Monday, February 04, 2008

Signs of the Economic Apocalypse, 2-4-08


Gold closed at 913.50 dollars an ounce Friday, up 0.3% from $910.70 for the week. The dollar closed at 0.6756 euros Friday, down 0.8% from 0.6811 at the close of the previous Friday. That put the euro at 1.4802 dollars compared to 1.4682 the Friday before. Gold in euros would be 617.15 euros an ounce, down 0.5% from 620.28 at the close of the previous Friday. Oil closed at 88.96 dollar a barrel Friday, down 2.0% from $90.71 for the week. Oil in euros would be 60.10 euros a barrel, down 2.8% from 61.78 at the close of the Friday before. The gold/oil ratio closed at 10.27, up 2.3% from 10.04 for the week. In U.S. stocks, the Dow closed at 12,743.19 Friday, up 4.4% from 12,207.17 at the close of the previous week. The NASDAQ closed at 2,413.36 Friday, up 3.7% from 2,326.20 at the end of the week before. In U.S. interest rates, the yield on the ten-year U.S. Treasury note closed at 3.59%, up four basis points from 3.55 for the week.

Since we throw around a lot of technical terms when discussing economic and financial matters, and in order to reduce mystification or obfuscation of the economy, a short glossary of terms might be helpful before discussing last week’s events.

Securities: Tradeable financial instruments, either debts (entitlements to the repayment, for example bonds) or equity (pieces of ownership, for example, stocks)

Inflation: When the price of goods goes up or the value of a currency goes down

Deflation: When the price of goods goes down or the value of a currency rises

Recession: Two conecutive quarters or more of negative economic growth

Depression: A severe or long recession

Economic Collapse: A severe or long depression

Currency Collapse: When a country’s currency drops to a fraction of what it was

Capital Flight: When investors pull their money out of a country

Stocks: Pieces (shares) of a company that can be bought or sold

Bonds: Instruments that can be traded carrying rights to repayment of debt

Yield: The percentage of interest on a debt instrument

Basis Points: Hundredths of a percentage point return on a debt instrument

Exchange Rates: The price of one currency in another currency

Revenues: A company’s income

Earnings: A company’s profit

GDP: Gross Domestic Product: The total value of a country’s goods

Correction: A ten percent drop in a market after a period of rising values

Dead Cat Bounce: When a market rises a little then falls again after crashing

Liquidity: Money (not necessarily cash, usually credit)

Last week little doubt remained that the United States is in recession with the news that the number of jobs fell.

U.S. Economy: Payrolls Fall for First Time Since 2003

Bob Willis

Feb. 1 (Bloomberg) -- The U.S. unexpectedly lost jobs for the first time in more than four years, increasing the odds the economy will fall into a recession and making it likely the Federal Reserve will cut interest rates another half point next month.

Payrolls fell by 17,000 in January after an 82,000 gain in December that was larger than initially reported, the Labor Department said today in Washington. None of the 80 economists surveyed by Bloomberg News predicted a decline.

Employment is one of the indicators, along with wages, production and sales, that help determine the start of economic contractions. The decline poses a further threat to consumer spending, which accounts for 70 percent of the economy, after households were already hurt by falling home and stock values.

“It is highly unusual for payrolls to fall except in a recession,” Christopher Low, chief economist at FTN Financial in New York, said in an interview.
“The Fed will have to keep cutting rates and we can expect a cut at the next meeting in March.”

Fed Chairman Ben S. Bernanke and his colleagues said Jan. 30 “risks to growth remain” after cutting the benchmark rate by a half-point, eight days after an emergency three-quarter- point move. Odds of another half-point cut, to 2.5 percent, in March rose to 70 percent from 68 percent late yesterday, according to April futures quoted on the Chicago Board of Trade.

