One of the most troubling trends is the belief that all is well because banks aren’t foreclosing on homes or the fact that there is no second wave.  Really?  Let us look at nationwide foreclosure filings shall we?

Who needs a second wave when the first wave is still in place?  Some in the housing industry seem to be patting their back that there won’t be a second wave of foreclosures (even though it is still high) and base this on the mounting distress inventory with Alt-A and option ARMs but no actual foreclosure filing.  The wave is hitting as people stop paying their mortgage.  Take for example option ARMs.  Nearly 50 percent of all outstanding option ARMs are at least 30 days late.  In other words, the borrower isn’t paying the mortgage!  Yet in some form of twisted abracadabra housing logic, this is avoiding the wave because banks are ignoring the problem.  The wave was the distress.  Foreclosures are still on the market.  The bank balance sheet is still loaded with mortgage junk.  But just because banks are putting their hands over their eyes doesn’t mean the issue was avoided.  In fact, it is corrupt to the core and the way they acknowledge this is absolutely stunning.  The fact that we have no solid financial reform after 2 years of major crisis is incredible.  Banks simply ignoring missed payments while taking trillions demonstrates what has become of our financial system and their idea of dealing with the problem.

Take for example HAMP:

“(Huffington Post) As of the end of January there were over 116,000 permanent modifications and over 67,000 permanent modifications pending final approval,” Geithner wrote in his letter, which the panel received last week. “This group of approximately 180,000 permanent and pending permanent modifications represents about a third of the population of total modifications who have completed the trial modification and are at a point in the process where they are able to convert to permanent.”

HAMP has been an absolute failure.  Yet HAMP is symptomatic of the bigger issue.  Banks were able to raid the entire U.S. Treasury and Federal Reserve for $13 trillion in backstops and bailouts, with no questions asked but then start talking about moral hazard when it comes to HAMP:

“Kucinich was pessimistic about the ability of any program that doesn’t involve principal reductions to help floundering homeowners. “Instead, we’re going to stay on this slow path to default, foreclosure and personal bankruptcy,” Kucinich said. “And our economy is going to continue to suffer.”

He added: “It’s funny that moral hazard is a concept when it comes to Main Street but not to Wall Street,” a reference to the massive bank bailouts.

More than 2.8 million homes were lost to foreclosure last year, according to data provider RealtyTrac. The firm expects a record three million foreclosures this year.”

I’ve talked with colleagues who are Republicans and Democrats and both are absolutely appalled by what is going on with Wall Street and the housing industry.  They have transformed our economy into one giant casino and houses are now life sized Monopoly tokens that are traded on the New York Stock Exchange with no regard to local economies.  Moral hazard applies to the masses yet those rules don’t apply to the plutocracy that sits on Wall Street.  While the stock market soars from the March low by a stunning 68%, job creation is nowhere to be found:

Where are the jobs?  Last month they blamed the snow and now next month, we can expect a big boost because of Census hiring.  That is great that we have thousands working at $16 or $17 an hour with no benefits but then what?  Are we going to do the Census every month?  Most Americans realize that things aren’t as rosy as Wall Street is leading on.  And California is certainly not doing any better:

California Doing a Housing Industry on the Budget

“SACRAMENTO, Calif.—Gov. Arnold Schwarzenegger said Tuesday that he vetoed the largest piece of legislation in a package of budget bills because it did not take immediate steps to cut spending.

Democratic lawmakers said the bill would have shaved $2.1 billion from the $20 billion shortfall projected for California’s budget through June 2011. So far, the Legislature and governor have agreed to just $200 million in spending cuts.

“It’s extremely important that we immediately jump into action and make midyear cuts,” Schwarzenegger told reporters on Tuesday. “We’re spending, right now, $600 million a month more than we’re taking in. It’s irresponsible.”

This came out on Tuesday by the way.  We still have a $20 billion shortfall and are spending $600 million a month more than what is being brought in.  So what does that mean?  It means more cuts or higher taxes.  How is this good for housing?  More importantly, how is this good for the state economy?  If we look at the unadjusted unemployment rate California is up to 13.2 percent unemployment (headline).  We are seeing 23 percent underemployment.  This is something none of us have seen in the modern era.  Yet those in the banking and housing industry are claiming mission accomplished just because banks aren’t moving on foreclosures.  This is their ultimate solution.  Because that is all they have.  This suspension of belief is their idea of avoiding the second wave.  Humor them and take this out to the logical conclusion.

Many Californians are underemployed as we have highlighted.  Those that are employed, can expect tighter wages and higher taxes thus cutting into their disposable income.  So how does this create higher home prices?  Even if banks “trickle” out inventory once that inventory hits the market it confronts the economic realities people have to live by.  That is why when we show examples of short sales they are selling at deep cuts.  Home prices have to reflect local area incomes and what people can afford.  Unless we plan on bringing back toxic waste mortgage sludge like Alt-A and option ARMs, people can only buy what their income can support.

If things are so fantastic in the housing market for California, I’m sure builders are out there in mass right?

Not exactly.  Because there is a glut of housing on the market.  And more importantly, that second wave of housing is sitting on the banks balance sheet.  So they won’t be making construction loans when they realize just how much inventory is really out there.  Just look at the above chart.  Building permits and construction jobs are at the trough.  No visible turn around.  And take a look at notice of defaults and foreclosures:

The only reason the foreclosure number has fallen was because of HAMP (which as we now know is a failure meaning more short sales or foreclosures will hit the market soon because many on trial mods will not make it to permanent modification status).  Whether it is a flood or just a steady trickle, this will happen.  And these homes sell for lower prices thus pushing area prices lower.  This is the next round for mid to upper tier markets.  They have bought some time but it is running out.  Eventually there will have to be some realization of local economic factors.

I was curious to see what industries were adding jobs:

Who will be buying the homes in 2010?  More importantly, why would people be overpaying for homes?  The above chart shows no real improvement in the real economy.  In fact, all the banking industry is doing is stalling the inevitable but at the same time sucking the taxpayer dry.  With the $13 trillion in bailouts and backstops we could have had enough to pay off every single residential mortgage in the United States and taken everyone to Disneyland.  Instead, we are financing the crony banking system full throttle robbery of the American people.

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About a month ago I wrote a post called “The coming wave of second mortgage writedowns” the gist of which was that the big four banks (Citi, JP, BofA, and Wells) had a shed load of exposure to now worthless second mortgages. With many first mortgages now hopelessly underwater, it stands to reason that second mortgages on those same properties have zero value.

The big four are certainly well aware of this problem and are looking for ways to extend the wherewithal of underwater borrowers and pretend they don’t need to take losses on these loans. On paper, these companies are very well capitalized. However, in the real world, the likely losses they must eventually take on loans already on their books would probably render them insolvent. This is what I hinted yesterday in my post on the stress tests.

