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Fingers of Instability Continues - Part II
Series Introduction - Click Here
In This Issue - 3 Fingers
Water, Water Everywhere, But Not a Drop To Drink!
Keys to the House
Water, Water Everywhere, But Not a Drop To Drink!
Do not think that because the credit markets are seizing up that there is no money in the financial system, there is. Bank and Corporate balance sheets are strong. Money market funds are in excess of 2.6 trillion dollars. There is plenty money looking for places to find short term yield, they just want to know they will "get it back". The money can't move as the ability to trust the collateral of the counterparties is in question. The Federal Reserve began to blink Friday morning by lowering the discount rate 50 basis points from 6.25% to 5.75%. It was a clever move and shows that the Federal Reserve under Bernanke is a wily group that is going to fully try and tackle the problems inherent in the Greenspan put. It's going to be Good cop versus bad cop in the open market committee, as Bill Poole scares the devil out of us and the rest of them make sure the baby IS NOT thrown out with the bathwater.
It will be better for us all if they can curtail the underlying assumptions of Greenspan's policies. In a fiat money and credit world irrational exuberance must be managed as much as possible as unrestrained GREED has lead to the problems we are now dealing with. The Greenspan put for those of you who don't know, is the assumption that if something bad happens to the INVESTING community, aka WALLSTREET, that the Federal Reserve will ride to the rescue. The seeds of this current crisis were laid by the Maestro Alan Greenspan when he bailed out Main Street and Wall Street after the NASDAQ bubble collapsed. I believe in this instance the most important parts of the financial system will be underpinned, while significant amounts of them will be allowed to fail. They will save Main Street, but allow WALLSTREET and poorly prepared bankers to take some very bitter medicine, leading to the ultimate pricing in of the problems by late October. It is going to be a fireworks show and is why the "fingers of instability" (see Tedbits archives at www.TraderView.com) series are back front and center. It is an opportunity if managed properly!
Fridays interest rate cut was designed to make the Federal Reserve the lender of last resort so the asset backed commercial paper market could UNFREEZE. This market is short term loans between collateralized counterparties. Because the value of MBS (mortgaged backed securities) market is in question, they threw all types of collateral out with the bathwater. Country wide mortgage was shut out of the overnight markets, with overnight funding levels for their operations reaching over 12%, it was forced to take down 11.5 billion from its back up lines of credit.
A shrewd move that forced the feds hand to step in, as the banks that provided this liquidity couldn't go to the money markets to cover their short term needs as it would not accept the countrywide paper. Thornburg mortgage, a solid upscale lender was similarly being shut out of the money markets, its book of mortgages consists of mostly Jumbos (loans over 417,000) and it is SOLID, could no longer originate loans. As you will see in the next Tedbit this can't be allowed to happen or we are all TOAST. Good risks MUST be able to find funding! What's a good risk? Someone with a solid deposit, verifiable job, income and assets coupled with a good appraisal not an inflated one.
Take a look at these graphs showing various types of credit vehicles and their recent behavior in respect to repayment:
Hardly a picture of disaster except for one big problem on the charts and it is "ARM"ageddon related. The rest of the categories are doing just fine, corporate bonds are doing fine as well, in line with these other benign categories. The problem at this point is everything is being PAINTED with the sub prime variable rate category. These other areas of the economy must be allowed to continue to do business as usual if Main Street is to be OK.
We now live in an asset and credit based economy, if either part fails to function the "grease" that allows short term funding (Life blood) to circulate then you know what happens, it dies. So the Federal Reserve in opening the discount window has in effect opened the checkbook, and you can look for it to widen in the future. As a tsunami of mortgage requirements are about to hit the proverbial FAN. The confidence in and the ability to lend new funds is essential to the financial system we practice throughout the world, so the mortgage lending community must be underpinned through this storm until investor confidence returns.
The Federal Reserve in its actions did a number of interesting things. First, it redefined the definition that the discount window had represented. Up until Thursday it was a penalty box, if a bank used it you were viewed as "IN TROUBLE" now it has been "redefined" by the fed as a good course of action that strong institutions should use. It broadened the definitions as to what could be used as collateral, lengthened the borrowing period to 30 days, and said they could roll their borrowing as many times as they wished. IPSO FACTO, these securities now have a bidder AS LONG AS IS NECCESARY for confidence to return to the private sector. The closer I look at Fridays fed actions the more I realize they did very little except psychologically support the markets.
It did not lower the fed funds rate, but if you look at the "markets" for this the easing has ALREADY occurred, 30 day T-bills are now trading around 4.9 percent a full 35 basis points below the Feds Target for Overnight rates, so look for it to be official at the feds next meeting. As I outlined several weeks ago and we will see in the next Tedbit look for easing to occur in rapid manner over the next 90 days maybe 2 full points at the discount window and 1.25 percent on the headline fed funds. As they must reduce the amounts of "KEYS TO THE HOUSE" from being collected by the banking, mortgage and MBS community.
