The Rating Game Scam

Bloomberg is reporting S&P, Moody's Mask $200 Billion of Subprime Bond Risk

Standard & Poor's, Moody's Investors Service and Fitch Ratings are masking burgeoning losses in the market for subprime mortgage bonds by failing to cut the credit ratings on about $200 billion of securities backed by home loans.

The highest default rates on home loans in a decade have reduced prices of some bonds backed by mortgages to people with poor or limited credit by more than 50 cents on the dollar and forced New York-based Bear Stearns Cos. to offer $3.2 billion to bail out a money-losing hedge fund. Almost 65 percent of the bonds in indexes that track subprime mortgage debt don't meet the ratings criteria in place when they were sold, according to data compiled by Bloomberg.

[Mish comment: 65% of the subprime bonds no longer meet the original (and flimsy) initial ratings criteria. One might think that would be reason to re-rate the bonds. Think again.]

That may just be the beginning. Downgrades by S&P, Moody's and Fitch would force hundreds of investors to sell holdings, roiling the $800 billion market for securities backed by subprime mortgages and $1 trillion of collateralized debt obligations, the fastest growing part of the financial markets.

[Mish comment: What's with this "may" stuff. We are obviously just getting started, and the wildfire is going to spread far beyond subprime]

"You'll see massive losses from banks, insurance companies and pension managers," said Joshua Rosner, a managing director at investment research firm Graham Fisher & Co. in New York and co-author of a study last month that said S&P, Moody's and Fitch understate the risks of subprime mortgage bonds. "The longer they wait, the worse it's going to be."

[Mish comment: Corporate America always puts off until the bitter end anything and everything that looks smells or tastes like medicine, no matter how sick the patient is and how badly the medicine is needed. The reason is simple: short term profits are at stake and the greed and fees to be made by protecting improper relationships is simply too overwhelming]

Institutional Risk Analytics, a Hawthorne, California-based company that writes computer programs for accounting firms, says 25 percent of the face value of CDOs is in jeopardy, or $250 billion.

Losses may rival the savings and loan crisis of the 1980s and 1990s. The Resolution Trust Corp., formed by the U.S. government to resolve the thrift crisis, sold $452 billion of assets at a cost to taxpayers of about $140 billion.

[Mish comment: Rival the S&L crisis?! These losses are not going to "rival" the S&L crisis. The S&L crisis vs. the current mess is more like comparing an ant to a moose.]

Executives at New York-based S&P, Moody's and Fitch say they are waiting until foreclosure sales show that the collateral backing the bonds has declined enough to create losses before lowering ratings on some of the $6.65 trillion in outstanding mortgage-backed debt.

[Mish comment: S&P, Moody's and Fitch say they are waiting for Godot. The fact that Merrill Lynch could not find buyers for the toxic waste at Bear Stearns was not good enough for them. Nor was the fact that the Bear had to put up over $3 billion to prevent a fire sale of assets. I guess if you can stop the fire sales, then you don't have to mark anything to market? Is that the idea? Of course it is. And it is an extremely risky game, that is guaranteed to blow up. I suspect all of the players no it now too. But as long as the game goes on, lucrative fees and more deals can be put in the pipeline. No one cares about the consequences down the line.]

"We're taking action as we see it," said Brian Clarkson, Moody's global head of the structured products in New York. "We're not doing knee-jerk responses."

[Mish comment: Of course you're taking action as you see it. You see that if you tip the boat you jeopardize relationships that you really ought not be in, in the first place. In other words you are not acting as an independent rating company at all. Not only are you not making "knee-jerk" responses you are doing anything at all other than cover up for those in trouble.]

Downgrades of CDOs "could finally force the hand of ratings-sensitive holders," Morgan Stanley analysts led by Vishwanath Tirupattur in New York wrote in a reported dated June 28. "Our worry is that this selling would be very unbalanced, with no established taker of risk on the other side, even at current market levels."

"The Petri dish turns from a benign experiment in financial engineering to a destructive virus," Gross, who oversees the world's biggest bond fund, said this week in a commentary on the firm's Web site. The companies gave the mortgage bonds investment-grade ratings, duped by the "six-inch hooker heels" of collateral that can't be trusted, he said.

[Mish comment: Petri dish is an apt description. But the mold is not only toxic but spreading. Is that stopping Moody's, Fitch, or the S&P? Of course not. All three have made it clear they are not going to react until the patient is dead.]

Fitch is "deliberate" in its actions, John Bonfiglio, the firm's head of U.S. structured finance ratings, said in an interview in his New York office. Fitch is a unit of Paris-based Fimalac AS. "I would not say we were slow."

[Mish comment: "Deliberate", yes that is a good word for what is happening. Fitch is taking "deliberate" measures to try and contain the mess rather than downgrade debt that the market has stated to downgrade and that Fitch should damn well better know deserves a downgrade. By the time any of the ratings companies actually does make a mammoth debt downgrade, the debt is likely to have hit bottom and ready to rally.]

S&P abandoned seven-year-old criteria for determining a bond's protection against default in February.

Under the old guidelines, S&P said a bond's "credit support'' must be twice the rolling 90-day average of the sum of value of mortgages delinquent by three months or in foreclosure plus real estate that has been seized by the lender.

[Mish comment: Guidelines? What guidelines? Who needs guidelines? Certainly the S&P has no use for anything that would make them downgrade this toxic waste before they are damn good and ready.]

Fitch, Moody's, and the S&P ought not be allowed to have outside relationships with companies whose debt they rate. By the way, the same idea holds true for the Merrill Lynch, Bear Stearns, and Goldman. I have talked about this many times before. But if there was ever any doubt about the ability of ratings companies to police themselves that doubt should now be erased. The current process is nothing but out and out fraud.

Addendum:
Hello from Homer Alaska. I have been in Alaska since June 23, fishing, kayaking, hiking etc. If you wanted an explanation for no economic posts from me for nearly a week, there it is. I simply had no computer access most of the time I was here. I arranged for some posts to be made for me in my absence (thanks trotsky) as well as a book review and a post on energy. I will be back in full swing next week.

Mish
http://globaleconomicanalysis.blogspot.com/

Bookmobile: Master Traders & Just what I said

I recently finished reading two books, both of which I can recommend. The first is "Just What I Said" by Bloomberg columnist Caroline Baum and the second is "Master Traders" by Fari Hamzei of Hamzei Analytics.

I did not know what to expect from either book, but once started they were both hard to put down. The books are completely different in style and content and perhaps who they will appeal to. Let's take a look at each.

Just What I Said

"Just What I Said" will appeal to anyone who wants to learn how the real economy works, in easy to understand lessons cleverly disguised as light hearted articles. The book (broken out into 19 distinct recurring themes) is a collection of the best columns that she has written for Bloomberg over the past seven years, some 1300+ columns in total. The amazing thing is her columns are as pertinent today as when she originally wrote them.

There are so many misconceptions about the economy floating around that simply refuse to die probably because not enough people have read her book. Caroline tackles many of those misconceptions in a manner that anyone could understand. Her style varies from funny, to serious, to sarcastic and everything in between.

Articles in the book range from understanding the yield curve, voodoo economics, the tax code, the US dollar, the trade deficit, the Time Magazine cover curse, the minimum wage, whether or not falling oil prices are good for the economy, the seen and unseen, the political economy, and much more. In one article she compared Alan Greenspan to Alfred Hitchcock. In another article she compares birds at her backyard feeders to the economy. And she is as dedicated to a free market economy as I am.

My favorite chapters are the key myth busting chapters: "Myths Under the Microscope", "Still Nonsense After All These Years", and "Oil Things to Oil People".

Inquiring minds might be interested in how this book came to my attention. I have been reading her articles for many years (but had not yet read her book) when I made a post on my blog called Caroline Baum on Inflation. In that post I sided with her on the Fed's understanding of inflation, as well as reader reactions to her Bloomberg articles. I ended my blog with ...

Note to Caroline:
All we need now is to get you firmly in the Austrian camp.
Lunch with Paul Kasriel just may cure those lingering "monetarist blues" that you seem to have. Can I try and set that up for you?
Cheers!

I did not know if my joke about Kasriel would fly with her or not, or even if she would see it. But there are "spies" everywhere. The next day I received the following email from Caroline:

Mish, It was interesting you matched us up. Kasriel TAUGHT me economics but he wasn't an Austrian at the time. I have toyed with them, done some reading, but I have some issues with their analysis.

A week or two later she sent me an autographed copy of her book which I thoroughly enjoyed and you will too. If you are interested in learning about how the economy really works in easy to understand terms while simultaneously being entertained with humorous analogies, this book is for you.

Master Traders

"Master Traders" will appeal to anyone who wants to sharpen their trading skills with tricks, tips, and approaches to both widely used and new trading methods. The book organized into chapters has a goal of providing "Strategies for Superior Returns from Today's Top Traders".

There are four basic themes to the book as follows:

1. Technical Analysis
2. Fundamental Analysis
3. Sentiment
4. Trading Size

When Fari was approached by Wiley Publishing to write this book he was wondering what to fill it with. Instead he chose a different approach: asking 14 of the best traders, analysts, and/or hedge fund managers he knew to write the introduction and the book's 13 chapters.

Greg Collins writes in the introduction, "The focus of this book is on exposing practical methods with the hope you can find an idea or two to actually incorporate into your daily routine. It's the difference between watching a bass fishing tournament and learning how to catch dinner yourself".

