Effor.com

In going through the financial news stories on various sites tonight, this one from the NY Times struck me as particularly insightful.  Lets see what they have to say about the state of the financial institutions….

The story starts with this: Somehow, $4.4 billion just evaporated at Merrill Lynch. Less than two weeks ago, Merrill Lynch valued the toxic mortgage investments on its books at $11.1 billion. Now, it is selling those investments for $6.7 billion — and financing most of the purchase to boot.

So two weeks ago, Merrill Lynch claimed that the value of their mortgage holdings (the bad ones anyway - they haven’t disclosed all of them) were worth $11 billion.  Today they’re supposedly worth only $6.7 billion.  That’s $4.4 billion utterly gone, destroyed by the decrease in value of the underlying assets.

I say “supposedly” because you haven’t heard the best part yet - Merrill is financing $5 billion of the sale of these assets (which are worth 40% less than two weeks ago) to Lone Star Funds.   I can’t find where I read it right now, but I think Merrill owns a big part of Lone Star Funds.  If this is true, they’re selling these toxic CDO’s to themselves in order to get them off the books.  Not good.

Here’s something from FoxNews on the story:  Lone Star Funds, a Dallas-based distressed-debt investors based run by John Grayken, will acquire asset-backed securities with a nominal value of $30.6 billion for $6.7 billion. The sale will help cut Merrill’s exposure by $11.1 billion from its level on June 27, leaving $8.8 billion of these securities on its books.

That’s 22 cents on the dollar.  The NY Times story linked above puts it into perspective: Executives at Citigroup, JPMorgan Chase and Bank of America began reviewing the bundles of mortgages, known as collateralized debt obligations, or C.D.O.’s, that their companies hold on their books. Those companies may have to lower their valuations, and take additional charges, if their assets are similar to those sold by Merrill.

Of the companies they mentioned, I personally think Citigroup is the one most likely to pull a Bear Stearns and disappear.

The NY Times story also said: Still, financial stocks rallied on Tuesday, as investors hoped the deal at Merrill signaled the troubles plaguing banks’ balance sheets might be coming to an end.

Anyone want to bet on that?  How many times are these analysts going to say that the troubles are over, that this is the kitchen sink quarter, that this must be the bottom?  I can find dozens of examples over the past 10 months.

In just one month, Merrill had to drop the value of some of their CDO’s from $30.6 billion to $6.7 billion.  What does that say about the honesty of their accounting?  Damn near everyone knew they’d have to write these assets down last year - but Merrill tried to delay their day of reckoning.

Regardless of the way the market reacted today, there’s no way Merrill is worth more today than last week.  But that’s what the stock price says.

I am forced to conclude that many investors are stupid, that they are betting on a short term gain, or that they are smoking crack - because the numbers just don’t add up.

If I’m right Merrill (which closed today at $26.25) will be lower a week from now after investors have had time to understand what this really means for Merrill.  Bank of America ($32.22) and Citigroup ($18.46).

One of these days I’ll have the guts to short individual stocks and make some money off of these things that should be obvious to everyone, but I’m chicken.  I have no position in any of the stocks mentioned in this post.

There’s a lot more to say regarding the market and financial stocks, but I’m calling it a night.  Stay tuned.

gk

I was responding to some comments to a post I made to www.seekingalpha.com a few minutes ago, when I said something that I think needs to be explained further.  I mentioned “leverage” and since that’s been in the news (especially regarding financial stocks) quite a lot over the past few months, I decided to expound on it a bit.

In the comment I referenced above, I said “Let’s say you have $1 million equity in your house, and you take it out in a HELOC. You take that $1 million and put 10% down on 10 other $1 million properties - and you depend on the renters to make your payments.“

That’s leverage.  I just took $1 million in assets (my home equity) and used it to gain control on $10 million in assets.  I used the words “gain control” rather than saying “to buy” because I don’t actually own them - the bank I borrowed the other $9 million from actually owns those properties.

