The American Housing Crisis Explained

This is the most illuminating video that explains the current crisis facing America and ultimately the rest of the world. Well worth watching: www.tickerforum.org/cgi-ticker/akcs-www?post=38857

Use Today as a Selling Opportunity

As we approach the end of the first quarter who will find that a number of shares will be pushed higher by portfolio managers to boost their performance. What will be interesting is that no one will call foul and look for the rumour mongers when shares are pushed higher but just let one share (read HBOS) be manipulated down and it is the end of the world - Just the way of the world I am afraid. Both actions are illegal and fraudulent but only one is punishable. It really looks like the "Credit Default Swap" CDS market is about to blow up, the companies that have been writing these insurance premiums have no way of ever paying up should they be called to do so. FGIC has admitted that they don't have the required capital to justify their Insurer status and if taken to the logical conclusion means that they are no longer an Insurer - This means that there policies are worthless. The problem is that all the banks and I mean all are still using these policies to back up their balance sheet liabilities. The banks are all insolvent at present. This is something that ypu wont read in the financial press or hear from the pump monkeys on Bloomberg and CNBC> As this rally is definitely in its final stages I urge everyone to exit any exposure they have to equities, especially banking shares. The market is only some 12% off its peak and has a long way to go. I have revised my downside target on the FTSE to 4700 now. Sell - You have been warned

This rally is only a blip!!!

Since the Easter weekend the financial press and the pump monkeys on CNBC have been calling the bottom of the markets and an end to the credit crisis - their reason is that the banks are passed their worst all the bad news is reflected and the actions of the Fed will now stimulate the economy which will rebound in the second half of 2008. This cannot happen for the following reasons: 1) The USA will now enter a protracted phase of slow growth similar the path followed by the Japanese economy since 1987 - The Nikkei Index is still 75% below it's peak and interest rate have been at zero for decades, one thing in their favour was that they had extremely high rates of personal saving at the time - The American consumer is virtually bankrupt. The lower bank rates will not allow the consumer to take on more debt and continue to spend the country out of recession, the banks will not be in a position to lend at any rate, they will have to become more risk averse in the practices. 2) You cannot have a system where profits are privatised and losses are made good by the public - the bail out of Bear Stearn's has cost each citizen of America $300!!. House prices still have a long way to fall to revert to the mean, this will increase the default rate which will bring down the value of the toxic bonds that the banks and now the Federal Reserve own further exacerbating losses on Wall Street. This equates to higher PE's on the averages, which in spite of the bottom pickers claiming the market is cheap makes it extremely expensive. Meridith Whitney who has been spot on on calling the banks earnings has just lowered her earnings for the entire banking sector to a loss of 28 cents from a profit of 75 cents - You cant have a P without an E. 3) US consumer confidence is the lowest it has been since March 2003 and expectations are the worst since the oil crises of 1974 - Hardly an environment for shares to rally. 4) Commodity prices have probably peaked as the big hedge funds will need to unravel their speculative positions as margin call increase for all their positions - No more 32x leverage by the banks and trading houses. Some of my targets on the downside have been reached - my next post will be an update and predictions for the second quarter Watch this space

Who is this guy Margin who keeps calling me?

This is the most radical change and expansions of Fed powers and functions since the Great Depression: essentially the Fed now can lend unlimited amounts to non bank highly leveraged institutions that it does not regulate. The Fed is treating this run on the shadow financial system as a liquidity run but the Fed has no idea of whether such institutions are insolvent. As JPMorgan paid only about $200 million for Bear Stearns – and only after the Fed promised a $30 billlion loan – this was a clear case where this non bank financial institution was insolvent. The Fed has no idea of which other primary dealers may be insolvent as it does not supervise and regulate those primary dealers that are not banks. But it is treating this crisis – the most severe financial crisis in the US since the Great Depression – as if it was purely a liquidity crisis. By lending massive amounts to potentially insolvent institutions that it does not supervise or regulate and that may be insolvent the Fed is taking serious financial risks and seriously exacerbate moral hazard distortions. Here you have highly leveraged non bank financial institutions that made reckless investments and lending, had extremely poor risk management and altogether disregarded liquidity risks; some may be insolvent but now the Fed is providing them with a blank check for unlimited amounts. This is a most radical action and a signal of how severe the crisis of the banking system and non-bank shadow financial system is. This is the worst US financial crisis since the Great Depression and the Fed is treating it as if it was only a liquidity crisis. But this is not just a liquidity crisis; it is rather a credit and insolvency crisis. And it is not the job of the Fed to bail out insolvent non bank financial institutions. If a bail out should occur this is a fiscal policy action that should be decided by Congress after the relevant equity holders have been wiped out and senior management fired without golden parachutes and huge severance packages. Nouriel Roubini 17/3/2007

