A New Wave of Defaults?

I have been working with a young couple for a year now. They have been up against it. They look pretty typical. They bought an apartment with a first mortgage and low down payment. Then they made improvements with a HELOC. He lost his good job and now works for less. She works long hours and they have a kid.

They are underwater on the 1st mortgage so the HELOC is worthless. Their monthly cash flow including debt service has been negative for a long time. They have been paying the mortgage(s) by drawing down more on the HELOC.

I advised them a year ago to stop the madness. They tried to contact their lenders for assistance but were told they did not qualify for a re-financing, as they were current on their mortgage.

I told them to stop paying. But they would have none of that. They had built up a credit rating that they were both very proud of. They did not want to lose that. But more importantly they felt that walking on IOUs was something that morally they could not do. I told them they were nuts but that I was proud to know them.

I sent them a link to last week’s Barney Frank letter to the big banks telling them to write down non performing second mortgages. I sent them the link for the BoA story and their program to write down principal for delinquent mortgage debt.

They called just now. They made up their minds. They will not pay either the 1st or the 2nd this month. The “entrance fee” to getting the debt relief they need is to not pay any longer. The cost will be a tarnished credit. They no longer care.

Does this story mean anything in the Macro Big Picture of defaults? I am certain that it does. A rising trend is about to become a rogue wave.

What Healthcare Success?

You have seen this before so please excuse the personal rant. Follows is a copy of a notice from my heavyweight health care provider, UnitedHealthcare/Oxford. Note that at the renewal rate insurance for a family of four now costs $58,600 a year.

In the Heathcare debate the CBO but out some numbers on insurance costs for a family. Their high-end number was 17% of household income. By that calculation a family would have to have an income of $345,000 to afford this plan.

This is no Cadillac. I pay minimums and co-pays. I had a surgeon I know and trust cut something recently. He was out of network so that cost $1,300. I have the Freedom Plan. But actually I am in jail. These folks have me over a barrel.

Consider the pricing differential for a husband and wife and a family of four. The kids cost an extra $1,629 a month. Pay that bill for eighteen years and it comes to a tidy $350 thou. Who in their right mind would want to have kids looking at that tab?

How many people are getting letters like this? Not many. 4-5 million is my guess. More every day is the certain answer. There is nothing in the Healthcare bill that is law today that changes this. There is no interstate competition. There is no reason to it. It is gouging.

I have to suck it up and pay these bills. But I am going to vote with my feet. For my State Senators, Charles Schumer (D) and Kirtsten Gillibrand (D) and my Congressman John Hall (D), don’t look for my vote or support this fall.

Disclosure: Long time Dem. Until recently, a district leader for the party. Steady contributor. Pissed.

Tim on the Hill - Ho Hum or Ahem?

I watched the Tim G. show today. I was not impressed. One and a half years after conservatorship the Treasury Secretary admitted he was on square one when it comes to a fix on the Agencies. He admitted he had been diverted, saving everything else required more immediate attention.

On future timing Tim was very vague. He said there would be meetings and progress made gathering a consensus of what could and should be done over “The next three months”. Read this to mean that the talk goes to the summer recess and the issue does not come up again until after the mid term elections. So the answer that Tim would not give on the timing for delivering a defined strategy for the Federal role in the mortgage market is sometime at least a year from now.

I found some of the following to be of interest:

On Barney Frank.

Barney runs this show. In my eyes he was rude on more than one occasion. I thought he abused his position with the gavel. There was, throughout the proceedings, a repeated statement by all that a bi-partisan approach would be required to forge a successful outcome. With that in mind you should have seen the rancor between the Dems and Reps. It’s pretty simple. They hate each other.

Barney added to the fray with a 10-minute historic review of legislative failures on GSE reforms. He blamed the Republican for all the problems. When asked about the growth of Sub prime at the Agencies while he was minding the store he blamed the Federal Reserve for not policing the issuance of junk mortgages. So basically Mr. Frank shares none of the blame for what happened. Wow!

