Financial Madness: Credit Default Swaps

This probably is not the blasting cap that will ignite the US financial system, since Fannie is obviously too big to fail by a number of measures above and beyond the potential impact to the Credit Default Swaps Market. But the day will come when something will ignite the debt bomb that the global banks have built.

Fannie Mae's credit default swaps widen 16 pct
Tue May 6, 2008 9:07am EDT

NEW YORK, May 6 (Reuters) - The cost of protecting Fannie Mae's debt with credit default swaps rose about 16 percent on Tuesday after the provider of U.S. home financing posted its third straight quarterly loss.

Five-year credit default swaps on Fannie Mae rose to about 50 basis points, or $50,000 a year to protect $10 million of debt, up from about 43 basis points on Monday, according to data from Markit Intraday.
Reporting by Dena Aubin; Editing by Theodore d'Afflisio

The problem seems so obvious. Swaps and instruments based on spreads were a useful way to manage risk. However, over time the banks started playing just the spreads themselves, and the amount of arbitrage over individual groups of bonds' risk has become as disconnected from the underlying reality of the marketplace as placing a wager on black or red in roulette. At some point they just started playing the numbers and let the real economy go to hell.

The banks have piled on an enormous amount of leveraged speculative BETS that have little or nothing to do with the actual business of loaning money and allocating capital, and using the deposits of the saving public wisely.

The banks are feeling safe using VaR (Value at Risk) to measure their exposure. The use of this measure of trading risk has a number of fatal assumptions built into it reminiscent of the portfolio insurance mania that preceded the Crash of 1987. Counterparties remain viable, markets remain liquid, normal distribution of the bell curve.

Why would they do this? Because as the dealers, the croupiers, they take a piece of the action, their percentage of every pot, and put it into their pockets as long as the play continues and the game remains in motion.

The nasty little secret is that they are not playing with their own money; they are playing with yours. They don't care if you lose as long as they get their percentage. Beyond that, they are not thinking that far ahead.

It was giving them access to the insured deposits of the nation and allowing them to take the nation's wealth to the gaming tables that set the wheels of this casino in motion. It was the repeal of Glass-Steagall.

In the short term they have power, real power, to make prices do what they wish them to do.

This will begin to cause havoc in the real world as price distortions create shortages and oversupplies. The price discovery mechanism of the markets is in their control for now. But when the day comes that the markets revert to the mean, when rude reality intrudes, we are going to see price gyrations, both up and down, that are going to seem astounding, impossible, unbelievable, and potentially devastating.

This is not a financial system operating responsibly. This is not even gambling. This is Madness because the wagers can never clear, they can never all be paid. The derivatives market has become a kind of semi-psychotic preoccupation with itself and a mathematical world of its own creation.

People will look back AFTER the crash and say, 'how could they have allowed this to happen?'

Here are some examples of how out of control and disconnected from reality the banks have become?

Will the World Continue to Support US Dollar as the Global Reserve Currency?

Its a legitimate question, as much as it may rankle the reading public who assume that what is now has always been and should always be.

There is no divine right of the American dollar to be the reserve currency of the world. If you take a look at it through the long lens of history it is without precedent, and for very good reasons largely technological in nature.

The Roman Empire comes to mind. One set of laws, one ruler, and one money system for a large part of the world. But was China concerned with the Roman Empire? Japan? Western minds tend to ignore the non-European world in history. and there is a good case to be made that the Roman government grew to the limits of its technological reach....and then fell apart over time in a Ponzi-like collapse.

We live in interesting times, far beyond the financial implications. It brings to mind the notion that economics is really 'political economy' as it was originally called, and its marriage with mathematics and pretensions to science are modern and probably overblown. Economics is probably more sociology than geometry. Economists can rarely predict major economic events with accuracy, but can bring forward many weighty-sounding arguments to support major policy decisions. Inevitably they seems to abandon their scientific pretensions and reach for centralized control to make their predictions come true.

We live in an era where there is a strong push for global government. This is the natural extension of a system of capitalism based on monopoly and Ponzi-style growth. It must keep expanding and controlling to the limits. Or it will fail.

The past 200 years have seen a series of tragic failures of central command and control governments and economies, of the right and the left. Its time for a change. Its time for the pendulum to swing back to a new emphasis on private liberties, and a renewal of the American spirit of a democratic republic with a strong emphasis on the rights and freedom of the individual.

May 3, 2008

Abandoning the USS Titanic
By Chan Akya

Yes, I know that the Titanic was not registered as a United States ship. The title though refers to the startling comparisons that can be made to the ill-fated vessel after it hit the iceberg in 1912, and the US today after it has hit the twin icebergs of the idiotic George W. Bush presidency and the subprime mess in the economy. I am not suggesting that the two were linked, only that an ineffectual government frequently makes a cyclical problem much worse by its own actions.

