Friday, June 27, 2008

Subprime or Prime, That is the Question

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It is amazing to me how I keep reading, over and over again, about the 'subprime' problem. Starting a couple of years ago, and back then, justifiably so, the term stuck.

Not only were people with low credit scores given fixed rate loans, as time went on, the guidelines and terms got better and better for the subprime borrowers. Soon it was 100% financing, then 102 and 103% financing, then no doc/stated income, meaning they could claim whatever income they wanted, with little worry the LO or lender would check. Yes, even those loans were 100% financing.

Next, the 'smart' people that run Wall street were so hungry for more loans to securitize, they began to offer adjustable rate, 100% loans. These loans could start out with a small rate, then reset to a larger rate. More often than not, these resets are proving to be more than these people could afford.

As could be predicted, it was the loans given to people with a proven track record of not paying bills on time that blew up first. But how big a percentage of overall loans over the last few years was this 'subprime' group?

By 2005, subprime loans had become 20% of all mortgage originations. In 2006, subprime loans became 24% of loans originated. It was in 2006 most of the subprime companies began to realize major problems, mostly with their buyback agreements. A clause in most of the agreements would force the originating lender to buy back the loan if it went into default. By 2007, subprime originations had fallen as a percentage of total loans to less than 10%.

The rise in adjustable rate loans has been more dramatic, and more encompassing, than the subprime arena. Washington Mutual became famous within lending circles for its Option ARM programs long before awareness of a 'subprime' problem. Countrywide followed suit, and took it to the next level with its "Fast and Easy' program. Fast and Easy became known as 'fast and sleazy', mainly because they were not verifying incomes, even though they had the borrower sign a piece of paper allowing Countrywide to pull past tax records to verify income.

Countrywide then sold these unverified loans to FNMA and FHLMC as prime loans. These loans are now defaulting at a rate greater than subprime. The fate of FNMA and FHLMC are in great peril because of the 'prime' loans Countrywide sold them, that now look to be 'not so prime'.

I still read in newspapers only about the 'subprime' problem. I still hear on CNBC, FOX and CNN about the 'subprime' problem. The majority of loans now defaulting were not subprime at the time of origination. They were 'prime'. The one thing they all have in common is they were, and are, adjustable rate loans.

The reason for most of the defaults is this simple fact - at the time of origination, the borrowers could afford the initial rate. Whether they bought for speculation or not, almost every borrower anticipated that when they took the loan the value of their property would go up. If they could not afford the reset, conventional wisdom was they would be able to refinance, get another low initial rate, and get a little extra cash, because, of course, the property would be worth more.

Because of this thinking, the idea if someone could actually afford the new, higher rate at reset was rarely factored in when considering ability to repay the loan.

Well, for the last 18 months, property values have not gone up. In fact, nationwide, property values have decreased more than 20% since January 2007. As each month goes by, a new phenomena rises in frequency, that of "Jingle Mail". Jingle Mail is the term assigned to homeowners who are walking away from houses because they are upside down in their mortgages, implying they are mailing their keys to the bank. Their reasoning is "why pay 25% more for my house than it is now worth, plus interest, when the same house across the street I can rent for 1/3 the monthly payment?"

This type of action from homeowners, unfortunately, is just starting.

Consider this; Mish at Global Economic Trend Analysis has been tracking one 2007 MBS bond issue from Wamu.
* The original pool size adding up all the tranches is $519.159M.
* 92.6% of the entire bond was rated AAA by both Moodys and S&P.
* 22.89% of the whole pool is in foreclosure or REO status after 1 year.
* 31.17% of the pool is 60 days delinquent or worse
* The top 5 tranches constitute $476.069M out of an original pool size of 519.159M. In other words, 91.7% of this entire mess is still rated AAA.

Folks, these are not subprime loans. They are prime and Alt-A. These were given to people with good credit scores. What's worse, is this entire MBS issue is heading for a complete rating downgrade.

These are all adjustable rate loans.

This is one of thousands of derivatives not yet downgraded. This particular MBS is actually better off than many others that have yet to be downgraded. Most of the MBS yet to be downgraded consist of 'prime' loans.

Because these loans are considered 'prime', the market, the ratings agencies, the banks have all been reluctant to mark these down. Many investment programs such as IRA funds, pension funds, retirement funds, both public and private, hold derivatives just like this one. All of these investment programs, plus many more, can only buy AAA rated investments. As these MBS issues lose their AAA rating, these investment programs must sell them.

