Goldman a Criminal? What's the Charge?

As of this writing there is no clarity as to what exactly the DOJ is looking at in the Goldman case.

The WSJ has this as the status:

Federal prosecutors are conducting a criminal investigation into whether Goldman Sachs Group Inc. or its employees committed securities fraud in connection with its mortgage trading, people familiar with the probe say.

What could a Federal prosecutor be looking at is a question to ask. I wish I knew. There is a lot riding on the outcome of this.

There are some things that are available to the public. I have some question about some it. Quite frankly it does not pass my smell test. Unfortunately I am not a lawyer, and therefore can’t really make any conclusions. Possibly those lawyers who read this well help us bloggers out.

We know from the Senate testimony by Josh Birnbaum that his unit, the Structured Products Group “SPG” shorted the common stock of public companies as part of their hedging strategy. Josh touted this in his annual review. The SPG made big money in a bad market. They made over three billion in revenues from shorts.

This from an Email from Josh in July of 2007:

Since 6/21, the SPG Trading group has paused in our equities trading while we work with management and market risk to come up with quantitative limits for these positions. It sounds like we are getting close to having something systematic in place, but in the meantime, we are looking for approval to opportunistically buy puts on certain mortgage originators, insurers, mortgage REITs, broker-dealers, and other related names exposed to RMBS, CMBS.

We also know from the testimony that Josh shorted the stock of Bear Sterns as part of his hedging strategy. He said that the SBG group used “mostly” puts in their activity. He described that he took a “macro view” of the market and hedged his risks accordingly. Josh made the link to his view of a declining sub prime/Alt-A market and the stocks of the financial companies who would be most impacted if things went south in high yield mortgage land.

Also in the testimony Josh stated that he had a number of names that he used in his short hedging strategy. That was an important statement.

From the public documents made available from the hearing is the following. I believe this is the trading/hedging positions for the SPG. My reading of this is that they were short Bear Stearns (via puts). They also were short WaMu.

Now consider this intro from a story in the WSJ. Clearly GS was doing big business with WaMu and their sub prime originator Long Beach Mortgage Corp.

Washington Mutual Inc. and its Long Beach Mortgage Co. subprime-lending unit rang up one of the worst failures in U.S. history. Left in the wake were billions of dollars of soured loans and questionable lending practices. But when times were better, the two companies had a powerful partner on Wall Street: Goldman Sachs Group Inc.

From the same WSJ article is this information:

May 10, 2007: Goldman and WaMu underwrite bonds backed by $532.6 million in mortgages.

So back in May of 07 GS puts a half-billion dollar deal together with WaMu and uses mortgages from Long Beach as part of the deal. Just as a guess GS had a pretty broad look at the quality of the mortgages at Long Beach and WaMu. The SPG traded these securities. They knew that the deal was a bomb, they probably connected the dots that WaMu should be on the “conviction short list”. A little help for Josh?

I am not sure how to describe that situation. I was looking for shorts in the summer of 2007. I wish that I had had the chance to look over the books of Long Beach before I made my choice. It would have made the job quite a bit easier.

Size Buyer now a Size Seller

The Social Security Trust Fund released some data today. There are some data points worth noting, they might lead to a conclusion. But first, for the history buffs, I want to show you a “Tipping Point”. I think the exact date was March 3rd or 4th. For sure it was sometime in March  that the SSTF went negative since Greenspan fixed things in 1983.

In March the CBO came up with a forecast for the fiscal year of a $29B deficit. I look at things on a calendar year basis. My number for the year 2010 is -$50 billion in cash flow (excludes interest). The components:

Payroll Tax: $640b
Tax on Income: $24b
Total in: $664b

Benefits: $703b
R.R. Ex.: $5b
Adm: $6b
Total out: $714b
Net Decrease in Cash: $50 billion

The significance of this is that the US Treasury will have to fund this shortfall. They will have to sell an additional $50b of debt into the public market. This $50b has nothing to do with what we call the deficit. This is money we have to borrow in addition to the deficit.

In prior years the SSTF has generated big cash surpluses. This cash was invested in Treasury securities that had an average life of 8 years and maturities ranging out to fifteen years. The TF was a great place to sell bonds. Their big appetite for long duration securities helped fund our deficits and extend the average life of our debt profile. But not any longer. That ‘tipping point’ is the first step on the way to a very steep staircase.

The following chart shows the actual cash surpluses of the TF over the last decade. The red is my 2010 estimate. I am not far off. Note that there is a big swing from the average from 2000-2008 (+$70b) and 2010 (-$50b). That difference comes to $120b. So at this nexus point a traditional “size buyer” is morphed into a “size seller”. This is not going to change. The net negative number will likely improve a bit in 2011 and 2012, after that the cash outflow will rise every year.

There is a very big debate on the future of interest rates. David Rosenberg sees deflation and a future credit market that looks like Japan’s for the past 20 years. Call that “Long Term Zirp” or “LTZ”. On the other extreme would be Jim Grant. His thinking is, “Sell Bonds Now” or “SBN”. Goldman Sachs is more in the camp of LTZ while Morgan Stanley has put its neck out with SBN.

There are dozens of very smart thinkers who are lining up on either side of this big fence. Therefore someone is going to be wrong and there is some big money to be made if you choose the right door. I can’t decide. The arguments on both sides are compelling.

The critical variable may come down to good old supply and demand. Just who is it that is going to be buying all this stuff that is coming down the pike. It will not be the SSTF. They are size sellers for a long time to come. It is my belief that there will be a cash flow shortfall for all of the other categories that make up the Intergovernmental Account “IG”. This means that the current holders of one third of all our debts will not only be on a buyers strike, but the IG Account may be cashing in $100b of chips a year.

I don’t see China, Russia, Hong Kong, UK, EU or OPEC increasing their holdings to accommodate the supply. There is not enough domestic demand either. The only scenario that I see that could work is if we have perpetual financial chaos outside our border that sucks money in because of the lack of alternative, and there is no increase in demand for credit in the real economy. Let’s just hope that is not the outcome.

One wild card would be for the US banks to become the "reverse lender of last resort". They would buy and hold the $4-5 Trillion of excess supply that is coming. Their balance sheets would explode. I am not aware of any economy that has worked (for long) where the private sector banks used their ability to multiply money by lending it to the provider of the credit (Treasury borrows from banks/Federal Reserve lends to banks through Repo window). Again, let’s hope that will not happen. That is Argentina.

When you are trying to sell a deal on Wall Street you go to a list of names and get “circles”. When you get enough circles you have a deal and drink champagne. If you don’t get enough you either revise the deal or just let it die. I would like to see those ‘circles’ for $5 Trillion of US paper over the next five years. All the names are there; we will not invent any new ones. What is the Pro-Forma ownership in 2015? I, for one, do not see a plausible result. Absent those circles I have to be in the SBN crowd.

FHFA's DeMarco on the FHLB's - Ugly

The FHFA’s acting director Edward DeMarco has proven to be a refreshing change from his predecessor James Lockhart. Mr. DeMarco has consistently delivered the straight story ever since he assumed responsibility. Yesterday was no exception.