Treasuries Rally

Treasuries, which fell earlier in the day, rose after the report, with 10-year yields dropping to 3.60 percent at 5:13 p.m. in New York, from as high as 3.66 percent. Stocks rose on Microsoft Corp. $44.6 billion bid for Yahoo! Inc., with the Standard & Poor's 500 Index gaining 1.2 percent, at 1,395.42.

A private report today separately showed that manufacturing unexpectedly grew in January, showing business investment is holding up as other parts of the economy weaken. The Institute for Supply Management's index rose to 50.7, a five-month high, from 48.4 in December, the Tempe, Arizona-based group said.
Manufacturers, state governments and construction companies lost jobs, today's report showed.

“Employment fell across a broad assortment of industries,” said Mark Vitner, senior economist at Wachovia Corp. in Charlotte, North Carolina. “It raises a number of red flags for the economy. There is no question economic growth has slowed to a crawl and the risks of recession are significant. That is why the Fed has cut interest rates so aggressively.”

The jobless rate, which is based on a separate survey from the payrolls figures, declined to 4.9 percent in January from 5 percent the previous month.

…The economy expanded at a 0.6 percent annualized pace in the fourth quarter, government figures showed this week, and many economists anticipate a contraction in the current period.

“We are in or near a recession,” David Greenlaw, chief fixed-income economist at Morgan Stanley in New York, said in a Bloomberg Television interview. “We'll see the jobless rate begin to drift higher over coming months.”

If all we are facing is a recession than we will be very lucky. Chances are much worse is in store either depression or collapse. Why? For one thing, the U.S. dollar, the world’s reserve currency is in risk of collapse because to prevent banks from failing the Federal Reserve Board is rapidly lowering interest rates, but that, in turn, makes dollars worth less on the international currency market.

Here is Mike Whitney on the banking crisis:
Rate Cut as Dagger
America's Teetering Banking System

Mike Whitney

January 31, 2008

Somebody goofed. When Fed chairman Ben Bernanke cut interest rates to 3 per cent yesterday, the price of a new mortgage went up. How does that help the flagging housing industry?

About an hour after Bernanke made the announcement that the Fed Funds rate would be cut by 50 basis points the yield on the 30-year Treasury nudged up a tenth of a percent to 4.42 per cent. The same thing happened to the 10 year Treasury which went from a low of 3.28 per cent to 3.73 per cent in less than a week. That means that mortgages, which are priced off long-term government bonds, will be going up too.

Is that what Bernanke had in mind; to stick another dagger into the already-moribund real estate market?

The Fed sets short-term interest rates (the Fed Funds rate) but long-term rates are market-driven. So, when investors see slow growth and inflationary pressures building up; long-term rates start to rise.

Bernanke knew that the price of a mortgage would increase if he slashed rates, but went ahead anyway.

How did he know?

Because 8 days ago, when he cut rates by 75 basis points, the ten-year didn't budge from its perch at 3.64 per cent. It just shrugged it off the cuts as meaningless. But a couple days later, when Congress passed Bush's $150 stimulus package, the ten year spiked with a vengeance, up 20 basis points on the day. In other words, the bond market doesn't like inflation-generating government handouts. So, why did Bernanke cut rates when he knew it would just add to the housing woes?

The fact is, Bernanke had no choice. He's facing a challenge so huge and potentially catastrophic; that cutting rates must have seemed like the only option he had. The banks are "capital impaired" and borrowing at a rate unprecedented in history.

The capital that the banks do have is quickly being depleted.

Banks are forced to borrow reserves from the Fed in order to keep lending.
A careful review of these graphs should convince even the hardened skeptic that the banking system is basically underwater. The sudden and shocking depletion of bank reserves is due to the huge losses inflicted by the meltdown in subprime loans and other similar structured investments.

"When US homeowners default on their mortgages en-mass, they destroy money faster than the Fed can replace it through normal channels. The result is a liquidity crisis which deflates asset prices and reduces monetized wealth," says economist Henry Liu.

