Vigilant Investor

We’ll, we’ve talked about it for years here on Vigilant Investor.   Your chief editor here has referred to it in annual reports to clients in his private consulting practice:  When honestly looked at the U.S. fiscal situation implies inevitable, long-term insolvency.

I don’t come to this conclusion lightly, although I’m reminded of it by reading that President Bush has signed the bill allowing for the Freddie and Fannie bailout to go forward, which includes the debt ceiling being raised to $10.62 trillion.  Yes, with a T.

Now, we’ve pointed out the sleight of hand that goes on with reporting deficits in the United States. This leads most of the sheep to accept at face value that the official federal deficit hovers around $200-300 billion each year.  Granted, that’s no song, but the reality is far higher when you actually account for all the obligations decades of Congressional profligacy has chained to the U.S. taxpayers’ backs.

The whole number is over $54 trillion - some $175,000 per living person in the United States — once you actually stop with the facade that the obligations of Social Security, Medicare and Medicaid are somehow not worthy of being included on the balance sheet.  Broken down to a net present value of future obligations figure, we’re talking an annual deficit number closer to $4.6 trillion, a gargantuan figure that keeps building each year politicians pretend it really does not  exist because doing so will only scare the electorate.  That’s because fixing the problem will require draconian cuts and tax increases; although tax increases of the levels required to make a difference won’t work since they’ll only strangle what little economic growth is going on at the moment, further reducing revenues.

But, alas!  When it comes to politicians, they do have another “out” that can maybe work for another election or two: inflation!  By inflation, I don’t mean rising prices, but rather the cause of the rising prices: increasing money supply.    This is the easiest way for politicians to pay down the promises they and their predecessors have made, and in case you have not yet noticed, it’s been coming to a gas pump and grocery check out near you for a number of years now.  Heck, when you can print money and your official department of statistics filled with lackeys looking to keep the guys controlling their salaries happy, we’ll…  This might explain why Social Security recipients received an unconscionable 2.7% raise for their 2008 payments when the price of eggs, milk, and flour are climbing at well over 10 times that pace!

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No doubt, there are quite a few problems behind why oil has jumped above $128 a barrel.  Never mind hooey arguments about greedy oil companies that resonate with the economic illiterates among the loudmouth media and the complaining voters.

While we don’t have much good to say about any politician on the matter of energy, we really can’t disagree with President Bush’s observations about pressuring the Saudi’s for more output:

“Our problem in America gets solved when we aggressively go for domestic exploration. Our problem in America gets solved if we expand our refining capacity, promote nuclear energy and continue our strategy for the advancing of alternative energies as well as conservation,” he said.

“One interesting thing about American politics these days is those who are screaming the loudest for increased production from Saudi Arabia are the very same people who are fighting the fiercest against domestic exploration, against the development of nuclear power and against expanding refining capacity.”

This, said Bush, after noting that Saudi output really is not the ultimate solution to the U.S. price problem.  Mind you, many in the U.S. Congress are wagging their fingers at the Saudis — like candidate Hillary Clinton — for not increasing their production significantly enough to alleviate U.S. price pressures, as if the world should rotate around the U.S. dilemma.  The same folks giving grief to the Saudis are the same ones who refuse to allow the U.S. to develop its own energy resources as Bush notes above.

Not that the Republicans have been any great movement as of late to get anything done themselves, with R candidate John McCaine having been a pivotal vote in the Senate preventing the development of Alaskan reserves.  Indeed, the U.S. has not built a new refinery in three decades, and refuses to allow development of both oil and clean burning coal, not to mention nuclear reactors.  Even environmentalists are preventing air windmills, much to the happiness of those with fancy homes on the coasts who loath having their million dollar views ruined by windmill farms harvesting the constant ocean breezes.

Hypocrisy aside, we’re not hearing one of the core causes for skyrocketing energy costs: plain old fashioned inflation. And by “inflation”, we don’t mean the modern misuse of the word to describe the consequences of inflation — rising prices –, but rather the actual cause of the rising prices: climbing money supply.   The world is now awash with dollars thanks to a steady thirty years of the Fed and the U.S. banking system creating dollar after dollar with its fractional reserve, fiat privilege.

