Death Spiral / No Bull Interview

I had an interesting interview today with Dave Donhoff at No Bull Mortgage regarding the implosion of New Century Financial and subprime lenders in general. Before checking in with Donhoff here is some recent news on the Death Spiral at New Century.

Several analysts agreed Monday that New Century Financial Corp., one of the nation's largest subprime mortgage lenders, likely faces liquidation or bankruptcy following revelations that it's under criminal investigation and in violation of debt covenants with several lenders.

"New Century is more likely to enter the death spiral we had feared, as filing delays, financial difficulties, likely restricted liquidity and regulatory/criminal investigations could conspire to limit its options outside of bankruptcy," Merrill Lynch analysts wrote early Monday.

New Century's shares were down more than 69% at $4.53 in afternoon trades Monday, after dropping in Friday's session as well. Analysts at Jefferies & Co. also said the company has moved into worst-case scenario territory with its Friday filing. They cut their rating on the shares to underperform from hold.

"New Century's situation is not unlike the 'Prisoners Dilemma.' If the majority of lenders stand pat, they can mitigate losses. However, if they believe that other lenders will pull their lines, those first to act will be best served," Jefferies analysts told clients.

Let's see. Now that New Century Finance has plunged a 69% on March 5th alone and is now down a "mere" 86.21% since February 8th, Jefferies finally managed to dredge up the nerve to cut their rating to "underperform" from "hold".

Here is a tip to Jefferies: When doing downgrades like this, try and do it when no news agency is looking. The way you did it makes you look silly. The point being someone may just start wondering about all of your other recommendations.

Then again, isn't everyone supposed to know that "hold" really means "sell"? But if so, then what exactly what do "underperform" and "sell" mean? While everyone is pondering that, inquiring minds are wondering: If a criminal investigation and an 86% plunge does not generate a sell recommendation, exactly what will? Note: 86% is from the February high to the downgrade by Jefferies. NEW plunged an additional 25% today bringing the total decline to roughly 88% .

No Bull Interview

What prompted my call to Dave Donhoff was his post on The Market Traders.

Mortgage Implode is only showing registered LENDERS.
BROKERAGES going tits-up are probably 10-15 to every individual lender.
BLOOD in the streets EVERYWHERE.

A phone conversation revealed that 10-15 is an extremely conservative estimate. There are no national statistics available and depending on how one classifies "brokerages" (e.g. the number of firms vs. the number of branches vs. the average individual running his business on his PC, the number could be as high as 100-1 or even 500-1.

The reason there is "blood everywhere" is that mortgages are being returned (sold back) not just to lenders from securitizations gone bad, but lenders are in turn forcing the re-purchase of those mortgages back to brokers in record numbers as well. A typical contract between a brokerage firm and a lender might stipulate that new loans must stay current for at least 90 days or they must be repurchased by the originating brokerage. On Alt-A or subprime loans the length of time might be as long as 6 months.

Now that delinquencies are rising everywhere, brokerage firms simply have not been prepared for the forced repurchases of loans. Donhoff noted that each lender's wholesale relationship contract is different as "stay current" timeframe requirements are negotiated between lenders and brokerages. The larger warehouse banks (e.g. Merrill Lynch, or Lehman) that provide the funding for retail banks like OwnIt, MLN, AmeriQuest, etc, have even stiffer requirements within their contracts.

Once a certain threshold of 90 day late pays is hit, contract stipulations might require reserve requirements that the retail banks can not meet. "The situation is not unlike a margin call" said Donhoff. "Unless reserve requirements are immediately met, new loan funding is shut off and the retail mortgage bank is forced out of business."

I asked Dave Donhoff how he was doing personally. Donhoff replied that he has a "ten year record of no mortgage buy-backs and no foreclosures". Perhaps that can be expected from someone who steers people away from risky loans and will not accept stated income loans if he thinks the applicant was exaggerating. Nonetheless Donhoff said "I was lucky. A few close calls over the years were all worked out."

I find it interesting that many small brokerage firms had to put up personal guarantees in the form of bonding and/or pledged personal assets. That means owners of those companies are personally liable above and beyond corporate liability. Looking ahead, there is potential for another wave of litigation over these blow-ups as the larger players start targeting some of those who not too long ago were riding high in their Ferraris. It's a death spiral on multiple fronts.

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

Vote of "no confidence" at CFC

There has been a stunning vote of "no confidence" by CFC insiders over the last six months. This chart says it all.

While insiders have been bailing as fast as they can (to the tune of 73% of their shares), institutional ownership has barely budged.

Perhaps this is not a fair comparison as the total number of shares held by institutions is enormous. Besides, who are those institutional owners going to sell their shares too anyway?

Then again, the discrepancy between what insiders and institutions are doing just might show the distinction between managing one's own money and managing someone else's.