This is one HUGE problem. Once they lose the AAA rating, they are not worth anywhere near what was originally paid for them. Everybody who has money in any mutual fund, IRA account, retirement fund, money market account etc. which bought any mortgage backed paper (which almost all of them have some) is going to lose money. Guaranteed. How much you will lose depends on how many derivatives your fund purchased. Do you know how to find these in your fund? It would be wise to find out, today.

A big part of the problem is how the media reports this. they continue to call it a 'subprime' problem. This creates the perception that less than credit worthy borrowers were given loans, and of course, the lowlifes are now defaulting.

By the end of this mortgage mess, many more 'prime' loans will default than subprime. Most resets for adjustable rate prime loans originated in 2005, 2006 and 2007 are still in front of us. Most of the loans originated in those years are adjustable rate. They will reset at a ratio based on what the prime rate is at the time of reset. The Fed has just sent a message to Wall Street that rate cuts are over, and rate hikes are likely.

The only way for people to realize this a huge problem is to stop labeling it a 'subprime' problem and call it what it is, an 'adjustable rate' problem.

Thursday, June 26, 2008

Gotta Love the Activists

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Life is interesting because of people like this. We need more of them.

I read Market Ticker almost everyday. Karl Denninger, who's opinions can be a little salty at times, is a genius. Karl has been an options trader for quite some time, and follows the markets with a sense of wit, wisdom and old fashioned honesty rarely seen in today's society. His ability to pick apart the actions of some of the biggest movers and shakers of the corporate world enlightens us to a view we cannot get in the mainstream media.

Do yourself a favor, as you find the time, to read what he has to say for the day. You may disagree with a few of his ideas, but you will always be entertained and informed.

The following is the whole excerpt from his most recent post. The subjects of my previous posts are an important part of why these people are protesting. I enthusiastically support them. Therefore:

Angry Citizens To Protest Federal Reserve and Government Fiscal Policies that have resulted in commodity price inflation, devaluation of the US dollar, and now threaten to destabilize the bond market.

Niceville, FLA (June 27th, 2008) – A group of Americans who met on an internet forum are converging on Washington D.C. from across the nation on June 27th to protest federal financial irresponsibility. The group, “Fed Up USA”, met for the first time last April to stage a protest outside Bear Stearns Headquarters after the Treasury announced $29 billion in guarantees to an LLC to entice JPMorgan to purchase the failed investment bank. This time, in Washington D.C., the group will continue to push for an end to government bailouts and the Federal Reserve’s acceptance of questionably-valued, unmarketable mortgage collateral in exchange for treasury paper. The group is also seeking greater transparency in financial reporting, elimination of SIVs and other off-balance sheet Enron-like accounting practices. The protest will begin at 8:00 a.m. at the Federal Reserve building. “Fed Up USA” plans to take the protest to the US Capitol later in the day.
The Federal Reserve’s acceptance of illiquid mortgages, car loans, boat loans, student loans, credit card receivables and foreign debt as collateral is unprecedented, even during the Great Depression. The Fed has already accepted so much questionable debt as collateral that it only has $25 billion of treasury bills left to exchange, representing 3% of its balance sheet at the time it bailed out BSC creditors. Karl Denninger, spokesman for “Fed Up USA”, explained the problem, “The Fed is in no position to orchestrate another bailout of a financial institution without calling into question the credit rating of the United States, the dollar’s status as reserve currency and the viability of the US bond market. But the Fed will do just that unless taxpayers demand that they stop. That is the reason it is so important to protest.”
“Meanwhile”, added Stephanie Jasky, “the Fed policy reliquifies banks to continue to lend to speculators without fear of risk as the Fed, in essence, has their back. That excess liquidity has found a profitable home in commodities, perpetuating the risky behavior that caused the problem in the first place. Furthermore, our elected officials appear to be encouraging fraud and financial irresponsibility by allowing banks to hide their bad assets. Instead, we are here to demand from congress and the senate that the speculators accept the consequences of their risky bets, not the taxpayers.”
If you’d like more information about FedUpUSA or to schedule an interview, please call Karl Denninger at 850-897-4854. Email is Website is

