Another Fin. Reg. Failure

The following graph is derived from data in Fannie Mae’s most recent monthly report. It compares the default rate experienced by Fannie on its book of conforming loans to the default rate on “enhanced” loans. The enhanced default rate is 4Xs higher than the regular default rate. Enhanced loans have performed very poorly over time.

When a Fannie loan goes bust there are many economic losers including:

-The borrower will likely lose the property and suffer a variety of losses.


-The lender (Fannie) will lose money.


-The taxpayers pay for all of the losses at Fannie.


-The process of foreclosure causes RE comps to fall and results in devaluation of values in communities, towns, cities, states and ultimately the whole country.


-As RE values decline so does the tax base of municipalities. This adds pressure on state and local government's finances. The response is to cut expenses. Very often these cuts come from school budgets. Exactly the worst place for cuts to come from if a country was trying to stay competitive in a global world.

The collateral damage of defaults is much larger than the loss incurred by the lender. It cuts across society and the economy. Our country desperately needs policies that reduce the cycle of default. Until the default rates return to the historical mean there can be little hope of a sustained economic recovery. Our private financial institutions will continue to be suspect. The process of the FDIC closing banks every Friday will not stop. The public lenders, Fannie, Freddie and FHA will continue to run up big losses. It will go on for years. The collateral damage will cripple towns, cities and states. As RE values decline individual wealth will go down and with it will go consumption.

For me the most remarkable thing about this is that the Fin. Reg. proposals do not even mention the mortgage insurance (MI) industry. The proposed new rules take a shot at re-regulating the banks, it provides some protection to consumers from predatory lending, it sort of addresses concerns regarding derivatives. But it does not touch the MI providers. How could that be possible?

There are (at least) two reasons for the carve out of MI in the Fin. Reg.

-MICA, the industry spokesman and lobby was successful in keeping the MI companies out of the legislation. A job well done by MICA on behalf of its members.

-There is a belief in Washington that our RE market and therefore our economy cannot succeed unless credit is available for financing 95%+ of the cost of a home. FHA, the government owned PMI provider, continues to provide 96.5% LTV financing. They have admitted that they are suffering big losses as a result. FHA will be forced to reduce this activity. There is no stomach in D.C. for another bailout. Therefore there must be a private sector MI to take up the slack when FHA is forced to change its ways. As a result the private PMI providers were excluded from Fin. Reg.

Before the May meltdown the PMI provider’s stock prices were all on a tear. The future for the PMI providers may look bright to some. But the idea of creating high-risk mortgages that by definition have a high default rate makes no sense. The lobbyist, MICA, and their MI members are winners. Everyone else will be the loser. Fin.Reg. is a joke.

NOTES:

Who is one of the biggest players in the PMI market? AIG of course. We are protecting AIG. What in the world are we thinking of?

The feelings are different over at AIG however.

100% financing is like a drug. Once your hooked it's hard to stop. Fannie can't quit. They are still making 100%+ loans to move their REO:

On the Edge?

Timmy G. is in Europe urging the financial leaders to, “ Do it Big and do it Fast!”. I think this was typical Dumb Tim. He is setting this up to come to a boiling point ASAP. That is the worst possible outcome. There are no short-term solutions to Europe’s problems. The EU has to buy itself some time to try to make adjustments. We need some cooler heads in charge. Instead "Cowboy Tim" starts shooting off a six-gun. As with most gunplay someone is going to get hurt.

The calendar is working against the Euro. With all that is going on I think positions are already light for the US interbank players. There is always risk for something to happen on a weekend. This weekend is no exception. To add to the problem is the three-day bank holiday. Based on past experience I would expect that the ‘commercials’ are likely to get involved in the market before the weekend begins. In this case I am referring to the hundreds of big time CFOs around the globe who have corporate Euro exposures. Almost all of them have natural long positions in either/or cash, inventory, earnings and profits, inter-company accounts and fixed assets. This crowd has been hearing the “rumor” of a change in Chinese reserve management all afternoon from the FX Corporate desks. They will look to lower risk before the weekend.

Of course there is no truth to the rumor that China is rethinking its holdings. It does not work like that. I would expect that China and many of the other big reserve countries will be reducing their incremental holdings of Euros for some time to come. That is a significant difference from big ticket selling. I am sure that there has been CB selling, there will be more in the future, but not the Chinese. That does not matter. Just the talk is going to keep the money moving.

NY equities were just a puke-out. That close is going to roll to Asia and later Europe. A bad day for Euro equities is going to put more visible pressure on the Euro against all crosses. It does not matter if this is logical or not. It just works that way.

If you measure sentiment by the talking heads, the markets are positioned for a “predictable” bounce off recent low levels. A 10-12% correction often brings that result. But we don’t have Europe blowing up very often either.

We took out the 110 level on the E/Yen today. I bet we will hear some silly statement tonight from a Japanese finance official, “A strong Yen is not desirable, MITI is monitoring market closely”. This crap talk will not work. But I doubt the Japanese will intervene.

We are playing with E/$1.2150 as Asia opens. There is a big black hole of uncertainty if we go under 1.21. I can’t imagine that we will not see this test soon.

The E/CHF is back to 1.4160. There was an explosion of trading a week ago in this cross. I maintain that the Swiss National Bank intervened very aggressively when the exchange rate fell to 1.4000. As with the $/E rate there is nothing blow 1.40. We have never seen that. Therefore by definition that is a high stress situation. Markets being markets I think it will have to go back to that 1.40 level just to see if the SNB is still around.

If the Swiss are not there, get a parachute.

"Cheery" Words - Unlikely Source

David Stevens the boss at FHA made some comments today that caught my eye. The full story here. Some highlights:

On the status of the US mortgage market:

“This is a market purely on life support, sustained by the federal government.”

FHA is now doing more business than both Fannie and Freddie. The reason is FHA is still offering 3.5% down payment mortgages. Mr. Stevens thoughts on this:

“Having FHA do this much volume is a sign of a very sick system.”

