Bank Balance Sheets and Earnings

Let's take a look at banks balance sheets credit card growth and other things through the eyes of Minyan Peter, who "helped build and ultimately ran a Wall Street asset-backed securities business and was treasurer of a top credit card company and treasurer of one of the largest banks in the Midwest." Many snips of wisdom from Peter follow.

A Bird's-Eye View of the Credit Conundrum

First, having been there at the beginning, the genesis of the asset-backed commercial conduits was regulatory capital arbitrage. Through the conduits’ convoluted structures, banks were able to "lend" huge amounts off-balance sheet and collect fees on no-capital-required lines of credit. No one - and I mean no one - ever expected these conduits to move from off-balance sheet back on-balance sheet and I don't think the market yet understands the earnings, capital and liquidity impact of this migration. If you figure you need anywhere from 6-8% capital per dollar of loans, then a move of $1.0 trln from off-balance sheet to on requires $60-80 bln in additional equity capital. I don't know about you, but I don't see this kind of free capital sitting around.

...

The last consumer led recession was around 1990. Since then, the SEC has placed enormous pressure on the banks to minimize their loan loss reserves. The SEC hates earnings management and the loan loss provision has historically been a key way for banks to "save for a rainy day." I don't think the market yet appreciates the fact that banks are currently provisioned for the top of the market.

....

Finally, no one is talking about it yet, but I think the market will soon begin to realize that the credit card lenders have in essence become the consumer lenders of last resort. As consumers have been shut out of the mortgage and home equity world, the last available credit is plastic. One statistic that I have found very troubling is the degree to which credit card balance growth is running ahead of retail sales growth - a key sign that the consumer is stretched.

...

Digging even deeper, you come away with more unanswered questions. First, annualized net write-offs for the quarter were up 17% - 5.4% of loans versus 4.6% during the year ago quarter. But behind that, masked by 14% balance growth, there is a 32% increase in the dollars charged off. Further, and to me more troubling, Target dropped its loan loss allowance from 8.3% of loans at the end of July 2006 ($501 mln) to 7.4% at the end of July 2007 ($509 mln). Had Target kept its provision at 8.3% of loans, the incremental cost would have been over $64 mln or almost 40% of the pre-tax quarterly earnings of Target’s credit card business. Alternatively, had Target kept its provision at the same 1.8 times net charge-offs as last year (an 8.3% allowance on 4.6% in net write-offs), the required ending provision would have been over 9.7% of loans - at an incremental cost to the company of almost $144 mln – all but eliminating earnings from the credit card operation for the quarter. Put simply, when measured in dollars (rather than percentages of balances) Target’s nearly flat year-on-year loan loss allowance does not synch with the increase in loan balances, delinquencies, charge-offs, and late fees.

And while I have used Target as an example, I don’t think Target is alone. As we have seen already in other parts of the credit markets, many banks and finance companies are managing their businesses as if today’s increases in credit deterioration are merely a “blip”, rather than the beginning of a broader, potentially more serious, decline. From where I sit, it looks like it is only going to get worse, and “it’s already in the cards.”

-Minyan Peter

Bank Earnings 101

From experience, I have found that most people are surprised to learn that banks’ net income is generally only between 1 and 2% on assets. And many people are also unaware that banks are generally leveraged 10:1.

So why are these points important?

First, small changes in interest rates and loan losses have a big effect on bank earnings. For example, in 2006, BofA had 70 basis points of loan losses, but in 2002 that figure was 110 basis points – a 40 bps difference. All things being equal, (and ignoring income taxes for simplicity) if we applied BofA’s 2002 level rate to its 2006 results, earnings would have been 28% lower.

...

Now while it takes time for higher losses and funding costs to flow all the way through to the bottom line (not all debt rolls over at once; nor do all bad credits charge off at once), I hope you can see by this example why the financial services community is so fixated on Federal Reserve interest rate cuts. By dropping short term interest rates, the Federal Reserve helps to offset the impact of higher borrowing spreads and loan losses. The difference between and a 25 and 50 basis point cut may not feel like much to you, but when all you're earning at best is 1-2% on assets, it is a huge deal.

-Minyan Peter

Bank Earnings 102: The Best of Times, The Worst of Times

As much attention as they will get, in the bigger scheme of things, their [the banks'] net incomes this quarter don’t matter. And they don’t matter because of one simple rule for financial services firms:

The income statement is the past. The balance sheet is the future.

Let me repeat it again. The income statement is the past and the balance sheet is the future, especially now.

At the top of a credit cycle, the income statement for a financial institution shows “the best of times”, but buried in the balance sheet is “the worst of times” to come.

...

History repeatedly reveals the ability of highly profitable banks to go down in flames. How many of you remember Texas Commerce Bank – AAA at the top, but gone at the bottom of a severe credit cycle?

Second, one quarter does not complete a credit cycle. We are at the beginning of a material economic change. Remember, we have only just seen the first month of employment decline. Loan loss provisions are predicated on the present economy, not on possibly better or worse future economies. This quarter’s provisions are likely to be relatively light based on the strength of our current economy. Similarly, any funding cost increases are just beginning to impact net interest margin.

Go back and read the 3Q '05 financial results for a few homebuilders and you will get my point. Few reveal any clues to their future demise– particularly the potential for balance sheet writedowns. And I expect the same this quarter for many banks.

But in much the same way as the housing industry has taken one-time write down after one-time write down for land values, I anticipate that we will see increasing loan loss provisioning by banks as the economy continues to weaken. Remember, the loans have been made. The only questions now are how severe the downturn will be and how many borrowers will be affected. If the housing industry’s forecasting prowess is any indicator, I would suggest we have a long way to go before we see the bottom of this cycle.

...

-Minyan Peter

Bank Earnings 103: Reading Bank Balance Sheets

While I anticipate that most of Wall Street’s attention at the end of the third quarter will be on bank earnings, for reasons I outlined in Banking 102, I strongly recommend that you focus on bank balance sheets. From experience, changes in bank balance sheet composition are much better predictors of future earnings than current period income statements.

So where do you start?

First, I would look at changes across the four different major investment/loan categories.

In investments “held for trading”, I would look for a significant overall balance reduction and an upgrading in quality. Both would be indications of a reduction in overall market risk appetite and a willingness to allocate capital to “volatile” capital markets and related businesses.

In investments “held for sale”, I would also look for a reduction in balances. As I mentioned in “Whispers from the Confessional”, I expect that you will see many financial institutions reducing their “available for sale” assets given the decline in secondary market liquidity. Watch as to where the assets went. There should be associated disclosure if the assets were moved into portfolio. And remember that once in portfolio, the accountants make it very difficult to move them back out to “held for sale.” So these moved assets will have to be funded through to maturity.

....

Associated with the loan portfolio, I would also review the loan loss allowance. Material changes in the allowance ratios (provision to charge-offs and provision to loan balances) are warning signs. So too are increases in loan portfolio delinquency statistics. Remember, credit cycles play out over a long period of time.

-Minyan Peter

Coming Bank Themes: Whispers From the Confessional

Thanks to the annual Lehman Brothers (LEH) Financial Services analyst meeting this week we have some early clues on banking results for the quarter. Based on the presentations I have read, as well as related press releases, here are some themes that I think you will see at the end of the quarter.

• First, expect a massive migration of “held for sale assets”, particularly non-conforming mortgage assets, into “held for investment” or “loan” categories. Some may even, as Washington Mutual (WM) did, try to portray it as “opportunistic portfolio growth”. But the reality is that the only way banks can avoid significant mark-to-market losses on mortgages they intended to sell, but can’t, is to move them into portfolio. And, remember, once these loans are in portfolio, related loan loss provisions are required. So you should expect higher provisioning even without any deterioration in credit quality, just due to forced balance sheet growth.
• Second, expect fair value write-downs on assets held for sale. As I wrote in Banking 102: The Best of Times, The Worst of Times, please remember that these write downs won’t flow through the income statement, but through Comprehensive Income. Look, too, for changes in the composition of banks investment portfolios. I expect that you will see highly liquid securities swapped for conforming mortgage securities. And with the run up in Treasury prices, I expect that banks with long maturity Treasuries in their investment portfolios have sold them wherever they can to book gains this quarter.
• ...
• Finally, expect higher provision forecasts due to both forced balance sheet growth and deteriorating credit quality.

