ABSOLUTE BOND CONTAGION
Jim Willie CB June 28, 2007
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When the contagion (denied no longer) is systemic, pervasive, broad, multi-faceted, and ominous in its lethal potential, perhaps one can calmly conclude that the system is merely adjusting to a total change in the seas. NO WAY!!! Without much doubt whatsoever, Bear Stearns is GROUND ZERO for the bond market firestorm. BS was forced to extend $3.2 billion in loans to its hedge fund clients, who attempted to liquidate but could not. That represents 25% of the BS entire capital. Don't worry. Both hedge funds will eventually die, but when they do, BS will possibly die with them. A few months time is all they bought. Call it a STAY OF EXECUTION in legal parlance. With great amusement on my end, reaction to the denial of contagion, the claimed containment of the subprimes, the assurance of no spillover into other arenas, housing recovery in the spring, capex from corporations leading the recovery, these have been met with my disgust, outbursts of laughter, and dismay that such broad deception and misrepresentation can pass as journalism and economic analysis. Without doubt, the economics profession is replete with more harlots than Piccadilly Square or Battery Park or any fine district in Copenhagen. Instead, their analysis and forecasts should be labeled what they are, bold promotion marred by giant lies.
Some old lessons were learned long ago when listening to Wall Street and the US Federal Reserve. Whatever topic they discuss, therein lies the problem. Ignore their words and focus on their topics. They cannot avoid discussion of their primary concern, distress, worst fears, and outright trepidation. Whatever they deny most strenuously, vehemently, and frequently, that is what will occur with the greatest of impact and damage. Whatever is boasted as a systemic strength and advantage, quickly discount it as only a fleeting factor to wither away within months. They scale slowly into reality, kicking and screaming, only when they are confronted with the obvious. They are last to detect true conditions. That is their other job, in contrast to being managers of the inflation apparatus.
The housing crisis and mortgage debacle are two sides of the same bubble powered by basic monetary and debt inflation. Just as the mortgages have begun to reset to higher adjusted rates (an average of 1.8% to 2.2% higher), the mortgage bonds must next be reset to lower ratings than 'AAA' which stands as an insult to the intelligence of a warm bodied investor with a pulse. The significantly higher monthly mortgage payments coincide with the massive mortgage bond valuation declines. Just as foreclosure auctions essentially go 'No Bid' with 90% of the home inventory to move, the mortgage bonds have gone 'No Bid' with those auctions in the public view. Far more fire sales of toxic mortgage bonds are in trouble beyond what the plebeians can observe. Next they must work through the phase of $2 trillion adjustable mortgages enduring a rate reset. Many home owners will face 50% monthly payment increases. Some will see a double. The bankers made the rules by which they will suffer. They imposed stiff pre-payment penalties for any refinance before full term of mortgage loans. They tightened lending standards to the point that 80% of all first-time buyers are refused loan applications. Bankers and lenders face a tough decision. Soon the cost of portfolio insurance will exceed the loss from their liquidation. Then mortgage bonds will be sold in droves. The subprime mortgage ABX index has plumbed no lows, lower than last February, the index measuring that portfolio insurance cost.
For the tenth consecutive month, the median home price has fallen on a nationwide basis. Aggregate prices are down 14% from the April 2006 peak. The last time conditions were so bad, the Great Depression was in full swing. We are now in the midst of the Great Orwellian Depression, where counterfeit money flows freely (mostly into wealthy pockets), economic statistics are all rosy (see Wobegon Days), spokesmen from government, banking, and Wall Street claim both the USEconomy and US stock market are in great shape, drugs are dispensed liberally upon the US public (see 'soma' in Brave New World), the military is first in line for money and supplies (largest non-corporate oil consumer in entire world), public monitors are commonplace, and the majority of the people acknowledge things are going in the wrong direction.
