The loss transfer scheme met with more than a cold shoulder from the public. It met with outright hostility. One New Jersey congressman said his calls were running 50-50: 50 percent “no,” and 50 percent “Hell no!”

The bailout also generated the derision it deserved. One blog posting described it succinctly: “Taking money from people who made good investments and giving it to people who made bad investments will make good investments in the future and the people who made good investments will keep making them even though they will have less money to do so.”

The lame-duck president let Secretary Paulson call the tune, while he tap-danced through a couple of White House performances: “…without immediate action by Congress, America could slip into a financial panic.” (His first treasury secretary, Paul O’Neill, said of the president at the time, “I don’t think he understands or knows much about any of this and it shows.”) Paulson, the former Goldman Sachs CEO, was determined to reliquefy Wall Street even at the risk of the treasury’s solvency. The bailout was sold to the governing classes under the guise of reinflating the mortgage market, an act of self-evident futility. If the last bubble could be reinflated, people would still be coughing up million s for dot-com business plans scrawled on cocktail napkins and the NASDAQ index would still be over 5,000. Unlike their counterparts in the Senate, members of the House, closest to the people and all up for reelection in a month, resisted the bailout at first go-around, but the pork fest of more giveaways, the heavy arm twisting, and talk of opponents being blamed for the next Great Depression prevailed. One representative, Brad Sherman, D-CA, claimed on the House floor that members were told without the bailout there would be martial law in America. And so the Paulson plan passed, a mechanism to transfer the losses from institutions that in the expectation of gain willingly undertook the risk of loss to those who had no opportunity for gain or willingness to undertake loss.

If the idea seems antithetical to the American way, it is. Philosophical consistency is not to be expected from politicians, but shouldn’t shame for supporting the giveaway have spread rampantly among Republicans? After all, the 2008 Republican platform had just been passed at the beginning of September. It addressed the mortgage meltdown in these terms: “We do not support government bailouts of private institutions. Government interference in the markets exacerbates problems in the marketplace and causes the free market to take longer to correct itself.” And what about modern-day conservatives who some years before opposed Hillary-care, insisting that socialized medicine is a mistake for the body politic? How then had socialized investment banking become overnight a prescription for economic health? When foreign heads of state, from Iran’s President Musaddiq, who was toppled for it in 1953, to Putin in Russia or Chavez in Venezuela, nationalize their country’s oil, they become enemies of the American state. But when American leaders nationalize finance, the people are told it’s for the good of all concerned. Before long South American Marxists including Hugo Chavez were taking great delight in calling “Comrade Bush” a fellow traveler.

The early costs of the frenzy of “rescues” were astonishing. A week into October, Bernanke claimed the Fed had already committed $800 billion in loans to banks and other activities, and that was before $200 billion for Freddie and Fannie and before the $700 billion bailout. The bailout gave news life to the expression “Legislate in haste, repent at leisure.” It only took a couple of months to notice that the bailout produced none of the promised results in mortgage values. The Treasury handed out the first tranche of the TARP money, $350 billion with virtually no accountability for how the money would be spent. Early in 2009 the Congressional Oversight Panel was able to conclude that the Treasury had paid $78 billion more than market value for the first $254 billion it spent.

While all eyes were on the bailout debate, September 30, like some eerie fiscal planetary conjunction, went unnoticed, a silent harbinger of America’s economic future. While fiscal year 2008 ended that day, rolling up an all-time-high deficit of $455 billion, the explicit national debt actually increased by more than a trillion dollars for the year, breaking through an astronomical $10 trillion. Meanwhile, all but eclipsed by the debate over the bailout bill, President Bush signed another stopgap spending bill that day. This one was for $634 billion, including $5 billion in earmarks, $25 billion in low-interest loans to automakers (yes, even foreign ones!), and a 6 percent bump in Pentagon spending. By the time he signed the bailout bill three days later, it had been a $1.34 trillion week. As part of the bailout, commanding the sun and the moon of economic reckoning to stand still, Congress raised the national debt ceiling to $11.315 trillion. (Four months later it would raise the debt limit again, this time to $12.1 trillion.)

The Paulson plan was presented as an attempt to undo the harm of mortgage market excesses by again inflating mortgage assets on the balance sheets of Wall Street players. It was a strange, homeopathic remedy, a “hair of the dog” approach for a problem that was caused by excess credit engineered the Federal Reserve to begin with. Rather than letting housing prices that had inflated beyond sustainability deflate, instead of letting a market of buyers and sellers arrive at some equilibrium, at values that reflected the actual conditions of supply and demand, the plan called for more of the asset inflation that led to the pumping of more air into the tire that had already had a blowout was ridiculous on its face, and the populists were right in suspecting that it was Wall Street welfare, a case of the politically connected of American finance passing the Old Maid of loss to the people.

Informed observers, the Cassandras who had seen the bubble forming and tried to raise the alarm when it would still do some good, were, of course, not consulted about the plan. Five years to the month before the Fannie and Freddie bubble popped, Congressman Ron Paul introduced a measure that would have avoided the calamity. His September 2003 remarks in the House Financial Services Committee on the dangers of government-sponsored enterprises (GSEs) like Fannie and Freddie are nothing less than a shockingly precise preview of exactly what came to pass:

“This explicit promise by the Treasury to bail out GSEs in times of economic difficulty helps the GSEs attract investors who are willing to settle for lower yields than they would demand in the absence of the subsidy. Thus, the line of credit distorts the allocation of capital. More importantly, the line of credit is a promise on behalf of the government to engage in a huge unconstitutional and immoral income transfer from working Americans to holders of GSE debt…

“Ironically, by transferring the risk of a widespread mortgage default, the government increases the likelihood of a painful crash in the housing market…

“Despite the long-term damage to the economy inflicted by the government’s interference in the housing market, the government’s policy of diverting capital to other uses creates a short-term boom in housing. Like all artificially-created bubbles, the boom in housing prices cannot last forever.

“When housing prices fall, homeowners will experience difficulty as their equity is wiped out. Furthermore, the holders of the mortgage debt will also have a loss. These losses will be greater than they would have otherwise been had government policy not actively encouraged over-investment in housing.

“Perhaps the Federal Reserve can stave off the day of reckoning by purchasing GSE debt and pumping liquidity into the housing market, but this cannot hold off the inevitable drop in the housing market forever. In fact, postponing the necessary, but painful market corrections will only deepen the inevitable fall. The more people invested in the market, the greater the effects across the economy when the bubble bursts.”

In viewing the Paulson plan, the Cassandras must have wondered how often the same discredited economic nostrums need to be refuted. But the administration didn’t turn to Ron Paul for advice. Nor did it consult the scholars at the Ludwig von Mises Institute, who had warned about the government-sponsored expansion of bank credit and money and its inevitable cycle of bubbles and busts. Instead Bush turned to Henry Paulson and his team from Goldman Sachs, despite the fact that under Paulson’s leadership as CEO, Goldman Sachs had been among the industry’s leaders in the issuance of subprime and other mortgage-backed securities, rotten paper that was downgraded scores of times by Standard & Poor’s and Moody’s Investors Service. And Bush followed the counsel of Fed chairman Ben Bernanke, who was on board and at the helm as the Fed frothed up the real estate and mortgage bubbles to begin with.

