Inconsistencies of the Economic 'Recovery'

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

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What created the Credit Crisis and the current 20 month recession (the longest since World War II) was the collapse in price of all the worthless real estate paper the was issued during the bubble years. As this blog mentioned yesterday, this problem has recently gotten 'better' because the accounting rules that determine the value this paper were changed. While playing make-believe is appropriate for five year old children, it's not a good idea for running financial system and just leads to bigger disasters later on.

The support for the real estate 'recovery' is thin to say the least. U.S. house prices supposedly went up during the last three months. This occurred even though home loans are hard to get and U.S. wages and salaries were down 4.7% year over year in June. This was the largest drop since records began in 1960. Employment is also down. As was mentioned last Friday, the unemployment rate dropped by 0.1% because a large number of people left the labor force. No matter how you look at it fewer people have a job. So who are these people who are paying higher prices for houses and what banks are lending them the money? All in all is seems highly unlikely that house prices could actually be going up given such conditions. If not, this set of numbers wouldn't be the only ones that have been altered recently to make them look better.

The other inconsistency in the real estate is getting better is that this was a drag on the big banks and brokers earnings in the second quarter. Many of them were increasing loan loss provisions. Fannie Mae, whose business is purely real estate related, illustrates the current state of affairs quite clearly. Fannie Mae lost $14.8 billion in the second quarter. Provisions for credit losses were $18.8 billion. The company stated in its earnings "We are experiencing increases in delinquency and default rates for our entire guaranty book of business, including on loans with fewer risk layers."In other words, all types of loans are going down the tubes including the prime ones. Total non-performing loans increased to $171 billion in the second quarter. They were up from $149.9 billion in the first quarter of this year and that was up from $119.2 billion in the last quarter of 2008. Well, that certainly looks like a recovery pattern, doesn't it?

Fannie Mae has requested an additional $10.7 billion from the U.S. Treasury to keep afloat. That it can get by this quarter with only an additional $10.7 billion cash infusion from the government seems optimistic. The company is essentially a bottomless pit for bailout funds. Both Fannie Mae and Freddie Mac's criteria for non-performing loans were changed around the beginning of the Credit Crisis to make it more difficult for a loan to be considered non-performing. Even with this fantasy, things still are getting worse. Somehow reality always seems to always get in the way of the government's best plans.

NEXT: More on the Real Estate 'Recovery'

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Credits of Mass Destruction

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

The New York Investing meetup has made a companion video to this blog entry. You can find it at: http://www.youtube.com/watch?v=qjGoOE2SwhY.

In the week of February 14, 2008, the Auction-Rate Securities market collapsed with almost 1000 auctions failing. Auction-rate bonds were long-term debts that had their interest rates reset in a Dutch Auction every one to 35 days. The market had been created in 1984 and from that time until the end of 2007, only 44 auctions had failed. The market had grown to over $300 billion and was a favorite place to borrow for local governments, hospitals, museums, student-loan agencies and closed-end mutual funds. As long as the auctions worked the rates for these borrowers remained as low as 3%, but if they failed (something no one worried about since this almost never happened), the rates could be punitively high - as much as 20%. Wall Street raised money from some of its best clients to fund these auctions, with promises that these investments were 'as good as cash'. After 24 years without problems, the end came suddenly and without warning. The big banks and brokers withdrew their support and overnight their clients who had invested in these 'good as cash' investments couldn't get their money back. The borrowers suddenly found themselves paying junk bond rates.

At almost the same time, VIEs 0r variable interest entities (also known as conduits or special purpose vehicles) made the news. VIEs are off-balance sheet items for banks (contary to popular belief, the Enron scandal did not do away with off-balance sheet items) and their amounts were revealed to be around $800 billion. The first major news of off-balance sheet items for banks concerned SIVs (structured investment vehicles), which are a type of VIE. This news appeared in the fall of 2007. SIVs were estimated to have an original value of $400 billion and this amount was considered so great that the U.S. Treasury department attempted to arrange an SIV bailout. This effort never got anywhere and was abandoned by December. Only two-months later, the off-balance sheet problem was revealed to be twice as large as originally thought. Furthermore, it was estimated that the VIEs were worth only 27 cents on the dollar. In an SEC filing, Citibank indicated that it had $320 billion in VIEs, which would mean it might have lost approximately $240 billion off-balance sheet. It had only written off $22 billion in losses up to that time.

