Saturday, October 30, 2010

Fed Practicing Ponzi Finance

from Pragmatic Capitalism:

The recent announcement that the Bank of Japan will be buying ETFs and REITs surely has Richard Koo upset.  After all, he has shown time and time again that such government intervention does nothing in the long-run.  The U.S. government is currently hoping for a similar asset response as they attempt to keep “asset prices higher than they otherwise would be”.  The problem, according to Koo, is that this is nothing more than a short-term psychological injection that separates fundamentals from reality.  In the end, government buying real assets does nothing to alter free cash flow and always fails.   In his Holy Grail of Macroeconomics he writes:

“Investors suffer heavy losses when the bubble collapses.  The speculative demand that had been supporting prices falls away, and chastened investors start to rely on upon DCF as a gauge of value.  Therefore, investors will not view asset-price increases brought about by the central bank purchases as being sustainable unless they are certain that the future cash flows generated by those assets will also increase.
Many governments have attempted to sustain or boost asset prices after the collapse of asset-price bubbles, but with the exception of the short squeeze orchestrated by the Hong Kong government in 1997, all have failed.  The reason is simple: market participants did not believe that these efforts would lift the DCF value of assets.  In October 2002, for example, the Bank of Japan launched a much publicized effort to buy shares held by Japanese banks.  But this effort not only failed to arrest the decline in Japanese shares, but left the Bank of Japan with large capital losses six months later.  Even in the U.S., aggressive easing by the Fed in the wake of the Internet Bubble collapse in 2000 failed to stop the NASDAQ’s decline.  It was only after demand for IT products had to pick up-that is, after the DCF of IT firms began to rise-that the NASDAQ shares began to stabilize and recover.”
This gets to the real crux of this sort of government intervention in markets.  It does not make people more productive, it does not create jobs, it does not increase output and it does not increase future cash flows.   The Fed and BOJ hope to spark an investment and hiring boom.  Unfortunately, there is no evidence that this sort of intervention can lower rates, increase borrowing or increase sustained economic activity.  The conclusions should be obvious to everyone.  A shuffling around of Fed assets does not alter private sector net financial assets.  It might alter perceptions in the near-term, but hoping for a sustained recovery generated by the Fed’s balance sheet is sheer fantasy.  Herding investors into risk assets that do not show the underlying fundamental improvement to sustain higher prices is nothing more than Ponzi finance.  Or what Brian Sack prefers to call ” United States monetary policy”.

Friday, October 29, 2010

U Mich Consumer Sentiment Modest Disappointment

This disappointment has had virtually no effect on the market. This was the poorest showing in nearly a year -- November 2009.

from Fox Business:

U.S. consumer sentiment worsened more than expected in October, hitting its weakest level since November, with concern about the economy high leading into next week's election, a survey showed on Friday.
The Thomson Reuters/University of Michigan's final October reading on the overall index on consumer sentiment came in at 67.7, down from 68.2 in September and below the 68.0 median forecast among economists polled by Reuters.

Q3 GDP Prints At 2.0%

This was slightly better than expected, but didn't move the needle much until open. Stocks are now back to flat. But most of it was based upon more inventory rebuilding, not sales. Thus, the internals were weak.

But Treasuries Rise on GDP Data

This is interesting because treasuries tend to rise on bad data. Does the bond market see something ominous that the stock market doesn't?

Thursday, October 28, 2010

Debase, Default, and Deny

Another phenomenal article by Gordon Long:

