Oil is set to hit $100 a barrel: Is This Deflation?

Here is an interesting reader question from last week:

Mish,
Oil is set to hit $100 a barrel.
Gold is set to hit $800 an ounce.
Other commodities are periodically breaking all time highs.
Is this deflation?

My Reply:

No, of course not.
Then again the price of oil has little or nothing to do with inflation, at least in any measurable sense.

The above sentence may seem shocking to many, but before we proceed we must agree on a definition of inflation. The definition of inflation that I am using is this: Inflation is an increase in money supply and credit.

For further discussion of that definition, please see Which Comes First: The Cart or the Horse? And with the horse in front of the cart where it belongs, let's look at oil prices.

Ten Possible Factors Behind Oil's Rise

• Oil can rise because of peak oil
• Oil can rise because of supply disruptions
• Oil can rise because sentiment is favorable to oil speculation
• Oil can rise because of increasing demand from other countries
• Oil can rise because of geopolitics
• Oil can rise because of war
• Oil can rise because of weather related phenomenon
• Oil can rise because of shortages in other energy sources
• Oil can rise because of monetary printing in countries outside the US that fuel malinvestments requiring oil
• Oil can rise because of monetary printing or expansion of credit in the US

Of those 10 points, only the last one pertains to US inflation. If someone can tell me to what extent oil is rising because of monetary printing or expansion of credit in the US, then we can talk about oil in terms of inflation. Since this cannot be done, it is impossible to measure the price rise in oil caused by inflation. The cause/result effect here is very important. One must put the horse in front of the cart to talk about inflation in any meaningful sense.

The same applies to copper, grains, and other commodities. For example: Grain shortages in Australia, drought, pestilence, hurricanes, and bad governmental policies in ethanol do not constitute inflation either. Nor can the Fed do anything about any of those.

However, that does not stop the Fed (and everyone else) from talking about the price of oil and grains as if the rise is due to or even sillier yet, going to cause inflation. Nor does it stop the Fed from talking about a whole lot of other things that cannot properly be measured either, such as capacity utilization and the CPI.

The one thing the Fed should discuss is the only thing the Fed does not discuss: An increase in money supply and credit.

In effect, the Fed puts the cart in front of the horse then completely ignores the horse. This is on purpose. It's in the Fed's best interest if people do now know what inflation is. The sad result is we have a monetary policy that discusses everything under the sun but money.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
Click Here To See My Five Most Recent Posts

Downward Spiral of Deep Junk

Reuters is reporting credit default swaps on Ambac, MBIA trading as deep junk

Credit derivative traders are valuing bond insurers Ambac Financial Group (ABK) and MBIA Inc (MBI) as deep junk credits, belying the companies' strong "Aa1" ratings, according to data by the credit strategy group at Moody's Investors Service.

Credit default swaps on Ambac are trading at around 620 basis points, or $620,000 per year for five years to insure $10 million in debt, according to data provided by CMA DataVision.

At Thursday's close, Ambac's swaps implied a rating of "Caa1," seven levels below investment grade and 14 notches below its actual rating.

MBIA Inc's default swap spreads, meanwhile, are trading as though they carry a rating of "B2," five levels below investment grade, and 12 notches below the company's "Aa2" rating, according to Moody's data.

Homebuilders Cut To Junk

In other news, S&P downgrades five US home builders

Standard & Poor's on Friday cut its ratings on five U.S. homebuilders, three of them to junk status, citing weak earnings and challenging conditions in the housing market.

Ratings of D.R. Horton Inc (DHI), Pulte Homes Inc (PHM) and Lennar Corp. (LEN) were cut into junk territory. The downgrades reflect the vulnerability of the home builders to the deteriorating housing market and macroeconomic conditions, S&P said in a statement.

D.R. Horton and Pulte were cut one notch to "BB-plus," one level below investment grade, from "BBB-minus." Lennar Corp was cut by two notches to "BB-plus" from "BBB." The outlook for all three companies is negative, indicating an additional cut is likely over the next two years.

