I Feel Like It's Already Happened.

I'm sure it's a personal projection of some kind - at least I should be. But it doesn't feel that way.

It feels as though someone has made a very important phone call - one of those ones where you feel like you're filled with ice water and you're shaking, but you sound normal. What came out of their mouths came out as something smart and strategic, but it was really a plaintive wail and a desperate plea. The person on the other end didn't hear it cry. They didn't make much of it - dispense with it quickly. They did think about it after they hung up, but they went back to work, then turned on the basketball game for a few minutes, had a glass of water and went to bed. In the morning there was just another full day.

But not on the other end. The night was easier than expected on that end. There was a feeling of relief, even a wry laugter. On that end they watched a good chunk of the basketball game and woke up feeling pretty good. Felt a little odd at breakfast, but had some orange juice - very refreshing. A few butterflies, but they headed in bright and early. Certainly a priority list today!

Meetings were fast and precise - they were professionals energized by the task of high-speed problem-solving. The situation was bad, but the rhythm was good. Then around 10 somebody freaked. Whether it was that woman who cried or that guy you knew was going to be a problem really blowing his stack - I mean losing control - it's hard to remember. Suddenly nothing was happening properly. The call and response was way off. The rhythm was broken and knuckles got very white.

Then an hour or so later - hard to tell - there was that weird feeling of suddenly not knowing what to do - having nothing to do, really. You couldn't call X until Y called back. The numbers were going to take at least two hours. The lawyers hadn't arrived yet.

You never knew what "it's over" was going to feel like - certainly you didn't imagine this. Then you realized that "over" meant having so much to do and no way to do it or get it done. "Over" meant that the many things you needed to do were now going to find you, instead of the other way around.

And then all of us found out.

The End Of Money

Getting to know the wild, Austrian-school, Libertarian culture of goldbugs has been really interesting for me. We disagree on so many things but see the same crisis - an existential threat to the world's money system. Goldbugs make government deficits to be the first-order threat because of absolute size and inflationary primacy. I join those who make the collapse of credit institutions to be the first-order problem. Some goldbug share this latter view, Mish Shedlock notably among them. Although I'm not a goldbug, Shedlock's writings are part of the reason I am a so-called “deflationist”.

Clearly the “short dollars on imminent hyperinflation” trade has fallen apart. The yen is getting crushed. Paper gold has been acting oddly. I'm sorry, but I happen to be one of those people who think ETFs can overwhelm futures markets a bit. Thought so with oil this summer. Many knowledgeable people disagree. But the real value of gold is something reasonable people can debate. In fact, it's debated every day in London, New York, Sydney and Hong Kong. Right now, the consensus is: “not so valuable as we thought last week”.

What is not being debated properly is the value of our financial system. On the NewsHour Secretary Geithner pre-announced that nobody will fail the “stress test”:

“These banks now have very substantial amounts of capital relative to what you would have seen in the U.S. economy going into previous recessions.”

The conventional view - Geithner's view - makes this economic crisis to be a crisis of “beta” - a “fat-tails” crisis which will revert to the mean. One problem with that assessment is collateral. In a sense, Bank of America is a huge CDO. CitiGroup is a huge CDO. AIG is a huge CDO. CDOs are fine, unless you very badly misrepresent the “C” - the collateral - and that's what's happened. So, I make it to be a crisis of “alpha” - a crisis of our financial system's intrinsic value and a crisis of collateral. The goldbug solution is simple – collateralize the system with gold. Goldbugs reason that if the problem is at the very core – the “fiat” or legal-accounting money system itself – then that system needs to be moved to solid collateral. I agree to this extent: If we don't deal with how our system is collateralized, we're finished

[I even reluctantly and partially agree that gold could be part of the answer, but that's for another piece.]

Jim Cramer sees the collateral problem. His mortgage plan is about spreading a huge hit to term collateral value over a very long time. If you look at this interview with Robert Shiller and take a gander at the chart below which shows percentages of negative equity homeowners as house prices fall, you get an idea just how huge a hit we could be talking about.


