Credit Default Swap Tsunami Approaches

Blomberg is reporting AIG Falls on Concern Losses May Have Been Understated.

American International Group Inc., the world's largest insurer by assets, fell the most in 20 years in New York trading after its auditor found faulty accounting may have understated losses on some holdings. AIG's auditors found "material weakness" in its accounting for the contracts, and the firm doesn't know what they were worth at the end of 2007, the filing said.

"It raises the question about whether management is in control of what's going on with their derivatives," Edward Ketz, a Pennsylvania State University accounting professor, said in an interview. "The uncertainty as to whether additional losses are coming is as unsettling as anything."

Fitch Ratings may lower the insurer's AA credit rating because AIG's "weakness in internal controls," coupled with "current market conditions, contributes to uncertainty regarding the valuation" of the derivative portfolio, the credit-ratings company said in a statement today.

Depression Levels In Housing

Back on August 9th Chief Risk Officer Robert Lewis said that almost all of its subprime mortgage holdings were safe unless the U.S. housing market crashes to "depression proportions."

By AIG's definition, housing must be at "depression levels". However, we are only in the third inning or so of housing declines. Six more innings are coming. What will AIG's swaps look like then?

It would be interesting to know who is on the other side of AIG's bet. The Wall Street Journal called me today asking my opinion on these swaps. I explained the real fireworks start when there is a major default on swaps. In all likelihood, at least for now, AIG can cover that loss. It will be painful and they may have to raise capital, but for now they can do so.

However, there are $45 trillion of credit default swaps out there. A default on a mere 10% would cause an economic disaster. Unfortunately, it's guaranteed to happen.

Companies like Citigroup (C), AIG (AIG), Merrill Lynch (MER), Lehman (LEH), Morgan Stanley (MS), might think they are hedged. If so they are only fooling themselves. Just what is a guarantee from someone like MBIA (MBI), Ambac (ABK), or Madame Merriweather's Mudhut Malaysia worth? The answer is nothing.

I mentioned dear Mmm. Madame Merriweather to the WSJ today and said that may as well be who is guaranteeing this stuff.

There are countless hedge funds out there, leveraged to the hilt in garbage that has not been marked to market. The same holds true for banks and as we have seen today, insurance companies like AIG.

At some point, some company will declare bankruptcy or a debt downgrade will trigger a claim. That claim will not be paid because the hedge fund or mudhut (whichever comes first) does not have the means to do so. A cascade of defaults will occur up the line on any corporation counting on that claim as part of their hedge.

Consider GM. The market cap of GM is $15 billion or so. There are about $1 trillion in credit default swaps bet on the success or failure of GM. It is virtually impossible for this to be hedged because there is not $1 trillion in GM bonds available as collateral.

The credit swaps on MBIA, Ambac, and the homebuilders trade deep into junk, some priced outright for default. Is there any wonder Moody's, Fitch, and the S&P are reluctant to downgrade MBIA and Ambac? The ratings assigned to Ambac and MBIA are a joke.

AIG Cannot "Reliably Quantify" Losses

The Financial Times has this take on The Debacle at AIG.

AIG produced the revised figures after PwC, its auditors, concluded that there was a “material weakness” in the way the insurer valued its exposure. AIG’s move came after Peer Steinbrück, Germany’s finance minister, warned at the weekend that losses on securities linked to US subprime mortgages could reach $400bn. AIG has written $78bn of credit default swaps on CDOs, which protect the purchaser from a CDO’s failure to pay.

The primary providers of the hedges are bond insurers such as MBIA and Ambac, whose ability to pay claims is causing growing concern in global markets. These have written about $125bn of protection on “senior tranches” of CDOs, according to data from Standard & Poor’s.

AIG told investors in December that it estimated valuation losses on its credit default swaps for October and November at just over $1bn. AIG has scrapped the adjustment because market conditions mean it cannot “reliably quantify” the figure.

Default Swaps Intensify Credit Crunch

Is the loss at AIG really $5 billion or is it $10 billion, or is it more? Don't ask AIG, they don't have any idea. AIG cannot “reliably quantify” the figure. That sure must be a huge confidence booster to investors.

Minyanville's newest professor, Rob Roy touched on this theme in Default Swaps Intensify Credit Crunch. Following are some snips from a lengthy article. Inquiring minds will want to read the entire article.

Over the past several years my firm has highlighted the risks in the sub-prime sector, the lax lending standards, and the housing bubble that peaked in 2005. The residual effects of these have been vast and continue to support our view that the unraveling of the debt issue is not contained.

Housing is clearly in a near-death spiral with inventories rising on months of available supply basis, despite many homeowners de-listing their homes and waiting for a turnaround. Here in Orlando there is 5 years worth of available home lot inventory waiting for developers to fill in the new suburban subdivisions that were developed.

Abnormal events are magnified with financial leverage, and even normal events can become catastrophic with large amounts of leverage. This is clearly seen with the sub-prime and other low quality loans that were packaged into Collateralized Debt Obligations (CDOs) and then sold off to institutional investors thirsty for higher returns.

The dollar has been rallying lately, which is contrary to what you might think, but what if the US actually is the best house in a bad neighborhood? Could the dollar rally against the Euro as the problems at European banks like Union Bank of Switzerland, Societe Generale, Deutsche Bank (DB), Barclay’s (BCS) and Credit Suisse (CS) surface day after day? Every day it seems, a new financing is announced by a major bank (lately by the likes of Citi (C), PNC, and Wachovia (WB) just to name a few) in order to ‘shore up capital’.

Just last night, MBIA placed $1 billion equity financing in order to keep its AAA rating. This comes after a $1 billion subordinated debt issue meant to accomplish the same thing. What comes after you issue debt, and then have to issue equity? Regardless, the bonds trade at CCC levels, so the market, including my firm, isn’t buying it.

Now enter the regulators, like the Insurance Commissioner of New York, Mr. Danalli. To solve this situation, the regulators are asking banks like Citi and a bunch of European banks (which already have their own funding problems) to ‘bail out the municipal insurers’. Supposedly we can’t let them fail because the result would be too large and would finally hit the individual municipal bond investor right between the eyes.

The problem with this potential solution is that the bailors (banks) have the same balance sheet problems as the bailees (insurance companies). The banks have hundreds of billions of dollars of exotic paper that they really don’t know how to price, yet if they let the insurers fail, they will be forced to write down their own positions simultaneously. This becomes one vicious cycle of capital raising in the banking and brokerage industry...

If you think the banks are a mess, try taking a quick look at the balance sheets of companies like Lehman (LEH) and Bear Stearns (BSC). These companies have balance sheets that are literally 40 times their shareholder equity. They also own 3 times their equity in what is known as ‘Level 3 assets’—those that can't be accurately priced, and can’t even be estimated based on a model. Level 3 is ‘mark to management’s best guess’.

Best guess is better than what Citi’s CFO said when asked about its $60 billion of CDOs. On the investor conference call he stated that their positions were ‘marked to a reasonable stab’. I know this may sound as if I am making this up, but sadly, I am not.

Many credit derivative transactions don't simply involve two parties but are often times the risk is passed from one party to the next several times. When an event occurs it causes a careful examination of the complicated legal documents which spell out the specifics of solving a default event.

In a legal case from last year, Bear Stearns loaned $10 million to a development in the Philippines which was backed by a Philippines government agency. In order to protect itself from default, Bear Stearns purchased protection from AON for about $425,000. AON was then short exposure to the Philippines government agency, and so then purchased protection from Societe Generale for $328,000. Offsetting the risk gave AON an easy $97,000, right?

