The Market Ticker

Following up on the quick mention now that I have a story to cite from Amherst:

Cure rates for these distressed loans remain low. Amherst noted a near 0% cure rate of all loans in foreclosure, 0.8% for 90 plus days delinquent, 4.4% for 60 days delinquent and 26.5% for 30-day delinquencies. All told, Amherst expects 12.42% of units (from the 13.54% of properties delinquent and in foreclosure) to eventually liquidate.

Let's put some numbers on this.

There are roughly 125 million single-family homes in the US.

Of those, roughly 30% have no mortgage on them at all.  This leaves 87.5 million single-family homes with mortgages.

Let us assume the average outstanding balance is $200,000 across the entire set and will take a 40% loss severity.  This is less than S&P has estimated for subprime loans and only assumes a roughly 20% market deficiency in the home price (the rest is from legal, rehabilitation and marketing expenses.)

These numbers are, with a high degree of confidence (90%+) low - that is, losses will exceed these estimates, perhaps dramatically so.  It is, for example, quite reasonable to believe that due to the concentration of defaults in higher-priced areas (e.g. California and Florida) that the average outstanding balance could be close to double that $200,000 value and the loss due to negative equity higher.

From this we can develop a "cocktail napkin" view of the losses to be taken in home mortgages for single-family homes (remember, this does not include condos, apartment buildings and similar "commercial" paper.)

$200,000 X 40% = $80,000 loss per foreclosure.

87.5 million homes with mortgages X 12.42% = 10,867,500 foreclosures.

10,867,500
x    80,000
=============
$869,400,000,000

or $869 billion in losses remaining in single-family mortgages alone.

What if the average outstanding is higher and negative equity greater than 20% (which is likely)?  Losses will almost certainly be well north of a trillion dollars.

The entire banking system and likely The Fed, given the quantity of Fannie and Freddie paper it has been and is "eating", is insolvent.  These facts are why the government is lying - they're well-aware of the near-zero cure rates and know that these facts mean that the banking industry has nowhere near sufficient capital to withstand these losses without folding like a paper cup getting stomped on by an elephant.

(Remember that these numbers do not include any commercial real estate losses and we have found that banks are frequently over-stating their claimed values for these loans by 50% or more - as was seen with Colonial.)

It gets better.  The FDIC has a negative balance both in its fund balance and the reserve ratio projected for the end of the quarter, which is, big surprise, tomorrow. Oh, and there is this pesky problem that the FDIC has - contrary to its mandate - been issuing bond guarantees for banks, so if and when that banking insolvency is recognized the FDIC will implode into a gravity well also, since it is on the hook for the entire deficiency of those bonds that were issued with its "guarantee" should they default.

Care to argue with the math folks?

You have to love the "moral outrage" expressed in articles like this:

The information that flowed from the banks, the ratings agencies, the regulatory agencies, and the mainstream media—the bedrock of the financial markets, in a sense—was viewed with great suspicion, and that created an opportunity for financial bloggers: a motley assortment of amateurs and professionals from all over the map. There are traders, economists, venture capitalists, financial advisers, and pajama-clad cranks all vying to explain the complex machinations that got us into this mess and to critique governmental solutions.

Complex machinations?  On the contrary.

The only thing that is complex is the web of lies put forward to cover up what is simple mathematical reality: You cannot expand credit at a rate faster than GDP forever without suffering a financial panic and collapse.

This isn't something from a "pajama-clad crank" - it is a mathematical fact.  The sort of fact that you were supposed to learn in sixth grade.

Really.

Sixth grade.

Yet our so-called "mainstream media", New York Magazine included, dropped math in the 5th grade and thus never participated in class.  The editor and financial page folks, along with those in ToutTV either never attended that class or are intentionally lying about what the math says must happen.

Take your pick: either we have "writers" and "reporters" in the mainstream media who lack a sixth-grade education or we have those who are willing to lie for money - on purpose - to the population.

Neither explanation is very complimentary.

Willful suspension of disbelief - and mathematical fact - is necessary for all financial frauds to be sustained for any length of time.  As soon as someone pulls back the curtain on that fraud they must be immediately savaged and called names, lest someone remember their sixth grade math class.

In the 1990s I read through literal dozens of S-1s from nascent Internet Companies that later failed.  Rhythms, Northpoint, Covad, Pets.Com, Infospace, Digital Island, 724 Solutions and many more.  Jim Cramer wrote a famous piece on "Winners of The New World" which, if you followed him, cost you nearly all of your money in just a couple of years' time.

