Rolfe Winkler

Barack Obama articulated a key point regarding housing in tonight’s Democratic debate. He said that if you freeze interest rates as Hillary wants to in order to “protect” homeowners, you’d actually punish others by raising their interest rates.

This is a fact that everyone in the mortgage/econo blogosphere knows…..if you fix prices, the market will break down. Banks will lose money on troubled/distressed/irresponsible borrowers whose interest rates are protected and will make up the difference by overcharging everyone else. Interest rates will increase overall, compounding our housing problems.

So I’m glad at least one of the Democratic candidates can articulate a basic understanding of the economic forces at play here.

Not discussed at length was Hillary’s idea to freeze foreclosures for 90 days to “work out” problems. It strikes me that much of the lending business could grind to a halt during this period.

The last thing we need is large scale government intervention on behalf of distressed borrowers. For the housing market to repair itself, house prices have to fall, which means the government has to let them fall.

But it’s not all gloom and doom apparently. Slowing GDP growth points toward recession sure, but the jobs market seems still to be growing better than expected:

The labor market may not be in weak shape after all. The latest forecast by payroll firm Automatic Data Processing shows job creation soaring in January.

Nonfarm private employment surged by a seasonally adjusted 130,000 during the month, ADP said. Adding in 22,000 government jobs (the average gain over 12 months), total nonfarm payroll gains are estimated at 152,000 for the month. That’s more than double most economists’ estimates for Friday’s Labor Department report. It would also represent a huge rebound from the 18,000-job increase the government reported for December. (ADP revised its December down to a gain of 37,000.)

The figures are compiled by the forecasting firm Macroeconomic Advisers using ADP payroll data covering about 24 million workers. The report said service-sector employment grew by 141,000, while employment in the goods-producing sector declined by 11,000, the fourteenth straight monthly decline. Manufacturing employment was flat during January, following 18 consecutive monthly drops.

One is left to wonder, though many economic statistics are deteriorating, why is the Fed cutting so aggressively when perhaps the most important economic statistic–i.e. unemployment–is still hovering around all-time lows? Even after last month’s jump from 4.7% to 5.0%, unemployment is still very low by historical standards.

Bernanke’s a smart guy, though, and likely sees storm clouds in the financial sector that WILL impact the jobs market more significantly. Still, such aggressive rate cutting even before the economy has fallen into recession seems like an overreaction. One that will only serve to blow up a new credit bubble…..

This morning the commerce department released 4th quarter GDP growth figures:

Gross domestic product rose at a seasonally adjusted 0.6% annual rate October through December, the Commerce Department said Wednesday in the first estimate of fourth-quarter GDP.

If you factor in inflation near above 3% YoY in Q4, then the real economy shrank.

Aside from the housing slump, slowing consumer spending, inventory liquidation and lower overseas sales restrained the economy. The 0.6% pace wasn’t only much slower than the third-quarter’s racing 4.9%, it was far below expectations on Wall Street. The median estimate of economists surveyed by Dow Jones Newswires was 1.2% GDP growth during the autumn months.

Economists still see only a 50% chance of recession this year. As more financial shoes drop–monoline insurers will be downgraded triggering billions more in writedowns, the commercial real estate bubble will implode–we’ll likely be a in a recession this quarter.

GDP acts as a scoreboard for the economy by measuring all goods and services produced. Its housing component, residential fixed investment, dropped by 24% in the fourth quarter, reducing overall GDP by 1.18 percentage points. Third-quarter investment had fallen by 21%, taking 1.08 percentage points out of GDP. The 24% drop was the worst since a 35% plunge during fourth-quarter 1981.

No surprise that residential fixed investment continues to crater……

The biggest GDP component, consumer spending, decelerated in the fourth quarter, rising 2.0% after increasing 2.8% in the third quarter. Purchases of durable goods rose 4.2% in the fourth quarter, after increasing by 4.5% July through September. Fourth-quarter nondurables spending rose by 1.9%. Services spending climbed 1.6%. Overall, consumer spending contributed 1.37 percentage points to GDP October through December; it had contributed 2.01 percentage points in the third quarter.

I’m amazed that consumer spending continued to expand, though again I’d note that inflation grew faster, meaning real growth in consumer spending was negative. And a not insignificant part of consumption growth was likely from gasoline purchases. What were the inflation readings?

The price index for personal consumption expenditures rose by 3.9% after increasing 1.8% in the third quarter.

The much-watched PCE price gauge excluding food and energy increased 2.7% after rising 2.0% in the third quarter.

The price index for gross domestic purchases, which measures prices paid by U.S. residents, rose 3.8% after increasing 1.8% in the third quarter.