S&P also cut Centex Corp's (CTX) debt rating by one notch to "BBB-minus," one step above junk status, from "BBB," with a negative outlook. It downgraded Standard Pacific Corp (SPF) by one notch to "BB-minus," three levels below investment grade, from "BB," with a negative outlook. And it changed the outlook on Ryland Group (RYL) to negative from stable. Ryland is rated "BBB-minus."

Downward Spiral of Junk

Homebuilders are just as sideshow. Homebuilder debt ratings affect a mere $15 billion in debt. Ambac (ABK) and MBIA (MBI) are the "real deal". Let's look further.

Bloomberg is reporting Merrill, Citigroup Debt Risk at 5-Year High on Subprime Concern

The risk of Merrill Lynch & Co. and Citigroup Inc. defaulting on their debt rose to the highest in at least five years on speculation that losses on mortgage-related securities will worsen, trading in credit-default swaps shows.

Credit-default swaps on Merrill Lynch, the third-largest U.S. securities firm, rose after a Deutsche Bank AG analyst said the firm may write down $10 billion more in assets linked to mortgage debt.

Credit-default swaps are used to speculate on a company's ability to repay its debt or hedge against losses. A basis point on a contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

Merrill Lynch, which last week reported an almost $8 billion writedown on securities tied to subprime mortgages, may mark down more for losses on collateralized debt obligations, Deutsche Bank analysts said today. Regulators also may be investigating whether New York-based Merrill Lynch violated accounting rules to delay reporting of the losses, the Wall Street Journal reported today.

"We have increasingly lost confidence in the financials of Merrill," Deutsche Bank equity analyst Mike Mayo in New York wrote in a note to clients today. "Our concern is relying on a company's statements that has no CEO and is facing a potential SEC investigation and may have engaged in questionable private transactions."

Credit-default swaps tied to MBIA Inc., the world's biggest bond insurer, rose 60 basis points to 480 basis points, the widest in at least three years, according to CMA Datavision in New York.

Ambac Financial Group Inc., the second-biggest bond insurer, climbed 63 basis points to 689 basis points, CMA prices show.

The last two sentences in the above snips hold the key to a cascade of defaults. Let's continue with that thought to see why.

Bloomberg is reporting a potential Industry Wide Downward Spiral in Bond Insurance.

Ambac Financial Group Inc. and MBIA Inc. shares fell, along with other bond insurers, as Morgan Stanley said the industry may face a "downward spiral" and Goldman Sachs removed its "buy" rating on the two companies.

The bond insurance industry has guaranteed more than $1 trillion of bonds issued by U.S. cities and states as well as bonds backed by mortgages, credit cards and other assets, and the guarantee allows borrowers to use the insurers' AAA rating. A loss of confidence by investors in the insurers' credit quality threatens the survival of the industry and the price of the thousands of bonds it guarantees.

Ambac, the world's second-largest bond insurer, fell $6.06, or 20 percent, to $23.51 today in New York Stock Exchange Composite trading. On Friday, Oct. 5, the shares closed at $70.11. MBIA, the biggest bond insurer, slid $2.55, or 6.7 percent, to $35.51. Four weeks ago they closed at $67.78.

"As the credit market continues to weaken, our confidence that guarantors will survive the credit meltdown is waning, prompting us to take a more conservative view of the financial guarantors," said Ken Zerbe, an analyst with Morgan Stanley in New York.

Zerbe said a worsening of defaults on mortgage, home equity loans and credit card balances "could prove to be the proverbial straw that starts the downward spiral in the viability of the guarantors' business model."

For more on Zerbe and Ambac please see Stock Buybacks: A Good Thing Or Slipped DISCs?

What Zerbe is missing this time is that the guarantors' business model was never viable. It was all sleight of hand and wishful thinking. Here is the key paragraph.

