Showing posts with label sub prime. Show all posts
Showing posts with label sub prime. Show all posts

Friday, March 27, 2009

Alan Greenspan Speaks

This article by Allan Greenspan needs no comment. The banking hole is close to two trillion dollars of which a third is plugged. The credit contraction is still ongoing and is only stalled because of no liquidity. This is well worth reading. Who is Obama listening to?

We need a better cushion against risk

By Alan Greenspan

Published: March 26 2009 19:37 Last updated: March 26 2009 19:37
The extraordinary risk-management discipline that developed out of the writings of the University of Chicago’s Harry Markowitz in the 1950s produced insights that won several Nobel prizes in economics. It was widely embraced not only by academia but also by a large majority of financial professionals and global regulators.

But in August 2007, the risk-management structure cracked. All the sophisticated mathematics and computer wizardry essentially rested on one central premise: that the enlightened self-interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency by actively monitoring their firms’ capital and risk positions. For generations, that premise appeared incontestable but, in the summer of 2007, it failed. It is clear that the levels of complexity to which market practitioners, at the height of their euphoria, carried risk-management techniques and risk-product design were too much for even the most sophisticated market players to handle prudently.

Even with the breakdown of self-regulation, the financial system would have held together had the second bulwark against crisis – our regulatory system – functioned effectively. But, under crisis pressure, it too failed. Only a year earlier, the Federal Deposit Insurance Corporation had noted that “more than 99 per cent of all insured institutions met or exceeded the requirements of the highest regulatory capital standards”. US banks are extensively regulated and, even though our largest 10 to 15 banking institutions have had permanently assigned on-site examiners to oversee daily operations, many of these banks still took on toxic assets that brought them to their knees. The UK’s heavily praised Financial Services Authority was unable to anticipate and prevent the bank run that threatened
Northern Rock. The Basel Committee, representing regulatory authorities from the world’s major financial systems, promulgated a set of capital rules that failed to foresee the need that arose in August 2007 for large capital buffers.

The important lesson is that bank regulators cannot fully or accurately forecast whether, for example, subprime mortgages will turn toxic, or a particular tranche of a collateralised debt obligation will default, or even if the financial system will seize up. A large fraction of such difficult forecasts will invariably be proved wrong.

What, in my experience, supervision and examination can do is set and enforce capital and collateral requirements and other rules that are preventative and do not require anticipating an uncertain future. It can, and has, put limits or prohibitions on certain types of bank lending, for example, in commercial real estate. But it is incumbent on advocates of new regulations that they improve the ability of financial institutions to direct a nation’s savings into the most productive capital investments – those that enhance living standards. Much regulation fails that test and is often costly and counterproductive. Regulation should enhance the effectiveness of competitive markets, not impede them. Competition, not protectionism, is the source of capitalism’s great success over the generations.

New regulatory challenges arise because of the recently proven fact that some financial institutions have become too big to fail as their failure would raise systemic concerns. This status gives them a highly market-distorting special competitive advantage in pricing their debt and equities. The solution is to have graduated regulatory capital requirements to discourage them from becoming too big and to offset their competitive advantage. In any event, we need not rush to reform. Private markets are now imposing far greater restraint than would any of the current sets of regulatory proposals.

Free-market capitalism has emerged from the battle of ideas as the most effective means to maximise material wellbeing, but it has also been periodically derailed by asset-price bubbles and rare but devastating economic collapse that engenders widespread misery. Bubbles seem to require prolonged periods of prosperity, damped inflation and low long-term interest rates. Euphoria-driven bubbles do not arise in inflation-racked or unsuccessful economies. I do not recall bubbles emerging in the former Soviet Union.

History also demonstrates that underpriced risk – the hallmark of bubbles – can persist for years. I feared “irrational exuberance” in 1996, but the dotcom bubble proceeded to inflate for another four years. Similarly, I opined in a federal open market committee meeting in 2002 that “it’s hard to escape the conclusion that ... our extraordinary housing boom ... finan­ced by very large increases in mortgage debt, cannot continue indefinitely into the future”. The housing bubble did continue to inflate into 2006.