Dear Mr. Bush

An Open Letter To United States Lawmakers President Bush 1600 Pennsylvania Avenue Washington, DC 20015 Transmitted by Fax CC: Joint Economic Committee Members House Financial Services Committee Members Senate Banking Committee Members Hillary Rodham Clinton, Senator New York and Presidential Candidate Barack Obama, Senator Illinois and Presidential Candidate John McCain, Senator Arizona and Presidential Candidate Dear Mr. President: It is now clear that we face a nearly-unprecedented financial crisis in this nation. Since President Clinton signed the repeal of the last pieces of Glass-Steagall, our banking system has intentionally and willfully ignored both the letter and spirit of the law when it comes to regulatory requirements and just plain old fashioned good conduct. The stress imposed by the collapse of the subprime lending space has exposed the truth – banks and other institutions have employed Enron-style financing vehicles to keep liabilities hidden and assets unvalued by the market, literally inventing valuations as they go along. Ratings agencies, paid by the seller of securities, have admitted to using flawed computer models – specifically, the assumption that house prices would never decline – in their rating of these securities. The Federal Reserve has been complicit in this game of “Hide Waldo” by first issuing “23A Exemption Letters” starting in the spring of 2007, and now, through the use of the “TAF” facility, it is preventing the investing and depositing public from learning who is under stress and to what degree. What is clear from the market, however, is both that this stress is real and that it is dangerously close to a breaking point. The expansion of the TAF facility on March 7th, 2008 is rumored to have been prompted by a potential collapse of one or more major financial institutions. Other institutions, including Thornburg Mortgage, have disclosed that they are restating earnings for the December quarter and may have to file for bankruptcy protection. If December’s earnings are being restated, that means they were aware of – but did not disclose – the level of stress they were under when they originally filed those reports. The secondary mortgage market, six months into this mess, remains almost completely frozen. In addition, Hedge Funds and other unregulated entities have been met with increasingly stringent capital demands and margin calls, with the latest two to fall being Peloton and now, it appears, Carlyle. Peloton has collapsed outright while Carlyle has been suspended from the public exchanges in Europe. These margin calls, along with a lack of trust and the ability of the market to absorb forced sales, have caused spreads on Fannie and Freddie paper to rise to historic wide levels. Mr. Bernanke and The Fed have lowered the Fed Funds Target from 5.25% to 3% over the last few months and the “slosh”, or free funds available in the Fed Banking System, has nearly doubled over that time. Yet this additional liquidity has done nothing to address the problem and won’t because the issue is not one of inadequate liquidity; rather it is a desperate move to hide the fact that a significant number of financial institutions in our nation are, if forced to mark all their paper to the market and recognize their exposure to off balance sheet vehicles, insolvent. At the root of the matter, Mr. President, is a lack of trust caused by the intentional acts of these institutions, and lack of regulatory enforcement by both the Federal Reserve and other agencies such as the OTS and OCC. As a direct consequence, those who lend money have literally taken their ball and gone home, either parking their funds in the Treasury market (irrespective of the yield being under the rate of price inflation) or sending their money outside the United States entirely. The Fed’s attempt to manage this crisis by injecting liquidity has only forced the dollar lower, which feeds a perverse cycle of price inflation in our economy. Oil is over $100 precisely because the dollar has been debased by 18% in the last two years. But for this intentional debasement, oil would be under $80 right now. Instead, the dollar continues to decline, and all goods and services priced in other currencies continue to increase in price. The economic impact of these actions on American Families has been catastrophic. Food and energy price inflation has destroyed the purchasing power of those on fixed incomes and families just starting out, such as Senior Citizens and our legal immigrants. Real purchasing power of the American Family has declined for the last three years while, according to the Federal Reserve’s latest documents for the 4th quarter of 2007, so has Americans’ net worth. That outcome is due to the lack of trust, which is the root of the problem – banks and others simply do not know who is bankrupt and who is not, because nobody is able to get an honest look at these institutions’ financial condition! I have been writing since last April in my Blog at http://market-ticker.denninger.net about this matter, and have continued to chronicle on a near-daily basis the insanity that is being allowed to continue in our financial markets. This beast was created through intentionally making unsound loans in the belief that the risk could be sold off and therefore quantity was the only metric that mattered, while quality was immaterial. This in turn drove up the price of houses to unsustainable levels. More than 100 years of history tells us that the maximum sustainable home price is approximated by a median home in a given area selling for approximately three times the median income in that same area. Today, most markets have home prices that are well in excess of this figure with coastal areas frequently running in excess of five times incomes. Proposals floated by various parties that attempt to prevent the correction of home prices to historical means will not work. Such price levels cannot be sustained, and it does not matter whether this is politically palatable or not. This is a matter of mathematics, not politics. Home prices must be allowed, and in fact encouraged, to contract until they reach economic equilibrium with household incomes. Government must not interfere with this process! Today, on the 7th, we had printed the second consecutive negative jobs figure. Since this statistic has been kept, two consecutive negative prints have, 100% of the time, indicated that a recession has begun within the last two to three months. We are in a recession, and it is incumbent upon our public officials to admit to our economic situation. I, and those who have signed this letter, call upon you Mr. President, the members of the House and Senate Banking Committees, and the members of the Joint Economic Committee, to immediately act to