Such rates should not be government guaranteed but they are. Money will always flock to the highest guaranteed returns.

Washington Mutual, Corus Bank, Bank United, Countrywide Financial and others are all attracting capital because of FDIC insurance. Can they make it up by lending it out higher? Perhaps, but only by taking on additional risk. Would those banks attract as much capital without FDIC insurance? Hardly.

It was excessive risk that got WaMu, Citigroup, Merrill Lynch, Bear Stearns, Countrywide and others into trouble in the first place.

If this financing scheme fails, the taxpayer will be left holding the bag. Does this ring a bell? It should because that is what happened in the S&L Crisis.

S&L Crisis Revisited

Wikipedia has this take on the Savings and Loan Crisis:

“The Savings and Loan crisis of the 1980/1990s was the failures of savings and loan association in the United States. Over 1,000 savings and loan institutions failed in ‘the largest and costliest venture in public misfeasance, malfeasance and larceny of all time.’ The ultimate cost of the crisis is estimated to have totaled around $160.1 billion, about $124.6 billion of which was directly paid for by the U.S. government.

“A taxpayer funded government bailout related to mortgages during the Savings and Loan crisis may have created a moral hazard and acted as encouragement to lenders to make similar higher risk loans during the 2007 subprime mortgage financial crisis.

“The background

“Savings and loan institutions (also known as S&Ls or thrifts) have existed since the 1800s. They originally served as community-based institutions for savings and mortgages. In the United States, S&Ls were tightly regulated until the late 1970s. For example, there was a ceiling on the interest rates they could offer to depositors.

“In the 1970s, many banks, but particularly S&Ls, were experiencing a significant outflow of low-rate deposits, as interest rates were driven up by the high inflation rate of the late 1970s and as depositors moved their money to the new high-interest money-market funds. At the same time, the institutions had much of their money tied up in long-term mortgage loans that were written at fixed interest rates, and with market rates rising, were worth far less than face value. That is, in order to sell a 5% mortgage to pay requests from depositors for their funds in a market asking 10%, a savings and loan would have to discount their asking price on the mortgage. This meant that the value of these loans, which were the institution’s assets, was less than the deposits used to make them and the savings and loan’s net worth was being eroded.

“Under financial institution regulation which had its roots in the Depression era, federally chartered S&Ls were only allowed to make a narrowly limited range of loan types. Late in the administration of President Jimmy Carter caps were lifted on rates and the amounts insured per account to $100,000. In addition to raising the amounts covered by insurance the amount of the accounts that would be repaid was increased from 70% to 100%. Increasing FSLIC coverage also permitted managers to take more risk to try to work their way out of insolvency so that the government would not have to take over an institution. When Jimmy Carter left office in January 1981, 3,300 out of 3,800 S&Ls lost money that year. In 1982 the combined tangible net capital of this industry was $4 billion. The chartering of federally-regulated S&Ls accelerated rapidly with the Garn-St Germain Depository Institutions Act of 1982, which was designed to make S&Ls more competitive and more solvent. S&Ls could now pay higher market rates for deposits, borrow money from the Federal Reserve, make commercial loans, and issue credit cards. They were also allowed to take an ownership position in the real estate and other projects to which they made loans and they began to rely on brokered funds to a considerable extent. This was a departure from their original mission of providing savings and mortgages.

“Imprudent real estate lending

“In an effort to take advantage of the real estate boom…many S&Ls lent far more money than was prudent, and to risky ventures which many S&Ls were not qualified to assess. L. William Seidman, former chairman of both the FDIC and the Resolution Trust Corporation, stated: ‘The banking problems of the 80s and 90s came primarily, but not exclusively, from unsound real estate lending.’

“Keeping insolvent S&Ls open

“Whereas insolvent banks in the United States were typically detected and shut down quickly by bank regulators, Congress sought to change regulatory rules so S&Ls would not have some acknowledge insolvency and the FHLBB would not have to close them down.”

Public Policy Causes of the S&L Crisis

While Wikipedia has many of the facts correct, pointing the blame at deregulation is missing the boat. In the Concise Encyclopedia of Economics, Bert Ely gets it right. Ely lists in his article 15 reasons but the first one really says it all:

“Federal deposit insurance, which was extended to S&Ls in 1934, was the root cause of the S&L crisis because deposit insurance was actuarially unsound from its inception. That is, deposit insurance provided by the federal government tolerated the unsound financial structure of S&Ls for years. No sound insurance program would have done that. Federal deposit insurance is unsound primarily because it charges every S&L the same flat-rate premium for every dollar of deposits, thus ignoring the riskiness of individual S&Ls. In effect, the drunk drivers of the S&L world pay no more for their deposit insurance than do their sober siblings.

“Borrowing short to lend long was the financial structure that federal policy effectively forced S&Ls to follow after the Great Depression. S&Ls used short-term passbook savings to fund long-term, fixed-rate home mortgages. Although the long-term, fixed-rate mortgage may have been an admirable public policy objective, the federal government picked the wrong horse, the S&L industry, to do this type of lending since S&Ls always have funded themselves primarily with short-term deposits. The dangers inherent in this ‘maturity mismatching’ became evident every time short-term interest rates rose.”

History Rhymes

This time it was banks taking riskier and riskier lending positions. The underlying belief was that property values always go up so there was no risk. That belief was blown out of the water.

WaMu is heavily into Pay Option ARMs. An accounting absurdity let WaMu (and others) record negative amortization from those ARMs as earnings. The investment community cheered what should have been an enormous red flag. The Pay Option ARM problem went ignored for months as the following chart shows:

The chart shows that Pay Option ARM problems finally caught up with Washington Mutual in July 2007. In spectacular fashion, there was an asymmetrical unwind of the credit bubble at WaMu and many other financial companies.

Now Washington Mutual is attempting to sure up its balance sheet by attracting capital at above market rates.

Watch Corus Bankshares

Corus Bank is another one to watch. According to its business model, as posted on Yahoo! Finance:

“Corus Bankshares, Inc. operates as the holding company for Corus Bank, N.A. that offers consumer and corporate banking products and services. The bank’s deposit products include checking, savings, money market, and time deposit accounts. Its loan portfolio primarily comprises commercial real estate loans, including condominium construction and condominium conversion loans; commercial loans; and residential real estate loans.

