Opinions on this?
So this weekend everyone who is a “who’s who” huddled in New York at The Fed to figure out what to do with Lehman Brothers.
The market sat on pins and needles, and in fact ramped by nearly 10 full handles (close to 1%) in the last 10 minutes before the futures locked up for the weekend, in the vain belief that there will be some “resolution.”
I’m here to tell you that there is no resolution, no fix, and we now face a stark choice between most of American Finance being sucked into the vortex, and everything, including you, being sucked into the vortex.
Yes, those are some stark - and harsh - words.
They’re also true.
Let’s begin with what we were told wouldn’t happen after Bear Stearns. We were told that Bear was an “extraordinarily” event, and that it was a “liquidity run” that doomed them; absent that, they were “fine.”
This was a lie.
In truth what doomed them is the same thing that dooms all of these other institutions - credit risk. The truth is that all of these firms have written paper imprudently across the spectrum - “subprime” loans, ALT-A loans, Commercial Real Estate loans and leveraged buyout loans, for starters.
Lehman, allegedly, has some $80 billion of this trash on its balance sheet. Who knows what its worth. A good part of it is probably worth 40 cents on the dollar - or less.
This charade has been promulgated and maintained by the ratings agencies, who were more than happy to assign “AAA” ratings to securities that had thin capital backing and assumptions about loss rates that required that the price of whatever asset was behind them would always and forever go higher.
This, of course, is an impossibility, but nobody in Congress bothered them with that minor little fact - even though Congress authorized them to play this game in the first place via their “NRSRO” designation.
The Truth is that Merrill, Morgan Stanley, and even Goldman are all in the same boat. The Fed and Treasury actions have given them roughly six months to “cut that crap out”, but they didn’t. They didn’t sell off their portfolios of junk, but what they did do was take the liquidity they were given and speculate in the commodity markets, earning a nice profit and allowing them to report better-then-disaster “earnings” while hiding the trash in “Level 3” buckets on their balance sheets.
The entire game was predicated on the idea that the market for housing and commercial real estate would turn within six months to a year from last summer.
We now know, of course, that this is total garbage; housing and commercial real estate are long-cycle businesses that average fifteen to eighteen years from cycle top to cycle top, and there is absolutely nothing you can do to change that.
As a consequence every one of these firms that has tried to “hide the sausage” is ultimately going to die. They have made the critical mistake of trying to play games instead of selling off their portfolio of trash last summer when it was still possible, and now are going to have to eat it - with disastrous results. It is highly probable that three years from now none of these firms will have survived in their present form.
Speaking of hiding the sausage, let’s talk about AIG and WaMu.
In AIG’s case they were writing credit default swaps like candy over the last few years. As I have repeatedly pointed out these instruments are nuclear devices and all of them tick at inception, but the timer’s window has duct tape over it. There has been zero margin supervision on these as they’re all “over the counter”; that is, no centralized reporting, no central clearing, no central control and no supervision - by anyone. Now AIG is in the uncharitable position of having nearly $500 billion of exposure to corporate loans and CDOs, with nearly all of it written to banks - the very institutions that are now in trouble!
WaMu, for its part, still has some $50-80 billion (getting an EXACT amount out of their 10Q is an exercise in high frustration) worth of ALT-A “liar loans” on its books, most of them the worst sort - “Pay Option” ARMs on which negative amortization builds into the loan balance. This caught my eye last April and as I’ve repeatedly noted should have caught the eye of regulators as well, with the OTS and FDIC stomping on their neck instantly when they reported 1Q 2007 “earnings” and were paying their dividend out of capitalized interest! But that didn’t happen and now we have a huge thrift trading at $2 and change. Why is the stock price $2? I’ll bet that if they were to mark all of their retained exposure to the current market price of those homes they’d be instantaneously insolvent.
Of course none of these banks or other institutions are taking their marks - including WaMu - but the market is quickly figuring out that home prices are not going to reverse and head higher - they are instead continuing lower, as they must, as until affordability returns there is no other possible path forward.
In markets like California where the median family income is $64,000 (as of 2006); this means the median home price must be about $192,000.
