Economic Rebalancing

noreply@blogger.com (RodgerRafter) — Tue, 10 Nov 2009 17:29:00 +0000

It's Not Risk, It's Fraud

We hear everywhere about the "risks" bankers took and how their bad bets came back to haunt us all. It's gotten so that every time I see the term "risk," I cringe.

The problem is not that they made reasonable bets and just got unlucky, as the term "risk" implies. The problem is that they fudged their accounting to show inflated profits over a period of years. This was done primarily through absurd loss assumptions on loans and the use of complex and deliberately confusing derivatives. Eventually the fraudulent schemes had to collapse under their own weight. Many of us saw it coming and warned others about it repeatedly and fruitlessly (read my posts on this blog over the past three years for proof of that).

The problem is systemic. Corporate executives want accounting rules that allow them to commit fraud and they lobby Congress aggressively to prevent fair and accurate accounting. The net effect of years of systemic fraud is that we have created huge amounts of imaginary wealth that inevitably will collapse. This occurred with the deflation of the internet stock bubble. It is occurring now in unwinding of the housing bubble. It will occur on a much larger scale as the liability for around $20 trillion worth of Federal, state and municipal government debts get transferred to the people. It will hit retirees especially hard as pension plans come up far short of being able to meet their obligations.

Inflation will likely be the primary means of transferring the losses to the masses. The Federal Reserve will choose to print the money it needs to keep our government operating after our foreign creditors finally stop throwing good money after bad. Salaries and pensions may or may not fall in dollar terms, but as the dollar loses value and inflation mounts, the real value of our salaries and benefits will decline.

We can reduce the damage we'll have to absorb in two main ways:

1. Individually, we can invest wisely. Many try to hedge their inflation exposure with investments in precious metals, but this strategy is not income generating, and fundamentally it just seeks to limit losses. A more practical approach is to invest in foreign assets that generate positive returns in other currencies.

2. Collectively, we can recognize that the problem is one of fraud, work to correct the systemic flaws that encourage and facilitate this fraud, and make sure that the individuals and institutions responsible absorb the greatest share of the losses. That means creating accurate and conservative accounting rules, breaking up the big banking powers to limit their excessive power, and forcing insolvent enterprises through a quick, efficient, orderly and honest bankruptcy process so that they can continue to operate free of fraud.

noreply@blogger.com (RodgerRafter) — Sun, 09 Mar 2008 14:07:00 +0000

How to Make Money in a Recession... (If You Are a Big Banker)

So you've just taken over as CEO of SuperMegaMonster Bank. Your predecessor skated off into retirement with a $200 million golden parachute, leaving you to manage $200 billion in bad loans and assorted toxic waste just as the economy is plunging into recession. What are you going to do?

Step 1: Write-Offs
Take huge one-time hits to your earnings and balance sheet and blame it all on the last guy. You'll be able to show a profit sooner if you don't have all these losses trickling in over time. When you do start claiming positive earnings again you'll get all the credit and big bonuses too.

Step 2: Offload Risk
Shift ownership of as much of your toxic waste as possible to the government and retail investors. Scare the crap out of government leaders and the Fed by telling them our entire economic system will come unraveled if they don't save the big banks. They'll enact a wide range of idiotic policies designed to bail you out of the mess your firm created and profited from in the first place. Public pension plans can be suckered into any investment so load them up with the worst of the worst.

Step 3: Credit Crunch
Call in loans to hedge funds, mortgage REITs and other investment schemes. They've served their boom cycle purpose and now they are expendable. Use the money that comes flowing back in to your coffers to purchase the securities that they are forced to unload at a steep discount. The Fed will loan you extra money at ultra cheap rates with your existing securities as collateral so that you can leverage up on even more cheap investments. Don't buy the hopeless stuff, just buy the higher quality stuff that will survive the recession or senior debt that will survive the bankruptcy process.

Step 4: Ride the Carry Trade
With short term rates low and yields high you can play the carry trade for maximum profit. Panicked investors will put their money in low yielding savings accounts and money market accounts and you can invest this in the long-term, high yielding stuff you soaked up in the credit crunch. As short term rates continue to fall, the spread widens and your profit margin increases.

Step 5: Kill Off Struggling Entities
Identify any exposure you have to companies or municipalities that are likely to become insolvent in a recession. Make sure you sell off any equities or long term debt you hold first. Then pull their short term funding to force them into bankruptcy. Layoffs and general panic will help you pick up more securities on the cheap.

Step 6: Eliminate the Competition
Take advantage of the struggling economy to wipe out any competition that grew too quickly in the last boom cycle. Sub-prime lenders? Savings and Loans? Small, local banks? REITs? Fannie Mae? Kill all you can while you can, as you don't want them to compete with you for banking business in the next boom cycle or investing opportunities late in the bust cycle.

Step 7: Debase the Currency
Lobby the Fed for low rates and the Federal Government for deficit spending. Remember that you are now a carry trader, rather than a creditor. It doesn't hurt you if borrowers pay you back in a debased currency because you get to pay back depositors in a debased currency as well. To the extent that you have equities, real estate and other hard assets on your books offset by short term debt, inflation actually works in your favor. Paper gains on these assets will help your case with the compensation committee around bonus time.

Reality
No doubt, the big banks are in a very precarious situation right now, but they have their tentacles wrapped around Washington and the Federal Reserve System. There is a clear path to banking profitability and it will come almost entirely at our expense as citizens, investors and taxpayers. All of these steps overlap in the timing of their effectiveness, and I expect we'll see most of the same themes continuing to pop up over the next couple of years as the recession deepens. So far we've seen:

1. A huge "stimulus" package that will help some distressed borrowers make some more mortgage payments. (Step 2)
2. A big increase in FHA, FHLB, Fannie Mae and Freddie Mac backed loans and securities to take up some of the load off of Wall Street with regards to the mortgage mess. (Step 2)
3. The invention of "Term Auction Credit" as a way of helping big banks sustain or increase their investment portfolios. (Step 3)
4. Falling short term rates to lower the borrowing costs for big banks. (Step 4)
5. Widening spreads to increase the profitability of banks that purchase new assets. (Step 4)
6. A large credit crunch that is forcing hedge funds and other investment vehicles to sell into a difficult market, with investors taking the losses. (Step 3)
7. Continuing rapid growth of the money supply. (Step 7)
8. Struggling municipalities. (Step 5)
9. Rising inflation. (Step 7)
10. A declining dollar. (Step 7)
11. A variety of measures designed to help forestall foreclosures and let banks fudge their accounting for bad loans. (Step 2)
12. The VISA IPO. (Step 2)
13. Big banks helping Thornburg Mortgage raise $230 million in stock offerings in January, only to give them big margin calls in March. (Step 5)
14. The collapse of hundreds of smaller banks and lenders. (Step 6)
15. The abandonment of the Auction Rate Securities market. (Step 3)
16. Seizing control of hedge funds to liquidate their assets. (Step 3)

Eventually the economy will hit bottom and the banks can go back to their even more profitable boom cycle business plan, where they make money by extending credit to anyone who wants to take risks and can make the payments in an expanding economy. It might take awhile for the dust to settle this time though, because the big banks sure managed to mess the economy up badly this time.

noreply@blogger.com (RodgerRafter) — Sat, 23 Jun 2007 15:47:00 +0000

Bear Stearns' Billion Dollar Hedge Fund Bailout

The news that two Bear Stearns hedge funds were being forced to liquidate is a big sign of trouble in the bond markets. My previous post showed how the market for the types of securities held by the Bear Stearns funds was tanking. Had the forced liquidations gone through, they likely would have been a serious strain on the market.

Bailing out the fund by taking over the creditor role from Merrill and others saves the bond market from more forced sales and saves Bear from the negative publicity. As the mortgaged backed bonds continue to deteriorate the losses will go back to being slow and steady, rather than dramatic and eye catching. Meanwhile, high risk MBSs continue to tank. Bear will probably pull the plug somewhere down the line so that hedge fund investors are the big losers and Bear as creditor will be largely protected.

