Beautiful Model For Fraud

I stumbled across an interesting article in the BBC called The US sub-prime crisis in graphics. Following is my annotated version of their lead graphic.

The New Model of Mortgage Lending



Click on chart for sharper image.

Anyone wondering why there was so much fraud happening need only look at the above chart. Poor working class cities like Cleveland, Ohio and states like California where liar loans were an accepted practice were veritable breedings ground for fraud.

How Subprime Lending Affected Cleveland



click on chart for sharper image

From the BBC article ...

For many years, Cleveland was the sub-prime capital of America. It was a poor, working class city, hit hard by the decline of manufacturing and sharply divided along racial lines. Mortgage brokers focused their efforts by selling sub-prime mortgages in working class black areas where many people had achieved home ownership.

They told them that they could get cash by refinancing their homes, but often neglected to properly explain that the new sub-prime mortgages would "reset" after 2 years at double the interest rate. The result was a wave of repossessions that blighted neighbourhoods across the city and the inner suburbs.

By late 2007, one in ten homes in Cleveland had been repossessed and Deutsche Bank Trust, acting on behalf of bondholders, was the largest property owner in the city.

After Creative Financing Comes Creative Lawsuits

Given the duration and severity of the housing bust, it is not surprising that lawsuits and legal probes are pouring out everywhere. Here are a few recent ones.

Baltimore sues Wells Fargo for subprimes

Black neighborhoods in Baltimore were disproportionately affected by the subprime mortgage fallout, according to a federal lawsuit filed Tuesday by the city, which is attempting to recoup the costs of maintaining neighborhoods wracked by foreclosures.

The lawsuit alleges Wells Fargo Bank NA engaged in a pattern of predatory lending practices in Baltimore's poorest neighborhoods, leading to foreclosure rates nearly double the citywide average.

"When you have foreclosures, the property values drop, and you get less tax revenue. There's fire and police costs that come from abandoned and boarded-up and vacant properties," said John P. Relman, a Washington-based attorney who is representing the city in the lawsuit. "It leads to crime and drugs and school problems as the community is being destabilized."

Cleveland Sues 21 Lenders Over Subprime Mortgages

Cleveland is suing 21 of the nation’s largest banks and financial institutions, accusing them of knowingly plunging the city into a financial crisis by flooding the local housing market with subprime mortgage loans to people who could never repay.

City officials hope to recover hundreds of millions of dollars in damages, including lost taxes from devalued property and money spent demolishing and boarding up thousands of abandoned houses.

"To me, this is no different than organized crime or drugs," Jackson said in an interview with Plain Dealer reporters and editors. "It has the same effect as drug activity in neighborhoods. It's a form of organized crime that happens to be legal in many respects."
The Baltimore and Cleveland efforts are believed to be the first attempts by large cities to recover losses blamed on the foreclosure epidemic, which has particularly plagued Ohio.

But Cleveland's suit is even more unique because the city has based its complaints on a state law that relates to public nuisances. The suit also is far more wide-reaching than Baltimore's in that it targets the investment banking side of the industry, which feeds off the mortgage market.

[Cleveland Law Director] Triozzi acknowledged the lawsuit, with its unique nature and 21 large defendants, could move slowly. He also expects the banks will request the case be moved to federal court. "I understand fully what we are up against here," the law director said. "We would not be doing this if we did not believe we had a sound legal argument to stand on."

Jackson, asked if long litigation would be worth the city's time and money, replied: "We're in this for the long haul. I trust Director Triozzi will tell me when to hold them or fold them."

Judge Corrigan will have to decide "how far up the food chain" to go in determining responsibility, said Cleveland State University Law professor Kathleen Engel, an expert on mortgage-backed securities. She believes the city can make a case against the investment bankers.

Ohio Attorney General Marc Dann also is considering a state lawsuit against investment banks. Dann said he is investigating "some of the very same people" identified in the city's suit.

Dann said a state filing is months away and probably wouldn't be submitted as a public-nuisance case. But he commended Jackson and Triozzi's "creative" approach.

"There's clearly been a wrong done, and the source is Wall Street," Dann said in a phone interview. "I'm glad to have some company on my hunt."

The defendants include Deutsche Bank, Wells Fargo, Ameriquest Mortgage, Countrywide Financial, HSBC Holdings, JPMorgan Chase, Washington Mutual, Citigroup, Bank of America, NovaStar Financial, Bear Stearns, IndyMac Bancorp, Credit Suisse, Fremont General, GMAC-RFC, Goldman Sachs, Greenwich Capital Markets, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Option One Mortgage.