“The bank focuses its lending activities in various metropolitan areas in Florida and California, as well as in Las Vegas, New York City, and the Washington, D.C. Corus Bank focuses it lending in many of the major collapsing real estate bubbles in the country. Were it not for FDIC insurance would anyone want to take a risk on Corus Bank’s CDs?”

Woes at Bank United

BankUnited is another bank in trouble over Pay Option ARMs. According to Yahoo

“BankUnited, whose $15 billion in assets makes it the largest bank based in Florida, reported large increases in provisions for possible loan losses on its monthly option adjustable-rate mortgages in 2007. The bank’s non-current ratio has been rising for those loans, which permit borrowers to defer some monthly interest payments and thus increase their loan balances.”

If you would like to see the complete list of companies with problems, take a look at High Yield CD Rates. They all will mention FDIC insurance. Without it, who would invest with these companies?

FDIC is a moral hazard that caused the S&L crisis. Perhaps we are in for a repeat performance.

Regards,
Mike Shedlock
January 9, 2008

P.S.: The economic landscape of 2007 was marked by the burst of the housing bubble. A New Year brings new possibilities, but that is not necessarily good news when it comes to our housing markets. We’ve seen and heard the bubble burst; now is when we could actually be seeing the worst.

This article was originally featured on Whiskey and Gunpowder

Similarities Between SL and the Housing Crisis

“After advising for weeks there were no huge charges on the horizon, UBS stunned the market on Monday with the massive write-down, saying it had obtained a 13 billion Swiss franc ($11.52 billion) capital injection from the Singapore government and an unnamed Middle East investor…

“UBS said the capital injection would enable it to raise its Tier 1 capital ratio to 12%, despite the hefty write-down of its exposures. Without the recapitalization, the $10 billion charge would have blown a hole in its capital base. Analysts say it is crucial for UBS to keep its Tier 1 capital in double figures in order to secure its franchise as the world’s largest wealth manager…

“‘UBS’ write-downs are large but conservative, and it has managed to find investors to take the risks,’ analysts at Dresdner Kleinwort said in a note to clients on Monday. ‘However, smaller groups may not have this luxury, and there is clear evidence of balance sheet stress emerging.’”

MBIA Receives $1 Billion Private Equity Bailout

Bloomberg reports that, seeking to avert a crippling reduction of its AAA credit rating, “MBIA Gets $1 Billion From Warburg Pincus”:

“Shares of MBIA, the world’s biggest bond insurer, soared as much as 27 percent after the company said it will sell $500 million of common stock to Warburg Pincus. The private equity firm will also backstop a rights offering of up to $500 million next year, Armonk, N.Y.-based MBIA said today. MBIA said it faces ‘significantly’ higher losses from a slump in the value of securities it guarantees.

“The added capital may help ward off a cut in MBIA’s top credit rating, which is under scrutiny by Moody’s Investors Service, Fitch Ratings, and Standard & Poor’s. MBIA’s AAA ranking stands behind $652 billion of state, municipal, and structured finance bonds, and losing the AAA credit rating would endanger those ratings, as well as cut off MBIA’s ability to guarantee debt, its main source of revenue.

“‘It’s a positive for the company,’ said Rob Haines, an analyst at CreditSights Inc. in New York. ‘It staves off the potential for a rating downgrade.’”

My Comment: A problem delayed is not a problem solved.

The insurers, led by MBIA and Ambac, are sitting on $100 billion of collateralized debt obligations backed by subprime mortgage securities. One billion dollars is peanuts, compared with their actual exposure. Bloomberg continues:

“Warburg Pincus, the New York-based firm started in 1971, will initially buy 16.1 million common shares, at $31 each. The firm will also receive seven-year warrants and have the right to appoint two directors… Mark-to-market losses will be more than in the third quarter, and the company will set aside as much as $800 million to cover losses it expects to take on securities backed by home equity loans, MBIA said…

“MBIA, in October, posted a $36.6 million loss because of write-downs on mortgage-related securities and halted stock buybacks to retain capital. So far this quarter, the company ‘has observed a further widening of market spreads and credit ratings downgrades of collateral underlying certain MBIA-insured CDO tranches,’ the company said in [its Dec. 10] statement.

“The fair value of the assets slumped by about $850 million in October, MBIA said. The company will have ‘significantly’ larger mark-to-market losses in the fourth quarter… ‘Given the magnitude of MBIA’s exposures, as demonstrated again this morning with UBS’ write-downs, I don’t see how $1 billion moves the needle,’ said David Einhorn, president of Greenlight Capital LLC in New York, which has a short position on MBIA.”

My Comment: Einhorn is clearly talking his book, but at least he admits it. Furthermore, I happen to agree with him. It took nearly all of that $1 billion, of which MBIA received only half so far, just to cover fourth-quarter losses. What now? The problem sure did not go away.

Bank of America Closes Institutional Fund

Denying a CNBC rumor of an asset freeze, Bank of America is closing its Columbia Strategic Cash Portfolio. Reuters reports:

“Bank of America Corp.’s Columbia asset management unit said on Monday it is closing a privately placed money-market fund for institutional investors.

“The bank’s Columbia Strategic Cash Portfolio fund, which has less than $11 billion in assets, has been closed to new investors, said Columbia spokesman Jon Goldstein.

“Goldstein denied a CNBC report that the fund had been frozen, saying that clients were being offered the option of cash redemptions or of switching their assets into other Columbia-managed funds.”

My Advice: Take the cash and run.

Minyan Peter on Vulture Buying

In response to Quint Tatro’s Minyanville piece on Monday, “Foreign Buyers at the Ready,” Minyan Peter wrote:

“While clearly foreign wealth funds and other offshore money is piling in to ‘bail out’ the capital infirmed, I would make a point about how these capital injections are being structured. Whether it is Citi, E*Trade, or UBS, new capital is coming in as either convertible debt or convertible preferred. Why? Because in liquidation, these new investments rank ahead of common shareholders when it comes to getting paid.

“As I have written previously, on the way down, vulture investors buy converts. At the bottom they go right for the common.”

Note: Peter is a former treasurer at a major U.S. bank.

Smack in the face of enormous losses at MBIA, with even bigger announced losses to come, the market is going giddy because MBIA received a down payment on a potential $1 billion max infusion. However, that infusion does not come close to covering MBIA’s subprime exposure.

The equity markets, in general, are acting as if all these problems are going to be solved by a one-time cash infusion from venture vultures and bailouts from oil producers.

