FedUpUSA

Archive for February 7th, 2010

Ken Lewis: If I’m Going Down, Hank Paulson and Ben Bernanke Are Coming Down With Me

No WAY is Bank of America CEO Ken Lewis going to be the only one to answer for the acquisition of crappy Merrill Lynch and its crappy bonuses, “a person close to Lewis’s defense team” (who may or may not be Ken Lewis himself) tells Charlie Gasparino today on the Daily Beast. NO WAY will he be a scapegoat, alone, for the people who twisted his arm to go through with the Merrill deal by telling him he would be fired if he didn’t. “If this thing goes to trial you can expect both Paulson and Bernanke to be on the witness list.” If he’s going down, he’s bringing them down, too. Bringing them down to Chinatown. Order in the court!

By Rocky Vega

02/06/10 Stockholm, Sweden – Despite the lack of any sustainable, long-term financing solution — and record debt levels — it seems one of the only thing Democrats and Republicans can consistently agree upon is more and more spending… whether through taxes or debt.

As Jesse Felder astutely points out, it’s a really unfortunate case of the pot calling the kettle black.

The Daily Reckoning

By Bill Bonner

02/02/10 Baltimore, Maryland – What a marvelous recovery! But there are so many unresolved mysteries! GDP growth over 5%…but, mysteriously, no jobs…and no rally in the housing market.

And now, to compound the mystery, Mr. Obama has come forward with a $3.8 trillion budget.

The markets like it. Stocks rose 118 points on the Dow yesterday. Gold went up $21. Investors see more hot money on its way…a Vesuvius of it…

The amount of the budget itself is staggering. That’s a lot of money. But even more staggering is the glaring omission: the Obama administration is planning to spend $1.6 trillion it doesn’t have. And that’s on top of the $1.35 trillion it didn’t have, but nevertheless spent, last year. Where is all this money coming from? Another mystery…

Let’s see…put those two deficits together and you’ve got a budget hole as big as the Milky Way… Nearly $3 trillion, or more than 20% of GDP.

Another thing that is mysterious about this galaxy of debt is that it comes just as the economy is supposed to be recovering. If you thought the economy were recovering, why would you risk such a huge, record-shattering deficit?

Nothing quite adds up. The GDP is expanding at a healthy pace – according to the numbers handed out by the feds. But people have few jobs and little income.

“Wage and benefit growth hits historic low,” reports The Wall Street Journal.

Employers aren’t employing. Workers aren’t working. And houses are no longer throwing off cash. That leaves more and more people with empty pockets.

Apparently, not even the feds themselves believe the economy is really out of the ditch. We are already rolling along on the recovery road – supposedly. Still, the feds send out the most expensive tow truck in history!

And now The Financial Times draws the obvious conclusion:

“US Deflation No Longer Seen as a Risk.”

You wanna bet?

The world’s number one economy is running huge deficits. But the world’s number two economy is running even bigger ones. Not much bigger…but slightly bigger.

In Japan, deficits are a bit larger than tax receipts. In America, they are a bit smaller. In both cases they are enormous…and growing.

For all its colossal deficits, Japan has not bought its way out of depression…or out of deflation either. Au contraire, the more it spends fighting deflation the further prices fall.

How could this be? Another mystery. How could government be so inept as to shoot itself in the foot whenever it pulls a trigger? How could it be so near-sighted as to aim for one thing and hit the thing it was meant to protect? How could it be so lame-brained as to do exactly the wrong thing at exactly the wrong time?

We can’t answer those questions…at least, not this minute.

So, let’s turn to the evidence. There it is in yesterday’s news report from Bloomberg:

“Consumer prices in Japan in record fall.”

And there you have another mystery, don’t you? Japan inflates the money supply with its zero rates over more than a decade…and its Godzilla budget deficits. And what happens? Its economy sinks and its consumer prices go down!

And so here comes the US of A following the Japanese lead…in the sincerest form of flattery…

Will it not get the same results?

We don’t know. But we wouldn’t be surprised.

We have a lot more to say about this…

…about how the economic theories behind these moves are corrupt, linear and superficial (if not downright stupid)…

…and about how the real driving force behind these deficits is politics, not economics. Economists are just useful idiots. The politicians are using them to grab more money and power for themselves and their friends…

…but let’s go directly to the denouement of this mystery story. Here’s what is really going on:

First, the GDP growth story is one part statistical noise, one part counterfeit, and one part damned lie. We’re in a depression. It will take years to resolve itself.

