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nospam@example.com (Karl Denninger) — Tue, 19 Aug 2008 08:12:00 -0500

"Here I sit all broken hearted....."

Oh I cannot tell a lie - NOT.

The sell-off yesterday was predicated by not only the Barrons' article I cited in the weekend Ticker, but also by a Reuters follow-up and, when queried, Treasury confirmed that it had no intention of immediately bailing out Fannie and Freddie.

Now of course that wasn't Paulson who said that, and we know the game by now, right?

That is, you let the market get frothed up good on the short side, all the Bears come out and sell the beJeezus out of anything Financial, and then, out of the blue, after you call certain "friends" to tell them in advance you suddenly "JamJob" the market with some sort of "news" that you're going to fix it.

Of course you can't fix it, but the goal is really to just kick off a furious short-covering rally and give a knee in the nuts to the shorts.

How many times have we seen this? And how many times do I believe that certain "favored people" were told in advance?

Oh, on the latter, all of them?

So what, precisely, was that nasty little rally late this afternoon, on heavy volume too? Do you really expect me to believe it was all organic? That there was no "whisper in the breeze"?

Uh huh. I've gotten wise to you Paulson, you snake.

I don't trust these guys as far as I can throw them.

With that said, the credit market says that Fannie and Freddie are toast. Nothing that the crooners have done can (or will) change that.

Let's get something straight here. This isn't just liar loans. Its everything securitized. That's why nothing Paulson can do will fix it, and if he has an ounce of common sense he will not throw the taxpayer to the wolves trying to do that which is futile.

Again, our friend the CMBX, with the glorious deterioration of just the last few days:

What planet are you on if you don't think this is a big deal? The AA and A spreads have blown out by 150 basis points over the weekend!

Something is blowing up.

Actually, that's a lie. A lot of things are blowing up in the credit world. In fact, its easier to list the things that aren't blowing up instead of the ones that are.

The ones that aren't blowing up (thus far) are:

Treasuries

That's it. A list with one item in it.

Most everything else is either at historical wides or is very close to it.

That's bad.

Paulson, of course, can remove Treasuries from that "safe" bullet list if he's stupid enough to actually try to bail out Fannie and Freddie. That is, if instead of doing what I recommended over the weekend, throwing them into receivership and then running down the portfolio, forcing people to take whatever medicine they have coming, he could try to "buy out" $800 billion in bad paper, or worse, decide that he's going to paper over the problem (with your tax money) and hide it. Either of those attempts has a high probability of drawing a big black line through "Treasuries" on the list above.

I hope he's smart enough not to do it, because Lord knows, we haven't got enough people in this country who "get it" and will raise hell in our streets, towns and in protest in DC to make clear that we the people will not tolerate such nonsense being offloaded onto the 80% of America who were prudent and did not make one dime in profit from this fanciful fraudulent credit binge from which all these "wonderful" Wall Street institutions - and their executives - extracted billions for themselves.

You want to know what's worse? Inflation expectations are totally "off the reservation." Forget about them being reasonable; there is nothing reasonable at all about what consumers expect.

After all, why should they? Gasoline poking around $4, egg, dairy and cereal prices doubling over the last couple of years, $5/gallon heating oil "locked" pricing for the upcoming winter. But as Bernanke says, "inflation expectations remain well-anchored."

Bullcrap.

Now we have a cute little problem. See, Bernanke has spent the last year throwing literally half his $800 billion balance sheet into the system to intentionally drive short-term interest rates below where they should trade on a "fair value" basis, into one of the largest commodity bull markets of all time.

But just like his predecessor Greenspan, who whined repeatedly that long term rates aren't coming down as I think they should, Bernanke is seeing the same thing.

What's worse, as spreads blow out for anything but Treasuries the cost of credit over longer periods of time is ramping to insane levels. To put this in perspective, the cost of "AA" Commercial Real Estate Credit is implied at 900 basis points (by the chart above) over the 10 year swap rate, which is currently around 5%. This means that the actual cost of that credit is close to 14%!

How much has lowering the Fed Funds target to 2% done for those people? NOTHING! If anything the excess liquidity and allowing people to continue to lie about their exposure and credit risk has caused spreads to blow wider and as a consequence the real cost of money, which is all that matters to people like you and I, has gone up, not down.

The market controls the real cost of money, not The Fed, and the market says "nuts" to Bernanke!

Want a mortgage? It costs, according to Bloomberg, 6.37% right now. A year ago? 6.24%. But what was the Fed Funds Target a year ago? 5.25%. So The Fed throws $400 billion into the pot to drive down short-term interest rates, and you see mortgage costs go upward, not down.

Who gets the extra? Bernanke's buddies, who are trying furiously to get you to take out that mortgage so they can steal that extra "vig" from you and not go bust.

But you, for your part, still can't afford the house. Why not? Because its too damn expensive, that's why. It costs more than 3x your annual income, and all the "liar loans" and "exotics" that used to be available are gone, as the Ponzi schemes that were being run that made them possible have imploded and buried their proprietors.

You want to fix housing? Drive prices down to no more than 3x incomes on average in a given area. Period. The quickest and easiest way to do that is to provide federal support for only 30 year fixed mortgages with 20% in cold, hard cash (no games) down and a maximum 36% DTI. Intentionally cut off ALL other mortgages from ANY SORT of Federal support, implicit or explicit. Poof. House prices come back to affordable levels because nobody will pay more and people can afford houses again with SUSTAINABLE and AFFORDABLE mortgages.

On to our next point, are you enjoying getting it in both holes as a consumer, while our government and The Fed continue to lie about the state of the economy and what's being served up next for you behind Door #1? There's something back there making noises suspiciously like a credit collapse monster and his name begins with a "D". While there are plenty of people who say you "can't" get either of those "D" things with price inflation screaming higher like this, they are wrong.

The way it happens is really quite simple. First you overlever the consumer with hopeless levels of debt, telling him that his balance sheet is "strong" and his house is the center of his "wealth", when in fact you're lying to him relentlessly for your own personal profit (as a "money man" or "broker", whether of stocks or mortgages.) You run media campaigns trying to get people to "live Richly".

Then reality strikes - the Ponzi scheme runs out of suckers. A Ponzi scheme the bankers and government intentionally constructed and let build to knowing unsustainable levels. At the same time, the intentional "loose money" policies of the government and banking system, from The Fed to the "fog a mirror" mortgages, create tremendous froth in commodity prices.

When it all comes apart the consumer gets it in both holes, as his purchasing power is utterly destroyed at the same time his so-called "wealth" is proven to be a phantom - but the debt he was encouraged to take on is still there!

And see, The Consumer is 70% of the economy; as a consequence when the consumer's balance sheet gets lit on both ends of the page and burns towards the center the entire economy goes in the toilet all at once. Suddenly, credit cards (which of course the consumer was encouraged to "lever up" with too!) and car loans (125% of sticker price anyone?) implode.

The only company left that makes money is the guy selling plywood to board up the once-busy storefronts.

Why do we, as Americans, tolerate this sort of crap?

This was not an accident - it was an engineered scheme devised for the explicit purpose of goading you into spending money you didn't have on things you didn't actually need so the bankers and lobbyists could make BILLIONS while literally BANKRUPTING YOU, and you fell for it!

Oh, and they passed "bankruptcy reform" at the same time so if you have an "above-average income" you can't get out from under the debt either; you're stuck with wage garnishment, preventing those who gave you credit they knew you couldn't repay on the original terms from being forced to take the loss that resulted from their intentional scheme.

Now let's think about our fine Presidential candidates for a moment.

Are you enjoying Obama and McCain spar in a Church over matters religious and snipe back and forth about "tax cuts for the rich" .vs. "tax cuts for the middle class", when in fact The Federal Government is currently turning the largest budget deficits in history, and doesn't have the money to provide a tax cut to anyone!

Are you enjoying McCain claim that Obama "tried to legislate Iraqi failure", while at the same time John McCain has ignored the fact that he was in Congress during the time Glass-Steagall was repealed, he was involved in the genesis of the credit bubble and willful regulatory blindness and even today he refuses to call for the fraudsters to be indicted, tried and jailed? How about focusing your "legislative" complaints on things like fraud throughout our financial system and Congressfolk who got $70,000 in benefit from "friends of important people" mortgages, while that same firm screwed millions of Americans out of their house? Mr. Jefferson of Lousiana was caught with an alleged $90,000 in cold hard cash (literally - in his freezer) and is under indictment - isn't $70,000 worthy of the same treatment?

