Doom-And-Gloom Club Welcomes A New Member

Those who have followed me for a while know that I have been a doom-and-gloomer since the beginning of 2008. A bit late to the party compared to some, like Noriel Roubini and Michael Panzner, but I have been trying to make up for lost time. Now I am not a doom-and-gloomer by nature. I am actually a fairly optimistic person. Nonetheless, I am not one to ignore reality, facts or statistics.

Yet there are others who have been late to recognize the pain we are in and are facing, but they seem to be waking up a bit. I am not going to mention the CEOs of financial institutions or those in government. These individuals are required to lie about how well things are going, from what I can tell. They constantly say how we have reached a bottom and how strong the American economy is at heart. Yeah, right.

Well, now a fellow optimist is joining the doom-and-gloom club. He has not been part of the "we are fine" crowd, to his benefit, but he is just now, from what I can tell, joining the ranks of doom-and-gloom. Warren Buffet, welcome to our vastly increasing club. Reality is reaching the masses. Yes, Warren is saying our economy is in a "shambles" for 2009 and probably well beyond. I feel vindicated.

http://www.bloomberg.com/apps/news?pid=20601087&sid=a1L50vuf_HiM&refer=home

Now it could be because his company's profit was down 96%. That might create a good bit of reality. Still, Buffet, if he is true to his own proclamations, is having the time of his life. This is the biggest market downturn in his life and he has money to invest, so he has to be a happy guy. As he has said, when there is fear in the market it is time to invest. He also once said he would be happy if the value of all his companies went down by 50%. He must be dancing around his house he is so happe!! So you have to ask yourself, is he now seeking to increase fear to better his own opportunities? Those that idolize Buffet have to realize he is very oportunistic and not the nice guy some think he is. He will announce he has bought a stock, which will drive up its price, but then request a SEC exemption from announcing when he sells out to avoid the price declining before he is out. He is a great investor, but not quite the clean guy some think. So you have to wonder whether his words express reality or support his investment goals - or both. Either way, I think he is right.

http://www.bloomberg.com/apps/news?pid=20601087&sid=aO.dAwhtKlAw&refer=home

Disclosures: None

Disclosures: None.

A February To Forget

That was a very ugly month, a very ugly month indeed. The DOW was down close to 12% and the S&P close to 11%, back to 1996 levels. The S&P is now lower than when Greenspan gave his famous "irrational exuberance" speech (I took this fact from Calculated Risk). But that is just the symptom, not the cause. What is the cause? Well, there are a host of candidates and unlike some news media organizations I will not tell you which one is to blame because all of them and thousands, even millions, more are to blame. Here is a compilation of a few prime candidtates:

1. Doubts over the new Administration's plans are top on my list. I don't like the way we are spending the money designed to turn things around and I have a large set of people, some very smart, who agree with me. Paul Krugman, a Nobel laureate in economics is among them. http://krugman.blogs.nytimes.com/2009/02/26/feelings-of-despair/ And others have observed that what Obama is doing is not that different than the prior Administration. Whatever happened to the candidate for "change"? http://globaleconomicanalysis.blogspot.com/2009/02/dear-mr-president-with-all-due-respect.html
2. The GDP dropped at a revised 6.2% rate in the fourth quarter. That rate of decline happening for the rest of this year will push us very close to the common definition of a "depression," which is a 10% decline in GDP. I fear we have accelerated that pace in 2009, so we could get to the big "D" this year. http://www.bloomberg.com/apps/news?pid=20601087&sid=a4hGytIkgj.U&refer=home
3. Citigroup is being partially "pre-privatized" (this is nationalization by a different name). Stock down about 40% today. The government is converting part of its preferred holdings to common, reducing current shareholders' interest by 79%. And the bondholders are nervous (and should be).
4. Real estate still in a slump and contributing a good bit to 2 above. Moreover, non-residential is on the verge of adding to the problem big time. http://www.calculatedriskblog.com/2009/02/investment-contributions-to-gdp.html
5. The government stress tests have begun and the standards for a worst case are secret as are the results of the test. Nonetheless, some possible leaks on the "worst" scenario for real estate suggests the "worst" is well within many mainstream predictions on reality. Whether these leaks are true or not, the secrecy around the base-line for the tests is creating market uncertainty.
6. Some liquidated CDO results are coming in and the results are in a word - terrible. Even the super-senior tranches are only recovering 32 cents on the dollar. Admittedly, the worst may be the first to liquidate, but this does not bode well. http://www.nakedcapitalism.com/2009/02/more-on-simply-dreadful-performance-of.html This may explain why Bank of America's loans are valued at $44 billion (that's with a B) less than they are carried on their books. Go figure. http://www.bloomberg.com/apps/news?pid=20601087&sid=aax9SfdVNbiE&refer=home
7. The length of this list is pushing up against my need to sleep. The list could go on a very long time but let me finish with another high note. We are deleveraging and we are a long way from the bottom in this process. When housing reaches a bottom AND deleveraging reaches an acceptable point, we might start to recover. Unfortunately, if you look at my housing bottom post earlier this week you will see we are no where close to the former and we are also no where close to the latter. http://globaleconomicanalysis.blogspot.com/2009/02/dear-mr-president-with-all-due-respect.html
8. The real reason for the market decline this month and year is that reality is setting in and we are returning to another reality. It is time to get ready for a new level of living. A sustainable level. Unfortunately, that level is well below what we have grown used to living. Well, get used to it. Hunker down.

Disclosures: None.

Some Good News and Some Bad News

Let's start with the bad news as we seem to be used to it - or numb to it. But first, let me qualify. There is plenty of bad news on multiple fronts. I am just giving you a piece on the real estate front. New home sales at are a record low. Mind you, the records started in 1963, so it is just a 46 year old record, but impressive nonetheless.

http://www.calculatedriskblog.com/2009/02/summary-post-new-home-sales-at-record.html

And the good news is also on the real estate front - go figure. I am not finding the specifics at the moment but the home sales in certain parts of California have improved over last year substantially. Mind you over half the sales are foreclosures or short sales and property prices have dropped 41%, but it seems a 41% drop is a pretty good bottom for now. Now we just need the rest of the country to drop that much and things will be dandy.

Disclosures: None.

CDS - What a Mess

Before I get to my discussion of the CDS market I haved to admit, my new goal in life is to understand everything being discussed in the linked post.

http://us1.institutionalriskanalytics.com/pub/IRAMain.asp

I get the direction of things and generally understand it, but I would love to understand in detail the specifics. Keep in mind, I am a lawyer, not an economist, so I focus on the macro side of economic life, yet I find the micro of great interest and my personal goal is to educate myself to understand it. Yes, you can teach an old dog new tricks.

In any event, they point to the credit default swaps as a continuing problem in this rescue. I have written about these at some length and will not repeat it here. Nevermind, I will repeat it. CDSs are quite similar to reinsurance spirals I litigated over, so this part I understand somewhat intimately - perhaps better than the linked authors. I have spent 25 years litigating mostly over insurance and this part I know.

What I did find of most interest is the fact that those providing CDS protection bought reinsurance, which if you are unfamiliar with it, it is insurance to protect insurance. For example, let's say I insure you for $10 million against a loss, in this instance a financial loss, for a premium of $100,000. But I am unwilling to take all that risk, so I reinsure that risk and pass on part of my compensation to someone who takes on part of the risk. I may pass on $9 million of the risk and hopefully pass on less than 90% of the compensation I received. There are likely middle-men here, like lawyers or brokers, skimming off some of the profit, so the reisurer is taking on a percentage of the risk for a proportionally smaller premium. And that reinsurer may pass on part of the risk to another reinsurer, now a retrocessionaire, who in turn does the same and so forth and so on - each probably getting less compensation, less premium, for the risk they are taking (proportionally speaking). That is a problem if it happened in the CDS market, and now I think it did. Unwinding these contracts is near impossible, and on this scale it probably is impossible. At a minimum, with reinsurance and retrocessions, rest assured we will spend decades unwinding the mess.

