Tuesday, April 22, 2008

Wall Street fairy tale

I wasn't going to write anything tonight, but a visit to Calculated Risk http://calculatedrisk.blogspot.com/ got me started. For those of you that found me from this site, I am glad you came. For those of you that know me from my outrageous posts and my refusal to join the inflation goes on forever to the sky crowd, I am glad you are here.

The news gets more confusing all the time, but the truth leaks out from time to time. The truth is the world has reached the tower of Babel level once more and the tower is about to topple. The size of the world economy has reached a level that is too large for the existing resources to support and too large for the United States credit machine to fund. We have run out of coal to put on the fire, as our housing was the last vestige of a consumer asset we had left. Now we are left to sell our multinationals and our food stuffs, which won't go on for long as the rest of the world could very well buy up the US food supply many times over with the amount of money floating around in the system.

Calculated risk had a short article about Shiller and his forecast that the housing problem might be larger than it was during the depression. There is no doubt that housing has had the means to be inflated onward and upward for several decades. The US isn't like Hong Kong or England, where prime real estate is centered in one special spot, but instead has a wide variety of housing markets, leading not only to more supply, but a harder to drive price spiral. The US has had, for a great number of years, the means to have a housing bubble, but the wide supply range has kept this from occurring.

Not this time. The credit bubble blows bubbles in all directions. What we have today is an unsupportable debt bubble that creates one group, unpayable debts that support through intermediaries, unpayable deposits. The middle men, banks, Savings and Loans, credit unions, brokerage firms and insurance companies to name a few are obligated for the difference between what is collectable and what is owed to depositors. In the meantime, the depositors are stuck with excess cash yielding insufficient interest rates seeking higher returns. The problem is that the buyer and seller merely trade cash and it never leaves unless it becomes the temporary property of the debtor who then puts it out of existence by paying their debt.

This is how bubbles get started. Since high prices lead to higher prices and high prices for assets always lead to low yields, the seeking is for a capital gain and not for an investment. An invetment would imply that the asset purchased could actually carry itself financially. Any examination of speculative real estate will find that it will rarely if ever rent for the payments and if we are talking about paying cash, sometimes it will barely bring back the taxes, insurance and maintenance. It is hard to call a total hedge against inflation as an investment, as there is no return against inflation.

But, once the game is spotted, it becomes a bigger fool buying from the previous bigger fool until they run out of fools. Sometimes the fools they run out of are the fools that finance the stuff, as they eventually are the ones that have to stand for the loss. When this stage is reached to any significant degree, we enter a new game called make believe.

The game of make believe works like this. It beckons back to yesteryear when the outlook was bright and cheery and everything always came back. Every thing always comes back as long as it isn't killed. That is what is different between speculative cycles and bubbles. The cycles always have worked out the make believe, where as the bubbles are a series of make believes come true that turn into a nightmare that doesn't end. The bubble has burst after decades of housing slowdowns being followed by booms and more slowdowns. Each was accommodated by easier credit, as they began to create statistics to show that only occasionally do housing markets get into trouble and they are almost alway local and center around the economy. Well, what happened when the stock market went bust in 2000? A recession? Not in housing there wasn't. Every record that existed in home sales prior to 1997 was decimated every year we were supposedly in a slow economy in the 2000-2004 period. Thus we had a downturn that was a boom in housing. When we should have taken a breath, we sped up. That is what a bubble does, defies economics. It defies the laws of supply and demand, the laws of the business cycle, the laws of risk and return and all the laws, and most certainly the law of reason.

What we are seeing today is the government attempting to keep the bubble going. Previously existing home sales are close to 5 million. This blows away the pre-1997 record of 4 million, but we are hearing about a housing bust, not a housing boom. This means in securities terms that people are buying falling knives and the government is trying their best to finance the speculation. Remember this when you look back at the carnage that occurred from events after this bubble burst because it will have been facilitated by the greatest cover-up in history.

What is the cover-up? I think the real cover-up is that honest inflation is over and deflation starts once the cat gets out of the bag. I am going to pick on Goldman Sachs as an example because I know just enough about Goldman to be found to be ignorant of the entire picture. But what I know is there is something rotten in NY. Goldman paid its 30,000 employees somewhere in the neighborhood of $21 billion last year. That would be a fine place to work with an average paycheck of $700K per year per employee. A good part of this was performance bonuses, I would say likely earned on what are called today, Level 3 assets.