Sunday, June 22, 2008

Don't Open the Door

The Wall Street Journal gave a scathing editorial. It is unusual. The reason I say this is because, the WSJ has mostly been a cheerleader over the last two years, despite tremendous writedowns among major corporations. These writedowns have occurred in one area, the investments with anything involving housing. More specifically, the debt associated with housing. Already passed by the House, a new bill will raise the loan limits, and reduce downpayments, on loans issued by the FHA that would classify for subprime.
Congress, in its place of eminence, certainly believes it can defy logic, gravity and the sun rising in the east if it passes this bill.
The WSJ begins "Well, this certainly is embarrassing. The Federal Housing Administration – the very agency the Bush Administration and Congress trumpet as the solution to the mortgage crisis – has announced that it suffered a $4.6 billion loss last year." The bill, quickly making it's way through the house and senate, will increase the loan limits, and bring upwards of $300 Billion new subprime and Alt-A loans into the FHA portfolio.
GNMA, widely known as Ginnie Mae, is the conduit for all FHA and VA financing. It is the only GSE to have explicit backing of the US Government. If there are any losses, taxpayer money is used to replace those losses.
I believe there will be significant losses with this new batch of loans. So does the WSJ.
The larger question is this - Why should the banks that originate these loans, and make the profit on them, be allowed to unload them, and leave the American taxpayer to pay the bill?
From WSJ-
"The Government Accountability Office finds that default rates among low or zero downpayment FHA loans are about three times higher than on conventional loans. They go Bust." " Mr. Frank's House bill would allow the FHA to guarantee a loan up to 125% of the average home price in any area."
What??? Into a declining market?
Believe this; if this $300 Billion gets in the door, there is a lot more coming up the sidewalk, wanting to come in for the party; From WSJ -
"The most reckless provision now on the Senate floor would allow the FHA to take over risky subprime loans from private banks. When FHA Commissioner Brian Montgomery announced the agency's losses last week, he warned that Congress's subprime loan bailout could plunge FHA deeper into the red. Senate Banking staffers tell us that lenders have all but admitted that, if the bailout becomes law, they will dump their worst loans onto the FHA."
How high do you want your taxes to be? How low do you want your property value to drop? It is inevitable that your children, and probably grandchildren will pay for this. Wanna make it your great-grandchildren?
The only way this can work is if property values come back up to where they were in Jan. 2006, and come back very soon.
I don't think that can happen in the next few months, do you?
In fact, commercial property is just beginning to follow the residential slide. The drag on our economy this creates will spell the end for many regional banks. This is not my opinion, it is the FDIC's opinion.
More taxpayer money to cover the losses of the speculative real estate boom. Congress should not use taxpayer money to back the excesses of speculation. Keeping people in their houses currently paying something every month is wise. To increase the number of people who will go underwater with their mortgages.... well, that is another thing.

Sunday, June 15, 2008

The Pitfalls of Derivatives

Many people, by what I read in articles and responses in the blogging world, seem to think MBS, and CDO's and other derivatives are the same. There is a distinct difference. This difference, understanding it, and how it came to be may shed light on a somewhat confusing subject. It is also why I believe everyone should be a little more concerned right now.

A little history as backdrop

I began talking of the pitfalls of derivatives in 1998, after the demise of Long Term Capital Management. LTCM was only one hedge fund. Its purchase and issuance of derivatives, and its subsequent collapse, caused worldwide panic in the financial markets. The Federal Reserve Bank of New York organized a bail out of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets. Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, JP Morgan, Morgan Stanley, Salomon Smith Barney, UBS and other firms, all kicked in to cover the losses suffered by LTCM, and thus prevented systemic financial fallout from occurring. Understand, the money they put in, they never got back. They knew they would never get it back. These banks knew they had just stopped a meltdown of the entire financial system from occurring.

The flight to liquidity during the bursting of the tech bubble caused the collapse of LTCM. Investors sought the cash from their positions with LTCM. As LTCM tried to liquidate, or sell in layman's terms, the derivatives they had, these derivatives were returning far less than the value LTCM claimed they held. So, if someone had invested $1000 in a derivative with LTCM, they might get $200, $400 or $600 depending on which vehicle they had bought. Quite a loss from a firm that claimed to offer 40% returns.

At the same time, 1998, Senator Phil Gramm of Texas lobbied for the bill that would remove the last vestiges of the Glass-Steagall Act of 1933. (There was a second Glass-Steagall Act otherwise known as the Banking Act of 1935.) Glass-Steagall required banks to create separate businesses for deposits of savings and deposits for investments.

In 1999, President Bill Clinton signed into law the Gramm-Leach-Bliley Act which repealed the Glass-Steagall Act of 1933. Now, banks could mix assets held in their commercial banks with assets held in their investment banks. The Gramm-Leach-Bliley Act allowed commercial and investment banks to consolidate.

Deregulation of the energy and telecommunications industries in the late 1990's ran unabated. Coupled with the Gramm-Leach-Bliley Act, a toxic brew of new accounting opportunities opened for large corporations. Exemptions from accepted accounting practices could now be given.