For now, Bear's response falls in line with what everyone in the industry seems to be doing - Pretend on your books that your asset backed securities or real estate owned is still worth far more than the market will actually bear. If you don't try to sell and continue to expand your borrowing you can keep up the charade for a long time. Eventually, losses will overwhelm the securities holders, but that doesn't have to be anytime soon if firms like Bear keep stepping up with more financing.

noreply@blogger.com (RodgerRafter) — Wed, 20 Jun 2007 01:11:00 +0000

Toxic Waste Hitting New Lows

Mortgage Backed Securities are split up into different tranches so that fund managers can choose between securities that will actually make good on their promised yield and securities that will generate a high return for a short while before blowing up. The highest rated MBSs are holding up OK these days, but the toxic waste is trading down to new lows. Besides the direction of the chart, also note the coupon yields. Suckers who bought the highest yielding junk are not getting a good enough yield for the risk they took:

AAA Coupon 0.090%
AA Coupon 0.150%
A Coupon 0.64%
BBB Coupon 2.240%
BBB- Coupon 3.890%

These are 2007-01 securities. If you took the BBB- with the extra 3.890% interest, you're already down about 40% if you Mark to Market:

Most of the AAA rated bonds don't deserve the high ratings. Underwriters play games and work with the ratings agencies to get the ratings they desire and the agencies have a big conflict of interest the encourages them to overrate bonds. AAA stuff holds up because there is far too much money being created and stored in money market accounts that has to buy something. This chart from the St. Louis Fed is very telling:

noreply@blogger.com (RodgerRafter) — Fri, 15 Jun 2007 18:10:00 +0000

Rising Interest Rates and the Carry Trade

Rising 10-year yields have been getting a lot of attention, although the rise hasn't been anything out of the ordinary given the uptrend in yields over the past 4 years:

It's also interesting to note that the yield hit a wall when it reached the same level as Fed Funds (5.25%). In normal times the 10-year yield would be considerably higher than Fed Funds.

However, it has made a big difference for home purchasers with the average 30-year contract rate up to 6.61% from 6.1% 5 weeks earlier. As rates rise, the "affordability" of homes for most buyers declines, adding more downward pressure to home prices. This all puts a greater strain on the consumer driven US economy. As I expect most long term US treasuries will either default or be devalued through inflation to the point that they deserve far higher rates to make up for the risk.

Rising yields also means falling market values for bonds already in the portfolios of carry traders. Fortunately for them, the dollar has also been rising fast enough against the Yen to avoid creating much margin pressure or forced liquidations.

Why yields are rising remains in question. Over the past two weeks custodial holdings of treasuries and agencies haven't increased at their usual rate, leading some to speculate that a lack of foreign buying is behind the rising yields. There have been plenty of statements from monetary officials suggesting they'd be reducing the rate at which they acquire new US treasury debt. This is probably having a small impact on rates, but I'm more inclined to stick with my original observation that primary dealers are the main factor influencing the shape of the yield curve.

The 1 1/2-month-stale data on TIC flows came out today, showing that private foreign investors were net sellers of treasuries, but that's normal in April because of the surge in US tax receipts. Major Foreign Holders TIC data showed that Official accounts also reduced short term treasury bill holdings.

Japanese Money Supply data keeps getting revised upward, suggesting that the carry trade is having a bigger impact than authorities realize. I expect that the Broad Liquidity is actually growing at about a 4-5% rate given the way the Yen has been pushed down in recent months, although it may take the Bank of Japan several more months before they realize this and respond to it:

Commentators have been asking for years what would happen if foreign demand for US debt declined. The answer now appears to be that US debtors would just start borrowing in foreign currencies to fund their needs. In my view this represents another escalation in the extent to which the global economy has become unbalanced. It's hard to imagine another escalation that would go beyond this, but with the versatility of the derivatives markets I won't assume this is the last stage. With the government providing tax free status to Samurai bonds it appears that those in control in Washington realize that expanding the debt pyramid is essential to keeping the game going for now.

noreply@blogger.com (RodgerRafter) — Thu, 07 Jun 2007 13:55:00 +0000

This is Just Criminal

On Wednesday stock of Novastar Financial was up almost 11%. The day before the stock of Accredited Home Lenders was up a similar amount. The excuse to pump up the stock in both cases was that the companies had found a way to transfer much of the toxic waste they had created to unsuspecting investors. In the case of Accredited, the company may arrangements to be acquired by Lone Star, a private equity fund. The investors in Lone Star 5, most likely pension plans and public endowments, will be stuck holding the bag for the defaulted loans stinking up Accredited's portfolio (it's so bad that their auditor quit and they still haven't filed their Q1 report with the SEC). In the case of Novastar they managed to complete another securitization for $1.4 billion of their subprime garbage. It's hard to imagine a responsible investor purchasing new Novastar securities after seeing what has been happening in the way of defaults within recent securitizations:

Each line above represents a different securitization over time. The y-axis shows the percentage of loans in the securitization that are at least 60 days delinquent, The x-axis shows shows the age of each securitization. The February 2007 loans are going bad even faster than the amazingly bad 2006 loans.

May was an especially bad month for loans entering the 30-59 day delinquent category. Most of these will add to next months 60+ numbers:

30-59 day delinquencies on the February 2007 securitization rose from 1.44% in April to 2.55% in May as the newer loans are going bad in a hurry.
On the March 2004 securitization they rose from 1.23% in April to 2.94% in May likely as a result of resets of 3 year ARMs resulting in higher payments that can't be met.

Countrywide Financial's Real Estate Owned has reached $1.75 billion dollars as of June 5th (real estate listed for sale on their website). Of course Countrywide is just one of many lenders who are riding a wave of foreclosures and putting off the day when they'll have to recognize the losses.

The sub-prime time bomb has not been contained, and it hasn't difused. It's been getting steadily worse, but the bond market hasn't had a dramatic reaction. This has given Wall St. time to dump toxic securities and companies into the portfolios of public and private pension plans.

noreply@blogger.com (RodgerRafter) — Wed, 06 Jun 2007 02:00:00 +0000

Retail Sales at a Snail's Pace

As a greater percentage of US consumers struggle with large debt burdens and tighter credit standards, this is predictably hitting the retail sector. Companies like Bed, Bath and Beyond have begun issuing earnings warnings, and it's not just home related retailers. According to the chain store sales data even Apparel stores were hit hard in April (only drug stores did well).

April was off partly because of the earlier Easter, but a larger downtrend is evident among multiple data series. Chain Store Sales:

ShopperTrak:

Jobs:

Russ Winter has been doing a great job tracking data on shipping volumes and sales tax receipts. It all points to a slowdown in sales, with debt service burdens being a likely culprit. Now that retail jobs appear to be in decline, the problem could compound as unemployed consumers will have even less to spend.

On the bright side retailers who cater to high end consumers still seem to be doing well. These firms showed good year over year comparisons for April:
+7.3% JoS A Bank
+1.0% Neiman Marcus
+3.1% Nordstrom
+11.7% Saks Inc.

noreply@blogger.com (RodgerRafter) — Fri, 01 Jun 2007 17:44:00 +0000

Bond Curve Normalizes Following Sub-Prime Meltdown

There has been a very interesting divergence in the direction of short term vs. long term treasury yields since the market turbulence of February and March:

The yield curve had been severely inverted for many months, but with long yields rising and short yields falling most of the curve has normalized.

The uptrend for long yields and the downtrend for short yields have been very steady and well defined:

My best guesses at what has been happening behind the scenes are:
1. Primary Dealers want higher long bond yields and lower short term rates.
2. Excess liquidity has created high demand for T-bills for money market accounts.
3. The opening of new carry trade positions has hit a fevered pitch in the past 3 months. Short term treasuries were the highest yielding and most liquid part of the curve, so much of dollars purchased with borrowed yen ended up there. The Yen has been pounded down by new carry trades and now is threatening to break through long term resistence in the 122/Dollar range:

Demand created by carry traders for leaves banks with very little desire for cash from the Fed. The repo rate has been well below the fed funds rate since Mid-April and Fed repos have been low.