I said:

I would say the stress tests were a mock exercise to instil confidence in the capital markets. This was important first and foremost because it would induce private investors to pay for bank recapitalization instead of taxpayers. But it was also important for the economy as a whole as the sick banking sector was dragging the whole economy down. The key, however, is that the tests were a mock exercise. Despite the additional capital, banks are still hiding hundreds of billions of dollars in losses in level three, hold to maturity, and off balance sheet asset pools. If asset prices fall and/or the economy weakens, all of this subterfuge would be for nought.

-Geithner: jusqu’ici tout va bien

And when I use the phrase ‘mock exercise,’ by mock, I mean fake. Mike Konczal has done a remarkable job of putting these two concepts – the worthless second mortgages and the stress tests – together.

He writes in a recent post:

Let’s talk specifics: Last June I made a DIY Stress Test, using values reversed-engineered from the public documents, where you could play around with the values online or download an excel spreadsheet yourself (it’s still one of my favorite blogging items). The backbone of the overview of results, page 9 from the Federal Reserve’s document, looks like this:

I’m going to isolate the four largest banks Frank questioned about second-liens, along with their loses as they’ve legally sworn to being accurate during the stress test:

Again, this is data as reported to the government by the major banks during the stress test of 2009. So what’s going on here? The four major banks have about $477 billion in junior liens, either in the form of a second mortgage or a home equity line of credit. If you go to the Fed Funds data online, you’d see that there’s about a trillion dollars of 2nd/Juniors out there, so the four major players have about half the market.

The four major players each report that they expect to have a 13-14% loss on these items under an “adverse scenario”, with Citi reporting a 20% loss under an adverse scenario. That means of the $477bn, $68.4 bn is junk that’ll never be collected on. This, combined with all the other expected losses (see the link to the stress test for the rest) meant that the four biggest players needed around $53bn to be raised.

Notice how Frank’s letter, and pretty much anyone you’d speak to who isn’t working for the four largest banks, assume that second liens in the country aren’t worth 86% of their value (for a 14% loss). You see in Frank’s letter “no economic value.” Huh. Well, that’s a problem.

Let’s look at these values again, assuming that the expected total loss would be 40%, and then 60%.

So the original loss from second-liens, as reported by the stress tests, was $68.4 billion for the four largest banks. If you look at those numbers again, and assume a loss of 40% to 60%, numbers that are not absurd by any means, you suddenly are talking a loss of between $190 billion and $285 billion. Which means if the stress tests were done with terrible 2nd lien performance in mind, there would have been an extra $150 billion dollar hole in the balance sheet of the four largest banks. Major action would have been taken against the four largest banks if this was the case.

See what I mean by fake?  The point is this whole charade is transparent to anyone who actually runs the numbers. Yet, you have people like John Cassidy spreading disinformation in the New Yorker, writing puff pieces of zero negative value with drivel like this:

Other critics dismissed the tests as a sham, arguing that the economic assumptions underpinning them were too benign. As the tests unfolded, however, it became evident that the government’s loss projections were quite high, and that many banks would be forced to raise considerable sums of money—in some cases, more than ten billion dollars.

Baloney. Run the numbers like Mike did, John; and then you wouldn’t make such asinine comments. Of course the stress tests were a sham.  They were a confidence trick to raise more capital and buy time for the banks to earn yet more still. The point was to allow the banks to ease into their losses. And that’s exactly what’s been happening for the past year.

The problem with the stress tests, however, is they gave the banks a way to get from under the yoke of the government’s TARP program. The banks said, “look, we are now well-capitalized even in the worst case scenario of the stress test. We want out of TARP.”

This is bad for three reasons.

• The big banks all paid back $25 billion in TARP funds. Smaller banks like Northern Trust paid back $10 billion or less. That’s hundreds of billions of capital that they all could have as a buffer against losses. Some of them raised additional capital to replenish the coffers. Nevertheless, net-net, we had less banking capital in the system after the repayments than before.
• Banks free of TARP paid out a lot of cash in bonuses that could have gone to shoring up their capital base.  Every dollar paid in cash compensation to staff is a dollar less of capital.  Had these banks been under TARP, they would have been forced to pay lower bonuses – if only for this year.
• The lower capital – and the fact that banks know that having renewed capital problems would mean the end of the line for them – means that banks are less likely to lend freely.  They understand that now is the time to husband capital. Heads would roll if a big bank or super regional which had repaid TARP had another capital shortfall.

The real question is: why is the Obama Administration running victory laps, unrolling the ‘Mission Accomplished’ banner on the credit crisis, as Mike Konczal describes it? I suspect this is just a political stunt to provide cover in the mid-term elections to somehow demonstrate that the Democrats fixed the problem which the Republicans created. 

I think it could backfire if only because the underemployment rate is still 17%. Nobody wants to hear the “I saved the economy routine” when they’re unemployed and losing their home.

About a month ago I wrote a post called “The coming wave of second mortgage writedowns” the gist of which was that the big four banks (Citi, JP, BofA, and Wells) had a shed load of exposure to now worthless second mortgages. With many first mortgages now hopelessly underwater, it stands to reason that second mortgages on those same properties have zero value.

The big four are certainly well aware of this problem and are looking for ways to extend the wherewithal of underwater borrowers and pretend they don’t need to take losses on these loans. On paper, these companies are very well capitalized. However, in the real world, the likely losses they must eventually take on loans already on their books would probably render them insolvent. This is what I hinted yesterday in my post on the stress tests.

I said:

I would say the stress tests were a mock exercise to instil confidence in the capital markets. This was important first and foremost because it would induce private investors to pay for bank recapitalization instead of taxpayers. But it was also important for the economy as a whole as the sick banking sector was dragging the whole economy down. The key, however, is that the tests were a mock exercise. Despite the additional capital, banks are still hiding hundreds of billions of dollars in losses in level three, hold to maturity, and off balance sheet asset pools. If asset prices fall and/or the economy weakens, all of this subterfuge would be for nought.

-Geithner: jusqu’ici tout va bien

And when I use the phrase ‘mock exercise,’ by mock, I mean fake. Mike Konczal has done a remarkable job of putting these two concepts – the worthless second mortgages and the stress tests – together.

He writes in a recent post:

Let’s talk specifics: Last June I made a DIY Stress Test, using values reversed-engineered from the public documents, where you could play around with the values online or download an excel spreadsheet yourself (it’s still one of my favorite blogging items). The backbone of the overview of results, page 9 from the Federal Reserve’s document, looks like this:

I’m going to isolate the four largest banks Frank questioned about second-liens, along with their loses as they’ve legally sworn to being accurate during the stress test:

Again, this is data as reported to the government by the major banks during the stress test of 2009. So what’s going on here? The four major banks have about $477 billion in junior liens, either in the form of a second mortgage or a home equity line of credit. If you go to the Fed Funds data online, you’d see that there’s about a trillion dollars of 2nd/Juniors out there, so the four major players have about half the market.