Well the project went bust, the developer did not pay and neither did the Philippines government agency. Bear sued AON for $10 million to reclaim their loss under the Credit Default Swap it had purchased from them and AON paid. AON then went and sued SocGen for $10 million asking for a summary judgment claiming that since the one CDS had been resolved it should automatically create a resolution for the second CDS. After several courts opined on the case, AON lost their case, and lost $10 million. The final court ruling was that the language in CDS1 and CDS2 were not identical and that the risk was not purely offset. So instead of making $97,000 they lost $10,000,000. Seems like documentation is a real counter-party risk.

The big question now is, if you have a derivatives contract, CDS, or CDO with another institution, you may start to wonder if your counter-party is sound, and if it is properly documented.

This is the largest risk we see going forward for the financial markets, when investors do not trust their counterparties, when counterparties suddenly decide to pull your financing due to 'balance sheet constraints' and when financial institutions do not trust each other that 'the other side of the trade will settle'.

Things to keep in mind as the credit default tsunami approaches

• No one can reliably quantify the amount at risk
• There is no liquidity in any of the exotic credit markets
• On some products there is no bid at all
  
• Counterparties do not trust each other
• Balance sheet considerations are causing financing arrangements to be pulled
• Various CDOs and CDSs as well as counterparty guarantees on those products are essentially worthless
• A major counterparty failure is all it takes to cause a cascade of defaults
  

Madame Merriweather's Mudhut Malaysia Inc phoned me minutes ago. I spoke with Mme. Merriweather in person. She was upset by my comments to the Wall Street Journal. She went on to say that her AAA credit rating was still intact, that she could make good on her guarantees, and that she was not in any way affiliated with Madame Merriweather's Mudhut Phillipines. "My mudhut is priceless" she stated.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Banks Need Bailouts, But Where's The Money?

At the G7 meeting Paulson says market turmoil is 'serious, persisting'.

The current turbulence in the world's financial markets is both 'serious' and 'persisting,' and it will take time to work through, US Treasury Secretary Henry Paulson told his counterparts from the world's seven richest nations.

'As the financial markets recover from this period of stress, as of course they will, we should expect continued volatility as risk is repriced,' Paulson told reporters in a prepared statement after meeting with finance chiefs from the Group of Seven.

My Comment: "Repricing of risk" is synonymous with "more capital needed".

'While financial markets are improving, it will take time to work through the current financial turmoil,' he said.

The Treasury chief expressed confidence in the world's largest economy, telling his counterparts that the United States would 'continue to grow' this year.

My Comment: You can't "continue" to grow if you're not growing. The US is in recession and it is going to be a deep one.

The former Goldman Sachs (GS) executive urged financial institutions to come clean about weak balance sheets.

'Past episodes of financial turmoil have demonstrated that recognizing losses and restoring capital are two of the very most important steps toward restoring financial normalcy,' he said.

Banks Need To Raise Capital Quickly

Reuters is reporting Paulson:Banks need to raise capital quickly.

U.S. financial institutions have to realise losses and raise capital quickly to stave off a credit crunch, U.S. Treasury Secretary Henry Paulson told the Nikkei business daily.

"The worst thing is if they don't raise capital, if they shrink their balance sheet, and then restrain their lending," Paulson said in an interview with the Nikkei published on Saturday.

Paulson also said financial institutions, including monoline bond insurers, must look to the private sector, not the government, to strengthen their capital, denying using public funds to support the banking system.

Paulson also said he welcomes investments from sovereign wealth funds, saying he has had many conversations with them and they all assured him that they are driven by the desire to maximise their returns.

Heart Of The Matter

Let's get to the heart of the matter. Paulson is saying that US banks are capital impaired. With a continual repricing of risk, walk aways and rising credit card defaults, banks are becoming more capital impaired with each passing day.

Paulson's statements are in stark contrast to those made by the Jim Glassman, senior U.S. economist at JPMorgan Chase & Co.

"There is no such thing as a banking system short of reserves. The Fed has absolute control over the supply. ... In a world where the Fed can print money, there is no shortage. The banks get the reserves they want."

My rebuttal to Glassman and the origin of those statements can be found in Borrowed Reserves And Tin-Foil Hats.

Obviously Paulson agrees that reserves cannot be printed into existence. Furthermore, and this is critical, Paulson recognizes there is insufficient means within the US to raise those reserves. The question is not one of liquidity but one of solvency.

Federal Reserve Emergency Powers

In the Panel on Government Sponsored Enterprises, Poole spoke on the Emergency Powers of the Fed.

In the interest of a full understanding of the Federal Reserve’s powers in the event of a crisis in the market for GSE obligations, I’ll outline the Fed’s powers as provided by the Federal Reserve Act.
....
The Federal Reserve has ample power to deal with a liquidity problem, by making collateralized loans as authorized by the Federal Reserve Act.

The Fed does not have power to deal with a solvency problem. Should a solvency problem arise with any of the GSEs, the solution will have to be found elsewhere than through the Federal Reserve.

The Fed can print easily enough. A string of coupon passes would do it (at the risk of sinking the US dollar of course). However, that would not put reserves into capital impaired banks, nor would it spur lending in a world awash in over capacity.

Where's The Money?

Right before he left Washington for Tokyo to meet Group of Seven (G7) financial leaders Paulson said: "If there's any doubt that they [banks] will not have enough capital, they should go out and get capital where it is available." Good luck!

Bank Of America Is Paying 3.7% On CDs in an attempt to raise money. Countrywide is bordering on desperation given the yield on short term treasuries and the Fed Funds Rate.

Here is a Countrywide Financial ad effective Saturday, February 9, 2008.



Does anyone see a hint of a problem here?

If not, here it is: 15 year mortgages are currently at 5.04% as stated by Bloomberg and cost of funds for Countrywide are 4.75%. That may look like a positive rate of return but it's not close, all things considered.

From Bad To Worse

Please consider the Fortune article Countrywide: From bad to worse.

The troubled lender posted a $422 million loss and revealed that a third of its subprime loans are delinquent.

The loss threw cold water on Countrywide chief operating officer Steve Sambol's confident assurances to investors in October that, "We view the third quarter of 2007 as an earnings trough, and anticipate that the company will be profitable in the fourth quarter and in 2008." Seen in this light, Countrywide's fourth-quarter loss, compared to a $621 million profit a year ago, is what the numerous class action attorneys circling Countrywide (CFC) will surely call "an unfavorable fact." Countywide finished 2007 with a loss of $704 million.

The numbers didn't appear to faze Bank of America CEO Ken Lewis's determination to acquire Countrywide, however. In a conference Tuesday, Bloomberg quoted him as telling investors. "Everything is a 'go' to complete this transaction.

Banks Compete For Capital

Here's a partial list of 6 month high yield CDs from Bankrate.Com.



click on chart for sharper image

Banks are competing for capital at unattractive rates. Countrywide is competing for capital at panic rates.

So where is the money? It's not in the US. Paulson has resorted to begging sovereign wealth funds to bail out capital impaired US banks.

Key Questions

• Is a massive sovereign wealth fund bailout of the US coming?
• When?
• How much is needed?
  
• At what price?
• Will it save the economy?

The answers to the first two questions are unknown. The answer to the third question goes up every day. The answer to the fourth question is: If there is a bailout, it will be at a very steep price. For proof, consider Cost of Capital "Ratchets Up" at Citigroup and Merrill.

For now, let's assume the bailout comes, on time, and as much as needed. The critical question then becomes "Will It Save The Economy?" The correct answer to that question is "How Can It?

Paulson and Bulls Clinging To Misguided Hopes of what sovereign wealth funds can do will have their hopes dashed yet again.