The cool water of liquidity to the financial system has BEGUN to be restored by these actions, as the balance sheet bombshells emerge over the next several months rest assured the spigots are OPEN if you are on SANTA's nice list, if you have been naughty you can be expected to perish. Both sides of this coin offers prepared investors OPPORTUNITIES, and the markets will go through wild rides up and down as the cockroaches emerge into the headlines. We and Wall Street are now in a real life reality show "SURVIVOR", some market participants will survive, while others will be booted off the island on a weekly basis. STAY TUNED!
Keys to the House!
We are facing a veritable Tsunami of ARM's (Adjustable rate mortgages) resetting over the coming year and the complexion of them and the holders of them are all over the map. The problem is exacerbated in that they are EMBEDDED in MBS (mortgage backed securities), CDO's (collateralized debt obligations), CLO's (collateralized loan obligations), etc. and as we will see in the previous Tedbit, not all the elements are in trouble good obligations are packaged with bad in these "Pandora's box" financial instruments. The Federal Reserve must create an environment which allows these to roll into the future, while removing the poor elements from them.
Let's take a look at a graph of the problem provided by Dennis Gartman of www.thegartmanletter.com and by extension Deutschebank's research department:
Graphically, this is the same chart as we used in dominos:
Countrywide mortgage if you don't know is the nation's largest mortgage lender (almost 20% of the market, arguably TOO BIG TO FAIL), at this point they are only making new mortgages to those that qualify under Fannie Maes or Freddie Macs requirements (under the $417,000 dollar threshold), and therefore the mortgage paper can be sold to these pseudo government guaranteed entities. Countrywide is not a saint, they have fathered and allowed some of the most gregarious abuses to occur. Countrywide is also a big player in the Jumbo markets, or should I say was. Thornburg in comparison is a saint and serves a market that also must be served as there are a lot of homes now priced above the Fannie and Freddie threshold. Just think if the higher priced homes and condos couldn't be financed to the levels of qualified bidders needs. Capital One just shut down its Greenpoint mortgage operations citing "unprecedented disruptions" laying off 1900 and taking an 860 million dollar charge to earnings. These companies are falling like dominos.
The mortgage market and its funding sources are currently unable to sift through these issues and allow this process to take place as there are a number of considerations that must be answered. The mortgage market is basically frozen, shrinking at rapid rate and facing a stern test as outlined above. Those ARM's sit in the hands of a number of different parties, The Good, the Bad and the Ugly. They consist of mainly two groups and have been facilitated by the third:
Real Sub Prime borrowers, people who had poor credit histories or were poorly qualified individuals and families, who saw the world of home ownership and wanted to join the party. Sincere in their hopes of a better future and frightened that their hopes of home ownership were skyrocketing away from them as prices did so as well. Pushed into ARM's by predatory lenders who made more if they convinced them to reach for unaffordable amount of buying which they could qualify for at 2% but were totally UNQUALIFIED for at normal fixed rates above 6%. Telling them that housing was a sure thing along with those journalists covering financial markets around the world. I still remember Greenscam expressing his incredulity at why ANYONE wouldn't take an ARM over a fixed rate mortgage: it was a thoughtless statement by the world's most powerful central banker. These people listened to and trusted him.
We must acknowledge these were not financial people: they were blue and white collar middle class people who in the most case do not understand markets and finance. Some will say it's no excuse, but it is. The truth is there is no excuse for what the regulators and the fed/treasury allowed to happen. These people are the victims of the poor schooling they were given and the public servants they placed their faith and votes in to PROPERLY regulate the economy and financial markets.
Liar and Ninja loans (they lied about their incomes and did not have to prove them, or Ninja "No income, no job, or assets"), these are loans which were taken out by opportunists in society, poorly educated speculators which saw the bubble inflating and the flipping opportunities and grabbed the BRASS ring. Commonly known as opportunists, "CON ARTISTS", scammers and Flim Flam men. They took the plunge because they could do so. They were facilitated by virtually unregulated mortgage brokers who made their fees "UP FRONT" along with appraisers that did so as well. These unregulated brokers did almost anything to get deals done. These buyers threw house after house into their flipping machines with massive cash kickbacks from lenders and sellers facilitated by the mortgage brokers who flipped them into the MBS markets being cranked out by the Wall Street investment banks. It is called mortgage fraud.