Meanwhile, foreign investors are still buying very large amounts of Treasury Bonds, probably because theiry the ones with the most dollars in need of a long term investment vehicle. Just about all of the Indirect bidder orders get filled as they still don't seem to be very price sensitive. (Indirect bidders are largely foreign central banks and overseas hedge funds.)

Primary Dealers, on the other hand, make up the biggest percenatage of bids and have (by far) the most unfilled orders at each auction. What they as a group are willing to pay effectively determines the interest rate coming out of auctions. They're generally the ones who are hurt the most by an inverted curve because their traditional business is to borrow money at short term rates and lend it out at long term rates.

Therefore, I expect primary dealers are the ones who are normalizing the curve on both ends as they seek to boost their profits in a time when they're facing large losses from mortgage defaults. This may help them in the short run, but it is having the effect of raising interest rates for new mortgages and refinancings. This will only put more pressure on the housing market as homes become less affordable to new buyers.

We'll see where rates go from here. There should be some resistance for 10 and 30-year bonds at 5%. That may put a lid on rising rates for a little while. Housing was in bad enough shape as it is. If rates break out above 5% that could be a nail in the coffin.

noreply@blogger.com (RodgerRafter) — Tue, 29 May 2007 02:51:00 +0000

Futures: The Easiest Way to Play the Yen Carry Trade

Tired of seeing hedge funds have all the fun? Want to play the Yen Carry Trade (YCT) like the big boys? Well, all you need is a futures trading account and you too can make huge, leveraged bets that the dollar will stay strong against the Yen. Of course you'll get wiped out like the rest of them if the Yen gets stronger in a hurry.

Here are some quotes for the Dollar/Yen on the New York Board of Trade futures markets. Notice that:
the June '07 contract closed at 121.325 Yen to the Dollar, while
the September '07 contract closed at 119.925,
the December '07 contract closed at 118.610, and
the March '08 contract closed at 117.360.

These prices reflect the interest rate differentials for Yen and Dollars. If you sell Yen by purchasing any of these futures, and the Dollar/Yen exchange rate remains constant, then the value of your futures will gradually rise over time. Buy enough futures contracts and you'll have a highly leveraged bet on the Yen appreciating relative to the dollar at a rate less than 4.5% per year. Here are some Yen/Dollar contracts graphed:

When you buy (Dollar/Yen) or sell (Yen/Dollar) the appropriate futures, the counterparty is typically a large banking institution like JP Morgan, Citigroup or Goldman Sachs. The big banking houses will usually then hedge their futures positions by borrowing actual Yen and then selling them for dollars on the Foreign Exchange markets. Together with the banks, your trades will amount to a full blown YCT that helps prop up the dollar and fuel America's excessive consumption.

The difference in Japanese short term rates (0.5%) and US short term rates (5.25%) is generally enough for the commercials to score a nice profit on the fully hedged position. If the exchange rate stays constant, you get around 4.5% with considerable risk, while they get around 0.25% with little or no risk. Of course fees, commissions and spreads cut into everyones profits. The numbers above are just for illustrative purposes.

Here's a nice chart showing the open interest as well as the relative positions of commercials and large and short speculators as reported to the Commodity Futures Trading Commission:

A year ago, Open Interest in futures contracts was low and the Commercials had gone short the Yen after a big unwinding of the YCT. Since then there's been a substantial increase in the size of the YCT, as reflected in futures positions, with two notable dips along the way (Oct-Nov & Feb-Mar). Neither of those dips in YCT positions was enough to push the commercials into being short Yen futures, but both coincided with sharp drops in the dollar relative to the Yen:

The Yen has been trending down against the Dollar since the beginning of 2005 when the interest rate differential between the US and Japan got large enough to make the YCT attractive. With commercials again very long Yen futures and rates more stable of late, it appears that the Dollar is poised for another sharp decline relative to the Yen. Of course the YCT could get more overextended before the next decline begins. Betting against the YCT can result in a very long, painful waiting game, as most small futures speculators have discovered this year.

noreply@blogger.com (RodgerRafter) — Sat, 26 May 2007 15:18:00 +0000

Japanese Investors and the Yen Carry Trade

Japanese retail investors have become very active in the Yen Carry Trade, helping to keep the value of the Yen suppressed for now. Here are some interesting quotes from a Bloomberg article:

Trading of currencies in Japan using borrowed funds rose 41 percent in the first quarter to 109 trillion yen ($896 billion), exceeding 100 trillion yen for the first time, the Financial Futures Association of Japan said.

Japanese individuals' trading volume accounts for 20 percent to 30 percent of the interbank foreign-exchange market in the Tokyo time zone,'' Fukaya said. "They are also active in London time after going home. They are becoming a rival to be reckoned with for institutional investors.''

The rise of the carry trade among Japanese retail investors is a good indication that it won't continue much longer. When retail investors arrive on the seen it provides cover for the bigger players to exit. To the average retail investor what's been working lately will probably always work. They here their friends boasting about their easy profits and they hop aboard the train, not realizing the risks they face if their highly leveraged bets go bad from a rising Yen. Just as marginated Nasdaq investors got cleaned out quickly in the sharp decline of early 2000, I expect that many japanese retail investors will have their accounts purged early in the game when the Yen Carry Trade starts to unwind. When it does, over a hundred trillion Yen could potentially be subtracted from the money supply to pay off margin debt. In the meantime, it's the YCT is providing a lot of interest income and trading fees for Japanes banks and brokerages.

Lately the YCT has been working espeicially well for anyone playing it, with the Yen falling against the dollar adding to gains from interest rate differentials:

noreply@blogger.com (RodgerRafter) — Fri, 25 May 2007 17:28:00 +0000

Next Stage of the Housing Meltdown

It took the homebuilders a long time, but they may finally be figuring out that they're in for a long, painful downturn. Their problem all along has been that they were building far to many homes for the nation's needs. The homes were selling well, up until late 2005 as speculators bought homes to flip or rent out and baby boomers bought retirement homes in advance with the help of low interest rates. But just as those trends were reaching saturation, builders got greedy and greatly expanded their inventory of land and communities under development. Rather than hold off on development as buying slowed, they rushed ahead with projects in the hopes that the customers would return in large numbers. When that didn't materialize, it took a long time for most builders to figure out that they were facing a long term liquidity crisis based on having too much debt and inventory that they can't easily sell.

Judging by the April Existing and New Home Sales numbers, it appears that reality has finally set in and builders are slashing prices to move inventory. New Home Sales numbers were up substantially in April from the first three months of the year on much lower sales prices, and inventory of finished new homes was down as well:

We probably haven't seen the peak yet, as the biggest rise in finished unsold homes usually comes in the second half of the year, but it's progress. The current group of finished homes for sale have been completed for 6 months, up from 3.9 a year ago, suggesting that not as many new finished homes are joining the group and bringing down the average. Meanwhile, the median price of new homes sold fell from $257,600 to $229,100 likely reflecting big price drops to move inventory. (I've heard of $220,000 price cuts in the Sacramento area.)

If builders have finally shifted into price cutting mode then it shouldn't take long for price cuts to hit the Existing Home Sales numbers. Today's release reflects sales made a month or two ago, but the inventory numbers are current and they jumped from 3.806 million homes for sale to 4.2 million. With an 8.4 month supply sellers are going to have to get more aggressive if they want to unload their homes.

The biggest sellers are now the mortgage lenders who've had to foreclose on large numbers of homes. Countrywide financial had over 8,000 properties listed for sale on their site as of 5/22/07, with total listed prices over $1.5 billion. Looking county by county at RealtyTrac yields some amazing "bank owned" numbers (5,706 in Sacramento County, CA for example and 11,578 in Los Angeles county). These guys probably have the most to lose from a drop in prices, as they've mostly avoided taking charges throughout the mortgage crisis so far. Their ability to get financing depends on an appearance of solvency.

