At the Crossroads of the Packaged Debt Financial Crisis

"I went down to the crossroad
fell down on my knees
I went down to the crossroad
fell down on my knees
Asked the lord above "Have mercy now
save poor Bob if you please...

Early this mornin'
when you knocked upon my door
Early this mornin', oh
when you knocked upon my door
And I said, 'Hello, Satan,'
I believe it's time to go."
Robert Johnson, Crossroads and Me and the Devil Blues

Steve Waldman writes an brief but excellent analysis of the Fed's recent actions in his Interfluidity blog here:
Repurchase agreements and covert nationalization

We like it, not just because most of the points agree with the same ones which we have. Its nicely written, compact, concise and to the point. We like his analysis, and found his summation to be exceptionally insightful. We learned a new slant on things from it.

You may object, and I'm sure many of you will, that our little thought experiment is bunk, debt is debt and equity is equity, these are 28-day loans, and that's that. But notionally collateralized "term" loans that won't ever be redeemed unless and until it is convenient for borrowers are an odd sort of liability. Central banks are very familiar with the ruse of disguising equity as liability. Currency itself is formally a liability of the central bank, but in every meaningful sense fiat money is closer to equity.

I do not, by the way, object to nationalizing failing banks. There are (unfortunately) banks that are "too big to fail", whose abrupt disappearance could cause widespread disruption and harm. These should be nationalized when they fall to the brink. But they should be nationalized overtly, their equity written to zero, and their executives shamed. That sounds harsh. It is harsh. One hates to see bad things happen to nice people, and these are mostly nice people. But running institutions with trillion-dollar balance sheets is a serious business. Accountability matters. These people were not stupid. They knew, in Chuck Prince's now infamous words, that "when the music stops... things will be complicated.", and they kept dancing anyway.

But accountability has gone out of style. The Federal Reserve is injecting equity into failing banks while calling it debt. Citibank is paying 11% to Abu Dhabi for ADIA's small preferred equity stake, while the US Fed gets under 3% now for the "collateralized 28-day loans" it makes to Citi. Pace Accrued Interest (whom I much admire), I still think this all amounts to a gigantic bail-out. And that it is a brilliantly bad idea from which financial capitalism may have a hard time recovering. Like a well-meaning surgeon slicing up arteries to salvage the appendix, the Federal Reserve is only trying to help."

We're not so concerned with the nationalization of the banks, as we are with the monetization of more bad debt as the result of the wealth gained by a relatively few insiders through reckless mismanagement and fraud. Although it will be presented as just a small amount for everyone to pay, just the price of a discount coupon, we've learned through the latest debt fraud in Iraq that 100 billion quickly grows to a trillion.

Yes, the world is still willing to take our dollars, our markers, our IOUs. And yes, we can keep pushing the envelope of integrity to see how long they will keep taking it. But like a good reputation, once pushed to the breaking point by serial deceit, our national currency will not keep taking this unscathed, and there is likely a point of no return.

So what ought to be done? By all means, let us continue to mitigate the collateral damage to the innocent that the banks have caused.

But let us also take counsel from the recent words of Tom Hoenig, Kansas City Federal Bank President:

"In conclusion, let me stress again my belief that the response to this crisis should be fundamental reform, not Band-Aids and tourniquets. "

The only way to resolve this is that any government intervention to resolve this must include:

1. A formal reinstatement of the Glass-Steagall restrictions on ALL banks doing business in the US including multinationals. A revocation of 23A exemptions and removal of the Fed's latitude to overrule any written law on their own volition. An end to self-regulation and revolving door government regulation by non-civil service political appointees.

2. A return to the concept of regional and local banks through a reinstatement of laws limiting bank ownership across state lines

3. A national usury ceiling for all interest rates and fees on all debt, both revolving and non-revolving, to prevent banks from perpetuating predatory interest rate schemes based on extending individual state laws.