On at least five occasions BF made clear that he would be focusing his attention on the rental market and not the privately owned homes. Just a hunch here. Barney sees a few million houses in inventory on the Federal level over the next few years from the REO of the agencies. I think this will be his new rental property.

On the timing of GSE reform:
“Don’t tear down the jails until the new ones are built”.

To a Republican Congressman:
“I don’t care what you do with your (allotted) time. You can sing a song if you want to.”

***************
Brad Sherman (D Cal.) asked Geithner about the scheduled drop in the “temporary” maximum loan limit for the GSEs (December). In his district the maximum limit would fall from $729,000 to $417,000.

T.G.
“I don’t have a judgment now on extending the temporary limits”.

Sherman pushed:
“Will the cuts in the limits at the end of the year kill the economy?”

T.G.
“I don’t have the answer to that”.

BK This from a Dem? Tim could not answer this question? It means he can’t go to the bathroom without asking permission.

****************
Mike Capuano (D Mass)
“Fan and Fred created and sustained the middle class”
“They (Fan/Fred) did bad things but not worse than the pirates of Wall Street”.

T.G.
“Not worse. They were better”. “Getting rid of F/F is a home owner killer”
Later TG added, "Fan, Fred and FHA are the only game in town for mortgages."

BK F/F created the middle class? F/F destroyed the middle class. Strong words from Timmy on the need to have the agencies around in one form or another.

*************
Treasury Secretary Tim Geithner on the question of the “Christmas Eve” unlimited support package for the GSE’s:

“I exercised the prior authority provided by my predecessor”.

BK The way he delivered this line was a ‘tell’ that he had practiced it in the shower this morning. These guys never owe up to the choices they make.

*************  
Jeb Hesarling (R Tex):
“F/F are tools of national economic policy” “They are an instrumentality of the Administration” “What is your time table for dealing with the GSE’s?

T.G.
“We will take an appropriate amount of time”

Hesarling:
Do we need a central GSE role in this country? No other country has a similar system.

T.G.
"Yes."

BK: Another sign that GSEs are going to be with us for some time to come.

****************
On the issue of Agency Preferred Stock

Rubin Hinosa (D Texas)
“Small banks in my district were urged to buy F/F preferred stock so that they would look better. They lost all their money in those investment and now do not have the capital to make new loans. What are you going to do to fix that problem?”

T.G.
“We are working on a $30b lending facility to help Community Banks offset their losses on GSE securities.”

Hinosa:
“Timing?”

T.G.
“Legislation is being drafted”.

Later Donald Manzullo (R Il.) goes in the same direction:
“T.Sec Hank Paulson stated in his book that the Treasury bought Agency debt to satisfy Chinese Banks. Community Banks bought (Agency Pref). Those banks were deceived by Fannie and Freddie. Why aren’t the Community Banks being treated like the Chinese?”

T.G.
“My predecessor did this.”

T.G.
“We are working on a plan to put in place a capital facility.”

Manzullo:
“If they were made whole on the Preferred we would not need a new lending facility”. “Do you need authorization from Congress to do a (preferred) stock buy back”?

T.G.
“I will have to get back to you on this.”

BK This puts the Pref issue “Out There”. I am not a lawyer but it seemed to me that our boy Tim is working on a back door plan to “make whole” all those nice Community Banks who bought Agency Pref. You can’t do that. One holder of Fannie pref gets made whole through soft loans and the other holder of Pref gets Dick’s hatband. And Timmy gets to decide who gets what? 

I think Tim opened a can of worms with this. He just admitted to working a side deal to help some more banks out. At the expense of those who bought the swill from the likes of Merrill Lynch? I don’t think so. Not sure that Hank actually said this in the book.

***************
On the question as to the timing of developing a "Covered Bond" mortgage market in the United States?

T.G.
"I don’t know."

***************
Shelly Capito (R WV)
“Are we (the government) competing with the private sector in establishing a private mortgage market?”

T.G.
“No. The banks are reporting that they see little or no demand for loans”.