Bloated inventory aggravates the housing crisis and mortgage debacle. Both new home inventory and new home inventory continue to rise. The supply side of the equation is getting worse. With tighter lending from institutions, with more caution from buyers, with removal of speculators altogether, the demand side is also getting weaker. So home prices will come down, like another 20% at least nationally. Reports stream in that even low-end homes are rising in inventory, and falling in price. About 80% of first time buyers are refused mortgage applications. The high end has already seen massive price markdowns and swollen inventories.
IRONY OF BEAR STEARNS, ODD MAN IN
The most intriguing element of the Bear Stearns incendiary news recently has been the inner motive for major Wall Street firms to turn a deaf ear to BS for help. In 1998, during the LongTerm Capital Mgmt fiasco, BS failed to offer help. So now WS offers them no help. However, although BS is the kingpin among collateralized debt obligation (CDO) broker dealers, the numerous WS houses have a basement full of similar mortgage backed securities (MBS) and other CDO bonds. One really needs a nice cartoon to depict this, but that is not a skill possessed here. The dozen major houses all share common dry kindling in their basement, or is it oily rags? By permitting Bear Stearns to set afire their basement contents, all Wall Street firms are vulnerable at an extraordinary level. BS is not 'Odd Man Out' but rather an insider of different stripes, disliked, but connected in important avenues of capital flow into toxic bonds. If truth be known, JPMorgan and Goldman Sachs probably own a similar wad of MBS and CDO. That claim is especially true if one considers the counter-party risk associated with client hedge funds.
Sadly, the system will grow much worse, not better. The victims and exploited have no power. Ironically, the power brokers have a fire in their basement, which is certain to spread to a grotesque level. The entire asset based bond market will suffer quantum losses once the rating agencies do the obvious, DOWNGRADE. We must observe to see how the US Federal Reserve and Dept of Treasury enable public money and phony money to offer grandiose assistance to themselves, just like in 1998 when LTCM was bailed out. Another dangerous signal has been how the USFed and Treasury are attempting to create new rules to collude for easier money and debt security creation. A serious fraud has been perpetrated to maintain value in these acidic CDO bonds. Rating agencies are complicit in the fraud, coming to the aid of their clients via negligence and dereliction of duty.
A bitter twist must be described. In the last two years, the degree of targeting by JPM and GSax against their own clients, gunning for their critical support levels, has become horrible enough to call the parent creditor brokers as PREDATORS. See Goldman Sachs and Amaranth for a vivid example. This current drama reeks of irony. Wall Street has permitted ignition of a fire which will reach their own foundations and ramparts. One can only wish that our compatriot precious metal and energy investors did not include whiz kids like hedge funds wearing propeller hats, who in turn are subject to the dastardly deeds of Wall Street giants.
In the Mussolini Fascist Business Model framework, these Wall Street firms are much like commanders of cannons fired upon the private sector. Recall the Bolsheviks with naval cannons directed toward the Romanov family in Russia. In the framework of Von Mises theories, these Wall Street firms are much like vampires sucking money out of the private sector. The competing currency war and race to the bottom are vividly coming to life. In the framework of a colonial time when the previous King George ruled, these Wall Street firms are akin to aristocrats lording over their castle, seizing booty as fellow wealthy citizens transport large chests of money via stagecoaches from castle to castle. With the police, regulators, and courts all aligned to protect those engaged in large scale theft along the roadways where the money changers ply their trade, one should not expect any prosecution, resolution, or change. The power factions will continue to thrive.
In this Fascist Business Model, the ruling elite have all the marbles, make all the rules, enforce those rules, protect their friends, collude with fellow agencies, abuse the power of government posts to further their cause of accumulation for wealth and power. For evidence, check the court decisions, the regulator actions (see SEC and CFTC), the lack of convictions inside Wall Street firms (see Enron, WorldCom, Tyco), the overturned convictions of minor Wall Street players (see Quattrone), the debt rating agencies sitting on their hands (see Fitch), the outsized short positions of gold & silver and other commodities like natural gas, the initial public auctions of Chinese banks (see ICBC). The gradually realized outcome of the Fascist Business Model, and why the elite love it, is that the Middle Class is drained, and the poor remain ever poorer. It is not a coincidence that the merger of the USGovt and big industry has occurred while the US Middle Class has suffered a tragic income reduction since the 1970's. Pay no attention to official income statistics, which are a woefully concocted spew. They reduce nominal income by a grossly inadequate degree, greatly distorting any reduction from price inflation. A constant income over the past six years would have declined in real terms by 7% to 11% each year. That is roughly a 50% decline in real terms!!!