One thing is clear: Insiders managing their own money seem to know what they are doing (get while the gettin is good), while those managing OPM are either stuck in their position with no one to sell to, or are simply oblivious to the risks.

CFC Weekly Chart



Technically CFC has been in a moderately tight weekly channel since the beginning of 2004, with 30 acting as support and 39 or so acting as resistance. Two attempted breakouts above that range both failed. Buying at support and selling into resistance has worked for years. The next reaction to support at or near 30 may be quite interesting to watch.

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

Google, Microsoft, and Evolution

Up until recently, Microsoft has trounced anyone that got in its way. The classic example is Netscape. Recently however, Microsoft is saying Google success is a wake-up call.

The success of Google opened Microsoft's eyes to the riches available in Web advertising, the chief technologist for the world's largest software maker said on Tuesday.

"It was a wake-up call within Microsoft," company Chief Software Architect Ray Ozzie said at a Goldman Sachs investor conference in Las Vegas. Google's success alerted Microsoft to the financial power of advertising and how it might complement revenue from subscriptions for its desktop software, he said.

Google derives almost all of its $10.6 billion in annual revenue from advertising, while Microsoft's loss-making Internet arm generated $2.3 billion in sales last year. Microsoft makes most of its money from its dominant Windows operating system and Office software suite.

"It is critical for Ray Ozzie to rethink how Microsoft competes in the Web world, because it is a totally different landscape out there and if Microsoft doesn't adapt it will get left behind," said Morningstar analyst Toan Tran.

Advertising vs. Software?

The above article makes it appear as if the battleground is advertising vs. software. Reality is different. On February 22nd Google unveiled Web-based office software.

Google Inc. will begin selling corporate America an online suite of software that includes e-mail, word processing, spreadsheets and calendar management, escalating the Internet search leader's invasion on technological turf traditionally dominated by Microsoft and IBM.

The expansion, to be unveiled today, threatens to bog down Microsoft Corp.'s efforts to persuade businesses to buy the latest version of its market-leading Office suite that was developed along with its new Vista operating system.

Google's software bundle, to be sold for a $50 annual fee per user, also poses a challenge to International Business Machines Corp. and its Lotus suite. Google has been offering a free version of its online software suite called Google Apps for the past six months. More than 100,000 small businesses and hundreds of universities nationwide are using the free service, Google said.

The fee-based version, Google Apps Premier Edition, includes five times more e-mail storage — 10 gigabytes per e-mail box — as well as a guarantee that all services will be available 99.9 percent of the time with around-the-clock technical support. Google also is adding mobile access to e-mail accounts through the BlackBerry devices that tether workers to their offices.

"This is a big step for us, but I think it's a reasonable step," Google Chief Executive Eric Schmidt said in an interview Wednesday. "Our product is so cheap that it's sort of no-brainer to try it out."

Upgrade price wars

Note: This section is technical. Non-geeks should concentrate on the price differentials and skip the rest.

Desktop Linux is looking at Upgrade price wars: Vista vs. Linux

Bottom line time, it will cost you $724 per PC to upgrade to Vista. Or, you could pay $170 per PC to get SLED (Linux that comes with business support). That's a savings of $554 per user desktop.

Now, you could argue that you can do better with Vista pricing than that, and the like. I won't argue with you. You can also drop the software costs of everything on the Linux side to zero. How? By firing your MCSE (Microsoft Certified Software Engineer) IT staffer and replacing him with a NLCE (Novell Certified Linux Engineer) professional and switching over to openSUSE 10.1 and using purely open-source solutions. When it comes to software and IT costs, there are almost endless variables. One thing, though, is certain: the upfront costs of a Linux desktop are far lower than Vista's price-tag.

You may feel absolutely sure that your users will find it much harder to move to SLED than to Vista. There, I will argue with you. Take a long, hard look at Vista, then take a look at SLED. Do the same thing, for that matter, with Office 2007 and OpenOffice.org 2.0. If your mind is at all open, I think you're going to find that users will face pretty much an even learning curve, no matter which operating system you switch to.

Putting aside all issues of Linux being more secure than Windows, and Vista lacking almost every significant feature it was supposed to include, just looking at the dollars and cents, just looking at getting office work done, SLED, the Linux desktop, is unquestionably the better choice over Vista.

Vista Security Cracked

If those were not a big enough headache in and of themselves it seems that Vista activation cracked by brute force.

Microsoft's unhackable OS activation malware has been hacked. It is a simple brute force attack, dumb as a rock that just tries keys. It is ugly, takes hours, is far from point and click, but it is said to work.

The method of attack has got to be quite troubling for MS on many grounds. The crack is a glorified guesser, and with the speed of modern PCs and the number of outstanding keys, the 25-digit serials are within range. The biggest problem for MS? If this gets widespread, and I hope it will, people will start activating legit keys that are owned by other people.