****************
Ron Paul (R Tex)
“What part of Austrian Economics don’t you like?”

T.G. responds with a smile and a sort of hat tip to the Austrians:
“Interest rates played a role”
“Moral hazard (gvmt. Gtee.) played a role”

BK The comment on interest rates being so low during the bubble as a cause of the 08 blowup is interesting. Greenspan swore on a stack of bibles recently that it had nothing to do with it at all.

****************
Bill Posey (R. Fl)
“Did you sign off on the (mega bucks) pay package of the F/F Executives?”

T.G.
“No.”


BK: TG takes credit for nothing. We really have to can this guy.

***************
Carolyn Maloney (D NY)
“What can be done to stop the GSEs from investing in projects like Stuy Town?”

T.G. “I don’t know”.

***************
Maxine Waters (D Cal.)
“The Housing Trust Fund lost its billion dollar financial support from F/F. What are you going to do to replace that lost funding for HFT?”

T.G. makes clear that he will address this problem.


BK The HTF is a Congressional fund of sorts. It was funded by the GSE’s as partial payback for soft legislation. This type of thing is why we are in trouble today. And Maxine and Tim have promised to fix the problem and restore the fund. Nothing has changed but the names.


*****************
On the issue of whether the debt of the GSE’s is a sovereign obligation and should be accounted as such on the federal balance sheet:

T.G.
“It is not sovereign debt. But we will pay it. Both past and future debt.”

T.G.
“The GAO has agreed that it is not necessary to consolidate the debts on the government’s books.”

BK Enough said.

SS - Update for Angry Bear

In early January I published a piece on the status of the SS Trust Fund. Dale Coberly and Bruce Webb responded that I was all wet. Later I posted a piece at Angry Bear where I attempted to support my contentions that the TF was running out of gas many years ahead of “schedule”. Talk about selling coal in Newcastle. No one bought that thinking.

In my last comment at AB I promised an update in March on how the year was progressing. Time is up. The critical numbers for payroll taxes are available for January – March. The benefit numbers are available for January – April.

The following are the 1st Q payroll numbers for 2006 – 2010:

Note that the 1st Q total of $166.2 is well less than 2009 or 2008. It, like many other big macro numbers (I.e. GDP) is back to where we were in 2006. Note also that the 06-09 1st Q percentage of the yearly total came in a fraction either way of 26%. I checked this ratio going back to 2000 and it does not vary much from the 26%.

IF you use the 26% number as forecast tool for the full year you come up with $639b as the full year revenue number.

Now the Benefits side:

Consider the four-month totals. The 2010 result (230.6) is 27% higher than 2006 (181.6). The clear observation is that the Fund is generating revenue at 2006 levels and spending like it is 2010.

A review of the “% of Annual” line show that the first 4 months correlate very highly to the annual results (a few basis points either way of 32.90%). Using this number we can again solve for the annual number. In this case the forecast using this approach is for expenses to be $700b.

Some perspective should these forecasts bear out:

-The annual Payrolls minus Benefits will be in deficit by $60 billion.

-The Fund uses a ratio of Total Taxes-Benefits as its primary measure of performance. The Fund will earn approximately $25B in taxes from benefits in 2010. Therefore the primary ratio of the Fund will be negative $35 billion for the full calendar year. The Fund predicted in its May 2009 annual report that this milestone would not be met until 2016.

The Fund will be in surplus for the full year 2010 after giving consideration to the other income/outgo components of the Fund.

I am using the following numbers for the full year:

PR Tax…… $640b
Other Tax....$25b
Interest……$110b

Benefits……$700b
Overhead….$6b
RR EX….....$5b

Net Surplus=~$65billion

Still a monster number. But that number is down 50% from 2009 and is only 1/3 of the surplus in 2006. These results, should they be realized, are very significant. This will compress the time frame where SS goes negative on a total basis.

The results so far in 2010 support my longer-range forecast(s)* made in January. The Fund will first go cash flow negative (includes interest) sometime between 2012 and 2014.