The Hudson Institute recently issued a white paper on the rating agencies. It is in no way comforting. Often confused erroneously with a mission charter similar to the Securities & Exchange Commission, these outfits are neither unbiased nor effective. Refer to Fitch, Moodys, and Standard & Poor as leaders who dominate their arena. My June Hat Trick Letter covered their utter compromised role. They are dependent for income from the investment banks whose debt security products they issue ratings on. They do not look backwards on old debt securities when refining their models, since they have already been sold. They routinely do not incorporate (ignore) the debt situation of borrowers. They are late in reacting to changed situations, like an obvious decline in home values, the collateral for many CDO bonds. The system is so screwed up, tilted toward corruption of the value of risky bonds. The lower tier juniors must be jettisoned first, before the higher tier seniors which comprise 90% of the market. One would hope that the system would be transparent, regulated, liquid, as well as fair & balanced. Unfortunately, it is none of the above, the last to fall being the liquid trait. One possible solution under consideration is for the Big Three Ratings Agencies to withdraw ratings of many high risk mortgage bonds and other collateralized bond securities. If a home auction or mortgage bond auctions attracts no bids, what is heir value? If you cannot say anything good about a bond, or can find no value, then say nothing at all!!!
Too much 'scratch & sniff' lately has revealed that such CDO and MBS bonds are worth far less than the lofty value associated with 'AAA' ratings attached. The odor is of financial sewage and excrement, not value. Recent attempts to sell $4 billion in junk mortgage bonds by Bear Stearns, another $850 million in similar junk by Merrill Lynch and JPMorgan, all failed miserably. Merrill managed only to unload $100 million of $850M of assets put up for auction sale. One problem is that the public usually has no appetite or interest in such bonds, even if of good value. They comprehend stocks. Also, pension funds have wised up, now realizing they bought a heap of overpriced mortgage bonds in the past, a mistake not to be repeated. Big Wall Street firms have butchered the balance sheets of many clients, passing on the junk. Hedge funds cannot be conned into buying any more junky bonds even at discount, since the discount once offered is grossly insufficient nowadays. Besides, some hedge funds have died. Public CDO bond auctions are the chosen route. Therein lies the problem, since public exposure means that the system must mark down prices. A failed auction means other similar CDO bonds must be reduced in value. THE PROCESS HAS BEGUN. The ratings agencies will be last to follow suit, not to be blamed for initiating the process.
Poor Bear Stearns is in trouble. They were forced to cancel that heralded Everquest initial public stock offering, where scads of acidic bonds were to be sold to the unsuspecting public. They would surely have lied on the value in the prospectus, read with magnifying glasses by the dullard public. Whether the SEC obstructed the IPO or not, who knows? Doubtful, since Wall Street is so deep into their pockets, that the SEC can seek relief in the bathroom without usage of hands. THE CRISIS IS FINALLY OUT IN THE OPEN. Being in public view, being visible to the army of analysts, having blood on the floor detectible to potential buyers, and worst of all, having the open wounds so clearly observable that the rating agencies must respond, THE CANCER MUST FINALLY BE DIAGNOSED IN THE OPEN.
In the United States, always a sucker can be found. Some are well dressed and well heeled, like perhaps even PIMCO. They are the Texas State Teachers Union gobbled up some discounted mortgage bonds. Now Wake Forest University in North Carolina is in the process of investing $25 million in discounted mortgage bonds promising to pay a hefty yield for income. Check the principal in a year or two guys! It might be down 20% to 30% at least.