In September 2008 the US came to a fork in the road. The Public Policy decision to not seize the banks, to not place them in bankruptcy court with the government acting as the Debtor-in-Possession (DIP), to not split them up by selling off the assets to successful and solvent entities, set the world on the path to global currency wars.
By lowering interest rates and effectively guaranteeing a weak dollar through undisciplined fiscal policy, the US ignited an almost riskless global US$ Carry Trade and triggered an uncontrolled Currency War with the mercantilist, export driven Asian economies. We are now debasing the US dollar with reckless spending and money printing with the policies of Quantitative Easing (QE) and the expectations of QE II. Both are nothing more than effectively defaulting on our obligations to sound money policy and a “strong US$”. Meanwhile with a straight face we deny that this is our intention.  
It’s called debase, default and deny.
Though prior to the 2008 financial crisis our largest banks had become casino like speculators with public money lacking in fiduciary responsibility, our elected officials bailed them out. Our leadership placed America and the world unknowingly (knowingly?) on a preordained destructive path because it was politically expedient and the easiest way out of a difficult predicament. By kicking the can down the road our political leadership, like the banks, avoided their fiduciary responsibility. Similar to a parent wanting to be liked and a friend to their children they avoided the difficult discipline that is required at certain critical moments in life. The discipline to make America swallow a needed pill. The discipline to ask Americans to accept a period of intense adjustment. A period that by now would be starting to show signs of success versus the abyss we now find ourselves staring into.  A future that is now significantly worse and with potentially fatal pain still to come.
Unemployed Americans, the casualties of the financial crisis wrought by the banks, witness the same banks declaring record earnings while these banks refuse to lend. When the banks once more are caught with their fingers in the cookie jar with falsified robo-signing mortgage title fraud, they again look for the compliant parent to look the other way. Meanwhile the US debt levels and spending associated with protecting these failed (and still insolvent institutions) are so out of touch with US de-industrialized productive capability that the US dollar is falling and forcing countries around the world to devalue their currencies in a desperate attempt to maintain competitive advantage. So much for the “strong dollar” mantra we heard endlessly for years from every US Secretary of the Treasury that needed foreign investment to fund our deficits. Like second rate powers, our word is no longer our bond.
The fork in the road which we chose has resulted in:
1) massive public debt levels that can never realistically be expected to be paid back,
2) Financial markets that are disconnected from fundamental historical values,
3) A global banking industry that can best be described as fragile and is realistically insolvent if the accounting games were to be removed.
I think most would agree that massive public, private and consumer debt levels are a central problem to the current global predicament. We also however need to appreciate that these massive debt build ups have also allowed the over-building of production capacity. We have global supply that is now outstripping demand.  The output gap in the US alone would require a theoretical -7% Fed Funds Rate according to the Taylor Rule (6)
The currency wars are being fought because global players are being forced to fight for a piece of the global demand pie that is growing at a slower rate (a first derivative problem) versus the capacity presently available and coming online. The Asian buildup of production capacity is nothing short of startling but it is premised on a free spending and 70% consuming US economy. A slowdown in the US and a weakening US dollar are major threats to political and social stability in the Asian export economies. Everything in the mercantile, export led Asian economies must be done to avoid this. The facts however are that there are no longer sufficient jobs in America to support past and present levels of consumptions. The middle class in America is quickly becoming extinct and with it the ability to famously ‘shop till they drop’.
What are the US politicos to do?  The well recognized Michael Hudson asserts in Why the U.S. Has Launched a New Financial World World War:
“Finance is the new form of warfare – without the expense of a military overhead and an occupation against unwilling hosts. It is a competition in credit creation to buy foreign resources, real estate, public and privatized infrastructure, bonds and corporate stock ownership. Who needs an army when you can obtain the usual objective (monetary wealth and asset appropriation) simply by financial means? All that is required is for central banks to accept dollar credit of depreciating international value in payment for local assets. Victory promises to go to whatever economy’s banking system can create the most credit, using an army of computer keyboards to appropriate the world’s resources. The key is to persuade foreign central banks to accept this electronic credit.
U.S. officials demonize foreign countries as aggressive “currency manipulators” keeping their currencies weak. But they simply are trying to protect their currencies from being pushed up against the dollar by arbitrageurs and speculators flooding their financial markets with dollars. Foreign central banks find them obliged to choose between passively letting dollar inflows push up their exchange rates – thereby pricing their exports out of global markets – or recycling these dollar inflows into U.S. Treasury bills yielding only 1% and whose exchange value is declining. (Longer-term bonds risk a domestic dollar-price decline if U.S interest rates should rise.)
What is to stop U.S. banks and their customers from creating $1 trillion, $10 trillion or even $50 trillion on their computer keyboards to buy up all the bonds and stocks in the world, along with all the land and other assets for sale in the hope of making capital gains and pocketing the arbitrage spreads by debt leveraging at less than 1 per cent interest cost? This is the game that is being played today.”
The chart to the right was published in early spring of this year specifically spelling out that a ‘Beggar-thy-Neighbor’ roadmap lay ahead.
How could I have been so sure when I put this chart together? The realistic fact about wars are that there are winners and losers. These however are not the people on the battlefield. Since Caesar, wars are about money. The winners are those who finance them and the losers are those that pay for them. Rich banking families are well documented to have financed both sides. It matters not much who wins but rather that a war is fought so money is made.
So who actually wins in a currency war?  The answer is found by forensically following the money.
The most effective way of following the money is to consider the major new innovations in the financial world. Like all wars the winner is the one who innovates the ‘combat technology’ the fastest.
We need to remember that the financial innovations discovered during and after the financial crisis such as: Collateralized Debt Obligations (CDOs), Credit  Default Swaps (CDSs), Structured Investment Vehicles (SIVs), Special Purpose Entities (SPE’s) and a raft of securitization products were the foundations upon which were built the “Toxic Assets” and the reason for the global financial crisis. The toxic assets were the catalyst which we continuously heard referred to during the crisis which forced the government into massive public debt government spending in an apparent attempt to avoid a financial collapse.