He spoke at the Directors of the FHLB conference. He delivered this message:

FHFA is looking for the FHLBanks to prepare for eventually moving derivatives activity to central clearing. This is a prudential matter, and one we anticipate the FHLBanks doing with or without legislation mandating it.

The time to be evaluating options in this area is now.

I could imaging the groans of the Directors when this message was delivered. What an elegant way of saying, “Mark you books down now boys, we can’t extend and pretend any longer”.

It is impossible to determine what the size of the losses the FHLB’s are looking at. Here is a look at the trillion-dollar balance sheet:

There may be some losses in the retained mortgage portfolio but I am assuming this is small beer. The $631b of “advances” is probably okay as well. These are short-term loans to Community Banks. These are the banks that show up on the list every Friday from the FDIC. If there is an issue here there is going to be a big problem.

The real concern is in the $284b of “investments”. This is all private label MBS. If the assets are marked to market the losses will be significant. 30-50% is possible. That would put the loss in the range of $80-$120 billion.

DeMarco's words on the “investments”:

“As we all know, when the credit characteristics of those investments changed, leading to losses on the FHLBanks’ holdings of private label mortgage-backed securities, the “normal” operations of some of the Banks were disrupted.”

That is a polite way of saying that they took a bath. Fannie and Freddie will cost us at least $400 billion. Add in another $100b for the FHLBs.

Did Josh Birnbaum Make a Slip? Did the Senators Catch It?

In the last 45 minutes of the testimony Josh Birnbaum (Co-head of the Structured Products Group (“SPG”) was asked a series of questions by Senator/Dr. Tom Coburn (R.Ok).

There was a document produced that was Josh’s year-end plea for bonus big bucks. A list of his accomplishments. Amongst the many swell things that Josh touted was his contribution to the accelerated use of the equities market in the SPG hedging and trading activity.

Bingo! Josh may have opened up to something that could blow up for Goldie.

Senator Coburn produced an internal Goldman report for the fall of 2007 that showed that Goldman had an open short on the stock of Bear Stearns. Coburn asked Josh if he was responsible for that short position.

After thumbing through the book Josh finds the report in question and looks back at the Senator, smiles, and says, “This is a firm wide report. I can’t determine if this is my department’s short position or not.”

Next Coburn asks, “How did you select the shorts you used?” Josh responded, “We had a macro view. I had a list of stocks that were correlated to the sub prime industry.”

For me this is a bit of a bombshell. It shouldn’t be. It was a perfect strategy for the sole reason that it worked. But consider the consequences.

In 2007 the SPG had gains from hedges of ~$3b and losses of ~$2b on write down of inventory. It was described that the hedges included (1) shorts on the ABX index (2) shorts on single name ABS (3) long CDS against a variety of single names and (4) they shorted common stock of companies that had a high beta to a downfall of the Sub-Prime/Alt.A market.

We know from the testimony Bear Stearns was on that “short” list. That entire list is public. I have not seen it so I will just guess that in the fall of 2007 GS was shorting the likes of New Century, WaMu, the mono lines, Countrywide, Bear Stearns, and Lehman. That list could have been broader; it might have included Fannie Mae and Freddie Mac, Citi, and BoA, even the likes of a Northern Rock or RBS.

One aspect of the collapse of 2008 was how destructive capital markets had become. The shorts pushed equities down so fast that managements and regulators lost control. The shorts were clearly predators. For me it was the shorts that destroyed the equity values. It was a near daily event.

My questions on this is (A) How much of this did Goldman do? (B) How much did the rest of the market do? (C) Did this exceptional demand for short interest in financial stocks accelerate the collapse of Bear, Lehman and all the others?

In the fall of 2007 the size of the Sub Prime and Alt.A market was many multiples of the market-cap of the financials that were the target of the short interest.

Essentially Goldman Sachs bought WaMu no-dock loans; against this they shorted Bear Stearns common. The hedge worked just fine. Unfortunately it cratered Bear Sterns and a few others and damn near took out the system.

As the broader disclosure of what happened in 2007-2008 (this ain’t stopping with Goldie) takes place we will see how much this predatory hedging actually upset the applecart. Its effect is unlikely to be zero.

I am conflicted on this. Hedging is only an option when selling can’t be done. Therefore hedging is integral to the capital market process. But there are degrees. I think that if one was long sub-prime ABS and hedged that risk with a short in the ABX index that is a commercial transaction and is part of risk management. However if this crosses over to where one could go long troubled mortgages and short the common stock of the Royal Bank of Scotland against it, I would say that is not a commercial hedge. I would call the later transaction a Prop Trade. It is a bet, not a customer transaction. I have no problem with prop trading. It should be funded with equity and there should be limitations. If that had been the case in 2007 that discipline would have constrained the growth of bad credit.

It is possible that the Goldman hedging strategy was predatory. It added to the systemic problems that later occurred. Possibly Senator Levin should ask a few questions on this line. I doubt that he will. I watched the proceedings and was convinced that the good Senator had no clue how things actually work.

Did the (admitted) shorting of BSC in October, November and December by GS lead to the collapse in March?

A Quarter Trillion Slugs To Die?

These are slugs. The one on the bottom is poisonous. You’ll find that one in Australia. Not to worry about these slugs and all their kin. They are doing just fine. It is more than likely that they will be around long after “intelligent” life is gone.

The slugs that may be going extinct are referred to as State and Local Government Securities. Those who use them affectionately refer to SLGS as “Slugs”.

SLGS are another of those weird things that make up our gigantic public sector debt. The total outstanding is about $210 billion. In the scheme of things that is peanuts. It is only 2.5% of the public debt. But who was it that said, “$200 billion here, $200 billion there….. Sooner or later we are going to run out of buyers".

SLGS are the product of a law dating back to 1969. The law limited and set rules for municipal bond arbitrage by large Muni issuers. It is (to me) an interesting and somewhat comical story.

States are allowed to issue Municipal bonds that are free of both State and Federal taxes. US Treasury bonds are fully taxable by the States and the Feds. If you assumed a person was in a State where their effective tax rate was 35% it would mean that a pretax Treasury bond yield of 5% was equal to 3.25% after tax. So if that person could buy a state muni that yielded 3.5% he would be well ahead on the investment (assumes no credit risk).

This arbitrage works the other way just as well. The States were able to issue long-term debt at 3.5% and invest in Treasury bonds with a similar maturity at 5%. States pay no taxes so this was just a way to coin money. And the States did just that all throughout the 60’s.

Forty-five years ago a few Wall Street bond traders, a number of lawyers and a bunch of State treasurers were ginning the system and creating an ‘early days’ derivative transaction that generated free income. Amazing how things have changed over the last half century. When it comes to financial engineering, the techniques are new. The motives are the same.

So in 1969 a ‘going broke’ Federal government put an end to the party. The SLGS were born from that.

SLGS have continued to provide an important role. They are used for Municipal Bond Defeasance. Think of this as if you had a 6% mortgage and now interest rates have fallen to 5%. You could (at least in the past) refinance the mortgage and save yourself some money every month. States are no different, but they face a problem. They can’t just pay off their old bonds. Those bonds all have call protection features. So those bonds can’t be prepaid or redeemed.

