Week of July 7, 2008

Sunday, July 13, 2008, 2:28 PM


July 8

Pending home sales index down 4.7% in May (July 7 – MarketWatch WASHINGTON)

In a sign that the U.S. housing market may weaken
further, an index of sales contracts on previously owned U.S. homes
fell 4.7% in May from the prior month, the National Association of
Realtors reported Tuesday.

The index, which is considered a leading indicator of existing home sales, was down 14% from the May 2007 level.

Nope, no recovery in housing yet. Last
month there was a slight uptick, and Lawrence Yun, the NAR chief
economist, hopefully said,  “Sharp price reductions are leading to a
quicker discovery of price equilibrium points. The West is already
seeing year-over-year gains in pending contracts.”
I guess our process of price discovery is not yet over….

Procter & Gamble to Increase Prices as Much as 16% (July 7 Bloomberg)

Procter & Gamble Co., the maker of Tide laundry
detergent and Head & Shoulders shampoo, will raise prices as much
as 16 percent because of higher costs for plastic, energy and paper.

are conditioned to expect that price increases are here to stay, and
they are going to see that across the board," said Peter Sorrentino,
who helps oversee assets of $16.7 billion at Huntington Asset Advisors. "They will try the store brands, but if the product performance isn't
there, they will switch back." His Cincinnati-based firm owns P&G

Inflation continues to rage across the
board. The fiction that is the so-called “core rate” of inflation is
now largely dismissed and discredited by most people. Most tellingly,
major companies have decided that consumers “are conditioned” to expect
higher prices and so we now have an inflation mentality settling into
the boardroom.

Remember, there are two components to
inflation, one being that actual amount of money floating around and
the second being the expectations of the populace. Looks like our
collective inflation expectations are rapidly becoming “unanchored."
Naturally, those of you who have been watching this game long
enough will know that this will translate into better buying
opportunities for gold and silver, as these inflation bellweathers
never do worse than when inflation makes a big headline like the one

Fannie and Freddie hit by fresh concerns (July 7 – Financial Times)

Shares in Fannie Mae and Freddie Mac plunged on
Monday as investors worried that the two giant government-sponsored
mortgage financiers would have to raise fresh capital.

and Freddie shares were down by as much as 18 per cent and 23 per cent,
respectively, at the peak of the sell-off after a Lehman Brothers
analyst said an accounting change could, in theory, force the two
biggest US mortgage financiers to raise an additional $75bn in capital.

That was followed by an announcement after the US markets
closed that IndyMac Bancorp, one of the largest US mortgage lenders,
was cutting over half of its jobs and stopping most new home loans
after regulators said it was no longer "well capitalised."

If Fannie Mae or Freddie Mac get into trouble, the entire financial system will get into trouble.
pretty sure this won’t happen because government regulators force a
system-destroying level of new capital infusions for the GSEs, but it
could happen due to good old-fashioned mortgage losses swamping these
two venerable institutions. It bears noting that both companies have
bought the lion’s share of all the new mortgage issuances this year.
Each year the rate of mortgage defaults exceeded the prior for the
years 2005, 2006, and 2007. How confident should we be that the 2008
vintage will be any better off, if not worse, than prior years?

Also, it bears repeating that FNM and
FRE are both heavily involved in extremely complicated derivative
trades - thousands and thousands of them, each. It’s entirely reasonable
to propose that a failure by FNM or FRE would cause massive shockwaves
throughout the entire financial system.

IndyMac Complains of Run on the Bank After Senator's Comments (July 8 - Bloomberg)

IndyMac Bancorp Inc., the California- based lender
that is firing half its employees, is facing "elevated levels of
deposit withdrawals" after U.S. Senator Charles Schumer said the bank
may be on the brink of failure.

Schumer's comments about
IndyMac's reliance on deposits purchased from third parties are causing
depositors to pull their money and causing added restrictions on the
lender's borrowings, IndyMac said in a filing today.

was one of the banks that was using relatively weak underwriting
standards on the basis that housing prices would continue to rise in
value,"said Jason Arnold, an analyst at RBC Capital Markets in San
Francisco, in an interview yesterday. "With prices coming down, that
became the bottom card in the house of cards built by these lenders."

demise of IndyMac would be the biggest collapse of a U.S. mortgage
lender since the bankruptcies of Fremont General Corp. and New Century
Financial Corp. The company's key asset is its Southern California
retail bank network with 33 branches and $18 billion in deposits,
mostly insured by the FDIC, Arnold said. IndyMac's inability to find a
buyer or attract capital, despite pressure from regulators, reflects
continued concern over the declining value of its loans, he said.