Sincerely,
David Goyette

December 7, 2009

The Bailout Was a Wealth Transfer Scheme was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Did that phrase have any effect–other than to help elect a presidential challenger–on our doing financial business as usual?  Nope.  Sure, we were on a bull run with a roaring (we thought) economy.  Everyone who wanted a house could get one, even if they couldn’t afford it.  Never mind if that six-figure mortgage, secured frequently by a four-figure (or less) income meant that you were upside down from the get go.  Option ARMs let you have your cake and eat it, too.  One of the more creative approaches was the Stated Income Stated Assets Loan, also known as a SISA (Liar’s) loan. Yep, it was and is exactly what it sounds like.  The income listed on the mortgage loan application was accepted as exactly what you said it was without any verification whatsoever.  This particular loan is now about as rare as the passenger pigeon due to the mortgage collapse.

Property values were always going to increase from here to eternity, so all you had to do was wait a while, refinance after your salary had increased (as it always had) and your home’s market value had multiplied.  Then you would have a standard 30-year mortgage, low interest rate, high income, money in the bank, stock investments and a 401K.  Life was good and you could concentrate on your golf game every weekend.

What everyone forgot, or ignored due to the good life blinders they were wearing, was a rather trite phrase that happens to be truth in a nutshell: What goes up must come down.

Fifteen years later came the mortgage meltdown and a global financial collapse.  A year after that, we managed to infect Washington, D.C. with an administration that seems determined to reduce the U.S. to the status of a third world country, complete with nationalization of its remaining industries, tax increases that would break the back of Atlas and an infantile belief that we’re on the road to recovery.

Y’all know that that Government Motors…ahem, General Motors…has been bailed out to the tune of tens of billions of dollars, with virtually no chance that any of it will ever be recovered.  Healthcare is the latest target in the crosshairs.  Opposed by darn near every person with a brain and the ability to read even a few pages of the proposed legislation, there is still a very real chance that it will be rammed down our throats by our erstwhile elected officials who are not only supposed to act in our best interests but actually listen to our comments during town hall meetings, by reading our emails, snail mail and paying attention to phone calls.

Do we need healthcare reform in some respects?  Of course we do.  No system, public or private, is perfect.  But the word is ‘reform’ or ‘improvement’, not ‘nationalization.’

Tax increases ain’t hit us yet, at least not in any widespread manner.  But they’re coming.  In fact, they’re already here in the form of increased fees that are being instituted by everyone from utility companies to towns and cities.  And just wait till the cap & tax…sorry, I meant cap & trade… bill is passed, signed and forwarded to your checking account.  What was a relatively healthy account, or at least surviving, will shortly wind up on life support.

So how is cap & trade going to be a tax increase on every person?  Simple.  That legislation, if enacted, will focus energy production on the so-called ‘green energy.’  Any method that produces carbon will be heavily taxed.  The result will be dramatic increases in the cost of electricity and since we all use electricity in some way, shape or form…including ways that most of us don’t even think about…every person in this country will be paying an increased tax as the result of rising prices on virtually everything.

Conservation, energy efficiency and reduction of your carbon footprint will become watchwords, possibly even additions to your local ordinances.

As for trying to jawbone this country onto the road to economic recovery, President Obama wandered several miles into fantasyland with his recent speech before Congress.  While his focus was the embattled healthcare legislation, he did manage to address the economic conditions with a two paragraph opening statement in which he said:

“When I spoke here last winter, this nation was facing the worst economic crisis since the Great Depression.  We were losing an average of 700,000 jobs per month. Credit was frozen. And our financial system was on the verge of collapse.

“But thanks to the bold and decisive action we have taken since January, I can stand here with confidence and say that we have pulled this economy back from the brink.”

Does this correlate with a 9.7% – 16% (depending on whose statistics you use) unemployment, ongoing foreclosures with many more to come, businesses closing, many States dealing with multi-billion dollar budget deficits, some perilously close to default, deflation in a few areas, etc, ad infinitum?

Of course, when this country only loses 216,000 jobs in August compared to 700,000 last January, I suppose you could argue that we’re moving in the right direction.  And let’s not forget that our financial problems were over when we discovered that printing presses actually functioned 24/7, enabling us to print fiat money…or Monopoly money if you prefer…whenever we needed it.  As long as we don’t run out of ink.  Happy days are here again!

Maybe it’s not the economy, stupid.

What do you think?

Regards,
Richard Marmo

September 11, 2009

Once Again, Stupid, It’s The Economy was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

So, this reasoning goes, the greater risk is that asset prices continue to fall. This is the classic debt-deflation point of view. The theory seems to fit the facts of what we are seeing in the marketplace right now.

I don’t dismiss these arguments easily — and there is more to it than what I’ve given you here. I’ve spent some time going over the arguments of some of deflation’s most persuasive and sophisticated advocates: money manager Van Hoisington, economist David Rosenberg and others.

Still, I think the endgame is for inflation — which is when paper currencies buy less. Given the choice of holding U.S. dollars or real assets (such as gold or iron ore or land), I’ll take real assets.

Over the weekend, Thomas Donlan at Barron’s had a good analogy for it all. He asked what you would rather own as store of value, bananas or corn? The obvious answer is corn, because you can store it for months. Corn lasts longer than bananas. Fruit rots. You can also use corn for a lot of different things — corn flour, animal feed, etc. You can also arrange to sell corn into the future, say, by arranging to deliver corn so many days from today.

Corn can lose value, obviously, as can any real asset. But it is a better choice than holding the bananas.

Donlan likens money to bananas and natural resources to corn. “In the modern economy,” he writes, “a barrel of oil is much like a bag of corn… Paper money and bank balances are more like the bag of bananas.” When currency rots, we call that inflation.

The problem with the deflation arguments long term, it seems to me, is that you are betting against a government’s ability to destroy its own currency. Governments are seldom good at anything, but one thing they are undeniably good at is destroying their own currencies. The dollar has lost 95% or so of its value since 1913. That’s a pretty darn good job. Other countries have been even more thorough.

So that would be the way to bet. Deflation may prevail today, but the real question is for how long. My own crystal ball is frustratingly cloudy on the issue. But the great rewards in investing are always with the out-of-consensus view.

The upside from holding Treasuries seems hardly worth the risk of being wrong, for instance. On the other hand, if we are right about currency rot, then we’ll make multiples of our money on natural resource stocks.

The downside on many commodities seems low, because the prices have already corrected. In several instances, as with oil and natural gas and iron ore, we are already below the marginal cost of production for much of the industry. So unless we don’t need these things at all anymore, the simple economics of the businesses involved help support a certain price structure.

Worse Than Subprime

And anyway, as far as the case for gold is concerned, I’ve been arguing that it is less about inflation or deflation than it is about creditworthiness in general. I wrote about this in your May issue (No. 35), The Great Deleveraging.

Gold does well during times of credit troubles. It did well in the 1930s, for instance, even though that was largely a deflationary era. Banking troubles made investors turn to gold.

On that front, we’ve got plenty of banking troubles on the way. Today’s Wall Street Journal headline, buried in the middle of the paper, hints at what’s to come: “Pick-a-Pay Loans: Worse Than Subprime.” The piece begins:

“For the third straight month, option adjustable-rate mortgages are generating proportionately more delinquencies and foreclosures than subprime mortgages, the scourge of the U.S.”

