Catalyst for Jawboning

Over the last several days, the Fed has trotted out multiple spokesmen to suggest there might not be another round of trash credit creation (quantitative easing). The Dallas Fed's Fisher came out on Tuesday and suggested the program should not be extended when it ends in June and that things may already have gone too far. Lockhart of Atlanta stated "it's a high bar" in response to questions about QE3. Minneapolis' Korcherlakota stated the economy would have to "worsen materially" to extend the bond market manipulation. Finally, Plosser of the Philadelphia Fed recommended not merely stopping or even reversing the bond buying but also raising interest rates.

The central bank should set a pace for selling its mortgage and Treasury holdings in conjunction with raising interest rates, Plosser said today in a speech in New York. He suggested selling $125 billion for every 0.25 percentage-point rise in the benchmark rate to almost eliminate $1.5 trillion in bank reserves.

So why is the Fed so concerned suddenly after abusing their authority in blatant fashion for more than two years? Clearly they don't care about inflation - having inflicted a tripling of oil prices, a doubling of most grains and even worse in some commodities upon the world. It would seem that they are concerned that people are catching on to what they are doing and starting to point the finger in the right direction. So now they need to very publicly posture as "inflation fighters" until people's attention wavers. And the spotlight is definitely turning their way. As the Financial Times reports:

The finger of blame is increasingly pointing toward central banks and the US Federal Reserve in particular. By printing money through quantitative easing, there are supposedly more dollars, yen and pounds chasing the same number of Beefy Crunch Burritos. Fed chairman Ben Bernanke actually was asked during a speaking engagement last month whether the central bank was culpable for the revolution in Egypt.

“I think it’s entirely unfair to attribute excess demand pressures in emerging markets to US monetary policy because emerging markets have all the tools they need to address excess demand in those countries,” said the clearly annoyed banker.

But an increasingly common view is that, with the very best intentions, he is at fault. Critics regularly cite the words of Milton Friedman, who said that “inflation is always and everywhere a monetary phenomenon”.

Essentially, the Bernak is standing over the body with a bloody knife in his hands and the lights have just turned on. He seems determined to brazen it out and has sent out his minions to talk about all of the wonderful things he's done and will do if we just leave him alone with his power. This is all an attempt to distract attention for the Fed's culpability in the destruction of purchasing power worldwide.

It is all about perception. That is why the Fed cares about inflation expectations, even while deliberately inflicting inflation on the economy. They can more effectively steal the value of your savings and income if you don't know what is going on. That job becomes much harder when the population starts to adjust their thinking and behavior to account for the destructive acts of the Fed. It is so important to prevent that change in thought and deed that Paul Volcker once raised short-term interest rates above 15% to prevent it.

With the spotlight now focused firmly on the Fed, this weeks' jawboning is just the first act of their attempt to change the subject. If that doesn't work, they might actually be forced to DO something. In particular they will need to act to stymie commodity speculation - which is the portion of the iceberg that everyone can see, as it affects the daily life of nearly everyone. While they are also likely to attempt to prop up the stock market, it will be tough to do both at the same time since commodity producers and related firms have been a key driver of the new equity bubble.

With private lending in the US essentially dead, the government is the sole source of credit growth right now. If the debt limit interferes with further bubble finance at the same time as the Fed is forced to try and look responsible, the speculative markets could be in for a rough ride indeed.

(F)Rebasing

Obviously there is a pretty bad discrepancy between those numbers in this morning's edition of blowing sunshine up your skirt from the Ministry of Truth.

current employment report

Given the size of the country, it SHOULD take 600k jobs to move the rate that much so obviously there's a problem here. How did this happen? Dig a bit deeper and you'll see that they simply defined 504k out of the labor force from December to January and rounding did the rest. Wave a wand and define those people out of existence. If they don't exist, they can't be unemployed now can they?

If you look at the chart, you'll see that they did the same thing in December from November. In that case only 260k unemployed people disappeared from the statistics. There is a clear and systemic effort to deceive the public about the state of the economy and it's getting worse.

latest household data

But there's is an even bigger deception in the numbers that helps to reveal the systemic fraud of the numbers. Last month the B(L)S claimed that their establishment survey measured 130,712k employed:

December 2010 employment report

But THIS month they show 130,265k employed and claim that it is an increase of 36k, rather than the massive drop of 447k that it actually is. They did this by altering history. Now, the record shows that 130,229k were working in December and the rest of those people have disappeared down the memory hole. It wouldn't be a concern if the revisions were random but the pattern is very consistent - almost perfectly so. Report good news now and back away later. This is the same game played with corporate earnings to deceive investors. Loudly trumpet "good" current results. Then quietly go back later and revise them down. Then use the revised numbers to show "growth" with the next fraudulent set of numbers.

The B(L)S calls this rebasing. Corporations call it a "one time charge" but it's the same scam. The objective in both cases is to mislead the public. It's nothing more than fraud with the goal of getting the public to buy the hopium of the confidence game. That's why I think that freebasing is a more appropriate name.