Are you enjoying Obama spending his time attacking McCain for "pandering to the rich" while he himself is ignoring the fact that States attempted to stop the subprime mess in the early part of the decade (before it got out of control) and both Congress and the Administration sat back while regulators over which BOTH have control intentionally overrode state regulators and prevented them from putting a boot on the neck of those who were preying on low-income families?

You want to talk about religion? How about having a discussion on what the candidate's faith - or for that matter any faith - says about honest and fair dealing? You know, what we haven't gotten from Washington DC over the last 20+ years, irrespective of whether it was a Democrat or Republican sitting in a particular chair? Do we now have a pair of snakes from The Garden of Eden running for the White House, where all we're really choosing between is which head is on the snake and whether that head has hair or is bald?

You want to talk about national security? Good. So do I. How do we accomplish it when our economy and thus our source of government funds (remember, government in the end only exists fiscally because it has taxing power, and that requires a strong economy) is impaired by reckless overextension of credit, lying, fraud and rampant thievery up and down both wall and main streets, none of which either candidate is willing to take on?

Maybe we as Americans are asking the wrong questions this election season.

End Times (for Fannie and Freddie)

nospam@example.com (Karl Denninger) — Sat, 16 Aug 2008 15:08:23 -0500

"I told you so, months ago."

Barrons put a nail into the coffin in an article due to show up on newsstands on Monday (subscription required)

"It is growing increasingly likely that the Treasury will recapitalize Fannie and Freddie in the months ahead on the taxpayer's dime, availing itself of powers granted it under the new housing bill signed into law last month. Such a move almost certainly would wipe out existing holders of the agencies' common stock, with preferred shareholders and even holders of the two entities' $19 billion of subordinated debt also suffering losses. Barron's first raised the possibility of a government takeover of Fannie and Freddie in a March 10 cover story, "Is Fannie Mae Toast?""

Yep.

But before I put forward a prescription for how I believe the government should act (and act it will, in due course), I want to take a look at how this all happened up front.

Let's look at an article in the International Herald-Tribune entitled "How Banks Sold Home Equity Loans":

"Still, "Live Richly" won out. The advertising campaign, which cost about $1 billion from 2001 to 2006, urged Americans to lighten up about money, and helped persuade hundreds of thousands of Citi customers to take out home equity loans - that is, to borrow against their homes. As one of the ads proclaimed: "There's got to be at least $25,000 hidden in your house. We can help you find it.""
"Ads for banks and their home equity loans often portrayed borrowing against the roof over your head as an act of empowerment and entitlement."
"Bankers defend home equity loans by saying they merely give customers what they want: easy credit to buy things they otherwise might not be able to afford." (Ed: you mean "can't afford but we'll make you think you can, right?")

"Live Richly" eh?

Hmmmm.

But back to Freddie and Fannie.

A large part of the trouble they're in is due to the more than half-trillion dollars worth of "ALT-A" - or liar loans - that they bought or guaranteed in the last few years. The GSEs claim that their mission statement is to promote "affordable housing" targets and this is why they got in trouble.

What part of buying loans from people who lied to get them and were demonstrably unable to afford the payments at their full level is about "promoting affordable housing"?

None.

These loans were made to real estate speculators in Florida, Las Vegas and California, in the main, along with pseudo-wealthy "middle class" Americans trying to "Live Richly." There was exactly no connection of any kind to low-income borrowers in the cities, where this mandate does in fact exist.

Nor is there a hint of prudence in Freddie and Fannie's recent actions since the stress became declared in their public statements (never mind that Freddie's CEO disclosed recently that their risk manager warned of this very problem quite some time ago.)

In the last quarter Freddie Mac's growth of on-balance sheet exposure exploded higher by 11% - all out of proportion to the declared "risk" they claim they now see, and in addition, they have taken down hedging costs, which means they're now even more exposed to interest-rate changes than they were before.

What prompted that? Both Fannie and Freddie went to OFHEO and The Bush Administration early in the year and told them they'd raise more capital in exchange for loosening their "excess capital requirements" and removing portfolio size caps. Fannie did raise the capital, but then lost nearly all of the additional capital in just one quarter; Freddie welshed on the deal and still hasn't raised jack, citing "market conditions", but they still got their loosened capital requirements and used the expanded capacity to lever up even higher!

This amounts to walking into a Casino, betting (literally) half your house, losing, and then doubling down. You either are a zero or hero, and the odds favor the zero.

Why is such behavior tolerated?

Because management believes they can blackmail Congress and Paulson into bailing them out - in short, they believe they can take these sorts of risks on purpose, not for their chartered and proper reasons in helping Americans but to enrich their shareholders and management, and get away with it - "heads we win, tails you lose."

Then there's the issue of exactly how they're valuing things. I've written about this many times in the past, and now Barrons is blowing the whistle on it as well. Is there any reason to believe that their "marks" reflect trading reality? No.

I believe both firms are intentionally overstating the marks on their assets, thereby making them appear to be in much better health than they really are, not to mention counting "deferred tax assets" that can't be spent (they're only "assets" to the extent you have taxable income in the future!) As written about in The Ticker in the past, this isn't my opinion alone - many have opined that under any sort of real "Fair Value" assessment both of the GSEs are insolvent right here, right now.

In addition we now know from both firms filings that they are intentionally refusing to take repurchases of defaulted mortgages from securitizations they guaranteed, instead choosing to make the interest payments themselves on those bonds. This is simple chicanery in that these defaults will not cure themselves; the GSEs are doing nothing more than pushing forward the day of recognizing the impact of these losses, which have already in fact happened. This sort of artifice and accounting trickery is an outrage.

What's even worse is that banks are and have been offloading paper to the GSEs as fast as they can, and the GSEs are still more interested in flooding their balance sheet than scrutinizing what comes in the door for sustainability and payment capacity. Anyone care to take a guess at what sort of real credit quality is behind that recently-acquired paper?

It is clear that both of the GSEs will and must fail.

I believe their failure from a market perspective is unavoidable as a consequence of their conduct and the resulting "quality" of their book.

I also believe they must be allowed to fail to set an example for all the banks, brokerages and others who have engaged in similar conduct - to point out that such sort of willful abuse of the taxpayer will not be permitted.

Here is what must happen now:

The government must force full, public, outside audits. The recently-announced Treasury action in this regard is a nice start, but not having access to the GSE's internal books is an outrage. Give us a full, public accounting.
All marks must be documented and defended. This, I believe, will force both firms into immediate receivership (bankruptcy.)
To the extent that management is implicated in intentionally falsifying reporting (if any), they need to be indicted, tried, and if convicted locked up.
The Government should then step in and forcibly purchase a large (~$10 billion each) interest in super-senior preferred stock, granting them the right to:
- Replace the board of directors and management
- Supersede all other classes of stock, suspending dividends across the board.
- Support the super-senior and senior coupon to the extent possible, until that capital is depleted.
The government then places both firms in rundown, fires management, and brings in outside parties to operate this process. All acquisition and forward funding ceases. The debt in the non-originated portfolio is sold off for whatever it brings and each class of debtholder is retired as the portfolio runs off, category-by-category. End of GSEs.
To take over the GSE's former function, Ginnie is authorized to guarantee the issue of mortgages to the general public (not just VA and FHA), but under strict, 20% down, 36% DTI, 30 and 15 year fixed term underwriting criteria. These notes are issued with the Ginnie explicit government guarantee. Note that Ginnie has never engaged in the sort of "hedge fund" nonsense that got the other two GSE's in trouble. This provides the mortgage liquidity function that Paulson and others believe is "critical." It puts the desired "floor" under housing, but at an actual sustainable price, which is, incidentally, quite a ways down from where we are now.

Most bondholders under this action would take no or very little loss.

Those who bought bonds from the far-riskier hedge-fund like activities, or the open-market purchases of ALT-A "assets" that are in fact worth far less than they're being carried at would be partially exposed, but this was a choice - if you look at what sorts of debt Fannie and Freddie have issued, it is not just single-family residential mortgage-backed debt, it is many different classes of bond linked to many different sorts of retained, purchased and guaranteed assets. You choose what you want to buy, and each has a very nice prospectus detailing what's in there.

If you bought bonds backing ALT-A liar loans to speculators in Nevada, then expecting the taxpayer to back up your bad purchase is beyond ridiculous and into the realm of theft and, if you threaten someone (like Paulson) over it, blackmail.