It’s an important distinction, because what happens to my $10 million in assets if just one renter falls behind on their payments?  Suddenly I can’t make my mortgage payments.  It’s only 10% less income, but it causes me to suddenly have to sell the whole $10 million in leveraged assets - because I can’t make the payments.

That’s what happened to Bear Stearns.  They had some assets which they leveraged (borrowed against) in order to buy (with other peoples money) other assets.  When one small part of the initial asset didn’t make their payment, the whole house of cards fell.

In my example, I used a leverage ratio of 10 to 1.  Bear Stearns was leveraged over 30 to 1.  I’ve sen some arguments from pundits (including Ben Stein) where they say the markets have over reacted; that a 10 percent jump in the rate of defaults doesn’t warrant a 20 or 30 percent drop in the stock price of financial companies. 

They’re wrong.  And they’re wrong for the reason above.  When you’re that highly leveraged; when you have 20 (or more) dollars of debt for every dollar of assets; you are hosed when just one percent of the underlying assets doesn’t pay up.

Suddenly you can’t make your payments on all the debt you’ve borrowed.  And since you really didn’t make much of a down payment anyway, you have no equity in the investment.  If you had some equity, you’d have a little breathing room.

But you don’t.  You need every dollar that you’ve counted on to make those payments - because you’ve leveraged your equity. 

And what happens when the value of thoseleveraged assets turns out to be too high?  You’re fucked.  Not only are you highly leveraged, but the base value of thoseassets has dropped, so now you are more leveraged than you were just a monthago.  And so you’re even more vulnerable when there’s a small rise in loan defaults and bankruptcies.

It’s a wild, wild world right now.  I can’t think of a single bank or REIT that I’d touch with a 10 foot pole.  Go ahead and Google the news results for the 3rd quarter of last year.  Check out all the stories that claimed that the 4th quarter was the “kitchen sink” quarter.  Be sure to read how damn near everyone thought that the banks and investment houses have finally fessed up and come clean.

Now watch the headlines during the week ahead.  Let’s se how many additional write-downs there are.  A lot of people have written me saying that I’m overestimating the impact of the sub prime stuff.  Many have told me that all of those losses for the upcoming rate adjustments (for the Option ARM’s and ARM’s written in 2005 through 2007) have been accounted for, and that there’s no where to go but up.

They may be right, but I don’t think so.  I don’t think people truly understand the impact of leverage.  I don’t think they truly understand that just a 3 or 4 percent drop in the base asset (mortgages) can cause a company to disappear.  

I’m not putting my money back into the market until I’m sure that risk has been priced in.  Given the (in my view) extremely optimistic earnings forecasts for 2008 and 2009, that risk is being ignored right now.  I may be wrong (I often am!) but I think I’ll be getting 2 or 3 percent in my money market funds while the optimists are losing 10 to 20 percent (or more) trying to bottom fish the market.

Any questions?

gk

From the 400 point rally today in the stock market, you’d think that the bulls are running rampant in Pamplona.  And you may be right, however….

Stocks are still down over 10% for the year.  The highly leveraged banks and Wall Street firms are still highly leveraged.  Massive amounts of mortgage backed securities - and their higher default rates coming this year and next - are looming.  When a CDO takes a 10% loss because the home owners can’t make the payments, that translates to a 300% loss on a 30 to 1 leveraged portfolio such as Bear Stearns and Lehman Brothers.  (Citigroup is also highly leveraged.)  The $2/share Fed ”take it or leave it” financed JPM buyout of Bear Stearns still needs to be approved by shareholders.  Hmmm…. How would you vote if you owned BSC?

As I’ve written before, this unwinding of the leverage in the financial markets will take quite awhile.  The longer the Fed props up failing companies, the longer it will take to hit bottom.   JP Morgan is getting a deal only because the Fed is guaranteeing $30 billion of BSC’s “assets.”  They’re not really worth $30 billion, but the Fed took that much risk away from JP Morgan.   That’s $30 billion that US taxpayers will end up spending to finance this bailout - because the underlying securities are “riskier assets.”