For example, at the Lehman Conference, Washington Mutual announced that it now expects a $2.2 bln provision for 2007. $2.2 bln is $500 mln more than it forecast in July and well above the $1.3 -$1.5 bln it forecast in April when it said that its provision forecast was “our best thinking regarding trends in loan delinquencies, foreclosures and housing valuations at this time.” WaMu’s latest forecast is also almost 2.5 times what it shared in its 2007 earnings outlook ($850 -950 mln) in October 2006.

-Minyan Peter

Thanks Peter!

A differing opinion can be found in Financial Sector: The News vs. The Numbers

We see three factors that could make XLF a very attractive investment for the second half of the year:

• Earnings estimates are rising—not falling.
• Actual results are strong.
• XLF is cheap.

I am betting on the comprehensive analysis of Peter vs. opinions that earnings are going to rise. A focus on PEs ignores leverage, increasing write-offs, and balance sheet conditions. A compelling case has been made that we are at the top of the credit cycle which 100% of the time has spelled problems for the financial sector and stocks in general.

It is important to remember that the Financial sector is 20%+- of the S&P by weight and and that does not even count quasi-financial companies like GE and GM heavily dependent on financing operations for earnings.

Chris Puplava on Financial Sense is asking Will Financials Be to This Bull Market and Economy What Tech Was to the Last?

Secular shifts in a sector’s predominance in the S&P 500 can be seen in the figure below that highlights three different sectors that have had their period to shine.



Energy was the top performing sector in the S&P 500 [in 1980] with the sector’s weighting increasing substantially as investors chased the returns being made in the sector. However, as more energy supply came onto the markets at a time of falling demand due to high oil prices, the bull market in energy came to an end.

The next major bull market in U.S. stocks was seen in the technology sector in the 1990s. Near the start of that decade, technology represented roughly 6% of the S&P 500 and vaulted to a zenith near 33% by the end of the century. However, overcapacity and excesses in the industry ultimately deflated the bubble in which the technology weighting in the S&P 500 fell in half to roughly 15% seen at the bottom of the last bear market.

As mentioned above, there are fundamental factors that often lead to secular shifts in sectors, and the predominant factor that has led to an increase in the weighting of the financial service sector is the price of the commodity it sells -- credit. Since 1980 there has been a secular bull market in paper assets as interest rates and inflation have fallen. As interest rates reflect the cost of credit, falling interest rates have led to an increase in the demand for credit as it has become cheaper to borrow, which has fueled the growth within the financial sector.

Chris goes on to compare mass layoffs in the technology sector in 2000 with mass layoffs in financial services today. Here is an interesting chart from his article.



Chris has many other interesting charts in his article.
I encourage you to take a look.

The Quarterly Banking Profile Second Quarter 2007 shows that loan loss provisions are rising while higher expenses are holding down earnings.

Insured commercial banks and savings institutions reported $36.7 billion in net income for the quarter, a decline of $1.3 billion (3.4 percent) from the second quarter of 2006, but $772 million (2.1 percent) more than they earned in the first quarter of 2007. The decline in earnings compared to a year ago was caused by higher provisions for loan losses, particularly at larger institutions, and by increased noninterest expenses.

Insured institutions added $11.4 billion in provisions for loan losses to their reserves during the second quarter, the largest quarterly loss provision for the industry since the fourth quarter of 2002.

Net charge-offs totaled $9.2 billion in the second quarter, the highest quarterly total since the fourth quarter of 2005, and $3.1 billion (51.2 percent) more than in the second quarter of 2006. This was the second consecutive quarter that net
charge-offs have had a year-over-year increase.

The amount of loans and leases that were noncurrent (loans 90 days or more past due or in nonaccrual status) grew by $6.4 billion (10.6 percent) during the quarter. This is the largest quarterly increase in noncurrent loans since the fourth quarter of 1990, and marks the fifth consecutive quarter that the industry’s inventory of noncurrent loans has grown. Almost half of the increase (48.1 percent) consisted of residential mortgage loans.

The balance sheets and loan loss provisions of large cap financials like Citigroup (c), JPMorgan (JPM), Washington Mutual (WM) , Bank of America (BAC), and even smaller banks like Corus (CORS) will be interesting to watch as the credit bubble pops.

Most importantly, the answer to Chris Puplava's question is "Yes". Many signs are in place for Financials to be to This Bull Market What Tech Was to the Last.

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

An Insane Bid For BBB Rated Bonds

I am attempting to reconcile a two things. The first is Foreign sales drop for U.S. bonds, notes.

Foreign investors bought a net of $19.2 billion in long-term U.S. securities in July, the lowest amount in seven months, the Treasury Department said Tuesday, suggesting that the credit crisis is denting demand for U.S. assets.

Demand for long-maturity securities such as bonds, notes and equities hit its lowest level since December and fell sharply from the downwardly revised $97.3-billion net inflow reported in June.

"The real culprit here is the credit crunch, which has caused a drastic slide in purchases of corporate and agency bonds, and I think it's only a taste of what's to come because the real problems didn't hit until August," said David Powell, senior currency strategist at IDEAglobal in New York.

Official foreign investors grew particularly wary of U.S. corporate bonds in July, with their net purchases falling to the lowest level since December 1995.

The second comes from Professor Bennet Sedacca on Minyanville who wrote a four part series on Friday called You have to be kidding me! Following is part 4.

You have to be kidding me! Part 4

So you think the debt "crisis" everyone is talking about has resolved the issue of mis-pricing of risk? Think again. Below is a real-life real-time situation that happened this week.

I had $120,000,000 to spend on 2.5 year duration GNMA, FNMA, FHLMC pools and CMOS (collateralized mortgage obligations). The securities I bought were rock solid in terms of structure and have virtually no way to extend beyond three years even if prepayment speeds go to zero. My yield? 5.12% for the whole portfolio.

Now, what do you think BBB rated two and three-year industrials trade for, according to Bloomberg? 4.99% and 5.25%, which averages to...? Yep, you guessed it. 5.12%.

So, I can either buy BBB corporates or US agencies at the same level. Granted, it is not the managers buying these bonds that are making the mistake. Institutions hire them, along with individuals, to buy BBB industrials. There is still too much money chasing these. I tell you, if you would have told me this was possible, I swear, I wouldn't believe it. But see this Bloomberg screen if you don't believe me.

I mean, for real, you have to be kidding me..!

Here is the chart Bennet posted.
(click on chart for a sharper image)

BBB Par Coupon Yield Curve



One possible answer to this apparent anomaly is the above chart is showing what happened last week while the first article pertains to what happened during the July/August credit crunch. But whatever the reason, or whoever is doing the bidding, as long as there is an insane bid for corporate bonds one step above Junk, the stock market is unlikely to crack.

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

Global Credit Crisis Weekly Wrap-Up

Inquiring minds just might be asking for a quick global recap of the current state of affairs in the global credit crisis. Here goes:

Global Credit Crisis European Style

ECB emergency fund tapped for €3.9bn

Minyan Peter: Why Europe Matters More

Minyan Peter: Should we see more trouble in the European bank market - and remember, we've already taken down two German banks and a British bank - I believe that all bets are off on the dollar/Euro exchange rate. At least in the short run.

Global Credit Crisis U.S. Style

Commercial Paper Market in U.S. Shrinks for Seventh Week in Row, Fed Says

The U.S. commercial paper market shrank for the seventh straight week as the Federal Reserve's interest rate cut fails to improve conditions for short-term credit.

Debt maturing in 270 days or less continued its biggest slump in seven years, falling $13.6 billion in the week ended yesterday to a seasonally adjusted $1.855 trillion, including a $17.3 billion decline in asset-backed commercial paper, according to the Federal Reserve in Washington. The week's decline is smaller than the previous week's drop of $48.1 billion, a sign that buyers are starting to return to the market after the Fed's half-point reduction Sept. 18 in its benchmark interest rate

You have to love the spin with this statement: "The week's decline is smaller than the previous week's drop of $48.1 billion, a sign that buyers are starting to return to the market".

Mr. Practical on Collateral:

The Federal Reserve executed a whopping $38 billion in repos this morning. Apart from the size, the most amazing thing is that they took $22 billion in mortgages as collateral. Perhaps I was wrong when I said the Federal Reserve would not wreck its balance sheet in attempting to reflate the economy. This is truly stuff of a Banana Republic.