4. A significant set of Congressional hearings and the appointment of a special prosecutor assigned to investigate, with FBI support, the pervasive frauds in the US financial industry from Enron to Tech to Subprime, with special attention to RICO statutes and individuals as well as corporations. The insiders will seek to offer up some designated patsies. We have to try and go beyond that and strike the root and not just the branches.

The last point deals not with retribution, but restoring accountability and deterrence on this happening again in five or ten years with some new Ponzi scheme. If we take no action it will happen again.

"If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered."

Thomas Jefferson, Letter to the Secretary of the Treasury Albert Gallatin (1802)

SP 500 Bear Market Update: March 8

Its not surprising that few know how to trade a bear market. They are the toughest markets, and tend to break all those nice models and short term indicators that worked so well in the smooth waters of a gradually rising bull market. Its probably psychological, but we are stunned at how few who actually traded it remember what the 2000-2002 bear market was like. In short, even with a roadmap, it can be a tough trail to navigate.

Here is our comparison of the current bear market and recession with the bear market and recession of 2000-2002. We use the SP500 as a relatively broad market index, as the performance varies among them. In 2000-2 the NDX was the leader to the downside as the trigger for the downdraft was the bursting of the tech bubble. This time around its the housing related stocks and the financials leading the way, but with remarkably broader participation. and demonstrated by the Russell 2000.

What these charts don't show is the extreme volatility behind these simple lines, and the intra-week swings high and low. Bear markets are notoriously hard to trade from positions, unless they are unleveraged and rock solid, and strictly in the intermediate direction of the market.

We'll know quite a bit more in the next two weeks. We'll update this comparison then.

The Trillion Dollar Wash and Rinse

The Housing Bubble party is over.

The bankers and brokers have collected their fees and exercised their stock options, collecting personal fortunes and gone to more favorable climes.

The households in the US are looking with dismay at their shattered balance sheets and rapidly depleting 'savings.' So who is going to clean up this mess, and pick up the tab for the collateral damage?

Surely you must suspect the truth. It will be all holders of the US dollar.


Mortgage market needs $1 trillion, FBR estimates
Without that, prices of securities will fall, raising interest rates on home loans
By Alistair Barr, MarketWatch
Last update: 3:24 p.m. EST March 7, 2008

SAN FRANCISCO (MarketWatch) - Why are interest rates on 30-year fixed-rate mortgages rising even as the Federal Reserve slashes interest rates and yields on Treasury bonds fall?

The answer is that the mortgage market is short of roughly $1 trillion in capital, according to Paul Miller, an analyst at Friedman, Billings, Ramsey.

The modern mortgage market works with lots of leverage, or borrowed money. Investors, including hedge funds and mortgage real estate investment trusts, buy mortgage securities, but finance a lot of their purchases with this leverage.

FBR's Miller estimates that $11 trillion of outstanding U.S. mortgage debt is supported with roughly $587 billion of equity. That's a leverage ratio of 19 to one.

But last year's subprime meltdown has undermined confidence inthe home loans that back these mortgage securities. Now the banks that finance most of these leveraged mortgage investments have started to pull back and impose margin calls, demanding more cash or collateral to back their loans.

This has sparked a de-leveraging cycle in which some highly leveraged mortgage investors have to sell assets to meet margin calls. Forced selling pushes prices lower, sparking more margin calls, which in turn produces more selling and even lower prices. (Especially when you are unwinding an obvious Ponzi scheme - Jesse).

When debt prices fall, yields rise, and that's what's happening to mortgage securities - even those backed by government sponsored entities including Fannie Mae (FNM Fannie MaeFNM) which are considered the safest. (The safest? Compared to a hand written IOU maybe - Jesse)

"The immediate impact is that [interest rates on] 30-year fixed-rate mortgages will have to increase relative to Treasuries," FBR's Miller wrote in a note to clients on Friday. "That is why we are experiencing pressure on mortgage rates despite the downward movement on the 10-year bonds."

Rates on 30-year fixed mortgages usually follow the movement of 10-year Treasury bonds, but this relationship has broken down as de-leveraging in the financial system takes hold.

The difference, or spread, between yields on "agency" mortgage securities backed by Fannie and Freddie and those on Treasuries rose to a 23-year high this week, Miller noted.