Now I am not sure it happened as much in the CDS market, but in the insurance market I dealt with, you had a number of regular players who continually layed off the reinsurance to each other and you often had company A being reinsured by company B, who is reinsured by company C who in turn is reinsured in part by company A, and so forth and so on. This created what we called spirals, sometimes tight spirals and sometimes looser. Eventually the loss got dumped out of the spiral to the fall guy. I suspect this very well may have happened in the CDS market too, at least to some extent.

To give some perspective, the reinsurance spirals I dealt with arose out of workers compensation insurance in the U.S. All told, a few billion of dollars were at stake, which for most of the players were big dollars. The company I represented was put into run-off because of it. We had a year long trial in England (one of the longest commercial trials in English history) that resulted in over a thousand page decision. (By the way, due to the decision, which is a major paper-weight in my office, all that I am saying here is quite public and, if you want, I can give you citations) We had about 130 contracts and ended up in a lot of disputes on those contracts. And all this was over very little in exposure compared to the CDS market. Now multiply this scenario to arrive at what at one point was an estimated $62 trillion in CDS obligations. I know there has already been a major effort to cancel off-setting obligations, i.e. cancelling out the spiral, but if - say - $20-30 trillion in contracts remain to be resolved, this is quite serious. How serious depends on how many default events trigger these CDS contracts. Based on the past two months, I think it will be a fair amount. In any event, even if I leave my company I expect to have a fair amount of work I can do until I retire (I hope).

Now I might add that the vast majority of CDS contracts are insuring something that the insured does not own. The trillions in dollars of contracts beat the global GDP by a few factors, so there is no conceivable way that this insurance, by and large, protects actual exposures. Rather, for the most part, it is gambing. A company (A) with no exposure to another company (B) or its bonds seeks to bet that company B cannot pay on bonds. So company A buys a CDS from company C, which for a premium is willing to take that bet. And when company B defaults, company A gets paid by company C even though company A had no company B bonds or other exposure to company B losses. Trillions of dollars tied to little more than a financial bet - that is good business. No wonder we are in a mess of trouble. We do not know who is on the point for these obligations -yet!

Meanwhile, the bank bailout is already being complicated by CDS contracts. Oh what a wicked web we weave.

http://us1.institutionalriskanalytics.com/pub/IRAMain.asp

Disclosures: None other than my involvement in reinsurance spirals as discussed above.

Big Banks Bad Bet

Not a lot of comment on this one as it is self-explanatory. Sudden Debt has a nice piece on how the banks are toast. Not just because of all the toxic debts, not because they have tens to hundreds of billions of bills to the taxpayers to repay, but because -even if you wipe the slate clean - their business model going forward is toast.



As Sudden Debt puts it, the act of avoiding risk by not lending is coming back to haunt the banks. After so many other business models are gone for them, like derivatives, M&A and the like, what remains is not enough to support them - at least not all of them. Now this begs the question, why are we so hell-bent on saving them all?



http://suddendebt.blogspot.com/2009/02/trouble-with-harry-or-ccc.html



Disclosures: None.

Bernanke Talks - Common Sense Walks

Bernanke assured investors today that the financial stress test is not a nefarious way to asses which banks to nationalize. Rest assured, we will only throw away taxpayer money on preferred shares and only convert them, i.e. partially nationalize, if extraordinary losses materialize. Well that puts my "Obama has a secret plan" idea to rest.

http://seekingalpha.com/article/120720-does-obama-have-a-secret-plan

I like it. I am really feeling much better now that we are spending all this money and getting no control, no bang for our buck. For institutions such as Citigroup and Bank of America we have already provided them more than their market capitalization all for some preferred shares paying a nice dividend. I have not done the math but I am sure with the nice dividend we will be made whole in a few hundred years. The taxpayers are screwed, which is all the more reason to bid up financials today, some over 20%. Heads shareholders win tails taxpayers lose. Nice equation.

