Wednesday, July 22, 2009

Time for a Real Cure; Chris Mayer Looks Beyond Subprime's Role in the Mortgage Market Debacle

Celebrating A Decade of Reckoning
US Edition Home Contributors Media & Testimonials archives DR's 10th Anniversary DR's 10th Anniversary
Wednesday, July 22, 2009

  • A depression takes a major structural change...
  • The feds still believe in stimulus; Wall Street still takes it...
  • More reports from the Agora Financial Investment Symposium...
  • Chris Mayer looks beyond subprime's role in the market...and more!

  • --------------------- Special Offer ---------------------------

    We're Putting $50,000 on the Line in Our NEW Stock of the Month Portfolio

    We're so confident in this strategy that we're putting our money where our mouth is... $50,000 worth of it in fact! That's how much we've put into a brokerage account to fund the real-money portfolio for the new StreetAuthority's Stock of the Month newsletter.

    Editor Amy Calistri is about to make another purchase, so it's not too late for you to join in and follow along with everything she does. Don't be left on the sidelines, go here to learn more.


    Time for a Real Cure
    by Bill Bonner
    Vancouver, British Columbia

    They're wrong. We're right.

    Now The Wall Street Journal says, "recovery likely in second half."

    And Goldman Sachs calls for a stock market rally similar to the rally in 1982.

    Who are we to say they are wrong?

    Well...we're The Daily Reckoning, that's who. And we'll say it: they're wrong.

    This 'recession' is already the second longest since the first leg down of the Great Depression. That downturn of the early '30s went on for 43 months. This one is now at 19 months - officially - which makes it longer than any other since the Great Depression.

    Is it over? Is it going away? Is that all there is?

    Nope. Nope. Nope.

    Instead, we are merely proceeding as we should, into a "deepening structural depression," as John Williams puts it.

    Yes, he uses the 'D' word too. Because a 'D' is what we have. Not an 'R'.

    It's a depression because it requires major structural change. A recession only requires time. And not even much time...just a few months to work down inventories. But a depression takes a lot of restructure industries and rebuild balance sheets. Debt needs to be paid down - or inflated away. And businesses need to redirect their efforts towards a more profitable line of activity.

    Both the increase in unemployment and the slump in industrial production are worst than at any time since 1945. As for retail sales and housing starts, they're the worst in the post-war record books.

    The figures tell us that something important is going on. But what's the key to understanding what it is? And how will it be cured?

    This key is to understand that this is a major structural depression. It can't be cured by more stimulus, because stimulus is what caused it.

    This time, we need a real cure...bankruptcies, workouts, deflation, defaults...and maybe, eventually, hyperinflation.

    None of those things happen easily or quickly. Businesses don't want to go bust. Families don't want to lose their houses. So if they get a lifeline from the feds, they grab it and hold on. And the longer they hold on, the longer it takes to make the structural changes that the economy needs.

    The length of time spent in unemployment is now longest since 1948. And consumer debt, at only 12% in 1982, is now at 18% of GDP. "With that kind of debt, there is no question that the feds will implement a tight money policy," said Marc Faber in his speech here in Vancouver yesterday. Instead, look for easier...and policies, he says.

    [If you couldn't make it to Vancouver, you can still hear Dr. Faber - and all the rest of the main session presentations - from the comfort of your own home. Get the Agora Financial Investment Symposium recordings here.]

    We learned that the feds have put up an amount equal to more than 150% to GDP to bailing out Wall Street: $23 trillion. No wonder Goldman is reporting record bonuses!

    "We have to spend money to keep from going broke," says Joe Biden, a man who is out of his depth in the bathtub.

    But when you've got that kind of money covering your much restructuring are you going to do? Not much.

    "Wall Street Learned Nothing," is a headline at Forbes, making the obvious point.

    The feds still believe in stimulus. And Wall Street still smiles and takes it. That's why the recovery is still a long way off. Now, the feds are in charge of the money...and in charge of key industries, including automobiles, banking, insurance...and soon, healthcare. They'll block innovation. They'll prop up ailing institutions. They'll provide more and more stimulus.

