Rolfe Winkler

The Federal Reserve will print money to buy $500 billion worth of mortgage-backed securities by June, specifically MBS issued by Fannie, Freddie and their sister Ginnie Mae.  And guess who the Fed has hired to manage the purchases?  PIMCO, Goldman, BlackRock and Wellington.

This is quite a scam for all of them, especially PIMCO.  The ultimate self-bailout you might call it.  As of June 30th, 61% of the PIMCO’s assets were invested in MBS.  $500 billion in total.  No doubt the others also own a pile of Fannie/Freddie/Ginnie bonds.

In sum, these firms just got hired to use the public’s money to buy assets from themselves. (Or, as Mr. Mortgage puts it, foxes are running the hen house.)

Is it any wonder why PIMCO chief Bill Gross argued so vociferously for Treasury to start buying troubled assets?  In a much publicized investor letter on Sept 4th, he said the following:

If we are to prevent a continuing asset and debt liquidation of near historic proportions, we will require policies that open up the balance sheet of the U.S. Treasury.

To be fair, he wasn’t wrong.  A “debt liquidation of historic proportions” is indeed what would have happened had the Fed and Treasury not stepped in.  And that would have crippled the world economy.  But Gross, the largest bond fund manager on the planet, may have been hardest hit of all.

Once upon a time, the Chinese owned hundreds of billions worth of MBS themselves, as did the Russians.  But when Fan and Fred collapsed, the foreigners skedaddled.  Can you blame them?  They had invested their people’s hard-earned savings in piles of Fannie and Freddie debt which, save for a U.S. Treasury guarantee, would have fallen precipitously in value.  Now the government has to make good on that guarantee, buying up all these MBS that no one else wants.

The Fed argues this will boost housing by lowering mortgage interest rates.  In reality, lower rates may actually “spur a new wave of defaults.”

By the way, the Fed will “monitor” each firm to avoid conflicts of interest:

Each investment manager will be required to implement ethical walls that appropriately segregate the investment management team that implements the Federal Reserve’s agency MBS program from other advisory and proprietary trading activities of the firm. The New York Fed will monitor each investment manager’s compliance with this requirement.

Good thing we have “ethical walls” to protect taxpayers.

As the Obama administration prepares its trillion-dollar “stimulus” package, economists like Paul Krugman are providing rationalizations for why such a package is necessary.  In his column today, he expands his spend-anything-to-get-the-economy-going-again argument, excoriating indebted states and municipalities for cutting back.  He makes it clear that his preferred solution would be for the Federal Government to take over state budget items currently facing cutbacks.

Naturally, he says nothing about where this money is supposed to come from.  Regular readers of this blog know there are only two places the money can come from: taxpayers or the printing press.

His column deserves to be taken apart piece by piece:

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Finally, a good article in the NYT’s series “The Reckoning.”  Past articles in this series have been weak, as Yves noted over at Naked Capitalism.  Besides the two pieces she cogently criticized, I was unimpressed with the story on Herb and Marian Sandler, the inventors of the option ARM.  I felt useful details were left out.

Lucky for NYT subscribers, the latest installment in the series, this one about WaMu, is quite good.

There are colorful stories about unqualified borrowers:

[E]ven by WaMu’s relaxed standards, one mortgage four years ago raised eyebrows. The borrower was claiming a six-figure income and an unusual profession: mariachi singer.

Mr. Parsons could not verify the singer’s income, so he had him photographed in front of his home dressed in his mariachi outfit. The photo went into a WaMu file. Approved.

More colorful stories about, um, unqualified loan officers:

“I’d lie if I said every piece of documentation was properly signed and dated,” said Mr. Parsons, speaking through wire-reinforced glass at a California prison near here, where he is serving 16 months for theft after his fourth arrest — all involving drugs.

Details about the “sweatshop” atmosphere in which WaMu employees pitched loan products:

Branches were pushed to increase lending. “It was just disgusting,” said Ms. Zweibel, the Tampa representative. “They wanted you to spend time, while you’re running teller transactions and opening checking accounts, selling people loans.”

Employees in Tampa who fell short were ordered to drive to a WaMu office in Sarasota, an hour away. There, they sat in a phone bank with 20 other people, calling customers to push home equity loans.

“The regional manager would be over your shoulder, listening to every word,” Ms. Zweibel recalled. “They treated us like we were in a sweatshop.”

Referral fees paid by WaMu to real estate agents, who often advised clients to take WaMu loans virtually guaranteed to blow up:

WaMu’s retail mortgage office in Downey, Calif., specialized in selling option ARMs to Latino customers who spoke little English and depended on advice from real estate brokers, according to a former sales agent who requested anonymity because he was still in the mortgage business.