Meanwhile, the credit markets have barely budged. LIBOR is down a mere one basis point from an extremely wide spread. LIBOR is suggesting banks still do not trust lending to each other, not even overnight.

The disconnect between the credit markets and the equity markets is simply staggering. Believe what you want, but the message from the credit markets is that a wave of bank failures is coming, and/or that balance sheet stress is going to get far worse before it gets any better.

Regards,
Mish

December 12, 2007

This article was originally featured on Whiskey and Gunpowder

Balance Sheet Stress and Vulture Buyers

In fact, not only would gold or silver probably not enter the conversation, chances are most people wouldn’t be able to name a single gold or silver mining company. That’s because even though gold has almost tripled and miners have risen over 600% since 2000, most people haven’t yet realized that precious metals have been outperforming the general market since then by leaps and bounds.

However, that may be about to change. The Fed’s decision to lower the fed funds rate by a larger than expected 50 basis points kicked the dollar index down to a record low. The euro traded over 1.40 per dollar for the first time, and the Canadian dollar reached parity against the U.S. dollar for the first time in over 30 years. These events reached the front page around the country.

This time, the dollar’s decline coincided with a sharp rise in public awareness about the weakening greenback. As a result, the precious metals bull market may be entering a new phase. When the general public becomes more aware of the dollar’s bleak future, more and more people will see charts comparing the price of gold and the U.S. dollar index and ask themselves why they haven’t been invested in gold:

Such a shift in public awareness is usually the ingredient that changes a stealth bull market — like the one we’ve seen so far in gold — into a raging bull market.

Every time people listen to the news, they are reminded of how stocks perform. They are reminded of interest rates and the bond market every time they get their credit card statement or check to see if it they should refinance their mortgage. They are reminded of the bull market in energy every time they fill up their gas tank. But unless they collect coins as a hobby, most people have very little regular contact with the price of gold. With the exception of a brief period at the peak in early 2006, the precious metals rally has garnered very little investor interest.

Since May 2006, fund flows out of precious metal stock funds have been huge, even though the price of gold remained near its peak. This suggests that even the investors who are aware of gold remain more interested in trading gold stocks than holding them for the long run.

All the sentiment signs suggest that we have a long way to go before gold is considered a must-have, long-term buy-and-hold investment. Such sentiment extremes are the stage at which all long-term bull markets end.

Technology stocks reached that pinnacle of sentiment in 1999-2000, and real estate reached that point in 2005-2006. The precious metals bull market may now just be at the dawn of its recognition by the public, which makes it unlikely gold is anywhere near an end to its bull trend.

The Amex Gold Miners Index consists of the 37 largest gold mining companies in the world. Over the past seven years, it has stair-stepped higher from a low at 180 in late 2000 to an intraday high at 1,266 in May 2006 — for a total gain of 603%. You can see the periodic consolidations outlined in black on the chart. Since May 2006, it has consolidated yet again, laying the groundwork for another sprint higher:

I have been keeping a sharp eye on miners ever since my paid service, The Survival Report, was launched in April. While I have anticipated a resumption of the long-term bullish trend, I’ve also been mindful that the correction from May 2006 was ongoing and could still produce more downside before it was completed. That downside came when the general market sold off in July and August and the miners were pulled down with it. The Amex Miners Index fell from a July high of 1,175 to an August low at 890 — a loss of 24% in one month.

However, that sharp loss in mining stocks was not accompanied by a decline in gold, and as soon as the general market stabilized, the miners quickly rebounded. The recovery was further aided by the Fed’s decision to lower the fed funds rate by 50 basis points, which led to a broad rally in miners and a breakout in gold above its May 2006 high.

The sharp sell-off in August appears to have been the washout that was needed to end the correction from May 2006, and the miners look to have now resumed their long-term uptrend. This means that mining stocks may just be the way to play this bull market.

Regards,
Mish

December 7, 2007

This article was originally featured on Whiskey and Gunpowder

Mining Profits from the Gold Bull

Many corporations will do anything to improve their stock price. Instead of going about this the natural way, many are simply buying back their own shares in a way to reduce the supply on the open market. This seems like it would make sense, but the strategy does not always pan out.

One of the worst cases was that of Ambac, which borrowed money to buy back shares right before it collapsed. While the company was buying back its own shares right before the price fell, the CEO and former CEO were able to dump millions of dollars worth of shares just before the collapse.

However, it’s not just a handful of companies involved in poor decisions. The Wall Street Journal reports:

“Driven by billions of dollars in share buybacks, record-setting buyouts. and a wave of mergers, the amount of stock in the market shrank by hundreds of billions of dollars in the past four years.

“With the supply of stock down and demand strong, the market rallied. Now, as the economy slows and credit markets buckle, high-profile companies are cutting back on buybacks, and some wish they held onto the cash they gave back to shareholders…

“Shares of Freddie Mac fell 29% on word that the mortgage company may halve its dividend and seek a capital infusion amid a record loss. Freddie might not be in this position if it hadn’t bought back at least $1 billion of common stock earlier this year and replaced it with preferred shares.

“Fannie Mae, the largest U.S. home-funding company, has tapped the markets more recently, raising $1.5 billion in less than two months by selling preferred stock. Fannie shares fell 25% yesterday and are at their lowest level since May 1996…

“Countrywide Financial Corp., which spent $2.4 billion in the past year to repurchase its shares, was forced to sell a chunk of its stock to raise money.

“Office Depot Inc., which bought back 5.7 million shares for an average price of $35 a share, said on its earnings call yesterday that it would like to buy its shares at the current price of $17.49, but can’t. Office Depot fell 7% yesterday.

“Home Depot Inc. said it will delay the rest of its massive stock buyback plan, while investors in Citigroup Inc. have turned nervous about the health of the bank’s balance sheet and capital levels, prompting management to say it isn’t in the position to repurchase shares…

“From the third quarter of 2002 to the second quarter of this year, more than $1.5 trillion of shares in non-financial companies has disappeared from the stock market through buybacks, mergers, or buyouts, according to the Federal Reserve. The number hit a peak during the second quarter of this year, when non-financial companies retired a seasonally adjusted net $192.5 billion of shares…

“Home Depot, for example, was downgraded in July by S&P to a triple-B-plus rating from A-plus. The rating agency specifically cited Home Depot’s plans to finance a $22.5 billion share buyback through the proceeds of an asset sale and $12 billion in debt as the main reason for the downgrade. Last week, Home Depot, which already spent $10.8 billion on buybacks in the first three fiscal quarters of the year, said it believes, ‘It is prudent to take a cautious stance with regard to the completion’ of the buyback program…

“Banks already are scaling back stock buybacks to conserve capital for other uses, like making loans to clients and setting aside money for bad loans. Further, the nation’s largest financial institutions may need to use their balance sheets to fund loans for private-equity deals, because anticipated buyers for those loans have dried up, leaving the banks on the hook.

