Goodbye Yellow Brick Road

Well, here we are, with the "purchase" of AIG by US taxpayers, the Fed, Treasury and everyone on Wall Street are praying the bond market does not collapse. 

What has happened is AIG, the largest insurer in the world, was about to eat hundreds of billions of dollars in Credit Default Swaps they wrote. These CDS are insurance policies written to protect against losses by exotic financial instruments called derivatives. So, the US taxpayer is now the proud owner of AIG, insurer to the world. The $85 Billion the Fed "loaned" to AIG gives the Treasury 79.9% ownership. Imagine that, the US Government now owns a publicly traded insurance company.

Not good news.

The problem is somewhat complicated, yet resides in the fact that most of the derivatives AIG wrote CDS on are now worth almost nothing. AIG has written CDS for $441 Billion, $307 Billion to European banks. The $85 Billion was the amount needed today to meet reserve requirements as the derivatives lose their AAA ratings and go to AA, A, BBB and lower. With each downgrade of a derivative class, the reserve requirements increase. Expect a lot more taxpayer money to go to AIG. Eventually, the reserve requirements will match the insured amount. So, AIG (now the American taxpayers) will cover the losses on derivatives for the European banks. 

Simply put, $85 Billion is a drop in the bucket. 

To add to this, AIG, and other insurers, are important cogs in the wheels of the financial world. AIG and other insurers MUST keep up their business lines, or no one will put new money in the system.

AIG is only one of dozens of companies to write CDS. What happens to other large insurers and reinsurers when they have to pay on derivative losses? To get the original AAA rating, issuers of derivatives had to buy the CDS. The reason US Treasury Notes are rated AAA is they have the full faith and backing of the US Government. They rated these risky financial vehicles the same as US Treasury Notes!

There are a lot of derivatives that have, are, and will go bad. Over $700 Trillion of them have been sold since 2002. 

Did you get that?

More than $700 Trillion in real value at the time of purchase has lost somewhere between 50% to 95% of its original price.

That's the real reason the Fed bailed out Fannie Mae and Freddie Mac. China had bought over $1 Trillion of these derivatives from Fannie and Freddie. Japan and Korea together had bought around $500 Billion. So, in one fell swoop, Mr. Paulson and Mr. Bernanke and the current administration thought it was better that the US taxpayer eat those losses than our trading partners. Even though these countries bought them hoping to make a profit, it is now going to the average American to cover the losses. Mr. Paulson knows that the federal deficit instantaneously increased by $1.5 Trillion, and he is being disingenuous when he states it might be $300 Billion.

Any action taken by congress to save the housing and mortgage market through Fannie and Freddie can only increase the burden of the federal deficit. Smarter people than I believe the recent actions involving the mortgage giants will eventually add somewhere around $5 Trillion to the national debt.

I can only guess what is next. All arrows though, point to disaster. Foreign investment in US Treasury notes is declining - very bad news, since we need purchases of at least $2 Billion per day just to manage the interest owed, never mind retiring some of the deficit. The amount we must sell each day increases with each bailout. Soon, we will not find enough buyers for Treasuries. That will be the day the US loses its AAA rating. 

There ain't no going back from that point.

It is hard to blame the media for not keeping up. Without advertising revenue, no media outlet is there to print or broadcast a story. 80+% of advertising comes from multi-national corporations. The majority of media outlets are now owned by a few corporations, whose sole interest is profit. If the advertisers don't like the stories, they take their money elsewhere. This is why FOX has been so successful - from the beginning, they made no bones about what they were. They told the big corporations "go ahead, write the story. As long as you spend your money with us, we will allow you news input." To remain in the game, most other media companies have had to accede a little, sometimes a lot,  just to survive. 

Problem is, deflection from the real story has become central. Why do I write about finances so much? Numbers never lie, they are immutable truths. In other words, in the financial world it is easy to find inaccuracies. Really, it is low hanging fruit, and I am lazy.