The preferred stockholders in this scenario would be in serious trouble while common equity holders would be just plain wiped out. Preferred holders might be able to (depending on how the quality of that retained portfolio actually works out over time) to recover some of their investment, but almost certainly not all.

The important point here is that the longer the government waits to do this the worse the losses will get for everyone, as housing prices remain in decline and they will continue to do so until they reach 3x incomes, on average, in each market area.

It is now CLEAR to anyone who has even a double-digit IQ that Bernanke and Paulson's ideas from last year of allowing financial institutions to lie, cheat, and try to borrow their way around telling the truth and selling off this debt to deleverage has only led to more losses as the value of the collateral has continued to decline.

As I said originally last summer the right move was (and still is) to force these people to sell off the debt NOW for whatever it will bring, because its value today is higher than it will be tomorrow.

We must force resolution of this problem now as we are headed straight for the result that Japan got by allowing their institutions to lie and fail to report their losses honestly, declaring their "marks" by fantasty, wish and dream instead of the market.

Today, more than ten years on, the Nikkei stock market has still not recovered from the loss of 2/3rds of its value, and the Japanese economy still has failed to bottom and recover.

Goodbye Fannie and Freddie, it was nice knowing 'ya.

Oh, and for my fellow Americans?

Exactly what will it take before you will get off your butts and start demanding that The Government stop allowing people to lie to you about matters financial?

Go back and read this whole thing. This mess did not happen in a day and you have consistently sat on your tush and bought your plasma TVs and iPODs, without regard to whether you could afford them.

You listened to those who intentionally deceived you for their profit and your loss, and you still are.

Do you hear the alarm clock in your head yet?

If not, how much more of your standard of living do you have to lose before you do?

"Where's The Kaboom?"

nospam@example.com (Karl Denninger) — Fri, 15 Aug 2008 08:02:00 -0500

Take your pick last night. Right after the market closed, the dollar started strengthening again. A lot.

Then, suddenly, the floor dropped out of Gold, and the S&P 500 Futures spiked HARD, with over 2,000 contracts bought at the market.

A few hours later, it happened again. And at 4:30, once more!

What in the Sam Hell is going on?

Simple, really. See, there are what - 8,000 hedge funds? Well, for 7,999 of them (up until the last few days anyway) they have all been in one trade, more or less - short dollar, long energy, short financials.

Nice, if and when it works.

But now that trade has been unraveling at a frightening rate. As the dollar has gotten stronger it has squeezed people. Hard. See, these guys are not just investing the money they get from rich folks all over the world - they are taking that money and borrowing, then investing that.

So when these bets go bad - oil falls, the dollar goes higher, or any of the "parameters" they've been working get the rug pulled out from under them, they have a huge problem, all at once, and they have a very bad hair day.

That's happening. In spades.

This is where the "recovery" has come from in the stock market the last month or so - you kick the shorts in the nuts and they cover, then the lemmings rushing in, once again listening to the idiotic calls of "the bottom is in" from media outlets like CNBC that will shove a microphone under the snout of anyone who toes that line.

This trade started unwinding slowly, but in the last week or two it has gotten very disorderly and so have the markets.

As credit has continued to deteriorate the weaker hands get flushed and forced out. This causes them to have to buy back their short dollar trade, which spikes the DX. THAT in turn spooks someone else, who then covers a big futures short, which in turn freaks out someone in the gold market, and they dump a big long.

Rinse, repeat, and continue until the dead bodies are all piled on the floor and only the cockroaches are left scurrying around.

Oh, and those very same Hedgies are some of the guys "guaranteeing" the credit in these default swaps, which means as they go down, credit continues to blow wide, never mind the actual deterioration which is far worse than claimed because these so-called "guarantors" can't actually pay.

What you need to understand is that there is nothing that can be done to stop this. Not by the government, not Bernanke, not The Fed, nobody. The overly-geared will die, one by one, until there is nobody left who has too much gearing on for the trade and credit risk they took.

What's worse is that some of our "big institutions", sensing this - that credit quality is deteriorating very, very rapidly, are looking for someone, anyone, to offload the bag to. Over the last few months they've found a few people they can try to throw the bag at - maybe those with poor risk controls, with automated trading systems that aren't actually verifying anything, and perhaps there's a bit of a pollyanna view at a few of them too?

If you can't find those folks because there aren't any of that sort buying the debt you're desperate to unload (since you know its going to go "boom!") then the next move is to "sell" that debt to some private equity guy but carry back the financing (in some cases on a non-recourse basis!), as several folks have done recently, which makes it look like you got 20 cents on the dollar when in fact you only got 5. For the Hedgie or P/E guy who makes the bet, its not a bad deal - they have a defined risk trade, like a CALL option. For you, the writeoff is real but its 75% less than it should have been, with the rest sitting out in limbo pending the truth being discovered in the fullness of time (when the deal blows up and your "non-recourse" deal comes back at you like a boomerang.)

How many of those folks will die, and what impact will it have on the credit markets in general? I can't quantify it accurately - I don't think anyone can. But what is obvious from the magnitude of these "little tremors", and the rapidly increasing rate at which they are coming, is that:

Its very bad.
Its getting worse, at an increasing rate.
A number of supposed "liquidity providers" have either been gamed (and this has not been recognized and reported to the public) or they're "buying" this debt with carried-back loans, making their actual risk of loss tiny compared to the nominal "value" transferred. In other words and to put it in terms "Joe Q Public" can understand, everyone is still lying!
There is a "supercritical" point where all asset values will get hit at once, unless the process runs to exhaustion first, and I don't think there is a snowball's chance in Hell that it will.

I may be wrong about the impending supercriticality, but if I'm not, well, it would be a good idea to be sure you are in safe places with your money.

Equities and debt other than treasuries would be in the "not" column on the list of safe instruments, and note carefully the very specific constraint on exactly what sort of debt is safe - all other, and I do mean all, is not.

Comport yourself accordingly.

They're Picking up Fish; Tsunami Curling Over

nospam@example.com (Karl Denninger) — Thu, 14 Aug 2008 07:27:00 -0500

95% of America has no idea what's coming.

That's because they don't listen to the credit and FX markets.

On the other hand, a few (very few!) people do. And those who do are reaching for new pairs of shorts, needing to replaced their soiled ones, every few hours - or minutes.

It really is that bad.

You're not being told on Bubble TV, mostly because people either don't get it or are trying like hell to figure out how they're going to get out of the mess they're in themselves, and are not all that interested in helping you find the door - its not very wide, there are a lot of people in the room with them, the curtains are on fire and they need to get through it first.

Let me give you a few hints, so you might understand:

This is just one (of many) examples. It is the "AA" rated "slice" of an index, specifically, the "Home Equity Credit" ABX index which is on, effectively, swaps on asset-backed paper.

As the name implies, this is Home Equity loans, the "AA", or one step down from the top (AAA) rated debt.

Notice where its trading? 10 cents.

The "AAA" slice is trading at about 50, by the way, and the "A" and "BBB" is in even worse shape.

That's nasty.

Now here's something that's even worse.

This is the "CMBX", or Commercial Real Estate (you know, shopping malls, apartment buildings, etc) spreads. I'll reproduce two:

These are quoted as spreads, or basis points, over the benchmark which is a swap (in this case I believe its the 10y). The important point is the direction of the graph. Higher = worse. In this case, a lot worse, in that these spreads have nearly doubled in less than three months!

But AAA only looks bad until you see this:

If that doesn't peel your whig back nothing will.

Twenty-five hundred basis points over Treasuries, and for all intents and purposes since June the direction of those spreads have been straight up?

Huh? Am I reading that right?

That's Guido-credit-card territory.

Now for the guy who wants to put one of these deals together, realize that the "BBB" piece is just that piece that gets "sliced off." His "composite" cost is probably somewhere around 10%; figure the swap is around 5ish, and then the "blended" spread on all the components once you do your magic winds up at around 500 over that.

That's bad. In fact its real bad; you have to be able to cash flow at that same 10% (of the gross on the deal) to break even, and of course nobody works for free. For all intents and purposes this marks that part of the market as "done", as in "baked", "well", or more likely, "crispy."

Now I want you to sit back in your chair, grab a snifter of quality Cognac, and cogitate for a minute.