What could alter this outcome? Given that the expense side is fixed it is dependent on a rapid (and permanent) increase in PR tax income. If the economy were to generate 10mm new jobs over the next year or so the Fund would stabilize and the year where the lines actually cross could be pushed out. But 2037 is no longer a realistic expectation for the time when SS would go “pay go”. As to the possibility that this 'miracle of job creation' actually happens, I would put the odds around zero.

My crystal ball can’t predict an answer to the question, “When will SS have exhausted its assets?” It will be interesting to see what the Trustees have to say on this issue in their upcoming report. I maintain that that date is irrelevant. The date to focus on is when does the Fund first go negative and not when the assets are depleted. And that date is right around the political and economic corner.

I think we can agree that this is a dead issue for 2010. Washington can’t take more pain after Health Care. I would say it is also not possible for this issue to be addressed in a presidential year. So that leaves 2012 out.

Therefore the only possible time for SS is 2011. What are the odds on that? I am no political pundit but I listen to my neighbors and read newspapers. It is my view that if the mid-term elections were held next month the Dems would lose the House. Of course the election is not next month. It is seven months away. America does tend to forget quickly. Surely there will be other issues on the table by then.

Should there be a political shift in November it would make it nearly impossible to find a politically acceptable solution for SS in 2011. I doubt the Administration would even try. We all know that SS is the “third rail”. They must come up with a “solution” for the D.C. mortgage agencies. That is a hot potato too. They can’t juggle these two balls. I say they will shelve any thoughts on SS.

If you buy into any of this you would have to conclude that the person who next takes the oath of office in January of 2013 will have a big horrible mess on their table. Failure to find a very quick solution could well be the event that turns the lights out. I understand that there are many who think that these milestones are meaningless. That SS was "designed" to to do this sooner or later.  I maintain that the Fund can't be permitted to turn this corner at this time.  The pressure that it will cause on the public sector debt will not be manageable. The accelerated timing of this is happening at a very terrible time.

 

Note:

I provided two forecasts using two methods. These were the numbers I used. If anything, I would have to downgrade them both based on the results so far in 2010. ($ in billions)

Method #1

2010  +74

2011  +49

2012  +24

2013  -1.2

Method #2

2010  +84

2011  +34

2012   -8

2013   -43

Sheila Does a Deal

The FDIC announced a $1.8 billion deal after the close on Friday. I thought it was interesting from a number of perspectives. As usual, I find fault with it.

The summary terms of the transaction can be found here. The following is what I thought important:

-This is a run of the mill MBS with bells and whistles. The big whistle is the guaranty. The FDIC has puts its chomp on the whole thing. That means that this has the full faith and credit of the US government behind it.

-The deal was priced as a discount to Ginnie Mae paper (also full faith guaranty). The FDIC remarked that there was “robust” demand for the paper. I should hope so. I high yielding AAA should not be a hard sale these days.

-The 1.8B deal was backed by $3.6B in mortgages that FDIC owned as a result of acquiring failed banks. The advance rate on the deal is 50% of face. What this means is that the mortgages in the portfolio are swill. No wonder the FDIC had to put its name on this to get it out the door.

-The collateral was valued at 70% of par. This is the same discount that was applied to the sale by FDIC of its performing mortgages that came from the failed Indymac bank. That deal has proved to a bust. The ex Goldman guys who put the Indymac deal together are now just raking it in, much to the chagrin of the FDIC and at the expense of the old Indymac borrowers.

-The Use of Proceeds is important:

(The proceeds) will be used to pay creditors, including the FDIC's Deposit Insurance Fund (DIF).

I think it is necessary to ask why this deal was done. I can’t come up with a valid reason. This is not a sale of assets. It is just a repo. The FDIC retains all of the risk associated with the underlying collateral.

The FDIC does not need this $1.8b. They just collected $45B from the banks that they provide insurance to. The banks were forced to cough up three years of premiums paid in advance. These borrowed proceeds will go back to the DIF fund and add to the kitty of money available to absorb more losses from the bank failures that will come on every Friday. But so what? The FDIC is just borrowing reserves. They need equity to support the coming losses, not more debt.

