Week of July 21, 2008

Sunday, July 27, 2008, 2:30 PM

July 22

Two Fed myths that need debunking (July 22 – Fortune NEW YORK)

There are two things you may have heard about the Federal Reserve Board, both of which are wrong.

an idea out there that the Fed may run out of money or government
securities as a result of the huge, high-dollar programs that it and
the Treasury have launched, or could end up having to launch, to keep
financial markets afloat.

But that worry overlooks the Fed's
amazing power to create as much money as it needs - out of nothing, as
it were. Here's how it works. If an institution borrows, say, $50
billion from the Fed, the Fed can just post a $50 billion credit to the
bank's account at the Fed, and the borrower can spend that balance on
whatever it wants. It is indeed as if the Fed created cash out of

This is an
interesting article, seeing as how it is in Fortune magazine. It caught
my eye, not because I learned something new about the Fed, but rather
because of the inability of the author to cleanly state the situation.
Note the phrasing of that last line “It is indeed as if the Fed created cash out of nothing.”

No, it is precisely, exactly the same as creating cash out of nothing. No “as if” about it.

But I understand
that the very concept that $50 billion can be created out of nothing by
the Fed and handed over to a client bank is a difficult concept to
accept. For most people, money is a very tangible thing. Poor people
starve to death for lack of it, and critical needs of society go unmet
for want of sufficient money, so the idea that one organization can, at
its whim, create as much or as little of this magical substance as it
wants grates against our daily experience. Which means that writing
about it cleanly is probably tricky as well.

So kudos to
Fortune and Alan Sloan for even raising the topic, because this is the
first I can recall ever seeing it mentioned in a major news outlet.

Freddie chief's jackpot (July 18 - Fortune NEW YORK)

Freddie Mac chief Richard Syron wants to avoid a
government bailout for many reasons. A filing the struggling mortgage
giant made Friday lists over 10 million of them.

Syron made
$10.6 million last year, according to Freddie Mac's latest report with
the Securities and Exchange Commission. Syron made by far the biggest
sum at the Reston, Va., company, pulling down a $1.2 million salary and
a $3.45 million cash bonus, in addition to millions more in stock
awards and other compensation for a total of $10.6 million. Using a
pay-disclosure measure that the SEC prefers, which treats the value of
stock and options differently, Syron's pay for 2007 was $18.3 million,
up 24% from a year ago.

I thought “bonus” meant a payment for a “job well done”?

I could be
wrong, but if the CEO of Freddie Mac was paid more than $9 million as a
reward for the performance of Freddie last year, then that was not a
“bonus.” That had to be "regular pay," because there was certainly
nothing there to be rewarded. Alas, this is what passes as ‘normal’ in
modern American corporate culture.

At any rate,
even as we are finding out that the early price tag for cleaning up
after Syron and his buddies over at Fannie is going to be in the
vicinity of $25 billion (for starters), he gets to keep all that
“bonus” money AND his job. Both prospects gall me.

Fannie, Freddie Rescue May Cost $25 Billion, CBO Says (July 22 – Bloomberg)

Fannie Mae and Freddie Mac would cost U.S.
taxpayers an estimated $25 billion over two years under a Bush
administration plan to rescue the mortgage-finance companies, the
Congressional Budget Office said.

CBO numbers assume Fannie
Mae and Freddie Mac won't exceed the $85 billion in fair value losses
on their balance sheets, agency officials told reporters in Washington
today. The CBO said today it's taking into account an almost 5 percent
chance credit losses may reach $100 billion.

I am going
to go out on a very fat limb here and state that the CBO estimate is
too low by a factor of at least 10. But $25 billion? This is an
improbably low number, given the size of the mortgage pools being held
and/or guaranteed (as bonds) by FRE and FNM.

Unbeknownst to
most, FRE and FNM hold pretty sizable pools of highly toxic mortgages
of the type that are already going sour at alarming rates at other
mortgage companies. I figure since FNM and FRE are staffed by humans,
they, too, will experience mortgage losses similar to those seen
elsewhere within that industry. I will be very surprised if the
ultimate tab is not in the vicinity of $750 billion to $1 trillion.

As always, these
bailouts start out with some number that seems reasonable, so that the
legislation can get passed, but then, as sure as night follows day, the
losses and payments will inexorably mount. Part of my confidence in
this prediction stems from the fact that I can’t recall any bailouts
that came in under projections, ever, and it also stems partly from the next news item:

California foreclosures up 261% from '07 levels

DataQuick reports today that foreclosures in
California soared 33% from the first quarter to the second quarter of
2008, and are running 261% ahead of year-ago levels.

from DataQuick: "Lenders started foreclosure proceedings on a record
number of California homeowners last quarter, the result of declining
home values and the rampant spoilage of a batch of especially risky
home loans made in late 2005 and 2006."