Okay folks, here’s what I’ve been
talking about…I do not consider a “bank run” to be anything other than
a sign that some people are exercising good judgment. It’s always spun
to sound as if silly, panicky people are reacting to vaporous rumors,
but a bank run sometimes just makes sense. First, if people had any
funds over the FDIC limits in single accounts, then seeing that money
withdrawn is eminently understandable.  Second, anybody watching the
stock price of IndyMac knows that this company is circling the drain.
No sense in leaving your money in a failing institution, is there?


July 9

Banks To Lose $1.6 Trillion Westport (USA)

The expected losses from the financial crisis will
reach $1600 billion. Financial institutions have so far announced only
$400 billion. This pessimistic forecast comes from a confidential study
by Bridgewater Associates, the second largest hedge fund in the world.

are facing an avalanche of bad assets,” says the study. The biggest
losses so far were with the U.S. credit banks. “We have big doubts that
financial institutions will be able to raise enough new capital in
order to cover the losses,” the authors write.

Associates in financial circles enjoy a first-class reputation, several
central banks are among its customers. “Bridgewater are on the
pessimistic side,” says George Magnus, Senior Economic Adviser at UBS
in London, “but they have it absolutely right.”

This analysis by the highly esteemed Bridgewater associates is not be dismissed lightly.

true, this means that banks will have to rapidly raise about as much
fresh capital as they’ve managed to accumulate over the past 80 years.
Not an easy task.

If true, we could expect more nationalization of failed banks, as we saw with Northern Rock in the UK a few months back.

US has not yet nationalized any banks or companies (although via the
PBGC we have nationalized a few pension funds), but I expect that to be
remedied soon enough.

GM would be a fine candidate as the first to go this route, as would a few large banks.

Pension plans suffer huge losses (July 7 – CNN Money NEW YORK)

Falling stock markets around the globe and the
credit crunch are putting the pension funds of some of the largest U.S.
companies into deeper financial holes, according to a report released

Since the credit crunch hit last fall, pension plans
funded by S&P 1500 companies have lost about $280 billion in
assets, according to an actuary at Mercer, a human resources consulting

On paper, the losses from last October tally $160
billion. However, according to Mercer actuary Adrian Hartshorn, the
asset losses are closer to $280 billion when pension plan assets and
liabilities are considered together. The assets, which totaled roughly
$1.7 trillion at the end of October 2007, fell by 17%, leaving about
$1.4 trillion in assets at the end of June.

Companies should
be concerned, he said, because - assuming no change in the market - a
typical U.S. company can expect their pension expenses to increase
between 20% and 30% in 2009. That's due to the higher cost of servicing
the pension plan's debt and the smaller return from the plan's assets.

There are three things to consider
when reading that company pension plans are performing badly in current
market conditions:

1) Company earnings are going to take a hit as pension expenses eat into profits this year and next.

The problem is actually worse than it appears because all companies
assume that their pension plans will steadily compound at a rate of
between 8% and 11% per year. The difference between a year of 8%-11%
compounding and an actual loss can be massive, especially as one looks
further out into the future. Compounding is truly a miracle, but
depending on it can be a complete disaster if it fails.

3) Corporate pension plans were already underfunded to the tune of ~$1.5 trillion, prior to this latest market insult.

together, we can expect quite a few more corporate pension plans to end
up in the hands of the Pension Benefit Guarantee Corp (PBGC), which is
already struggling with the ones it is attempting to service (notably
the one from United).

And anybody who wants to claim that
corporate earnings are going to advance smartly from here needs to
factor in the impact from truing up these underfunded pension

Tehran Warns West Against Attack (PARIS)

A senior Iranian official was quoted Tuesday as
threatening that Iran would respond to any military attack by striking
Israel and America’s vital interests around the globe.

case that they commit such foolishness, Tel Aviv and the U.S. fleet in
the Persian Gulf would be the first targets to burst into flames
receiving Iran’s crushing response,” said Ali Shirazi, a representative
of Ayatollah Ali Khamenei, Iran’s supreme leader, according to the ISNA
news agency.