This is where the SLGS come into play. Here are the steps:

1) State has outstanding $10mm of a 10 year Muni at 5% callable in six years.
2) State can now borrow at 4%.
3) State borrows $10mm for ten years at 4%.
4) State uses the $10mm of newly borrowed funds and buys SLGS from Treasury that match the maturity of the old 5% bond.
5) State delivers the SLGS to a Trustee who receives future interest/principal payments from Treasury and who will disburses it to the old bondholders.
6) Upon the completion of #5 the old 5% bond is “defeased”. It is no longer either a cash or accounting liability on the State’s books. The State has achieved the desired savings in debt service expense and extended the average life of its liabilities.
7) On the call date (six years later) the bonds are called. The SLGS mature. The proceeds are used to pay back the bondholders. The Trust is dissolved.

Now you understand SLGS. Here's why I think they are a dying breed:

-A State can’t defease an old bond if the cost of new borrowing is higher that the old coupon.

-A State that was looking at a growing debt load would be nuts to defease old debt. They have to raise new money to meet current liabilities, forget about prepaying stuff that does not come due for 6 or 8 years.

-California is now borrowing at a premium to Treasuries. Many states will follow their lead. That is the end of the SLGS arbitrage.

-The biggest issuers of Muni's (and users of the SLGS window) are also the same States that are either now in trouble or are headed for trouble.

Here are some reports on SLGS outstanding. It is headed south and will continue to head south.

As the SLGS account runs down, the liabilities will have to be replaced, dollar for dollar, with “real” investors. The Chinese Central Bank, The Bank of England on behalf of the Chinese Central Bank, or possibly the mystical “households” and “others” will have to pony up for the increase.

Someone will point out that when SLGS mature an investor someplace gets cash and that investor will go out and buy some Treasuries to offset the shortfall. Sorry. It doesn’t work like that. Not when Ben B. has the ZIRP on. There are far too many better things to invest in.

USA Vs. GS - Pot Calls Kettle Black?

The SEC has charged Goldman Sachs with a 10b-5 violation. The accusation is that GS:

“Made untrue statements of material facts or omissions of material facts.”

So there are essentially two accusations. A) They flat out lied and B) there were things about the Abacus transaction that probably should have been disclosed but were not.

For me, (A) is a matter of law and contracts. Lawyers will battle that question out. (B), on the other hand, is a much more subjective issue. From the facts that are out there today it would appear that there were Omissions made. Those Omissions were potentially material. There was clearly a large group of individuals involved with the transaction that basically knew, or had strong reason to believe that the Abacus transaction was deeply flawed and the probability of success for a buy side investor was very low. There is evidence that the highest levels of management at Goldman Sachs held these views on Sub Prime synthetic transactions.

I want to focus on B (material omission) and compare the Abacus deal to what I consider to be the worst transaction in the history of finance. That transaction was the $4.6 billion of the Fannie Mae Preferred Stock issued on May 7, 2008. This very large piece of crap went into the garbage can four months after it was issued. It paid one lousy quarterly dividend of 2% and then poof it was all gone. The original investors saw a 95+% loss of their principal. It was a wipe out that was four times the size of the Abacus deal.

When comparing the Fannie pref deal to the Abacus deal it is very important to make the distinction of who got bilked. In the case of Abacus some sophisticated investors took a big risk with other people’s money and lost. In the case of Fannie the deal was sold retail. It went to unsuspecting investors. It was peddled to Community banks across the country. It went to public bond funds and into thousands of IRA’s. It went to widows and orphans. There can be no question that the standards of disclosure must be higher on a public deal sold retail than a private deal sold to sophisticated investors.

The underwriters are the ones closest to the transaction. Here’s where the conflicts of interest and real material omissions can occur. Check out the names on the bottom of these two slides. There are some things to observe here.

The first slide is a Fannie Pref deal from December 2007. Note that Lehman and Merrill are on the top of the list as co leads and Goldman Sachs and JP Morgan were ranked second. There are others who are in still smaller type. In ‘street talk’ this ranking means: who was responsible, who did the most, who got paid the most, who has the biggest dick and who should you first call if there is, heaven forbid, a problem.

Now consider the May 08 slide. Goldman is now on the center bottom (the lowest rank according to custom) and good old JPM is nowhere to be found. Functionally these two opted out of this deal.

Also compare the commission paid to the underwriters. 1% in 07 and fourteen months later it’s up to 3.5%. That is big money. The difference in commission income was $125mm. The riskier the deal the more the Street makes. So the underwriters got fat. But Goldie and JP said no. If they wanted to be on the top of the list they could have been. They chose not to because of the risk that the pref deal would blow up in their and their client’s faces.

GPM and GS walked away pretty clean from the mortgage meltdown. They dodged the bullet because they saw it coming. Likewise, they saw the wave coming for Fannie. Wall Street knew this deal was doomed. But they sailed it off into the coming storm and kept the fees.


Former Treasury Secretary Hank Paulson understands the need for a higher standard of disclosure for public deals than anyone I can think of. He ran GS for years; he understands securities law as well, if not better, than most Wall Street lawyers. He knew that Fannie Mae was headed into a crisis.

From Hank’s book “On the Brink”:

In June of 2006 he met with Emil Henry Treasury AT and was briefed on the GSE’s, his thoughts of this meeting:


“It didn’t take a genius to see that something had to be done”

Also from the book:

“Fannie and Freddie were disasters waiting to happen”.

Throughout the crazy markets of 2008 Paulson had near daily contact with the captains of the big banks and Walls Street firms. His call log is littered with conversations with Blankfein. I don’t believe for one second that in May of 2008 he was not acutely aware of the perilous state of the entire mortgage market and thereby the likely implosion of the Agencies. He not only let $4.6b of bad paper go to weak hands, he encouraged it to happen. He and the rest of his staff were pushing OFHEO (Fannies regulator) to get the Pref deals done. Other than behind the scene pressure Paulson had no direct involvement with the Fannie deal. So technically there is no material omission of facts. On the other hand he helped get something done that he must have know was going to blow up.

James Lockhart, the head of Fannie’s regulator OFHEO (now FHFA) understood the state of Fannie in May 08. I’m no fan of Mr. Lockhart, but I am quick to admit that he is very bright, well educated and a seasoned pro. This guy was looking at what was coming on a daily basis. He had to understand that a crisis was brewing. He was desperate to get a Fannie recap done in May of 2008. He knew he would be gone soon, regardless of who won the coming presidential election (he now works for Wilbur Ross doing distressed debt transactions. Fitting.). His interest was to kick the can down the road so his childhood friend, George Bush could get out of D.C. before the lights went out. He pushed Fannie hard to get the deal done. He traded a release from a two-year old consent order against Fannie in exchange for the completion of the equity recap. As a result Fannie was allowed to increase its leverage ratios. Keep in mind that this was just four months before Fannie went into receivership. The OFHEO notice:

Another fellow in the story who is on my list of material omissions is the CEO, Dan Mudd. Dan was ex GE Capital, President and CEO. Let’s be clear on this one. You do not achieve the Big Kahuna status at GE unless you know your stuff cold. You have to live and breathe corporate finance, debt and credit to get that seat. So here again I have to assume that someone this connected had to have know in May of 2008 that the end was nigh. He should not have let the deal get done. He had enough insight to see the lines crossing, yet he let the deal go through. He was conflicted. Half of Washington was breathing down his neck. He gambled other people’s money and he lost it. If he had stiffed the likes of IKB or other pro investors I would have no problem. But he paid $150mm in fees so he could rip off smaller investors.