“The capital issue is especially pressing at Citigroup, which recently saw a key measure of a bank’s capital cushion, known as Tier One, fall below its target of 7.5% for the first time in years. The bank has said that it doesn’t expect to repurchase shares until it restores its capital ratio in the middle of next year. While some have questioned whether Citigroup will have to consider cutting its dividend, the bank says it doesn’t intend to do so. People familiar with the matter say there are other steps it can take to shore up its capital position.”

Rethinking Buybacks

The AP reports that “Investors Need to Look Closer at Share Repurchases, as They Don’t Always Enhance Holder Value”:

“Repurchases, which some companies use borrowed money to pay for, don’t always reduce share counts significantly, according to S&P equity analysts and study authors Stewart Glickman and Todd Rosenbluth.

“For every 100 shares bought back during the study period from Jan. 1, 2006-June 30, 2007, 78 shares were added as a result of the exercise of stock options, shares issued to fund acquisitions, or for follow-on stock offerings…

“The study found that 20 billion shares were repurchased during the period, which contributed to a mere 22% reduction in the total outstanding stock — or 4.4 billion shares — for the companies that were actively buying back stock.

“Also, companies don’t always buy their shares at a low price. More than one-third of companies have seen their stock price fall since repurchasing shares — meaning they paid a premium. The stocks that dropped the most compared with the average prices paid for repurchases were Circuit City, KB Home, Pulte Homes, Centex, and Countrywide Financial, according to the S&P study…

“Most of the 423 companies that repurchased stock during the study period would have done better investing the cash in an S&P 500 index fund, or even more conservative holdings.”

Let’s build a list of companies recklessly squandering capital from the above articles and other known happenings:

Squandered Money List

• Countrywide
• Home Depot
• Citigroup
• Fannie Mae
• Freddie Mac
• Ambac
• MBIA
• Circuit City
• KB Home
• Pulte Homes
• Centex
• Toll Brothers

Obviously, that is a very short list of the worst offenders, as there is not room to list 423 companies. The most galling thing is that 78% of buybacks went for insider options. Shareholders got a mere 22% of the pie, and most of that was wasted.

For all this corruption and graft, shareholders look the other way as executives grant themselves and the boards they sit on enormous salaries and perks. To top it off, insiders were massively bailing on their own shares while squandering shareholder money. Nice work if you can get it.

Regards,
Mish

November 26, 2007

This article was originally featured on Whiskey and Gunpowder

I Want My Buybacks Back

Greenspan on the Housing Bubble

Greenspan is blaming the decline of the Soviet Union and the end of the Cold War for worldwide housing bubbles:

“It was a geopolitical switch in which market capitalism very quietly overtook central planning, and that created substantial booms throughout the world …creating an excess of savings, which drove down long-term interest rates virtually everywhere. And virtually everywhere, it sprouted a housing bubble.”

In essence, he wants us to believe that housing skyrocketed 10-plus years after the fall of the Soviet Union in some sort of delayed reaction, and that it was just by coincidence that this happened after the Fed slashed rates to 1%. Clearly, Greenspan is attempting to absolve himself of his role in the housing bubble.

It gets more interesting:

“Central banks gradually began to lose the power of affecting longer-term rates, as we demonstrated rather conclusively in 2004, when we raised short-term rates very rapidly and ended up with no increase whatsoever in long-term rates, and indeed, it stayed that way in 2005 as we continued to tighten.”

Greenspan has selective memory. The Fed did not raise rates rapidly, as this testimony of Chairman Alan Greenspan on July 20, 2004, shows:

“In May, the FOMC believed that policy accommodation needed to be removed and that removal could be accomplished at a pace that is likely to be measured. At our meeting last month, the FOMC raised the target federal funds rate from 1% to 1.25%, and the discount rate was raised commensurately. Policymakers reiterated that, based on our current outlook, the removal of accommodation would likely proceed at a measured pace.”

And Greenspan kept the “measured” pace at a quarter point per meeting for 17 consecutive meetings. It was perfectly measured, and certainly not the “very rapid rise” he talked about in the Fox interview:

“What that demonstrated pretty much around the world is that central banks no longer have the capacity to significantly impact longer-term rates, and it’s the longer-term rates that create bubbles.”

The rebuttal to this nonsense is that by lowering interest rates to 1%, all sorts of speculative lending took place based on the spread between banks’ ability to borrow at 1% and lend at a higher multiple. It is highly unlikely the market would have lowered short-term rates to 1% or kept them there for long if it did. Greenspan either is being disingenuous or is a complete fool to put forth this set of arguments on the housing bubble.

Greenspan on the Central Bank and Gold

Fox: “So why do we need a central bank?”

Greenspan: “Well, the question is a very interesting one. We have, at this particular stage, a fiat money, which is essentially money printed by a government, and it’s usually the central bank which is authorized to do so. Some mechanism has got to be in place that restricts the amount of money which is produced, either a gold standard or currency board or something of that nature, because unless you do that, all of history suggests that inflation will take hold with very deleterious effects on economic activity…There are numbers of us, myself included, who strongly believe that we did very well in the 1870-1914 period with an international gold standard.”

Fox: “We did well without the Federal Reserve. People forget that.”

Yes, they do. And that last paragraph was one of the few things Greenspan has ever said that made any sense.

Regards,
Mish

Novmeber 19, 2007

This article was originally featured on Whiskey and Gunpowder

Every Which Way But Me

The Financial Times article can be found here, U.S. Congress Takes Aim at ‘Speculative’ Crude Oil Trades . Lets play a little game and see if substituting “Google,” “Bear Stearns,” or “stock prices” for oil makes as much sense.

