At the time, I got excited. I thought real action was coming. Unfortunately, my initial prejudice against fellow Americans held up. They are lazy, gullible, and apathetic. If I touched a nerve there, prove me wrong. I’m about to show you a significant flaw that has already made a small group of people serious money. If you want in, it’s time to man up.

Further Perversion of MBS Ridiculousness

So far, the U.S. government has piled up more than $2 trillion worth of debt to finance bailouts for banks, insurance companies and even the struggling auto industry. And unless you are the CEO of one of these companies or worth enough to make sweetheart deals like Warren Buffett, you haven’t received a dime of this money. That’s all right, because the government’s overreaction to this recession left an opening for gutsy investors.

As you know, mortgages have been the central problem in today’s economic meltdown. From there, greedy financial product creation boards went crazy. You’d have to be living under a rock not to hear the terms “collateralized debt obligations” and “credit default swaps.” These are the real doozies in today’s market slide.

However, the most important term in today’s financially-minded world is “mortgage-backed securities.” You see, it’s not the mortgages that caused the system to fail. It was the mortgage-backed securities, or MBS. These securities are not a new development in the financial world. In fact, they’ve been around longer than most of the “too-big-to-fail” banks Washington is bailing out.

During the last Depression, in 1938, President F.D. Roosevelt helped create the National Mortgage Association. Later, the word “federal” was added to the beginning. This organization, now called Fannie Mae, was created to bundle mortgages together and resell them as – you guessed it – mortgage-backed securities.

Wall Street’s further perversion of this already perverted “asset class” is a story for another day. But these “securities” are important today because the actions of the last 9 months of government intervention combined with plenty of MBS ridiculousness created an enormous opportunity for income investors.

You see, 2008 was a tough year for Fannie and her brother, Freddie Mac. Both companies’ shares lost about 98% of their value. The highly incompetent and worryingly scared Bush Administration took them over. In a very important piece of legislation, these two government-sponsored enterprises (GSE) were placed under the authority of the brand-new Federal Housing Finance Agency (FHFA).

In September, the FHFA took extraordinary action by placing Fannie and Freddie into a federal conservatorship. This conservatorship, backed by the U.S. Treasury, was designed to guarantee all GSE-backed securities. This September announcement means that the U.S. Treasury is obligated to pay anyone holding a Fannie- or Freddie-backed MBS. That’s a 100% guarantee by the U.S. Treasury. In a moment, I’ll tell you why this is important…

The Pseudo-Bank Loophole

The financial industry is full of penniless banks, uninsured insurance companies, and toxic assets. But it also includes about five pseudo banks that are in the perfect spot to take advantage of the collapsing market and the U.S. government’s desperate attempts to save it.

These companies are called mortgage real estate investment trusts, or REITs. If someone would’ve come up to me and asked me what I thought about a mortgage REIT a few weeks ago, I’d have laughed at them. But after I did some research, I found a bailout loophole that this small sector uses to make a few people very rich.

These mortgage REITs buy mortgage-backed securities from Fannie, Freddie, and occasionally Ginnie Mae (Government National Mortgage Association) at about a 5% yield. Until Bush’s ridiculous Fannie/Freddie bailout, the only government-backed securities came from Ginnie. Now, after the September conservatorship announcement, Fannie- and Freddie-backed securities are backstopped by the U.S. Treasury. That means whoever holds securities originally bundled by Fannie, Freddie, or Ginnie will get paid.

I can’t stress this enough… Until the U.S. government declares bankruptcy or the Chinese army overtakes Fort Knox, these securities are as safe as Treasury Notes. But here’s where it gets interesting…

Multiplying the Spread for Government-Guaranteed Income

The five (or so) pseudo banks that receive this “government-guaranteed” income from mortgage securities are still financial companies. And what do financial companies do? They leverage the hell out of any debt they can grab.

Here’s how it works:

Mortgage REIT A buys a bunch of government-backed MBS from Fannie. In turn, he receives a AAA+ credit rating because his portfolio is 100% backed by the U.S. government. He takes his credit rating to Lending Banks X, Y and Z. These banks give REIT A a bunch of 90-day, $100 million loans at 2% interest to buy more mortgage securities from Fannie. And we repeat, again and again.

When all is said and done, REIT A is leveraged 6-to-1. Its income comes from the 3% spread between its borrowing rate and the yield on the MBS. Multiply that by its leverage ratio, and REIT A grosses 18%.

Because of an obscure law that publicly traded realty companies cut decades ago, REITs aren’t taxed (so long as they pay shareholders all of their earnings through dividends). Therefore, with everything else equal, REIT A’s shareholders receive an 18% dividend yield.