The Permanent Bailout

Milton Friedman once said that "Nothing is so permanent as a temporary government program." The central banks, as rogue private bodies exercising governmental powers a proving that axiom true yet again. The Federal Reserve claimed yesterday that we are in a recovery but none of their emergency programs can be rolled back.

... the Committee decided today to continue expanding its holdings of securities as announced in November. In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011.

Meanwhile, over in Europe, there is growing recognition that the bailouts have failed and that the money isn't going to be paid back. Instead of actually admitting anything of the sort, the ECB is now talking about effectively making the loans permanent. Sure, they SAY it's going to be a 30 year loan instead of 3 years but if Ireland and Greece can't pay the money back now and continue to run deficits, what makes anyone think they'll be in a better position to pay it back later?

The question sort of answers itself. The bailouts are throwing good money after bad as every one of these banks is so far underwater they can't even see the surface from here. Without honest accounting, we have no idea just how deep that hole is but it certainly looks like a bottomless pit from here. It's been stunningly clear for a while now that so much bad debt needed to be purged from the system but the central and TBTF banks have made every effort to PREVENT such a purge.

(Wall) Street Corner Hustle
The latest brainstorm from the ECB is exactly the same sort of shell game. Greece and Ireland can't pay the money back and they know it. Instead of acknowledging reality, we'll just convert it into a long-term "loan" so they don't have to pay it back within the term and maybe even the lifetime of the people making the decisions. It can't be paid back and it won't be paid back but maybe they can keep up the lies for a little while longer.

This is simply more Extend and Pretend so that they can keep trying to fool people into impoverishing themselves by overspending and taking on too much debt to keep up the illusion. That is the meaning of "prosperity" in a keynesian ponzi economy. You use inflation to convince people to eat their seed corn, making them feel better - for a little while. This is why central bankers place so much emphasis on "confidence" - in practical terms that measures the willingness of the population to deplete their capital and eat their seed corn due to the inflationary deception of the central banks.

The UDB gave us the biggest illusion of false prosperity the world has ever seen. The bankers are now trying to cover their tracks and delay the inevitable hoping you'll forget their complicity. But the best simple summation can be found from the creators of South Park:

The Law

Here at Financial Jenga we have hoped, even prayed for the law to be enforced for the last couple of years. Yet the fraud has raged unchecked and if anything grown worse. Banks have mass filed false affidavits to fraudulently seize houses through the foreclosure process and then said "oopps, we made a technical paperwork error" when caught. At first they got away with it. They HAVE seized houses through this procedure when there was no mortgage and no lien at all.

The Fed has gone and done things far beyond the scope of authority given to it by Congress - like using our money to prop up the investment banks and the stock fraud they are running. They are given the power to buy exactly two thing - bonds carrying the full guarantee of the US government and short-term loans for planting of crops. Buying junk bonds containing mortgages violates both the letter and the spirit of their charter. Buying stocks is so far beyond their legal powers that someone should be in prison and probably a lot of someones.

No one has shown much sign of really stopping the Fed yet but the Massachusetts Supreme Judicial Court landed a major blow for the law today by confirming a lower court ruling that nullified two foreclosures because they plaintiffs couldn't show they owned the property. In both cases, "robosigned" affidavits were introduced as proof of ownership and later shown to be without merit.

The state Supreme Judicial Court today upheld a judge’s decision saying two foreclosures were invalid because the banks didn’t prove they owned the mortgages, which he said were improperly transferred into two mortgage-backed trusts. As reported by Bloomberg:

“We agree with the judge that the plaintiffs, who were not the original mortgagees, failed to make the required showing that they were the holders of the mortgages at the time of foreclosure,” Justice Ralph D. Gants wrote.

While there have been many similar rulings across the country, this is the first such decision by a state supreme court. And since property law is still properly the jurisdiction of the states, this decision is final as far as Massachusetts is concerned. Hopefully they will follow up with prosecutions for the mass of fraud represented by those false affidavits.

And this entire financial crisis is bound up with a struggle to centralize political power in Washington. One of the key enablers of the late-bubble madness was the effective nullification of state lending regulations. This was done in 2004 when the Office of Comptroller of the Currency used federal preemption to overrule state laws against predatory lending. It was one of the worst moments of the Bush Administration:

The Office of the Comptroller of the Currency Feb. 21 published for comment a ruling that Georgia's predatory lending law, the Georgia Fair Lending Act (GFLA), is preempted for national banks.

At the same time, it issued two advisory letters to national banks to clarify its expectations for banks to avoid involvement with "predatory" lending practices.

So basically, the OCC's action wiped out state legal protections against predatory lending. And they substituted a finger wagging "don't do it" with a nudge and a wink to just go ahead. And of course the very worst mortgage paper was written over the next three years after the change. We have documented the results of those no-doc, alt-A and option ARM loans here from the very beginning. But those abusive mortgages would not have been possible without Washington stepping in to remove the legal shield that states provided their citizens.

