International Forecaster Weekly

Billions In Lossess Will Become Trillions In Losses

The Game is up for the Banks as they now face limits on derivatives, trillions remain outstanding in credit default swaps, American meddling in Iraq to continue indefinitely, Insider buyers were pushing Bear Stearns out of business,Russia defeats NATO in Georgia, Iran blockaded by US Navy, Apple backdating settled with SEC, ugliness in mortgage land

Bob Chapman | August 16, 2008

After $500 billion in losses that will eventually end up in the trillions, Gerald Corrigan, former Vice Chairman of the NY Fed, has submitted a report that proposes to place server limits on derivatives, bring them under regulation to protect retail investors from their more egregious products. This is something Alan Greenspan and his Fed fought against ferociously. Banks now realize the game is up. The mega profit center is history. We do not think the proposal goes far enough, but it is a step that Wall Street and banking won’t like and that non-financials should welcome. It will lead to the downsizing of finance and a cutback in globalization. The report proposes a prohibition on selling auction-rate-securities to retail investors.

The disaster that is symptomatic of what went wrong is the auction-rate-securities. There was preferred stock issued by corporations and particularly financial institutions and auction-rate municipal bonds, issued by municipalities.

The first auction rate preferred stock was issued in 1984 by Citigroup. In 3 years the market had grown to $12 billion. In 24 years it had reached $300 billion. In February 2008 the market collapsed. As a result of banks refusing to continue to make markets in securities they created, leaving everyone particularly municipalities hung out to dry.

In the end the banks were forced by state attorney generals to buy back the paper from which they had walked away from. The only reason the banks bought the preferreds and ARS’ back was that they figured out the settlements were a pittance of what they would have to pay in settlement of class action suits.

Switching gears slightly here we deal with the credit default swaps. They are supposed to represent a hedging transaction to reduce risk. All Corrigan recommends is transactions be cleared through a clearing house. Overall corporate debt in the US is $20 trillion, yet the principal amount of CDS outstanding exceeds $60 trillion, thus 2/3’s of the volume is speculative and has nothing to do with hedging. This is a major profit center for banks. As a result, there are trillions of dollars of losses not yet declared in these instruments.

The foundations of preferreds, ARS and CDS are gambling instruments in a casino and they confer no value to our economy. Having central clearing only reduces counterparty risk, but that action overlooks the massive speculative risk to players and to our economy. The risk is still out there and hasn’t been addressed and these derivatives can easily take down the entire financial system. Short selling of credit should be banned and the only parties who should be allowed to use CDS’, should be those who can show a definite need to hedge risk.

We brought to your attention four years ago how these CDS vehicles would take down Fannie Mae and Freddie Mac. We were right they did. Wait until the total losses are tallied then you will get the picture. As usual no one wanted to listen. We were crazy, we recommended a short on Fannie at $58.00 it was last seen at $11.00, after having rallied over the past couple of weeks. What Fannie and Freddie were doing was over-leveraging and they got away with it because of an implied government guarantee, which unfortunately became reality. On top of that they were not properly regulated due to politics and campaign contributions. They had become a system of largess mainly for Democrats. In time their losses will exceed $2 trillion.

You can then include on top of these horrible pending losses the day to day losses in purchasing power by the 17% increase in money and credit that translates today into 13-5/8% inflation. Lies, lies and more lies.

The only reason Corrigan has proposed anything is that ARS, CDS, SIVs, CDOs and ABS are all unsound. All of Wall Street knows it and now the public does. They all have to be eventually terminated. Once Wall Street and banking comes to terms with this the stock and bond markets will take a big hit, one that will last for years.

Since 1992 we have lived in an illusion of prosperity. Free trade, globalization, offshoring and outsourcing have dismantled our industrial base dropping workers from $31 an hour to $10 to $12 an hour. The illusion was kept alive by the Fed via massive creation of money and credit and unnaturally low interest rates. The result is that consumers spent far beyond their means. Who would want to save dollars that depreciated daily versus gold and other currencies?