With interest rates artificially held down by the Fed, and government-supported mortgage yields artificially held high to promote more MBS buying, we get a spread (and thus, income) that’s extremely large. And with these companies required to pay shareholders all of their earnings, we get an extraordinarily large dividend yield.

Finally, because of the mortgage mess, shares of these companies are undervalued. While most financial companies deserve their shares driven into the ground, these mortgage REITs don’t.

Investors with big cojones have already taken advantage of this. The spreads are even larger and safer now. If this is new to you, I suggest you check it out before investors jack shares back up – deflating the dividends’ effect.

Sincerely,
Jim Nelson

April 6, 2009

Fannie Mae and Freddy Mac for Safe Income was originally featured on Whiskey and Gunpowder

Richard Layard from the London School of Economics, offered a way forward:

“We should stop the worship of money and create a more human society,” he writes. “Happiness has not risen since the 1950s in the US or Britain,” he points out, despite big increases in wealth. “Modern happiness research can help find answers,” he believes.

“Old fashioned socialist planning is the only coherent alternative to a collapsing capitalist economy,” an alert FT reader added.

Given the depth of these insights, we decided not to dive into this discussion headfirst. Instead, we will simply mock the swimmers from the bank. Brazil’s president, Lula da Silva, for example, could only come up with a campaign slogan: “The future of human beings is what really matters.” But who can blame them? They want a capitalism that makes people happy…fairer, gentler, greener… they want to reform it…to housebreak it…to cut its balls off so they can safely put it on a leash and introduce it to their daughters.

But they miss the point of it altogether: we can’t reform capitalism; it reforms us. Capitalism punishes mistakes and rewards virtue (or good luck) – not necessarily quickly or gently…but roughly and imperfectly, like a hanging judge in a frontier town. On paper, of course, we can do better. Imagine a world where public employees are saints and geniuses who do such a swell job of allocating capital that we want for nothing. But then, when we get a chance to see them in action, we find that they are bigger rascals than the capitalists themselves.

This week, under pressure from its new proprietor – the U.S. government – AIG released a list showing who had gotten more than $100 billion of its bailout money. At the top of the list of recipients was a familiar name – Goldman Sachs. In a truly astonishing co-incidence, Goldman is the firm that had been run by the very person who headed up the AIG rescue – former Treasury Secretary Hank Paulson. And what serendipity! Lloyd Bankfein – Goldman’s top man now – was actually in the room with the feds when the AIG rescue plan was put together.

In the room; in the deal. But the big scalawags ducked out of the press almost immediately. Instead, the headlines focused on the small fry. AIG paid bonuses of $450 million – some charged it was $1 billion – to its executives. These guys shouldn’t get bonuses, came the popular outcry; they should get a firing squad.

You’ll recall the story. The insurance giant AIG lost money on a series of gambles. For example, it gambled that it could insure the mortgage payments of people who couldn’t afford to buy a house. During the bubble years, people bought houses at outrageous prices. They could borrow 80% of the purchase price from government-backed debt mongers Fannie Mae and Freddie Mac. Buyers were supposed to put up the other 20% themselves, giving lenders a margin of safety in case the transactions didn’t work out as planned. But, if an insurance company would guarantee the other 20%, Fannie could cover 100% of this “enhanced” mortgage loan. AIG found that insuring this part of the loan was profitable – as long as nobody asked questions. But then the market price for the collateral dropped – by as much as 50% in some areas. Suddenly, people were walking away from their houses. Defaults on these “enhanced” loans ran at 5 times the rates on normal Fannie-backed mortgages.

An ordinary person would look at these facts and pronounce the same judgment as the capitalist market: AIG and Fannie both deserve to go broke. But give him enough higher education in the economics department, or a job in government, and the fool rushes in –with someone else’s money.

In the theory of bailouts, an ailing firm is given a helping hand when it needs it. This gives it time to get back on its feet, and prevents it from dragging down its employees, lenders, investors and counterparties. But what actually happens is much simpler. Money goes from the pocket of the person who earned it…to the pocket of someone who didn’t…from the innocent bystander to the fellow who caused the accident. Capitalism takes money away from erring capitalists; the capitalism improvers give it back to them.

And who decides who gets the loot? Ah…as soon as you hold them up to the light, the angels’ wings fall off. By and large, these are the same cherubim and seraphim – such as Hank Paulson – who were supposed to be leading…regulating…and controlling capitalism when it ran into a ditch. Not a single one raised a warning. Instead, they whooped for the free market and passed the whiskey bottle to the driver! And now, thanks to their bailouts, AIG continues writing insurance against mortgage loans. Seventy-three AIG executives continue getting $1 million bonuses. A long line of reckless counterparties goes unpunished. And Hank Paulson offers advice to Financial Times readers on how to make capitalism work better.