address this issue before we find ourselves in a fully-developed deflationary credit collapse – that is, a re-run of either Japan’s experience or worse, ours of the 1930s, both of which were caused, at their root, by the same abuses and lack of government oversight and regulation. In short, if we are to avoid the worst potential outcomes, it is imperative that the following actions be announced immediately as public policy by our Government and implemented without delay: · All securities and instruments traded and held for investment by regulated financial entities must have a CUSIP assigned and be traded on a public exchange or their value must be established by independent appraisal (in the case of a house or other real property.) All real property already has a tax appraisal available; properties carried by banks and other financial institutions must not be “marked” at values in excess of those appraisals, and appraisals must be updated whenever ownership changes hands, including via foreclosure actions. We must stop ‘mark to model’ and ‘mark to myth’; if you cannot obtain a bid for a thing, today, its value for today is zero! These marks must be taken nightly for tradable instruments and no less often than annually for real property. · Margin requirements must be enforced against all market participants. It is simply obscene that we have firms rated “AAA” who hold less than 1% of their exposure in actual capital. That is not “AAA” credit irrespective of what anyone tells you, and when the bond market is trading their debt at 70 cents on the dollar, the market is saying that this firm is rated “C” – or just above default – at best. In addition, the idea that a bank or hedge fund can write a credit default swap without having to prove capital adequacy for the duration and reserve commensurately is an outrage – these are forms of insurance and must be regulated as such. · All off-balance sheet vehicles must be banned and existing ones immediately brought back onto the balance sheet of the firm involved and disclosed in full. Enron collapsed in no small part because these off-balance-sheet vehicles allowed them to hide their exposure until it was literally too late to do anything about it. We cannot afford a repeat of the “Enron experience” on an even larger scale, one that threatens our banking system! · We must either get rid of the NRSRO label for ratings agencies, allowing free and open competition, or we must hold those certified agencies to their ratings. Hiding behind a free speech disclaimer while enjoying oligopoly protection is an outrage; either all are free to speak or there must be no protection. In addition, as BASEL sets reserve requirements for banks based solely upon ratings, the systemic risk of a “gamed” ratings system should be obvious. That the current environment has been systemically gamed for years is now obvious for all to see. This must be cleaned up immediately. · All credit instruments must be subject to “Regulation FD” disclosure requirements. It is outrageous that bond rating agencies are given details on the mortgages and other instruments inside “CDOs” that are not available in the prospectus to buyers. · Fraud must be aggressively prosecuted in all instances. There were many homeowners who lied on mortgage applications but there were also just as many financial institutions who literally made up data for their models when it was missing instead of rejecting the loans outright. The worst abuses were in the “stated income” or “liar” loans, but the problem is not limited to that area of the market. The FBI must go after not only homeowners who lied but also the banks that deceived by omission or commission the purchasers of these securities, and those who continue to deceive with improperly booked capitalized interest earnings on homes which have declined in value below their mortgage balance. · Fannie and Freddie’s capital adequacy must be investigated and stringently monitored. If either of these institutions were to collapse the results would be catastrophic. The Federal Government cannot bail them out as that would cause a rocket shot in treasury yields which in turn would greatly increase the cost of government borrowing – which we cannot afford given the national debt and current budget deficits. Therefore, it is critical that OFHEO be extraordinarily diligent to insure that this does not happen, and that Fannie and Freddie ONLY buy fully-documented loans with no more than a 36% back end ratio and no more than an 80% LTV. This is a material tightening from current guidelines but it must be put in place immediately as it represents the benchmark of sound mortgage lending for more than 100 years. I recognize that these changes would cause some institutions to fail immediately. Nonetheless, the consequence of not taking these actions will be far worse, and the probability of that outcome is extremely high. Mr. Thomas Hoenig, President of The Federal Reserve Bank of Kansas City, said during a speech on March 7th in Brazil (available at http://www.kc.frb.org/SpeechBio/HoenigPDF/HoenigBrazil3.7.08.pdf) the following: “I believe there may be merit in considering formal liquidity requirements, and perhaps loan-to-value ratios for banks and other financial institutions, especially the large institutions that provide liquidity and risk management products to other financial institutions and to financial markets. I also think that it is time that we extinguish some of the off-balance sheet fictions that have developed to excess in recent years.” “In conclusion, let me stress again my belief that the response to this crisis should be fundamental reform, not Band-Aids and tourniquets. “ “I believe a central bank must have the legal authority to require this information from the supervisory agency on terms set by the central bank. A voluntary exchange of this important information is no more likely to be effective in a financial context than it was in the U.S. intelligence community prior to 9/11.” This, of course, was not widely reported in our “mainstream media”, but Mr. Hoenig is correct on all points. These actions need to be taken right here and now. I call upon you to act today in order to prevent the economic catastrophe which looms over our nation due to the artifice and outright fraud of the last ten years. I look forward to a public response from all recipients of this letter, addressing the points herein and announcing policy initiatives immediately. Our capital and credit markets cannot wait for the election or for long cycles of public hearing and comment. We must act now or our credit markets will remain seized as market participants cannot be forced to either lend or borrow. Our nation is in grave economic danger and requires your immediate attention. Sincerely, Karl Denninger

