ES -- DX/CL -- isee -- cboe put/call -- specialist/public short ratio -- trinq -- trin -- aaii bull ratio -- abx -- cmbx -- cdx -- vxo p&f -- SPX volatility curve -- VIX:VXO skew -- commodity screen -- cot -- conference board

Thursday, July 31, 2008


the mix tape

i lost it back in college. made for me by a girl with whom i shared a vivid and lovely summer fling in 1989 on the brink of leaving home and everything that came after, i rarely get near my memories of high school without thinking of her and of it. i can't begin to reconstitute it all, but i'll be damned if that'll stop me from trying.



reclaiming judaism for jews

though not much in the public spotlight, as this is where reportage fears to tread for reasons now plain to him, joe klein has attempted to engage in a deeply-needed dialogue within the american jewish community about the nature of neoconservatism and indeed the politics of american jewry.

Time columnist Joe Klein's accusations that Jewish neoconservatives, who played a particularly visible role in the drive to war in Iraq and have since pushed for military confrontation in Iran, sacrificed "US lives and make the world safe for Israel," have spurred angry charges of anti-Semitism and personal attacks from critics at such neoconservative strongholds as the Weekly Standard, National Review, and Commentary.

But the fierceness of the controversy surrounding Klein, generally considered a political centrist, highlights the growing antagonism between neoconservative hardliners and prominent US Jews whose more moderate views are aligned more closely with those of the foreign policy establishment.

The controversy began June 24, when Klein argued in a Time blog post that the "fact that a great many Jewish neoconservatives – people like [independent Democrat Sen.] Joe Lieberman and the crowd at Commentary – plumped for this war [in Iraq], and now for an even more foolish assault on Iran, raised the question of divided loyalties."

Within a day, Abraham Foxman, head of the Anti-Defamation League, accused Klein of espousing ,"age-old anti-Semitic canards about a Jewish conspiracy to control and manipulate government."

The reaction from the right-wing press was even harsher. Commentary editor John Podhoretz reiterated the accusation of "anti-Semitic canards," and called Klein "manifestly intellectually unstable."

Writing in National Review, former George W. Bush speechwriter Peter Wehner called Klein "a man who cannot control his anger and even hatred."

But Klein has refused to back down, accusing his attackers of using charges of anti-Semitism to silence criticism of neoconservative policies.

"When [Commentary writer] Jennifer Rubin or Abe Foxman calls me anti-Semitic, they're wrong," he said in an interview. "I am anti-neoconservative."

many neoconservatives would like to convict klein for making the distinction in that last bit, but he is of course absolutely correct to make it.

i have previously noted that anti-zionism is not anti-semitism -- though klein has not here even remotely expressed the thought, one can validly believe that the establishment of the political entity of israel was a mistake and not only honor the religion and culture of judaism but defend it. that is far more than klein has said in this dustup, but a growing number of americans and even israelis believe exactly that -- the creation of the israeli state may have been the apotheosis of zionism, but it has been profoundly damaging not only to palestinians but to the levant as a region, americans as a people and to judaism as an institution of religion and culture by dint of its political establishment -- and can do so honestly, fairly and without religious or any other particular prejudice. the advent of "constantinian judaism" as termed by marc ellis has served on this view primarily to pervent and dilute the high moral aims of the jewish faith by conflating it with the amorality of power, in (among others) the manifestation of messianic zionism. the consequences can be argued to have been as damaging inside israel and to israelis as anywhere else in the world.

far short of that, however, as uri blau implied the enabling of likudnik ideology has been the mission of a narrow group of representatives which has wrongly presumed to speak for both israelis and american jews. there is an active israeli political left which is supported by huge numbers of american jews, but you would never know it by the words of those who most powerfully purport to speak for israel and judaism in washington. the decay of the foremost political organization of that disposition has given me hope that an avenue can open that will allow a cultural and therefore political reconsideration in america of what unconditional support for israel and more particularly for the israeli right wing has wrought. joe klein and the work of j street and the israel policy forum are bolstering that hope now, capitalizing on the observation of gary kamiya:

How long AIPAC will hold sway depends on how long it can convince politicians that it speaks for American Jews. It doesn't, but only American Jews can prove that. American politicians are not going to stop paying homage to AIPAC until there's an alternative -- and only Jews can provide it.

i had great hope for ariel sharon's last gambit -- and still have, even with all the disappointments of kadima (though there were many). israel has nevertheless moved in a positive direction in recent months even as it has allowed irrational hysteria regarding iran to dominate its front pages and at times foreign policy discourse.

but for israel to truly begin to repair the damage of decades of national paranoia -- and for judaism to reclaim its rightful moral heritage -- american jews like joe klein must be successful in advertising to the american political establishment that AIPAC and neoconservatism do not speak for american jewry. when that unflinching american political support for israeli militarism is broken and the management of the interests of anglophone empire there questioned critically, real progress toward peace in the holy land, as well as the improvement of the lot of both palestinians and israelis, will be realized.

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nationalizing the banking establishment

doesn't seem possible, does it? and yet, in the throes of crisis, the door has been opened.

The Federal Reserve will be able to lend more easily to failed banks under government control because of a provision in legislation that bailed out Fannie Mae and Freddie Mac.

In the rescue signed into law by President George W. Bush yesterday, the Fed will no longer have to pay penalties on loans it makes to institutions taken over by the Federal Deposit Insurance Corp.

The measure may mean more use of the central bank's balance sheet to prop up the U.S. financial system,...

prop up is one thing, nationalize another. but the clear implication here is that the fed will abet the FDIC, removing the pressure for the FDIC to liquidate failed banks by selling their assets. the unwillingness to liquidate is already in plain sight at indymac, which the FDIC is now operating with no prospect of asset sale.

For some, the exemption opens up the Fed to more political pressure to lend to government agencies, instead of forcing Congress, the FDIC, or the Treasury to explain to taxpayers why they need more money.

``Once the Fed starts lending to a bridge bank, or indirectly to the FDIC, where is the incentive to ever stop?''
said Walker Todd, a former Cleveland Fed attorney and visiting research fellow at the American Institute for Economic Research in Great Barrington, Vermont.

The FDIC had $52.8 billion in its deposit-insurance fund as of March 31. The FDIC could raise more money by tapping a $40 billion credit line it has with the U.S. Treasury, increasing assessments on its members, or turning to Congress.

``Like any open depository institution, there will be short-term borrowing needs by the bridge bank,'' which may need to ``tap the discount window,'' Gray said, referring to the name for the Fed's direct loans to commercial banks. ``Longer-term borrowing needs would typically be met by a loan from the FDIC.''...

A request by the FDIC could always be rejected by the central bank. Still, the removal of the penalties may open up the Fed to more political pressure, possibly encroaching on its independence, analysts said.

``Why should they be doing it?'' said Robert Eisenbeis, former Atlanta Fed research director and now chief monetary economist at hedge fund Cumberland Advisors LLC. ``The whole idea'' of the rules in the Federal Reserve Act is ``to make it costly and difficult to support an insolvent institution.''

indeed that was the purpose of the federal reserve act, which -- being written by bankers in more capitalistic times with a greater fear of government -- was designed to prevent the central bank from usurping the private banking industry piecemeal. that fear has clearly been superceded.

with mass bank failures likely just around the bend, the fed, treasury and FDIC are quietly arranging for a nationalization of a significant segment of the banking industry in an effort to delay or prevent -- not assist or ease, but delay or prevent -- broad financial asset liquidation and a debt deflation that would be deeply injurious to the money center banks that are their primary constituency. government agencies have been aiding and abetting insolvent institutions for many months now, the most recent manifestations being the de facto bailout of fannie mae and freddie mac as well as the delays in the implementation of accounting rules that would reintermediate banks. as every effort is made to slow the liquidation, systems are being put in place which will allow for the strengthening of these too-big-to-fail banks at the expense of their smaller bretheren.