What the lawsuit alleges

The firms are accused of creating a public nuisance by making mortgages available to people who had "no realistic means of keeping up with their loan payments."

Cleveland Foreclosures



N.Y., Connecticut Probe Wall Street Loan Disclosures

New York and Connecticut are investigating whether Wall Street banks failed to disclose sufficient information about risks involved in investments linked to subprime loans, Connecticut's attorney general said.

The new focus in existing probes of the mortgage industry is whether banks left out material details in their disclosures about the risks posed by extremely high-risk loans, deceiving credit-rating agencies and investors, Connecticut Attorney General Richard Blumenthal said today in a interview. The states are also investigating lax underwriting standards, he said.

"The point is whether the banks knowingly withheld information so the disclosures may have been deceptive or misleading," Blumenthal said. "These questions are front and center in an ongoing investigation that has reached no conclusions."

Fraud and bubbles go hand in hand. Fallout from this will be brewing for years.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Commercial Real Estate Crash Underway

The Financial Times is reporting Squeeze halts sales in office property.

US office property sales fell by the largest amount since the September 11 2001 terror attacks in the final three months of last year, raising fears that commercial real estate is heading for a meltdown.

The volume of office space sold in the final quarter of 2007 fell 42 per cent to $26.5bn, compared with the same period in 2006, according to data released on Friday by Real Capital Analytics, a real estate data company. Sales of property portfolios fell to $5bn, after logging $105bn in the first three quarters.

My Comment: First transactions plunge. The property values plunge. This is going to play out just like residential.

"What's happening now is a capital markets event," said Dan Fasulo, managing director at RCA.

Spreads on CMBX, an index that tracks commercial mortgage backed securities, have recently suggested that default rates are expected to reach three times historical levels. But analysts say commercial property is not expected to suffer the same slump as housing because it has not experienced such high levels of overbuilding.

My Comment: What analysts are they talking to? Commercial real estate overexpansion in the face of a consumer led recession is monumental.

However, if the US economy experiences a deep recession, commercial property is considered to be at risk. Demand for space is largely driven by the health of the business environment.

"The wildcard is whether or not the US falls into a recession.

My Comment: The wildcard is whether or not we have a depression. We are already in a recession.

What's causing the market to hold up is the high level of occupancy and high level of rent," said Mr Fasulo. "Unless [there is a recession] you are not going to see a [major] deterioration."

My Comment: The market is crumbling as I type. Vacancies will soar. Banks are going to be stuck with overvalued commercial real estate for years. Too many projects were built on too optimistic lease rates and occupancy rates.

Commercial Real Estate Bond Yields Soar

Bloomberg is reporting Commercial Mortgage-Bond Yield Spreads Rise Most Ever.

The extra yield over benchmark Treasuries that investors demand to own top-rated commercial mortgage-backed securities rose this week by the most ever, according to a Morgan Stanley index.

The average spread over similar-maturity Treasuries for AAA rated 10-year securities jumped 32 percent to 244 basis points, the index shows. The extra yield over 10-year swap rates, a more commonly used benchmark, rose 48 percent to a record 185 basis points, the biggest increase since October 1998 amid the collapse of Long Term Capital Management LP and Russia's debt default.

[For More on Long Term Capital Management LTCM please see Genius Fails Again.]

Commercial-mortgage bonds rated BBB-, the lowest investment-grade, traded at a record average yield spread over Treasuries of 1,309 basis points this week, up 24 percent from last week, according to data from New York-based Morgan Stanley. Over swap rates, the spread rose 25 percent to a record 1,250 basis points.

Analysts including Darrell Wheeler at Citigroup Inc. in New York blame speculative investors such as hedge funds that are placing bets on commercial mortgage-bond defaults with so-called Markit CMBX index contracts for the rising CMBS spreads.

Citigroup Bet The Farm On Musical Chairs

Blaming the hedge funds and shorts like Darrell Wheeler is doing is beyond lame. If Citigroup want to point fingers, it should look into a mirror first, then point.

Chuck Prince: No End Soon to Buyout Boom: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing".

Citigroup bet the farm on mortgage backed nonsense, SIV nonsense, and other nonsense in the foolish belief they would find a chair when the music stopped. They didn't. So Chuck Price danced out the door, golden parachute intact as his reward for wrecking the company.

Now Citigroup is dancing like mad, pointing fingers in the wrong direction, and needing to raise more capital every day. Citigroup will not survive in its present form. The end to its capital impairments are nowhere near in sight.