The four major players each report that they expect to have a 13-14% loss on these items under an “adverse scenario”, with Citi reporting a 20% loss under an adverse scenario. That means of the $477bn, $68.4 bn is junk that’ll never be collected on. This, combined with all the other expected losses (see the link to the stress test for the rest) meant that the four biggest players needed around $53bn to be raised.

Notice how Frank’s letter, and pretty much anyone you’d speak to who isn’t working for the four largest banks, assume that second liens in the country aren’t worth 86% of their value (for a 14% loss). You see in Frank’s letter “no economic value.” Huh. Well, that’s a problem.

Let’s look at these values again, assuming that the expected total loss would be 40%, and then 60%.

So the original loss from second-liens, as reported by the stress tests, was $68.4 billion for the four largest banks. If you look at those numbers again, and assume a loss of 40% to 60%, numbers that are not absurd by any means, you suddenly are talking a loss of between $190 billion and $285 billion. Which means if the stress tests were done with terrible 2nd lien performance in mind, there would have been an extra $150 billion dollar hole in the balance sheet of the four largest banks. Major action would have been taken against the four largest banks if this was the case.

See what I mean by fake?  The point is this whole charade is transparent to anyone who actually runs the numbers. Yet, you have people like John Cassidy spreading disinformation in the New Yorker, writing puff pieces of zero negative value with drivel like this:

Other critics dismissed the tests as a sham, arguing that the economic assumptions underpinning them were too benign. As the tests unfolded, however, it became evident that the government’s loss projections were quite high, and that many banks would be forced to raise considerable sums of money—in some cases, more than ten billion dollars.

Baloney. Run the numbers like Mike did, John; and then you wouldn’t make such asinine comments. Of course the stress tests were a sham.  They were a confidence trick to raise more capital and buy time for the banks to earn yet more still. The point was to allow the banks to ease into their losses. And that’s exactly what’s been happening for the past year.

The problem with the stress tests, however, is they gave the banks a way to get from under the yoke of the government’s TARP program. The banks said, “look, we are now well-capitalized even in the worst case scenario of the stress test. We want out of TARP.”

This is bad for three reasons.

• The big banks all paid back $25 billion in TARP funds. Smaller banks like Northern Trust paid back $10 billion or less. That’s hundreds of billions of capital that they all could have as a buffer against losses. Some of them raised additional capital to replenish the coffers. Nevertheless, net-net, we had less banking capital in the system after the repayments than before.
• Banks free of TARP paid out a lot of cash in bonuses that could have gone to shoring up their capital base.  Every dollar paid in cash compensation to staff is a dollar less of capital.  Had these banks been under TARP, they would have been forced to pay lower bonuses – if only for this year.
• The lower capital – and the fact that banks know that having renewed capital problems would mean the end of the line for them – means that banks are less likely to lend freely.  They understand that now is the time to husband capital. Heads would roll if a big bank or super regional which had repaid TARP had another capital shortfall.

The real question is: why is the Obama Administration running victory laps, unrolling the ‘Mission Accomplished’ banner on the credit crisis, as Mike Konczal describes it? I suspect this is just a political stunt to provide cover in the mid-term elections to somehow demonstrate that the Democrats fixed the problem which the Republicans created. 

I think it could backfire if only because the underemployment rate is still 17%. Nobody wants to hear the “I saved the economy routine” when they’re unemployed and losing their home.

If you want to see how quickly credit is contracting take a look at this:

The chart above merely highlights what you already know. Banks no longer trust the average American.  While they based all their bailouts on the idea that taxpayer money was needed to keep banks lending this has been a lie.  In fact, banks need the money to plug the hole that their toxic assets are burning on their balance sheets.  You can also look at the amount of credit card offers you are getting in the mail to gauge how quickly the market has changed.  No longer do banks want to give credit out (that is, unless it is government backed like mortgages which they are all the more willing to lend out).

The U.S. has over 8,000 banks with the large concentration of assets in 10 banks.  These banks continue to use bailout funds to plug the problems from the boom years.  But this is not in the best interest of average Americans.  If Wall Street and politicians were honest, the bailouts would have been labeled as a massive charity to the elite of the country who made disastrous bets over the past decade.  The public takes the lumps while Wall Street actually gets richer.  While banks don’t want to reel in their spendthrift ways, Americans are pulling back:

Americans are now having to save more and more of their money as is expected in a tough economy.  Yet banks are back to gambling in the stock market while shutting down lending to consumers.  Banks are playing the poor me card by arguing that with too much tight regulation, they can’t make loans because they are worried about future balance sheet problems.  Thanks for telling us after you took the public money under false pretenses!  But this is all a political ploy to steal from the working class.  With so many people just unable to even service the debt and rising bankruptcies, banks are now going after good customers who pay their bills on time each month just because they are running out of “options.”  Don’t be fooled.  They are reaping billion dollar profits because they are using excuses to squeeze the golden goose dry.  How about we allow the typical American to borrow at the subsidized low rate from the Federal Reserve directly?  Why in the world do we need banks to operate as loan sharks in between?  What we need is to transform the banking industry into a utility model.  A model designed to serve the people, not the banks.  After all, why should they get the privilege of borrowing at criminally low rates while everyone else has to pay the interest and subsidize their gambling adventure?

Even after all the correction in the market American households still carry an inordinate amount of debt:

A giant portion of income simply goes to pay off debt.  A large part of the debt is interest or money the banks can suck out of the neck of middle class Americans.  Banks live off this margin.  Take for example a $100,000 30 year fixed rate mortgage at 6 percent:

Principal:             $100,000

Total Interest:   $115,838

In the end, you are paying more than the initial cost and all that interest goes to who?  What purpose does it serve?  Banks are delusional and want the public to believe in the propaganda that they need to charge a higher rate because of “risk” in the loan.  Are they kidding?  We already know that they are being supported by the entire Federal Reserve and U.S. Treasury.  They can make the most insane kind of bets and ultimately the taxpayer will eat the bill.  And keep in mind many of these banks are borrowing at low levels from the Federal Reserve.  Why not allow the public to keep some of that interest?  How is this bad?  If banks were lending their own money it would be a different story but they are not.  They are creating a dishonest narrative and most Americans are not buying it because they operate in reality and not some parallel universe where you can create something out of nothing.