The rating Agencies had a single A on the Pref. If you looks at all of the qualifying language in the rating you would see that there were a dozen caveats as to what might go wrong. But retail brokers and retail investors and regional community banks don’t read that language. An A rating was supposed to mean something. This could have read: “We are rating this A. We are assuming that it will not rain in the next six months.” It was pouring outside when they made the call.

So rating agencies, regulators, corporate executives, senior government officials and a sizable chunk of Wall Street omitted material information on the Fannie deal. The investors were wiped out less than six months after the transaction closed. Doesn’t that sound like Abacus with different players? In many ways the Fannie deal was more heinous.

I doubt the SEC will look into this one. No sense in one branch of the government suing another. It would just look silly. So to hell with those small investors. The SEC will focus its attention where there is something to gain. Possibly to the benefit of some big shot investors and politicos.

I am no fan of GS, and believe they should get taken down a few pegs. But in 07 and 08 everyone was selling crappy deals. Even government agencies.

WSJ On Fed's Mortgage "Assets"

Jon Hilsenrath at the WSJ had an interesting article titled “Fed’s Focus: How to Sell Its Mortgage Securities” I read Hilsenrath. He writes well, he knows his stuff and he is connected. I think he is blowing “Fed Speak” at us with this one. Here’s the link, you decide.

Reading the article I was left with the impression that JH had used both public information and the thinking behind some ‘off the record’ conversations with Fed officials. The Fed does not tell what it is going to do unless it wants to. Ever. Not even to Jon Hilsenrath. So when you see this “Fed speak” it should be considered in that light

The article is a rehash of the Feds balance sheet dilemma. It raises the question of, “What’s the Fed going to do with all that paper it just bought?”

On reading, you are supposed to get this warm feeling that the Fed is acutely aware of the size, scope and significance of their QE actions. That these steps were just a ‘natural’ consequence to the “Emergency” and now that we’re returning to normal the “Emergency Measures” are going to be unwound. No problem. They have this completely under control.

The article (I think) leaks the information that next weeks Fed meeting will continue the ZIRP Forever language (at least six more months). It also confirms that there will be some more of the “experimental” reverse repos in the coming weeks.

JH points to the public comments of some Fed members indicating that that they actually want to sell some of what they own. To me this is just noise to make it appear that there is a real debate. There will be no Fed selling of MBS for at least 24 months. The quote from Bernanke on this topic:

"I currently do not anticipate that the Federal Reserve will sell any of its security holdings in the near term, at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery."

This is completely open ended. He might as well have said, “We will start selling when the terror threat level is returned to green.” Don’t hold your breath.

So the article leaves us with the inescapable conclusion that the Government effort to prop up the mortgage market is now completed and the next phase is going be a period of relative balance sheet stability followed by a plan to unwind the mess. That is peachy news and we should all be very happy, right?

Well I am not. Some facts here. The Fed dramatically (and predictably) slowed its purchases of MBS in March. They have made no new purchases since then. So they have lived up to the bargain, but the other arm of the federal financial puzzle started buying in MBS at just the time the Fed stopped. The Treasury department through Fannie and Freddie started a program that commenced in March and will continue for some time to come where they will be buying in $100rds of billions of MBS. So the beat goes on and on. From our friends at Fan and Fred:

F/F will buy in defaulted mortgages and pay the holders of the MBS cash. This will come to the investors in the form of a pre-pay of principal. It is very normal for a portion of the principal to be returned to the investors on a monthly basis. The F/F steps just accelerate the process. When the investors (big funds) get the principal back they (usually) turn right around and plow it back into new MBS issues.

The steps taken by F/F are completely different in form to the Fed’s purchases of MBS but in substance they have the same affect. It decreases the outstanding mortgages, and therefore influences mortgages spreads. Keep the game going for a bit longer.

I admit that I am an old cynic and generally assume the darkest motives. But the timing of F/F to start their buy back programs in March and April at precisely the same time that the Fed is “finished” with its business is no coincidence. It was planned and coordinated months ago. This is just more manipulation. Bernanke understands this and probably had a hand in the timing of the F/F buyback programs.

The fact that the government is continuing to impact mortgage rates was not mentioned in the JH article. In fairness, his piece was directed to just the Federal Reserve's role in the buy ins. But I don’t think we are getting the full story from the WSJ. We are getting what the Fed wants us to hear. The real story is that Washington simply can’t stop interfering in the mortgage market. If D.C. really did stop, we would have a problem. And they know it.

FDIC Sells Junk Zeros

The FDIC announced two deals today. The first was a 1.38B CDO that was “secured” by $4.5 bil of Corus Bank sludge. The assets were non-perform construction loans and REO “assets”. The coverage ratio on this one is 3.25X1. This implies the assets are worth about 30 cents on the dollar.

The second transaction was a $653mm deal secured by 1.2 B of Franklin Bank SSB loans and more of those REO assets.

The debt sold today against this package of swill is non-interest bearing. The notes sold at a discount. At the maturity (up to four years) the junk notes will be paid at par.

I don’t think you could sell this deal to even IKB. It is just crap. But it went out the door in about two seconds. The reason is that the discount notes are full faith and credit of both the FDIC and Uncle Sam. These notes are as solid as Treasuries and the yield is better.

The zero coupon feature was done because the underlying assets have no predictability of either cash flow or disposition of the assets.

You have to ask why this was done like this. The FDIC is not in need of cash at the moment. They are sitting on $50b or so of Special Issue Treasury notes. If they were a little tight they have a $500b line of credit from Treasury that they could draw on with no questions asked and much cheaper pricing than these deals got.

These are not securitized financings. This gets nothing off the books of the FDIC. It is just straight debt. So far this year there have been about $4b of this type of paper issued. More is clearly coming. Does it matter if the FDIC borrows another $20b in our name this year? Not really. $20b is just a drop in the debt bucket these days. The FDIC would not need to borrow money if it’s DIF Fund was at the $50-60b surplus that it should be at. This debt is just another way to kick the can down the road a bit farther. The FDIC needs equity, not more debt. But in this case equity equals bailout and we wouldn’t want that.

J.P. and the Fat Cats

If Goldman Sachs had packaged up some swill and sold it to the public they would be in a world of hurt. But that is not what happened. The Abacus deal was sold to sophisticated investors. There were no widows or orphans in this story.

The Subscription Agreement on a deal like this requires the buyer to make a number of representations and warranties. Basically they say that the buyer has the power to do this, that any approvals that may be required have been obtained, that they have received complete copies of the execution document and all other related documents. And most importantly, that they understands the risks that have been identified. There is no defense that says, “Goldman said it was okay”. There is no defense that says, “The rating Agencies said it was okay”.

We have created a big casino with big players who have absolutely monstrous piles of chips in front of them. I have no problem if they battle it out with themselves. To some extent this pool of fast cash equity makes our system work. If anyone thinks that this is not a predatory environment they are just wrong. If you play in this world and you are the “dumb money” you deserve to get knocked out of the tournament.