US Federal Reserve head Ben Bernanke has taken on the role of the second in command whose job it is to scream "full steam ahead", even as it becomes wildly apparent that it is a structural problem in the economy, not a mere cyclical downturn. As a number of other commentators have written in Asia Times Online, including Julian Delasantellis and The Mogambo Guru, the problem with the US is that of excessive borrowing that has fed a consumption boom. Almost three-quarters of the US economy is consumption, compared with the more usual 50-50 mix considered "normal" in Economics 101 textbooks.

This excess of consumption creates the massive borrowing needs of the US, which are immediately supplied by a bunch of supplicants, be they Middle Eastern dictators or imagination-free Asian central banks. What many of us on this website have been writing about is that this edifice is cracking and quite likely to fall over.

Kuwait strikes

On Thursday (May 1), the finance minister of Kuwait, Mustafa al-Shiwali, suggested that Gulf Cooperation Council (GCC) countries were considering an idea to abandon their long-standing US dollar pegs. This is a minor news item to be tucked away in page 20 of the financial press, which it has been – but rather emblematic of a systemic shift.

For years, Gulf countries have held US dollars as an article of faith, with an almost religious fervor. These were the same countries that considered the same action in the 1970s, and indeed it was the Kuwaiti finance minister of that time who famously asked, "Why should we sell our black gold in exchange for unguaranteed currency notes [US dollars]"?

The aftermath of the crisis in the 1970s was greater US meddling in the region, propping up friendly dictators around the region and stoking the flames of war in Iran-Iraq that culminated in Saddam Hussein marching his forces into Kuwait in 1990. Perhaps that was America's idea of punishing the Kuwaitis, but we would never know that for sure.

Despite owing a debt of gratitude for getting their country back, it is interesting that Kuwait today is concerned more about domestic inflation that has run away to absurd levels, and less about kicking the US when it is down. Call that the new world, if you will.

The story though is complicated, because on the same day, the Kuwait Sovereign Fund announced it would increase its stakes in US financial firms Citigroup and Merrill Lynch, in effect continuing the trend for the rest of the world propping up the US financial system's malcontents.

The likely consequences of Gulf countries abandoning their US dollar pegs will be twofold. Firstly, their overall holdings of US financial assets, such as government bonds and shares, will have to fall dramatically. Financial analysts around the world assume that this will take the form of such investors in future buying fewer US dollar assets. I however think that it is more likely we will see actual selling of such assets, particularly the really dumb US Treasury bonds that offer yields roughly in line with official inflation and less than half of unofficial inflation figures.

The second consequence of Gulf states abandoning their dollar pegs is that they will increase the price of oil commensurately to ensure that their "local" income does not suffer. For example, if you pegged your currency at 100 to the US dollar and so were getting 1,200 in your currency for oil; and after de-pegging let us say that it rises to 75 on the dollar, you would need to bump up prices to ensure that you still get 1,200 in your local currency for oil. That means oil prices denominated in US dollars would have to go up some 30% to compensate.

The immediate impact of this on Asia would be quite nefarious, particularly for oil-importing countries ranging from Japan to India. Every one of them with an ability to allow their currencies to appreciate (and here I include only Japan, China, South Korea and India) will do so, in turn triggering the same first- and second-level reaction as suggested above from Gulf states' de-pegging, that is to sell US financial assets and raise prices of their exports accordingly.

It gets worse for weaker Asian states such as the Philippines and Indonesia, which don't really have the ability to push up their currencies. They will struggle to control inflation and failing that, embark on new rounds of government borrowings. This is the scenario I painted earlier in the year, which highlighted increased problems for smaller countries against the bigger ones in Asia.

The final consequence of the decline of US power is global in nature, namely a search for an absolute value reserve. That would be physical commodities including oil, copper and whatever have you. The easiest though would be gold.

Abandoning the USS Titantic - Asia Times

Microsoft Withdraws Its Offer to Yahoo

This is probably a good move by Microsoft and a bad move by Yahoo.

Microsoft would have destroyed Yahoo, much more quickly than Yahoo is destroying itself.

May 3, 2008

Mr. Jerry Yang
CEO and Chief Yahoo
Yahoo! Inc.
701 First Avenue
Sunnyvale, CA 94089

Dear Jerry:

After over three months, we have reached the conclusion of the process regarding a possible combination of Microsoft and Yahoo!.

