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.

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.

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.

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:

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.

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.

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.