But before all those looking to get rich quick on these stocks start to celebrate too much, read a bit between the lines. He noted things might change if extraordinary losses materialize. Heellllloooo!! If the losses so far are not considered extraordinary I don't know what is. Yet rest assured that if you do not think they are there now, they most certainly will be in due order. Don't get me wrong, I am partially in equities and have no short positions so I made money today, but I still don't believe it.

http://www.bloomberg.com/apps/news?pid=20601087&sid=auD.fPbtkf5I&refer=home

Now the real kicker is that he sees no reason to destroy the "franchise value" of these organizations. Yeah, right! How much franchise value do these companies still have?

Now I have to admit he has a bit of a point on creating legal uncertainty. For example, what impact does nationalization or partial nationalization have on credit default swaps? It may or may not be a default event. Who knows for sure as these multi-trillion dollars worth of insurance-like contracts are written off the grid. In other words the contracts say whatever the parties agreed for them to say. So it is at least conceivable that nationalization would trigger some. Certainly any move that zeros out the bondholders will do so. So I can appreciate the desire to avoid this move. And I can appreciate this is not in our "culture." But I can appreciate more that I don't like throwing my taxpayer money away and getting nothing for it. The widows, retirees, pension funds and the like only deserve what they get if they are still in these financial stocks. Moreover, I have few qualms about putting the final nail in that coffin if 90 nails have already been hammered in by the market.

We do, however, need to do this in one strike. Take out all the dead wood all at once to avoid doubt about the remaining banks. That, at least, is what I still suspect is the Obama secret plan with the stress tests. Advice to Obama - getter done!!

Disclosures: None

P.S. How can you tell if Bernanke, Lewis, Thain, the Fed, the FDIC, the Treasury, politicians or others in this financial mess are lying - their lips are moving. I know it is an oldy but a goody. As a lawyer, I hear it all the time.

Now I Am Truly Scared

You have undoubtedly heard of the Case-Shiller Index. It is a commonly cited index for tracking housing prices. The December read is now out showing a YoY drop of 18.5%, worse than predicted. That is not what is scaring me.

The "Shiller" part of the index comes from its co-producer Yale Professor Robert Shiller. He has an index of American home prices going back to 1890. According to this index, the housing bubble we just experienced was by orders of magnitude worse than any other we have ever seen in this country. Moreover (you better be sitting) housing prices have a lot further to drop, and I mean a LOT further, before returning to the trend line. He believes we are only halfway back to fair value and usually during a correction we overshoot fair value. The linked interview is well worth the five minutes it takes to play. If you do not have the time, the linked chart tells it all.

http://www.businessinsider.com/shiller-house-prices-still-way-too-high-2009-2

You add into this equation the effects of a global downturn, job losses, reduced wages and the like and one can easily imagine us overshooting the trend line significantly.

I firmly believe we will not find a bottom on the economy until we find a bottom on housing. From this data, that bottom is still a long way off, as in 3-5+ years off, and it is a lot lower than most have predicted. That is far worse than this doom-and-gloomer was thinking. We can only hope Robert Shiller is wrong, but unfortunately this is one guy who knows what he is talking about on real estate.

Disclosures: None

China Struggling

I guess it is no news that the entire globe is struggling. China, I believe, will soon, if not already, hurt more than most. They were a big supplier of a world economy that is now on the ropes. And now the signs of stress are on the rise.

Moreover, they built up for a local economy that does not and will not exist any time soon. According to this piece from the LA Times, Beijing alone built up 500 million square feet of commercial office space since 2006, which is more than exists in all of NYC, and about 100 million feet sit vacant. That is roughly a 14 year supply IF things keep going as they have over the past few years before the downturn, which ain't happening.