We have been in recession 1-1/2 years and it is getting worse. This will be the worst recession since the Great Depression.

In addition to recessionary problems we are saddled with a coming bailout of debt. If you add all the agencies together we are looking over $2 trillion that we’ll have to pay back.

We know the Iraq War and occupation was not about oil because the administrations in London and Washington have assured us it wasn’t. What they had to say turns out to be lies because BP, Exxon Mobil, Shell and Total have written contracts that have been signed by the Iraqi government. They have 2-year contracts and have the inside track on at least 60% of the cheapest oil to extract in the world. Big oil has again had its way and it is back with a vengeance. The result as well is that Iraq has become a long-term vassal state. The US is authorized to conduct military operations and to detain anyone they want arbitrarily. America will also have 50 military bases in Iraq, full control of Iraqi airspace, legal immunity for US military and private security firms, and the right to conduct armed operations throughout the country without consulting the Iraqi government. Our Congress has no say in this matter because George and the neocons didn’t call this a treaty. Great Britain received a similar treaty in Iraq in 1930. America is now about to feast, as Britain did in the 1920s, off of Iraq’s wealth in another famously exploitative deal.

This means today that insurgent warfare will go on indefinitely. It is certain that Bush’s neocon blueprint for indefinite foreign rule in Iraq and the takeover of its oil will be forced by threats of the Iraqi people.

June business inventories roe 0.7% as sales rose 1.7%. Retail sales ex autos rose 0.4%, this was the smallest monthly gain since January’s 1%.

July import prices rose 1.7%. June’s plus 2.6% was revised to plus 2.9%. They rose 21.6% yoy, the largest increase in 26 years.

Import prices for petroleum prices rose 4% in July and were up 79.2% yoy. Non-petroleum product increases were 0.9% in July and up 8% yoy, the largest gain since 6/87 and 6/88.

Chief investment strategist at Merrill Lynch Richard Bernstein says the credit crisis is broad and deep, and global financial companies even after having reported $500 billion in losses have a long way to go. This validates our assumptions made a year ago. Investors are significantly under-estimating both the scope and extent of the credit bubble and the consequences of its subsequent deflation. The lingering effects of the crisis means banks and brokerages need massive consolidation because of the glut of lending worldwide.

Sales at retailers fell in July for the first time in five months off 0.1% following a 0.3% gain mom. This is the result of the end of the stimulus package affect. The public didn’t spend most of the money, they paid bills.

Recently the FDIC spent 25% of their insurance funds leaving them $39.6 billion having spent $13.2 billion. They said they’d use a maximum of $9 billion. They obviously are not telling us the truth. Then later they said they spent $15 billion. All we know is they are a bunch of bumbling idiots. We didn’t see any failures last Friday night. We wonder what the FDIC Friday Night Financial Follies will bring this Friday?

Yields on mortgage securities guaranteed by Fannie Mae rose to their highest relative to Treasuries since March on concern that defaults are spreading to ALT-A and prime mortgages from the subprime loan category.

Fannie’s current coupon on their 30-year fixed rate bond is 6.02%, 212 bps more than Treasuries of similar maturities. That is 26 bps from the 22-year high of 328 points reached March 6th, a week before the Fed completed the financial assassination of Bear Stearns. Although Fannie won’t accept any more ALT-A loans, and they make up 11% of their $3 trillion portfolio, they also account for 50% of second quarter losses. The rising yield reflects rising risk. We expect both Fannie and Freddie’s yields to move substantially higher over the next year in spite of government moves to nationalize both GSEs.

In May the Bush Veterans Affairs Department banned voter registration drives at veteran’s facilities. Why would the neocons do something so stupid? It is because they lash out at anything or anyone that disagrees with them. Veterans in hospitals, nursing homes, rehabilitation centers and homeless shelters are bitter about fighting a no win war for corporate profit.

Twenty-one Secretaries of State, both Republican and Democrat have asked VA Secretary James Peake to lift the ban. Our government is a disgrace and no longer serves Americans – only corporate interests.