Wendy Gramm, then head of the Commodity Futures Trading Commission and wife of Texas Senator Phil Gramm (the second-largest recipient of Enron campaign contributions), granted Enron an exemption from government disclosure rules at the company’s request; shortly afterward, she resigned from the CFTC and joined Enron’s board of directors.

We all know how that turned out.

Funny thing is, Phil Gramm is now a lobbyist for UBS, the large Swiss bank recently under scrutiny by the SEC for teaching wealthy American clients how to create overseas accounts to hide profits for the purpose of avoiding taxes.

Phil Gramm is also John McCain's lead economic advisor.

So, with all of these changes to economic policies, the stage was set for expansion of risky financial vehicles that the banks could sell for huge fees.

MBS and the derivatives built on them

There are somewhere around $600 Trillion in derivatives, globally. Most are built on the backs of US Mortgage Backed Securities and other debt such as credit card debt, auto loans, and even student loans.

MBS are derivatives of the first order. The issuer of the MBS gathers multlple mortgages, usually similar in nature (ie. Nov. 2006 first lien ARMs) and bundles them together. The bundles can represent $20 million, $100 million or more in mortgages. This is called securitizing, and creates a bond for the issuer to sell. This new bond of MBS actually owns the underlying mortgages. Should a mortgage contained within an MBS go into default, and subsequently be liquidated, through short sale or foreclosure sale, the MBS is first in line to get the money from those proceeds.

CDO's, CLO's, CMO's, SIV's and the like are derivatives of the second order. A CDO is usually made up of several MBS issues, each portion called a tranche. Each tranche is calculated to offer a certain rate of return. Most often, a few of the tranches in a CDO have very risky MBS, such as subprime mortgages, which have a higher rate of return, thus raising the overall rate of return of the CDO. CDO's squared, and all things similar, are derivatives of the third order. CDO's squared contain two or more CDO's put together.

All derivatives of the second order are bets on the performance of the underlying MBS or whatever debt is contained in the original securitization. All derivatives of the third order are bets on the performance of derivatives of the second order.

MBS and CDO’s are distinctly different, and I believe many people are not realizing that yet.

$ 13 Trillion MBS. $ 600 Trillion Derivatives. Is it sinking in yet?

Most of the twenty-five largest banks have exposure to derivatives and blown MBS representing 300%, 400% and some many more times, their hard assets. Chase is the single largest holder of derivatives in the world. There are somewhere around $600 Trillion in derivatives, globally. Most are built on the backs of US MBS and other debt. In Sept 2007, Chase had $92 Trillion in derivative holdings, almost 1/6 of all derivatives. Their hard assets in Sept 2007 were $ 1.3 trillion.

Theoretically, even with only a haircut of 5%, on paper, they are insolvent. The losses on derivatives, as a whole, will be no less than 50% across the board. They are bets on the performance of MBS. The derivatives of the second or third order do not own the mortgages, they are only bets on the performance of those mortgages contained in the original MBS. The MBS is still there, intact, and it owns those mortgages. The owner of a CDO cannot assume the property of a foreclosure represented within one of its tranches, because the CDO is only a bet on whether that mortgage would perform and reach maturity.

Already proven in court in Cleveland, CDO's have no claim to the underlying mortgages. The owners of over $1 billion in CDO’s tried to get the foreclosed properties represented in the issues they bought. The judge, once it was explained to him what the CDO’s were, laughed and tossed their case out. The attorneys could not produce any documents to show the owners of the CDO’s held the notes to those properties, because they don’t. The holders of the underlying MBS to those CDO’s hold the notes, and they aren’t giving them to the buyers of CDO’s.

Do not bet against Chase

I am not saying Chase is going bankrupt or will be taken over, exactly the opposite is true. Chase will be one of the big boys gobbling up damaged banks and other damaged assets. But, it is not due to their being healthy, it is due to the fact they are the largest shareholder of Treasuries held by the Federal Reserve. Other banks are not in the position of control that Chase and a few others are. Do bet against the banks that do not have the control, for they will be acquisition targets.

The Fed, if the worst case should happen with our economy, will be forced to draw a line in the sand. The entities on the correct side of that line in the sand, determined by their ownership of treasuries held by the Fed ,will be protected at all costs. Those not on the correct side of the line in the sand are a target to be taken over as they get hammered by writedowns.

Right now, it is a good guess that only three entities are on that correct side of the line in the sand. Chase, BofA and Citi. Citi will have more money from the middle east pumped into it. I do not like that two people from the Middle East now own 10% of Citi. Get ready, they are going to own at least 20% by the end of this mess. The Fed will use every resource to protect Chase and BofA. Why, because they will use the Treasuries that Chase and BofA own to protect them.