 A couple of weeks ago, I thought we were headed for a repeat of the Carter years and stagflation, but it’s beginning to look more and more like we’re repeating Japan’s mistakes of the 1990’s.  Low interest rates, keeping bad debt on the books (instead of recognizing the loss and getting it over with) propping up banks with fake assets on their books, etc. 

Japan still hasn’t fully recovered from the 1990’s.  I sincerely hope that we don’t continue making the same mistakes, but today’s 3/4% drop in both the discount and Fed funds rates isn’t helping.  That only serves to drive up long term inflation, and that (rather than deflation that I’m reading about) is my long term worry.

As regular readers know, I don’t try to predict short term market swings, I simply try to stay on the right side of the market during long term trends.  I don’t know if today’s action signals a turnaround or not; my gut says no - because of the reasons listed above - but my gut doesn’t make the market move.

Regardless, I don’t see any fundamental change in the long term trends of the dollar going down, commodities (especially gold, silver, corn, and oil) going up, and the broad market (especially financials) going lower.

My feeling is that the majority on the street think that the worst news is behind us; that most people are looking for a reason to buy.  They’ve discounted all the bad news and they’re ready for another bull market.  I don’t think they’ll get it just yet.

Too many firms have too much debt.  Too many firms are leveraged enough so that a small change in the base assets (mortgages in most cases) results in a huge change to their balance sheets.  One little piece of unexpected bad news will be enough to cause a dramatic sell off.  I’m talking about a sell off big enough to trigger a halt to trading. 

I think the coming upswing in the foreclosure rate (because of all the ARM’s taken out in 2005 through 2007) hasn’t been fully factored in to the stock prices of the companies that are using these mortgages as collateral on their loans. 

When people realize how little capital is propping up these companies, share prices will drop.  The dollar will drop, and commodities will rise.  Again, I have no clue what the market will be at in a week or a month.  I don’t know if commodities will be higher a month from now or not.  But I’m betting that 10 years from now, you’ll be glad you bought gold at $1000/oz, silver at $20/oz, oil at $105/barrel, etc. 

If we really are following the deflationary path Japan took in the 90’s, the Dow may well be at 7000 10 years from now.  As it stands, buy and hold investors are down from where they were 8 years ago….  How much longer do we need to prolong the agony? Take the losses now, write off the sub prime and alt-a loans, get it over with!

Of course that’s just my opinion, I could be wrong.  :-) 

gk

Just two days ago on Wednesday, March 12th, Bear Stearns CEO Alan Schwartz said (I’m quoting from a Reuters story) “We don’t see any pressure on our liquidity, let alone a liquidity crisis.”

He also said “We have $17 billion or so excess cash on the balance sheet.”

Today he said “Our liquidity position in the last 24 hours had significantly deteriorated.  We took this important step to restore confidence in us in the marketplace, strengthen our liquidity and allow us to continue normal operations.”

Bullshit.  Rumours about Bear Stearns and their problems have been circulating for quite awhile.  I even mentioned it here on Monday in a post titled “Who is this guy Margin - and why does he keep calling?” 

To put it bluntly, Schwartz lied.  He knew he was lying when he said it.  He should be fired immediately and prosecuted for fraud.

The bailout of Bear Stearns by the Fed today is the tip of the iceberg.  This will get worse, and the Fed has now set a precedent of bailing out non-banks.  Here’s a quote from a CNN story today. 

“The crisis, however, is not isolated to Bear Stearns, said Christopher Whalen, managing director of Institutional Risk Analytics, who predicts that the liquidity crunch will only get worse. The heart of the problem is that no one knows how to value the assets these Wall Street firms are carrying so noone wants them.  A lot of firms are right behind Bear,” he said”

gk

Nice article in the NY Times today about some of the problems in the financial world.  I hate to say I told you so (not really, but it’s sounds slightly less smug) but I’ve said all of this before.  Despite Mr. Krugman’s pessimism, he is still underestimating the size of the problem. 

