Not Your Father's Deflation: Rebuttal

Peter Schiff argues it's Not Your Father's Deflation.

Among those rational enough to perceive the looming economic downturn, a heated debate has arisen that centers on whether the slowdown will be accompanied by inflation or deflation.

Those in the deflation camp believe that money supply will collapse as a natural consequence of the implosion of the biggest credit bubble in U.S. history. As loans go bad, assets, which collateralize these loans, will be sold at fire sale prices to satisfy creditors. It is also argued that a recession will reduce consumer discretionary spending, causing retailers to slash prices to move their bloated inventories. This is the way the situation played out in the 1930's and this is how many expect it to happen today.

My Comment: Indeed that is part of the debate but by no means all of it. Schiff misses many deflation arguments in that simplistic analysis. We will get to them momentarily.

There are several key differences between then and now, which argue against the classic deflationary scenario. In particular, the Fed's ability to pump liquidity into the market in the 1930's was limited by the gold backing requirements on U.S. currency. No such limitations exist today. This distinction is critical. When credit was destroyed after the Crash of 1929, the Fed was not able to simply replace it out of thin air. Today however, the Fed will likely print as much money as necessary to prevent nominal prices from collapsing. In fact, in the infamous speech that spawned his "helicopter" sobriquet, Ben Bernanke explained how the printing press can be used to stop deflation dead in its tracks.

My Comment: Schiff makes a false assumption that the Fed can replace credit out of thin air. The Fed is simply not in control of credit at all. The Fed can encourage borrowing but it cannot force it. The second failure by Schiff pertains to monetary printing. There are constraints on the Fed that he ignores. For example the Fed cannot simultaneously target both money supply and interest rates. Should the Fed pursue a massive printing campaign, interest rates will rise. Think of the consequences for housing and commercial real estate. Schiff ignores the consequences of interest rates on existing debt, much of which is variable rate. Furthermore, think about what rising rates would do to future expansion plans of businesses.

To fully understand the way inflation and deflation affect prices, we need to differentiate between assets, such as stocks and real estate, and consumer goods, such as shoes and potato chips. If we measure prices in gold, as we did during the 1930's, both asset and consumer goods prices will fall, with the former falling faster than the latter. So in that sense the deflationist are correct. However, in terms of today's paper dollars, this outcome is completely impossible. During deflation, money gains value, so prices naturally fall as fewer monetary units are required to buy a given quantity of goods. In the coming deflation, real money (gold) will gain considerable value, so prices will therefore fall sharply in gold terms. Paper dollars however, which have no intrinsic value at all, will lose value, not only as the Fed increases their supply, but as global demand for the currency implodes.

My Comment: While it makes sense that the demand for currencies other than gold fall, it is important to understand that it is not just the US dollar we are talking about. There is no major country on the gold standard so it is relative demand between other competing currencies that will determine how fast they fall in relation to gold.

In addition, we no longer have a US or even a Western world economy. Global wage arbitrage puts enormous downward pressure on wages. That pressure will not go away no matter what the Fed does.

Regardless of what anyone thinks, prices can only rise to the extent that people can afford to pay for goods and services or that banks are willing to extend credit. Without a driver for jobs, and with downward pressure on wages for the jobs we do have, prices will be constrained. If somehow prices rise above people's ability or willingness to pay for them, there will be not be buyers. Look one step ahead: Think of the consequences for jobs if people stop spending because they cannot afford to pay for things. Take still one more step: What does that do to the existing pile of consumer debt? Schiff fails to look ahead at what he is proposing.

The way I see it there are only two possible scenarios. The more benign outcome would we be one where asset prices fall, even in terms of paper dollars, but consumer goods prices continue to rise. This would be the stagflation scenario.

The more catastrophic scenario is one where asset prices hold steady or even resume their ascent, while consumer goods prices rise even faster. This of course is the hyper-inflation scenario, and is the worst possible outcome. I see no possible scenario where consumer goods prices fall in term of paper dollars.

My Comment: Schiff sees only two possibilities because he ignores a half dozen variables as well as downstream consequences of those variables.

• Banks are unwilling to lend
• Consumers and businesses are unwilling to borrow
• Consumers stop buying goods they cannot afford
  
• The Fed attempts to print but rising interest rates put an end to it
• Global wage arbitrage
• Jobs

I will add to the list in the recap at the end but for now let's continue with more of what Schiff has to say.

Many mistakenly believe that when the U.S. economy falls into recession, reduced domestic demand will lead to falling consumer prices. However, what is often overlooked is the fact that as the dollar loses value, the rising relative values of foreign currencies will increase consumer demand abroad. As fewer foreign-made products are imported and more domestic-made products are exported, the result will be far fewer products available for Americans to consume. So even if the domestic money supply were to contract, the supply of goods for sale would contract even faster. Shrinking supply will be a major factor in pushing consumer prices higher in America.

My comment: Once again Schiff is making an assumption. That assumption is the US dollar drops. It is a dangerous place to be when 90% think a certain something will happen. I suggest anti-dollar sentiment is indeed that bad even though the Euro is massively overvalued vs. the US dollar as is the British Pound. The fundamentals in the UK and EU are as bad as in the US and the property bubbles just as big. As an aside I do expect the dollar to sink vs. the Yen.