If you don’t drive or eat, inflation was a mere 2.7%. If you do, it was near 4%. [Another post this week will discuss why, despite these elevated inflation numbers, some folks still fear DEFLATION more than inflation. It's a fascinating debate....]

But as credit is tightening, so is the consumer’s ability to finance incremental consumption. Without credit, 2008 will likely show a contraction in consumer spending. Since it drives 70% of the economy, a decline in consumption will most likely mean GDP contracts in the aggregate.

The stock market, incidentally, may cheer this number. The fact that GDP growth came in below economists’ expectations will give the Fed extra incentive to cut interest rates this week. Right now Fed Funds futures are assuming a 50 bps cut in the target rate. Count on it.

This, of course, is unfortunate. Cutting interest rates won’t solve our economic problems, it will just mask them with cheap money. A good way to think about this is to look back at BKUNA’s recent earnings call.

On it, the Florida bank’s management team spoke about the benefit they’ll derive from lower interest rates. Lower rates will help option ARM holders refinance into fixed rate mortgages. That’s not a bad thing in and of itself. But throwing more credit at housing only serves to keep prices high. We know, based on housing’s historical relationship to median income, that prices are still way to high. To bring sanity back to that market, prices must revert to the mean. Cheap credit keeps that from happening, it keeps the bubble from deflating.

[It's interesting that BKUNA would want folks to get out of ARMs and into fixed rate mortgages. The bank makes more money on ARMs, or should after rates adjust upward. But they know better than anyone that as ARMs reset, borrowers will simply mail in the keys and walk away from the property......]

Anyone remember Countrywide’s 3rd quarter conference call, when Mozilo said the company would be able to return to a profit in the 4th quarter? Didn’t happen:

The latest results included $1.62 billion in write-downs on its mortgage-servicing rights — which was more than offset by $1.99 billion in hedging gains — and $394 million in write-downs on $7 billion in loans it was unable to sell due to “disruption in the capital markets and a severe lack of liquidity.” The quarter also had $87 million in restructuring charges.

Revenue fell 58% to $1.16 billion from $2.76 billion.

The mean per-share loss estimate of analysts polled by Thomson Financial was 30 cents on revenue of $1.72 billion.

“While considerably improved from the previous quarter, Countrywide’s results for the fourth quarter of 2007 were adversely impacted by further credit deterioration across the industry and continued illiquidity in the secondary mortgage markets,” said Chief Executive Angelo Mozilo.

Loan production fell to $61 billion from $90 billion in the third quarter. Delinquency rates on conventional loans, prime home equity loans and subprime loans all rose from the third quarter. As of Dec. 31, 33.6% of subprime loans are delinquent, compared with 29.1% in the third quarter. Conventional loans saw its delinquency rate climb to 5.76% from 4.41%.

The company’s provision for credit losses rose sharply to $924 million from $72 million a year earlier, but dipped from the third quarter’s $937 million. Net charge-offs, loans it doesn’t think are collectable, rose to $192 million from $14 million. Non-performing assets rose to 2.9% of total assets from 1.65%.

BankUnited’s earnings call late last week was chock full of quotes that are worth noting for the record. I will post again once I’ve been through their detailed financials. In the meantime, this should entertain:

–Mgmt noted that the stock is down (to $5, from a 52 week high near $29). This they blamed on “unregulated short sellers, the market and the general economic climate.” Hmmm. Nothing to do with the asset side of your balance sheet? The fact that 60% of the loan book is Option ARMs? Maybe it’s that 53% of the residential loan portfolio is in Florida, 9% is in California, and 7% is in Arizona….the bubbliest of the bubble states? Or maybe it’s becuase 92% of the $7.5 billion OptionARM portfolio, 55% of the total residential loan portfolio, is accumulating negative amortization?

Yup, must be those nasty short-sellers.

–A year ago, because BKUNA had “no non-performing assets….[the bank] had no structure to handle” NPAs. So they’ve now built up a team of 50 “from scratch.”

–Mgmt trumpeted multiple times on the call that they have “no exposure to subprime.” Fair enough. Though they didn’t care to mention that only 17% of the residential loan portfolio was full doc/employment verified. The rest is stated income, low doc or no doc. This fact they buried literally at the bottom of their earnings press release.

–Mgmt has a strategy to improve shareholder returns, they plan a return to their roots in “retail banking.” What’s a key pillar of this strategy? “Wealth management.” Oh, the irony. One wonders: will there be much wealth left to manage in Florida after the state’s housing mess works itself out?