Looking at the money supply graph, you can see that the various measures of U.S. dollars have been on a steady rise since the 1980s, and especially ramped up in the 1990s.   Most were lulled to sleep about the ugly effects of inflation due to two factors, both of which served as siren songs for the unsuspecting public and the herd of sheep hitting their record bonuses on Wall Street:

1. Inflating nice asset prices like stocks, bonds, and houses
2. Exported inflation dollars bought cheap goods made abroad, a honeymoon that lasted until the last few years, when foreign nations were flush to the gills with dollars and ready to part with them to buy things that were not so easily printed and common — and very essential, like energy!

“The Federal Reserve as other central banks is obviously taking onto its balance sheet a lot of mortgages these days.” “Well, the creators of the Federal Reserve system would be rolling over in their graves if they knew the Federal Reserve is buying mortgages.”
– Former Federal Reserve Chariman Paul Volcker

Whether or not the creators of the Fed would be rolling over in their graves is debatable in our opinion. Like Andrew Jackson — we believe central bankers have always been dangerous, incompetent meddlers. We feel the Fed should never have been created — and and that it continues to prove itself as bungling as any other central planning committee. But we digress…. That said, the former chairman’s grave concern over the central bank taking on billions of not so hot private debt is quite valid.

Volcker went on to warn that recent intervention by the Fed in securities markets might compromise it’s independence. He went on to say that the Fed’s inability to contain inflation will create a 1970’s like scenario. Again, he’s right there. We’ll also add, it’s too late Paul — the nationalization of the US private debt has begun. When politicians, who’s outlook is only as far as the next election — get involved, the trend will only accelerate. So to will corresponding inflation and Dollar degradation.

Beyond the blatant example of the Fed’s $30 Billion bailout of Bear Stearns — we now see Senator Christopher Dodd proposing the creation of an FHA program to insure refinanced mortgages following partial forgiveness of the loans by lenders. OK, let’s think about this. In an environment where U.S. foreclosures have risen 65% over the past year — and private banks/lenders are preferring to seize homes rather than renegotiate with already defaulting borrowers — the Federal Government is going to step in with money it does not have (but will be all to happy to print) — to back already bad debt.

Also, earlier this month, the Fed agreed to accept securities backed by student loans pledged as collateral for Treasuries the central bank would in turn lend to Wall Street Investment Banks. Let’s analyze that deal. Investors had become far less willing to finance student loan debt at pre-existing prices — due to liquidity issues, the economy, and the fact that consumers (including students) are hurting — and are therefore higher credit risks. The cost to finance such loans would have to naturally go up. Wall Street investment banks (you know, the ones who paid themselves billions in record bonuses over the past year) were less willing to hold onto securities they owned backed by this type of debt. However, if they tried to sell it — they would sell it for a loss. No worry, the Fed would lend/swap them Treasuries for the riskier (and worth far less) student loan backed securities.

Effectively, you have the government, or quasi government institutions backing substandard debt with money it will have to print. That spells one thing — accelerating inflation — and the always accompanying confiscation of private savings. And we’re not talking the low single digit inflation figure the government “calculates” (and bases Social Security payment increases on). We’re talking about the inflation you see in the supermarket ($4 for a handful of blueberries anybody?) — and at the gas pump.

When we hear the Treasury Secretary, or the Chairman of the Fed talk tough on inflation and defending the Dollar — we just smile. When we hear political candidates blaming oil companies and “speculators” for rising prices — we smile again.

We think the next 3-5 years will be quite interesting.

“I think we were really on the verge of a financial collapse of unbelievable proportions that we haven’t seen since the 1930’s.”
– Former U.S. Treasury Secretary Paul O’Neill describing the Bear Stearns bailout in an April 16, 2008 interview on Bloomberg

Read that quote again by Paul O’Neill – because, yep folks, that’s really where things stand. Our financial system effectively patched together by an inflationary, money printing band-aid. And, as the real estate markets in England, along with those in Spain, Ireland, et al. continue to melt down, we maintain our belief that the whole fiasco is far from over. (Our regular readers know we said the same when conventional pundits said the worst was over in 2007).