"It is the leverage game playing havoc with the system," he wrote. There are two ways to resolve the problem. Either inject $1 trillion of new capital into the mortgage market, or allow prices of mortgage securities to fall (and interest rates on home loans to climb), Miller said. The mortgage market won't be able to raise $1 trillion, so prices have to fall, he warned.

"There is no quick fix here," the analyst said. "It will take about six to 12 months for the pricing pressure to alleviate on these mortgage assets."

"This will be painful, but it must be allowed to play out in an orderly fashion in order for the mortgage market to achieve equilibrium," Miller concluded.

Alistair Barr is a reporter for MarketWatch in San Francisco.

Is the Fed Monetizing Bad Debt?

There is a funny situation going on with the Fed this morning.

As you know the Fed conducts two types of open market operations, permanent and temporary, through their NY office. This is how they manage their monetary policy.

There is a third type of hybrid repo recently created called the Treasury Auction Facility (TAF). Its similar to the Temporary Open Market Operation except its opaque and the terms are lengthier, and the types of collateral they accept appear to be looser than the Treasuries and agencies which are customary. Its a kinder, gentler, more discreet Discount Window. They kicked the amount up to 100+ Billion this morning. We like to think of it as "free money (below the inflation rate) for the banks" in return for shakey collateral.

Here's what we find confusing. The Fed has not conducted a 'Permanent Open Market Operation" since May 2, 2007. That's right, almost a year ago. At least, that is, before this morning when they conducted a 10 billion dollar permanent operation.

NY Federal Reserve Permanent Open Market Operations

What surprised us was that this is not an ADD, which is a purchase on their part and an addition to the money supply, but a sale of Treasuries to the banks by the Fed out of their own account in return for 'cash' which is considered a DRAIN.

Huh? The big tickle has been the liquidity crunch, so the Fed does a DRAIN?

Here's our take. The Fed has been taking all sorts of collateral from the banks at the TAF window. The banks are going to have to mark this debt to market at some point. We don't know how the Fed is actually valuing it for their repo purchases, since it has no liquid market.

In turn, the banks have plenty of short term liquidity. but they need to recapitalize and use that to build their cash flows with a 'multipler effect' which is tough to do with short term monies. The multiplier of a permanent add is 9x based on a 10% reserve requirement.

So the Fed, having just lent the banks 'cash for whatever' turns around and sells US Treasuries to the banks in return for the amount of 10 Billion which the Fed has recently lent to them short term with God knows what for collateral. How was that collateral valued? Who takes the loss?

See the gimmick? The Fed is letting the banks borrow short from the TAF on questionable collateral and get some nice solid long term Treasuries that can be loaned to the Public at 9x the amount or 90 billion. Looks better on the books, gives them some breathing room, and is nice and quiet.

If that was too complex an explanation, we'll offer the one from our friend Sean in Zurich:

They [the Fed] said they were going to neutralize the new TAF/term RP stuff... so banks end up funding their dodgy mtges with Tim at NYFRB and holding bills to compensate.

And there you have it. Selectively placed helicopter money. Our only curiousity is what exactly the Banks will be showing on their books when they start honoring FASB 157 and start marking to market. Are we going to be going through this at the end of each fiscal quarter for the forseeable future with the Fed playing Mr. Market?

Statement Regarding Sale of Treasury Bills from System Open Market Account

March 7, 2008

On Friday, March 7, 2008, the Federal Reserve’s System Open Market Account will sell $10 billion of Treasury bill holdings for settlement on Monday, March 10. This action is being conducted by the Federal Reserve Open Market Trading Desk (the “Desk”) in conjunction with the series of term RP transactions announced earlier today in order to maintain a level of reserves consistent with trading at rates around the operating objective for the overnight federal funds rate.

The Desk will continue to evaluate the need for the use of other tools to add flexibility to its open market operations. These may include further Treasury bill sales, reverse repurchase agreements, Treasury bill redemptions and changes in the sizes of conventional RP transactions.