For example he says “But what worries me more is that the move seems trivial compared with the size of the problem: $200 billion may sound like a lot of money, but when you compare it with the size of the markets that are melting down — there are $11 trillion in U.S. mortgages outstanding — it’s a drop in the bucket.”

By comparing the size of the Fed bailout to the amount of outstanding mortgages, I think he’s missing the bigger picture - the derivatives that are using that $11 trillion as leverage.  (To be fair, probably less than 10% of the mortgages will default, but that’s still about $1 trillion.)  

I don’t remember right now where I read this, but the average leverage is something like 20 to 1.  That means that the $1 trillion in eventual defaults will lead to more like $20 trillion in losses.  That’s where the problem lies.  That’s why companies are getting margin calls.  That’s why they aren’t able to meet those margin calls.  And that’s why many of them will not be around next year at this time.

Who will be the first big name to disappear?  If I knew that, I’d be getting paid some big bucks for the info!  But rumour has it that Bear Stearns and Washington Mutual are very highly leveraged.  And for what it’s worth, Citigroup has been talking a lot lately about how much they have in reserve.  Me thinks they protest too much….   I have no position in any of these, just giving my opinion.

gk

Interesting daily update from The Daily Reckoning.com.au today.  The Mogambo Guru said (in part!):

I know what will happen in a crisis, because I know what the crisis is, which is that derivative holders will not be getting the money they were supposed to be getting, because the guys who owe them the money are already bankrupt, because they didn’t get the money they were supposed to get from guys who were bankrupt because the guys who owed them money were bankrupt, and they are all bankrupt because they put up a lousy $3 of their own money, and borrowed another $97 to buy an asset worth $100, and now that asset is worth only $90!

That’s what basically happens when someone defaults on a loan.  It’s a whole chain of people going bankrupt - or at the least taking huge write-downs - because a sub-prime borrower can’t make his payments.  The elephant in the room is the amount of money involved.  According to Wikipedia, it’s over $500 TRILLION!

To put that $500 trillion number into perspective, the total GWP (Gross World Product) of the entire world is estimated to be about $65 trillion.  The total market value of all the publicly traded shares in the world is about $44 trillion.  (These numbers are from The CIA World Factbook.)  And according to Wikipedia, the total value of all the property in the developed countries in world is about $62 trillion.

In other words, the money in derivatives total about three times the total of all the above values - combined.  That’s what happens when you leverage real property multiple times.  And when the property that the whole house of cards is built on drops in value by just a little bit, guess what happens to the chain. 

Does a derivative crash make any sound?  We’re getting ready to find out….

gk

Just yesterday I mentioned the CNBC report about Ambac that caused a major market revesal a couple of weeks ago, and now it happens again today.  How many times are these people going to cry wolf?  And (perhaps a better question) when do people stop believing what CNBC says?

Perhaps the strangest part of today’s story is who they are counting on for the bailout….  Citigroup!  But the market was way down this morning partly because of a report that Citigroup needs a lot more money to stay afloat.  The report said:

Sameer Al Ansari, Chief Executive of Dubai International Capital told delegates at a private equity conference thatit will take more than the combined efforts of the Abu Dhabi Investment Authority, the Kuwait Investment Authority and Saudi investor Prince Alwaleed bin Talal to save the bank.

“It’s going to take more than that to rescue Citi,” Ansari said. He added that more write downs are expected and that Gulf investors would be required to bolster Citi.

Pardon my ignorance, but just how exactly is a financially troubled bank supposed to bail out anyone?  The answer of course is by borrowing money via the Fed’s Term Auction Facility (TAF) which doesn’t need to be disclosed. 

My take is that the longer we prop up this house of cards, the longer it will take to put it behind us - and the harder the crash when they do eventually fail.  We should let these businesses (and investors and borrowers) go under now.  It’ll be a terrible quarter or two, but it’ll be done with.  The way this is going, these financial problems are going to drag on for years,

gk

I’ve seen this a couple of times over the past few days, but here’s CNN’s version of a story about “homeowners” simply walking away from their homes.  I say “homeowners” because most of these people put little or no money down, they took out teaser rate ARM’s, interest only - or even negative amortization loans - so they’ve never had any equity to speak of anyway.  They didn’t “own” their homes, they were renting them.