The interesting thing about economics is that people have been conditioned to believe in the charade that it is a mysterious, complex, science – and to be successful at understanding it, explaining it to the great unwashed, and at running large portfolios – one must be a superior mathematician educated at the most prestigious of universities. As we watch the same geniuses educated at said universities – some of whom had supposedly developed mathematical models which had eradicated risk – continue to drive hedge funds (and at least one major Wall Street brokerage firm) valued in the $ billions straight over the cliff – we say – “oh really?”

We instead choose to take Harry Truman’s quote — “There is nothing new in the world but the history you do not know” – to heart when we look at economics. History is in fact the study of human behavior – of what has worked, and what has failed. To ignore historical facts one must be either arrogant, a fool – or an arrogant fool. So, as Sir Alan Greenspan and his knights at the Fed Round Table repeatedly cut rates earlier this decade – we warned that the unfolding scenario looked a whole lot like Japan in the 1980’s and 90’s! A Stock market bubble, followed by a stock market crash – and subsequent economic pain. Then came massive interest rate cuts to supposedly “stimulate” – which instead caused a real estate bubble – followed by a real estate collapse, and a severe, prolonged recession.

Sound familiar?

What next? We see the bailouts continuing — simply because the alternative is the severe and necessary corrective pain to clean out the mess and get prices of all things back in line. And what politician, Wall Street banker, investor, or voter wants to deal with that reality? And bailouts spell inflation. Not the fudged low-ball inflation that’s used to calculate Social Security payment increases or “official” economic growth. We’re talking about real inflation. The rapidly rising kind you are seeing at the supermarket and the gas pump on a daily basis. As these inflationary bailouts continue – look for prices of all things tangible to increase dramatically.

Commodities bubble? We think not – because bubbles require excessive stockpiles/inventory/supply – and we don’t see that at all – in anything. And we see inflationary (money printing/bailout) policies accelerating.

Oil at $125 in the near future anyone? $5 Dollar gas at the end of the year? Food prices continuing through the roof? It would not surprise us at all.

Regulators “are playing with fire,” said Allan Meltzer, a Fed historian and economics professor at Carnegie Mellon University in Pittsburgh. “With good luck, none of these liabilities will come due. We can’t expect that good luck, and we haven’t had it.”
– Bloomberg (March 26, 2008)

The reason you want solid collateral to secure a loan is obvious. You want to protect adequately against the borrower’s potential inability to pay you the loan back. How interesting that the Fed is taking 30 $ Billion of illiquid mortgage securities as collateral from otherwise insolvent Bear Stearns to bail the Wall Street firm out. As intriguing (alarming) — is the Treasury’s encouragement of Fannie Mae and Freddie Mac to buy more mortgage-backed bonds.

We ask — who in their right mind would lend out their own money backed by such risky collateral? Who today would buy mortgage backed bonds with their own money?

Ah, there lies the rub! It’s not their money which backs these shenanigans – it yours!

We’ve continually warned about the bailout addicted U.S. Another voice of clarity and reason all along has been Bill Fleckenstein. As usual, he nails it in his latest commentary, “Catering to the Bailout Nation.” BTW, Bill’s recently released book Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve – is definitely worth a read! We wonder — has anyone ever been un-knighted? Can they do that?

Any reasonable person knows that bailouts beget more (and larger) bailouts. Like a drunk having another drink, it’s just going to make the hangover (and resulting inflation) even worse.

Also, ask yourself this one – why are big Wall Street banks getting bailed out (with taxpayer money) – when the 5 largest recently paid themselves 39 $Billion in bonuses?

Think long and hard about the answer to that one – because you are paying for it – in overt taxes, and the great hidden tax – accelerating real inflation.