I first want to convey my personal thanks to you, your management team, and Yahoo!’s Board of Directors for your consideration of our proposal. I appreciate the time and attention all of you have given to this matter, and I especially appreciate the time that you have invested personally. I feel that our discussions this week have been particularly useful, providing me for the first time with real clarity on what is and is not possible.

I am disappointed that Yahoo! has not moved towards accepting our offer. I first called you with our offer on January 31 because I believed that a combination of our two companies would have created real value for our respective shareholders and would have provided consumers, publishers, and advertisers with greater innovation and choice in the marketplace. Our decision to offer a 62 percent premium at that time reflected the strength of these convictions.

In our conversations this week, we conveyed our willingness to raise our offer to $33.00 per share, reflecting again our belief in this collective opportunity. This increase would have added approximately another $5 billion of value to your shareholders, compared to the current value of our initial offer. It also would have reflected a premium of over 70 percent compared to the price at which your stock closed on January 31. Yet it has proven insufficient, as your final position insisted on Microsoft paying yet another $5 billion or more, or at least another $4 per share above our $33.00 offer.

Also, after giving this week's conversations further thought, it is clear to me that it is not sensible for Microsoft to take our offer directly to your shareholders. This approach would necessarily involve a protracted proxy contest and eventually an exchange offer. Our discussions with you have led us to conclude that, in the interim, you would take steps that would make Yahoo! undesirable as an acquisition for Microsoft.

We regard with particular concern your apparent planning to respond to a “hostile” bid by pursuing a new arrangement that would involve or lead to the outsourcing to Google of key paid Internet search terms offered by Yahoo! today. In our view, such an arrangement with the dominant search provider would make an acquisition of Yahoo! undesirable to us for a number of reasons:

•First, it would fundamentally undermine Yahoo!’s own strategy and long-term viability by encouraging advertisers to use Google as opposed to your Panama paid search system. This would also fragment your search advertising and display advertising strategies and the ecosystem surrounding them. This would undermine the reliance on your display advertising business to fuel future growth.

•Given this, it would impair Yahoo’s ability to retain the talented engineers working on advertising systems that are important to our interest in a combination of our companies.

•In addition, it would raise a host of regulatory and legal problems that no acquirer, including Microsoft, would want to inherit. Among other things, this would consolidate market share with the already-dominant paid search provider in a manner that would reduce competition and choice in the marketplace.

•This would also effectively enable Google to set the prices for key search terms on both their and your search platforms and, in the process, raise prices charged to advertisers on Yahoo. In addition to whatever resulting legal problems, this seems unwise from a business perspective unless in fact one simply wishes to use this as a vehicle to exit the paid search business in favor of Google.

•It could foreclose any chance of a combination with any other search provider that is not already relying on Google’s search services.

Accordingly, your apparent plan to pursue such an arrangement in the event of a proxy contest or exchange offer leads me to the firm decision not to pursue such a path. Instead, I hereby formally withdraw Microsoft’s proposal to acquire Yahoo!.

We will move forward and will continue to innovate and grow our business at Microsoft with the talented team we have in place and potentially through strategic transactions with other business partners.

I still believe even today that our offer remains the only alternative put forward that provides your stockholders full and fair value for their shares. By failing to reach an agreement with us, you and your stockholders have left significant value on the table.

But clearly a deal is not to be.

Thank you again for the time we have spent together discussing this.

Sincerely yours,

/s/ Steven A. Ballmer

Steven A. Ballmer
Chief Executive Officer
Microsoft Corporation

HELOCs: the Next Shoe to Drop?

Once again Mr. Mortgage proves to be an extraordinary source of information on the mortgage debt crisis with regard to HELOCs: Home Equity Lines of Credit.

Fresh news out…S&P pulled a slick one. They STOPPED rating second mortgage RMBS citing “anamolous and unprecedented” borrower behavior. Here is a little piece from Bloomberg that enhances the previous story very well, calling all Home Equity loans ‘junk’.

Remember, this is a $1.3 TRILLION market with the bulk belonging to very few banks such as BofA, Wells, Chase, CITI, Countrywide, WAMU, National City, GMAC and IndyMac. I put a couple of nice quotes below. This could turn out to be a fairly large story in the making.

Read the complete story here:
HOME EQUITY LOANS - A BIG BANK KILLER. S&P STOPS RATING 2ND MORTGAGE RMBS!

Download the Fitch Report here:
US Home Equity Woes: Banks Grapple with Higher Losses

This is our own compilation of US Financial Institution Exposure to HELOCs from Fitch in which we provide sorts by percent equity, assets, and loans.


Eenie meenie minee moe, which bank will be the next to go?