So, what do you do? There is really no differentiating between a legit copy with a manually typed in wrong key and a hack attempt. Sure MS can throttle this by limiting key attempts to one a minute or so on new software, but the older variants are already burnt to disk.

There is nothing MS can do at this point other than suck it down and prepare for the problems this causes. To make matters worse, MS will have to decide if it is worth it to allow people to take back legit keys that have been hijacked, or tell customers to go away, we have your money already, read your license agreement and get bent, we owe you nothing.

I can go on and on about problems with Vista but I won't. Every release of Microsoft is the same way. New Microsoft releases are plagued with so many problems yet people keep buying their software anyway. Will it be different this time?

Time to switch?

Wired takes up that question with an appropriately named article Google Apps: Should You Switch?

Google's new web-based office software suite, which the company announced Thursday, is a swift kick to the teeth delivered squarely in the direction of Microsoft. Or is it?

Google Apps Premier Edition is a collection of office tools for businesses -- word processor, spreadsheet, e-mail, calendar and web page creator -- all of which are accessible through a web browser. Pricing is set at $50 per user per year, less expensive than Microsoft Office but with much the same functionality. Microsoft has its own web-based suite of tools in Office Live, but the company's offering doesn't match Google's. And Google isn't going after Office Live, it's going after Office.

Reasons to switch to Google's web-based office suite:

• Cost. Compared to the $500 list price for the full version of Microsoft Office Professional 2007, Google's $50-per-year price tag is cheap. Telephone, e-mail and web support are included in that price, so organizations could see a drop in IT support costs as well.
• Centralized data storage. Documents are available from any web browser, upping the convenience ante for remote workers. Plus, 10 GB is plenty of room. For most users, that's more than they'll ever need.
• Security. A bonus: Gmail arguably has the best spam and virus filters of all the web-based e-mail services. Gmail uses SSL for mail connections. On paper, that's just as secure as Microsoft's desktop solutions.
• 24/7 access to the work space. The beauty of web-based applications is that they are accessible from any computer with an internet connection, anywhere in the world. Also, every worker in the company gets the same tool set -- like a standard corporate software install without the production and installation costs.
• Cut the Microsoft leash. Any company switching to Google Apps will be free of Microsoft's sluggish upgrade cycle and confusing, restrictive licensing requirements.

Reasons to stay.

• Privacy. This is a big one. Persuading any company, large or small, to store sensitive intellectual property, financial documents and customer data on a server owned, sheltered and maintained by Google would take a truckload of trust.
• Regulatory compliance. Certain industries are bound by regulations concerning storage, transfer and privacy of data.
• Google Apps is incomplete. Where's the PowerPoint killer? Also, anyone who keeps their entire contact list in Outlook is going to be seriously underwhelmed by Gmail's contact-management features.
• Working on the web is weird. Users who have grown accustomed to the smooth responsiveness of desktop applications will feel like a stranger in Web 2.0 land. Latency issues, Ajax-powered user interfaces and the absence of true drag-and-drop functionality will prove a turnoff for many.
• No offline access. Even in today's "always on, always connected" corporate environment, the tubes occasionally get clogged. Plus, there's no Wi-Fi on airplanes yet. Web-based applications are useless when the user isn't connected to the internet. Also, documents stored at Google can't be retrieved when Google can't be reached.

Wired sums all of this up and concludes "There are just as many reasons to stick with the status quo". I disagree. Microsoft is an aging dinosaur. Still, that has not stopped it yet. So let's look at things in another light. Where is Microsoft's growth going to come from? India? China? Brazil? Think again. Are those countries going to shell out big bucks for Vista or go with Linux for free?

The answer should be obvious: Linux. The savings are simply too great. Paying $500 for office with the programming staff required to support it, is eventually just not going to fly either. Those few who need PowerPoint, or special graph features in Excel likely have a genuine need for Office. For everyone else, forget about it.

Still, large mainstream businesses will be reluctant to change until costs force the issue. In that regard Microsoft it is more likely to slowly fade into the sunset over time than succumb to any quick knockout blow. In the meantime expect Google and Open Office to put increasing pressure on the price Microsoft can get for its software.

At $50 a year, when that includes disaster recovery, backups, remote access, and zero upgrade hassles, Google Apps look increasingly attractive just as the cost of Microsoft software looks increasingly overpriced.

Dell Considers Linux

On March 7th Reuters reported Dell may offer Linux as alternative to Windows.

Dell Inc. is considering offering the Linux operating system as an alternative to Microsoft Corp.'s Windows on its personal computers, a Dell spokesman said on Tuesday.

The PC maker said it received more than 100,000 customer requests for Linux in a "suggestion box" posted on Dell's Web site less than three weeks ago.

"We are listening to what customers are saying about Linux and taking it into consideration," said Dell spokesman David Lord. "We are going forward. Let's say, 'Certainly stay tuned.'"