Oil demand in the first half of 2008 fell by an average of 800,000 barrels per day yoy. Of course, there is no recession – only slower economic growth. This drop helped offset a 1.3 m/b/d increase in non-industrial countries. The net is global oil consumption rose by 500,000 b/p/d over the first half of the year. Gasoline prices fell from $4.11 in July to $3.81 per gallon and that should again increase consumption at least marginally.

Presently heating oil is $4.34 a gallon, up 31% from last winter and natural gas is $15.58 per thousand cubic feet, up 22% yoy.

As an adjunct to the Bear Stearns financial assassination someone wagered $1.7 million that Bear Stearns’ shares would suffer an unprecedented decline within days. Now options specialists believe in retrospect that the buyer, or buyers, made a concentrated effort to drive the 5th biggest securities firm out of business, just as we predicted, while the events were in progress. The buyers reaped a profit of $270 million. Who were the buyers who bought puts 50% below the price with just a week to exploration? And, why hasn’t there been an investigation by the SEC? And, who were the profit markers? It is not even on the page of rational behavior, unless you have inside information. Bear Stearns was deliberately destroyed and these put buyers were part of the process. Who is the SEC protecting this time, our government, JP Morgan Chase or whom? When asked for comment the SEC refused to answer questions.

Why did $22 billion in credit lines disappear in a few days? Why were large clients pulling their accounts? Why were counterparties refusing to do business with Bear? Investors with credit default swaps tried to get other firms to buy their positions, but to no avail.

There is no question that the out-of-the-money puts point to a raid. Nothing like this has ever happened in the options market before. The rig was in and Morgan, the Fed and our government orchestrated the entire caper. Bear Stearns was the victim of insider trading.

Hearings in the Senate Banking Committee in April produced nothing.

The SEC, via Chairman Cox, told Congress in July that the SEC is probing whether illegal trading spurred the collapse both in Bear Stearns and the 72% fall in Lehman Brothers shares.

Illegal naked short selling turbo charged the effect of false rumors on Bear Stearns shares and the SEC is well aware of this. They won’t talk about it because they allowed the rules to be broken, so major Wall Street firms could make more billions and screw the public. Everyone on Wall Street knew the rig was in, so who made the big bets and why? In today’s SEC, Washington and Wall Street we’ll probably never know. The crooks will have it all covered up.

Russia strengthened its position and stake in Caspian oil resources by its success against Georgia. This is a major foreign policy defeat for the US, Israel and NATO.

Iran is in nuclear talks yet the American flotilla of 40 warships, some nuclear armed, are blockading the country. This is the biggest force since the Iraq invasion.

New York Attorney General Andrew Cuomo said on Thursday that J.P. Morgan Chase will pay fines to settle investigations into their actions in the auction-rate securities market. J.P. Morgan agreed to pay a $25 million fine, while Morgan Stanley agreed to pay $35 million, Cuomo said during a press conference. Both banks also agreed to buy back auction-rate securities from retail clients, including individuals, charities and small businesses, he said. The companies will repurchase a total of roughly $7 billion of these securities, the attorney general added. J.P. Morgan said it will buy back about $3 billion of securities at their original value. The difference between the original value of these securities and the market price is about $400 million, the bank estimated.

The Securities and Exchange Commission said Thursday that it has reached a settlement deal with Nancy Heinen, the former general counsel of Apple Inc., over charges related to stock-option backdating. Heinen has agreed to pay $2.2 million in disgorgement, interest and penalties without admitting or denying guilt. She has also been barred from serving as an officer or director of any public company for five years, and been suspended from practicing law before the Commission for three years. The SEC had charged Heinen with fraudulently backdating large stock-option grants to senior Apple executives and altering company records to conceal the fraud. Heinen had previously denied all charges.

The conduit, the market for securitization, through which mortgages and other debts are packaged and sold as securities, has become sclerotic and almost totally dependent on government support. The problems, intensified by bond investors who have grown leery of these instruments, have been a drag on the economy and have persisted despite the exercise of extraordinary regulatory powers by policy makers.