A couple of quotes from CNN’s story - here’s the headline:
Homeowners: Can’t pay? Just walk away
More and more borrowers are watching their house values sink while the cost of their loans skyrockets. What to do? Skip out on the mortgage all together.

Yeah, that’s a good plan.  Just “buy” a nice house which you can’t afford, then stay there for a year or two until your rate adjusts and you can no longer pay for it.  Then mail the keys to the bank (hence the term jingle mail) and walk away.   Next thing you know they’ll be wanting a bailout from the Fed’s…

Another quote: The Los Angeles-based writer bought two properties in Hancock Park, west of downtown, using no-down, interest-only mortgages in 2006. He paid just over $1 million for both.

Often they chose hybrid adjustable rate mortgages (ARMs) that came with low initial payments. After a few years, interest rates on these loans reset higher. But buyers thought they could count on the increased value of their homes to refinance into affordable, fixed-rate loans.

Question - If you couldn’t afford a fixed rate loan on a house 2 or 3 years ago when rates were at a 40 year low, why the hell did you think you’d be able to afford to refinance before the interest only or ARM reset?  Were you counting on a huge raise that never came through?  Or did you just get more house than you could afford on a 15 year fixed rate loan?  If so, you’re too stupid to be a homeowner anyway.

Go ahead and blame it on predatory lending practices, blame it on your real estate agent, blame the economy, blame the house pricing slump, blame your neighbor - just be sure you don’t take responsibility for your own decisions, because that would mean you’re an adult.  And if you did any of the things above, you’re not an adult. 

You’re also not a victim, you’re the cause of the current mess.  You’re the one walking away (or defaulting) on a mortgage that you promised to pay.  You’re the one who is causing banks to lose money because you lied about your income on your application.  And when those banks write down a loss on your loan and their stock price drops, you’re probably bitching the loudest because now it’s hitting your 401k and Roth accounts - although maybe I’m giving you too much credit - anyone who did the above loans is probably not bright enough to plan for their own retirement - you’re counting on Social Security. 

I normally don’t call people names, but if you fall into the category of the people above - you are stupid.

gk

I have a “My Yahoo!” page setup with a couple of portfolio’s, one to view the funds I have available in my 401k.  The other has a few stocks that I own in various accounts, such as the kids college funds, a Roth IRA, and a small “play” account.  The second portfolio also has a few stocks that I’m interested in, plus the major indexes so I can tell at a glance what the market is doing whenever I’m interested.  So with one click on a favorites button, I can see what’s happening during the day.

With the Fed due to announce on Thursday, I was was curious to see how the markets would react, so I checked my custom Yahoo! page several times during the day.  It never fails, when the Fed does ANYTHING, the markets react big time - the only question is will they go up or down? 

All morning the market was down slightly, 30 to 40 points most of the day.  When the Fed announced at 2:15pm, there was an instant surge up, with the Dow up as much as 200 points very briefly.  Then the news hit about Financial Guaranty Insurance being downgraded from AAA to AA.  Stocks immediately took a nosedive, and ended the day right about where they’d been until the Fed announcement - down about 40 points.

In case anyone is wondering why a downgrade of a fairly insignificant bond insurer caused such a downturn, I’ll try to explain it as I understand it. 

Bond insurers do just what their name suggests - they insure corporate and municipal bonds.  It’s an important function which allows corporations and municipalities to sell their bonds at a lower rate than they might get based on their own rating.  For example, lets say that Memphis needs a new sewage treatment plant at a cost of $100 million.  They don’t have $100 million laying around, so they need to borrow it - but (lets assume) they already owe $200 million for other projects, and there is some doubt that they will have the money to repay the sewage bonds on time.