–They seemed to make a big deal that 2006 vintage mortgages were the only ones popping up in NPAs and therefore the problem is manageable. Anyone else think 2005 and 2007 vintages will continue to perform just fine?

–Lest we all be fooled, management emphasized that “Florida is thriving!” And that “employment losses in construction are being absorbed.” Management is downright happy to be in Florida, which they describe as “one of the best markets, if not the best” to be in.

–At the end of management’s monologue about the quarter’s results, they noted that the bank will weather the housing storm because they have an “excellent management team.” No comment.

Oh, by the way, not once during the half-hour monologue did management mention negative amortization. Nevermind that NegAm made up 63% of net interest income in the quarter.

Then the call moved into the Q&A session…….

Q: Loan loss reserves increased from $59 million in the Sept. quarter to $118 million in the most recent quarter, but NPAs (again: non-performing assets) were $431 million, up from $209 million. Doesn’t it seem like reserves should be higher given the rapid increase in NPAs?

A: If NPAs continue to increase, reserves will increase. But we “don’t anticipate a reserve increase of this magnitude next quarter.”

Q: What happens if the nation falls into recession?

A. We think South Florida, where our loans are concentrated, is “resistant” to recession. All the “immigrants” coming from Latin America, you see.

Q: For non-performing loans, how are LTVs varying from the time when those loans were originated?

A: LTVs on NPLs is 90%, up from an average of 78% at origination. 9% of the increase is due to a decline the valuation, 3% is due to NegAm.

Q: S&P has estimated that losses from subprime loans will reach 30%. Thoughts?

A: S&P clearly messed up their ratings on debt securities so we’re not inclined to trust their estimates now. And remember we didn’t get involved in subprime. We never had 1% start rates. Those “are a joke!” [Note: high dudgeon!] Our disposal costs are 11%. That includes losses due to valuation, “but doesn’t include carrying costs.”

Q: How much of the residential portfolio is 30-89 days past due?

A: Last quarter it was $234 million and we anticipate this quarter’s number will be “slightly above” that when we release it. [They found the number later during Q&A, it was $290-$300m, up a "slight" 27%]

Q: How will lower interest rates impact you?

A: They will benefit us. As rates come down and conforming limits go up, more people will be able to refinance. [Anyone else peeved that the Fed is pumping liquidity back into the market? Or that taxpayers, er, Fannie and Freddie will take on more risk?]

As part of the “stimulus” package Congress is set to approve, we’re about to put taxpayers at far greater risk from the housing collapse. One of the most dangerous parts of the package is raising the threshold for “conforming” loans, which will raise, from $417,000 to perhaps $730,000, the value of mortgages Fannie Mae and Freddie Mac are allowed to guarantee. Already Fannie and Freddie back over $4.0 TRILLION of single-family home mortgages, hundreds of billions of which are subprime, Alt A, high LTV, low FICO, etc. And they have only $80 billion of capital to absorb losses. What does that mean in English?

Take a simple analogy. Say you buy a $100,000 house and put down 2%. If the value of the house falls 30%, you suddenly owe $98,000 on a house that’s worth $70,000. You might simply choose to walk away from that debt. Foreclosure looks bad on your credit report, but that’s a better option than lightening your bank account $28k unnecessarily.

Fannie’s and Freddie’s $80bn cushion is about 2% of the total debt that they back. The value of the mortgages on their books have to fall only a few percentage points for their capital to be wiped out.

Once upon a time, circa 2006, when home values could “never decline,” no one thought much of the risk at Fannie and Freddie. If house prices are always rising, then mortgage debt is easy to refinance, insulating the two giants from losses. But in our brave new housing world, where prices are likely to fall nationally and by as much as 30%, Fannie and Freddie will absorb massive losses.

Unfortunately, Fannie and Freddie can’t just mail their keys to a bank and let the bank handle the problem. Well, actually they can. The trouble for the rest of us is that their bank is the U.S. Treasury.

Limiting the value of “conforming” mortgages to $417k helped to limit the growth of Fannie’s and Freddie’s mortgage portfolio. And it prevented the two from funneling additional financing into the frothiest markets where homes are often priced higher. Raising the limit to $730,000 could help holders of as much as $500 billion of mortgage debt refinance into newly conforming loans. They get lower interest rates, taxpayers take on the risk.

But don’t take my word that this is a bad idea. Ask James Lockhart, the chief regulator who oversees Fannie and Freddie:

We are very disappointed in the proposal to increase the conforming loan limit [above $417k] as we believe it is a mistake to do so in the absence of comprehensive GSE regulatory reform. [Government Sponsored Enterprises = Fannie and Freddie] To restore confidence in the markets we must ensure that the GSEs’ regulator has all the necessary safety and soundness tools.