Despite all the talk about it, deleveraging probably has not happened in America. Collateralized leverage has likely skyrocketed. Fed Chairman Bernanke implicitly recognizes this. Markets were relieved to hear the Chairman didn't intend nationalization. An expert on providing liquidity, Bernanke now plans to create equity - balance sheet collateral, if you will. Preferred at first, “rolling” to common as loan collateral and quality deteriorate. The idea has balance sheet elegance and the more “we the people” find out management has screwed up their businesses, the more right we'd get to tell them what to do.

It's a great concept. The Diamond and Dybvig model of central banking says that in a crisis the government should trade immediate-term credit for long-term exposure. Big-government conservatism says in a crisis the government should intervene first with money (and guns), then take authority only as a last resort. It's wonkish and wonderful – an academic tour de force. So why am I hearing Jim Cramer in my mind's ear shouting “Bernanke's being an academic! It is no time to be an academic...!”?

It's because I'm not sure how cash helps these institutions. It didn't help AIG. The banks already have much more than enough cash. If they can't use what they have, how will more help? Banks need to get assets with longer-term value into their portfolios faster than their collateral is deteriorating (and risk is rising). Ben Bernanke apparently believe they can create or find those assets.

Those banks? With that management? In this economy? With their cost structure? Really?

I saw Dick Bove talking about how the banking system was very profitable. I nearly fell off my chair. $59 billion positive cash flow? So they can pay back the TARP in what, 10 years? 15? I got back on my chair and listened to his excellent point about franchise intangibles' being an important part of overall value. But has he read what Ken Lewis thinks are the most valuable parts of his franchise? The biggest, crookedest mortgage writer in history and a failed investment house? Those are the “stars”? When institutions issue thousands of “AAA” securities that turn out to be junk, their franchises suffer – badly and justly.

I've read the BAC bulls. I believe Geitner wants to bring in private investors. But these banks already have investors who are a big part of the problem. Bondholders represent a big portion of liabilities so, again, let's think of the banks as a bond – a huge, multi-maturity CDO. We know the collateralized leverage of this bond has soared and the credit quality has plummeted. The principal of many long-dated tranches has gotten killed, but the short-term tranches have been saved – so far.

Is the bond still paying the coupon? As Dick Bove points out, almost. But why do people focus on that? The structuring is destroyed and the collateral is crap. By taking the TARP money, Citigroup, AIG, BAC, etc. have declared an intention to pay the coupon out of the new, “free” government collateral. Unless the government intends to let banks and bondholders pretend the entire real estate bubble never happened, it won't be enough. To boot, I have very little faith the structuring of these CDOs will improve. When I look at BAC, I see a CDO that has gotten bigger, not better. And Citigroup? AIG?

The challenge is bad structure and bad collateral, which is why serious people are finally talking about capitalizing our financial system with full-faith-and-credit (FFC) instruments. I have no idea how it took so long. Laugh if you want, goldbugs, but it's a step forward. It's sure a lot more sensible than cash. It's not magic, but FFC bonds would immediately change institutions' capital profile. Of course the bondholders will still be pounding on the doors. Even if you don't think these bondholders are too big to fail, we certainly don't want them freaking out again, either. The stories are wild about the last time they freaked out, but the facts are bad enough.

I think we need to deal with the bondholders separately. But I don't know, maybe Bernanke, Geithner and the holdover crew (who missed the entire bubble in the first place) really do intend to re-collateralize the people who bought and sold all the bad debt. Why make people unhappy? Apparently, it wasn't the investors' fault. They were, after all, only professional financiers.

So how does “the end of money” come about? Option 1 is that the crew gets ahead of the process and creates hyperinflation. Yet, the dollar is a very, very big money system and “fortunately” the crew have shown no capacity to get ahead of the process. Option 2 is that as collateral collapses, they continually pay out slightly less than the deterioration. This is the Japanese “lost decade” prescription for deflation. And of course hidden costs can jump out and cause instability, as in the AIG catastrophe. This would also be deflationary. That's why I feel deflation is the more-likely outcome.

Finally, adding value to the money system is not a forlorn hope. It can happen. Actually, we know that it will happen - eventually. It's really just a question of how long we want it to take. Many smart people say the problem isn't so bad and I respect that. However, I humbly suggest that if large numbers of people refuse to admit they lost money in what might be the biggest bubble in human history, money as we know it will end – at least for a while.