The Shadow Knows

Today's topic is Shadow Inventory - the foreclosed or soon to be foreclosed properties that banks are stuck with and which are not listed for sale. As a result, they are not found in any formal listing of housing inventory when existing home sales are reported. This has been a problem for a long time, as we mentioned many months ago in Household De-formation.

The media's silence on this issue has been almost total. Probably because any reasonable discussion of the topic would severely undermine the illusion of stability they are trying to project. This weekend, the Wall Street Journal took a stab at estimating the damage. Their conclusion is that it would take 107 MONTHS to clear the shadow inventory at current sales rates. Obviously not a number that the bankers and their apologists in government and media are anxious to publicize.

Over the summer, banks appeared to be making some headway. The government’s mortgage-modification program helped some people get current on their payments, taking their homes out of the foreclosure pipeline. At the same time, homebuyer tax credits helped boost sales. Combined real and shadow inventory fell to 91 months of sales in May.

Lately, though, a new wave of defaults appears to be coming in, in part related to the high rate of failures on government modifications. As of September, some 1.9 million homeowners had missed one payment on their mortgages, up 14% from March. Meanwhile, home sales have slowed sharply with the end of government stimulus.

The government "assistance" was never going to help many people, much less actually succeed on a large scale. However, it was helpful for the banks - aiding them in concealing the collapse of their collateral for another year or so (i.e. another Bonus Cycle).

But the good news is that we can expect the housing market to start to recover - in another eight or nine years.

Fraud and Failure

Recent news on the housing front confirms what we have been saying about that market since the inception of Financial Jenga. In sum, there is no real stabilization much less recovery, the costs of attempting to maintain the illusion continue to rise rapidly and any cessation of government interference and manipulation results in rapid breakdown of the fake "market" which was created by those policies.

In the first instance, we now see the failure of HAMP as redefault rates among those "helped" by the program soar. An absolute majority of the government-sponsored loan modifications have now re-defaulted but they did give utterly baseless hope to debtors, thus trapping them into making continuing payments on a hopeless mortgage.

The ongoing cost to prop up Fannie Mae and Freddie Mac continues to rise. Last week the NY Times reported that the cost of those bailouts has now reached $148 billion and will likely total $389 billion. Bloomberg cites a "reasonable worst case scenario" for the ultimate tab which could be $1 trillion or more.

The creation of the tax credit for housing purchases induced a temporary uptick in the number of sales. But like many other government actions, this merely succeeded in pulling forward future demand into the present - which is now the past. We have now entered the void created by that pulling forward. The existing home sales number yesterday and the new home sales number today both demonstrate that in clear terms. Today's existing sales number was nothing short of a disaster. The headline on Marketwatch says:

New-home sales plunge 33% to record low in May

But that fails to reflect the full scale of the drop. In addition to May being down, April was also revised lower. This is a game we should all be familiar with by now. Actual may sales were 300k annualized. But the April report had 504k units sold but it has now been revised to 446k. That allowed the comparison to be reported as merely 33% down rather than over 40%. Either way it's not good and May set a new record low. Apparently, new houses just don't sell unless a big tax credit is piled on top of the subsidized mortgage loans.

Yesterday's existing home sales number was less dramatic but still indicated a housing market in trouble. The decline of 2.2% contrasted with an expected gain of 4%. The tax credit doesn't seem to have accomplished anything of value but at least it fraudulently paid out $9 million to 1,300 prison inmates.

Lies, Damn Lies and Statistics

This morning, the Bureau of Labor Statistics release triggered news report to put up a huge headline:

431,000 Jobs Added in May

That sound impressive on the surface but the reality is much less than it seems. When you dig down into the numbers you can see just just how little really is there. First, the Census Bureau hired 411,000 temporary workers who were counted as part of the 431,000. The BLS claims 41,000 private-sector jobs were created, with the discrepancy likely coming from net layoffs at state and local levels of government.

Let's drill down a bit farther and take a look at the Birth-Death model that we have written about before. When we look there, note that the "model" has added 215,000 private-sector jobs for May. By backing out this estimate, we can conclude that the actual survey measured a net loss of 174,000 jobs in the real economy.

We can also dissect the Unemployment Rate in the same fashion. This statistic is based on the Household Survey, where the jobs created number is based on the Establishment Survey of employers. The Household Survey again shows that the number of people with jobs shrank in May - in this case the measured loss was 35,000 jobs. That is not as bad as the Establishment survey but still pointing in the wrong direction. The only way the BLS was able to report a lower unemployment rate was because they reduced the Labor Force by 322,000 workers, even while the pool of employable citizens rose by 170,000 people. Basically. BLS arbitrarily said 600,000 people ceased to exist for purposes of their calculations this month - so they could report a lower unemployment rate.

This is clearly a piece of propaganda designed to keep the ignorant public "confident" and spending despite reality. Like much else that comes from government, BLS reports have become riddled with accounting tricks that amount to fraud in order to paint a rosy picture. Don't be taken in.