This is a smoky term. Rather than take the write downs that Merrill Lynch and Morgan Stanley took, Goldman mysteriously moved something like $30 billion from Level 2 to Level 3 assets. I think Level 3 derives its value from, well lets look back and use our imagination. Well, I know of some damn nice land that I wish I could get a loan to buy using my imagination of what I think it should be worth. I think I could put 100% of what it costs in my pocket, plus buy a 5 year annuity to make the P&I payments. But, I couldn't sell it for anything close to what I could imagine it to be worth. This is one of the things that makes land investment such a torture. In any case, Goldman paid huge bonuses for stuff that probably bankrupted the company.

What would happen if the auditors went in and declared a spade a spade and Goldman was broke to the world? The world supply of toilet paper would be drawn down in half by noon on such a day and the sewers flooded with you know what. What would break Goldman? The revelation that what they held to be good securities on their books were actually junk and not collectible. Goldman has something like $60 billion of this doubtful crap on their books, twice their net worth. The idea the housing market is going to walk again very soon and walk like it isn't crippled is all that is holding this stuff up to the world as potentially worth anything.

There are a bunch of them out there not coming clean. I think the banks coming clean are doing so only because they want to get the capital infusions ahead of those that might be too late for the willing parties to infuse anything. But, if Goldman came clean, then they would have to give back those huge bonuses that were earned off profit making losing propositions. I am wondering about Wells Fargo, another bank engaged in subprime lending and large in the mortgage business. Where are their losses? Are they God and too damn smart to make bad loans in a market where everyone else pretty much went bust? Hear no evil, see no evil, speak no evil? It goes on and on.

Then we have the import market, the domestic market and the stock market. The US consumer binge has been run off home equity. So has the education system and the stock market. Do you think the earnings of SPX companies are going to sustain themselves in a debt deflation? I think the stock market could fall 90% before this one is done and home prices 50%, enough to wipe out the mortgage lending business.

There is a whole lot at risk here. For one, the deposits in banks don't go away as bank liabilities when their assets go bad. In a sense they do go away with the bank because the only means to pay the deposits is with the deposits. No one else has any money to collect or should I say to pay into an insurance fund. You could say inflation, but what if the value of all deposits in the US fell without any new deposits being created? It is clear with all the junk debt companies out there that debts never die and I would venture there will be a system of digging up corpses to get the gold out of their teeth before this one is done, but in any case money disappears when debt is paid. If we suddenly saw the dollar lose 50% of its value without any new lending, do you think we would have inflation or deflation over a longer term?

There is no doubt in my mind that we would see a huge deflation even though logic would scream inflation. For one, who would be able to borrow money at 100%? Second, the reason we are in this trouble in the first place is debt is going bad, not because it is safe to lend to all comers and all securities can now be made to perform as AAA. That was what got us in this and it won't be done again for maybe 300 years. Third, those with cash balances would likely hoard what they had and not spend it at all for anything other than necessities, leaving consumer goods unsold. People forget those that have cash have it because they didn't give it up. They won't throw it out because they suddenly feel poorer, unless they use it to acquire some asset for sale by some debtor so he can use the money to get out of debt and extinguish it.

Then there is the GSE's. I am getting the drift that the US is done selling the world any kind of debt that doesn't say direct obligation of the US treasury. This means that the indirect guarantees mean nothing. Why buy them if you can get the real thing? It is clear that suddenly if they aren't buying Sallie Mae debt, then the debt of the GSE's, FNM and FRE and their dreaded link to mortgages isn't going to be appetizing for the world markets. We are about to see the Fed have to buy up the credit line of FRE and FNM due to the fact they can't move their own paper. This can't go on for long.