As we head into the next phase of the housing downturn, we should see prices decline more rapidly in most areas, with builders leading the charge, followed by desperate homeowners (there are enough of them still out there with equity to preserve if they can avoid foreclosure with a sale). I still expect most lenders to drag their feet on lowering prices, and the ones who are getting liquidated are most likely the ones bringing large numbers of homes to auction these days.

noreply@blogger.com (RodgerRafter) — Wed, 23 May 2007 04:05:00 +0000

How Yen Carry Trade Benefits Japan

(I was asked about the unwinding of the Yen Carry Trade on another forum, so I wrote up this quick summary.)

Hedge funds playing with other people's money borrow Yen, which they'll eventually have to pay back with interest. As they buy dollars and other currencies with the Yen it drives the Yen down for now and helps Japanese manufacturers sell their goods.

It also creates profits for Japanese banks who normally have trouble finding enough Japanese to borrow money and keep the money supply growing. I estimate around $50 Trillion Yen have been created out of thin air by Japanese banks for Yen Carry Trade related borrowing. Interest on this new money is pure profit for japanese banks. Call it $10 Billion in profits annually for Japanese banks with other economic benefits as long as the carry trade continues.

The YCT is a Ponzi scheme with the BoJ acting as chief schemester. To keep the yen suppressed requires ever more borrowing of Yen to be sold for other currencies, which in turn leads to greater profits for the Japanese banks. Also, most of the trades entered into by hedge funds playing the YCT accept very high long term risk in order to maximize short term gain. Eventually, however, long term realities coupled with the weight of the Yen denominated debt and the will bring the majority of hedge funds playing the trade back down to earth. As the trade unwinds, the Yen rises and carry traders will lose out on the conversion back to Yen, resulting in a very large gain for Yen holders (i.e. the entire Japanese economy).

The BoJ tends to go for extreme economic interventions to benefit the Japanese banks. It pumped a huge amount of liquidity into the Japanese economy during the recession years, then drained it out during big carry trade years. The Yen created by the YCT sit in Japanese accounts waiting to be converted in to foreign assets when the trade unwinds. The BoJ can create as much new liquidity as it likes to offset the conversion of those Yen into foreign assets when the YCT unwinds.

There will likely be a very large economic shift when the trade does unwind. Japanese manufacturers will be at a huge disadvantage, but Japan will be sitting on monstrous amounts of foreign reserves. The Japanese consumer sector will likely take off as Japan adjusts to a much higher standard of living.

In answer to your question about the Japanese stock market, I'd expect the Japanese manufacturers with enough overseas production to do well, while those will all their production in Japan should have trouble. I'd also expect Japanese retailers and service providers to do well. For now, however, the YTC continues stronger than ever and the Japanese consumer sector has been weak.

noreply@blogger.com (RodgerRafter) — Mon, 21 May 2007 21:07:00 +0000

These Stories Tell the Sad Story of the US Economy

The US economy is dying a slow painful death. The body is suffering as many consumers are buried under a mountain of debt, foreclosure rates are soaring and the housing market is awash with vacant homes that can't sell.

Life support for this terminal case comes in the form of foreign purchases of US assets, the Yen Carry Trade and credit creation to increase leverage and risk in the business sector. The infusion of cash drives up profitability of US businesses, provides jobs and creates an illusion of financial health that can only be considered temporary.

Debt burdens are already at levels where they can only be serviced by the addition of more debt. Without foreign investment and rapid money supply growth the profitability of most American businesses would tumble. Without private equity capital, hedge fund borrowing and increasing corporate leverage the stock market would tumble. A look at the contributions of each of the leading economic indicators, gives a good "indication" of where the US economy is being led:

Negative or Flat Economic Statistics:
Average Workweek = -.06%
Initial Claims = -.12%
Vendor Performance = -.07%
Capital Goods Orders = -.08%
Building Permits = -.25%
Interest Rate Spread = -.06%
Consumer Expectations = -.08%
Consumer Goods Orders = 0%
Subtotal: -0.72%

Positive Stimulants:
Money Supply, M2 = +.12%
S&P 500 Stocks = +.15%
Subtotal: +.27%

Total Leading Economic Indicators: -0.45%

M2 and the stock market are being manipulated upward with easy credit and the huge flows of borrowed and foreign money into equities, which in turn is providing a great deal of short term economic stimulus. If not for this, all the other indicators would be down worse and the total measure of leading economic indicators would be pointing toward a very sharp recession.

Wall Street understands the sad state of affairs very well, but rather than seeking constructive reform of the financial system a feeding frenzy has erupted among the sharks circling the carcass. New money is being created to fund private equity deals at an accelerating rate and US assets are being sold off as quickly as Wall Street's dealmakers can find willing sellers. It's as if there is a mad rush going on to extract the most fees possible before the day comes when there's nothing left to plunder. The following articles give a snapshot view of how the flood of foreign and new money are propping up stocks and the economy for the time being:

1. Saudi Firm Buys GE Plastics for $9 Billion.
"General Electric Co. said Monday it will sell its GE Plastics division to petrochemicals manufacturer Saudi Basic Industries Corp. for about $11.6 billion.
GE said it would use the proceeds primarily to increase its planned 2007 stock buyback program. It now expects to buy back $7 billion to $8 billion in stock, up from the previous plan of $6 billion. The deal is expected to create a net gain, after taxes, of $1.5 billion for the conglomerate."

With hundreds of billions of US dollars to invest, oil producing nations are gobbling up bonds and equities on a massive scale. Meanwhile GE seeks to prop up their stock price and increase leverage through greater share repurchases. Credit problems at GE Capital may be beginning to put some pressure on GE's liquidity. Much of the money they receive from the Saudi's will probably get loaned out to other businesses through GE Capital. The Saudi's are letting us sell off our hard assets in order to fund excessive consumption of oil.

2. Countrywide Financial Raises $4 Billion.
"Countrywide Financial will use a portion of the net proceeds from this offering to fund repurchases of up to 23 million shares of its common stock simultaneously with this offering and expects to use the remainder for general corporate purposes."
It came from new convertible debt in a private placement and Countrywide will use around a billion of that to buy back stock. With defaults leading to a liquidity crisis for many lenders countrywide is trying to buffer their cash position with low interest debt at the expense of future share price appreciation.

3. China Takes a $3 Billion Stake in Blackstone.
"The agreement gives China's government a stake in the private equity boom sweeping the globe and hands a key alliance to Blackstone at a time foreign investors struggle to gain support from the Chinese government for takeovers of domestic assets."

Like the Saudi's, China is rolling in trade gap dollars and getting tired of piling them into US treasuries and agency debt. They're looking for investments that won't lose as much ground to inflation as faith in the dollar begins to unwind.

Every day seems to bring more stories like the ones above - money being created to fund share repurchases, US assets being sold to fund the trade gap. When the game comes to an end it sure won't be pretty.

noreply@blogger.com (RodgerRafter) — Sat, 19 May 2007 16:08:00 +0000

China announced that they are widening the trading band for the RMB last week. That's a way of saying that they are going to let the dollar fall faster. As the Chinese are already accumulating far more dollars than they want, their choice is either to keep the accumulate more or let the dollar fall. I did a quick graph of each time the dollar dropped 5 fen (0.05 yuan) and the dollar has been faster lately:

In contrast, the dollar has been rising against the Yen over the past year:

I attribute the falling Yen almost entirely to a Yen carry trade that has gone completely out of control. When the market for high yielding, subprime mortgage backed securities (a favorite of carry traders) started to reflect the reality of the housing market back in February and March, the Yen strengthened initially but then came tumbling back down as carry traders increased the size of their bets. Against the Euro, the Yen's extreme recent weakness has been especially clear:

With the US bull market on it's last legs, the Dow Jones Industrial Average keeps making new highs. The recent strength of the large cap stocks relative to everything else suggests a desperate prop job:

The most successful hedge fund over the past two years continues to pile into stocks, and especially Dow stocks, the performance of the stocks they've chosen hasn't been good, but that doesn't really matter if the rising tide is lifting all boats and their leverage is high enough:

Renaissance is just one of hundreds of hedge funds borrowing Yen and buying up large cap stocks these days. As long as the game is working, they'll keep playing. Just don't expect it to go on forever.

noreply@blogger.com (RodgerRafter) — Mon, 07 May 2007 00:16:00 +0000

How Big is the Yen Carry Trade?