Why?

Because of willful suspension of mathematical review and fact.

A read through those S-1s disclosed that these firms had laid claim to literally more than one hundred times the world's GDP. 

At best 99 of 100 of those firms were destined to blow up.  It was a mathematical certainty. 

In reality 999 out of 1000 blew up, because the "old world" - the WalMarts of the world - didn't give up their share willingly, or at all.

After the tech market cracked I gave one of the few interviews that was published in a "durable" media you can still find in which I said:

"I refused to take any stake in the acquiring firm. The shell game being played by these corporations is astounding," he said.

Denninger has also steadfastly avoided investing any of his personal fortune in the Internet: "I refuse to have anything to do with the Nasdaq 100. There will be a shake-out, and when it comes, it will be ugly and it will happen fast."

He might as well have been speaking of Black Week, April 10 through April 14, when the Nasdaq crashed.

The volatility of Net stocks in the past few weeks makes Denninger seem prescient, but his dislike for the unseemly marriage of breathless hype and dubious business plans is visceral.

"Amazon.com has proven there is a race to zero in margins. It should be a US$2 stock," he said.

Amazon bottomed in the $5s - from a high of $113.

More importantly, what changed from 2000 to now in this regard?  Margin improvement?  Not really.  Competitors went bankrupt?  Yes.  GDP expanded?  Yes, or did it?  Did we really see expansion of output or did we lie about it by expanding leverage (credit), borrowing more and immediately consuming it, calling this "GDP"?

Technically that is GDP, but it's not sustainable.  You can only press such a bet as long as you have available margin to pick up more and more debt against something that people consider "collateral." 

But when you do so to consume the steak dinner you ate this evening has turned into fertilizer within 48 hours while the debt you took on remains and demands to be serviced.  You've not advanced actual output in the economy in terms of sustainable growth one iota - all you've done is pulled forward tomorrow's earned dinner into today.  When tomorrow comes you can't buy that same dinner again, unless you once again pull forward yet more demand.

The reality of compound growth eventually derails all such plans.  All we argue over in that regard is timing - something that the mavens of Wall Street never bother to talk about in public.

Even as the market has improved, the economy has shown glimmers of stability, and many of his fellow bears have capitulated, Ivandjiiski has clung ever more tightly to his convictions.

"The market"?  Oh, you mean fraud street?  Well sure, when The Fed buys up a trillion dollars of questionable assets, including those that have a near-certainty of monstrous losses, thereby overpaying for them and spitting out printed money, you can expect some of it will go into the stock market - and it did.

Speaking of the market, what part of a P/E of 129 sounds reasonable?  Yes, I know, that includes the nasty earnings quarters that will roll off next year.  But even disregarding those and looking at rosy estimates for the next year the market (given its low yield) is pricing in GDP growth of 5-7% for the next 4 sequential quarters.  No economist with any shred of credibility has such a rosy forecast for actual economic growth, and with good reason - there is absolutely nothing in the employment and industrial capacity numbers to suggest that such an outcome is remotely possible.

"The economy is showing glimmers of stability?"  Where?  Jobs?  No - employment is not only still falling but we need to add more than 250,000 jobs a month just to keep even with immigration and the birth rate.  Never mind that while the government said we lost 200,000-some jobs last month, the household survey - that is, the actual count of people who aren't working - disclosed nearly a million fewer people in the workforce than the month before.  The difference?  Government doesn't count you as "unemployed" if you give up looking, and further government is counting tens of thousands of "new small businesses starting" (in excess of those closing.)  Do you believe the latter, and why would you omit the former?  Let me guess - someone who gave up looking for work magically has gained the ability to spend money at the store and foreclosed homeowners will set up shop selling gas and sodas on the nearest corner?

I think not.

"Fellow bears capitulating?"  Yep.  Lots of people have capitulated.  They've bought into the Fraud Street and DC pontifications that "math doesn't matter", just like Dick Cheney's famous screed that "deficits don't matter."

In the short term, perhaps.  One can lie, cheat and steal for quite some time, and the famous saying "the market can remain illogical for longer than you can remain solvent" is absolutely true.  If you're a short-term trader there's money to be made there - I made a nice wad of it from close to the 666 lows up into the upper 800s on the S&P, simply because bets on the end of the world can only win once - and if you do win, you're not around to collect.  As such I'll take the other side of that bet - when Hell's Gate beckons.

But in the end the math always wins and fraud is always exposed. 

It may take years to happen, but it always does.