It has rarely been a problem of judging when risk is historically underpriced. Credit spreads are reliable guides. Anticipating the onset of crisis, however, appears out of our forecasting reach. Financial crises are defined by a sharp discontinuity of asset prices. But that requires that the crisis be largely unanticipated by market participants. For, were it otherwise, financial arbitrage would have diverted it. Earlier this decade, for example, it was widely expected that the next crisis would be triggered by the large and persistent US current-account deficit precipitating a collapse of the US dollar. The dollar accordingly came under heavy selling pressure. The rise in the euro-dollar exchange rate from, say, 1.10 in the spring of 2003 to 1.30 at the end of 2004 appears to have arbitraged away the presumed dollar trigger of the “next” crisis. Instead, arguably, it was the excess securitisation of US subprime mortgages that unexpectedly set off the current solvency crisis.

Once a bubble emerges out of an exceptionally positive economic environment, an inbred propensity of human nature fosters speculative fever that builds on itself, seeking new unexplored, leveraged areas of profit. Mortgage-backed securities were sliced into collateralised debt obligations and then into CDOs squared. Speculative fever creates new avenues of excess until the house of cards collapses. What causes it finally to fall? Reality.

An event shocks markets when it contradicts conventional wisdom of how the financial world is supposed to work. The uncertainty leads to a dramatic disengagement by the financial community that almost always requires sales and, hence, lower prices of goods and assets. We can model the euphoria and the fear stage of the business cycle. Their parameters are quite different. We have never successfully modelled the transition from euphoria to fear.

I do not question that central banks can defuse any bubble. But it has been my experience that unless monetary policy crushes economic activity and, for example, breaks the back of rising profits or rents, policy actions to abort bubbles will fail. I know of no instance where incremental monetary policy has defused a bubble.

I believe that recent risk spreads suggest that markets require perhaps 13 or 14 per cent capital (up from 10 per cent) before US banks are likely to lend freely again. Thus, before we probe too deeply into what type of new regulatory structure is appropriate, we have to find ways to restore our now-broken system of financial intermediation.

Restoring the US banking system is a key requirement of global rebalancing. The US Treasury’s
purchase of $250bn (€185bn, £173bn) of preferred stock of US commercial banks under the troubled asset relief programme (subsequent to the Lehman Brothers default) was measurably successful in reducing the risk of US bank insolvency. But, starting in mid-January 2009, without further investments from the US Treasury, the improvement has stalled. The restoration of normal bank lending by banks will require a very large capital infusion from private or public sources. Analysis of the US consolidated bank balance sheet suggests a potential loss of at least $1,000bn out of the more than $12,000bn of US commercial bank assets at original book value.

Through the end of 2008, approximately $500bn had been written off, leaving an additional $500bn yet to be recognised. But funding the latter $500bn will not be enough to foster normal lending if investors in the liabilities of banks require, as I suspect, an additional 3-4 percentage points of cushion in their equity capital-to-asset ratios. The overall need appears to be north of $850bn. Some is being replenished by increased bank cash flow. A turnround of global equity prices could deliver a far larger part of those needs. Still, a deep hole must be filled, probably with sovereign US Treasury credits. It is too soon to evaluate the US Treasury’s most recent public-private initiatives. Hopefully, they will succeed in removing much of the heavy burden of illiquid bank assets.

Friday, January 18, 2008

Aubie Baltin on US Credit Contraction

After my cheery note yesterday on the looming stress of very expensive oil, I realized that I forgot to mention the one other way in which it will be partially resolved. By a global slowdown in general demand while the economy retools for other energy resources.

I share with you this investment letter by Aubie Baltin which makes the case of how bad it will get. It is meant to scare the hell out of you, so do not take it to heart.

Without question the US economy has to unwind a lending spree that was huge. The good news is that the rest of the world was simply not so stupid and retains a sound currency and credit system and will inject the necessary equity to clean up the mess. And yes they will extract their pound of flesh as well they should. And the rest of the world is now big enough to do this.