Fannie’s and Freddie’s poor risk management and accounting practices put taxpayers at even great risk. Both have been mired in an accounting scandal the last few years due to problematic accounting.

Perhaps it’s useful to think about why the government is making this move. The private mortgage lending market is slowing considerably, and for good reason: lenders bear more risk when properties are falling in value. Since many sober economists are now predicting house prices could decline 30% nationally, that’s pretty much all properties.

Borrowing to buy properties valued below $417k remains easier because lenders can sell these mortgages to Fannie Mae and Freddie Mac, who will package them into mortgage-backed securities and sell them off to investors. Investors are willing to buy them because Fannie/Freddie have the backing of the Federal Government. And they have to invest their billions somewhere. The MBS market is the only one that can suck up all that capital.

The value of the government’s implicit guarantee backing mortgages is easily seen in the differing interest rates between conforming loans and non-conforming loans.

It makes sense that loans backed by taxpayers would be available at lower interest rates than those not backed by taxpayers.

——–

At this point, prices have to correct in the housing market. Taxpayer subsidies backing mortgage loans artificially inflates house values.

I’m not arguing that we should simply let house prices collapse. A slow unwind is preferable to a sudden crash. But prices must be allowed to fall or the market won’t repair itself. A recipe for long-term economic stagnation is to keep funneling taxpayer subsidies to borrowers so that house prices remain elevated.

If there’s a lesson to be learned from capitalism’s triumph over communism it is simply this: free markets determine prices and the allocation of resources far more efficiently than government. More government will make the housing problem worse.

It was another bad quarter for BankUnited in Florida.

Non-performing assets jumped:

The ratio of non-performing assets as a percentage of total assets increased to 2.99% at Dec. 31, 2007, up from 1.39% at Sept. 30, 2007. The allowance for loan loss was $117.7 million at Dec. 31, 2007, compared to $58.6 million at Sept. 30, 2007, and $39.2 million at Dec. 31, 2006. The allowance for loan losses as a percentage of total loan portfolio was 0.93% at Dec. 31, 2007, compared to 0.46% at Sept. 30, 2007, and 0.34% at Dec. 31, 2006.

The majority of loans on its balance sheet carry negative amortization:

As of Dec. 31, 2007, BankUnited’s option-ARM balances totaled $7.5 billion, which represented 70% of total residential loans and 59% of total loans. For the quarter ended Dec. 31, 2007, the growth in negative amortization was $47 million, compared to $48 million for the quarter ended Sept. 30, 2007. Of the $7.5 billion in option-ARM balances, $6.9 billion had negative amortization of $317 million, or 4.2%, of the option-ARM portfolio.

Excluding the provision for loan losses, “operating earnings” were $17.3 million. Negative Amortization, that is interest income from option ARM loans recorded on the income statement not actually received in cash, was $48 million……back that out and the company’s operating earnings were negative.

More later.

That’s a question I’ve been getting from some readers recently. Notwithstanding this afternoon’s dramatic rise in stocks, the first 2.5 days of the week made it look as if the world was coming to an end. After Bernanke lowered interest rates, stocks fell dramatically anyway, before climbing back a bit Tuesday afternoon. It was Tuesday morning that a reader asked, why isn’t the government doing more?

To which my reply was: what is the government going to do? Bernanke just made an emergency rate cut, the largest in years. Bush and the Democrats are busy outbidding each other on a “stimulus” package. What else can they do? The reader suggested the government offer to bailout failed banks. But the government already backs GSE debt I responded. If the shit really hits the fan, if house prices decline 30% nationally as so many have predicted (most recently Merrill’s chief economist), you can bet Fannie and Freddie will fail. That alone could cost more than the S&L scandal. How many more failed banks is the government supposed to back? And which ones? And how do you make that decision now before any have failed?

Politicians are short-run thinkers always in ass-covering mode. If the economy implodes they’ll want to be able to say they at least tried to do something. Nevermind that acting too soon will tie their hands when action is more desperately required later on.

Indeed, all this action strikes me as ludicrous. Wall Street yells loud enough in their ears and Congress and the Fed decide they have to act. But are their actions helping? The rate cuts I can understand: even though aggressive easing threatens an unhealthy unwind of dollar-denominated securities, you can plausibly argue that with bank balance sheets shrinking, deflation is the real threat. [Remember, in a monetary system that relies on fractional reserve banking, money is largely created as banks make loans. As their balance sheets shrink, so does their lending capacity.....as the supply of credit goes, so goes the supply of money].