Even ignoring currency issues, Schiff is making another huge assumption about the of supply of goods. Take away the US market for goods and China and Japan have massive overcapacity. Without exports to the US and Europe, China would crash. This situation might change 10 or so years down the road, but export economies are not remotely close to being able to ignore the US consumer, at least not now or anytime soon.

Let's now turn our focus to stagflation. When someone says stagflation I am not sure what they really mean. It's important to have definitions so I will repeat mine. Inflation is the expansion of money and credit. Deflation is the contraction of money and credit. Stagflation does not really fit in to the discussion per se. By context though, it seems as if Schiff is talking about prices. For more discussion on the definition of inflation and deflation please see Inflation: What the heck is it?

I concede the prices of imported goods can rise as Schiff suggests and one of the ways is by tariffs. However, remember what Smoot-Hawley did to the great depression: Tariffs forced import prices higher, killed trade, and worsening the Great Depression. Was that "stagflationary" or "depressionary"?

There are other ways prices can rise and one of them is the effect of peak oil. Peak oil in and of itself simply does not belong in the inflation/deflation debate at all.

Schiff continues:

In addition, since trillions of dollars now reside with our foreign creditors, even if many of these dollars are lost due to defaulted loans, those that are not will be used to buy up American consumer goods and assets. As a result of this huge influx of foreign-held dollars, the domestic dollar supply will likely rise even if the Fed were to allow the global supply of dollars to contract, forcing consumer prices even higher. In fact, a contraction in the domestic supply of consumer goods will likely coincide with an expansion of the domestic supply of money. The result will be much higher consumer prices despite the recession. So even though Americans will consume much less, they will pay much more for the privilege.

My Comment: once again Schiff ignores wages, jobs and the ability of people to pay for massively rising prices. Furthermore, any influx of foreign dollars will likely be in the form of convertible deals like that we have seen between Bank of America (BAC) and Countrywide (CFC), Citigroup (C) and Abu Dhabi and Morgan Stanley (MS) and China Investment Corp. Those deals all involved shareholder dilution, none of them did a thing for US jobs or wages, and none of them is going to force any prices higher on anything, especially consumer goods that Schiff is talking about.

The real risk of course is that the Fed gets more aggressive as it realizes that the additional credit it is supplying is not flowing where it wants. If the Fed drops enough money from helicopters it will eventually reverse the nominal declines in asset prices.

Unfortunately, that road leads to hyper-inflation and disaster. No matter what, even if the Fed succeeds in propping up nominal asset prices, they can do nothing to sustain their real values. Consumer goods prices will always rise faster, leaving the owners of those assets poorer no matter how high their nominal values climb.

My Comment: This is where Schiff goes off the deep end. There is no risk of the Fed "dropping money out of helicopters". Schiff ignores the fact that the Fed is a private business. The Fed is no more apt to give money away than Pizza Hut is apt to give away free pizzas for a year to all comers.

At best, the Fed can provide liquidity. Yes, the Fed will do everything it can under the sun to get consumers to borrow and banks to lend. However, in the end the Fed cannot force either.

Ultimately the Fed will be constrained by ZIRP (Zero Interest Rate Policy), just as Japan was. Given massive overcapacity in housing, commercial real estate, restaurants, nails salons, etc there is simply no reason for businesses to want to expand business. Nor is there any reason for banks to be willing to extend credit to all but the most credit worthy borrowers. Rising defaults may even impair capacity to the point many banks are unwilling or unable to lend at all. The only reason expansion got as carried away as it did is the psychology at the time suggested residential and commercial property would forever rise. That psychology changed. More on psychology in a bit as it is a key factor.

Liquidity from the Fed is in reality nothing more than a loan. Liquidity is not the same as free money and the Fed will not be giving away the latter. Furthermore, liquidity is a coward. In the face of rising defaults spreading to commercial real estate, home equity loans, and even credit cards, the Fed's attempts to add liquidity will go straight down the drain.

Things ignored by Schiff

• The Fed is a private business unable to give away money
  
• The Fed would not give away money even if it could. Ultimately it would destroy their own wealth and power.
  
• The Fed can provide liquidity (loans) but not capital (money). However, liquidity is a coward in the face of rising defaults.
  
• The Fed can encourage but not force banks to lend or consumers of businesses to borrow.
  
• The Fed can at most control either interest rates or monetary printing.
  
• A massive printing campaign that actually found its way into the market would cause interest rates to rise, further putting deflationary pressures on both residential and commercial real estate.
• There is rampant overcapacity in housing, commercial real estate, and autos, so there is no reason for businesses to expand.
  
• Global wage arbitrage is an enormously deflationary force.
  
• The Fed cannot create jobs or force wages higher.
• Even if the Fed found some back ended way to give money to banks, and they actually carried that plan out (both are doubtful) it would not help cash strapped consumers pay back loans.
  

Starting with one faulty assumption that lack of a gold standard changes things, Schiff ignores 10 major things that remain the same. Here is a bonus 11th: velocity. Let's discuss velocity through the eyes of Japan:

Some argue that Japan never went through deflation. One basis for that argument is that "money supply" as measured by M1 never contracted over a sustained period. The other argument is that prices as measured by the CPI never fell much. Once again we have a flawed argument about consumer prices and a flawed argument that only looks at money and not credit.