Consider the plight of a couple of firms who operate like Hedge Funds (or are Hedge Funds!), buying the slices of that paper and gearing up, making lots of money the last few years. In fact, they crowded most other people out of the market and drove bids so high that money got very cheap for a lot of people in their marketplace.

But now the spreads have blown out on that paper as the underlying loans have started to show stress, and that paper is worth much less. Some might be even tripping "acceleration event" clauses in the structuring, or worse, defaulting outright. Consider those ABX and CMBX charts for just a little while, and then think about the fact that this isn't just residential HELOCs or Commercial Real Estate - it is in fact every kind of loan made to, literally, everyone.

Ok, so here you sit, geared up, oh, let's be generous and call it 20:1, maybe 30:1, maybe even 60:1, and you've been carrying marks at, oh, 98, 99 cents. You're taking losses, and in fact they're pretty big losses, but that's only because you have a absolutely enormous amount of book out there. As a percentage, those losses are quite small but when geared up like this you wind up bleeding out on the sidewalk screaming for a blood transfusion to keep you alive.

But now your accountants or worse, your auditors notice that heh, the ABX.HE says that "AA" debt is 10 cents. CMBX BBB spreads are 2500 basis points over Treasuries, or close to a 30% (!) yield.

You think about the duration times spread for a few seconds and turn white as a ghost at what this implies about the "value" of the paper you're holding, not to mention the odds that it really is a zero, and what's worse is that you borrowed the money to buy it!

Oh, and Mr. Pencil-Neck (that's the Auditor on the other side of your desk) is tapping his shoe on the floor impatiently.

He wants to know, you see, how you came up with that impairment and charge on your last set of financials.

Folks, this isn't bad, its a full-on meltdown, China Syndrome style. Its happening right here and now, under your nose. As this noose tightens further, and tighten it will (notice that all the "stick save" games the government has played have had only transient impacts on the progression of this problem) credit will choke off system-wide - not because people don't want it (witness the desperation of Americans evident in the latest Consumer Credit Report), but because people can't pay - they're over-encumbered and simply unable to support any more debt!

The happy-face folks on BubbleVision are not talking about it, but this does not mean it is not happening.

It most assuredly is.

Now you know, and have time to act.

I recommend running, and ignoring the fish, because the door is quite narrow and essentially every levered institution is in the room with you.

Think about who's on that list for a bit.

That's your homework assignment.

PS: CPI up 0.8% (!) headline, 0.3% core, real earnings down; Jobless claims 450,000 last week, continuing claims to 3.4 million. Futures bleed.

Need a Loan? No Income? No Problem!

nospam@example.com (Karl Denninger) — Wed, 13 Aug 2008 11:47:47 -0500

www.payroll1099.com

And we wonder how it all happened..... and where, oh where, the cops might be (click for a larger size copy)

The Real Story Behind Freddie Macs "NY Game"

nospam@example.com (Karl Denninger) — Wed, 13 Aug 2008 08:26:00 -0500

There was muted outrage from Freddie Mac's announcement that they would not buy any subprime paper originated in NY as a consequence of a new law that holds those who invest in the paper partially accountable for fraud:

"Freddie won't buy loans dated on or after Sept. 1 that meet the state's subprime definition, the McLean, Virginia-based company said today in a lender bulletin on its Web site. New York Governor David Paterson last week signed new foreclosure and lending laws that tighten legal protections for borrowers.
The legislation holds mortgage buyers like Freddie liable in ways that ``we have no way of monitoring and preventing,'' company spokesman Brad German said in a telephone interview."

There are two problems with this claim.

The first is that this essentially shuts down all secondary market paper into Freddie for subprime lending, since the entire point of pooling loans makes it impossible to separate out NY from other states, as was pointed out aptly by Mtgspy on his blog.

The bigger issue, however, is what is really behind all this sound and fury.

While I may be analyzing this incorrectly, I don't think so... and if I'm right, the implications, when they are recognized in the market, are going to be one hell of a "black swan" event.

See, Freddie and Fannie had their "stabilization" that Paulson allegedly got with his "housing bill." Or did they?

Hmmmm.... look at mortgage rates. Look at the TNX. Now look at Fannie (NYSE: FNM) and Freddie's (NYSE: FRE) share price. Freddie is trading at just over $5/share.

But more importantly spreads are back to where they were (wide) just before Bear Stearns blew up.

Is the market sending a signal to the GSEs, specifically:

No more leverage you fools; take it down now, or we will take you down. 60:1 is too damn high, and 200:1 on your credit book is outrageous. Stop it. Now.

Maybe.

And if so, there is exactly nothing that the government can do about it, because any attempt to use "The Bazooka in The Pocket(tm)" that Paulson was given simply transfers that consequence from the GSEs to government debt generally! In fact, there's an argument to be made that the strong showing for government debt the last couple of weeks has been precisely this sort of warning communicated in "Bond MarketSpeak" - "you may think you have a Bazooka but we've got the shells and an empty launcher won't do you a damn bit of good!"

Back when Clinton won his first term, he had terribly expansionary plans for US Government spending, with HillaryCare being only a part of it.

All those grandiose plans were torpedoed by Mr. Market, who made quite clear to him that Treasury Debt funding costs would get materially more expensive if he tried it.

The President of The United States was bullied by The Bond Market.

Is it happening again?

I think so - the evidence, in fact, says it is so.

So what we have now is "happy face" folks looking for excuses as to why they can't do this or that, trying to lay it off on government regulation and laws, just like Clinton did when HillaryCare was torpedoed.

Remember?

It was "The Neocons" who shot it down, remember?

Wrong.

The bond market said "Screw you Herr Presidente!" and that was that.

Here's the problem with being less than honest about it, if this is really what's going on. When you're The President and your piece-de-resistance program gets torpedoed and sunk by The Bond Market you are embarrassed, but that's pretty much the end of it.

But when you're The US Mortgage Market Makers, the bond market tells you to go screw, and you're less than honest about it, you better hope nobody figures it out, because if the facts of exactly why you aren't (can't) increase liquidity in the system become widely understood then we'd have to go back to honest, fair, reasonable lending under sustainable underwriting standards!

You know, 20% down, 36% debt-service-to-gross-income (total), 30 year fixed, no games, no "seller contributions", no bullcrap?

Gee, what a horror that would be (Hint: Housing immediately corrects to sustainable pricing, all at once, roughly 3x incomes, on average, in a given area.)

How 'ya like 'dem apples Mr. Paulson?

Now we know why you were stuttering on Meet The Press.

Watch for Fannie to follow suit, and for this "we're not buying X" stuff to expand. If it does, you've got your answer, and in the fullness of time - and likely quite soon - you will see the market come to the same realization that I had last afternoon.

PS: I can't wait for Dodd and Frank to get the memo. The look on their faces will be priceless, and you can bet they'll do their screaming behind a closed door where we won't be able to see it. I'm sure publically they'll blame the "Republicans" - just like Clinton did.

And just as it was with Clinton, it will be a lie.

Pull up a chair and grab some , this is going to get fun

Price Inflation / Home Deflation

nospam@example.com (Karl Denninger) — Tue, 12 Aug 2008 08:25:03 -0500

Here it comes....

Mr. Mortgage once again blowing the doors of reality for those who live in holes - 1/3rd of all homeowners who bought in the last five years are underwater. (Bloomberg was cited as the source on this)

Oh, and this understates the case, because many people HELOC'd or Refi'd after the original purchase, which just makes the problem worse.

The worse news is that these are averages; in several parts of California (Stockton, Merced, etc) the percentages are over 90%, and in several others (inland empire) its over 80%.

The ponzi finance folks have overplayed their hand, and we're going to have to pay for that. Credit bubbles never unwind "cleanly" or "nicely"; there is always an element of severe pain associated with such games when they come apart, and that time is now.

Why should homeowners not intentionally default if they're underwater and have nothing else that can be taken by the lender beyond the house? You've read several times here in these pages that in my opinion, if you're underwater you have every right to dispassionately evaluate your circumstances, including the impact on your credit from intentional default, and if it makes sense, to do exactly that.

There are many who say there is an "ethical obligation" to pay what you agreed to pay. But, in fact, that's simply not true. The contract you signed is within the four corners of the page, and it spells out the precise relief that is available to both sides if the bargain is not upheld, along with the law in your locale. Further, there were plenty of elements of fraudulent "valuation" in many of these deals, including sellers who "silently" contributed to the purchase, thereby causing comparables to be recorded at higher prices than actually were paid. This was and is an intentional distortion of the market price for those homes, and it is still going on with these "down payment assistance" programs.