These loans include only partial-interest payments. So the loan balances on many of these loans have actually gone up while housing prices tumbled. It’s a disaster. As of April 36% of these loans were at least 60 days past due.

These pathetic loans will mean more large losses for banks — in particular Wells Fargo, J.P. Morgan Chase and others who were active in these markets. Wells Fargo, the WSJ points out, has a mountain of this stuff — $115 billion of crap.

So as long as we have banking troubles, we have the potential for fear to return in a big way. And that is when gold does well.

In other cultures, too, gold is more naturally a part of the wealth-storing equation than it is in most Western countries. In places such as China, India and the Arab world, people see gold more readily as a store of wealth than the typical American or European. These areas of the world are on the rise, and their gold holdings are also rising.

Beyond this, gold stocks are cheap again. Gold also has a seasonal tendency to be weak in the summer months. So against all this, I’d use the market weakness in the gold price and in gold shares to pick up your favorite gold miners.

Have a good week, and I’ll write you again soon.

Regards,
Chris Mayer

July 22, 2009

Gold Stocks Take a Hit Plus Worse Than Subprime was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The present “value” of a future receivable is the subject of speculation. Laws that constrain how much banks may lend should not presuppose any relation between the two. The debate of “mark to market” accounting versus “mark to model” accounting, each of which makes such a presupposition, misses this point.

Take, as an example, a simple toy model: Two mortgage banks each lend $300,000 to two home buyers, in return for $700,000, $300 K principal and $400 K interest, in monthly payments over the next 30 years. They can each make $400 K profit over that rather long time scale. How much is the right to collect the $400 K in the future worth at the present time? Who knows? Banking laws should not be formulated in such a way that their enforcement requires knowing it.

Now suppose each bank sells the other an identical “security” backed by the mortgages (MBS), for $500 K, soon after the loans are made. The exchange of identical securities is obviously an empty exercise in terms of meaningful wealth, yet, on paper, each bank has lent out $300K and received $500K shortly thereafter. Sounds like a $200K profit, right? True, they spent $500K buying each other’s MBS, but in return they each got an MBS worth (for the time being) $500K, so they broke even on that; you can hardly consider it a loss. Where, then, did the $200K profit come from? It came from the future, and was declared a profit in the present. With that profit, the banks can immediately bloat their operating costs by paying its employees bonuses, larger salaries, and hiring more employees.

Now the paper trail in the mortgage industry is of course far more complicated than the toy model, but I bet that underneath all the complicated mortgage derivative paper, the same principle was at work: anticipated future wealth was cashed in and distributed in the present. For example, the obligation in a credit default swap or insurance policy on a mortgage may be activated as soon as the default is declared, even though the default was on a future debt repayment. Creditors that collect their insurance on a defaulted debt enjoy a payment in the present on a debt that would have been collected in the future.

Debating how much anticipated future revenues are worth at present does not change a basic fact of life: A promise is worth less than what is promised. The risks that the promise might not be kept are a form of negative `wealth. Mortgage-backed securities simultaneously create mutually canceling positive wealth (short term profits) and negative wealth (future risk) out of thin air, the way positive and negative charge are created by a spark. In this manner, they allow present wealth to flow, like electric current through a short circuit, from the depositors to the bank administration. In the above example, the promise of $400 K in future interest payments is worth only $200 K at present. The risk that it might not be paid, which is worth minus $200 K, is the “hole” left by the profit grabbed by the bank. There is only one acceptable limit to the amount of negative wealth that mortgage banks should be allowed slip to its depositors without their consent: zero. (Would you debate how many short circuits should be acceptable in a car battery?)

The banking laws should therefore insulate the future from the present to the full extent possible. A proper evaluation of a bank’s solvency should respect the dimension of time; it should both keep track of the bank’s books and regulate their activities accordingly on a year-by-year basis well into the future. The amount of interest they promise to pay out in 2015 should be tied to the amount they expect to collect in 2015. The maximum amount of debt to which they are liable at present should be tied to their present reserves, not to anticipated future revenues. Confusing future receivables with present assets is asking for trouble, no matter by what mathematical modeling procedure you compare the two.

Uncertainty in how much anticipated future interest payments are worth at present should remain the risk of speculators, not depositors. The depositors, whose money was loaned to the home buyers, are already assuming a fair share of the risk merely by parting with cash in exchange for the collateral, whose value may yet go down, and granting occupancy to the home buyer. Anyone’s rights to a share in the future interest payments should be predicated on their waiting patiently for them.

Physicists used to think that a particle had a particular energy at any instant, but finally, in formulating quantum mechanics nearly a century ago, they realized that it doesn’t. The shorter the time interval over which you try to guess the energy of a particle, the greater the uncertainty in your guess. Only after physicists humbly (and therefore with great difficulty) accepted this uncertainty did they proceed to the dramatic advances of the 20th century in understanding the microscopic structure of matter. Maybe it is time for economists and accountants, now puzzling over the microscopic details of failed financial instruments, to make a similar transformation, and accept the fact that future receivables simply don’t have a well-definable present value.

Short term gain and long term consequences go together like love and marriage. The current difficulties of lending institutions is what we folks get from their recent whoopie. The future has just arrived, and there is plenty more of it.

Regards,
David Eichler

June 16, 2009

The Uncertainty Principle in Accounting was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

I got someone in “the business” talking, and scribbled cryptic notes frantically for over an hour.  The bottom line, as we all say tritely, is that in the opinion of a real expert…

The sky is not falling, Chicken Little.

Yes, some chunks did, and there are still a few faint cracks, but don’t worry about it because hard times can provide great opportunities for growth and profit, and they’re hard at work proving it.  My congratulations to those of you who deduce on no clues whatsoever which sector of the economy is feeling very good about business these days, even though the answer is not obvious.  Here’s a clue if you didn’t:  which portion could say, “The competition is gone!  There’s a bigger share for those who are left?!”

My source, who spoke on conditions of absolute anonymity, said enthusiastically, “Now is a great time to be hunting a job!”  He…she…let’s say “she”…added that it is important to think for yourself, and although “she” doesn’t consider “herself” a stock market expert, despite having studied it, put the Contrarian position perfectly:  “If  people are complaining about it, I’m going to invest in it.”  The source continued, “What’s going on in the MSM exacerbates the situation and confounds those of us who know what is really going on.  We all knew that our competitors were in trouble and that their business practices would catch up with some of them eventually.”  Part of being a Contrarian is times when it appears we’re going with the herd, but we’re doing it for different reasons.  One of my rules is to investigate what I know before I get excited about fields where I am ignorant.

My attention was riveted from the moment my source said that the government–and we!–are being stampeded into looking at the sky and acting like Chicken Little.  I was spellbound a minute later when I heard a complacent, “We all knew that Indy Mac’s behavior would catch up with them.”  (We should have known that professional, dignified mortgage bankers don’t approve of churning, an amplification that emerged later on, as we should have known that serious bankers don’t lend to those with poor credit scores, no collateral, and food stamps as “income” given any choice.)