Just think of the billions charged in overdraft fees.  This is criminal.  Why not just default debit cards to stop once the account is dry?  Instead they want people that charge a $2 burger a $39 over draft “convenience fee” for this nonsense.  Are you kidding?  Most people don’t want this.  They find out the hard way and now billions have left the wallet of consumers for this nice little loan shark fee.  $39 can buy you lunch for a few days so this is nothing to laugh at when 38,000,000 Americans find themselves on food assistance.  The bulk of the billions are paid by the poor.  Good job banks for helping your fellow Americans.  Yet banks are leeches sucking the productive life blood out of the economy with gimmicks like this.  Time to break the banks up and turn them into utilities.

Take for example JP Morgan.  They announced a Q4 profit of $3.28 billion.  Where did they make their money?

“(Huff Po) JPMorgan’s biggest trouble spots were in consumer banking and credit card lending. The bank’s retail financial services division, which includes its mortgage operations, lost $399 million. That was worse than the final quarter in 2008, when credit markets had essentially shut down because of the collapse of banks including Lehman Brothers.

The company reported increases in mortgages that were charged off, or classified as uncollectible, including prime mortgages, the highest quality home loans. It also reported an increase in home equity loan charge-offs.”

Wait.  So mortgages are being charged off as foreclosures remain high.  And this has spread to so-called prime mortgages as the unemployment and underemployment rate remains at 17.9 percent.  So let us write off mortgages to average Americans.  Where in the world did they get those billions?  Maybe they made good money in their credit card unit:

“The credit-card lending division lost $306 million during the final three months of 2009. Results would’ve been worse had the bank not had a payment holiday in the period.”

More losses here?  So we’ve ruled out credit cards and mortgages which have become the life blood for Americans.  We’re running out of places to look for where they can make a $3 billion profit:

“Despite the ongoing problems with consumer banking, JPMorgan is still performing well because of its robust investment banking unit. As long as stock and bond markets continue to improve, the bank will be able to churn out profits and reward its employees handsomely.

JPMorgan’s investment bank earned $1.9 billion during the fourth quarter, while its asset management division generated $424 million in net income.

Fees from financing debt and stock offerings continued to surge in the fourth quarter. Debt financing fees jumped 58 percent to $732 million from the same quarter a year earlier, while stock financing fees climbed 66 percent to $549 million.”

And there you have it.  We are financing Wall Street’s wonderful gambling casino once again while the traditional banking model has collapsed.  How this isn’t the number one priority for the government and the people to fix is simply astounding.  How we have had no serious financial reform after 26 months of the Great Recession boggles the mind.

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But the underlying facts of how the new rules will play present a very different picture; and also an interesting dilemna for the real estate agent who is supposed to be the ‘listing agent’ for the seller in the transaction…

The articles states:

Under the new federal program, a lender will use real estate agents to determine the value of a home and thus the minimum to accept. This figure will not be shared with the owner, but if an offer comes in that is equal to or higher than this amount, the lender must take it.

Now, in truth it does not say the listing agent will be the agent who determines the price; in which case what we are saying is simply what is already true: the lender will hire an agent to do a BPO and then they will use that BPO to determine the price of the property… This is a fine plan, assuming of course that the BPO Agent is knowledgable and takes the time to do a fair assessment of the property; and more importantly, is not an REO agent looking for new inventory which he or she can easily obtain by pricing the property so high that no matching offers come in… And assuming that a BPO is a better market determiner than actual bonafide offers to buy the property coming from real buyers willing to purchase the property.

We might mention this also ignores the other new glitch in these sales: the new buyers’ lender has to agree to loan against that property in an amount that will satisfy the short selling lender and not violate the new lenders guidelines as to what the property is worth!

And what is the problem with that? The problem is reflected in an earlier paragraph in the article:

The lenders’ thinking, said the economist Thomas Lawler, went like this: “I lend someone $200,000 to buy a house. Then he says, ‘Look, I have someone willing to pay $150,000 for it; otherwise I think I’m going to default.’ Do I really believe the borrower can’t pay it back? And is $150,000 a reasonable offer for the property?”

Short sales are “tailor-made for fraud,” said Mr. Lawler, a former executive at the mortgage finance company Fannie Mae.

While the lender may be thinking they want the borrower to pay off the loan at whatever its face value may be; the reality is that the lender is the one who wrote the loan and took the risk that the property was WORTH the face value of the loan. And they did this in an escalating pricing bubble that was created by their easy money, stated income, no doc, interest only, neg am, alt a, option arm, 125% LTV lending environment.

In fact, it is perfectly arguable that the lenders in these cases knew full well that the values of these properties would not sustain and had no reason to care. They were making their profits upfront and simply bundling and selling off the paper generated from these over-inflated loans on the front end as well. Never mind that it is now becoming clear that these very same lenders were and are engaging in behind the scenes betting against their own instruments for a profit.

So to make the giant leap of stating without any consequence, and outside of any reality considerations that the lender wants the value of their loan [unless the borrower is UNABLE to pay] is to ignore the rampant fraud committed by the lenders in the creation of these loans in the first place.

Oh, but I forgot, we are pretending that that fraud never really happened and that the banks all just ‘thought real estate prices would never come down” which; if you are a banking expert is a perfectly ‘legitimate’ excuse for how to run your lending department! Because, after all you are supposed to be the financial professional; and the homeowner is supposed to be the less wise consumer.

If it were true that lenders didn’t have any idea about real values, or how to create them or inflate them, there would be no laws on the books preventing lenders from precisely this type of front loading fraud whereby they can entrap borrowers in ‘teaser rate front end loans’ which they know are unsustainable and then arrange to collect from borrowers right through foreclosure sales and on to forever on those same now-undervalued foreclosed properties through deficiency judgments, wage garnishments and collections.

There would be no Non Recourse loans if there had never been just this type of fraud uncovered in previous lending cycles in communities across the country.

To make the blanket assumption and statement that the lenders want their money is patently absurd given the circumstance of how they created the loans.

Unless we are also willing to simply state for the record that the entire real estate bubble and lending frenzy was merely an unethical ruse to enslave the people of this country and dozens more in unsupportable debt which the lenders then would use to strip the savings, assets and wealth of the ‘borrowers’ for their own benefit.

Newport Beach California was the perfect fore-runner of this same bubble effect for all to see - but apparently the banks and the goverment have all only been involved in real estate since the turn of the new century. They didn’t know!

And now they want to help the homeowners to the tune of $1500 for having had the stupidity to get involved with these lenders and get that loan - and this is the help they can expect now that their savings are gone, their credit is ruined and the down payment they put up was the first part of the price drop to count in the deal.

For all the loans out there where there was no down payment, it is one story - but for the thousands and thousands where there was, there is another - and in either case, the lenders win and the homeowner/borrowers lose. and the lnders’ defense in all of this is that they, the financial experts involved in the transactions “did not ever expect real property values to come down”?  Right. Because ‘financial expert’ does not include the knowledge of market cycles? Give me a break.