Greg goes on to talk about self-awareness, humility, focus, risk management, experience, and instinct. All of those are important concepts and all of those can be found in the introduction alone.

Jeff deGraaf has a chapter on Playing with Fear and Arrogance. "Contrary to what 99% of the investment population thinks, trading is not about being right. Being right is easy. Trading is about being wrong; and navigating this inevitable occurrence distinguishes winners from the losers in the long run."

Phil Erlanger talks about Trading Seasonality.

Kevin Tuttle has a chapter on Evaluating Probabilities to improve Profitability.

Tim Ord talks about The Secret Science of Price and Volume.

Jon "Doctor J" Najarian, a 24-year veteran on the options market, including the floor of the CBOE talks about "A New Options Game". The game has changed so much that Dr. J sold his floor trading firm in October 2004 moving from being an options maker to an options taker in the process. The doctor has 5 tips for market takers and option players need to understand those tips to be successful traders in this space. This chapter is a must read for option traders.

Fari Hamzei has a chapter on The Secret Messages of Equity and Options Markets. His method involves using a dollar weighted put/call ratio.

Jeffrey Spotts talks about Making Sense of Market Moves: Using Technical and Fundamental Analysis Together.

David Miller discloses The Keys to Biotech Investing. This was one of the most interesting chapters for me. David Miller talks about the difficulty of fundamental research in the biotech sector and has developed 5 rules and 3 themes to help overcome those difficulties. I would consider this chapter a must read for biotech investors just as I would consider Doctor J's chapter a must read for options traders.

If someone can get one or two good trading ideas out of a book the book is usually worthwhile. Master Traders offers a bakers dozen of ideas to choose from and I heartily endorse it.

Final Thoughts

Many of the writers of the chapters in Master Traders have services or product offerings to sell. To me that does not detract from the ideas presented in the book. Good ideas are after all still good ideas, and one can take the ideas presented and run with most of them without subscribing to any services.

Furthermore, and in the interest of full disclosure, there is absolutely nothing to disclose. I do not benefit in any way should someone subscribe to any of those services. Nor do I endorse books or products just because I received an autographed copy.

I give two thumbs up to both books.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Why does fiat money seemingly work ?

written by Trotsky, edited by Mish

This is part 2 of a 2 part series. Part 1 was Misconceptions about Gold.

Imagine that you live on a small island mining the local salt mine, together with Pete the fisherman and Tom the apple grower. You'd exchange your salt for Pete's fishes and Tom's apples, while they would exchange fishes and apples between them.

One day Pete says: "Instead of fish, from now on I will give you pieces of papyrus with numbers marked on them. (Papyrus grows in near unlimited quantities nearby, to the obvious benefit of Pete)." Pete continues "One papyrus mark will represent 1 fish or 5 apples or 2 bags of salt (equivalent to current barter exchange rates). This will make it easier for us to trade among ourselves . We won't have to lug fishes, apples and salt around all the time. Instead, we simply present the papyrus for exchange on demand."

In short, Pete wants to modernize your little island economy by introducing money - and he already has one of those $1 papyrus notes with him, which he's eager to exchange for salt.

You'd laugh him out of the room, since you would realize that the papyrus per se is not of any value. If you were all to agree on using the papyrus, its value would rest on a promise alone - Pete's promise that papyrus he issues is actually backed by fish. Since the stuff grows everywhere, he could easily issue it by the bucket load. In fact, it's unlikely that any of the islanders would ever come up with such an absurd idea.

More likely they would use another good for which there is an actual demand (for instance, a rare type of sea-shell that is prized as an ornament and only seldom found on the island) as their medium of exchange.

In short, a free market medium of exchange/store of value can only be something with an already established demand. No worthless object would ever emerge to function as money in a free market.

So how did it happen?

How did essentially worthless objects come into widespread acceptance as money? To answer that question, we need to take a brief look at history.

Flashback: Rome 27 BC

Rome’s history of inflation and money debasement actually began with Cesar’s successor Augustus, whereby his method was at least not a prima facie fraud. He simply ordered the mines to overproduce silver in an attempt to finance the empire that had grown greatly under Cesar and himself.

When this overproduction began to have inflationary effects, Augustus wisely decided to cut back on the issuance of coins. This was the last time that a Roman emperor attempted to honestly correct a monetary policy blunder, aside from a brief flashing up of monetary rectitude under Aurelius some 280 years later.

Under Augustus’ successors, things began to deteriorate fast. Claudius , Caligula and Nero embarked on enormous spending sprees that depleted Rome’s treasury. It was Nero who first came up with the idea to actually debase coins by reducing their silver content in AD 64 , and it all went downhill from there.

It should be mentioned that Mark Anthony of Hollywood fame financed the army he used in his fight against Octavian – then later Augustus – also with debased coinage. These coins remained in circulation for a long time, obeying Gresham’s Law – "bad money drives good money from circulation".

Left: An AD 275 specimen of Aurelian’s Antonianus, 1 part silver to 20 parts copper .

In AD 274 Aurelius entered the scene with a well-intentioned monetary reform, which fixed the silver-copper content of the then most widely used coin (the Antonianus)at 1:20 – however, just as soon as this reform was instituted, the silver content resumed its inexorable decline.

Left: Emperor Diocletian the price fixer

In AD 301 Emperor Diocletian tried his hand at reform, this time by instituting price controls, an idiocy repeated numerous times thereafter, in spite of the incontrovertible evidence that it never works (Richard Nixon’s ill-fated experiment being the most recent example) .

Naturally, those price controls accelerated Rome’s downfall as goods simply began to disappear from the market place. Merchants began to hide their goods rather than accept the edict to sell them at a loss. This is of course why price controls are always doomed to failure.

One recurring feature of Rome’s long history of debasing its money was a perennial trade deficit due to overconsumption. Does this sound vaguely familiar?

The leap from clipping coins to outright fiat money

How was the leap from debasing coinage to outright fiat money accomplished?

There are two distinct intertwined historical developments that led ultimately to the present system.

Goldsmiths become bankers

The idea of fractional reserve banking was first introduced by the forerunners of our modern day banking system, the goldsmiths.

Goldsmiths were used as depositories for gold and silver, and the receipts they issued for such deposits soon began to circulate as the first bank notes – especially once they hit upon the idea to make them out to the ‘bearer’ instead of tying them to a specific deposit.

Above: An early goldsmith bank receipt

The convenience of carrying these bank notes instead bags of gold and silver soon caught on, and it didn’t take long for the goldsmiths to realize that deposits were rarely claimed in great quantities. It followed that one could temporarily lend deposits out and collect interest on such loans. So far so good – this is the legitimate business of banks.

But the goldsmiths decided to go one step further, issuing additional receipts for gold, even if they were not actually backed by a deposit. This is what came to be known as ‘fractional reserves banking’ - lending out far more ‘money’ than one actually has in the form of deposits.

Obviously this is fraud. Nonetheless, it’s perfectly legal today, but in essence it remains the same fraud it has always been, with the main difference being that today it's a more sophisticated as well as officially sanctioned fraud.

When bank notes were backed (at least partially) by gold and silver on deposit, fraud of this nature was frequently held in check by bank runs (or from a banker's perspective, fear of bank runs). Nowadays, no such fear exists. The ‘lender of last resort’ – the central bank – can (at least in theory) prevent such bank runs by conjuring new ‘money’ out of thin air. In essence, a de facto insolvent banking system is supported by this trick.

Tally sticks and Charles II

The other historical development that can be seen as an ancestor of the modern day fiat money system is England’s application of the medieval ‘tally stick’ method of recording debt payments.

Taxes in the largely agricultural economy of the Middle Ages were usually paid in the form of goods, and these payments were recorded with notches on wooden sticks that were then split length-wise (one half remained with the tax payer serf, as proof of payment). This was an ingenious method of avoiding counterfeiting.

In AD 1100, King Henry the First ascended the English throne, and adopted the tally stick method of recording tax payments. By the time of Henry II, taxes were paid twice a year, and the tally sticks recording the partial tax payment made at Easter soon began to circulate in a secondary discount market – i.e., they began to be accepted as payment for goods and services at a discount , since they could be later presented to the treasury as proof of taxes paid.

It didn’t take long for the King and his treasurer to realize that they could actually issue tally sticks in advance, in order to finance ‘emergency spending’ (not surprisingly, such emergencies often involved war – after the extortion of tax money the second big hobby of governments).

The selling of these claims to future tax revenue created the market for government debt – an essential part of today’s fiat money system as well.



A wooden stick, masquerading as ‘money’.

By 1660, the English monarchy , after a brief hiatus of experimentation with a pseudo-republican government under Cromwell, was reinstated and Charles II began his reign but with vastly reduced powers, especially in the realm of taxation.

Since Charles had to beg for tax money from the parliament, he struggled mightily with paying his vast pile of bills. Whenever Charles wrangled permission to raise taxes from parliament, he immediately went to cash in the future tax receipts by selling tally sticks to the goldsmiths at a discount. This necessitated the introduction of previously referred to method of making such debt payable to the bearer, which allowed the goldsmiths to sell it in the secondary market to raise funds for more lending to the King.

They also began to pay interest to depositors, in order to attract still more funds. At that stage of the game, the goldsmiths had a good thing going for them, since the King was the equivalent of a triple A rated sovereign borrower, who could always be relied upon to cover his debt with future tax receipts. No one thought it problematic that the vaults soon contained more wooden sticks than gold . There was an active market in this government debt, and the goldsmiths profited handsomely.