Mr. Practical on the Countrywide Mortgage Restructure Free-For-All:

It is merely an attempt to delay the inevitable restructuring can take many forms, and from CFC's perspective what it is attempting to do is essentially extend a life line to higher risk borrowers.

This of course has consequences, such as immediate cash flow/earnings impact, and the associated impact on ABX pools and CDOs as outlined below.

Further, it introduces perhaps the unintended consequences that the writer puts forth--that is a deliberate attempt to get one's mortgage restructured at terms favorable to the borrower.

Global Credit Crisis Canadian Style

Canadian Credit Crisis in a nutshell

• $40-billion in ABCP is frozen.
• The Québec Pension Plan (Caisse) and the Ontario Teachers' Pension Plan are on the hook as are 40 other trustholders, mining companies, paper companies, etc all of which thought they were buying short term easily marketable notes.
• What they were really buying was toxic waste from troubled mortgage loans in the U.S.
• A workout plan called the Montreal Accord was originated by Caisse. The proposed solution was to convert short term debt to long term debt some of which stretches out all the way to 2015, just to break even.
  
• While this may suit the needs of Caisse, some companies need money now to fund mine operations and the like. Those companies do not want their money tied up for years.
• "Most noteholders [still] don't know what they're holding."
• Uncertainty over the frozen $40-billion ABCP is spilling over into the rest of the credit market in Canada, driving down demand and forcing companies to cancel projects because of the soaring costs of funding.

Global Credit Crisis Russian Style

Russian liquidity trouble starts to boil

A senior Russian banker warned on Wednesday of debt defaults as the liquidity squeeze in Russia tightened following the global credit crunch and interbank lending rates climbing to a two-year high. “If debt markets remain closed until the end of the year the situation is going to get very difficult for many banks,” said Oleg Vyugin, chairman of privately owned MDM Bank and former head of Russia’s financial markets regulator.

“There could be some defaults. The Russian rouble bond market is not working.”

Overnight lending rates in Russia climbed to 10 per cent, the highest since mid-2005, even after the central bank on Wednesday pumped an additional $2.56bn into the banking system via two one-day repo auctions.

“Banks are not lending to each other,” said Alexei Yu, a fixed income trader at Aton brokerage. “But it is largely due to internal reasons. Tax payments are falling due at the end of the month and at the end of the quarter, banks must bring their accounts in line with the regulations of the central bank. By the beginning of October, the situation will ease.”

I see "the situation [in Russia] will ease by the beginning of October".

Since that is just two days away, I feel obliged to ask "What year?"

Global Credit Crisis UK Style

UK public finances worse than expected

The UK government’s finances swung into deficit in August, registering the worst readings for that month since records began, official data showed on Monday. The public sector borrowed £9.1bn in August, £2.3bn more than in the same month the previous year and above forecasts for borrowing of £6.6bn.

Richard McGuire, strategist at RBC Capital Markets, said the figures suggested there was “little scope for the government providing much in the way of a counterbalance to likely much softer growth in the private sector.”

If that was not bad enough The Bank of England fears squeeze on companies

Evidence that the credit squeeze will hurt the UK economy emerged yesterday when a Bank of England survey showed companies were likely to be hit hard by higher borrowing costs. This was followed by one of Britain's biggest housebuilders reporting plummeting sales in the wake of the Northern Rock crisis.

The news came as recriminations over the handling of Northern Rock continued with Richard Lambert, director-general of the CBI employers' organisation blasting the Bank, the government and the Financial Services Authority at a dinner in Newcastle last night.

He said the tripartite system had "been found wanting under fire", creating scenes on Britain's streets that should occur only in a "banana republic".

Global Credit Crisis Chinese Style

Beijing imposes price freeze

China is to enforce a freeze on all government-controlled prices in a sign of Beijing’s alarm about rising popular anger over inflation, now at its highest rate in more than a decade. The order freezes a vast array of prices still under the control of government in China, ranging from oil, electricity and water to the cost of parking and park entrance fees.

“Any unauthorised price rises are strictly forbidden . . . and in principle there will be no new price-raising measures this year,” the ministries said.

Current Conditions Summary

• Public spending is out of control in the US and UK.
• Banana Republic charges are being leveled at the US and UK.
• Runs on the bank occurred in the US and UK.
• The Fed is accepting mortgages as collateral in the US for the first time.
• Foreclosures are at all time high in the US.
• The US dollar is at all time lows.
• Japan is still struggling with deflation.
• Two failed banks in Germany were bailed out by the ECB.
• There are US Congressional threats of tariffs against China.
• There is a proposal to freeze short term commercial paper for up to 7 years in Canada.
• Housing bubbles in the US, Spain, and Australia are deflating.
• Housing bubble in Canada is still inflating.
• China refuses to float the RMB and sterilize US dollars flooding in. That in turn is fueling Chinese inflation.
• Price controls that can't possibly work were implemented in China in response to Chinese aforementioned Chinese inflation.
  
• Commodity prices are soaring.
• Oil is at record high prices.
  
• A Massive carry trade in Japan is fueling a plethora of asset bubbles around the globe.
• $500 Trillion in derivatives are floating around dwarfing the size of the global economy.
• The global credit bubble dwarfs by orders of magnitude the credit bubble preceding the great depression.

Other than the above, the global economy seem pretty normal and rather well balanced. It's a tribute to just how well central bankers have done their jobs.

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

Time To Break Up The Credit Rating Cartel

The Associated Press is reporting Pension Fund Sues Moody's Over Ratings.

In a lawsuit filed in federal court in Manhattan, the Teamsters Local 282 Pension Trust Fund alleged the New York company's ratings of bonds backed by subprime mortgages -- including bonds packaged as collateralized debt obligations -- were materially misleading to investors concerning the quality and relative risk of those investments.

"Moreover, even as a downturn in the housing market caused rising delinquencies of the subprime mortgages underlying such bonds, Moody's maintained its excessively high ratings, rather than downgrade the bonds to reflect the true risk of owning subprime-mortgage-backed debt instruments," the lawsuit says.

The lawsuit is seeking class-action status for all purchasers of Moody's shares from Oct. 25, 2006, to July 10, 2007.

The Executive Shuffle

In response to the lawsuit and SEC investigations Moody's shuffles executives, seeks subprime changes.

Moody's Corp's (MCO) Moody's Investors Service, a ratings agency accused of helping inflate the subprime mortgage bubble, named three new ratings executives on Wednesday and proposed changes in the subprime rating industry.

In a statement, Moody's said that, after talking to industry participants, it was calling for information about non-prime loans that get bundled into bonds to be verified by third parties. Issuers of non-prime mortgage bonds should provide stronger warranties to investors regarding loan information.

The last thing we need is "third parties" verifying non-prime loans. That creates pressure to make more loans prime and it brings into question all sorts of problems with determination of "third parties" and their competence.

SEC Investigation at S&P and Moody's

The SEC is investigating Conflict of interest charges at US credit ratings agencies.

Credit ratings agencies need to separate their rating and advisory functions because of conflicts of interest in their relationship with Wall Street, the newly appointed head of a high-level government advisory panel said on Wednesday.

"I do not think that the market can discipline ratings agencies sufficiently," said Mr Mindich, chief executive of Eton Park Capital and a former colleague of Hank Paulson, the Treasury secretary, at Goldman Sachs, the investment bank.

Christopher Cox, chairman of the Securities and Exchange Commission, told the Senate panel his agency was investigating whether companies such as Standard & Poor's and Moody's were "unduly influenced" by issuers and underwriters that paid for credit ratings.

Agencies Deny Inflating Ratings

The Independent is reporting Credit agencies deny inflating ratings to beat rivals.

At the heart of the controversy is the fact that it is the Wall Street banks that pay the agencies to rate the new products. One after another, Senators accused the agencies of giving artificially high ratings to ensure that the business did not go to their rivals.

Senator Jim Bunning, a Republican from Kentucky, described the process as "like a movie studio paying a critic to review a movie and then using a quote from his review in the commercials". A Democrat, Robert Menendez, said the agencies were "playing both coach and referee".