The party is over even though hope lingers on.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Paulson Dismisses Decoupling 'Myth'

We discussed the decoupling myth many months ago, but more recently in Global Decoupling Myth Shattered In Equity Selloff and Bulls Cling To Misguided Hopes.

Reality is finally sinking in elsewhere, including Treasury Secretary Paulson. Consider G-7 Growth Warning May Prompt Additional Rate Cuts, Lower Taxes.

Group of Seven officials, warning of further financial-market turmoil, indicated they'll be forced into more interest-rate cuts and tax reductions to shore up the global economy.

Bank of Canada Governor Mark Carney signaled he'll lower rates, and European Central Bank President Jean-Claude Trichet repeated that risks to Europe's expansion have increased.

"The current financial turmoil is serious and persisting," Paulson said. "I always thought that decoupling was a myth. What happens in any country, that's a major country, impacts what happens in the rest of the world."

Service industries in the euro region expanded at the slowest pace in more than four years in January, and business and consumer confidence retreated, reports last week showed. The risk of companies defaulting on high-risk, high-yield loans as measured by the benchmark Markit iTraxx LevX Senior Index rose to a record.

"We are observing an ongoing, significant market correction" and "unusually high uncertainty" is hurting growth prospects, Trichet told reporters after the G-7 meeting.

"If the situation worsens in the markets we'll see greater coordination," said Stephen Jen, chief currency strategist at Morgan Stanley in London. The slowdown isn't severe enough for them to "step on the gas" right now.

Japan Machinery Orders Down

Recoupling spreads to Japan as machinery orders are down, sparking fears over economy.

Japan's closely watched machinery orders fell for the first time in five years in 2007, official data showed Friday, sparking fears that a US slowdown may pull Asias largest economy down.

The private sectors core machinery orders, which exclude particularly volatile demand from power companies and for ships, fell 4.0 per cent in 2007 from the previous year, with orders in December alone tumbling 3.2 per cent.

The machinery orders are closely watched by policymakers and markets as a leading indicator of corporate capital spending. The December fall was significantly steeper than a drop of 0.8 per cent expected by the market and marked the second straight month of decline after a 2.8 per cent drop in November.

Is Japan Hiding Bad U.S. Debt?

The Telegraph is reporting Japan is the next sub-prime flashpoint.

There is still $300bn of bad debt out there, and Japan could be hiding most of it. Just as battered investors had begun to glimpse signs of recovery in America, the next shoe has dropped with an almighty thud in Japan. Echoes are rumbling across the Far East.

The Tokyo bourse has crumbled, suffering the worst start to the year since the Second World War. The Nikkei index is down 17 per cent since Christmas, and the shares of Japanese banks are leading the slide. Mizuho Financial, Mitsubishi UFJ and Sumitomo Mitsui have all been punished as hard or even harder than those US banks at the epicentre of the sub-prime debacle.

The nagging fear is that Japan's lenders - the conduit for the world's greatest stash of savings - have taken on a far bigger chunk of mortgage securities, collateralised loans obligations and other exotica from America's structured credit boom than they have yet revealed.

Americans and Europeans have so far confessed to $130bn of the estimated $400bn to $500bn of wealth that has vanished into the sub-prime hole. Somebody, somewhere, must be sitting on a vast nexus of undisclosed losses. We may find out soon enough whether the hold-outs are in Japan. The banks have to come clean under the country's strict new audit codes by the end of the tax year in March.

"We think this is where the next big problem is going to pop up," said Hans Redeker, currency chief at BNP Paribas.

"We know from Bank of Japan's lending survey that the banks are already tightening hard, so something is brewing. Right now, we are in the lull before the second storm in global markets, and Asia is going to be the source of the nasty surprises," he said.

The iTraxx Japan index measuring default risk of 50 Japanese companies saw its biggest one-day jump ever on Thursday to 77.5. Rightly or wrongly, it is flashing a serious distress signal.

What we know is that Japan's economy - still the second biggest in the world by far - has fallen over a cliff since October. It remains joined to America's hip after all. The decoupling theory has failed its first test.

Britain Facing Huge Job Losses

The Times Online is reporting Britain Facing Huge Job Losses.

TWO in every five employers plan redundancies over the next three months, according to an influential survey to be published tomorrow. It comes as two leading business groups warn of weak business confidence and a sharp slowdown in growth.

Retailers had been very downbeat about prospects for January following a poor December, with like-for-like sales rising only 0.3%. This week’s figures will come as a relief, but the BRC is likely to warn that any strength is likely to be temporary.

This will be the big fear if the warning of many redundancies from the Chartered Institute of Personnel and Development comes true. Its winter labour market outlook, also in conjunction with KPMG, is set to show that 38% of the more than 1,500 employers surveyed plan redundancies over the next three months, with a quarter intending to let go at least 10 employees.

Although it is normal for a proportion of employers to be planning redundancies, the latest figure is sharply up on the 17% number three months ago.

Global IT Forecast Cut

The Financial Times is reporting Global IT spending forecasts cut on recession fears.

Forecasts for global IT spending in 2008 have been cut, as fears of a recession in the US puts the brakes on growth.

Global spending on IT goods and services is expected to grow to just $1,695bn in 2008, a 6 per cent increase on last year, according to Forrester Research, the market research group. This represents a significant slowdown from 12 per cent growth last year.

Only two months ago, Forrester predicted IT spending would grow 9 per cent to $1,7580bn this year, but the group has pared this forecast back after a series of poor reports on the US economy.

IT spending growth in the US, which accounts for about a third of the global total, is expected to slow to 2.8 per cent, from 6.2 per cent growth last year.

Spending in Asia is expected to be about 9 per cent, the strongest region for growth, but still representing a slowdown from 15 per cent growth last year.

In Europe, IT spending growth will fall from 15 per cent last year to 5 per cent.

Bad news on the global economy has been pouring out for months. Paulson had no choice to dismiss it. Then again, the administration is still talking as if a recession that 70% of the population knows we are in can somehow be prevented.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Obama: The Next President Of The United States

Meet Barack Obama, the next president of the United States of America.

Unstoppable momentum is now a gale force wind propelling Barack Obama towards the Democratic nomination. That same wind is blowing stiffly in the face of Hillary Clinton and even more so (when it comes to the presidential election) John McCain.

Grass roots will carry the banner for the first time since McGovern in 1972. Barack Obama will win the Democratic nomination and go on to beat McCain in the presidential election of 2008.

The reason, believe it or not, is an attitude change about "walking away".

This might sound strange so let's start with a recap of what I said in Moral Obligations Of Walking Away.

National Referendum On Walking Away

Most don't realize it but there is currently a national referendum on walking away that is page one news every single day. I am talking about decision 2008, the presidential election.

Will we walk away from Iraq or not?

• A vote for John McCain is a vote for the status quo of wasting trillions more dollars and countless more lives in Iraq.
• A Vote for Obama is a vote for exiting that hellhole and having discussions with Iran.
• A vote for Hillary Clinton is a vote for wishy washiness, political expediency, and the same stubborn unwillingness to admit mistakes that we see in Bush.
  

For the record, I voted for none of the above in the primary. I voted for Ron Paul. But like it or not, barring some sort of miracle one of the above is going to win the presidency.

The moral obligations of walking away from Iraq

• Do we have a moral obligation to spend money in Iraq after we blew it to smithereens?
• Do we have a moral obligation to admit mistakes and stop wasting lives of soldiers?
• Do we have a moral obligation to repair the decaying infrastructure of the US instead of attempting to be the world's policeman?
• Do we have a moral obligation to the Citizens of the US to get out of the region, given that being in the region dramatically escalates the risk of terrorism against the US?
• Do we have a moral obligation to stop wasting billions of dollars in jet fuel flying needless missions all over the world when crude oil prices are so high?
  