HOLLOW PERVASIVE DENIALS
Like peeling the layers from an onion, removing the various hollow denials has been a staged process. The denial of a wider mortgage problem beyond the infamous subprimes was the first truly hollow denial to be peeled back. The Alt-A mortgagors found themselves in the line of fire from resets, delinquencies, and defaults. Then came the claim that the banks and large lending institutions could handle the problem. Upon closer inspection, one can see that at least $750 billion in questionable mortgage toilet paper has been strewn around the balance sheets of their owners, whose combined value is in the neighborhood of $850 billion. Then came the wishful thinking that the housing market would stage a recovery in the spring. Isn't that when more homes go on the market, both existing (for school vacation reasons) and homes from builders (after winter construction)? Then came the absurd claim that home prices had begun to stabilize and the worst is over. The inventory glut is testimony to the falsity of such claims, along with the vastly reduced home buyer traffic flow. Then came an absolutely absurd claim that business capital expenditures (business investment) will come to the rescue, and actually lead the way for consumers. How utterly absurd! A consumer driven USEconomy contradicts such a claim instantly, as we have seen. Nowhere is there a 'build it & they will come' mentality in the Untied States. More like, 'if they can borrow, they will spend' is the motto. Borrowing funds is a tough sell nowadays. Capex does not lead, it follows. Income depends on the financial centrifuges in this upside down USEconomy where the financial tail wags the aging three-legged dog. The missing leg is the manufacturing sector. One should note that the denials can be integral parts of the US Mythology.
Obviously, the decline on the tangible housing side and the bond security side have just finished the first deadly stages, ready to proceed to the next stage, then to the truly interesting and challenging phase when meltdown is the topic on a daily basis. Again, pay attention to the topics, ignore words. It started with 'Subprimes' and then 'Home Builders' and then 'Mortgage Bonds' with the next topics to be 'Credit Derivatives' and then 'Meltdown' and then 'Hedge Fund Blowup' and then finally 'Bailout' discussed on a regular basis to such an extent that the enlightened are annoyed, and the tone deaf can hear.
My forecast stands. With each passing month, my trio forecast looks increasingly likely. The last two are the latest conclusions.
- the bailout will be at least $1 trillion and possibly much more among bond holders
- the housing decline will wipe out all gains in national home values since 2001
- all except one or two home builders will declare bankruptcy
- USFed wants considerable destruction so as to consolidate the banks
- USFed wants broad economic decline to usher in the North American Alliance.
The band of professional analysts has begun to properly describe the situation, using words such as 'tip of the iceberg' and 'tipping point' and 'interconnected' and 'domino effect' among others. This will be interesting to observe.
IMPACT ON GOLD
Much depends on key decisions to be made. Will the Euro Central Bank hike interest rates again? Probably yes. If so, then the USDollar will test DX=80 again, and USTreasury Bonds will once more face a selloff. If truth be known, the biggest factor behind the May-June USTBond selloff on the long end was the scuttle ditch executed by China and Russia. The USGovt has little place in making demands to China regarding trade, yet did so. The debtor listens to the rules, decisions, and abides. The USGovt displays little wisdom in deploying a missile system pointed at Russia, when Putin controls an enormous strategic advantage in energy production AND distribution. The Druzhba Oil Pipeline in Lithuania now serves as the first linkage between the Energy War and the Renewed Cold War. Details are in the June Hat Trick Letter report. It is not being repaired, so the Baltic States suffer. Lithuania supported the US Military deployment.
Will the Bank of Japan hike interest rates eventually again? Probably yes, but unsure when. They must. If they do not, they leave their entire economy and financial system wide open and vulnerable to inflation. Economic growth, monetary growth, financial market growth, consumer spending growth, these all greatly outpace the measly 0.5% official interest rate within Japan. Of course, one should never lose sight of the key subservient role of Japan to supply the Western world with easy money for carry trades. Without the Yen Carry Trade, the Western banks would have gone bankrupt long ago.