“We knew they were going out of business eventually.”  Argh.  Things we wish we’d known earlier, and all of those who predicted it take your bow.   “Indy Mac is just an example, of course.  We knew the risks Fannie and Freddie were being made to take and had a good idea of risks others were taking.  Any time there is a lot of money to be made…”

I wish that I were at liberty, sometimes, to tell you more about my sources, but you don’t have the famous “need to know,” and discretion is the better part of valor if I want more comments later.  I have friends who are Engineers (four different fields of Engineering), and friends who are truck drivers–who know a lot of interesting things…and people.  I know oil men, cattle men, well diggers, and grandmothers.  I hang out with landsmen, retired football coaches, goat herders, hog hunters, and college professors.  Anything I quote directly is precisely what I was told.  I never accept as truth anything more than once removed, and then only when someone I trust says, “I know because X told me so personally,”  and X is in a position to know.  Everything is a direct quote that has been checked via e-mail for accuracy by my source who has been employed in the field for nearing fifteen years and worked only for very well known banks, always in the mortgage field.

“There are three ways to make money in the mortgage loan business:  the interest on the loan, servicing the loan, and selling loans.  LIBOR, the London Inter Bank Offering Rate, which is both a leading index and very volatile, was and is often the index of choice.  This dynamic makes it easy to persuade borrows with a low rate and sell investors on the exponential potential.

The lender profits on the initial loan and again by selling over the rate.  Money exists in servicing the loan; however, you have to be willing to do what is in the best interest of a customer if you are to originate and service a loan.”

Fascinated, frantic scribbling, wondering how London got into all this…and all of you are probably laughing, “There is no way LBT wrote ‘This dynamic makes it easy to persuade borrows with a low rate and sell investors on the exponential potential.’”  No,  I really didn’t.  What’s the line?  “You are only thinking I am speaking your language!”

“A big part of the problem was banks that were making bad loans, packaging them, and swapping them to those who did not do due diligence and find out exactly what they were buying.”  Momentary sigh of relief, glad to be back to something I understood.  Derivatives, right?!

“What government and the average intelligent business analyst don’t seem to grasp is that there is a bigger share of business for those of us who are left!  The competition is gone. It is gone for the lender, for the brokers, and for the investors.”  If the marble doesn’t drop with a big thud for you, it did for me.  Of course that is how it has to be, because even when heavy-handed Statists muck things up they can’t prevent at least some part of free market principles from working in their sweet, inexorable way.  Yes, the government threw trillions of dollars at failing financial institutions, but those still gasping for air are never really going to recover.  Yes, Goldman Sachs has so many alumni in high places that it will hang around, but the vigor and the power are probably gone.  The successful banks will absorb what is valuable that the government hasn’t confiscated first, and the husks will wither away.

“We smile when we hear there is no money available for loans.  We have more business than we can handle with the staff we have!  It is a great time to be in mortgage banking and to hunt jobs in investment banking.  We aren’t short of money or clients, we’re short of people who know the business.”  Another good area to consider is “It’s a great time to be a broker, too, since too many gave up and closed up shop because they were listening to the news instead of paying attention to what is actually going on…or were unqualified to be in the business at all merely looking to make some fast cash.  New housing starts are up again this month.  In my (territory, area, circle of influence) I had to figure out how to get time off for eight staff members with personal closings this month!  We’re 2,000 loans behind right now and every day we worry about how to get an extra 86 over our usual average completions moved forward lest we be fined for not finishing within a specific time.”  THAT, friends, strikes me as a very interesting bit of information, particularly since the person quoted will be moving into the new house currently under construction less than a month from now.   I can tell a hawk from a handsaw occasionally, and when senior mortgage bankers conclude that “We looked at all the aspects and concluded we are nearly as recession proof as it is possible to be.  We pounced on Mr. Obama’s offer of $8,000 for first-time buyers.  By building we get exactly what we want and more for the money than we would buying a ‘depressed value’ MacMansion.”  I, for one, conclude that those who are driving (as opposed to those who are getting paid $40 Mil a year) have confidence in the future as well as knowing what they are talking about.

There are always pockets that do well no matter how bad the economy gets, and it could make a lot of difference if we consider trusting at least some bankers not to be cowed, unscrupulous, or over-paid idiots.  The house in question is custom designed, with all the extras, a modest little 3400 square feet for two professionals in their early thirties.  Their thought is to spend four or five years in it–and build again.   This certainly indicates confidence in the ability of the housing market to recover in the future, at least sufficiently to store current outlay safely at present value.

“For most of us it is business as usual.  Sure, we got memos from high up saying that we can no longer have box seats for sporting events…and we asked ‘What box seats?!  We don’t get box seats!’  We were told we couldn’t have parking for our limousines any more.  What limousines?”

My source is in the strata of business where there are a few levels higher but most are subordinates.  Not high enough up nationally to be in an interesting position where they could have made um, unusual lucrative deals, shall we say, and not being paid millions in salaries and bonuses, but definitely informed enough to know what is going on industry-wide and plan their futures accordingly.

“No money to loan?  We have lots of money to loan, and those who have good credit still have no problems getting loans.  It takes a little longer, for several reasons, but lack of funds isn’t one of them.  We are back to smart lending instead of fog a mirror lending.”

Huh?  That certainly isn’t what we’re hearing from politicians and the MSM!

We’ll go into some specific reasons, other than extra caution, that it takes longer to get a loan approved in the next segment.  “We’re lending far more of our own money than TARP money because that carries a lot more demands and restrictions.”  It didn’t seem polite to ask, but if it were my bank I would certainly be skimming the very best loans and funding them with my own money.  Mind, there was no hint of that in the conversation, and perhaps professional bankers have standards that forbid “cherry picking” or “high grading.”

“If rates weren’t so low I would recommend an ARM, an Adjustable Rate Mortgage.  You’re borrowing cheap money from yourself with one of those, so to speak, since you can choose what to pay.  Use what you don’t have to pay on the mortgage at 3% to pay off those 17% credit card bills or to put the full amount your employer will match into your 401K.  If the air conditioner goes out, have it replaced; banks will work with you since we have an incentive to keep your house in good sale condition.  The key is to find a stable lagging index that is tied to something like the cost of funds.”

That’s what you have to look at, not the ARM, but what it is tied to; index + margin = rate.  Take COFI, the Cost of Funds Index for I think the 11th District which is used in California, Nevada, and so forth.  They tend to lag badly, so if a bank can pick up a lower rate at LIBOR and sell the loan to someone using COFI there is money on both ends.”   Gosh, and lots of us were thinking an ARM was the devil’s invention.

“You don’t have to refinance if the interest rate goes down; your ARM will do that automatically.”

“We’d really rather write a standard mortgage at a set rate because that way we can manage our funds better and know which will be more lucrative to sell or to keep.”

Fascinated, I asked if there were some formula for what I had been told long ago, on how big a difference it would make if the buyer made even double principle payments each time.  “Most people get paid bi-weekly” They DO?  I thought most got paid weekly or monthly…shows how many regular jobs I’ve had in my life, I guess.  “so the best plan is to use a biweekly option if available and pay extra each time you can afford it, but make payments every two weeks.  Ask ahead of time.  Some banks will hold your first payment until the second one comes in and makes a ‘full’ payment.”

“Aha!  Keeping both the interest that is accruing and the float!”

Gentle smile at the toddler’s knowledge.  “A good bank will go ahead and pay towards the loan and re-amortize.  In addition, you will be making thirteen payments a year, and on average a thirty-year loan will be paid off in twenty-three-and-a-half years.”  Wow.