• Is there a moral obligation to let Europe and Japan defend themselves rather than depending on US overseas bases and US taxpayer dollars to defend them?
• Is there a moral obligation for the US to walks away from Europe and Japan with so many suffering here?
  

Where people "draw the line" on walking away is going to play a major role in determining the next president of the United States.

Fortune Magazine interviewed me last week about "Walking Away" in regards to housing. As important as walking away is to the housing market, I told them to look ahead to what "Walking Away" from Iraq means politically and economically and that it would decide the next election. Two days later I found this.

Poll: Leaving Iraq will help economy

The public has decided (and they are correct) that It Is Time To Leave Iraq. What's really interesting is that leaving Iraq is the number one choice to help the economy. Let's take a look.

AP Poll: Stimulus Checks Welcome, but to Really Help the Economy US Should Leave Iraq.

The heck with Congress' big stimulus bill. The way to get the country out of recession — and most people think we're in one — is to get the country out of Iraq, according to an Associated Press-Ipsos poll.

Pulling out of the war ranked first among proposed remedies in the survey, followed by spending more on domestic programs, cutting taxes and, at the bottom end, giving rebates to poor people in hopes they'll spend the economy into recovery.

The $168 billion economic rescue package Congress rushed to approval this week includes rebates of $600 to $1,200 for most taxpayers, the hope being that they will spend the money and help revive ailing businesses. President Bush is expected to sign the measure next week. Poor wage-earners, as well as seniors and veterans who live almost entirely off Social Security and disability benefits, would get $300 checks.

However, just 19 percent of the people surveyed said they planned to go out and spend the money; 45 percent said they'd use it to pay bills. And nearly half said what the government really should do is get out of Iraq.

Forty-eight percent said a pullout would help fix the country's economic problems "a great deal," and an additional 20 percent said it would help at least somewhat. Some 43 percent said increasing government spending on health care, education and housing programs would help a great deal; 36 percent said cutting taxes.

"Let's stop paying for this war," said Hilda Sanchez, 44, of Waterford, Calif. "There are a lot of people who are struggling. We can use the money to pay for medical care and help people who were put out of their homes."

People Sick Of War For Economic Reasons

The public has finally had enough of this war, not because of the lack of progress, the constant bickering, or sadly to say even the needless killing. Rather the public has lost support for this war for economic reasons. And they are right on that score. Our defense budget is a national disgrace.

Please consider Bush's Proposed $3.1 Trillion Budget.

President Bush submitted a federal budget of $3.1 trillion on Monday, declaring that the spending plan would keep the United States safe and prosperous and, despite its record size, would adhere to his principle of letting Americans keep as much of their own money as possible.

“Thanks to the hard work of the American people and spending discipline in Washington, we are now on a path to balance the budget by 2012,” the president said in an introductory message.

We Can No Longer Afford To Be The World's Policeman

The public has decided the budget is preposterous. It is not only preposterous, Bush's statements are a blatant lie. You cannot balance the budget by spending more than you take in, year after year after year.

We are spending ourselves to death. That irresponsible spending is reflected in the sinking dollar and the rise of gold. All the needless military missions are reflected in the price of oil. The US military is the largest user of oil in the world. People have finally figured this out.

"The Pentagon’s proposed budget is $515.4 billion, an increase of 7.5 percent over this year, meaning that military spending would be the highest in inflation-adjusted terms since World War II."

Where were the fiscal conservatives? The only one you can find in either party is Ron Paul. I voted for Ron Paul in the primary. I am proud of that vote. It was a vote for honesty, dignity, smaller government, fiscal prudence, and a vote against mindless governmental meddling. Ron Paul is far and away the best candidate from either party, but it simply is not his day.

Military Spending



The above chart from GlobalIssues.Org

What Hath War Bought?

Let's reflect on what we have gotten for all of our military spending. Over $4 trillion dollars (yes, that's trillion) has been spent on defense over the past seven years could not even catch one man, Osama Bin Laden. We blew Iraq to smithereens and have noting to show for that but lost lives, less oil flowing now than before the war, and increased risk of terrorism. The kicker is we drove Iraq towards the Shia fundamentalists that are now ruling Iran.

The world was behind us after 911. They are not behind us now. We lost a golden opportunity to lead the way.

Lost in the wreckage of all this waste is the fact that our own CIA trained Bin Laden. It was probably the best training mission in the history of the CIA, a "job well done" for sure.

Finally! At long last, the public is deciding we cannot afford to be the world's policeman. It takes a long time to change attitudes but attitudes have clearly changed. Campaign 2008 is exactly about attitudes, especially arrogant attitudes.

The Great Divider

Bush ran on a campaign of being "The Great Uniter". Does anyone remember that? Even Republicans are distancing themselves from the arrogant attitude of Bush who has been as stubborn about everything as he has been wrong about everything.

Internally the US has not been more divided since the Vietnam War. However Bush was partially correct. One of his legacies will be that he will be the first president in history to single handedly unite most of the world against us.

Why Hillary Will Fail To Win The Nomination

• Hillary will fail because she is as stubborn as Bush.
• Hillary will fail because she is as arrogant as Bush.
• Hillary will fail because she cannot admit a mistake.
• Hillary will fail because she supported the war.
• Hillary will fail because she continues to lie about why she supported the war.
• Hillary will fail because people do not trust here to exit Iraq.
• Hillary will fail because she is an insider representing the status quo.
• Hillary will fail because she too is a divider.

Why Obama Will Be The Next President

• Obama is a uniter who will exit Iraq and talk with our enemies instead of attempting to bomb them into an attitude change.
  

The public is sick of this war for economic reasons. Polls show the single most important thing we can do economically is leave Iraq. That's all you need to know. There are plenty of reason to vote against Obama. I for one, will not like many of the programs he will support.

But there is one powerful reason to vote for him. That one reason is enough.

Obama is smart enough to understand you cannot bomb enemies into an attitude change and it is a waste of money to even try.

Can Super Delegates Save The Day For Hillary?

Please consider What role for Democratic 'super-delegates'?

It’s called the Democratic Party, but one aspect of the party’s nominating process is at odds with grass-roots democracy.

Voters don’t choose the 842 unpledged “super-delegates” who comprise nearly 40 percent of the number of delegates needed to clinch the Democratic nomination.

The category includes Democratic governors and members of Congress, former presidents Bill Clinton and Jimmy Carter, former vice president Al Gore, retired congressional leaders such as Dick Gephardt, and all Democratic National Committee members, some of whom are appointed by party chairman Howard Dean.

In early 1970’s, the party’s rules were reformed to open the process to grass-roots activists, women, and ethnic minorities. Sen. George McGovern, the leading anti-Vietnam war liberal, won the 1972 nomination. McGovern turned out to be a disaster as a presidential candidate, winning only one state and the District of Columbia.

So without reverting to the days of party bosses like Buckley, the Democrats decided to guarantee that elected officials would have a bigger voice in the nomination.

There were, Mayer says, two motives in giving elected officials a big voice in the nomination.

"One was not to get (ideologically) extreme candidates; the other was to avoid the Jimmy Carter phenomenon — where you had a guy who was not very experienced and not very well regarded by most of his fellow governors, but nevertheless managed to win the party’s nomination," Mayer said.

But “it is very difficult to argue” that the super-delegate system “has consequences, unintended or intended,” said Mayer.