But that is always the problem with improving capitalism…even in the slapstick American way. The reformers promise a ‘new deal,’ but they’ve always got an ace up their sleeve somewhere.

Enjoy your weekend,
Bill Bonner

March 27, 2009

The Capitalism Reformers Caper and Prance was originally featured on Whiskey and Gunpowder

The credit economy is dead and the dead credit residue of that dead economy is going where dead things go. It came into the world as “money” and it is going out of this world as a death-dealing disease, and we’re not going to get over this disease until we stop generating additional zombie money out of no productive activity whatsoever. The campaign to sustain the unsustainable is, besides war, the greatest pitfall this society can stumble into. It represents a squandering of our remaining scant resources and can only produce the kind of extreme political disappointment that wrecks nations and leads to major conflicts between them. I don’t know how much Mr. Obama buys into the current adopt-a-zombie program — his Treasury designee Timothy Geithner was apparently in on this weekend’s Citicorp deal — but the President would be wise to steer clear of whatever the walking dead in the Bush corner are still up to.

All the activities based on getting something-for-nothing are dead or dying now, in particular buying houses and cars on credit and so it should not be a surprise that the two major victims are the housing and car industries. Notice, by the way, that these are the two major ingredients of an economy based on building suburban sprawl. That’s over, too. We’re done building it and the stuff we’ve already built is destined to lose both money value and usefulness as the wrenching transition goes forward.

All this obviously begs the question: what kind of economy are we going to live in if the old one is toast? Well, it’s also pretty obvious that it will have to be based on activities productively aimed at keeping human beings alive in an ecology that has a future. Once you grasp this, you will see that there is no reason to despair and more than enough for all of us to do, so we can recover from the zombie nation disease and get on with the next chapter of American history — and I sure hope that Mr. Obama will get with the new program.

To be specific about this new economy, we’re going to have to make things again, and raise things out of the earth, locally, and trade these things for money of some kind that we earn through our own productive activities. Don’t make the mistake of thinking this is optional. The only other option is to go through a violent sociopolitical convulsion. We ought to know from prior examples in world history that this is not a desirable experience. So, to avoid that, we really have to put our shoulders to the wheel and get to work on things that matter, and do it at a scale that is consistent with what the world really has to offer right now, especially in terms of available energy.

In my view — and I know this is controversial — a much larger proportion of the U.S. population will have to be employed in growing the food we eat. There are many ways of arranging this, some more fair than others, and I hope the better angels of our nature steer us in the direction of fairness and justice. The prospects of a devalued dollar imply that we very shortly will not be able to get the all the oil-and-gas based “inputs” that have made petro-agriculture possible the past century. The consequences of this are so unthinkable that we have not been thinking about it. And, of course, the further implications of current land-use allocation, and the property ownership issues entailed, suggests formidable difficulties in re-arranging the farming sector. The sooner we face all this, the better.

Regards,
Jim Kunstler

November 26, 2008

Zombie Economics, Part I was originally featured on Whiskey and Gunpowder

“Just like natural organisms, the financial system must have death to evolve into a better form…”

NOW THAT HE’S WEARING some sort of do-good government hat, even Hank Paulson is not thinking straight.

Regulate in New York and finance goes to Toronto. Regulate in London, it goes to Frankfurt or Paris — and since Toronto, Frankfurt and Paris are run by the same nervous bureaucrat-types, we can reckon soon enough that the entire financial markets will be hosted out of Singapore and Shanghai.

There they will accept the risks as well as the rewards, to their very considerable long-term benefit.

You simply cannot enjoy being the financial center of the world but start bleating for government bailout whenever asset prices dip a few percent. As Paulson is demonstrating, the regulatory price for being bailed out is far too high. We must all grow up and take a full measure of punishment. The banks must take theirs.

Let the shareholders and depositors take theirs too. Just like natural organisms, the financial system must have death to evolve into a better form. Of course, this sounds like a callous statement, but it may be the only way to avoid the moral hazard that Paulson is seemingly creating.

Paulson’s plan is a dressed-up confiscation of the profits of the cautious, and a transfer of those profits straight back to unreconstructed gamblers in the worst offending banks. This is very unwise. When will they learn their lesson? If reckless behavior is continually bailed out, when will we ever see a reversion to more risk-averse times? Sometimes a sound and safe bet is the correct one.