Almost all Derivatives built on MBS will return at best, 50 -60%, and only a small fraction will do that. Derivatives that include other debt such as credit cards and auto loans, forget about it. There will be some value, but it will be somewhere between 10 -25% by the time they can be liquidated. The Fed is allowing banks to now securitize auto loans, credit card debt and other junk, and exchange it with the Fed for US treasuries, which the bank can then go borrow against. The Fed, before the swaps, had around $800 Billion in US Treasuries. More than $240 Billion in the last 6 months has been swapped.

It is the exact amount that futures trading on commodities has gone up since January. So, when people scream about speculators driving up oil, it is the banks that are most in trouble that are the speculators. How do you like those cookies? Creating another bubble. What happens if oil retreats back to $110? Massive losses. Of borrowed money. Of borrowed money guaranteed by US Treasuries swapped with the Fed for dubious debt that might get 50 cents on the dollar.

Any losses of those treasuries will be replaced not by Chase or BofA or any other bank party to the swap, but with taxpayer money.

As for my prediction on what will happen - nobody has a crystal ball, but the losses are already there and being hidden in level 3. Everyday that property values decline, those losses increase. If the assets in level 3 are hedged with a commodity, such as oil, and it falls from a pop of the bubble, the losses are magnified. There is a good case for an L shaped recession such as Japan has experienced over the last decade or so. The problem with comparing it with our current circumstances is that our overall losses, due to derivatives, are a few thousand times greater.

A depression, maybe, if the Fed doesn’t stop with the swaps it is almost guaranteed.

Sunday, June 8, 2008

The Oil Boil

Hubbert's Peak, better known as Peak Oil, has become a subject much like politics and religion, not to be discussed at a dinner party. Since this is no dinner party, let's discuss it.

M. King Hubbert was a maverick in the field of geoscience. Besides Peak Oil, Hubbert explained the plasticity of large areas of the earths crust due to the immense pressures upon the rock layers, and that deformation of the Earth's crust was observable over time. No one disputes this theory today. Hubbert won several top awards for his field, served as President of The Geological Society, taught at both Stanford University and UC Berkeley, worked for Shell Oil Co. until his retirement, then worked for the USGS as senior research geophysicist. Yet, no one remembers him today for anything but Peak Oil.

In 1956, at an oil industry conference in Houston, Hubbert explained that peak oil production in the US would occur in the late 1960' or early 1970's based on current rates of usage, plus increasing rates of usage based on historical patterns. He was almost laughed out of the auditorium while giving his presentation. In 1970, his prediction became true. Every oil company, oil engineer and geophysicist agreed in 1970 that decreased production in the US was occurring, and no amount of new wells would change that. In 1975, The National Academy of Sciences confirmed their acceptance of Hubbert's calculations on oil and natural gas depletion, and acknowledged their previous estimates had been "overly optimistic." Hubbert became famous.

In 1974, Hubbert predicted global peak oil production would occur somewhere in the mid 1990's, again based on models of usage and increasing rates of usage. As before, cynicism dominated the responses. Other projections greatly contradict Hubbert's assertions; M. King Hubbert's calculations, and their implications for the world economy, remain controversial.

A little history

In 1980, the US had many issues facing it. Rising interest rates, fear of another oil embargo such as 1973, high unemployment, rising food prices and to add to that, our largest ally in the Middle East, Iran, had just deposed its leader, the Shah. To top it off, the students who made up the bulk of the rebels, stormed the US Embassy in Teheran and took everyone inside hostage. The Iranian students blamed the US for the 1953 overthrowing of a democratically elected leader, Mohammed Mossadegh, and the subsequent abusive reign of the Shah.

Poor Jimmy Carter just could not get anything going his way.

In the Presidential Campaign of 1980, Ronald Reagan offered a verbal assault on the Soviet Union, and a get tough stance with Iran. Veiled, and not so veiled, threats of military action against Iran were the norm during Reagans campaign speeches. The Carter administration was not making any progress in getting the hostages freed, and because of this failure, Reagan won by a very large margin.

In 1981, the total of US GDP spent on defense was around 8%. The Soviet Union, on the other hand, spent somewhere between 45% - 48% of their total GDP on defense, trying to keep up with America. The majority of their revenues came from the sale of oil, which they poured into defense. The USSR's infrastructure was lacking, food shortages existed, unemployment was high and the one element of pride all Soviet's could look to, their national hockey team, had lost to the lowly American amateurs the year before.