If we examine the latest raft of new weaponry, we can easily see where this is headed, how the money will flow, who wins and unfortunately who loses.
1-    FIAT PAPER BOMBERS - Quantitative Easing

Quantitative Easing is an euphemism for printing money. The US has embarked on a massive untested trial in recklessly printing money.
2-    CURRENCY MISSILES - US$ Carry Trade

Like the hydrogen bomb was to the early atomic bomb, the US$ Carry Trade is to the original pilot Japanese Carry Trade. IF QE are the bombs, then the US dollar carry trade are the missiles that deliver the bombs. With borrowing costs in the US approaching zero, a weakening carry currency and unlimited money creation, we have the perfect carry trade missile that can and will hit any economy in the world.
3-    REGULATORY ARBITRAGE - Guarantees and Contingent Liabilities

I have written extensively how the financial crisis has served as a vehicle to shift debt obligations from the banking and private sector to the public sector. This has been achieved through government guarantees, the use of balance sheet contingent liabilities and interest rate / currency swaps. It is the battlefield strategy of Regulatory Arbitrage.


The extensive hidden use of Public Private Partnerships & Private Finance Initiatives (PPP/PFI) recently came to light during the European Sovereign debt crisis. This tool has become the guidance system for missile delivery since it allows the conversion of freshly printed fiat paper into real, unencumbered, revenue producing assets.

5-    AN UNREGULATED $615 TRILLION – Derivative Swaps 
The unregulated, off balance sheet, offshore, non exchange traded, private SWAP vehicle is the ideal vehicle with which to control global financial markets. The Sultans of Swaps now operate much as the Bond Vigilantes did at one time but with different control and much different motives. The growth of the SWAP market in interest rate and currency swaps effectively muzzled and obsoleted the Bond Vigilantes of yesteryear.
HOW THE MONEY WILL BE MADE – Paper Assets Exchanged for Real Assets

1-    TAKE OVER PUBLIC SECTOR ASSETS – buildings, land, treasuries.
2-    TAKE OVER PRIVATE SECTOR ASSETS - land and resources.
3-    TAKE OVER OF SOVEREIGN TREASURY – transfer of sovereign treasury gold holdings
4-    MAJOR CORPORATE CONSOLIDATIONS  - reduced competition, reduced monopoly laws and emergence of cartels
5-    NATIONALIZATION OF PRIVATE & PUBLIC PENSIONS - government grab of financial assets
The financiers of the currency wars understand that real wealth in its most simplistic essence can only be created by:
Paper money is simply a tool for the trading of wealth. When money is backed by a hard asset then it also becomes a store of that wealth. However that is not the case with fiat currencies. Though Gold is real wealth it does not grow wealth, but rather stores it or protects it from the debasement of paper ‘trading’ instruments. Ideal real wealth is wealth that continues to grow and yet maintains its inherent value. Over the longer term it is usually better to own well managed, unencumbered agricultural producing land, producing mines and production facilities than just the wealth product they output. The Rothschild banking family learned this hundreds of years ago and is the reason why they moved from solely owning gold to energy, mining, agriculture and selective base materials process production.