From what I see this deal was priced rich. Barclays Bank was the sole book runner. I am sure they got paid well for that slot. The investors must love it too. So if the buy side loves it the sell side has got to be a bit poorer as a result. Why would the FDIC want to put money in investors and underwriters pockets? The most likely answer to this is that they wanted this initial deal to go out the door quickly. They must be planning to do more of these deals.

I hate the idea that yet another government entity is now in the RMBS business. We already have three catastrophic failures on our hands, Fannie, Freddie and FHA. We don’t need another one.

I hate the idea that this has the full faith and credit of the US. This is a repo 105 deal all over again. It is just optics, there is no substance. There is no reduction of risk to the taxpayer. This transaction just adds to the overall cost.

The FDIC has a $500b line with Treasury. This borrowing could have been accomplished much cheaper if that route were taken. The reason that did not happen is just more optics. If the FDIC had borrowed from Treasury the word ‘bailout’ would have been uttered. We wouldn’t want that to happen would we?

This is just a measly $1.8b. So who cares? At the end of the day no one will. But this debt, like all of the other $7 Trillion of liabilities will not appear on the balance sheet of the US. But it should. No one wants to tell the truth of exactly how much debt the central government has. Much has been said of late of how Greece and others have manipulated their books to make things “look better”. This is just another example of how the US is doing exactly the same thing.

The most troubling thing about this deal is the precedent being set. The final line from the FDIC on the transaction:

This offering marks the first issuance of notes by the FDIC since the early 1990s and the first issuance by the FDIC of FDIC guaranteed debt backed by the full faith and credit of the U.S.

Are they proud of this? They are using the most valuable resource this country has, our already tarnished credit rating. The more debt that is issued in our name, the poorer we become. When does it stop?

On Banning CDS

A lot has been written and said in the past few weeks about CDS. Almost all of it has been bad press for the poor boys who write and trade this stuff for a living. Heads of State, leading academicians and economists, the MSM and even some of the financial blogs have all been pounding the table on this issue. The message has been pretty clear. “Something has to get done, or we are really really going to blow up next time”.

The catalyst for the recent uproar has been Greece and to a lesser extent the other PIIGS. The perception has been created that somehow the existence of a CDS market for Greek Government Bonds has caused a crisis. Nothing could be farther from the truth. We now know that CDS had very little to do with the yield spike in GGB’s. It was the movement by the low rent bond traders (AKA global investors) that caused this hiccup. Greek CDS was the tail that got wagged. Not the other way around. But the vitriol continued. Wolfgang Munchau wrote on this topic last week. The following quote summed up his thinking:

“The case for banning CDS is about as strong for banning bank robberies.”

Some of the arguments against CDS include:

(I) They are unregulated.


(II) They create the opportunity for excessive leverage.


(III) They are used for and encourage speculation.


(IV) They may be written by under capitalized firms. Depending on the outcome this could create an excessive financial risk for the writer and thereafter cause a systemic risk. (The AIG story)


(V) They can, by their very existence, precipitate or fuel a financial crisis.

CDS is functionally an insurance policy one can buy to protect against default of payments from a borrower. While it is different in a number of respects from payment default insurance, it really is the same thing. If you accept that CDS = MI then you have to look at what is happening in that market. Mortgage CDS is the big casino; Greece and all the others are just a sideshow by comparison.

First consider the private sector side of this. The mortgage insurance industry (MI) is represented by an outfit called MICA. The current and recent members of this group include:

S&P updated its views on the Mi providers in November 2009. Does this sound like a group that is adequately capitalized? Their comments:

Overview
• The mortgage insurance industry continues to face significant challenges
during 2009, to the extent that many mortgage insurers have reported
losses exceeding our expectations.
• We believe that the macroeconomic environment may be having an
increasingly negative impact on the prime mortgage insurance books,
suggesting an elongation of the loss cycle beyond our prior expectations.
• As a result, we are placing the ratings for several mortgage insurance
companies on CreditWatch with negative implications.

As of February 2010 this group had mortgage insurance in force totaling $850 billion. Anyone who recognizes these names and understands these ratings knows that this group is under capitalized. The number of insolvencies of these firms and their failure to make timely payments under their insurance obligations has already strained the mortgage market. This group clearly represents a systemic risk to the system.