We first should look at the history of housing from a historical perspective because many old paradigms of housing have fallen.  Let us first look at nationwide data from 1910 and 1920:

Source:  Census Archives

I decided to dig up some old Census data to show how dramatically housing has shifted over the years.  Many in the housing industry assume that real estate has always been the way it currently is but forgetting about history can lead many into challenging situations.  In 1910 and 1920 the majority of Americans rented their home.  Of the 20 million dwellings in 1920 only 4 million were mortgaged.  Today, the majority of American households own a home.  The homeownership rate has fallen since the crisis started.  California is not immune to this trend:

The nationwide homeownership rate stands at 67.3 percent down from the peak of 69.4 percent back in 2004.  In less than a century the housing market completely transformed.  We went from a country dominated by renters to one dominated by homeowners:

So how did we go from a large number of renters to a majority of homeowners?  Much of the jump came because of government financing in the housing market:

Source:  Hoover Institution

In the middle of the Great Depression the National Housing Act of 1934 was passed to bring on more affordable mortgages and also created the Federal Housing Administration (FHA) and the Federal Savings and Loans Corporation.  The central reason for this was to stem the issues deep in the foreclosure crisis of that time.  The FHA and the FSLIC created the network to allow steadier access to mortgages in the market.  Some factors that came about from this was the push for suburban sprawl and also less focus on improving inner city housing.

There have always been promoters of real estate.  Even in the depths of the recession people were championing real estate in California:

I found this piece from a 1933 California newspaper.  The cries of available supply, lower taxes, and benefits to the real estate industry were already loud and clear back in the 1930s.  You would think that the Great Depression would at least dampen the spirits of housing promoters but that didn’t seem to stop many.  If a Great Depression didn’t stop the promotion maybe a World War?  Not even that could stop the hype:

The above comes from a 1942 newspaper spot.  One thing is certain when it comes to California real estate.  There is always a boom going on, it just depends who you ask.  Timing is such an important factor in purchasing real estate.  Many who bought in California from 2004 to 2007 took the brunt of this current housing bust.  But the usage of highly toxic mortgages has created a long lasting legacy of problems that we are still working through.  The problems are still embedded in the market and many mortgages sit in a financial state of suspension.  This will continue at least throughout 2010.

Let us look at California housing prices going back to 1940:

Source:  Census

Home prices have gone up steadily since the 1940s.  Some decades saw much higher price growth.  The biggest jump came between 1970 and 1980 when home prices went from $23,100 to $84,500 increasing by a factor of 3.65.  This decade has seen the slowest growth since the 1940s.  In 2000 the median California home price came in at $211,500 and today the median home price is $247,000 (an increase of 16 percent while the state’s inflation rate is closer to 30 percent over this timeframe).  So California real estate has now witnessed a lost decade adjusting for inflation.  The likelihood of seeing  a nominal lost decade in prices cannot be ruled out.  Some areas in California like the Inland Empire are already seeing this happen.

Yet what has really happened in California was the transformation of housing into a speculative commodity.  This can be seen by how much income is eaten up by home prices:

It is tempting to look at the above chart and say that home prices are overall cheaper than they were in the 1980s if we factor in the median home price and household incomes.  However home prices are still too expensive and if we look carefully above household incomes never really caught up after the massive inflation of the 1970s.  Access to debt covered up much of this lost purchasing power.  The current median home price in the state is also deceptive because of the massive amount of foreclosure re-sales in the last two years.  Most of these have come from lower priced markets while mid to higher priced areas remain in bubbles.  The above chart highlights the overall sales in lower priced markets and still comes out showing a very expensive market in California.

Much of the rise in home prices this past decade came because of maximum leverage mortgages that didn’t even take into account incomes that were falling further and further behind.  Many of these mortgages didn’t even look at income.  The above chart pulls points at each decade so we miss the 2007 peak in home prices.  If we include that point the chart would look like this:

When you look at the peak price data, it shows how historical this bubble was.  In places like Los Angeles and the Bay Area many homes that are still selling for peak prices were built back during the last home building craze in the prime counties.  Take a look at this 1942 ad:

Much of this massive construction took place decades ago in some of California’s biggest and oldest cities:

Massive population centers are nothing new for the state.  And a growing population will increase housing demand but not how most think:

Source:  Legislative Analyst Office

California is still lacking in affordable housing.  The days of cheap fuel will make it harder for other Inland Empires to sprout up from the ashes.  People forget that California has an enormous amount of land that is similar to Arizona and Nevada.  The Central Valley has plenty of room.  Why don’t they build this out?  For one, access to employment but also the cost of energy to keep these new cities up simply does not make economic sense.  It is unlikely that we will see $1 gas again so fuel is going to impact the suburban sprawl dream that started back in the 1930s.  New housing has to be smarter and more compact near city hubs.  Look at places like Tokyo for example.  We always hear the real estate building crowd that we need more friendly permits but then they go out and build sprawl just like they did back nearly 100 years ago.  Is this really good for our longer term prosperity?  Also, it might have reached its natural end.  People can’t afford to commute from these outer regions.

There is no arguing that the population will grow in California over the next decades.  Yet to assume that this will mean another real estate boom is incorrect.  Look at China for example.  They are now contending with mini bubbles in real estate and they have massive population centers throughout the country.  The big issue in the coming decade is going to be smart and affordable housing.  Ironically many of the current government programs are making housing unaffordable by propping up failed banks.  It also keeps the current structure in place since so much money is involved.  Yet that doesn’t mean it is smart policy going forward.

So what will we see in the next decade?  It is very likely that the homeownership rate will dwindle lower in California.  As more and more people are classified as “part-time” workers with no employment security, a large part of our population will need the mobility of renting or simply won’t have the income to purchase a home.  When people purchase a home, it requires a level of security in their employment.  If a large part of the population doesn’t have that, many will opt to rent, some by choice but many others because of economic reasons.  City hubs will probably see bigger growth as people move closer to employment opportunities.  This isn’t the 1920s when 1 out of 4 people were farmers.  It will definitely be an interesting decade when it comes to California housing.

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a

Yes, I said CRASH, and I meant it.

Why?

"Events" like this:

SINGAPORE/CAIRO, March 1 (Reuters) - Copper is likely to
climb when trading starts on Monday, lifted by uncertainty over
supply after the world's top copper producer Chile was pounded
by a massive earthquake, analysts said over the weekend.

The front-month contract opened up more than 8%.

This, despite the fact that the earthquake was hundreds of miles away from the mines in Chile and there was zero damage to them.  Some were offline for a few hours due to power failures, but none suffered any physical or structural damage, nor did their export points and the transportation network between the two.