“Most people spend four to seven years in a house, so they never actually see the benefit of the 5% interest rate they think they have.  Do the math; the true interest rate is shocking.”

“People really need to find out what mortgages do and what terms they are really getting.  Go on line and look up ‘the Banker’s Secret.’  That is what needs to be changed.”

In the early stages most of PITI is going towards interest, and it should actually be considered “ITIP,” because the principle gets what’s left over after interest, taxes, and insurance.  We all “know” that, but we haven’t tried to work out an advantage to off-set it.

Here’s a comment made in another context that certainly has application to what is going on politically and in many sectors of the financial world:  “If you solve the problem, you don’t have a business any more!”  That is practically up there with the Ten Commandments in terms of rules for big government.

That should give you enough to think about, and perhaps even incentive to talk to a banker you know well.

In the next segment we will go into mistakes banks make that you can work out pretty easily for yourself in terms of how they treat you, which will help you choose one.  Profitable good management makes a difference, and one place it shows up is in customer service.

I hope you found this as interesting, unexpected, and even soothing, as I did.  I’m not one to doubt the courage of my convictions, and I remain convinced that we are in for a doozy of a Depression.  At the same time, I can be persuaded by facts from an expert.  When someone who has been everything from an underwriter up and down tells me that a bank I had qualms about is doing very well no matter what MSN tells me, I’m willing to adjust as necessary.  I couldn’t elicit an opinion on what banks might still fail (“There are always banks that can fail, and there are still those who may, but I wouldn’t sell the majors still standing.”) but even though I might not buy Wells or BOA and such, I wouldn’t sell any stock I had in them either.

Regards,
Linda Brady Traynham

June 2, 2009

Update: I just learned that a young former Marine friend who was accepted at a good medical school and planned to start this fall does not intend to spend the next decade of his life and at least a quarter of a million dollars becoming an M.D. for the best of good reasons:  Hillary Care Plus.

Clay plans to enroll in Veterinary school here at A&M, instead, because he will be out in under four years, he will still be a “doctor,” and any vet who tries at all is remunerated very handsomely.  Nearly twenty years ago the average vet cleared $100 K.  I don’t know what they do now, but I know what vet bills can run.

True, Clay will get bitten and kicked occasionally, but toddlers bite and kick, too.  There is no point in going through arduous training for a third of your professional life only to be told that the government only wants family practitioners who will be overworked, underpaid, and overruled by bureaucrats.  As a vet he will be able to order and perform an MRI any time he thinks his patient needs one, and no one will complain about the medications he prescribes.  Since pet insurance is a fairly new and small field he won’t have a lot of office expenses affiliated with that, either.  I may well let him build a clinic here on the ranch in return for his services!

Government Meddling Hasn’t Eradicated the Mortgage Market was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Even the UK’s small, tightly packed mainland, floating off the edge of Europe, includes disparate and distinct real-estate markets. Glasgow is as different from London as Cornwall from Cheshire. But in the main (and the mania), and with a peak of 185,000 new dwellings under construction in 2006, the broad sweep of house-price inflation…followed by an inevitable slump lasting six years or so…tends to apply across the nation.

In the United States, in contrast, new housing starts at the peak of what pundits, economists and investment bankers clearly felt was a coast-to-coast boom in 2006 approached 1.63 million amid a total housing market of 128 million units spread across 3.5 million square miles.

By necessity, that makes the idea of an “average” home price more slippery. But let’s not let such quibbles clog up our spreadsheet! Not after math PhDs, applied to mortgage-backed zeroes, clicked and dragged the answer “AAA” whenever asked. And not before we contend with the data itself.

This first chart’s solid enough, thanks to the certainty with which the Census Bureau dispenses its data.

It shows the median price of new US housing, at sale, divided by the ounce-price of gold, monthly average. And as you can see, new housing has swung wildly – measured in ounces – over the last 45 years. Quite clearly, one made a better home for investment than the other over distinct periods, as the mid-way price of new homes (half the market paid less, the other half more) was rocked and rolled by booms, bubbles and busts in both bricks and bars.

Second up, existing homes bought on the secondary market – and the same picture, but only on an annualized basis (and with the National Association of Realtors thrown in as a source) for the Census Bureau’s less lengthy, less detailed data.

You can see, between the two charts, how new housing during this last real-estate boom (2000-2006 in nominal prices) began and topped out much sooner when priced in terms of gold. New units also reached further above existing-home prices too, peaking at $243,000 in 2006 – then 550 ounces of metal – or some 10% higher than the secondary market.

Perhaps that extra cash paid for new homes’ expanding foot-print. But it’s also worth noting, turning aside from Gold Investment for a moment, that new US home prices this decade also saw the mean outstripping the median as never before. The gap between average and mid-point prices, in fact, gaped from one-fifth or less (1975-1999) to as wide as 30% during the summer of 2006. Which might show, we guess, a growing number of super-priced units way up at the top-end of the market…bought and paid for, perhaps, with bonuses skimmed off mortgage-backed bonds sold against the sub-median half.

Finally, the money shot…

True long-run figures for housing, like the concept of “average” itself, are more sketchy than Mel Gibson after a night on the sauce.

We’ve used Robert Shiller’s invaluable numbers, of course, but they only come as an index, itself built from five sources stretching back to 1890. Rolling those numbers back from today’s current average ($175,000 according to the NAR) only throws up big gaps with the Census Bureau prices collated and published every 10 years starting with 1940. It also puts the price of US housing above $4,000 in 1900 – and in 1900 dollars, too – when average wages were just $2 per day.

Okay, so home-buying was yet to meet democracy through that great 20th century liberator, the securitized mortgage loan. And yes, two-thirds of US homes had yet to gain running water, let alone electricity. But as in the UK data, Gold Bullion regained its Great Depression value in housing as the Great Inflation of the 1970s peaked out, suggesting (to us, at least) that its utility as a store of value was little diminished by new bath fittings and copper wiring.

The broad sweep – smoothed out to fix those anomalies which our quick desk-bound research, a mere 5,000 miles from the Library of Congress throws up – remains as broad and as sweeping as either gold bulls or bears might hope to spy.

From here, the bottom in housing may still be to come, at least priced in gold. Broad-sweeping investors are invited to draw their own conclusions.

Regards,
Adrian Ash
BullionVault

May 6, 2009

U.S. House Prices in Gold was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Maiden Lane runs right past the foot of the N.Y. Fed, and this address hosts the most poisonous assets on its balance sheet.

As any anti-Fed Reservist among you will agree, the Reserve’s balance sheet is nothing but the stomach lining of the poorly run banks…only there’s no acid (free-roaming liquidity) left to do any digesting.

Before I tell you what this costs us to hold this stuff, let’s take a look at what it is.

Meet Maiden Lane I, Maiden Lane II, and Maiden Lane III… some of the ugliest portfolios you may ever meet.

In Maiden Lane I, we’ve got the commercial and residential mortgages that JPMorgan didn’t want. That’s right, when the guv’ment colluded in the hookup, it didn’t throw the baby out with the bathwater. It rescued the baby to spare JP from being a new surrogate father dupe. JP, you see, knew enough about the Florida and California housing markets to want no part in shouldering that burden. It was already nursing too many of its own sunny-state-sour-mortgage bastards. Too bad banks aren’t more like rats, hamsters, and other rodent ilk that can just swallow the unwanted babies up.