In many cases the law makes clear that the only relief available to the lender is to foreclose and take your house.

As I've noted, companies exercise what is called "efficient breach" - that is, an intentional breach of a contract undertaken by them because the costs to he breach are less than that of compliance - all the time.

In fact, your bank has probably engaged in this practice in their business efforts at some point in the last few years, and if it made sense for them to do so with you, they would.

If you get caught in the next few years having to move then you will not have choices. It is far better to decide to default than to be forced into it, all things being equal. The "average holding period" for a house is seven years; jobs change, you may get married or divorced, or have some family event that mandates that you change your residence.

So I repeat and emphasize my previous advice:

If you bought a "bubble house", defined as anything bought in the last five or so years, find out where you stand in terms of your mortgage(s) and the home's value, and then go see a good attorney to explore your options. Spend the few hundred dollars.

If it makes sense for you, after consideration of all of the impacts upon your life, positive and negative, to intentionally default on your mortgage, then do so.

By doing so, if it makes sense in your individual circumstance, you will be helping the market to clear.

On the Price Inflation front, has anyone noticed the change in beef prices recently? I certainly have, and its not pretty. Beef had not participated (much) in the price inflation among agricultural products until recently, as feed costs rose. This sounds nutty but its true - ranchers were selling down their herds because they couldn't feed them, preventing the price increases from showing up as beef supply was ample.

Not any more! In the last few weeks beef prices have started to spike hard across the board. While this is not yet as bad as it could get, for those of us who are carnivores (myself included) this is making a noticeable dent in the grocery budget.

This is unlikely to be a short-term phenomena even if feed costs were to retreat (which they won't until and unless we stop being stupid and burning food in our gas tanks!); see, it takes time to grow cattle, you know. They don't pop out of their mommas ready to be slaughtered and turned into hamburger and sirloins.

Dairy continues to rocket higher as well. Cheese, in particular, has undergone a rocket shot in price, rising by about 25% in the last couple of months. That one wasn't missed by me either.

Its just more of the "squeeze", and the reason that those who claim we are going to have a "hyperinflationary" blowout need to check their thesis.

If you squeeze prices on one end and earnings and wealth on the other, how do you sustain hyperinflation? Remember, government gets its ability to spend by taxing people. If you squeeze people on both ends then the taxing power of government disappears along with the population's standard of living and jobs.

This is the underlying problem with the hyperinflation thesis; every government that has attempted it has ultimately blown their own head off.

The policy wonks in the government, including The Fed, talk tough about "keeping it from happening here" but when push comes to shove, as we have seen, attempts to prevent a debt bubble deflation are tremendously destructive to the real purchasing power of the population - and their efforts have, thus far, been half-hearted!

This is the ultimate check and balance on such behavior, because without discretionary purchasing power there is nothing to tax, and the government dies.

The sooner we as Americans recognize that we are going to have to take our medicine - that this "debt bubble" behavior was not limited to housing, it was not limited to consumers, but in fact was spread through the entire economy and must be forced to deflate, the better off we shall be.

Mauling Monday

nospam@example.com (Karl Denninger) — Mon, 11 Aug 2008 08:53:00 -0500

As in "Mauled by The Bear", and I ain't talking economics. Try Russia.

While this weekend was light on economic news, it sure wasn't in the Geopolitical file drawer.

Georgia and South Ossetia had a dust-up that turned into something just a hair short of full-on war.

The importance of this cannot be overstated; among other things the oil and gas pipeline that goes through Georgia is the only path for oil in that region of the world that does not go through Russia and thus isn't under Russian control.

And Russia, this weekend, make quite clear that they're interested in what we call "regime change" in Georgia.

The backdrop on this is pretty nasty. South Ossetia is internationally-recognized as part of Georgia. Russia has, for years, been issuing Russian passports to the entire population of South Ossetia, and the people there would "prefer" to identify with Russia, mostly because they share ethnic ties with North Ossetia, which is Russian.

The South Ossetians have a significant component of their population that is unhappy enough with being "Georgian" to intermittently lob shells southbound. Last week late the Georgian government got tired of it and decided to step on the malfactors, which instantly ignited both a ground and air assault from both sides, with Russia chipping in for the South Ossetians.

Energy, as I have noted before in this blog and over at Musings, is likely to be the next major cause of conflict between global powers. Here lies "Exhibit A".

So long as this remains contained to Georgia, and does not result in Russia gaining control of the pipeline, it is of little consequence in the grand scheme of things.

If, however, either of those tests fails - if Ukraine, for examine, decides to enter the dust-up or if Georgia proper were to fall to Russia, then things suddenly get a lot more interesting, and not in a good way.

Consider the possibilities if the entirety of Eastern Europe's oil and gas supply is under Russian control. Remember folks that Russia has cut off pipeline feeds into Eastern Europe in the not-so-distant past.

The FDIC is going to need more cash; under the law they will be forced to go back to their member banks and raise insurance premiums. The problem with the insurance system is of course that when you have some "bad actors" like IndyMac the good folks get to pay for it, as the bad ones are dead. Not too cool, but this is what we get with the system we have designed and permitted.

Why is this bad? Go look at the weakest banks and you will find them as the ones paying outsize-returns on CDs. Must be nice to be able to attract people into a sinking ship without a risk of the people getting on drowning, as you get to bill your failure to the sound.

Next up is the dollar; it has been rocketing higher. Huh? I've been warning people that the "short bucky" trade is both overdone and predicated on the rest of the world being ok while we go bowl-swirling; in point of fact my thesis has been, since this started, "we're screwed and the rest of the world is screwed worse!"

This is a good place for the buck, as people do their damnedest to acquire dollars to pay down debt they can retire.

The ugly-stick in this is that we are now in a world of negative real interest rates; that is, you're being paid to borrow again when measured against price inflation.

This is not a good situation in that it is a raw attempt to force another bubble to form "somewhere"; it is incapable of working, however, because there is an insufficient unencumbered asset base available to fuel it compared to housing, but it can and will fuel speculative froth as the "free" money goes looking for a way to "win" and those with hard, desirable assets flip between believing in a "hyperinflationary" future (which IMHO is a horsecrap) and the reality of deflating asset prices.

The problem with the hyperinflationary scenario is that in a world where money is fungible with credit and most of what's being spent is in fact credit due to the credit bubble you need to find an asset base that can "secure" further borrowing.

We seem to be out of those, never mind that banks really dislike the idea of having their $300,000 loaned out to buy a house turn into a loaf of bread.

Oh, the mainstream media is all over the Bear Stearns "bankruptcy PUT" plays now. But is anyone asking the real question implied by the following paragraph?

"That night, Schwartz got a call from Treasury Secretary Henry Paulson making it clear that the Bear Stearns had until Sunday evening to find a buyer because the Fed planned to withdraw its financial backing. Paulson, who didn't want the government to appear to be bailing out a Wall Street firm, then brokered the sale to JPMorgan."

Hmmmm..... Schwartz wouldn't be the one who leaked that, would he? It would make no sense to leak the information that your own firm is about to go "boom" due to what amounts to a bombing run by your competitors (one of whom just happens to sit on the board of the NY Fed.)

So exactly who did leak that information into the market where it could be traded on - that The Fed intended to withdraw funding that they had put in place just a few days before?

We have the folks at The Fed, including the board of the NY Fed which brokered the original line, and every one of them, along with Paulson, should be under subpoena right now.

All phone calls, all emails, everything.

I smell smoke.

Oh, and by the way if you're wondering why people would be so brazen as to trade on such a thing with PUTs that are that far out of the money with a week until they expire, you need only look at the willful blindness of the SEC with regards to the crazy "Buffet buys the world" rumors that had been run for the express purpose of pumping stocks in various sectors over the preceding six months.

Not one indictment or investigation had issued over these rumors, and to date, there still hasn't been one.

When the cops sit back and eat donuts while the robbers hold up banks, is it any surprise that the robberies get more brazen over time?

Helicopter Ben? Bah.

nospam@example.com (Karl Denninger) — Sat, 09 Aug 2008 14:43:51 -0500

This weekend's entry is a focus on "hyperinflation" .vs. "deflation" as the possible paths forward for The United States.

Let us take a purely analytical look at this matter. I'm going to ignore people's words, because we have seen over the last few years exactly how much value you can attribute to the jawboning coming out of such asshats as Bernanke and Paulson.