They could do so because Greenscam, er Greenspan was holding the money spigots WIDE OPEN for his "current employer's" aka (also known as) public servant friends seeking REELECTION (the president and both sides of the aisle in congress) and also to his friends in the investment banking industry (Wall Street) aka "his future employers". Both groups wanted their near futures to be bright: in the case of the public servants "any" decision is a good one that serves their reelection hopes. In the case of the investment banks, they wanted product to sell and book fees on, their balance sheets had taken brutal beatings in the 2000-2003 bear market. The money and credit creation was creating huge oceans of demand for "INVESTMENT PRODUCTS" from the United States and abroad from our suppliers. Yield on treasuries and interest rates instruments were "Nothing" as the maestro kept his finger firmly holding down rates. The principle export of America at that time was DOLLARS, as it is today. So those receiving them needed to find investments for them. As Bernanke calls it a "surplus of savings", resulting in Greenspan's "conundrum" of lower interest rates was the result of too much demand, just as we saw in the housing bubble. It is now a debt bubble as well.
But the investment banks went too far, their greed for fees required that they package them and put ratings on them so investors could sift through the various categories and risk reward profiles and purchase the flavor they could be comfortable with. But they put anything into them, liar and ninja loans, they didn't even check if these people existed, they just threw it (the bad mortgages) into the investment sausage. Unfortunately, the greed for fees did not stop at the investment banks, the ratings agencies: S&P, Moody's, and Fitch saw the gravy being offered them and the hocus pocus of the quants at the investment banks involved and couldn't resist. They questioned very little from their big money clients on Wall Street. The rating agencies profits have soared since 2002, and now we know why as they put their stamp on TRILLIONS of dollars of these mortgage backed securities.
Who owns these "MONSTERS" called mortgage backed securities? Foreign and domestic Banks (as reserves, some estimates say that domestic US banks hold up to 60% of their reserves in securities tied to MBS or debt of one sort or another), foreign and domestic investors, cash management firms, pension funds, insurance companies, and institutions, etc. Big, but not very sophisticated money, they buy luxurious offices, limos and ratings agency "STICKERS" (AAA, AA, A, BBB, BB, B, etc.), classic Peter Principle people: they have risen to the levels of their incompetence. They do not understand the math that underpin the products and TRUST the people selling this to them to do their fiduciary duty and know the devils in the details! Only they don't.
The quants are just men and women who have taken the CFA exams (certified financial analysts) and passed, instantly turned into investment stars even though they "HAVE NO EXPERIENCE", they are in love with the math, and to them everything is in the numbers. It is the math that has propelled them to the highest places in the investment world and they are in love with it. Make no mistake math is important, but less than half of the equation of deciding what is good and bad in making investment decisions, qualitative analysis, understanding methodology, risk controls, careful account monitoring, and due diligence is all important to making good investments.
I can't tell you the amount of QUANTS I have met who DO NOT KNOW of what they speak, amiable dunces masquerading as experts in evaluating and recommending investments. BASED ON THE NUMBERS. And the biggest money in the world is under their guidance. OUCH! Supposedly we are in a once in a hundred year event, what horse poop, the volatility that is unfolding has been witnessed many times in the last 37 years by YOURS TRULY! The math is a lie: the reason its failing is that it is predicated on assumptions which are NOT TRUE! When their mathematical "MODELS" fail so will the investments which they recommended based on it. I remember last week listening to CNBS, er CNBC about Matthew Rothman a university of Chicago PhD and Quant manager saying: "it's a once in a 10,000 year event and it happened 3 days in a row", how absurd, we were in caves then, you know the math is flawed if those words can come out of their mouths.
Unfortunately we now have two groups which are BOTH losers, it is the people who bought the investments (betrayed by the investment banks, rating agencies and regulators they trusted) and the people who bought the homes with poor advice from the sales organizations (betrayed by the same group), the Federal Reserve in conjunction with the regulators which were ASLEEP at the wheel as predatory lenders ran amok among the populous at large. Many of the ARM's have penalties for refinancing, early payment penalties, unreadable loan agreements full of legalese as per the law by indecipherable to you and me! It was a disaster that was plainly on display, I wrote about it in October 2005, but the people in charge could only see the money and the next election.
Those ARMs are now resetting, and since those homes are now not worth what was paid they cannot refinance as no lender in their right minds would take a balance sheet nightmare and move it onto their own books, so the MBS holders and the good people must come to an agreement to roll the paper into something that has the time necessary for the money printing machines to do what they are supposed to do "INFLATE" them to solvency. At today's mortgage rates those homeowners wouldn't qualify at all for the homes they now hold, the only thing that will save them is lower rates which allow them to qualify at the lower rate, so low for the up escalator in interest rates, inflation be damned. Hopefully the authorities will go after the BAD group, they are fraudsters pure and simple. The stories I hear about cash mortgage kickbacks are hair curling as buyer and seller fool the lender together.