Here is a retake of the above article with some slight modifications:

“‘Right now, it is funds and speculators who invest in oil Google — and financial markets interfere with the oil stock market,’ [Secretary-general of OPEC Adbullah] al-Badri said in Vienna.

“The idea that speculators — often used as shorthand for hedge funds — may be trading in a way that results in unusual price movements has gained traction among some U.S. lawmakers…

“As chairman of the Senate Permanent Subcommittee on Investigations, [Sen. Carl] Levin produced a report this year on ‘excessive speculation” by collapsed Bear Stearns hedge funds Amaranth in natural gas CDO markets on the New York Mercantile Stock Exchange and the Intercontinental Exchange, an "over-the-counter" platform. Mr. Levin, energy consumer groups, and some utilities bagholders say this hit consumer prices want their money back…

“Since the collapse of energy trader Enron, the Commodity Futures Trading Commission has charged 63 companies and individuals for violations in the sector, and obtained more than $300 million in civil settlements…

“In the U.S., lawmakers New York Attorney General Andrew Cuomo, angered by the lack of a legal basis for the CFTC to fully oversee trading in OTC energy markets are to strike out at Washington Mutual directly, is pushing legislation to widen the agency’s powers his power to sue federal banks.

“Last week, Congressman Peter Welch of Vermont introduced a bill to require ‘government oversight of the trading of unregulated energy commodities Google stock trading to prevent price manipulation and excessive speculation.’”

Think about it. Why is it that speculation in Google, Treasuries, CDOs, asset-backed mortgages, etc., is all welcome, but speculative trading in oil is not?

The root of the problem is not speculation, nor is the problem the high price of oil. The root of the problem is economic conditions that foster, and even encourage, speculation in oil, commodities, gold and silver, currencies, and high beta stocks like Google, Apple, and Research In Motion.

Bernanke and the Fed purposely foster inflation. This drives down the value of the dollar and encourages speculation.

Ron Paul vs. Bernanke

Ron Paul blasted Bernanke in Congress last week as seen on this YouTube video . Following is a transcript:

“We [need to] get down to the bottom of this and define what inflation is, and not look at only prices. This was taught by the free market economists all through the 20th century. They said, ‘Beware, [the central banks] will increase money supply, but they will make you concentrate on prices. And they will give you CPIs and PPIs and fudge those figures.’

“We ignore the fundamental flaw, and that is not only have we had a subprime market in housing, the whole economic system is subprime in that we have artificially low interest rates. This has been going on for 10 years or longer, and now we are bearing the fruits of that policy.

“Instead of looking at consumer prices, which nobody in this country really believes, we need to talk about the distortion, the malinvestment, the misdirection, the bad information that is gotten from artificially low interest rates. In many ways, people refer to you as a price fixer. You fix interest rates. When the Fed fixes interest rates at 1%, that is price fixing.

“The real deception is when we distort the value of money, when we create money out of thin air.

“We have to get back to the very fundamentals of where this problem [bubbles] comes from. And the bubbles occur when we have mal-investment and the creation of new money.

“So my question boils down to this: How in the world can we expect to solve the problems of inflation — that is the increase in the supply of money — with more inflation?”

If Congress wants to reduce speculation in oil, houses, the stock market, and everything else, it should abolish the Fed and let the free market, as opposed to the price fixers, set interest rates. Instead, Congress is sponsoring more absurd regulation.

Government oversight of oil trading makes as much sense as government oversight of Google trading. None.

Regards,
Mish

November 13, 2007

This article was originally featured on Whiskey and Gunpowder

Double Standard Time

Just five things:

1. Lack of authority.
2. People would use it to pay off debt.
3. Banks do not want to be paid back with money that is worthless.
4. The Fed will act to bail out banks, not consumers.
5. Hyperinflation ends the game. The Fed is simply not in the business of destroying itself.

Rest assured the Fed is going to do almost everything under the sun to encourage more borrowing. That includes slashing the discount rate and the fed funds rate, loosening rules on collateral, etc. Some of those we have already seen. This is likely the first inning.

But the one thing the Fed is not going to do is send everyone $100,000 or $10,000 or even $5,000. If for some reason I am mistaken and the Fed starts sending out checks or depositing money into people’s checking accounts to a significant degree, then I am willing to eat my deflation hat. Just so we are clear on this, another piddly $300 from Congress is not enough.

The Cart and the Horse

Many people in government and the media misunderstand the causes of inflation. In an attempt to answer some of the questions people have, Peter Schiff wrote this in an editorial article on Gold-Eagle.com:

“Inflation has only one cause, and that is the Federal Reserve itself. In the United States, the supply of money and credit is regulated by the Fed. Since inflation is by definition an increase in the supply of money and credit, only the Fed can create it.

“If the money supply were held constant, increases in some prices would be offset by decreases in others. The result would be no overall inflation. In fact, without government-created expansions of the money supply, the natural tendency of prices would be to decline as technology allowed for more efficient production of goods and services. So while most regard the Fed as the primary inflation fighter, in reality, it is the sole inflation creator.”

That is a near-perfect explanation. Certainly, Schiff’s definition of inflation is perfect: “Inflation is by definition an increase in the supply of money and credit.”

Schiff did make an error, however. That error is in the phrase “only the Fed can create it.” When it comes to credit, the statement is simply wrong. Money, in the form of credit, is borrowed into existence every day. This is a systemic problem, and the Fed is clearly not in control of it.

Money as Debt

There is an educational five-part YouTube series on money and debt. It covers in nice cartoon animation what has happened to money over time, fractional reserve lending, how money is created today, why interest rates are so low, why we get unsolicited credit offers, and why debt is exploding.

The video concludes that it is taking exponential increases in debt (money) to stave off a collapse of the entire banking system, and that this cannot go on forever.

Click here to see this five-part series on debt.

I agree with the video that there are practical limits on how high debt can get. Unfortunately, the video’s conclusion is a bunch of socialist nonsense: Eliminate interest, let governments — and only governments — create money, and supposedly, government will then use that money wisely to build roads and bridges that will add value to society.

However, the video does a reasonable job of pointing out many of the problems with the current system of debt creation in a very entertaining and (for the most part) educational way. On that basis, I recommend watching all five parts.

Ability to Take on Debt Is Not Infinite

At the top of this article, I outline five reasons the Fed is not going to give money away. If one believes that rationale, then one must logically accept there is a practical limit to debt, at least at the consumer level.