On the status of FHA’s “book”:

"FHA has been taking steps to shore up its program after being left with “terrible portfolios” from 2007 and 2008."

The FHA, Fan and Fred now account for 90% of U.S. home lending. Stevens is right, the system is sick. An obvious way to decrease the percentage of the federal involvement in the mortgage market is for the Feds to stop lending money on terms the private sector would not. An easy way to achieve this is to reduce the geographic lending limits for all the D.C. lenders to where they were in 2007-08, that was about $417k. That number was goosed up to over $700k for a number of areas in 2009.

The temporary limits will expire at the end of this year. After the shellacking that the “ins” are likely to take on the issue of “big government” this coming November it is likely that the temporary limits will be allowed to expire. At a minimum, significantly lower levels may be set.

The good news is that the vast majority of states, towns and cities in the country will not be impacted. Their limits are already less than $417,000. The bad news is that the major metro areas will be hard hit. The following cities could see a drop in federal lending by as much as $300,000.

Metro areas:
D.C.
Baltimore
Boston
NY
LA
San Francisco
Seattle
Sacramento

“They” are going to have to do something. It is not sustainable for the federal government to be 90% of the market. The head of the FHA has said so. Cutting the limits is an easy way to do it. Possibly a RE play is to barbell the country. Go long Chicago and Dallas and short both coasts. If that is too complicated, just go short.

Note:
There are some areas where federal lending limits are “silly” high. To me it looks like a subsidy for rich people. When the limits are considered I would be surprised if there were not some adjustments. Key West, Nantucket and damn near every ski resort town in Colorado, Utah and Wyoming are over $700k, more than 3xs the national average. Possibly some additional short “fodder”.

The Swiss Did It!?

Swiss National Bank President, Phillip Hillebrand, in an interview with the Neue Zuricher Zeitung, May 8, 2010:

“We will not allow that the euro zone problems and an excessive rise in the franc to lead to deflation in Switzerland. That defines our policy with regards to the exchange rate. The bank will act in a decisive manner if needed.”

There has been a lot of speculation in the past 48 hours on who did what in the FX markets as far as intervention is concerned. The Treasury Department has a “no comment”. The ECB and the SNB have been mum. I will stick my neck out and say it was the Swiss that did it. A two-day chart of Euro/CHF:

The two vertical lines are evidence of market intervention. That is not just short covering. This was a size buyer that did not care if the execution was sloppy. It looks to me like an effort at “shock and awe”. Some thoughts:

-As of 3/31/2010 the SNB had Euro 53b in reserves. They reported that these holdings had a mark to market loss for the Q of CHF3.1b ($2.9b). The NZZ has reported that SNB purchased an additional Euro10b in April. It should therefore come as no surprise that the SNB bought more Euros and sold more CHF in the past day and a half.

-The graph shows that the FX rate was just a tad above 1.40 for a few days prior to the blow up. I suspect that this was the SNB providing support to the market on an ongoing basis. These are stabilizing efforts. It is a “containment" policy it is not “shock and awe”.

-The night of the Merkel “no trading” rules the Euro/$ hit a new low. Logically there would have been pressure on the Euro/CHF. But it held. Here I suspect that “resting orders” were in place to continue the containment.

-Watching the market on Wednesday I concluded that there were three separate rounds of intervention in the E/CHF. Each resulted in a spike in the rate and then a resumption of trading. The end result was a 2% backup. That is a big move in this cross. This activity all took place during peak European and NY FX markets. At that time there are thousands of players. The market is deep and big numbers can get done. The intervention required to move the market this much would have to be more than Euro 5b.

-The E/CHF rate was fairly quite today. Until 2 pm. Then another demand driven gap upward. I saw no reason in the other markets for this gap. If a “real” market player wanted/needed to buy size E/CHF they would not have done it a half-hour before the futures close. This stinks of “Shock and Awe”.

-The E/CHF market is a derivative of the $/Euro and $/CHF. To unwind demand for E/CHF one could buy $/CHF and sell $/Euro. The crosses have to match out with the cash prices. During European trading the CHF crosses all have big floats. But in late NY markets they do not. So if a big buyer of E/CHF appears it will result in a seller of $/Euro. (Demand for Euro). This explains why the E/$ rate went ballistic this afternoon.

But why? I am not sure. There could be many motives at play.

The SNB had every reason to intervene. They said they would and they did. They did what they have been doing for months. But in my opinion the shock and awe of the last few days is very atypical of the SNB. The question is, “Were they asked to change their strategy?”

The ECB has shown their hand. They have not actively intervened during European markets. If they had we would know about it. The ECB would have announced their efforts publicly. The job of the ECB is to manage a downward path for the Euro. They are well aware of the collateral damage to the other markets a weak Euro could cause. They need a weaker Euro, but they can’t afford a collapse of the bond/equity market. So Trichet calls up Hillebrand and says,

JCT: “Do us a favor. Make a very big bid in the E/CHF. This will help us out against the dollar, pound and Yen.” Hillebrand could have said,

PH: “Okay, we will step up to the plate over the next few days. First in Europe and the next day we will attack the weak Chicago market. But here is the deal, The ECB has to cover our losses. We'll roll them for you at Libor +2.”

JCT: “We’ll cover the losses. It doesn’t matter any more. Go out and kill some wolves for us.” (Heard muttering in the background: “Cheap Swiss”)

There is a Fed NY role in this. All Central Banks talk to each other (they also call big market makers). For me it is not possible for the SNB to have done anything in the NY trading hours without the knowledge, advice and consent of the NY Fed. This scares me a bit. We are in very nervous times. There has been no public statement of any intervention. So this is the stealth variety. I am not suggesting that the NYFed did anything today or yesterday. But if the SNB did, they had a chat:

SNB: “We are thinking of calling JPM in NY and putting in a market order to buy up to 3b E/CHF. What do you think?:

NYF: “Swell idea. The S&P is in the dumper. We are getting calls from all over. If you bid for size it will roll into the dollar market and bid up the Euro across the board. Is that what you want?”