If you thought price does not matter, 100,000 customers in 3 days think otherwise. Even though Open Office and Google Apps are not as good as Microsoft Office, for many (perhaps most) Open Office or Google Apps will be good enough.

Copyright Issues

Has Microsoft has seen the writing on the wall when it comes to software sales? Perhaps. They are now attempting, too little, too late (as well as too big, and too cumbersome) to challenge Google over ad revenue. With that in mind please consider Microsoft attacks Google on copyright issues.

Microsoft on Tuesday launches a fierce attack on Google over its “cavalier” approach to copyright, accusing the internet company of exploiting books, music, films and television programmes without permission.

Tom Rubin, associate general counsel for Microsoft, will say in a speech in New York that while authors and publishers find it hard to cover costs, “companies that create no content of their own, and make money solely on the back of other people’s content, are raking in billions through advertising and initial public offerings”.

Mr Rubin’s remarks, presaged in an article in Tuesday’s Financial Times, come as Google faces criticism and legal pressure from media companies over services allowing users to search online for books, films, television programmes and news. Viacom, the US media group, instructed YouTube, which Google owns, to remove 100,000 clips of copyright material.

The Financial Times is writing about The rights and wrongs of Google content.

Google now faces a backlash from publishers that make the professional “content” – from films to television programmes and books – on which it relies. They argue that Google is playing fast and loose with the intellectual property of others in order to attract users to its services. ....

It must be fun for Microsoft, accustomed to defending its own dominance of personal computer software, to have a David-like dig at the internet’s Goliath. .... Companies, especially powerful ones, cannot get away with riding roughshod over the wishes of smaller enterprises just because it suits them. Microsoft has discovered that painfully over the years. Now it is Google’s turn.

Attempting to portray itself as David in a battle with Goliath (as Microsoft is attempting to do) seems laughable. Besides, exactly when did Microsoft learn it could not ride roughshod over smaller players?

Regardless of what Microsoft wants you to believe, this battle has nothing to do with copyright issues, or David vs. Goliath either. This yapping shows that Microsoft is increasingly concerned about its business model. And with attacks on that business model from Linux, Open Office, Google, and Apple, Microsoft should be concerned. This is what happens to aging dinosaurs when evolution passes them by.

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

Moody's in Wonderland

Moody's appears to be evaluating credit risk from behind the looking glass, somewhere in Wonderland. I base that statement on the reasons Moody's is giving for raising the credit ratings on large US banks. Please consider the Bloomberg article JPMorgan Chase, Large U.S. Banks Have Ratings Raised by Moody's.

JPMorgan Chase & Co., Bank of New York Co. and State Street Bank & Trust Co. gained higher credit ratings from Moody's Investors Service Inc., which said the U.S. government would back the banks if they faced default.

Moody's announced new guidelines for bank credit ratings last month that consider financial strength along with any support companies may get from government and financial institutions if they get into serious trouble.

Moody's gave JPMorgan, of New York, and State Street, of Boston, ratings of Aa2, a level higher than their prior Aa3. Bank of New York rose two notches to the highest rating, Aaa, from Aa2. A higher credit rating can lower a company's cost of raising money by signaling to lenders and investors that they face less risk.

Moody's made the switch to make its ratings reflect reality, said Gary Bauer, Moody's managing director for banks in the Americas.

"Too Big to Fail"

"People already feel like they're too big to fail," said Jonathan Hatcher, senior research analyst for corporate bonds at Delaware Investments, which holds $98 billion in corporate bonds.

The new policy has the potential to produce "really interesting" upgrades in Japan, where government support helped banks stay solvent during the 1990s, Hatcher said.

In a stunning display of twisted logic, Moody's has made it a blessing to have rising default risk.
By raising credit ratings, Moody's lowered big bank's borrowing costs with the likely consequence of ensuring that when the bailout comes it will be larger than it would have been otherwise. Gary Bauer at Moody's says this "reflects reality". Meanwhile Jonathan Hatcher of Delaware Investments points to Japan as the model and says "they're too big to fail".

Earlier today, speaking from behind the magic mirror somewhere in Wonderland, Greenspan proclaimed "A bottom has been hit in the decline of U.S. home sales".

Planet Earth Perspective

Reporting from planet earth on the other hand is Mr. Practical with this perspective on the economy.

The relatively small sell-off in global stocks has the media scrambling for reasons and apologists regurgitating their normal excuses. The Wall-Street machine churns out bull after bull to assure us that “the bottom of the housing slump has been reached” and “stocks have no more downside.”

There is a reason for the sell-off, although none has been touched on by mainstream sources. Does anyone remember Japan raising rates? For nearly a week nothing happened, so the connection was lost. Even marginally higher interest rates are death to the massive structural problems that exist. The fact that they will take years to correct is something that most do not want to contemplate. Central bankers assure us everything is fine. This is, if I can identify one thing, the problem.