The only year when they may have an impact was in 1984, he said. The loyalty of Democratic elected officials probably helped Walter Mondale survive an unexpectedly strong challenge from Sen. Gary Hart who had beaten Mondale in New Hampshire and other primaries.

“The super-delegates clearly gave him his majority and helped him wrap up the nomination earlier,” Mayer said.

“Do the super-delegates have the capacity to resist the choice of the overwhelming majority of primary voters and caucus participants? The answer, I think, is a clear ‘No,’” said Mayer.

Nevertheless, there’s a romantic streak in some political junkies who fantasize about a scenario in which the nomination could still be in doubt at the end of the primary season.

That hasn't happened in either party in 30 years.

Political Hacks and Warmongers Support Hillary

There is little doubt that political hacks and warmongers support Hillary. But as I said at the very beginning of this post: The groundswell of public support is wind at the back of Obama. So is momentum, and so is fund raising.

Obama has succeded where McGovern failed. Obama has united those sick of war for any reason with those convinced that leaving Iraq is the single most important thing economically we can do for the country. That is a powerful union!

In contrast, McCain has split the Republican party in pieces and his support for the war in Iraq has the country united against him.

Look back. McGovern, the last grass roots candidate, lost the election because the morality of the war and the hundreds of thousands dead simply were not as important as the economy. McGovern failed to unite a war-torn country around an economic cause.

McCain stands for more economic waste, more war, and more divisiveness. Hillary stands for more wishywashyness on Iraq and pompous arrogance elsewhere else. Hillary, like McCain are lightning rods. The country is sick of lighting rods.

Obama has managed to do what McCain and Hillary have not: Unite the country with a simple three word message conveying a positive attitude about change.

Yes We Can

The Huffington Post is writing Why "Yes We Can" Inspires.

This election is shaping up to be the first where technology will be both a medium and a message for the election. The last four years have seen technology and the web weave themselves into politics and allow regular people to produce and distribute content that would have been unimaginable just an election ago.

The Black Eyed Peas and Jesse Dylan (son of Bob) may not count as ordinary voters, but their new music video "Yes We Can" is a model for the types of things that people can do today in this first campaign of the information age that never would have been possible before.

The new video overlays Barack Obama's "Yes We Can" speech after the New Hampshire primary with music and accompaniment from stars like John Legend, Herbie Hancock, Common, Kareem Abdul Jabbar, Scarlett Johansson, Tatyana Ali and Nick Cannon. It's a perfect example of the types of content that never would have seen the light of day just four years ago-where could you have bought enough TV airtime to air a 4:30 television ad? How could you possibly have gotten enough nationwide exposure to make it possible?



Click Here To Play New Video

Click Here To Play "Yes We Can" Speech

"I'm blown away by how many people wanted to come and be a part of it in a short amount of time. It was all out of love and hope for change and really representing America and looking at the world," will.i.am told ABCNews on Friday.

The video, which just hit the web this weekend, has already begun to go viral in a big way. I've had friends send it to me on both Twitter and Facebook already and video views on YouTube are rising by the hour. Plus, who knows how many times the original video has been viewed on YesWeCanSong.com?

This video also speaks to another unique facet of "the First Campaign": Creativity moves people and thus votes. For decades, media consultants could be assured that their ads would be viewed on television because there weren't other options. Now with the rise of TiVos and DVRs, commercials are a button press away from disappearing and the traditional advertising roadblock doesn't work.

On the web, unless something makes you stop and say "That's fascinating" you won't pass it along to someone else. Going viral means creating great content and it should be instructive to all candidates that we're seeing the voters go the extra mile to help boost their candidate of choice -- as Howard Dean said four years ago, "You have the power to change this country," both through voting and creating viral content.

And it's in that final sentiment that one can see why the new "Yes We Can" song is so powerful. That simple theme of "We Can" perfectly sums up the hope of an insurgent campaign -- it's not a front-runner's slogan.

Politics should be all about doing the impossible. As Joe Trippi used to tell us on the Dean campaign, "You gotta believe!"

Destiny: Barack Obama will be the next president of the United States of America.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Love Affair With Credit Cards Is On The Rocks

The Discover U.S. Spending Monitor is Reporting Consumers Wary, Plan to Reduce Spending.

The Discover U.S. Spending Monitor recorded its third consecutive monthly decline in January, falling more than four points to 86.1 as economic concern continued to grow and post holiday spending intentions moderated.

Both the economic and spending components of the index reached new lows in January as just over 70 percent of consumers now think the economy is in decline and 48 percent feel the same way about their personal finances.

The number of people preparing to spend more next month fell to 30 percent, down a point from December and five points from October.

At the same time, consumers seem to be ratcheting down plans for spending in areas beyond necessities. Nearly half (49 percent) of the January sample said they expect to do less discretionary spending in February. That’s nearly 5 points higher than December and a full 10 points more than what consumers said last September. Discretionary spending was not the only area consumers were expecting to cut back. They also intend to spend less on household improvements, major personal purchases and savings.

For the first time, consumers making $75,000 or more showed a significant change in spending intentions. In December, for example, 14 percent of people making more than $75,000 a year said they intended to spend more on discretionary items like entertainment and travel. In January, that number dropped to just nine percent.

Nearly 60 percent of this income group said they would hold February spending on par with January. Last month that same sentiment was expressed by just under 45 percent.

The most dramatic shift in attitudes in January occurred among consumers with annual incomes of $75,000 or more. Their economic confidence sharply declined in January. Twenty-nine percent rated the economy as poor and only 8 percent rated it excellent. The January figures compare to 20 percent and 12 percent respectively for December.

Attitudes Lead The Way

The Wall Street Journal is reporting Credit-Card Pinch Leads Consumers To Rein In Spending.

America's love affair with credit cards may be headed for the rocks.

Credit-card delinquencies are rising across the nation, a sign that some Americans are at the end of their rope financially. And these mounting delinquencies, in turn, have prompted banks to tighten lending standards, keeping people who have maxed out their cards from finding new sources of credit.

The result could be a sharp pullback in consumer spending that would further weaken the slowing U.S. economy.

Such a pullback may already be taking shape. Yesterday, the Federal Reserve reported an abrupt slowdown in consumers' credit-card borrowings. In December, Americans had $944 billion in total revolving debt, most of it on credit cards, a seasonally adjusted annualized increase of 2.7%. That was off sharply from seasonally adjusted growth rates of 13.7% in November and 11.1% in October. And it reflects the volatility in consumers' spending habits as economic growth sputters.

Evidence is mounting that the plastic-fueled spending spree won't last. In December, an average of 7.6% of credit-card loans were either at least 60 days delinquent or had gone into default, up from 6.4% a year earlier, according to research firm RiskMetrics Group. The analysis includes a broad swath of more than $200 billion of credit-card loans that are sold off to investors by major card issuers like Citigroup Inc. (C), Capital One Financial Corp. (COF), American Express Co. (AXP) and J.P. Morgan Chase & Co (JPM).

After J.P. Morgan doubled the interest rate on her credit card to around 30% and lowered her credit limit in December, Jennifer Campion, a 39-year-old computer-software instructor in Chandler, Ariz., decided to eat out less often and to forgo her daily coffee at Starbucks so she can pay off her outstanding card balances.

"Our whole lifestyle has changed at this point because of this strict budget we're on," says Ms. Campion, who has a total of about $7,000 in credit-card debt.

Consumers Want Out Of Debt Trap

"Our whole lifestyle has changed at this point because of this strict budget we're on."

That statement says it all. And when they get out of debt, hopefully they will have learned a valuable lesson to not run those card balances back up again.

Zombie Debt

Newsday is reporting collectors come after debt you didn't know you had.