But Vickie Tillman of Standard & Poor's credit market services said that the agencies took every care to try to ensure accurate ratings, and that no analyst was ever paid according to the amount of business he or she generated, or the types of ratings given. "S&P does not and will not issue higher ratings in order to garner additional business," she said.

Indiscretion or Incompetence?

In Mispricing Risk / Conflict of Interest I talked about the obvious conflict of interest between ratings companies and the companies they rate.

In Moody's In Wonderland I wrote about Moody's stunning display of twisted logic, whereby they actually made it a blessing to have rising default risk.

In The Rating Game Scam I commented on a Bloomberg article accusing the S&P and Moody's of Masking $200 Billion of Subprime Bond Risk.

In Fitch Discloses Its Fatally Flawed Rating Model, I talked about fatal flaws in rating housing related debt.

Obviously there are huge conflicts of interest. So the advisory panel is talking about a need to "separate rating and advisory functions".

Would that stop people within a company from talking to each other? Would it eliminate pressure from management from one group or another to get revenues up? Would it stop rumors or allegations of improprieties? The answer to all three questions is no.

This is just more regulation on top of more regulation. Would physically splitting up each of the functions into two separate companies be the solution. No, that's not it either. The root of the problem lies in government intervention and sponsorship of the ratings agencies in the first place.

The rating agencies were originally research firms. They were paid by those looking to buy bonds or make loans to a company. If a rating company did poorly it lost business. If it did poorly too often it went out of business.

Low and behold the SEC came along in 1975 and ruined a perfectly viable business construct by mandating that debt be rated by a Nationally Recognized Statistical Rating Organization (NRSRO). It originally named seven such rating companies but the number fluctuated between 5 and 7 over the years.

Establishment of the NRSRO did three things (all bad):

1) It made it extremely difficult to become "nationally recognized" as a rating agency when all debt had to be rated by someone who was already nationally recognized.
2) In effect it created a nice monopoly for those in the designated group.
3) It turned upside down the model of who had to pay. Previously debt buyers would go to the ratings companies to know what they were buying. The new model was issuers of debt had to pay to get it rated or they couldn't sell it. Of course this led to shopping around to see who would give the debt the highest rating.

With that I have to sit back and laugh at one of the original opening statements in this article: "I do not think that the market can discipline ratings agencies sufficiently," said Mr Mindich, chief executive of Eton Park Capital and a former colleague of Hank Paulson, the Treasury secretary, at Goldman Sachs, the investment bank.

Clearly Mr. Mindich does not understand the free market. The problems arose because the free market was disrupted by a misguided mandate by the SEC.

Those interested in more information on this topic can read Removing a Regulatory Barrier by Senate Republican Jon Kyl or Creating a Competitive Rating Agency Sector by the American Enterprise Institute. Also note that the number of rating agencies is back up to 7 from 5 as of September 25 2007. See SEC Reanoints Rating Agencies.

The Solution is Amazingly Easy

Government sponsorship of organizations and intervention into free markets always creates these kinds of problems. The cure is not an executive shuffle, third party verification or half-measures and more regulation that mask over the issues by splitting functions within an organization. The SEC created this problem by creating the NRSRO. The problem is easily fixable. It's time to break up the cartel by eliminating the rules that created it. Moody's, Fitch, and the S&P should have to sink or swim by the accuracy of their ratings just like everyone else. Ratings would be a lot better if corporations had to live or die by them. Free market competition, not additional regulation is the cure.

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

Global Credit Crisis Canadian Style

An ABCP Asset Backed Commercial Paper Crisis is Brewing in Canada.

"It's a made-in-Canada problem," said Claude Lamoureux, head of Ontario Teachers' Pension Plan. Many people in the market "didn't know or didn't ask questions" because they were making more profits than elsewhere, he added.

The Canadian ABCP market attracted a flood of foreign financial institutions such as Barclays Bank and Deutsche Bank, who exploited the gaps in the Canadian ABCP rules to make big profits at lower risk to themselves, sources said.

By June this year, Canada's ABCP market was about 10% of the size of the market in the United States, although the overall U.S. financial system is proportionately far larger than Canada's.

When concerns surfaced in August about the underlying assets in ABCP -- many of which have included troubled mortgage loans in the U.S. -- some owners of ABCP were caught off guard. Owners of ABCP were under the belief that they could convert it to cash or another similar product at the end of 30 or 60 days but instead were left holding the product.

Canadian investment bank Coventree Capital Inc. became one of the first major victims of the global credit crunch when it was unable to trade the ABCP it was holding because of the general seizing up of credit markets around the world.

Following Coventree's collapse, Canadian non-bank owners of $40-billion of troubled asset-backed commercial paper -- pension funds and corporate treasury departments -- were forced into an unprecedented joining-of-forces known as the Montreal Accord to try to salvage their holdings.

One of the big players in the crisis is Caisse, the Québec pension plan. GlobeAndMail is reporting ABCP credit crisis spells big trouble for Caisse.

Controversy comes by way of reports that the Caisse holds between $13-billion and $20-billion of the $35-billion in now illiquid non-bank asset-backed commercial paper (ABCP) gathering mould in Canadian accounts.

The Caisse has total assets under management of close to $240-billion, but its reporting requirements do not cover all of that amount. What's more, if a viable secondary market emerges for the converted paper, the Caisse could conceivably have a good chunk of the investments off its books by year-end. That may not protect the Caisse from taking a hit, but trading losses on investments bought and sold during the calendar year don't show up on the annual statement.

Rescue Plan on the Ropes

An agreement between some of the players to convert short term debt to long term debt as the solution to the crisis is now on the ropes as a Stalemate threatens the Montreal rescue plan.

With the deadline for an agreement less than a month away, hopes of success for a plan to rescue about $40-billion of illiquid asset-backed commercial paper are growing steadily dimmer, sources say.

Under the so-called Montreal proposal, the frozen commercial paper would be converted into longer-term floating-rate notes, thereby providing holders with a way to get their money back. But now the major banks and investors behind the plan are finding their progress slowed and even blocked by hurdles they never imagined when the plan was launched in August.

The Montreal proposal was launched on Aug. 16, three days after the non-bank sponsored ABCP market was hit by contagion from the subprime mortgage crisis in the United States, triggering a string of default warnings from issuers.

The plan was spearheaded by pension giant Caisse de depot et placement du Quebec supported by nine other banks and financial institutions that participated in the market. That group was later joined by a committee of investors chaired by Osler, Hoskin & Harcourt lawyer Purdy Crawford that will oversee the restructuring.

The trouble is, everyone is serving a different agenda.

"The question becomes, will everyone play along," said Mario Mendonca, an analyst at Genuity Capital Markets. "But that's a hard one to answer. We are in uncharted territory. [The proposal backers] are making this up as they go along."

Meanwhile, uncertainty over the future of the frozen $40-billion ABCP is spilling over into the rest of the credit market in Canada, driving down demand and forcing companies to cancel projects because of the soaring costs of funding.

A workout at this stage appears to be a pipe dream.

The legal complexities facing Purdy Crawford and the committee that has been struck to solve the crisis is daunting. It's folly to think it can be done in 60 days.

Workouts like Stelco and Air Canada involved a single corporate empire. The third-party ABCP workout resembles a Cecil B. DeMille film, with a cast of thousands. One lawyer notes there could be as many as 40 trust structures alone, each of which has a weighty trust indenture that must be reviewed, and assets that must be dissected before anyone knows their legal options.

Toss into the mix those who issued the paper, those who created the investment conduits, those who provided liquidity, the SWOP providers, and dozens of companies holding suspect notes and it makes a highly volatile situation. And the information void: After almost 60 days, most noteholders don't know what they're holding.

The committee has to figure out how to turn short-term notes into mid-or long-term floating rate notes and do it with little pain. But many lawyers say it's likely someone will have to take a haircut and the question is:Who will it be?

Don't look to corporate Canada to bear that burden. Most have retained counsel and some of them are getting pretty itchy at the trigger. They didn't buy long-term paper and they have financial obligations of their own. Some have raised capital to build mines and expand operations. They likely signed contracts with suppliers who will shortly be demanding payment to start projects and will sue for breach of contract.