Maiden Lane II, a wily female with a lotta curves, has more Alt-A mortgages and subprimes than she can sell. In fact, she’s in hot water with her pimp right now. We’re talking $937 million as of Dec. 31, 2008. I don’t see her working that debt off anytime soon — nor paying back the $180 million she’s already lost — no matter how many PPIP pimping sessions happen with the Wells Fargos and hedge funds hard by the ol’ Sunset Strip. The Fed says she’s worth a whopping $11.4 billion, but we expect the private market will treat the Fed like a huckster selling a kneecapped racehorse. You’re lucky to get 25 cents on the dollar for this.

The newest balance sheet abomination, little Maiden Lane III, was born on Oct. 31. The genes, if you will, are the worst recessives: asset-backed securities issued circa 2006 and commercial CDOs circa 2007. A third of this baby’s “silver spoon” worth is pure speculation grade, viz. most likely to default. All told, $26.65 billion of this $26.8 billion problem child are valued using mathematical models — not tangible market prices. We’re afraid of what will happen when this tyke hits the “terrible 2s.”

Somehow I have trouble seeing who will want to buy the bowls of porridge these Maiden Laners make. In the meantime, just cross your fingers that the principal on these things gets returned.

How Much Does It Cost You?

In just taking the sop from AIG and Bear Stearns — the cream of the failed capitalist crop — the Federal Reserve took on $74 billion in subprime and bad lease refuse. On April 23, it reported a yet-unrealized loss of $9.6 billion.

We’re not down the toilet yet, but we may have to use TARP money just to pay back our own central bank. Is this really what Mr. Treasury Secretary wanted?

Meanwhile, we who are on the hook — despite the best efforts of the Freedom of Information Act and a Bloomberg News lawsuit — are not allowed to see the names of the banks involved, the specific amounts they requested, or the “assets” the banks are offering as collateral. The only reason we know anything about AIG is that the Fed owns 80% of it.

Why aren’t we allowed to know? Not some kind of “It’s unconstitutional” argument. Simply this. The government, trying really hard to paint the pig, doesn’t want to a) trigger a bank run or b) ruffle the shareholders’ feathers one bit.

But the big thing to note here is that the Treasury is now bailing the Fed out. Meanwhile, it’ll try to distract you by drawing out this “bank industry stress test” to maximum media effect.

The Stress Test Sham

On Friday, we learned what methods the Fed regulators employed to test the top 19 banks in the United States. Meanwhile, it tells the banks privately whether the institution merited a “pass” or “fail” grade. And the regulators, despite the Obama-Geithner injunction to transparency, are asking the banks to stay on the QT and very hush-hush.

Only on May 4, will we, the Treasury shareholders, be told the results.

The whole dog-and-pony show was for us and us alone, and we’ll be the last to learn the truth. The information, they say, “could alarm depositors and investors.”

What does it matter if the stock market drops 300 points in one day or over the course of a week? Joe the average shareholder isn’t a day trader and will still be either up on a passed bank or down on a failed one. End of story.

This consolation just in from Northwestern University researchers: An upcoming article in the journal Psychological Science touts: “Denial Can Bring Marital Bliss.”

Its concluding point: “If denial paints a partner better than they really are, the relationship is bound to be satisfying, as long as no one is slapped in the face with reality.”

We’ve been slapped in the face with reality. And when the government botches its delivery of denial, like a nurse bad with the needle, we know the drawing of cash to come is really going to hurt.

How did we fall so low? Wasn’t there a time when we loved Wall Street?

When the Romance of the Street Went Sour

From our long-suffering, early-rising coffee drinker Eric Fry, over at Rude Awakening:

“Specifically, the Paulson bailouts sought to divert hundreds of billions of taxpayer dollars toward Wall Street finance companies, and to do so as secretly as possible. In the name of ‘systemic risk,’ the former Treasury secretary dispensed hundreds of billions of dollars to the likes of AIG, Citigroup, and his former employer, Goldman Sachs, without ever seeking or receiving a single vote from an elected official. Thus, as it turns out, the only system genuinely at risk during Paulson’s tenure was the American system of honest and transparent financial markets.”

Yes, Eric, that was the great problem. And this same man asked for a lighter whip to be laid on the back of Wall Street…by lobbying the rule change that let banks leverage themselves to the hilt — eating their own tripe, the same they were selling to everyone else. (We’ll leave aside his role in the Bank of America/Merrill Lynch morass, for now).

But we still don’t get at the true root of the problem until we look at another revenue stream. Because, let’s face it, what marriage doesn’t come down to finances?

This cash flow doesn’t come from the central bank. It’s the one that flows straight into political action committees and individual campaign coffers.

Federal Election Commission Pulls Back the Curtain

In a lovely snippet on the threat of a full-scale Senate probe, in the penetrating Ferdinand Pecora style of the 1930s, we found a treasure trove of good stuff already uncovered.

Consider this.

In the past 20 years of elections, who do you think came out as the biggest political contributor?

The energy companies, yesterday’s super villain?

Nope. Guess again.

How about the pharmaceutical industry?

No dice.

Financial services topped the charts.

Just looking at the past two years alone, we see sobering numbers.

The financial giants in grey bespoke largess donated $463.5 million. The energy companies, the ones Congress was just scolding when oil ran up over $100 a barrel, donated only $75.6 million.

Breaking it down to our two initial banking survivors of the subprime fallout, Citibank and Goldman Sachs, gets even fishier.

In 20 years, Goldman Sachs foisted over $30.9 million in donation dough. Citibank was almost as generous, at $25.8 million. The only company who rained down more congressional support? AT&T, which always seems to be keeping pesky antitrust cases at bay.

But use your imagination and think about it for a sec. If you’re the CFO for a large financial outfit, doesn’t $30.9 million spread out over 20 years seem like the best insurance policy you could ask for?

That’s a measly $1.545 million per year in premium.

Heck, that’s proved way more functional than AIG’s great insurance policies for Wall Street! Was not Goldman Sachs one of AIG’s biggest counterparties? Our money’s on Maiden Lane III being created especially to honor it.

Good thing Goldman Sachs is doing so well, and is ready to pay back that TARP money, eh? It may well be why it was in such a rush to be the first to give bailout money back. But you may be amused to learn that the payback date depends in part on the results of those so-secretive stress tests.

From our vantage point, GS can’t be as healthy as it appears. By changing the calendar month of reporting, it erased the reality of a $1.5 billion loss, for example. That wasn’t illegal, and it was the result of its bank holding company conversion, but it was extremely convenient — destroying any easy attempt of shareholders to compare quarters.

There has also been suggestion that Goldman’s Q1 2009 was so plump and juicy thanks to AIG transfer payments, but we’ve not yet run the fine-toothed comb over that Goldman 10-Q to qualify the speculation. However, either way you cut it, there were some big one-time hedges that paid out, but there’s no reason to think they’ll pay again.

There’s always the ever-paying hedge — or should we said hegemony — of letting the government just pick a little out of your pocket.

Regards,
Samantha Buker

April 28, 2009

Field Trip to Maiden Lane: Home at Last on the Fed’s Balance Sheet was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Remember the great hope for Hope Now…?