One mistake after another has been made in an attempt to ‘kick the can down the road’ and avoid the inevitable necessity to restructure the debt. Unfortunately when it is restructured it will be at the expense of the public and not the original parties. The cost to the tax payer will be insurmountable debt and the forced surrender of pubic assets. Public assets that in the future will be charged for by ’Private Banking’ and Special Purpose Entity (SPE) owners.
            => BAILOUTs:  Banks, AIG, GM, Fannie Mae / Freddie Mac
                        => ZIRP
                                    => TARP & ARRA          
                                                => HAMP, Cash for Clunkers etc.
                                                            => Extend & Pretend Accounting
                                                                        => QE I (Buying $1.7B in        
                                                                               (Mortgage & Treasury Products)
                                                                                    => QE II
Like a well oiled machine the sequence of events continue to unfold as laid out in my Extend & Preserve article series. The implementation of Quantitative Easing (QE I) and change in GAAP Mark-to-Market accounting treatment ignited the initial rally leg. With further refinements (see EXTEND & PRETEND - Manufacturing a Minsky Melt-Up) it continued until it became evident that the US employment and GDP were not improving in any meaningful manner despite $13T of Spend, Lend and Guarantee initiatives. Then as the polarization of the EU wanting ‘austerity’ policies versus the US wanting ‘stimulus’ measures, the US dollar began weakening and stocks stopped their retracement in June. When Bernanke signaled QE II in August the financial markets were once again ignited and the US dollar weakened further. The financial markets are now propelled by both euphoria and fear of more liquidity being made readily available. It will not end well as we naively get caught in the spider’s carefully laid out trap.
An interesting fact is that the US has positioned itself for this war as a result of the spending on previous wars. According to Michael Hudson (5):
“What destabilized the system was war spending. War-related transactions spanning World Wars I and II enabled the United States to accumulate some 80 per cent of the world’s monetary gold by 1950. This made the dollar a virtual proxy for gold. But after the Korean War broke out, U.S. overseas military spending accounted for the entire payments deficit during the 1950s and ‘60s and early ‘70s. Private-sector trade and investment was exactly in balance.
By August 1971, war spending in Vietnam and other foreign countries forced the United States to suspend gold convertibility of the dollar through sales via the London Gold Pool. But largely by inertia, central banks continued to settle their payments balances in U.S. Treasury securities. After all, there was no other asset in sufficient supply to form the basis for central bank monetary reserves. But replacing gold – a pure asset – with dollar-denominated U.S. Treasury debt transformed the global financial system. It became debt-based, not asset-based. And geopolitically, the Treasury-bill standard made the United States immune from the traditional balance-of-payments and financial constraints, enabling its capital markets to become more highly debt-leveraged and “innovative.” It also enabled the U.S. Government to wage foreign policy and military campaigns without much regard for the balance of payments.”
We don’t need to go into the additional costs of the wars in Iraq and Afghanistan, Homeland Security (War on Terror) and military base expansion into 130 countries which have exploded the US fiscal deficits. Suffice it to say that these and all wars since Vietnam are wars that have been conducted without increasing taxes – a historical first which draws little attention or concern.
The present fiat currency system will end based on the strategy of Debase, Default and Deny! It is my opinion that it will be replaced by a system structured on the IMF and BIS’s Strategic Drawing Rights (SDRs) partially backed by precious metals. The question to be asked however is not what will be the replacement for fiat currency, but who will have ownership of the assets after this war ends?  Who will pay the requisite ‘tribute’ that goes to the victors?
“Fiat Paper Bombers Spotted Overhead!!”

Sign Up for the next release in the Currency Wars series:  Currency Wars
Follow developments in the Currency Wars daily at Tipping Points
(2) 10-04-10 Economic Measures Continue to Slow Hussman Funds   John P Hussman Ph.D.
(3) 10-11-10 No Margin of Safety, No Room for Error Hussman Funds   John P Hussman Ph.D.
(4) 01-19-10 Bernanke’s Sorcery Will Fail  Arun Motianey
(6) 10-27-10
The Fed's impending blunder  Ambrose Evans-Prichard, 

Dollar in Freefall

"...if indeed the Fed sees the Dollar as one of its key policy levers for preventing inflation from staying below its mandate for a prolonged period the Dollar needs to fall a lot further from here."  --Robin Brook, Goldman Sachs

Gold Gleams

Stocks Reverse, Go Negative

Surprising reversal to me. Something is afoot!

The Fed polled the primary dealers this morning to know what they want the Fed to do with QE2. Unbelievable. Monetary by poll!

Another Dollar Drubbing

Futures Rise on "Seasonally Adjusted" Jobless Claims

Previous claims were revised higher! Actual claims were also higher! But stocks are also higher!

Wednesday, October 27, 2010

Turbulent Day for Stocks

Durable goods was up 3.3%, but only in the transportation sector. Everything else was down 0.8%.

Existing home sales were up 6.6%, a good showing.

But stocks are down for worries over QE2, Fed over-reach, P&G and Whirlpool earnings,

Tuesday, October 26, 2010

What Inflation Looks Like in Real Life

by Jake Weber of the the Casey Report:

The Casey Report provides a useful glance at the real inflation currently ravaging items that are actually purchased by Americans, not those captured by the Fed's BLS statistics: "On average, our basic food costs have increased by an incredible 48% over the last year (measured by wheat, corn, oats, and canola prices). From the price at the pump to heating your stove, energy costs are up 23% on average (heating oil, gasoline, natural gas). A little protein at dinner is now 39% higher (beef and pork), and your morning cup of coffee with a little sugar has risen by 36% since last October." Of course, the ongoing deflation in items purchases requiring leverage will continue to skew the CPI so far south to make all those who bought 5 Year TIPS yesterday at negative yields end up losing money on the transaction.
Chart of the Week: Inflation in the Real World, by Jake Webber of Casey Report
As is often the case, there is a big difference between what the government statistics are reporting and what’s going on in the real world. According to the most recent inflation reading published by the Bureau of Labor Statistics (BLS), consumer prices grew at an annual rate of just 1.1% in August.

The government has an incentive to distort CPI numbers, for reasons such as keeping the cost-of-living adjustment for Social Security payments low. While there’s no question that you may be able to get a good deal on a new car or a flat-screen TV today, how often are you really buying these things? When you look at the real costs of everyday life, prices have risen sharply over the last year. For simplicity’s sake, consider the cash market prices on some basic commodities.