SNB: “We are after the wolves today.”

NYF: “Suits us, Have at em. But one suggestion, do it at 2 pm. A few weeks ago a size order in Chicago at 2:30 caused a 10% micro burst in equities. Maybe you can do that again today. Wouldn’t it be a hoot if we actually killed a whole pack of wolves!

I don’t have a pipeline into the NYFed, the ECB or the SNB. This "take" on the market action in the past few days just lines up with the facts. If I am right, there are a few conclusions.

-The monetary authorities are very worried and are willing to use aggressive strategies to calm instability.

-Using the SNB as a single source of global currency intervention will not work for long. The ECB and the Fed are playing weak hands. They know if they intervene and fail it is lights out. So their active/visible participation is a last resort option.

-Another chapter in this story will be written soon. Possibly this weekend.

Next on the Contagion List – UMS?

I am looking at the tape(s) and it appears to me like everything is cracking up. The most troubling is the widening of sovereign spreads. That beat goes on. With that in mind I looked at who might be next on the list of countries that the wolves (AKA-“Global Bond Investors”) close in on. To make a big move on the global financial stability scale I think it would have to be a country whose GDP is north of $1 trillion. Here’s the list.

Of the 15 names a few (Spain and Italy) are already being pursued by wolves. Russia is not likely to be a problem in this round. Nor is Brazil or Korea. That leaves Mexico.

Before considering some of the negatives in the Mexico story I want to address the one issue that is the most compelling argument against a Mexico problem. That is their reserves. The Mexican Central Bank is sitting on $98b of cash. Consider this chart:

While this horde of money would appear sufficient to insure a soft landing for Mexico I want to draw your attention to where the reserves were a year ago. From June of 2009 to recently reserves have gone steadily higher. This $25b of capital was part of the global “risk on” phenomenon. Money that had left Mexico looking for a safer port during the 08-09 financial “crisis” came back home. New money came in as capital began looking for cheap equities. Consider the Mexican Bolsa:

The Peso faired better as the money returned:

But that $25b was hot money. It came in fast; it will leave just as fast. While Mexican investors could take comfort in the weekly reserve number in the past, just the opposite will likely happen in the future. We are in a risk off mode. Some of the money that came to Mexico is going to be leaving. Looking at a few short-term charts makes me wonder if the process has not already started:

Mexico is an oil exporter. They are getting killed by the recent drop in crude. They supply the US with 1/3 of our crude yet they still run a current account deficit. In 2009 it was a lumpy $10b.

For me, the most troubling number comes from the CIA. They put Mexico’s external liabilities at $177b.

This number represents both the public and the private sector liabilities. There are many assets against this that are denominated in dollars. But I am still troubled. This external liquidity is the issue of contagion. Global holders of these IOU’s are putting their money back in the wallet. A contraction of credit for Mexico of 20% would put a big dent in those reserves.

If the price of oil slips another $10, Mexico’s name is going to come up with the wolves.

Solution to the Budget Crisis – Do Nothing!

The Commission on Fiscal Responsibility and Reform held their first meeting recently. These chitchats will continue on a regular basis until December when their thoughts will be made public. Former Sen. Alan Simpson, R-Wyo., the panel’s co-chair, summed up the difficulty the commission faces:

“It's going to be like giving dry birth to a porcupine.”

While Senator Simpson has provided a colorful description of what lies ahead I think he (and most others in D.C.) are doing us a disservice. As it turns out a significant portion of the revenue problems can be fixed. All that Congress and the President have to do to right the revenue ship is: Do Nothing.

Consider this first graph of the CBO projected budget deficits through 2020. The graph measures the size of the annual deficits. These very big deficits assume that various tax credit/deductions are eliminated and taxes on income are increased.

This second graph shows what would happen if Congress and the President were to extend existing tax breaks. The three big areas of tax increases come to $3 trillion over the ten-year period.

Our tax code is littered with provisions and temporary “fixes” that have the affect of reducing tax revenues. Each of these provisions has a drop-dead date attached to it. If Congress were to just say “no” to extending any of this we would generate $5.3 trillion over the next decade. That much money would go a long way toward addressing our fiscal imbalances.

The CBO has a list (Expiring Tax Credits) of the nasty tax breaks that could fall prey to the setting sun. The list is three pages long. Many are important incentives for alternate energy. There are some that smell like pork. For example the Depreciation Classification for Certain Race Horses could be eliminated. That would save us $500 million. But these categories don’t amount to much. We need to go after the big bucks. We need trillions, not billions.

Our politicians will be faced with two difficult choices. Either they can go to their constituents and corporate contributors and say with glee:

“I voted to raise taxes on every damn think we could think of!”

Or they could do it the easy way and say:

“I did not vote for any tax increases. My record is clear. I did the responsible thing. I did nothing”.

Given how things work in D.C. and that a fair swath of the population hates everyone (red or blue) at the moment it would seem reasonable that our leaders will do what is necessary (and expedient) and do nothing at all. With that in mind it is worth taking a look at the CBO list to see what big-ticket tax increases are in store between now and 2020.

-EGGTDDC (AKA- The Bush Tax Cuts) Letting this roll off into the sunset on 12/31/2010 will result in a $1.6 Trillion tax increase. Big money and it would result in an immediate increase in revenue. This increase will come from those making over $200k. On average this will mean about 2% off the bottom line of 5-10mm households. A substantial hit.

-Raise long term capital gain to 28%. This comes to $350b over the ten-year horizon. It is not a big category but a politically important one. This is going to happen.

-Estate and Gift taxes will add $570b. I think this one is a layup. Sorry trust funders.

-Expensing of Investment Property will save $300b. Your incentive to own any real property will be diminished.