Although Japan was rapidly printing money, a destruction of credit was happening at a far greater pace. There was an overall contraction of credit in Japan for close to 5 consecutive years. Property values plunged for 18 consecutive years. The stock market plunged from 40,000 to 7,000. Cash was hoarded and the velocity of money collapsed. Those are classic symptoms of deflation that a proper definition incorporating both money supply and credit would readily catch. Those looking at consumer prices or monetary injections by the bank of Japan were far off the mark.

In the end, one factor alone is going to seal the fate. That factor is called the psychology of deflation. Simply put, the Fed cannot force consumers or businesses to borrow or banks to lend.

The lesson from Japan should be crystal clear on this. If Schiff's argument held any water, Japan would not have been in deflation for 18 years. An argument that the US is not Japan is a red herring. Schiff's thesis is that lack of a gold standard somehow prevents deflation. That thesis has already been blown out of the water.

Finally, the massive consumer debt overhang in the face of global wage arbitrage and rising unemployment increases, not decreases, deflationary pressures in the US. If one is looking for differences, there is no internet boom to look forward to provide jobs and cushion the deflation blow as happened in Japan. Another difference is the savings rate. Japan had savings to draw from. The US does not. Once again this increases deflationary pressures in the US. Debt is deflationary when it hits the point it can no longer be serviced.

A careful examination shows there was only superficial analysis made by Peter Schiff when he argued It's not your father's deflation. The housing boom has gone bust. A commercial real estate bust follows. Consumer psychology and bank attitudes towards risk taking are changing slowly but surely. The rate of change will pick up rapidly once unemployment starts to rise.

In the final analysis, deflation is all about risk taking and psychology (the ability and willingness of consumers to borrow and the ability and willingness of banks to lend) not about the gold standard.

Addendum: For continued discussion please see Peter Schiff Replies to Deflation Rebuttal.

Addendum #2:

Is the Fed a Private Institution?

I need to make a clarification to one thing I have said above in referring to the Fed as a private institution. My statement was incorrect.

See Who owns the Federal Reserve? for this clarification: "The Federal Reserve System is not "owned" by anyone and is not a private, profit-making institution. Instead, it is an independent entity within the government, having both public purposes and private aspects."

That statement does not materially change arguments presented above or elsewhere about the powers of the Fed.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Weekend Fun with Sallie Mae and Countrywide CEOs

For some weekend fun please consider point 2 of last Wednesday's Five Things Sallie Mae CEO Just Wants to "Get the F*ck Outta Here!"

Sallie Mae CEO Just Wants to "Get the F*ck Outta Here!"

Seriously. He does. But we'll get to that in a moment.

• First, Sallie Mae (SLM) CEO Albert Lord told investors in a pretty defensive conference call that an increase in borrowing costs would hurt the company's profit growth.
• Lord said that as a result of the failure of the $25.3 billion J.C. Flowers deal to go through, the company will need to raise capital despite the higher cost.
• That's about all he said.
• The call was otherwise an exercise in futility.
• In one particularly hostile exchange, Lord said he "didn't know" the answer to the question what SLM stock is worth.
  "We're trying to put together projections together here, Al," one questioner said. "We're trying to figure out what your stock is going to be worth and you've got to give us some guidance."
  "You should give Steve [McGarry, Managing Director of Investor Relations] a call," Lord said.
  "But you're the CEO," the questioner objected.
  "That's right. I'm the CEO," Lord replied. "Next question."
  
• Let's cut to the chase. We're no public relations expert, but here's a tip: It's probably not a good idea to close out a particularly testy investor call by saying, "Steve, let's go, there's no questions, let's get the f*ck outta here."
• But hey, that's just us.
• Check it out at the 26:40 mark via the mp3 file here.

It looks like Sallie Mae is more than a little testy over the fact that the deal between Sallie Mae and J.C. Flowers collapsed. But this is an amazing first conference call for a new CEO.

Countrywide CEO with Hoofy and Boo



Click here for some practical advice for Angelo Mozilo CEO of Countrywide.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Merger and Takeover Activity Chills

Before we get to mergers and takeovers, let's take a quick look at autos. I will tie the two together shortly.

According to Standard & Poor's Ratings Services

automobile sales look set to decline in the world's three largest established markets -- the US, Europe, and Japan -- in 2008, further squeezing global car makers' margins, but said the booming BRIC nations -- Brazil, Russia, India, and China -- hold some hope for growth.

S&P expects North American industry sales to decline to the lowest level in 10 years in the uncertain economic environment, and said the severe downturn in the commercial-vehicle market shows no sign of easing.

However, the BRIC nations, which represent 20 pct of global car sales, are predicted to increase strongly by more than 10 pct per year over the medium term, S&P said.

Yet, even if demand is robust, profitability in China has already sunk to world average levels due to fierce competition, overcapacity, and market fragmentation. It therefore cannot offset the effect of persisting negative industry trends in established markets, S&P said.

Looking ahead to future job growth, the severe downturn in the commercial-vehicle market is one sign of things to come.