Trembling Pillars of Fraud

Over the last two weeks we have seen a series of indications that some of the key elements supporting manipulation of market pricing mechanisms are beginning to tremble. We have seen equity prices rise despite the lack of any significant increase in profits. We have seen commodity prices spike without much increase in real demand. In our opinion the key institutions behind this mess are the major Wall Street (TARP) banks, government agencies and the Fed. They have all played a major role in creating credit inflation, with subsequent asset bubbles and debasement of our currency. But understand this: if you 'look through' each of those institutions you will find the US government backstopping each and every one of them. Each of those has come under increasing attack and as the supports have begun to shake, the fraudulent pricing they have promoted has also begun to unwind. As politics has supported bubble dynamics, so it can destroy them - live by the sword, die by the sword.


Fear and Loathing
First, Yahoo Finance reports that Wall Street's bonuses being paid out now will total $145 billion. That is greater than 1% of US annual GDP. In a normal year that number would be insane. After the disaster those same players inflicted on the US and global economy, that number is downright obscene. Bailouts were indefensible to start with and now you can add infuriating arrogance to the list of offenses. Public anger may be getting through to Congress and without siphoning off taxpayer money via the legislature, the rest of the Wall Street con game doesn't work. It has now gotten so bad that according to Dow Jones Newswire the TARP still exists only courtesy of a Senate filibuster by its supporters.

Fear of angry constituents has taken on a new urgency for our elected officials in the wake of a shocking Republican victory in the Massachusetts election for Senate. With citizens realizing that the Fed's actions have been a pure handout to Wall Street, the reconfirmation of Ben Bernanke as chairman is now very much in danger. Today, the NY Times reports that two additional senators abandoned him. With Geithner at Treasury already under serious scrutiny by Congress for his role in the bailout of Goldman via AIG and the subsequent attempt to hide the details, the two most prominent faces of bailout nation are both in danger of being forced out.


Friendly Fire
The biggest blow psychologically may be the rhetorical broadside from President Obama against the big banks that are a key leg of the credit inflation machine. His speech yesterday called for them to be cut down to size and shackled. This was a frontal attack on the concept of Too Big To Fail, with its implicit taxpayer guarantee for the stupid risks taken by big banks. The Obama Administration has given Wall Street nearly everything it wanted so the Street must now feel shocked that their tame politician has turned on them viciously. We have long felt that once the anger of the populace rose to sufficient levels, the political class would throw the financial elites under the bus in the interest of self-preservation.

Our government has betrayed our nation's citizens in many ways - from the TARP to the uncapping of taxpayer losses on Fannie and Freddie on Christmas Eve. The failure of those policies to make things better or even to stop them from getting worse is now obvious. The failure has become political kryptonite - so much so that Rep. Barney Frank is calling for Fannie Mae and Freddie Mack to be abolished. Frank has been one of their main defenders and cheerleaders for years if not decades. For him to even contemplate such a call tell us that taxpayer bailouts have become the political equivalent of Ebola.

Political support lies at the very foundation of attempts to revive the bubble by inflating credit and eroding the dollar. It is clear that this political support is evaporating before our very eyes and the state of the markets is beginning to reflect that. Suddenly the political foundation of Bailout Nation isn't looking too stable and the pillars resting on it are beginning to tremble violently.

B(L)S

This weekend we would like to take a look back at the economic contraction that the talking heads would have you believe is already over. Of course there is no way that it true. The extreme deficit spending we referred to in Federal Funhouse could result in a short euphoria before the creditors pull the plug - just like maxing out your credit cards before declaring bankruptcy. But the real economy is in horrible shape and nowhere is this more apparent than in the labor market.

Today's critical data comes from the Bureau of Labor Statistics (BLS). Their unemployment data released Friday was loudly trumpeted as good news when all it really said is we're bleeding to death a little slower. Others have commented on and analyzed this data so we'd like to take a longer view of things - examining the size of the pool of blood on the ground as it were.

We're going to use the BLS monthly data for the last two years. Note that at the end of 2007, the potential labor pool (civilian non-institutional population) was 231.9 million and last month it was 235.9 million - an increase of 4 million potential workers. But the numbers for the labor force have lagged badly behind. At the end of 2007 it stood at 153.1 million and by July 2009, that had only increased to 154.5. Population growth would suggest that number should have been 155.5 million, with two thirds of the added adult population contributing to the labor force. Since the Labor Force is the basis for calculating the unemployment rate, clearly the current numbers are understated. As a mental exercise, let's see what happens if a million workers aren't shuffled off into statistical never-never land. That would be another million unemployed with an unemployment rate of 10.1%. I suspect that a lot of statistical games will go into keeping that number in the single digits as long as possible.

Further, the labor force participation rate (percentage of adult population in the labor force) has been falling since the late 1990s. This indicates that the recovery from the post-tech bubble crash never made it back to the highs of that period and the current further decline indicates that people think the economy is so bad they've quit looking for work. This allows the BLS to conveniently eliminate them from the unemployed category though they are still just as jobless. The bottom line is that the economy has to generate nearly 10 million jobs just to get us back to that lower high of the mid 2000s but it is still destroying jobs even as the population continues to grow.