-Eliminating the deferral on AMT will generate $530b. This is an ugly tax. I have been subject to it for years. I think of it as a 28% flat tax. But it really is a bastard of a flat tax because certain deductions are still permitted, while others are not. Here is how the IRS describes the AMT:

The AMT is a separately figured tax that eliminates many deductions and credits, thus increasing tax liability for an individual who would otherwise pay less tax.

What are those deductions/credits that you might lose? (1) Child-care, (2) State taxes, (3) local property taxes, (4) medical expense and (4) charitable contributions. Basically if you live in NY or California (or state with high income tax), own a home where property taxes are high and have three kids and support your church; bend over. This tax is going to hit between 10 and 20mm people. If your individual or combined income is ~$125,000 look out.

Something along these lines is coming. We have survived high tax burdens in the past and will likely do so this time. The most critical factor in the CBO analysis of the future deficit is not expenses or taxes. It is the growth in the GDP of our economy.

In a utopian world we would have tax receipts of 15% and expenditures of 18%. We are far from utopia. In 2010 we are looking at tax receipts of 10% and expenses of 25%.

Consider this graph of the CBO’s projected growth of GDP. They assume an average growth rate of 4.38%. I think it is going to be closer to 2%.



The difference between the CBO estimate and the more realistic 2% comes to a whopping $22.5T over the ten years. Apply a 15% tax rate to that missing growth and you end up with $3.3trillion of less revenue. That is equal to all the tax income that will be created by the big rate increases that are coming. In other words, nothing will have been accomplished.

If we fail to grow, we die. The deficits will overwhelm us. It is very difficult for me to imagine how we can grow if we implement these (or similar) tax increases. We will bump back and forth from good years to bad and the average growth will be closer to 1% versus the 4% we need. That said, I still think we will do “Nothing”.

On Contagion

In my neck of the woods when you need some stonework done you hire Ecuadorians. They know their cement and have a good eye for laying up stone. They also work weekends. Not more than one in fifty of these workers are here legally. I had an interesting discussion with the mason I use.

He is 30. Been here for six years. Works six days a week. Some years ago he put a nest egg together of $20k. He used that money as a down payment on a two-bedroom apartment back in Quito, that cost him $80k. He got a dollar mortgage on the $60k balance and rented the apartment to a government worker for $400 a month. The rental makes him net cash flow positive on a monthly basis. A smart investment for a guy looking to go back home someday. But he has a problem lurking. He is at risk to contagion. I doubt that he understands that. But he does know he has a big FX risk in front of him.

His words:

“The government will be forced to stop the dollar as the currency. When this happens the rent money I receive will be worth much less than the $400 I get now and my debt is in dollars.”

Some background.

Ecuador dollarized its economy in 2000. This step brings immediate benefits to the country involved. It has the impact of reducing inflation, it increases the countries ability to borrow from external creditors and the predictability of a stable currency helped encourage domestic investment/growth.

Ecuador is in that sense a bit like Greece. It tied its currency to a horse that at first dragged it ahead, but ultimately the reality of a weak economy tied too closely to a strong one leads to a blow up.

Ecuador is already a pariah in the international financial community. They have defaulted on their debt twice in the last decade. Most recently in December of 2008 when they stopped payment on $3.8 billion of bonds. in June of 2009 they bought in most of the debt for pennies on the dollar. At the time I was surprised, Ecuador had reserves in the bank. There was no economic need for the default. This was about politics:

Calling Foreign Debt 'Immoral,' Leader Allows Ecuador to Default

Washington Post 
Saturday, December 13, 2008

So where does a country go when it is need of some money and it has been shut out normal channels of lending? Iran and China of course. This has not been a smooth ride either. Consider these headlines over the past few months. It does not look like China is such a “willing” lender after all.

Correa said that he “unilaterally ended” talks with the Chinese Eximbank “because of the mistreatment and the rudeness”

“We will not forget this.”— Rafael Correa, Ecuadoran president

AFP, QUITO
Monday, Mar 22, 2010

It would seem that President Correa has a short memory, or a big need for some “fast cash”. Less than a month later the talks with the Chinese were back on:

Ecuador Restarts Negotiations With China For Electric Project

QUITO -(Dow Jones)- 4/27/2010

If Ecuador can’t find the money it needs from the Chinese they can turn to Iran. At least that’s what this headline suggests:

Iran to build power plants in Ecuador

by Peter Ward on Mar 8, 2010

But the Iran money might be all talk. An existing line of credit appears to be untapped. I found the following errata on the subject from the Economist to be oddly written. More curious is that a link to this retraction is widely featured on the web site of the Central Bank Of Ecuador.

Correction: Ecuador's Central Bank

Apr 15th 2010 | From The Economist print edition

We are happy to clarify that although Ecuador's Central Bank signed an agreement in December 2008 under which Iran's Central Bank has set up a credit line of $40m, extendable by $80m, at the Export Development Bank of Iran for the use of Ecuadorean importers, none of this money has been deposited in Ecuador. We apologise for any confusion.

As near as I can tell Ecuador has few friends. They appear to be shooting themselves in the foot. This kind of stuff gets you in the global doghouse fast:

Ecuador Blacklisted for Money Laundering
6 Apr 2010

FATF has identified Ecuador as having strategic deficiencies. Ecuador has not delivered a clear high-level political commitment to address these deficiencies. Ecuador should address these deficiencies, including by: (1) adequately criminalizing money laundering and terrorist financing; (2) establishing and implementing adequate procedures to identify and freeze terrorist assets.

Short-term issues are stacking up against Ecuador. They are dependant on oil exports for cash. The annualized drop in value of the oil exports was $1.5B in just the past two weeks. There is another deadline coming up. This one could prove important. It is my understanding that there is a May 31 deadline for the repatriation of dollar assets by a number of Ecuadorian banks. We’ll see if that happens. The numbers; GDP: $108b, Current Account 2009: deficit $1b, Budget deficit (2009): $2b. Ugh.