Housing is weak, commercial real estate is weak, financials are weak, and we are soon going to find out about retail, in what is expected to be the worst holiday shopping season since 2002.

Chrysler CEO says We're 'operationally' bankrupt.

Chrysler Corp., the troubled automaker bought by private equity just four months ago, is scrambling to sell assets amid indications of huge losses, as access to cash becomes increasingly scarce, according to a published report Friday.

"Someone asked me, 'Are we bankrupt?'" the Wall Street Journal quoted Chrysler boss Robert Nardelli telling employees at a meeting earlier this month. "Technically, no. Operationally, yes. The only thing that keeps us from going into bankruptcy is the $10 billion investors entrusted us with."

To raise money, Chrysler is looking to sell over $1 billion in land, old factories, and other holdings, even if it has to let those properties go for under book value, the Journal said.

Chrysler's owner, Cerberus Capital Management, is now facing serious subprime-related losses from GMAC Financial Services, which it bought from General Motors (GM) for $12 billion, and is also trying to walk away from a now pricey deal to buy United Rentals Inc., (URI) the Journal said.

Cerberus bought Chrysler from German automaker Daimler in a deal that closed in August.

In the arrangement, Daimler (DAI) essentially paid Cerberus to take the automaker, which fell to No. 4 in U.S. sales behind Toyota Motor (TM) in 2006, in an effort to get out from under a $1.5 billion loss from last year, along with continued obligations to union members and retirees

Damage Control by Cerberus

Attempting to undo damage from the above statement, Cerberus issued this statement on Chrysler.

First and foremost, it is important to note that Chrysler is not only meeting, but, in many cases, exceeding its financial targets heading into 2008.

Importantly, Chrysler has ample liquidity.

We are very excited about the new products coming in 2008. These include the legendary Dodge Ram pickup truck, the Dodge Journey crossover, the relaunch of the historic Dodge Challenger -- which has already generated 8,851 customer orders -- and two, all-new, large hybrid SUVs, the Chrysler Aspen and the Dodge Durango, demonstrating our support for the environment and more fuel-efficient vehicles.

I remain unconvinced. Both Cerberus and GM were not thinking clearly. GM had the chance to unload all of GMAC and failed to do so. Cerberus made a huge mistake with GMAC. Cerberus also made a huge mistake in agreeing to buy United Rentals. It can thank its lucky stars they backed out of it. A judge just ruled United Rentals Can't Force $4 Billion Cerberus Buyout.

United Rentals Inc., the largest U.S. construction-equipment rental company, lost a bid to force a $4 billion takeover by Cerberus Capital Management LP when a judge ruled the agreement allowed the buyer to pull its offer.

United Rentals fell 17 percent, after reaching a one-year low of $17.32. More than 10.1 million shares were traded, almost four times the three-month daily volume.

Delaware Chancery Court Judge William B. Chandler III ruled today that United Rentals officials should have known that Cerberus executives believed they had a right to pull out of the deal at any time as long as they paid a $100 million fee.

"There's some clarity here for the private-equity firms that if you have an agreement, you're protected," Steven Kaplan, a professor at the University of Chicago Graduate School of Business, said in a phone interview. "For United Rentals, part of this can't be recovered because it was predicated on debt markets that no longer exist."

United alleged Cerberus's RAM Holdings buyout entities agreed in July to pay $34.50 per share for United Rentals' stock, and reneged on the deal in November amid weakened U.S. credit markets.

The judge concluded that the contract was "ambiguous on account of its conflicting provisions" and involved "a deeply flawed negotiation" process.

Cerberus made a $100 million mistake. I cannot comprehend a proposal to buy a construction-equipment rental company in the midsts of a housing collapse and the start of a decline in commercial real estate. Clearly this collapsed deal as well as GMAC and Chrysler calls into question the overall strategy and management at Cerberus.

Other Buyouts Collapse

Other buyouts have collapsed as credit investors balked at buying bonds and loans committed to fund the transactions. Kohlberg Kravis Roberts & Co. and Goldman Sachs Group Inc. in October abandoned their $8 billion purchase of Harman International Industries Inc.

Investors led by J.C. Flowers & Co. walked away from their $25.3 billion deal to buy SLM Corp., the biggest U.S. education lender, after the Reston, Virginia-based company refused to consider a lower offer.

A suit over Flowers' decision to renege on the offer is pending in Delaware Chancery Court.

The agreements that have fallen apart threaten to "chill" merger activity, said Roy Behren, who helps manage $2 billion at Westchester Capital Management in Valhalla, New York.

Dog Days at Cerberus

BusinessWeek is taking a look at Dog Days at Cerberus.

The bad news for the investment powerhouse keeps coming—and it goes deeper than Chrysler and GMAC.

Cerberus Capital Management sweated for months over its $7 billion bid to buy the construction equipment leasing company United Rentals (URI). With the financial markets in turmoil, the investment management firm pushed hard to renegotiate the price. When that failed, Cerberus abandoned the deal on Nov. 14, just days before it was set to close.

In hindsight, Cerberus' bets on housing, financials, and autos look perilous. It bought GMAC Financial Services, which owns a mortgage lender, as the real estate bubble was bursting.