How much does the USFed and USGovt want for the USEconomy and banking sector to suffer? This is the quintessential question, whose answer might be known only to the cabal in power, pulling faraway strings tied to US leaders. An astute contact has posed the theory, based upon considerable observation, that the Dynamic Duo of JPMorgan and Goldman Sachs have undertaken two key and different functions. My reference is of the Evil Twins. Well apparently, they have two distinct roles which have evolved over time. ArthurC (friend of friend) poses the theory that JPMorgan will serve as the 'waste basket' to capture the brunt of the underwater credit derivatives. Since well past a salvageable state, JPM will serve as the consolidated garbage can that the Powers That Be require for any and all destroyed financial instruments. The JPM house is beyond reproach, can easily sidestep audit, is not burdened by disclosure, can have losses forgiven or bailed out secretly, works for national security (thanks Security Czar Negroponte), and will never be coerced into revealing the boils, cysts, and blemishes under the skirt. On the other hand, Goldman Sachs serves as executor in charge of enacting change through policy. They boast a growing list of partners sitting in very important powerful political positions. Some claim GSax manages the outsourced US financial operations. The tentacles have extended and continue to extend. The appointment of Robert Zoellick as head of the World Bank is the most recent. In addition to Secy Paulson at Dept of Treasury, we have Josh Bolten as the White House Chief of Staff.
GOLD WILL SOAR WHEN THE RESCUE BEGINS.
The difficult questions remain which shed light on when that might be. Will the USFed cut short-term interest rates if demanded by the bond market? Even if the long-term interest rates rise in the market more subject to equilibrium forces? Personally, my preference is to own silver and silver mining stocks. One is hard pressed to find a story where central banks dumped tonnes of silver bullion. In fact, silver delivery is so constrained and obstructed, that a silver default is the present reality in my book. The image of Helicopter Ben showering the nation with money is not accurate. He and his compromised USFed institution will flood their banking compromised cousin cadre with money.
When mortgage bonds are properly price finally, the impact will be huge, extending broadly to the entire credit market. Why? Contagion will spread because almost everything in the bond market is connected, via credit swaps, spread contracts, and an array of complicated derivatives (sometimes called exotic). Leverage has been abused broadly and pervasively and for a long time. Subprime and other higher risk mortgages have defaulted to a degree inconsistent with the value of related CDO bonds which contain them. Losses will grow suddenly into the hundreds of billion$ when the downgrades finally come, when the bond markdowns finally come. Many investment institutions are not permitted to hold bonds which fall below a certain investment grade. So sales are almost automatic, forcing bond principal values much lower. Be sure that the major Wall Street banks and broker dealers are working feverishly to dump as much of their toxic bond holdings on unsuspecting hedge funds, pension funds, and public as possible before the great price valuation cuts. Sheer weight of gravity might run ahead of the rating agencies to pushing the next lever. The pervasive unspoken fear among experts is the degree of the contagion. Corporate bonds, junk bonds, emerging market bonds, these are certain to be detrimentally affected. Insofar as foreign central banks are concerned, they hold some hydrochloric mortgage acid. They could easily sell some USTBonds in order to offset some mortgage losses. Does that qualify as contagion? Sure. Gold traditionally benefits from the ratcheted degradation of systemic risk.
Bear Stearns has earned the label 'Tip of Iceberg' with full justification. My view is systemic contagion, not isolated contagion. Any mortgage bond rescue package will render the USDollar vulnerable to another PROFOUND round of devaluation. Gigantic money creation adds to the supply of USDollars, sure to cause an exchange rate devaluation, unless most other major currencies suffer the same dilution. With the sequence of crises engineered and papered over, the USDollar will be mostly 0's and 1's soon, and not much value at all. Gold is counting on that eventuality. Pushing the gold price down will be the sewer effect from liquidations. Pushing up the gold price will be the heavy downward pressure on the USDollar.