Does it matter if Ecuador goes turtle? No. Most of the damage has been done. I doubt that a blow up in Ecuador would make the papers. Their $108b annual GDP is about the same at Utah or Arkansas. But in the unstable world that we live in the wings of this butterfly could still cause high winds elsewhere. That is the nature of contagion.

My mason has a plan should there be a monetary change in Ecuador:

“I want to go home and get married. But I may have to stay a few more years to pay the dollar debt.”

How does this fit into the “Big Picture”?

U.S. Department of State Background Note

Ecuador

It is estimated that there are over two million Ecuadorians currently residing in the U.S.

What is the cost to America for these two million people? Most of them are not legal. The flap of the wings brings more contagion.

Some of our pals with Ecuadorian President, Rafael Correa.

FHLBs - Errata

On April 28th I published a piece on the FHLBs. Later I was contacted by the FHFA (the regulator for the FHLBs). They pointed to a factual error in the blog and asked me to publish a correction.

I said the following. It is not correct that the FHLBs will suffer total losses of $100b:

"Fannie and Freddie will cost us at least $400 billion. Add in another $100b for the FHLBs."

The FHFA provided a link to a balance sheet of the FHLB’s. The following is a slide of that report. As you can see there is a line item marked investments of $284B.

I relied on a the following sentence from an FHFA report to evaluate the investment portfolio:

FHLBanks' investment portfolios consist primarily of MBS securities, chiefly Agency MBS or highly rated private-label MBS.

When I think of the term, “Private label MBS” I immediately think losses. And it is correct that the FHLBs have and will continue to suffer losses from these holdings. But the amount of the PL MBS in portfolio was substantially less than I had assumed.

The clarification provided by FHFA on this is as follows:

As discussed, the key point is that private-label MBS are $46 billion (not the $284 billion you had in the blog), and that the FHLBanks have already recorded credit charges and non-credit other-than-temporary impairments on these securities.

Some thoughts on this:

-I try quite hard to stay on track with my writing and this was a pretty serious error. I used a number that was not properly vetted and this resulted in a bad conclusion.

The broader issue of the Blogs and the accuracy of what is in them has been raised on a number of occasions. I have no editor that is looking over my shoulder. Nor do many of the other bloggers who produce the 200-300 articles on finance that are appearing every day. Yet the blogs are proliferating. I, for one, get more useful information and ideas from the blogs than I do from the MSM.  I think that the blogs do a very good job of providing information and the error rate is fairly low.

-I know that when someone writes a piece that is not grounded in fact the comments will explode. There are too many smart people in the audience. When writers like me make a mistake it is rare that the readers do not bring them on the carpet. That was the case in my blog post. The following are some comments from readers:

Anonymous said...
Just to be clear - of the $284B of investments, only $152B are MBS and of that $152B, only about $47B are private-label MBS. The problem is much smaller but still a potential problem for some banks, such as Seattle, Pittsburgh, Chicago, and Boston.

Anonymous said...
The comment above is right, you have the numbers completely wrong: the private label mbs are less than 50bln, AND those securities have for the most part already been impaired and written down substantially.

Clearly these folks had a better handle on the facts then I did. I tried to get these individuals to contact me so that I could get the numbers straight. It was my intention to do a clarification but the commentators (no doubt it was someone from the “inside”) did not come forward. If they had I would have done the rewrite.

-I am concerned that this will be used by either the MSM or the government agencies to discredit the blog’s contributions to the public debate on the critical issues we face. It shouldn’t. The proper takeaway should be that bloggers do make mistakes and that readers should always look at the comments to see if there has been a challenge on the facts as presented. There is often more value in the comments than the blog.

-I am well down on the list of bloggers. Less than 15,000 people read the piece in question. But it got the attention of the FHFA and they basically insisted on a correction. My positive spin on this is that the “deciders” are reading the blogs. Possibly we should re-double our efforts.

-The sentence. “Fannie and Freddie will cost us at least $400 billion” was not objected to by the FHFA. I specifically asked them, “Could you confirm that the only objectionable/incorrect aspect of this piece was the statement on the magnitude of loss for FHLB?” Their argument was with the FHLB loss, not the Fannie and Freddie numbers I used. I am left wondering about that.

-I apologize to the FHFA/FHLBs and the readers for the error. Thanks to the FHFA for bringing it to my attention.

Where's Sarkozy When We Need Him?

Five days ago French President Sarkozy said:

“We will confront speculators mercilessly.

The only speculators who got “confronted” in the last few days are the speculators who bet that this plan would work.

The White House must be livid. From reports it is clear that Obama was involved in hatching the EU TARP. He must have pushed on Bernanke to open the swap windows. The President told the Europeans the plan had to have teeth. Five days later the US is getting sucked down the European rat hole. There is no bazooka to save the Euro.

There is no chance for a soft landing of the European debt crisis until the Euro finds a level of support. That support can be had if the ECB/Fed were to intervene. They could hold any reasonable level of the Euro they chose to. But only for a short period of time. They know this.

This is setting up as a Plaza Accord type event. That would imply a 10-20% one-time devaluation of the Euro.

Something like that might work. The capital outflow would stop. Europe would get a leg up through exports as a result. China and the US would suffer as a consequence, but that is likely to happen regardless of how this works out.

There may not be a one-time adjustment in FX rates. This could alternatively get dragged out in the markets over the next few months. The end results will be the same. The US will have an overvalued currency, its balance sheet is in many ways worse than those under attack today. The main event of the sovereign risk story will then begin.

I found this video of the history of the Plaza Accord. Lots of still familiar faces; including Paul Volker, Alan Greenspan and a very young Paul Krugman. That was 25 years ago. The shoe is on the other foot today. But not much else has changed.

LINK

The ECB is Living in "Weak Town"

I have always watched the Swiss Franc. To me it is the “pure play” measuring system for how the Euro is fairing. The following long and short-term charts tell the story. We closed at the low today. We’re just a few bips away from a new big figure on Euro/CHF.