one might consider this as a preparing of the way to a reprise writ large of the early 1990s nordic banking crises. questions remain as to whether the migration of bad private debts onto the government balance sheet will spark a currency crisis, as the united states today -- unlike the nordic recapitalizations then or japan in 1992 -- is a massive net debtor to foreign securities holders with a much higher degree of financialization and national-debt-to-national-income.

this last point is essential. government is in essence taking steps to prevent the eradication of debt in a massive deleveraging liquidation, as this effectively constitutes a destruction of the supply of credit and therefore money. the consequence, occuring as it would from such lofty heights of indebtedness, would be a powerful deflationary spiral.

but the primary problem in the united states is an inability to support these levels of indebtedness with the underlying income of the society -- and at a time when it is becoming clear that national income will be falling -- a point re-emphasized just today with a five-year-high in unemployment claims. virtually every fix now being proposed within the establishment involves the encouragement of further indebtedness by using the government balance sheet and currency management to artificially lower the cost of credit.

in the end, however, this is tantamount to driving private credit out of the system. the cost of credit for the borrower is, after all, the return realized by the investor. proposals to suppress credit costs are equally proposals to foist minimal or negative real returns on investors. which is in part why foreign private investors are already diversifying away from the united states.

in the cases of the nordic economies or japan, those poor returns were foisted upon domestic savings. but the united states is a country, please recall, that currently has no savers -- it is the greatest debtor nation the world has seen, dependent on flows from foreign investors on the order of 6% of gdp, or $700bn a year.

minyanville's kevin depew articulates at length today on the american banking welfare state that is being assembled. his thought is that we are to experience a serious deflation without much hazard of a severe currency crash.

The dollar crisis camp misses two key points: 1) massive widespread reduction in debt requires accumulation of dollars to pay it down. 2) the government's balance sheet won't be simply the expansion of liabilities, but assets too. Not everything is going to zero.

I'm not defending the spending of taxpayer money on public works projects, but simply pointing out the reality, which is that whether one agrees with these projects or not, they often build up the asset side of the ledger as well. Infrastructure spending, research and development, military spending. These will all be projects we see going forward.

Also, which has been the main thing I want to point out, this is a multi-year, perhaps decade-long process. The key, for now, to avoiding the dollar calamity you mention, is in extending for as long as possible the unwind.

Everything the government is doing, everything the Federal Reserve is doing, everything the Treasury is doing, is taking place with that aim solely in mind: extending the unwind. By extending it for as long as possible, the potential for a currency crisis - which, by the way, no entity on the planet wants - is reduced in probability. It could still happen, but the probability of it is reduced.

As long as the unwind is extended, the deflationary process will occur as an orderly progression, people will see their wealth evaporate in slow motion, and on the other side of this "crisis" politicians will be free to resume their inflationary policies and the looting of the assets of the middle and lower classes.

this slow unwind is exactly what the nationalization of the banking establishment would facilitate. even as unrewarded foreign holders of american debt move out of dollars, the demand for dollars to be employed in debt reduction is likely to soak up redemptions for so long as the chain reaction is effectively slowed by government intermediation. this will be the key to preventing a dollar crash and some form of runaway inflation.

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sold QLD

admittedly a nervous move -- following a selling climax like we saw two weeks ago on july 15, one should typically expect a longer duration/magnitude upside move than this. but my logic is twofold.

first, the nasdaq 100 is emitting some short-term negative divergences -- 20d new highs, volatility envelopes, participation over 10dma, mcclellan oscillator -- and there exists a decent probability of at least a retest of the july 15 low before any intermediate term move higher. this was the lesson of looking back at past 250d new low spikes (a junior version of which we got july 15). as the index has already hit my meager price target, that's enough for me.

the s&p 100 and 500 are behaving better -- probably consequent of their greater inclusion of financials, which have rallied powerfully. and we're not seeing much growth in 20d new lows. and, though things became a bit overbought on july 23 from the short-term volatility envelope perspective (which is the point from which the indexes now appear to be weakening somewhat) the longer-term version is still has headroom. so i might be early to move out, maybe plain wrong -- indeed, i'm not shorting right away, though that will come later i suspect. but i submit that safety in the current environment is at a premium, particularly playing the long side.

the second element is that the relative performance of the nasdaq 100 vis-a-vis the NYSE seems to have peaked in june. technology (which the NDX is overweighted in) hasn't done very well in that time. until the performance spread between the indexes contracts to more normal levels, long SSO/short QID may be the way to trade.

my DIG long is still open, with a consideration of adding to. my average cost is around 90, and DIG is at 89 or so this morning -- and has traded as low as 82 in the last week as DJUSEN failed to 615 (as earlier considered possible). but the internals are behaving very well on teh retrenchment. rising new lows on each price stab down, volatility envelopes improving from oversold alongside, mcclellan as well. yesterday was a 98% upside day in the basket. on the whole, DJUSEN looks a good setup to push resistance at 675, possibly 700-710. i broadly consider oil to probably be in the process of breaking down out of a terrible futures-driven bubble, but will trade the chart regardless.

UPDATE: i did add to DIG this morning around 89.



fasb rule 140 delayed


The Financial Accounting Standards Board postponed a measure, opposed by Citigroup Inc. and the securities industry, forcing banks to bring off-balance-sheet assets such as mortgages and credit-card receivables back onto their books.

FASB, the Norwalk, Connecticut-based panel that sets U.S. accounting standards, voted 5-0 today to delay the rule change until fiscal years starting after Nov. 15, 2009. The board needs to give financial institutions more time to prepare for the switch, FASB member Thomas Linsmeier said at a board meeting.

``We need to get a new standard into effect,'' Linsmeier said, though ``it's not practical'' to begin requiring companies to put assets underlying securitizations onto their books this year.

the reason it isn't practical, of course, is that the government is having a difficult enough time preventing money center bank failures as it is. implementing fasb 140 would probably send citi and some other large banks currently circling the drain straight down the plumbing into the sewer.

barry ritholtz compares it to the zombification of japanese banks in the aftermath of the early 1990s troubles, from which they are only now recovering. he's not wrong -- the policy response to the anticipation of large bank failures has been essentially identical thusfar. provide cheap liquidity through central bank borrowing, steepen curves to ensure positive carry, do everything within the power of government and the wall street cabal to prevent proper accounting on the pretense that this is all merely a temporary liquidity squeeze that will blow over and should be ignored.

dear reader, if this were just a liquidity problem it would be over by now. it is a debt and solvency problem -- the largest debt and solvency crisis to face the developed world since the 1930s. ritholtz is absolutely correct to say that delaying the implementation of fasb 140, if it has any effect at all, will likely have negative ramifications in time and price by thickening the dark clouds of uncertainty over the american financial system.

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Tuesday, July 29, 2008


state government revenue collapses

some might have been expected. california, for example, is at the epicenter of the housing bust and has long been one of the least conservatively managed of all the fiscal states. it is facing disaster with the seizure of the housing market, which has ended not only transfer tax revenues but also killed the booming construction industry. the result, per mish:

Gov. Arnold Schwarzenegger has prepared an order to cut the pay of about 200,000 state workers to the federal minimum wage of $6.55 an hour until a budget is signed.

Administration officials said Schwarzenegger was expected to sign the order, a draft of which was obtained Wednesday by The Times, early next week as part of an effort to avert a cash crisis. The deadline for passing a budget was July 1, and without one soon, the officials said, California may be unable to borrow billions of dollars needed to keep the state solvent.

but other states are in on the act -- states far from suffering california's housing depression. take new york.

In a rare, brief televised address, Gov. David A. Paterson announced on Tuesday afternoon that he would call the Legislature into an emergency session on Aug. 19 to address what he called an economic and budget crisis confronting New York State as a result of plummeting revenues and rising costs.

The new governor avoided any mention of new taxes, instead arguing forcefully for austerity. He said he was calling on the Legislature to reduce the size of the state workforce; cut agency spending; reduce property taxes for homeowners; aid New Yorkers with the soaring costs of home energy; and even consider public-private partnerships that would take over state assets.