Daytraders and speculators can make a lot of money on speculative froth and lies, but investors - those who are in the market for decades as a method of building wealth for retirement - have a more-pressing problem - they have no control of or way of knowing in advance when the fraud-laced games will fail.  As many boomers have discovered in the last year these games have a habit of coming apart at the seams right about the time you think you'd like to retire, blowing your carefully-laid plans that have spanned decades into dust.

The impact on the real economy that inevitably must filter down from boomers losing half or more of their retirement along with their house cannot be overstated.  While their combined wealth remains formidable the fact that they've taken horrific losses in the last two years is a fact - and one that the mainstream media would prefer to ignore.

That willful ignorance becomes perversion, however, when that very same media prints derisive articles like this one, as it is likely to lure a not-insignificant number of those boomers, already kicked and bloodied, back into the ring of fraud at the top - just in time to lose yet more money - and perhaps enough this time to drive them to destitution.

For the long-term investor there is no argument to be made for returning to a froth-driven market until and unless the fraudulently-granted credit is flushed from the system and one can once again read a balance sheet with some reasonable expectation that it reflects reality.

Given the proclivities of the government and media that day appears to be merely a glimmer on the horizon - a glimmer that in fact may be nothing more than a mirage.

Proceed at your own risk.

Or must we go entirely off the cliff and play Wile-E-Coyote?

Yes, I know, we "came back from the brink."  Or did we?

Let's look at a few facts:

The Fed is literally the entire mortgage market.  Yes, really.  As Chris Martenson points out (correctly) we have issued roughly $685 billion in new mortgages through August, while The Fed has bought $722 billion of mortgage paper and GSE debt (I argue illegally, and have for months) with printed money.  That is, they are the market - not a part of the market.  But reality is much worse - there is no market when a central bank simply buys with printed money, intentionally overpaying.  After all it's not their money, right?  (On the contrary, it's yours they're spending - without your consent!  Must be nice eh?)

Fannie announced a change in lending policies today, effectively tightening mortgage credit.  The "new criteria" will get rid of the 50%+ DTIs they used to allow and demand a 620 FICO.  This is still massively below anything that can be considered "prudent"; the average FICO is reported to be 680.  But Fannie has found that FICOs under 620 are in fact defaulting at a rate nine times higher than those with a higher score (!)  Nine times is 800% - that's bad, right?  They didn't release the percentage of loans that they had bought with the lower scores - so we don't know how ugly their book is - but remember, The Fed effectively owns all of their current-year issuance.  This could end very badly for them - and us.

We claim that we're "helping homeowners" yet a recently-run study by Amherst (on Bloomberg this morning) shows that missing just one payment on your house places the probability of eventual default at 75%.  Miss two and the probability is 95%.  Any loan against which there is a "reasonable likelihood" of default must be reserved against according to GAAP (and just plain common sense) according to its probability of loss and recovery value.  Yet most banks don't even consider an account "late" until it reaches 120 days behind!  This is outrageously optimistic and is well beyond the threshold of intentional fraud if those numbers from Amherst prove up (and I suspect they do; consider that if you miss a payment you must make two at once to catch up!)   Banks are willfully hiding probable losses on these loans for the simple reason that were they to reserve against them they would be instantly recognized as bankrupt.  The fact of the matter is that they are bankrupt and our so-called 'regulators' are looking the other way rather than recognize massive control and accounting fraud.

The Fed has run monetary policy on a "Ponzi" basis for nearly three decades; in only one year out of 28 has their "monetary policy" resulted in improving rather than degrading credit stability¹.  This is a mathematical fact.  We have become inebriated with excessive credit consumption throughout society, including the private and government sectors.  This in turn has led government regulators to willfully and intentionally ignore the foundational principle of sound banking: one must never lend more unsecured than one has in excess capital and willfully stick their heads in the sand as credit growth has exceeded GDP expansion.  In addition the government has "cooked" both GDP and inflation indices ("CPI") as a means of further justifying bankrupt policies by distorting reported economic statistics.

We ask "where did the credit go" repeatedly as consumer leverage has risen but personal consumption has risen at a slower rate.  There is in fact no mystery: production was offshored to China, India and Vietnam (among others) and replaced with lower-wage "service" jobs.  We have used credit as a means of masking our falling real standard of living by engaging in serial Ponzi Finance - first with the Internet Bubble and now with the Housing Bubble.  But the Internet Bubble was small potatoes compared to the Housing Bubble, and we've run out of "bigger bubbles" we can blow to take the Housing Bubble's place.  As defaults mount the facts are exposed whether we want them to be or not: our earnings power has been severely damaged as a whole by the intentional off-shoring of high-quality jobs and the importation of lower-quality (and lower-wage) workers into the US and we have tried to make up for the deficiency through borrowing.  But borrowed money has to be paid back - and we can't make the payments.