Federal Reserve Bank of Richmond President Jeffrey Lacker said the worst may not be over for U.S. banking losses, the Charlotte Observer reported, citing comments he made at an economic journalism seminar yesterday. How many times have we heard that over the past nine months?

Another scheme that financial companies have employed during the crisis is to regularly reclassify assets from Level 2 to Level 3 and vice versa. Level 3 assets have no market so values have to be guessed.

Level 2 assets are ‘marked by model according to tangible data.’ Ergo if you have a beneficial model you move assets from Level 3 to Level 2 to generate better marks and earnings.

Which leads us to JP Morgan – For most of the US financial crisis the media and pundits hailed JP Morgan as having a ‘fortress-like balance sheet’ even though it has over $80 trillion of derivatives. JP Morgan CEO Jamie Dimon has been portrayed as the Financial Wizard of Oz.

So for the past several months most investors and people assumed that JP Morgan somehow managed to avoid all the crappy paper and ancillary problems that plague the industry. One group that thought otherwise averred that the Bear Stearns bailout was engineered to help JP Morgan obfuscate its problems and borrow massively from the Fed without public concern.

But the revelation of a relatively miniscule $1.5B write-down has destroyed the illusion of JP Morgan’s imperviousness to the financial mess. This has led analysts, investors and wise guys to re-examine JPM.

One disconcerting JPM fundamental is the amount of its Level 2 assets. An astute money manager alerted us that, “The market is obsessed with Level 3 assets levels but forgot to notice that of JPM's total $1.775 trillion in assets, $1.575 trillion are Level 2 or mark to model. The whole loan, MBS and Level 2 are what presents the real danger when the raters finally get there.”

An astute money manager notes that a dazzling array of ugliness has surfaced this week in mortgage land. “The financial problems that appeared earlier this year were preceded by unprecedented subprime RMBS downgrades. In recent days similar downgrades have appeared on Alt-A and Jumbo Prime. The problem here is Alt-A and Jumbo-Prime mortgages dwarf the subprime universe both in overall size and what remain on banks balance sheets.”

Ratings on Alternative-A securitizations took another pounding this week -- with downgrades hitting classes of deals as far back as 1995. Citing higher-than-anticipated rates of delinquency, foreclosure, and real estate owned in the underlying collateral relative to credit enhancement levels, Moody's Investors service downgraded more than 900 tranches of nearly 90 Alternative-A residential mortgage-backed securities. Alt-A classes downgraded by Fitch Ratings were in the thousands. Standard & Poor's Ratings Services lowered ratings on 72 classes from 14 Alt-A RMBS issued in 2005, 2006, and 2007 because projected credit support for the affected classes is insufficient to maintain the previous ratings given current projected losses.

Easy Al believes the housing bottom will occur in 2009, which is three years after his first call of ‘the bottom’ in housing. He also believes that FNM and FRE should’ve been nationalized and equity holders

wiped out. Then the GSEs should’ve been dismantled into several privately held units.

US credibility is again on the line as the Bush Administration stumbles to respond to the Russian invasion of Georgia. So far the Administration has been missing in action, to put it mildly. The strategic objective is twofold: to prevent Moscow from going further to topple Georgia's democratic government in the coming days, and to deter future Russian aggression. Reshaping U.S. policy toward Russia will take longer than the months between now and January 20, when a new President takes office. But Mr. Bush can at least atone for his earlier misjudgments about Mr. Putin and steer policy in a new direction that his successor would have to deal with. If that successor is Barack Obama, this is an opportunity to shape a crucial foreign policy issue for a novice who could very well go in the wrong direction.

The alternative is ending Mr. Bush's tenure on a Carter-esque note of weakness. To paraphrase General Clay: Whether for good or bad, how the U.S. responds to Russia's aggression in Georgia has become a symbol of American credibility. By trying to Finlandize if not destroy Georgia, Moscow is sending a message that, in its part of the world, being close to Washington can be fatal. If Mr. Bush doesn't revisit his Russian failures, the rout of Georgia will stand as the embarrassing coda to his Presidency.