Recent news on the housing front confirms what we have been saying about that market since the inception of Financial Jenga. In sum, there is no real stabilization much less recovery, the costs of attempting to maintain the illusion continue to rise rapidly and any cessation of government interference and manipulation results in rapid breakdown of the fake "market" which was created by those policies.
In the first instance, we now see the failure of HAMP as redefault rates among those "helped" by the program soar. An absolute majority of the government-sponsored loan modifications have now re-defaulted but they did give utterly baseless hope to debtors, thus trapping them into making continuing payments on a hopeless mortgage.
The ongoing cost to prop up Fannie Mae and Freddie Mac continues to rise. Last week the NY Times reported that the cost of those bailouts has now reached $148 billion and will likely total $389 billion. Bloomberg cites a "reasonable worst case scenario" for the ultimate tab which could be $1 trillion or more.
The creation of the tax credit for housing purchases induced a temporary uptick in the number of sales. But like many other government actions, this merely succeeded in pulling forward future demand into the present - which is now the past. We have now entered the void created by that pulling forward. The existing home sales number yesterday and the new home sales number today both demonstrate that in clear terms. Today's existing sales number was nothing short of a disaster. The headline on Marketwatch says:
New-home sales plunge 33% to record low in May
But that fails to reflect the full scale of the drop. In addition to May being down, April was also revised lower. This is a game we should all be familiar with by now. Actual may sales were 300k annualized. But the April report had 504k units sold but it has now been revised to 446k. That allowed the comparison to be reported as merely 33% down rather than over 40%. Either way it's not good and May set a new record low. Apparently, new houses just don't sell unless a big tax credit is piled on top of the subsidized mortgage loans.
Yesterday's existing home sales number was less dramatic but still indicated a housing market in trouble. The decline of 2.2% contrasted with an expected gain of 4%. The tax credit doesn't seem to have accomplished anything of value but at least it fraudulently paid out $9 million to 1,300 prison inmates.
This is total panic time. They're now firing off everything that they have after the first several attempts at an options expiration week stick save failed badly. Basically, the Treasury is guaranteeing virtually everything now with backstops for money market mutual funds and a new super SIV for bad assets. But as Fredrick the Great said: "He who defends everything, defends nothing!" This was a simple acknowledgement of military reality - concentrate on protecting the most important assets. Spreading yourself too thin invites defeat in detail and the destruction of your forces. Then the enemy can loot at leisure.
The government seemingly doesn't understand this but they will. There simply isn't the money to do everything and in their arrogance the Fed and Treasury have over-reached badly. By trying to save all of the bankrupt financial companies, they are weakening the defenses of the strategic key - Treasury debt. The bond market is already demanding 50 basis points more in interest than just days ago. Another way to look at it is that 10-year government bonds have lost 3.5% of their value in that time. The Treasury is the logistics depot from which the army defending every other target is being supplied. If it falls, the war is over and our enemies win.
One shot wonder, long-term consequences
The SEC, erstwhile market watchdog is barking up the wrong tree again. They sat on their hands and did nothing while the disaster built all around them and now they are attacking the group pointing out the problem, not the ones who caused it. In banning short-selling, they also increase the probability that there will be no bounce when the next decline occurs since short-covering is the one thing that has kept our stock market from collapsing like much of the rest of the world's. The fact that they feel the need to use this one-time guaranteed short-squeeze now ought to tell you everything you need to know when the cost is so high for so little gain in terms of time. This tells me that election politics are paramount here since there is at least a chance (maybe 50/50) to delay the crash by 6 weeks. There is little prospect that we make it 6 months. With so little difference, I'd prefer it occur before the election to guarantee an Obama presidency. Whichever party holds power over the next 4 years will be discredited for a generation (after Hoover and GD 1.0, the Republicans were unable to build sustainable majorities for two generations). Though I'm disgusted with both political parties, there is at least some chance that the Republicans will return to their Reaganite roots after a time in the wilderness. I have no hope at all where the Democrats are concerned. The fundamentals are positively horrific and much depends on sustaining the illusion of control. Short-sellers overwhelmingly profit from disparities between perception and reality - as such, they are always among the first to point out that the emperor has no clothes. Given the stakes, anyone who sees through the deception must be punished and silenced.There isn't even enough tax money to cover the normal operations of our bloated government, much less this madness. But the bond market was willing to make up the difference as long as there was a high probability of repayment. But the checks that Paulson is writing with his mouth right now are guaranteed to bounce and some bond buyers are noticing. From a low beneath 3.30% this week, the yield on the 10-year Treasury bond has skyrocketed by 50 basis points. The fact that the bailout silliness has more than doubled that deficit doesn't help at all. Like any fool who continues to spend far beyond his means, the creditors will charge us more and more to borrow until insolvency.The only solution is immediate cuts in government spending and the repudiation of all the backstops that have been proposed. Getting within shouting distance of a balanced budget is the only thing that can prevent an imminent spike in Treasury rates. The entire game depends on the willingness of foreign savers to fund the now gaping chasm of the Federal Deficit. If they balk, the whole structure is endangered. By taking on the toxic waste of the financial industry, all the US government has done is place itself at risk in the inevitable implosion. This is too large for any government or even all of them together to solve. Remember how Congress sent the GSEs out to save a drowning housing market and the "lifeguards" not only failed the rescue but also got pulled to the bottom right along with everybody else? That is precisely what is going to happen to the US government if they don't extricate themselves now. A blowout in borrowing costs was a precursor to the demise of Fannie and Freddie; we appear to be seeing a super slow-mo, reverse-angle replay with the Treasury right now.One reason the US survived GD 1.0 without the political damage in the rest of the world (think Hitler, generals in Japan, Peron and petty dictators from Pilsudski to Metaxas) was the fact that the our government's finances never reached a state of existential crisis. The deficit (what there was of it) and government bonds were always sure to be paid back. That assurance is not present today and the government's actions are making ultimate repayment ever less likely. The Argentine example is particularly poignant. In the early 20th century, that country had a higher per capita income than the USA. After decades of socialist and corporatist policies under the Perons, they became the ongoing basket case and borderline Third World country they are today.