What I don’t understand is the “stimulus plan.” Today the Wall Street Journal reported that Ds and Rs are both looking to expand it. Before the latest market hiccup, the Democrats were pushing for rebate checks for all Americans whereas Republicans were talking about tax breaks for individuals and incentives for business investment. Now they’re working on a bill that combines BOTH ideas.

The Senate Banking Committee Chairman thinks the government should buy deeply distressed mortgage assets. I’m all for buying distressed mortgages, but that activity is best left to expert investors.

It’s good to see candidates fumble in this mess because many are betraying utter ignorance of basic economic principles. Hillary and John Edwards argue we should be “freezing interest rates” on ARMs for 5-7 years. Have they considered the interest rate penalty everyone else will face? Interest rates are prices. Fixing them is tantamount to fixing prices. Go ask the Venezuelans what price-fixing does to economic activity.

The answer is it stops it. Our economic problems can either be allowed to work themselves out, or allowed to fester for years.

There are no good choices right now. The government’s true failure was allowing banks to create this systemic crisis in the first place. You can tell from this strident rant of a post that I favor laissez-faire, supply-side economics. Yet moderation is called for. Just as banks have risk management departments to check the activities of rogue traders, the government should have some basic regulatory structure to prevent systemic crises. Ad hoc of course.

All we would have needed in this latest crisis were regulations limiting subprime lending practices, and perhaps rules about rating agencies getting paid by the underwriters of the bonds they’re rating. That’s all. Simple stuff. Hardly socialist.

What bothers me, at the end of the day, is that Congress and the President appear to be panicking even BEFORE we’ve entered recession. If ever a steady hand was called for, it is now. Too bad we haven’t elected any.

It has occurred to a few commentators that repeal of the Depression-era Glass-Steagall Act may be partly to blame for the banking and real estate morass we find ourselves in today. Glass-Steagall, you may or may not recall, effectively locked commercial banks and investment banks out of each others’ businesses. It was felt at the time the law passed, that the Great Crash was exacerbated because commercial banks had been allowed to underwrite securities and had therefore exposed depositors to stock market risk…..(to the extent that their deposits disappear if the bank saw heavy losses from its exposure to the stock market).

Ironically, the Greenspan Fed began to gut the act in the 80s, in the middle of our last banking crisis.  Its full repeal came a year after Citicorp and Travelers announced their merger in 1998.  Since then, for instance, Citigroup can take depositors’ money while at the same time exposing its balance sheet to immense risks by way of massive leverage. The idea that commercial banks should principally be concerned with protecting depositors’ capital seemed quaint in the late 90s I guess.

Here is a fascinating passage from a Frontline report published in 2003 regarding the repeal of Glass-Stegall [Though not repealed until 1999, various provisions of the act were "reinterpreted" or otherwise overridden in the 20 years leading up to its full repeal]:

In the spring of 1987, the Federal Reserve Board votes 3-2 in favor of easing regulations under Glass-Steagall Act, overriding the opposition of Chairman Paul Volcker. The vote comes after the Fed Board hears proposals from Citicorp, J.P. Morgan and Bankers Trust advocating the loosening of Glass-Steagall restrictions to allow banks to handle several underwriting businesses, including commercial paper, municipal revenue bonds, and mortgage-backed securities. Thomas Theobald, then vice chairman of Citicorp, argues that three “outside checks” on corporate misbehavior had emerged since 1933: “a very effective” SEC; knowledgeable investors, and “very sophisticated” rating agencies. Volcker is unconvinced, and expresses his fear that lenders will recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public. For many critics, it boiled down to the issue of two different cultures – a culture of risk which was the securities business, and a culture of protection of deposits which was the culture of banking.

Hah! Boy was Volcker right. And isn’t it hilarious (tragic?) that the government was duped into believing that the SEC, “knowledgeable” investors and “sophisticated” rating agencies could protect the banking system from repeating the mistakes of 1929?

Would Glass-Steagall have prevented the current credit crisis?  Probably.  Clearly credit excesses could have been contained if underwriters and loan officers were still competing with one another instead of conspiring with one another.

What is clear is that the securities industry can’t be trusted to police itself. Greenspan argued we shouldn’t regulate mortgage lending. Do people still believe he made the right call on that one? The fact that hedge funds aren’t regulated is foolish. After the LTCM debacle you’d think the financial system would wise up and prevent single-players from building themselves into systemic time bombs. Yet 10 years on, the situation is far worse. Don’t believe me? Wait a year.

[Update 3/16/08: Bear Stearns.....the first domino to fall. Funny how the Fed responds by offering investment banks access to its discount window, something that's never been done before. So investment banks get access to Fed loans without being subject to any Fed regulation. Talk about a bailout.]