Great Pyramid of Geezer

An update by Karl Denninger at Market Ticker today got the old synapses firing. Denninger points out that pension plans are in trouble and cites a Wall Street Journal article strongly suggesting accounting fraud in public pension plans. The WSJ says:

Based on their preferred accounting methods -- which discount future liabilities based on high but uncertain returns projected for investments -- these plans are underfunded nationally by around $310 billion.

The numbers are worse using market valuation methods (the methods private-sector plans must use), which discount benefit liabilities at lower interest rates to reflect the chance that the expected returns won't be realized.

Last year we warned about the same phenomenon in private sector pensions in Some Key Questions and The Limits of Optimism. In every case the culprit was the same - overly optimistic assumptions about investment returns allowed a financially deficient structure to be sold to key constituencies as safe and sound. The wild optimism that causes managers to overreach like this and causes others to believe their literally incredible assumptions are part and parcel of the Universal Debt Bubble (UDB). Only in such a manic environment can such outlandish claims be regarded as anything other than the fantasies they are in reality. Even worse, a bubble atmosphere makes those assumptions even more dangerous than normal by burdening assets with inflated starting values, making the required price appreciation even less likely than usual. But as long as such tales are believed, a small sliver of capital can be made to support grand promises in the future.

Unfortunately, the credulous public has been misled in any number of similar ways. Robert Prechter of Elliott Wave International recently described the process by which banks also shrank the capital supporting their balance sheets to a tiny fraction of what had previously been required and considered prudent:

In the early 1990s, the Federal Reserve Board under Chairman Alan Greenspan took a controversial step and removed banks’ reserve requirements almost entirely.

To do so, it first lowered to zero the reserve requirement on all accounts other than checking accounts. Then it let banks pretend that they have almost no checking account balances by allowing them to
“sweep” those deposits into various savings accounts and money market funds at the end of each business day... The net result is that banks today conveniently meet their nominally required reserves (currently about $45b.) with the cash in their vaults that they need to hold for everyday transactions anyway.

Sure or Insure
Yet the problems of inadequate capital hardly end there. Like pensions and banks, insurance is another area that succumbed to the ubiquitous optimism of the UDB. Insurance companies became so accustomed to capital appreciation well above the historic norm that they began to take them for granted. Many annuity policies and guaranteed investment contracts were written promising high fixed rates of return based on that experience. This has proven devastating for many insurers, who are now rushing to rewrite such contracts. This is a microcosm for the weak capital position of much of the industry as key asset classes for most life and casualty companies are stocks, bonds and real estate. Like every other leveraged institution out there, the insurers have taken a beating on those assets and their promises to deliver future benefits are increasingly in doubt. Which brings us to a similar structure with the biggest capital shortfall of all.


GovernMENTAL Institutions
For the most part, capital is literally a foreign concept in this sector. Few governments have significant reserves, much less any real capitalization. Except in regions where government-owned enterprises dominate the economy, the primary source of revenue for most institutions is taxes - on the private sector naturally. So instead of actual capital, governments have something even more volatile - a projected future revenue stream. As with every other sector we have examined so far, those projections about the future are subject to the psychological distortions that accompany large-scale financial manias. In an environment of historic extremes like the UDB, those distorted perceptions can easily become fatal. We see that today in the sad case of California - where the state is issuing IOUs because they are out of money. Having accustomed themselves to double-digit annual rises in tax revenue, Sacramento (and other state capitals) simply spent it all. Those projections and plans aren't working out so well anymore.

The US Federal Government is arguably in even worse shape. Borrowing this year is likely to approximately equal tax income. No entity can spend twice its income for long and hope to survive. The remnant optimism of the UDB has settled in one of its last-ditch redoubts: faith in government. In addition to the spending spree, Washington has also embarked on a series of empty promises that would make a serial polygamist blush. Not content to merely guarantee deposits through the FDIC, the Feds now do the same for bank bonds through TLGP. Fannie and Freddie debt is backed thorough a de facto nationalization and money market mutual funds are guaranteed by the Federal Reserve. Many trillions of government "guarantees" are piled atop the roughly $1 trillion of deficit spending for this fiscal year. These promises are lighter than a feather but certainly worth their weight in gold. In other words there is no way Washington can deliver but they are hoping nobody notices and that the empty promises will inspire "confidence" in the economy. Like many other sectors, various levels of government are attempting to cover huge obligations with inadequate resources.

Frankly, it's sad that so many people fail to see the little man behind the curtain putting up the front that is the Great Oz. These large and varied institutions have stretched themselves far too thin and are praying for another bubble to bail them out again. The title of this missive refers to those who will bear the brunt of the damage from our return to reality - those who bought into the promises of these institutional pyramid schemes and don't have the time to recover financially. The frenzy of financial pyramid construction certainly put the Egyptians' little excursion in stonework to shame. In reality, the old truths would have served us well, but like every bubble generation in history, ours has convinced themselves that "this time it's different" when it never really is. Like those who have gone before, we will learn the hard way when two things we all learned as children would have prevented much of this mess:

• Never count your chickens before they hatch.
• Save for a rainy day.