Christopher Whalen at Institutional Risk Analytics said today that he expected to see some legal action against the sell side player in the Abacus story, John Paulson (“JP”). While I respect Mr. Whalen’s views on most matters I am going to disagree with him on this. JP is going to take a walk on this one. The SEC has said as much already. It is not a crime to be a predator.

But there are rules that should not be broken. Powerful players can’t take their wars and predatory ways out on the little guys. No widows and orphans can get hurt or taken advantage of. And that takes us to JP’s successful buy side investment. He teamed up with a bunch of powerful fat cats and bought a big portfolio of troubled mortgages from the FDIC. The FDIC got the mortgages from the failed IndyMac Bank.

It is safe to assume that early on in the process the SEC must have considered some sort of complaint against JP. The conclusion is that there is nothing wrong with engineering a short position. Those out there that would like to see a ban on naked derivative shorts (i.e. CDS) should take note. The SEC just endorsed this practice.

That said I am sure that there are some in high office who would have liked to knock JP down a few notches. To many eyes this will look like he is the bank robber that got away with a big haul and laughed at the cops. Possibly those that feel this way should look at JP’s big buy side trade.

On 12/17/2008 The FDIC announced that it had reached a definitive agreement with IMB Management Holdings, LP (love the name) to acquire a substantial portion of the Indymac residential loan portfolio. The deal was finalized on March 19, 2009. The final purchaser was OneWest bank. This bank was controlled by the IMB partnership. Some thoughts on this deal:

-At the time it was agreed to the FDIC admitted that there were no other buyers around. So the worst bid (aka “least costly”) was also the best bid.

"The current economic climate is challenging for selling assets, but this agreement achieves the goals that were set out by the Chairman.”

“It was determined that the bid from IMB Management Holdings, LP, was the least costly to the Deposit Insurance Fund.”

-In Schedule 202 of the “Loan Sale Agreement” is the following information regarding the purchase price of the assets from Indymac. Based on these numbers you would have to agree that JP bought low.

-There is evidence that the FDIC has had some “sellers remorse” on the sale of Indymac assets. On 2/21/2010 they did a $2 billion deal where they sold more underwater mortgages. Based on the over collateralization of that transaction it would appear that similar pricing (haircuts) to the OneWest discounts were established. There was a big difference between the OneWest deal and the CMO that was recently done. This time around the FDIC kept the equity. What upside is in the portfolio is theirs to keep. The FDIC kept the equity on a $2b deal but gave it away to One West in a $16b deal. Way to go JP&Co.

-There has been some criticism of the FDIC/OneWest deal. Some have suggested that the new owners of the Indymac mortgages have not been treating the old customers very well. For example:


A judge in Riverhead, N.Y., went so far as to cancel a Long Island couple’s loan obligation in November, saying OneWest, which was the loan servicer, had failed to cooperate in efforts to avoid foreclosure and calling the bank’s actions “harsh, repugnant, shocking and repulsive.”

In December 8, 2009 OneWest worked with the Sheriff’s department to change the locks on a distressed home despite agreeing to work with the borrower just 8 days prior. This was done without any court actions which bypasses acknowledged and mandated Due Process on home foreclosures.

Several judges have issued Temporary Restraining Orders and Preliminary Injunctions against OneWest preventing OneWest from foreclosing on properties where the borrower claims OneWest failed to follow proper procedure in foreclosing on the property or otherwise violated the borrower's rights.


The following story is from an individual who I think got screwed royally by OneWest. This specific example took place after the Letter of Intent between One West and the FDIC were executed.

Borrower Status: Non-performing first mortgage.
Loan Balance as of 3/2009: $292,000
Cost of loan to One West: 55% or $160,600.
All cash settlement offer made to OneWest: $286,000.
Immediate gain to OneWest: $125,400, or a 78% return.
Stated reason why the settlement offer was rejected by One West:
“Only full payment will be accepted by the ‘Investors’.”

The Who’s Who list of Fat Cats who put up the $1.3b to make this magic happen:

In case you can’t read that I’ll recap the players in this Consortium:

Steve Mnunchin – Goldman Alum - Billionaire
John Paulson – Goldman Alum - Billionaire
J. Christopher Flowers - Goldman Alum – Billionaire
Robert Leeds – Goldman Alum – Billionaire
Michael Dell – Dell Computer – Goldman Client – Billionaire
George Soros – Big Goldman Client – Billionaire

That is a team of fat cats. Collectively they probably give a few hundred million a year to important charities. Soros is trying to give it all away. But on every Monday this group goes back to work screwing the little guys in this world who have no chance at all to stand up to them. For the life of me I can’t figure this state of mind out. Who wants to make money squashing bugs? These guys are billionaires yet they are sucking dimes from small fry.

Should some powers to be like to take a shot at JP and some other fat cats for what they have contributed of late to the general welfare they should look at OneWest. If there is any doubt that this is a winner for JP and the “Consortium” consider that the bank earned $1.6B (120% return on the initial investment) in just 12 months. From now on it is just gravy for the rich boys.

Possibly someone should talk to that Judge in Riverhead. I doubt he used the words: “harsh, repugnant, shocking and repulsive”, without some facts behind it. Alternatively they could talk to my friend who got stomped on by the Consortium. He went bankrupt; the house is still for sale. His words to me on this: “I have been screwed over and broken all over $6000.”

I would add another description to OneWest and the big money that owns it. Greedy. The fat cats of this world should take their gains from other sophisticated investors. It’s a low-rent move when they ride herd outside where they should be. That money is tainted, and they know it.

No Endives!

I went to my Korean grocer today. The bin where the endives usual sit was empty. I got this wrapper with the nice recipes. My endives come from Brussels. The ones I wanted are probably sitting in an Antwerp warehouse rotting.

We can go a long time without endives. But there are other things that we will need that are not going to get here if the volcano continues to block air traffic from Europe. It's impossible to predict how an act of god will turn out. I’ll try.

There are only three possible outcomes. Either the eruption continues at its current level, or it could increase in size, or it goes dormant. Two of the three possible outcomes are bad news. Absent anything else, the Base Case has to be that the damn thing continues.

Looking at charts of past performance of a stock or a market really does not provide an answer to what may happen next. But looking in the past is the only guide we have, so we use it. That the volcano blew ash for two full years 190 years ago is of little relevance today, but I will use it. Therefore a conservative Base Case would be for a continuation of the current ash production for at least three-months, alternatively it would belch periodically for several years.

If that were to happen a question to ask is how far will the ash cloud move? Once again there is reason for concern on that. In the northern latitudes the prevailing winds are referred to as the “Westerlies”. These winds are influenced by the Jet Stream. This stream of air circles the globe in an erratic pattern. It ranges from 4 to 7 miles from the surface of the earth. It can be as large as 1,000 miles wide and three miles deep. It moves at speeds up to 300mph.

This first picture shows generally the position of the Westerlies:

The following picture is difficult to read, it shows the jet stream position as of February 2010. Notice that it goes from Europe to Russia, over Asia, the Pacific and right over the US. There are reports that the volcano is spewing ash nine miles into the atmosphere, well into the range of the jet stream. The Base Case has to assume that this has some influence on air traffic north of the equator. Gulp.