In these difficult times, profit (or more accurately the avoidance of loss) should be benefiting those who troubled to understand the risks in the system, and avoided them. But Paulson’s plan is currency creation, and a devaluation of the good quality assets owned by the cautious. He fails to understand that unless the system occasionally rewards caution there is no reason ever to be cautious again.

Where Goldman Sachs should be duly rewarded for its safer bets, Bear Stearns should be given its due punishment for its uncontrolled risk. If the stock needs to fall all the way to zero, that’s how Bear’s cookie should have crumbled. Instead, the company has been rescued and placed in the safe, strong arms of JP Morgan. Where is the justice?

The market works better without these rescues. Only by appropriate economic reward to the cautious, when they are right and everyone else is wrong, will caution sit well beside risk-taking in the financial system. The real threat to New York and London’s continued dominance of the world’s future financial system is government regulation itself.

Mr. Paulson should read F.A. Hayek’s classic The Road to Serfdom, and he would understand the inevitable failure of his rescue plans. He would see how these top-down rules remove society’s flexibility until one day we all wake up in a paralyzed “command” economy, where nothing can be done without official sanction.

Instead, he has forgotten what a command economy means. He should study the history of communism’s economic successes. It won’t take him long.

Regards,
Paul Tustain
BullionVault
April 1, 2008

The Problem with Bailouts was originally featured on Whiskey and Gunpowder

“Steer clear of the new gold rush,” urges Jason Zweig, a senior columnist at Money magazine.

“Don’t give in,” says Janice Revell, another senior hack at CNN’s glossy monthly. “Step out of the stock market, even temporarily, and you may miss the whole point of owning stocks.”

“Aw, just lend! Lend! LEND!” screams the Federal Reserve. Sporting its usual crystal meth grimace, it’s stumping up $200 billion in Treasury bills for desperate New York brokers to kick-start the world’s capital markets. And now they can use flakey mortgage-backed bonds as collateral.

Stepping in “to address liquidity pressures” like this — and getting your chums at all the other top central banks to do the same — looks like the next best thing to buying mortgage-backed bonds altogether. But while central banks surely don’t want to become “home buyer of last resort,” it’s got to be better than doing nothing. Right?

Acting early and often must work out cheaper in the end. Mustn’t it?

Well, you’ll never guess what. As anyone who ever fell for interest-free vendor financing knows only too well, the cheapest option — always and everywhere — is to avoid spending any money at all.

As a professional economist would put it, “We find no evidence that accommodating policies reduce fiscal costs.” That’s how two senior economists at the World Bank put it in a 2002 report studying 30 years of systemic banking crises across 94 countries.

Borderline crises hit 44 nations. And on average, the World Bank economists found, “governments spent an average of nearly 13 percent of GDP cleaning up their financial systems” as a result of the bailout programs they tried to implement.

“Indeed, each of the accommodating measures examined,” they continued — citing “open-ended liquidity support, blanket deposit guarantees, regulatory forbearance, repeated (and thus initially inadequate or partial) recapitalizations, and debtor bailout schemes — appears to significantly increase the costs of banking crises.”

Weird like pineapple on pizza, don’t you think? Because the seven central banks jumping to hit the panic button this week are all members of the World Bank. They actually helped found it back in 1944. More than that, the central banks led by Ben Bernanke, Jean-Claude Trichet, Mervyn King, and the rest all figure in this 2002 report.

All except the Swiss National Bank, that is…

1. S&L USA: The slow-motion savings and loan collapse in the United States destroyed some 1,400 institutions and took another 1,300 banks with it between 1984-1991. Direct cost to the U.S. taxpayer? Some $180 billion, or three percent of annual economic output.
2. Europe’s Bad Banks: Staff at the European Central Bank might like to recall the Greek and Italian bailouts of the early 1990s…or the $10 billion failure of France’s Credit Lyonnais in 1995…or Germany’s Girobank crisis in the mid-1970s?
3. Japan’s Lost Decade: The 1996 rescue of Japan’s zombie banks cost more than $100 billion in public funds. Two years later, the Obuchi Plan spent another $500 billion of taxpayers’ money — some 12 percent of Japan’s GDP — on loan losses, bank recapitalizations, and depositor protection.
4. The U.K.’s Repeat Failures: From the “second line” crisis of the mid-1970s to the collapse of Johnson Matthey in 1984, BCCI in 1991, Barings in 1995, and now Northern Rock in 2007, the U.K. authorities have repeatedly failed to spot trouble before wading in with taxpayers’ cash.
5. Canada, 1985: The Bank of Canada itself notes how the failure of 15 members of the Deposit Insurance Corp. — including two banks — accounted for less than one percent of the total banking system. Yet it led to long-term liquidity loans, funded by the public, plus 15 years of expensive court wrangling.
6. Sweden’s Systemic Crisis: In the early 1990s, two banks accounting for one-fifth of all Swedish banking assets were declared insolvent. By 1994, five of the six largest banks faced serious problems, costing taxpayers four percent of GDP in government support.