It's unclear just how much work it will take to fix GMAC, the financing arm of General Motors (GM). A Cerberus-led group paid $14 billion for a 51% stake in September, 2006. Cerberus wasn't exactly an industry newcomer. It had a front row seat at the subprime show with Aegis Mortgage, a lender it took control of in 1996. Yet Cerberus jumped into GMAC at exactly the wrong moment. Price defends the move: "There was one time to buy GMAC. We wanted it and took action."

The short story? Aegis filed for bankruptcy in August, and GMAC's mortgage group ResCap has been bleeding red ink.

"I don't think anyone is panicked," says one Cerberus insider. But "we sure as hell didn't expect GMAC to be what it turned out to be."

In early December, it pulled out of a deal to buy Option One Mortgage (HRB) from H&R Block (HRB) as conditions deteriorated in the housing market. Earlier, Cerberus walked away from its bid for Affiliated Computer Services (ACS), after the ACS's independent directors sought other offers.

Cerberus seems unfazed by it all—and confident that it can turn around the troubled companies. "We believe at the other end of the current deep, dark valley is a sunny one from which we'll emerge with a bunch of great companies," says Price. "We do well in good times and bad."

A rising tide of financial insanity kept the Cerberus boat afloat. What seems to be keeping that boat afloat now is fortunate timing of collapsed deals right before settlement.

Heading forward, those who keep throwing caution to the wind are going to regret it. It's far too early to be bargain shopping.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Insurance from MBIA and Ambac Worthless

Readers of this blog have known how useless the guarantees of MBIA and Ambac have been for quite some time. Three of the more recent examples are MBIA and Ambac's Capital in Doubt and Will Ambac and MBIA Survive? and just several days ago Financial Day of Reckoning Approaches.

The realization that guarantees from Ambac and MBIA are worthless is finally dawning on state and local investors as the following Bloomberg headline shows: Muni Insurance Worthless as Borrowers Shun Ambac.

State and local borrowers are discovering that buying municipal bond insurance from MBIA Inc. and Ambac Financial Group Inc. is a waste of money.

Wisconsin sold $154.6 million of general obligation bonds last month at interest rates usually available only to borrowers with the highest credit ratings. Wall Street firms didn't require the state to insure the bonds, even though Wisconsin is graded four levels below AAA, amid signs that bond guarantors may lose their own top rankings.

"Either the Street or investors didn't see the underlying value of the insurance," Frank Hoadley, Wisconsin's director of capital finance, said in an interview.

Wisconsin, California, New York City and about 300 other municipal issuers sold bonds without buying insurance in recent weeks, avoiding premiums that are as high as half a percentage point of the bond issue, according to data compiled by Bloomberg.

"Taxpayers give insurers $2 billion a year because of a dual-rating scale," said Matt Fabian, senior analyst and managing director of Municipal Market Advisors, an independent municipal bond research firm in Concord, Massachusetts. "You could easily save taxpayers that $2 billion by rating them on the same scale as corporate bonds."

None of the insurers responded to requests for comments.

Business Model Broken Beyond Repair

Look who recently shunned buying recent insurance:

• California decided against insuring $1 billion of borrowings last month because of doubts about whether bond insurance provides any value, said Tom Dresslar, spokesman for California State Treasurer Bill Lockyer.
• New York City, the largest borrower among U.S. cities, decided in November to sell $100 million of uninsured variable- rate demand obligations instead of auction-rate securities, which are usually insured. The city sold the bonds Dec. 4.
• Central Puget Sound Regional Transit Authority, located in Seattle, sold half of a $450 million bond offering in November without backing from a financial guarantor. Some investors said they didn't want the insurance because of doubts raised about the insurers' ability to pay and maintain ratings, said Tracy Butler, treasurer of the transit system.
• Wisconsin, California, New York City and about 300 other municipal issuers sold bonds without buying insurance in recent weeks, avoiding premiums that are as high as half a percentage point of the bond issue, according to data compiled by Bloomberg.

Ambac and MBIA would not comment because about the only thing they could say is "Clearly our business model is broken beyond repair".

Kiss goodbye any ideas that Ambac and MBIA will raise rates to cover losses. Both can look forward to declining revenues and rising defaults. Over time that will prove to be a lethal combination.

Shameless Pretending By Moody's, Fitch, and S&P Continues

MBIA is admitting a $30.6 billion in CDO exposure causing Morhan Stanley analyst Ken Zerbe to state "We are shocked that management withheld this information for as long as it did." But the interesting is that MBIA states that they Previously Disclosed $30.6 Billion Multi-Sector CDO Exposure.

The information posted on December 19, 2007 discloses no additional Multi-Sector CDO exposure. Standard & Poor's, Moody's and Fitch have confirmed that this information was provided to them and was taken into consideration in their recent ratings analyses. The information was also made available to Warburg Pincus prior to their entering into the previously disclosed Investment Agreement, and that agreement is not affected by this information.

That is kind of interesting because it seems to have caught Fitch by surprise as Fitch Places 173,022 MBIA-Insured Issues on Rating Watch Negative.