Reflections from South Africa

I have just returned from a two week trip from the Southern tip of Africa and thought I would share some of my observations. This is my first visit in six months and I was amazed at how the mind set and attitude of the people I interacted with has dramatically changed in that time. Since then we have seen Jacob Zuma take over the leadership of the ANC and Eskom start to invoke their load shedding arrangements, the Rand has also weakened considerably even against a globally defective dollar, something which I must say I never predicted. I was extremely impressed by the developments at OR Tambo airport, the extent of the new facilities and the friendliness of the the immigration staff - this is a 100% improvement over the last visit and I sincerely hope this continues as this is the first glimpse of a foreign tourist. Unfortunately this is where it ended. My trip to the car rental area was a minefield of illegal taxi drivers offering to take me to Sandton, surely what is needed is a regulated taxi rand where a visitor can queue up like most International cities and have metered and regulated trip into the city center, no such luck. The aggression and lack of courtesy afforded other drivers is very pronounced, ten minutes of driving and the tension starts to creep through your veins, making up one place in a three lane highway by changing lanes six times is par for the course, taxis come at you from all directions even the emergency lanes. My biggest shock was however the negativity of my friends (of all races) who have all been extremely bullish on the Rainbow Nation since 1994. Everyone has a story of a violent crime, a rape a murder of someone close to them. The talk around the dinner table is no longer of how good the way of life in South Africa is and how can you possibly take the London climate and has moved to where did I think the best areas of the UK are to move to or should they consider the US or Australia. Why the sudden change in perception, I think the realisation that the infrastructure is no longer holding up and that 2010 World Cup may possibly no longer happen has a lot to do with it. The fact that it is also no longer cheap to live in South Africa is starting to impact a number of peoples decisions on leaving too, people where amazed to find out that food, clothing, electricity, water are a lot cheaper in the UK even at 15 to 1. I guess only time will tell whether South Africa just becomes another African statistic - I sincerely hope not.

Sell all your assets while you can!!!