While problems with the auction-rate securities market and VIEs had not been predicted and appeared seemingly out of nowhere, warnings were being made about the Credit Default Swaps market (CDSs). These were derivatives that were a type of bond insurance and the functioning of this market was threatened on a number of fronts - particularly from bond insurers losing their top credit ratings or a failure of a major counter-party (any large bank or broker). The Fed would have to publicly bail out Bear Stearns in mid-March 2008 to prevent the collapse of this market. The CDS market was so huge at $62 trillion that it was four times the size of the U.S. economy and was effectively a financial nuclear weapon that could wipe out the entire system. If this happened, it would likely be sudden and without warning just like the collapse of the auction-rate security market (and Bear Stearns).

NEXT: Gold, Silver, and Oil - The Basics of Price Movements

Daryl Montgomery
Organizer, New York Investing meetup

For more about us: Please see our web site: http://investing.meetup.com/21.

Central Bankers Gone Wild

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

The New York Investing meetup has made a companion video to this blog entry. To see it, please go to: http://www.youtube.com/watch?v=y9kzKAzn2Ig

In the hundred years before the Federal Reserve existed, aggregate inflation in the United States was approximately zero. This does not mean that there was never any inflation, inflation did indeed exist, but that the periods of inflation were offset by periods of deflation so that over a long period of time there were essentially no changes in prices. A new era for inflation began when the Fed was created in 1913. Except for the Great Depression in the 1930s, deflation essentially disappeared from the United States economy and there were only periods of lower or higher inflation. This continuing inflation resulted in a 1923% inflation (based on understated official figures) for the first 95 years of the Fed's existence. Conversely, it could be said that the U.S. dollar had lost 95% of its value during this time. And the remaining 5% seemed to be endangered as well.

The beginning of 2008 saw what was probably the biggest injection of liquidity into the U.S. monetary system by the Fed in history. There were two massive rate cuts separated by only 8 days. First there was a 75 basis point cut in the Funds Rate on January 22nd and this was followed by a 50 basis point cut on January 30th. The previous time the Fed had cut rates by 75 basis points was when the Funds rate was at 20%. The January cut took place from a 4.25% level and was the first inter-meeting cut since the 9/11 crisis. Only two months later the Fed would again cut the Funds rate by another 75 basis point, this time from the 3.00% level. Based on the starting levels, the cuts in the Funds Rate was enormous and took place in a very brief span of time.

The cut in the Funds Rate was by no means all the liquidity that the Fed was pumping into the system. The TAF (Term Auction Facility) auctions were raised from $20 billion to $30 billion each by January and would reach $50 billion for each auction in March. Two additional auction facilities were added to the TAF by March - the TSLF and the PDCF. The TSLF (Term Security Lending Facility) was set up to swap $200 billion of treasuries for illiquid securities being held by the banks. The PDCF (Primary Dealer Credit Facility) opened the Fed's credit operations to the 20 firms that bought treasuries directly from it. The Fed had only lent money to commercial banks during its entire history and the PDCF represented a big extension from its traditional scope of operations.

The impact of the Fed's liquidity boosts caused the money supply to explode. MZM (money with zero maturity and therefore available for immediate use) grew by an over 37% annual rate in the first quarter of 2008. This would have been OK if the economy was expanding by around 37% as well, but the economy was contracting instead. The difference between money supply and economic growth was more than enough to create a massive future inflation problem and possibly even hyperinflation. How much inflation would actually take place was something only time would tell.

NEXT: The Fed's Manipulation of the Stock Market

Daryl Montgomery

Organizer, New York Investing meetup

For more about us, please go to our web site: http://investing.meetup.com/21

Government Investment Pools Dry Up

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

While the downgrades of the bond insurers threatened U.S. municipalities with higher future interest costs, it became obvious in November 2007 that there were far more immediate risks to public finances when there was a run on Florida's Local Government Investment Pool . The run began when word got out that the Investment Pool had exposure to $1.5 billion in defaulted and downgraded SIVs. Florida had to freeze withdrawals to prevent the fund from collapsing. The municipalities that got out early were lucky, all others had to find emergency funding to meet their payrolls for police, firemen, hospital workers, teachers, and other employees.