Proof of concept is easy enough to find. Massively rising delinquencies, foreclosures, and bankruptcies should be proof enough. At the state level, it’s easy to see what is going to happen. Unlike the federal government, states are required to have balanced budgets. That means one of three things:

• Raising taxes
• Cutting spending
• Floating bonds to postpone the problem.

Raising taxes headed into a consumer-led recession will not work. Cutting spending is absolutely needed, but will throw people out of work at the worst time. Postponing the problem is not solving the problem. Postponement only makes things worse.

This is yet another version of “Economic Zugzwang,” wherein there are no winning answers (at least as far as politicians are concerned).

The proper solution is to let free market forces work. If that means banks fail, then banks fail. If that means the stock market collapses, the stock market collapses.

Letting (encouraging) the dollar fall to zero is not a solution, for the simple reason it does not create any jobs where they are needed, which is right here, right now.

Given the amount of credit in the system versus actual cash and global wage arbitrage and slower consumer spending, it would take a mammoth effort from Congress and the Fed to forestall the inevitable once again.

A Sure Thing?

Right now, the surest bet in the world is that when the dollar drops, the U.S. stock markets rise. How long that remains so is anyone’s guess.

There is going to come a time when borrowing dollars to invest in equities is going to blow up. Of course, the carry trade may blow up first (sinking everything in its wake). Perhaps a massive derivatives unwind sinks everything first. Then again, perhaps the trigger is something from way left field that no one is watching.

What I am certain of is this: The fuse is now lit. The structural imbalances worldwide have never been greater, and the fuel at the end of the fuse is enormous. In addition, the amount at risk increases every day.

The interesting thing is that no one knows how long the fuse is. For some inexplicable reason, everyone acts as if they can get out before the stick ignites. It’s simply not possible.

Regards,
Mish

October 30, 2007

This article was originally featured on Whiskey and Gunpowder

Which Comes First: The Cart or the Horse?

First is the rising credit card borrowing trends being seen in the wake of the subprime mortgage collapse. Homeowners, fearful of foreclosures, are continuing to borrow from credit card companies while payment defaults are much higher than last year. According to MSNBC, credit card companies have had to write off payments as uncollectible in the first half of 2007 30% more than last year and delinquencies are expected to rise in the next six to 12 months.

Many think that problems will be avoided as long as employment holds up, so let’s explore the idea that jobs may be the next shoe to drop…

Temporary employment leads and the implications appear unpromising now that the year-over-year change in temporary employment has gone negative. This is bad enough, but one must also consider soaring mass layoffs.

Layoffs began rising dramatically in August, and the financial sector was responsible for nearly half the cuts.  Many mortgage and subprime lenders could not stand up to the pressure of the housing market and were forced into bankruptcy.  This was highlighted by the collapse of Home Mortgage Investment Corp. who fired nearly its entire workforce.

Commercial real estate may be the next shoe to drop and in our opinion, we think it’s going to get crushed. It is overbuilt, over-loved, and due for a collapse. If Ben Bernanke thinks he as a problem now, watch what happens when commercial real estate blows up. Fannie Mae and Freddie Mac might be able to keep people in their houses in lieu of foreclosure by renegotiating terms down and down again (for a while, anyway, but certainly not forever), but bank funding of unneeded strip malls is another thing, indeed.

Other shoes to consider would be a derivatives blowup, a massive unwinding of the carry trade, homebuilder bankruptcies, or a collapse of the U.S. dollar. But so many shoes are in the air and falling that it’s going to be difficult to say precisely which shoe hits the ground first. That’s what happens when it rains shoes…

With all of these shoes starting to drop, it’s time to short short transports. Here’s why…

First, housing has clearly stalled and shows no sign of recovery. With mammoth numbers of adjustable rate mortgages resetting between now and March 2008, things can, and likely will, get much worse. Shipping material for new construction will continue to weaken. Also, shipping needs, to furnish new homes, will continue to weaken as well.

Next, commercial real estate is poised to fall. Deals are collapsing as people who can get out, are getting out. The rate of increase of building new stores, as well as the merchandise required to fill those stores, will fall. That clearly means reduced shipping demand.

And, a weakening job market means less consumer demand. Falling consumer demand means fewer items need to be shipped. Due to this falling demand, truckers can no longer pass on rising fuel costs. One leading shipping company recently cut fuel surcharges 25%, despite crude prices near all-time highs. Don’t be fooled, these price cuts are not done out of the goodness of their hearts. There is a reduced demand for shipping.

Coming out of the 2001 recession, shipments increased until 2005. They began leveling off, and then declined throughout 2006 and so far through 2007. It’s no coincidence that this more or less mirrors the topping of the real estate cycle.

Supply Chain Digest is also reporting that inbound container volume growth has slowed dramatically at U.S. ports over the past year, with May 2007 traffic down 0.2% from a year earlier. This confirms the slowdown we are seeing in truck tonnage, and also suggests the consumer-led economy is slowing.

As the market continues to open its eyes to the effects housing is having on the broader economy, we are seeing important sectors of stocks break down from their bull trend. Now we have seen the transportation stocks follow suit. Over the past year, the Dow transports had rallied themselves into a wedge pattern that usually results in a significant top.

During the market sell-off from the July high, the transports broke down out of their wedge and have consolidated. Breakdowns like this one usually result in a swift move that retraces the entire wedge pattern, which would be more than a 25% decline from here.

Smart investors should recognize this trend and plan accordingly.

Regards,
Mish

October 11, 2007

This article was originally featured on Whiskey and Gunpowder

The Next Shoe to Drop?

“Current difficulties afflicting the real estate sector have, to date, been confined to the residential sector; business outlays for structures have been quite strong. Since its peak in 2005:Q4, real residential fixed investment expenditures have declined by 19%. Over the same interval, real business investment in structures has increased by 21%. If you plot these two series on a chart, they would look like scissors: one line going up and one line going down — and their slopes would be quite steep. Indeed, their slopes suggest that the current rates of change are not sustainable. Housing will not continue to fall at double-digit rates, and outlays for business structures will not continue to increase at double-digit rates.”

Poole is quite correct. Outlays for business structures will not continue to increase at double-digit rates. Commercial real estate is extremely overbuilt. Overcapacity is rampant.