Bernanke Thwarted By Commercial Mortgage Rates

Bloomberg is reporting Bernanke's Easing Thwarted by Surging Commercial Mortgage Rates.

Federal Reserve Chairman Ben S. Bernanke is proving powerless to prevent a deteriorating commercial real estate market.

While the yield on 10-year Treasury notes fell 1.43 percentage points in the past three months to the lowest since 2003 following four interest rate cuts, the cost of borrowing for apartment buildings, offices, retail properties and hotels climbed as much as 1.25 percentage points, according to David McLain, principal and chief investment officer of Palisades Financial LLC, a private equity firm in Fort Lee, New Jersey.

"The market is locked up right now because there's a huge overhang of leveraged assets of every type, development deals that won't meet projections made last year when things were rosy," said David Tobin, a principal at New York-based Mission Capital Advisors LLC, which was involved in $5 billion of asset sales last year. "It will end just like the residential housing market."

Bernanke's easing hasn't stopped the $3.2 trillion commercial market from starting a slide that mirrors the housing decline, where prices have dropped for the first time since the Great Depression. U.S. commercial property prices probably will fall 10 percent in 2008 from last year's peak after rising 60 percent since 2002, said Dan Fasulo, director of market analysis at New York-based research firm Real Capital Analytics Inc.

Delinquencies of securitized commercial mortgages may quadruple in the next 18 months to almost 4 percent, said Kenneth Rosen, an economist at University of California, Berkeley, who runs a real estate hedge fund. About 70 percent of commercial mortgages are pooled into commercial mortgage-backed securities that are sold to investors, Rosen said.

In Japan, land prices rose last year for the first time since 1991 and sales of commercial mortgage-backed securities probably increased 18 percent, said Douglas Smith, managing director of commercial real estate at Deutsche Bank.

"Japan is the only functioning market globally for CMBS," Smith said last month. In the U.S., "not many deals are being done and the European market is essentially shut down."

Markit CMBX Index

Here are the Markit CMBX Indices for those wanting to keep score. Up is down (that is a rising chart shows increased likelihood of default). Here is one such chart.



CMBS Ratings

• “AAA” means a rating of AAA (if rated by Fitch or S&P) or Aaa (if rated by Moody’s) by any two of Fitch, Moody’s or S&P.
• “AA” means a rating of AA (if rated by Fitch or S&P) or Aa2 (if rated by Moody’s) by any two of Fitch, Moody’s or S&P.
• “A” means a rating of A (if rated by Fitch or S&P) or A2 (if rated by Moody’s) by any two of Fitch, Moody’s or S&P.
• “BBB” means a rating of BBB (if rated by Fitch or S&P) or Baa2 (if rated by Moody’s) by any two of Fitch, Moody’s or S&P.
• “BBB-” means a rating of BBB- (if rated by Fitch or S&P) or Baa3 (if rated by Moody’s) by any two of Fitch, Moody’s or S&P.
• “BB” means a rating of BB (if rated by Fitch or S&P) or Ba2 (if rated by Moody’s) by any two of Fitch, Moody’s or S&P.

Recent Postings On Commercial Real Estate

• Jan 17, 2008 Glut Of Mall Space Headed Our Way
• Dec 27, 2007 Commercial Real Estate Transactions Plunge
• Dec 26, 2007 Commercial Real Estate Dominoes Collapse
• Dec 21, 2007 Refreshingly Simple Commercial Real Estate Implosion
• Nov 28, 2007 Commercial Real Estate Market Is Imploding

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

Mike Morgan January 2008 Update

I was not expecting an update from Mike but I received this email just moments ago. Here is an edited version of what he sent clients.

After receiving a lot of frantic phone calls this week, I thought it might be easier to put something out. The big question has been "Is this the bottom?" My response is, Are you kidding?

For those of you wondering what is going on over the last couple of weeks, read some of my pieces from a year ago. Not much has changed, so there is no reason to write for public consumption. I don’t pick stocks, nor do I talk about trades, so I’m not concerned with the run up in the builders over the last couple of weeks.

I can tell you this. I wrote about all of the builders that have filed BK and are going under. I wrote about them two years ago. I said one third of the current builders would go BK, and I still believe it. In fact, I said at least three of the top five would not make it. That is still the case. Nothing has changed when you look at impairments to come, JV issues to come, inventory and the economy.

Do I pull these things out of a hat? No. I actually spend time in the field. You can only do so much with numbers. But when the numbers don’t match reality, BINGO. So here’s five reasons why we are nowhere near the bottom.