The problem is that the noteholders are subject to the trust indentures, preventing lawsuits. Hence, handcuffed. Far worse, it's trustees who control the litigation process under the trust indentures. Right now they're laying very low. Moreover, if a trustee were to launch some type of enforcement action, it would trigger defaults of the derivative assets in the paper and then it's a nuclear bomb scenario.

Where are the mining companies, the paper companies and the mineral companies that were sold this stuff ? They're not at the table. Makes you wonder who is being set up to take the haircut?

Canadian Credit Crisis in a nutshell

• $40-billion in ABCP is frozen.
• The Québec Pension Plan (Caisse) and the Ontario Teachers' Pension Plan are on the hook as are 40 other trustholders, mining companies, paper companies, etc all of which thought they were buying short term easily marketable notes.
• What they were really buying was toxic waste from troubled mortgage loans in the U.S.
• A workout plan called the Montreal Accord was originated by Caisse. The proposed solution was to convert short term debt to long term debt some of which stretches out all the way to 2015, just to break even.
  
• While this may suit the needs of Caisse, some companies need money now to fund mine operations and the like. Those companies do not want their money tied up for years.
• "Most noteholders [still] don't know what they're holding."
• Uncertainty over the frozen $40-billion ABCP is spilling over into the rest of the credit market in Canada, driving down demand and forcing companies to cancel projects because of the soaring costs of funding.

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

Global Credit Crisis U.S. Style

Bloomberg is reporting Commercial Paper Market in U.S. Shrinks for Seventh Week in Row, Fed Says.

The U.S. commercial paper market shrank for the seventh straight week as the Federal Reserve's interest rate cut fails to improve conditions for short-term credit.

Debt maturing in 270 days or less continued its biggest slump in seven years, falling $13.6 billion in the week ended yesterday to a seasonally adjusted $1.855 trillion, including a $17.3 billion decline in asset-backed commercial paper, according to the Federal Reserve in Washington. The week's decline is smaller than the previous week's drop of $48.1 billion, a sign that buyers are starting to return to the market after the Fed's half-point reduction Sept. 18 in its benchmark interest rate

You have to love the absurd positive spin with this statement: "The week's decline is smaller than the previous week's drop of $48.1 billion, a sign that buyers are starting to return to the market". Since when is a decline a sign buyers are returning?

Minyanville's Mr. Practical had this to say:

The Federal Reserve executed a whopping $38 billion in repos this morning. Apart from the size, the most amazing thing is that they took $22 billion in mortgages as collateral.

Perhaps I was wrong when I said the Federal Reserve would not wreck its balance sheet in attempting to reflate the economy. This is truly stuff of a Banana Republic.

The implied Fed Funds rate is now trading at 4.88% which is over the desired rate. The Fed is having to force more and more credit into the system to keep rates low. Banks just don't want to lend.

This is truly stuff for the history books. As stocks blindly stumble to new highs, the risk is almost unimaginable as to what happens if/when this fails.

Mortgage Restructure Free-For-All

Reuters is reporting Countrywide sees modifying 25,000 mortgages in '07.

Countrywide Financial Corp (CFC), the largest U.S. mortgage lender, said on Monday it expects to modify terms on nearly 25,000 home loans this year to help people avoid foreclosures.

The company said it has already modified more than 17,000 home loans this year, and provided assistance on about 35,000 mortgages, including through repayment plans, postponements of payments and refinancings.

Yesterday Mr. Practical talked about Countrywide in Mortgage Restructure Free-For-All in response to a question from Minyan J. about that restructuring. Here is a portion of his reply:

Minyan J,

That's the issue. It is merely an attempt to delay the inevitable; restructuring can take many forms, and from CFC's perspective what it is attempting to do is essentially extend a life line to higher risk borrowers.

This of course has consequences, such as immediate cash flow/earnings impact, and the associated impact on ABX pools and CDOs as outlined below.

Further, it introduces perhaps the unintended consequences that the writer puts forth--that is a deliberate attempt to get one's mortgage restructured at terms favorable to the borrower; in a sense, by having a restructuring go through, it is another point of price discovery, and leads to mark downs of all assets associated with that price discovery, which necessitates secondary actions on the part of other financial market participants.

That is, as price discovery increasingly occurs, and assets are marked down, it widens the asset/liability gap and necessitates further asset liquidation and or reversions of credit extensions in order to manage one's balance sheet.

It is this issue of price discovery which the Fed probably seeks to forestall as long as possible, as it is a ticking time bomb. For example, when Hovnanian (HOV) recently held its big weekend home sales event, the homes that were sold at a 20% "discount" to original levels essentially marked down the entire neighborhood by levels approaching 20%, and hence an individual's asset side is suddenly worth a lot less, necessitating adjustments in spending habits to reflect such a price discovery in order to maintain similar asset/liability ratios prevailing prior to the sale.

...

for a host of reasons, such as the stigma attached with such a negative credit event on your record and the likelihood that CFC is attaching several pre-requisites to the pool of people they are willing to do this for, among others.

That said, the people that do get through the filter and are willing to restructure their mortgages are likely far worse credits – meaning that CFC’s restructuring is likely to make matters worse by dragging out the inevitable (foreclosure) while providing the incentive (as you mentioned) for borrowers on the cusp to get better terms.

This is, like the Fed’s 50 bps rate cut, an attempt to forestall the inevitable price discovery that will affect these pools of mortgages. In the banking business, it is always preferable (from a cash flow and profits standpoint) to take your medicine all at once rather than delay it, unless, as an institution, you are so close to actual bankruptcy/bank run conditions that you are forced to put off the medicine taking.

Sadly, almost the entirety of the banking industry forestalls anyway.

Commercial Paper is still falling, it's taking more pressure from the Fed to keep rates low, the economic underpinnings of the economy get weaker by the day, and banks still do not want to lend. For now, the equity markets are ignoring all this.

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

Global Credit Squeeze European Style

The Financial Times is reporting ECB emergency fund tapped for €3.9bn.

The European Central Bank’s emergency lending fund, which attracts a penal interest rate, was tapped on Wednesday for €3.9bn – the largest sum since October 2004, the Frankfurt-institution has revealed.

The surge in demand for the ECB’s “marginal lending facility” pointed to the difficulties still being faced by European banks as a result of the global credit squeeze. The ECB revealed no details but it is likely that more than one borrower was involved. Use of the marginal lending facility attracts a 5 per cent interest rate – significantly higher than market rates.

The ECB took the initiative among central banks in addressing the credit squeeze on August 9, when it pumped an unprecedented €94.8bn into money markets. But it has kept a clear distinction between such liquidity-boosting operations and its main interest rate policy, aimed at combating inflation over the longer term.

German inflation data, meanwhile, suggested that eurozone prices could soon be rising at a rate in excess of the ECB’s target – an annual inflation rate “below but close” to 2 per cent.

Growth in the broad money supply measure, M3, which the ECB sees as sending early inflation warning signals, remained high at 11.6 per cent in August, only slightly lower than July’s record of 11.7 per cent.

German inflation data, meanwhile, suggested that eurozone prices could soon be rising at a rate in excess of the ECB’s target – an annual inflation rate “below but close” to 2 per cent.

“Once the money market distortions fade, very strong M3 growth in combination with the increase in price risks….will probably bring inflation concerns back into the ECB’s focus,” said Marco Kramer, economist at Unicredit in Munich.

Since December 2005, the ECB has lifted its main interest rate eight times to 4 per cent. It had planned another rise, to 4.25 per cent, this month but shelved the move because of the uncertainty about the macroeconomic outlook resulting from the credit squeeze.

The ECB which does does focus on credit expansion as reflected by M3 (unlike the US which discarded the measure) is boxed in by a credit crunch that originated in the US.

Why Europe Matters More

Minyan Peter, popular on the "The Ville" has this take on Why Europe Matters More back on September 7th.

While I know everyone’s attention is on the U.S. equity market this morning, I wanted to revisit why I put so much emphasis on the European credit markets. Let me summarize why.

First, as the rest of the market is quickly discovering, the European banks have been the major liquidity providers to the asset-backed commercial paper market. Those banks’ ability to meet their liquidity obligations to refund maturing paper is a clear sign as to whether this cycle can wind down in an orderly fashion, or whether there will be a panic. But to be clear, we are in wind down mode, and one that will take years.