On average, our basic food costs have increased by an incredible 48% over the last year (measured by wheat, corn, oats, and canola prices). From the price at the pump to heating your stove, energy costs are up 23% on average (heating oil, gasoline, natural gas). A little protein at dinner is now 39% higher (beef and pork), and your morning cup of coffee with a little sugar has risen by 36% since last October. 

You probably aren’t buying new linens or shopping for copper piping at the hardware store every day, but I included these items to show the inflationary pressures on some other basic materials that will likely affect consumer prices down the road.

The jump in gold and silver prices illustrates that it’s not just supply and demand issues driving the precious metals higher – the decline in purchasing power of the dollar is also showing up in the price of physical goods. It is because stashing wheat and cotton in the garage is an impractical way to protect purchasing power that investors are increasingly looking to protect themselves with the monetary metals – a trend that is now very much in motion.

Ballistic Beans

Broad Commodity Indexes Continue to Rise

Note, however, on the daily chart that volume is showing a decline and a divergence in the lower panel.

The High Price of Rice

I may not be able to afford my favorite -- Chinese food -- for much longer. I am also a huge fan of Thai, Lao, and sometimes Japanese food.

Consumer Confidence Beats Expectations, Stocks Surge Temporarily

from Fox Business:

U.S. consumer confidence rose slightly in October but remained near historically low levels as concerns about the labor market persisted, according to a private sector report released on Tuesday.
The Conference Board, an industry group, said its index of consumer attitudes rose to 50.2 in October from a revised 48.6 in September.

Case Shiller Contracts in August

“A disappointing report. Home prices broadly declined in August. Seventeen of the 20 cities and both Composites saw a weakening in year-over-year figures, as compared to July, indicating that the housing market continues to bounce along the recent lows,” says David M. Blitzer, Chairman of the Index Committee at Standard & Poor’s. “Over the last four months both the 10- and 20-City Composites show slowing growth, after sustaining consistent gains since their April 2009 troughs.
“The month-over-month growth rates tell the same story. Fifteen of the 20 MSAs and the two Composites saw a decline in the month of August as compared to July levels. The 10- and 20-City Composites fell 0.1% and 0.2%, respectively. Indeed, the housing market appears to have stabilized at new lows. At this time, it does not seem that any of the markets are hanging on to the temporary momentum caused by the homebuyers’ tax credits.”

Monday, October 25, 2010

Here Comes Mortgage Meltdown, Act 2 (part 2)

part 2 from John Mauldin:

At the end of last week's letter on the whole mortgage foreclosure mess, I wrote:
"All those subprime and Alt-A mortgages written in the middle of the last decade? They were packaged and sold in securities. They have had huge losses. But those securities had representations and warranties about what was in them. And guess what, the investment banks may have stretched credibility about those warranties. There is the real probability that the investment banks that sold them are going to have to buy them back. We are talking the potential for multiple hundreds of billions of dollars in losses that will have to be eaten by the large investment banks. We will get into details, but it could create the potential for some banks to have real problems."
Real problems indeed. Seems the Fed, PIMCO, and others are suing Countrywide over this very topic. We will go into detail later in this week's letter, covering the massive fraud involved in the sale of mortgage-backed securities. Frankly, this is scandalous. It is almost too much to contemplate, but I will make an effort.
But first, let me acknowledge the huge deluge of emails I got over last week's letter, the most I can ever remember. I thought about just making this week's letter a response to many of them, but decided I needed to go ahead and finish the topic at hand. Maybe another time. As a side note, I quoted a letter that came to me anonymously via David Kotok. I said if I found out who wrote it, I would give them credit. It was originally written by Gonzalo Liro, at
Many of you wrote to point out that his argument about the tracking of title was not correct, but others pointed out many other issues as well. This is one of the most complex problems we face, and I got a lot of good information from readers. It just makes me wish I had our new web site finished so you could avail yourselves of the wisdom among my readers. We are close, down to final changes. And now, on to today's letter.