• The builders have only taken from 15 – 50% of their impairments. Some have been better than others, but overall I’d say it’s about 30% with 70% yet to come. Jim Wilson and Ivy think we’ve seen the worst. They still have their heads in the ground. Do your own homework. Just look at the number of communities impaired and the level of impairments.
  
  
• The talking heads seem to think the Bernanke fix is going to make everything nice. The Bernanke fix was about as helpful as a shot and a beer for a heroin junkie. It’s not going to fix anything. If anything, it will make a lot of things worse.
  
  
• Nearly every other analyst still fails to understand the value of getting out in the field. As for being near the bottom – nonsense. As for all of these terrific land, condo and community deals at 50 cents on the dollar – poppy cock. If you think paying 50 cents on the dollar is a smart move, when something is worth 25 cents, go for it. Better yet, call me. I have tons of it. Even worse than paying 50 cents when something is only worth 25, is the fact that much of the stuff we have looked at is actually worthless. How can that be, you ask? Trust me. It can. It is. And I’ve seen deals go down where the buyers bought themselves a liability.
  
  
• The financial write downs from the banks and mortgage companies are not over. I am still hearing the same thing ... “We don’t know what we own. And even if we did know, we don’t know how to price it.” Some of these guys have tried to sell small pieces, in order to mark to market. Guess what? No bids!
  
  
• Bank inventory – I’ve written about this a little. We’re seeing this problem start to pus up. I figure it will take about another 8-12 months before it pops. Basically, the banks have no clue what to do with the properties they are foreclosing on and the properties where buyers have stopped paying their mortgage. There are some extreme examples, but we’re seeing the same basic problems nationwide. Eventually, this problem will hit the markets hard in prices and inventory. It will also be an investment opportunity for a large fund to step in, providing they have their ducks in a row before approaching the banks.

Four areas of concentration for my clients have been fruitful.

• Biotech – Not the stocks, but the land in areas where biotech parks are being developed in Florida. The University of Miami just announced their own biotech plans.
  
  
• Senior Care Living
  
  
• Deep Water Land
  
  
• Unique Office Space Opportunities – This one is something that takes advantage of the drop in office building prices, as well as the hit the economy is taking at the small business level. Very intriguing opportunity.
  

Condos – Not a chance. Even the deals at 30 cents on the dollar are garbage. Be very careful here. I’ve seen a lot of deals where formally smart money thinks they are getting a deal. They are a bad deal. Be very careful. It is too soon.

The Bottom Line: Expect to see lower margins, lower sales, growing inventory, lower prices for land and finished product, all adding to more impairments and losses with much more to come.

Regards,
Mike Morgan

Contact information for Mike Morgan about this article or for Ground Zero Consulting Services to Wall Street and Retail Buyers: Email Mike Morgan

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

Changing Social Attitudes About Debt

There has been a slow, steady shift in consumer sentiment towards debt since the beginning of the year. For quite some time, many were debating whether it was even happening. At Thanksgiving, the first real hints of what was coming could be found in poor turnout for pre-Christmas sales. Still, most assumed consumers would come through at Christmas like "they always do". Except this time they didn't. Christmas Retail Sales Disappointed in spite of bigger than ever discounts. After Christmas sales disappointed as well.

Consumers Are Retrenching

It's now clear to everyone that Consumers Are Retrenching As The Economy Weakens.

Joi Freemont, a dentist in suburban Atlanta, doesn't have to look further than her appointment book to tell that people are worried about money.

Patients who used to get their teeth whitened all the time "now want to think about it a bit," she said. Braces? "People were getting them for the kids, for themselves, but now they're waiting," she added. And when people get cavities, they have their fillings done one a month, not five or six at a time, she said.

As a result, Freemont and her husband are worried their income could drop and are trying to be more prudent with their money. They're monitoring spending more closely and continuing to whittle down their credit card balances and her dental school debt, she said.

Professor Depew was talking about the above article in point number 3 of of Tuesday's Five Things.

And so the consumer balance sheet repair meme continues to grow. As those who have read Five Things over the past couple of years know, this is not a behavior that began in August or September as the credit crunch began to manifest, it's something that has been building for years.

Consider talk show host and television personality Dave Ramsey. Chances are pretty good that by now you know who Dave Ramsey is, but just in case, he's the host of a popular, widely-syndicated show, "The Dave Ramsey Show," that is heard on the more than 300 radio stations and seen on Fox Business Television.