Every nation that has ignored the foundational principles of sound banking and credit for a sufficient period of time has suffered either severe economic depression or monetary collapse.  There are no exceptions.  The United States and other western nations suffered ugly Depressions in the 1870s and 1930s.  Weimar Germany, Zimbabwe, Argentina and others suffered monetary collapses.  Going further back Tulip Mania and the Fall of Rome were both caused by monstrous mis-allocation of credit leading to hyperinflation in assets, the monetary supply, or both.  The cause of these collapses and depressions is mathematics, not political.  It can no more be avoided given improper banking and credit policy than can perpetual motion be achieved.

A "mere" 7% growth rate - what many economists would call "robust" economic expansion - causes the amount of whatever is being grown (or consumed) to double every 10 years.  Each doubling in fact consumes (or grows) more than all of the previous time ever in history put together!  Jimmy Carter lost his re-election bid in no small part because he had the audacity to make the (true) statement that this was impossible to continue into the indefinite future in regards to energy consumption.  It is equally impossible to continue this into the indefinite future when it comes to GDP or, for that matter, credit.

Two functions of growth, where one is greater than the other, will always eventually run away from one another and, where the larger is dependent on the smaller to be able to be sustained, collapse becomes inevitable².  This is an extension of the above point.  In economic terms if credit expansion exceeds real output expansion (since output is necessary to pay the servicing costs of credit of course) collapse of the system is inevitable, with the only variable being the amount of time that elapses before the collapse occurs.

Ok, so given all of these facts what can we do about it?

We can force improperly-granted credit - that is, credit granted to those who can't pay, to be recognized as bad debt and defaulted.  This will result in the bankruptcy of lenders who imprudently made loans, but it also will result in the clearance of that bad debt from the system.

We can force lending going forward to take place such that all unsecured lending must be made only against excess capital on a dollar-for-dollar basis.  This provides an immutable counter-cyclical check and balance on lending and leverage.  If a bank wishes to grant someone a 100% LTV mortgage, they can - but since real estate fees and closing costs average 8%, they must at closing have 8% of the value of the loan in segregated cash reserves!  If the loan is for 92% or less of the current value they need no immediate cash reserves.  There remains the risk of asset valuation declines, of course, which could force the immediate sale or capital raising requirement; as such most institutions would choose to build in some sort of "cushion" against that contingency by requiring a larger down payment.  Credit card loans would carry a high interest rate (as they do now) and be limited in line size since they would require 100% reserves (being entirely unsecured); auto loans would likewise have a sizable down payment requirement since new automobiles depreciate markedly upon delivery.

We can demand that system liquidity (and thus interest rates) be set no lower than that which holds the "Ponzi Finance Indicator"¹ to a slight positive bias with automatic (per statute) corrections made should the ratio fall negative.  This will cause rates to be sufficiently high so that "ponzi finance" (that is, debt taken to finance consumption) is never a large enough percentage of the whole as to imperil the stability of the monetary system.  We must also demand and insist upon accurate reporting of GDP and inflation statistics, of course; both of these computations need to have the built-in "adjustments" that currently distort their results removed.

We have but two choices: we can accept the mathematical reality of compound growth rates and our attempt to cheat math through fraud or we can plunge off the cliff of history, as every other government and economy that has willfully ignored these mathematical realities has done.

Credit demand has effectively collapsed in The United States³ as we have reached the limit of debt service given the degradation of earnings power in the American People along with grossly-imprudent credit expansion.  Further attempts to "stimulate the economy" via yet more credit creation cannot succeed, as we have reached the limit of the geometric progression of both credit and output in terms of sustainable debt service. 

Attempting to hide credit deterioration will only cause the inevitable contraction of both to be more violent and disorderly. 

It is mathematically impossible to prevent the outcome that now faces us; we are choosing only between the violence with which it comes and whether we have control over the process, or whether it will inevitably jump any "fire lines" we try to establish and potentially consume not only many private businesses and individuals but the government itself.

It is time to choose wisely; we face not a matter of politics or "pie in the sky" economics as practiced by ivory-tower academics, but rather the cold, hard mathematical realities that are inviolate and impersonal - the mathematical realities that control our destiny.