With today’s 75 basis point rate cut – we see continued evidence as to whom the Fed really serves. As we have long said, it’s not you and I – it’s the Big Wall Street Banks. The “Big Rip-Off” of your savings continues. Jon Markman gets right down to it…

Standard & Poor’s said it cut or may reduce ratings of $534 billion of subprime-mortgage securities and collateralized debt obligations, as home loan defaults rise. The downgrades may extend losses at the world’s banks to more than $265 billion and have a “ripple impact” on the broader financial markets, S&P said.

That’s from an article on yesterday at Bloomberg enunciating some of our concerns about the shock waves downgrades can have through the system. While the article elaborates on how nobody saw this coming, again we remind you to peruse our archives detailing this fiasco from day one.

Meanwhile, there’s this gem today, also from Bloomberg:

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How bad is it for housing? 60 Minutes provides a decent postmortem on the entry into the housing crash… If only they could haven warned people when it mattered –before it collapsed, like we did! The only thing missing is any revelation of where all this easy money came from. That answer is the Rosetta Stone of where we are in this crisis.

This piece truly puts a visual on the breadth of this crisis. One gentleman walking Steve Kroft through foreclosed properties when, towards the end of the piece, he thinks we’re lucky if we’re through the first 40% of this. Too bad the problem will not remain contained only to housing. As the monoline insurers backing many of the bonds continue to run into liquidity issues (e.g. Ambac, MBIA, and ACA Financial Guarantee) collide with the emerging problems in commercial and retail real estate, as well as those coming to the surface in revolving credit — credit cards, auto loans, etc. — we think 40% is a bit too optimistic.

As Jim Grant points out about all the assurances that this situation would remain “contained in subprimes,” and then “to just housing,” at best we can expect this will remain contained to planet earth.

From Bloomberg:

Moody’s lowered its rating on commercial paper issued by the Orion Finance structured investment vehicle, or SIV, to “Not Prime” on Nov. 30, saying its net asset value is inconsistent with Orion’s former Prime-1 rating. Montana owns $50 million of the paper. Moody’s put another $105 billion of SIVs on review for a possible downgrade, of which Montana holds $80 million and Connecticut holds $300 million, records show.

Connecticut’s Short-Term Investment Fund, which invests cash for state agencies and municipalities, is holding $300 million in debt issued by SIVs that may be downgraded by Moody’s. The state’s $5.8 billion fund held notes issued by SIVs affiliated with Citigroup as of Sept. 30: Beta Finance, Dorada Finance and Five Finance, according to its most recent quarterly report.

Connecticut also holds $100 million in defaulted SIV notes issued by Cheyne Finance.

Meanwhile, in Montana, they contemplate another problem:

 (Senator Dave) Lewis, a member of the Legislative Audit Committee in Montana, questioned whether the state board’s policy of allowing pool participants to remove their money at full value, which concentrates the risk among those with money still entrusted to the pool. The majority of the money in the pool belongs to state agencies.

“I think we may need a special session of the state Legislature,” he said.

The market sure is cruel on its insistence that mispriced assets be rationally valued to clear the air.  And it is just more pressure to get these assets marked to reality vs. marked to fantasy or political convenience.

Of course, the alternative is to flood more cash into the system so that these assets appear to be 100 cents on the dollar.  But that’s a solution with a heavy price of its own.

Defaulters don’t pay taxes on properties, and those with plummeting house values will demand  reassessments.   That’ll put pressure on governments that like to plan ahead on revenues generated during the good times.   CNNMoney reports that California alone is expected to see a property tax reduction of $3 billion in 2008.

Yet governments are no different than anyone else during these artificially engineered booms.  They and their taxpayers will be footing the bill for any miscalculations encouraged by the bubble in housing — yet more victims of lose monetary policy.

In the bond market, commercial property investors are about as creditworthy as U.S. homeowners with subprime mortgages. “Commercial real estate is a full-blown bubble that feels very much at a bursting point,” said Christian Stracke, an analyst in London at CreditSights Inc., a fixed-income research firm. “There’s a fairly toxic mix of factors at work.”

Tha’s from an article worth reading on Bloomberg.com.   As our post earlier today indicated, the problem of inflationary induced dislocations is hardly confined. Entire economies bend to where the wealth is redirected.  Commercial real estate will be yet another shoe to drop.

