through its massive support of proxy wars waged by Hizbullah and Hamas - might one day have missiles with nuclear warheads is Israel's worst security nightmare. Politics is not just about facts, but also about perceptions. Whether or not a perception is accurate is beside the point, because it nonetheless leads to decisions.

This applies in particular when the perception concerns what the parties consider to be threats to their very existence. Iranian President Mahmoud Ahmadinejad's threats of annihilation are taken seriously in Israel because of the trauma of the Holocaust. And most Arab governments share the fear of a nuclear Iran. Earlier this month, Israel celebrated its 60th birthday, and US President George W. Bush went to Jerusalem to play a leading part in the commemoration. But those who had expected that his visit would mainly be about the stalled negotiations between Israel and the Palestinians were bitterly disappointed. Bush's central topic, including his speech to Israel's Knesset, was Iran. Bush had promised to bring the Middle East conflict closer to a resolution before the end of his term this year. But his final visit to Israel seemed to indicate that his objective was different: he seemed to be planning, together with Israel, to end the Iranian nuclear program - and to do so by military, rather than by diplomatic, means.

Anyone following the press in Israel during the anniversary celebrations and listening closely to what was said in Jerusalem did not have to be a prophet to understand that matters are coming to a head.

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