In this article Japanese bureaucrat Hiroshi Watanabe says that there won't likely be a "hasty unwinding" of the Yen Carry Trade, and hints that the total size of speculative carry trades is around $100 billion, rather than $1 trillion as some estimate. I'm skeptical of these claims, as I believe the YCT suits the profit motives of Japanese bankers very well for now. It's also providing cover for the Bank of Japan to reduce its US treasury holdings, and if the trade doesn't keep expanding, then the demand it is creating for trade gap dollars and new US debt will disappear, pressuring the Yen back up, which doesn't suit the Japanese government's political motives very well at the moment.

To try and get an idea of how big the YCT has become I took a look at grwoth in various portions of the Japanese money supply:

Based on an exchange rate of 120 Yen = 1 Dollar...
From April of 1998 to April of 2001 Japanese M2+CDs grew $471 Billion, while M3+CDs grew $636 Billion (meaning non-M2 components of M3 declined sharply) and Broad Liquidity grew $1,020 Billion.
From March of 2001 to March of 2004 Japanese M2+CDs grew $956 Billion, while M3+CDs grew $61 Billion (meaning non-M2 components of M3 declined sharply) and Broad Liquidity grew $328 Billion.
From March of 2004 to March of 2007 Japanese M2+CDs grew $281 Billion, while M3+CDs grew $626 Billion, and Broad Liquidity grew $902 Billion.

As I read it, the Japanese government and Bank of Japan were busy running up debt and stuffing money into people's pockets as an attempt to stimulate the economy during the recession years of 2001-2003. Since then they've been draining liquidity, but the Yen carry trade has picked up the slack, causing the total money supply to grow much more rapidly.

For the $100 billion estimate to be true, domestic Japanese credit expansion would likely be responsible for the bulk of the surge in broad money. For the $1 trillion estimate to be true the Yen carry trade would likely be making up for a several hundred billion dollar liquidity drain by the BoJ. My own hunch is that the total amount of borrowing in Yen for speculative carry trade bets by investors outside of Japan is probably over $500 billion. On top of that, the amount of official Japanese money invested abroad is about $1 trillion and there may be another $1 trillion in private Japanese money invested abroad.

The borrowed money for speculative purposes is quite a racket for Japan, where a portion of global investment returns are steadily cyphoned off by Japese banks. Watanabe doesn't forecast a "hasty" unwinding, but a slow and painful unwinding would be just as bad for the pension plans and other investment pools run by global hedge funds. Keeping the slow bleed going forever is probably plan A. Japan has the ability to stuff liquidity back into the system, just as they did during 2002-2004 in a way that can keep the Yen's rise unhasty. Foreign borrowers will have to pay back their Yen loans at a greater cost than they bargained for if the BoJ handles things in the best interests of Japan. Western politicians and bankers play along because for now it means a stimulated economy and short term profits.

If plan A fails, and some systemic shock causes a sudden rush by carry traders to get out, then plan B, a hasty rise in the Yen and forced liquidation of foreign carry traders probably works out best for the Japanese as they wouldn't want to let foreign hedge funds get off too easily. After a thorough cleansing of the trade I could see the BoJ rushing back in with another round of liquidity to return the Yen to manufacturing friendly levels. With the Yen near four year highs, entering new carry trades is probably an especially bad idea around now, and its not surprising to see the Watanabe trying to be more encouraging of sucker bets. While he says that the trades "won't be unwound in a hasty way," the 20% rise in the Yen we saw in 1998 would work very well as part of plan B today.

The Yen Carry Trade has been a big part of global economic imbalances and like the rest of the imbalances I believe it must eventually come back into balance one way or another. As we see the rebalancing process taking hold via a strugling US economy and declining US consumer purchasing power, I expect we'll also see a big drop-off in US investment returns as a result of either a gradual or "hasty" unwinding of the carry trade.

noreply@blogger.com (RodgerRafter) — Tue, 01 May 2007 17:59:00 +0000

A Possible Rate Cut Next Wednesday?

The Federal Open Market Committee meets next Wednesday, and I haven't heard any speculation out there about a rate cut on the Fed Funds target from 5.25% to 5.00%. However, the daily Repo rate has been below the target for the last two weeks. Today it was 5.06%, with somebody having the nerve to bid 4.98%. I personally take this as a signal to the Fed that certain banks want short term rates lowered.

The member banks want lower rates and a normal yield curve. Inverting the curve was fine and dandy for squeezing out competition from the subprime lenders, but now big banks are getting in trouble too. They'd like to cut the rates they have to pay depositors and boost the rates they collect from borrowers. That will restore some profitabilty to their core business to offset some of what they are losing through defaults.

A Fed Funds rate cut would not be good for the dollar, although it's the higher yielding long term securities that matter the most for carry traders. If longer term yields fall (boosting the price of securities) it helps those already in carry trades, but it discourages new traders for entering into them and sucking up supply of trade gap dollars. That could lead to a falling dollar, much higher long term rates and a falling stock market.

Up until now, the Fed has been on the side of protecting the dollar and US banking profits tied to the Yen carry trade. If the Fed goes through with the rate cut next week or at the June 27/28 meeting we could be in for some dramatic changes in the rebalancing process.

noreply@blogger.com (RodgerRafter) — Sun, 29 Apr 2007 21:33:00 +0000

The Carry Trade and the Supply of Japanese Yen

Money is created by banks when people borrow it into existence. In the US, there are no shortage of people wanting to borrow money for consumption or investment. In Japan finding borrowers is a bit problamatic because, culturally speaking, the Japanese are very good savers. The Japanese government has done it's part in running up huge debt until recently:

In June 2003, with the Fed cutting interest rates to an ultra-low 1.00%, and deflation remaining a real problem in Japan, the Bank of Japan went wild printing Yen and buying dollars. This forced the Yen down and boosted Japanese manufacturing, allowing the the BoJ to ease off. Since then the BoJ has wisely been selling US treasuries and soaked up much of the liquidity they had added to fight off deflation:

More recently, I believe foreign carry-traders are behind much of the borrowing that has kept deflation from taking hold in Japan. In June of 2004, the Fed began raising US interest rates from 1.00% all the way up to 5.25% two years later. With each hike, the value of the dollar was boosted relative to the Yen because of the Yen carry trade became much more attractive. As more carry traders borrowed Yen and purchased US dollars or other currencies it helped expand the Japanese money supply.

The carry trade is serving the policy needs of the BoJ and Japanese government very well for now. With each new Yen borrowed into existence, it stimulates the Japanese economy. Japanese exporters have an easy time unloading the dollars they receive from American consumers and Japanese bankers profit from interest payments on the money they create and loan.