Second, there has been a significant debate among financial pundits around the ability of the rest of the world to “decouple” from the U.S. consumer debt issues. (That is to say, the rest of the world will continue to motor along just fine, even though the U.S. is in an economic slowdown.) Economic prosperity requires a strong financial services sector. You can’t grow an economy if banks are unwilling (or unable) to lend money.

If the European banks become preoccupied with the fall out from their U.S. credit exposures, it will more than likely reduce their ability to lend into their domestic markets. (And we are already seeing concern about this being voiced by the ECB.) Without liquidity, their domestic market growth will slow down. ...

Third, the Spanish housing market is already in a significant decline and you are beginning to see commentary regarding a possible (and I believe real) U.K. housing bubble. ...

Finally, without economic strength in the United States and, I believe increasingly likely in Europe, the looming question becomes Asia. ...

Minyan Peter

Minyan Peter offered these thoughts today:

What I don't believe US investors appreciate is how much of our credit is in the hands of European financial institutions - either on balance sheet or through special-purpose vehicles. And as the consumer continues to deteriorate it can't help but impact Europe first. As I said to someone the other day, watching the European markets is like watching the coming attractions of a movie.

It also feels to me like we are beginning to see a breakdown between the commodity markets and the dollar/Euro exchange rate. Many participants believe that these two markets will continue to move in tandem - the dollar will fall and commodity prices will rise.

But exchange rates reflect relative economic strength. Should we see more trouble in the European bank market - and remember, we've already taken down two German banks and a British bank - I believe that all bets are off on the dollar/Euro exchange rate. At least in the short run.

I don't know that the market is positioned at all for that. And how that plays out through the commodity/China trade will be interesting to see.

Minyan Peter (Position in FXI.)

Beneath the surface a global credit crunch is still simmering even if the stock markets suggest otherwise. Thanks Peter and thanks Minyanville for that focus on Europe for our European friends.

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

Death Spiral Financing

Last night I talked about Homebuilder Wizardry at SPF in Target Warns and Blames Florida - Lowes Blames Dry Weather

Standard Pacific Corp. (SPF) said it would offer $100 million in convertible notes, and that its board of directors has eliminated the company's quarterly cash dividend. The company expects to save about $10 million annually, with the funds to be used to pay down debt.

So SPF is eliminating its dividend to pay down debt by $10 million while at the same time announcing a new $100 million debt offering. Is this new math or just homebuilder math?

Convertible Offer Details

Today let's take a closer look at the convertible offering. As usual the devil is in the details. Standard Pacific is offering $100 Million of Convertible Senior Subordinated Notes Due 2012.

Stephen J. Scarborough, Chairman, Chief Executive Officer and President of Standard Pacific Corp.(SPF)today announced the pricing of the previously announced public offering of the Company's $100 million aggregate principal amount of 6.0% convertible senior subordinated notes due 2012.

Concurrently with the offering of the notes and the convertible note hedge transactions, the Company entered into a share lending agreement with an affiliate of Credit Suisse, pursuant to which the Company will lend 7,839,809 shares of its common stock to such affiliate. Under the share lending agreement, the share borrower will offer and sell the borrowed shares in a registered public offering and will use the short position resulting from the sale of such shares to facilitate the establishment of hedge positions by investors in the notes offered.

While the borrowed shares will be considered issued and outstanding for corporate law purposes, the Company believes that under U.S. generally accepted accounting principles currently in effect, the borrowed shares will not be considered outstanding for the purpose of computing and reporting earnings per share because the shares lent pursuant to the share lending agreement must be returned to the Company on or about October 1, 2012, or earlier in certain circumstances.

That offering specifically allows shorting and thus is in stark contrast to the Bank of America (BAC) / Countrywide Financial deal (CFC) deal that came with share restrictions to prevent shorting (see Countrywide Bailed Out by Bank of America?)

Pure Desperation

This type of financing agreement is about as desperate as one gets. Prof. Fil Zucchi was talking about it today on Minyanville.

A whole 6 days after Robert Toll was speaking about the housing crash in the past tense the Spider Homebuilders (XHB) made new lows on the back of Standard Pacific (SPF) 12% drop. The latter, one of the three horsemen of the housing apocalypse (at least based upon the current Credit Default Swap spreads), issued convertible debt which, short of a "death spiral financing", looks stunningly onerous. It also eliminated its $10M/year dividend. That's right Minyans, a publicly traded homebuilder is down to having to pull its skimpy dividend to make ends meet.

Homebuilder Credit Default Swaps



The above chart thanks to Prof. Zucchi and Minyanville.

Based on Fil's chart of Credit Default Swaps the "three horsemen of the housing apocalypse" are: Beazer Homes (BZH), Standard Pacific (SPF), and Hovnanian (HOV). For a better idea of the relative risks, pay attention to the credit spreads, not just the numerical rankings.

Disastrous Quarter At Lennar

The Financial Post is reporting Lennar results plunge as housing woes worsen.

"Heavy discounting by builders, and now the existing home market as well, has continued to drive pricing downward," Lennar Chief Executive Stuart Miller said in a statement. "Consumer confidence in housing has remained low, while the mortgage market has continued to redefine itself, creating higher cancellation rates," he added.

Article Recap

• This was Lennar's worst ever quarterly report
  
• Sales down 44%
• Loss was $513.9 million ($3.25 per share)
• Land writeoffs were $3.33 per share
• Jobs slashed 35%
• More job cuts coming
• Incentives increased to $46,000 per home from, $35,900 per home
• New orders fell 48%

Lennar (LEN) is #7 on the Credit default swap list. The higher up the list, the more likely the market perceives risk of default.

Get used to hearing statements like this: "confidence in housing remains low". Similar statements are starting to spread to other areas of the economy.

In Is the Fed Deflating? I noted that changes in consumer and corporate psychology (confidence) lead the market as opposed to changes in the market affecting confidence. It's an important idea that cannot be stressed enough.

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

Is the Fed Deflating?

I received a record high number of Emails last weekend asking me to comment on a recent article by Gary North. Following is one such request:

Mish, Gary North has an analysis that he e-mailed out today claiming that the Fed is actually deflating. I'd appreciate your comments on his article if your time permits.

The article in question is Bernanke Has Snookered Us All. Following is a very condensed extract:

Bernanke and the Federal Open Market Committee (FOMC) have done something extraordinary. They have publicly lowered the FedFunds target rate, and have forced down the actual FedFunds rate to meet the target rate, while deflating the money supply.

You read it here first: "deflating."

I am doing my best to stick with the available facts. These facts are not consistent with what I thought the FED would do, as recently as August 28. They are surely not consistent with what the hard-money camp is telling you the FED has been doing.

If your mother says she loves you, check it out.

Gary North

Gary makes his "deflating" claim by looking at changes in base money supply. Rather than copy the chart he presented, I will reproduce it from the same source so that additional charts in this article all have the same look and feel. I am also going to add a few comments to some of the charts.

Monetary Base Seasonally Adjusted 2006-07-01 To 2007-09-21
Chart as North presented (my comments in red)



(Click on chart for better resolution)

I do not see much of anything in that chart so let's look at year over year percentage changes.

Monetary Base YOY% changes 2006-07-01 To 2007-09-21
Seasonally Adjusted





(Click on chart for better resolution)

As Gary points out "an increase of 1.8% is tight money policy by previous Fed standards" But 1.8% is still in positive territory. There is far more to it than that, however, which I will address in just a bit. But right now let's take a look at longer timeframes.

Monetary Base YOY% 1994-01-01 to 2007-09-21



(Click on chart for better resolution)

The above chart speaks for itself. On the basis of base money supply (actual monetary printing) no claim can be made about rampant Fed printing. It just can't be done.

M2 1960-01-01 To 2007-09-21




(Click on chart for better resolution)

No doubt some will point to M2 or M3 (many pointing out a conspiracy theory regarding the discontinuance of M3) that money supply is soaring.

The problem with using M2 or M3 as a measure of money is that both include credit transactions. I happen to agree with Gary that the distinction between money and credit is paramount.

I recently discussed this idea in Is the U.S. printing money like mad?

My own preferred monetary measure is called M Prime (See above article) but the closest approximation from readily available sources is M1. So let's take a look at M1.