According to that agent, WaMu turned real estate agents into a pipeline for loan applications by enabling them to collect “referral fees” for clients who became WaMu borrowers.

And why no one in the executive ranks at WaMu cared to stop any of it:

For WaMu, variable-rate loans — option ARMs, in particular — were especially attractive because they carried higher fees than other loans, and allowed WaMu to book profits on interest payments that borrowers deferred. Because WaMu was selling many of its loans to investors, it did not worry about defaults: by the time loans went bad, they were often in other hands.

Loan production was the name of the game.  More loans equaled higher “profits” equaled bigger bonuses.  Risk management was the last thing on anyone’s mind.

There’s more great stuff in the article.

Check it out folks, the White House is in foreclosure.  The Atlanta White House that is.

Above is a picture of 3687 Briarcliff Rd, NE in Atlanta, Georgia.  The 7 BR, 5.5 bath, 16,500 square foot behemoth is on the market for $9.9 million according to the Atlanta Journal Constitution:

Owner Fred Milani, a builder of luxury homes, has 10 finished houses in the area waiting for buyers, and a lender has threatened foreclosure. He needs money.

So he’s put his home of seven years, the White House, on the market for $9.88 million, the 12th most expensive listing in metro Atlanta.  DeKalb [County]’s valuation is much less — $2.8 million.

“I believe in Jesus. He’s always blessed me, and at the last minute he’ll come rescue me,” Milani said Thursday.

According to the article, Milani is paying $50,000 per month in interest on loans for the 10 homes he’s built but failed to sell.

Another problem Milani faces involves a dispute with a lender over payment on a $1.75 million note. That’s led to the White House being scheduled for foreclosure auction Jan. 6, the research firm Equity Depot says. The sale won’t occur if a settlement is reached.

A November foreclosure sale of the White House was headed off when an agreement was struck on payment of a $1.675 million loan, Milani said.

According to a 2004 AJC article, Milani was born a Muslim in Iran, but converted to Christianity in 1995, 16 years after moving to the U.S.  Apparently he’s eager to spread The Word, as you can see from the message on his lawn.

Can you guess Milani’s lender?  IndyMac. (hat tip to Justin for digging up this nugget on RealtyTrac)

I’m not sure Jesus is going to rescue Fred Milani, but maybe FDIC Chairwoman Sheila Bair will.  She’s running IndyMac on behalf of taxpayers ever since Uncle Sam seized it in July and she has been rather aggressive in her efforts to modify IndyMac mortgages in order to avert foreclosures.

Give her a call Fred.  Maybe she can hook you up with a bank charter so you can access the TARP.

…

But seriously folks, with the cost of various bailouts spiraling out of control, how long will it be before Barack has to mortgage the real White House?

CR notes that the savings rate (measured as a percentage of disposable income) is starting to recover:

It looks like savings from lower gasoline prices is showing up as savings – as opposed to other consumption – and this process of increasing savings is a necessary step towards restoring healthy household balance sheets.

See his post for a nifty chart of the emerging recovery in savings.

At the same time, retail sales, particularly for “luxury” goods including jewelry, are getting clobbered.  According to Bloomberg:

Consumers spent at least 20 percent less on women’s clothing, electronics and jewelry during November and December, resulting in what may be the biggest holiday-shopping sales decline in four decades.“It’s been difficult, much more difficult than anyone expected,” Gilbert Harrison, chairman and chief executive officer of retail advisory firm Financo Inc… Consumers “will spend on necessities, they’ll spend on what they need, but they’re being very particular in what they’ll buy.”

And the WSJ notes that even lottery ticket sales are down:

The sour economy is striking the one source of government financing that had been widely regarded as recession-proof: lotteries.

Education programs are a common beneficiary of lottery sales, which fell 2% in the third quarter from a year ago.

Across the U.S., many state lotteries are reporting hefty declines, with ticket sales down nearly 10% in California and more than 4% in Texas over the past few months. In good years, these lotteries have turned over more than $1 billion apiece to education programs, the most common lottery beneficiaries.

Consumption must decline for savings to increase.  It will be painful for the economy, 70% of which is still driven by consumer spending, but increased savings are the only path to sustainable economic recovery.

Haggling is up at the nation’s retailers, according to AP (via Drudge).

If you’re looking for an extra bargain before the holidays, you may only have to ask. With holiday sales shaping up to be the lowest in years, possibly the worst since the industry began annual comparisons in 1969, retailers say they’re taking consumers’ demands for good deals seriously. Some are extending return policies, while others are matching competitors’ prices. Many are volunteering on-the-spot discounts and even letting customers haggle prices well down from what’s marked in a desperate bid to make the cash register ring.