As of August it was $350,000, or still a bit over 40% overvalued!
Every bank with retained exposure to California of any material extent is in serious trouble and most of them with fail outright.
This is simple mathematics.
The regulators had to know this was going to happen years ago as the median price reached nearly nine times median income in 2005 and 2006.
They willfully looked the other way.
Then we have Fannie and Freddie, who were the architects of the housing credit bubble. A story you need to read detailing this - in the mainstream media (now, after the explosion of course) is found on MSNBC today:
"The Clinton administration wanted to expand the share of Americans who owned homes, which had stagnated below 65 percent throughout the 1980s. Encouraging the growth of the two companies was a key part of that plan.
“They have always done everything in their power to massage Congress,” Leach said.
And when they couldn’t massage, they intimidated. In 2003, Richard H. Baker (R-La.), chairman of the House Financial Services subcommittee with oversight over Fannie Mae and Freddie Mac, got information from OFHEO on the salaries paid to executives at both companies. Fannie Mae threatened to sue Baker if he released it, he recalled. Fearing the expense of a court battle, he kept the data secret for a year.
An employee at one of the companies said it was already a constant discussion around the office in 2004: When would the regulators notice?
“It didn’t take a lot of sophistication to notice what was happening to the quality of the loans. Anybody could have seen it,” the staffer said. “But nobody on the outside was even questioning us about it.”
President Bush had pledged to create an “ownership society,” and the companies were helping the administration achieve its goal of putting more than 10 million Americans into their first homes.
And there you have it. Fannie and Freddie effectively (if legally) bribed and blackmailed their way through Congress - just like the Investment Banks, just like Treasury, and just like The Fed.
Note carefully that both Clinton and Bush administrations are implicated in the above-cited article. Those who try to make this a partisan issue are simply wrong - this is a leach-fu** issue, in that America, as a whole has come to believe that the government can make everything ok and can provide for us.
Health care, retirement, housing, automobiles, gasoline, heating oil, electricity, hurricane and other disaster relief, jobs and so on.
All the government’s responsibility.
On 9/11 Hank Paulson tried to calm down jittery GSE paper holders with this pithy little comment regarding the Fannie and Freddie Fiasco:
"The stock purchase agreement is designed to discourage Congress from trying to change the terms of the agreement, the Treasury said. If Congress did try to change the law, it would open itself up to legal challenge, the fact sheet said.
``As with any contract, the parties to the agreement may modify the covenants by mutual agreement only,’’ the Treasury said. "
Of course Hank.
What’s left unsaid is that (1) you can’t sue Congress successfully unless it allows itself to be sued (there’s this little thing called “sovereign immunity” that gets in the way) and (2) Congress appropriates the money in this nation under the Constitution and could - and should - refuse to fund your mess.
Good luck with “performance” on that contract if you don’t have the cash!
Paulson, like the rest of these fools, thinks he can bludgeon people into holding this GSE paper. In truth anyone who is not unwinding it at this point and running away is a five-alarm idiot, as I’ve previously noted, because the entire Treasury department changes hands along with the rest of the Executive branch of government in four months time.
We keep hearing that “its all ok, and the government is here to help and solve the problems we face as a nation.”
The Truth: Its all a house of cards.
EVEN THE FDIC:
"We were wrong. As a former FDIC chairman, Bill Isaac, points out here, the FDIC Insurance Fund is an accounting fiction. It takes in premiums from banks, then turns those premiums over to the Treasury, which adds the money to the government’s general coffers for “spending . . . on missiles, school lunches, water projects, and the like.”
The insurance premiums aren’t really premiums at all, therefore. They’re a tax by another name."
Betcha you didn’t know that.
That’s right folks - there is no FDIC insurance fund.
Just like there is no Social Security insurance fund, or Medicare insurance fund.
They are all accounting FICTIONS that our Congress has created and allowed because we keep demanding that they spend more than they have.
To keep us, and foreign bond investors (who must pony up $2 billion per day to keep this charade alive) from freaking out and saying “no mas!” they rob and steal every nickel from every nook and cranny they can so their “budget deficit” looks much smaller than it actually is.