M1 1980-01-01 To 2007-09-21 Seasonally Adjusted



(Click on chart for better resolution)

M1 1980-01-01 To 2007-09-21 YOY % changes
Seasonally Adjusted



(Click on chart for better resolution)

Gary had this to say in his article "I don't think my message has penetrated the thinking of most hard-money contrarians. They keep citing M-3, which was canceled by the FED a year ago, and which was always the most misleading of all monetary statistics. Year after year, the M-3 statistic was four times higher than the CPI. The M-3 statistic was worthless from day one."

I agree whole heartedly with the idea that M3 is a fatally flawed measure of monetary printing. It also a very unreliable predictor of the CPI. But even if M3 (and credit/debt creation) is useless for many things, it cannot be totally ignored. With that thought in mind, let's explore the idea of how money is created.

How Money Is Created

Paul Grignon's video Money as Debt is offers tremendous insight into how money is created (as long as one realizes it's not really money the author is talking about but rather a money substitute better known as debt). Please view the whole thing. It might open your eyes.

The first 3/4 or so of the video describes exactly what is happening but Grignon goes seriously astray by blaming a gold standard for past problems when the real culprit is fractional reserve lending. In the last 1/4 the author Grignon again goes off the deep end by proposing government intervention as the solution to the credit bubble when it is in fact government intervention that has created the mess we are in. Nonetheless, the video is likely to be a great eye opening experience for many that explains how credit is soaring while base money is relatively flat.

An Email From Gary North

One of the Emails I received last weekend was from Gary North. He asked me if I could find any flaws in his analysis. What follows from here on down is my reply to Gary:

Gary, you are correct about many things:

• The Fed is not massively printing as most claim.
• As measured by M1, M Prime, or Base Money the Fed is actually tight.
• M3 is a poor predictor of CPI inflation.
• There is a huge difference between credit and money.

It is very easy to prove the statement "the Fed is not massively printing" but people believe what they want to believe. However, Fed policies have been such to enable super easy credit transactions to take place by holding interest rates too low too long. When interest rates are held too low, asset bubbles build and credit/debt transactions soar. So does the velocity of money. But the Fed ignores these bubble (in fact even embraces them) as long as consumer prices are held in check.

Thus it's a serious mistake to look at base money, M1, or M' in isolation just as it is to look at M3 in isolation. One must also look at Fed policies to see whether interest rate polices foster enormous expansion of credit.

A rapid expansion of money supply tends to lead to outcomes as seen in the Weimar Republic or Zimbabwe, but a rapid expanse of credit is what we saw prior to the great depression.

But it's more complicated than that. To predict price stability, one also needs to look at what central bankers worldwide are doing. It is foolish to believe the Fed can directly control prices (and more importantly wages) in a global economy where every day the U.S. is becoming less and less relevant.

The carry trade in Japan has also significantly distorted the world's economy. When will that unwind? The answer is no one really knows for sure . When it does bust, the impact will be stunning in significance and it likely won't be good for stock prices.

One cannot ignore the effects of psychology. In fact one has to start with psychology. It is confidence about the future (or pure desperation) that causes people to borrow and spend as opposed to save for a rainy day. We are starting to see changes in confidence now. I talked about confidence (sentiment) in Don't Worry All Recessions Are Local.

A strong case can be made that the credit bubble is popping now based on many changes in sentiment. Evidence can be found in canceled deals (see Buyout Bingo Reversal Continues), Northern Rock (see Crisis at Northern Rock Comes to a Head) and also in enormous disruptions in asset backed commercial paper (See Prof. Fil Zucchi's post Will Boom Boom Carpe Diem?)

In addition, one needs to consider the velocity of money. I talked about velocity, M1, and Japan in Inflation: What the heck is it?

If one uses M1 or base money as the sole measure of deflation, then we are indeed close. But if one believes that inflation/deflation is the expansion or contraction in money and credit, then as of now we are not close "technically speaking". But that can change on a dime.

Housing sentiment changed overnight as did willingness to fund LBOs by Citigroup(C), Merrill (MER), Lehman (LEH), Bear Stearns (BSC), and Goldman Sachs (GS). Chuck Prince (Citigroup CEO) went from being the belle of the ball to paying an exit premium to leave the ball prematurely.

We have seen rapid changes in psychology in housing, asset backed commercial paper, and LBOs. Consumer attitudes toward debt are changing as well. The trend change in the U.S. from consumption towards saving is coming.

I certainly thought this credit bubble would have ended by now. When it does happen, it will hit businesses like a brick wall. Many signs suggest the credit bubble is now popping but we have been down this path before, only to have some other aspect keep the bubble inflating.

No one can put a date on it, but we do know is that credit bubbles end in deflation. We also know the Fed will be powerless to stop deflation when it comes. The best explanations as to why can be found in Mr. Practical's missive on The Fed's Limitations , my Interview with Paul Kasriel, and Mr. Practical's article What Future Does the Credit Crunch Bring?

Economic and credit contraction are both coming as the inability to service debt spreads from housing, to commercial real estate, to consumer credit. At the leading edge of this tsunami is a massive change in debt psychology by all the key players. Those who ignore the warnings are likely to drown.

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

Target Warns and Blames Florida - Lowes Blames Dry Weather

Reuters is reporting Target Warns on September Sales.

Discount retailer Target Corp. (TGT) warned on Monday that its September sales at stores open at least a year would be well below its prior forecast due to weak sales in Florida and the U.S. Northeast.

On a recorded message, Target said it expects same-store sales to rise between 1.5 percent and 2.5 percent for the five weeks ending Oct. 6.Earlier this month, the No. 2 U.S. discount retailer behind Wal-Mart Stores Inc. (WMT), forecast September same-store sales to rise 4 percent to 6 percent.

There must be one hell of a recession going on in Florida if that caused a national forecast change from 6% to 2.5% on the high end forecast. Perhaps the U.S. Northeast is in a recession too. But Don't Worry All Recessions Are Local.

Meanwhile Lowe's warns profit could trail forecast.

Retailer Lowe's Cos Inc (LOW) warned on Monday that full-year profit could trail its prior forecast, saying dry conditions in some parts of the United States were hurting sales.

Lowe's, which is holding its analyst meeting on Tuesday, said "current sales are trending below" expectations as drought conditions in the mid-Atlantic, Southeastern and Western parts of the United States hurt sales of outdoor products such as mowers and patio furniture.

"Lowe's sales trends have reversed the apparent improvement seen" in the second quarter, Sanford Bernstein analyst Colin McGranahan said in a research note.

In August, when it posted second-quarter results, Lowe's trimmed its full-year profit outlook from a May forecast of $1.99 to $2.03 a share, citing subprime-market concerns. But it also said at that time that sales trends were improving in some regions despite the housing woes.

"Even as we face easier prior-year sales comparisons as we progress through the year, many uncertainties remain, and it seems prudent to further temper our sales and earnings outlook," Lowe's Chairman Robert Niblock said in the statement on Monday.

Back on May 21, Robert Niblock Lowe's CEO was saying Housing market near or at bottom.

The housing market may be at or near bottom. But don't expect a dramatic turnaround anytime soon. He also said he's especially worried about three real estate markets: California, Florida and the Northeast.

Lowe's and Target must have the same state playbook even if one is blaming what the other should view as "good weather".

Homebuilder Wizardry

MarketWatch is reporting More bad news expected in home sales and reports from KB Home, Lennar.

Standard Pacific Corp. (SPF) said it would offer $100 million in convertible notes, and that its board of directors has eliminated the company's quarterly cash dividend. The company expects to save about $10 million annually, with the funds to be used to pay down debt.

[Mish comment: Let's see if I have this straight. SPF is eliminating its dividend to pay down debt by $10 million while at the same time announcing a new $100 million debt offering. Is this new math or just homebuilder math?]

Wall Street analysts see Lennar (LEN) reporting a third-quarter loss of 55 cents a share, on average, according to a survey conducted by Thomson Financial. "The risk is a higher-than-expected level of impairments, potentially coming from joint-venture investments," wrote Banc of America Securities analyst Daniel Oppenheim in a report to clients.

Meanwhile, KB Home (KBH) is expected to see a third-quarter loss of 67 cents a share, according to consensus estimates. Oppenheim expects orders will worsen to an 18% year-over-year decline due to weakness in August as the company's "build-to-order model likely faced tough competition from the large inventory of [speculative] homes for sale."