An attack of Iran, by the US or a proxy, is a very worrisome prospect.

is warning that they plan to fight back if attacked and that they
consider the US and Israel to be joint partners on the matter,
regardless of whichever one actually does the shooting.

Fair enough.

bears mentioning that Iran and Iraq are completely different beasts.
Iraq had a feared autocratic leader and a military decimated by a
decade of strict sanctions that limited both spare parts for existing
military equipment and acquisition of new hardware.

Iran has a
strong military, much of it trained by the US at US facilities (notably
their pilots and ground commanders); it is a larger country with three
times as many people; and it has fresh military hardware from both
China and Russia.

Most importantly, they have a lot of relatively
rugged terrain lying adjacent to the Strait of Hormuz from which they
could launch concealed missiles against oil tanker traffic should they
so chose.

If they did this, 25% of the world’s daily allotment of
oil would be immediately cut off, which would spark an amazing increase
in the price of oil, as well as lead to rationing of supplies if the
cut-off was maintained for more than a few weeks.

July 10

Bernanke Says Fed May Continue Lending Into Next Year (July 8 - Bloomberg)

Federal Reserve Chairman Ben S. Bernanke, seeking
to allay renewed concerns over the health of the nation's financial
system, said the central bank may extend its emergency-loan program for
investment banks into next year.

"The Federal Reserve is
strongly committed" to financial stability and is "considering
several options, including extending the duration of our facilities for
primary dealers beyond year-end," Bernanke said in a speech to a
conference in Arlington, Virginia.

FDIC Chairman Sheila Bair
has also said an agency should be given such liquidation authority for
investment banks. The FDIC has that power over lenders whose deposits
it insures. In the case of commercial banks, the use of taxpayer funds
in an emergency requires the approval of two-thirds majorities of the
FDIC and Fed boards, and of the Treasury secretary in consultation with
the president.

What’s being said here is that the Fed
is concerned that the markets, specifically large banks and securities
firms, have misinterpreted past Fed actions to mean that they will be
bailed out in the event of a financial accident.  Well, that’s
certainly the impression I came away with, so I suppose it is a
legitimate concern.

The reason it’s a problem is that bigger
risks lead to bigger rewards, and all of Wall Street feverishly pursues
rewards every minute of every day.  Without some perceived penalty,
such as the prospect of the bankruptcy and dissolution of their
company, risky behaviors will continue and the problems will only grow
larger and more intractable.  So the Fed is trying to walk a knife-edge
here by both saying that they will continue the past bailouts into next
year, and starting to use some words hinting that government support
might be a little less forthcoming in the future.


Once again, we are treated to an enormous
gap between the words (“we’re going to be tougher in the future”) and
the actions (“you guys can keep using all that money we gave you plus
anything else you need until next year”).   The real problem I have,
though, is with the trial balloon floated by the FDIC chairman
proposing that the respective boards of the FDIC and the Fed, plus the Treasury secretary, have the power to dedicate (and encumber) taxpayer
money for future bailouts. Yikes.
We’re not talking about a few
dollars, we are talking about hundreds and hundreds of billions of
dollars. Call me old-fashioned, but I kind of think that since the power
to appropriate and direct taxpayer money rests fully with the US Congress, it ought to stay there. The thought of a group of potentially
less than 30 people, most of whom exist in a world of revolving-door
job opportunities with the companies that would receive the bailout
money, could direct hundreds of billions of dollars without a full
debate before the larger legislative body, makes me very uncomfortable.

Bottom line: this financial crisis is not over by a long shot.

The Fed is, to their credit, trying new
things and seeking to navigate some very rough terrain, but their
efforts, in my estimation, are far too little and far too late to have
any hope of avoiding a pretty dark period of financial pain.

Citi: Banks Will Have $5 Trillion Restored to Balance Sheets (July 7 –

Accounting changes expected to take effect by 2009
will add $5 trillion to the balance sheets of banks and other U.S.
financial institutions, says Citigroup’s head of global credit strategy
Matt King.

The changes will return to banks’ books the
majority of the assets that were securitized previously — but those
assets will not need to be funded, King told the Financial Times.

I absolutely love the attempt at the
spin on this one - “$5 trillion restored” sounds so big and positive,
right? – but this would be an utter disaster for banks.  The issue is
that by “restoring” the $5 trillion to the balance sheets, two things
happen: an asset is recorded, and a corresponding liability is
recorded.  If the liability is larger than the asset, then this is a
very bad thing, because it will force the banks to raise capital to
cover the difference to remain within regulatory guidelines.