The debt-securitization process is in a state of collapse. The market for structured investments -- MBSs, CDOs, and Commercial Paper -- has evaporated, leaving the banks with astronomical losses. They are incapable of rolling over their short-term debt or finding new revenue streams to buoy them through the hard times ahead. As the foreclosure-avalanche intensifies; bank collateral continues to be down-graded which is likely to trigger bank failures.

Henry Liu sums it up like this: "Proposed government plans to bail out distressed home owners can slow down the destruction of money, but it would shift the destruction of money as expressed by falling home prices to the destruction of wealth through inflation masking falling home value." ("The Road to Hyperinflation", Henry Liu, Asia Times) It's a vicious cycle. The Fed is caught between the dual millstones of hyperinflation and mass defaults.

The pace at which money is currently being destroyed will greatly accelerate as trillions of dollars in derivatives are consumed in the flames of a falling market. As GDP shrinks from diminishing liquidity, the Fed will have to create more credit and the government will have to provide more fiscal stimulus. But in a deflationary environment; public attitudes towards spending quickly change and the pool of worthy loan applicants dries up. Even at 0 per cent interest rates, Bernanke will be stymied by the unwillingness of under-capitalized banks to lend or over-extended consumers to borrow. He'll be frustrated in his effort to restart the sluggish consumer economy or stop the downward spiral. In fact, the slowdown has already begun and the trend is probably irreversible.

The financial markets are deteriorating at a faster pace than anyone could have imagined. Mega-billion dollar private equity deals have either been shelved or are unable to refinance. Asset-backed Commercial Paper (short-term notes backed by sketchy mortgage-backed collateral) has shrunk by $400 billion (one-third) since August. Also, the market for corporate bonds has fallen off a cliff in a matter of months. According to the Wall Street Journal, a paltry $850 million in high-yield debt has been issued for January, while in January 2007 that figure was $8.5 billion---ten times bigger. That's a hefty loss of revenue for the banks. How will they make it up?

Judging by the Fed's graphs; they won't!

Bernanke's rate cuts sent stocks climbing on Wall Street, yesterday, but by early afternoon the rally fizzled on news that Financial Guaranty, one of the nation's biggest bond insurers, would be downgraded. The Dow lost 37 points by the closing bell.

The plight of other major bond insurers, MBIA and Ambac, could be known as early as today, but it is reasonable to expect that they will lose their Triple A rating. According to Bloomberg:

"MBIA Inc, the world's largest bond insurer, posted its biggest-ever quarterly loss and said it is considering new ways to raise capital after a slump in the value of subprime-mortgage securities the company guarantee". The insurer lost $2.3 billion in the fourth-quarter. Its downgrading from AAA will "cripple its business and throw ratings on $652 billion of debt into doubt." Many of the investment banks have assets that will get a haircut.

The New York State Insurance Department tried to work out a bailout plan but the banks could not agree on the terms (ed note: "They don't have the money")
"Bond insurers guarantee $2.4 trillion of debt combined and are sitting on losses of as much as $41 billion, according to JPMorgan Chase & Co. analysts. Their downgrades could force banks to write down $70 billion, Oppenheimer & Co. analyst Meredith Whitney said yesterday in a report." (Bloomberg)

The bond insurers were working the same scam as the investment banks. They found a loophole in the law that allowed them to deal in the risky world of derivatives; and they dove in headfirst. They set up shell companies called "transformers", (the same way the investment banks established SIVs; structured investment vehicles) which they use as "off balance" sheets operations where they sell "credit default swaps , which are derivative instruments where one party, for a fee, assumes the risk that a bond or loan will go bad". ("The Bond Transformers", Wall Street Journal) The bond insurers have written about $100 billion of these swaps in the last few years. Now they're all blowing up at once.