So why did price spike more than 8% even though all this was known by the market before it re-opened for trading?

No part of the markets are trading on fundamental values, nor on forward business expectations.  They are instead trading as "hot money" repositories where speculators rotate in and out of various instruments literally on a minute-by-minute basis.

This is how crashes happen.

When there is no fundamental value underlying a market there is no floor on price.  Price then becomes one thing and one thing only - the number at which you can find another sucker to take your position from you.

This is how tulip bulbs went nuts in Holland, it is how houses went nuts in California in 2005, it is how tech stocks went nuts in 1999 and it is how oil went nuts in 2008.

But now literally everything has gone this way.

Take European national debt.  We now know that Italy, for example, was cooking their books as early as 1995.  This means that bond buyers overpaid for their bonds and took less coupon than they should have.  This should have resulted in an immediate destruction in the value of those bonds when discovered, but it did not. 

Why? 

Because there was still a bigger fool.

Tech stocks were the same thing in 1999.  These "companies" claimed the global GDP some 100 times over between the IPO-issuers in 1998 and 1999.  This, of course, is impossible.  Yet people kept buying even though mathematically 99% of them had to lose all their money.  Ultimately, they did exactly that.

Oil went to $150 in 2008 even though demand was cratering.  It then collapsed to under $40.  It is now double that, even though we have a record supply on hand, to the point that tankers are sitting around full of crude with nowhere to unload it to, and nobody to buy at the price paid.  Yet the price continues to go higher.

These conditions, historically, always produce crashes.  Each and every time.  Go ahead and look back through history with a dispassionate eye.  Find me a market that displayed a complete disconnect with fundamentals such as this and did not crash. 

You can't.

The issue for investors, of course, is that it is almost impossible to determine who will finally stand up and blow a whistle that others listen to.  These manias go on longer than anyone would think possible.  Always.  I was stunned in 1999 as the Nasdaq doubled.  Likewise in 2009 I was stunned as prices went straight up on companies that based on any dispassionate analysis are worth zero - for example, every large bank with undisclosed off-balance-sheet exposures (that would be most of them.)

The overnight move in Copper is yet another confirmation point.  Big banks leasing oil tankers to fill up and moor somewhere "waiting for price to go up" was the first indication that this mentality had taken hold last year.  Stocks were the next, of course, and now we have it in copper.

That the "animal idiocy" came just months after the 2008 crash tells me that we've learned exactly nothing.  That the idiots in places like CNBS, including most especially people like Kudlow and LIESman, who have seen enough dances to both know and be able to identify this pattern, refuse to discuss what's going on borders on criminal journalistic misconduct.

If we had indications in the real economy - that is, other than government borrow-and-spend - that we were turning the corner, I'd be a bit more sanguine.  Unfortunately no such indication has appeared, despite literally six months of claims from the media that it's "just around the corner." 

No it's not folks.  What's around the corner is another collapse, worse than the 2008 one, because the bad debt has been stinking up the joint even more as it decays into a putrid mess.

A dead fish doesn't get more palatable the longer you leave it out on the kitchen counter.  We've learned nothing collectively or in the government regulatory apparatus from the last three years - indeed, government has become drunk on the premise that it can borrow and spend over $1.5 trillion annually to present a false veneer of prosperity and economic improvement. 

But borrowing money doesn't make your economy more prosperous.  It indeed makes it less so, because you not only have to pay that money back some day, but for the duration of the time you have it outstanding you must also pay interest.

When I see a nation rocked by a massive earthquake and one of its major exports spikes upward by 8% in price when it is known to the market that disruption to that nation's production of that commodity from the event was zero, that's the bell being rung to tell you to be damn careful if you think "happy days are here again" - right here, right now.

IRA popped up this morning with an article that makes some of the points I've been harping on for a year or so now….

Even as bank securities holdings are rising in aggregate, loan portfolios and assets overall are shrinking at an accelerating pace - evidence, we believe, that deflation remains the chief threat to the global economy. As we said two weeks ago, when the Fed embraces a zero rate policy, what they are telling investors is that bonds and other rate-sensitive financial assets have no value. We've been talking about the shrinking bank balance sheet for more than 18 months and thankfully this key statistic is starting to get broad attention.

Right.

The problem with this premise is that not only does it destroy the asset base (think savings accounts, CDs, etc) that banks require to have a healthy lending environment, it also drives funds in two corrosive and destructive directions:

1. It encourages carry trades which are inherently destructive because the capital lent leaves the nation where it was borrowed.  That is, it is put to work somewhere else, instead of in the borrowed currency.

2. It forces people out the risk curve and while at the same time it destroys bank capital bases it exposes the capital that wants a low-risk (or "risk free") home into risk assets where it can be destroyed.

When you look at credit quality of these "assets" (especially MBS) you see a truly frightening picture.  The Fed's intentional overpayment has masked an enormous valuation:coupon disconnect; the internal credit quality in these things continue to go to hell, yet the coupon has been stable rather than rising to reflect this deterioration.  That shouldn't happen in a rational market, but there is nothing rational about The Fed's interference.

Now consider the lowly retail investor who is in a money market fund with his "must not lose" money.  He is earning zero, and many of these funds are at present absorbing fees.  This is causing them to run at a net loss, as any attempt to post a negative interest rate to investors will result in an instantaneous run on the fund.  Yet ZIRP makes it effectively impossible for these funds to return a positive yield.

Remember, without these funds there is no lending base and thus no credit growth.  The perverse impact of ZIRP is that it destroys bank capital bases, as over time people will simply not sit for a zero yield - effectively or otherwise.

As I have noted for the last three years (and which IRA also notes in their paper) the only solution to a debt-overhang economic dislocation is to force the excessive and unpayable debt to default.  These defaults bankrupt the institutions and borrowers that were imprudent, but in doing so they also clear the market.  This also forces yields to rise to reasonable levels, restoring a yield curve that reflects duration and inflation risk, yet allows the capital base of the sound banks to be rebuilt, as they are able to attract deposits, especially time deposits, with reasonable yields on these instruments.

In other words, it attracts capital to the financial institutions - not debased currency or credit.

Only loaned (and thus borrowed) capital promotes economic growth.

The Fed's puerile thought process is that "all yield is the same", "all borrowing cost is the same", and "all credit source is the same."  This is a chimera.  The Fed is incapable of producing capital, even by printing.  It can produce credit and it can debase existing money, diluting all existing currency, but it cannot create capital.

Capital is created only by real production in the economy.  No other action creates it.  Yet the loan of capital is what gives rise to the granting of credit without debasement of all existing currency.

The Fed is powerless to do this, but it can destroy the conditions necessary for capital to be lent.