And certain Olympic venues are either being torn down or significantly changed. Can you imagine the Bird's Nest as a shopping mall. No - well its owner can. The construction there was rampant and now it is time to pay the piper. Sad to see.

http://www.latimes.com/business/la-fg-beijing-bust22-2009feb22,0,1213023.story?track=rss

So you think China, as a major manufacturer and supplier of the rest of the world, will truly suffer badly due to slowing world demand? They are, after all, the biggest manufacturing country in the world right? NOT!! That title, folks, in terms of value or profit squarely belongs to a country most today hardly even consider to be a manufacturing society - the U.S. of A. Yes for every $1 of value manufactured in China, the U.S. manufactures $2.50 in value. We have switched over time to the high cost, high value products. You know, like jet engines, heavy equipment, military products and the like. As the leading manufacturer, in terms of value, we are suffering the same fate as China for our manufacturers. If you have any doubt, ask GE, whose stock fell to its lowest level today since 1995. Talk about a lost decade.

http://www.ritholtz.com/blog/2009/02/us-remains-worlds-leading-manufacturer/

Disclosures: None - Fortunately I no longer have my GE stock.

The Lost Decade Plus

Many refer to the economic mess in Japan in the early 1990s, as leading to the lost decade for Japan. Well at the moment Japan is looking at the lost score (you know, as in four score). The new lost decade crowd is here in the U.S. Both the Dow and S&P are back to levels not seen since 1997.

http://www.calculatedriskblog.com/2009/02/party-like-its-1997.html

My last post yesterday asked where the market is going. I noted my belief that we are in a new, lower, trading range and were at or near the top of that range. Today was more proof of that. We are in for a world of hurt with no easy fix. Hunker down.

Disclosures: None

So What Else is New?

Citigroup needing more government support - nope, old news.

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aVw5u2ehimYc

AIG needing more government support - nope, old news.

http://www.bloomberg.com/apps/news?pid=20601087&sid=a_Mj2UeRcQRA&refer=home

Banks slashing dividends - nope, old news.

http://www.bloomberg.com/apps/news?pid=20601087&sid=aDh7NR3XwXNA&refer=home

Government lying through its teeth in a failed attempt to boost confidence - nope, old news.

http://globaleconomicanalysis.blogspot.com/2009/02/purposeful-joint-lie-by-treasury-fed.html

Car companies on the brink of bankruptcy - nope, old news.

http://www.nakedcapitalism.com/2009/02/treasury-soliciting-bankruptcy-funding.html

I guess history does repeat itself.

Disclosures: None.

Cannot Build It That Cheap

One of the problems facing builders is that excessive foreclosures in certain markets are leading to home prices a good bit cheaper than they can build a new house. In those locations, even when prices stabilize it will be some time before they can build houses for a profit, and even longer before they can do so for a good profit. Expect more home builder bankruptcies. Unfortunately those bankruptcies in some areas will make no difference in competition for those that remain. The competition is banks with foreclosed properties.

http://www.calculatedriskblog.com/2009/02/home-builder-we-cant-compete.html

Disclosures: None

Where Is The Market Going??

I have noted a couple of times lately that I thought the market was heading south, breaking through support levels, and finding a new range. The past week would argue in favor of what I have said. I am not saying I am right yet, but there is some pretty good proof that I am not off the mark too much.

I have to say, however, that I think we are still at the top end of the new trading range. Nothing scientific here, just reading the tea leaves. I see no good news on the immediate horizon and the bad news is gaining steam. I still think we are not just in an L shaped recession, but a depression. Not as bad as 1929, but not that far off. Time to hunker down!!