As far as I can see no solution has yet been devised to address the cancers sitting in these MBS (mortgage backed securities), and certainly none for the mountains of ARM's we see illustrated above. Until there is this nightmare is set to continue as one shoe drops after another. The Federal Reserve has chosen the discount window and it is being reported they will only take mortgages that are guaranteed by Freddie or Fannie, which means there really is nothing on the table yet.
Otherwise it's the "KEYS TO THE HOUSE" as those home owners turn them over to their lenders scattered around the world (those that bought the securities, CDO's, CMO's, etc. from the WALL STREET investment banks) and descend into the hell of the new bankruptcy laws (bought and paid for from your public servants from their banking industry patrons, when I grew up it was called USURY and indentured servitude). That route means a MUCH longer workout period as the housing markets recovery will be postponed indefinitely into the future and millions of lives are destroyed on the petard of the entrenched elite in Wall Street and Washington DC. Only one thing ameliorates this: the people and companies that did this fraud are now staring down the eye's of the TRIAL BAR and the vultures of the legal profession, the public servants will try to pin the tail on somebody and buy votes in the same stroke with a bailout that must be done to some degree, its going to be a MULTI SNAKE fight. Wall Street vs Public Servants vs MBS holders and the trial bar. LOL. So as Richard Russell says: It's inflate, or die!
Hedge fund redemption day August 15th, came and went and what was the result? A short term bottom in all markets as redemptions ruled the day. De-leveraging and carry trade liquidation provided the impetus for a short term capitulation low as hedge funds cleared their books in a violent manner; we need look no further than the carry trade to see it convulse as hedge funds did as they were told by their customers: they liquidated! Let's take a look at the yen carry trade heading into this important day for people who wished to redeem their investments for payment at the end of the quarter:
This is the fingerprint of hedge fund redemptions from nervous investors around the world, as they were received over the five days preceding the redemption deadline the hedge funds hit the exits to minimize additional losses. It only Looks like a 15% loss, nobody does this trade without leverage of at least 3 to 1, and many run it at triple this amount. So the losses were 45% to 100% if done only in the currency markets, and as they took the buy side off in the stock and commodity markets, it took ALL the markets down to a selling climax midday Thursday the 16th. Elephants were stampeding in the markets. It was clearly outlined to you in domino's (see Tedbits archives at www.Traderview.com). As the balance sheet bombshells emerge over the next 90 days you can expect this to be repeated over and over again as the buy side in "ALL MARKETS" (commodities, stocks, emerging markets, raw materials, precious metals, buy side currencies such as the British pounds, Aussie dollars etc.) is unwound to cover the borrowing in yen.
This is a scary chart, but an opportunity, the yen carry trade is FAR from over. Deflation is still firmly in place in Japan and interest rates there are going nowhere there, especially not up! In the funding currency's inflation is edging up at a brisk clip, so they may retreat slightly in yield but promise high yields going forward. You can see this convulsion every year or two in the carry trade as we did last year from early march till mid may. It is only an opportunity and will give you a good signpost as to when its all clear to enter the BUY side of many markets worldwide as the "Crack up Boom" resumes its march into the future.
In conclusion: As the world undergoes the de-leveraging and repricing of risk from the foolishness of the "Fingers of Instability" outlined above. It is setting the stage for the next reflation of the worlds asset backed economies. Look for a trading range environment until the end of the month as every rally is used by investors to lighten up. This adjustment is not over by a long shot as the strategy to address the tsunami of ARM's resetting must be devised by the global financial and central banking authorities.
It's not yet clear what that will be, the markets will have to administer more pain first, and you can count on that happening, surprises are in the air. The powerful interests aligned against each other are ferocious and they are fighting for something they covet over everything "Money and power". Somehow those MBS that hold those sub prime mortgages have to have a workout that allows the good homeowners to "KEEP THE KEYS" to their homes. Somebody has to BUY them as the investors that hold them DUMP them as there is no market to sell them into, they are radioactive and full of emotions at this point. Everyone's waiting for the next shoe to drop.
The mortgage backed securities markets face another storm on the near horizon as well, it's called construction loans, and it's the money that was already raised to fund the overbuilding of condos in every big city in America, these buildings were already funded before the downturn really gathered steam in the beginning of the Year. They can now be seen as dozens of construction cranes dot the major cities skylines, right into the teeth of an oversupply that was materializing before they dug the holes for them. These projects should have been canceled or postponed. Fingers of instability and opportunity. This is going to move markets all over the place: volatility is opportunity so do your homework and thrive. How will they deal with these problems? Print the money of course. Once these adjustments are priced in and in place things will continue as the "Crack up boom" moves into the future. Thank you for reading Tedbits, if you enjoyed it send it to a friend, and subscribe its free at www.TraderView.com.
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