It is not reasonable to assume that there will be a shutdown of air travel. As of today only a small portion of the northern hemisphere has been impacted. Even that area will begin some flights in the coming days. While it is likely that ash particles will ultimately circle the globe that does not mean that air traffic would be severely affected. It is equally reasonable to assume that the level of interruption will not be “0” either. The Base Case has a range of 10-40% in curtailment. I will use the mid-point of 25%.

The international air cargo business soared from 2005 to 2007. Then it tanked with everything else. It was recovering strongly in the 1st Q of 2010. I have some data from IATA from 2005. I checked it with recent tonnage and insured customs values in Miami and London. I think this data is representative of what the market for global airfreight shipments were prior to the eruption. If anything, it would understate the pre-volcano numbers.

The 2005 total was $3.25 Trillion. That comes to 35% of the total global trade of $9.2T. Total world GDP in 2009 was ~$60T. So the value of the goods shipped by airfreight comes to 5% of the total. That ain’t hay.

The Base Case knocks the impact down. It comes to about $1trillion per year, call that $100b per month on average. It is still 1.5% of total GDP. It is enough to make a difference.

What’s in those cargo planes? Everything. The US total domestic/international number was a staggering 82 million tons in 2009. Think of flying 50 million Ford Taurus’s someplace. What’s in those containers? Electronics, microchips, pharmaceuticals, medical devices, gems, cash/checks (tons of it), on-time parts delivery and an amazing volume and value of food products.

This smoker is worth watching. It could change a lot of things. Let’s hope it goes back to sleep for another 200 years.

GS, the SEC and Timing

It is possible that the SEC investigation into the bad acts of Goldman Sachs evolved over a period of time and the decision to announces formal charges just happened to take place on Friday. I doubt that very much.

A few thoughts:

-This investigation has been ongoing for a long time. At some point we will know when it was initiated and when Goldie became aware of it. Reuters has a report quoting an unnamed source that the Wells Notice relating to the SEC inquiry was delivered six months ago. My own instincts on this are that is was even longer than that. This could easily have been going on for a year.

-Mary Schapiro (head of SEC) does not go to the bathroom without first checking with Rahm Emanuel. To say that this is a high profile case is a silly understatement. This is THE case of the century. The decision to go forward with a public complaint last Friday was done with the President’s knowledge and approval.

-Everyone in D.C. has been pointing to the financial markets as a measure of the “success” of their policies. They point to DOW 11,000, they point to narrowing credit spreads, and they look at wealth creation as the “report card” which validates their actions. I don’t believe these folks are stupid at all. They knew full well that the initial reaction of the markets would be very broadly negative. They must have considered that the SEC action could have lasting consequences to the capital markets. They knew that they had spent a kings ransom to bring the banks back to life, they must also know that this step could have the effect of undermining all of that.

Given the foregoing I have to assume that at some point the SEC sat down with Blankfein and said, “Do you want to pay a big fine, not admit any guilt and agree to be good boys in the future?” Again a guess: If on Friday the announcement had been that GS had agreed to a $3b fine and the case was closed GS’s stock would have risen and the broad market would not be worrying about how sloppy things are going to be in the next few weeks. I think Blankfein would have written a very big check to avoid the headlines we are seeing today.

So for me a central question is, “Why last Friday?” Possibly we will never know the answer to that. But I have my own suspicions. This step was made at this time to influence the outcome of the financial regulation that is now being discussed and drafted. What better reason to implement big reforms than a big splashy case in the papers that all but proves that our big banks are crooks and they need to be regulated into oblivion.

So far this weekend I have received three mass email messages from the President. None have connected the dots directly to the SEC case with Goldman. But the hints are obvious:

bruce --

It has now been well over a year since the near collapse of our entire financial system that cost the nation more than 8 million jobs. But the flaws in our financial system that led to this crisis remain unresolved.


Wall Street titans still recklessly speculate with borrowed money.

We cannot delay action any longer. It is time to hold the big banks accountable. Arm-twisting lobbyists are already storming Capitol Hill, seeking to undermine the strong bipartisan foundation of reform with loopholes and exemptions for the most egregious abusers of consumers.


It's a fight worth having, and it is a fight we can win -- if we stand up and speak out together. So far, all 41 Republican senators have signed a letter opposing reform -- but there is still time for individual senators to do the right thing.

Thank you,

President Barack Obama

Millions of these emails have gone out in the last 24 hours. I can imagine that a lot of people who get this message are saying to themselves this morning, “The President is right! The SOB’s at GS are a bunch of crooks, we should shutter the bastards!”

At some point we will know what motivated the SEC to move last Friday. Should it be determined that the timing was driven to influence the outcome of pending legislation it will be a very sad day for America.

George Bush used fear to get us into a war. Obama seems to be orchestrating “fear of financials” to achieve his objectives. Bush’s war has proved to be a disaster; I doubt that the effort to rein in the financials will have a better outcome.

Hot New Biz

North of NYC, in Westchester County, some lawyers are working a new hustle. From what I hear the phones are ringing off the hook.

It’s pretty simple. A significant number of homes that were either built or reappraised from 2003 on are paying a property tax based on a value that in many cases no longer exists. There has always been a statutory process where inequities in values/tax rates can be addressed and resolved. But values were always rising so there were very few cases. Until last year.

So here is the deal, and it is pretty compelling. The legal fee is 75% of the first year savings payable on the day the taxes are officially lowered. You pay nothing if no relief is granted. Call that a “win win”.

The process is not a slam-dunk. The proof required to determine that a property has a current value meaningfully below the tax-appraised rate has to be compelling. I saw a case recently where a house was on the market and got sold at $1.1mm. There were contracts signed. Because there were clear documents showing a willing buyer and seller at $1.1mm there was no need for appraisals. The tax liability was based on a value of $1.6mm. The result? A $15,000 reduction in annual taxes. $12k for the lawyer. Next case.

There is a part to this that just makes me laugh. Most people don't have the ‘smoking gun’ of contracts to establish value. They have to have the property professionally appraised. So the same guys who a few short years ago were over appraising every property they looked at so the borrowers could over leverage are now finding (and documenting) every which way to drop the current value as low as possible.

There is always a hustle someplace.

Elizabeth Warren's Chance in the Sun

Elizabeth Warren has been all over the media of late. This lady is a ‘hot property’. And with good reason. She has all of the credentials. Harvard Professor, eight books, the Chairperson of the Congressional Oversight Panel, she’s on the list of the top fifty “Most influential lawyers in America” her name even has come up as a candidate for the Supreme Court.

Not only does she have the credentials, she has a look. There is something about her that when she talks to the camera you get a warm feeling and think, “Finally there is someone who is making some sense of this mess!”

I think she is blowing smoke.

Today there was another Congressional hearing on the status of mortgage defaults in this country. We have a significant portion (20+%) of homeowners that are now underwater on their mortgage. The big banks went to the Hill and swore they were doing just about everything to unscramble the eggs. Our boys from JPM said that it would cost “hundreds of billions” to write down the principal of the mortgages that are underwater. 'Heaven forbid that that would happen', was the warning. I was left wondering what the real value of their book was given their defense that they could not afford to realize the embedded losses.