The King meanwhile decided to circumvent parliament and began to issue tally sticks as he pleased (as an aside, one half of such a stick, which originally remained with the treasury had a handle and was called the ‘stock’ - the term that has evolved to describe shares in publicly listed corporations today) .

Naturally, Charles was more than happy to exchange wooden sticks for gold, and not surprisingly, soon kicked off a veritable credit boom by upping his wooden sticks production.


Left: Charles II, the "Merry Monarch", in all his splendor, eyes focused on the loot.

Why was he nicknamed the "Merry Monarch"? Well, you would be merry too if you could kick off an enormous credit boom by exchanging sticks for gold.

So what does a king do with all that gold he received for sticks? During his 25 year reign, he waged 3 losing wars (2 against the Dutch, one against France); he survived 4 different parliaments (only the first of which wasn’t hostile to him); he helped to establish the East India Company, made shady deals with Louis XIV of France (his cousin), sired a horde of illegitimate children of which he acknowledged 14, and was renown for his hedonistic court. That's a lot of "merry".

Of course, there was a natural limit to this debt expansion. Once all the money attracted from depositors had been transferred to the King, additional deposits could only be acquired by means of offering higher interest rates than previously.

By 1671 the annual discount on the King’s debt had reached 10% and due to redemptions nearly overwhelming funds raised by new debt issues, things clearly had ceased to work for him. Charles suddenly and conveniently remembered that there was a law against usury on the books, and lo and behold, interest rates in excess of 6% were not permissible.

With all his recent loans carrying a far bigger discount, he simply declared the debt illegal, and stopped payments on it (with a few judiciously selected exceptions). Overnight, the King’s tally sticks reverted back to what they had really always been – worthless sticks of wood.

The King’s creditors, chiefly the goldsmiths and their customers, had, quite literally, "drawn the short end of the stick" (if you ever wondered where this expression came from, this is it).

Left: Charles II as he is apparently remembered today – a knight in shining armor, not the tyrannical thief that he really was.

Although tally sticks were still used until the early 19th century, and even formed part of the capital of the Bank of England when it was founded in 1694, the secondary market never truly recovered from this blow. Charles had, with the stroke of a pen, killed the better part of London’s budding banking system, and transformed countless of his creditors into destitute involuntary tax payers.

To add insult to injury, he even gained a propaganda victory, as the public tended to blame the goldsmiths for the mess (they were of course not entirely innocent, and above all had been quite gullible).

What the tally stick system and its application by Charles II however did achieve, was to plant the idea of how a fiat money system might actually be made to ‘work’.

John Law’s fiat money experiment in France

It was a Scotsman – John Law – ironically born in the very year (1671) when Charles defaulted on his debt, who tried the first great fiat money experiment inspired by these ideas. Living in exile in France, he found a willing partner in Philppe II Duke of Orleans' near bankrupt state for putting his ideas into practice.

Left: Philippe II, Duc d’Orelans, the Regent of France. When Louis XIV of France died in 1715, Philippe d'Orleans became Regent to the five-year-old King. Together with John Law, they combined to economically wreck France.

John Law's basic idea was that the more money in circulation the greater the prosperity of a country. His ideas can be found in a treatise he published in 1705 entitled Money and Trade Considered.

Right: John Law - World's first Keynesian economist

In his words, "Domestic trade depends upon money. A greater quantity [of money] employs more people than a lesser quantity. An addition to the money adds to the value of the country."

With the above logic, John Law arguably became the world's first Keynesian economist.

John Law became the comptroller general of finances and set up the Banque Generale Privee (later the ‘Banque Royale’), which used French government debt as the bulk of its reserves and began to emit paper money ‘backed’ by this debt – with a promise attached that the notes could be converted to gold coin on demand.

In an effort to make the new paper money more palatable to a distrustful public, it was decided to make it acceptable for payment of taxes (this idea is key and we will get back to it). A credit and asset boom of vast proportions ensued, especially after Law decided to float the shares of the Mississippi company, which enjoyed a trade monopoly with the New World and the West Indies.

Between 1719 and 1720 shares in the company rose from 500 to 18,000 livres. Then, predictably, the bubble burst, and it lost 97% of its market capitalization in the subsequent bust. Enraged and nervous financiers tried to reconvert their bank notes into specie in the ensuing massive economic crisis, but naturally, the central bank’s promise of convertibility could not be put into practice – it had inflated the supply of bank notes too much (the notes traded at discounts of up to 99% in the end).

The government at first tried to stem the tide with edicts forbidding the private ownership of gold , but in the end, the enraged mob drove Law into exile, and the fiat money experiment ended with the Banque Royale closing its doors forever .













Above: 1720: Investors in Law’s Mississippi Company scam want their money back

The crisis following the collapse of Law’s Mississippi enterprise gripped all of Europe – the eloquent master of fiat disaster had seduced investors from all over the continent, many of whom were suddenly penniless. Confidence in other European corporations eroded as well, and a great many bankruptcies took place.

Failures Everywhere

The history of the world is filled with examples like the above. Unfortunately time and space considerations will not let us detail the backdoor coup that enabled the establishment of the Federal Reserve, FDR’s sinister gold confiscation, Nixon’s dropping of the last remnant of the dollar’s gold convertibility, or China’s earlier experiment with paper money which ended in a disastrous hyper-inflation.

The brief monetary history of Rome is intended to establish the fact that the State has sought to engage in theft from the citizenry via monetary debasement from the very dawn of Western civilization. The focus on the 17th century application of the tally stick system in the UK as well as the focus of the transformation of London’s goldsmiths to bankers is meant to establish from whence the idea of putting together a workable fiat money system stems. This is an extremely important part of monetary history but is generally a less well known one.

The above historical recap was written to fill in some additional as well as essential information if one wants to understand how we arrived where we are today. With that history lesson out of the way, let's now address the question we asked at the top. How did worthless objects come into widespread acceptance as money?

Public Demand for Fiat Money

For a long time, States were forced to accept gold's role as money. The absurdity of introducing unbacked paper money wasn't considered a viable avenue of robbing the citizenry. Rather, heads of State resorted to 'clipping' their coins or diluting their precious metals content if they wished to inflate. These early instances of inflation via reduction of the precious metals content of coins were intimately connected to the downfall of entire empires – most famously, the Roman empire. But along came Charles II, followed by John Law who had a brilliant idea for gaining public demand for fiat currency.

Demand for fiat money was created by its acceptance for payment of taxes.

What we have here, is really no less than the explanation for why pieces of paper with some ink slapped on them are not a priori laughed out of the room, as we proposed would happen with Pete’s papyrus promises in paragraph one. The demand for this paper is established by its acceptance for the payment of taxes.

The two major pillars of the system are based on coercion: directly via the legal tender laws (which decree that fiat currency must be used/accepted for all payments of debt, public or private) and indirectly via the value imputed to government debt which rests on the faith in the government’s ability to extort enough future tax revenue to be able to repay its debt.

This latter point is extremely important for the system to function. Government bonds are the tally sticks of our age, and serve as the main ‘backing’ of bank notes and their digital counterparts in circulation. They are what is tying the government and the banking system together, via the central bank.

The central bank has the power to ‘monetize’ such debt by creating money out of thin air, however, this roundabout way of going about it is an essential part of the confidence game, the creation of the illusion of value.

Theft of Purchasing Power

Left: Fiat currencies in the 20th century - monetary catastrophes unfolding at varying speed since the birth of the Federal Reserve.

Image thanks to the Gold Eagle editorial Fiat Money Systems. (click on image for a better view)

Since the central bank’s balance sheet is largely composed of government debt, it has an incentive to manage the public’s ‘inflation expectations’ and inflate the currency as inconspicuously as possible.

This does of course not mean that the inflation racket is inhibited per se. The theft has merely been organized in such a way that the people don’t complain too much.

If the government had to actually raise taxes instead of borrowing the staggering sums of money it uses to keep its welfare/warfare programs running (and keeping the vote buying mechanisms well oiled) it would have to raise taxes by so much that it would face a rebellion.

Instead government resorts to inflation.

Inflation is nothing but a cleverly disguised tax and that is the real meaning of that last chart.

The fox guards the hen house

Richard Russell, in a recent missive, reminisced about the $125 his first job after college earned him per month and the then high $22.50 he had to pay every month for his $10,000 GI life insurance policy. A new car cost $450. Those were princely sums in the 1940’s, but have become what he now calls ‘chump change’.

Obviously this hasn’t happened overnight although it can, as witnessed by Zimbabwe. Rather the public has become used to and injured by the ‘inflation tax’ proceeding at what appears to be a snail’s pace (at least according to the government’s official ‘inflation data’, which is like the fox guarding the hen house). It is of course not possible to measure an ‘average price’ of disparate goods , so this is just another part of an elaborate scam.

With the legal tender legislation in place, fiat money has also successfully put gold out of circulation. After all, no one is going to use ‘good money’ for transactions when he has the choice of using ‘bad money’ instead. Indeed, what has happened is that gold has increasingly shifted from the world’s monetary bureaucracies into private hands, as a store of value.

On a global basis, only about 2.5% of all official central bank reserves are in gold nowadays (obviously, some countries have far larger percentages of their reserves in gold, most notably the US and many European countries – even so, these reserves pale in comparison to the amount of fiat money and credit they have issued).