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

Don't Worry All Recessions Are Local

Does anyone remember the mantra "All Real Estate Is Local"? Somehow that plug has stopped. What stopped that plug is the fact that real estate is now down nationally for the first time since the great depression.

It's now time for a new mantra. I propose the following: "Don't Worry All Recessions Are Local". With that, let's take a look a few states.

Florida is in Recession

It's crystal clear that Florida real estate is in a recession. It should also be clear that Florida in general is in a recession. Those who disagree can give Mike Morgan a buzz at Morgan Florida. He can fill you in on some of the details.

Michigan is in Recession

The state of Michigan is also in a recession. As proof I offer 42,000 jobs lost in state since August 2006.

Statewide August seasonally adjusted unemployment rates rose four-tenths of a percent from this time last year, with three-quarters of the 56,000 payroll jobs lost in Michigan since August 2006 occurring in manufacturing and construction sectors, according to the Dept. of Labor and Economic Growth (DLEG).

While the national jobless rate remained unchanged at 4.6 percent, Michigan’s 7.4 percent unemployment rate in August increased over July’s 7.2 percent rate. The August rate was the highest monthly rate for the state since September 1993.

Total employment fell by 28,000 over the month as unemployment rose by 12,000 and the state’s labor force declined by 16,000 in August. “Michigan’s labor force in 2007 has declined in six out of eight months,” said Rick Waclawek, director of DLEG’s Bureau of Labor Market Information and Strategic Initiatives.

What About California?

Inquiring minds might be saying "Who cares about Florida or the Midwest rustbelt, what about California?" That's a good question.

Let's take a look starting with this headline: Californians not optimistic about economy.

A mood of gloom has settled on California in the past few months, with foreclosures and tightening credit causing more residents to see bad times ahead than at any time since 2003.

The sagging confidence in the economy also is influencing voters' opinions of their elected leaders, the Public Policy Institute of California reported Thursday, with distrust in state government "near an all-time high." Most of those polled said they think state government is run by big interests and wastes taxpayer money.

Economic pessimism jumped by 20 percentage points since the beginning of the year, the poll found, with 59 percent of residents saying they expected bad economic times in the coming year. Among "likely voters," 62 percent were pessimists.

Worriers outnumbered optimists in every region of the state, every income bracket and among homeowners and renters alike. That is unlike typical responses during this stage of an economic downturn, said Mark Baldassare, PPIC president and the survey's director.

Two Key Ideas

• Distrust in state government is "near an all-time high."
• Worriers outnumbered optimists in every region of the state, every income bracket and among homeowners and renters alike. That is unlike typical responses during this stage of an economic downturn.

Inquiring minds are asking "Why the change in sentiment?"

Could it be that California Foreclosures are up 200% from Last Year?

The 2nd Quarter National Delinquency Survey, released recently by the Mortgage Bankers Association (MBA), shows that California mortgage loans entering foreclosure have reached 25-year highs, with subprime borrowers bearing the brunt of the storm. The MBA linked market factors such as declining home prices and an increase in housing inventory to the grim foreclosure situation in California, but failed to acknowledge the risky products and deterioration of lending practices in their own industry. “Brokers and lenders pushed risky products that maximized their profits, but lost sight of the basic fundamentals of lending,” said Paul Leonard, director of the California office of the Center for Responsible Lending. “Subprime borrowers were set up for historic levels of failure.”

Is sentiment sinking because of rising foreclosures?

Believe it or not, the answer to the last question is no. Sentiment is not sour because foreclosures are up. Foreclosures are up because sentiment went sour! The pool of greater fools dried up (a sentiment change), then and only then (and it took a long time thereafter) did California sentiment change. And sentiment, like a fully loaded supertanker at warp speed, is very difficult to turn around.

The LBO Dance

The sudden reversal in willingness to fund LBOs regardless of value is also a change in sentiment. You may wish to take a look at Saturday's post Buyout Bingo Reversal Continues with that thought in mind. Here's the key idea "If Goldman and Citigroup don't want the deals or the debt, why should you?"

I did not explicitly say so but it was a sudden change in sentiment that is causing these deals to collapse.

Indeed, Chuck Prince, CEO of Citigroup marked the tip top in LBO mania when he proclaimed “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing". For more on this idea see Slope of Hope.

Chuck Prince is no longer dancing. In fact he is willing to pay significant money to get out of his last dance. And just as Chuck Prince suggested, things are now "complicated".

It's Just Local

Who cares if Michigan is in a slump? Ohio, same thing. After all both Michigan and Ohio are do nothing rust belt states. Florida? The demographics argument that everyone wants to move to Florida is now turned upside down as boomers exit Florida.

It's debatable whether or not California is a recession now or not. But it soon will be. And as each state slips into recession, simply click your heels together three times and repeat after me, "I'm not worried, all recessions are local."

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

Playing Hardball With The UAW

The deadline passed and UAW workers strike GM plants. "We're on strike. It's too late to call us back now," UAW Local President Chris "Tiny" Sherwood told Reuters as a union-imposed strike deadline passed at 11 a.m. EDT.

The UAW is shocked by GM's failure to recognize worker contributions.

“We’re shocked and disappointed that General Motors has failed to recognize and appreciate what our membership has contributed during the past four years,” said UAW President Ron Gettelfinger. “Since 2003 our members have made extraordinary efforts every time the company came to us with a problem: the corporate restructuring, the attrition plan, the Delphi bankruptcy, the 2005 health care agreement. In every case, our members went the extra mile to find reasonable solutions.

“This is our reward: a complete failure by GM to address the reasonable needs and concerns of our members,” said UAW Vice President Cal Rapson, director of the union's GM Department. “Instead, in 2007 company executives continued to award themselves bonuses while demanding that our members accept a reduced standard of living.

Negotiation Fact Sheet

Facts about GM-UAW labor talks

• GM and the UAW have been discussing a historic deal that would shift the automaker's obligation for more than $50 billion of retiree health care to a trust fund aligned with the union. The UAW has also asked for assurances that GM will not shift more production outside the United States to lower-cost economies such as Mexico.
• GM, which has posted a combined loss of $12.3 billion over the past two years, already cut its factory payroll by more than 34,000 and plans to shutter 12 plants by 2008. GM's U.S. market share, which reached 46 percent in 1978, had plunged to 24 percent by 2006.
• The average GM worker made $39.68 per hour in 2006 with benefits including health insurance representing another $33.58 per hour. U.S. automakers argue escalating health care costs amount to a labor cost disadvantage of almost $30 per hour on average against Japanese rivals led by Toyota Motor Corp.

Job Security and Health Care are Top Issues

Reuters is reporting job security and health care as issues.

GM and UAW negotiators had agreed during the weekend to the broad terms of a deal that would reduce GM's nearly $5 billion annual health-care bill, people briefed on the talks said.

Under that plan, widely considered the central issue in the complex talks, GM would shift responsibility for retiree health care to a new UAW-aligned trust fund.

Wall Street analysts have said such a step could cut GM's annual costs by $3 billion in exchange for a one-off payment expected to top $30 billion. Other key issues in the talks include GM's desire to hire new workers at a lower wage rate and the union's request that the automaker commit to maintaining production in the United States over the duration of the coming contract.

An agreement between management and the UAW was essentially worked out over health care but failed on job security and other issues. The UAW struck GM in response. Who has the better hand?

GM Daily Chart



(click on chart for a crisper image)

The share price of GM rose earlier this month on news of possible agreement on a health care package. Shares of GM are still holding their own in face of the strike.

Overcapacity Issues

Headed into a recession there is still an overcapacity issue. The Car Connection is asking Will Auto Sales Slow in 2008?

Most major forecasts for new car sales have been reduced. J.D. Power & Associates said it now expects sales of only 16.2 million vehicles this year. Doubt also is beginning to creep in about the forecasts for 2008 and some observers are beginning to speculate car sales won't recover until 2009.

All or Nothing Hardball?

The outlook for cars sales in the US is simply not very good. GM management seems to understand that. And GM's cost structure is still high compared to Toyota and others. So management simply will not accept any contract clauses that prevent moving still more operations to places like Mexico.

What this all boils down to is GM management seems determined to break the UAW in a game of all or nothing hardball. For now anyway the market seems to like it. Who can hold out longer?

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