Concurrent with its related rating announcement earlier today on MBIA Inc. (MBIA) and its financial guaranty subsidiaries, Fitch Ratings has placed 173,022 bond issues (172,860 municipal, 162 non-municipal) insured by MBIA on Rating Watch Negative.

Fitch placed MBIA's 'AA' long-term rating and 'AAA' insurer financial strength (IFS) rating on Rating Watch Negative following the rating agency's updated assessment into MBIA's current exposure to SF CDOs backed by subprime mortgage collateral and various CDO-squared transactions, as well as MBIA's exposure to RMBS.

Fitch is maintaining the 'AAA' insurer financial strength of MBIA. Exactly what kind of complete nonsense is this? In Downward Spiral of Deep Junk I noted:

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.

Things have surely worsened for MBIA since then. But the pretending by Moody's, Fitch, and the S&P continues, smack in the face of revenues that anyone can see are going to decline significantly.

As of the November 11 2007 10-Q MBIA had $6.96 billion in working capital. They have guaranteed $30.6 billion in CDOs and have other questionable exposure as well. In the face of all these problems all three credit rating agencies have maintained the AAA rating of MBIA.

In It is now time to downgrade the monoliners Nouriel Roubini writes:

The current charade of pretending that the monoliners are under review to give them time to raise more capital to avoid such a downgrade is another case of rating agencies supporting a rotten business model. The actual behavior of such monoliners has proven that they are not transparent, that they hold or insure a mass of skeletons and toxic waste securities and they have been dishonest in hiding from investors the toxic waste that they hold and insure. So it is time to stop this charade of rating forbearance and admit that the emperor has no clothes: a business model that cannot survive without an AAA rating is conceptually a business model that cannot deserve under any circumstance an AAA rating; period! Arguing otherwise is believing in voodoo black magic.

I heartily endorse that viewpoint even as I disagree with Roubini as to what the solution to this mess is. See Missing the Boat on Monetary Easing for my free market solution vs. price fixing schemes elsewhere.

The Charade Of Pretending Will Continue

As long as Moody's, Fitch, and the S&P get paid by the companies whose debt they rate, the charade of pretending will continue. Sadly, it is in the financial best interest for all involved in the scam, for the pretending to go on long as possible.

Rather than getting paid based on the accuracy of reports, government sponsorship of the big three insure they get business no matter how deeply flawed their analysis is. And let's face it, there have been some enormous lapses in judgment by all three to the point of actual fraud investigations into the rating agencies by Ohio attorney general Marc Dann.

So not only are the guarantees of the insurers worthless, so are any ratings made by the big three. Moody's comes flat out and says it themselves.

Moody's Code Of Conduct

"Moody's has no obligation to perform, and does not perform, due diligence." See Fitch Discloses Its Fatally Flawed Rating Model for more on that disclaimer as well as problems at Fitch.

I certainly agree with Moody's assertion of itself. It is perfectly clear Moody's does not perform due diligence. The entire system reeks from the head down and I propose we chop off the head of this beast and Break Up The Credit Rating Cartel.

Unfortunately, all I hear are screams of more government intervention by misguided fools wanting to add another layer of regulation on top of things. These same people expect a government that brought us FEMA, Fannie Mae, a broken Medicaid system, built bridges to nowhere in Alaska, and who wasted $trillions in Iraq, can put in an oversight system for the rating agencies.

Enough already. Government sponsorship of the ratings agencies created the problem. The solution is simple: Government unsponsorship of the ratings agencies.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Minyan Mailbag: Vulture Financing

In response to Minyan Mailbag: Morgan Stanley Questions where I responded:

"Arguably Bank of America is hoping Countrywide (CFC) goes bankrupt. If that happens, Bank of America (BAC) will have first crack picking up pieces of Countrywide, notably their servicing operation, for an extremely cheap price."

I received this reply from Tom who writes:

So, this is what Wall Street vultures look like when they circle. They make deals to "help" a company, all the while hoping that they get to pick the carcass clean. Cool.

Yes Tom, you have it correct. But here is the trick: Please consider what Minyan Peter, former treasurer for a major US bank has to say about Credit Cycle Bottoms.

...should the economy continue to deteriorate as I expect, the banking system will once again require further capital and the “denial” that once joined bank issuers and investors together will be transformed to fear. And with that capital will be raised not through equity issuance, but through sales of non-credit assets at fire sale prices. Those able to throw good assets overboard will survive. Many will not be so lucky and will end up in the arms of the regulators.

As much as we may be critical of the terms struck by Citigroup (C), the deal got done. Remember, credit cycle bottoms are defined more by what couldn’t get done than what could.

Please note the above timely advice was written by Peter on November 28.Look at what has transpired since then with E*Trade (ETFC), MBIA (MBI), and most recently Morgan Stanley (MS).

The key point here is that deals are still getting done. The bottom will not occur until it is nearly impossible to get a deal done at all. In the meantime, expect more and more US assets to get sold to China and the oil producing states. This is the payback for reckless US consumption that still continues today.

Those who see the balance of trade deficit as being a positive are obviously delusional. However, denial runs deep.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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One Way Door in Property Funds

The BBC is reporting No exit for Friends property fund.