“Revenues are dropping dramatically,” the governor added. At the start of May, the state budget office projected a cumulative deficit of $21.5 billion over the next three years. Now, just two months later, that estimate has risen to $26.2 billion — “a staggering 22 percent increase in less than 90 days.”

Mr. Paterson offered another example of the rapid deterioration in the state’s finances. In June 2007, he said, the 16 banks that pay the most on their business profits remitted $173 million to the state treasury. “This June, just a month ago, they sent us $5 million — a 97 percent decrease,” he said.

He vowed, “We will cut spending. Government will learn to do more with less.” He called for help from business and labor leaders and New York’s representatives in Washington to support him.

not commonly understood is the fact that state and local government spending is 11% of gdp -- not quite the 20% of uncle sam, but a considerable chunk. while paul mcculley sets aside concerns of crowding out private financing needs and potential runs on the dollar to advocate levering up (further) the federal balance sheet to overcome the paradox of deleveraging, state and local entities are far less able to finance themselves in this manner.

they instead will be cutting back spending and services, laying off employees and elilminating programs, and generally contributing to the slowdown in the economy. though the federal government can use finance as a countercyclical buffer -- even if that works much better when you're not already in hock for $10tn, and that not counting the GSEs you're backing, which has the institutional risk analyst highlighting the need to raise policy rates 100bps in order to bolster the dollar even though they well understand that over a thousand banks are either stressed or becoming so -- the states are procyclical and look to be helping drive down economic activity from this point forward.

UPDATE: one might further note that the treasury is hammering the market with supply at the same time as the fed is shedding balance sheet quality though their special facilities and selling treasuries through the FOMC to sterilize expanded lending. this is helping to drive interest rates higher. the takeaway: countercyclical federal financing has limits.

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covered bonds

treasury secretary and goldman man hank paulson is fronting for the latest liquidity scheme for the housing market over the last couple days -- covered bonds. of the longtime staple of housing finance in europe, i earlier said

moving to a covered bond format in the distant future seems very possible, but what are its near term ramifications? this is private finance, and the covered bond market in europe has been shuttered for a year. capital is currently too threatened to step into a quagmire of highly questionable valuations and bottomless house price forecasts. so the chances of a workable covered bond market in the near term seem very remote to me -- and if one is attempted, i would expect the flow of capital to mortgage markets to be severely restricted.

while moving to downsize and disassemble fannie and freddie is a laudable longer-term goal -- and while a privately-financed covered bond market is a more reasonable substitute for the originate-and-distribute model -- how this format is supposed to liquify american mortgage markets in the depths of the greatest credit unwind of the last 70 years is beyond me. so while its longer-term raison d'etre is plain, one has to begin to ask what other ends this scheme is being presented just now as a means toward.

given the desperate state of high hypocrisy and open thievery that wall street is in, one should have the most cynical view possible of this adventure from the outset. investment banking has a very long martial history of making a shield of noble aims from behind which the spear and sword of self-interest are brandished with vulgar zeal.

as such, consider this prologue via rge monitor by london banker:

If I had to guess, I suspect what we will soon see is something near to the following scenario:

Lists will circulate of troubled banks likely to go into FDIC receivership. Blogs have been full of such lists as of this week, quite suddenly, as it happens. The FDIC has to have a list because there are so many banks approaching insolvency that they are queued for FDIC receivership rather like planes circling Heathrow waiting for runway clearance to land.

Several of the central players in the recent market dramas - particularly those investment banks and hedge funds on close terms with Mr Paulson (naming no names, but initials GS comes to mind) - will go strong and aggressive for the covered bond market. They will go around to their list of troubled banks, which of course they will have compiled independently using Texas Ratio maybe, rather than having any foreknowledge of FDIC concerns. They will issue covered bonds to these trouble banks against any assets with real, proveable value left on the banks' balance sheets. They will be praised to the heavens by their friends in Washington as providing timely and necessary liquidity to a troubled banking system, proving the efficiency of the free market, bravely bearing the risk of new credit in exchange for troubled bank assets.

When the troubled bank nonetheless fails, our golden circle creditors get the good collateral in an expedited release from FDIC under its new policy statement. The FDIC is left with all the toxic waste assets and liability for depositor insurance claims, with no prospect of recovery of any value from the insolvent bank liquidation.

When the FDIC itself becomes insolvent, which it surely must do as this game gets played to its obvious outcome, then the FDIC gets a GSE-style bailout via Treasury finance and the poor taxpayers get reamed again.

In the corporate sector, we could see the same kind of issuance. Covered bonds will be used to render profitable assets off soon-to-be-bankrupt corporates, leaving pensioners and other creditors with the stripped carcass in the liquidation.

Am I too cynical? Is this a genuine attempt to realistically help improve liquidity and prosperity for America's banks? Or are the banks already destined to fail going to be looted and pillaged by the insiders before being burnt, leaving smouldering ruins for taxpayers to contemplate?

I'm not sure on this one, so I'm looking forward to views from those more expert here.

one does not have to consider this to be the solitary goal of the push for covered bonds to realize that it will be one of several dynamics that emerge from the establishment of the market. this is a means to strengthen large banks by raping smaller ones -- and strengthening banks too big to fail is very much in the front of the minds of washington financial markets authorities.

UPDATE: more via david merkel.

UPDATE: even more from steve waldman, who rightly points out that, for the short run anyway, covered bonds serve mostly to strengthen large banks' claims on the united states treasury.

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Monday, July 28, 2008


merrill marks to market?

the marks employed by the national australia bank last week were cause for concern in some quarters, but others pooh-poohed the applicability of these marks to wall street.

dismiss no more -- merrill is selling $30.6bn worth of super-senior CDOs for $6.7bn to lone star. and how bad did they need to sell the stuff?

Merrill Lynch will provide financing to the purchaser for approximately 75% of the purchase price. The recourse on this loan will be limited to the assets of the purchaser. The purchaser will not own any assets other than those sold pursuant to this transaction.

in other words, merrill is still on the hook for something like $5bn when eventually the assets are marked not to 21 cents on the dollar but zero.

to help offset the massive hit of this desperate sale, merrill will dilute their shareholders, with the considerable multiplier of the ratchet provision of the earlier capital raising from temasek. via bloomberg:

Merrill may sell as much as 356.5 million shares in the offering, the firm said today in a presentation for potential buyers. That represents a 36 percent increase over the number outstanding at the end of June. The price of the new shares will be set tomorrow, according to the presentation.

as one can tell by lone star's ability and desire to get merrill to finance the transaction to a bankruptcy-remote entity, merrill is panicked and the CDOs are worth nothing like $7bn. lone star's actual stake in the venture looks a lot closer to 5 cents on the dollar.

in other words, national australia bank's marks are in fact where we're headed -- this ride, rough as it has been, is about to get a whole hell of a lot faster and scarier. color yves smith disillusioned.

Read that twice. 22 cents on the dollar, and that with 75% financing. So the real price is lower or zero. Take your pick. And the urban legend in finance land (and I was a believer till just now) was that subprime paper had been marked down pretty well, but Alt-A and Option ARM still has a way to go.

a lot of people are just goddamn plain broke at these price levels. wall street is taking some bounding steps toward fulfilling the worst expectations of us all.

UPDATE: the NAB and merrill writeoffs are linked, says yves smith -- but with merrill's valuations spurring NAB's, not the other (and chronologically announced) way around.

The National Australia Bank's shock write-down of $830 million worth of collaterallised debt obligations (CDOs) can now be explained.

It was triggered by a move from struggling US investment bank Merrill Lynch to get rid of billions worth of CDOs in which the NAB was a co-investor.

Merrill's took a decision to sell the CDOs at a written-down value and the NAB had no option but to follow suit. Its larger write-down than Merrill Lynch (90% vs. 78%) reflects its lower ranking of security.