“Unfortunately, recent events suggest that housing will remain weak for several more quarters; stabilization may not begin until well into 2008. Probably the most important statistics in this regard are the number of unsold new homes still on the market relative to their current sales rate and the recent trends in house prices…”

“Some potential homebuyers are no doubt delaying purchase because they expect house prices to fall.”

This is a critical point. Consumer psychology is extremely important. The secular bull market in housing reached a pinnacle in summer of 2005 with people standing in line overnight hoping to be one of the lucky ones to buy a Florida condo. It does not get much more insane that that. A massive overbuilding of commercial real estate has occurred, as well. A consumer-led recession will highlight all the commercial malinvestments sooner or later.

“As seen in Figure 8, prices have decelerated sharply nationwide. According to the price index published by the Office of Federal Housing Enterprise Oversight (OFHEO), through the second quarter of 2007, prices are still a bit above year-earlier levels.

“However, another measure of national house prices — the S&P/Case-Shiller price index (SPCSI ) — actually declined 3% in the second quarter from a year earlier. A subset of this measure, indexes based on house prices in the 10 and 20 largest U.S. markets, suggests that prices have declined even more in the third quarter. In July 2007, the 10-city composite has declined 4.5% from 12 months earlier and the 20-city composite has declined about 4%.”

Any index that suggests home prices are up year over year is fatally flawed. On this point even Shiller is a blazing optimist. By excluding enormous declines in new home prices, builder markdowns, and incentives, Shiller has dramatically understated the nature of the declines. The OFHEO data are from Mars.

“Although this episode of financial turmoil is still unfolding, my preliminary judgment is that there are no new lessons. Weak underwriting practices put far too many borrowers into unsuitable mortgages. As borrowers default, they suffer the consequences of foreclosure and loss of whatever equity they had in their homes. It is painful to have to move, especially under such forced circumstances. Investors are suffering heavy losses. There is no new lesson here: Sound mortgage underwriting should always be based on analysis of the borrower’s capacity to repay and not on the assumption that a bad loan can be recovered through foreclosure without loss because of rising property values.

“The Federal Reserve has neither the power nor the desire to bail out bad investments. We do have the responsibility to do what we can to maintain normal financial market processes. What that means, in my view, is that we want to see restoration of active trading in assets of all sorts and in all risk classes. It is for the market to judge whether securities backed by subprime mortgages are worth 20 cents on the dollar, or 50 cents, or 100 cents.”

Poole is correct that the Fed has no power to bail out bad investments (at least not forever). However, it is disingenuous to state it has no desire or willingness to try to do so. Recent Fed actions should be ample proof.

“Although there is a substantial distance to go, restoration of normal spreads and trading activity appears to be under way, and we can be confident that in time the market will straighten out the problems. We do not know, however, how much time will be required for us to be able to say that the current episode is over.

“Thank you. I’d be delighted to take your questions.”

Who’s Responsible?

The most galling thing about Poole’s speech is his attempt to blame the free market for problems entirely created by:

• The Fed
• The SEC
• Political hacks.

The Fed’s Role in the Housing Bubble

It is widely understood that the Greenspan Fed fueled the blowoff top in housing by slashing interest rates to 1%. In a direct challenge to Poole’s statement that “The Federal Reserve has neither the power nor the desire to bail out bad investments,” the Fed did just that. Instead of letting banks suffer for stupid loans to dot-com companies and foreign countries, it bailed out the banks by blowing an even bigger bubble in housing.

However, the Fed’s role in this mess goes far beyond an ill-fated decision to slash rates to 1%. The Fed has had a decade’s long history of keeping rates too low too long, and throwing liquidity at every problem that arises. By purposely punishing savers for the benefit of risk takers, the Fed creates a moral hazard and an expectation of still more bailouts when something goes wrong.

Minyanville Professor Vitaliy Katsenelson spoke about this on Tuesday in “The Cost of a Government Bailout”:

“The largest cost of a government bailout is one that is not readily apparent — the so-called moral hazard, wherein society shields investors from the fallout from their actions. The unintended consequence of a government bailout is that it sets the stage for an even greater housing crisis next time, since it suggests to purchasers that owning a house is a risk-free endeavor. If your home’s price goes up, great. If it goes down, you claim to be a victim, and society compensates you for the risk you’ve taken. With screwy incentives like that, the cost of the next bailout will make today’s housing crisis look like a cakewalk.”

The SEC’s Role in the Housing Bubble

Poole is claiming, “Weak underwriting practices put far too many borrowers into unsuitable mortgages.” That finger is pointing the wrong direction.

The real problem with underwriting is the conflict of interest at rating agencies in conjunction with interest rates policies that encourage speculation. I spoke about that idea in “Time to Break up the Credit Rating Cartel.”

Government sponsorship of rating agencies created the problem. The free market solution is to let Moody’s, Fitch, and the S&P sink or swim by the accuracy of their ratings. Instead, they operate with impunity, like any government-sponsored monopoly.

The Political Hack’s Role in the Housing Bubble

The ownership society, 300-plus housing bills to make housing affordable, the creation of GSEs, tax incentives, etc., all play a role to make housing unaffordable. Government should not promote one means of living over another. It gives an unfair advantage to a select percentage of the population (single-family homebuilders and homeowners, for example) at the expense of renters. Promotion of housing also leads to rising property taxes that become a burden to those on fixed incomes.

The latest insanity comes from Barney Frank, chairman of the House Financial Services Committee, who sponsored a bill creating an Affordable Housing Trust Fund designed to provide affordable housing for low-income families.

No Housing Lessons Learned

• The Fed has learned nothing
• The SEC has learned nothing
• Political hacks have learned nothing.

Poole was wrong when he said, “There is no new lesson here.” He was wrong because he does not even understand what the problem is.

Instead of attempting to figure it out, we see legislation on top of legislation on top of legislation. The legislation onion grows more layers every year. Each layer of legislation masks (at best) or compounds (at worst) the problems of the previous layer. The only way to fix the problem is to scrap our tax laws in entirety, dissolve the Fed, stop promoting housing (and everything else, too), and get government out of our lives.

Regards,
Mish

October 10, 2007

This article was originally featured on Whiskey and Gunpowder

Poole Party — No Housing Lessons Learned

“The U.S. consumer price index continues to be a testament to the art of economic spin.

“Since wages, Social Security cost-of-living increases, and some agency budgets are tied to it, the government has a vested interest in keeping it as low as possible.