The city of Memphis might be able to sell their bonds at a 10% interest rate (all these numbers are 100% made up - they’re for example use only!) on their own, but if the bonds are insured by a AAA rated insurance agency, they may be able to sell them at a 6% rate - which saves the city a LOT of money on a 20 or 30 year bond.   Let’s assume that the insurer also insured other debt instruments, such as mortgages, derivatives, and CDO’s (Collateralized Debt Obligations), as most of them do in order to have a broader customer base. 

Now what happens when the bond insurer doesn’t have enough money to pay off the claims they’ve insured?  Those city of Memphis bonds were that were yielding 6% because they were insured by a AAA rated (investment grade) insurer, are suddenly being guaranteed to be repaid by a AA (”less than” investment grade) insurer.  The bond ratings are only as good as the insurer, so guess what happens?  Yup, the rate goes up to match the increased risk.

Note that this doesn’t affect bonds that have already been sold.  The people who have bought them will be repaid on time, and at the going rate when they were purchased.  The problem is that very few people actually hold onto bonds for the whole term - they sell them on the secondary market in order to free up their money for something else; buying a home, car, sending little Sally to college, or to move the money to something that they think will give a better return.

In other words, bonds are traded almost like stocks, and almost as often.  When you have a bond fund in your 401k and you move money in or out of it, someone is buying and selling those bonds, be they government bonds as in the example above, or corporate bonds, or maybe even someones mortgage.  So, if I owned a $1000 city of Memphis sewer bond yielding 6% and I wanted to sell it to get my money out, no one in their right mind would settle for a 6% return because it’s no longer investment grade (AAA) rated.  They will demand a higher interest rate to compensate for the increased risk.

You need to realize that the interest rate doesn’t actually change, the price of the bond changes instead, which is effectively the same thing.  If the price I sell the $1000 bond at is $900 instead of $1000, the effective yield to the new owner (assuming it’s a 10 year bond) is 6.667% instead of 6%.  And it yields 7.454% if they hold it for the full 10 years to maturity.  At least that’s what the calculator at http://www.moneychimp.com/articles/finworks/fmbondytm.htm says.  Your mileage may vary. 

The thing to keep in mind is that as the bond is worth less on the secondary (reseller) market, the effective interest rate goes up.  The opposite is also true - if the price of the bond is worth more, the interest rate (yield) goes down.  That’s why Treasury bonds (which are backed by the US Government and your tax dollars) are considered a “safe haven” in times of turmoil.  More people want them because they are the safest investment you can make, so the price goes up.  Simple supply and demand.

Now back to the Memphis sewer bond.  If the insurance company is now rated lower, those sewer bonds are now riskier, so they drop in price.  No one wants to buy or trade them anymore.  The secondary market has dried up, and (since I can’t sell them and do something else with my money) we have a credit crunch.  I can’t invest that money in a new business, I can’t invest that money in the stock market, and the asset I paid $1000 for is only worth $900, so I can’t borrow as much using that bond as collateral.  My net worth has also decreased by the amount that the bond has dropped in value.

Extrapolate this out.  Instead of an individual owning  one or two bonds, imagine that I’m an institutional bank or investment company, such as Bear Stearns.  I have billions of dollars in bonds - both government and corporate - that I own as assets.  In order to get a better return for my shareholders, I’ve borrowed against those assets (just like you or I might take out a second mortgage using our home as an asset) and invested the borrowed money in the stock market, or other places where I think I can get a better return on my investment.  

Overnight my assets  have dropped in value by a good percentage just because the insurer of my AAA rated bonds was rated one notch lower.  What happens?  Since I’ve borrowed against the assets which have dropped in value, I suddenly owe more than what the assets are worth - just like if I’m “upside down” on my car loan or mortgage.  I can’t sell it for what I owe on it, so I’m stuck with something that’s worth a lot less than I owe. 