Don’t the current heads of the world’s biggest central banks ever flick through World Bank research reports while waiting to get their teeth straightened or beards trimmed?

But given the current collapse of real estate markets, banking models, hedge fund credit lines, and short-term liquidity the world over since last August — back when gold bullion traded one-third below today’s current price — who in their right mind would bother to read a study of 113 truly system-wide banking crises in 93 countries between 1970-2000?

No one running monetary or fiscal policy in the G-7 group of top economies, that’s for sure!

“If the countries in our sample had not pursued any such [supportive or bailout] policies, fiscal costs [borne in the end by the taxpayer] would have averaged about one percent of GDP — little more than one-tenth of what was actually spent,” write Patrick Honohan and Daniela Klingebiel in their report, published in January 2002.

What’s more, trying to bail out or support failing banks did nothing to reduce the economic drag that followed, according to Honohan and Klingebiel’s analysis. The so-called “output dip” never responded to government meddling — not unless the central bank stepped in to ease liquidity problems at crisis-hit banks with unlimited cheap loans.

That kind of support — exactly the support given to Northern Rock as it went belly up in September last year — is only one step removed from the marketwide support now being offered to New York brokers today. Yet it “actually appears to have prolonged crises,” write the two World Bank bean counters, “because recovery took longer” following liquidity loans to effectively insolvent banks.

In other words, the only sure way of prolonging a financial crisis is to try to delay it. Say, by putting taxpayers “on risk” with $200 billion in mortgage-backed loans.

“Things could have been worse,” the World Bank goes on. If every country hit by a systemic banking crisis during the 30 years to 2000 had piled in with liquidity support (like the G-7 central banks are offering today) or blanket depositor guarantees (as the U.K. government did with Northern Rock), the final bill of trying to clear up the mess early would have risen sharply.

Throw in regulatory forbearance — letting “zombie” banks continue their operations, even though they’re technically bust — plus repeated recapitalizations and debtor bailouts, and “fiscal costs would have reached more than 60 percent of GDP.”

Nasty rumors keep whacking “living dead” bank stocks in London, Tokyo, Frankfurt, La Defense, and Wall Street right now. And so far, taxpayers aren’t on the hook for recapitalizations; UBS and Citigroup have gone to Asian and petro-wealth funds for that. Ben Bernanke has so far only demanded that subprime lenders write off the value of outstanding loans, rather than calling on Congress to issue the checks directly.

But if the authorities sat on their hands during this crisis, the fiscal cost might equal one percent of GDP, the World Bank report suggests. Donning a cape, tights, and mask, instead — and pretending they can unwind the mal-investments caused by record low-interest rates from the Fed after the tech stock bubble burst — the cost may rise 60 times over.

That’s more than a 98 percent saving, if only the G-7 authorities would sit back and let the failed banks fail.

Put these findings to one side, however. Because what’s most remarkable about the World Bank study — other than the fact central bankers are so clearly ignoring it — is that anyone could ever imagine things differently.

Throwing “good money after bad” is a moral hazard that everyone’s grandma knows to avoid. And just like the truly historic bubble in credit that created it, the endgame for today’s official response to this historic banking crisis looks as inevitable as it’s sure to prove painful.

“Fiscal outlays are not the only economic costs of bank collapses,” note Honohan and Klingebiel. “The losses covered [by taxpayers] — which are caused by bad loan decisions — reflect wasted investable resources. Furthermore, a government’s assumption of large, unforeseen bailout costs can destabilize fiscal accounts, triggering high inflation and a currency collapse — costly in themselves — as well as adding to the dead-weight cost of taxation.”

High inflation and a currency collapse, you say? As a rule, smarter investors spotting this trouble in good time can switch into hard currency to hedge their domestic inflation risk.

But today’s systemic banking crisis crosses all developed economies…from North America to Japan and Australia onto Europe and the United Kingdom. So unlike the Asian crisis of 1997, you can’t flee the Thai baht by hedging with dollars today. Nor can you flee the Hungarian forint for the safety of French francs or Deutsche marks, as you could when 25 percent of Budapest’s banking assets were caught in a mass bank failure in 1993.

Where to go? What to use as a hedge against all currency risk?

Regards,
Adrian Ash
BullionVault
March 14, 2008

Central Bank Bailouts was originally featured on Whiskey and Gunpowder