They Knew What They Were Selling
It's hard to know where to start. There is just so much here. So let's begin with testimony from Mr. Richard Bowen, former senior vice-president and business chief underwriter with CitiMortgage Inc. This was given to the Financial Crisis Inquiry Commission Hearing on Subprime Lending andnd Securitization andnd Government Sponsored Enterprises. I am going to excerpt from his testimony, but you can read the whole thing (if you have a strong stomach) at (Emphasis obviously mine.)
"The delegated flow channel purchased approximately $50 billion of prime mortgages annually. These mortgages were not underwriten by us before they were purchased. My Quality Assurance area was responsible for underwriting a small sample of the files post-purchase to ensure credit quality was maintained.
"These mortgages were sold to Fannie Mae, Freddie Mac [We will come back to this - JM] and other investors. Although we did not underwrite these mortgages, Citi did rep and warrant to the investors that the mortgages were underwritten to Citi credit guidelines.
"In mid-2006 I discovered that over 60% of these mortgages purchased and sold were defective. Because Citi had given reps and warrants to the investors that the mortgages were not defective, the investors could force Citi to repurchase many billions of dollars of these defective assets. This situation represented a large potential risk to the shareholders of Citigroup.
"I started issuing warnings in June of 2006 and attempted to get management to address these critical risk issues. These warnings continued through 2007 and went to all levels of the Consumer Lending Group.
"We continued to purchase and sell to investors even larger volumes of mortgages through 2007. And defective mortgages increased during 2007 to over 80% of production."
Mr. Bowen was no young kid. He had 35 years of experience. He was the guy they hired to pay attention to the risks, and they ignored him. How could a senior manager not get such an email and not notify his boss, if only to protect his own ass? They had to have known what they were selling all the way up and down the ladder. But the music was playing and Chuck Prince said to dance and rake in the profits (and bonuses!). More from his testimony:
"Beginning in 2006 I issued many warnings to management concerning these practices, and specifically objected to the purchase of many identified pools. I believed that these practices exposed Citi to substantial risk of loss.
Warning to Mr. Robert Rubin and Management
"On November 3, 2007, I sent an email to Mr. Robert Rubin and three other members of Corporate Management... In this email I outlined the business practices that I had witnessed and attempted to address. I specifically warned about the extreme risks that existed within the Consumer Lending Group. And I warned that there were 'resulting significant but possibly unrecognized financial losses existing within Citigroup.'"
And now taxpayers own 75% of Citi, and our losses to them are huge. They are going to get worse, as we will see.
Now let's turn to the testimony of Keith Johnson, who worked for various mortgage companies and in 2006 became the president and chief operating officer of Clayton Holdings, the largest residential loan due diligence and securitization surveillance company in the United States and Europe. This is testimony he gave before the Financial Crisis Inquiry Commission. Part of the testimony is by his associate Vicki Beal, senior vice-president of Clayton. The transcript is some 277 pages long, so let me summarize.
Investment banks would come to Clayton and give then roughly 10% of the mortgages that they intended to buy and put into a security. Clayton rated them on whether the documentation was what it was supposed to be, not as to whether they thought it was a good loan. Still, 46% of the loans did not have proper documentation (out of a pool of 9 million loans) and 28% had what was determined to be level 3 disqualifications that simply had no mitigating circumstances. Understand, these were loans that were already written, and there was no effort to check the facts, just the documentation.
And ultimately 11% of these loans (39% of the level 3's) were put back in by the investment bank. And what happened to the loans that were rejected? (This might require an adult beverage and a few expletives deleted.)
Popping Through
They were put back into another pool, where again only 10% of the loans were examined. Quoting from the testimony:
"MR. JOHNSON: I think it goes to the 'three strikes, you're out' rule.
"CHAIRMAN ANGELIDES: So this was a case of - okay, three strikes.
"MR. JOHNSON: I've heard that even used. Try it once, try it twice, try it three times, and if you can't get it out, then put -
"CHAIRMAN ANGELIDES: Well, the odds are pretty good if you are sampling 5 to 10 percent that you'll pop through. When you said the good, the bad, the ugly, the ugly will pop through."
Yes, you read that right. If a loan was rejected a second time, it went back into yet another pool for a third try. The odds of coming up three times, when only 5 or 10 percent are sampled? About 1 in a thousand. Popping through, indeed.
Clayton presented their data to the ratings agencies, investment banks, and others in the industry. They were frustrated that no one was really paying attention or taking heed of their warnings.
Here is what Shahien Nasiripour, the business reporter for the Huffington Post, wrote (his emphasis). For those interested, the entire article is worth reading. (
"Johnson told the crisis panel that he thought the firm's findings should have been disclosed to investors during this period. He added that he saw one European deal mention it, but nothing else.
"The firm's findings could have been 'material,' Johnson said, using a legal adjective that could determine cause or affect a judgment.
"It's unclear whether the firms ended up buying all of those loans, or whether Wall Street securitized them all and sold them off to investors.
"'Clayton generally does not know which or how many loans the client ultimately purchases,' Beal said. That likely will be the subject of litigation and investigations going forward.
"'This should have a phenomenal effect legally, both in terms of the ability of investors to force put-backs and to sue for fraud,' said Joshua Rosner, managing director at independent research consultancy Graham Fisher & Co.
"'Original buyers of these securities could sue for fraud; distressed investors, who buy assets on the cheap, could force issuers to take back the mortgages and swallow the losses.
"'I don't think people are really thinking about this,' Rosner said. 'This is not just errors and omissions - this appears to be fraud, especially if there is evidence to demonstrate that they went back and used the due diligence reports to justify paying lower prices for the loans, and did not inform the investors of that."
"Beal testified that Clayton's clients use the firm's reports to 'negotiate better prices on pools of loans they are considering for purchase,' among other uses.
"Nearly $1.7 trillion in securities backed by mortgages not guaranteed by the government were sold to investors during those 18 months, according to Inside Mortgage Finance. Wall Street banks sold much of that. At its peak, the amount of outstanding so-called non-agency mortgage securities reached $2.3 trillion in June 2007, according to data compiled by Bloomberg. Less than $1.4 trillion remain as investors refused to buy new issuance and the mortgages underpinning existing securities were either paid off or written off as losses, Bloomberg data show.
"The potential for liability on the part of the issuer 'probably does give an investor more grounds for a lawsuit than they would ordinarily have', Cecala said. 'Generally, to go after an issuer you really have to prove that they knowingly did something wrong. This certainly seems to lend credibility to that argument.'
"'This appears to be a massive fraud perpetrated on the investing public on a scale never before seen,' Rosner added."
It's Time for Some Putback Payback