When A Plan Is Not A Plan

Secretary Geithner's plan for bank recovery is not viable and - as described so far - not sound. However, its lack of detail is not only understandable but good. Implicit in this un-plan is the question: "How do we get private money back in the banks and the credit markets?" So long as Secretary Geithner keeps asking that question and allowing it to guide him, he will be okay as he goes through the process of realizing that we *can't* get private money into the markets because private money does not and cannot trust the banks.

The trouble is there is also another question looming: "How do we get money into the economy?" This is a separate and far more pressing question and if not handled carefully, it could lead to rash decisions made in panic, haste and with more money than anybody as ever imagined. A deflationary crisis gives governments LOTS of room to maneuver. They can create LOTS of money and fund LOTS of programs - and nothing will work quickly enough. This means the tendency to think things through starts to diminish and we have to fight that. 

And just to be clear, I believe the deflationary crisis cannot now be avoided if indeed it ever could have been. Everyone outside the government is acting exactly the way people act to create a deflationary disaster. Bankers (obviously), business leaders and even governors, mayors and county executives are doing exactly the wrong things and exactly the wrong time, as you would expect them to do. This is the initial stage of the deflation during which none of these people can see the collective result of his actions yet. Each institution looks to preserve itself without seeing that by doing the same thing at the same time they are bringing us all down. For example, by trying to "get ahead of the curve" and cut their costs with big initial layoffs, American businesses have assured that unemployment will rise above the level the financial system can withstand. 

The federal government is trying to get ahead of the curve in the other direction, pouring out money as fast as it can. The problem is that the government is pouring out money to, in effect, prevent things that have already happened. The government has to get to a place where it can pour out money on the economy that will exist 6-12 months from now, not the economy that exists today or two months ago. The problem is that it is very hard to tell the voters that in a very short time, there will be fewer banks to rescue and in a very short time, there may be no point trying to prop up the market for consumer debt such as credit cards. Careless, reckless, "never, never" planning by the consumer credit industry means that around 10-12% unemployment, the backbone companies in that industry will start to fold. At that time the the federal government will run into a huge question: "Who in the world can we even lend money to?"

Right-wing ideology has blinded people to the obvious answer. In any economic crisis, you first lend to institutions that have the legal authority of taxation - the power to compel people to pay the money back. You lend to the states, cities and counties. You demand the highest standards of accounting, demand reform and then give them the money. It's just the wise thing to do. Then you lend to the institutions that have the best *ability* to pay the money back and can create the most economic benefit. You also do as much direct aid to individuals as possible, keeping in mind this unifying principle: ultimately, you are lending money to the people to put the life of the nation back together and they must do that through the bedrock institutions and through their own creativity and sense of purpose. You must give the people the capacity to build. 

One of the great things that World War II did for America - in fact, the only great thing it did for anyone in the world - was that it gave the American people a task that was too huge for anyone to tell them how to do it. Everybody became an "entrepreneur" in the mission to beat the Axis, from the fellow with a rifle, to the lady with a riveter, to the folks with the slide rules, pencils and heads to scratch with them. The War made America realize that this was their fight - all of them. So we invested in soldiers who had only weeks before been unemployed young men nobody cared about. Business executives got off their high horses, popped the bubble reputation and asked "how can I help?". American women said: "give us the job" and this time, we gave it to them. 

In more ways than one, the War was a war against the Depression. It was a horrifying way to solve a bad problem - the worst possible solution. Hopefully, we can look at that war, look at what was good in our nation's reaction and re-create that without the horror. 

The Econolypse, The Dollar, And Gold

I think we need a name for all this. "Credit Crisis" is lame. "Great Depression 2" is not only lame, but it misrepresents what is happening. It keeps us in the mindset of fighting the last war. For me, we are in "The Econolypse" (must credit my good friend V.R. on that one).

The Econolypse will twist our heads off. It is the The End of an era, and therefore a massive disillusionment is in store. No, it's not the disillusionment you thought was coming because that wouldn't be a disillusionment, would it? Unless you are already insane, the Econolypse will make you doubt what you know, who you thought you knew and why you ever believed you knew either of them. People who read economics are always modelling everything. This is that thing you can't model. Look, you're smart. If you could have modelled it, so could other smart people. And if they could have modelled it, it wouldn't have happened.