By the way, I recommend reading the full Frontline post at the link above. The key banking figure that appears to have promoted the gradual erosion and then repeal of Glass-Steagall in addition to supporting the merger of Citicorp and Travelers is none other than the man who, arguably, created the housing bubble……Alan Greenspan.

A priceless moment on Capitol Hill the other day. Marcy Kaptur is the Democratic Congresswoman from Ohio’s 9th District. She’s been in Congress since 1983.

The woman is on the House Budget Committee and she doesn’t know the difference between the Fed Chairman and the Treasury Secretary. Folks, these are the people helping to steer our economy……

If you’ve been surfing the economics blogosphere recently, you’ve likely seen charts of various economic indicators pointing towards a recession. Forthwith, my (growing) collection. Lots more of these out there. If you’ve got one to add, send it our way:

YoY change in unemployment, by month. From the NYT:

Credit Card Trends, (via the NYT, hat tip Mish):

Manufacturing sentiment. The Philadelphia Fed’s general economic index:

Money Supply (using the “M Prime” calculation of the Von Mises Institute, again thanks to Mish). Check out that link for a full explanation of the M Prime money supply calculation. Fascinating read.

Housing Starts and Completions (hat tip CR):

The Philly Fed’s calculation of states with increasing activity. Thanks to CR.

…..to drop, that is. The large bond insurance companies, Ambac and MBIA, may soon see their debt downgraded to junk like their smaller cousin ACA. This will make the insurance the two have written against bond defaults virtually worthless. The fear many have is the havoc this could cause in municipals. I’m not as concerned with that piece of the market; Warren Buffett’s Berkshire Hathaway is gearing up to insure high quality municipal issues. And with $40 billion of cash on its balance sheet, Berkshire Hathaway is in a good position to write insurance. Besides, default rates on municipals have always been close to zero. There will clearly be disruption in the municipals market, but not the widespread bloodletting that we’re seeing with securities tied to subprime. At least I hope not.

My concern is about counter-party risk. As the WSJ reports today, the monolines tried to goose net income by insuring abstruse derivative contracts from the structured finance world. These guys facilitated bets that were being placed by hedge funds and others who bought credit default swaps and other securities that pay off in the event an issuer defaults on its debt.

Here’s an instructive image from the WSJ article:

Ambac and MBIA are two of the largest players on the left side of the chart. If they go under, the contracts held by those on the right side that dealt with them are effectively worthless. It’s hard to know what the impact will be if hundreds of billions of derivative contracts suddenly have zero value.

One thing’s for certain, it would lead to billions more in write-downs at the major Wall Street banks, which will further reduce their capacity to lend.

[At the risk of going off on a tangent here, this is a big reason many argue inflation really isn't a big threat right now. Inflation literally refers to currency losing its value. Currency loses its value when there is more of it relative to the amount of goods and services available in the economy for purchase. How is money created? Primarily through fractional-reserve banking, which is a technical term that refers to the process by which banks create money when they make loans. But as banks write-off billions, their capacity to lend is reduced. To the extent that banks aren't able to make new loans, they are taking money out of the economy. That's why Japan faced the threat of deflation for so long even though their interest rates were effectively zero. Banks didn't have any money to lend.]

Back on topic, a good quote from the article regarding potential new writedowns:

Bill Gross, chief investment officer at PIMCO, recently told investors that if defaults in investment-grade and junk corporate bonds this year approach historical norms of 1.25% (versus a mere 0.5% in 2007), sellers of default insurance on such bonds could face losses of $250 billion on the contracts. That, he said, would equal the losses some expect in the subprime-mortgage arena.

The trouble is, Ambac, MBIA and the other insurers behind these contracts don’t have sufficient capital to pay out in the case of defaults. A way to think about it is to imagine an insurance company not carrying enough capital to pay off insurance policies written to homeowners hit by a catastrophic storm. $250 billion is a rather catastrophic storm alright. One the bond insurers clearly wouldn’t survive.

With no central trade processing of credit-default swaps, defining trading-partner risks can be a Herculean task. Mr. Buffett learned the difficulty of unraveling such complex instruments in 2002 when he directed General Re Corp., a reinsurer that had been acquired by his Berkshire Hathaway Inc., to pull back from the business of these swaps and other derivatives. It took General Re four years to whittle the business from 23,218 contracts to 197 by the end of 2006.

Doing so involved tracking down hundreds of counterparties to General Re’s trades, many of which Mr. Buffett and his colleagues had never heard of, he says, including a bank in Finland and a small loan company in Japan, to name just two. One contract, Mr. Buffett says, was designed to run for 100 years. “We lost over $400 million on contracts that were supposedly” safe and properly priced, “and we did it in a leisurely way in a benign market,” Mr. Buffett says. “If we had to unwind it in one month, who knows what would have happened?”