    A growing group of analysts and strategists now calls for another big stimulus package. You see, the current stimulus program hasn't worked. Why not? Well, because it was not enough...or not properly focused, say economists. In either case, the solution is not hard to figure out. Even Nouriel Roubini says, "More stimulus is needed."

    So more stimulus is what we will have...and a collapsing economy...and a falling dollar...and more!

    [Rob Parenteau, over at The Richebacher Letter knows of a few things you can do to protect his latest report here.]

    More news from the Agora Financial Investment Symposium in Vancouver:

    "The Agora Financial Investment Symposium is in full swing," writes Kate Incontrera, reporting from the Fairmont Hotel in Vancouver. "We kicked off the conference yesterday with an opening speech from our own Addison Wiggin. He mentioned that as he was packing for Vancouver, he tried on his suit, and something happened that's never happened to him before: his pants didn't fit. His jacket didn't fact, none of his clothes fit.

    "'Rationally,' Addison said, 'I know what happened - if you don't exercise and you don't eat well, you get fat.

    "'What's happening in society in the wake of the crisis is similar,' he continued. 'People took risks and now they are paying the price. If you invest badly, you will go bust. But government is trying to stop this from occurring. We know how this is happening, but we are apathetic and we aren't doing anything about it...just like my belly.

    "'We all know the consequences, but we don't engage in the enterprise to try to stop it.'

    "In addition to the Gloom Boom Doom Report's Marc Faber (whose speech Bill mentioned, above), we also had a presentation from Juan Enriquez, which was so engaging, and his facts and data so astounding, I sat with my mouth agape for most of the presentation.

    "'The key to managing crises,' said Juan, 'is to keep an eye on the long term while you are dancing in the flames.

    "'Think of the crisis as a tsunami. But behind it is a bigger wave, which is technology. That is how money has been made over time.

    "'How we produce stuff and where we produce is fundamentally going to change like it did in the Industrial and Digital Revolution,' continued Juan. 'Farmers will be making medicines and programming life.'

    "Juan spoke a lot about 'life sciences', which includes stem cell and human genome research. He believes that this new field will change every industry in the world, just as the Digital Revolution did.

    "Also presenting yesterday was Capital & Crisis' Chris Mayer (who you will find in today's guest essay spot), perennial favorite Rick Rule, and The Rude Awakening's Eric Fry.

    "Eric pointed out that there has been much discussion lately surrounding 'normal'. When will the markets return to 'normal'?

    "'But is normal a good thing?' he wondered from the podium. 'There is no comfort in a normal divorce, normal root canal, etc. Normal is not static and is not always good. Familiar doesn't equal safety.

    "'Think of the familiar names, WaMu, AIG, Fannie Mae (just to name a few) that created big car wrecks.

    "'American assets to us, are the most familiar, and thus, most comforting thing. Comforting is OK as long as someone is watching your back. But when the people that are supposed to be watching your back are the ones that are causing the problems, you are in trouble.

    "'There will be a new "normal",' concluded Eric, 'and the U.S. will most likely lose their grip as the superpower of the global economy.'

    "Today, we have presentations from our currency counselor Chuck Butler, Breakthrough Technology Report's Patrick Cox, and frequent DR contributor James Kunstler. Tonight, we have the 'Whiskey Bar' panelists from all backgrounds, debating everything from the future of energy to the nature of the free market system. We will have a full report for you tomorrow."

    [As much as I would like to go on and on about each presentation, we only have so much room to work with. But you don't have to miss out - recordings of each main session presentation are available...and if you purchase the CDs or MP3s (or both) before the conference ends on Friday, you will receive them at a steep discount. The insights and advice each presentation brings is invaluable - get your Agora Financial Investment Symposium recordings here.]
    And back to Bill, with more thoughts:

    Opposite us on the flight to Vancouver was a nervous man with a short beard and a swarthy look. He appeared to be from the Middle East. He fidgeted. He seemed to sweat. He took off his shoes and crossed his legs like a yoga instructor. It was a remarkable feat for such a fat man. He prayed.

