Monetary System Still Undergoing Stress Test - Cheat Sheets Supplied

Includes: FMCC, FNMA, GLD, IYR
by: Economic Disconnect

The Monetary System Stress Test
Monday October 19, 2009 may be looked back on in the future as the beginning of a serious examination of all things money. Across the entire spectrum of media there were tales and write ups that spoke to the very nature of the problem of our financial system:

It only exists in a notional sense, it is dependent upon confidence, it cannot withstand even minor shocks, and long ago it was freed of any tethers to reality and thus has no meaning behind it.

The following are the pertinent pieces of the puzzle, with some commentary.

How The Federal Reserve Bailed Out The World
Zero Hedge had extensive coverage of Monday's must read paper by the Bank of International Settlements (BIS) which recounts and details the Federal Reserve's action taken last year to bail out practically the entire world banking system. The stunning announcement of swap lines with countries all over the world was glossed over at the time due to overall panic levels, but the BIS opens up the books and really shows how bad things were.

I would encourage you to read the entire write up. My own take away is that banks the world over are insane, and worse, they are making plays that simply cannot be backed by their own butts. Any strain on the system that demands full up front payments between banks cannot be made good because the assets most banks have are in turn just financial instruments themselves, not underlying hard assets. It is like a bank has say 1 apple, but 100 apple contracts tied to it. As long as they need never have to part with the apple, the game goes on. If they have to make good, well you get the idea.

I highlighted this story the other night in the comments section and I have to say it turns my stomach and makes me want to throw in the towel on trying to make any difference in this entire process:

20 Year Old Buys Home With $183,000 FHA Loan And Just 3.5% Down
Without question, Tejada's loan is toxic--to her and to the taxpayers who are backing the loan. Her house cost $155,000. Tejada's loan was apparently made on a micro-down payment of just 3.5%, the minimum down payment to qualify for an FHA loan. On top of this, however, she got an additional government backed loan to make improvements. Her total loans amount to $183,0000. In short, she was immediately underwater on her new house.

The monthly payments on her debt amount to $1328. Her income is $2470, leaving her with just $285 a week to live on. She's paying 54% of her income to make the mortgage payments. She earns that income by holding down one full time and two part time jobs. Obviously, this woman has a strong work ethic. But it also means her income is precarious. With unemployment still rising, she obviously should be worried about losing one of her three jobs. A loss of one of them would likely leave her unable to make the debt payments.

Tejada appears to be using imaginary numbers about the value of her house. She says that when she bought it, the house was just a “box” with no kitchen or bathroom. Now it is "gorgeous". She claims the renovation has increased the value of her home from $155,000 to $255,000.

This should be criminal. The lady in the article would be better served to try and get some kind of education rather than work 3 dead end jobs trying to be a house flipper of old. That said, what the hell do I care what anyone does with their life? This lady is just another sure to be loser in the Darwinian challenge of economic life. So wheres the rub?

Oh yeah. This is an FHA loan which means you and I will foot the bill when this all goes bad. Nothing, not one thing has changed win regards to the unnatural desire for the government to trap more people into buying homes. FHA loans for everyone, tax credits for all, and just let the taxpayer get the bill. Of course if things keep up, I would not worry about actually paying for any of this anyway.

So what does a wildly inflated stock market really mean? Nobody knows, but here is one example how even faced with stark numbers and reality it is party on in stocks:

Fannie and Freddie Shares Dive on Zero-Value Prediction
...Even presuming that the old Fannie (FNM) and Freddie (FRE) portfolios would earn net operating profits over the next 10 years as the mortgage crisis abates, the companies still would have negative equity at the end of that period because of what they owe taxpayers, Keefe says.

"In this scenario, both the common and preferred equity of the [companies] should be worthless," the firm says. "Our bad bank analysis suggests that the companies will still owe the government almost $100 billion by the end of year ten. As a result, we are ... cutting our price targets to $0."

Speculators ran wild with Fannie and Freddie shares in August, driving both up more than 200%. Fannie peaked at $2.04 on Aug. 28; Freddie peaked at $2.40 the same day. But the stocks have been drifting lower since then as interest has waned.

Did YOU GET THAT TRADERS? 10 years out and FNM and FRE are a ZERO.