Everyone is Happy

It is also important to note that although they are being subjected to a hidden tax, most citizens actually are quite happy with things as they are. As Gary North has observed in a recent essay, everybody involved appears to be happy, the robbers as well as the robbed.

The banks are happy to be part of a cartel led by the central bank, which gives them immense latitude in indulging in consistent and flagrant over trading of their capital – spurred on by the moral hazard created by having a ‘lender of last resort’ at their disposal, with no restrictions on how much ‘money’ it can conjure up out of thin air;

The politicians and the bureaucrats are happy because there is no restriction on their spending and there is nothing stopping them from buying votes or indulging in whatever ‘pet projects’ they happen to dream up.

And lastly, among the people who should actually rise in protest, there are large sub-groups that are either wards of the State and dependent on its largesse (the shameful secret of the welfare state is that it makes irresponsible slaves out of previously free and responsible people), or have been seduced by the banking cartel’s propaganda and amassed so much debt in the pursuit of consumption that they are quite happy to see money being devalued at a steady pace.

Wealth Producers Have No Say

In a nation of debtors, inflation is the politically most palatable form of monetary policy – after all, everybody is focused on the short term (politicians and bureaucrats on their terms of office, consumers on their debt and their desire to buy more things they don’t need with money they don’t have, and so forth).

No one considers for a moment, that in the long run, this policy means ruin. Over time, the middle and lower classes will see their real incomes and living standards shrink ever more, while the true beneficiaries of inflation – those who get first dibs on every dollop of newly created fiat money – amass more and more of the wealth that is stolen from its producers by inflation.

Not surprisingly, the small elite that actually profits from the fiat money system is quite content to take the long term view for itself.

The actual producers of wealth are a very small group, too small to have a decisive voice in how things should be run. They would have to pull a John Galt type stunt and all go on strike if they wanted to exercise some pressure. Unfortunately, big business is usually in bed with the State and also happy with the status quo.

One must always keep in mind that big corporations are generally not in favor of truly free, competitive markets. They give lip service to the idea, but concurrently lobby for anti-competitive regulations all the time.

Decades of successful propaganda

The propagandistic effort in support of the fiat money system has been enormous over the decades, and has been extremely successful.

Left: Greenspan unlocks the secret of making fiat money "as good as gold".

When Alan Greenspan told Ron Paul on occasion of his semi-annual testimony in Congress that he believed "we have had extraordinary success in replicating the features of a gold standard" he knew quite well that this was a bald-faced lie.

And yet, no one outside of Ron Paul would have even thought of questioning this absurd assertion.

As to why it is obviously a lie, consult the chart above. The dollar has lost 96% of its purchasing power since the Fed has been in business.

Let us also not forget that there still is a remnant of a market economy operating alongside the huge swathes of economic activity that have been appropriated by parasitic entities such as the State and its dependents.

It is this remnant that produces all of our wealth, in spite of the fiat money system. It involuntarily supports the system’s continued viability by doing what it does best – enhancing productivity, and thereby exerting downward pressure on the prices of goods and services (which works against the upside pressure on prices created by monetary inflation).

This in a nutshell shows why the system ‘seems’ to work – and actually does work on a short term basis.

Economic Interventionism vs. the Free Market

Apologists of the current system tend to laud its "flexibility". In reality this argument is nothing more than an argument for economic interventionism which history proves time and time again can't work in the long haul.

Another commonly heard argument is: "If the economy is to grow, so must the supply of money", as if that were immediately obvious. In fact, most people who hear this sentence do believe it to be a truism. In reality, increasing the supply of money confers no benefit whatsoever on society at large. It is not important how much money one has in terms of number entries in one’s bank account, it is important what this money can buy. Didn't John Law's experiment prove this beyond a shadow of a doubt?

It is not 100% certain that a modern free market economy would settle on gold as its money. In fact, it is not important what would emerge as money. What is important is that the decision on what should be used as money would be arrived at voluntarily by the collective actions of market participants.

That said, it seems highly likely that the previous historical period of trial and error that has led to the establishment of precious metals as money would still be accepted as having produced a satisfactory outcome by a modern free market economy. After all, we know that gold trades in the marketplace as if it were money. See Trotsky on Gold - Misconceptions about Gold for proof.

In a free market with a relatively stable supply of money, the supply and demand for money would still be subject to fluctuations similar to that for other goods, depending on time preferences. The free market interest rate would at all times correctly signal to entrepreneurs what the state of time preferences was at a given point in time, allowing them to allocate capital in the most efficient manner.

A fiat money system with interest rates administered by a bureaucratic central economic planning agency meanwhile constantly sends wrong signals to entrepreneurs about expected future demand and the true cost of capital and thereby encourages malinvestment.

The phases during which credit expands and malinvestments proliferate are known as "economic booms", and everybody loves them. When the liquidation phase occurs, otherwise known as "busts" few people are aware that it is the preceding booms that are at fault. And so the cry for more monetary and fiscal intervention arises, which lengthens and deepens the malaise by putting malinvested capital on artificial life support.

On the other hand, the free market tends to consistently lower the prices of goods and services over time. That is the logical result of increasing productivity. This is why the widely accepted tenet that we "need some inflation of the money supply to enable the economy to grow" is a complete lie.

Government mandated fiat currency simply does not work in the long run. We have empirical evidence galore – every fiat currency in history has failed, except the present one, which has not failed yet.

Nonetheless, the current fiat system is more ingeniously designed than its predecessors and has a far greater amount of accumulated real wealth to draw sustenance from, so it will likely be relatively long lived at least as far as fiat money systems go.


How long can this one last?

Bernanke shows us...

"It will work this long."

In a truly free market, fiat money would never come into existence. And that is why Greenspan is wrong. Governments can not create something "as good as gold". History clearly shows that that only the real thing will do.

Trotsky
http://globaleconomicanalysis.blogspot.com/

Running a Car on Saltwater

A new method to separate hydrogen and oxygen atoms in water has been discovered by an Ohio inventor, John Kanzius. This video has been making the rounds but most who have seen it are skeptics. I think it's worth a look.

Separating hydrogen and oxygen from water economically has been one of the holy grails of energy production for a long time. Such separation has long been achieved, but unfortunately not in an economical manner. Let's see how this new method does.

Burning Saltwater



click here for a fascinating video

How did John Kanzius stumble on his invention? Interestingly enough he was seeking to cure cancer. His idea was to use radio waves to heat certain metals like gold. Nano particles of gold would be injected into cancer patients and those particles are attracted to cancerous cells. Next radio waves would heat those particles and kill only the cancer cells. He did not discover a cure for cancer (not yet anway) but he did discover his radio frequency generator could burn saltwater.

There are obvious implications such as powering turbines or engines now running on gasoline if his solution could work on a scalable basis. When asked what will he would do with profits from his invention, his reply was "keep looking for a cure for cancer".

A Question of Efficiency

So far his method fails as the article Fire from Salt Water shows.

John Kanzius has found a way to burn salt water with the same radio wave machine he is using to kill cancer cells.

Kanzius was testing his external radio-wave generator to see if it could desalinate salt water, and the water ignited.

While the phenomenon is interesting, it is not yet practical for energy generation. More energy is consumed by the radio frequency device than is produced for burning.

Efficiency-wise, they are presently at around 76 percent of Faraday's theoretical limit.

Conventional Electrolysis

Devices such as the Hofmann voltameter have been used to produce hydrogen from water as the article Electrolysis of Water shows.

The Hofmann voltameter is often used as a small-scale electrolytic cell. It consists of three joined upright cylinders. The inner cylinder is open at the top to allow the addition of water and the electrolyte. A platinum electrode is placed at the bottom of each of the two side cylinders, connected to the positive and negative terminals of a source of electricity.

When current is run through the hofmann voltameter, gaseous oxygen forms at the anode and gaseous hydrogen at the cathode. Each gas displaces water and collects at the top of the two outer tubes, where it can be drawn off with a stopcock.

Electrolysis in nature

Plants electrolyze water in the process of photosynthesis with very little energy required using a natural catalyst. If this method were developed industrially high levels chemical energy in the form of hydrogen could be produced at little cost and with absolutely no environmental damage.

The old problem was generating electricity cheaply enough to make the process energy efficient. The new problem seems to be inability to produce radio waves cheaply enough to make the process practical for large scale applications. Can this possibly work in theory?

Easy to Disbelieve

There is a ton of internet articles out there claiming it is impossible. Do a search. You will find them. The one common theme in most of them is the idea that Kanzius claims to have invented a perpetual motion device. Burn water (or rather oxygen and hydrogen separated by his device) to achieve energy. What do you get when you burn oxygen and hydrogen? Water.

Perpetual motion device? Not really.

As I see it, he is using radio waves to heat up sodium ions hot enough to cause the hydrogen and oxygen in water to separate. Stop the radio waves and the process stops. That is far from perpetual motion. Can it possibly be that some magic frequency causes saltwater to turn into hydrogen and oxygen producing more energy than it took to generate the microwaves?

I am not a physicist so I simply do not know. But I am convinced that this is both a new method and not a hoax. Proof that it is not a hoax are the patents given to the process. Here is a list of John Kanzius Patents. As best as I know, not a single patent has ever been erroneously given to the maker of a perpetual motion device.

But that does not mean this process has any practical application unless the process is efficient enough. So he key question then is ....

Is this theoretically possible?