At the beginning of 1981, oil was around $40 per barrel. Oil has been the lifeblood of the US economy since WWI. The incoming Reagan administration was well aware that if they could get the price of oil lower, thus reducing transportation and production costs, it would provide a boost to the economy. The new leaders in the Reagan State Dept. also knew how much the Soviets relied on their oil revenues. Sometime in February or March of 1981, both the Saudis and Kuwaitis doubled their projections of known reserves of oil. There had not been any new studies done, nor any known miscalculations that were revised. Many believe that the Reagan administration was able to convince the Saudis and Kuwaitis to 'overproject', which in turn would bring down the global price of oil and ease economic pressures.

Many may disagree with this theory, but those that hold it point to the sale of five AWACS radar and intelligence planes to the Saudis, over the strong objections of Israel. They say that it was the Reagan administration's "Thank You" to the Saudis for doubling projections of known reserves, practically overnight.

The rest is history; the price of oil plummeted to $20 per barrel. The Soviet Union was denied half the revenue it was realizing from oil exports. Already underspent throughout its economy, the USSR was dealt the death knell with oil revenues plummeting. Thus, the decline of the Soviet Empire was achieved without firing a single shot. The Afghan invasion, and subsequent withdrawal of the Soviets, was merely a sideshow that allowed the Reagan administration to continue casting the Soviets in an ever increasing bad light.

Here's the problem; Saudi Arabia and Kuwait have never gotten off those numbers. They now even claim to have more, recently raising their projections, despite the fact that at Al-Ghawar, the largest oil field in the world, they began pumping in water in the late 1990's to force more oil out. The amount of water now coming out is close to 60%. That means 60% water, 40% oil. From what I have read, when the amount of water exceeds 85%, it becomes physically impossible to render the oil useful. That leaves me this question; If almost half of the oil left in the largest oil field in the world is not usable, does that mean the Saudis really only have half of the reserves they say they do?

The price of oil continues to go higher, even though both the Saudis and Kuwaitis have claimed they have more. Some of the rise in oil is speculation. Since December, large banks have exchanged their damaged MBS securities with Federal Reserve held US Treasuries through the TAF and other swap facilities to the tune of $240 Billion. It just so happens to be the amount of increase in futures trading in commodities since late December, but that is another story.

Besides, the amount of speculation has nothing to do with ramp up in usage by China, India, Brazil and Russia. What was not calculated by Hubbert or any one else in the 1980's was how much the increase in usage would be from Asia. It is almost 3 times what they used for their calculations back then.

There is also the problem with the value of the US Dollar. Oil has been, until recently, globally traded in US Dollars. Because of the rapid increase in our deficit, the value of the dollar versus all other currencies has gone from 120 to 73 over the last 6 years. That means the US Dollar will now buy 40% less than it would 6 years ago. The rise in such things as food and other goods is a direct consequence of the weakened dollar. The dollar has less value, so more dollars are needed to buy the same amount of goods.

It is easy to think that oil had to go up at least 40% in real terms. But, it has gone much higher. In 2001, oil traded at $20 or so per barrel. It closed Friday at $139 per barrel. That is somewhere around a 600% increase in 7 years. I am just waiting for the price at the pump to catch up.

Again, back to the problem; Hubbert predicted Global Peak Oil would occur in the mid 1990's. In the 1980's, some predicted Peak Oil between 2007/8 - 2015, as contrary positions to Hubbert. Well, we are here. Much of the hyperbole about drilling in ANWR and the Gulf of Mexico is superfluous. The projections for ANWR from the USGS would fuel the US, at current rates of consumption, for a period of 45 - 200 days. That's all. Why all the political wrangling? I'll leave that to you to decide. Just ask your congressperson this "If drilling in ANWR and other protected areas is so important, why is the majority of oil now produced in Alaska being sold to Japan?"

Yes, there are oil shales, vast amounts with as much oil as the middle east had 40 years ago. But the only processes to get it out are so environmentally damaging that the costs far outweigh the benefits.

The oil sands in Canada, and new technologies for retrieval, are very promising, and Canada will prosper greatly in the next decade or two. But they cannot extract it at the same rate the middle east has, thus, if the middle east production declines, so does the availability of oil.

Then there is the Williston Basin. It is within the contiguous US (and part of Canada). USGS gave projections last month of 4 Billion barrels, and that may be low. Other geophysicists put the reserves at 200 - 400 billion barrels. But that has yet to be seen.