That’s why unemployment remains high…and why there will be no recovery in housing prices. They may go up. They may go down. They won’t ever get back to the bubble highs of 2006 – not in real terms. Not in our lifetimes.

Second, the mystery of the $1.8 trillion deficit – it too is a mixture of mendacity, audacity, and intellectual laxity. In short, the feds are spending so much money for one reason only: because they think they can get away with it.

Can they?

Of course not…not really. Here’s what is going to happen…

The reality of the non-recovery is going to catch up with this market. Stocks were down in January. Most likely, they’ll sink for the rest of the year too.

The economy will slide as the de-leveraging process continues. It won’t be straight down. But by fits and starts, the mistakes will be corrected…

…but that brings us back to this $3.8 trillion government budget. Its purpose, in large part, is to prevent the corrections from occurring. The feds will try to turn the US into Zombieland, just like the Japanese feds did. You’ll see massive federal spending taking up some of the slack from the private sector – but essentially wasting money on useless projects. And you’ll see major zombie corporations – GM…AIG…etc – propped up with taxpayer’s money.

Speaking of AIG, special agent Neil Barofsky is on the case. He’s ‘probing’ 25 cases of possible fraud involving TARP funds. The AIG bailout is one of them. The original price tag for saving Goldman’s speculative positions with AIG was $85 billion. The whole tab later came to $182 billion.

The flatfoot Barofsky wants to know where the money went. To tell you the truth, we’re curious too – although we doubt there will be any surprises.

But back on our beat…how the mysteries get resolved…

…we know why the economy is winding down…and we know why the feds are running such huge deficits…

…but big deficits aren’t pushing up prices in Tokyo; they’re having the opposite effect. They’re pushing them down. Does that mean US deficits will get the same results – the economy and prices lower instead of higher?

We don’t know…but our guess is that ‘yes’ is the right answer.

The Daily Reckoning

You Had Better Cage The Monster CONgress (AIG/GS/CDS)

Posted by Karl Denninger

I’ve been writing about this now over a year in regard to the mess that became of AIG, their “financial products” unit, and what I believe is culpability not only of certain financial parties but more importantly our regulators of these firms.

Now The NY Times has published a new article that makes clear that my clarion call for major changes in these areas of the market were not only spot-on, but are even more necessary today than they were back then.

A.I.G. had long insured complex mortgage securities owned by Goldman and other firms against possible defaults. With the housing crisis deepening, A.I.G., once the world’s biggest insurer, had already paid Goldman $2 billion to cover losses the bank said it might suffer.

A.I.G. executives wanted some of its money back, insisting that Goldman — like a homeowner overestimating the damages in a storm to get a bigger insurance payment — had inflated the potential losses. Goldman countered that it was owed even more, while also resisting consulting with third parties to help estimate a value for the securities.

Read that carefully.  The NY Times is making this sound like AIG had insured losses against securities Goldman was holding.  That’s what insurance is, right?

Here’s the problem: Goldman didn’t own the securities.

In addition to offering to cancel its own contracts, Goldman offered to buy all of the insurance A.I.G. had written for several other banks at severely distressed prices, according to three people briefed on the discussions.

Negotiating with Goldman to void the A.I.G. insurance was especially difficult, Federal Reserve Board documents show, because the firm did not own the underlying bonds. As a result, Goldman had little incentive to compromise.

Now do you see the outrage in these so-called “protection devices”?

They aren’t.  They were raw bets.  Very highly-leveraged gambling instruments that had a very low cost at origination – a cost all out of proportion to their eventual potential return.

We do not let “just anyone” buy insurance.  You must have an insurable interest.  That is, I can’t buy fire insurance on your house.  If I could, I might – and so might 20 of my best friends.  We might even target those homes we think might have fires.  We could even bribe the folks doing a controlled burn nearby to be a little less careful than they ordinarily would.  Or, in the extreme case, one of us might just set a fire on purpose!

None of this is allowed in the insurance marketplace because it creates too many incentives for people to set fires and otherwise cause calamities, whether through outright unlawful conduct or helping along “a series of unfortunate events.”

In the regulated options, futures and stock markets we have controls on this sort of thing as well.  To short a stock (legally) you have to be able to borrow it.  That is, someone who owns it must lend it to you first (perhaps in exchange for money.)  As more people short the cache of people willing to lend out that stock for free will evaporate, and you’ll have to start paying up for the privilege of borrowing it.  This is a natural check and balance on placing negative bets via shorting.