This is to be expected.  With credit tight and unemployment up, there is less money chasing goods and services in the economy.  But store shelves are, for the moment, still stocked with previously purchased inventories.  So supply is high relative to demand.  When supply is greater than demand, prices fall, sometimes quickly.

This is deflation in action.  And Bernanke is panicked about it.

When demand goes down and prices fall, businesses go bankrupt.  When businesses go bankrupt, more jobs are lost and demand falls futher.  Prices continue to fall, leading to still more bankruptcies and job losses. As Bloomberg notes in an article on today’s consumer spending figures (which actually weren’t too terrible):

The deteriorating job market means consumers will probably further rein in spending; economists including those at Morgan Stanley estimate more than 400,000 people will lose their jobs this month.

It’s a vicious circle that policy makers panic about since ever-higher unemployment is a social cancer to be avoided.

The solution proposed, however, isn’t a solution at all because it will only lead to much higher unemployment over the long-term.  The Fed has lowered interest rates to zero and is now planning to “print” money in order to encourage more lending.  If credit is more widely available, folks can borrow in order to spend, inflating demand.

But for how long?  Have we learned nothing from the housing bubble, where excess investment and freakishly easy lending standards pumped prices to unsustainable levels?  Driving people deeper into debt in order to “keep the economy going” is a recipe for short-term stimulus but also long-term disaster.

Debt has to be paid back eventually.  Inflating demand artificially by easing credit standards just encourages more current consumption at the expense of future consumption.  Folks borrowing to buy stuff today will be paying off debt tomorrow.

This is America’s future: working to pay off debt. The more debt we run up today, via ridiculously huge “stimulus” packages, government bailouts and unfunded retirement liabilities (Medicare/Social Security), the more consumption we’ll be forced to forego in the future.

The only real solution is to pay off debt today, which means consumption will fall and businesses will fail.  In short, we need to let the business cycle happen.  Of course this is terrible news for folks who lose their jobs or see their pay cut.  But in the long-run it’s the only real solution.  The more debt we incur to artificially inflate demand today, the more jobs will be lost in the future anyway.

Yes, jobs will be lost if we let businesses fail.  But our consolation will be much cheaper prices on everything from houses to flat-screen TVs!

The FDIC is running out of cash.  Quickly.  In a press release earlier this week, the FDIC noted that the Deposit Insurance Fund shrank considerably last quarter:

The FDIC also announced that in the third quarter, the Deposit Insurance Fund (DIF) decreased by 23.5 percent ($10.6 billion) to $34.6 billion (unaudited). The reduction in the DIF was primarily due to an $11.9 billion increase in loss provisions for bank failures, which represents the estimated losses for FDIC-insured institutions that are likely to fail over the next 12 months. Accrued assessment income increased the fund by $881 million. Interest earned, combined with realized and unrealized gains (losses) on securities, added $653 million to the insurance fund.

According to the Journal article that covered the release, that figure represents 0.76% of total insured deposits ($4.6 trillion) in the U.S.  For instance,  WaMu alone had over $180 billion of deposits, of which about $140 billion were FDIC-insured.

The key fact to understand here is that the Federal Government, via FDIC, is on the hook to bail out bank depositors.  Keep this in mind next time you wonder why the banks have received an open credit line to the U.S. Treasury.  The Federal Government is on the hook to bail out depositors and it doesn’t have the money to do so.  It has to prop them up or let them fail.

What would have happened in early October if the banking system had been allowed to collapse?  Depositors would have run to the bank to discover not only that banks are insolvent, but that FDIC doesn’t have the cash to pay them off.

The FDIC does have an open credit line at Treasury if it runs short of cash. But what would Treasury have done if the whole system collapsed?  Where could it borrow the multiple trillions necessary to bail out, well, everyone?

As large as it is, the $700 billion TARP bailout is small by comparison.  I know the Fed has now agreed to “print” an unlimited amount of money to buy Treasuries in order to keep interest rates low, but could they fund $4.6 trillion of government obligations in one shot?