ZIRP does exactly that by ruining the incentives necessary for those with actual capital to be induced to lend that capital.

The Fed should have learned this from Japan, but refused to look at the evidence under their nose.  Instead, Bernanke has continued down a ruinous ivory-tower path born out of his own fertile imagination in relationship to how markets and incentives actually work, conflating the concepts of "money", "credit" and "capital."

Addressing this problem and correcting it requires admission that both Paulson and Bernanke, along with Summers and Geithner, were wrong.

In the world of Washington DC where "I screwed the pooch" are four words you will never hear a politician utter, such a sea change will require that either President Obama grow a pair of balls or that he be shackled by a massive shift in power in Washington DC - and those who come in to do so actually understand the difference.

Odds on that event were unavailable at presstime.

But perhaps more important, the idea that CDS have legitimate uses is questionable. They are used to hedge credit risk (sometimes) yet their pricing, per Bloomberg or any of the common commercial models, price CDS based on volatility, which is not based on any assessment of the underlying credit. So the idea that the pricing reflects default risk is spurious; indeed, CDS failed abysmally in predicting financial firm default risk during the crisis (Lehman was a particularly vivid illustration). But they serve to perpetuate the erosion of proper credit analysis (why bother if you can just lay off the risk?).

In the last two days, Gretchen Morgenson of the New York Times and Wolfgang Munchau of the Finacial Times have both launched salvos at CDS. Munchau’s is even more vituperative than Morgenson’s, which given the sober sensibilities of the Financial Times, suggests that opinion on the other side of the pond may be coalescing against the product.

Morgenson points out that even Ben Bernanke has started to question the legitimacy of CDS, but peculiarly is not as hard on his remark as she should have been:

“Using these instruments in a way that intentionally destabilizes a company or a country is — is counterproductive, and I’m sure the S.E.C. will be looking into that.”

Yves here. Huh? How, pray tell, is the SEC, of all regulators, going to look into CDS? CDS are specifically exempt from SEC regulation. If anyone has (or could decide it has) jurisdiction, it’s the Office of the Comptroller of the Currency, and the Fed. So saying that swaps are a problem, and saying that someone who cannot possibly look into them will handle them, is just a fancy form of regulatory three card monte.

And if anyone had any doubts that the CDS market is officially backstopped, look no further than the Bear Stearns and AIG rescues. To put not too find a point on it, the industry understands full well who is the ultimate bagholder:

United States commercial banks, those with insured deposits, held $13 trillion in notional value of credit derivatives at the end of the third quarter last year, according to the Office of the Comptroller of the Currency. The biggest players in this world are JPMorgan Chase, Citibank, Bank of America and Goldman Sachs.

All of those firms fall squarely into the category of institutions that are too politically connected to fail. Because of the implicit taxpayer backing that accompanies such lofty status, derivatives become exceedingly dangerous, said Robert Arvanitis, chief executive of Risk Finance Advisors, a corporate advisory firm specializing in insurance.

“If companies were not implicitly backed by the taxpayers, then managements would get very reluctant to go out after that next billion of notional on swaps,” he said. “They’d look over their shoulder and say, ‘This is getting dangerous.’”

Morgenson is positively tame compared to Munchau. I’m quoting him more liberally, because the tone of his remarks are remarkably pointed for him and the FT generally. Notice that he explicitly, and repeatedly, says the use of naked credit default swaps looks an awful lot like a crime:

I cannot understand why we are still allowing the trade in credit default swaps without ownership of the underlying securities. Especially in the eurozone, currently subject to a series of speculative attacks, a generalised ban on so-called naked CDSs should be a no-brainer…. Unfortunately, it is legal…

A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point. Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies.

Economically, CDSs are insurance for the simple reason that they insure the buyer against the default of an underlying security. A universally accepted aspect of insurance regulation is that you can only insure what you actually own. Insurance is not meant as a gamble, but an instrument to allow the buyer to reduce incalculable risks. Not even the most libertarian extremist would accept that you could take out insurance on your neighbour’s house or the life of your boss.

Technically, CDS are not classified as insurance but as swaps, because they involve an exchange of cash flows. The CDS lobby makes much of those technical characteristics in its defence of the status quo. But this is misleading. Even a traditional insurance contract can be viewed as a swap, as it involves an exchange of cash flows. But nobody in their right mind would use the swap-like characteristics of an insurance contract as an excuse not to regulate the insurance industry. The fact that, unlike insurance, CDSs are tradeable contracts does not change the fundamental economic rationale…

Yves here. The “tradeable” aspect is exaggerated. While standardization of contracts has helped, most CDS are not traded; dealers lay off their risks by entering into offsetting swaps. Back to Munchau:

Another argument I have heard from a lobbyist is that naked CDSs allow investors to hedge more effectively. This is like saying that a bank robbery brings benefits to the robber. A further stated objection to a ban is that it would be difficult to police. There is no question that a ban of a complex product, such as a CDS, involves technical complexities that commentators like myself probably underestimate. It is conceivable, for example, that the industry might quickly find a legal way round such a ban. Then again, we would not consider legalising bank robberies on the grounds that it is difficult to catch the robber.

So why are we so cautious? From conversations with regulators and law-makers, I suspect they are not always familiar with those products, to put it kindly, and that they may be afraid of regulating something they do not understand. They understand, or think they do, what a hedge fund is. Restricting hedge funds is something they can sell to their electorates. Hedge funds were not at the centre of the crisis, but they are a politically expedient target. Banning products with ugly acronyms that nobody understands seems like unnecessarily hard work…

Yves here. Hedge funds and Wall Street prop desks replicating certain structured arb strategies that relied on CDS were far more important in the crisis than is widely understood. You’ll be hearing more about that in due course. Back to Munchau:

But naked CDSs have played an important and direct role in destabilising the financial system. They still do. And banks, whose shareholders and employees have benefited from public rescue programmes, are now using CDSs to speculate against governments.

Where is the political response? The Germans want to bring it to the Group of 20, but they hesitate to do anything unilaterally. Christine Lagarde, the French finance minister, was recently quoted as saying: “What we are going to take away from this crisis is certainly a second look at the validity, solidity of sovereign [credit default swaps].”

A second look? I wonder what they saw when they looked the first time.

Yves here. The other defenses of CDS I’ve heard are equally dubious. One is they add to liquidity. Ahem, were corporate bond investors ever suffering from a lack of liquidity? That paper doesn’t trade much because most investors are buy and hold. Even when I was a kid, in the early 1980s, when there was as much appetite for corporate bond trading as are likely ever to see due to high uncertainty over interest rates. Yet no one complained about illiquidity in the corporate bond market (as in yes, it may not have been that liquid, but no one felt inconvenienced, dealer spreads were not seen as problematic). And as CDS drain liquidity in crises. As bond yields rise, intermediaries and hedge funds, both of whom are leveraged and normally serve as liquidity providers, have to tie up of their scarce cash and collateral in posting margins on CDS positions. So they suck liquidity out of markets are precisely the worst possible moment.