A market economy works because its participants are entrepreneurs. The economy rewards their production and mercilessly punishes their sloth. The economy should provide its own liquidity through production and then savings. In its self-interest it seeks the best value and destroys the worst. It tightens liquidity when debt gets too high and loosens it when it's too low. Government steps in with some regulation to ensure fair play. Fine.

But when government grows too big and through its hubris believes its bureaucracy knows more than the market, the seeds of eventual deflation are sewn. I am not talking about the re-distribution of income through taxes (that is another story); I am talking about direct intervention in the supply of credit to “ensure price stability.” That lie is due to the political refusal to allow the market to tighten.

The problem becomes worse when big government aligns itself with big business (the extinction of entrepreneurs) to affect the natural self-correction processes of the market.

Years of debt accumulation are not cured by a 5% correction in stocks as Wall-Street wants you to believe. A major debt correction, one that the market has been trying to accomplish for years but is rejected time and time again by Fed policy, is necessary to correct the huge imbalances that exist. To deny the necessity of this eventuality is human.

Total U.S. debt is now 3.6 times GDP and continues to grow. But new debt is having less and less effect in driving economic growth: more income is going to service that debt and less to creating production, the stuff that generates income. The second highest U.S. debt has ever been was 2.9 times in 1929. Despite Mr. Bernanke’s false recollections of Fed actions back then, they created an immense amount of liquidity (credit) trying to cure the stock market crash. The market did rally back temporarily as a result, then slowly crashed much worse as that new credit just went to short term speculation in stocks. The new money did no real good because there was already too much capacity, so the credit never went to creating production. The same thing is happening today. It now takes $7 of new debt to make $1 of GDP where it only took $1 in 1980 and $3 in 2000.

And the consumer, which is most of the economy, is in trouble too. Today household debt is now 130% of income. That is up from 100% just in 2001, 70% in 1986, and 40% in 1953. How quaint we were back then.

So step back from the TV and take a good long look. The US' problems are not solved by a 5% correction in stocks and the coming debt correction won’t take a week and then go away. We do not know how it manifests nor do we know the timing of it. But you should know the nature of the beast and the only way to fight it: reduce risk before everyone else does.

Best Regards,
Mr. Practical

Thank to Professor Succo at Minyanville for practical advice to those living on planet earth: "reduce risk before everyone else does". It is only in Wonderland (and/or the Twilight Zone) that it make sense to upgrade banks because there is a 98% chance of a government bailout if things go bad. OK, perhaps the "reality" is that the Fed won't let any big banks fail. But does anyone remember the zombie companies in Japan that resulted from similar actions?

I discussed some of this previously in Malinvestments, Predatory Lending, and Demagogues

Instead of taking a hit in 2002, Greenspan and Bernanke made matters worse by creating the mother of all housing bubbles. Instead of allowing people to go bankrupt, we passed laws making it harder, and those laws have already started to backfire. Instead of stopping subprime lending earlier, institutions repeatedly dropped lending standards to meet growth requirements. Instead of taking writeoffs now, lenders are refusing to admit mistakes hoping on a wing and a prayer that these bad home loans will cure themselves. Those loans will not be paid off either. We are following in the footsteps of Japan except that our consumer debt loads will make it worse. The Fed has learned nothing every step of the way.

For some reason Moody's and others seem to be a mad rush to join Greenspan, Bernanke, and Lereah in Wonderland. Then again, perhaps all of them have discovered a new dimension entirely and are evaluating things from the Twilight Zone. Could it be that the reality of planet earth is simply too much for any of them to handle right now?

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

Malinvestments, Predatory Lending, and Demagogues

Caroline Baum has another great article out today entitled As Housing Goes Bust, Lenders Become Predators? What follows is the condensed version. I suggest reading the entire article.

Congress is gearing up for hearings on predatory lending, the latest chapter in its long history of barn-door-closings on already-departed horses. Delinquency rates on these risky home loans are rising, subprime lenders are going belly up at an alarming rate, criminal probes of some lenders are under way (the trial lawyers must be salivating at the prospect of a whole new class of class-action suits), and front-page stories are proliferating almost as fast as you can get a no-money-down, no-questions- asked mortgage.

Last week, federal financial regulators, including the Federal Reserve, Office of the Controller of the Currency and the Federal Deposit Insurance Corp., proposed a series of guidelines "to address certain risks and emerging issues related to subprime mortgage lending practices, specifically, particular adjustable-rate mortgage (ARM) lending products."

Congressional committee chairmen have already invoked the idea of "predatory lending" to create interest in planned hearings. In an opening statement at a Feb. 7 hearing, Dodd said "that predatory and irresponsible lending practices are creating a crisis for millions of American homeowners."