Three other observations I’d like to make:

• FDIC’s $34.6 billion fund is mostly invested in Treasury bonds.  Like the Social Security “Trust Fund,” it’s invested in IOUs the government has written to itself.  But what is Uncle Sam’s IOU actually worth when he’s already written $60 trillion of them?  (Adding the long-term liabilities for Social Security/Medicare to the trillions of new guarantees made in the last few months.)
• I’m reminded of the Brad Pitt/Edward Norton movie “Fight Club.”  Their plan, you may recall, is to blow up credit card company buildings so that their records disappear and “everyone goes back to $0.”  If the banking system fails, the Federal Government very likely won’t be able to bail out depositors.  Everyone with money in a bank could theoretically go back to $0.
• The $4.6 trillion figure is only insured deposits.  It doesn’t include the FDIC’s new guarantees backing corporate debt under the “temporary liquidity guarantee program.”  Banks including B of A, Goldman, Morgan Stanley, Chase, Citigroup, GE and Wells Fargo are availing themselves of this program, selling tens of bilions of dollars of debt insured by FDIC.  Asset managers are thrilled to scoop up this debt.  They get a little extra yield over Treasuries and a government guarantee to boot!  Nevermind that FDIC doesn’t actually have any cash to pay claims should any of these companies default…

…

I wonder if the $4.6 trillion figure of total insured deposits takes into account the new limit of $250,000.  According to a chart on page 32 of the FDIC’s 2007 annual report, insured deposits as of Sept. 30th 2007 were about $4.1 trillion and growing quickly.  But back then, deposits were only insured up to $100,000.  Did the boost to $250,000 only increase insured deposits by 10%?  Maybe.  I’m not sure.

According to an article on WSJ.com, S&P “took the first step” toward “potentially” lowering GE’s credit rating from AAA.

Credit analyst Robert Schulz warned earnings and cash flow at GE Capital could decline enough over the next two years to warrant a downgrade, and revised the company’s ratings outlook to negative from stable…

Frankly I think this is comical as S&P is moving long after the market decided GE was no longer a top credit.  Would a AAA credit require $139 billion in government guarantees to backstop its debt?

With a leverage ratio over 50:1, GE is at far greater risk than most acknowledge.  Or not, considering that the Fed and Treasury have now extended an implicit guarantee to ALL major financial institutions.  They will not allow another Lehman.  (It’s been said that perhaps the best trade is in the debt of the large financial companies.  Since the government won’t let any more of them blow up, you might as well buy the companies’ bonds whenever they can be had at a tidy discount.)

Benefiting as they are from so much taxpayer largess, it should be a crime that the big banks and GE are still using cash to pay dividends to shareholders.  These companies desperately need to cut leverage.  A great way to do that is to stockpile cash on the balance sheet rather than pass it on to shareholders.

The sorry fact is, GE is not doing enough to raise capital to repair its balance sheet.  Here are the measures they’re planning to take:

GE announced plans several months ago to raise equity, eliminate share repurchases and not increase its dividend for the first time in more than three decades in an effort to defend its AAA rating…

“Not increasing the dividend?”  Wow.  Pretty aggressive.  They have raised cash by selling stock, but GE needs to do more to cut that huge leverage ratio.  Selling businesses for cash would be another step, but that seems unlikely in this environment as no one wants to punt a business at “fire sale” prices.

Earlier this week, GE said it has ended, at least for now, its effort to sell or spin off its consumer and industrial business because of growing skepticism about the conglomerate’s ability to pull off a deal in the current business climate.

No doubt it’s hard to sell a big business when potential buyers probably can’t get credit to finance a purchase.  Of course, there’s always the Merrill Option: finance the purchase of your assets with your own money…

One question regular folks consistently ask about the housing bubble/financial crisis: Why did it go on so long?  Why were bankers putting risky borrowers into toxic mortgage products almost engineered to blow up?

One answer is that no one saw it coming.  “Hoocoodanode?” says CR.  “Who coulda known?”  That’s part of it of course.  Most everyone involved convinced themselves that “house prices never fall.”  If that were the case, borrowers would be able to refinance perpetually and banks would never take losses on their loans.

A more specific answer, however, has to do with the incentive structures for the bankers themselves.  As a decent article in today’s NYT explains, bonuses were driven by short-term profits.  For compensation purposes, the long-term risks involved in generating those profits were irrelevant:

In all, Merrill handed out $5 billion to $6 billion in bonuses [for 2006]. A 20-something analyst with a base salary of $130,000 collected a bonus of $250,000. And a 30-something trader with a $180,000 salary got $5 million.

But Merrill’s record earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has since lost three times that amount, largely because the mortgage investments that supposedly had powered some of those profits plunged in value.

Unlike the earnings, however, the bonuses have not been reversed.

As regulators and shareholders sift through the rubble of the financial crisis, questions are being asked about what role lavish bonuses played in the debacle. Scrutiny over pay is intensifying as banks like Merrill prepare to dole out bonuses even after they have had to be propped up with billions of dollars of taxpayers’ money. While bonuses are expected to be half of what they were a year ago, some bankers could still collect millions of dollars.