However, it means that equity will be king for a decade in the US as the banking system goes back to behaving like banks. The credit balloon is gone having been stolen, leaving the banks with the fallout.

In the meantime, it is wise to recall that what happens in the wrong neighborhood in Cleveland to mortgage debt is simply the absolute extreme worse case and does not reflect what is really happening in the rest of the country which will ride through this storm very nicely.

The only damage most will incur is a lowering of their expectations. And the need to not drive the car so much.

Also, let us not forget that THAI oil production promises to deliver the necessary crude to our refineries and could do it easily within the current price regime.

We are in the early days of a global transition out of the oil economy and massive volatility is a natural part of this unpleasant process.

YOU HEARD IT HERE FIRST - RECESSION 2007


In my letters dating back to the beginning of 2007, I selected a credit spread between Junk Bonds and Treasuries (buy Treasuries, short Junk Bonds) as my #1 best, lowest risk SURE THING trade. The spread has increased from a near all time low of 3% to a current spread approaching 7.5% and “you ain’t seen nothing yet.”

But that was just a trade, why should you have listened? But that trade was not the only thing that you heard here first. Month after month, there has been a total barrage of optimistic projections from all avenues calling for a continuing Goldilocks Economy, leading to accelerating earnings and an ever rising stock market not only here in the USA but around the world as well, especially in the emerging markets. They were right about the rest of the world, but I stood front and center against this constant harangue of optimism, pointing out the expanding cracks in the dam that everybody else either refused to see or actually did not notice. The seeds of a MAJOR BEAR MARKET were being sown. And it would not be just an ordinary Bear Market like we had in 1998 or 1994 or 1990, but more along the lines of a 50% 1973-74 breakdown and quite possibly a 15 to 20 year 30’s type Depression.. Not very many, if any, analysts agree with me yet, but I no longer hear any of them laughing.

RECESSION 2007

We can never know in advance the actual start date of a recession. It is only after all the numbers, that everyone waits for with baited breath, have been revised 3 or 5 times can we know for sure when a recession started; it won’t be too much longer before my call that we started the recession in the 4th quarter of 2007 is confirmed. And yet the Government, the FED, Wall Street and the Media keep insisting that, at worst, we will just have a slowdown in the first half of 2008 with a resumption to 4% plus growth by the second half of the year. The drop in housing prices is now over 18 months old, the longest sustained drop in history, but we still have no recession? The first people laid off were the illegals, so they didn’t show up in the unemployment figures. What do you think the numbers will show next quarter after the carnage in the financial sectors hits? And I always thought smoking dope was illegal!

MARGIN CALLS

All modes of deals that appear like sure things must and will fail for one or both of two reasons. The takeover and buyout private equity craze always sows the seeds of its own destruction as more and more money chases fewer and fewer good deals. They become overpriced and making the deal becomes of prime importance as they worry about the workout later. After all, the deal makers like the Hedge Fund managers, take their money up front and the Banks always are left holding the bag, Secondly, interest rates are so low that risks are no longer being taken into account. Underestimating risk is the surest road to doom and we are already witnessing the consequences. Here too “we ain’t seen nothing yet” as the margin calls begin to fly and there is a scramble to rob Peter to pay Paul, as one deal after another gets into serious trouble and collapses since no provisions at all were made for a possible recession. We are now witnessing what can happen to the biggest and best such as C, CFC, MER and BSC and how many more shoes are yet to fall?

IT WAS THE EXPANSION OF CREDIT THAT LIFTED ALL BOATS AND IT WILL BE THE CONTRACTION AND THE ALMOST COMPLETE DRYING UP OF CREDIT, THAT WILL BRING THEM ALL BACK DOWN TO REALITY.