I hate to paraphrase anything from the Star Wars series but it is too apropos: This is how freedom dies - to thunderous applause.
It is critically important to understand the decline in overall credit levels in order see just how powerful the emerging deflationary trend is. One of my favorite analysts is Doug Noland of Prudent Bear. His Credit Bubble Bulletin is an indispensable tool for anyone hoping to fully understand what is happening. From his latest edition:
Total Commercial Paper increased $1.1bn to $1.753 TN. CP has declined $471bn over the past 46 weeks. Asset-backed CP fell another $5.0bn last week (46-wk drop of $447bn) to $748bn. Over the past year, total CP has contracted $390bn, or 18.2%, with ABCP down $412bn, or 35.5%.
So there is a hole roughly $400 billion wide of destroyed credit in the shadow banking system of SIVs and other off-balance sheet entities. That would be pretty tough to fill. And in the immortal words of Ronco "But wait, there's more!" Bloomberg reported yesterday that CDO defaults since October now total 200, with a face value of $220 billion. Given the performance of the ABX and CMBX indexes, it seems safe to value the defaulted CDOs at 50% of face value or less. So add at least $110 billion to that already deep hole of vanishing commercial paper. This is all on top of whatever enormous losses emerge in the official banking sector.
So what new credit is being created to counteract all of this credit destruction? No help from the official banking sector, including the Fed. Back to our friend Doug Noland:
Bank Credit dropped $24.8bn to $9.339 TN (week of 6/18). Bank Credit has now expanded only $126bn y-t-d, or 2.9% annualized.
Fed Credit has increased $1.1bn y-t-d and $27bn y-o-y (3.2%).
There is very little ability to create new shadow credit now that the inherent riskiness of these absurdly complex vehicles has been exposed. A lot of investors are learning the hard way that if you can't understand it, you shouldn't buy it - a lesson that goes all the way back to the Mississippi Company and South Sea Bubbles of the early 18th century. The entire panoply of complex derivative securities is being revealed for the severely under capitalized pyramid scheme that it always was: SIVs, conduits, auction-rate securities, CDOs, CDS, asset-backed commercial paper and more.
The Universal Debt Bubble was a massive confidence scheme but the marks are now wise to the game. A whole new generation of "investors" with no memory of the current scandals will have to grow up before such a thing can be attempted again. We are witnessing the slow-motion collapse of the multi-trillion dollar shadow banking sector. With (commercial) bank credit also beginning to drop and Fed credit nearly stagnant, the supply of credit to support asset inflation is shrinking outright.
Expect more pain across all major asset classes that are typically purchased in highly leveraged transactions.
The Universal Debt Bubble (UDB) has enabled many activities that could never be sustained in anything resembling a normal environment. Perhaps nowhere is this more clear than in the field of corporate finance and the related debt and equity markets. Let's look at the borrowing side first.
Just as with housing, cheap credit was widely available in the corporate sector. Anybody could borrow and at much lower than normal interest rates too.
One of the most important effects is that it was almost impossible to default on a debt. Since there was almost always another lender lined up to make a loan, companies refinanced instead of going bankrupt. This was very similar to the way homeowners refinanced instead of facing foreclosure. The magnitude of the drop in defaults was astounding. A study by Moody's showed that over 32 years the lowest rated bonds (Caa, Ca and C) averaged 23.7% defaults each year.
http://www.moodysasia.com/SHPTContent.ashx?source=StaticContent/Free+Pages/MDCS/Asia/Corporate+Bond+Ratings+and+Rating+Process.pdf
With the UDB in effect, the default rates for those risky bonds has fallen to virtually nothing:
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"Issuers rated CCC or lower typically default at an average annual rate of 25 percent, as measured by Fitch. In 2006, the default rate for such issuers was 4.5 percent, the lowest in 20 years."
http://www.ibtimes.com/articles/20070111/junk-bonds.htm
With consequences seemingly abolished, borrowers lenders began to behave badly - just as they did in the mortgage market. More and more of the bond deals funded were in the lowest credit categories: the corporate equivalent of subprime. The structures were increasingly convoluted and risky. Toggle notes were issued, giving the debtor the right to pay interest either in cash or more bonds - reviving the disastrous pay in kind (PIK) structure from the 1980s. This also looks suspiciously like an option ARM or negative amortization loan. Covenant lite loans removed most of the traditional protections for the lender, echoing the no-doc, no verification trend in mortgages. The parallels are uncanny - just as they should be since they were caused by the same UDB forces.
Once all of this foolishness is gone, we should see things revert to their historical levels. If we see anything close to normal, junk bond losses will be substantial. There are many other resemblances and we may deal with them at a later time. But the next topic for discussion will be what companies did with all of the money they raised in the bond market.