This is an amazing article by Proffesor Roubini who was calling this market in Davos in 2007 and was almost laughed off the stage - well worth a read. Nouriel Roubini | Feb 05, 2008 Why did the Fed ease the Fed Funds rate by a whopping 125bps in eight days this past January? It is true that most macro indicators are heading south and suggesting a deep and severe recession that has already started. But the flow of bad macro news in mid-January did not justify, by itself, such a radical inter-meeting emergency Fed action followed by another cut at the formal FOMC meeting. To understand the Fed actions one has to realize that there is now a rising probability of a “catastrophic” financial and economic outcome, i.e. a vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe. The Fed is seriously worried about this vicious circle and about the risks of a systemic financial meltdown. That is the reason the Fed had thrown all caution to the wind – after a year in which it was behind the curve and underplaying the economic and financial risks – and has taken a very aggressive approach to risk management; this is a much more aggressive approach than the Greenspan one in spite of the initial views that the Bernanke Fed would be more cautious than Greenspan in reacting to economic and financial vulnerabilities. To understand the risks that the financial system is facing today I present the “nightmare” or “catastrophic” scenario that the Fed and financial officials around the world are now worried about. Such a scenario – however extreme – has a rising and significant probability of occurring. Thus, it does not describe a very low probability event but rather an outcome that is quite possible. Start first with the recession that is now enveloping the US economy. Let us assume – as likely - that this recession – that already started in December 2007 - will be worse than the mild ones – that lasted 8 months – that occurred in 1990-91 and 2001. The recession of 2008 will be more severe for several reasons: first, we have the biggest housing bust in US history with home prices likely to eventually fall 20 to 30%; second, because of a credit bubble that went beyond mortgages and because of reckless financial innovation and securitization the ongoing credit bust will lead to a severe credit crunch; third, US households – whose consumption is over 70% of GDP - have spent well beyond their means for years now piling up a massive amount of debt, both mortgage and otherwise; now that home prices are falling and a severe credit crunch is emerging the retrenchment of private consumption will be serious and protracted. So let us suppose that the recession of 2008 will last at least four quarters and, possibly, up to six quarters. What will be the consequences of it? Here are the twelve steps or stages of a scenario of systemic financial meltdown associated with this severe economic recession… First, this is the worst housing recession in US history and there is no sign it will bottom out any time soon. At this point it is clear that US home prices will fall between 20% and 30% from their bubbly peak; that would wipe out between $4 trillion and $6 trillion of household wealth. While the subprime meltdown is likely to cause about 2.2 million foreclosures, a 30% fall in home values would imply that over 10 million households would have negative equity in their homes and would have a big incentive to use “jingle mail” (i.e. default, put the home keys in an envelope and send it to their mortgage bank). Moreover, soon enough a few very large home builders will go bankrupt and join the dozens of other small ones that have already gone bankrupt thus leading to another free fall in home builders’ stock prices that have irrationally rallied in the last few weeks in spite of a worsening housing recession. Second, losses for the financial system from the subprime disaster are now estimated to be as high as $250 to $300 billion. But the financial losses will not be only in subprime mortgages and the related RMBS and CDOs. They are now spreading to near prime and prime mortgages as the same reckless lending practices in subprime (no down-payment, no verification of income, jobs and assets (i.e. NINJA or LIAR loans), interest rate only, negative amortization, teaser rates, etc.) were occurring across the entire spectrum of mortgages; about 60% of all mortgage origination since 2005 through 2007 had these reckless and toxic features. So this is a generalized mortgage crisis and meltdown, not just a subprime one. And losses among all sorts of mortgages will sharply increase as home prices fall sharply and the economy spins into a serious recession. Goldman Sachs now estimates total mortgage credit losses of about $400 billion; but the eventual figures could be much larger if home prices fall more than 20%. Also, the RMBS and CDO markets for securitization of mortgages – already dead for subprime and frozen for other mortgages - remain in a severe credit crunch, thus reducing further the ability of banks to originate mortgages. The mortgage credit crunch will become even more severe. Also add to the woes and losses of the financial institutions the meltdown of hundreds of billions of off balance SIVs and conduits; this meltdown and the roll-off of the ABCP market has forced banks to bring back on balance sheet these toxic off balance sheet vehicles adding to the capital and liquidity crunch of the financial institutions and adding to their on balance sheet losses. And because of securitization the securitized toxic waste has been spread from banks to capital markets and their investors in the US and abroad, thus increasing – rather than reducing systemic risk – and making the credit crunch global. Third, the recession will lead – as it is already doing – to a sharp increase in defaults on other forms of unsecured consumer debt: credit cards, auto loans, student loans. There are dozens of millions of subprime credit cards and subprime auto loans in the US. And again defaults in these consumer debt categories will not be limited to subprime borrowers. So add these losses to the financial losses of banks and of other financial institutions (as also these debts were securitized in ABS products), thus leading to a more severe credit crunch. As the Fed loan officers survey suggest the credit crunch is spreading throughout the mortgage market and from mortgages to consumer credit, and from large banks to smaller banks. Fourth, while