CREDIT AND LENDING

Most everyone still refers to the sub-prime loans as being the problem. But nothing could be further from the truth. The mere fact that the President, Congress and all of the presidential hopefuls are coming up with plans to solve the effect and not the problem is proof positive that sub-prime is not the real problem. It is the massive 5 to 10 year overhang of unsold homes brought about by the massive over building that five years of 25% plus per year compounded price increases that fueled massive speculation and was exacerbated by the 1% zero down ARMS that allowed even poor people to speculate and rich people to over speculate. Sub–prime was just the beginning as it has already spread to Alt 1-A and prime loans as people walk away from their negative equity, overpriced homes.

In the 4th quarter of 2007, we saw the biggest increase in auto loan delinquencies in 8 years, in conjunction with $350 million loss to Sally May and a suspension of all types of securitization sales by 1st Marblehead Corp. And don’t forget the 26% increase in credit card delinquencies. THE DOMINOS HAVE JUST BEGUN TO FALL.

More importantly is the fact that banks must shrink lending 20% to 25% and call in loans in an effort to return their capital ratios to their mandated levels. Brokers and Hedge Funds must also curtail their borrowing at somewhere between $18 to $25 for each $1 lost.

THE PSYCHOLOGICAL FOUNDATION OF LENDING AND THEREFORE LIQUIDITY IS CONFIDENCE. When confidence is lost and the credit spigot is shut off, it ties the hands of the FED so that they can do nothing about increasing the money supply and all the rate cutting has and will go for naught: Except to weaken the Dollar.

RETAIL SALES

In 2007, the consumer represented 72% of GDP and in the face of a crashing real estate market, which involves an all time high 70% of the population, THEY kept on insisting that consumer sales would not be affected even in the face of $100 /bbl oil. Be careful to whom you are listening to. Go back and check what your favorite analysts have been saying over the last 6 months to a year or so. If they could not see the 10 foot high writing on the wall then, what makes you think that they can do anything else but follow the crowd in the future as they all continue in their myopic ways all the way down to the eventual bottom If you want to stay abreast or even ahead of what is coming, don’t forget to mail in your subscription to “UNCOMMON COMMON SENSE.”

INFLATION

Last month, we were hit with a 0.8% per month inflation number, which annualized comes out to an inflation rate of over 9.6% per year and they claim it was only a one month aberration, that there is no inflation. If everyone is still insisting that inflation is not anything to worry about, then why is Bernanke not cutting interest rates by at least 50 basis points if not a full 100 basis points in order to get ahead of the curve? What is wrong with all these so called experts? Are they still living in a dream world refusing to admit to themselves that the party is over? INFLATION is, despite all the manipulation, beginning to roar. Don’t they realize that rampant inflation always leads to a crash?

WHAT DO WE DO NOW?

.The first thing that you must do is to GET OUT OF DEBT, especially margin debt. Those of you who have been following me are now sitting comfortably in cash and have sold into the December rally. Although it did not make the new all time high that I was hoping for, it was nevertheless a good enough rally to have allowed you to get OUT of all your long positions in great shape. If you were smart enough to have gone short, it is time to take your profits and wait for the coming bounce to re-establish your shorts.

SPECIFIC STOCK RECOMMENDATIONS ARE RESERVED FOR SUBSCRIBERS.

GOLD AND SILVER

For those of you who have been long time readers of my letters, you should have at least 1/3 to 1/2 of your liquid assets in Gold and Silver Bullion as well as their underlying stocks. For both old and new fans, you can start accumulating the higher quality Juniors and buy Bullion and the Majors on any $45 to $75 pullback in the price of Gold. THERE IS NO RUSH. The first major Wave I has probably just been completed even if only at the lower end of my target range. But have no fear, we still have up Waves III and V to look forward too. DO NOT TRADE YOUR CORE GOLD POSITIONS.

SPECIFIC BUY AND SELL RECOMMENDATIONS WHICH I HAVE NEVER GIVEN IN THE PAST ARE RESERVED FOR SUBSCRIBERS ONLY.