On the American side, Wall Street is making a killing off of the easy short term gains. Bonuses for investment bankers are at an all time high. Unfortutely the profits are mostly temporary. The carry trade is so large that it cannot be unwound successfully for most participants (who are mainly hedge funds). The Bank of Japan will be in control of the exchange rate as carry traders get squeezed out of their positions. I expect it will slow and steady, so that Japanese banks get repaid on their loans before most of the capital . Meanwhile hedge fund investors will be the ones left holding the bag.

noreply@blogger.com (RodgerRafter) — Fri, 27 Apr 2007 15:44:00 +0000

Vacancies as a Function of the Rebalancing Process

The favorite vehicle for foreign investment into the United States over the past two years has been mortgage backed secuirities. Fannie Mae and Freddie Mac offer a guarnatee that their secuirities will make their payments, which creates an impression of safety for a huge portion of the MBS market. Money pouring into MBSs has fueled extreme levels of housing construction, to the point that American builders have been adding far too many homes to the market. This shows up in the vacancy data released today:

Vacancies for rent rose steadily from 2000 through 2003 in bad economic times, while the sharp uptick in vacancies for sale has likely been a more recent function of the end of the speculative bubble and the mortgage squeeze. Vacancies are likely to continue rising both because the market and economy are continuing to weaken and because homebuilders haven't reduced construction enough. Today MDC Holdings released their numbers and they show an increase in homes under construction without buyers (year over year):

This is true for virtually all the builders, as they have too much land on their books and too many communities still opening up. They ignored the building inventory problems and in 2005 got extremely aggressive with their expansion plans just as the market hit its peak. MDC is still opening up new communities in the worst markets:

As the rebalancing process proceeds, Americans will continue to lose purchasing power. That should be incorporated into the homes they live in. Just as people will have to downside their consumption of imported goods, they'll have to downsize their homes. Single family detatched housing was the biggest product of the housing bubble. The vacancy rate for 1 unit homes is up to 2.5% from 1.5% just 2 years ago. Stress will continue to build in this area as builders like MDC add to inventory at a time when fewer Americans can afford to live in McMansions.

noreply@blogger.com (RodgerRafter) — Wed, 25 Apr 2007 18:46:00 +0000

Hedge Fund Borrowing Propping Up the Dollar and Stock Market

Yesterday I read an article listing the 10 highest paid hedge fund managers in 2006. Topping the list for the second year in a row was James Simons (go bears!), so naturally I wanted to find out what I could about how his hedge funds make their profits.

According to the article, "the hedge fund firm employs roughly 80 PhD's who develop computer programs to seek out price anomalies in a wide range of markets, including equities, commodities, futures and options." I don't have any insights into what Renaissance is doing in the commodities futures and options markets, but at least in terms of equity holdings, the record is pretty clear. The fund began buying aggressively in Q3 2005 and got more aggressive each quarter, almost tripling their equity holdings during 2006:

Before fees, Renaissance's Medalion fund earned a return of 79% (44% after fees). With the stock market up just 15% last year and Renaissance's holdings spread out among almost 3,000 different equities, it's safe to assume that a large amount of leverage was employed to boost the return numbers. Most likely the Fund borrowed Yen during 2005 and 2006 and used these funds to buy dollars and then US equities and other investments. With the Yen down against the dollar over the past two years, highly leveraged borrowings would have greatly increaed the overall returns. Of course a falling dollar and/or a falling stock market would have led to magnified losses, rather than magnified gains.

The biggest spike in buying came during Q4 last year, and the holdings numbers are still fresh, showing which positions were added to and which were reduced. One thing that jumped out at me was that the 4 stocks where the most new capital was directed were all Dow Industrials:

The three stocks getting the most new capital on average accounted for more than triple what other top investments received. Dow Stocks also made up 3 of the top five on the sell side. In all, a net of $2.5 billion was poured into Dow Industrials by Renaissance during the last quarter of the year. This likely helped boost the Dow, as the total index was up 6.71% during the quarter, while the 10 Dow stocks purchased by Renaissance rose a weighted average of 8.11% and the 6 stocks sold only rose a weighted 6.33%. Interestingly, the Dow stocks with shares bought by Renaissance in Q4 were poor performers in Q1 2007 (falling 1.85%) when compared to the good performance of their recent sells (+1.30%), implying that they really weren''t good stock pickers.

When the 80 PhDs go looking for "inefficiencies" I don't get the impression they are doing much analysis of value in a traditional sense. It is noted that Simons hires mathematicians, rather than MBAs, so the soundness of a companies business model and it's future projected earnings are not likely to be a big factor in the computer driven trading strategies. In looking at the stocks where they took on a position of over 5%, there were plenty of stocks with negative earnings per share and high price to book values:

While I believe the 80 PhDs are extremely good at creating successful computer models and trading strategies, I don't need a PhD or a sopisticated computer to figure out what are likely to be the main underlying secrets to their success. The biggest and most lucrative inefficiences to exploit are technical in nature (rather than fundamental). The computer models are probably especially good at detecting when too many people have shorted a stock or when to arbitrage profits out the greedy short term bets options traders like to make. Prices can be manipulated for short term gains or they can simply be driven up almost endlessly for positions the company already holds. The following table shows the date when Renaissance reported going over the 5% ownership threshold for stocks (prior to the start of Q4), and then includes the number of shares added during Q4, presumably boosting the net asset values of the fund:

The next table shows the increasing number of new positions that went past 5% during Q4:

Buying up a large enough number of shares in a stock can drive up the price. We can be sure the programs have concluded that thiswill improve their performance, but given the complexity of the programs involved we can't be sure if the people behind the programs really understand the difficulty of reversing course when the fundamentals of a company or the market deteriorate. The chart of Renaissance's total equity investment over time has the look of a system out of control. It is probably indicative of the our whole financial system, dependent on ever higher rates of borrowing and credit expansion until the day when finally credit from abroad is cut off. Perhaps Simons is already well aware of this and sees no choice but to head forward at full steam.

I don't think "inefficiencies in the markets" is as good a description as "flaws in the system" when it comes to describing the success of computer trading models in generating high returns for hedge fund managers. In my opinion, the stocks Simon's holding are valued less efficiently as a result of his actions rather than more efficiently. Also, in my view, the market as a whole is driven higher through the leverage he and other hedge funds employ, while long term economic instability they are creating should be pointing toward lower valuations.

In an abstract, disconnected kind of way, the computer models probably account for the basic conflict of interests in the hedge fund compensation model: Heads we both win, tails you lose. If the models seek to maximize gain for the hedge fund managers, then they will seek to elevate risk to a very high threshold. While the fund has a track record of earning 36% per year for almost 2 decades, one year of 100% losses would of course negate that for anyone who let their profits ride or came late to the party. I could concoct a scheme to guarantee 50% returns on aveage. Three years of 100% gains, followed by one 100% loss equates to an average return of 50%, but a net loss of -100% for the investor. Meanwhile, I as manager would be syphoning out my 20+% per year before blowing all the rest of the investors money in the final year. If I programmed a computer to simply maximize my projected gains as the manager, an extremely high risk strategy would be the result.

Renaissance is taking on a very high degree of risk. With over $47 billion leveraged into the stock market, they won't have a fun time trying to get out once the market finanally turns ugly. How deeply the bias toward risk is represented in the core mathematical models is a question for the PhDs. Simons has reportedly collected around $3.2 billion in compensation during the last 2 years alone. When most people see those kind of numbers the reaction is that nobody could possibly deserve to make that much money. In my view, Simons has created a brilliant business model that takes advantage of flaws in the system. To the extent that he is profiting from the mistakes of other traders there is no real harm done to the economy. Indeed Simons has done a lot of good through his charitable contributions. However, to the extent that Renaissance is creating systemic risk by (possibly) playing the Yen Carry Trade, creating excess liquidity and promoting malinvestment Simons may be doing substantial economic damage to this country and the world.

The thing I'll be most intersted in watching is wether Renaissance has the ability or desire to reduce its risk exposure before it is too late of if they'll just continue taking on more risk until the system reaches its final limits. Hopefully I'll find some more clues to this in the Q1 holdings report they'll release in May.

noreply@blogger.com (RodgerRafter) — Thu, 19 Apr 2007 18:47:00 +0000

Trends in the Jobless Claims Point Toward a Slowing Economy and More Foreclosures

The housing slowdown has gone through two distinct stages so far. The first was related to the rapid exit of flippers who had been putting down deposits on pre-construction homes and then selling them for a profit before the homes were finished. Speculators created a demand vaccuum when it realized they needed to get out of contracts and inventory early last year. The second stage has been related to the tightening of credit and a shift in market psychology cutting into the number of willing and eligible buyers. Usually speculators and easy credit policies complete their cycles without too much of a an impact on the market, but this time they've been big enough to make for a very noticeable slowdown.