Buying PUTs or transacting in the futures market has costs too.  Those regulated markets have defined margin requirements and they are enforced – nightly.  The cost of buying a PUT includes something for the guy who sells it to you, as he is going to hedge his bet by being short the stock.  Thus, as the number of PUT buyers increases the premium demanded rises – precipitously so as the demand for those PUTs goes up.  Finally, buying a PUT doesn’t come with the right to demand anything more from the seller – his margin requirements are enforced by the exchange and you don’t get to hold the money. 

These OTC CDS contracts had another insidious feature: They apparently included a clause that not only would a downgrade of the security trigger margin requirements but so would a downgrade of AIG. 

The terms, described by several A.I.G. trading partners, stated that A.I.G. would post payments under two or three circumstances: if mortgage bonds were downgraded, if they were deemed to have lost value, or if A.I.G.’s own credit rating was downgraded.

The perversity of incentives here is that if you can demand that your counterparty hand over more and more “margin” to you it is possible to actually force a downgrade by your actions and thus cause even more margin to have to be posted!  This, of course, harms the firm’s liquidity and makes a further downgrade more likely. 

Rinse and repeat to destruction – which, incidentally, is exactly what happened.

This is dramatically different than the regulated markets, where valuations are determined by the market, not by one of the parties at interest and the margin requirement is fixed by the deficiency (if any) against the final strike price and the market’s price – the person who happens to be short gets no benefit (or harm) due to his or her credit rating.  If you’re underwater, you post margin.  If not, you don’t, but in neither case does the person on the other side of the trade get to hold the margin funds!  He gets your money only when he closes his position or the option expires (if it’s in the money.)

These “synthetics” (such as the Abacus CDOs) are an outrage on their face.  These are not created from the purchase of actual physical asset (e.g. a mortgage security) but rather by someone writing a credit-default swap against a reference.  These are then bundled up and sold.  When a credit-default swap is then written against a synthetic CDO it is equivalent to writing a gambling contract on a gambling contract as nobody in the chain owns an actual physical asset (such as a loan)!

The simple fact of the matter is that “naked” CDS exposures need to be prohibited right now.  They never should have been allowed and not a damn thing has changed.  Purely synthetic instruments need to be traded on an exchange in each and every case as a means of preventing chicanery, where margin can be enforced transparently on a nightly basis by a neutral third party in the middle of all transactions – the nominal buyer for every seller, and seller for every buyer.  This third party (the exchange), having no skin in the game either way, will not permit the abuses that are too easily committed when you have over-the-counter transactions of this type.

The article referenced makes a decent case that AIG didn’t fall off the cliff, it was pushed.  There are even allegations raised of collusive conduct which, if true, add an even more serious angle to this entire story.

But at the end of the day the problem boils down to the same basic facts I have been harping on since the beginning:

• Writing “insurance” on something the purchaser doesn’t own isn’t insurance, it’s a gambling contract.

• When such gambling contracts stack up to a great degree there are huge incentives for someone to commit financial arson.  Whether they did or did not is a matter for debate, but that the incentives exist to structure deals in a way that are easily detonated so you can profit from them as exposure increases is not open to debate.  Such incentive does absolutely exist – and we must eradicate it.

• To prevent fraud and gaming of the system, such contracts must be on a regulated exchange where each buyer and seller deals with a neutral third party (the exchange itself) that is responsible for nightly margining, trade reporting, open interest and bid/offer maintenance.  These facts must be exposed at all times to the public so that the market operates in a transparent fashion and neither side of the transaction can be “pushed”.

• The exposure of these contracts on said exchange will also prevent disasters like AIG from occurring, as the fact that they are short “X” will become instantly visible to everyone, including their regulators.  The precise exposure they are taking on will thus be known at all times.

• We must bar backstopped entities (such as banks and insurance companies) from trading in or creating synthetic instruments such as this in the first place.  These are not hedges as by definition there are no actual hard assets behind them.  The argument that they are created to fill a demand from the market is true but irrelevant – the fact remains that with no actual hard asset acquisition behind them they serve no fundamental credit intermediation purpose which is the purview of banks and insurance companies – they are, instead, pure speculative instruments.  Let the hedge funds, operating without any sort of financial backstop, create these all they want – and trade them on a regulated exchange – but keep the banks and insurance companies out of it.

We have not neutered this monster in the slightest.  Indeed, the latest rabble in the market with regard to Greece, Spain and Portugal is, not surprisingly, about (once again) credit default swaps blowing out.

And again I ask – who wrote those CDS naked on these nations to people who didn’t actually hold underlying positions in the bonds without them being traded on a central exchange, and why, after 2008 and 2009, do we still let that crap go on?