INTERIM LETTER

Pardon the shortness of this letter, but it is only an interim letter that I don’t usually write. I just thought that, given the situations in the markets, a little hand holding was in order. Even I would not mind a little hand holding from time to time. As far as my own portfolio is concerned, I had a terrific month so far: I covered most of my shorts yesterday (Tuesday) into the close and I sold a few calls against some of my Gold positions on Monday. I know that I don’t have a crystal ball, but maybe I have a crystal eye or better yet, a little good luck. I’ll take luck over brains any time. Next week, my letter will be all about how to make the most money out of a MAJOR BULL MARKET IN GOLD. For those of you who are not lazy and would like a head start, go back into the archives at gold-eagle.com and re-read “RIDING THE GOLDEN BULL and 21st Century Gold Rush.

GOOD LUCK AND GOD BLESS January 16, 2008

UNCOMMON COMMON SENSE:. Start date is February 1st Subscribers will be receiving it two weeks early and it will contain specific buy and sell (sell short) recommendations. The fee is $199 per year and there is a 100%, satisfaction guarantee

Aubie Baltin CFA. CTA. CFP. PhD

2078 Bonisle Circle

Palm Beach Gardens FL. 33418

aubiebat@yahoo.com

561-840-9767

Monday, November 26, 2007

Transition to THAI oil production

Now that Thanksgiving is over, I think that we are facing a true winter of discontent. The global economy has to absorb and adjust for several uncomfortable changes over the next year. I am personally a perennial optimist but also a realist.

We have to overcome a shrinkage in US purchasing power known also as credit, brought on by the unraveling of the sub prime lending business, while the global economy is now eating an energy tax in the form of much higher fuel costs. This is not funny.

What is more, there is little reason to think that the credit decline will not be felt globally. Institutions are taking hits everywhere and they simply will not have as much liquidity. Remember that it was excess liquidity looking for a home that created this mess in the first place. And real estate price inflation took place just about everywhere.

We can thus expect a rolling squeeze on borrowers lasting about three years or more as inventories are unwound. I personally think that there is enough global liquidity slopping around to sponge up the excess housing inventory in the US within three years or very quickly.

Higher energy costs will impact everywhere, but in the US in particular. There is plenty of room for a recession style contraction in the economy that cannot be bailed out this time with cheap money. It is already dirt cheap.

The best scenario is for the oil price regime to stay generally neutral over the next three years while the credit markets work through their problems. In spite of the heated press. the credit situation will work itself out because the global economy will continue to expand for at least another generation or two simply because of the transition to a global middle class modern economy.

A shift in the price of oil to $200 per barrel will surely precipitate a serious recession. The problem is that looks as likely as a decline back to $60 per barrel. In the meantime, the industry and the users are all in denial. New discoveries now are still far too few, although they are been made, and they all need decade long lead times to become productive. The necessary wells that should have been discovered over the past fifteen years were not made.

The only technical fix that is even on the horizon and looks like it may be implemented is the THAI production protocol. It actually looks like the second coming of the oil business. although few have heard of it.

Right now it is been successfully tested on the deep tar sands in Alberta. Three well pairs are now sustaining 2,000 barrels of fluid per day with a water cut of around 50%. They have all started in the past eighteen months. They are currently shaking out the sand handling problems and perfecting the process. Two more years of production should see theses wells paid for. I do not know how long the wells will operate until the available resource is properly depleted and I am sure that the operators do not know either.

The real payoff, however, is that this protocol can be rolled out on thousands of wells just on the tar sands. And there are negligible inputs required unlike the mining protocol. And it can really be done very quickly in Alberta.

This exact same technology can be applied in theory in every other oil resource in the world and can lead to the recovery of huge amounts of left behind oil.

The creation of a pyrolysis front in the oil bearing formation upgrades and mobilizes the bulk of the remaining oil all0wing it to flow readily to the production well. If the oil cannot escape, it is likely to be burnt providing process energy.

Unheard of seventy percent recoveries are been touted by the project promoters.

If THAI fails, then the oil option will continue to evaporate and quickly. Right now, we are trying to get through the next several years while facing pending production declines.