The good old formula E=MC² tells us that there is more than enough energy in the universe for us to exploit. All we only have to invent are the technologies that can achieve efficient conversion.

Let's now turn to an article I found regarding this process on the website
Desalination Research And Development Breaking News Incisive Analysis

Update: I talked on the phone to one of the scientists Ed Apsega at APV Engineering in Akron Oh. They tested John Kanzius process. I was told the flame burned at more than 1700 degrees Celcius or 3000 degrees Farenheit. (Its not clear to me currently as to whether the energy yield is more or less than 1:1. Why? Well the APV engineering scientist Ed Apsega said the energy yield was much more than 2:1 and later I talked to John Kanzius–he said the energy yield was less than 1:1.)

But In a later comment to Fire from Salt Water we see this set of replies:

June 06, 2007
John Kanzius write:

"Since it appears we now have now achieved more than unity, I am going to do an embargo on releasing all further information.

"Actually there are smart individuals who have posted on different web sited and actually have a pretty good idea of what is happening."

June 01, 2007

"I am in the process of redesigning the electronics for the saltwater as to see what efficiency we can achieve.

"Why does everyone think this is a form of electrolysis?

"Some scientists who have made comments on certain web sites actually understand the mechanism of action.

"Regarding moving this forward, I want to see what are the best results we can achieve with joules in vs joules out. A chemist in Houston whom I know is going to be doing a couple of things for me this weekend." -- John Kanzius (June 01, 2007)

Once again there are two interpretations to those comments. Both are readily available on the internet. Here they are:

1. Kanzius is not talking because his device is a hoax and has been disproved.
2. Kanzius is not talking because he is on the verge of success if not achieved outright success.

I cannot say if Kanzius has achieved practical application success or not but I am willing to say this is not an outright hoax. I am also willing to suggest that practical application could be theoretically possible. Any physicists out there can feel free to chime in.

For those who think Mish is perpetually gloomy, I hope this article proves otherwise. I firmly believe that the free market, if left alone, will eventually solve the energy crisis and most other problems as well. (Now can we please let the free market handle things?!)

Running a car on saltwater may be impractical, but running turbines to generate electricity is potentially another matter(providing efficiency can be achieved). Regardless of practical application or not, we can all admire the spirit of John Kanzius. Everyone but the oil companies and oil exporters can wish him the best of luck at solving this problem.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Misconceptions about Gold

written by Trotsky, edited by Mish. see addendum.

Few markets are as widely misunderstood and subject to so many misconceptions as gold. Many of those misconceptions stem from gold's dual role as a commodity and money. This post will attempt to clear up some of those misconception with a few facts. Let's start with one key fact.

Gold is Money

How can I actually claim that 'gold is money'? After all, it is not used as official money anywhere and barring isolated instances of payments made from a digital gold account, it is unlikely that one will ever make a payment in gold these days.

In addition, central banks seem intent on 'demonetizing' gold, as the biggest CB holders of gold (except the US) continue to unload it, ostensibly to earn the higher returns provided by bonds. Selling gold for returns is actually a spurious argument, because reserves are just that: reserves. And the primary purpose of reserves is not to produce a return.

In spite of all this, we still know that gold is money, because it trades in the market as if it were money. Let's see if we can prove that thesis.

Gold Supply and Demand

If gold's price were determined by fabrication demand alone (jewelry and industrial uses), it could not possibly trade at a price of $650 oz.

Many gold analysts, from the mainstream to fringe groups such as the Gold Anti-Trust Action Committee (GATA) claim that they can predict what the gold price will do by adding up annual fabrication and investment demand (as well as dehedging demand by miners) and contrasting the resulting total with annual supply (mine supply, central bank selling, disinvestment and scrap). In short, they analyze the gold market in the same manner as they would analyze the copper market.

It should be immediately obvious that this can't be correct. After all, nearly the entire gold ever mined (approximately 150,000-160,000 tons) is still here. In short, the total potential supply of gold is some 97-98% greater than the gold produced every year (approximately 2,600 tons).

On that basis it makes no sense to apply traditional commodity supply/demand analysis based on annualized trends in the gold market.

Simply put, there is a big difference between commodities that are effectively used up (aside from scrap residual returning to the market every year) and a commodity the indestructibility and durability of which inter alia made gold the 'money commodity' in the first place.

Jewelry Demand vs. Monetary Demand

One can further illustrate gold's unique nature as money with a study of gold prices vs. jewelry demand. If record fabrication demand for gold (jewelry) must be good for the price of gold, then a historic high in jewelry demand should in theory coincide with a high gold price.

However, record high jewelry demand in 1999 - 2000 in actual fact coincided with a 20 year bear market low in the gold price - the exact opposite of what traditional commodity supply/demand analysis would suggest.

We can therefore conclude that there must be a source of gold demand that is of far greater importance than the jewelry and industrial demand components, and that demand constitutes the true driver of the price of gold in terms of fiat money.

Indeed, there is. This demand component is called 'monetary demand'. Monetary demand and the supply of gold is actually best described as the 'degree of reluctance of the current owners of gold to part with their gold at current prices' since, as mentioned above, some 160,000 tons are owned by somebody already.

De facto gold acts in the markets as if it were another currency rather than a commodity. It often keys off other currency cross rates, such as dollar/euro , and has a strong tendency to ignore all the typical supply/demand analysis thrown at it by the mainstream (including the World Gold Council which should know better).

A rising gold price usually begets falling jewelry demand, which is exactly what the theory of price elasticity would suggest. But at the same time, rising prices actually tend to stoke investment demand, just as a developing uptrend in the stock market tends to invite more demand rather than less as this chart, courtesy of Sharelynx Gold shows.

Click on the chart for a better presentation.



The above chart shows that the record high in jewelry demand coincided with the 20-year bear market low in the gold price. So what was driving the price of gold higher? We know it was monetary demand driving the price because the total fabrication demand for gold has been basically flat since 1999.

Ironically enough, the chart also shows the price of gold was falling for over 20 years even as fabrication demand was rising. This is further proof that fabrication demand is not the most important driver of the price of gold. Finally, it should also be noted that some jewelry demand, especially in India, is in reality monetary demand in disguise.

The sin of attaching importance to jewellery demand in gold price forecasts is engaged in by all the major brokerage houses. This leads even the best of money managers to making mistakes, as evidenced below:

Legendary value investor Jean-Marie Eveillard recently stated the following in a Fortune interview:

"When we started our gold fund in 1993 - which proved to be six or seven years too soon - I mistakenly thought that my downside was protected by the fact that jewelry demand was fairly vibrant. But I was wrong. I think gold moves up and down based on investment demand mostly."

The WGC (World Gold Council) meanwhile tries to gauge 'implied investment demand' respectively 'dehoarding' retroactively, by adding up known new annual supply (from mining, scrap, central bank selling and hedging) and contrasting it with known annual fabrication demand. The difference, it reckons, must represent 'implied investment demand' (presumably the demand from gold ETF’s figures in these calculations as well these days).

However, as we noted, investment demand is also expressing itself by the reluctance of current gold holders to sell at a given price. This reluctance can not be measured, and actual investment demand is therefore also not measurable.

Gold Mine Production vs. Total Demand



The above chart depicts another peculiarity of the gold market’s supply/demand situation: As the price of gold rises, mine production actually flattens out and falls. There are two reasons for this unusual response to higher prices.

1. During low gold price environments, mines are forced to ‘high grade’ (i.e., mine higher grade portions of their orebodies). Once the price rises, they shift their mining activities to lower grade portions of their orebodies, that haven’t been economic to mine previously.
2. During periods of low gold prices, exploration spending falls, so that once prices rise, very few new mines are set to open and take up the slack from depleted mines. It can take up to 7 - 10 years from the discovery of an economic orebody to the point when mining can begin.

What motivates monetary demand for gold?

To answer this question one must look back at how gold evolved to become money in the first place. First of all, it always was a commodity with a demand based on its usefulness for creating ornamentation and jewelry, so there was a prior demand for gold that made it useful in barter.

In addition to that, its non-corrosiveness, divisibility, fungibility and easy portability weighed in its favor for use as money. Lastly, its scarcity and the fact that its supply is unlikely to suffer sudden increases, regardless of the wishes of the money issuing authorities, made it a prime candidate to act as a store of value.

There is a single historical exception to this gold supply dogma, and that's when Spain imported (stole) gold from the New World in the 17th century leading to inflation in Europe. Nowadays, mine supply is around 2% of the total stock of gold per annum and it's highly unlikely there will be much deviation from this percentage. Thus a similar gold-based inflation today would be extremely unlikely.

This latter point - that the State can't create gold out of thin air - is what lies at the heart of the monetary demand for gold.

In our modern day fiat money system with its fractional reserves banking systems and free-floating paper currencies, gold is the only form of money safe from the depredations of central bankers. It therefore serves in the widest sense as a barometer of confidence in this central bank administered system.

Considering that the US dollar has lost about 97% of its value against gold since the Federal Reserve has been in business, one can conclude that confidence in fiat money has been waning rather precipitously over time. This trend is certain to remain a one-way street over the long term, with occasional fluctuations as confidence in paper (or digital) money waxes and wanes.

Unfortunately, this sad state of affairs doesn't seem to worry the engineers of inflation. They only get worried when it happens too quickly (so fast that everybody takes notice). One should add here that in the back of the mind of the typical monetary bureaucrat there is this little voice that says: "If push comes to shove, we can always take it back by force." After all, it wouldn't be the first time.