To put it bluntly, zero. Go watch the video again if you need a reminder of the prescience and accuracy of their public statements.

No, I want to examine the two options and what they mean for people who are actually pulling the levers of policy.

Let us first define the roles here. Bernanke, Chair of The Fed, is a Banker. So is Chase, Morgan Stanley, Citibank, Wachovia, WaMu, Wells, etc. All banks. All of the people who The Fed serves are in fact bankers, and The Fed is made up of bankers. Each and every one of them.

They make their money borrowing and lending money. That's all they do.

But money is just a medium of exchange, really. It has value only because other people will give you things, whether they be hard goods or services, in exchange for some of it.

Absent a willingness to make that exchange currency has value only as a way to heat your home - as fuel.

So let's assume that the bankers lend you $300,000 to buy a house. You buy a house, but can't make the payments. This is a microcosm of what's going on right now.

The bankers have a choice - they can force foreclosure, in which case they own a house, or they can force hyperinflation, in which case you can pay them. Those are, in fact, the two options, although of course those are endpoints and "something in the middle" can happen too.

Which of the two would you, as a banker, prefer?

When you made the loan that $300,000 was, roughly, the equivalent of a small yacht, or a (very) fancy car.

In a deflationary environment the banker gets as much of your money as he can, and then he also gets the house! You lose big, but does he lose? Well, not really. He started with an asset (money) that was roughly the utility value of the home, and he ended up with the home itself, which has the same utility value. Further, the money he gets before you default goes up in value, as premium comes out of hard assets.

That is, he might have not only the house, but enough money to buy a yacht as well (at a distressed sale.)

The banker makes money in terms of real value in a deflationary environment. You, on the other hand, being debt, get rammed.

Ok, now let's look at hyperinflation. Let's say that the government prints up $300,000 and sends it to everyone in the country. Hurray! You can pay off your mortgage, and you do so.

But what happens to the banker?

He gets reamed in both holes. Yes, he has his $300,000 back, but what does that $300,000 buy? Oh, not very much eh? Go look at Zimbabwe, Argentina, or any other place where hyperinflation takes hold. The banker gets stiffed in a big way (as does anyone else who's business it is to move and hold money) because what once bought a house now only buys half a house, or less.

Those who argue that Bernanke will "hyperinflate" have a tiny little problem with their thesis. That thesis depends on Bernanke and the rest of the banks (who are, in fact, his masters as well as his servants) acting in a fashion that is explicitly against their own self-interest.

Oh, and by the way, they know this.

See, banks normally want a small amount of inflation. Just enough to make it not worth it for you to hoard cash, as it slowly devalues. This forces you to spend and invest, lest you see your purchasing power disappear.

But what a bank never wants to see is an inflation rate that is above their lending "spread", or the difference between their cost of funds and what they charge. If that ever happens then they lose big; remember, all banks are leveraged and as such small "percentage" base losses get multiplied by their leverage ratio!

So exactly what is all this "poppycock talk" about helicopters and such?

Quite simple, really. You start talking about deflation and people freak out. You want to be Fed Chairman? You don't dare say that you'd respond to a credit crisis by allowing deflation to take place. Never mind that it would help you and your buddies - it positively reams everyone who is in debt, and that's 80% of the population, plus the government itself!

So no, you put on a happy face.

But would you really, if push comes to shove, choose to hyperinflate?

Oh hell no.

Look at what people do folks, not what they say.

Especially when dealing with public officials.

Every one of those folks is in their office because they're good liars.

It Begins..... (Friday 8/8 Edition)

nospam@example.com (Karl Denninger) — Fri, 08 Aug 2008 09:10:00 -0500

So yesterday Citibank "settles" their suits with various people and agrees to "buy back" all of the frozen auction-rate securities (ARS) that customers hold, at par.

This is (or will be) shortly followed by every other bank on the street doing the same thing.

Why did this suddenly happen? Two reasons:

The markdown from par really isn't that bad. 5 cents off, maybe.
There was a real risk they were going to lose in court. Badly. I've seen some of the prospectuses and some of the account statements. These things were basically sold as if they were a money market, and often were listed as "cash equivalents" on customer account statements. That's more than a bit over the line, and is utterly indefensible.

In any event this is yet one more exotic that is no longer going to be where it doesn't belong.

But that's not the real story today. No, that's BNY Mellon, who is suing Bank America/Countrywide.

I've talked about the problems with that acquisition before, with the biggest one being that BAC has refused to formally guarantee Countrywide's debt.

This is a major issue should BAC start to dismantle the value in the Countrywide enterprise and/or transfer part of it (say, the servicing part?) into their organization.

See, the bondholders bought those bonds with the support of the value of the firm behind them. BAC cannot (legally anyway) just strip off pieces and leave a skeleton there, which is then allowed to die, and screw the bondholders. That won't work, and if its attempted, Sir Judgealot is likely to play "unwind" on that with ugly consequences.

But now Bank NY/Mellon has decided to get preemptive and ask a judge to declare that an act of default already happened. Weeeeelllll.... how long before there are 20 more suits behind theirs, and perhaps an involuntary bankruptcy petition?

Most of the time that's not a good idea; you force a BK you get less as a bondholder, if it can be avoided. But if you fear asset strippage (or just plain rottage)......

This bears watching.

But the real news out this morning is Fannie. No, not that they lost four times the estimate (duh), but embedded in the news release were a few "tidbits", if you were.

First, "regulatory capital"; $47 billion. Sounds like a lot, right? Uh, except that they have a $3 trillion book, between credit and retained.

That's an enterprise leverage ratio of 63:1, or roughly double Bear Stearns was just before it blew up.

As I've noted, there are all sorts of "dirt" in those numbers too. Tax benefits, for one, which are (of course) only worth something if you pay taxes (because you made money.) Take that back out and the numbers look even worse.

But this is old news - I've ranted about this for months, and nobody cares. (We all know they will blow up, but heh, we're all watching American Idol, and this makes it all good, right?)

No, the bigger news was embedded in the series of flash news releases - Fannie is ceasing the purchase of ALT-A paper.

Huh? ALT-A eh?

I thought we were told by the politicians that Fannie and Freddie were providers of liquidity to "conforming" mortgage holders; that is, fully-documented, even if they've redefined "prime" in recent years.

Ah, grasshopper, now you are starting to understand the lie that you've been told, and why its a problem.

See, the truth is that Fannie and Freddie have been buying both ALT-A (liar loans, interest only, etc) and subprime. That's right, they've been playing "hedge fund" along with mortgage originator and guarantor!

This is what you get when people are allowed to run without having to take their own credit risk and deal with the market absent an "implicit" backstop.

You get monsters. Frankenstein. Godzilla. Mothra. LochNess. Stay-Puft Marshmallow Man. Ok, ok, maybe not Nessie; she's cute.

Then the monster steps on your church and flattens it.

Fannie and Freddie have an enormous amount of exposure to both subprime and ALT-A on their credit book, nearly all of it purchased from others, not originated for them.

In other words, the firms went out into the marketplace and bought this paper.

People wonder why I'm rabidly opposed to any taxpayer-funded support of these clowns? This is not a firm providing market support and liquidity for borrowers on loans they originated and controlled, directly or indirectly; they literally have been going into the market and buying this paper on their own for investment purposes!

THAT is where the largest concentration of risk and loss has come from.

Therefore, my position that I have elucidated over and over on these guys - cut them off and let them fend for themselves in the marketplace.

If Congress, at the same time (or subsequently) decides that we need a mortgage market liquidity provider with government involvement (an assertion that I am willing to accept but have not yet seen convincing evidence of) then establish an explicit government agency operating with a completely transparent book that the public can monitor and provide oversight of, with the benefit of same going to the public to reduce the public debt.

Oh, and before you listen to Barney Fife, er, Frank or Chris Doddering, er, Dodd on the "value" that Fannie and Freddie have brought to American Homeowners, you might want to first read a paper published by The Fed in 2005. It makes quite clear that the largest beneficiary of Fannie and Freddie's existence has been Fannie and Freddie themselves - that is, their shareholders, employees and executives.

The "money chart" is here (click for a bigger one)

What's this mean? It means that the impact of having the GSEs in the market has been a "whopping" improvement in your interest rate of 0.04 to 0.12%!

That's right, four to twelve basis points.

All of the rest of the benefit has gone to someone other than you as a homeowner.