Insurer Friends Provident has told investors in its £1.2bn property fund that they must wait to access their money because of a market downturn. It said it had taken the measure to avoid having to sell commercial property such as shops and office blocks in a hurry at low prices.

Investors must now hold off for six months before being able to take cash. The BBC's business editor Robert Peston said there has been a "collapse of confidence in commercial property". "The flight from property is a pronounced trend," he explained.

"Friends is the first fund to prevent retail investors cashing in, but other fund managers, including Schroders and UBS, have put a block on withdrawals by institutional clients," he added. "Their behaviour is rational, if alarming.

It has been reported that the fund's cash buffer of 14% in July had been reduced to 5% by departing customers.

"Unless investors' demands for redemptions are stemmed, there would be forced sales of substantial properties," Mr Peston continued. "And such forced sales would precipitate a vicious, self-reinforcing downward spiral in property prices."

"For banks and other financial institutions, the next wave of losses after sub-prime is likely to come from direct and indirect lending to commercial property," Mr Peston said.

You cannot stem investors from wanting to leave by freezing the fund, any fund.

Freezing the property funds now makes as much sense as Bear Stearns freezing their hedge funds in February. Had investors been allowed to exit they would have gotten at least something back. It might have been 40% but it would have been non-zero. Now Bear Stearns Fund Manager Probed on Withdrawal.

Federal criminal prosecutors investigating the collapse of two internal hedge funds at Wall Street firm Bear Stearns Cos. are examining whether a Bear executive improperly withdrew money he had invested in one of the funds while making optimistic forecasts about the portfolio's prospects, people familiar with the matter say.

Weeks before the two funds began imploding in April, fund manager Ralph Cioffi moved about $2 million of his own money from the riskier of the two hedge funds into another internal fund with a separate investment strategy, these people say.

Mr. Cioffi's move effectively lowered his exposure to the riskier of the two failed funds when it was on the brink of significant declines, these people say. No other senior Bear executive invested in the funds, according to people familiar with the matter.

So not only did Bear Stearns freeze withdrawals, the fund manager himself exited while making bullish pronouncements. One of the funds later went to zero, the other to a few cents on the dollar. Unfortunate investors were trapped all the way.

Commercial real estate prices are headed lower. The proper strategy is to sell now to minimize losses. However, no one can exit. The door is closed and investors are trapped in a sinking ship. Why anyone want to invest in any fund that has a door open for entry but closed for withdrawals is beyond me.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Refreshingly Simple Commercial Real Estate Implosion

Portfolio.com is writing about Wall Street's Next Crisis.

Now that the subprime shakeout is nearly over, another real estate mess looms, this time in commercial property.

My Comment: This article is off to a rocky start. The subprime blowup is well underway but by no means over. Two more waves of Alt-A and Pay-Option-Arms are coming up and those waves are now approaching shore. The Pay-Option-Arms problem could be worse because it will saddle lenders with hugely underwater properties.

In their own way, however, commercial-real-estate loans were no less foolish than those made to home buyers with speckled credit. And as with the subprime mess, the reckoning will come.

My Comment: Much better. I agree with both statements.

The implosion is going to be a refreshingly simple and familiar story. The commercial-real-estate frenzy has none of the nagging complications found in the residential market. There aren't any targets of predatory lending. There are no huge failures by government regulators. The aftermath won't see people thrown out of their homes—an unadulterated societal ill regardless of whether they should have known better or were tricked into taking on loans they couldn't afford.

My Comment: Once again I whole heartily agree. But ironically enough "refreshingly simple" adds its own complexities in that there will be no options to deal with it. Unlike residential housing where there are numerous plans to keep homeowners in their homes they will all fail. See Paulson's Plan Is Nothing But Lip Service for more on this idea.

On the other hand, with commercial real estate there will not be lawsuits, bailout plans, lip service, or any other of complexities. When store owners can no longer afford the rents they will go bankrupt and break leases. When property owners can no longer make mortgage payments to banks they in turn will go bankrupt and banks will end up owning buildings.

In this "refreshingly simple" world, Congress will not attempt to make lease payments for bankrupt businesses.

Let's make it clear up front: The commercial-real-estate blowup—while ugly—won't be as bad as the current housing crisis. It's a smaller market, and any single property often has a diversified group of tenants with different sources of income. The supply of buildings didn't increase dramatically over the past several years, as in residential real estate. And the losses won't be as severe, because many commercial spaces can be refashioned for new occupants.

My Comment: This is a mixed bag but I think commercial real estate is as overbuilt as housing is. However, the total amount at risk is smaller. On the other hand, the amount at risk is likely to be more concentrated because the size of the deals are far greater. Those deals are in fewer hands. As for new occupants in a slumping area: forget about it.

Right now, there is about $730 billion in commercial-mortgage-backed securities outstanding. "Not only have we been in a rising tide, but the loans are very different in underwriting standards than even five or 10 years ago," says Alan Todd, head of commercial-mortgage-backed-securities research at J.P. Morgan. "We haven't been through a cycle yet" with these new structures, he adds ominously.

My Comment: What's been securitized is one thing, what banks are holding is another, and the concentration of risk is a third. Obviously there are lots of guesses here but a sure-fire prediction here is this is going to end ugly.