Investment banks large and small originated a lot of subprime garbage in the 2005-2007 era. This week PIMCO, Black Rock, Freddie Mac, the New York Fed, and - what I think is key and no one has picked up on - Neuberger Berman Europe, Ltd., an investment manager to a managed-account client, came together and sued Countrywide for not putting back bad mortgages to its parent, Bank of America. This is the first of what will be a series of suits aimed at getting control of the portfolio and peeking into the mortgages. (Text of lawsuit at
Basically, if buyers of 25% or more of a mortgage-backed security can come together, they have standing to sue the mortgage servicer to do its duty to the investors and make putbacks of bad mortgages, and if they fail to do so the plaintiffs can take control of the process and take the issuer to court directly (that's a very simplistic description but roughly accurate).
There are two key take-aways. First, note that a European entity is involved. Hundreds of billions of dollars of this junk was sold to European banks and funds. And these guys get together at conferences (sometimes they even invite me to speak). So Helmut will be talking to Lars who will talk to Jean Pierre and they will realize they all own some of this junk. They will be watching with very real interest to see how the big boys at PIMCO and Black Rock and the New York Fed fare in their efforts. And then you can count on them all piling on (more later on this).
Second, little noticed this week was the fact that The Litigation Daily wrote that Philippe Selendy of Quinn Emanuel Urquhart & Sullivan has been retained by the Federal Housing Finance Agency (FHFA), which oversees Fannie Mae and Freddie Mac, to investigate billions of dollars in potential claims against banks and other issuers of mortgage-backed securities.
Who? Not on your celebrity list? Just wait. He will soon be getting the best tables everywhere. He and his firm are the guys representing MBIA in all their cases against Countrywide and Merrill Lynch. And they are kicking ass. Slowly to be sure, but very steady. That means Fannie and Freddie are getting ready to get serious.
They were sold well over $227 billion of the subprime garbage issued in 2006 and 2007. And the bad stuff started before then. But they have one advantage that the guys at PIMCO, et al. don't have: they (or actually the FHFA) are a federal agency. That means they have subpoena power. The agency has sent 64 subpoenas to issuers of mortgage-backed securities, and although they have not said who they went to, they obviously include almost everyone and clearly all the big players. (They couldn't have ignored Goldman, could they? Naah. Too obvious.)
From American (I know, this website is probably already on your favorites list, but for those souls who actually have a life I provide the text):
"Through those subpoenas, the agency could gain access to the loan files for the mortgages that backed the securities it bought and thus establish whether the mortgages were what the issuers represented them to be in securities contracts. According to the Journal, the difficulty of obtaining loan files has been a big obstacle for investors trying to force issuers to repurchase bonds.
"If the FHFA were to decide down the road to initiate litigation, it would still have to have the support of a percentage (usually 25 percent) of its fellow bondholders for each issue. But given what the agency and its Quinn lawyers will be able to see before bringing suit, it probably won't be too hard to get other investors on the bandwagon." (
It is tough not to jump to the conclusion, but we need one more piece of the puzzle before we get there.
The Worst Deal of the Decade?
Arguably Bank of America had Merrill shoved down their throats, but no one can say that about the acquisition of Countrywide. And Countrywide could end up costing BAC $50 billion or more in losses. That may prove to be a serious candidate for worst deal of the decade. (Although WAMU is a leading candidate too!)
Let's look at a report by Branch Hill Capital, a hedge fund out of San Francisco. And before we start on it, let me point out they are short Bank of America. You can see the full PowerPoint at
(And let me say a big thanks to the author of the report, Manal Mehta, for all the background material he sent me and his help with this week's letter. It helped make it a lot better. Of course, any erroneous conclusions or outrageous statements are all mine.)
First, they point out that the potential size of Bank of America's (BAC) liabilities is $74 billion (with a B). And that is just for Countrywide. That does not include Merrill, which is also large. Against that they have set aside $3.9 billion. You can count on more suits than just the PIMCO, et al. mentioned above.
In the MBIA case, the judge has ruled that the suit can proceed even though BAC has denied responsibility. Although on appeal, this is high-stakes poker. Countrywide originated over $1.4 trillion of mortgages in 2005-2007. MBIA alleges that over 90% of the defaulted or delinquent loans in the Countrywide securitizations show material discrepancies. Care to take the under in the over/under bet on that?
Further to the case on BAC, Merrill was the largest originator of subprime CDOs during the housing boom, for another $120 billion, along with about $255 billion of residential mortgage-backed securities.
And then there are all those CDOs (collaterized debt obligations). Merrill did a lot of those that went sour. This deserves it own leter, but a gentleman named Wing Chau went from making $140k a year to $25 million in just a few years, putting together CDOs from Merrill, some of which were completely bankrupt in just six months.
Countrywide has already settled with the New York pension funds for $624 million, one of the largest securities fraud settlements in US history. And the line is growing longer.
Of course, BAC CEO Brian Moynihan denied this week that there is a problem. Let's look at Moynihan's statements at the last earnings call and compare them to what the judge in the case said earlier. Moynihan:
"... we execute repurchases on a loan by loan basis... And as we learn more, and again, our perspective on this - we're going to be quite diligent as I said in defending the interest of our shareholders. This really gets down to a loan-by-loan determination and we have, we believe, the resources to deploy against that kind of a review."
Back in June the judge on the case (a Judge Bransten) said (from the transcript):
"I think that it makes all the sense in the world that you can use a sample to prove the case because otherwise I can't imagine a jury listening to 386 thousand cases. Even if you have that available, nevertheless you are not going to present that to a jury or even to a judge. I'm patient but not that patient. So therefore it is going to be a sample in the end..."
OK, let me get this straight, Brian. Your company committed fraud, with robosignings and all the rest, and you won't man up and take responsibility? You and your lawyers want to thrash this out, case by case, fighting a trench-warfare, rear-guard action? Well I'm afraid that's not going to work out for you. There are so many examples of Countrywide outright fraud that it is going to be hard to convince a jury that BAC is not on the hook. Will it take years? Of course.
You can read the PowerPoint for details. Bottom line: BAC is probably liable for putbacks that could total over a hundred billion. And that is just BAC.
Think Citi. And any of the scores of mortgage originators and investment banks. There were a couple of trillion dollars in these securitizations issued. Plus how many hundred of billions of second-lien loans? And can we forget CDOs? And CDOs squared?
And let's not forget all those completely synthetic CDOs that were written at the height of the mania. Most of it AAA, of course. Frankly, anyone stupid enough to buy a synthetic CDO should lose their money, but that is not what the courts will base their decision on. It is all about representations and warranties. And maybe a little fraud.
I picked on BAC because that is the analysis I saw. But it could be any of dozens of banks. Look at this list from the Branch Hill PowerPoint.