The big fix is the national bailout of the big banks after their bond holdings collapse. Gold investors are counting on it, since the flood of monetary inflation will be acute, huge, and sure to find plenty of haven in gold. The USTreasury Bond market might be severely damaged, the price (and yield) will respond to reduced foreign willingness to hold. The prestige and reputation of the US$ and USTBond are sure to be degraded and shamed. Always the flip side, mortgage rates will rise as the meltdown occurs. The housing market will be slammed one round after another. The new mantra will not be focused on recovery, but when will the bleeding end? And when will the bailout rescue be officially enacted? The fresh money in colossal volumes used in rescue, called monetary inflation by the wise, called liquidity by the deceitful, will be the harbinger of the march to $1000 gold.
The big problems are that the USFed might prefer to be slow to recognize the debacle, the rating agencies might prefer not to downgrade at all, and the big banks & broker dealers might succeed in containing their fire for many more weeks or months. Conditions must worsen much more before the USFed takes drastic action. The momentum, ripple, and feedback effects have much more pathogenesis to occur. Actions behind the scenes are almost assuredly desperate. We are close to an event where USFed has a repeat of September 1998 when they flooded the system to bail out LTCM and destructive Nobel Prize winner schemes. In a system dependent upon monetary inflation, even genius is guaranteed to take the system to the brink, and to disappoint the managers and investors alike. Even the LTCM bailout had a secret motive, to cover up the need for a gigantic short cover rally in gold. Has anyone noticed that the Bank of Italy has no gold to offer in official Euro Central Bank sales? That is because they lost their gold in the LTCM fiasco!
With Asians withdrawing from recycled trade surpluses into USTBonds, with Persian Gulf nations rumbling over USDollar pegs which heap price inflation upon their local economies, the USFed has been forced to monetize the USGovt federal debt on an increasing basis. Ever since the Chinese decided to send a message (decreasing their holdings of USTBonds for a month to show Bernanke they could play nasty with his interest rates), the USFed is trapped in a minefield with multiple tripwires. Ben has begun to go public in his reflections of reality, that both the housing crisis has more negative momentum to suffer, and the household pain from wealth reduction will be much more damaging. He has yet to publicly awaken to the mortgage debacle and its devastation. They are two sides of the same fiasco. Some hard evidence of strain was seen with a recent USTreasury auction. One went out in early June at a 1.9 bid cover ratio on the 30-year bond. No rally ensued afterward, rendering all buyers almost instantly underwater. A bid cover ratio of 2.5x is normal. Bond dealers have good memories; they will not be burned too often.
Prices for food cannot be all that bad. Heck, bananas sell for 4 cents each here in Costa Rica. Cantaloupes sell for $1 only. A full meal with frijoles, vegetables, either chicken or fish can be found for under $4 at several nice locations, some with a great upper view of passing pedestrians. Plenty of them are worth the view. The level of beauty, appeal, and personal appearance is easily 10-fold greater than in the corpulent states. That makes for high consumer confidence here on the eleventh parallel, where the long spring rainy season is close to an end. Pura Vida!
The word for mortgage in Spanish is 'hipoteca' whose verb form has additional meanings of to compromise and to jeopardize. Hmm, how true! Another interesting perspective is that a home mortgage is essentially a leveraged home credit derivative, which does not have margin calls in mark-to-market calculations, but which can indeed have rising margin requirements. The M2M would require full payment or additional down payment in equity if the home dropped in value. The rising margin has come in the form of adjustable rate resets. Homeowners have begun to benefit from an education that many novice futures contract participants receive, namely losing all their money rapidly. They believed the realtors and so-called experts, that home values never go down. So this is what Greenspan boasted about on financial innovation, effective risk offload, and some such nonsense? When will the Greenspan legacy and reputation be downgraded? Maybe never, since he offloaded the risk to Bernanke.
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Jim Willie CB is a statistical analyst in marketing research and retail forecasting. He holds a PhD in Statistics. His career has stretched over 24 years. He aspires to thrive in the financial editor world, unencumbered by the limitations of economic credentials. Visit his free website to find articles from topflight authors at www.GoldenJackass.com. For personal questions about subscriptions, contact him at JimWillieCB@aol.com
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