there is serious uncertainty about the losses that monolines will undertake on their insurance of RMBS, CDO and other toxic ABS products, it is now clear that such losses are much higher than the $10-15 billion rescue package that regulators are trying to patch up. Some monolines are actually borderline insolvent and none of them deserves at this point a AAA rating regardless of how much realistic recapitalization is provided. Any business that required an AAA rating to stay in business is a business that does not deserve such a rating in the first place. The monolines should be downgraded as no private rescue package – short of an unlikely public bailout – is realistic or feasible given the deep losses of the monolines on their insurance of toxic ABS products. Next, the downgrade of the monolines will lead to another $150 of writedowns on ABS portfolios for financial institutions that have already massive losses. It will also lead to additional losses on their portfolio of muni bonds. The downgrade of the monolines will also lead to large losses – and potential runs – on the money market funds that invested in some of these toxic products. The money market funds that are backed by banks or that bought liquidity protection from banks against the risk of a fall in the NAV may avoid a run but such a rescue will exacerbate the capital and liquidity problems of their underwriters. The monolines’ downgrade will then also lead to another sharp drop in US equity markets that are already shaken by the risk of a severe recession and large losses in the financial system. Fifth, the commercial real estate loan market will soon enter into a meltdown similar to the subprime one. Lending practices in commercial real estate were as reckless as those in residential real estate. The housing crisis will lead – with a short lag – to a bust in non-residential construction as no one will want to build offices, stores, shopping malls/centers in ghost towns. The CMBX index is already pricing a massive increase in credit spreads for non-residential mortgages/loans. And new origination of commercial real estate mortgages is already semi-frozen today; the commercial real estate mortgage market is already seizing up today. Sixth, it is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200 plus subprime lenders that have gone bankrupt. This, like in the case of Northern Rock, will lead to depositors’ panic and concerns about deposit insurance. The Fed will have to reaffirm the implicit doctrine that some banks are too big to be allowed to fail. But these bank bankruptcies will lead to severe fiscal losses of bank bailout and effective nationalization of the affected institutions. Already Countrywide – an institution that was more likely insolvent than illiquid – has been bailed out with public money via a $55 billion loan from the FHLB system, a semi-public system of funding of mortgage lenders. Banks’ bankruptcies will add to an already severe credit crunch. Seventh, the banks losses on their portfolio of leveraged loans are already large and growing. The ability of financial institutions to syndicate and securitize their leveraged loans – a good chunk of which were issued to finance very risky and reckless LBOs – is now at serious risk. And hundreds of billions of dollars of leveraged loans are now stuck on the balance sheet of financial institutions at values well below par (currently about 90 cents on the dollar but soon much lower). Add to this that many reckless LBOs (as senseless LBOs with debt to earnings ratio of seven or eight had become the norm during the go-go days of the credit bubble) have now been postponed, restructured or cancelled. And add to this problem the fact that some actual large LBOs will end up into bankruptcy as some of these corporations taken private are effectively bankrupt in a recession and given the repricing of risk; convenant-lite and PIK toggles may only postpone – not avoid – such bankruptcies and make them uglier when they do eventually occur. The leveraged loans mess is already leading to a freezing up of the CLO market and to growing losses for financial institutions. Eighth, once a severe recession is underway a massive wave of corporate defaults will take place. In a typical year US corporate default rates are about 3.8% (average for 1971-2007); in 2006 and 2007 this figure was a puny 0.6%. And in a typical US recession such default rates surge above 10%. Also during such distressed periods the RGD – or recovery given default – rates are much lower, thus adding to the total losses from a default. Default rates were very low in the last two years because of a slosh of liquidity, easy credit conditions and very low spreads (with junk bond yields being only 260bps above Treasuries until mid June 2007). But now the repricing of risk has been massive: junk bond spreads close to 700bps, iTraxx and CDX indices pricing massive corporate default rates and the junk bond yield issuance market is now semi-frozen. While on average the US and European corporations are in better shape – in terms of profitability and debt burden – than in 2001 there is a large fat tail of corporations with very low profitability and that have piled up a mass of junk bond debt that will soon come to refinancing at much higher spreads. Corporate default rates will surge during the 2008 recession and peak well above 10% based on recent studies. And once defaults are higher and credit spreads higher massive losses will occur among the credit default swaps (CDS) that provided protection against corporate defaults. Estimates of the losses on a notional value of $50 trillion CDS against a bond base of $5 trillion are varied (from $20 billion to $250 billion with a number closer to the latter figure more likely). Losses on CDS do not represent only a transfer of wealth from those who sold protection to those who bought it. If losses are large some of the counterparties who sold protection – possibly large institutions such as monolines, some hedge funds or a large broker dealer – may go bankrupt leading to even greater systemic risk as those who bought protection may face counterparties who cannot pay. Ninth, the “shadow banking system” (as defined by the PIMCO folks) or more precisely the “shadow financial system” (as it is composed by non-bank financial institutions) will soon get into serious trouble. This shadow financial system is composed of financial institutions that – like banks – borrow short and in liquid forms and lend or invest long in more illiquid assets. This system includes: SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short term liquid liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks these non-bank financial institutions don’t have direct or indirect access to the central bank’s lender of last resort support as they are not depository institutions. Thus, in the case of financial distress and/or illiquidity they may go bankrupt because of both insolvency and/or lack of liquidity and inability to roll over or refinance their short term liabilities. Deepening problems in the economy and in the financial markets and poor risk managements will lead some of these institutions to go belly up: a few large hedge funds, a few money market funds, the entire SIV system and, possibly, one or two large and systemically important broker dealers. Dealing with the distress of this shadow financial system will be very problematic as this system – stressed by credit and liquidity problems - cannot be directly rescued by the central banks in the way that banks can. Tenth, stock markets in the US and abroad will start pricing a severe US recession – rather than a mild recession – and a sharp global economic slowdown. The fall in stock markets – after the late January 2008 rally fizzles out – will resume as investors will soon realize that the economic downturn is more severe, that the monolines will not be rescued, that financial losses will mount, and that earnings will sharply drop in a recession not just among financial firms but also non financial ones. A few long equity hedge funds will go belly up in 2008 after the massive losses of many hedge funds in August, November and, again, January 2008. Large margin calls will be triggered for long equity investors and another round of massive equity shorting will take place. Long covering and margin calls will lead to a cascading fall in equity markets in the US and a transmission to global equity markets. US and global equity markets will enter into a persistent bear market as in a typical US recession the S&P500 falls by about 28%. Eleventh, the worsening credit crunch that is affecting most credit markets and credit derivative markets will lead to a dry-up of liquidity in a variety of financial markets, including otherwise very liquid derivatives markets. Another round of credit crunch in interbank markets will ensue triggered by counterparty risk, lack of trust, liquidity premia and credit risk. A variety of interbank rates – TED spreads, BOR-OIS spreads, BOT – Tbill spreads, interbank-policy rate spreads, swap spreads, VIX and other gauges of investors’ risk aversion – will massively widen again. Even the easing of the liquidity crunch after massive central banks’ actions in December and January will reverse as credit concerns keep interbank spread wide in spite of further injections of liquidity by central banks. Twelfth, a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy. Market prices include a large illiquidity discount on top of the discount due to the credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Capital losses will lead to margin calls and further reduction of risk taking by a variety of financial institutions that are now forced to mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit. The triggering event for the next round of this cascade is the downgrade of the monolines and the ensuing sharp drop in equity markets; both will trigger margin calls and further credit disintermediation. Based on estimates by Goldman Sachs $200 billion of losses in the financial system lead to a contraction of credit of $2 trillion given that institutions hold about $10 of assets per dollar of capital. The recapitalization of banks sovereign wealth funds – about $80 billion so far – will be unable to stop this credit disintermediation – (the move from off balance sheet to on balance sheet and moves of assets and liabilities from the shadow banking system to the formal banking system) and the ensuing contraction in credit as the mounting losses will dominate by a large margin any bank recapitalization from SWFs. A contagious and cascading spiral of credit disintermediation, credit contraction, sharp fall in asset prices and sharp widening in credit spreads will then be transmitted to most parts of the financial system. This massive credit crunch will make the economic contraction more severe and lead to further financial losses. Total losses in the financial system will add up to more than $1 trillion and the economic recession will become deeper, more protracted and severe. A near global economic recession will ensue as the financial and credit losses and the credit crunch spread around the world. Panic, fire sales, cascading fall in asset prices will exacerbate the financial and real economic distress as a number of large and systemically important financial institutions go bankrupt. A 1987 style stock market crash could occur leading to further panic and severe financial and economic distress. Monetary and fiscal easing will not be able to prevent a systemic financial meltdown as credit and insolvency problems trump illiquidity problems. The lack of trust in counterparties – driven by the opacity and lack of transparency in financial markets, and uncertainty about the size of the losses and who is holding the toxic waste securities – will add to the impotence of monetary policy and lead to massive hoarding of liquidity that will exacerbates the liquidity and credit crunch. In this meltdown scenario US and global financial markets will experience their most severe crisis in the last quarter of a century. Can the Fed and other financial officials avoid this nightmare scenario that keeps them awake at night? The answer to this question – to be detailed in a follow-up article – is twofold: first, it is not easy to manage and control such a contagious financial crisis that is more severe and dangerous than any faced by the US in a quarter of a century; second, the extent and severity of this financial crisis will depend on whether the policy response – monetary, fiscal, regulatory, financial and otherwise – is coherent, timely and credible. I will argue – in my next article - that one should be pessimistic about the ability of policy and financial authorities to manage and contain a crisis of this magnitude; thus, one should be prepared for the worst, i.e. a systemic financial crisis.