Bottom line?

The claim that the GSE's have been of "tremendous benefit" to the American Homeowner is a whopping LIE, perpetuated by Congress who wants you to think they've done you a huge favor over the years.

In truth, they've done nothing of the kind, and now they want you to swallow up to $1 trillion dollars in risk for a benefit you never received in the first place.

Don't be a fool.

In geopolitical news there may be an all-on war between Russia and Georgia. Pray that doesn't spread folks. If NATO gets involved on Georgia's side this has the potential to get extraordinarily ugly with frightening speed. We can only hope that cooler heads prevail, but I'm not confident that they will.

"Keep Your Hands Off My Fannie!"

nospam@example.com (Karl Denninger) — Thu, 07 Aug 2008 13:28:00 -0500

So says Raines (former Fannie CEO), in an OpEd at the WSJ:

His points, one-by-one, but without expansion (buy a sub guys, its worth it):

"The current losses at Fannie and Freddie have nothing to do with the accounting restatements of several years ago."

I'll give you this one. Its the only pass you're gonna get.

"Fannie and Freddie do not have outsized losses from the meltdown in subprime mortgages."

No, they have outsized losses from redefining "prime" to be "fog a damn mirror", systematically dismantling, on purpose, the credit standards which stood for more than 50 years as the definition of a "safe, sound, prime" mortgage. Those, for new readers, are once again:

30 (or 15) year fixed term.
20% down in cash, no BS games, no "seller participation", etc.
28% "front end" (PITI) ratio to income, and 36% "back end", or DTI, ratio (all debt service to gross income.)

These standards were developed over time after The Depression because in the 1920s lenders did the same stupid crap that they did this time! They wrote interest-only balloon notes and other forms of exotic financing, which then collapsed when the Ponzi game was no longer able to be maintained by finding a bigger sucker.

Now we've gone out and done it again, and you're trying to justify it.

This speculative credit frenzy is WHY we had The Great Depression, and any dispassionate analysis of credit and market trends prior to 1929 shows this in absolute clarity.

Fannie and Freddie are still, to this day and in the middle of the bust, handing out AU approvals with DTIs well over 40%. TODAY.

That was unsound, it is unsound, and it will always be unsound.

Unfortunately this mess is not just Fannie and Freddie's. Its also the mess that every American finds themselves in, it is the reason we had a housing bubble, it fed the bubble and it encouraged the MEW-cum-ATM machine mentality.

These practices caused the losses that are now rippling through the housing industry to take place. It provided the "justification" for the subprime and ALT-A mess, being directly responsible for part of both by "providing liquidity" in buying up some of those securities after they were produced. It gave cover to the lenders and mortgage officers who saw these loans, chock full of fraud from the first instance, whether it be by appraisers, false income claims or hidden debts passed up and down the chain, some landing on the GSE's credit book. And it set a horrible example for the financial system as a whole, brazenly claiming that there was no such thing as too much leverage; after all, 1/2 of 1% of reserves is pretty damn close to zero, isn't it? Even at "full firm leverage" of 60:1 it remains at more than double the maximum "reasonable" investment bank gearing under good times, and three times where people seem to be targeting now (~20:1)

Yet to this day neither Fannie or Freddie are making any effort to sell down that book and get their leverage under control. To the contrary; as this mess has progressed they've been out buying more and arguing for lower capital requirements!

"The losses at Fannie and Freddie do not result from their large on-balance-sheet portfolios, where they manage an interest-rate spread between the debt they issue and the mortgages they hold. "

Right, they result from the off-balance sheet credit book, which makes their book-keeping look better than it actually is, just like a hedge fund or investment bank that has a whole buttload of similar "investments."

There was a firm that pioneered this sort of thing, in fact. Their name was ENRON.

Does anyone remember how it turned out for them?

"The shareholders of the GSEs have not received windfall profits in the past for which they should be punished today. "

Irrelevant. The shareholders of the GSEs have sat idly by and owned their shares, collecting dividends, on a firm that has a regulatory capital "requirement" that permits them to be geared in their credit book at more than 200:1. This is only five or more times the gearing in the most aggressive hedge funds and investment banks.

Who would ever think something might go wrong with that?

When you buy stock in a company that takes on more risk than it should you usually wind up with a big fat zero. If you'd like an example of another "too big to fail" company that took on too much risk and blew up, I present to you MCI/Worldcom, of which I was a shareholder when it went "bang." I believed (foolishly) that it was "too important to the government" (heh, it only handled like 60% of their communications at the time) to be allowed to blow chunks and die.

Bad bet, 100% loss. That's called "a learning experience" and the GSE shareholders need to receive one.

There is one critical difference. I didn't demand that anyone bail me out of my bad bet. I ate my loss like a man, instead of acting like a 2 year old that just got told "no" as he tried to stick his fingers in the light socket.

"Finally, the companies have not yet received a bailout. "

Yet.

Mathematically, this Ponzi scheme must end. In fact, with a 200:1 gearing ratio in the credit book just 1/2 of 1% of hard loss bankrupts you.

That's an inconvenient little problem, isn't it?

Now here's the obvious follow-on question - why is it that Morgan Stanley, who was hired to "examine" the risks for Treasury, isn't going to get to look at the internal books of the GSEs?

I'm rather curious about the marks on these retained securities in the credit book, in particular, and how "observable" they really are.

See, by Freddie's own statements, they have a negative net worth.

Right now.

The GSEs need to be forced to take down their credit book and full operational leverage to no more than 20:1, and it must come without one thin dime of contribution from the Taxpayer.

The Taxpayer got nothing out of this speculative fervor other than a crushing personal and federal debt load.

It is time to stop the stupidity while we still have national economic sovereignty available to us.

Boom boom boom boom boom!

nospam@example.com (Karl Denninger) — Thu, 07 Aug 2008 08:14:00 -0500

Ok, let's start with the first one - Freddie Mac.

Anyone catch FBR's "earnings call" from Miller on Tuesday? Here 'ya go:

"Miller's team said today that Freddie will report second- quarter net income of 50 cents a share -- instead of a loss of 63 cents as previously forecast -- because an increase in interest rates boosted the value of some assets. "

Uh huh. That call, by the way, caused quite a bit of buying on Tuesday.

What did they actually report? Over $1.50/share in losses.

This guy needs to depart. Its one thing to be wrong, its another to fail in such a colossal fashion that even a chimp would be embarrassed to put in your performance.

I'll bet that the "new regulator" in the housing bill refuses to enforce their mandate. See, Freddie told OFHEO (the former regulator) that they'd raise capital before June 30th. Here we sit in August after Congress handed Hanky Paulson an $800 billion "blank check" to bail them out as he sees fit, which has had the effect of the market considering the potential for the common stock to go to zero (which it should, by the way) to be quite high.

Syron has basically told Congress "go screw a goat", and Congress has, thus far, said "ok".

For exactly how long are citizens going to put up with this sort of arrogance? You want a backstop Syron and Mudd? How about you bend over it and we the people will take care of business?

The solution to Fannie and Freddie is in fact quite simple - divorce the "hedge fund" side from the newly-minted government guarantee and cut it off. If it dies (at 200:1 leverage, what do you think is going to happen?) then it does. Too bad. The "investors" bought a bunch of crap paper knowing full well what Freddie (and Fannie) had for gearing and deserve what they get.

If, as I noted before, Congress determines that it is in the best interest of the United States to have a formal Government issuer of mortgage paper, then so be it. I'm ok with that, especially at times like this. Structure one with completely-open-to-the-public books and sound lending, based on the time-honored 20% down, 36% DTI and 30 year fixed note. No cheating, no tricks, no BS. That's it. There is your liquidity backstop and the means to prevent the all-on implosion of the housing space, and its based on sound guidelines that produce sustainable home ownership.

So why hasn't this happened, now that we have had an outright refusal to do what the firm said it would a few months ago? Simple - $200 million in lobbying. In other words, legalized bribery and 300 million citizens who are too absorbed in American Idol to raise hell about the looting of their paychecks.

So what we now have is a pair of corporations, one of which was at one time an explicit government instrumentality but was spun off, the second a competitor to the first, both private corporations with no government guarantee whatsoever (both their prospectus and in fact the law governing them state so in plain black ink.) They do demonstrably unsound things, including successfully pressuring their "regulators" (remember folks, banks have no explicit federal guarantee but are regulated, so don't try making the argument that the presence of a regulator makes them guaranteed!) to allow them to gear up at more than 200:1 in parts of their operation. They also, with the full knowledge of Treasury and Congress (they're required to report annually on the loans they buy and hold, whether originated with their guarantee or purchased on the market), fueled the housing bubble via radically-loosened lending standards.