Critics say bonuses never should have been so big in the first place, because they were based on ephemeral earnings. These people contend that Wall Street’s pay structure, in which bonuses are based on short-term profits, encouraged employees to act like gamblers at a casino — and let them collect their winnings while the roulette wheel was still spinning.

“Compensation was flawed top to bottom,” said Lucian A. Bebchuk, a professor at Harvard Law School and an expert on compensation. “The whole organization was responding to distorted incentives.”

Even Wall Streeters concede they were dazzled by the money. To earn bigger bonuses, many traders ignored or played down the risks they took until their bonuses were paid. Their bosses often turned a blind eye because it was in their interest as well.

“That’s a call that senior management or risk management should question, but of course their pay was tied to it too,” said Brian Lin, a former mortgage trader at Merrill Lynch.

Bankers and mortgage brokers got paid for generating accounting profits, regardless of the balance sheet risk involved.  In a world of low interest rates (as was the case in the twilight of Alan Greenspan’s term as Fed Chariman), there was huge investor demand for higher-yielding fixed-income products.  Wall Streeters, were happy to oblige, taking investor money and putting it into ever more complex “structured finance” products. CDOs, synthetic CDOs, MBS, etc.  Mortgage lenders and everyone else involved in real estate were themselves getting paid to keep the gravy train rolling.

These complex products generated rich fees up front, when they were packaged and sold.  But what of the long term risks?  The article tracks the career of one particular Merrill Lynch banker:

[In 2006] Mr. Kim’s team was eagerly bundling risky home mortgages into bonds. One of the last deals they put together that year was called “Costa Bella,” or beautiful coast… The $500 million bundle of loans, a type of investment known as a collateralized debt obligation, was managed by [Bill] Gross’s Pimco.

Merrill Lynch collected about $5 million in fees for concocting Costa Bella, which included mortgages originated by First Franklin.

But Costa Bella, like so many other C.D.O.’s, was filled with loans that borrowers could not repay. Initially part of it was rated AAA, but Costa Bella is now deeply troubled. The losses on the investment far exceed the money Merrill collected for putting the deal together…

By the time Costa Bella ran into trouble, the Merrill bankers who had devised it had collected their bonuses for 2006.

And therein lies the rub. Bonuses at every level of the organization—not just traders’ bonuses, but also top executives’ and risk managers’—were tied to this year’s profits, with no future penalty for this year’s deals blowing up later on.  If your current year pay is based on this year’s profits, you’ll work your ass off to maximize this year’s profits and pay little mind to the long-term risks.

Why did they do it if the whole thing might blow up later?  Because before the music stopped playing, the guys at the top would have already generated millions of dollars in bonuses for themselves.  The goal was never to build sustainable businesses, it was to gamble and win big quickly.

This was true all over the finance world, not just at the top of it in NYC.  Bankers got rich from deals that generated short-run accounting profits even though the profits were totally illusory.  The article mentions that Merrill has so far written down $54 billion, more than the company’s combined net profit of the previous 20 years.  Or take my favorite example, BankUnited in Florida.  They built Florida’s biggest regional bank on one particular loan product, option ARMs, virtually guaranteed to explode.  Sure enough, this year’s writedowns are nearly 3x the previous three years’ profits.  But executives have already banked years of lavish pay.

And then there’s the guys at the very top, the hedge-funders like Ken Griffin at Citadel and the private equity moguls like Leon Black at Apollo.  These guys took huge leveraged bets that generated spectacular short-term profits for a few years.  Those bets are now blowing up, but why should they care?  Yeah, it must cause them some heart-burn that the firms they worked to build are imploding.

But they can feel comforted by the hundreds of millions in bonuses they earned previously, which of course they’ll get to keep.

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Here’s a funny piece from The New York Times (via The Economist):

CATHERINE RAMPELL asks a very good question—how does the architect of a Ponzi scheme plan to bring said Ponzi scheme to a satisfactory end? Given the finite number of suckers on the planet (though admittedly, the illusion of limitlessness is often convincing), any Ponzi scheme, once begun, must end (generally in tears). So what’s the exit strategy? Ms Rampell notes that in small-time scams, the perpetrator can just hope to flee the scene once the jig has run its course. Or, he can try and turn the business legit before the sucker supply runs thin. Or he can live it up, recognizing that death or jail looms. But there is a fourth possibility:

“Get elected to Parliament. After scamming millions of Russians in the 1990s, Sergei Mavrodi promised his broke investors that he would get their money back with taxpayer funds if they elected him to the Russian Duma. He was, in fact, elected. And voilà, his election gave him parliamentary immunity from criminal prosecution.”