Black Swan Day

September 15, 2008.

So much to write about today.

The first day which truly marks a turning point no one wants to see. All caused by the people we elect, and the people we pay to manage our money and economy. In the end, they will be the only ones to prosper, with your tax dollars.

Major news is missing the boat, as they have for the last twenty years. The financial storm that is coming has been building in plain sight for decades. Many we trust to give us good information actually lied, or were too stupid to see the truth. There is no other way to describe their behavior. 

As long as they were on television, they were "experts." The journalists assigned to present the stories gave us fiction, a point that will be salient soon enough. 

Our politicians have taken bribes to get their jobs, which come with benefits average people do not get. In return, they gave a wink and a nod and a few bills introduced to pay back the bribes, so they could get more bribes.

Back to events of the day.

From itulip;

FIRE Economy D-Day: Greenspan's Black Swan

Following this economic and financial market crisis, the cycle of global recession will not have the same impact on the US in 2008 as it did in the previous case in 1930. The US in 1930 was a net creditor but is today a net debtor, with its dual trade and fiscal deficits funded by massive daily capital flows from foreign private investors and central banks – mostly the latter.

What A Mess

Market Ticker lays out the basics;

"So this weekend everyone who is a "who's who" huddled in New York at The Fed to figure out what to do with Lehman Brothers. 

I'm here to tell you that there is no resolution, no fix, and we now face a stark choice between most of American Finance being sucked into the vortex, and everything, including you, being sucked into the vortex. 

Yes, those are some stark - and harsh - words.

They're also true.

Let's begin with what we were told wouldn't happen after Bear Stearns.  We were told that Bear was an "extraordinary" event, and that it was a "liquidity run" that doomed them; absent that, they were "fine."

The media, led by CNBC and Fox Business has paraded every analyst they could pay, er, find, to tell us all is well and the crisis is over. They have consistently done this for the past two years. Not one major US news source has gone against this trend.

Bernanke, Paulson and the White House have also been consistent. So far, the count is over 100 announcements in the past eighteen months alone that all is "contained" and the need to spend taxpayer money to give to the banks that made bad bets is in our country's best interest.

"Our best interest" will increase the deficit by at least $3-5 Trillion over the next few years, and it could be a lot more. The banks knew, after 1998 with LTCM, that the Fed would put a floor in to prevent market collapse. So, they decided that pawning off risk through loans made to people who had no possibility of repayment would be OK, as long as someone else held the bad paper, and the government would come in and bail them out if it went bad. For the banks, it was a no lose situation. Huge fees, huge profits, huge bonuses would be paid out, and if their bets went bad, the taxpayer pays for the loss. Pretty sweet deal, for the banks. Pretty crappy deal, for the taxpayers.

Market Ticker continues;

"So America, what are you going to choose to do about this?  Sit on your hands?  Tap your foot?  Drink another beer?  Turn on the NFL?

Its your money they're spending in DC, you know. You've been lied to repeatedly by the clowns inhabiting Washington. Democrat, Republican, elected, appointed, its all a piece of the same mess.

Here, once again, is The Truth for those of you who wish to hear it:

Homes cannot sell, on average, for more than three times average incomes.  Period.  Short-term distortions can and do occur, but over longer periods of time (decades)house prices cannot advance faster than wages.

• We will not see the bottom of the mess in housing or the economy generally until houses sell for that three times income.  Those who say we will are simply wrong.  Attempts to delay or reverse this adjustment will make the total economic impact far worse and in fact can easily lead us to an economic depression.
• Those firms who made bad investments must be forced to eat them.  If this results in their insolvency then it does.  We cannot clear our credit and economic systems until we know who is bankrupt and who is not.
• We as individuals and our nation as a whole must stop spending more than we make.  This is not negotiable.  We as a nation are beholden to foreign interests at present to the tune of $2 billion per day in external funding requirements.  If that funding is interrupted for any reason - such as a loss of confidence - we are instantaneously plunged into DEPRESSION. 
• The market is vastly overvalued with essentially the entirety of its "future earnings appreciation" predicated on a resumption of the "FIRE" (Finance, insurance and real estate) economic boom.  The only "boom" that is occurring and will occur is a series of explosions.  The S&P 500, without that "acceleration", has a fair value somewhere around eight hundred.  Yeah - 1/3rd lower from here and fully half off its all-time high."
  