The bond insurance industry has guaranteed more than $1 trillion of bonds issued by U.S. cities and states as well as bonds backed by mortgages, credit cards and other assets, and the guarantee allows borrowers to use the insurers' AAA rating. A loss of confidence by investors in the insurers' credit quality threatens the survival of the industry and the price of the thousands of bonds it guarantees.

Because of the "guarantee", god only knows what kind of garbage got rated as AAA. In return for the "guarantee" , companies like Ambac collect a fee. When times are good they keep collecting fees. When the proverbial * hits the fan, the guarantee is worthless. Is this a viable business model?

What we do not know is how much of that "AAA" paper banks are holding is really deserving of "AAA" status as opposed to being rated "AAA" because someone "guaranteed" it.

Ambac (ABK) Daily Chart



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MBIA (MBI) Daily Chart



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At Thursday's close, Ambac's swaps implied a rating of "Caa1," seven levels below investment grade and 14 notches below its actual rating.

MBIA Inc's default swap spreads, meanwhile, are trading as though they carry a rating of "B2," five levels below investment grade, and 12 notches below the company's "Aa2" rating, according to Moody's data.

Ambac was down another 20% on Friday. MBIA was down another 6.7%. Clearly the market is beginning to wonder just how much those "guarantees" are worth.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
Click Here To See Mish's Five Most Recent Posts

Music Stops for Chuck Prince

Flashback July 10, 2007

Chuck Prince: No End Soon to Buyout Boom “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".

Flash Forward November 2, 2007

The party is over and the music has stopped for Chuck Prince. His last dance is a two-step out the door. Citi's Prince Plans to Resign

Charles Prince, the beleaguered chief executive of Citigroup Inc., is planning to resign at a board meeting on Sunday, according to people familiar with the situation.

Just a few weeks ago, board members including Robert Rubin, the influential chairman of Citigroup's executive committee, expressed support for Mr. Prince and said that his job wasn't in jeopardy. "I think Chuck's going to be here for a lot of years," Mr. Rubin said in an interview last month.

Any change of heart may also have been spurred along this week after the board of Merrill Lynch & Co. ousted its embattled CEO, Stanley O'Neal.

In reporting its third-quarter earnings, Citigroup warned that it endured a surge in late payments on consumer mortgages in September, costing the bank $3 billion in higher losses and reserves against future bad loans and hurting the value of loans Citigroup hopes to sell to investors. Chief Financial Officer Gary Crittenden said the trend is likely to continue.

Citigroup also booked $1.56 billion in pretax losses tied to loans and subprime mortgages that were to be repackaged and sold to investors.

Equally important, the bank said its capital levels had dwindled to below the company's internal target ratios. Executives said the company would stop repurchasing its own shares until it rebuilt its capital, a process it hopes to complete by early next year. Some analysts and other experts think Citigroup will have to take more drastic actions, such as selling off assets or slicing its dividend payouts.

In after hours stock action shares are up 2%+- to $39+-.

Prince's retirement solves nothing actually. And of all the issues at Citigroup, capital levels is the most critical one. With capital concerns come side issues such as a Question of Solvency at Citigroup.

Let's play American Pie in honor of Chuck Prince.

We all got up to dance,
Oh, but we never got the chance!
`cause the players tried to take the field;
The marching band refused to yield.
Do you recall what was revealed
The day the music died?

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

Jobs Report From Alternate Universe

In a report from an alternate universe somewhere else in space and time U.S. Payrolls Rose 166,000 in October.

American employers added almost twice as many jobs as forecast in October, helping steer the economy clear of recession even as the housing slump deepens. Stocks advanced and Treasury notes weakened after the report, which economists said makes an interest-rate cut by the Federal Reserve even less likely next month.

My Comment: Stocks advanced? Treasuries weakened? Look again.

"The labor market continues to be inconsistent with fears of a recession," said Dean Maki, chief U.S. economist at Barclays Capital in New York and a former senior economist at the Fed. "This report will increase the Fed's conviction that it should keep rates unchanged in coming months."