The simple fact is that of the 1.1 mm who have requested mortgage relief only 170k have gotten it so far and almost all of those have been temporary reductions in monthly payments but no reduction in principal. It is nearly two years since this blew up. We have made almost no progress in addressing it. We are kicking a can down the road and hoping that ZIRP finally causes some housing inflation to balance the books. That is not working at all. It is just causing bubbles outside of residential real estate.

Ms. Warren had strong words regarding the bank's stubborn position today. From her interview on ABC World News:

“It really is stunning that this is the position that we are in. The American taxpayers have shoveled out 100’s of billions to rescue these financial institutions and now those same institutions don’t want to be part of the solution”.

So she gets more respect and more visibility for bashing the banks. But my question for Ms. Warren is, “What are you doing in your own back yard?”

Warren should look at the numbers and start stirring this pot to where she might actually get something done. Right in the House. She can call up Barney Frank and get the numbers. She could have lunch with Shaun Donovan over at HUD. He has all the info for the FHA. Even better she could take the time to drop over to see Mike DeMarco at the FHFA. He has tons of numbers too. The all have the same number for what they have contributed to principal debt relief. The answer is close to zero.

The ultimate cost of the Washington mortgage lenders will exceed $500 billion. As of today it is a blank check. It will be many multiples of the net costs of the TARP. So when Elizabeth talks of “shoveling tax-payer money” there is no greater shovel full in history than what exists right now in D.C. The idea that “Those same institutions don’t want to be part of the solution” should not extend to the 70% of the mortgage market that Washington now owns is flawed logic. And she is well aware of that fact.

I’m not sure what ‘office’ Ms. Warren is pursuing. She could set a very high bar if she stood up to the plate and directed her rancor and visibility toward the Agencies. She could influence the outcome of this. She can either lead, or she can bad talk the private sector. If she does step up she will have the support for any office she wants. If she doesn’t, she may go back to Boston and teach law.

Sheila to Charge a Fair Price for TBTF?

The FDIC came out with a New Rule Proposal for pricing the FDIC insurance for the nations biggest banks. Basically the plan is to scrap everything that has been done in the past and replace it with a new methodology where the pricing of the insurance will reflect the risks that the FDIC faces when insuring the depositors.

“The FDIC would replace the financial ratios currently used with a scorecard consisting of well-defined financial measures that are more forward looking and better suited for large institutions. The proposal also includes questions about how to incorporate other risk measures, like the quality of underwriting or risk management practices, in the future.”

There is no doubt where this new “Scorecard” approach is headed; right smack into the TBTF’s face. The objective of the new approach? Answer:

“To revise the deposit insurance assessment system for large institutions, which pose unique and concentrated risks to the Deposit Insurance Fund.”

I would love it if one of those “Well defined financial measures” were to include CDS pricing. A recent look at the CDS pricing for BoA was 1.125% per annum. The average pricing by the FDIC for all banks is approximately 30BP. One-third of what the Street charges.

So who exactly is going to get hit over the head with this? Answer: Every big bank in the US, including our buds at Goldman.

"A highly complex institution would be defined as an insured depository institution with greater than $50 billion in total assets that is fully owned by a parent company with more than $500 billion in total assets. The designation also would apply to a processing bank and trust company with greater than $10 billion in total assets."

This sets up two interesting sideshows:

-The banks are going to be paying ~60-70BP for insurance. That is a very big number to pass onto depositors when interest rates are less than one percent. Possibly Sheila should speak with Ben about raising short-term rates. That way the banks can screw the depositors for the full hit and still pay 1/8% on deposits. As it is now, the banks will be underwater on all those nice deposits they have.

There will be a 60-day comment period. Look for all the big banks to respond. They will whine like children over this. Terrible hardship and all that. I can’t wait. The sniveling we will get from these responses will make great fodder for the Blogs.

Goldman will look at this and will have to ponder the wisdom of becoming a bank holding company. A possible consequence will be that they reverse once again and go back to being an investment bank. If they did that they might as well go the whole route and just go private. Then they wouldn’t have to take flack from the regulators or pay Sheila’s vig.

I have to (once again) give some credit to Sheila Bair on this one. No one else is willing to tackle the issue of TBTF and the systemic risk that they create. This is potentially something that will force the broader issue of TBTF to a resolution. The Banks will hate Sheila’s high prices so much; they might actually change their ways.

Just a question, Does the new proposed pricing mean that they were mispricing in the past and therefore encouraged speculation with depositors money? I think so.

Ban All CDS! (Except the “good” stuff)

Those that are looking for a ban on CDS should consider where this takes us. The mother of all CDS providers in the US is the FDIC. Throwing stones at the evolving CDS market should be done with an eye to where the stones might fall.

The FDIC does not provide much detail on its current status. The last annual report was from 2008. From this we get the Insured Deposit number on 12/31/2008 of $4.5T. I don’t have a more recent number but I think the 4.5t is still a reasonable estimate +/-5%.

In November of 2009 the FDIC finalized a $45 billion three-year prepayment of insurance premiums. The link to the FDIC re the details.

Put this together and you get an estimate on the pricing of the FDIC insurance. $4.5T divided by $45b equals 1%. Divide again by three and you have 33 Basis Points a year.

Now consider this slide on the recent pricing for CDS on BoA. Note that the price to insure $10mm of Senior bonds is $116,000 (~1-1/8% per year) payable each year for the five years.

Some observations:

-A comparison of BoA’s CDS pricing to the FDIC average pricing produces a similar result. Yes the CDS are triple in price but there is justification for that differential. One insures deposits, the other insures so called senior debt. But in actuality the depositor’s rights are more senior (less risk). Also, the FDIC insurance is plain vanilla and limited to a maximum of 100k, while the CDS market will handle many multiples of that and provide maturity flexibility. And finally, the FDIC is not trying to make a profit. Wall Street makes nothing but profits. The difference between .33 and 1.16 is not so significant, the variance is justified.

-The FDIC does not charge a flat fee to all of the member banks. They have a rating system called CAMELS that is used in establishing an individual bank’s costs. The CDS market does the same thing. Costs for protection vary from institution to institution based on perceived or measurable risk.

-Both FDIC and CDS have annual up front costs and future pay as you go costs. Those that get the protection pay for it. In the case of the banks, they pass this onto the depositor/customer. Those that seek to protect some downside (or those who merely want to make a ‘bet’) using CDS pay the price for protection.

-If a bank defaults the FDIC pays the depositors 100% but gets the loan portfolio to offset some of the losses. The writer of CDS absorbs the losses up to the remaining value of the collateral. The settlements have similar features.

-There is no true public market or opaque disclosure on either the FDIC pricing or CDS. It would not be practical (if not impossible) to change this in any meaningful way without undermining the utility and functionality of these roles.

-Buyers of naked CDS are attempting to make a buck. Every Wall Street house has a brokered CD business. They sell $99,000 FDIC insured high yield CDs to their customers. They are gaming the system, there are big numbers involved. Everyone is out to make a buck.