Ramsey has been talking about the evils of debt and the virtues of debt-free living for more than a decade. In fact, his career began in 1992 when he began selling books on financial health following his own personal bankruptcy crisis in the late 1980s. But only recently has Ramsey really been able penetrate the mass public's consciousness. Why? It's not because Ramsey suddenly improved his message, it's because social mood finally reached a point where his message is not just acceptable but sought out.

The psychological factors that have made Ramsey a household name are the same factors now working against the ability of the Federal Reserve and the government to stimulate credit demand.

I found 26 different versions of the same story, in various newspapers or magazines. Here is a sampling of the headlines.

• U.S. consumers pull back on spending, worry more about debt as economy weakens
• Consumers are cutting back
• US consumers worry about debt, pull back on spending
• Consumers pull back as economy weakens
• Americans buckle up for slowing economy
• Empty Malls as Economic Fears Spread
• Americans tightening their belts
• Consumers now spending less, worrying more
  
• More consumers start to show financial restraint

Changing Attitudes Are Now News

Even Starbucks is affected.

The AP is reporting Starbucks tests $1 coffee, free refills. "Faced with growing competition from cheaper rivals, Starbucks Corp. is selling small cups of drip coffee for $1 with free refills as part of a test in its hometown."

Coffee is a minor thing, but unwillingness to spend $5 for a cup of coffee had to start sometime. This attitude is spreading. And it's the attitude that's important, not the coffee.

Bernanke can't reflate if consumers won't spend, banks won't lend, and businesses won't expand. If prices are coming down (as they are with houses), consumers will wait. Those worried about their job will wait. Those starting to worry about retirement will wait. People will wait for houses, cars, and boats. People will vacation closer to home and spend less eating out. People will cut back in all sorts of ways.

Homeowners just Walking Away

Cutting back on coffee and dental work is one thing, walking away from houses is another. Bernanke has to be petrified about homeowners just handing over the keys and walking away. The New York Times calls it Jingle Mail.

WHAT do banks call it when a troubled borrower abandons her home, sending them the keys? “Jingle mail.”

And what do they call it when an irate borrower abandons his home, yanking electrical outlets from walls, leaving faucets running and otherwise trashing it on the way out? “Taking the inside of the house with you.”

Calculated Risk was talking about "walking away" in Wachovia: Homeowners just Walking Away.

From the Wachovia conference call: “Part of one of the challenges is, and we've mentioned this before, a lot of this current losses have been coming out of California and it's -- they've been from people that have otherwise had the capacity to pay, but have basically just decided not to ..."

This echoes the comments of BofA CEO Kenneth Lewis last month: "There's been a change in social attitudes toward default," Mr. Lewis says. ... "We're seeing people who are current on their credit cards but are defaulting on their mortgages," Mr. Lewis says. "I'm astonished that people would walk away from their homes."

I do not know why anyone should be astonished at people walking away. It should be expected. Right or wrong, how hard is it for anyone to see consumers blaming appraisers, bankers, real estate agents, processors, and homebuilders (many of whom cashed out millions or even a billion in the case of Countrywide's Mozilo) for their woes. Yes, many were greedy and some were willing participants to fraud, but the banks were even greedier.

Citigroup CEO Chuck Prince's statement No End Soon to Buyout Boom: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing".

Chuck Prince typifies the arrogance of Wall Street that people are starting to resent. I talked about Prince and Mozilo's "golden parachutes" in Nationalization of the Banking System. Meanwhile, in the face of billion dollar bonuses at the brokerages, Joe Homeowner is left holding the bag.

Should People Just Walk Away?

I stumbled across an interesting blog called "Dad Talk" the other day. You might want to check it out. In Should Money-Troubled Americans Just Walk Away From Their Homes? Dad gives some pretty good reasons for doing just that. Let's take a look.

If Americans immediately walked away from negatively amortized mortgages, the crisis would end much faster. Here’s why:

1. Stressed homeowners who walk away from their properties can move into a rental and cut their monthly expenses, easing financial stress. Yes, their credit would be wrecked for a few years, but not as severely as if they foreclose or declare bankruptcy.

2. Financial institutions could unload properties more quickly because they would gain control faster than in foreclosure proceedings. By the way, this is already happening to some degree. The less time a home spends in limbo, the less likely it is to be damaged.

3. Here’s the really painful part: home prices would plummet, forcing additional homeowners to consider unloading properties. This was going to happen anyway, but bailouts and lower interest rates will just prolong the whole mess.

4. Financial institutions would be forced to come clean much faster than to date. Trust would be restored in surviving institutions once the carnage ended.

5. The economy will go into a full recession too fast for the Fed to lower rates and for politicians to enact wasteful bailouts.