The point here is that we are stuck. Either we enter into mutually assured destruction or we take a chance the market will work its way out of this with new brokerage companies, new bank accounts and some fashion of keep from starving socialism to float the bankrupt. In either case, the country is broke and the world is broke along with the country because all that is owned by the rest of the world was borrowed by the United States. The inflation game has no solution at this point. There is no way that demand can be sustained by inflation, as the only inflation machine in the world is the US. The inflation cookie jar is American housing and American housing is collapsing in price during a boom. What happens when housing sales go back to normal, in the 3.5 million range? It appears to me that we then have as many as 2 years supply of homes on the market and the only remedy for those that have to sell is foreclosure. There are vacant existing homes in the US that exceed 2 years supply at this time, meaning that to solve demand, no one would have to move for 2 years and all the housing needs could be solved. This isn't a situation where we have a 90 day down period and the sales pick up with the economy. In fact, the economy is hitting on all cylinders, except the housing bubble has burst. The only reason we are selling 5 million units a year is the economy is booming. A recession takes home prices to the depths of hell and sales maybe down to 2.5 million, half of what we see now. It also destroys the fairy tale Wall Street has read to us.

Tuesday, April 8, 2008

Who has the free money to get us out of this?

There is a guy on the Prudent Bear board who calls himself Raven. Raven comes along every rally and tells the bears they are going to be buried by a record move in the market up. He isn't the only one out there calling for a massive rally to bury all bears and make all that are in rich. CNBC parades these guys across the stage every day. Monday, April 7, 2008, Washington Mutual received $7 billion in new capital for essentially 50% of is stock. The new price was $7 per share though Wamu was trading for around $11. Bulls had another one fixed, at least they think so.

After examining the Wamu deal, I had a sneaking suspicion that quite possibly the buyers found a place to cover their shorts. That would be an innovative deal, to short cut someone else causing a run on the stock by putting up money and thus making it impossible to exit a winning trade. This is a novel idea, especially if the players had use of the short sale money. Under the idea of repurchase agreements, it isn't beyond the realm that this very thing happened. Should a group have shorted this stock at lets say $30 per share and up and built a large position, they would now be in position by taking $7 of this $30 per share and buying 100% of the stock they were short with the funds they received from the repurchase agreement. Instead of putting in $7 billion, they would be walking out with $23 billion. This is a far fetched idea, but with all the scams that go on this day and time and the thieves lurking in the securities game, I wouldn't be surprised.

But, this is a theoretical idea of where to get some money. In any event, a capital infusion in a bank goes into outer space. A bank can only use money as a balance sheet entry and it ceases to exist as soon as it is paid into the bank. This means there is now new debt out there with no mathematical solution. Selling what you don't own to get money and creating money in a fashion that it can only exist in the minds of men and nowhere else are pretty wild ideas. But, where does the consumer who has to either own equity positions in what he sells or go to prison for conversion, get his money?

Greenspan was on the TV today. Greenie didn't have good news and Maria Bartaroma knew it and kept changing the subject. Greenspan was there to defend his record which is getting worse all the time after earning the name Maestro for his management of the Fed. For those that don't understand the system of banking, Greenspan might as well have been using Greenspeak. But, he was amazingly clear on what he was saying. What he was saying is don't look for things to turn around very fast.

The bulls are treating it like it is past and better times are ahead. Greenspan said exactly the opposite. He pretty much said the banks and Wall St. firms had a lot of deleveraging to do. Now, how do banks and Wall St. firms deleverage other than taking loans and securities off their books? Would it be possible that the massive run up in money supply has been through the massive need for money to carry the crap that the banks and Wall St. firms got stuck with? I think it is very possible. Not only possible, but very probable. In fact, I think it is pretty much the case. How much credit can a firm like Goldman carry if they go 15 to 20 to 1? A trillion dollars? $500 billion? Multiply that times 3 or 4 and you might get the idea if it has all been piling up instead of being passed through? Of foreign countries, how many want any debt marketed by Wall Street after this debacle? How much do you think they lost on CDO's? I bet it is many times what the banks have reported. You think they want more of them?

In any case, they either take in capital and make the money represented by the capital disappear or they cut their loan portfolio to deleverage. There is a lot to be sold and no money to buy it, so it will have to be marked down. What do you think these Fed loans are? They are funding loans the banks made to themselves that they expected to borrow from another bank instead. The banking system was insolvent or at least the very largest lending banks were. They are continuing to allow for the use of credit cards, but then again, credit cards are fee generators. But, the prime lending is getting tougher and tougher. With inadequate capital, few banks are in position to take the risks.

What we had was a subprime boom. We have been riding subprime for a lot longer than people think and we have been living off home equity for at least the past 30 years. Now the ball is rolling backwards. There won't be any subprime to get us out of this. This is what the bulls are missing, no subprime, no bull market.