The perennial lesson to be drawn from the coming slump: You can't protect greedy and myopic people from themselves. Everyone knew that the [commercial-real-estate] business is highly cyclical. Indeed, a huge downturn had occurred as recently as the early 1990s, within the memory of most of the professionals now in the market.

My comment: I certainly agree with that.

Amid the tall office spires of America's cities, big-money pros have simply been playing a game of greater fool, trying to bring in huge returns with borrowed money and sell out before the arrival of the crash they knew was coming. And in this case, the fools won't just be famous developers. Some of the same banks and Wall Street firms now entangled in the subprime residential crisis will also be caught in the mess. The commercial-real-estate meltdown will be a market failure, pure and simple. We will be able to look at the wreckage in the next several years with wonder and awe, untroubled this time by sympathy for those left holding the bag.

My Comment: It will be a failure alright, but it will not be a "market failure", at least not a "free market failure". The Greenspan Fed purposely and willingly created the housing bubble. Commercial real estate went along for the ride. Please see Missing the Boat on Monetary Easing for more on this idea.

Here's what we know about what happened in commercial real estate: Lending standards fell, starkly. Or as I prefer to see it, they were thrown out of the 60th-floor window of that gleaming office tower in downtown Atlanta/Phoenix/New York/San Francisco/insert your city here. The gap between the cost of debt servicing and the cash actually being generated by the buildings narrowed. What's more, it used to be that banks made loans for no more than 80 percent of the value of a property to ensure a healthy cushion of protection, but by the early part of 2007, loans were sometimes made for 120 percent of a property's value. Who would be so crazy as to lend more than a property is worth? Anyone who believes in perpetual-motion machines—that is, that rents and underlying property values must always go up.

My Comment: "Who would be so crazy as to lend more than a property is worth?" That's a good question but that is not the worst of it. Consider this simple fact: A 90% loan and a mere 10% decline wipes out all equity. My opinion is commercial real estate is going to plunge 20% or more easily.

A prime example is Tishman Speyer Properties, which paid a record price for two giant New York apartment complexes. To make the purchase work, the company must now figure out a way to kick out current tenants—many of whom have their rents stabilized by law—at a faster rate than has been managed in years past, in order to replace them with ones who will pay more. Historically, that turnover has been about 6 percent, says Todd, but Tishman Speyer is assuming a rate of more than double that for the first couple of years, and 10 percent for the next few after that.

My Comment: That is a “prime example” of how insane things got. And it is by no means an isolated event. Tishman Speyer Properties is in deep cereal trouble as is anyone who lent them money.

Harry Macklowe, a famed New York real estate buccaneer, leveraged himself to the gills to buy seven New York office buildings from E.O.P., a side agreement to the Blackstone purchase. He borrowed $7.6 billion, based on stratospheric valuations, while putting a minuscule $50 million of his own equity into the deal, financing much of the purchase with short-term debt. Since the summer, Macklowe has struggled to refinance the debt in increasingly choppy markets. And he has had to put up as collateral his trophy property, the General Motors Building in midtown Manhattan.

My Comment: Harry Macklowe made one greedy bet too many. He can look forward to losing his trophy property for that greed unless he takes appropriate measures immediately to prevent it.

Lending standards had been loosening across the industry for years. Standard & Poor's and Moody's both voiced early concerns in late 2004 and the beginning of 2005. Sure, "supply and demand is in balance, but that's not a license to loan more money against a given cash flow," says Tad Philipp, Moody's managing director of commercial-mortgage finance. "What we were seeing was riskier and riskier loans, and the loans got riskier still. And we are just past the top of the cycle."

My Comment: Spare me the sap. Exactly when did any of the rating agencies act on this?

Despite their misgivings, the ratings agencies kept slapping seals of approval on commercial-real-estate structures. Just as they did when rating securities containing residential mortgages, the agencies relied heavily on recent historical data, which were misleading.

My Comment: Bingo

To its credit, Moody's started requiring higher levels of protection in the spring of 2007. S&P and Fitch, according to a J.P. Morgan analysis, lagged significantly—and won market share as a result. Those two will come to regret that they didn't respond faster to the Moody's move.

My Comment: Giving Moody's any credit for this is ludicrous. The analogy is like praising a student for a D--- because someone else got an F. There is no credit to be given here, only greed and shame.

There is no question Fitch is the worst of the lot. As proof I offer Fitch Discloses Its Fatally Flawed Rating Model. Having said that, and with apologies offered to regular readers for repeating myself so often It's Time To Break Up The Credit Rating Cartel.

Ask And Ye Shall Receive

Those bullish on commercial real estate may wish to consider this anecdotal evidence on the Downtown Sacramento Commercial Real Estate Photolog.

Mish and others requested more CRE photos, so who am I to deny them? The following is a random sampling of the glut in commercial real estate in downtown Sacramento. It is by no means comprehensive, but I think it does represent the glut fairly well.

Click on the above link to see some of the overbuilding in commercial real estate in Sacramento. For more on Southern California Real Estate you may also wish to consider An Elk Grove Commercial Real Estate Photolog.

Max keep those photologs coming. If California is any guide (and I think it is) your images show how refreshingly simple the commercial real estate implosion is going to be.

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