Clinton never ran a budget surplus if you simply add back in the FICA receipts he stole to “balance his budget.” Bush of course never even claimed to run a surplus. Every administration since the 1970s has played this game to one degree or another, and we, Idiot Nation, sit back and let it happen.
Now the check is on the table and the waiter is tapping his foot.
So America, what are you going to choose to do about this? Sit on your hands? Tap your foot? Drink another beer? Turn on the NFL?
Its your money they’re spending in DC, you know. You’ve been lied to repeatedly by the clowns inhabiting Washington. Democrat, Republican, elected, appointed, its all a piece of the same mess.
Here, once again, is The Truth for those of you who wish to hear it:
Homes cannot sell, on average, for more than three times average incomes. Period. Short-term distortions can and do occur, but over longer periods of time (decades) house prices cannot advance faster than wages.
We will not see the bottom of the mess in housing or the economy generally until houses sell for that three times income. Those who say we will are simply wrong. Attempts to delay or reverse this adjustment will make the total economic impact far worse and in fact can easily lead us to an economic depression.
Those firms who made bad investments must be forced to eat them. If this results in their insolvency then it does. We cannot clear our credit and economic systems until we know who is bankrupt and who is not.
We as individuals and our nation as a whole must stop spending more than we make. This is not negotiable. We as a nation are beholden to foreign interests at present to the tune of $2 billion per day in external funding requirements. If that funding is interrupted for any reason - such as a loss of confidence - we are instantaneously plunged into DEPRESSION.
The market is vastly overvalued with essentially the entirety of its “future earnings appreciation” predicated on a resumption of the “FIRE” (Finance, insurance and real estate) economic boom. The only “boom” that is occurring and will occur is a series of explosions. The S&P 500, without that “acceleration”, has a fair value somewhere around eight hundred. Yeah - 1/3rd lower from here and fully half off its all-time high.
Let’s look at the reality of the housing market, starting from the same place - a wage-earner with a $60,000 household income who bought a $400,000 house in 2005. The price was the “median” in your area and so is your income.
Let’s look at the two scenarios:
We “let you” refinance into a 30/fixed. However, you still own a house that was sold at double the sustainable price. Your “new P&I payment” would be $2,386 (6%, 30 year fixed). But you only make $5,000/month (gross), which means your total debt load on the P&I alone is 47%. Deduct your tax liability on that $60,000 (figure a 20% all-in marginal rate) and suddenly you have only about $3,700 a month net-net take-home. You are spending sixty four percent of your net income on interest and principal! Yes, you get a tax write-off on the interest; balance that against insurance costs and they probably net out. To put this in perspective you have $1,300 left for everything else in your budget - food, gas, electricity, car payments, etc. You will eventually go broke with this “refinance”.
You foreclose. Your home drops in price (after another year or two) to $200,000. You can now buy the house for $1,193 P&I! You still have the same $3,700 in take-home pay, but now your P&I is 32% of your take-home, and you have $2,500 left after making your mortgage payment. That is more $1,200 additional every month, and leaves you able to afford food, energy, gas, and your car payment.
Solution #2 forces you through a “Credit Event” and trashes your FICO but leads to sustainable housing and prevents you from going completely underwater.
This same scenario applies to every other area of finance.
Those commercial construction loans that were made at unsustainable cap rates must be allowed to fail and those properties be sold at “fire sale” prices. This will lead to sustainable commercial real estate.
The “LBO” loans made on ridiculous terms must be allowed to blow up and those firms go through bankruptcy. This will lead to sustainable business models and risk-based pricing going forward.
Yes, there is considerable pain associated with being one of the people who is on the “wrong side” of any of these blowups. If you are a bank or other institution that wrote swaps against these deals, or is holding this paper, you are going to take a terrific beating - perhaps enough to kill you in the process.
But this, folks, is good, not bad.
It is only through the imposition of market discipline, which is really just a fancy way of saying “when you do something stupid you go bankrupt”, that we prevent future stupidity.