6. Once home prices reach a low enough level, investors will snatch properties up and offer them as rentals.

7. This will stabilize the home market and offer a steady income source for property investors. (Currently, home prices are too high for leasing purposes.)

8. After the initial pain, the economy should begin its rebound.

Of course, few economists will ever make a suggestion such as this. Why? It sounds defeatist. It’s cruel to homeowners. It’s anti-American. Financial institutions would howl in protest.

What's cruel to homeowners are the work around plans guaranteed to make the participants debt slaves forever. Those bailout plans were specifically handcrafted so that only those with no equity would benefit.

Those "bailed out" may be happy at first, but eventually the participants will realize they are being played for suckers. A day of reckoning will come when people $40,000 underwater on their home and struggling, start to realize they can walk away and save up a down payment by renting rather than paying off a mortgage where they can never catch up.

Others, struggling, but still making payments will eventually come to resent those who walked away and became debt free. They too will walk. And thus walking is guaranteed to become more and more socially acceptable over time.

With the economy heading into recession, many will be forced out of a job. For those, walking away will be the only way to survive.

Throwing Away Money

Remember the catchphrase "throwing away money on rent"? The bottom will come when people start bragging about the day they stopped "throwing away money on an overpriced house". That's a long ways away from here in terms of both price and time. For a hint at how long, please see When Will Housing Bottom?

The secular trend towards consumption has peaked.

A year ago only fools saved money. Saving money is becoming more socially acceptable with each passing day. Eventually it will be embraced. Attitudes towards risky lending practices by banks are changing too. I talked about risk aversion by both banks and consumers in Banks Attempt To Freeze Balance Sheets. Changes in social attitudes about debt, risk, and spending, are about to make Bernanke's life miserable. Changing attitudes are exactly why Things That "Can't" Happen will happen.

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

Watching The Corporate Bond Bubble

Traders believe the corporate debt markets will get worse.

So far, most of the rout in the debt markets has been linked to the US subprime mortgage debacle. Increasingly, however, many hedge funds are betting there is far worse to come for the corporate debt market as well.

Hedge fund managers and the trading desks of some of the savviest firms on Wall Street are expecting a severe downturn in the corporate debt market. A big part of their bet is that bonds will perform far worse than in previous meltdowns, because financial engineering has created so many layers of debt on top of unsecured bonds, which are the last debt to get paid in the event of a default.

Their pessimistic views are not yet borne out by traditional benchmarks of corporate health. Historically, the markets tend to focus on corporate debt default rates but this measure is under scrutiny. In December, the average default rate reached a record low of 0.26 per cent. S&P's Leveraged Commentary & Data analysts think the data is so misleading that it has created a shadow default rate measure by including companies that are not able to pay interest and have taken advantage of clauses in their documents that allow them to issue more debt when they have no cash to pay out interest.

This time, the amount of debt and the number of companies whose debt trades below par - or at less than 100 cents on the dollar - may be a better indicator of things to come.

Virtually every loan in the market now trades below par, a far cry from six months ago when virtually every leveraged loan traded above par.

As long as corporate cash flows hold up, distress isn't likely to be widespread. But thanks to the inventiveness of bankers, Wall Street and the private equity owners of companies in trouble can buy time because lenders sometimes allow them to issue more debt if they cannot pay their interest in cash - the so-called payment-in-kind debt.

Such terms are great for owners and the borrowers, because companies can stay afloat without creditors pulling the plug. However, in some cases, companies that are no longer truly viable stay afloat longer than they should, destroying more value and eating up more capital than they should, and lowering recoveries for creditors when they finally do hit the financial wall.

In the past, there were lots of early warning signs of looming stress when cash-strapped companies could not meet the terms of their loans. But after years of easy credit, there are fortunate borrowers who are tied to virtually no terms.

David Rubenstein, co-founder of Carlyle Group, has observed that even if many of the companies he owns wanted to default, they could not because they have no obligations at all.

Today, the gap between where loans trade and where bonds trade is the highest since May 2005 when the rating agencies considered lowering their ratings on the American car companies, which caused a short-term swoon in the credit markets.

This gap highlights the poor outlook for corporate bonds. This is the result of "a lethal cocktail of falling equity and bond prices and poor economic news", says S&P, the rating agency, adding that defaults are already higher than official numbers.

It Toggles The Mind

I spoke about "toggle bonds" and "covenant light" strategies that allow companies to pay back debt with more debt in Toggle Bonds - Yet Another High Wire Act. The credit markets have now stopped such insanity but so far anyway, not much has blown up yet.