My comment: Fed's conviction to leave rates unchanged? You can't be serious. Dean Maki must be talking about the Fed in some alternate universe somewhere.

Wages rose less than forecast, suggesting compensation may provide less of a cushion against declining home values in coming months. Hourly wages rose 3 cents, or 0.2 percent, on average to $17.58 in October and were up 3.8 percent from a year earlier.

My comment: How can they even begin to talk about wages as a cushion against home prices. The idea is absurd. Consider the following conversation. Honey, I have good news and bad news. The bad news is the value of our house fell $200,000. The good news is my hourly wages went up by 3 cents.

The Official (Alternate Universe) Data

On November 2, the BLS released the Employment Report for October 2007

Nonfarm payroll employment rose by 166,000 in October, and the unemployment rate was unchanged at 4.7 percent, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. Job gains occurred in professional and business services, health care, and leisure and hospitality. Manufacturing employment continued to decline, and construction employment was little changed.

The overall numbers look OK on the surface but once again the devil is in the details.

• Manufacturing shed another 21,000 jobs this month and continues to lose jobs every month.
• Government added 36,000 useless workers.
• Leisure and hospitality (typically very low paying jobs) added 56,000 jobs.

But the amazing stats are once again found in the Birth/Death Assumptions.



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The BLS has shown a net gain of jobs added to new businesses in both construction and financial activities nine consecutive months from February through October.

The BLS is assuming not only that jobs were added, but that new unaccounted construction businesses were created in this environment where business capex spending has been weak, housing has been horrid, and over 170 lenders have gone out of business or stopped writing loans since last December as per the Mortgage Lender Implode-O-Meter.

Clearly this is reporting from an alternate universe.

A note of caution: One cannot take the birth death adjustments and subtract them from the reported numbers because one set of numbers is seasonally adjusted and the other is not.

Household Survey Data

The household data showed a civilian labor force decline of 211,000 and an overall employment decline of 250,000.



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Bond Market's Reaction



In this universe, Curve Watchers Anonymous is watching the yield curve and quipped, "If the bond market does not believe this jobs number then why should I?"

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

Mortgage Lending Scorecard

Mortgage Lending and Financials were not the place to on Thursday (and the rout is continuing so far today). Here is Thursday's scorecard:

• GMAC, the home and auto lender formerly owned by General Motors Corp.reported a $1.6 billion loss on lower demand for mortgages and higher provisions for failed loans and impaired assets.
• Radian (RDN) , the third-largest U.S. mortgage insurer, reported a $703.9 million loss after writing off $468 million on a unit that invested in subprime mortgages.
• MGIC Investment Corp. (MTG), the largest U.S. mortgage insurer, declined $2.25, or 12 percent, to $17.11.
• Washington Mutual Inc. (WM), the largest U.S. savings and loan, fell 7.6 percent.
• Countrywide Financial Corp. (CFC), the biggest U.S. mortgage lender, lost 7 percent.
• MetLife (MET) slipped 4.8 percent
• Conseco (CNO) dropped 10 percent, the most since emerging from bankruptcy in 2003.
• American International Group (AIG), the world's largest insurer, fell 6.1 percent.
• MetLife (MET) lost $25 million from its $1.8 billion of investments in 25 hedge funds in the third quarter, Chief Investment Officer Steven Kandarian told analysts on a conference call today. The New York-based company had another $47 million of losses linked to investments in homebuilders and CDOs.
• Ambac (ABK) bonds were downgraded to "deteriorating'' from "stable'' by Gimme Credit Publications Inc. because of the world's second-largest bond insurer's risk from CDO obligations.
  

GMAC is majority owned by a buyout group led by New York-based Cerberus Capital Management LP. GMAC's results included a $2.3 billion loss at its Residential Capital LLC mortgage unit.

The above synopsis thanks to Bloomberg.