As insurance providers these companies are supposed to be regulated. But they functionally are not. The fact that a number of them continue to exist and write new policies (AIG) proves that there is no useful regulation.

MI insurance allows a borrower to acquire a home with no or very little skin in the game. We have learned that this is bad business and leads to defaults. The D.C. mortgage agencies have learned this lesson the hard way. They have been suffering defaults on their book of “enhanced” loans at multiples of the rate of conventional mortgages.

In the heyday of mortgage silliness the MI companies were insuring up to 105% of the purchase price of a home or condo. This never should have been allowed to happen. It clearly encouraged speculation and there is no doubt that excessive leverage was the intended result.

In my opinion the MI industry has all of the negative characteristics (I-V) that the detractors of CDS point to.

The private sector side of the MI business is a joke. But it is small beer compared to what the D.C. lenders have been doing and continue to do. As of the most recent reports, Washington has the following mortgage CDS outstanding:

These numbers speak for themselves. That 50% of all mortgages outstanding are guaranteed as to their performance by the central government is the definition of a systemic problem. No one has any skin in this house of cards.

The D.C. mortgage players are regulated, but by whom? The FHFA. The FHFA and its predecessor OFHEO have never regulated the agencies properly. The proof of that is staring us in the face. The absence of proper oversight will cost the American taxpayers at least $500 billion dollars before this mess is over. FHA will have its hand out for a federal bailout by year end.

None of the mortgage agencies have adequate capital for this type of underwriting risk. The joke is that they have no capital at all. The equity necessary to absorb the losses comes from the taxpayer. We are writing a check to cover that shortfall every quarter. That check averages $10 billion dollars a month. And every month the agencies write more CDS contracts. Nothing has changed.

The agencies have already proven that they constitute a systemic risk. They helped create the mess in we are in today. They encouraged speculation in the housing market. They have created the excessive leverage that has caused the economy to shudder. If in the next few years we find that the recovery does not hold and we slip into a protracted period of recession it will be the mortgage agencies that will be the albatross that brings us down.

The D.C. mortgage players clearly have all of the negative characteristics (I-V) that those opposed to CDS are worried about.

It is all well and good for the press, our political leaders and many deep thinkers to throw stones at the CDS market; no doubt some of these stones are well intended and justified. But for me it is misdirected. How can someone throw these stones while there is a $ 6.5 trillion CDS market right here in the US and it is sanctioned and encouraged by everyone one who has a say in the matter?

The reason is simple. Expedience and survival are at stake. If we woke up on Monday and there were new rules that eliminated the MI and federally sponsored guaranties on individual mortgages we would be in a depression by the end of May. Our system would simply freeze up and die if that would happen.

To a much lesser extent the same is true in the global debit insurance business or CDS market. If that were taken out of the equation it would have significant global deflationary impacts. Those that are taking up the mantle against CDS should address their concerns to where the truly big numbers lie. They also need to understand that the direction they are headed will lead us to that horrible sucking noise of deflation that everyone seems so desperate to avoid.

SS Trust Fund 1st Q 2010 Results - Still Slipping

The Social Security Trust Fund is able to make accurate estimates on the major components of its monthly cash flows. Therefore the first quarter operating results for the Fund are in. Only the payroll taxes and benefits paid numbers are currently available for January, February and March of 2010. The raw numbers show clear acceleration of the deterioration in the Funds dynamics. They also give us some insights into the employment situation in the country. The conclusions are not good.

This chart summarizes the payroll tax (both FICA and SECA) receipt numbers for 09 and 10.

The 1st Q 2010 YoY top line for the Fund is down by 6%. A very significant drop. There are 160mm workers that contribute to SS. The simple math would suggest that there are 9.3mm workers that are no longer contributing to the system (or are contributing at a much lower rate). The BLS NFP report, which looks at a different set of numbers for employment, suggests that the drop in payrolls is only 2.5mm during the same period. This is not an apples to apples comparison, however, I have looked at this from every which way and it is my conclusion that the BLS numbers have to be significantly understating the loss in jobs. The payroll tax receipt numbers can’t be that badly skewed. They are hard numbers.