Nobody consciously chooses an Econolypse. Believe me, if anyone were to choose an Econolypse, it would be socialists. I know socialists - real, actual socialists, not liberals or Progressives - and they are very, very unhappy with what is going on. Oh, and if you think this was all caused by Greenspan and that the government is acting outrageously by bailing out all these firms - so do they. That's right. You probably agree with socialists.

I agree with...almost nobody, I guess...but such an attitude can help one pick one's way forward in this kind of darkness. It's a pretty simple algorithm: you go completely contrarian. Look at the pervading beliefs. List them. Now list their opposites. Now try to stitch together a world where all those things are true at the same time. Looks weird, huh?

Fortunately for you (and unfortunately for me) I have already been living in this dark world for some time. I've been waiting for you. Others of you think you have a good idea what this dark world looks like. No, you haven't. I dare say this because vast majority - or even all - of the people who are as least as smart as you are and who predicted the downturn also predicted something else - something big - that not only did not come true, the opposite came true. And that was the "Fall of the Dollar". This summer, they thought they were seeing it unfold before their eyes. Finally the imbalances had become too great. Finally it was all coming apart. The new Weimar Republic was here. Hyperinflation was just days away.

They thought this as the dollar (here I use the Dollar Index) went from 88 in 2006 to 78 in 2008. They were sure of it when the dollar went from 78 to a miserable 72 in just a few months. They still thought it when the dollar went from 72 to 80 (just a blip). They were sure of it when the dollar went from 80 to 76 (that's more like it) and they were still pretty sure of it as the dollar went from 76 to 88, although they were starting to put together some caveats like "flight to safety". Now that the dollar has fallen from 88 to 84 (and may head down even more), they are sure once again that they know what's going on.

If only it was true.

Because even a rip-roaring dollar inflation would be welcome right now. It would ease a lot of minds and show that we were in just the kind of plain, old stagflation we're used to. It's probably not going to happen and that is pretty frightening. The Fed and Treasury are doing literally everything they can think of to re-inflate the dollar and it is just not working. The fundamentals are just too strong and the dollar shortage is just too acute.

It's simple supply and demand. The market needs dollars, the world's credit system is no longer producing them and even the U.S. government cannot supply enough right now. The huge Fails To Deliver in the Treasuries market are no accident. The demand is enormous. The market has spoken. Treasuries are where the large players want to hold their money. So after this pause, it pains me to predict that the dollar will head much higher - like to 97-100.

Along with this breakout, we should expect panic and disorientation. Actually, the cause for the breakout - the bankruptcy of yet another huge firm (I'm worried about Banco Santander, personally) or some major collapse of yet another credit market - will cause the panic. Things will move from bad to incomprehensible. That should help gold. You have to respect the fact that gold is a highly emotional market that can move 10% in any given day. Gold could easily go through $850 and even spike to $900 intraday. Or, maybe, gold is done here at $820. Either way, gold is a commodity and in a deflation, it will deflate. The deflation of gold is long overdue. Gold is radically overpriced in terms of silver, oil, the dollar and even the gold lease rate. Basically people across the world will be given a choice among three things: U.S. dollars that can buy anything, their own currency that buys less and less, or gold that might hold value but can't really buy anything on its own. Once gold stops holding value, there is no investment thesis for it.

I hope I'm wrong. I really do. As scared as people are now, they are going to be even more scared when they find they have to sell a commodity they do understand - gold - and buy a currency they know, but don't understand - the dollar.

Will it happen tomorrow? Probably not. Will it happen in the next few months? Look, we are only at the beginning of this thing. It will happen and, much sooner than we would like,...

...We will all live in very interesting times

The New "Four Horsemen" of the Econolypse

Citigroup

Berkshire Hathaway

Unemployment

Gold


To quote Jim Rogers from an October 31 interview on Bloomberg:

" I wouldn't lend money to a guy with phony bookkeeping and you wouldn't either."

I disagree with a lot of what Jim Rogers says (his call to buy agricultural commodities in that interview was an absolute tragedy), but this is a simple, accurate analysis of the problem. Citigroup is a three-headed monstrosity of phony bookkeeping - call it "The Three C's." Commercial Real Estate + Credit Cards = Citigroup. The bank is a black hole about to get on its black horse and ride out into the world on Monday.