It seems so simple and most of us will never forget. With the optimistic assumptions that undergirded the psychology of the UDB evaporating, any program sporting the words insurance or guarantee must be treated with great skepticism.

Over Extended

We note with some amusement all of the talk about cash "on the sidelines" as if it's ready to pour into the stock market at the drop of a hat and take us to new highs. Nobody wants to admit that this is the cash that doesn't really exist. That fact was recognized by the market last year and earlier this year but has been obscured by a massive campaign of deception, propaganda and guarantees from Washington and Wall Street. Because the current mutant economic system depends on citizens digging themselves ever deeper into debt slavery, anything which causes them to save instead of borrow and spend is seen as the enemy and this includes the truth.

Much of the "cash" is in banks and money market mutual funds, both of which invest in debt that has become extremely dubious. The truth is that none of the "assets" (loans) that are backing the "cash" have gotten better and most have gotten significantly worse over the last 3-4 months. Credit card default rates now stand at a record high (again) for the fourth straight month. Auto loans are nearly as bad. 12% of all mortgages are now either in foreclosure, default or delinquent - but in any case they are not being paid. Commercial mortgages are quite bad now on the way to much worse and the State of California is so broke it is issuing IOUs instead of checks.

So what is going on here? The government-banker campaign has succeeded in getting one important group of people to dig themselves deeper into debt - speculators. If you look at the NYSE margin data, you will see that the ratio of margin debt to credit balances in margin accounts is at the highest it has been in a long time - 1.61. One can think of this as the ratio of margin actually used to unencumbered cash balances in those same accounts and so it measures the willingness of brokerage account holders to take on leverage as a percentage of their portfolios. The last time the ratio was this high was July 2007, just before the crisis began with the first round of emergency Fed intervention. Slightly lower levels were seen at the absolute top in October 2007 and again in September 2008, just before the largest leg of the stock market crash.

The latest data is from May and we await the June report with anticipation. The recent data show the speed with which a wildly speculative spirit has returned to stocks despite the small gains relative to the preceding decline. The fact that so many speculators have already leveraged up so heavily means that much of the fuel has already been burned off, leaving the market in a very vulnerable and over-extended position. These speculators have set themselves up for more crushing losses - note how much smaller both the margin and credit balances are than at any time in the recent past. Any significant decline at this point holds the potential to become self-sustaining as heavily leveraged positions become unsustainable in the face of the decline and subsequent margin call. In fact a cascade of margin calls could easily result.

Stocks are being bought but not by the cash on the sidelines. It appears that existing speculators margining themselves deeper into debt are the key driver of the bear market rally. The fact that they have used nearly all of their firepower and exposed themselves to potential forced selling is hardly bullish.

Fed Deception Wears Thin

Two critical events in the last 24 hours:

1) AIG reports an enormous loss
This is very important since insurance is the largest financial sub-sector which does not have access to the Fed's discount window, which has been used to conceal the losses or the various swap programs designed maintain the fraud that some banks are not insolvent. Given that, an honest report from AIG gives us some insight into what the REAL situation looks like in the financial industry and it's not pretty. With the strains imposed on the Fed's balance sheet by their past actions there is essentially zero chance that the insurance industry as a whole will get access.

Yesterday's selloff was triggered by an SEC announcement that greater disclosure would be required in the balance sheets of investment banks. Financials dropped hard. Essentially anything that interferes with the ability of the banks to commit fraud is going to tank the sector since fraud is the only thing between some of them and bankruptcy. The follow through from AIG just reinforces this as the look behind the curtain revealed loses of nearly $8 billion this quarter and there's no end in sight. They will raise $12 billion in new capital and also (weirdly) raise the dividend. So they bought back stock when it was expensive a year or two ago. Now they're selling when it's cheap. Buy high, sell low is not a good way to make money. We saw this trend coming back in November and wrote about it in Tactical Nukes

"Liquidity" has been removed. LBOs of any real size are dead. Instead of buying back shares to reduce the supply, corporations are starting to issue more stock and increase supply just as demand is falling. It looks to me as if the even the tactical bull case has been nuked at this point. The strategic case is long-dead. What is the reason to still own stocks today?

Also they are raising cash but will increase the rate at which they burn it by paying out higher dividends. Hello? Earth to AIG, anybody home?

2) Citigroup to sell half a trillion dollars of assets
$500 billion - that is a big number. Just for perspective, that is twice as large as all of the Fed's uncommitted assets. Like I've said before, Citigroup is too big for the Fed to save and this at least shows that management is taking action to control the damage on their own. For that I applaud them.

The flip side is going to be truly problematic for the financial sector though. Most of the Fed's actions have been aimed at preventing everyone from finding out what these assets are really worth. They've loaned out a bunch of money specifically so that banks could hold the assets instead of selling them - thereby establishing a market price for them. This announcement from Citi indicates that the game of hide the garbage may be over finally. Since the asset base involved is so big, there is no entity on the planet with enough money to allow them to hold on indefinitely. Once market prices for the assets are established, balance sheets across the financial world will have to be adjusted to the new valuation levels. This should result in another big round of writeoffs and losses.