Buffett has also referred to derivatives as financial weapons of mass destruction. A tongue-in-cheek comment when he uttered it. We’re likely to see them wreak more havoc with the banking system over the next year……

I hope the system survives.

Below is an e-mail I received from a friend who was manufacturing CDOs for a big bank until very recently. The guy knows his stuff and offered the following thoughts. To follow his thinking, you might want to open up the image in another window and toggle between that and his analysis.

My question to him was whether bigger writedowns are still to come from Citi and other banks. You’ll notice he comments about the havoc that will be caused if the “monolines” go under. Monolines are the insurers that back risky mortgage bonds, MBIA and Ambac. Take a look at their stock prices recently.

-RW

disclosure is very uneven. Really, the market wants each company’s full inventory out there. But companies won’t put that out for the same reason they won’t list all the stock positions they have on each desk- it puts them at a comparative disadvantage when they try to take on or put off risk. True, since EVERYONE KNOWS all the banks are trying to throw risk off, it probably matters less if they do this, but I think that the banks know that as soon as they disclose specific deals, the press will start picking apart the worst of them on front pages. Lots of banks have deals that Ralph Cioffi or Chris Ricciardi or someone else at risk of being in a high-profile lawsuit were in, and if they disclose these, they’ll be linked with those guys, even if they just bought the positions in the secondary market.

for fun, I looked at Citi’s 8K today: here are the money lines:

1) Write-downs of $17.4 billion, on sub-prime related direct exposures. These exposures on September 30, 2007 were comprised of approximately $11.7 billion of gross lending and structuring exposures and approximately $42.9 billion of net ABS CDO super senior exposures (ABS CDO super senior gross exposures of $53.4 billion). On December 31, 2007, sub-prime related direct exposures were comprised of approximately $8.0 billion of gross lending and structuring exposures and approximately $29.3 billion of net ABS CDO super senior exposures (ABS CDO super senior gross exposures of $39.8 billion). See detail in Schedule B on page 12.

Schedule B (if the image below doesn’t appear, try hitting refresh. If it still doesn’t work, go to sec.gov and pull up Citi’s most recent 8-K filing):

So what I see from this: it’s hard to know exactly how severe the writedowns are, because it is not clear that the assets were being held at par to start with. I’d say that given the breakdown of product types and assuming the the price of the mezzanines was already written down some, the numbers look like reasonable writedowns from what I remember. But you’ll see the ‘hedged exposure’ of 10.5B is treated solidly with a reserve of less than 1B: I imagine that is almost all held against monolines, and I would expect that the bonds they are written on are all crap, since Citi sold most of the better stuff’s Supersenior on the ABCP market. If the monolines go bad, I think you can expect at least another 5B of writedowns in CDOs alone, maybe more.

Furthermore, I’d imagine that the real impact of the monoline downgrades is in the muni and corporate bond markets, because those are their main businesses. No one is really looking there now. The banks won’t be the main people hurt there, but I wouldn’t even know how to quantify the loss of value. would be tremendous.

Anyways: favorite line from this chart: unsold ABS tranches: previously worth $2.7B, writedown of $2.6B, now worth $0.1B. Wow.

Is the smart money really that smart? Remember how, back in August, B of A’s $2.0 billion investment in Countrywide was interpreted as a vote of confidence? Investors voted by bidding up the shares significantly the day of the announcement. Watching CNBC this past week, the Power Lunch anchor asked Felix Rohatyn if the conventional wisdom, that BofA’s planned acquisition of CFC signaled a bottom, was correct. Felix, playing the cheerleader like a good investment banker, said yes.

That got me thinking. Have past capital infusions signaled bottoms? Clearly not, as the table below demonstrates. Starting with the fifth column from left, I’ve listed the stock price just prior to the announcement of the capital infusion. The “high, post” column lists the stock’s high after the announcement. Then the date when that high was reached. And if you scroll to the right, you’ll see where the stocks’ prices are today, and the percentage change from the high after the announcement…..drum roll please…..

So is the smart money smart? Well in some cases no, for instance B of A’s August investment in Countrywide. But as was pointed out on Minyanville yesterday, the latest capital infusions are coming with so-called “ratchet” provisions. What are those you ask? Let Minyan Peter explain (hat tip to Mish):

In the terms for both the Merrill (MER) and Citigroup (C), convertible transactions are “ratchet” provisions. For those not familiar with the term, when an issuer agrees to a ratchet, it gives the security holder the right obtain better terms in the future under certain conditions.