I have been watching watching AFBIX as a proxy for junk bond stress for quite some time.

The investment seeks to provide investment results that correspond generally to the inverse (opposite) of the total return of the high yield market consistent with maintaining reasonable liquidity. The fund normally invests at least 80% of net assets in CDSs and other financial instruments that in combination should provide inverse exposure to the high yield debt (junk bond) market. It seeks to maintain inverse exposure to the high yield bond markets regardless of market conditions and without taking defensive positions in cash or other instruments. The fund is nondiversified.

AFBIX Weekly Chart


click on chart for sharper image

AFBIX is an inverse fund so a rising chart shows junk bond stress. Stress in corporate bonds during the mid-summer credit crunch has abated for now. How long that lasts, I do not know. What I do know is that a junk bond implosion is another "shoe" waiting in the wings that has not yet dropped. Eventually it will.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Continuing Saga Of Ambac & MBIA

Dateline January 23, 2008
Ambac , MBIA Surge As Bailout Talk Grows Louder

Ambac Financial Group, Inc. (ABK) is now up 57% on reports New York State's insurance regulators met today with US banks to discuss raising new capital for bond insurers. Ambac rival MBIA Inc. (MBI) is up 30%.

Dateline January 24, 2008
MBIA, Ambac Fall as New York Says Rescue Needs Time

MBIA Inc. and Ambac Financial Group Inc. fell in New York trading as the state's insurance regulator said a rescue for bond guarantors will "take some time" and analysts cast doubt on the agency's ability to manage the task.

The meeting convened yesterday in New York lasted about two hours and included some of the world's largest banks and securities firms, said a person familiar with the gathering, who wasn't authorized to speak publicly. Among those represented were Goldman Sachs (GS), Merrill Lynch (MER) JPMorgan Chase(JPM), Citigroup (C) and Wachovia (WB).

Dateline January 24, 2008 2:15 PM EST
Bankers Downplay Reports of Bond Insurer Rescue

Bankers who met with New York insurance regulators to discuss a reported bailout of troubled bond insurers downplayed the meeting's significance Thursday, with one calling it a "non-event."

Bankers told CNBC that there was no consensus formed at the meeting and no movement on creating substantial plans for a rescue. Moreover, reports of the meeting may have made a bad situation for the industry worse, bankers said, as a subsequent jump in bond insurer stock prices scared off private equity firms that may otherwise have injected capital into the companies.

Dateline January 24, 2008 After Hours Session
Ambac Jumps on Speculation It May Be Bought By Billionaire Ross

Ambac Financial Group Inc., the bond insurer whose shares have plunged 87 percent in a year, rose in extended New York trading on speculation billionaire Wilbur Ross may buy the company.

Ross, who became a billionaire by buying distressed steel and textile businesses, is in talks to buy New York-based Ambac, the Evening Standard reported, citing people it didn't name. A deal may come within the next two weeks, the newspaper reported on its Web site.

Ambac jumped $1.67, or 15 percent, to $13, after dropping 17 percent in regular trading.

Dateline Jan 25, 2008 (London)
Mortgage bond insurers 'need $200bn boost'

America's biggest mortgage bond insurers collectively need a $200 billion (£101 billion) capital injection if they are to maintain their key AAA credit ratings, a figure that dwarfs a plan by New York regulators to put together a capital infusion of up to $15 billion, a leading ratings expert said yesterday.

The failure to maintain their AAA ratings will lead to a further round of multibillion-dollar writedowns among the Wall Street banks and other large owners of the bonds, Sean Egan of Egan Jones Ratings Company, said. It would also push some of them into receivership, Mr Egan added.

Egan Jones makes its money by selling its research to money managers, rather than through fees from the companies it rates.

Mr Egan's warning comes after the New York Insurance Department, which regulates the state's insurance industry, held a hastily convened two-hour meeting this week to try to persuade key Wall Street firms to bail out the bond underwriters. The meeting is thought to have been attended by about 25 people, including representatives of Citigroup, JPMorgan, Goldman Sachs and Lehman Brothers, which would be likely to suffer if the bond insurers went under.

Mr Egan has a B-plus rating on MBIA, the biggest bond insurer, which is 13 notches below the AAA-rating it has from S&P, Moody's and Fitch.

Eric Dinallo, New York's insurance superintendent, who is leading the talks with Wall Street, sought to play down the markets' hopes for the talks yesterday. He said: “It must be understood that these are complicated issues involving a number of parties.”