“Yet your real cost of living — what you keep after taxes, medical bills, college expenses, and other household costs — is probably much higher than the 2% annual rate the government reported in July, showing a slight decline…

“Gerald Prante, an economist with the Washington-based Tax Foundation, found that median real estate taxes on owner-occupied housing went from $1,614 in 2005 to $1,742 last year. ‘That’s an increase of 7.93%, more than double the inflation rate in that time period,’ Prante says…

“Medical expenses are given short shrift, as well. It wasn’t that long ago when employers could cover almost all of an employee’s health care bills.

“Now workers are shelling out an average of $3,281 from their paychecks for family medical coverage, according to the Kaiser Family Foundation, a nonprofit organization based in Menlo Park, Calif. The average premium for a family policy is more than $12,000 annually.

“Since 2001, health premiums have risen 78%, while wages have only gained 19%. The government’s inflation measure during that stretch was 17%.

“When making goals for your portfolio returns, it’s wise to avoid using the government’s inflation rate as a benchmark. Aim higher. Shoot for outpacing your household’s cost-of-living increase. That’s the most important number to beat.”

The Fed, Like Wasik, Wants Everyone to “Aim High”

Right now, the Fed is desperately trying to encourage everyone to “aim high.” It’s the only way to stave off a severe consumer-led recession. But eventually, a severe recession will come whether anyone is ready for it or not.

The Fed always wants to put off the inevitable. In the process, bubbles get bigger and bigger as everyone aiming high is willing to take on excessive risk, perhaps counting on the Fed’s ability to control the economy and the stock market.

Is the Fed in Control?

Federal Reserve Governor Frederic Mishkin thinks so. Minyanville professor Kevin Depew was talking about the Fed’s ability to stabilize prices in Point No. 3 of last Friday’s “Five Things…”:

“Last night, Federal Reserve Governor Frederic Mishkin gave an interesting speech at the Domestic Prices in an Integrated World Economy Conference in Washington on ‘Globalization, Macroeceonomic Performance, and Monetary Policy’:

• According to Mishkin, ‘The Federal Reserve and other central banks retain the ability to stabilize prices and output’
• And ‘central banks still retain the ability to control short-term interest rates, which affect the domestic cost of credit and long-term interest rates, and so can continue to do their job of stabilizing inflation and output’
• Perhaps he wrote this speech before August
• Either way, the quote of the day comes near the end of his speech when he makes this astonishing claim:

‘Has globalization been an important part of the story of inflation’s remarkable decline in recent years? In terms of direct effects, the discussion here provides a clear-cut answer: No. Inflation has come down in the old-fashioned way. Tighter monetary policy and a commitment to price stability by central banks throughout the world have led to lower inflation and an anchoring of inflation expectations.’

• What’s hilarious — and we mean ‘hilarious’ in the most cynical way possible — is that we read the Mishkin speech not 10 minutes before reading a Bloomberg article from John Wasik (‘CPI’s Lie on Household Inflation Doesn’t Wash’) that noted the following: ‘The U.S. consumer price index continues to be a testament to the art of economic spin’
• Wasik notes that ‘millions are falling behind inflation because wage increases aren’t keeping pace with the cost of medical care, lost employment benefits, homeownership expenses, energy, and transportation’
• True enough. The net effect in this cyclical upturn in inflation, however, is NOT MORE INFLATION
• That is the disconnect
• The seeds of long-term malinvestment and overproduction — globally — that masquerade today as ‘benefits of globalization’ are now beginning to wilt under central bank policy that is precisely the opposite — demonstrably — that Mishkin describes as ‘tighter monetary policy and a commitment to price stability.’ The opposite
• For inflation to create more inflation, which seems to be what everyone is looking for these days, there must be consumers with both the desire and the ability to push forward purchases to get ahead of rising costs
• The alternative is inflationary pressures that terminate at the point where appetite for credit diminishes and transitions to risk aversion
• In other words, these speeches by Federal Reserve speakers congratulating themselves on successfully defeating inflation are in reality unwittingly congratulating themselves on simply being around at the very beginning of the deflationary credit contraction.”

If the Fed were in control, the dot-com crash would not have happened, we would not be in an even bigger housing/credit bubble than that that is now bursting, and the dollar would not be at all-time lows. Please see “Can the Fed Control Prices?” and “The Activist Fed and Credit Cycles” for more discussion of who is in control.

Is Now the Time to Aim High?

Wasik’s advice might be suitable (or not) for someone who is 20 or 30, but the closer a person is to retirement, the worse Wasik’s advice becomes. Such advice ignores the possibility of a sustained stock market downturn, a severe bear market, and/or a consumer-led recession with rising unemployment.

It took seven years for someone in a diversified basket of S&P stocks to recover from the crash of 2000-01. Treasuries did better, without the risk. Nonetheless, I salute Wasik for pointing out the sham that the CPI is. However, it is because of the debasement of the dollar and distortions in the CPI that the Fed has practically forced risk down everyone’s throat.

But one must be cognizant of herding behavior that has nearly everyone thinking exactly like he is and the Fed wants. Aim high. Shoot for the moon. Do or die. You are losing money by saving. Buy assets. Only fools save. In the long term, stocks always go up.

The problem is that aiming high is synonymous with increasing risk. Up till now, risk taking has been rewarded.

But what happens when everyone does the same thing? More to the point, what happens when everyone does the same thing for 20 years or longer? Eventually, risk gets so unappreciated that various asset classes go to the moon. Consider real estate. About a year ago, the mantra was that real estate always goes up. There will never be a national housing decline, because all real estate is local.

Here is the big question: Is this more like 1994 or 1929? In other words, is this a midcycle correction or the cusp of collapse? Everyone ignores the latter possibility. Japan underwent deflation in which land prices and the stock market fell for 18 years. There was no depression. Life still went on. The same scenario can happen here too, regardless of what anyone thinks.

Essentially, the same advice given for real estate (you cannot buy too much home, home prices always go up) is now being touted for stocks. There is an amazing belief in the Fed’s ability right now to control the business cycle, as well as price stability. It’s not warranted. At this stage of the cycle in a slowing economy, with rampant overcapacity, a tenuous job climate, and no real reason for businesses to expand, the odds are that aiming high is precisely the wrong thing to do.

Regards,
Mike Shedlock ~ “Mish”

October 1, 2007

This article was originally featured on Whiskey and Gunpowder

Time to Aim High?