Disclosures: None

So Long RBS

The Royal Bank of Scotland is on the chopping block. It will be split into a good bank and bad bank with hundreds of billions (of pounds) of toxic assets to be sold off for pennies on the dollar - and the vultures are lining up. It is Britain's biggest corporate loss and, more importantly, it is the corporate parent to my U.S. bank, which is apparently surviving in the good bank. The sell-off will be one of the biggest ever seen and will significantly reduce the bank's trillion pound balance sheet. This was a bank too big to fail.

One individual, Jay Levine, led the bank's charge into sub-prime mortgages in the U.S. and he left the bank in 2007 after earning 40 million pounds over three years. Hopefully someone will have the good sense to sue him for all that and more. There are plenty of legal theories you can think of and this type of foolishness needs to be rewarded with a host of lawsuits. Perhaps bankrupting those that led us to the brink with legitimate lawsuits premised on their negligence and malfeasance will warn others in the future not to tread there. If I were not in-house now, I would love to go after some of these less than stellar greedy individuals. It would be a good ride.

Meanwhile, however, what Britain is doing here is a road-map for the U.S. No bank is too big to fail. You can take them down and remove them as competition for their healthier brethren. The sooner the better as we cannot keep spending hundreds of billions on technically insolvent banks on life support.

The military has this concept known as triage and the U.S. government needs to take a page from that book. You need to look at the banks and prioritize. Those that are obviously going to die are last in line. They need to be wound down orderly but otherwise deserve the least money and attention. Those that are critical but can survive deserve the most money and attention. And those only slightly wounded need to be patched up and put back into the field. Just my two cents on this.

http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article5780280.ece

Disclosures: None.

Balance

Obama plans on reducing the federal budget to $533 billion by the end of his first term. And I plan on winning the lotto. Who do you think has the best odds?

Now I like the idea of taxing the rich more and cutting spending on Iraq (though I think we are looking at increased Afghanistan spending), but even with both of these I cannot fathom reducing the deficit. A better goal would be to reduce the rate at which we are increasing it, but even that seems like folly at the moment. Obama himself noted that we could be incurring a trillion or so in deficit per year for years to come. Still, I agree it make sense to let Bush's tax cuts to the rich lapse. We cannot afford them right now and the rich, despite all their losses of late, can better afford the pain than some elderly poor person trying to decide between food, heat and medicine. That trickle down thingy just does not work too well until it is government enforced through taxes.

http://www.bloomberg.com/apps/news?pid=20601087&sid=aKS2yjxfkmjU&refer=home

I am not trying to upset the Reagan fans who liked his trickle down thoughts, but even George Soros is now tracing the roots of our current economic decline back Reagan, back to regulators abdicating their responsibility and back to a philosophy that the markets are best left alone. The markets are driven by greed and greed has a nasty backlash. Everyone needs someone to watch over them.

http://www.bloomberg.com/apps/news?pid=20601087&sid=ay0FPxGdth_k&refer=home

Moreover, I am a major fan of balance. Economists like to doctor it up with words like mean and the like, but I prefer to refer to it as balance (though I do talk about mean from time-to-time). What do I mean by balance? Well, let me give you an example. The disparity in the U.S. between the rich and the poor has been increasing for a very long time. Stats show that the average "Joe the plumber" on the street has no more net value or income than he did eight years ago. Yet over the past decade the rich, by-and-large, have grown richer. The gap has grown. But the rich, who are free to spend their money here or wherever in the world they please, have at times failed to recognize where their bread is buttered. Those groveling masses supply about 70% of the U.S. GDP, so when they cannot spend, the rich also feel the pain. When the lower and middle class get in over their heads in debt to manage a semblance of a decent life, the rich prosper for a while. Yet while the rich get richer, those supporting them simply go more into debt. Eventually the cycle breaks and things must return to a better balance. The poor and middle class spending allows the earnings of the rich. And the rich need to understand that. We need a balance and things have gotten out of balance. We are reverting to mean, we are reverting to balance. Two slightly different ways to view the same proposition. When the rich realize better that their wealth depends on the survival of those on whom they are standing, the sooner we will build better balance.

Disclosures: None