Could we see a hundred billion in losses to the major banks? In my opinion we will for sure, over time. $200 billion? Probably. $300 billion? Maybe. $400 billion? It depends on how organized the investors in the securities get and what gets settled out of court. Out of a few trillion dollars in securitizations? It's anybody's guess. I just made mine.
But let's not forget the $227 billion sold to Fannie and Freddie. Taxpayers are on the hook for $300-400 billion in losses. Those putbacks could save us a lot. Will this threaten the viability of some banks? Maybe. But most will survive. BAC made $3 billion last quarter. A steep yield curve (with the help of the Fed) can cure a lot of evils. But it will absorb the profits of a lot of banks for a long time.
And that of course, will come back to haunt the rest of us as banks have to raise more capital and get more conservative.
Anyone who owns stocks in banks with relatively large MBS exposure is not investing, they are gambling that the losses will not be more than management is telling them. There will be no bailouts (at least I hope not) this time around. Fool me once, shame on you; fool me twice, shame on me. There will be little sympathy for shareholders or bondholders this time, if it comes to that.
One more sad point. The FDIC (read taxpayers) is liable for some of this, as they took over some of these institutions. It just keeps on coming.
Final rant. If you were part of a group that knowingly created or sold flawed and fraudulent mortgage-backed securities to pensions and insurance companies and took home tens of millions in bonuses, up and down the management chain, maybe you should consider moving yourself and your money to a country that does not honor US extradition, because my guess is that, as all this comes out, you may have to hire some very expensive lawyers and get measured for pinstripes.
And the Mozilo agreement was a sham. Sigh. That would be the equivalent of fining me $10,000 and letting me keep my tanning bed. I don't have the space to go into the fraud at Countrywide, but their internal documents show they all knew what was going on.