Chucky Cuts Off Own Head? Mortgages And More On Tuesday [Updated 9:18 CT]

Interesting day!

Best Buy reported this morning and their results, to be blunt, sucked.

The hidden part of this announcement (from a standpoint of press coverage) was same-store sales. Up 3%, which sounds good, but in fact its terrible. Why? Because Circuit City is bleeding market share like an open femoral artery, and Best Buy is the beneficiary of that deterioration. Yet they're not benefiting much!

If you can only pick up 3% in gross sales when your next-best competitor is doing the "gusher of blood" routine, something is wrong. When your biggest sales gains are in low-margin products, even more is wrong.

Yesterday afternoon I took a trade on the July $47.50 PUTs for $1.25 and sold them this morning for $2.20. There was probably more there - it looks like I should have held them a bit longer this morning, but that's ok - it was a nice trade and a nice profit, with less than a 24 hour holding time. What's not to like about that? Not worth talking about that one, given that I didn't put it on until the close (thus nobody could have followed me anyway) up front...... Its Circuit City's turn to screw with the market tomorrow.

In other "ignored news", the Redbook Retail Sales index came in -0.8%, below forecast (it was forecast to rebound from last months -1.0%). The ICSC Store Sales index came in -1.0% as well, below the previous 1.0% increase.

Gee, do you think Chuckie is having a problem yet? How come we keep hearing from economists saying "the consumer is strong" when we have a 1% drop in retail sales - not from one survey, but from two!

And this, by the way, is the from the same prognosticators who said consumer spending would rebound in the retail sales for the month of May. Remember? April was an aberration due to bad weather and the Easter shift?

I'm back in as of yesterday morning with my Q PUT play.

Permits and housing starts came in like dogcrap, as expected. My shorts on the builders continue to look good, and I continue to ride that wave downward. In potentially very ominous news the western region of the nation showed the biggest decline in permits and starts; the western region has held up the best so far in the housing downturn. If we are now seeing this roll through to the west, we may be now seeing "reality" intrude into the "teflon" part of the nation, which bodes ill for future trends in this sector for the next six to twelve months.

On the goofy news page WaMu is losing some of its gains from yesterday on the clearly bogus buyout rumors. This sort of thing is getting to be so commonplace that I have to wonder if the companies are actually starting or participating in these rumors on their own! That, of course, could be highly illegal - but the pattern here, now going on for months, has to lead one to wonder.......

Potentially big, the 10 has broken the trading channel to the downside on yield. But it has also decoupled from equities - this sort of move a few days ago would have resulted in a monster rally in equities - its not happening now, with all the indices ignoring it today. As a consequence we have to take the 10 off the list of "market movers" for the time being. The next few days are "do or die" in terms of the 10s direction.

Oil is down slightly to $68.62 - just under $69. I still think we're looking for that 7-handle and its going to be showing up very soon - like this week or next. Its hard to make a bullish case if you can't keep inflation under control in things that people really need to buy, and that would include food and energy. So far, no dice on that. We need a low 6 price on oil or even a 5-handle to get there, and that's not in the cards. Neither is gasoline likely to get materially cheaper. Add to that food inflation and you've got real trouble, as these act just like a huge tax increase on Chucky, and Chucky ends up with less money to spend on things he wants to buy. Ergo, "Best Buy" - and if you think that story has had the last chapter written, I suspect you're going to be sorely (and perhaps unprofitably) surprised. Update: Late in the day the oil rally resumed, with it now trading over $69. That 7-handle looks inevitable and a few traders are now chattering about an eight handle. Can you say $4/gasoline? Hope so. Wanna bet on Chucky spending like a drunken sailor with gas over $3.50 before the end of the summer, and perhaps as high as $4 - and that's without a hurricane in the Gulf?

The mainstream media is starting to really pound the table on the subprime story, almost ignoring the real backstory on this - its not subprime, it is the irresponsible lending across the plethora of homeowners, which drove the ability of the asset bubble to expand to 5x annual income.

"This isn't about the economy; it was a preventable problem, and that's what makes me so angry," says Prentiss Cox, associate law professor at the University of Minnesota. Noting foreclosures have risen even as the state's unemployment has fallen, he blames the problem on bad loans and bad regulation."

Well, yes. But this isn't a subprime problem, nor one about minorities and other "disadvantaged" people. In short, the real story is one of greed, avarice, and conspiracy, and it started with the Federal Reserve's attempt to prevent a recession following the 9/11 terrorist attacks.

And since the Fed is, legally, a private corporation, there really does need to be a discussion about regulatory failures. Of course we know that discussion won't happen at the level it needs to, because if that box were to be opened you'd never get the snakes back inside and they'd bite an awful lot of people.

So instead we get the usual media play - "oh look at those poor minorities, those poor disadvantaged people who were preyed on by these eeeeeevvvvviiiilllllleeee capitalists."

Uh huh. Cut the crap USA Today. God, what a leftist pile of trash. And by the way, historically, yes it is about the economy, because housing busts lead economic weakness - not the other way around. Do you guys actually read history in your economics classes? Or did you get your "experience" in the field from a Crackerjack box?