The market turns on them because in point of fact you can't sustain a housing market via debt slavery and Ponzi finance; it has to be via sustainable ownership capacity. This exposes the credit quality of their book for what it is - severely deteriorated from what it was 20 years ago, on purpose. Investors squeal that they might lose money (and perhaps quite a bit of it) and suddenly, after a few threats from sovereign funds, Treasury panics and ramrods through Congress what amounts to a complete rewrite of Title 12, Chapter 11A of the US Code, turning the GSEs from government-chartered (but not guaranteed or backstopped) enterprises into fully-supported arms of the government - without at the same time assuming full governance and control of the firms. All of this puts the entire United States financing system - the US Treasury - at substantial risk of an all-on meltdown in the coming months and years, while holding exactly nobody accountable for the mess they made.

Neither Democrats or Republicans seem to actually want sustainable home ownership. If they did, they'd be working to force home prices down, and you do that by getting rid of the fraud and "speculative" lending programs, forcing leverage to contract to sustainable levels. As I've noted there's nothing complicated about this - never in the history of mankind and commerce has something become more affordable by becoming more expensive!

AIG blew chunks all over investors after the close, losing $2.06/share.

To put this in perspective, as of 90 days ago the median estimate for earnings was $1.67. As recently as last afternoon it was 63 cents. The low estimate was a loss of 31 cents, which the firm handily outdid by losing nearly seven times the most pessimistic estimate.

But the real bad news was embedded in the earnings release; their mortgage insurance group, which primarily writes "prime" PMI policies, has a 4.9% 60-day late rate at present, almost a double from a year ago.

The significance of 60 day lates is that these aren't a "missed payment" due to a mistake or temporarily hiccup. Once you're two behind, you're in trouble and the odds are high that foreclosure will be coming to visit you soon.

These guys are in serious trouble. The insurers all place their money with various "alternative" investment vehicles such as hedge funds in an attempt to scootch yield. This works great in a positive market, but now we're in a bad one, and those investments are returning little or even losing money. What's far worse is that with the decline in business in general you've got an ultra-competitive environment for underwriters, so the revenue side of the house gets squeezed too. Down this rabbit hole can lie a real mess, although nobody seriously expects AIG to take a dirtnap. Nonetheless, their stock got hammered (and deservedly so) in the aftermarket, down about 10%.

That mortgage-insurance stat is confirming what has been said by others; there is a major dislocation happening right now in the ALT-A and prime mortgage space. Recessions usually come with some sort of uptick in prime delinquencies, but this one is likely to be especially bad, because "prime" was redefined in the last ten years or so to be "not really prime."

As noted in the past, "prime" now essentially means "has a 700+ FICO score."

Unfortunately what it doesn't mean is what PRIME is actually defined as, which is:

20% down in cash, no fancy crap
A 36% DTI (back end ratio) or less; in fact, "automated approvals" will issue even today at or beyond 50%, especially if you have the "bolster" of a balance in an IRA or 401k (never mind that early withdrawal from the former or borrowing against the latter is one of the dumbest things anyone can EVER do, as they're protected assets in a bankruptcy)
30 year fixed term

Oh, for the days in which mortgages were sustainable, had a capital cushion of equity, and the homeowner could actually afford the house! Over the last four years the percentage of actual prime mortgages issued has been, from a statistical point of view, near-zero!

The bad news is that homes will become affordable by these traditional standards again whether or not the Democrats and Republicans, or the Fannies of the world, want them to or not. It is inescapable that until sound lending is the basis upon which valuation is determined the housing market will not bottom and those who tell you otherwise are lying.

Since I see zero evidence that any of this has become evident to anyone in power, never mind the "I'm ok so long as American Idol is on TV tonight" groupie set (that'd be 99% of America) as of this time, we are a good two years away from anything approaching a bottom, because from the time of realization to implementation will be about a year, and to shake out and clear inventory at the new, lower price will require a second year.

The CMBX space continues to get more and more nasty. Commercial construction is a totally-unappreciated risk for community and regional banks in the system as a whole. These loans are going bad at a frightening rate and the gearing in these institutions, along with (especially the community banks) their relatively thin capitalization means that just one or two bad deals that happen in the wrong size and time can sink the institution. These failures not only will stress the FDIC but also will choke off even more routine commercial and consumer lending - count on it.

If you recall my thesis has been since last spring that "we're screwed, but the rest of the world is screwed worse." How's this sound?

"Adding to the ECB's concerns is the fact that seven European countries index wages to inflation, a policy Trichet has labeled ``extremely dangerous.'' In Belgium, Cyprus and Luxembourg, wages are automatically adjusted for past consumer-price increases, while Spain, France, Malta and Slovenia also have some form of indexation, according to the ECB.
``The ECB will continue to see a worrying trend in wage growth,'' said Jacques Cailloux, chief euro-area economist at Royal Bank of Scotland Group Plc in London. ``This is likely to remain the central bank's dominant worry and will probably push it to raise rates again despite signs that downside risks to the economy are materializing.''"

Ding ding ding ding ding. Boy, it has to be fun being in the BOE and ECB meeting rooms today. Oh to be a fly on the wall......

Both, by the way, left lending rates alone.

Yesterday I was accused of being full of "fearful self-centeredness" by an associate. Probably one of the many who has ran screaming from me talking about the truth.

Self-centered? Uh, no. I wouldn't call spending close to $5,000 over the last month faxing petitions and traveling to DC to press flesh and try to get people to view the world through clear lenses instead of coke-bottles or rose-colored flypaper evidence of such a thing.

Fearful? For our nation's future, and that of my daughter and her family down the road? Yes.

For myself? No; I'm not in the "Mad Max" camp and absent that there is little that could lead to me having reason to fear. Fearful people don't travel to DC and wave signs on street corners; if I was concerned about black helicopters or an all-on economic collapse I'd be cowering in a corner somewhere or digging my fallout shelter and stocking it back with rice and beans. That has never been part of my psyche and never will be.

I do believe we are facing a time in this nation economically that may rival the 1930s. But that is not a thing to fear. Busts follow booms; it is a natural part of life that when one pushes the pendulum too hard one way, it will return and clock you on the rebound. This isn't to be feared, it is to be viewed as the opportunity that it is. If you've been prudent, remained out of debt and have capital to deploy, there are some incredible opportunities coming your way in the next few years.

Patience is the virtue that you need at times like this, as it was in the 2000-03 tech wreck; it is not until everyone on CNBC is saying to puke up all your stocks and never buy one again that you want to be back into that market long for investment purposes, and until nobody wants to touch real estate we will not bottom in that area either. Keep your powder dry and look for the opportunities; if you're a trader, these are salad days, albeit with more than enough volatility to cut your head off should you get overextended. So play thoughtfully, not in fear.

Fear is for those who have tried to ride the euphoria, refusing to leave the party while the music was still playing, and now have an ugly situation in front of them. There are many in this circumstance; people who have "geared up" and are rabidly scrambling for an exit door, now having discerned that indeed the curtains are on fire.

One wonders if I stumbled upon such a person by accident last noon.

Hmmmmm....

Jobless claims up to 455k, over the psychologically important 450k level.

One final note - my commentary about the Chinese threatening to dump GSE debt and thus demanding the housing bailout of Fannie and Freddie (under the table) sparked a hell of a firestorm on the forum and apparently pissed off a lot of people when I got more than a bit rough in the discussion there.

Let me point out that this is the second threat by the Chinese in about a year. Anyone remember last August when The Chinese threatened to dump dollars unless we did their bidding? There was quite a lively thread on the forum about it at the time.

The difference? That time Paulson dismissed them with a jeer. This time he bent over the table.

My comment on it a year ago? Here it is, from that thread - I hope you don't mind rough language:

"You do not understand these people. I've done business with them (and the Japanese) before, and it is apparent that they believe we've told them to get fucked.

Well, Congress did.

Problem is, they're the fucker and we're the fuckee. Not so smart. We made the mistakes 10+ years ago all the way down the line up until now, and we're in trouble."

I hate being right, and we had damn well better wake up and smell this coffee before it goes down our crotch.

Its boiling hot.