Smaller and more nimble players may choose to get out quickly, before this enormous wave of selling. The selling itself will drive down prices, especially when it occurs on this scale. Just as the buying induced by the credit bubble drove asset prices up. If I were a manager in the banking sector (which thankfully I am not), I would front-run the sale of Citigroup assets so as to get the best price NOW. Sometimes he who panics first, panics best.


My major concerns at this point are where to put my money to keep it safe. The Fed games have ensured that we have little information on which to base our analysis. JP Morgan and Bank of America seem to be the "designated survivors" in the banking sector. Lending directly to the Federal government via Treasuries and small community banks with very high lending standards seem like the only other viable options. I am hopeful the these latest revelations bring the equity indicies back to more rational levels so that we can avoid the severe crash that a sudden recognition event would cause.

Sea Change on the Street

Guys, there was a huge change of tone over the last two weeks and especially this week. The denial that has ruled Wall Street for so long is beginning to show major cracks. We're finally seeing grudging admissions that this is a much bigger problem than they were willing to admit. What used to be just a "subprime" crisis is now a "mortgage" crisis.

The terrible reports from major retailers like Pennys, Macys, Kohls and the spectrum of apparel shops along with restaurants like Starbucks, PF Chang, Chipotle, Brinker and Panera are causing the Street to question the "resilient consumer" thesis. They should since it is based on the ability of the consumer to dig themselves into an every deeper hole of debt. But McDonalds and Target did well and Walmart OK. What does it tell you when spending is switching from department stores to discounters and from premium or sit down restaurants to the golden arches?

We don't hear the word "contained" much anymore do we?


Smacking Fannie
Fannie Mae is messing with their accounting to hide rapidly rising losses. They snuck in the accounting change that cut reported losses by almost half. This sort of game has been very common at financial companies in the last few years. They usually get away with it but this time investors noticed and slammed the stock down 20% in just a few sessions. The executives at Fannie must feel like Mike Leach when one of his OLinemen gets called for holding. We're going to see a LOT more of this simply because there is so much out there to find.
More doubts about Fannie Mae's disclosures


Commercial Divers
Next, we get the first real world confirmation that commercial real estate pricing is now falling. Synthetic indexes like the CMBX and credit indicators have been indicating decline for many months. The MIT index covers CRE owned by large pension funds and showed a decline of 2.5% for Q3. That would imply that prices rolled over either during Q2 or early in Q3. Commercial joins residential and commercial construction spending should follow shortly.
MIT index shows first drop in commercial property value since '03

Just incidentally, the subtitle "Indicates housing woes, credit crunch 'may be spreading' " trips one of my pet peeves. There is not a housing crisis spreading to other sectors like a contagious disease. This is more like a genetic heart defect inherited by a group of brothers from the Credit family. One, let's call him "Bob Residential" has a near-fatal heart attack. Another, named "Joe Consumer" is in the hospital for major symptoms but nothing life-threatening yet. "Jim Commercial" and "John Corporate" are having chest pains. The media wants to blame Bob for everybody's problems but the reality is they were all flawed from birth (of the current crop of loans).


Goldman Shocker
Goldman Sachs, which had previously been very bullish, is now calling for $400 billion in direct losses from the crisis in mortgages, plus $2 trillion in withdrawn credit as bank reserves shrink. Well, at least they've got the right number of zeros now but they still fail to account for anything beyond residential real estate.
U.S. could face $2 trillion lending shock

Quote:

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"The macroeconomic consequences could be quite dramatic," Hatzius said in the note to clients. "If leveraged investors see $200 billion of the $400 billion aggregate credit loss, they might need to scale back their lending by $2 trillion."

Hatzius said such a shock could produce a "substantial recession" if it occurred over one year, or a long period of sluggish growth if it occurred over two-to-four years.

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The related article in Forbes made me roll my eyes and mumble "nice job Goldman, what took you so long?" This was obvious to anyone who bothered to do elementary analysis even a year ago. It's also why the Ben Stein's of the world have always been full of it. His "analysis" failed to account for how much the losses would push down the price of everyone else's houses or how the damaged financial system would be forced to cut lending. Duh!
Cost Of The Crunch? $2 Trillion, Says Goldman

Quote:

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In July, for example, Fed Chairman Ben Bernanke put subprime-related losses at $50 billion to $100 billion. "Even at the time, these numbers seemed quite optimistic," wrote Goldman economist Jan Hatzius, in a note Friday. "Now it is clear to most observers that they are far too low."

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So it looks as if the new bull case is huge losses and probable deep recession. Goldman has been a constant cheerleader since they have a lot to lose from this scenario. IMO, they have simply calculated that the loss of credibility from continuing to spew slanted nonsense now outweighs the loss of business if the economy and market fall a little sooner. Make no mistake, they would be extremely unlikely to make such a change unless they felt the events were already on the doorstep.