Time Preferences

In the shorter term, the motives of gold holders who to refuse to sell (possibly even adding to their position) often depend on immediate concerns such as real interest rates, inflation expectations, the spread between short and long term interest rates as a proxy for the likely bias of monetary policy, and the exchange value of the US dollar.

Typically gold is a counter-cyclical asset that does best in real terms when liquidity evaporates. At times however, there can be pro-cyclical demand when equity, commodity, and gold prices are all rising strongly, and liquidity is more than abundant.

In the end, such price fluctuations in gold are a bit like Warren Buffet's famous remark about the stock market being a 'voting machine in the short term and a weighing machine in the long term'. In the short term, all sorts of considerations can be used to 'explain' movements in the gold price, but in the long term, gold acts as the aforementioned barometer of confidence in central bank issued fiat money.

Up next: Why does fiat money seemingly "work" at all?

[The above link added after the fact for reference purposes.]

Addendum:

Mish asked me if I would consider writing a series of posts on his blog about gold. I was pleased to take advantage of his offer. Together we came up with the topics, I did the writing, and Mish did the editing. A question came up as to what name to make these posts under. The name “Trotsky” had its origins as a joke handle I started using a long ways back on Kitco. I'm as anti-Leon Trotsky as one can possibly be. I'm not particularly fond of the handle anymore, but it's now the name I am associated with and we decided not to change it on short notice.

Trotsky
http://globaleconomicanalysis.blogspot.com/

Toggle Bonds - Yet Another High Wire Act

While doing some research on "toggle bonds" and “covenant light” deals, I came across an article in the GlobeAndMail called Private Equity's High-Wire Act that describes both nicely. This following excerpt is further proof of just how insane credit lending has become.

Behind the veneer of the self-congratulation, jaw-dropping riches and plain excess – witness Blackstone Group chief Steve Schwarzman, who made $400-million last year and hired Rod Stewart to perform at his 60th birthday party – the first cracks are beginning to appear. Some private equity players say too many deals are getting done at prices that are too high; on average, buyouts firms in the U.S. are paying roughly 50 per cent more for assets than they were in 2001.

The bidding wars are great for shareholders of public companies, but afterward, they also leave those businesses encumbered with far too much debt, much of it borrowed under looser terms than ever. Some of the biggest buyout deals of the past few years – Freescale Semiconductor in the U.S., Masonite International in Canada – are already showing some financial strain.

Today, a few bankers have publicly voiced concern about foolish lending, among them Bank of America chief executive officer Ken Lewis, who recently got the attention of the world's banks when he said: “We are close to a time when we'll look back and say we did some stupid things.”

In the U.S., banks hold just 20 per cent of “leveraged loans,” a term that describes not just buyout loans but other junk debt, according the Standard & Poor's.

The other 80 per cent is held by institutional investors – hedge funds, mutual funds, pensions, insurance companies and so on. The biggest buyers are financial engineers who acquire a bunch of loans, pool them together as collateralized loan obligations, or CLOs, and sell them off in pieces – very often to those same hedge, mutual and pension funds.

CLOs didn't exist during the big buyout wave of the late 1980s, and they didn't become “dominant” buyers of high-risk loans until 2002 and 2003, says Steven Miller, who analyzes the speculative loan market for S&P. While they've been a haven for the banks as a place to easily offload speculative loans, the presence of CLOs creates a longer daisy chain – middlemen upon middlemen – dividing those loans up into ever-smaller slices.

The result is that the banks, now acting more as loan brokers, are less vigilant about the kinds of loans they arrange, since they know that they likely won't be holding the loan for long.

Does this sound familiar? It should – because it's similar to the way the U.S. subprime mortgage operated during its high-growth years. Mortgage brokers, scurrying to sign up clients as quickly as they could, were lax in weeding out customers with poor credit. When those borrowers began to default in large numbers, the usual buyers for subprime debt quit purchasing it, and those left holding billions in poor-quality loans – companies like New Century Financial – went broke, out of business, or swallowed their losses.

The fees for arranging loans are as alluring for the commercial banks as they were for subprime lenders.

“It's like crack cocaine for them,” says the unnamed private equity partner. In LBO deals, “the banks don't care any more about the [quality of] credit. As long as they can sell it all, they're fine.”

Large private equity firms know this and are taking advantage. The heated competition for their business means not only cheap money, but easy terms.

So-called “covenant light” deals, such as Kohlberg Kravis Roberts & Co.'s $26-billion takeover of First Data, remove many of the usual conditions attached to loans; borrowers aren't required to keep their debt below 6 times their annual EBITDA, for example, or to ensure that their interest payments consume no more than half of their cash flow. (EBITDA is earnings before interest, taxes, depreciation and amortization.)

The idea is to “make it harder for the banks to find a default that would allow them to call the loan,” says Jay Swartz, a lawyer at Davies Ward Phillips & Vineberg LLP who works on private equity transactions. How many big LBOs are being done covenant light? When it comes to deals by KKR, Blackstone Group and other large private equity shops, “virtually all” are done this way now, confesses a New York-based banker for a large Canadian financial institution.

Three years ago, U.S. firms taken over in LBOs had free cash flow that equalled 2.6 times their interest expense - so if the business took a dive and cash flow fell by half, they could still make their payments. That's no longer the case. The cash-flow coverage ratio has shrunk to 1.7 times, according the S&P's Mr. Miller, the lowest level since the bull market of the late 1990s.

These are the subprime borrowers of the corporate world, and they, too, have their own inventions for making a heavy debt load a little bit easier. The housing industry had adjustable-rate mortgages; Wall Street has "toggle bonds," which allow the borrower to choose to pay interest by issuing more bonds, paying even higher interest, instead of cash.

Toggle bonds are not a totally new concept, but they tend to be issued only in exuberant times. They have proven to be dangerous in an economic downturn.

It's easy to understand why a company would want to sell a toggle bond, but harder to reckon the appeal for those buying them. Who wants to lend money to a company that's so strapped for dough, it can't even pay its interest in cash?

The reasons are simple. Many hedge funds use borrowed money themselves to amplify returns. So all they need to do is find some debt that's yielding, say, 10 per cent, buy a lot of it with money they've borrowed at 7 or 8 per cent, and collect a healthy spread - and fat fees - in between.

And if that strategy explodes in their faces because they end up holding some worthless junk debt? So be it. For as long as it lasts, it's an easy route to profits. Hedge funds get into trouble and are forced to close shop all the time, but no one ever asks them to return their fees (generally 2 per cent plus 20 per cent of the investing profits).

"Why would you not just take the highest possible risk with other people's money? If there's literally no downside, it's the rational thing for you to do," says Mr. Fridson.

The history of such lowly debt like that is not very encouraging; usually, more than one-third of it goes into default within the first three years. It's not a question of whether a large LBO implodes, but when it will happen and who will be left holding the bag.

It's no secret there have been relatively few defaults on even the junkiest of junk so far this year. The reason is simple: companies that would (and should) have been wiped off the face of the earth by default were given a lease on life by investors willing to refinance that debt on insanely favorable terms to the debtors, regardless of risk.

“The process feeds on itself until the patient dies”

The speculative action in LBOs, junk financed buybacks, and toggle bonds is indeed quite like that of junkies hooked on crack cocaine. It's fitting that the words junk and dealers both apply. The only difference is this high comes from debt leverage instead of cocaine. And why not pile on the risk and shoot for the stars with as much leverage as possible? After all it's OPM (other people's money) being bet. In both cases the next fix takes more and more leverage to generate the same high. And in both cases the process feeds on itself until the patient dies. But before this all blows up, enormous fees are generated for the dealers, in this case investment bankers and hedge funds.

Fantasy Land for Corporate Treasurers

The Standard discusses toggle bonds in Junk bonds spark jitters.

"Defaults are almost non-existent today and, well, we know that doesn't hold forever," said Thomas Lee, who stepped down last year from Thomas H Lee Partners, the Boston-based takeover firm he founded 32 years ago.

"When the economy goes bad, defaults will spike up from 1 percent into the 9 percent level," Lee said at the Milken Institute Global Conference in Los Angeles last month. "If that happens then the financing part grinds to a halt" for LBOs, he said. More than half of the junk bonds sold this year were used to pay for leveraged buyouts and mergers and acquisitions, notes Barclays Capital.

Money is so easy to come by that for the first time some investors agreed to let borrowers choose to make interest payments in cash or in additional bonds. "This is fantasy land for corporate treasurers," said Edward Altman, a professor of finance at New York University's Stern School of Business.

The growth of toggle bonds is a symptom of too-easy credit, Fridson said. Giving companies the ability to pay interest with more debt rather than cash shows they "have a reasonable likelihood of needing to exercise that option," he said.

Companies are piling on debt even as the economy slows. Total debt for about 300 companies rated BB and B rose by 16 percent last year, double its growth in 2005, according to Fitch.

Ford Motor lost US$282 million in the first quarter and is US$23 billion deeper in debt than it was a year ago. The Dearborn, Michigan-based company's US$3.7 billion of 7.45 percent bonds due in 2031 trade at a yield premium of 4.63 percentage points, down from 5.38 a year ago, according to Trace, the bond-price reporting system of the NASD. Ford is rated Caa1 by Moody's.

More than US$108 billion of so- called covenant-lite loans, or those that do not hold borrowers to limits on quarterly debt, have been completed this year, compared with a total of US$36 billion in the previous 10 years, according to S&P's LCD.