I will, for the moment, go with Hubbert on this one. His track record with all of his work is pretty impressive. To end, I will leave you with a quote from M. King Hubbert;

"Our ignorance is not so vast as our failure to use what we know."

Saturday, June 7, 2008

Bernanke and Paulson

(Click on image for better view)

Courtesy of someone via Mike "Mish" Shedlock at GlobalEconomic Trend Analysis

Friday, June 6, 2008

Insurers in Trouble

On their website,, the Financial Times reports:

"NEW YORK (Standard & Poor’s) June 5, 2008–Standard & Poor’s Rating Services today lowered its financial strength ratings on Ambac Assurance Corp. and MBIA Insurance Corp. to ‘AA’ from ‘AAA’ and placed the ratings on CreditWatch with negative implications.
Along with those two institutional cuts, $1000bn (that's $1 Trillion to we Americans) of bond issues will also lose their triple A’s.'

"NEW YORK June 6, 2008– Standard & Poor’s Ratings Services lowered its financial strength ratings on XL Capital Assurance Inc. (XLCA) and XL Financial Assurance Ltd. (XLFA) to ‘BBB-’ from ‘A-’. The ratings remain on CreditWatch with negative implications.
The downgrade reflects our current assessment of potential losses on the companies’ 2005-2007 vintage RMBS exposure, direct and indirect, which is higher than previous estimates. In our view, XLCA and XLFA’s combined capital cushion is inadequate at the previous rating level to absorb those losses'

"Standard & Poor’s Ratings Services lowered its financial strength ratings on CIFG Guaranty, CIFG Europe, and CIFG Assurance North America Inc. (collectively CIFG, or the company) to ‘A-’ from ‘A+’ and placed the ratings on CreditWatch with negative implications.'

"Standard & Poor’s Ratings Services placed its ‘BB’ financial strength rating on Financial Guaranty Insurance Company (FGIC) on CreditWatch with negative implications. The rating previously had a negative outlook. Likewise, Standard & Poor’s placed all other FGIC ratings, as well as those of parent company FGIC Corp., on CreditWatch with negative implications."

Well, where can we begin?

To start, I wonder how many pension funds and the like are holding the $ 1 Trillion plus in RMBS and derivatives that must now be sold onto the open market, where there are no buyers? More importantly, is your retirement account one of them?

Every single one of the bond issues described above started as AAA, all within the last two to three years. To add to the enormity, these downgrades represent only a fraction of issues that have been and are being currently downgraded as housing valuations decline and foreclosures rise.

And to go from AAA to BBB-?!? From investment grade to almost junk in less than a year. With the bond issues on negative watch! KABOOM! Think the "Credit Crunch" is going to ease anytime soon? I don't. In fact, it just got a whole lot 'crunchier'.

How do Fitch's, Moody's and S&P not get regulators galore in their offices and in their books is a mystery to any honest people. They gave AAA ratings to Mortgage Backed Securities which were built on mortgages given to people with poor credit histories. That means they had a track record of not paying their bills on time! How could these securities get the same rating as the safest investment in the world, a United States Treasury Bond?

Yesterday it was reported that AIG is under scrutiny by the SEC. They are asking AIG how they valued their Credit Default Swaps (CDS) in light of the $5.29 Billion loss in the 4th quarter 2007 and the $7.81 Billion writedown in the 1st quarter 2008. Hmmmm. Yes, how did you value them?

Credit Default Swaps are used to insure RMBS, CDO's and other derivatives. As the derivatives lose value, the issuers of the CDS must make good on the losses. Doesn't take long to realize that with $600 Trillion in derivatives, with a 20% to 40% to 60% blow-up, that some very large companies playing in that game are going to go bye-bye.

Thursday, June 5, 2008

Mispricing of Risk

Everyone has now been affected by the market turmoil or rising gas and food prices or a reduction in the value of their home or all of the above.

It is all about the mispricing of risk. It has been actively occurring since the inception of financial vehicles that are called "derivatives." All the big boys at the big investment banks are in on it. So are the guys at the Fed and Treasury (they came from the big investment banks). In this decade, large pools of debt used to fuel the Leveraged Buyout Frenzy were accumulated by taking Mortgage-backed securities (MBS), dividing them into parts called "tranches", repackaging and then selling them.

The problem resides in the fact that all these pools not only include high rated mortgages (prime with good to great credit scores), they also include equal parts of subprime loans (bad credit scores) and Alt-A loans (no income verification). These are then packaged into investment bond vehicles called Collateralized Debt Obligations, Collateralized Loan Obligations and Collateralized Mortgage Obligations. Even though each of these "derivatives" have high levels of loans with questionable performance standards, they were rated AAA by all of the ratings agencies.