And there’s a reason that banks stored
these massive mounds of loans “off-balance sheet”… most of this stuff
is highly leveraged and of dubious quality.  It is a very safe bet that
the liabilities vastly outweigh the assets for this $5 trillion pool of
junk. If that gap is in the vicinity of $1 trillion, then the entire
capital of the entire banking industry will, in aggregate, be wiped

In short, I will be very surprised if this
potential rule change actually goes through any time soon. Rather, I
expect it to go back to some subcommittee for further review. Lots of
further review.
However, there is one other option which is
mentioned further in the article, “King speculates that because of the
huge amount of money that’s involved, the Fed may simply want to see
the assets on balance sheets for accounting purposes but not consider
them as regulatory capital.”

This would split the difference by bending
the rules so that the $5 trillion wouldn’t count against bank capital. 
Think of this like being down $100,000 at the craps table, but the pit
boss is only going to consider the actual chips in front of you when
deciding if you can borrow some more money from the casino.

July 11

Fannie, Freddie Downgraded by Derivatives Traders (Update2) (July 9 – Bloomberg)

Credit-default swaps tied to $1.45 trillion of debt
sold by the two biggest U.S. mortgage-finance companies are trading at
levels that imply the bonds should be rated A2 by Moody's Investors
Service, according to data compiled by the firm's credit strategy
group. The price of contracts used to speculate on the creditworthiness
of Fannie Mae and Freddie Mac and to protect against a default doubled
in the past two months.

The bailout of Bear Stearns Cos.
arranged by the Federal Reserve in March signals the government won't
allow the companies to fail, Robert Millikan, who manages $5 billion as
director of fixed income at BB&T Asset Management in Raleigh, North

"We're looking at it from a standpoint of, if the
Fed is not going to allow a problem with Bear Stearns, they're
certainly not going to allow a problem with Fannie and Freddie,"
Millikan said. "With all the exposure that banks have to Fannie and
Freddie, the ripple effect through the whole financial system would be
unbelievable if they were allowed to fail," he said.

As with GM, we are seeing the larger
financial community begin to walk away from the Credit-Default Swaps
associated with Fannie Mae (FNM) and Freddie Mac (FRE) in tandem with
steep declines in the share price.

At first the widening CDS
spreads will not be overly large, but if real trouble lurks, we’ll see
them blow out significantly for FNM and FRE, as we are now seeing with
GM. As the article mentions, there is near unanimity among the
financial set that the US government “won’t allow” FRN and/or FRE to
get into trouble.

From my perspective, I’m not sure that the US government is large enough to prevent a serious problem from happening.


exposure here is potentially as high as $1 trillion or even $2 trillion
dollars. If there were no other financial obligations on the plate,
this is a staggering amount of money that would require non-US sources
to accommodate if the pace of the crisis required sudden borrowing.

the US is also funding a stimulus package, 2 wars, $300 billion of
homeowner bailouts, and nearly a trillion dollars of other official
intervention, ranging from the FHLB ($160 billion) to the Fed term
auction facilities (a few hundred billion more).

That is to say,
we’re already hip-deep in throwing a lot of money at the problem, and
any hits to FNM and/or FRE would have to be considered against this

Further, if FNM and/or FRE ‘go down,’ it is very likely
that other financially exposed companies, such as GM and GE, will
stumble at the same time. In short, I do not question the desire of the
US government to swoop in and save FNM or FRE, I only question the

So if the government is going to take one or both of these companies over, it had better do so quickly.

Which brings us to the next article…

U.S. Weighs Takeover of Two Mortgage Giants (WASHINGTON)

Alarmed by the growing financial stress at the
nation’s two largest mortgage finance companies, senior Bush
administration officials are considering a plan to have the government
take over one or both of the companies and place them in a
conservatorship if their problems worsen, people briefed about the plan
said on Thursday.

The companies, Fannie Mae and Freddie Mac,
have been hit hard by the mortgage foreclosure crisis. Their shares are
plummeting and their borrowing costs are rising as investors worry that
the companies will suffer losses far larger than the $11 billion they
have already lost in recent months. Now, as housing prices decline
further and foreclosures grow, the markets are worried that Fannie and
Freddie themselves may default on their debt. Under a conservatorship,
the shares of Fannie and Freddie would be worth little or nothing, and
any losses on mortgages they own or guarantee — which could be
staggering — would be paid by taxpayers.