Note that none of this whining is going to stop reality from intruding - eventually. Its ssstttaaarrrrttttiiiinnnnggg......

"NEW YORK, June 19 (Reuters) - Bids for the main index of subprime mortgage bonds dropped to a record low on Tuesday as concerns of losses at a hedge fund and weak housing suggest a deeper downturn for the debt."

The root cause of this mess was cutting the cost of borrowing to a net negative interest rate (this occurs any time the cost of money is less than the growth in GDP and/or inflation); in a circumstance where the cost of borrowing is less than inflation you can simply borrow money, put it into anything that expands in price at the inflation rate (better is even nicer), then pay it back and pocket the difference. This is not difficult to figure out and is the genesis of the "carry trade", yet it will always produce asset bubbles, as people who have more than a couple of firing neurons will figure it out and pile in!

But when a bubble pops, you get damage. Lots of it. And when leverage is involved the damage can vastly exceed the gain - you now have a situation where negative real impacts above and beyond the gains that were made can and will occur. When that leverage reaches astronomic levels, as occurred here with common ratios being 10:1, you have the stage set for catastrophic ripple effects that travel through the credit markets and reach "across the aisle" to equities as leverage unwinds and liquidity disappears.

So let's talk about what really happened here. The Fed, by making the cost of capital negative, caused a huge pile of money to flow into the economy in an attempt to prevent a significant recession. This capital flowed mostly into real estate, because we had just had a stock market "crash" in the tech area, and people were spooked by that. This drove affordability to all-time lows and inflated the price of houses.

Unfortunately, inflating the price of houses is a severely bad thing, because in the end people really do need houses and they have to be able to pay for them too! So when this "corrects", as it is now, you get severe market dislocations. Those who believe this will not "ripple through" to the greater economy are delusional - it not only will, it must, because housing-related activity is a huge part of our GDP.

Now add to this old-fashioned corporate greed and you have the genesis of real trouble. See, lenders make money off interest rate spreads, but they really make money when you walk in the door, by ladling up the pot with fees and costs, all of which you pay - either through higher interest rates, points, or just plain old fashioned cash. So it is severely to the interest of a lender to write you a mortgage that will force you to come back in a year or two to refinance.

Ergo, the famous subprime "2/28" loan and, for people with better credit scores, the "Interest Only ARM" or, for those who really want to juggle bottles of nitroglycerine, Neg-AM "Option ARM" loans.

But what the lenders also know is that most people who have crap credit have it for a reason, and those who buy beyond safe lending levels will still be beyond safe lending levels a few years hence. Divorce. A medical catastrophe. An orgy of borrowing without concern for ability to repay. An economic collapse in the industry where you worked (e.g. automakers). A housing market that continues to accelerate, making your personal affordability index even worse when you come back and refi again than they were when you originated the first mortgage.

These causes of damage do not go away in two years, nor do the bad entries in your credit report. In fact, those entries don't roll off for five to seven years, and until they do go away, your score will not rise enough to be considered a "great" credit risk. What's worse, the structured problem with affordability will not go away at all until and unless the market suffers a major price decline, wiping out all of your equity and perhaps more than you have built up!

So by writing you a loan that will reset in 2 years to a rate they know you cannot afford they force you to come back into the office and eat another helping of fees, while at the same time destroying the equity you built and the amortization time you consumed. In short, they turn you from being a "homeowner" into a "renter-in-fact", with the bank being the landlord.

Nice, eh?

What the lenders didn't count on was that the market for houses would turn - that equity wouldn't continue to build at a 10%+ rate. See, they were extracting 10% of the house's value in junk fees and "costs", pocketing the whole 9 yards, and they were not just doing it to subprime borrowers, they were also hosing all those with GOOD credit in exactly the same fashion.

This means that you need two years to "break even", roughly, on the refinance. Never mind that you never broke even at all - you took your built equity and gave it to the freaking bank!

But now you can't refinance and are stuck with a note you can't make the payments on! The inevitability of this happening - eventually - was known to the lenders and Realtors, who are, after all, the professionals.

I have zero sympathy for the lenders, CDO buyers and swap writers who are going to get their butts handed to them in this debacle. They profited by intentionally deceiving consumers up and down the line and they deserve what's coming to them.

This is not over by any stretch of the imagination as the market must correct to a median price to median income ratio of 2.5 - 3:1 before the housing market will recover.

We've "gotten away with it" in corporate earnings thus far mostly because this same bubble severely damaged the dollar as an exchange currency, making exports cheaper for other nations to buy from us. This means that if you're a Caterpillar, your earnings go up. Earnings up, stock prices rise. Nice, right?

But that doesn't help those of us who actually live in the United States and have to earn our living here. We see real inflation because the things we buy that are imported, either as raw materials or as finished goods, go up in price - precipitously so. Our trade deficit blooms, which means our reliance on foreign governments to finance our lifestyle increases as well. None of this is sustainable without a severe economic correction to the means, and we continue to whistle past the graveyard in the equity markets, believing that it will be all ok.