I am still trying to figure out how anyone could possibly have been interested in buying GMAC from GM. Even more puzzling was GM's reluctance to part with all of it as opposed to 51% of it.

Urgent Message From Citigroup

The Mortgage Lender Implode-O-Meter is noting an Urgent Policy Notification from Citigroup: Effective October 31st 2007, Citi Home Equity will discontinue lending on all Purchase Money transactions for properties in California.

It's too bad that Citigroup sold its umbrella in February. What are those California clients supposed to do in this downpour?

Then again, given the Question of Solvency at Citigroup, perhaps Citigroup needs that umbrella more than its client do.

Why is it there is never an umbrella when you need one?

By the way it's Minyan Peter who deserves the credit for this umbrella quip. He was all over Citigroup's case on October 2 in A Look Inside Citigroup's Writedowns.

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

Question of Solvency at Citigroup

Market Watch is reporting Citigroup shares drop as dividend is put in doubt.

Citigroup shares tumbled more than 6% in afternoon trading Thursday amid new concerns that the financial services conglomerate may not be able to support its hefty dividend payout. In the near term, Citi (C) may have to raise more than $30 billion by either selling off assets, slashing its dividend, raising capital or resorting to a mix of these measures, analysts at CIBC World Markets said.

"Based upon our thesis that over the near-term Citigroup will be forced to sell assets, raise capital or cut its dividend to shore up its capital ratios, we believe the stock will be under significant pressure and could trade into the low $30s," according to CIBC.

Richard Bove, an analyst with Punk Ziegel & Co., doesn't dispute that Citigroup has issues, but solvency is not one of them, he said. Citi's had a profit of $13.6 billion and it had net free cash flow of $18 billion through the first nine months of 2007. Bove also said Citi has $240.8 billion in liquid trading account assets that can be used for liquidity.

"These numbers indicate that this bank is both liquid and well-capitalized," Bove wrote. "At the end of the third quarter, Citigroup posted $2.355 trillion in assets. This was more than any other American bank and possibly more than any bank in the world."

Notice how Bove cleverly pointed out the asset side of the equation while conveniently forgetting about liabilities. Let's rework Bove's statement to see the other side of the story.

"At the end of the third quarter, Citigroup posted $2.227 trillion in liabilities. This was more than any other American bank and possibly more than any bank in the world. A mere 5.4% decline in the value of Citigroup's assets would make Citigroup insolvent."

Citigroup's assets look great in a vacuum. However, those assets do not look so great in relation to liabilities. Leverage has never been greater, and much of that leverage is now in exactly the wrong places: residential and commercial real estate.

Citigroup CEO Chuck Prince's next "dance step" is likely to be out the door.

How Good is Debt Insurance?

Some think this debt is insured. For that, let's take a look at Ambac (ABK).

Ambac Financial Group, Inc., through its subsidiaries, provides financial guarantee products and other financial services to clients in the public and private sectors worldwide. It operates in two segments: Financial Guarantee and Financial Services. The Financial Guarantee segment offers financial guarantee insurance and other credit enhancement products, such as credit derivatives for public finance and structured finance obligations. It also provides financial guarantees for bond issues and other forms of debt financing.

Ambac (ABK) Daily Chart



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For an article on financial shenanigans at Ambac please see Stock Buybacks: A Good Thing Or Slipped DISCs?

Debt insurance is only as good as the solvency of the guarantor. The market is starting to question the value of those guarantees. For additional proof you might want to consider looking at a chart of mortgage guarantor MBIA (MBI).

MBIA (MBI) Daily Chart



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Notice today's selloff in Bank of America (BAC) Citigroup (C), Countrywide (CFC), JP Morgan Chase (JPM), Washington Mutual (WM), Corus Bank (CORS), Bank United (BKUNA), etc. This selloff is not over a possible dividend cut at Citigroup, profit taking, diminished odds of further rate cuts or any other thing the talking heads might be saying.