"We've created an unproductive asset," says Joe Carson, director of global economic research at AllianceBernstein. "A house doesn't produce income." Mortgage debt rose by $4.7 trillion from the end of 2000 through the third quarter of 2006, according to the Fed's Flow of Funds report. "We created as much debt in housing in the last six years as we did in the prior 50," Carson says.

After the late 1990s stock market bubble, the economy recovered with a combination of interest-rate relief and income growth, he says. That rate relief was the cause of the current housing bubble, former Fed Chairman Alan Greenspan's claim about the Berlin Wall coming down notwithstanding. How can the cause also be the cure?

By the Time Congress or the Fed gets around to doing something, the time to do it is already long over. Subprime lenders are dropping like flies, bankruptcies are soaring, flippers have stopped flipping, and credit lending standards have tightened dramatically in the aftermath of one housing disaster after another.

Now that the market has imposed its solution (dramatically tightened credit lending standards in the wake of bankruptcies, foreclosures, defaults, and REOs) Dudley Do-Right (as played by Congress) is leading the charge to save Nell Fenwick from Snidely Whiplash. (Click on the above link for an audio of the charge. Image thanks to IMDb.)

Sorry Dudley (aka Congress/Fed), Nell Fenwick has already lost the deed to her ranch.

Congress and the Fed are acting trillions of dollars too late in credit lending and four years too late in time to save dear Nell and tens of thousands of folks just like her. This was entirely predictable right down to the Avalanche of Lawsuits, the congressional hearings, and the final finger pointing. Those hearings are nothing but demagoguery and a complete waste of time. Not only has the market already imposed its solution but all the finger pointing will be in the wrong direction.

The roots of this problem are numerous attempts by Congress and this administration to promote the "ownership society", the creation of GSEs, hundreds of pieces of congressional legislation supposedly to make housing more affordable all of which had the exact opposite effect, and to top it all off the Greenspan Fed came along slashing interest rates to 1% in a misguided attempt to prevent deflation in the US.

In short it is not "that predatory and irresponsible lending practices are creating a crisis for millions of American homeowners" it is Congress and the Fed fostering an environment that not only allowed but actually encouraged this to happen.

Unfortunately the demagogue's fingers will be pointing every which way except at Congress and the Fed. Ultimately legislation will be enacted to prevent this from happening again. That legislation is sure to do nothing to solve the existing problem , but rather it will be written in a manner that will cause some other different problem down the road.

The key point in Baum's article, however, is not predatory lending, nor is it about congressional demagoguery, nor is it about the avalanche of lawsuits that are coming down the pike. Here is the key paragraph.

"We've created an unproductive asset," says Joe Carson, director of global economic research at AllianceBernstein. "A house doesn't produce income." Mortgage debt rose by $4.7 trillion from the end of 2000 through the third quarter of 2006, according to the Fed's Flow of Funds report. "We created as much debt in housing in the last six years as we did in the prior 50," Carson says.

Bingo! Austrian economists would call this malinvestment. For all this artificial boom, we did not create any productive capacity, we did not even improve infrastructure. All we did was pile on debt. That debt will not be inflated away, wages will simply not rise fast enough, and jobs will become harder to find in the upcoming recession. That debt will be deflated away via bankruptcies. The process has started and it has a long, long way to go before it's over.

Instead of spending money on productive assets we are actually selling assets to foreigners to finance our reckless spending habits. We have also wasted what will eventually amount to trillions of dollars to blowing up Iraq, and since no one else is willing to say this, I will: Every life lost in Iraq was wasted as well, every single one of them.

Compare and contrast how we have been wasting dollars to what China and India are doing with their dollars. Yes, China has built tons of overcapacity, but unlike us they at least have capacity, and unlike us China and India have massively improved infrastructure while we have allowed ours to go to waste. Proof of that statement is easy. Schwarzenegger needs $500 billion to rebuild California and that is just California! Other states are in similar messes with both infrastructure and pension plans.

The market is in the process of repricing those malinvestments right now. That is why subprime lenders are blowing up, home prices are falling, defaults and foreclosures are rising, and credit lending is imploding. In attempting to prevent deflation the Fed has essentially guaranteed it. Congress played right along giving the banks and credit card companies exactly what they wanted: A bankruptcy reform act written to make people debt slaves forever. This fostered risky credit card lending in the belief that those loans will be paid back. They won't.

Instead of taking a hit in 2002, Greenspan and Bernanke made matters worse by creating the mother of all housing bubbles. Instead of allowing people to go bankrupt, we passed laws making it harder, and those laws have already started to backfire. Instead of stopping subprime lending earlier, institutions repeatedly dropped lending standards to meet growth requirements. Instead of taking writeoffs now, lenders are refusing to admit mistakes hoping on a wing and a prayer that these bad home loans will cure themselves. Those loans will not be paid off either. We are following in the footsteps of Japan except that our consumer debt loads will make it worse. The Fed has learned nothing every step of the way.