Many investment programs such as state pension programs, union pension programs, money market funds etc, are allowed to buy only AAA rated securities, and they bought these because they had a higher yield than other "safe" securities. US Treasury notes are AAA. The ratings agencies, with a little encouragement from the big investment banks, rated these obviously risky securities the same as US Treasury bonds.

Well, as you may have noticed, we have recently had a little downturn in real estate values in this country. This has created a landslide of foreclosures and late payments on loans. Since the performance on these "derivatives" is predicated on people paying their mortgage payments, uninterrupted, the ratings on all of these "derivatives" are actively being downgraded to A, BBB, or worse. Now, any investment program designated to only have AAA rated securities must sell what isn't rated AAA, at a loss, because the market won't bear the full value. If you have money in any investment program that bought derivatives, your value (principal) is now declining.

What's worse is there has been no active market for any of them since last summer.

Most of these derivatives have no buyers, so their essential worth is somewhere around $0.

Since there are no buyers, the accounting rules used by all the banks, brokerage firms, hedge funds and private equity funds allows them to claim that there are "no observable inputs", meaning there is no current market for them. Because there are "no observable inputs", the holders of these "securities" are allowed to move them from active balance sheets, "Level 1" accounting, meaning they must, at the end of the day, balance its worth just like you with your checkbook, to an area of financial accounting called "Level 3".

"Level 3" accounting allows the holder to claim the value of whatever product they designate "with no observable inputs". So, if a brokerage firm has a CDO they invested $1,000,000 into, they can still claim it has $ 1,000,000 of value if they move it into "Level 3". Even if there are no buyers, which means it may be worth $0.

In reality, most of these derivatives have some value, and the only reason there are no buyers is because anyone who may invest in these is smart enough to know we are nowhere near the bottom of the decline in housing prices. Since we are nowhere near the bottom, it is hard to estimate how many foreclosures, thus defaults on mortgages, there will be. Each of these derivatives will retain some value, but it is hard for anyone to see now if it keeps 10% of its value, or 50% of its value.

Consider this: In 2007 Global GDP (Gross Domestic Production) was in the neighborhood of $52 Trillion. The amount of "derivatives", and the bets made on them, total somewhere near $600 Trillion. More than 91% of all derivatives are traded outside of any regulatory agency, in one on one transactions, much like a blackjack table at a casino. The value that has been placed on them is not "marked to market", meaning they are not bought and sold on the open market, thus credibly determining value, but are labeled for value by the issuing investment bank. Almost all of these "derivatives" are not on the active accounting sheets of the investment banks, but rather are "off-balance sheet". The biggest name most of us know who used these accounting principles was Enron.

Since most derivatives are traded in one on one transactions, there are two entities fortunes tied to that "bet". You could be on the winning side of the"bet', yet still not get paid if the other side is insolvent. This is called counterparty risk. If the holder of the derivative is claiming full value in "Level 3", and knows they cannot get paid because the counterparty to their "bet" will be insolvent should they be forced to pay, should the holder of the derivative be allowed to claim full value in "Level 3"? Hence, this is the real question about the whole Bear Stearns debacle, and I have seen no one in the mainstream press ask about this.

If you have been paying attention, the fortunes of the reinsurers, such as Ambac and MBIA have turned down considerably. This is due to their having to pay claims on the derivatives which banks, hedge funds and investment banks took out on them. Essentially, it seems as though neither of these companies have anywhere near the amount of money needed to cover the losses on these derivatives. Many of these "wraps" as they are sometimes called, are known as Credit Default Swaps, or CDS. CDS, and all things similar, are soon to go the way of the derivatives they were meant to provide support for.

There is no way for Ambac or MBIA to survive. Both are initiating lawsuits now, claiming that the loans underlying the derivatives they wrote insurance policies for were fraught with fraud, which they could not have known about.

Many banks have "Level 3" holdings that exceed their hard assets by several times. Soon, most of the financial institutions with "Level 3" holdings will be forced to start bringing them into "Level 1". Even with only a 50% loss, many banks will be in a position of losses exceeding capital by 3, 4, or more times.

What will be really interesting is this - China bought close to $1 Trillion of MBS Securitizations with 2005 and 2006 originations from the US. Anyone want to take a stab at how much they are worth now? How upset will they be with a 20% loss? 30% loss? A 50% loss?

They aren't the only foreigners to have these. What do you think was all the fuss with the German banks a few months ago? Germany has already nationalized two banks who had significant exposure to the US real estate market.

More to come........
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