There is no good new for the Fund on the expense side either. While there has been variations on a month to month basis, the trend line for benefits is northward at a 5% compounded growth rate. And that percent number has nowhere to go but up as the boomers get checks. The following chart looks at the growth in benefits over the past ten years.

The actual results for the Fund are not available. The reporting for interest income, income tax receipts (outside of FICA and SECA), the operating expenses and the costs of the Railroad Retirement are not available. In 2009 these numbers were +$118b, +$20b, -$6b and -$4b respectively. It is unlikely that these numbers will vary too much in 2010.

Based on the assumption that these other numbers will remain static and that payroll receipts will stabilize to the 2009 numbers for the remainder of the year the following forecasts of the full calendar year can be made:

Benefits paid will exceed Payroll tax receipts by $40b (+660b, -700b). In my opinion this is the primary measure of financial soundness. This number was -$5 billion in 2009.

The Fund uses the ratio of total tax receipts to benefits paid as its soundness measurement. Based on the 1st Q results it would appear likely that the full year results of this ratio will be negative $20b ($700b-680b). Should that happen, it would be the first time in the Fund’s history. The Trustees of the Fund have suggested that this significant milestone will not occur until 2017. This party seems to be starting six years earlier than was planned.

When I look at the Fund I look at cash flow. All of the experts on this topic say that is a dumb way to look at it. Annual cash flow is meaningless when you are looking at something that has $2.5T in assets and will, under the very worst of conditions, be able to pay the bills for 15 years or so. I disagree. It’s all well and good to ignore cash flow when cash flow is positive. But when it goes negative it is the first gentle step that leads to a very slippery and steep slope.

Interest income for the Fund is a non-cash item. They get credit for more paper. There is something about this process of automatic money creation that bothers me. I believe the Fund must ponder this question as well. In their reports they publish on a monthly basis their net cash position. The following is their annual summary for 2009. Note that the net cash flow is a positive $3b.

The following is a graph of the annual net cash flow of the Fund. You can see that the surplus is crashing. Based on the 1st Q 2010 results we will be in the red for the full year. This problem could make health care look like a walk in the park by comparison.

Barney Eats Seconds – Or Blows Smoke - Or Both

Yesterday Barney Frank came out with a letter addressed to some of the big banks putting some muscle on them. He wants them to write off their second lien mortgages. He thinks the seconds are junk. His words:

"Large numbers of these second liens have no real economic value."

In this case I just want to shoot the messenger. Not the message. Subordinated debt is not money good when there is a problem. Period. There is a problem and the Second’s deserve the losses. In that sense I would support the pressure on the banks to move more aggressively to write this unpayable crap off. It is part of the cleansing process.

Mr. Frank has lost his right to contribute to this debate any longer. He speaks with a forked tongue. As Chairman of the House Financial Services Committee Congressman Barney Frank is well aware of the financial activities of the D.C. mortgage Agencies. I don’t believe he calls the shots or even has a veto on significant policy decisions. But I also doubt that anything big happens without his knowledge. If he strongly objects to something it either won’t happen or it will get restructured to where he will bless it.

With that in mind it is important to look at how the subordinated creditors (seconds) of both Fannie Mae and Freddie Mac have been treated. The answer is they are being treated like kings. The holders of the Sub debt are making a bundle. They should be facing a near total loss.

The following are three slides of Fannie’s Sub debt. Note that these bonds trade on a daily basis, that they are trading at significant premiums to par and also that our pals at Moody’s and S&P rank this swill at a very respectable AA.

How could the subordinated debt of a functionally bankrupt entity be trading at a premium and be ranked investment grade? That’s easy. D.C. put the “fix” in on this one. Here’s the language from Fannie as to how this magic could happen:

Freddie did not want to be bothered with the problems with its sub debt. They just bought it in. They borrowed from the Fed to do it. This was part of the $175b of unsecured debt of the Agencies that was part of the QE process. Here is the public announcement of the Freddie buy back. Note that the bonds were bought in at significant premiums. I wrote a piece on this back in July. I referred to this buyback as heinous. It’s still heinous.