Bloomberg published a story on November 21 noting JPMorgan analysts are suggesting that ACA Financial Guarantee Corporation, one of the nations largest bond default insurers of collateralized debt instruments, may be “thrown to the wolves.” This comes after S&P placed its “A” rating of financial strength on “CreditWatch with negative implications” based on a variety of factors on November 9. S&P is the only ratings company that has a rating on ACA.

That downgrade was in response to ACA Capital’s (the parent company ACA FGC) announcement that it had $1.04 billion net losses in the 3rd quarter, compared with earnings of $16.1 million over the same period in 2006. Meanwhile, Pershing Square Capital’s William Ackman yesterday predicted ACA wil go bankrupt.

Now, if a downgrade takes place, counterparties that insured their CDOs with ACA FGC would find themselves with a big problem. Reported the Financial Times on the day of the S&P warning,

Because ACA Financial is rated A – well below the industry norm of AAA – its CDO CDS contracts contain a provision requiring it to post collateral in the event of a downgrade, said the market participant. Such provisions require ACA to post cash equivalent to the mark-to-market loss of the CDS contract pursuant to a ratings cut.

ACA said in a 10-Q filing this week(from Deloitte Touche) that it won’t meet collateral requirements if its rating falls below A-. In other words, ACA FG would become insolvent and default on its insurance agreements, as the FT story points out.

Which brings us back to JPMorgan’s observations noted above. Reported Bloomberg, Continue Reading »

In April 2006, GM ditched GMAC — its highly profitable finance unit — ostensibly to raise cash given its ongoing struggles to keep the head above water.   Back then we questioned the motives, and in todays credit-crisis environment, it appears as if Sun Tsu is terribly proud despite GM Vice Chairman, Bob Lutz’s comments to the contrary.  Says Lutz, “… we thought we were doing it to raise cash … but it turns out what we were really doing was reducing our exposure to ResCap.”

Whatever the case, GM claims that it has no contingent liabilities from the unfolding credit crisis that has cost GMAC a $1.6 billion 3rd quarter loss, although Lutz admits “The only downside is if … ResCap (the residential mortgage arm of GMAC) keeps doing worse and worse, and we keep having to absorb our 49 percent of the worse and worse.”    GM already slopped in $1 billion as part of their agreement with 51% stakeholder Cerberus Capital Management LP, but otherwise claims it has a firewall in place.   ResCap lost $ 2.3 billion due to the subprime problems in the 3rd quarter alone.

Well, that hardly is a vote of confidence for ResCaps future for those who believed the credit markets would have serious problems long before things really imploded this past August.

But as we suspected, Sun Tsu is likely very proud of GM’s work.  Now, if only GM could sell more cars and solve that massive unfunded pension and health care liability hangover.

Today we learn that the Fed has again made another temporary liquidity injection to qualify as the largest since the times around 9/11 in order to provide grease for the still shrinking U.S. commercial paper market. The amount, $47.25 billion, was to defend the federal funds target of 4.50% that had traded as high as 4.81% earlier in the day — and was largely attributed to $40.5 billion of rollovers in “maturing operations.”

Now, if you’re like most folks, much of what that means — well, it may as well be in Greek. Moreover, what lies beneath the surface is opaque and functionally down the rabbit hole that even pros have a hard time making sense of what actually has been going on. After all, is that not largely what we can deduce from the lock-up of the credit markets?

Some might suggest FAS 157 — the new accounting rule that makes it harder for banks to hide market values of hard to value securities through mark to model valuations — might be a little painful, but will also finally restore some clarity to the system. We encourage readers to catch up on the changes: No doubt it will provide clarity, although we believe the recent large write-offs from major players are only the tip of the iceberg on institutions coming clean.

Now, while the difference between what FAS 157s Level 1, 2, and 3 assets actually mean in real terms is still quite Greek (and yet to be valued), we can’t help but remind readers that the fundamental problem of this highly public fiasco that started in the mortgage back securities markets really are a distraction from the actual problem that will eventually be exposed. Continue Reading »