Wednesday, August 27, 2008

MBS Deep Freeze

According to various sources, the GSEs Fannie Mae and Freddie Mac have been buying somewhere between eighty and ninety percent of all mortgages recently. This has led to very rapid growth of their mortgage portfolios. Just a few weeks ago, this report appeared in Newsday:
Fannie Mae, the largest provider of funding for U.S. residential mortgages, on Wednesday said it grew its investment portfolio in June at the fastest annualized rate in nearly five years.

Fannie Mae's mortgage portfolio increased at a
22.8 percent annualized rate to $749.6 billion in June, from $736.9 billion in May, the Washington-based company said in a statement.

The government-sponsored enterprise (GSE) has been boosting growth in its investments since its regulator earlier this year began easing requirements on capital it must hold against the assets. Lawmakers consider such purchases by Fannie Mae and rival Freddie Mac as playing a key role in supporting the U.S. housing market that is going through a wrenching downturn.
What a difference a month makes. Buried deep inside a Bloomberg article today, we find this:

Freddie's portfolio expanded at a 9.8 percent annualized rate to $798.2 billion in July, the slowest since March. The holdings may shrink this month based on forward commitments, according to the company's monthly volume summary today. Fannie expanded to $758 billion, an annual rate of 14.4 percent, the smallest increase since April.

The declining demand from the federally chartered companies, the biggest buyers of home loan securities, is sending mortgage prices lower and causing home loan rates to increase.

``It's become pretty obvious that they're not going to be able to grow going forward,'' said Walt Schmidt, a mortgage-bond strategist at FTN Financial Capital Markets in Chicago. ``Without a capital raise, you're not going to see a major recovery in'' mortgage securities.

Growth went from north of 20%, to low double or high single digits, then possibly to NEGATIVE in just a few months. It is a tribute to the speed with which leveraged pyramid schemes fail once the confidence is gone. Since the massive growth of the GSE portfolios was unable to arrest the rapid fall in bloated housing prices, the removal of this prop and sidelining the buyer of last resort is likely to result in another down leg in prices and unit sales.

Although Treasury Secretary Paulson pushed the GSE bailout bill through Congress by saying he needed a bazooka so he wouldn't have to use it, the market appears to have called his bluff. The problem is that many commercial banks hold Fannie and Freddie preferred stock as part of their capital. Simply guaranteeing the debt does nothing for the preferred it would be wiped out in the re-organization - adding another hit to capital and more failed banks. Government purchases of preferred stock would be less bad for the banks but they would still be diluted and have less capital. Only purchasing common stock would leave the preferred (and bank capital) intact. But that would bail out the management and prevent a much, needed re-organization of the companies. More to the point, it would also be seen as a pure bailout and politically very damaging heading into a national election.

There has been very little reason for the credit inflation crowd to cheer lately and the rapid growth of the GSE portfolios was one of the few bright spots for them. This growth appears to be done as well. The Shadow Banks are now shattered banks as off balance sheet vehicles are unwound and hedge funds shut their doors. We should expect to see even more of the later in the near future. The WSJ reports that July was the worst month ever for the Morningstar 1000 hedge fund index at negative 3.07%.

Monday, August 25, 2008


We turn to Europe in this commentary as important events are occurring there behind the scenes and Asia has gotten the lion's share of the attention recently. The mariner's distress call actually comes from French, where "m'aidez" simply means "help me." We thought that would be a particularly appropriate title as Europe's financial system is starting to show signs of severe distress. From the actions of the CBs over there, we can infer that the problems there may be significantly worse than here in the US. Current open market operations show that the ECB has 451 billion Euros (about $640 billion) outstanding. This dwarfs the Fed total of just over $300 billion - including all liquidity facilities. It's pretty clear that there are many European banks in deep, deep trouble.

Starving for Dollars
It is also becoming increasingly clear that the European financial system has a desperate shortage of dollars. Since much of the debt outstanding is denominated in dollars and many European banks have taken in dollar deposits as well, there is a need for them to transact in our currency that is not reciprocated. When the Fed and foreign CBs set up the currency swaps, there was some suggestion that the purpose was to give the Fed enough Euros to intervene in the currency markets. That really didn't make much sense as the Treasury and the Fed have conducted a sub rosa weak-dollar policy for years. The logical and obvious explanation is now coming to the fore - Europe is seriously short of dollars and if they were forced to go out into the market and buy dollars, our currency would strengthen too much for the planners at the Fed who have been attempting to devalue it.