  
  Will we hear the news on what's next? Will it be accurate? Or at least try to be. 
  I can tell you this, if there is a happy face put on the events over this last weekend, watch out. Bank of America has to be the in the race for "Most Stupid Bankers." First, they buy Countrywide. At the time, Countrywide was bankrupt by at least 5 or 6 times their assets, and BAC bought them for $4 per share. The pesky bondholders from Countrywide refuse to lose their money, so BAC's plan to pick the good assets and scuttle the rest of Countrywide has been hampered. They are afraid additional lawsuits will only add to their losses.
  Now, it looks like they will buy Merrill Lynch for $29 per share. MER is not worth anything. They have exposure on derivative losses exceeding capital by 10 times, they are bankrupt. The only reason the market doesn't know it is because accounting rules allow them to hide the losses in level 3. Those losses can never come back, because they are on bets on MBS that has already gone bad. 
  BAC knows the Fed will give them taxpayer money to cover the losses. 
  McCain and Obama know this, too. Both candidates have people advising them who created this problem. Just google Gramm Leach Bliley Act for McCain. Google Penny Pritzker for Obama. Don't take my word on it, read for yourself.
  The more the Fed and the government try to "save" some of these banks that got us into this mess, the bigger the mess will be.
  When will we have the media tell us this. 

The Promise That Was Once Rome

The Roman Empire was truly great at its height. Ruling most of the known world, Rome stretched from the north Atlantic Ocean to the Indian Ocean. Due to the sense of superior government, fair laws and blessings of the Gods, Rome expanded its borders knowing all those that came under its rule would be better. With many neighbors they shared trade and commerce, enriching not only themselves, but those they were at peace with. Rome became the place to seek your fortune. It was the envy and hope of the world. 

Though they practiced slavery for some time, they also had a representative republic. Every Senator came from Quaestors which were elected in local provinces. Senators then sought favor for their home lands. Senators also controlled the finances, foreign affairs, assigned military commands and provinces, and debated and passed decrees for the Empire.

Through the military, which was the largest and best trained the world had ever seen, the enemies of the Empire were kept at bay. Many legionnaires were committed to troubled areas not only to keep order, but to prevent enemies from amassing within its borders. 

By the beginning of the 3rd century, the Roman Empire had become broken. Senators were considered hedonistic and greedy, with charges of corruption commonplace. Taxes were high to support the massive military and largess of the Senate. With the exception of Marcus Aurelius, the last few Emperors turned what was a beneficent relationship with far provinces into one of greed, with the army to extract more taxes. 

As the Emperor, Senate and the privileged demanded more monies to supply their lifestyles and bring more gifts home, the army was increased and sent to Africa and the Middle East to extract more taxes. Once friendly neighbors grew weary of the demand for greater profits from Rome. Skirmishes and small wars were frequent. Increasingly, more and more resources were committed to far provinces to maintain the money supply. The threat along the northern borders from nomadic tribes from the east was given little thought. There were no peoples in the north to extract goods or taxes from. They were barbarians, to whom money meant nothing. So, more legionnaires were sent where the money was. 

Rome had one-quarter of her military in the Middle East when Alaric and his barbarians sacked Rome in 410. Again in 455 and 472 Rome was invaded. In each instance, a large portion of the military was elsewhere, trying to control diverse cultures while draining Rome of desperately needed resources.

Rome eroded. 

No more would Rome conquer in the name of bringing light to the world. 