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disaster talk

a couple of articles today highlighting not the best case but the worst; not how we get out but what happens if we don't.

the july 25 commentary of kurt kasun at prudent bear, pointing out among other things the imminent approach of zero hour.

as least as frightening, frank veneroso via yves smith -- with an updated version of marc faber's figure 10.

Over the last year the U.S. has undergone the worst financial crisis in the three generations since that horrific episode of the 1930s. Even though we have had a severe financial crisis the ratio of total credit market debt to GDP keeps on rising. This could have occurred because government was socializing debt, but that has not happened yet.

Private debt to GDP rose as rapidly last year as it did before the onset of the financial crisis. It even rose in the first quarter of this year as the financial crisis intensified. But unlike the 1930s, when this ratio rose even though economic agents did not want it to rise because nominal income was falling, in this episode the private debt to GDP ratio has kept rising because fee hungry lenders continue to engage in expanding credit to profligate over-indebted borrowers. If one looks at this chart with a historic perspective it is clear that this ratio cannot keep on rising. But if you ask people in the market place whether we must go though a period in which credit falls sharply relative to income they will say that need not be. It is widely acknowledged that it has taken several units of debt to produce a unit of GDP in recent years.
[again -- zero hour approacheth -- ed.] Most people strangely assume that will be the case in the next recovery. The same attitudes hold for our policy makers. They do not talk about an eventual reduction of credit relative to income. They talk about providing new channels of credit to offset constricting ones; for example, expanding the lending of the GSEs to offset the falloff in securitizations. Can the moon shot in the debt to GDP ratio keep going on, like so many assume? Or has something happened that makes at least a reversal, if not mean reversion, imperative now?

veneroso explains that the tech bubble which yielded the housing bubble has now yielded the commodity bubble -- an impoverishing bubble which, by diverting cash flow from debt service, will amplify the other primary reason for imperative mean reversion: deep, widespread insolvency on a scale simply too big to bail. in short, serial bubble blowing is at an end.

It has been calculated from the flow of funds accounts that the ratio of aggregate mortgage debt to residential real estate value reached a peak of 50% when the home price and home finance bubbles reached their peak at the end of 2006. But the flow of funds accounts do not capture second and third mortgages. They do not capture the home equity loans that are in portfolios other than those of the commercial banks. There is a large “other” household debt item in the flow of funds accounts which includes various such claims against residential real estate collateral. I encountered one ratio calculated by the housing finance industry that suggested that, at the home price peak at the end of 2006, the aggregate loan to value ratio was 57%.....

If home prices fall nationwide by 35%, it follows that the average loan to value ratio will exceed 90%. About 30% of all residential real estate in value terms is without a mortgage. For all real estate with a mortgage, the distribution of mortgage indebtedness is very skewed. With the average loan to value ratio rising to almost 90%, a huge share of almost all mortgage debt will be deeply underwater. All studies show that when mortgages are well underwater there are defaults and foreclosures. This applies to the majority of mortgage debt classified as prime as well as the margin of mortgage debt classified as subprime. If home prices mean revert, the odds are high that in the shakeout that will follow the total credit market debt to GDP ratio will finally fall from its moon shot trajectory.....

even where bailouts on this scale are attempted, the likelihood of unintended onsequences -- both in crowding out private refinancing efforts and forcing an interest rate rise on american treasury creditworthiness concerns -- will be high.

moreover, the truth is that the system of finance is supported not by recapitalization alone but credit growth -- meaning the return to the behavior that got us into this mess -- a prospect that looks even more distant for the private mortgage market than for the inherently inflationary and precariously positioned GSEs, per doug noland. as such, asset values would likely continue to decline in an effort to return to normal valuations to income even in the advent of recapitalizations -- though perhaps the probability of undershooting would be mitigated.

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I really appreciate your work daily. Keep doing it. Make more people wise.


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Friday, July 25, 2008


more reading

merrill's david rosenberg sees deflation as the likely outcome. awareness is rising.

nouriel roubini on why sovereign wealth funds -- contra my hopes -- will not be participating in the recapitalization of american banking anytime soon.

brad setser reflects at length on the crisis, now a year old.

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where we're headed

macro man notes along with others that the writedowns announced by national bank of australia may take on outsized dimensions before the pain in the financial sector is finished.

For Macro Man, the most interesting recent developments have come from Down Under (and Just Over). While it has yet to garner too many substantial headlines, the news that National Australia Bank (NAB) has written down its US RMBS portfolio to 10 cents on the dollar could send shockwaves through the financial system.

Much of NAB's book was made up of AAA securities, so to mark them down so drastically certain suggests that "the model", whatever it is, is broken. Now, when you consider that a whole host of banks are either marking this stuff much higher on their balance sheets, or have moved it to the limbo of "Level 3" make-up-whatever-price-you-want assets, a publicly-disclosed 90% write-off on similar assets could represent a rather unpleasant dash of cold water in the face of much larger fish than NAB. No doubt a host of banking execs are cursing NAB into their Cheerios this morning; after all, nobody likes a whistle blower, especially when there's plenty of other bad news to deal with.

from the original source:

The move, which means NAB has written down about 90 per cent of its former $1.2 billion portfolio in US residential mortgage securities, plunged banking stocks into the gloom again, with National Australia Bank falling almost 13 per cent to $26.81 before recovering to $26.96 in early afternoon trading....

The head of NAB Capital, John Hooper, said the bank had moved to adopt a "worst case'' view on the bank's collateralised debt obligations, which hold the US housing mortgage investments, because of recent bad news from the deteriorating US housing market.

He said while losses on the portfolio stood at only 2 per cent at present, the stock of houses for sale in the US market now added up to 10.6 million, partly due to large numbers of forced sales and foreclosures.

This was leading to houses being sold at prices that only recovered 45 per cent of the outstanding loan.

On top of this, out of 10 CDO investments, NAB is only ascribing value to two "super senior'' issues.

NAB has moved to write off the entire value of eight "senior'' CDOs because the structure of the debt means it is unlikely to receive any money at all from the distressed sales of US houses.

Mr Hooper said the $4.5 billion in other loan assets was held in a better structure, and was backed by corporate loans that were not experiencing the huge dislocations occurring in the US housing market.

i've spent the last couple days ruminating on how we might get out of this mess and how we can't. but it must be said that if THIS how triple-a RMBS and CDOs end up being marked, the scale of the problem is far greater than anyone has yet dared to estimate -- and we will surely be seeing debt deflation run stronger and further than most anyone expects as much of the american banking system ends up insolvent.

UPDATE: more via reuters.

[NAB] have pulled the pin out of a grenade; there’s no going back now.

and the aussie business spectator.

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Thursday, July 24, 2008


the run on washington mutual

via calculated risk and bloomberg:

Washington Mutual Inc. tumbled more than 20 percent for a second day as Gimme Credit LLC said unsecured creditors were ``pulling funds'' from the biggest U.S. savings and loan.

Gimme Credit analyst Kathleen Shanley cited the decline in federal funds purchased and commercial paper to $75 million from $2 billion at year-end, which Washington Mutual reported this week in its second-quarter results. Securities sold under agreements to repurchase dropped to $214 million from $4.1 billion at the end of 2007, she wrote.

Washington Mutual, known as WaMu, reported a $3.3 billion second-quarter loss on July 23. Rising delinquencies forced the Seattle-based company to boost provisions for bad loans. While WaMu said it has enough capital after raising more than $7 billion earlier this year, Shanley said liquidity remains a concern.

``We won't use the phrase `run on the bank,' but we would be remiss if we did not observe that many creditors have quietly been pulling funds,'' wrote Shanley, based in Chicago. Their actions are ``presenting an increasing funding challenge,'' she wrote. Gimme Credit is an independent research firm serving corporate bond investors.

long time coming. paul jackson of housing wire notes that there are skeptics of the analysis, but it caught my eye that jackson mentioned:

Looking at deposit activity in the second quarter, it’s worth noting that WaMu saw total deposits drop $6.13 billion between the end of March and the end of June to $181.9 billion in total, with $3.4 billion of that total drop coming out of retail deposits. Total deposits are roughly 10 percent below year-ago levels, as well; and while overall deposits are falling, brokered deposits are rising. WaMu reported $19.3 billion in consumer brokered deposits at the end of Q2, up $1.5 billion from one quarter earlier.

this is very similar to what was transpiring at indymac.