The following is a chart derived from CIA information on External Debt. These are just the liabilities. There are assets on the other side of this ledger in many cases. I put a check next to the big Euro’s. $16 trillion between France, Germany, Netherlands, Italy and Spain. I exclude Ireland, Belgium and Luxemburg because these liabilities are tied to assets.

 A question to ask is, “How much of the 16T is owed internally within the Euro Zone?” A lot of it is. Therefore the bulk of this is “protected” by the EU emergency measures. A different question to ask is, “How much of the $15T is owed outside of the Euro Zone?” My answer to that is, At least 20%, or $3T.

What percentage of this amount is still in weak hands is to be seen in the coming weeks. Depending on how things work out the ECB could be looking at Euro 1 Trillion of supply. I can’t imagine that they would even attempt to monetize this much debt. We would quickly move to "Plan B" if that were to happen.

A number of European leaders, most notably President Sarkozy believes that there are a pack of evil wolves after him. His simple solution is to kill the predators and eliminate the menace. This is misguided. These wolves are actually of the species called “Global Bond Investors.” On the whole this is a pretty intelligent lot. They are not predators at all. For the most part they are risk adverse investors. And damn near every one of them will vote with their feet if they don’t like what the see.

One thing the bond crowd is looking at this week is the Euro exchange rate. And that is not setting up as a pretty chart. The NY close is at a level where a little bit of Friday pressure could send us to 2010 lows and possibly pass the low of 1.2475 set in 2009.

Should that happen a few hundred thousand of those bond investors are going to be crapping in their pants all weekend long. This bunch hates uncertainty. They are getting 3-4% return on their money. That is too little reward to take risks.

I can’t imagine a situation where the EU bond markets are stable with narrowing spreads and at the same time the Euro is weak. That simply will not work. For there to be a soft landing to this story the Euro has to be stable. A declining trend, regardless of how gradual, will just undermine the willingness of those investors to hold 3% bonds.

We may see the ECB in the FX market tomorrow. Friday is always a good day to make a “splash”. Anything below 1.25 is a level they should defend. If they don’t, the phones at the ECB bond desk will start ringing with big offers for bonds.

The boss at the ECB, Mr. Trichet, is a very smart man. He knows as well as anyone that the EU is in deep trouble unless the Euro is devalued to a level where it looks attractive to capital. That level is a least 10% from where we are today. It could be 20%. It is certainly not 1.25.

To me it looks like the ECB is damned either way. If they let the Euro work lower on a daily basis bond investors will leave. If they try to hold an artificially high level the Bundesbank/ECB will end up owning more Euros than they can hold. Either way they are playing a weak hand.

NO FX?

I have been waiting for some clarification from either the Fed or the ECB on a new intervention policy. Nothing. I called a few banks in NY and they told me that there was no intervention of any sort in the US market today.

Looking at the macro situation it is easy to paint a picture for a lower Euro against a basket of currencies. The EU is not a growth story. Strong currencies generally are supported by above par growth. The region clearly has problems. You don’t bring in the IMF unless you really, really need to.

I am left guessing on the near term future of the Euro. Given the absence of “official guidance” the market will have to figure out what is the "right" price.

There is more bad news coming for the EU. Not every day will be up 10% in stocks. Greek bonds soared today to 7%. A month ago we called that level a crisis. Today it is a big relief rally. My assumption is that at sometime in the near future the market will have to lean on the Euro a bit and determine exactly what the intentions of the ECB/Fed are.

I would not expect to see a one-day decline of 1% in the Euro go unchecked by the Central Banks. If we trade to a level they do not like they will step in and the next minute the Euro will be a big figure higher.

If the European monetary officials wanted to see the Euro above 1.30, then today would have been the day they would have showed their hand. Numerous EU officials made clear their desire to “burn” the evil speculators. But nothing happened on the FX battle front. As of the close in NY the Euro is a tad under 1.28. There is nothing strong about that price. Only dumb speculators have been hurt with a short Euro so far.

The most optimal outcome for the EU would be for the Euro to gradually weaken over a period of many months. The competitive advantage they would gain would help offset the deflationary forces that reduced public sector spending will bring.

This policy objective could be referred to as the: Managed Dirty Downward Float (“MDDF”). Watch out if this is the policy that unfolds. It will not work. The Central Banks are not big enough not to absorb this.

In my opinion the Euro is better priced at 1.1 than 1.30. If we get there without a blowup in the other markets I will be amazed. The cat and mouse game between the market and the Central Banks will likely have the first act this week. If we see evidence that the objective is “slow the decline” versus “It goes no lower” it will be the 'tell' that this is MDDF.

There will be another few rounds of betting before the last 'all in' wagers are made. But as of now, the cards are being dealt.

It's One of Three Doors

The market’s reactions to the EU/Fed steps are predictable. Cruddy bonds are higher, cruddy currencies are higher and cruddy bank stocks are higher. German and US bonds are lower. That is also predictable. As the week progresses we will see if the EU financial authorities have the guts to stay this course and bid crap bonds to par with German Bunds.

For the PIIGS to truly benefit from this we have to see that Euro country bond rates fall to small spreads over Germany. Greece is still a dead duck with long-term rates at 7%. The only solution is to drive the yields down to a point where the Greeks can successfully service their debt. By my calculation they need a ten-year at 4%. About 100BP over Bunds. I hope that the European monetary authorities attempt to achieve this feat. They would have to buy half of Greece’s outstanding debt to do it, but they seem hell bent to try.

The Euro is 3 big figures higher than where it was at 3pm Friday. This is also a logical response to the threat of coordinated intervention by the Fed and ECB. But does anyone get the fact that a strong Euro is exactly the opposite of what the Euro Zone needs?