Local, State and Government investment pools existed in at least 20 states and were essentially special money market funds that bought short-term debt and were set up to get higher yields that would otherwise have been available. Little did they know that these slightly higher yields were being produced by taking on massively higher risk through exposure to subprime toxic waste that the big brokers (Lehman in Florida's case) were more than willing to sell to them. Problems were by no means isolated to Florida either. In the last days of November, Montana school districts, cities and counties withdrew 10% of the total $2.4 billion in its investment fund after the rating on one of the pool's holdings was lowered to default. The state of Maine had invested 3% of it money, apparently on Merrill Lynch's advice, into a fund only two weeks before its credit rating was lowered to junk status. Financial difficulties with government investment pools were also reported in Orange County, California and Seattle, Washington.

While the losses of the Government Investment Pools were certainly serious, were they isolated of were they likely to spread? If these ultra-sophisticated money-market funds got into trouble, wouldn't it be reasonable to assume that the money market funds open to the individual investor might suffer similar problems in the future? By the late fall of 2007, it had already been reported that Bank of America, SunTrust, Wachovia and Legg Mason had taking steps to prop up money market funds that contained securities of possibly questionable worth. And it looked like the formerly safest of investments were in some cases becoming among the riskiest.

Next: Subprime Freezes Over

Daryl Montgomery
Organizer, New York Investing meetup

For more about the New York Investing meetup, please go to our web site: http://investing.meetup.com/21

Sovereign Wealth Funds Bail Out the Banks

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

As the credit crisis unfolded in the fall of 2007, a number of big banks and brokerage houses were desperate for capital - far more desperate than was ever admitted publicly. While they needed large cash infusions to continue operating, a number of sovereign wealth funds in the oil-rich Gulf and the Far East had swollen coffers of dollars that they needed to place somewhere. It was therefore almost inevitable that some of the first bailouts (an insolvent financial institution requires multiple bailouts) of struggling financial institutions would be done by sovereign wealth fund purchases. By the end of 2007, it was estimated that these funds would make at least $37 billion of investments in Western financial companies.

The idea of foreign investment as a means of providing capital was not a completely new one. Prince Alwaleed Bin Talal of Saudi Arabia had purchased 5% of Citibank (then Citigroup) when it was reeling from the Savings and Loan Crisis in the early 1990s. Earlier in 2007, China purchased a $3 billion stake in Blackstone's IPO, which debuted just before the collapse of the private equity bubble and promptly plummeted in price. By November, Abu Dhabi had bought a 4.9% stake in Citibank for $7.5 billion. At the time of the purchase, rumors were circulating on Wall Street that Citi might be insolvent. U.S. government officials admitted being involved in the transaction, which begs the question as to whether or not they would have allowed the deal to go through if it wasn't absolutely necessary for Citibank's survival.

In early December, the Government of Singapore Investment corporation got 9% ownership in UBS for a little less than $10 billion and an unnamed middle eastern investor (thought to be Oman) bought a 2% stake. China then bought a 9.9% stake in Morgan Stanley only days before Christmas. Singapore's Temasek Holdings then helped bail out Merrill Lynch on December 24th. By mid-January, Citibank was already in need of a second bailout by the sovereign wealth funds, only two months after the first one had taken place. The Government of Singapore, the Kuwait Investment Authority and Price Alwaleed were part of a $12.5 billion capital infusion for which they got some ownership of the bank in return. On the same day, only weeks after its first cash infusion from a sovereign wealth fund, Merrill Lynch received an additional $6.6 billion from parties including the Kuwait Investment Authority and the Korean Investment Corp.

None of these deals had to undergo scrutiny by the U.S. Committee on Foreign Investment, which only examines whether acquisitions by overseas buyers compromise national security when their stakes rise above 10%. Given the large number of sovereign wealth funds and wealthy individuals in the Gulf States and Far East, it would be possible for their aggregate ownership to reach 100% without a review ever taking place.

Next: Government Investment Pools Dry Up

Daryl Montgomery

Organizer, New York Investing meetup

For more about the New York Investing meetup, please go to our web site: http://investing.meetup.com/21