"The normal thing is two to four years after the issuance for defaults," said NYU's Altman. "Deals with little covenants, toggles, push back the timeline. But it's gotta happen."

Note that as Ford went $23 billion deeper in debt the presumed risk of default dropped given that spreads fell by 75 basis points.

Postponing the Day of Reckoning

Investment News describes toggle bonds and distressed debt in general the situation in Returns on distressed debt piquing investor interest.

Distressed debt can be risky, but that hasn’t stopped investors from turning to it in search of extra yield, industry observers say. Returns on distressed debt — junk bonds with a very high likelihood of default — were a strong 11.4% in the first quarter, outstripping all other asset classes, according to a recent report from Standard & Poor’s in New York.

But there isn’t a lot of distressed debt available for those investors who hope to jump on the bandwagon, said David Keisman, an analyst at Moody’s Investors Service in New York.

There is so much liquidity in the market right now that financing is easy to come by, he said. Companies that normally would have found themselves in default have been able to refinance their debt, Mr. Keisman added.

But are these “rescues” permanent or are defaults merely being pushed off for a later date? That is a distinction Mr. Keisman said is impossible to determine until it is too late. “No one is forecasting much of a default rate in 2007,” he said.

There have been 10 sales of toggle bonds this year, totaling $5.14 billion — a record, according to S&P.

The effect of toggle bonds, as well as some of the rescue financing, however, will be to push off junk bond defaults to a later date, said Martin Fridson, chief executive of FridsonVision LLC, a New York high-yield research firm.

Junk bonds — and distressed debt, in particular — will continue to win fans, because it is hard to predict what the catalyst might be for a rise in defaults, said Rick Fulmer, a Denver-based vice president and bond trader with D.A. Davidson & Co. of Great Falls, Mont.

Because spreads between high-yield bonds and U.S. Treasuries are much tighter than normal, investors have to take on more risk for less reward. But the economy still is strong, and companies still are able to pay off their debt, Mr. Fulmer said.

The Catalyst

Here's an interesting sentence from the above article: "It is hard to predict what the catalyst might be for a rise in defaults."

I strongly disagree. The catalyst is easy to predict (even if the timing itself is difficult). It will be a sudden change in risk tolerances of hedge funds, investors, and/or others to do these deals.

I talked about sudden changes in sentiment in Consumer Sentiment Wanes as Housing Slumps.

Flashback Summer 2005

Floridians were camping out overnight in lines to buy Florida condos. Prices were soaring. Did prices start falling or did the pool of fools willing to buy Florida condos at increasingly absurd prices dry up first?

Flash Forward Summer 2007

Will stock prices drop first or will the pool of fools willing to finance increasingly absurd leveraged buyout deals and debt financed stock buybacks dry up first?

In 2005 the conventional wisdom was that it would take much higher interest rates to sink housing. Conventional wisdom was wrong: the catalyst was a sudden and sustained change in the willingness of fools to invest in Florida houses . In short: the pool of greater fools simply dried up.

Whether it's housing, leveraged buyouts, toggle bonds, distressed debt in general, or stock prices, it will be a change in appetite for risk that leads the charge.

With that thought in mind let's turn or focus on the question: "But are these 'rescues' permanent or are defaults merely being pushed off for a later date? That is a distinction [that] is impossible to determine until it is too late."

Too Late Already

I suggest that it is possible to determine whether or not it's too late. Furthermore I suggest that it's already too late.

Flashback December 13 2005: It's Too Late. This is what I wrote:

I think it's too late.
In fact I know it's too late.
How do I know?
The following Email I received tonight should explain it nicely.
When you see stuff like this, not only is it too late, it's way too late.

Just and there was too much housing and subprime garbage in 2005 to be unwound, there is now too many toxic CDOs, toxic CLOs, toxic toggle bonds, toxic LBOs, and simply too much toxic stuff in general to be unwound. And when the unwinding attempt really gets going (it has now barely started) there simply will not be any bids for most of this toxic garbage. Want proof? Just ask Bear Stearns. The debacle at Bear Stearns is but a drop in the bucket for what's to come.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Mike Morgan June Update

Following is a June update from Mike Morgan at MorganFlorida. I will dispense with blockquotes in the interest of saving space. Note: I receive weekly updates but only have permission to post one a month. Here goes from Mike Morgan, with a specific focus on WCI....

June Update
Mike Morgan

Quote of the Week – “I don’t believe time is on their (WCI) side, given the deterioration of the Florida condo market.” Dan Oppenheim, Banc of America

What Was He Thinking Quote - "We do think if you're dumb enough to buy a home builder, you ought to buy us," Ryland Group Inc. Chairman and Chief Executive Officer R. Chad Dreier, at the JP Morgan Conference this week.

Market Conditions – We’re seeing a pickup in traffic, but the buyers have become quite aggressive in low bidding. One of my clients offered $300,000 on a $350,000 home and would not raise the bid. The seller was not interested in even considering the bid, and did not want to counter. With rising inventory, the only way for public builders to compete with traditional sellers, foreclosures and short sales, is to drop prices. I believe we have reached a point where builders’ margins have been reduced to low single digit and negative margins.

WCI – The big news is certainly WCI. The Board decided to delay the annual meeting at Icahn’s request. This gives him time to unravel his positions. WCI noted that Icahn is conducting tours of the properties. Unfortunately, he’s touring the properties with WCI representatives instead of someone who would show him what the real story is.

Debt – Icahn must have realized, if he gained Board seats it would have triggered the debt at 101%. This alone was reason enough for Icahn to walk away. Even without triggering the debt, I believe WCI is facing a debt crisis. They either are or will shortly be in violation of covenants. Will the banks declare a default? No. The banks realize there is no equity, and the banks already have enough problem loans in the housing industry. Recent downgrades of several major builders to junk status is warning enough that WCI or anyone considering WCI has a debt crisis looming.

[Mish note: I asked Mike to clarify that debt triggering event. This was his response: The debt covenants have restrictions for control of the company. If somebody new gets on the board, the debt holders can call in the debt at 101% of face value immediately. You can find that in the offer Icahn made under some of the notes. So, as you can see, there was never any chance of Icahn getting on the board. If they were going to say yes to him, he would have figured out a way to wiggle out. Instead, Ackerman and Company made Icahn’s job a lot easier by keeping the stock high to give Icahn a chance to unravel his positions. This may have been nothing but a shell game from the start ... with Icahn NEVER having any intentions of buying WCI at $22.]

Lawsuits – We’re hearing of more lawsuits brought by buyers against WCI for delay in delivering units. I also anticipate a lawsuit from Ichan against WCI, Ackerman and Hoffman. Ackerman and Hoffman sold stock north of $21, even though they told shareholders Icahn’s offer was not enough at $22. When Icahn completes his due diligence, I would find it unlikely that he doesn’t realize WCI has misrepresented the health of the company.

Votes – I believe Icahn had more than enough votes to get on the board. Here are the 10 largest institutional holders as of March 31, 2007:

Carl Ichan and Affiliates – 14.5%
Sandell Asset Management – 9.7%
SAC Capital Advisors 9.5%
Highbridge Capital Management – 8.5%
Dimensional Fund Advisors – 7.1%
Hotchkis & Wiley – 6.6%
Canyon Capital Advisors – 5.9%
Morgan Stanley – 4.9%
D.E. Shaw – 4.9%
Neuberger Berman – 4.8%

In addition to the institutional holders, Hotchkis controls another 7.6% of the stock through two of their funds.

The problem he faces is demonstrating what he is going to do with the debt and the company if he influenced enough of the large holders to back his efforts. With no hidden value coming to the surface, it’s clear Icahn has no choice but to back away swinging.

Time – Dan Oppenheim summed it up best with our Quote of the Week. As we move into the slowest selling season, and the Florida inventory of towers and single family homes continues to build, WCI’s value drops daily.

Listings at Bal Harbour – There was one new listing in Bal Harbour this week, but the startling fact here is the withdrawal of 29 listings. As of Saturday, there were 69 active listings in on the Miami-Dade MLS board. The drop in the number of listings can only be attributed to what I discussed last week. If your property is listed within a time period set by the lender, they know you are a flipper, and they will not finance the property.

It’s obvious now that sellers are finding this out the hard way. As we get closer to the WCI proposed closing date, buyers are finding it difficult to obtain financing. Absent financing, many of these buyers will not be able to close . . . even if they were dumb enough to think they can flip these properties.

I must update last week’s number, since I found a glitch in the Miami-Dade MLS system. It appears three agents have listed properties with a misspelling of Bal Harbour as Bal Harbor. This means there were 102 listings last week, one new listing this week, and 29 withdrawals. The current number of MLS listings in Bal Harbour are 69. However, there may be more listings entered improperly, and there are many pocket listings that agents will not put on the MLS in order to get around the financing restrictions.

Listings at Harbour House – This is the condo that shares the Bal Harbour property and entrance. There are 26 listings in the Harbour House.

Other Listings – In Area 22, where Bal Harbour is being built, there are condo 1,813 listings over $500,000. There are another 3,500 under $500,000!

Builder Downgrades – Lennar joins the ranks of builders facing downgrades by Moody’s and S&P. On Friday, Moody’s put Lennar on a watch list, which means they see at least a 40 percent chance of a downgrade to negative at some point in the next 18 months.