Specifically, (and in a nutshell) should Merrill issue more than $1.0 of additional convertible equity, or Citigroup $5.0 billion in the next year at a lower conversion price, the holders of the deals announced this morning can get the new price.

For existing Citigroup/Merrill shareholders, should such a further capital raise occur at a lower stock price, their dilution will be significantly compounded because of the ratchet.

At least to me, the inclusion of a “ratchet” for both of these companies suggests that, while still available, the true price for incremental capital has gone up significantly.

Shareholders in troubled financial services companies should not take this lightly.

Remember when AAPL was forced to drop the price of the iPhone from $499 to $399? Obviously that pissed off all the folks that had paid $499 only a couple months before. AAPL gave prior customers a “ratchet provision” of their own, offering them rebates on the higher price they paid.

Sovereign Wealth Funds clearly want to protect themselves from further deteriorations in the stocks of the financial companies they’re bailing out. Put simply: they’re not confident in the price they’re paying today. Or if they are, they want to be protected if they’re wrong. It doesn’t matter, the result is the same: existing bank shareholders may have their holdings diluted twice. Today, as they sell pieces of their banks to SWFs in exchange for capital infusions and also in the future when SWFs come back to demand rebates on the price they paid in the first place. They only get a rebate if these companies have to go back to the well for more capital and are forced to offer a better price at that point. But that seems likely to me for some reason!

These investments may protect bank balance sheets, but they ARE NOT bullish signals on the continuing earning power of the banks’ underlying businesses.

Not everyone is losing from the subprime mortgage bomb. Hedge-funder John Paulson is said to have earned $3-$4 billion last year profiting from the implosion of subprime mortgages. That’s cash folks. Not the kind of illiquid paper wealth that Bill Gates or Warren Buffett have. And Paulson earned it in one year. The previous record for hedge fund compensation I believe was set last year when John Arnold at Centaurus was on the other side of the trades that drove Amaranth under. It is believed that Arnold made $1.5 to $2.0 billion in 2006.

George Soros, perhaps the most famous hedge funder of them all, made his mark when he “broke the Bank of England” in 1992. That trade reportedly netted him $1 billion. Plenty of course, but his mark has now been surpassed by at least the two guys above.

There’s lots of interesting stuff to talk about here. How is it that these guys made so much money? Well the first thing readers need to understand is the compensation structure of a hedge fund. I spent five years at one so I know this structure well. The key is 2 and 20.

A management fee of 2% is charged on assets under management, analogous to the management fee that you pay when you invest in a mutual fund. In addition, most hedge funds keep 20% of profits as well.

So for instance: say XYZ Fund begins with $100 million of assets and rises 50% over the course of the ensuing year. At the end, assets under management are $150 million, of which profits are $50 million, 20% of which is $10 million. Oh and there’s the $2 million management fee collected during the year too.

You understand now why Wall Street traders want to be hedge fund managers, not mutual fund managers. They get paid very handsomely to bet big with other people’s money.

Some hedge-funders take 50%(!) of profits, like Steve Cohen at SAC Capital. Why are investors willing to pay ridiculous fees like this? Because some managers are really THAT good. SAC reportedly returned 13% this year AFTER that hefty fee, significantly beating broader market indices.

Lots of hedge fund managers certainly AREN’T worth outsized fees. Guys like Paulson are.

Paulson earned his pay because he figured out HOW to profit from the decline in subprime mortgages. And because he bet big. Think about that problem for a second. You know house prices are going to fall. But how do you place a multi-billion dollar bet on that outcome? You can short housing stocks, but there are only so many stocks out there to short. And anyone who’s ever shorted a stock knows that it can be VERY difficult to borrow enough shares to make a bearish bet of substantial size.

Paulson used highly complex trading strategies involving credit derivates and indices tracking subprime mortgage backed securities. Trades like this aren’t available to individuals. They must be structured through an investment bank and are typically only available to large institutional investors.

Now for the numbers behind Paulson’s gains. According to the WSJ, Paulson’s firm began the year managing $7 billion. His two primary funds returned, get this, 590% and 350% respectively. That’s in one year folks.

Good traders learn how to profit from volatility.

The kicker to this story is that Paulson–who’s not related to the Treasury Secretary–just hired Alan Greenspan, the man many blame for creating the subprime crisis in the first place.

Oh and by the way. Hedge fund profits aren’t taxed as income, they’re taxed as so-called “carried interest.” What does that mean? Paulson will likely pay 15% on his 2007 windfall, not 35% like the rest of us…..that’s an extra $700m the tax man can’t get his hands on…..