This is happening at most of the major banks and investment companies all at the same time - the credit crunch “crunches” even tighter.  No one will buy my assets for anything near what I owe on them, so I owe a lot more overall than what what I’m worth.   What can I do?  There are three ways to approach it:

1)  I can ‘fess up and admit that I owe a lot more than my assets are worth.  I produce a quarterly earnings report that shows how much my assets have fallen in price.  That’s what the major investment banks have been doing.  That’s essentially what happened when Merrill Lynch “wrote down” $7.9 billion in the 3rd quarter.  The same for when CitiGroup reported $18.1 billion in write offs.  And when UBS writes down $14 billion, and when (pick your bank writes down billions more).

2)  I can pretend everything is fine and do nothing.  I can say that everything is coming up roses in my report, and everyone believes me.  After all, there really isn’t a loss until you sell the asset for less than you paid for it.  But that’s a house of cards, just like if you or I were upside down on our car loan.  You have to keep making the payments long after you’ve paid what it’s actually worth.   But you can’t sell it and you can’t borrow against it.  Your money is locked up and unavailable to loan to anyone else.

3)  I do what most banks and investment company are doing - at least in my opinion.  I combine the previous two methods.  I write down some assets, but I don’t dare write down all of them that are affected - because that would make it clear that my prestigious company is nothing but a house of cards.  But eventually I will have to come clean and fess up, because the stuff I’ve invested the borrowed money in (mainly other peoples debt obligations) isn’t going to pay enough for me to keep making my payments on the original loan (bond) that I bought.

That’s basically what’s happening in the markets right now - but it’s actually 10 or 100 times worse than this.  That’s because banks and investment companies don’t do what I described above - they do it times 10 or 100.  No one really knows the real numbers, but it goes something like this:

I get a sub-prime home loan from a local bank at a ridiculously low teaser rate that resets in 2 or 3 years.  My local bank doesn’t want to wait that long to get their money back, so they sell my loan to someone else.  The company who purchases my loan (at a discount) also wants to use their money for other things, so they bundle my sub-prime loan with other (mostly prime, but a mixed bag) loans and bonds and sell it to someone else.  My sub-prime loan is a very small part of the overall loan, so you’ll probably get most of your money - if not all of it - back at this point.  Besides, this company paid an insurance premium on the whole thing (it’s actually broken up into “traunches” at this point, but that’s another subject) to be insured by an AAA rated bond insurer.

But the company who now “owns” your AAA rated sub-prime mortgage also wants to get higher returns than the discounted teaser rate (here’s where your super low ARM for the first 3 years hits everyone else) they are getting on paper, so they again bundle it with other loans and bonds, and sell it to someone else.  After all, it’s investment grade AAA rated (and because of the discounts in price every time it’s sold) lot’s of pension funds and other conservative investors will buy it for the nice interest rate they’ll receive.

And the returns will only get better as the teaser rates adjust!  That’s assuming that I can pay my mortgage after my rate resets anyway.  If I can’t, the whole house of cards falls down.  My loan is bundled with hundreds or thousands of others at this point, so if I default on the loan (that I can no longer pay because I was stupid and bought more house than I could afford) it affects the whole bundle.  The owner of that bundle has to take a write off for the amount of my loan - so that AAA rated insurer has to pay up for my non-payment.

But guess what?  How was that AAA rated insurer making money?  By investing their capital into AAA rated debt instruments - thats’ right, the insurers assets are in the same (or a derivative) of the same AAA rated securities that they’re insuring.  So they can’t pay up, because the sub-prime mortgages that they own as assets aren’t making their payments either.

The same debt has been resold over and over.  The same debt has been counted as an asset by 3 or 4 or 10 different companies - because it’s been leveraged multiple times.  An example of leverage is when I buy a stock or bond “on margin” from my broker.  In effect, I’m borrowing money from my broker based on nothing but my guarantee to repay them when the asset goes up in value.   But because my neighbors’ house has also gone down in value (because of the foreclosure on my sub prime loan) none of these leveraged assets are worth what they were. 

The biggest problem is that NO ONE KNOWS where these sub prime mortgages are today.  They’ve been bundled with other prime loans, sold as CDO’s, used as assets against leveraged loans, etc.  No one wants to purchase them so the price keeps falling.  And as the price of a bond (or any other debt instrument) falls, the interest rate goes up.