Credit default swaps (CDS) have turned out to be a gold-mine for the bond insurers and they've given a boost to the banks too, by freeing up capital they use in other ventures. "The banks profited on the interest rate difference between the CDOs (collateralized debt obligations) they bought and the payments they made to transformers...The banks sometimes booked profits upfront on the streams of income they expected to receive." (WSJ)

Neat trick, eh?

Even now that the whole swindle is beginning to unravel, and tens of billions of dollars are headed for the shredder; industry spokesmen still praise credit default swaps as "financial innovation".

"It's too early to say we're going to ban all these products," said Guenther Ruch, administrator for Wisconsin's insurance regulation and enforcement division. (WSJ)

Maybe Ruch is right. Maybe it is too early to ban all these dicey financial inventions. But he may change his tune when Wall Street gets a whiff of the billions that'll be lost in downgrades and the markets start to tumble.
Other countries that have indulged in “financial innovation” while enjoying an asset bubble like the United States are in for nasty surprises as well. The U.K. is now bracing for a million foreclosures:
Warning over one million homes at risk

Economic slowdown would leave many borrowers vulnerable, says FSA

Jill Treanor

The Guardian

Wednesday January 30 2008

More than a million homeowners could be at risk of serious financial difficulty and possibly losing their homes in an economic slowdown, the City regulator warned yesterday.

The Financial Services Authority is preparing for a tougher climate of rising inflation and a slower economy. It fears that many homeowners with large mortgages who have borrowed three and a half times their salaries or more could be at risk.

The warning comes as surveyors predict today that 123 homes a day will be repossessed this year. The FSA cites three warning signs on mortgages:

· The loan was taken out for longer than 25 years;
· It is worth more than 90% of the home;
· The amount borrowed is 3.5 times or greater than income .

Over a third of all mortgages sold between April 2005 and September 2007 fall into one or more of these categories. This suggests that more than 2m of the 5.7m mortgages written during this period are of potential concern.

It is the 1.04m customers whose mortgages contain two or more characteristics who most concern the FSA. It calculates that the number "most likely to default on loans" - those whose mortgage falls into all three categories - is 150,000.

The regulator is concerned that many borrowers are badly prepared for worsening economic conditions. It believes homeowners may have become too reliant on cheap credit and rising house prices to sustain levels of spending.

The FSA's concerns are based on the current economic climate deteriorating and an end to the easy credit available to many customers over the past two years.

A "significant minority" of customers could find their finances become very tight if lenders react to any worsening in financial conditions by cutting the number of mortgages they are prepared to sell.

The pressure on homeowners may not be eased by cuts in official interest rates either. The Bank of England is expected to sanction another cut next week - on top of its quarter point reduction in December. But the FSA admitted it was "not clear" whether the reduction would be passed on by the mortgage lenders, whom it notes could actually raise rates to deal with the pressures on their business.

Lyndon Nelson, the FSA's head of financial strategy and risk, said: "It is not necessarily the affordability of the mortgage. It is their other debt. Customers with other borrowing in addition to the mortgage are struggling."

"The other borrowings tip them over the edge," he said.

This could have repercussions for the wider economy if house prices start to ease and other spending slows.

The warning comes in the FSA's Financial Risk Outlook, which it uses to describe the risks it sees over the next 18 months. The regulator notes that the new loans were "concentrated in groups which historically have not been homeowners" which could make it difficult for lenders to predict how they will behave.

The FSA also points out that the level of repossessions is still relatively low, but believes they will rise. This is borne out by the Royal Institution of Chartered Surveyors, which today predicts about 123 homes a day will be repossessed this year.

The FSA has already sounded the alarm over 1.4m fixed-rate mortgages which are due to mature in the next 12 months and has warned mortgage lenders not to rush into repossessions.

The warning is just one of the "priority" risks it has identified for the next 18 months. The others include customers losing confidence in another financial firm, in the way they did with Northern Rock; concerns about the business models of some banks since the credit markets tightened; and a potential increase in finance crime caused by the downturn.

Labels: , ,


Post a Comment

<< Home