“Let’s not harp on about the costs, absurdities or risks of governments meddling in real-estate bubbles when they burst,” wrote BullionVault as the Bush administration pushed the initiative front-and-center in Dec. 2007.

“This is about hope. Hope now. Let’s worry about tomorrow some other time.”

Too bad tomorrow’s turned up, but with 917,000 homes foreclosed since then regardless. A further 1.3 million foreclosures are now in progress according to Hope Now’s own data, with nearly one-in-twenty of all US mortgages standing 60 days late or more on debt service.

Some 8.3 million mortgages risk being drowned by negative equity, too. So even if the lender moves to foreclose, the asset won’t cover the debt – if they can find a buyer at all – making the net loss of wealth truly systemic for America’s banks.

Which is kinda where all this began, only the other way round.

“Mortgage performance steadily declined each month in 2008,” says Hope Now in its full-year data. “One in 10 loans was delinquent in some way by December,” despite Hope Now itself helping modify and refinance almost a quarter-million loans that month. It helped modify and refinance a quarter-million loans yet again in January. By then, however, US real estate had lost $2.4 trillion of its value year-on-year, reckons First American CoreLogic.

Puff! It was gone, just like that. Which kinda makes you wonder where it all came from in the first place.

“There is broad agreement that until we begin to stem the tide of foreclosures, you will not get an end to the current crisis,” says Barney Frank, Democrat chair of the House Financial Services Committee, pointing to the, ummm, foreclosure crisis.

Put another way, “The remedy for [today's] deflationary delevering and mini-depression is simple and almost axiomatic,” as Bill Gross, head of the Californian bond giant, wrote last month:

“Stop the decline in asset prices.”

Such a happy truism; stop prices falling, and you’ll stop pricing falling. But how to achieve it? Maybe Gross doesn’t quite mean what he says. Not as simply as he says it, at least. Not without trimming his (occasional) moustache into a neat little paintbrush. You know, more like that highly-strung German chap who stole Charlie Chaplin’s look (minus the hat and cane) in the 1930s.

But that word “delevering” – it throws up the real problem sparked by declining asset prices: the gap between what they’re now worth, and how much money was borrowed to buy them.

“One in five US homeowners with mortgages owe more to their lenders than their properties are worth,” First American CoreLogic goes on, as quoted by Reuters, “and the rate will increase as housing values drop in states that have so far avoided the worst of the crisis.” That army of drowning, not waving debtors now threatens to swell by one-quarter if home prices slip only 5% further from here, as well.

Negative equity, of course, doesn’t in itself force default. It’s inability to pay, most often sparked by loss of income, which forces late payments. But negative equity makes the problem systemic. Because it gears up the net loss and spreads it from debtor to lender, levering the pain of foreclosure from the hurt of the home-loser to the net lending loss suffered by banks.

Lenders end up out of pocket – and so too might their lenders in turn – even if they can sell the house reclaimed to settle the mortgage. All of which, as we say, just replays the merry-go-round spiral of soaring house values and E-Z credit in reverse.

“Making Home Affordable will offer assistance to as many as 7 to 9 million homeowners,” said the Treasury on Wednesday. (Note the friendly, if all-too pessimistic, use of the singular “home”). Yes, the new commander-in-chief is leading a fresh charge against house-price deflation and the still-surging surge in foreclosures.

Once more, with feeling!

“The Home Affordable Refinance program will be available to 4 to 5 million homeowners [who] would be unable to refinance because their homes have lost value,” the Treasury went on, “pushing their current loan-to-value ratios above 80%…

“The Home Affordable Modification program will help up to 3 to 4 million at-risk homeowners avoid foreclosure by reducing monthly mortgage payments.”

Now throw on top the one million mortgagees expected to declare themselves bankrupt when Obama’s “cram down” bill wins the day in Senate (which it will), and up to 10 million American home-buyers look set to refinance or re-modify their loans, just 15 months after Dubya Bush and Hank Paulson swore blind that refinancing and re-modifying would stem the depression in housing.

Might it work this time round instead? Given that the cram-down act will enable federal judges to extend mortgage terms, slash the interest rates agreed with lenders, and cut the outstanding debt owed by insolvent homeowners, and you might expect the flood of foreclosures to slow. Destroying 1,000 years of contract law should achieve nothing less, you might hope. And that might stop home-prices tumbling. Right?

“Throughout 2008, the re-default rate ranged between 30% and 40%,” explains Hope Now, defining such recidivist shame as “any mortgage that is 90 or more days delinquent or in foreclosure 6 months after the date it was first modified.”

One-third of bad loans turned bad once again, in other words, even after the lender cut the debtor some slack. So perhaps the new hope for housing should just cut straight past the chase and go to the credits. Y’know, the bit where the state seizes outstanding home-loans entirely, and re-modifies their terms to give houses away free to what once were called “the buyers”.

Any house first bought for “no money down” should become a no money home, a free gift to the debtor. How’s that for putting a floor under prices!

“More householders than ever own their homes,” said the Census Bureau in 2001. Way up at 66.2%, however, that record ratio wasn’t high enough either for government or the finance industry. Hence the non-stop shilling by President Bush of home-ownership as a way to defeat racism, poverty, Bin Laden, you name it.

The number of owner-occupied homes had in fact swelled by nearly one-fifth in the previous 10 years. And since the 1990s marked prosperity (and even a shrinking fiscal deficit!) as interest rates ticked lower, runaway growth in home ownership was surely been an unalloyed good. Only an anti-American fanatic would think otherwise, you’ll agree.

But smothering fresh chunks of California, Nevada and Florida in hard-top failed to concrete over the basic facts of economics, however. Because where demand finds itself sated, but supply continues to build, over-capacity follows and prices start to fall back. And even before the housing recession became a depression, excess capacity was building fast in the US housing supply. The rate of occupation slipped from 87.5% to 86.4% between 2005 and 2007, while the total number of units crept higher to 128.2 million on the Census Bureau’s latest data.

Trying to stall or reverse this cold fact will clearly take more money – and more stupidity – than even the Bush administration could throw at the task. Such as, say, via fascism or hyper-inflation. Put a floor below prices, beneath which it’s illegal to sell; or allow house prices (if not the S&P too) to slide only in real inflation-adjusted terms, printing money to inflate the cost of living while nominal realty prices hold steady.

That would allow the slide in real asset values to continue, even as nominal prices stay flat or fall. Because short of socializing all houses and so taking their value to zero – a trick tried to sad effect across Eastern Europe c.1917 to 1991 – this tinkering and tweaking is just fighting a trend that cannot be stopped.

In this credit deflation, where the nominal price of all things is shrinking, that which inflated the most should now shrink the fastest. Both its share of total economic value and its absolute pricing are working to reverse their misallocation over the last decade and more.

And double the inflationary trouble means double deflation once the bubble has burst – as the financial services industry is only just finding out as well.

Regards,
Adrian Ash
BullionVault

March 9, 2009

Hope Now: Pretending People Can Keep Their Homes was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

DAY TRADERS in spring 2000, shoeshine boys in 1929, the “meaner rabble” in 1720s London…

Glancing at the history of speculative bubbles, as we do all too often here at BullionVault, we find the ordinary sort, in fact, acts as the very pin itself.