Admittedly, this exit strategy has limited applicability. It didn’t even work very long for Mr. Mavrodi, whose parliamentary immunity was revoked and who eventually landed in prison.

Clearly, what Mr Madoff needed to do was pay Rod Blagojevich for a Senate seat, from which he could pressure Treasury to bail out his sorry investors. That probably wouldn’t even have been the most corrupt thing to happen this year.

But Madoff couldn’t buy it.  The Somali Pirates got there first.

The Dallas Morning News published an article on the new bubble in Treasuries, a point raised here last month.  It came out last Friday, actually, but I just saw it today (hat tip Coppedge):

As bubbles go, this one doesn’t have quite the same cachet as, say, the Internet bubble, the energy bubble or the housing bubble. But many financial experts are calling this year’s monster rally in U.S. Treasury bonds just that – bubblicious…

The article, which does a good job of capturing both sides of the deflation/inflation argument, is worth quoting at length.  My comments are at the bottom.

“In a recession or a depression or whatever it is we are in right now, the certainty of the U.S. Treasury yield and getting your money back is worth something to people,” said Howard Simons, a bond strategist at Bianco Research in Chicago. “They want to ride out the storm in Treasuries. It is the flight-to-safety notion.”

So as demand increased, bond prices started to rise and yields on Treasuries of all maturities began to fall gradually. But that was just the beginning of the massive slurping at the government trough.

“The flight-to-safety idea accounts for some of the price increase, but that is not the full story,” said Marc Pado, U.S. market strategist at Cantor Fitzgerald in San Francisco. “When the government started pushing money into the banking system [in November], that is when you really saw bond prices soar.”

Last month, Congress passed a $700 billion bailout plan to help shore up the nation’s banking system, and so far about $250 billion of that is working its way into the banking system. But instead of lending this money to new customers, banks are buying Treasuries to recapitalize and improve their debt-to-equity ratios, Mr. Pado said. That means the nation’s banks are also responsible for driving up demand for Treasuries, and hence, the price.

“And it’s not just U.S. banks, but banks in Asia and Europe are trying to recapitalize too, and they are buying U.S. Treasuries,” he said.

As if that weren’t enough, on Nov. 25 the Federal Reserve announced it would purchase up to $100 billion in mortgages from Fannie Mae, Freddie Mac and the Federal Home Loan Banks. Again, this pushes money into the financial system, and these institutions purchase Treasuries, Mr. Pado said.

The danger for bond holders is that eventually both the banks and stock investors won’t need to buy as many bonds, demand will slow, prices will drop and yields will rise.

“It is insanity that the 10-year bond yield has fallen to 2.7 percent,” Mr. Pado said. “I mean inflation over the next decade will drive yields higher than that, and the prices lower.”

At the moment, though, the economy is in recession, commodity prices are falling and deflation is more likely than inflation, said Mr. Simons. So he thinks bond yields could go even lower and prices higher.

“I know everyone thinks that the economy is going to get better and that will create inflationary pressure and hurt bonds, but I am not so sure that will happen anytime soon,” Mr. Simons said.

He points to Japan’s deflationary spiral that lasted for years in the 1990s as a telling example of what can happen. Several times interest rates in Japan fell to levels where no one thought they could fall lower, but they did.

If the United States fell into a deflationary spiral like Japan’s, Treasury bonds would be an excellent place to weather the storm. However, that’s the worst-case scenario and is not likely to happen, said James Floyd, senior analyst at the Leuthold Group, a Minneapolis money management firm.

He believes investors will start avoiding government bonds because of their low yields and begin taking risks again in the stock market and with corporate bonds and even junk bonds, which currently are yielding almost 22 percent.

“Treasury bonds have been the right investment this year, but I can’t imagine why anyone would want to stay in them going forward,” Mr. Floyd said. “When [interest] rates start to move higher, you will see a rush out of these things, and that won’t be pretty.”

Floyd clearly disagrees with Simons.  Simons basically argues that with the credit bubble collapsing so quickly, financial institutions may go down with it (and take your money with them).  In that kind of environment, simply protecting your wealth may be more important than growing it, hence investor willingness to accept literally 0% on short-term “risk-free” Treasuries.

The part about banks loading up on government paper is also pretty important.  Banks desperately need to recapitalize in order to bring down their leverage ratios.  Lending to the government by buying “riskless” Treasuries rather than lending to regular folks by making “risky” loans improves their risk-based capital ratios significantly.