Uninsured deposits began to run off in mid-2007, long before Senator Schumer's letter. In fact, the bank actively replaced slight declines in FHLB advances and a drop in uninsured deposits with insured deposits, and particularly with fully insured brokered deposits under $100K.

and that's hardly a surprise, given that some minority of depositors have had their head in the game and are proactively protecting their savings. but in this environment, on the heels of indymac, wamu is dead as a doornail. press reports like this can quickly end up being the kiss of death. i wouldn't be surprised if depositors just now awakening to the danger were queueing in their branches right now.

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credit crisis loss estimates still growing, part 4

following on part 3 -- not sure how i missed this one, but venerated dresdner allianz analyst frank veneroso's take breaks the $2tn mark. he has some frightening comments on corporate debt as well.



bill gross and housing price support

some time ago i wrote of comments made by PIMCO's bill gross:

gross ... either does not understand the mechanics of house prices (very doubtful) or is being disingenuous when he claims that the government can "support housing prices" by buying packaged loans even in a massive public intervention (whereas is might do so in a large inflation, by debasing the currency and allowing a big fall in real prices to occur as nominal prices are essentially static). what the government can do by such an act is help deleverage the money center banks, investment banks and hedge funds that are holding these illiquid, loss-making securities, recapitalizing them by buying their troubled assets as artificially inflated prices. importantly, the same holds for fannie mae and freddie mac, which increasingly appear fit for nationalization in total.

for gross to be correct, not only the banks but the whole shadow banking system would then have to use their newfound capital strength to... dive right back into the huge leverage and widespread fraud that characterized the mortgage market in recent years! that is exceedingly unlikely to happen, in my view.

recapitalized banks are very likely instead to follow the mode of past bubble-burstings (a precedent set very clear to japanese technocrats if not americans) and find ways to allocate capital to economic sectors that have been the best and safest -- not the worst and most troubled -- recent performers.

and yet i read again today via yves smith that gross is still trying to find ways for government to halt house price declines.

PIMCO estimates a total of 5 trillion dollars of mortgage loans are in risky asset categories and that nearly 1 trillion dollars of cumulative losses will finally mark the gravestone of this housing bubble. The problem with writing off 1 trillion dollars from the finance industry’s cumulative balance sheet is that if not matched by capital raising, it necessitates a sale of assets, a reduction in lending or both that in turn begins to affect economic growth, creating what Mohamed El-Erian fears as a “negative feedback loop.”

A trillion dollars is a lot of money, but in this age of photoshop wizardry it seems that experts can make just about anyone or anything look good. Lose a trillion? Well, just write it off a little more slowly, or suggest that mark-to-market accounting is not applicable to banks and investment banks. ... But the reluctance to remark rancid mortgage loans rests on the heretofore inevitable conclusion that home prices will bottom and then reflate within a reasonable period of time. If they go down even more, and stay down, well then Washington – Wall Street – and ultimately, Main Street – we have a problem. That is why Hank Paulson and in turn Christopher Cox are waving their independent but coordinated wands in an effort to 1) prevent a market run on the price of bank and investment bank stocks until there is enough time to reflate the U.S. housing market, and 2) ultimately recapitalize our primary mortgage lenders – FNMA and Freddie Mac. An interesting press release by the CBO on July 22nd, by the way, points out that the GSEs are barely solvent (9 billion dollars) when their assets are valued at current market prices. Housing’s cow needs to turn into a bull real quick.

Make no mistake, the current conundrum that must be solved is: how to make the price of 120 million U.S. barns stop going down in price and then to make them go up again. That, however, is easier said than done. One of the wisest men I know has this serious but admittedly impractical solution: have the government buy one million new/unoccupied homes, blow them up, and then start all over again. Absent that, he’s not quite sure what to do, nor am I, with the exception of the next paragraph’s proposal.

Up until this point, the joint efforts of the Fed and the Treasury have been directed towards maintaining the stability of our major financial institutions, recapitalizing their balance sheets in “current form,” and lowering the cost of mortgage credit. All are crucial to any solution, but it is this third and last point where markets have failed to cooperate. With Fed Funds having been lowered from 5¼% to 2%, it would have been logical to assume that the price of mortgage credit would go down as well and that the price of homes would at least slow their current descent. Not so. As Chart 2 points out, the yield on a 30-year agency mortgage-backed loan has actually risen since the Fed somewhat unexpectedly began to lower Fed Funds in early September of 2007. Add to that of course, the increased fees, points, and total spread that an actual homebuyer pays to finance his purchase now as opposed to then, and it is obvious that homes are not the bargains that starving realtors claim they might be. Financial asset prices, as well as those for homes, are really the discounted present value of what investors believe those assets will be worth far into the future. When the discount rate – in this case a 30-year mortgage – rises faster than the expectations for home prices themselves – then the price of a home falls. 7% + “all in” yields for current home financing, in contrast to prior periods of monetary easing, are lowering, not raising the discounted present value of an existing home. Blow them up? Well, yes, I suppose if we could. But absent that, lowering the cost of mortgage credit via the omnibus housing/GSE bill now placed before the Congress and the President is the best way to begin the long journey back to normalcy.

says yves:

Readers will no doubt note the curious failure to acknowledge the delevering as the result of mounting insolvencies, which makes the idea of stopping the fall in loan (sic) prices an exercise in fantasy.

private mortgagemaking is all but dead for the time being, i agree. but even if the banks are recapitalized from outside and the deleveraging of high finance slowed or stopped, which bank is going to immediately start hosing the mortgage market with ultracheap loans and neither underwriting standards nor care if the loan could actually be repaid? that's what it took for american household incomes -- which in real terms actually declined over the whole timeframe of the boom -- to support such a massive runup in prices. and that is something like what would have to happen again to halt price declines at current levels, much less reflate them to 2005 levels.

the whole principle of price-to-income valuation in the housing market is to assess affordability by time-honored measures of normal and sustainable lending that endangers neither the mortgagor nor the mortgagee.

gross proposes to shift risk to the government by forcing lower mortgage rates -- effectively nationalizing the mortgage market and turning the GSEs into explicit policy instruments. but he doesn't seem the quail at his own words:

... the cost of credit is going up, not down, in contrast to prior cycles, because astute investors recognize the myriad of global imbalances that threaten future stability. In addition to home prices, $130 a barrel oil and their resultant distortion of global wealth and financial flows head that list.

those investors include foreign central banks, who would recognize the effort of the united states to turn treasury bonds into a conduit for subsizied housing in perpetuity and reprice them accordingly.

backstopping what the GSEs have already wrought is one thing, and that itself may prove prohibitively expensive and enough to drive treasury rates higher on inflationary/sovereign default concerns. then turning the GSEs into liquidity firehoses for the housing market, enabling all interested americans to get mortgages prices so far below market interest rates that the "free money" aspect becomes comparable to what we saw a few years back is quite another -- and sounds like an excellent plan to create a run on the american treasury.

a still imprudent but far less dangerous plan is to accept house price valuation mean reversion as banks liquidate mortgage exposures and the GSEs are nationalized and wound down to a more manageable size -- and use the government balance sheet as a means of recapitalizing the core of a downsized banking sector in the aftermath.

UPDATE: paul jackson at housing wire takes away less concern about gross' proposals.

In other words, HW readers, we’re facing a housing cycle that in the short run isn’t likely to solve itself. Which means it’s time to strap in. Gross suggests that the housing legislation now making its way through Congress may be of some help, at least in the form of making sure that the primary sources of mortgage liquidity don’t blow up in the near-term.