The bid to cover ratios from recent auctions make the point quite forcefully. The last set of TAF auctions in the US produced ratios of 1.51 and 2.19 (for the initial 84-day facility). The comparable ECB auctions in Euros had a bid to cover of 1.58. But ECB dollar auctions were bid at 4.56 and 3.85. US banks' demand for dollars appears to be roughly equal to Eurozone banks' demand for Euros. But Eurozone demand for dollars is twice as great as either one. This trend is confirmed by the result of the Swiss dollar auctions. Those had bid to cover ratios of 2.90 and 4.90. Finally, note that the Fed is not auctioning off Euros or Swiss Francs to anxious American bankers.

In addition, the high-yield bond market in Europe is completely frozen. Not one junk issue of any size has come out of Europe this year or for quite a few months of 2007. Retail sales there are falling farther and faster than in the US and the housing bust there has barely begun. Granted that theoretically the ECB had more room to cut rates than the Fed but the strength of unions and the social program costs make a wage-price spiral much more likely in the Eurozone, which seems to be constraining the actions of the ECB.

Friday, August 1, 2008

UDB meltdown

We have often spoken of the UDB (Universal Debt Bubble) and how it had permeated nearly every asset class and geography. It's existence is the reason that we have often chided believers in economic "decoupling" as fantasists. We wrote about the structural weaknesses of the Asian economies in China Syndrome and Silent Scream. The trend has been quite clear lately as India teeters on the edge of recession and Japan's trade surplus collapses. Today we receive additional confirmation (as if any were needed).

The last bastion of the "decoupling" fantasy is China. Yes OPEC and Russia can remain strong as long as oil prices stay high but that scenario rests on the further assumption of nearly unlimited demand growth out of Asia (especially China). Chinese growth had continued to be high even as it trended down for 5 consecutive quarters. Now we see a report that the industrial sector is SHRINKING outright over there. Bloomberg reports that Chinese PMI fell to 48.4 in July (anything below 50 indicates contraction). Naturally, there will be apologists who will blame the entire decline on the Olympics and the shutdown of industry in the Beijing area. I present for their edification import orders:
The output index fell to 47.4 in July from 54.2 in June, while the index of new orders dropped to 46.2 from 52.6. The index of export orders declined to 46.7 from 50.2.
Clearly, there is no correlation between demand for exports and the Olympics. While that is likely and aggravating factor, it's a long way from the heart of the problem. Exports are the be-all and end-all for China's economy and they are going down in no uncertain terms. This should be no surprise as the end demand in their trade partners is clearly weakening. This is horrible news for China, as their entire economy is a pyramid leveraged to exports. What we wrote in China Syndrome less than a month ago has particular resonance given this report:
Essentially, everything will be fine as long as everyone there believes the economy will continue to expand at a breakneck pace and invests accordingly. This is virtually the definition of a pyramid scheme.

The most likely trigger for a fall in China's capex is weakening exports. They don't even have to stagnate to trigger real problems, much less fall. When the current investment pattern is predicated on rapid and continuous growth, material decline in the growth rate should be sufficient to kick off lower capital spending. An event the magnitude of 1980 would cause a direct hit of 12% of GDP in China in addition to any multiplier effects and that is hardly unthinkable. Keep in mind that exports themselves account for 33% of Chinese GDP so any outright decline there would be a real problem for them - likely triggering a minimum 20% fall of GDP. Frankly it will be difficult for them to avoid it given the economic and political climate in their trading partners.
China is simply following the same pattern that we have already seen in India. In China's case, the slowing of demand may have been masked by the massive construction projects and inventory building prior to the Olympics. In many ways, this event is similar to the Y2K phenomenon that marked the top of the tech bubble. It is a date-certain occurrence which inspired massive spending and investment as well as hoarding and stockpiling (for different reasons). That date also marks the absolute cutoff of all related investment and spending as well as a potential inventory draw down. In this instance, the cycle is exacerbated by the reduction or cessation of industrial activity in and around Beijing. So instead of a gradual reduction in industrial production growth like India, China looks to be set for a sudden end to growth.

We see problems globally, not just in the US and Asia. Deflating housing bubbles in Spain, the UK, Italy and Australia. Retail sales falling across the developed world, with their supplier nations beginning to follow suit. This is no ordinary credit crisis. It is the beginning of the end for the largest and most extensive credit bubble in all of human history - the Universal Debt Bubble. No nation, no asset class will escape the effect of the bubble bursting. Preserve your wealth, reduce risk and get ready to buy assets on the cheap on the other side of this mess.