And So The Saga Continues

• Ambac and MBIA popped 57% and 30% respectively on a "Non-Event".
• Egan Jones, a company that gets paid based on how good its analysis is as opposed to Moody's Fitch and the S&P who get paid regardless of how bad their analysis is, claims the monolines collectively need to raise $200 billion to deserve an AAA rating.
  
• Clearly AAA or AA ratings on Ambac and MBIA are absurd.
  
• It's Time To Break Up The Credit Rating Cartel.
• Unless billionaire Wilbur Ross has suddenly lost his marbles he will run, not walk away from this deal.

Addendum:

On January 18th 2008 Bill Ackman wrote a letter to Moody's and the S&P regarding the monolines. Here is point #8 of Bill Ackman’s Letter to Rating Agencies Regarding Bond Insurers.

I encourage you to ask yourself the following question while looking at your image in the mirror:

Does a company deserve your highest Triple A rating whose stock price has declined 90%, has cut its dividend, is scrambling to raise capital, completed a partial financing at 14% interest (now trading at a 20% yield one week later), has incurred losses massively in excess of its promised zero-loss expectations wiping out more than half of book value, with Berkshire Hathaway as a new competitor, having lost access to its only liquidity facility, and having concealed material information from the marketplace?

Can this possibly make sense?

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Banks Attempt To Freeze Balance Sheets

Echoing what I said days ago in Fiscal "Stimulus" Doomed To Fail, MSNBC is reporting Impact of bold Fed rate cut may be limited.

While the move helped slow a global slide in stock prices Tuesday, the long-term economic impact of cutting interest rates may be limited.

Why? To paraphrase an old campaign slogan, it’s the housing market, stupid.

Even as housing starts continue to fall, the inventory of unsold houses has risen. With prices falling in many parts of the country, buyers are waiting for a turnaround before they start house hunting again.

My Comment: Therein lies the first key. Psychology is a major driving force. Consumers have decided home prices will keep falling. And as long as home builders keep building at a pace greater than sales, inventories will continue to rise and prices will continue to fall. As the recession steepens, massively increasing numbers of foreclosures will exacerbate the problem.

Lenders and investors have already written off roughly $100 billion in losses so far. But no one knows how much more debt will go bad — or who is holding the bad paper. So even after the Fed has flooded the system with money, lenders remain tightfisted for fear that the borrower won’t be able to pay back the loan.

“Large money center banks have virtually frozen their balance sheets, reluctant to lend even to good credit,” Scott Anderson, a senior economist at Wells Fargo Economics, wrote in a note to clients Tuesday.

My Comment: Therein lies the second key. Banks are unwilling to lend. Now we see a significant change in psychology on part of both consumers and lenders.

However, banks did not freeze balance sheets. Rather they are "attempting" to freeze balance sheets. They are failing in the mission because rising foreclosures are forcing assets onto the balance sheets in spite of a decreased willingness to lend.

Citigroup (C), Merrill Lynch (MER), Lehman (LEH), and Morgan Stanley (MS) all have had to sell assets to shore up balance sheets.

Capital Impairments in the Eurozone

Capital impairment problems are not isolated to the US. A Rogue Trader caused a $7.2 Billion Loss at Société Générale by making massive futures bets that markets would rise. Now Société Générale needs to increase capital by €5.5 billion in the "following weeks."

Reluctance to Lend Hits U.K.

The Times Online is reporting UK mortgage approvals fall to 11-year low.

The British Bankers' Association (BBA) today show the number of home loans granted by lenders fell from the previous month's 43,944 to 42,088 approvals in December — the lowest since 1997.

The record fall is 22 per cent below the six-month average and 37.8 per cent below December 2007. Gross mortgage lending also declined from £16.5 billion in November to £15.1 billion.

Lenders have become much more cautious about whom they lend to after the emergence of the sub-prime mortgage crisis in the US, where companies granted home loans to individuals with a poor credit record.

The above are not isolated incidents. There is systemic capital impairment and increased risk aversion everywhere you look, on the part of consumers and banks alike. This is where the hyperinflation theory falls flat.

Those wishing to review both sides of the debate however, may wish to read Not Your Father's Deflation: Rebuttal and Peter Schiff Replies to Deflation Rebuttal.

In the final analysis, deflation is all about risk taking and psychology (the ability and willingness of consumers to borrow and the ability and willingness of banks to lend). Right now Bernanke specifically, and central bankers in general, more than have their hands full in this regard.

However, hope springs nearly eternal. Thus Faith In The Fed May Be The Last Bubble To Pop.

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