“[L]owering the cost of mortgage credit via the omnibus housing/GSE bill now placed before the Congress and the President is the best way to begin the long journey back to normalcy,” he suggests, although it’s clear from his remarks that even Gross doesn’t believe it’s a great way to get there. But our options are somewhat limited by a cost of credit that seems stubbornly set on rising further amid growing fears over inflation.

“The cost of credit is going up, not down, in contrast to prior cycles, because astute investors recognize the myriad of global imbalances that threaten future stability,” Gross said.

Which means that homes are in for a rough ride, something that the investment side of the mortgage business is now coming to grasp. Fitch Ratings, for example, suggested Thursday afternoon that home prices nationwide may fall 25 percent of more in real terms over the next 5 years.

strap in, indeed. you can expect government to throw the kitchen sink at this problem over the next couple of years -- but there seems to be less than a ghost of a chance of halting the slide in home prices.

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Wednesday, July 23, 2008


how do we get out of this mess?

so things are in the shitter and look likely to get worse in the near term as recession builds momentum. looking past that, however the question going forward is, "how are we likely to try to get out of this crisis?"

the links to nouriel roubini's tech ticker interviews are everywhere, but i'll cite 1440 wall street.

roubini drills right to the core of the housing problem here. the economic unit we call the united states became deeply overleveraged in the credit boom which ended in 2007 and now carries more debt than it can service. what is needed for resolution is debt reduction, sometimes otherwise known as deflation.

but how can we get there without going through a process of unmitigated liquidation and cascading defaults? roubini posits that there are essentially two avenues for public policy here -- either explicitly nationalize the mortgage market and guarantee investor capital, or allow losses in mortgages to materialize and subsequently nationalize most of the banking system.

make no mistake -- as the housing delevering runs its course, these are the options. the latter would be the sweden model, effectively. the institutional risk analytics roundtable of last week gave a frightening window on what roubini is saying. when jonathan rosner suggested that house prices still have another 15-20% to correct -- something i consider to be a given, even optimistic, as i commented here -- the response was telling.

Wallison: ... Banks that hold this paper would see their capital decline in value along with the value of the GSE debt. Then we really would begin to see the failure of banks or at least the inability of banks to make new loans. My hope is that we can stabilize the GSEs and see the housing market also stabilize. But if Josh is right about the real estate market declining another 20 points, the GSEs will have to go into receivership. Then the question will be where is the US government going to get the money to ensure that the GSE debt is serviced. ...

Rosner: Yes and Treasury is worried about brokers while we are getting ready to see a couple of thousand small and medium size banks sold or closed in the next year or more.

it is worth remembering that the great depression saw about 11,000 banks fail out of a pool of 25,000. banks were then smaller and more localized -- today there are about 8,000. rosner is positing bank failures on a level not all that far from those seen in 1932-33.

O'Driscoll: If Josh's prediction about the real estate market declining further is correct, then I don't know what we'll do about the banks.

Wallison: Well, if Josh is right about real estate prices, then the Fed is going to have to open up investments in banks to non-financial firms. We should be getting rid of the BHCA entirely to raise the capital the industry needs. ...

Wallison: If Josh is right about the direction of housing and it goes down another 20%, yes there will be a huge crisis in the banking industry and at FNM and FRE, and the US government will be heavily involved. It has to be. ...

The IRA: As much as I'd like to see Josh's pre-pack plan
[a plan to give a 10% haircut to holders of GSE debt, doubtful in the opinion of the others to be acceptable to foreign central bank holders -- ed.] given a chance to work, it is really hard to see global central banks agreeing to such a scheme.

Rosner: Then we are probably going to see the result nobody wants, namely the junk status of the GSEs eventually transferred to the US government itself and a potential credit ratings downgrade of the US.

in other words, wall street got drunk and now we all get to share in the hangover. and that from a man who ought to know.

a successful nationalization of a large part of the banking system would be predicated on massive foreign recapitalization assistance, either through direct ownership transfer or through foreign central bank funding of the necessary treasury debt issuance that would accompany a government recapitalization.

there is clearly -- as rosner points out in this last statement -- some queston as to whether that help would be forthcoming. china is even now accelerating the depegging of the yuan, bringing forward the end of vendor finance for the largest player in that game, fostering what will eventually end up being a terrible currency crisis for the united states dollar. the spectre of what would effectively be a sovereign default by the united states is suddenly on the table. and a run on the dollar would lead in a roundabout way to the same disorderly deleveraging and economic collapse that we are hoping to dodge in the first place.

roubini apparently does not consider this to be the end of the debt supercycle as defined by the bank credit analyst if he thinks that moving the GSEs on balance sheet will not spark a treasury debt repudiation. but if dollar recycling slows as foreign vendor currencies -- the yen and yuan particularly -- are allowed to strengthen against the dollar in an american financial crisis and economic recession, it is hard to escape the notion that market interest rates will continue to rise more than would be expected in coming months and years as the united states is weaned from foreign financing. this would exacerbate economic stagnation and deepen the recession.

but the takeaway for housing market and economy watchers is that an explicit nationalization of the GSEs with debt guarantees in the area of $1tn or more may well be considered a hallmark of a resolution of the financial sector crisis.

UPDATE: via yves smith, indeed it would seen roubini is on to something!

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rising interest rates too?

you wouldn't think it could get more bleak -- the collapse of securitization and shadow banking, a foreclosure meltup, failing banks, the blackest consumer outlook in 30 years, government bailouts of GSEs, energy commodities near (hopefully past) all-time-highs, collapsing margins driving the year of the corporate default, sharply rising unemployment, recession taking a strong hold over most of the country, overlevered individual cash flow and balance sheets under intense pressure all the way up the scale, financial troubles now spreading globally through the conduits of globalized finance and trade -- what more could go wrong?

let's try interest rates.

i noted the other day freddie mac's plans to draw back from the loan purchasing that currently is the only fuel for american home sales. that is likely to have the effect of reducing mortgage credit and raising mortgage rates.

what i didn't note, however, is that the anticipation of that inevitable withdrawal -- in conjunction with the now-near-complete withdrawal of private capital from mortgage lending -- has already sent mortgage interest rates skyrocketing. and today so reports both the wall street journal, new york times and the mortgage brokers association.

the trend, it must be said, has been in place since the deflation scare of mid-2003. a check of the mortgage-x rate chart shows that rates on conforming 15- and 30-year fixed rate mortgages is near the highs of the last six years -- in particular spiking in the last week. as the times chart here shows, riskier jumbo rates have gone through the roof.

for context, we should put this in terms of cash flow -- in other words, how have these changes affected purchasing power for buyers with a certain amound of income to dedicate to housing?

per bankrate -- for a conforming 30-year fixed, rate have jumped to about 6.5% from 5.8% in may and 5.4% three years ago (in 2005, at the height of the boom).

using bankrate's housing affordability calculator, let's input a fiscally responsible party with $120,000 in gross annual income, $30,000 in down payment saved, no other debt whatsoever. rules of thumb suggest a mortgage payment of about $2800 might be the upside limit.

at a 5.4% rate, this party with that payment could finance a $525,000 home -- at 5.8%, that becomes $507,000 -- at 6.5%, it's $470,000. that's a 10% cut in purchasing power from three years ago, and a 7% cut in just the last eight weeks. and of course that's not the end of the obstacles, for many mortgage makers are protecting themselves now in the midst of declining asset values and shaky financial conditions for mortgage insurers by requiring 20% down payments. that puts our hypothetical party into wait-and-save mode, as 20% of a $470k home is $94k.

but in truth this isn't the real story for this kind of buyer, as the loan size they are contemplating above puts them into the jumbo mortgage market -- where risk and rates are higher. for a jumbo 30-year fixed, rates have moved to 7.5% from 7.0% in that same eight-week span and about 5.7% in 2005. the upshot is that purchasing power has come down from $512k in 2005 to $450k eight weeks ago to $430k today -- a 16% reduction from the boom.