A 261% increase…is that a lot?

California, and
I mean most of it, not just a few select zip codes, participated fully
in the real estate bubble and is experiencing record-breaking levels of
foreclosure activity. As a consequence, house prices are falling with quite a few LA zip codes
showing house price declines in excess of -50% from peak. This means
massive losses for mortgage companies, and it means further price
declines are in store.

We will not see meaningful recoveries in house prices until (and unless) we see a rise in median incomes. Recent data shows
that median incomes have barely kept pace with inflation over the past
8 years, and recessions are notoriously difficult environments for pay
gains, so we might expect little, if any, relief from income gains over
the next few years.

July 25

U.S. foreclosures more than double in second quarter (July 25 - MarketWatch)

LONDON (MarketWatch) -- U.S. foreclosures in the
second quarter more than doubled from the year-earlier quarter and rose
nearly 14% from the previous quarter, RealtyTrac said Friday. "Although
much of the fallout from foreclosures is being driven by rampant
activity in a few states, such as Nevada, California, Florida, Ohio,
Arizona and Michigan, most areas of the country are seeing at least
some increase in foreclosure activity," said James J. Saccacio, chief
executive officer of RealtyTrac. Bank repossessions accounted for 30%
of the activity, up from 24% in the first quarter, which RealtyTrac
showed was a sign of progression toward purging the problem loans out
of the system.

I know that many
people are desperately searching for a sign of a bottom in housing, but
as discussed here (endlessly), no bottom can be had until house prices
once again match incomes (at a minimum) or even become relatively cheap
compared to incomes (which is more likely, given the propensity of
markets to overshoot).

Sorry to say, the data does not yet support any calls that the bottom is in.

NAB will shock Wall Street (July 25 - Business Spectator)

The National Australia Bank's decision to write
off 90 per cent of its US conduit loans will have dramatic
repercussions around the world. Wall Street will be deeply shocked when
they understand the repercussions of what NAB has done. It is clear
global banks have nowhere near provided for their exposures to US
housing loans which in the words of John Stewart are experiencing a

We are now way beyond sub-prime. NAB says that it
is suffering a 55 per cent loss on American housing loans an event that
has never happened in the history of a developed country in recent
memory. This is an unprecedented event and means that the cost of
bailing out the US financial system is now far beyond the highest
estimates. A US recession is now locked in, but more alarmingly, 55 per
cent loan losses point to the possibility of a depression.

This is the most
important article of the day. A bank in Australia (NAB) has taken the
bold step of writing down some of their US-based mortgage holdings by
the alarming amount of 55%. This is well beyond anything that US banks
have yet done, and you can be sure that NAB did not do this lightly. My
read is that the NAB write-down is much closer to reality and it speaks
to a massive, massive problem lurking in the US that has not yet been
publicly recognized by any of our fiscal, corporate, or monetary

Assuming that the 55% figure is correct, it implies that there are somewhere around 2x to 3x more losses, above and beyond what have already been admitted, lurking out there right now in our financial system.
It's hard to overstate the importance of understanding the implications
of this information if it turns out to be true. In short, it would mean
that the US banking system, in its entirety, is bankrupt. Not each
individual bank, mind you, but in aggregate these potential losses
would exceed all the capital that currently exists in the system.

Please read this article.

Russia, China to hold energy talks amid oil demand (Business Week)

A top Russian official will visit China this
weekend for high-level talks on energy policy, coming amid surging
Chinese demand for oil.

China's oil demand, of course,
continues to grow. As will energy use all across the planet. Why?
Because the number of people on the surface of the planet is increasing
exponentially, and humans require energy to live. Therefore, energy
demand will continue to grow. With every release we find out that China
has yet again exceeded its past energy consumption and import records.
There is no sign (yet) that the current US slowdown is having any
effect on Chinese oil consumption.

Investors buy gold bars in record numbers (July 25 - Telegraph)

Volatile stock markets and a lack of confidence
in the UK banking system has boosted demand for gold bars and coins
from private investors to levels not seen for 25 years. Tens of
thousands of investors have rushed to buy gold from bullion dealers
over the past year, during which the gold price has broken through the
$1,000 barrier on occasions.