Solvency is the issue here, and I am not just talking about Citigroup. I am talking about solvency of the system itself. Rate cuts fueled this mess. Rates cuts cannot be the answer.

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

Rate Cuts: Is It Two and Done?

All eyes were on the Fed's FOMC statement on Wednesday as if it meant anything. In reality, the statement was irrelevant for the simple reason that no one can possibly believe a thing the committee says.

The Action: The Fed cut by 1/4 point in spite of a GDP that came in as a surprise.

The Reaction: The dollar sank, oil and gold hit new highs. Those stuck in ARMs did not benefit at all. Mortgage rates are still higher than they were a year ago in spite of a total of 75 basis points (.75%) cuts by the Fed and an additional 50 basis point (.50%) cut in the discount rate.

The stock market gyrated wildly but settled pretty much where it was before the announcement. The sad thing is that no one can possibly believe the reasons the Fed gives for what it does. The Fed seems more inclined to wordsmith what the market expects rather than do what needs to be done. Reasons can be made up along the way. It's pretty clear that's exactly what happen. So much for transparency.

The committee did manage one dissenting vote. Here's what I want to know: Was there a volunteer or did Thomas M. Hoenig draw the short straw?

For the record: I am in gold and a libor based mortgage. Both benefited from today's action. I do not think the Fed should have cut.

Is It Two and Done?

Curve Watchers Anonymous was watching the action today and here is the top question on their collective minds: Is It Two and Done?

The following FOMC Probabilities Chart will show the basis of the question.



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The odds of rate cuts in December plunged immediately on the FOMC announcement.

Was this because of the cleverly arranged short straw dissent? Who knows? What we do know is that the market will forget all about Wednesday as soon as Thursday. On Thursday will come the weekly unemployment numbers on Friday will come the monthly jobs report.

Payroll Playbook

If the jobs numbers are bad, the odds of a rate cut in December will again rise. In reaction, the dollar will likely be under pressure, and gold will likely find a bid.

In short order, everyone will have long forgotten about Thomas M. Hoenig and the irrelevance of the latest FOMC statement.

Numbers That Matter

There are some numbers that matter. Happenings in commercial real estate are at the top of the list. I will get to commercial real estate early next week but for now let's concentrate on housing vacancies. I talked about housing vacancies in Pent Up Housing Supply. The numbers seem so unreal that some have questioned them.

Professor Eugene Linden is also on the case. He is writing about An Underappreciated Housing Number.

Since 1965, the high water mark for homeownership was 69.2%, reached in the second and fourth quarters of 2004. Before 1998, the ownership rate never topped 66%. Then came exotic mortgage products and unscrupulous mortgage brokers. Suddenly a cohort of Americans who never before could qualify for mortgages found themselves in homes, and the homeownership rate marched steadily upward through the early 2000’s.

Sadly, these newly minted homeowners quickly began to demonstrate why they couldn’t get a mortgage before. Astonishing numbers of subprime borrowers in these exotic mortgages never even made the first payment. The predictable consequence is that the homeownership rate is once again declining. How far this goes will be hugely consequential for the economy.

Given that it’s now easier to arrange a golf outing with Tiger Woods than it is to get a mortgage, it’s reasonable to expect the ownership rate to revert to pre-credit bubble levels of about 65%. Even if no additional houses are built, that would shift another 3.5 million homes and apartments from the owner-occupied column to the rental or vacant columns. This is not what a market already groaning with 17.9 million vacant units needs.

I am not holding my breath waiting for that phone call from Tiger Woods for a golf date, but residential real estate is nowhere near the bottom with this kind of pent up supply.

The interesting thing is these rate cuts are not helping borrowers one iota.
Here is the scorecard to prove it.



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The Fed does not care about borrowers in trouble. All the Fed cares about is bailing out banks that made stupid decisions lending to those who never had any business buying a house. In that regard "Two and Done" won't cut it. Look for more rate cuts down the road. Just don't believe the reasons why.

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