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

Avalanche of Lawsuits

Lawsuits are springing up everywhere. For a typical example, please consider the March 4th article in Arizona Republic concerning Litigation Over Mortgage Schemes.

Dozens of civil lawsuits alleging the gamut of mortgage fraud, from cash-back deals to lying about income on loan documents, have been filed against Valley firms and individuals during the past few months. Fraud experts and regulators say the lawsuits are only the beginning as the fallout from mortgage fraud starts to hit the Valley. Cash-back scams involve getting a mortgage for more than a home is worth and pocketing the extra money. The deals inflate home values and leave lenders with losses from loans worth far more than the house itself.

"Banks are going to force mortgage brokers to buy back bad loans, and mortgage brokers don't have the money so they are going to go under," said Richard Hagar, a national mortgage and real estate fraud expert with American Home Appraisals based in the Seattle area. "This is the beginning of the wave of lawsuits, lost licenses and criminal indictments in Arizona."

The Beginning Wave

• Phoenix-based Biltmore Bank is suing Security Title of Arizona and a group of others over a cash-back deal. The suit alleges the group worked together to get Biltmore to fund a $1.3 million loan for a home valued at $800,000 and then pocketed the extra cash.
• A Lehman Brothers investment trust in New York and Aurora Loan Services in Denver are suing the parent company of First National Bank of Arizona over 38 home loans. They say the bank misrepresented the values of properties, and the income, debt and employment of some of the borrowers. Lehman and Aurora bought the loans as investments and want the bank to buy them back.
• San Francisco-based Transnational Financial Network is suing Phoenix-based Lending House Financial and a Scottsdale investor who purchased 22 Valley homes within days of each other last spring. Transnational funded loans worth nearly $2 million on seven of the homes but says it wasn't notified the investor was buying multiple properties and his real debt level wasn't disclosed on mortgage documents.
• Tucson-based mortgage lender First Magnus is suing its former Valley loan officer, Tyson Rondeau, for fraud and negligence. First Magnus claims bad loans are costing it nearly $1 million.
  

Class Action against NovaStar

FindLaw is reporting Dreier LLP Files Class Action Lawsuit Against NovaStar Financial.

Dreier LLP announced that a class action lawsuit was commenced in the United States District Court for the Western District of Missouri, on behalf of purchasers of the common stock and/or call options and/or sellers of put options of NovaStar Financial, Inc. ("NovaStar" or the "Company") during the period May 4, 2006 through February 20, 2007, inclusive (the "Class Period"). The complaint alleges violations of the federal securities laws, including Section 10(b) of the Securities Exchange Act.

The Complaint alleges, among other things, that: (i) NovaStar's reported financial results during the Class Period were falsely inflated; (ii) Defendants misrepresented the quality of the Company's mortgage loan portfolio and its ability to pay dividends; (iii) Defendants failed to disclose that the Company's reported financial results and projections were based upon faulty assumptions because of inadequate internal controls; and (iv) Defendants failed to disclose that the Company lacked a reasonable basis to make projections regarding its ability to maintain its status as a REIT. The Complaint further alleges that, as a result of these false statements and omissions, NovaStar's securities traded at artificially inflated or distorted prices. On February 20, 2007, after the close of trading, NovaStar shocked the market by announcing disappointing fourth quarter and year end 2006 financial results and warning that the Company expected to make very little, if any, REIT taxable income for the next four years. In reaction to this news, the price of the Company's stock declined more than 30% on extremely high trading volume. The Plaintiff seeks to recover damages on behalf of all members of the proposed Class.

Class Action against New Century Financial

Market watch reported Brower Piven Announces Class Action Lawsuit Against New Century Financial.

The law firm of Brower Piven, A Professional Corporation, today announced that a securities class action was commenced on behalf of shareholders who purchased or otherwise acquired the common stock of New Century Financial Corporation between April 7, 2006 and February 7, 2007, inclusive (the "Class Period").

The action charges that defendants violated federal securities laws by issuing a series of materially false and misleading statements to the market throughout the Class Period, which statements had the effect of artificially inflating the market price of the Company's securities.

$77 billion in claims in New Orleans

The Times-Picayune is reporting N.O. asks whopping $77 billion in claim to corps.

Submitting a claim for a staggering $77 billion, the city of New Orleans joined tens of thousands of would-be plaintiffs who rushed to beat a Thursday deadline to alert the Army Corps of Engineers that they may sue for losses resulting from the levee breaches after Hurricane Katrina.

Also joining the queue were Entergy New Orleans, the city's bankrupt electrical utility, which is seeking $655 million, and the New Orleans Sewerage & Water Board, which put in a claim of about $460 million, spokesmen for the agencies said.

While they are likely to be among the largest filed, the three claims became part of an avalanche of paperwork that poured into the corps' Leake Avenue headquarters as Thursday's 11:59 p.m. deadline approached, corps personnel said.