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Tuesday, July 22, 2008


end of the broker/dealer model?

nouriel roubini through yahoo tech ticker says that the investment bank model is dead.

The problem, he says, is that broker/dealers use the same model as banks -- borrow short and lend long -- only they borrow on even shorter timeframes, use more leverage, and don't have the kind of government backstop banks enjoy.

In the wake of Bear Stearns' demise, which showed how brokers are vulnerable to a "run on the bank" if they can't get overnight funding, the Fed temporarily opened its discount window to brokerage firms. But making that option permanent means submitting to the same kind of regulation and capital requirements as banks; that, in turn, means a very different business model -- and much lower profitability -- for Wall Street firms, whose current business model is "not viable," he says.

the difficulty i have with this call is that the broker/dealer model has a long history, as does borrowing short (even wholesale) and lending long (and illiquid). i think roubini deeply underestimates the reckless love of profit that motivates the i-bank model (or, for that matter, the unregulated hedge fund).

that's not to say disasters will not proceed from them. the infamous year 1929 saw the collapse of levered investment pools in a horrifying credit squeeze that ultimately undid 19th-century capitalism. but the basic model that roubini disavows here is still operating today.

the trouble the four independent broker/dealers are in is certainly a result of their business model, but more exactly is the result of overlevering their business model into an asset deflation. it may very well threaten and eventually end the independent existence of all four as it did bear stearns -- but that does not mean we will not see the permanent eradication of levered finance.

probably roubini isn't suggesting anything so profound as a change in human nature -- indeed i imagine his point is simply that this crop of broker/dealers is as dead as the bank of the united states. but levered finance will be back, regardless of what wickedness this way comes.

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indymac aftermath

john mauldin passes on the analysis of cumberland advisors with respect to indymac.

IndyMac's regulator, the Office of Thrift Supervision (OTS), closed the institution on Friday, July 11 and turned it over, as the law requires, to the FDIC to act as receiver and insurer of deposits. The FDIC's preliminary estimates are that the failure will cost it somewhere between $4 and $8 billion. ...

IndyMac was a hybrid savings institution spun off from the now defunct Countrywide, that specialized in the origination, servicing, and securitization of Alt-A (low-documentation) mortgage loans. It grew very rapidly, doubling in size between March 2005 and December 2007 from $16.8 billion to $32.5 billion. Its funding in rough order of importance consisted primarily of Federal Home Loan Bank (FHLB) advances and insured and uninsured deposits. The advances were a particularly important source of funding, accounting for between 32% to 45% of its total liabilities.

IndyMac's reported capital declined over the period from its peak of $2.7 billion in June of 2007 to $1.8 billion at the end of March 2008. Uninsured deposits began to run off in mid-2007, long before Senator Schumer's letter. In fact, the bank actively replaced slight declines in FHLB advances and a drop in uninsured deposits with insured deposits, and particularly with fully insured brokered deposits under $100K. At about the same time, the bank's stock price began to plummet, dropping from a high of about $35 per share in June to about $3 just prior to the Schumer letter. Additionally, earnings also turned negative in the fall of 2007. These factors all pointed to a very troubled institution whose situation was continuing to worsen.

Despite the OTS examination in January and subsequent actions by the institution to change its strategy, its capital position continued to decline and earnings deteriorated. In the face of this, OTS director John M. Reich maintained that IndyMac was adequately capitalized and the institution touted that fact in its SEC filing. In fact, in the bank's March 31, 2008 10Q it stated that tangible and Tier 1 core capital stood at 5.74%, well above the regulatory requirements for the bank to be classified as well-capitalized. Risk-Based Tier 1 capital was 9% and Total Risk-Based capital was at 10.26%. Given that it was supposedly adequately capitalized and was done in by a liquidity problem as some $1.3 billion of deposits ran off, it stretches credibility that the bank's failure would lead the FDIC to estimate that it could stand to lose between $4 and $8 billion.

How could losses of this magnitude accumulate in just a matter of a few days due to a supposed run of $1.3 billion? The answer, of course, is that they didn't.

The bank was likely to have been deeply economically insolvent, which was masked by faulty accounting according to current rules and regulatory standards
. Clearly, the bank's active bidding for brokered deposits and reliance upon funding from the FHLB amounted to a big gamble – financed by other government entities – that it might weather the storm. Keep in mind that IndyMac had, at closing, about $10.1 billion in FHLB advances and perhaps even Federal Reserve discount window borrowings as well. Any such borrowings would be over-collateralized with high-quality assets – in this case the collateral was largely mortgage-backed securities. Such claims stand ahead of insured deposits or the FDIC in the liquidation. This means that much of the best collateral that could have been used to backstop the FDIC or shared to reduce losses to uninsured claimants was instead siphoned off by other agencies. Indeed, the FDIC initial estimates are that uninsured depositors may receive fifty cents on the dollar of uninsured deposits.

What emerges from even a partially informed and quick analysis of the available evidence and data is the suggestion that (a) the institution was in deep trouble long before it was closed; (b) the OTS appeared to be late to the party, despite market signals; (c) OTS actions were ineffective when measured against the intent of FDICIA; and (d) the institution engaged in moral hazard behavior by pumping up its brokered deposits that were 100% insured and borrowing from the FHLB, and possibly the Federal Reserve. The bottom line is that the FDIC is left to clean up the mess and the costs associated with regulatory ineptitude, and the moral hazard behavior will be paid for collectively by the banking system through higher FDIC premiums on the surviving banks.

one wonders how many other regional banks out there are publishing extremely high CD rates to draw in brokered deposits and leaning on the FHLB because uninsured deposits are fleeing. it must be very, very many.

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Monday, July 21, 2008


the flood -- dynamic hedging

on the heels of comments earlier today on deteriorating housing liquidity and deteriorating corporate liquidity, doug noland of prudent bear offers a view on how the freezing of more and more of the credit markets in the aftermath of a spectacular boom is increasing the odds of a dislocation in equities.

This week benchmark Fannie Mae MBS yields jumped 31 bps, to an 11–month high 6.15%. Spreads versus treasuries widened 18 bps to the widest level (206bps) since the height of the crisis in March. Also this week, the SEC took an extraordinary step to tighten the rules for shorting the large financial stocks. These developments are not unrelated.

In JPMorgan Chase’s and Citigroup’s earnings conference calls, both major lenders this week noted deterioration in prime mortgages. This provides additional confirmation that the mortgage crisis is now reaching the bedrock of our nation’s mortgage Credit system. And particularly with the mortgage insurers, the GSEs, and the leveraged speculating community having come under varying degrees of stress, a tightening in “conventional” mortgages will now significantly exacerbate the mortgage/housing/financial/economic crisis.

In years past, I have occasionally used my fictional “town by the river” analogy to demonstrate how the introduction of inexpensive flood insurance and a resulting speculative boom in writing this protection fostered a building boom along the river. The financial (insurance, lending and speculation) and economic (building, asset inflation, and spending) aspects of the boom were interrelated and reinforcing. In my fictional account, the booms were further spurred by a drought that both inflated the profitability of writing risk insurance (attracting throngs of speculative players) and buoyed complacency for those living, building, and spending freely near the water’s edge.

These dynamics set the stage for the inevitable dislocation in the flood insurance market. With the arrival of the first torrential rains, there was a panic as the thinly capitalized “insurers” rushed in a futile attempt to re-insure their risk of potentially catastrophic losses in the event of a flood along what had become a highly over-developed river bank. Few in the insurance market had built reserves, as most speculators simply planned on hedging flood risk in what was, at least the time of the boom/drought, a highly liquid insurance marketplace. Worse yet, over time the pricing of flood protection had become grossly inadequate with respect to the mounting (“Bubble”) risks that had developed over the life of the financial and economic booms. Any reinsurance available during the crisis was priced prohibitively.