-On the business of making a buck let me point out that there has to be risk takers in any functioning private market. Stocks, bonds, commodities, you name it. If you take out the risk capital these markets will not perform in a way that we need them to. Same is true for CDS. Markets create capital and share risks. Putting a plug in that process will end badly.

-An argument has been put forward that CDS creates excessive leverage that could collapse the writer and thereby trigger a systemic risk. The position is that there is not sufficient capital supporting this growth of CDS. A valid argument given that AIG is still staring at us. This may well be a fatal flaw of the CDS writers. But it is worth looking at how solid the FDIC is.

The answer is that the FDIC is as good a credit as the US Treasury. They both have full faith and credit guarantees from our Uncle Sam. They have about $40b of cash left from the “Prepay” and they have an unused, but immediately available, no strings attached, line of credit from the Federal Financing Bank (Treasury) for up to $500 billion. So it would appear that there is no comparison to the private sector providers of CDS.

Today the FDIC has no equity. They ran down their rainy day fund of $55 billion last fall. They functionally borrowed equity through the prepay. But at the end of the three-year period it is unlikely that they will have replenished any of their reserves. The FDIC is very solvent, but at the same time it is broke.

We will resolve the TBTF issue. And soon thereafter a former TBTF will fail and it will fall to the FDIC to save the system. With no money in the till they could not withstand a “Top 20” bank failure, so they would draw on Treasury to make good on their promises, but the taxpayer would once again be stuck with the tab.

The wart that both CDS and FDIC share is that there may not be enough behind them if things go upside down again. The FDIC is striving to replenish its reserve to 1.2% of deposits (from zero). That comes to ~$60billion. It will take them years to get that, and they will be lucky if they do. But even that much money is not so big anymore. Any of the current TBTFs would take out that reserve and then some. The equity behind private label CDS is equal to that percentage up front. It grows every year. For me the systemic risk that will take our breath away comes from a failure/bailout of the FDIC. Not the blow up of a top ten bank from a bad CDS book.

Without the FDIC our banks would implode. With them would go a good number of foreign financials. So the FDIC is central to the system. Without them we go “poof”. But we need to understand that their business model is pure CDS. And it is 100% leveraged. Dump this at our risk.

Too Much Rain Will Kill You

A long time ago I was talking to an upstate dent corn farmer. He said of the weather:

“A drought will scare you to death, but too much rain will kill you.”

That bit of poetry fits a lot of things. Excesses are always bad. Some scare you to death others could even kill you. Possibly when it comes to monetary policy Mr. Bernanke should listen to the farmers. He is raining ZIRP on us and he won’t let up. Too much rain is a bad thing.

March set a record for rainfall in the North East. I can attest to it. There was as day last week where the earth started to become something closer to Jell-O. It was all water.

Like the markets, the weather is random. There are many factors that come into play. For me the big enchilada in weather is the El Nino La Nina cycle. That process brings us the extremes. We just passed through a significant El Nino. No doubt the flooded basements can be blamed on that.

The following two slides look at the water temperature difference between La and El. In an El Nino the warm water pushes onto Ecuador, when the cycle reverses the warm water appears in other parts of the Western Pacific. If you look at the maps more globally you see that the warm water changes throughout the world, it influences water temperatures from New England to Korea. Cloud cover drives this self-perpetuating energy source. Cool water produces fewer clouds, so the water gets direct sunlight and warms. When it reaches certain levels it produces clouds (storms). The absence of sunlight and the storms cools the water and the cycle is repeated.

There are folks who live and breath this stuff. They have all the live data from buoys. They can tell you exactly where we are, but they have not been able to predict the future. They try hard, but they are about as successful as your average sell-side analyst. The problem, in my opinion, is that there is too much Vol. and the turns at the tops and bottoms are vicious. Consider trying to price the Vol. and trading the peaks and valleys of this chart.

The tops and bottoms are always spikes with big reversals. This is the blow off of storms. We get bad weather, the ocean cools. Like overheated markets El/La cycles often end violently.

Notice that in just the last few weeks we have been screaming off the recent peak in El Nino. This non-weatherman reads this break as a sign we are in for a few months of good weather. I wish I could feel as optimistic on the markets. I would, if Ben eased up on the rainmaking.

What's More Important: Debt to GDP or Supply?

There may be a flaw in the thinking our economists, financial leaders, the MSM and (even) the bloggers. Everyone is looking at the debt issue based on some ratio of total debt to GDP or debt service to GDP. This is the way it has always been done and is both right and appropriate. How much debt can be afforded is a ratio of the borrowers income whether it is an individual, a company, a State or a Sovereign. But there is (to me) evidence of a new metric developing. Supply is quickly becoming the determinant for the cost of borrowing, not debt to GDP levels.

Consider California. They have a monster GDP. Their debt to GDP is one of the best in the country. They have debt equal to only 6% of GDP. Massachusetts and Rhode Island are north of 20%.

But California is the official junk borrower. They just paid 5.8% for ten-year money. On a taxable equivalent yield that comes to 9%. Cali's CDS spreads are also in the tank. Their spreads are trading even up to Bulgaria. It is not their GDP that is the problem it is their visible supply of paper.

The inversion of the ten-year swap spread is completely crazy. It is almost impossible to think that this could happen. But it has. This is all about supply folks. $200b a month of new IOUs is the issue. The Debt to GDP ratio for the US is a disgrace. It is still favorable to most other sovereigns. But we’re now trading to a AA. We pay more for term debt than many other nations.

The US has $8+T in federal paper outstanding to the public. That will increase by 50% or more in the next five years. The Agency paper in public hands is an additional rollover problem. It is likely that Social Security will be a net seller during this period. They once funded 50% of our deficits.

Will someone please tell me who is going to take this on? Consider the list of existing big holders. I will give you an argument against any of them solving this supply problem. Please don't tell me that US households are going to pony up for this. And don’t tell me that I shouldn't worry about supply because Ben B. will buy whatever is necessary. We would be destroyed in less than three years if he did that. And he knows it.

At every step of the way over the past twenty-four months the “markets” have forced the policy makers hands. From Bear to Lehman, to AIG, TARP, ZIRP, QE, Bizzaro Budgets, Clunkers, HAMP and all the rest. The objective was always to blunt the markets. The Stock, Treasury bond, Real Estate, Corporate bond, MBS, ST/LT interest rates, currency, swaps and derivatives markets have all been manipulated for some time now. The question is, “who has been manipulating whom?” More important is, “who is winning?”

At this point I see that the ‘markets’ have successfully forced the global policy makers to absorb the absolute giant share of the credit losses of the bubble. A monumental cost will come from the D.C. lenders. They are hobbled with bad debts, while the remaining private financials have earned a bundle on the ZIRP. The market has forced the socialization of total debt/bad debt to a point where the remaining nut is manageable.

With the end of QE the cycle is now complete. The maximum amount of risk in the form of credit exposure and aggregate debt has now been passed to the public sectors around the world. As markets are wont to do, they are likely to turn on their benefactors now that they have succeeded. If total supply and visible supply are going to become more powerful forces than traditional metrics of determining debt pricing, it will have to end up at America’s doorstep. We are the ‘category killer’ when it comes to supply.