The third stage will likely be due to the more traditional cause of housing slowdowns - job losses and a slowing economy. During the last recession, initial jobless claims climbed up over 400,000 per week, but have hovered around 300,000 much of the time since then. People losing jobs is traditionally the biggest cause of mortgage defaults (rather than reseting ARMs). Looking at the seasonally adjusted Initial Claims data demonstrates a rising trend:

The big spike last May was due to the brief shutdown of the Puerto Rican Government. Other than that, the rising trend seems clear and fits well with the well established slowdown in residential construction.

Looking at unadjusted numbers year-over-year (over-year), the recent rise over 2006 levels is clear, although the numbers are now roughly where they were in 2005:

Unemployment levels are still low historically and there isn't likely to be a big uptick in mortgage defaults based solely on the new claims we're seeing right now. The seasonal December and January layoffs may be adding to the rise in recent delinquencies we've been seeing, but it won't be until July when we get another seasonal spike. In September and October of 2005 we saw spikes from the big Gulf hurricanes.

In Year-Over-Year percentage terms, the uptrend is especially clear:

The rate of change in 2006 was mostly negative, even without the hurricane comparisons. The rate of change began to swing sharply positive in February 2007.

Job losses may be contributing to the rise in foreclosures, although resetting ARMS, stagnating price and tightening credit standards are almost certainly the largest causes for now. It'll be interesting to watch the foreclosure numbers when job losses do pick up. Here are a couple of charts from RealtyTrac's monthly foreclosure press releases:

Realtytrac is not exactly a reputable source when it comes to producing economic reports, and it is clear their data is far from perfect. Nevertheless it generally conforms with what other data sources are saying: The economy is on shaky ground and millions of middle-class Americans are feeling the squeeze.

noreply@blogger.com (RodgerRafter) — Wed, 18 Apr 2007 01:03:00 +0000

Shoppertraking the Retail Slowdown

Russ Winter has been reporting a wide range of indicators showing a slowdown in retail sales over on his blog. He's been watching the mainstream retail sales numbers as well as tax receipts and other obscure indicators.

It's a little hard to see through the the seasonal variations due to the earlier Easter this year. Nevertheless using a six-week moving average smoothes out Shoppertrak's data pretty well:

I've maintained for a good while that government and banking interests are geared toward prolonging the status quo, so it's the final exhaustion of the US consumer that will have to bring the global economy back into balance. For now, consumers don't seem to be willingly giving up their buying habits, so poverty is the face of the exausted US consumer: NY Times article on US poverty levels

noreply@blogger.com (RodgerRafter) — Mon, 16 Apr 2007 19:44:00 +0000

Contradictions Between the Treasury and the Fed Data

According to the Fed's H41 statements, Marketable securities held in custody for foreign official and international accounts went from $1.176156 Trillion on 1/31/2007 to 1.205004 Trillion on 2/28/2007, showing an increase of about $29 Billion for the month of February. Meanwhile, the Major Foreign Holders portion of the TIC data released by the Treasury Department today shows Foreign Official accounts only increasing by about $3 billion to $1.451.3 trillion. Estimating January's custodial additions as $17 billion contrasts against the Treasury's reported official subtraction of $3.6 billion.

First I have to say I think that the treasury data is the less reliable of the two and subject to large revisions like the one that usually occurs in June. Also, since the Treasury data has been higher than the Fed data going back as far as this source of historical Treasury MFH data goes.

If we assume that both data sets are reasonably accurate then one of these appears to be a likely explanation:
1. Official foreign accounts at the Fed were big net buyers while official accounts not at the Fed were big net sellers.
2. Non-official international accounts at the Fed were especially big buyers.
3. Both of the above.

Who is buying remains the big question, and I can only find clues, not answers. Total foreign holdings rose $24.3 billion, so non-official investors were likely buying. As a whole, Japan's estimated holdings dropped by $10 billion in February, calling into question my thought that it could be the Bank of Japan intervening as the did in 2003-2004. The total decline was probably down closer to $12 billion because Japan's June series revision was down $21.5 billion. Year over year Japan is down $38.6 billion. China, meanwhile was up $16.3 billion in Feb, had a +$44.3 billion revision in June and is up $97.8 billion year over year. Chinese and Japanese official accounts could be the culprit, if China was buying through the Fed and Japan was selling outside the Fed. However, evidence below suggests that China may not be buying primarily through the Fed.

I've seen the conspiracy theory floated around that the Fed is using secret offshore accounts to buy up US treasuries. IF these accounts actually exist and are included in the non-official international accounts data then they could also explain the big disconnect between TIC and H41 numbers. However, that conspiracy theory has been around for more than a year and prior to the last two months Treasury data was rising faster than Fed data.

The June series revision is the result of a survey sent to institutional bond holders to find out what countries they were really holding securities for. The UK always sees a huge downward revision because it is a major financial center holding bonds for investors from all over the world. Last June UK holdings dipped by $155.6 billion on the revision. Japan also dipped substantially (by $21.5 billion). The biggest gainers were Foreign Official, China and (by default) the United States. Foreign Official and the US both rose by around $120 billion, while China added $24.3 billion. China probably made up a significant chunk of the Foreign Official additions. US institutional investors, and especially hedge funds, probably made up most of the share of treasuries that were being held abroad for US investors.

Still more questions than answers. All comments and theories are welcome.

noreply@blogger.com (RodgerRafter) — Sun, 15 Apr 2007 05:08:00 +0000

Banking System on the Verge of a Major Crisis

A couple of posts ago, I described how the delinquencies were creating a liquidity crisis for mortgage lenders. Many of them have had to declare bankruptcy because they haven't had enough financing to make up for the lack of cash flow they are facing due to rising delinquencies and defaults.

The overall leverage of modern US banks and their exposure to real estate loans has become extreme just at the point when loan defaults are getting out of hand:

The lessons learned from the bank runs that led to the Great Depression have long ago been forgotten by regulators. Banks need to have reserves on hand in order to remain solvent in difficult economic times. Unfortunately holding cash reserves cuts into profit margins, so banks have lobbied the Fed to reduce reserve requirements and allow much greater leverage. Now that banks are developing a strong need for cash many are realizing that they don't have enough of it available:

Both of the above charts display historical data from the Fed's H8 reports. Looking at more recent H8 data gives an indication of how the current banking crisis is unfolding. Over the past year, Banks were very aggressive in expanding real estate lending, commercial lending, corporate bond purchases and lending to securities speculators. Meanwhile, they were extremely lax in setting aside reserves in cash, US treasuries and Agency debt. Here are the year over year increases from March 2006 to March 2007 for the main categories of banking assets:

Real Estate Loans and Leases: +10.56% to $3,316 Billion
Treasuries and Agency Debt: +1.96% to $1,186 B
Other Securities: +12.72% to $1,051 B
Commerical Loans: +12.78% to $1.074 B
Interbank Loans: +21.30% to $365 B
Security Loans: +15.99% to $313 B
Cash Assets: -6.27% to $294 B
Other Loans and Leases: -1.59% to $525 B
Total Bank Credit: +8.40% to $8,366 Billion

Up until Mid-February, most banks didn't think there was a whole lot to worry about because they were able to sell off as much real estate exposure as they liked to investors through mortgage backed securitizations. That source of liquidity came to a grinding halt a couple months ago, and since then there have been some eye-catching developments on banking balance sheets. Real Estate Loans and Leases suddenly reversed course, recording the largest single month decline on record (-1.83%). Cash assets also declined suddenly (-3.32%). In the past, February and March have been big months for banks to acquire US Treasury and Agency debt, as the Treasury faces its tightest season before Tax day in April. Here's the February+March net buying totals for the last 5 years:

2003 $36.2 Billion in Treasuries and Agency Debt to $1075.7 B.
2004 $95.8 Billion to $1200.2 B
2005 $33.3 Billion to $1217.4 B
2006 $34.3 Billion to $1185.9 B
2007 $11.1 Billion to $1209.1 B

The lack of buying by US banks is probably another reason why Foreign Official Accounts had to step up in a big way during Q1 (adding over $140 Billion in securities during the 13 weeks ending last Wednesday).