After Kim Mullen filed for bankruptcy in 1993, she cut up all her credit cards in her lawyer's office. Since then, the Levittown resident has managed to obtain a good credit rating.

But in December, a debt collector contacted her, saying she had an unpaid card balance of $5,655 from 1992. With interest, the letter claimed, the debt had grown to $19,400.

Many credit card companies have started selling delinquent accounts to collectors to boost quarterly earnings, according to a report by Kaulkin Ginsberg, a Rockville, Md.-based adviser on debt collection.

Bank of America Sucker Play

Bank of America (BAC) abruptly notified cardholders in good standing their rates would skyrocket if they didn't opt out fast. It's A Credit Card You Want to Toss.

Credit-card issuers have drawn fire for jacking up interest rates on cardholders who aren't behind on payments, but whose credit score has fallen for another reason. Now, some consumers complain, Bank of America (BAC) is hiking rates based on no apparent deterioration in their credit scores at all.

The major credit-card lender in mid-January sent letters notifying some responsible cardholders that it would more than double their rates to as high as 28%, without giving an explanation for the increase, according to copies of five letters obtained by BusinessWeek.

What's striking is how arbitrary the Bank of America rate increases appear, credit industry experts say. In recent years, many card companies have turned to a practice called "risk-based pricing," where they will raise a regular paying consumer's rate because of a decline in the person's FICO score.

But Bank of America appears to be taking an even more aggressive stance because, beyond credit scores, it is using internal criteria that aren't available to consumers. That makes the reason for the rate increase even more opaque. "Congress has faulted credit-card companies for lack of transparency in raising rates," says William Ryan, a financial industry analyst at Portales Partners, a New York-based research firm. "Bank of America is bringing it to a new level."

Analysts also say they are surprised by the magnitude of the rate raises Bank of America is imposing on affected cardholders. Michael Jordan, 25, a software developer who lives in Higganum, Conn., says he received a letter from Bank of America in late January advising him that his card rate would rise from 9.99% to 24.99%. The software developer, who earns $80,000 per year, says he was "shocked" because his payments had been on time and his credit score hadn't changed in the last year.

Bank of America is trying to get ahead of Amanda Pennington, 29, of Euless, Texas. She says the bank raised her credit limit three months ago from $5,000 to $8,000 because of her strong payment history. Then she got the letter from the bank in mid-January notifying that her rate would rise from 15.74% to 25.99%. When she called, she says, the bank told her it was raising her rate because her balance was now too high, though it was still under the higher new limit the bank had previously granted.

Adam Levin, CEO of Credit.com and former head of New Jersey's Division of Consumer Affairs, says he is surprised Bank of America would risk bad public relations with its rate increases, given the congressional hearings in December. The bank risks alienating new customers and existing ones by being so brazen, he says, adding, "Either Bank of America has more financial troubles than it is willing to admit or it has a level of institutional arrogance that is unacceptable."

What's Driving BAC's Decision?

Is Bank of America that desperate for cash or is it simply greedy? Perhaps it's a bit of both.

Just as mortgages were bundled up in packages and securitized, so is credit card debt. Who wants to hold that paper when defaults are rising? Capital impaired banks don't want that risk sitting on their balance sheets, nor does anyone else at existing prices.

To find buyers for the debt, lenders are jacking up interest rates and fees. But when they do this to perfectly good customers (suckers), especially suckers with good FICO scores and/or suckers for whom they recently upped credit lines, it smacks of arrogance. BAC will come to regret that arrogance.

While on the theme of sucker plays, be sure to Read the Fine Print On Credit Cards, and stay away from two cycle billing processors like Discover Card (DFS) if you carry a balance.

Better yet, stop being a sucker and don't carry a balance.

Tactics Guaranteed To backfire

• The sudden rate hike will throw some consumers so far behind the curve, they simply give up. In other words, defaults may soar on account of their actions.
• Some customers will find a better rate elsewhere.
  
• Some customers with multiple cards will stop using their Bank of America card.
  
• Some customers will vow to get out of the debt trap because of these rate hikes, and manage to do just that.
  
• Congress won't sit for these actions.

Under the Bush administration, lenders got everything they wanted and then some when the bankruptcy reform act of 2005 was rammed through a Republican Congress. The real purpose was not bankruptcy "reform" but to make people debt slaves forever. When the Republicans lose the White House in November (and there should be little doubt this is going to happen), there is going to be payback. The tactics of BAC and other lenders will be one of the reasons.

From the next Congress I look for proposed legislation to reduce fees, to restrict ability of lenders to change terms, to kill the Zombie debt industry, and possibly even impose rate caps. The industry will scream but their greed will have brought it upon themselves.

Attitudes on debt are already changing. And actions by Bank of America and other companies are hastening those attitude changes. Thank you Bank of America, for screwing yourself. You deserve it.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Will "Walk Aways" Increase Discretionary Spending?

I received an interesting email from "PR", a Senior Equity Analyst in Retailers for a major firm that I agreed not to disclose. Here's an interesting take about "walking away", and how that might affect discretionary spending. Here goes from "PR"...

Hi Mike

I am fascinated with your take on walking away from debt.

Some background. I live in the far west ex-burbs of Chicago (Yorkville), and we are starting to see what you have been talking about for some time. The first house in our subdivision was foreclosed about 9 months ago. That wasn’t a walk away; that was a get out notice from the sheriff. A few months later, there was another house that had a for sale in the front lawn, and the owner moved out a few weeks later. Another house went on the market one day and the owner loaded up a U-haul the next and drove away at 4am. And since September, we have seen six more homes that are “for sale” but the owner is long gone. Interestingly, all three homeowners used those Pods trailers instead of a movers or U-haul. Note: our subdivision is about 4 years old and has about 110 homes.

After reading your work, I began to examine the attitudes of my neighborhood. The first foreclosure was one of those borderline families you often write about. They were in over their heads and couldn’t afford the house they were living in. Most likely mortgage reset. In any event, the scuttlebutt around the neighborhood was one of scorn, shame, and embarrassment. No thought was given to the negative impact to the value of all our homes in this subdivision. With each subsequent “pre-foreclosure,” people’s attitudes softened about their ex-neighbors. Gone was the Scarlet F; it was replaced with empathy, understanding, and even compassion. Maybe the attitudes have changed because people now realize that the value of their homes have fallen off a cliff. They don’t have time to shame their ex-neighbors when they are worrying about their wealth is being vaporized or a $400 natural gas bill or car payment or the kids or whatever.

Now, I understand that this is one neighborhood in one small town in the Midwest. I also know this is anecdotal evidence. But as I have learned covering retail stocks for so many years: I trust my eyes and common sense and ignore people with a vested interest in the outcome of a situation. My eyes and common sense tell me that times are changing. It has become more socially acceptable to walk away from your house. If one of my neighbors walked away today, most of the remaining neighbors would shrug their shoulders, say that’s too bad and move on. I will be looking for the next phase of this shift in attitude, when remaining homeowners think or say I wish that was me moving—getting out from this 3,000 square foot rock that has ruined me financially.

As an aside, I think this shift in behavior could be bullish for retailers. Those foreclosures and walk-aways are freeing up a lot of discretionary income. It makes a lot sense to walk away from your underwater house. Take a family of four with a $2000 mortgage with another $7500 in taxes. That’s a pretty standard profile out here. Move out of the house and rent a 3 bedroom town home for $1400. That frees up $900/ month in cash flow. At this point, attitudes haven’t changed enough to discourage discretionary spending when people have the money to spend. But that is another discussion.

Thanks for the insight and keep up the great work Mike.