So regardless of what the Fed does with interest rates, real rates are going up right now.  And the value of all those “assets” held by banks and investment companies is going down.  I think it’ll take years for all of this bad debt (and the subsequent write downs) to work their way through the system.  I don’t know who, when, or where, but I think more than one major bank will fail.  Its’ assets will be bought by another bank and/or the government, but the end result will be the same.  We’re borrowing money to pay back borrowed money.  At some point this always fails.

Personally, I think we’re in for a repeat of the late 1970’s, with high interest rates, little to no growth, and higher inflation.  Because of all the leveraged debt, I think the true picture will only be clear years from now.  Some are saying that we’re entering a deflationary period.  It could be, but my money is betting that “you ain’t seen nothing yet” regarding write downs and losses.  When this house of cards comes down, no one will want the dollar, so it’ll inflate dramatically - especially if the Fed keeps lowering rates and effectively printing more money.  It’s simple supply and demand, and we’ve got way to much supply right now.

This post ended up being a stream of consciousness type of post.  I had one point in mind (the importance of bond insurers) when I started, but it morphed into the other types of debt that make up this house of cards.  It’s way longer, and much more rambling than I originally intended, but hopefully it will provide some insight.  As always, if you spot a factual error, please let me know so I can correct it.  My intent is to enlighten, not to obscure.

gk

I wonder how Doug Kass is feeling about this advice he gave on Jan 14th?

http://www.thestreet.com/s/kass-katch-buy-the-financials-yes-buy/newsanalysis/investing/10398482.html

Yup, you read that right - he said to “Buy the Financials. Yes, Buy”.  Since Mr. Kass published his story on the 14th, the Financial Sector Index (XLF) is down more than 8% - and it was down 10% at one time Friday.  I may be wrong (I often am!) but I don’t think buying on the 14th would have been a good idea….

I think it’s waaay to soon to be looking at this sector.  Personally, I think we’ll see a couple of big bank failures before the financial house of cards has collapsed fully.  No, I don’t know who it will be, but I do know that you don’t make money in the long run by borrowing money (especially at today’s higher rates) to pay down debt.  Eventually you run out of willing lenders (can you say credit crunch?) and you have to face the music.

Banks and other lenders have been putting off the inevitable for quite awhile, and they may be able to postpone it a bit longer, but borrowing from Peter to pay Paul still works the same way it did 100 years ago.  It doesn’t.  Infusions of capital from the Middle East, reductions in the Fed Funds Rate, and issuing corporate bonds simply makes the eventual crash worse.

In my humble opinion, we’re heading into a very rough period for almost all asset classes, but “soft” things like made up financial assets and corporate profits (measured in the dollar) will fare much worse than “hard” assets, such as commodities.  Another 20% to 30% decline from here is not out of the question, so sell some stocks and put the proceeds into simple money market funds or commodities.  In other words, it’s time to keep your powder dry (conserve your capital) so you can afford to pick up some bargains when this train wreck is over.

gk

It’s never wise to bet against the Oracle of Omaha, Warren Buffett.  It looks like he’s using the substantial resources of Berkshire Hathaway to move into the bond insurance arena.  Bond insurer’s are the ones left holding the bag IF the entity which issued the bonds (business or government) defaults on the bonds they’ve sold and can’t pay the bond holders back.

I think it’s significant that Buffett is moving into this field with a fresh start - it would’ve been much easier to simply buy one of the companies that already issue bond insurance.  Since Buffett has in excess of $40 billion laying around returning money market rates, it would have been easy for him to buy a current player at sale prices.  Since he didn’t, what does that tell you about the current bond insurer’s?  Hint: The sub-prime fiasco has yet to bottom out.  Buffett knows this and decided to get in the business before the others went bankrupt.

Anyway, good article on it here:

http://www.businessweek.com/bwdaily/dnflash/content/dec2007/db20071228_263014.htm?chan=rss_topStories_ssi_5