In recent years banks have been net sellers of treasuries and agency debt from March to January. This time they'll probably be especially large sellers as the need for cash increases. Foreign official accounts are probably the buyers of 2nd-to-last resort, but many of them have been indicating for awhile that they want to reduce their exposure to US debt. The Fed is the buyer of last resort for treasuries, as they can create as much money as they desire and purchase treasuries with permanent injections (they did two last week). Of course doing this would be highly inflationary at a time when inflation numbers seem to be coming in above the Fed's acceptable range.

How long will foreign officials and investors be willing to buy up US debt at these historically low interest rates?
How sharp will the contraction be in real estate lending?
How many banks will be ruined in the process?
How long will it be before other areas of excessive bank credit begin collapsing under their own weight?
How deep of a recession will this all cause?

Stay tuned. As the data keeps coming in, I'll keep blogging what I see in the numbers.

noreply@blogger.com (RodgerRafter) — Fri, 13 Apr 2007 18:36:00 +0000

Regional Factors in the Rebalancing Process

February's Trade Gap numbers showed a sixth straight year-over-year decline, strongly suggesting that the trade gap really has begun to rebalance. When you look at specific countries and regions, you can get a better idea of how and why it is happening:

While China continues its upward trend (ignore the seasonal fluctuations), Japan and Canada have been flat and Europe has shown a significant decline.

The biggest factors for the regional differences (in my mind) are related to individual currency strengths. The Euro has been on the rise since late 2005 and it eventually had the cummulative effect of narrowing the trade gap with the US. The Yen and Canadian dollar, meanwhile, have been volatile but essentially flat over the last year (Canada making up most of the North American trade gap). China has been slowly increasing the value of the RMB, but China's infrastructure and technical expertise are improving so fast that their competitive advantage is rising in spite of the currency shift.

Japan probably isn't happy about their stagnating exports to the US. They faced a similar problem in late 2003 and early 2004 with slowing export growth and a rising Yen. Back then they went balistic with currency interventions, selling Yen to buy US Dollars in order to surpress the value of the Yen. The strategy worked, and the trade surplus with the US began growing again:

That extreme intervention showed up as a big surge in Official Custodial Holdings at the Fed, but that is now being dwarfed by a new buying surge that has taken place in the first part of 2007:

Is Japanese intervention again behind the surge? I think in part it is. The other part is probably a result of the massive Yen carry trade in play. As Yen are borrowed into existence by hedge funds, and sold for dollars, these dollars find their way back to the Bank of Japan and then get spent on US debt securities. My casual observations of the US markets have had the appearance of a strong increase in carry trade activity, with the Yen weakening pretty much every time the US markets rally.

The carry trade has a huge positive long term impact for Japan. The Japanese banking system creates Yen out of thin air and loans them out at around 2% interest. If foreign investors are borrowing about $1 trillion per year, that's $20 Billion in profit for the Japanese economy, assuming that currency rates stay level. Of course the Bank of Japan will be in position to control the exchange rate as they have in the past. When it comes time to end the game, they can let the Yen rise in a controlled fashion to squeeze carry traders out of their positions for an additional 5, 10, 15% profit.

Defaults are a minor concern, so I expect the eventual rise of the Yen will be controlled. This would also protect Japanese manufacturers from a sharp, disruptive rise. Hedge fund managers will normally close down their funds and pay back their creditors before they go totally bust. This enables them to get back in the game because pleasing financiers is more important than pleasing investors. If played right, the Yen Carry Trade is free money for the Japanese economy at the expense of global hedge fund investors.

As for China, it is clear that the rate of change in the RMB simply hasn't been fast enough to reverse the growing trade gap with the US. However, the US consumer appears to be running out of fuel. With the mortgage equity engine stalled, and consumer debt burdens overextended, the US trade gap with China may soon contract under its own weight. China has already begun preparing for the day when most of their exports are to other regions and where domestic demand is increased with a rising standard of living.

Even with manipulation of the currency markets by Japan and China, global trade imbalances appear to be on an unavoidable path toward rebalancing.

noreply@blogger.com (RodgerRafter) — Thu, 12 Apr 2007 16:28:00 +0000

Foreclosure Pipeline Update From Novastar

NFI was kind enough to provide their monthly update on the status of their securitizations and the good news is that 30-59 day contractual delinquencies were down on almost all of their issues. The bad news is that's normal for March and that the default levels are still very high. The peak for new delinquencies may have occurred in December, as many subprime borrowers appear to have chosen a lavish holiday season over making their mortgage payments. Those defaults hit the 30+ day threshold in January and 60+ threshold in February. Time will tell whether or not the tightening of credit in March leads to a big enough surge in defaults to top December's levels. The total percentage of borrowers failing to make monthly payments continues to grow steadily as more loan begin defaulting each month.

The following charts show the composition of bad loans for the securitization of December 2005 and the two securitizations of June 2006 as they've grown month by month:

Credit quality in the 12/05 issue was bad enough, and the level of defaults continue to rise. Delinquencies in the June 2006 issues are already twice as high as they were at this stage for the 12/05 issue. One interesting thing to note is that lately NFI has been much quicker to push delinquent loans into and through the foreclosure process in the hopes of raising some cash.

Even more importantly, we should note that Novastar has only just begun to recognize losses on the portfolio. To do so would be to call into question their solvency at a time when they are worried about creditors cutting off funding. Meanwhile the number of homes in the foreclosure process and the number of homes on the books waiting to be sold is ballooning out of control. As long as Novastar avoids selling those homes at a loss they can pretend there has been no hit to earnings. However, the lack of mortgage payments flowing in must be made up for by NFI when they make interest payments to the investors who bought the securities.

Right now, Novastar is facing a liquidity crisis similar to the one that forced New Century into Bankruptcy. Consequently, Novastar is desperately "exploring strategic alternatives" to declaring bankruptcy themselves. It's hard to imagine that anyone will be foolish enough to bail Novastar out of their terrible position.

Let's be perfectly clear here:
1. Cash is tight for the lenders because many borrowers aren't making their payments.
2. It's going to get tighter as the percentage of defaults continues to rise.
3. This is just the first stage, a liquidity crisis that is wiping out many lenders as their creditors scramble to protect themselves.
4. The next stage will cut to the core of the ponzi nature of our financial system.
5. Homes sitting on the books and in the foreclosure process are increasing much faster than they are being sold.
6. The big losses haven't even begun to be recognized yet by mortgage lenders, mortgage insurers and the GSEs.
7. The losses will be massive and spread out over a long period of time as home prices enter a long, steady decline.
8. The liquidity crisis faced right now by the subprime lenders will spread to almost anyone who's solvency is in question.
9. Huge amounts of imaginary wealth will be wiped out in the financial sector and in the greater economy.

During their conference call today Mortgage Insurer MGIC Investment Corp. was pressed on Novastar's condition, and did their best to dodge the issue. MGIC is Novastar's main insurance writer and they maintained that Novastar has been a good customer. That may change soon when Novastar has to start pushing through more loss claims. For now, MGIC is in complete denial, thinking that the market overreacted to the subprime crisis during the first quarter. In addition to primary mortgage insurance, MTG also has large invesments in joint ventures that buy distressed consumer credit receivables (Sherman Financial Services Group) and invest in and service subprime loans (C-BASS). Denial is probably the best way for them to preserve their sanity these days. (The last 10 minutes of the call is the most worth listening to.)