Personally, I have my doubts as to the “risklessness” of Treasuries, certainly over periods longer than a year or two.  Looking further out, inflation should come back strong, hammering the real value of government debt.

For my part, I wonder what’s going to happen when bond yields inevitably turn up and Uncle Sam has to refinance the national debt at higher rates.  I mean, look what happens when adjustable rate mortgage borrowers see their rates reset upward.  I know, I know: the government can print the money it needs to pay back its debts.

That’s what scares me.

Investors will have to keep waiting for BankUnited to publish its latest financials.  Today Florida’s largest regional bank, an option ARM specialist, released a “non-timely filing notice,” noting that they will be unable to make their annual filing with the SEC by the Dec. 15th deadline.

The filing includes a “going concern” warning.

Other highlights:

At June 30, 2008, the Bank had Tier 1 Core Capital of 7.6% and Total Risk-Based Capital of 13.9%. Subsequent to June 30, 2008, the Company and the Bank have incurred substantial losses…as a result we will be reporting a significant decrease in these ratios on our Annual Report on Form 10-K.

We expect to also report a loss of approximately $327 million in the fourth fiscal quarter of 2008 (ending Sept. 30th).

BKUNA has already reported losses of $209 million through the first three quarters of fiscal 2008.  Add the $327 million mentioned above and you have $536 million of losses this year.  BKUNA’s total reported net income for the three YEARS from 2005 to 2007 was $193 million.  They lost nearly three times that amount in the year through September.

And things will only get worse.  Defaults for its option ARM portfolio aren’t expected to peak until 2010.

Such massive losses are hammering the company’s capital base so the Office of Thrift Supervision has ordered BKUNA to raise enough capital to maintain a “Tier 1 Core Capital” ratio of 7% and a “Total Risk-Based Capital” ratio of 14%.  Such massive losses since June (combined with the bank’s inability to raise new capital) mean these ratios have deteriorated significantly from the levels noted above.

Even if we are successful in meeting the capital ratios mandated in the (OTS Consent) Order, we cannot assure you, given our current level of losses, that we will not need to raise additional capital in the future. We are in negotiations with a fund to raise capital and restructure our balance sheet. We cannot assure you that these negotiations will be successful. If such negotiations are not successful there is substantial doubt about our ability to continue as a going concern.

I’d like to know which “fund” they’re negotiating with.  Given BKUNA’s massive exposure to toxic Option ARMs in Florida, losses are likely to continue for years.  Since there’s little chance the government is going to absorb BKUNA’s bad loans, I wonder why a private party would provide their own cash to mop up the bank’s losses.  Still, WaMu got TPG to pony up over a billion dollars (all of which was lost), so I guess anything’s possible.

Why can’t BKUNA make a timely annual filing?  They don’t have staff capable of keeping the books…

We had an insufficient complement of personnel with a level of accounting knowledge, experience and training in the application of generally accepted accounting principles commensurate with the Company’s financial reporting requirements due to the impact of the deterioration of the residential housing market and general economic environment on our business…As a result, internal control over financial reporting and disclosure controls and procedures were not effective at September 30, 2008.

New CEO Ramiro Ortiz has his work cut out for him.

The recession is here and credit is disappearing.  Shopaholics everywhere must now cope with the reality that accumulation is no longer possible at rates of the recent past.  The middle column in yesterday’s WSJ is particularly funny (sad?)…

On Black Friday, the day after Thanksgiving and the first official day of the holiday shopping season, 31-year-old confessed shopaholic Nikki Ebben was holed up in her bedroom in Appleton, Wis., while her husband went to Wal-Mart to snag a $500 flat-screen TV. Ms. Ebben, who has maxed out 15 credit cards and racked up more than $80,000 in debt, says she vowed to stay away from stores. Still, she couldn’t resist the temptation of e-commerce, particularly the appeal of 30% off and free shipping. While her husband was gone, she spent $400 at Toysrus.com and Target.com, using money from the couple’s joint bank account.

“I went crazy,” admits Ms. Ebben, whose mother stopped speaking to her for a time because she owed her parents so much money.

CNBC also has a story about shoppers coping, or not…

In the coming months, mental health experts expect a rise in theft, depression, drug use, anxiety and even violence as consumers confront a harsh new reality and must live within diminished means.

“People start seeing their economic situation change, and it stimulates a sort of survival panic,” said Gaetano Vaccaro, deputy clinical director of Moonview Sanctuary, which treats patients for emotional and behavioral disorders. “When we are in a survival panic, we are prone to really extreme behaviors.”