Well, it won't be guys. Home prices are going to decline. Not a bit - significantly. We have never managed to get through a major housing downturn without a recessionary reaction in the broader economy.

NEVER.

Further, as real interest rates rise, as they must globally and they are, the dollar advantage seen in the last six months will disappear as the dollar recovers. Thus, now you will see FX disadvantages in companies with foreign operations. Oops! Now couple that with slowdowns in domestic sales and.......

But, but, but... what if the 10 continues to slide and interest rates go back down, and so does the dollar? Then the "China Syndrome" happens - at some point foreign governments, faced with extreme capital losses since their US bonds are priced in dollars, are forced to unload or at least stop buying as our debt turns over.

When that happens then real interest rates skyrocket as bond sales to those foreigners disappear and so does our economy.

The "talking heads" were on again today - with a clown from JP Morgan saying "its different this time." Oh really? No big hit to construction jobs eh? You're not counting all those illegal aliens are you? Let me guess - in addition to not paying taxes, they also don't spend money at the store and gas station? Oh wait - they do? Hmmmm....

Reality is that this piper needs to be paid. And as with all things, he will get his due. It is simply a matter of when, not if, the chickens will come home to roost and start crapping all over the party.

The latest on the Bear/Merrill/Blackstone hedgie Nitro Pile is that the creditors aren't all that impressed with the purported "stabilization" plan. The word "bullshit!" has been rumored to have been said more than once....... will it blow up in their faces? It just might. There are all sorts of people who don't want to see a detonation happen (like, for instance, all those bagholders with OTHER bets in that space who would be crushed by a big downdraft and forced repricing of those bonds) but it appears that The Prisoner Dilemma is beginning to play out here, with the natives getting very, very restless. The first one who breaks ranks will start the stampede.......

The key question: Are we trying to herd horses here..... or cats?

And oh, by the way, on a technical level the S&P keeps bouncing off that 1535-1540 level. One of two things is coming - a breakout north or exhaustion.

Heh Chuckie, did we just see you do one of these, given the Redbook and ICSC stats released - ignored by the "talking heads" - this morning?



How's that end, exactly, and what does it mean for the economy - and equities?

Late update: It appears that Merrill has had enough of the BS from BS. They are now going to sell not $400m worth of subslime bonds but at least $800m. They apparently have started distributing a list of the securities to potential bidders.

A great second-order question to this - if this fund was levered at 10:1 (although it looks like it might be closer to 15 or even 20:1!) and loses 25%, exactly how does that happen without generating a margin call? You see, if I have $600m and borrow to a total of $6b, once the first $600m is lost, or 10%, I am now into borrowed money! In the world of people who are watching the store, I get a margin call at that point, because I am now out of "my" money and am losing the banker's cash! Apparently, this did not happen here, and the obvious questions become "Why the hell not?" and "If Merrill and others are watching the store with only one eye, how many more billions have walked out the door in losses that they don't know about (yet)?"

Why do I have a suspicion that this is nowhere near "contained" and we're going to be hearing a lot more about it in the coming days?

The WSJ has updated this story with the following:

"Two big hedge funds at Bear Stearns Cos. moved toward the brink of closing down last night as a bailout plan developed over several days fell apart in a drama that could have wide-ranging consequences for Wall Street and investors."

Looks pretty ugly in the late update......

BTW, here's the cute part of the story:

"It would have reduced each creditor's risk profile by 15%, the fund's managers argued, but it carried with it a stiff requirement in return: that no lender initiate a margin call, or request for additional cash or collateral, for a 12-month period. Some creditors found those ground rules unacceptable, prompting them to seek a quicker exit."

Now that's balls. Here's the gist of it:

• First, we lose our $600 million dollars.
• Then, we lose a couple billion of your money. You should have issued a margin call when our $600m was gone, but you screwed up (gee, was anyone watching the store over at Merrill and friends? You have to wonder - if their surveillance and credit management is this loose, what else are they ignoring?)
• You finally wake up and issue a margin call.
• Finally, as if losing all your money isn't enough, we cajole our parent company to put up $1.5b more, but we have the balls to demand that if we lose that money, plus even more of yours, that you not issue any more margin calls for a year!

It takes church-bell size balls to put something like that on the table, and begs the obvious question - exactly what sort of shizstorm do these fund managers think will be unleashed by an auction of this toxic waste in the form of mark-to-markets in other hedge funds and/or the primary broker's own portfolios, and how much of this crap does Bear Stearns hold themselves, since they were apparently willing to risk $1.5b of THEIR money to prevent the asset auction!

There's only one reason to issue a "request" like that - you believe you have a gun to the head of your creditors in that if they say no an auction of the assets will hurt them badly enough that they're willing to risk losing several billion dollars more in order to keep it from happening!

I suspect we're about to find out, since it appears that Merrill told them to go pound sand and may auction the assets tomorrow afternoon.

Beware when you see the tide unexpectedly go out, leaving fish flapping on the mud. While that might look like a great opportunity to grab some "free fish", it may also be shortly followed by, well..... just ask the people in Phucket.......