The Bleeding Edge
Of course, Hatzius at Goldman is just catching up to David Rosenberg at Merrill, who turned quite bearish 6 months. The guys who had this right from the beginning are Paul Kasriel at Northern Trust and a pair of academics - Nouriel Roubini at NYU and Robert Shiller at Yale. Notice that none of them work for investment or money center banks. Earlier, I linked the Bloomberg interview with Morgan Stanley's head of credit strategy, calling for a greater than 50% chance of the credit markets coming to a "grinding halt." The scary thing is that Roubini is now going further and saying the "risks of such a generalized systemic financial meltdown are now rising."
Nouriel Roubini's Global EconoMonitor

This is obviously not something I've foreseen. My expectation has been for severe and widespread losses, with a few major firms failing. Roubini has not yet published his full analysis but I pray that his conclusions are wrong though I will consider them with an open mind. Just as I've prayed that my own conclusions were wrong despite believing in them wholeheartedly. The problems seem inescapable. Hope for the best, prepare for the worst.

Australia Leads the Way

The race to the bottom in financial responsibility reached a new milestone today. The Reserve Bank of Australia - their equivalent to the Fed agreed to take asset-backed debt paper as collateral for repo loans to commercial banks. The Wall Street Journal reports this morning:

Banks that may be forced to assume assets from the conduits that have financing coming due could themselves face shortages of capital.

To head off such a problem, Australia's central bank, the Reserve Bank of Australia, has relaxed rules on collateral it will accept for short-term funding. This would enable banks to take more time to evaluate which portions of the asset-backed commercial-paper market are most affected by ailing subprime mortgages.

In doing so the Australians went beyond the Federal Reserve, which doesn't accept such paper as collateral in repo operations but did recently clarify it was willing to accept a wide variety of such paper for its lesser-used, and costlier, "discount window" loans to banks.

Basically, the RBA is willing to accept asset backed paper as collateral for loans now. The Fed will apparently do the same but only at the discount window where distressed banks come to borrow, hat in hand.

Conduits and structured investment vehicles (SIV) enabled banks to move assets off the balance sheet, where they would no longer count against their required capital. By providing these entities with a guaranteed line of credit, the bank was on the hook if investors who normally provide funding got cold feet. Of course, it was assumed that the high times would last forever so such a thing could never happen but naturally it did.

In hindsight, it can be seen that the conduits and SIVs were an attempt to evade the reserve requirements and banking regulations. These things traded on the credit and the good name of the bank but never appeared anywhere in the financial statements. Simply another clever, legalized fraud. Taxpayers should not be on the hook for this sort of gamesmanship.

Fed Actions and Terrorist Attacks

We are beginning to see severe impairment of credit functions - the fruits of massive and long standing frauds that have recently come to light. By now, many of you are familiar with the 'mark to model' fraud, where the imaginary prices generated by a computer model are preferred over the actual prices which are being paid by actual people - especially when using the former allows firms to report gains rather than the losses they have suffered in reality. With some 'investment grade' paper trading at huge discounts to par, the rating services have a lot of explaining to do. The fee structures for structured finance create serious conflicts of interest.

"S&P, Moody's and Fitch have made more money from evaluating structured finance--which includes CDOs and asset-backed securities--than from rating anything else, including corporate and municipal bonds, according to their financial reports. The companies charge as much as three times more to rate CDOs than to analyze bonds, published cost listings show."

Then there are the garden-variety frauds that occur in every credit cycle and are endorsed or at least accepted by the accountants. Low losses in good times are assumed to be permanent and provisions for losses are small - inflating reported bank profits. This is often compounded by banks which drain their pre-existing reserves to inflate profits further. When combined with loose credit standards, nastiness is practically guaranteed to ensue since the low losses will be followed by very large losses once the weaker borrowers come under pressure. Financial 'innovation' simply adds to the problems since it is nearly always used to take on more risk, not reduce risk.

At the end of a massive credit cycle like the one we have just experienced, financial earnings are wildly overstated, assets are significantly overstated, credit quality is very bad and it is very difficult to distinguish the banks with some troubled assets from those that are insolvent. Under these conditions, it only makes sense to be very cautious when making loans.

Uber cautious lending is exactly what is happening today. Spreads on risky bonds have widened dramatically as investors demand to be compensated for risk again. New issuance of junk bonds has been virtually nil for eight weeks. More ominously, about half of the commercial paper (CP) market seems to be in the process of going away. There is almost no interest in asset-backed CP except at punitively high interest rates. In fact, this market judged the Fed's discount rate cut to be about as useful as a terrorist attack.

"Even the Fed's decision to cut the discount rate that it charges banks failed to revive demand. The rate for overnight borrowing in the asset-backed commercial paper market soared 0.39 percentage points to that price on Aug. 17, the biggest rise since the Sept. 11 terrorist attacks."

The bizarre rally in stocks is especially puzzling in light of the continued deterioration in credit quality and availability. This is way beyond 'whistling past the graveyard' by the equity markets; it's more like cramming fingers in their ears, kicking and screaming "lalalalalala I can't hear you!"