Greenspan said the players were now insisting on re-regulation. We get the idea it was the people that wanted it, the Congress, but he says it is the investors and the banks themselves that want it. This is very important because it is going to restrict the leverage employed and most likely remove so many derivatives from the game. There are those that think the game is going back to normal, but no one wants the products the last game produced. We probably haven't seen the end of the game yet.

Greenspan also said there would be losses as long as the housing market was down. It was reported today that pending sales hit an all time low. What they left out was the all time low was since 2001. The Realtors Association is using bubble data and calling it all time low type stuff. It is missed on this idea that housing has been in a bubble since the mid 1990's, at least the sales have been there. Prior to 1997, we never sold the minimum number of homes sold in a year since, including 2007. This is new or preowned and we are still close to 5 million in preowned home sales. The market had never done 4 million prior to 1997. Thus we are still in a boom, taking on risky buyers in the sale of real estate.

This is not a new paradigm and it won't go on much longer. The PMI companies are getting killed. Next it will be the GSE's and the private label mortgages, which have already been waxed very badly. There is a lot of crying going on when in fact the industry is operating at boom levels and prices are declining despite this fact. To base data against a fiction is deceptive and this is what is going on. People would be stunned if they took this year out of context and compared it to those years prior to 1997, to find that the sales are records against the non-bubble years.

What does this all say? I believe it means we have real troubles. For one, the bulls have been diving into the home builders and the financials. They have also been hot on the gadget companies like Apple. The homebuilders can undersell the market until the market drops to where they can't build at any profit whatsoever. I think we are headed there, quite possible with 2 years supply of homes on the market before this one is done. Every subprime sale that occurred in the previous decade won't occur in the next decade. Before it is all done, FHA, FHLBB, FHLMC and FNMA will all need to be bailed out. So will the PMI companies. Where does the industry go if the zero down game is done?

How important are homesales? Well, when a home is sold, it frees up a lot of cash. Should a 40 year old sell a home he bought when he was 30 for twice the money, quite likely he will take this money and pay his credit cards or put it in the market or save it for college and get a maximum mortgage on his next home and take advantage of the home interest deduction. So, a $200,000 sale will free up maybe $80,000. This might be as much money as this guy makes in a year or 2. The consumer spending boom is dependent on such a game.

I don't know if you know where I am going with this, but Who has the free money to get us out of this? The bulls seem to think it is coming. I don't know where they are going to get the buyout financing that drove the market last time? I don't know where they are going to replace the stock buyback money that was coming out of the financials? Who is going to replace the easy credit given creditless people? What is going to happen to corporate earnings if activity declines even 2%? Have any of you ever examined the earnings of an automobile company during a recession and the boom afterwards? With a very marginal increase in sales, they go from going broke to record profits. What finances China and India? Don't you realize that the US has created all the basis of credit in those countries and without extra dollars, they cannot expand their economies? Does anyone recall what happened to Japan in 1990 after the US sneezed?

The question that keeps getting asked is why isn't the market lower with all the shoes dropping? For one thing, they haven't allowed any shoes to drop. They are all dangling and we haven't yet to see what the impact of keeping these shoes in the air from hitting the ground. What few realize is what the Fed is getting for all this cleaver financing is the capital base of all of these companies. Also, they don't realize that we haven't seen the earnings impact that is going to occur from this mess. Every prediction has been wrong so far because they aren't operating in reality. Reality is there are 3 to 4 million preowned sales in a good year, not 5 million in a bad year. Reality is that people are spending good credit, not soaked in subprime credit. Reality is that AAA means AAA, not junk bond CDO's leveraged to the moon. Reality is that trade is roughly balanced, not out of balance by $700 billion every year and rising.

The market is propped because there isn't anything in the US that foreigners can buy other than the corporations and treasuries. Who wants the crap that Wall Street presented us? What is going to happen when the interest rates rise enough to induce the solvent banks to trade their cash in on t-bills and leave the insolvent ones perpetually propped up by cheap Fed credit in return for their performing assets? When is the market going to value itself according to risk instead of derivative portfolio? We are looking at a risk free rate of return out of the SPX and it will go negative as soon as earnings adjust to the new financial reality