Tony Baird of Baird & Co,
one the UK's biggest gold bullion dealers, said business was getting
busier and busier – with punters investing £1,500 to £150,000 in gold
bars and coins. Baird, who has been in the gold business for 40 years,
claimed that demand was on a par with the late 1970s.

added: "We have had queues in here. People are nervous of the stock
markets and they are nervous of the banks. Northern Rock was a trigger
and now Fannie Mae and Freddie Mac have stirred things up again this

I am not
surprised by this news. There is every reason to hold gold right now.
First, there is the fact that inflation across the globe is running at
levels not seen in decades, and inflation is always a good reason to
hold gold. Second, we also have the threat, however remote, that the
entire paper-based banking system could shut down and reopen with most
people suffering massive losses (think Argentina in 2001).

Gold taken into
your physical possession has this marvelous quality of not
simultaneously being somebody else's obligation. It simply sits there,
inert and shiny. That alone sets it apart from nearly every other asset
I can think of. Why is gold valuable? I don't actually know, but I'm
not one to argue with 6,000 years of recorded history.


Two More Banks Fail (July 26 - MartketWatch)

SAN FRANCISCO (MarketWatch) -- Two more banks
were shut down by federal regulators late Friday, who sold the banks'
deposits to Mutual of Omaha Bank. It brings to seven the number of bank
failures so far this year.

The FDIC said the failures would
likely cost the FDIC's deposit insurance fund roughly $862 million. The
failed banks had combined assets of $3.6 billion, .03% of the $13.4
trillion in assets held by the 8,494 institutions insured by the FDIC.

Mutual of Omaha Bank has more than $750 million in assets and operates
14 retail branches in Nebraska and Colorado with commercial lending
offices in Dallas and Des Moines, Iowa. It is a subsidiary of insurance
and financial services company Mutual of Omaha.

Well, that's a couple
more banks gone down. Two comments here. The first is that the banks
that failed had combined assets of $3.6 billion, representing "0.03% of the ... assets ... insured by the FDIC,"
yet this will cost the FDIC $862 million, which represents 1.8% of the
remaining pool of insurance funds. 1.8 is sixty times larger than 0.03.
It doesn't take a lot of higher math skills to see that the FDIC
insurance pool is kinda small compared to what it's supposed to be

My second
comment is that I found it surprising that Mutual of Omaha, with only
$750 million in assets, was deemed a suitable buyer for the $3,600
million in assets of the First National Bank Holding Co. This seems
like the minnow eating the shark. Even more mysteriously, Mutual of
Omaha was reported to have paid a 4.1% premium for the deposits of
FNBH, which represents $131 million . That seems like a tall order for
a relatively small retail banking outfit. Oh well, I guess those Wild
Kingdom shows were more profitable than I thought.

'Stealth' Housing Bailout: It's Bigger Than You Think (July 26 - CNBC)

With Congress on the eve of passing a historic
bill that would give the Treasury a blank check to lend money to Fannie
Mae and Freddie Mac, it’s worth looking at how much money the
government has already pumped into the system during the housing crisis.

The numbers are staggering and likely to get much larger. What we have
here is, through a variety of programs, a stealth bailout where more
than a trillion dollars of taxpayer guarantees have been extended to
the housing market, both to keep it going and to clean up the mess from
the past.

I looked at the changes over the past year to the
balance sheets of four governmental and quasi-governmental agencies—the
Federal Reserve, the Federal Home Loan Banks, the Federal Housing
Administration and Fannie Mae and Freddie Mac. The objective was to see
how much additional financing they have provided to the housing market.
The total: $1.43 trillion.

I added up these same
numbers a couple of months back and came up with a figure of $1.1
trillion and I am not surprised to see that they've advanced by another
$300 billion so rapidly. The thing you need to ask yourself is, "If
things are continuing to spiral downwards at this pace, even with an
injection of $1.4 trillion, how bad are they, really?"

It needs mentioning
that this $1.4 trillion does not represent new money, but rather loans
of one sort or another made by a government institution to the mortgage
and banking industries. However, because they were government loans,
this places the taxpayer on the hook for any losses that might result.
In short, this is certainly the largest appropriation of public money
without a single congressional oversight hearing in all of history.

The magnitude of
this number also tells you that even as our public officials (e.g.,
Hank Paulson) express confidence publicly, in private they are
scrambling like mad. It's figures like this that tell me to maintain a
highly defensive investing stance as the risk of a systemic meltdown
remain exceptionally high.

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