Thanks "PR" for an interesting neighborhood perspective about changing attitudes in suburbia. Now what about the idea that this process will "free up discretionary spending"?

I don't think so. Some who lost their houses may be looking to save up for another one. Others who lost their houses might have done so because they lost their jobs. In that case, making the rent payment will be hard enough. And finally, I believe still most of them will have learned something from the debt trap and vow "never again".

A secular peak in credit lend and consumer spending has been reached. The attitude shift in just the past six months has been amazing. But the change has only just begun! We are still in the realization phase: realization that home prices are not coming back.

For everyone who has walked away, there must be 500 thinking about it. Those still thinking about it are not going on a spending spree anytime soon, unless of course it is also in preparation of walking away from their credit card debt as well.

Finally, unemployment is set to skyrocket as the boom in commercial real estate comes to an end.

Consumers, Credit, and Complications

John Mauldin had an interesting take on unemployment in Consumers, Credit, and Complications.

Last week jobless claims rose almost 20%, to 378,000. This week they came in at 356,000. These last two weeks represent a marked increase in initial unemployment claims but, as many bulls point out, that number is nowhere near the levels that would indicate a recession.

The problem is, if we're in recession we should be seeing a higher initial unemployment claims number. The "we are not in a recession camp" is absolutely correct about that. And yes, we've seen a marked rise in continuing claims the last two weeks, but not as high as one would think to be the case if we were in a recession. Yet continuing claims are up by 10%, which based on the past would suggest we are in a recession. So why the seeming disconnect?

An answer comes from David Rosenberg, the North American economist for Merrill Lynch, who points out that jobless claims number may be suspect. Let's look at what he says in his recent analysis:

"First, the jobless claims are being distorted right now because the seasonal factors are looking for retail sector layoffs in January but these layoffs are not happening because there was no hiring in November and December. So the seasonal factors are depressing the claims data to the downside right now - look for them to hook up in coming weeks. But anyone putting their faith in claims in January given all the early-year distortions ... good luck. No mention made, by the way, that the backlog of continuing claims has spiked up 10% over the past year and the last time that happened, well, was in late December 2000 - the recession began the very next quarter.

"Second, the focus on payrolls at this stage of the cycle is fraught with risk. In 90% of the business cycle, the payroll survey is the one to focus on, given its lack of volatility and huge sample size. But the 10% of the time when the payroll survey does not work well is at turning points in the business cycle. Why? Because being a poll of companies, what the payroll number misses are the self-employed and there are more than 10 million of them.



click on chart for sharper image

"So the bottom line is that what the payroll data have missed is the fact that over the past six months, 520,000 self-employed individuals have fallen by the wayside (more than were lost in the entire 2001 recession).

This may also be why it is that claims are suppressed - having never paid into the unemployment insurance program, these people are not necessarily entitled to any benefits. The population- and payroll-concept adjusted data show that employment fell 400,000 in November-December combined (because Thanksgiving landed so late in 2007, both months have to be looked at together, whether it be for jobs or retail sales). So we think the view that job growth is hanging in is, just in plain simple language, wrong."

Look for unemployment to rise to 6% (or more) in the coming quarters. This will of course put a damper on consumer spending.

Any increase in discretionary spending coming from those walking away (if indeed any at all) will pale in comparison to those who lost their jobs, those who still have a job but whose commissions have fallen off the cliff, those who are about to lose their job and are very afraid, and those who are OK but whose attitude toward spending has changed or is about to. For all these reasons, Fiscal "Stimulus" Doomed To Fail.

The service economy is now in reverse. Retailers have no choice but to cut employment. Look for this trend to pick up steam as things feed on themselves. Retail spending, especially discretionary spending, has only one way to go and that way is down, and down big time.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Borrowed Reserves And Tin-Foil Hats

Many people have been asking me about Caroline Baum's recent article How Non-Borrowed Reserves Became a Sexy Subject. Let's take a look at the highlights.

....
What's caused the hullabaloo recently is the dive in non-borrowed reserves from $44 billion in early December to minus $8.8 billion at the end of January.

It isn't a mystery what happened. The Fed announced the creation of a Term Auction Facility on Dec. 12, enabling banks to borrow for 28 days versus a wide range of collateral. The minimum bid the Fed accepts is the expected funds rate one month out, which in the current environment means cheaper funding costs than the fed funds market.

So what would you do if you were a bank?

Lower Cost Loans made through the TAF are categorized as borrowed reserves. The Fed had $50 billion of loans in place at the end of January, which "caused the borrowed reserves figure to balloon and the non-borrowed figure to decline by a corresponding amount,'' said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, in a Feb. 6 commentary.

All of a sudden, people who never glanced at the Fed's H.3 statistical release are now experts on "Aggregate Reserves of Depository Institutions and the Monetary Base.'' Their e-mails have the same sense of foreboding as the missives put out by the Black Helicopter/Tin-Foil Hat crowd.

....

[The Tin-Foil Hat crowd] is overlooking the fact that the Fed is "a monopoly provider of reserves," said Jim Glassman, senior U.S. economist at JPMorgan Chase & Co.

"There is no such thing as a banking system short of reserves. The Fed has absolute control over the supply."

There may be times, such as late last year, when banks are reluctant to lend to one another for a period longer than overnight. "And any one bank can have a problem'' funding itself, Glassman said. But in a world where "the Fed can print money, there is no shortage," he said. "The banks get the reserves they want." ....

Glassman is flat out wrong.

There is indeed such a thing as a banking system being short of reserves. In addition, the Fed does not have absolute control over supply of reserves. Let's start with a discussion of how the TAF works and work our way to the correct conclusions.

Banks participating in the Term Auction Facility (TAF) have to put up collateral for the amounts they borrow.

Term Auction Facility

Under the term auction facility (TAF), the Federal Reserve will auction term funds to depository institutions. All depository institutions that are eligible to borrow under the primary credit program will be eligible to participate in TAF auctions. All advances must be fully collateralized.

Discount Window Collateral

The Federal Reserve Banks accept a broad range of assets as discount window collateral. Discount window loans must be collateralized to the satisfaction of the local Reserve Bank. [Click here for more about Pledging Collateral.]

The Reserve Banks will consider accepting as discount window collateral any assets that meet regulatory standards for sound asset quality. A listing of the most commonly pledged asset types can be found by clicking on the Collateral Margins Table on this site. Depository institutions should direct questions regarding specific assets to local Reserve Bank staff.

Clearly, the Fed does not hand out reserves willy-nilly. It lends them, but only if banks have sufficient collateral. Furthermore lending is not "printing". Thus Glassman, the senior U.S. economist at JPMorgan Chase & Co. really needs an education here.

Still more education is required. The Fed does not have "control" over supply of reserves because it does not have control over assets held and loans made by member banks. If Glassman's thinking is representative of bank thinking in general, it's no wonder banks balance sheets are so $#@%'d up.

A shortage of reserves comes into play when banks no longer have sufficient collateral to exchange for temporary reserves. Banks that do not have sufficient collateral, do not get loans from the discount window or the TAF. Period. End of Story. The Fed does NOT simply "print money" and hand it out to capital impaired banks. Bankruptcies result.

Reserves At Citigroup

If Citigroup could have borrowed reserves from the Fed at 3-4% wouldn't it had done so instead of raising $7.5 billion from Abu Dhabi at an interest rates of 11%? See Petrodollars Return Home and Abu Dhabi Deal Raises Questions About Citigroup's Health for more on Abu Dhabi.

Citigroup went back to the well a second time under even more onerous terms as discussed in Cost of Capital "Ratchets Up" at Citigroup and Merrill.