The more we can to to contain this product the better, but I am afraid it will take another meltdown to teach us the lesson we should have learned from the last one.

But perhaps more important, the idea that CDS have legitimate uses is questionable. They are used to hedge credit risk (sometimes) yet their pricing, per Bloomberg or any of the common commercial models, price CDS based on volatility, which is not based on any assessment of the underlying credit. So the idea that the pricing reflects default risk is spurious; indeed, CDS failed abysmally in predicting financial firm default risk during the crisis (Lehman was a particularly vivid illustration). But they serve to perpetuate the erosion of proper credit analysis (why bother if you can just lay off the risk?).

In the last two days, Gretchen Morgenson of the New York Times and Wolfgang Munchau of the Finacial Times have both launched salvos at CDS. Munchau’s is even more vituperative than Morgenson’s, which given the sober sensibilities of the Financial Times, suggests that opinion on the other side of the pond may be coalescing against the product.

Morgenson points out that even Ben Bernanke has started to question the legitimacy of CDS, but peculiarly is not as hard on his remark as she should have been:

“Using these instruments in a way that intentionally destabilizes a company or a country is — is counterproductive, and I’m sure the S.E.C. will be looking into that.”

Yves here. Huh? How, pray tell, is the SEC, of all regulators, going to look into CDS? CDS are specifically exempt from SEC regulation. If anyone has (or could decide it has) jurisdiction, it’s the Office of the Comptroller of the Currency, and the Fed. So saying that swaps are a problem, and saying that someone who cannot possibly look into them will handle them, is just a fancy form of regulatory three card monte.

And if anyone had any doubts that the CDS market is officially backstopped, look no further than the Bear Stearns and AIG rescues. To put not too find a point on it, the industry understands full well who is the ultimate bagholder:

United States commercial banks, those with insured deposits, held $13 trillion in notional value of credit derivatives at the end of the third quarter last year, according to the Office of the Comptroller of the Currency. The biggest players in this world are JPMorgan Chase, Citibank, Bank of America and Goldman Sachs.

All of those firms fall squarely into the category of institutions that are too politically connected to fail. Because of the implicit taxpayer backing that accompanies such lofty status, derivatives become exceedingly dangerous, said Robert Arvanitis, chief executive of Risk Finance Advisors, a corporate advisory firm specializing in insurance.

“If companies were not implicitly backed by the taxpayers, then managements would get very reluctant to go out after that next billion of notional on swaps,” he said. “They’d look over their shoulder and say, ‘This is getting dangerous.’”

Morgenson is positively tame compared to Munchau. I’m quoting him more liberally, because the tone of his remarks are remarkably pointed for him and the FT generally. Notice that he explicitly, and repeatedly, says the use of naked credit default swaps looks an awful lot like a crime:

I cannot understand why we are still allowing the trade in credit default swaps without ownership of the underlying securities. Especially in the eurozone, currently subject to a series of speculative attacks, a generalised ban on so-called naked CDSs should be a no-brainer…. Unfortunately, it is legal…

A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point. Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies.

Economically, CDSs are insurance for the simple reason that they insure the buyer against the default of an underlying security. A universally accepted aspect of insurance regulation is that you can only insure what you actually own. Insurance is not meant as a gamble, but an instrument to allow the buyer to reduce incalculable risks. Not even the most libertarian extremist would accept that you could take out insurance on your neighbour’s house or the life of your boss.

Technically, CDS are not classified as insurance but as swaps, because they involve an exchange of cash flows. The CDS lobby makes much of those technical characteristics in its defence of the status quo. But this is misleading. Even a traditional insurance contract can be viewed as a swap, as it involves an exchange of cash flows. But nobody in their right mind would use the swap-like characteristics of an insurance contract as an excuse not to regulate the insurance industry. The fact that, unlike insurance, CDSs are tradeable contracts does not change the fundamental economic rationale…

Yves here. The “tradeable” aspect is exaggerated. While standardization of contracts has helped, most CDS are not traded; dealers lay off their risks by entering into offsetting swaps. Back to Munchau:

Another argument I have heard from a lobbyist is that naked CDSs allow investors to hedge more effectively. This is like saying that a bank robbery brings benefits to the robber. A further stated objection to a ban is that it would be difficult to police. There is no question that a ban of a complex product, such as a CDS, involves technical complexities that commentators like myself probably underestimate. It is conceivable, for example, that the industry might quickly find a legal way round such a ban. Then again, we would not consider legalising bank robberies on the grounds that it is difficult to catch the robber.

So why are we so cautious? From conversations with regulators and law-makers, I suspect they are not always familiar with those products, to put it kindly, and that they may be afraid of regulating something they do not understand. They understand, or think they do, what a hedge fund is. Restricting hedge funds is something they can sell to their electorates. Hedge funds were not at the centre of the crisis, but they are a politically expedient target. Banning products with ugly acronyms that nobody understands seems like unnecessarily hard work…

Yves here. Hedge funds and Wall Street prop desks replicating certain structured arb strategies that relied on CDS were far more important in the crisis than is widely understood. You’ll be hearing more about that in due course. Back to Munchau:

But naked CDSs have played an important and direct role in destabilising the financial system. They still do. And banks, whose shareholders and employees have benefited from public rescue programmes, are now using CDSs to speculate against governments.

Where is the political response? The Germans want to bring it to the Group of 20, but they hesitate to do anything unilaterally. Christine Lagarde, the French finance minister, was recently quoted as saying: “What we are going to take away from this crisis is certainly a second look at the validity, solidity of sovereign [credit default swaps].”

A second look? I wonder what they saw when they looked the first time.

Yves here. The other defenses of CDS I’ve heard are equally dubious. One is they add to liquidity. Ahem, were corporate bond investors ever suffering from a lack of liquidity? That paper doesn’t trade much because most investors are buy and hold. Even when I was a kid, in the early 1980s, when there was as much appetite for corporate bond trading as are likely ever to see due to high uncertainty over interest rates. Yet no one complained about illiquidity in the corporate bond market (as in yes, it may not have been that liquid, but no one felt inconvenienced, dealer spreads were not seen as problematic). And as CDS drain liquidity in crises. As bond yields rise, intermediaries and hedge funds, both of whom are leveraged and normally serve as liquidity providers, have to tie up of their scarce cash and collateral in posting margins on CDS positions. So they suck liquidity out of markets are precisely the worst possible moment.

The more we can to to contain this product the better, but I am afraid it will take another meltdown to teach us the lesson we should have learned from the last one.