The next "black hole" is unemployment. It's not black because we don't have the information. It's black because we're all ignoring it. You keep hearing that unemployment will "possibly go as high as 8% by the end of 2009." Ridiculous. Add up just the announced layoffs (if you can) and you will see that we'll be lucky if unemployment isn't 8% by the end of January (although the number may have to be revised upwards in February or March). There is 8% unemployment in California already and California has led the nation in economic trends - good and bad.

The Horseman of Unemployment has Citigroup is on its horse and when those two are mounted, Berkshire Hathaway is next to ride. Unemployment will insure that the companies behind Berkshire's "investment" in junk bond CDS suffer devastating losses and default. Citigroup's debacle will kill worldwide averages and insure our insane levels of volatlity stay nice and high. Buffett bet long the averages and short volatility in 2007. Nice trade, Oracle.

Therefore will the Banshee of Berkshire ride, causing terror across the land.

With all the panic, gold should do nicely - maybe $850/ounce, maybe a bit higher. But as she mounts that next rise, beware, the Golden Goddess also mounts her horse and prepares to ride - fast - down Mt. Econolypse into the tiny and ever-shrinking town of Deflationville in the valley below - and then on to the valley below that and then the valley below that.

That will not be a nice time. People will be a little confused then.

But I predict this is an economy which will require total capitulation in all the financial markets before it turns. We must all be terrified and frustrated before the Econolypse will pass.

...And then things will start to turn around.



May you live in interesting times.

The Smoking Gun

By 2004, the FICO system was gamed.

It was the final step in the destruction of Wall Street, a destruction engineered by the rapacity and dishonesty of American mortgage and fixed-income firms. Here, on Portfolio.com, Michael Lewis reveals the mechanism of that destruction in the best article I have yet read on the origins of the Credit Crisis. Mr. Lewis hasn't hipped to the FICO story yet, but he'll get it. He covers all the rest. The article is absolutely a must-read for anyone who wants to understand what really happened.

I first realized FICO got gamed while reading a paper by the American Enterprise Institute's Peter J. Wallison. Mr. Wallison is the principal author of the Republican talking points on Fannie and Freddie. Wallison has been carrying Wall Street's water for many years in their jihad against the GSEs. If you think Fannie and Freddie are to blame for it all, Peter J. Wallison earned his money. Like all good con men, Mr. Wallison sticks to the truth as closely as possible for as long as possible, but he slipped up with one simple sentence:

There are many definitions of a subprime loan, but the definition used by U.S. bank regulators is any loan to a borrower with damaged credit, including such objective criteria as a FICO credit score lower than 660.

Emphasis mine, but those words "objective criteria" jumped out at me.

Obviously the most objective criterion of credit risk is the actual default rate. Wallison talks about the default rates in the GSE portfolio coming largely from private-lable RMBS, but he does not cite the default rates for the actual borrowers to whom he objects most. I wondered why. If you read the paper and then look at the data (as best you can), I think you'll find something surprising.

First, it turns out that Mr. Wallison is correct that Fannie and Freddie DID take on borrowers with FICO scores lower than they should have - although not in the way he implies. But I found that the borrowers to which Mr. Wallison attributes so much damage actually defaulted at LOWER rates than that same FICO cohort defaulted for private banks. Moreover, because Fannie and Freddie bought Alt-A mortgage paper, Alt-A mortgages and even guaranteed a few Alt-A borrowers (but a very few), one can glean from the data that the farther away a borrower of a given FICO score was from the GSE's full due diligence process, the more likely that borrower was to default. Relative to the private sector, the GSEs were better judges of default risk and their default rates prove it. Even the private-label Alt-A paper bought by the GSEs has a markedly lower rate of default than the industry average.

Still, it was strange. Relative to how it worked in the private-sector data, FICO significantly OVER-predicted defaults in the GSE portfolios (when taken as a whole). If FICO is an "objective" measure, this should not have happened.

And then there is the question of the vintages.

That question became very intriguing to me when I read a much-quoted working paper published by the St. Louis Fed entitled: "Where’s the Smoking Gun? - A Study of Underwriting Standards for US Subprime Mortgages." I've long ago learned that people who have something to hide generally hide it in the title and the appendices. So, I went looking for the smoking gun the authors said was not there and quickly found it.