By the time of the morning commute, cars already had clogged the two-lane River Road and miles of connecting arteries. The miles-long traffic jam got so thick that the federal agency established satellite pick-up points on Carrollton Avenue and Magazine Street.

"We took people out of offices to help out: engineers, lawyers, secretaries, you name it," spokesman Chris Accardo said. "At one time, we might have had 50 people out there."

Hours before the cut-off time, enough bags and boxes of claim forms had arrived to fill an 8-by-10-foot room, corps spokeswoman Kathy Gibbs said.

Litigation Nightmare

In June of 2006 in Litigation Nightmare & Heartbreak Hotel I mentioned a 12 point list of lawsuit items.

Litigation Items

1. Buyers suing developers for non-performance
2. Developers suing speculators for flipping properties in violation of contracts
3. Subcontractors suing developers for non-payment
4. Subcontractors suing general contractors for non-payment
5. Class action lawsuits against single family homebuilders and condo developers for faulty roofing, HVAC, electrical, and plumbing systems
6. Lawsuits against inspectors for not catching code violations
7. Condo boards and individual homeowners suing developers for shoddy work
8. Lawsuits against appraisers for inflated values
9. Lawsuits against banks when project fundings are halted
10. Lawsuits over completed condo units being substantially different in size, interior finishings, and quality than how they were represented pre-construction
11. Lawsuits by anyone and everyone against anyone and everyone over various fraud allegations
12. Of course we can’t forget counter suits by anyone and everyone against anyone and everyone over anything and everything

Judging from Morgan's lawsuit vs. Lennar, various recent class action lawsuits against prominent subprime lenders, and "Dozens of civil lawsuits alleging the gamut of mortgage fraud, from cash-back deals to lying about income on loan documents" (the latter just in the state of Arizona alone), it is safe to say that a fresh wave of litigation has started.

Things appear to be just as Richard Hagar of American Home Appraisals suggests: "This is the beginning of the wave of lawsuits, lost licenses and criminal indictments." The key word in that sentence is "beginning". The avalanche has a long way to slide before we can even begin to think it is approaching the bottom of the hill.

This post originally appeared in Whiskey & Gunpowder.

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

Operating Earnings and OPM

This thought from Henderson Global Investors reflects the Sentiment of the Day

"Equity markets had gone up a lot and almost uninterruptedly since last June and some markets had perhaps become a little expensive, creating the right climate for a fall."

Yes operating earnings look great, arguably never better. Nonetheless, valuations are more than a "little expensive" and there is no "perhaps" about it. John Hussman of Hussman Funds explores this idea, along the the Yen Carry Trade and OPM (Other People's Money) in Rapunzel Gets a Trim

Operating Earnings and OPM

A few comments about prevailing bullish themes here. Probably the main bullish theme at present is the misguided focus on "forward operating earnings," which create the impression that stocks are reasonably priced. This piece of bait contains a very long, sharp hook, which is likely to keep many investors on the line well into the next bear market.

Expectations for future operating earnings assume that current, record high profit margins will not only be sustained, but will expand further. Yet even when earnings ultimately fall short, analysts will be under no obligation to lower their "forward" expectations, at least initially. The resulting illusion of cheap valuations, fairly early in the next bear market, is likely to keep a great many investors holding on deep into the decline (whenever it begins in earnest). As in many other bear markets, earnings will probably decline convincingly only after a great deal of damage has already been done.

I cannot emphasize enough that price/earnings ratios, especially those based on "forward operating earnings," are unusually poor metrics of valuation at present.

A related theme is the notion that stocks must be good values because of the private equity buyouts we've been observing. It's important to understand that these buyouts are being done with OPM – other people's money – and that the main factor driving them is not low stock valuations but low risk premiums. Risky debt can currently be issued at interest rates barely above the low yields on default-free Treasuries. This will certainly end badly for investors in low-rated credits (as companies that issue sub-prime mortgages are beginning to realize). It is no indication of attractive stock market valuation.

What happens over time is that forward earnings keep getting ratched up and up over time as if improving conditions can go on forever. We saw this with homebuilders and subprime lenders already. Though those sectors have now imploded.

For unexplained reasons (most likely because there is no sensible reason) we are told by Bernanke, Greenspan and a choir of cheerleaders on CNBC that housing weakness will not spread over into other sectors. How can it not spread into other areas? A trillion dollars worth of property is going to see huge increases in interest rates this year, real estate agents without sales have little to no income coming in, mortgage equity withdrawal (MEW) has all but dried up, and home prices are declining even as property taxes are rising. Furthermore, each decrease in home sales means less furniture, less trucking, and less appliances that are needed, etc.

Nonetheless speculation with OPM continues. After all there are lucrative fees to be made underwriting these deals, 20% fees on profits by hedge funds, and big management fees (because of enormous assets under management) by mutual funds. If any of these blow up, who cares, it's your money not theirs.

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