As a society, we’ve come to define ourselves by the amount of stuff we have.  Look no further than U.S. GDP, two-thirds of which is driven by “consumption.”  The CNBC article notes that politicians encouraged spending in the wake of 9/11 in order to keep the economy going strong.  What happened to patriotism being about sacrifice?

At this point, the conventional wisdom is that the Great Accumulation can’t be allowed to stop.  The economy wouldn’t survive it.  Look at the Detroit bailout.  Economists and politicians everywhere acknowledge that Detroit automakers have made bad decisions, but most argue they must be rescued anyway.  We can’t let them fail because too many jobs would be lost.

But why rescue those jobs?  To what end?  So the U.S. auto industry retains the capacity to build/sell 15 million autos per year?  Annualizing auto sales for November suggests the market for new cars is probably half that now.  Thinking dispassionately about the matter, is it such a terrible thing if Americans buy fewer cars?

Frequently I’m asked where the title of this blog comes from. The answer is the Option ARM loan, which may be the most toxic mortgage product ever invented.

Yesterday 60 Minutes had an ok story on Option ARM and Alt A mortgage loans (via YMOYL). It doesn’t go into any detail about why Option ARMs are so toxic. They probably figured negative amortization was too complex a topic to dive into in a twelve minute piece. The two scary facts mentioned are that Option ARMs are defaulting at spectacularly high rates and that the wave of defaults for such loans has only just begun.

I wrote a piece in this month’s Housing Wire Magazine regarding a particular Option ARM lender that is in deep trouble. BankUnited.  BKUNA was the largest Option ARM lender in Florida I believe, one of the chief enablers of the kind of reckless speculation featured in the video.  It’s also the latest lender to hit the Implode-o-Meter.

Not only is the Bernie Madoff story fascinating, there is a lesson in it for all of us as the title of this post suggests.  How did he keep the scam going so long?  Why weren’t regulators asking tougher questions?  How did he lose $50 billion?  Where did all that money go? That’s the crucial question to me.  And it’s a question we must ask of ALL our financial institutions.

In a fractional reserve banking system, where banks take your deposits to make loans, your money is gone the instant it’s deposited.  You give money to the bank because they pay you interest on your deposit.  Banks in turn hand your hard-earned cash to borrowers.  The bank makes money by paying you a lower interest rate on your funds than it receives from those to whom your funds are lent.  “Net interest margin” this is called.

If your money is gone the instant you put it in a bank, why do we all keep doing it?  How does the banking system continue to function?  Because we all trust that, in general, the banks will make good loans that will be paid back.  That’s what they get paid for after all: to judge credit risk.  All of us with savings would like to make a return on those savings.  There’s nothing wrong with that.  Since we don’t know how to lend money, we hire professional lenders to do it for us.

But in the age of structured finance and securitization, banks thought they were passing off credit risk to investors, so they stopped measuring it. And investors thought credit risk was being diversified away in the tranches of mortgage-backed securities so they didn’t worry about it.  But credit risk never disappeared.  It was just passed around like a hot potato.  

So I ask again: Do you know where your money is?  You may get an account statement from your bank each month, and I’m sure the number at the bottom looks correct to you.  But, and this is the crucial question underneath the financial crisis worldwide, is your money really there?

What if, like Bernie Madoff’s Ponzi hedge fund, your bank got too many withdrawal requests all at once?  What if, like Bernie Madoff, your bank didn’t actually have the cash on hand to meet a larger than average request for funds from depositors?  If that happened, and the Fed wasn’t in a rescuing mood, your bank would fail instantly…just like Bernie Madoff.

But of course this has already happened.  Bear Stearns, Lehman, Merrill, WaMu, Wachovia and, I would argue, CItigroup as well.  In effect, they all received massive redemption requests that they were unable to fund.  They’ve all lost so much money on bad investments and crappy loans, while keeping so little cash in reserve to protect themselves against those losses, that they all went bust long before Bernie Madoff.

Our banking system is a Ponzi scheme similar to Bernie Madoff’s.  The former just happens to be legal. Keep that in mind the next time you look at your bank statement.

…

[Want to know more about the scam that is fractional reserve banking?  I invite all my readers down the rabbit hole.]

[And by the way, the only thing separating Lehman from the other firms above was that it was allowed to implode.  The others have been saved via direct government bailout (Citi), by government sponsored mergers (Bear, WaMu) or by white knight corporate acquirers (Merrill, Wachovia).  And if they hadn't received money and implicit government backing via the TARP, the other large banks---Chase, B of A, Goldman Sachs, Morgan Stanely, GE Finance---would also have collapsed by now.]