Back in 1990, when I first began working on the short-side, there was an estimated $50bn to $60bn in the hedge fund community. The few of us actually shorting stocks were primarily focused on diligent fundamental company “micro” research and analysis. It was not until some years later that “market neutral” and “quant” strategies took the financial world by storm. And back in the early nineties the OTC (over-the-counter) derivatives industry was just starting to take hold. Today’s Wild West CDS (Credit default swap) marketplace didn’t even exist.

Nowadays, the “leveraged speculating community” is measured in the multi-Trillions; the derivatives market in the hundreds of Trillions. The scope of players and sophisticated strategies utilizing short-selling is unlike anything previously experienced in the markets. And similar to how drought magnified the boom along the river, it was the boom in leveraged speculation and derivatives that played the instrumental role in fueling self-reinforcing Credit expansion and the resulting Credit, asset price and economic Bubbles. But those Bubbles are bursting – the torrential rains are falling and there is today extraordinary and overwhelming impetus to “reinsure” – to offload - the various risks that ballooned over the life of the protracted boom.

Many writing the multitude of types of market insurance incorporate “dynamic hedging” strategies. This means that few hold little in the way of actual “reserves” to pay in the event of major losses. Instead, they rely on “shorting” various securities that, in a declining market, will provide the necessary cash-flow to satisfy any insurance obligations. This all worked wonderfully in theory, and the basic premise of modern day risk hedging capabilities was supported by the nature of highly liquid boom-time financial markets. But “torrential rains” have a way of rapidly and dramatically altering marketplace liquidity. The reality is that entire markets cannot insure themselves again declines. Any attempt by a large swath of the marketplace to hedge exposure will be problematic. Selling will either immediately overwhelm the market or the “put options” accumulated as protection will create acute market vulnerability to self-reinforcing selling pressure and market dislocation.

Today, there is little liquidity in the securitization or corporate bond markets. So, the multi-Trillions of strategies relying on shorting securities for hedging and speculating purposes have gravitated to the relative liquidity of U.S. equities. And, when it comes to hedging against or seeking profits from heightened systemic risk, one can these days see rather clearly how incredible selling pressure can come down hard on the 19 largest U.S. financial institutions. And when one considers the scope of derivative strategies that incorporate “delta hedging” trading dynamics – where the amount of selling/shorting increases as the market declines (systemic risk increases) – one recognizes the possibility of a marketplace dislocation along the lines - but significantly more systemic - than the “portfolio insurance” fiasco that fueled the 1987 stock market crash.

Importantly, this issue of acute systemic risk has taken a turn for the worst with the recent deterioration in the conventional mortgage market. The highly exposed GSEs, mortgage insurers, and leveraged speculators are positioned poorly to withstand a bust in prime mortgages. The fate of the U.S. Bubble economy today rests on the ongoing supply of low-cost "prime" mortgages. Any meaningful tightening in conventional mortgage Credit – including the lack of availability of mortgage insurance, required larger down payments, and/or tougher Credit standards – would have a major impact on Credit Availability for core housing markets throughout the country (many that have thus far held together fairly well). Such a tightening would put significant additional downward pressure on prices, exacerbating already escalating problems for the GSEs, Credit insurers, and speculators.

this amounts to an explanation of why short interest has been steadily marking all time highs. being unable to dynamically hedge in credit market underliers due to extreme liquidity constraints, operators have resorted to hedging credit exposures in the remaining liquid market of equities. as credit market conditions deteriorate, the impulse to reinsure portfolios dynamically grows -- and sets the stage for a crash in much the same manner as cascading hedging forced the events of late october 1987.

as such, credit market events must be watched very closely.

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credit spigot shutting for corporates

via mish -- bloomberg reports.

Issuance slowed as the average spread on investment-grade bonds climbed to 7 basis points shy of its 2008 high and junk- bond spreads surpassed 800 basis points for the first time since March. Federal Reserve Chairman Ben Bernanke's forecast of weaker growth and accelerating inflation left few windows for treasurers to tap debt markets.

not for a lack of issuers...

``People have been waiting and waiting and there really hasn't been a good spot,'' said Brady, who helps oversee about $5 billion in fixed-income assets. ``The market hasn't really recovered.''

but for a lack of willing investors.

``You've seen some real ugliness in the high-yield market in the last couple of weeks,'' he said. ``It's really hard to get people to focus on new issues, on putting new risk in their portfolios, when they've already got a lot of the old risk.''

debt-financed corporations are being pushed to the brink by speculative high input costs, falling output revenues and crisis conditions in the credit markets that might otherwise sustain them through a rough patch.

as real defaults mount, i fear we may hear again from the credit default swap market. note that, while earlier bank estimates had a tenfold rise in defaults as a base case, comparisons have since arisen to previous downturns where high yield corporate defaults maxed out at over 10%.

UPDATE: more from ft -- the "year of the corporate default" is upon us.

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the worst possible news for housing

as the troubles at fannie mae and freddie mac picked up steam in recent weeks, i sometimes felt queasy as i pondered my long-held belief that the GSEs would not be allowed to go quietly into liquidation. it was evident early in the crisis that there were deep problems. as things worsened and politicos started pushing the GSEs into the role of housing savior, deeply knowledgeable analysts like jonathan rosner made plain that FNM/FRE were going to struggle to save themselves.

slowly it has dawned on markets that great depression housing comparisons are legitimate, and that this spells damnation for any housing finance entity geared up to a 65x leverage ratio. particularly those which, as articulated very well by the economist this week,

did not stick to their knitting. In the late 1990s they moved heavily into another area: buying mortgage-backed securities issued by others. Again, this was a version of the carry trade: they used their cheap financing to buy higher-yielding assets. In 1998 Freddie owned $25 billion of other securities, according to a report by its regulator, the Office of Federal Housing Enterprise Oversight (OFHEO); by the end of 2007 it had $267 billion. Fannie’s outside portfolio grew from $18.5 billion in 1997 to $127.8 billion at the end of 2007. Although they tended to buy AAA-rated paper, that designation is not as reliable as it used to be, as the credit crunch has shown.

... Joshua Rosner, an analyst at Graham Fisher, a research firm, who was one of the first to identify the problems in the mortgage market in early 2007, reckons Fannie and Freddie were buying 50% of all “private-label” mortgage-backed securities in some years — that is, those issued by conventional mortgage lenders. This left them exposed to the very subprime assets they were meant to avoid. Although that exposure was small compared with their portfolios, it could have a big impact because they have so little equity as a cushion.

the result was a run on the stock of the GSEs in what amounted to a test of the implicit government guarantee that stands behind agency debt instruments. the government predictably and halfheartedly rose to the occasion, failing to nationalize the stricken companies outright -- probably in fear of fomenting a spike in treasury rates, even a possible run on both treasuries and the dollar -- but offering planned liquidity assistance through the treasury (with congressional approval) and the fed (as soon as needed).

but overlooked in the panic and subsequent relief is the fact that FNM/FRE remain in very deep trouble and will likely have to reduce the scale of their operations. confirmation of that appears to be coming today, as bloomberg reports (via calculated risk) that freddie mac will be cutting its purchases of mortages. one can be sure that fannie mae is not far behind.

and this is the worst possible news for the housing market, barring an actual GSE failure. for fannie and freddie now account for in excess of 80% of all home lending in the united states as private banking has utterly fled mortgagemaking, being already far more exposed to the sector than it would ever care to be again. as they are compelled to withdraw from loan purchases, there is no alternative but for fewer loans to be made -- and those that will be made will carry significantly higher interest rates to reflect risk premium. this will force housing demand down, housing inventory higher, housing prices lower, and foreclosures higher. further, in a continuation of the awful spiral we have been privy to all year, this will accelerate losses at the banks and GSEs alike, forcing further withdrawal from credit offering, in turn forcing housing demand down further still.

where is the bottom of this spiral? an eventual equilibrium of positive carry, i suspect, with possible detours including either an explicit nationalization or a recapitalization/breakup/sale of the GSEs, quite probably with an undershooting of valuation metrics to trough levels as mortgage finance transitions to a new model.

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