Barney Frank owes us an explanation. How can he maintain that second lien mortgages have no economic value while he supported a money good attitude toward the sub debt of the Agencies? He can’t have this one both ways. If he tries to have it both ways it will just prove that he is an opportunist blowing smoke at the electorate.

That the Sub Debt got favorable treatment in the conservatorship was a historical mistake. I don’t think it was a mistake at all. It was quite deliberate. Some big shots put some muscle on some folks to get this carve out. I, for one, would like to understand where that muscle came from.

The numbers here are both big and at the same time rounding errors. The total of the sub debt in question comes to only$15 billion. The taxpayers will pay this in full. The total losses the taxpayers will bear as a result of the Agencies will exceed $500b. So the question, “What’s another $15b in the scheme of things” is relevant.

For me this $15b is a number the taxpayers should not bear. It is exactly the same mentality that went into the back door bank bailout re AIG. That deal ended with the banks involved getting paid 100% when they should have been entitled to a much smaller number. The Fan/Fred sub debt treatment is no different than that.

So Congressman Frank which door do you choose? If you want to do the “right” thing today, you have to reverse the “sins” of yesterday. Possibly the best choice is to choose neither. Having been part of the sins of the past you make a very poor spokesman for what should be done today.

Barney Makes Hash

Barney Frank (D. Mass) is head of the very powerful House Financial Services Committee. Barney is the Rainmaker for the country’s mortgage agencies, Fannie and Freddie. He was the Don that blessed everything that happened for years. Without him these two dead ducks would not be the disaster they are today. And Barney Frank has no clue how our system works. He proved it several times on Friday.

He started with a stupid comment in the WaPo: "People who own Fannie and Freddie debt are not in the same legal position [as those who own] Treasury and I don’t want them to be. ”. During the day he tried to backpedal away from this dangerous assertion. But he really stuck his foot in his mouth in an interview with Maria Bartiroma.

Click here for link.

At several points in the interview Frank makes clear his view that mortgage securities issued by either Fannie and Freddie prior to the September 2008 (conservatorship) were tainted and there was no certainty that these would be paid in full.

When Maria pushed him on this ridiculous position she asked him what should the foreign central banks, who have been long term holders of Agency paper do, he responded, “Who will they sell it to? Themselves?” Is Mr. Frank suggesting there is no liquidity in aged mortgage paper guaranteed by the Agencies? If there is a shortage of liquidity he may be responsible for it.

These comments prove that Congressman Frank has no clue what he is talking about. There is no basis for a different treatment of Agency securities based on issue date. There has been no bankruptcy that would establish seniority on new issues of debt.

As part of the QE effort the Fed has purchased a boatload of agency paper that was issued prior to conservatorship. Does Mr. Frank believe that this is money good and the original holders are out in the dark?

Who might be the holders who own Agencies from prior to 8/08? A lot of US bond funds, a ton of widows and orphans and yes, a few big foreign central banks. Barney F. wants to screw that audience?

For myself, I would love to see that this gets blown out of perspective. I hope that China or some other Asian central bank says, “Sorry, too much confusion. We vote with our feet now. Bye, Bye”. I hope that Geithner is forced to contradict his pal Barney. I hope the mortgage market spread against Treasuries backs up about 25BP as a result of this foolishness.

That is unlikely to happen. The reality is no one listens to Barney Frank. They know he is just blowing smoke so he can look like he is playing tough to his audience back in Massachusetts.

We need a wake up call. Maybe a big blip in the mortgage market would do it. We need to get rid of the likes of Barney Frank. He led us into this mess. He is still mucking things up. And he is still running the show and setting the policy for the future.

We got rid of the fat cats from the private sector financial institutions that caused all our problems. We got rid of the fools who ran Fannie and Freddie into the ground. Now it is time to get rid of the politicians that pulled all of the strings and made/let it happen.