These two stocks were part of the rag tag bunch that started the early low volume high gap up rally last April. There is no reason that the two companies have not been delisted and closed, so of course there must be a very good reason they have not indeed. I put it to the readers to surmise as to why.

One of the few rational thinkers still walking around free is David Einhorn of Greenlight who made a speech at the Buttonwood Gathering that makes so much sense it almost makes you want to cry reading it. Many aspects of what I have tried to make clear here are recounted by Mr. Einhorn, and as usual, he terms it more clearly than I am able (various excerpts):
Einhorn on Gold, Sovereign Default and More

On Bernanke and Geithner:
Presently, Ben Bernanke and Tim Geithner have become the quintessential short-term decision makers. They explicitly “do whatever it takes” to “solve one problem at a time” and deal with the unintended consequences later. It is too soon for history to evaluate their work, because there hasn’t been time for the unintended consequences of the “do whatever it takes” decision-making to materialize.

Please note this is not sniping, it is a fact. More:

On arguments that the lesson of 1937-8 is not to withdraw stimulus too soon:
An alternative lesson from the double dip the economy took in 1938 is that the GDP created by massive fiscal stimulus is artificial. So whenever it is eventually removed, there will be significant economic fall out. Our choice may be either to maintain large annual deficits until our creditors refuse to finance them or tolerate another leg down in our economy by accepting some measure of fiscal discipline.

This is a clear point. Those of the Keynesian bent argue that by propping up demand whether or not that demand is real makes no difference. On a graph maybe that is true. In the real world is does make a difference. More:

Channeling Stephen “There-is-no-exit” Roach:
As we sit here today, the Federal Reserve is propping up the bond market, buying long-dated assets with printed money. It cannot turn around and sell what it has just bought.

There is a basic rule of liquidity. It isn’t the same for everyone. If you own 10,000 shares of Greenlight Re, you have a liquid investment. However, if I own 5 million shares it is not liquid to me, because of both the size of the position and the signal my selling would send to the market. For this reason, the Fed cannot sell its Treasuries or Agencies without destroying the market. This means that it will be challenged to shrink the monetary base if inflation actually turns up….

….The Fed could reach the point where it perceives doing whatever it takes requires it to become the buyer of Treasuries of first and last resort.

Again, clear arguments. Final section:

On his gold thesis:
I have seen many people debate whether gold is a bet on inflation or deflation. As I see it, it is neither. Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible. Gold did very well during the Great Depression when FDR debased the currency. It did well again in the money printing 1970s, but collapsed in response to Paul Volcker’s austerity. It ultimately made a bottom around 2001 when the excitement about our future budget surpluses peaked….

….When I watch Chairman Bernanke, Secretary Geithner and Mr. Summers on TV, read speeches written by the Fed Governors, observe the “stimulus” black hole, and think about our short-termism and lack of fiscal discipline and political will, my instinct is to want to short the dollar. But then I look at the other major currencies. The Euro, the Yen, and the British Pound might be worse. So, I conclude that picking one these currencies is like choosing my favorite dental procedure. And I decide holding gold is better than holding cash, especially now, where both earn no yield.

And this is a key point.

It has long been a central premise here that gold is an answer to reckless fiscal policy. Reckless policy most often results in inflation, hence the "gold is a inflation hedge" mantra. I see it as something more.

Poor decisions on monetary policy, currency questions, bond manipulations, and an over extension of government well past its ability to pay for said intervention can lead to inflation. It could also lead to deflation. It could also lead to default. None of these things are good.

It is said that world currencies are far worse off than the US dollar, and that may be true. But this does not mean anything in and of itself.

While on the surface things look better, nothing below the surface is looking up. Insider trading probes show once again the moral emptiness of Wall Street. Many indicators look like everything is fine (TED spread, LIBOR) but these metrics were purposely targeted to look better and mask underlying weakness.

The monetary system is still undergoing a stress test of its very own. So far the Fed and the Treasury have supplied the needed cheat sheets for the test to be barely passed. Should the flow of funny money stop for any reason it is my opinion that the monetary system will fail the test in short order.

I again think of the lead off article today. The money just is not out there, it does not exist. The only way forward is to keep anyone and everyone from demanding real payment and not just rolling over debt and commitments. That was the true core of the financial crisis; Banks and depositors the world over wanted to be paid in full with hard currency or hard assets and it they not exist. Better not to ask.