The world’s largest common market, consisting of 500mm people, has just gone hat in hand to the IMF for a bailout. They had to get the financial wherewithal from the Fed in NY to do it. And the markets are celebrating this?

My question is how quickly does this backfire on America. The key measurement will be how low does the US bond market go in response. As of this morning the US yield curve has steepened. The 5,7,10 and 30 year are up in yield by an average of 16BP.

There are three possible outcomes at this point.

-The first is that the Euro bailout package has some legs and the results will last more than a few days. Should that be the case, the US 10 year will go toward 4% and the 30-year will move to 5%. This will not be without domestic consequences.


-The second is that that the market will see through the charade of debt that is again unfolding and by week’s end we will have retraced most of this morning’s moves. That is a scary outcome. There is no round two on this bailout. This is it. The global economy has made an “all in” bet.


-The markets all go “Goldilocks”. Stocks are steady to higher. Strong sovereign bonds are stable, weak sovereign bonds rally, CDS spreads for all forms of credit collapse, commodities stabilize and resume a modest advance and gold goes back to $1,050.

I think the third is the least likely outcome. Keep your eyes on the bond market; stocks are now just a sideshow.

Sarkozy Will Get “Stuffed”

It appears that the markets are in for some action next week. The EU leaders have pledged to put a package of measures on the table for the market to absorb by Sunday evening.

There are no details of what may be coming as of yet. This is happening so fast that I doubt they actually have a plan. What plans they will come up with are all going to be short term fixes for the excessive volatility we have seen.

We know from an article by Jon Hilsenrath at the WSJ that the US Fed has opened existing swap lines to the ECB. This means that intervention in the currency markets is coming. I wrote about this last week. My thinking is the same today. If the ECB has a “Go it alone” plan to intervene in the FX markets it will not work for long. Only coordinated intervention including BOE and the US Fed will have anything but a short-term impact. Therefore it is critical to see who is going to be involved come Monday.

There are a number of news leaks that suggest that a Euro 600 billion emergency lending facility will be put in place to support Europe’s 1,000 banks that are in need of some “Fast Cash”. This is terrible news. This just confirms that those same banks were facing a liquidity crisis at week's end (AKA- A run on the bank). While E600b is a big amount of money it is a drop in the bucket when it comes to the total funding requirements in Europe. The question will quickly arise, “What happens when the 600B is gone?” This is quite different from the TARP approach where equity was thrown at the banks. That equity had a 10-15X’s leverage affect. This is just a new funding source. It does nothing to address the quality of the assets being funded.

What is missing from the leaks from the EU is a plan to buy distressed sovereign debt in the public market to absorb the excess supply and beef up prices. We know there is pressure from the Banks to have this happen. They are sitting on underwater sovereign bonds. These are public securities with a massive float. I don’t think  the ECB has the resources to make much of a dent in the bond market. It is much bigger than they are. If they drive the prices of sovereign debt higher it is likely that they will get offers for more than they could possibly buy. There may be some demand from global investors for Spanish debt at 6%; there will be no private demand if the rate is artificially set at 4%. The higher they drive up bonds the more sellers they will meet.

On the issue of buybacks one has to ask, “Where will they get the money?” A credible buyback would have to start at Euro 500b. Is Germany going to backstop that? I can’t believe that they will. If they do, their debt cost will just rise and nothing will have been accomplished. My worst fear is that in order to finance the buy ins they look to the Federal Reserve Bank in NY to provide dollar based funding.

I don’t think that America has yet woken up to the fact that our share of the Greek bailout is ~$20b (via the IMF quota). When we learn that the Fed is funding Europe with big money there will be a backlash. The Fed is already in hot water for their easy money policy. A $500b loan to Europe by the Fed will not go over too well with the folks in America. If something like this were agreed to over the weekend and we wake up on Monday with a new bailout there will be a very sharp reaction. Several folks in D.C. (Grayson) will attempt to stop it. Bernanke understands this, Geithner does as well (maybe). A new Marshall Plan for Europe is simply not in the cards. If that is what is attempted it will fail miserably. The most likely outcome will be that the US is rapidly sucked into the European sovereign debt crisis.

There is some very clear anger being voiced from the leaders in Europe. French President Sarkozy stuck his foot deeply in his (mouth) on Friday night with these words:

“We will confront speculators mercilessly. They will know once and for all what lies in store for them.”

In my view this was a stupid move. He is saying, “Come on speculators, I will take you all on and crush you!” He has not one chance in a 1,000 to achieve that. His words prove that he has no idea what he is talking about. This not a matter of evil speculators and their evil tools (CDS). This is about massive fiscal imbalances that everyone understands are unsustainable. Borrowing more to fix the problem will be the end game for Europe.

It is likely that as a result of what will be forthcoming there will be some very big swings in market prices on Monday. The Vol. will be going up, not down. The initial result will, no doubt, be a backup in many markets. The Euro will be higher, European sovereign bonds will trade higher; maybe even equities could catch a bid. But the critical question will be, “For how long?” Depending on the resolve of those in charge this could last for a bit. At least a week and more likely a month. But it is doomed to failure. Should we get to June and the benefits of these emergency steps wane there will be yet another crisis. The bonds will fall again as will the Euro. When that happens there will be no second bailout. Sometime in the next two months we will hear that great sucking noise again. And when it is heard there will be no stopping it.

Get your seat belt on speculators. You are about to be attacked. This will be a lifetime opportunity to make money. For investors, stay clear of this. There is nothing but risk and downside. “Risk off” is the right place to be if you don’t have a helmet on. I can’t wait.

The Yen Did It?

As of this writing none of the big trading houses has fessed up to adding a zero on an e-mini electronic order. We shall see. I think it was connected to a move in the Dollar/Yen. When that break occurred it triggered some Algo machine to sell. And that happened when the NYSE had a halt.

Computers are behind this. Mary Shapiro at the SEC has been very reluctant to tackle this issue. Not any more. Look for her to make a statement shortly. The axe is going to fall on an important part of how the markets function.