The authors boldly claim that:

Our results indicate that there is no evidence of a dramatic change in underwriting standards in the subprime market, particularly for originations after 2004. Given the multidimensional nature of ex ante credit risk, it is difficult to emphasize weakening in terms of some attributes as a decline in overall underwriting standards. The results show that while underwriting may have weakened along some dimensions (e.g. lower documentation), it also strengthened in others (e.g. higher FICO scores).

So, I immediately looked at their FICO data. It was shocking. To make the claim they make, you have to completely ignore the performance of the FICO cohorts and the fact that people in the business know that data. If you look at Table 12 (which divides FICO cohorts very suspiciously, but, that's another question) you will find that for the FICO cohort 660-720, first-year mortgage default rates went up a bit in 2004, doubled in 2005, quintupled in 2006 and were about eight times higher than normal in 2007. The numbers were terrible for all FICO cohorts, but that big one with SO many borrowers was just appalling.

So in 2004, bankers had suspect data and kept lending. In 2005, they had alarming data and kept lending. In 2006 they had shocking data and just kept right on lending faster than ever. In 2007, it was a travesty and they still kept lending until the whole thing blew up. Now these Bozos writing for the St. Louis Fed have the nerve to claim that underwriting standards didn't fall? Lenders knew that FICO has already failed. They knew it was gamed. Their data showed it conclusively. As if the data weren't enough, they could see the sudden profusion of new "Credit Reporting Agencies" and all the "score borrowing" and "rapid readjust" nonsense going on.

They didn't want to see it. The FICO cohort that was falling apart represented the bulk of their profitable borrowers. This was not the sub-620 extreme or the low-profit Prime book. This was the thick part of their bell curve. FICO was gamed. FICO was junk. But question FICO and you yanked the emergency brake on the Gravy Train. So not only did they not question it, they started to rely on FICO almost exclusively. They started to insist on having as little OTHER data on borrowers as possible. When they asked for the Equifax reports, they stopped asking for the employment and income data. They started pushing "low-doc" and "no-doc" paper out the door as fast as they could. See no evil, hear no evil and make a buttload of money.

You'll find that all lenders - including the GSEs - raised their FICO score standards in the later years of the crisis - to no avail. FICO was no longer "objective". It had become the foundation of a scam. As Michael Lews writes of one of the people who saw through the scam:

[He] knew subprime lenders could be scumbags. What he underestimated was the total unabashed complicity of the upper class of American capitalism.

A crisis like this is not an "'or' crisis". It's not a question of looking back and deciding whether this happened "or" that happened. It's an "'and' crisis". This happened "and" that happened but the "this" - the malplactice and fraud - predominated. Yes, there were stupid borrowers and stupid buyers of these securities (including the GSEs) at both ends of the line. But the cause of this crisis was pervasive malfeasance by the people in the private-sector, non-GSE business of selling American mortgage debt to borrowers and customers. Starting with the FICO, there was fraud at every step of the way up to and including the derivatives on the stuctured products. The willful ignorance and stupidity of borrowers and customers were just the whipped cream and cherry on top. We are living through the results what is the largest case of financial malpractice in human history - "malpractice" at best.

I'd call it "fraud".

This is why Paulson's plan's won't work: You can try every excuse in the world, but you can't fix this problem until you admit what it was and is.

Fraud.


May you live in interesting times

The End of The Era Of The Martingale

What do Barack Obama's election and the credit crisis have in common? They are both signals of the end of an era. They called it the "End Of History", and they were just as wrong as the phrase alone would lead you to expect they would be. But that didn't stop them. They were so sure of themselves that in the face of adversity, they just kept doubling their bets.

Didn't work out so well.

It was not just the now-central follies of ignoring the Kurdish Question, having too much confidence in Musharraff or the total blind faith put into the insane notion that somehow bankers would always tell the truth and be responsible that led us to the state we're in. It was a Culture War against doubt and intellectual skepticism itself. It was an iron-clad belief that what worked yesterday would always work. And in the waning year it became the nothing more than a Ponzi scheme depending on the emotional camouflage of the martingale.

The conservative business and political elite gave the world the message that they would back down to nothing short of total repudiation and that is very nearly what they've gotten. That is how martingale's always end: bankruptcy.