Dozens Of Banks Will Fail

Reuters is reporting Dozens of U.S. banks will fail by 2010.

Dozens of U.S. banks will fail in the next two years as losses from soured loans mount and regulators crack down on lenders that take too much risk, especially in real estate and construction, an analyst said.

The surge would follow a placid 3-1/2 year period in which just four banks collapsed, all in the last year, RBC Capital Markets analyst Gerard Cassidy said in a Friday interview.

Between 50 and 150 U.S. banks -- as many as one in 57 -- could fail by early 2010, mostly those with no more than a couple of billion dollars of assets, Cassidy said. That rate of failure would be the highest in at least 15 years, or since the winding down of the savings-and-loan debacle.

"The initial round of failures will come from smaller banks with limited access to capital and overexposure to commercial real estate," Cassidy said.

Analyst Tanya Azarchs expects the pain to spread to regional banks, and especially "some of the smaller players that have yet to feel the full extent" of the credit crunch.

Cassidy said: "The regulatory focus is now acutely on commercial real estate. The problems are centered around construction loans in residential housing. Home prices and sales are declining. This leaves builders unable to carry the debt they took on because they can't sell their homes."

A top U.S. bank regulator, Comptroller of the Currency John Dugan, said on Thursday that his office was prepared to intervene if banks with large real estate exposure maintained unreasonably low reserves for bad loans.

Remarks By Dugan

Remarks by John C. Dugan Comptroller of the Currency January 31, 2008

Over a third of the nation’s community banks have commercial real estate concentrations exceeding 300 percent of their capital, and almost 30 percent have construction and development loans exceeding 100 percent of capital. Here in Florida, as in other states where housing is so important to local economic growth, the concentration levels are more pronounced. Over 60 percent of Florida banks have CRE loans exceeding 300 percent of capital, and more than half have C&D loans exceeding 100 percent of capital.

We’re now entering a stage of the CRE credit cycle where problems have started to surface and losses have started to increase – which is the second inescapable fact I mentioned at the outset.

In terms of asset quality, our horizontal reviews have indeed confirmed a significant increase in the number of problem residential construction and development loans in community banks across the country.

Given these circumstances, what do we see as the consequences in the coming months? Not surprisingly, there will be more frequent interaction between supervisors and banks with concentrations in CRE loans that are declining in quality. There will be more criticized assets; increases to loan loss reserves; and more problem banks. And yes, there will be an increase in bank failures.

I want to emphasize today, as we see the clear signs of CRE credit quality declining, that we will expect banks with CRE concentrations to make realistic assessments of their portfolio based on current, changed market conditions. That may require you to obtain new appraisals. For those of you in stressed markets, it will almost certainly require you to downgrade more of your assets, increase loan loss provisions, and reassess the adequacy of bank capital.

I firmly believe that in this environment, increases in loan loss reserves for many banks are both warranted and prudent. I would be extremely surprised if your auditors disagreed with this position – but if they do with respect to a national bank, I urge you to contact your examiner-in-charge or Assistant Deputy Comptroller. If we have to intervene in this situation, we will not hesitate to do so.

Read this again and again until it sinks in:

Over a third of the nation’s community banks have commercial real estate concentrations exceeding 300 percent of their capital, and almost 30 percent have construction and development loans exceeding 100 percent of capital.

There will be more criticized assets; increases to loan loss reserves; and more problem banks. And yes, there will be an increase in bank failures.

Why Will Banks Fail?

• Banks will fail because they do not have sufficient reserves.
• Banks cannot borrow those reserves because they do not have sufficient collateral.
• The Fed's collateral requirements do not permit printing money and handing that money over to failing banks.
  
• The Fed will not change those requirements and start printing money because of the "checkmate" scenario discussed below.
  

Does the Fed care about borrowed reserves?

Here's a statement that caught my eye from Baum's article made by one of my favorite economists, Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago.

"There is no relationship between non-borrowed reserves and anything the Fed cares about, be it inflation, employment or real GDP."

On this point, I believe Kasriel is correct. However, the Fed has not been concerned about many things that history proves they should have been concerned about: housing, lending standards, derivatives, ARMs, and asset bubbles for starters.

Here's the deal. Bank reserves are net borrowed. This comes at a time when commercial real estate is about to plunge and bank balance sheets are loaded to the gills with them.

This also comes at a time when social attitudes towards debt are going to impair Bernanke's ability to inflate. For more on social attitudes, please see 60 Minutes Legitimizes Walking Away, Changing Social Attitudes About Debt, and a Crash Course For Bernanke.

Finally, banks will not be going deeper to the "TAF well" as long as the rules state "All advances must be fully collateralized." Once collateral runs out, it's the end of the line.

If the Fed is not concerned about this situation, they soon will be.

Of course there are those who believe the Fed will break the rules and eliminate all collateral requirements. So far anyway, they have not done so. Let's assume however, when push comes to shove, the Fed acting under duress does just what Glassman says, and provides permanent capital for free.

The Checkmate Scenario

Stop and think what massive printing would do to the US dollar and long term interest rates. It's called Checkmate. And that is why the Fed would not do what Glassman suggests, even if they could. The market won't allow it!

Let's review Weak U.S. Dollar May Be 'Checkmate' for the Fed: Caroline Baum.

"It's check for the economy now; it's facing checkmate," says Paul Kasriel, director of economic research at the Northern Trust Corp. in Chicago.

"Checkmate is the dollar. Bernanke's problem is that if he cuts, the dollar will go down even more. He may not be able to provide as much support for the economy as his predecessor."

.....

Credit events are deflationary by nature. Simply put, when lenders sustain large losses, they can't extend credit.

Caroline, you had it correct the first time! "Simply put, when lenders sustain large losses, they can't extend credit."

And by substituting the word "print" for "cut", Kasriel has it correct as well. Cutting interest rates is one thing, physical printing of dollars is another.

An Interview With Kasriel

For more on the checkmate scenario, please consider an Interview with Paul Kasriel.

Kasriel:

U.S. banks currently hold record amounts of mortgage-related assets on their books. If the housing market were to go into a deep recession resulting in massive mortgage defaults, the U.S. banking system could sustain huge losses similar to what the Japanese banks experienced in the 1990s. If this were to occur, the Fed could cut interest rates to zero but it would have little positive effect on economic activity or inflation.

Short of the Fed depositing newly-created money directly into private sector accounts, I suspect that a deflation would occur under these circumstances. Again, crippled banking systems tend to bring on deflations. And crippled banking systems seem to result from the bursting of asset bubbles because of the sharp decline in the value of the collateral backing bank loans.

Mish: So when does it all end?

Kasriel:

That is extremely difficult to project. If the current housing recession were to turn into a housing depression, leading to massive mortgage defaults, it could end. Alternatively, if there were a run on the dollar in the foreign exchange market, price inflation could spike up and the Fed would have no choice but to raise interest rates aggressively. Given the record leverage in the U.S. economy, the rise in interest rates would prompt large scale bankruptcies. These are the two "checkmate" scenarios that come to mind.

Who's Wearing The Tin-Foil Hats?

Few have been better at correctly calling out the Tin-Foil hats over the years as Caroline Baum. I am a Baum fan. I recommend her book "Just What I said". You can find it on my recommended reading list on the left. I did a review in Bookmobile: Master Traders & Just what I said.

In this case however, it is Jim Glassman, senior U.S. economist at JPMorgan (and anyone else who believes reserves will be printed into existence) who are wearing the Tin-Foil hats.

Things That "Can't" Happen will happen. And those with misguided faith in the Fed's ability and willingness to print reserves are in for a rude awakening.

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