Charts used in this Ticker

1: The "Ponzi Finance Indicator" - when the indicator is negative then debt is compounding at a greater rate then GDP, and vice-versa.  Negative values denote decreasing monetary stability, positive values denote increasing monetary stability.

2: A simple chart showing how badly (and quickly) debt "runs away" from GDP.  Assumptions are that both debt and GDP begin with $1,000 outstanding at "year zero" and GDP increases at 5% a year, with the "spread" as indicated for each curve.

3: Credit outstanding in the US, by sector, cumulative.  Note that with the exception of Federal Government debt all other sectors are either flat or contracting.

Janet Tavakoli has launched another salvo related to the massive Fraud Street machine:

Wall Street gave mortgage lenders large credit lines (similar to credit card debt) and packaged the loans into private-label residential mortgage backed securities (RMBS).  Most of the RMBS was rated “AAA,” since subordinated investors absorbed the risk of a pre-agreed amount of loan losses.  But many RMBSs were backed by portfolios comprising risky fraud-riddled loans.  Most of the “AAA” investment was imperiled, and subordinated “investment grade” components were worthless.  Wall Street disguised these toxic “investments” with new value-destroying securitizations and derivatives.¹

As I have repeatedly pointed out it is not possible for the value in a transaction to ever be higher than at the point of origination of a loan.  It is mathematically impossible for it to be otherwise as the cash flow from the debtors is a fixed quantity; you can divide it up and siphon part of it off, but you can't manufacture that which does not exist.  Any claim that you can do so is fraud on its face.

Meanwhile, collapsing mortgage lenders paid high dividends to shareholders (old investors) and interest on credit lines to Wall Street (old investors) with money raised from new investors in doomed securities.  New money allowed Wall Street to temporarily hide losses and pay enormous bonuses.  This is a classic Ponzi scheme.

Securities laws chiefly apply to financiers (the underwriters and traders) that create, sell, and trade securities.  Underwriters are responsible for appropriate due diligence, an investigation into the risks.²   If you know or should know that investments are overrated and overpriced when they are sold, those facts must be specifically disclosed.  If you fail to disclose material information, expect to be investigated for fraud. If you have a mortgage subsidiary, expect it to be investigated, too.

One question: When?

An IMF official asserted: “You can’t prove fraud” and insisted it was in the interest of risk managers not to let their institutions collapse.  (He was unable to attend my exposition based on Chs. 5-12 of Dear Mr. Buffett).   This IMF officer isn’t just soft on crime; he’s in denial.  Failure to recognize fraud led to statements like the one that opened Chapter 2 of the IMF’s April 2006 Global Financial Stability Report:

Actually, proving fraud is simple: All you need to do is prove that a financial institution marketed securities from some batch of debt that had as its total claimed return a number greater than the original deals that went into the package. 

This requires nothing more than a calculator.  The claimed returns are known from the marketing and the coupon on each asset that went into the package is also known.  2 + 2 still equals 4 and if the institution claimed to have "manufactured" wealth it committed fraud.

Likewise, the risk-adjusted return of each loan in the package is known (interest .vs. growth at the time of origination.)  If, at the time of origination, the risk-adjusted return of the "securities" was greater or equal (remember, nobody works for free!) than the components, once again, fraud was committed.

Yes, there were thousands (or tens of thousands) of loans in a package.  So what?  We have a thing called a "computer" nowdays that makes summing and dividing large quantities of numbers a trivial, sub-second enterprise. 

To demonstrate that fraud was the essence of these securities we need only show that a financial institution represented that it had invented perpetual motion in the financial sense.  As that is mathematically impossible any such claim is ipso facto fraudulent.

Troubled financial entities should be put into receivership and restructured.  Old shareholders will be wiped out.  Debt-holders will take a haircut (discount) along with a debt for new equity swap to recapitalize the entity.  But the job won’t be complete until we separate high risk activities from traditional banking in a return to a Glass-Steagall like structure with regulators that indict fraudsters, snuff out systemic fraud, and allow honest bankers to prosper. 

The laws already exist; it is illegal to promote perpetual-motion machines and take money from people for their promised delivery, irrespective of where and how you claim to have "invented them", because such a machine, whether in the form of a physical engine or a financial product, cannot possibly exist.

Janet does a great job in this piece of exposing the web of interconnections between parties, including the fact that Tim Geithner headed the NY Fed when the "big burst" of this fraudulent activity took place and that as the NY Fed's head at the time he was directly and personally responsible for the willful regulatory blindness to what was an obvious and "in your face" scam.

As Janet says, we have the tools to take care of these problems - we simply need to will to use them.