*Sigh* The losses here are going to be staggering, and the sad fact is that all of this was completely avoidable.

that we’ve been disastrously led down this financial rabbit hole, the
taxpayers are being asked, even before any solid, public discussion has
taken place, to pony up an open-ended amount of bailout funds.

This is an outrage.

We are actually going to be asked to pay in two ways. First with direct bailout monies. Second,
because those monies don’t actually exist, with higher inflation. In
short, a highly regressive tax (inflation) that preferentially feeds
off of those least able to afford it is the ‘solution’ to remedy a
couple of decades of greed and hubris by those who are already rich and
powerful and who should have known better.

I do not support a taxpayer bailout of the mortgage giants.

I support massive losses by those who made bad decisions.

includes people who overpaid for houses and those who trafficked in the
obviously defunct mortgages that supported the charade.

The simple
truth is that all of this cannot be resolved until house prices sink
back to affordable levels, and that eventuality will only be delayed,
not prevented, by these ill-formed government bailout attempts.

To Avoid Stalling Out, G.M. Plumbs Its Resources (July 9 – NYT)

Despite a broad overhaul since 2006, the nation’s
largest automaker may soon have to raise new operating capital to
offset a steep decline in United States vehicle sales. Investors
worried about its prospects, including the possibility of bankruptcy,
have driven G.M.’s stock down to about $10, its lowest point in more
than 50 years. G.M. executives privately dismiss the notion that they
might someday be forced to seek Chapter 11 protection, but pressure is
building on Wall Street for the company to raise cash in the equity and
debt markets.

Simple math suggests the automaker has enough
cash to last through 2009, if analysts’ estimates are accurate that
G.M. is spending $1 billion more each month than it is taking in. But
G.M.’s cash cushion seems far from comfortable given the extraordinary
drop in auto sales.

The problem here is that GM is already
a dead company that happens to still be staggering around on its feet
looking for a good place to drop.

Even if we spot GM every luxury
in the world – a new line up of fuel efficient cars, a workforce that
costs one-half as much and new factories – they still probably couldn’t
make it.

The legacy costs of past pension and healthcare obligations alone are nearly enough to drag GM down.

The truth is that cars can be made profitably in the US, as Honda and Toyota have made perfectly clear.

sad fact is that GM entirely missed the boat on rising fuel costs –
again – and finds itself perfectly out of position – again – and in
dire straits as a consequence – again.

Somebody remind me, why do CEOs make so much money?

any rate, I personally would not hold any GM stock, nor would I try to
game their bonds for a few quick bucks. This company is right at the
top of my list for bankruptcy, and I’ll need to see some very serious
reformations to their balance sheet and operating decisions before I
would test those waters.

Fed Sees Turmoil Persisting Deep Into Next Year (July 9 – NYT WASHINGTON)

Federal policy makers have concluded that the
turmoil plaguing the housing and financial markets is likely to spill
deep into 2009, becoming one of the most significant domestic problems
to confront the next president when he steps into the White House in

Ben S. Bernanke, the chairman of the Federal Reserve,
publicly indicated on Tuesday that he believes the problems will
persist into next year when he outlined a series of steps the Fed is
considering in the coming months.

One such step would extend
low-interest lending programs to Wall Street’s largest investment banks
into next year. The programs, one of which was set to expire in
September, can continue only if the Fed issues a finding that there are
“unusual and exigent circumstances” that justify them.

Finally, Ben Bernanke is publicly
acknowledging what many commentators (including myself) have been
saying for quite some time. This crisis is not going to resolve any
time soon.

Personally, I am looking for some big, scary, cathartic event to mark some sort of a temporary bottom.

don’t see any way for us to get out of this without one or several very
large financial companies going bankrupt or having the dollar crash in
response to ‘too much rescuing.’

The financial rot is too deep to patch over, even with the sizable fixes already employed by the Fed and US government.

I am expecting a real confidence-shaking crisis to emerge, either
spontaneously, or as a consequence of some event such as an ill-advised
attack on Iran.

I expect it this year, and my hope is that you take
the necessary steps to protect your wealth and financial sanity prior
to the arrival of this crisis.

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