Now Rome was being invaded. All the better parts taken. Left with a shadow of her former self. 

Just for the sake of debate, imagine Rome and the US being analogous. Due to human traits and behaviors, assuming equal conditions for advancements in knowledge and technology, where is the US at equivalence with the Roman Empire in its life? With a greater understanding of Roman history than above, how do the two empires compare, if at all? Has the religious intolerance in the Middle East only been a factor for Rome and the US? If the Romans couldn't control the Middle East, is it correct to assume it is controllable today?

Forgive me. I forgot it was silly of me to ask. I am not a journalist. If it were worth asking, a journalist would have asked it. You know, the people who go to university for 4 years to study how to ask very good questions. They have gotten the important answers. 

I just hope Brittany and Paris can be friends again.

Lipstick on Pigs

Building up to the election, it is hard to find news.

I am not talking about CNN and MSNBC. You can watch both all day long. Unless something horrific, such as monster hurricanes and train wrecks (no, really), all I hear are opinions, on the viewpoints, of what the existential meaning is of an utterance by a tired politician on the campaign trail.

I believe a direct conversation of the economy, more specifically banks and the taxpayer money being used to replace their bad bets, is in order. Is it right to use taxpayer money to cover the bad bets of Wall Street and Main Street Bankers?

From CNBC.com;

The end result of the global economic slowdown may be the U.S. announcing national bankruptcy as the government cannot afford the bailouts that it promised and the market will not bail out the government, Martin Hennecke, senior manager of private clients at Tyche, told CNBC on Thursday.

"We expect a depression in the United States. We expect a depression, very possibly, also in Europe," Hennecke said on "Worldwide Exchange."

The estimated $300 billion cost of the Fannie/Freddie bailout will probably be considered as a loss that the government will have to take, therefore passing it on to taxpayers, he explained.

"We already have $3 trillion of debt, as far as the U.S. government is concerned. These debt figures across the U.S. economy are rising very sharply."

When the government can no longer pass the United States' "immense debt" on to taxpayers, it will turn to the holders of U.S. dollars, leading to the eventual downfall of the currency, Hennecke said.

"Definitely, it (the dollar) is not a safe place to be invested in, as real inflation is closer to 10 or 11 percent than the actual inflation numbers given by the U.S. government," Hennecke said on "Worldwide Exchange".

Investors should avoid exposure to debt and stay away from leveraging on any investment or asset, including property, Hennecke advised, adding that "banks have been too highly leveraged in the past, private households, everybody."

Following is one of the issues the candidates are desperate to avoid. They know the less people realize, the fewer tough questions they are forced to answer. It is a complicated issue, but is the most important issue right now, just edging out Iraq;

MBS and the derivatives built on them
There are somewhere around $700+ 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 (and may include other forms of debt that have been securitized), 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.

Almost all derivatives of the second and third order are owned by commercial banks, investment banks and central banks. Why? In creating the underlying MBS, they withheld portions of the subprime rate of return, which, if they owned that portion, would make them more profit. They then assigned that portion to the CDO's and other derivatives. They then sold these to other banks, and themselves. 

MBS and CDO’s are distinctly different. 

I hear many people tell me they "know" what a derivative is. I know they have no idea what a derivative is. How do I know? They keep buying financial stocks, just before they tumble.
$13 Trillion MBS. 

$700 Trillion Derivatives. 

$600+ Trillion in bets on the performance of the $13 Trillion.

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 $700 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 1/7 of all derivatives. Their hard assets in Sept 2007 were $ 1.3 trillion. Bank of America, before Countrywide, had $42 Trillion in derivative holdings with hard assets a little over $1 Trillion. After Countrywide, that spread widened considerably.

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 issued by Deutschebank 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.

The ability of mainstream media to tell us about lipstick is amazing. Hats off to Matthews, I would never have guessed that was important. I would have thought the loss of the commodities markets, the loss of AAA rating on US treasury notes and the bankruptcy of America were more important.