Either way some damage was done. This is a picture of one stock that traded 3450 shares at .01 cent or $.34. It was worth more than$140,000 at the close. The trade above for 7,254 shares at 41 cents resulted in a paper gain to someone of $300,000. These will be reversed. What a system.....

CBs to the Rescue?

I made the following predictions back in December. Things have evolved in ways such that I am close to being completely right or completely wrong on both of them.

-The Federal Reserve will become active in the foreign exchange markets. At different times of the year they will both buy and sell dollars. Their objective will be stability. These efforts will be referred to as “smoothing operations”.

-There will be no breakup of the Euro. Greece will not pull out. The strong members will provide some relief for the weak. But the problems will not go away and the possibility of some form of two-tiered Euro will be a matter of open discussion. It is in this context that the Fed’s FX intervention takes place.

In my opinion the decline of the Euro in 2010 has be orderly, up to the last week. Two "big figures" on any given day is part of the adjustment process that is necessary due to the changing fundamentals. That is not disorderly. But we have lost five big figures in a week. That is a big adjustment, but is still not the Central Banker's definition of a market that would necessitate coordinated intervention. But it is getting close. A few more days at the current pace would likely get us to the point where some action may be required.

The problem is that the Euro/$ is the "go to" trade that reacts to every bit of bad news that is coming out of the EU. I am not sure if the Euro is falling because Spanish bonds are in the crapper or if Spanish bonds are getting hit because the Euro is so weak. If the deep thinkers at the EU central bank are in the later camp then they must be itching to react. Everything they have built for the past 20 years is coming unglued. They are unlikely to go down easy.

I dismiss the news/rumor/importance of the BIS being in the market. If something is going to come it will arrive with a bang and it will not be subject to any guesses. There will be clear statements by the ECB that they have, “Acted decisively to stabilize markets”. They will sell 10-30 billion dollars into the market over a few days. That is not that big an amount in the FX markets, but it will have the effect of re-establishing the notion of “two way risk”. It has been far too easy to make money shorting the Euro. They need to change that risk/reward equation.

This possible action could take a number of forms. Should it happen it would look like one of the following:

A) The EU Central Bank draws down swap lines at the Fed and sells dollars for its own account. This is the “Go it alone” approach. It will not work. It will look like a weak effort that does not have the support of the other central banks. It will fail in short order.

B) The ECB and the Swiss National Bank would intervene jointly. The Swiss would buy Euros and sell the CHF. (They love to do that, but have been bashed by the market in the past). While this approach would be better than A, it would not get the job done.

C) The Bank of England joins in with the ECB and the Swiss. This would be a hell of a party, and probably would reestablish a two-way market. But I don’t think it will happen. There is too much election pressure for the BOE to get involved, unless:

D) The Fed joins the festivities. That would be decisive, and with the US cover the Brits would get in the game.

A and B will end badly, C will not happen. Only D has a chance of buying two to three months to address some of the problems. At best this means by the end of the summer we will be back at it.

It is equally possible that the global CBs will do nothing and the Euro makes a beeline to 1.10. That approach will end badly as well. My prognostications will not come true. If the Euro was to collapse, Greece would be forced out of the Euro Zone, and it would be followed in short order by a sharp decline in economic activity for 500mm people.

I made another prediction back in December. If A, B or the “Do Nothing” plan are in the future, then I think this one will come home:

-Gold prices will trade as low as $900 and as high as $1,400. $1,400 will come first.

Forty years of history:

It amazes me how little things change over time.

FDIC Takes a Whack in P.R. – Agencies Next?

Last Friday the FDIC did a big cleanup of the banking sector in the 51st state, Puerto Rico. Three banks were closed, a total of $20.5 billion of assets were transferred to new owners. In the process, The FDIC recorded a charge of $5.3 in their DIF fund.

The Puerto Rican disaster is the biggest loss since the FDIC was forced to absorb Indymac bank in 2008. Some perspective on the magnitude of the loss:

In 2009 the FDIC raised $45 billion from its member banks. This amount represented a three-year prepayment of the banks insurance premium. Therefore the premium income available to absorb losses is $15 billion a year. Puerto Rico just cost one third of the annual income.

Puerto Rico has a decent sized economy. The CIA puts their GDP at $88 billion. If they were a state they would be ranked 35th in Gross State Product (“GSP”). It would have just nosed out Mississippi. By way of comparison California has a GSP of 1.85T (21Xs PR) Illinois, 634b (7Xs PR), Florida $744b (8Xs PR) and Georgia $400b (4Xs PR).

PR has a total population of 3.9mm. California’s population is 37mm (9Xs PR), Florida 18.5mm (5Xs PR) and Illinois has12.9mm (3XsPR).

Based on the size of the economy and the population the losses experienced by the FDIC in PR are way out of proportion. It begs the question; “What were the regulators doing?” The PR losses at the FDIC will not be born by the taxpayers. They will be born by the banks that are part of the system. They will be forced to pay higher insurance fees to offset the total losses. Tough luck for them, but those costs will be passed to consumers dollar for dollar.

The D.C. mortgage lenders Fannie Mae, Freddie Mac and FHA all have a big exposure to Puerto Rico. The losses relating to the PR loan exposure will be funded by Treasury (AKA – the Taxpayers).

This web site lists bank own properties in Puerto Rico. Of the 214 listed homes 161 (80%) are owned by either Fannie Mae or Freddie Mac.

In the grand scheme of things Puerto Rico is not going to sink any of the Federal lenders. However the losses in Puerto Rico are likely to be proportionately larger than in the 50 States based on population. The question is why? Puerto Rico is strategically important to the US. Financial aid is/was justified. A portion of that aid was delivered through Fannie, Freddie and the FDIC.

If we ever get around to addressing the problems of the Federal Government’s role in the mortgage market, on the top of the list should be the need to separate what are good lending standards and Federal subsidies.