Prozac for Wall Street

Well we are only three weeks into the year and we are rapidly approaching my target levels on te downside. I must admit that I thought that we would have the usual January run up to my topside levels but this did not occur. Last nights 75 basis point cut in the Fed Fund rate will not help the markets at all and here is why: 1) The Fed does not set interest rates the banks do and they aint going to start lending to the already overstretched consumer again - What Sir, would you like another sub prime loan ton pay off your old one? 2) There is already too much liquidity in the system, look at the T-Bill rate at 2.5% 3) The opinion that the East will keep the global markets expanding is incorrect - last year the spend for consumers was as follows: US $9 trillion, China $1 trillion and India $600bn. The consumer is paramount and he cant draw on any more credit facilities unless his house price rockets again. This ain't going to happen. 4) What happens if you are one of the few who has been saving - you are being screwed to keep the market propped up. Who is the Fed working for: Wall Street Banks?? The market will continue to fall - don't try to catch the falling knife

Predictions for 2008

After a number of years being away from the coal face of the markets and just watching and observing them from a distance I have decided to include in my blog a yearly review and monthly updates. I guess this is mostly for my own benefit but also for those of you who may be interested; perhaps we could start some sort of forum to discuss my ideas as I am sure that a number of people will disagree. As I am now living in London I feel that I may perhaps have a different view to those of you in South Africa who have a different agenda in terms of a micro and macro outlook for the world’s economies. I have been known a perennial bear for most of my life but some of you will remember that I can be bullish, having called the bottom of the industrial market in 1995 and the bottom of the Rand in 2001. I sincerely believe that the credit crunch that started in the 4th quarter of 2007 has been entirely misunderstood and misinterpreted by mainstream media and as a result equity markets are not pricing in the reality of the situation. Financial shows like CNBC are totally wrapped up in underplaying the effect of this and in fact are only interested in one thing and that is talking the markets up – this is bordering on massive fraud and they will, I believe at some time in the future be called to account to justify their position given the facts that they know are reality but refuse to divulge. One interesting snippet regarding the wonderful Jim Cramer (CNBC pundit) is that on 29th January 2000he listed 10 stocks that you had to own no that the internet was changing everyone’s lives and that is “was different this time”. If you had heeded his advice 6 of his recommendations went bankrupt and your portfolio as of today is down 90% and he STILL has a job at the network and is still calling a bull market for 2008. 2007 will always be known as “Credit Crunch Year” and I believe that the full impact of this burst bubble will only play out during the duration of 2008, the common media is still on the theme that it will have an impact for the first half of 2008 and then all will be fine during the second half and equities and the housing market will continue on their unabated upward movement. Don’t be fooled, it cannot happen, the world is on the brink of a major collapse in the banking system, the problem is one of solvency and not liquidity as the Central Banks are declaring war on at present. The major problem facing the banks is the write off of their bad loans which many still are marking to market against an enormous amount of Insurance Policies and derivative hedges taken out to protect their exposure to sub-prime loans, CDO’s etc. The problem is that the Insurance Companies and some of the counterparties to these contracts are themselves insolvent and will never be able to settle their obligations to these contracts. To date the banks have admitted to write-offs of $100bn but I expect this figure to reach $1 Trillion, this will effectively wipe out the worlds banking capital. Not many people understand the fractional creation of money in the banking system but the loss of $1 Trillion effectively wipes out $14 Trillion in lending capacity of the banks so the lowering of interest rates by the Central Banks will have no effect on the ability of consumers to start another round of borrowing and therefore the start of the so called resumption of growth in global economies. Inflation vs Deflation A number of prominent economists are predicting higher inflation for 2008 and some even talking about stagflation; I am definitely in the camp of a global deflation scenario leading to a recession in the US and perhaps even a 1930’s type depression. As the banks embark on saving themselves and recapitalising from the Chinese and Middle Eastern Sovereign funds they will become very risk averse and lending to both the corporate and the consumer will effectively dry up. Unemployment will start to creep up as layoffs in the housing and financial sectors start to take effect. This will exacerbate the housing crisis and have a serious impact on company profits and balance sheets further limiting their borrowing capabilities. This will have the fundamental effect of little money chasing too many goods and effectively causing price erosion – Beware the gold bugs as the price of precious metals will be severely impacted in Q2. Shift of Power to the East The US as the global leader is now in question and as the financial implications of a severely bankrupt economy emerge the vast wealth and trade surpluses accumulated by the East over the last decade of uncontrolled US spending will allow control of a number of Industries including the financial sector to move to the East – This will effectively limit the US ability to be a worldwide aggressor (They have attacked 20 countries since the end of WW2). The long term impact of this is a subtle shift to a Muslim dominated world in the next decade. Country Views South Africa As South Africa’s higher interest rates against the falling rates in the US and European Zone remain the Rand will remain extremely strong as global cash, although diminished will continue to look for yield enhancement. I therefore see an extremely strong Rand through to the middle of 2008 and then it will start to deteriorate as the commodity prices fall and the geopolitical risk of the African Continent start to weigh. For the reasons above I see a surge in the Alsi for the first half of the year and then a substantial re-rating lower in the second half, this will only occur if the major markets see a slow and orderly down trend and not a panic induced crash in the first six months. Don’t bet that the rugby world cup will save the equity market as this is already priced into the index. Asia The Asian economy is probably the swing factor in the global economy that might mitigate the collapse of world trade, they will continue to grow but at a much lower rate than 2007 as demand for their exports start to diminish as the western economies slow. The bubble of the Chinese market may continue to expand for the first six months of this year but look for a serious re-rating at the end of 2008 Japan

The japans equity market will continue to struggle as they grapple with a sluggish economy and extremely low interest rates, they are suffering from an internal deflationary spiral and will continue to do so during 2008. This is the scenario that I believe will play out in America this year, one must remember that the Japanese market is still less than 50% of its peak at the end of their real estate bubble in the latter stages of the 1980’s. UK

The outlook for the UK market looks grim, the housing bubble is starting to unwind albeit 18 months later than the US and consumer spending is starting to slow with weaker than expected retail sales reported for the Christmas period. The City is highly dependant on the US banks and as their business contracts we will see a number of high profile lay-offs. Interest rates will continue to fall but may be limited by the inflationary fears of $100 oil and inflating food prices. The credit crunch scenario will continue to haunt UK banks and Insurance Companies through the whole of 2008. Housing prices will slide by at least 15%. USA

The US is already in recession and the only debate is how long it will last and whether it becomes a deflationary depression, the big factors that will dictate this are: - The continued housing slump - Consumer spending patterns - Collapse of the commercial real estate market - The collapse of the CDO ($2 Trillion) market due to the insolvency of the bond insurance companies. - Presidential race for the White House America and unfortunately the rest of the world will now have to pay the price for a decade of more of excessive spending, lack of saving and total greed and the fraudulent scam of CDO’s, SIV’s and other derivative structures. Conclusion: 2008 will be a year to conserve capital and cash and bonds will probably offer the best return in a deflationary global economy, a number of banks will go to the wall and don’t think that the South African banks will be immune. It will therefore be prudent to spread your cash between the banks and only have the guaranteed minimum with each one. I will endeavor to do a monthly update on these predictions and track them into the year end. May you all have a capital conserving 2008