Bankruptcies – The Wall Street Journal reported on Georgia home builders this week, and the bankruptcy filing of Meyer-Sutton. It’s a small builder, but is it just a sign of what is to come. In Pennsylvania, Elliott Building Group filed for bankruptcy last week. And let’s not forget Kara Homes, the largest private builder in New Jersey. They filed for bankruptcy as well.
The Journal also noted that BOA foreclosed on five property developments in Georgia, and they did so at a loss to the 20% hit to the original principal amount. For the larger banks, these failures are not a problem But for the smaller local and regional banks, these issues spell disaster.

Here are some startling statistics about banks with Georgia loans: First Nation, Gainesville Bank & Trust, NetBank, Community Bank and Bankers Bank all had more than 50% of their total loans in construction, ranging from 54.2% to a whopping 78.8%.

Subprime Goes to Wall Street – Goldman Sachs noted that earnings were hit by subprime problems. Goldman Chief Financial Officer David Viniar said in a conference call that the subprime sector's woes are not over and to expect "more pain" before the problem is purged.
"The subprime saga will not be sufficient to derail the U.S. and world economy," Lehman's Jack Malvey said at the Reuters Investment Summit in New York." Well, you’ve got to wonder why he would even make this statement, unless some of his colleagues are discussing a crisis far greater than the talking heads will lead you to believe.

And here’s the proof: ABN Amro fears a world housing crisis is looming. A note from ABN Amro noted fears for the health of the US housing market have captured headlines, but the degree of over-valuation is more severe in Britain, Australia, Spain and Ireland. ABN Amro found that UK residential property is 50% overvalued, whereas US houses are 25% too expensive.

Last month UBS said it would shut down Dillon Read Capital Management after they lost $123 million . . . and subprime was cited as a chunk of this. And this week Bear Stearns seized control of $400 million of the assets of an internal hedge fund out of fear they were not going to meet a margin call. Bear Stearns puts the finger on the fund’s bets on risky home loans. We’ve got a more than a trillion dollars in questionable housing boom related loans out there, including residential, commercial and builder loans.

Subprime Goes to College – It’s not just housing. Here is a link to an article from The New York Times about subprime college loans, with grads burdened with $900 a month payments at rates as high as 20%.

Mortgage Rates – At the beginning of 2007 the rate on a 30 year fixed was 6.18. It now stands at 6.74. On a $300,000 home, that means an additional $1,680 a year in mortgage payments or $140 a month. Adjustable rate loans have accounted for 25-33% of loans since 2004.

Most of these loans are at rates under 4%. Now you have a hike in the monthly mortgage payment approaching $700. Between now and the end of the year, it is estimated more than $100 billion in subprime loans are scheduled to reset.

The rise in rates means a much lower affordability index for seller, including builders. A homeowner that qualified for a 4% interest only ARM a couple of years ago based on a $1,500 a month mortgage could afford a $450,000 home. If that buyer were able to find an interest only mortgage today, they could only afford a $267,000 home! That’s a 40.66% hit to the price of the home they can afford. I don’t know of any builders that had 40% margins . . . even at the peak.

It gets worse. It is tough to find 100% financing - interest only lenders now. So if this were a 90/10 loan that cuts a lot of other folks out of the market.

Mortgage Games – Despite what you hear from the mortgage companies and the feds, you still see an awful lot of commercials and internet ads for no-doc loans, 100% loans, etc. And then there is the cash back deal. This involves hiking the sales price of the home artificially. As long as you can get an appraiser to manipulate the numbers, you can pull this off. Basically, the price goes up on paper, but the seller agrees to give the buyer cash-back at the closing. Nothing new here, but it seems to be new for Wall Street and the media. Here is a link to an article from The New York Times called Payback Time discussing Cash Back.

And if you think Cash Back is creative, how about loans piggybacking on someone else’s credit. The New York Times is definitely on the case of mortgage fraud.

Spillover – When a family in a $300,000 homes is faced with a $700 a month mortgage hike, there will be spillover.

Condo Spillover – Here’s one you will not hear from many folks. When units in a condo are foreclosed there is no unit owner to pay the Condo Association Fees for maintenance, taxes, insurance, utilities, etc. The burden falls on the folks that did close and are still alive. If you have a building with a 50% foreclosure, that means the COA fees double for the remaining owners. This will have a domino effect on foreclosures, sales prices and overall sales.

Lawsuits – This is a booming area of the economy. Lawyers continue to file lawsuits against builders for a host of issues ranging from defective homes to predatory lending. But here’s a twist. Coast Bank (Florida) shareholders filed suit against borrowers. Fifty borrowers shot back with their own lawsuit claiming the bank schemed to defraud them. The attorney for the borrowers says he is going to file another 75 lawsuits for borrowers who claim they are stuck with homes and lots worth less than what they owe.

Coast Bank made $110 million in loans to 500 customers of Construction Compliance Inc., a now bankrupt home builder on the Gulf Coast. The attorney for the borrowers said he may wind up working out the loans with the FDIC if they take over the bank. And he may succeed, since regulators recently hit Coast Bank with a cease and desist order for unsafe and unsound banking practices.

Countrywide Financials REO’s – A picture is worth a 1,000 words. Or in this case, 8,726. This is a visual of Countrywide Financials REO’s



Duetsche Bank – DB initiated 325 foreclosures against condo owners in Miami-Dade, Broward and Palm Beach during the first four months of this year for a total unpaid mortgage value of $70 million. DB claims they have either sold these loans, securitized them or they are acting only as a trustee. Okay, I’ll buy that. But what I won’t buy, is the condo crisis is not going to touch anyone. Somebody, somewhere is going to get clobbered. U.S. Bank and Bank of New York are two other banks that have initiated large numbers of foreclosures, 211 and 164 respectively. Not far behind is Wells Fargo with 131 and HSBC with 104. I guess they sold all their loans as well.

Unfortunately for these big banks, I think we are going to see some lawsuits from the people and pools that bought these loans . . . and there are still more than 100,000 condo units that have not been delivered.

DB was overall the top dog in foreclosures with 2,125 condo and single family foreclosures in the first four months of this year, representing $507 million. DB’s share of the South Florida mortgages in foreclosure represents 17% of the total.

Virginia Market Numbers – These are April numbers, as they lag in reporting like so many other boards. For the Metro DC market sales fell 12.17% in April from 1,857 in April 2006 to 1,631 in April 2007. So despite what you hear, this market is not “dancing on the bottom,” “ready to rocket,” or “holding up well.” And the average price fell 2.43% from year ago pricing to $543,166.

Orlando Market Numbers – For the Orlando MSA new listings rose 6.31% in May from April with 6,200 new listings. A year ago there were 2,842 new listings in May.

Sales - Sales in the Orlando MSA for May rose 1.30% to 1,550 from April, but May’s numbers represented a 45.46% drop from May 2006 sales of 2,842. What more can I say.

Florida Woes – This week our legislature passed a proposed tax relief bill. It will go on the ballot on January 29. It’s ugly. Local governments must roll back budgets by $15.6 billion. Florida schools lose more than $7 billion over the next five years. That should be great for a state that already lags the nation in education. Florida ranks 32 in teacher salaries.

Florida is going to be facing monumental budget problems over the next 3-5 years. On the bright side, this will probably attract more buyers, but for those that understand the dynamics, it will be an easy decision to look at NC, SC or GA versus Florida.

One more comment here that is going to hurt. Businesses do not have a property tax cap. We have already seen 400% jumps in property insurance for businesses over the past few years. If the current tax proposal passes, everyone agrees businesses will be the hardest hit . . . with no protection, no caps and a big budget deficit to fill.

NAR Economist in Florida – The NAR’s new Chief Economist, Lawrence Yun, spoke in Florida this week. He predicted a “sonic boom” for Florida if the Legislature succeeds in bringing insurance premiums back to earth. He didn’t paint as rosy a picture as David Lereah has done, but he is sorely mistaking if he thinks Florida can control the insurance premiums.

The State of Florida is now the largest insurer of homes in Florida. They lost a couple billion dollars two years ago. They are facing more red ink now . . . and that’s without any hurricanes in two years. A repeat of a Hurricane Andrew today, would bankrupt the State of Florida.

In addition to the property tax issues discussed above, taxpayers foot the bill for the homeowner insurance deficits. So that means if you are insured with Allstate, and your neighbor is insured with the State of Florida, you are paying part of your neighbors insurance bill!

Yun did follow in Lereah pattern as Chief Cheerleader, when he said there is nothing alarming about the housing markets in this region. “It is very, very manageable,” he added. That doesn’t balance very well with a report in the St. Petersburg Times, where they noted that, “an economist suggested the gap between incomes and home prices would depress housing values 40 percent.” Unfortunately, they didn’t name this brave soul.

Mortgage Bankers Association on Florida – According to Doug Duncan, MBA’s Chief Economist, “[t]he number of houses and condos on the market is so large that it would take almost three years to sell them all in Palm Beach and 31 months in Broward, if the pace of recent sales continue.” He categorized the foreclosure crisis in Florida as acute. But he didn’t limit it to Florida. He said the percentage of payments nationwide for subprime that were more than 30 days past due has jumped to 15.75%.

Video of the Week – Florida Auctions. The builder is Levitt.



Disclosure: Of the stocks referenced today, I have no positions but I am involved in two lawsuits with Lennar. I am the defendant.

The Shadow

Thanks "Shadow"
Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/