The one thing needful at the top of each bubble, the rabble also takes on the role of greatest sucker, too. Piling in as the smart money runs for the exits, the common or garden investor pays top price. He or she is then left holding the “asset” as its price collapses…and by that time, the Lear jets have long since cleared the tarmac…taking the money with them.

Think of it as the classic “life cycle” pitch from your financial adviser, only with a sidesplitting twist. There, you’ll find a retirement wannabe moving from “accumulation” to “distribution” and then “legacy.” In a market-wide bubble, by contrast, the smart money first accumulates an asset, before distributing it to the dumb money, which is then left holding a legacy of wipeout losses and debt.

Ha! It’s a laugh a minute when the poor schmucks find the “wealth” they’ve gathered is evaporating in the sell-off.

But something’s amiss with the pattern of the latest financial bubble to burst — the bubble inflated by cheap home loans worldwide. Yes, “Every fool aspired to be a knave,” as a broadside noted of the South Sea Bubble nearly 300 years earlier. No-doc and low-doc loans aren’t known as “liar’s loans” for nothing.

But rather than the fools merely failing to turn knave now they’re losing their homes, they have also succeeded in pushing the foolishness far higher up the food chain. The greatest excesses have come at the top, up in the marble-topped kitchen of haute finance — where the mortgage-backed securities, credit default swaps, and collateralized debt obligations still can’t be served, mercifully, to ordinary investors calling their broker directly.

Driven by the “liar’s loans” of 2003-2006, in fact, this last gasp of air into the U.S. housing boom saw the mortgage lenders and their creditors — the investment banks — playing the fools every chance they got.

Mortgage lenders happily played the fool, apparently safe in the knowledge that the magic of securitization — of packaging home loan assets for sale to other financial institutions — would get them “off risk” quick smart. Why worry about risk when appraising a new loan? The chance of default by the wannabe homeowner was set to become somebody else’s concern.

Nor was the chance of default a concern for the investment banks, either. In running the sale of the home loan-backed bonds, they simply passed on the risk…letting it trickle through their fingers in return for a fat fee. Bundling higher-risk securities into a CDO with enough boxes ticked to qualify for a triple-A rating, managers could earn up to 0.75% of the sum total. One asset manager says he’d expect a payout of $2.5 million each and every year until maturity on a $500 million CDO.

With the moneymen playing the fools so gladly, therefore, it’s no surprise to find mortgage underwriting changed beyond recognition between 1998-2006, as First American Financial recently reported:

• Adjustable-rate mortgages as a percentage of new mortgages rose from 0.7% to 69.5%
• Negative amortization loans, for which the principal owed actually increases over time, rose from 0% to 42.2% of the market
• Interest-only home loans, for which the borrower has to cover only the interest due, leaving the principal for repayment sometime in the far future, rose from 0.1% to 35.6%
• Silent seconds, issued on the back of outstanding loans to the most vaguely related people, rose from 0.1% to 38.7%
• Low documentation — where the greater the lie, the greater the loan — rose from 57% to 79.8%.

In short, the U.S. mortgage market switched from cautious fixed-rate borrowing to head-in-the-sand ARMs…while the underlying debt was left untouched or actually grew larger…as borrowers struggled to meet just the interest alone after fudging the numbers to bag a loan they could never repay.

Most shocking of all, as Robert Rodriguez of First Pacific Advisors has noted, “is that the origination volumes for the last two years, when the most egregious deterioration in underwriting standards occurred, total more than the previous seven years of originations combined.”

In short — and just as in every bubble before it — the value of cash taken out by the smart money at the top of the U.S. home loans scandal was greater than the entire accumulation preceding it.

Quite who this smart money was, however, remains a real mystery. For the dumb money pumped in at the top actually came from hedge funds and Wall Street insiders, rather than flowing to them! This time around, it was the smartest guys in the room who played sucker — lending money to homebuyers with no thought for risk and no hope of repayment.

A victory for us poor fools at the bottom, perhaps? Trouble is for the “meaner rabble,” of course, the knaves and the fools at Bear Stearns, Queen’s Walk, Basis Capital, IKB, BNP Paribas, Barclays Capital, and everywhere else using our retirement savings to inflate that last gasp. Put mortgage-backed tomfoolery aside, in fact, and you’ll find the same problem — professional investors neglecting the concept of risk in search of easy returns — right across the developed world’s pension portfolio right now.

“24% of all the hyperleveraged assets managed by large hedge funds ($1 billion or more) internationally belong to pension funds and endowments,” says a June 18 report from Greenwich Associates, as quoted by Paul Gallagher in the Executive Intelligence Review. “This average is just below the 25% limit at which an individual hedge fund, under the [U.S.] Employee Retirement Income Security Act (ERISA) as modified in 2006, becomes an investment adviser with fiduciary responsibility for the pension fund doing the investing — something hedge funds, obviously, do not want to do.”

More than that, pension funds have also stumped up one-fifth of the money held in “hedge funds of funds,” the aggregating superfunds run by many large banks. In the first half of 2007, around 40% of current flows into the hedge fund industry have come from pension funds. And “As pension fund money is coming in,” says Gallagher, “it’s allowing ‘smart’ money to get out.”

Or rather, the flood of pension fund money was allowing the smarties to get out before the start of August. Now even the dimmest pension fund trustee…sitting on even the farthest flung beach for his vacation…will know just how foolish buying mortgage-backed bonds and derivatives would make him today. Quite how the so-called smart money now plans to exit the high-leverage debt markets is anyone’s guess.

“The overall flow of capital into hedge funds has dropped dramatically — from $40 billion each quarter over January-September 2006,” Gallagher goes on, “to just $12 billion in fourth-quarter 2006, and $20.7 billion in first-quarter 2007. Numerous reports, including a new one from Chicago-based Hedge Fund Research Inc., have shown ‘high net worth individuals’ reducing their net hedge fund investments by half between 2006-2007 — investing instead into real property and stocks. They now account for only about 20% of the assets of hedge funds, which were supposedly made for them.”

Instead of high net worth billionaires, it’s now Joe Public left holding this junk, thanks, of course, to his well-paid retirement fund managers. As late as May of this year, Jean Fleischhacker — a senior managing director at Bear Stearns — was telling fund managers gathered in a Vegas ballroom that they could generate 20% annual returns from unrated mortgage-backed credit derivatives. The Dallas Police and Fire Pension Fund bought its first CDO in early 2005. “We were beefing up our risk, and we were hoping for a greater return,” said Richard Tettament, head of the $3.2 billion fund, to Bloomberg in March. He couldn’t say what kind of collateral was actually backing the CDO, but he reckoned the returns were above 20% in 2006. The largest bank in the United States, Citigroup, recently sold $140 million in just this kind of unrated junk to the California Public Employees’ Retirement System, too.

Members of the CalPERS scheme have just got to wonder, along with the rest of us: How much is that $140 million worth today? Because the “meaner rabble” really did climb on board this mega-geared bubble in liars’ loans.

It’s just that in this money bubble, most people had no idea they were even involved — let alone put at risk. It should offer small comfort, however. Giving control of your money to a financial “expert” might indeed prove the most foolish decision of all.

Regards,
Adrian Ash

August 17, 2007

A Bull Market in Fools was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.