    Was he afraid of flying? Was he planning to blow up the plane?

    After the plane took off, he got out what looked like a cellphone...or a detonator. We figured we should remind him that the War on Terror is over, just in case. But now we were getting nervous. So we leaned over and asked.

    "Are you a Christian?"

    "Allahu akbar!" he replied.

    We took his response as a negative.

    "Are you planning to blow up the plane?" we continued. If he were, we knew we wouldn't be able to stop him; we just wanted to know before everyone else.

    "Allahu akbar!" came the reply again.

    "Just let me know if you need any help with any electronic devices," we offered.

    Then we realized that he didn't speak English, so we left him alone.

    If he was going to blow up the plane, he'd have to do it on his own.

    We only watch television in hotel rooms...and then only to be appalled. As for radio, we only listen to it in taxicabs and restaurants - against our will. On our way to the airport, for example, the cab was tuned into a talk show. The subject: a man who was upset because he was not dead.

    The story, which we think was set in England, was of a man who had been given only six months to live by his doctor. The man had cancer; the doctor said he was a goner.

    So, he drew out his retirement funds and decided to enjoy the last of his days. He fixed up the house. He took a vacation. He did whatever sensible people do when they realize they are checking out.

    But then, wouldn't you know it, he didn't die. And now he's really cheesed off. He charges that his doctor gave him bum advice. He wasn't really dying of cancer at all. Instead, he says he had some other ailment that went away on its own. And now, he's as healthy as a cow pie weed - but he has no money left. So he's suing the doctor and the National Health Service.

    Poor fellow.

    But do you think the callers were sympathetic? Not at all. Universally, they denounced him as an ingrate. He should accept the judgment of the deities and be thankful, said one and all.

    "He's lucky to be alive," said one radio activist from Leeds. "But it kinda makes you want to kill him, doesn't it?"

    "Yeah," said another from Manchester. "Think about all the people who really are dying of cancer. Every one of them would gladly trade his retirement funds for a cure."

    All true, of course.

    But the man has a point too. Imagine that on the day you were scheduled to be hanged, the hangman had a heart attack? How disappointed you would be.

    Until tomorrow,

    Bill Bonner
    The Daily Reckoning

    --------------------- Special Offer ---------------------------

    Get all the Benefits of This Year's Agora Financial Investment Symposium...

    ..without traveling to Vancouver. You can get all the recordings of the main session speeches...and all the investment idea picks - without leaving the comfort of your living room.

    Get your virtual seat at this year's conference...but act fast! After the conference is over, the prices of these recordings will jump by at least $100. Take advantage of this low price, and get the Symposium CDs here.


    The Daily Reckoning PRESENTS: During the housing mania, it seems that the majority of the United States suffered from a mass delusion. They believed that their house would always go up in price...but their mortgages payment wouldn't follow suit. As Chris Mayer points out, below, the mortgage bubble infected a number of areas beyond subprime. Read on...

    Beyond Subprime
    by Chris Mayer
    Gaithersburg, Maryland

    We have mountains of debt to work through yet. The last bubble was one for the ages. We've all heard stories of one kind or another...

    There was the glass cutter who earned $5,000 per month, pretax. WaMu gave him a $615,000 home loan with payments of $3,600 per month.

    There was a house - a shack, really - that appraised for $132,000 and got a mortgage of $103,000. The owner hadn't worked in 13 years. Upon foreclosure, a neighbor bought the house and paid $18,000 just to tear the thing down.

    And the most eye-popping of all: A house in Fort Myers that sold for $399,600 on Dec. 29, 2005 - only to sell for $589,900 on Dec. 30, 2005.

    America, it seems, just went crazy - borrowers, lenders, nearly everybody. These anecdotes and others are told in a new book titled More Mortgage Meltdown by money managers Whitney Tilson and Glenn Tongue.

    But what caused the mania and how we got there is less to the point than what happens from here.

    "If the problems in the mortgage market were limited to subprime loans, then the carnage would be mostly behind us," the authors note. Subprime loans were the riskiest mortgage loans. Prime loans were where the borrower made a substantial down payment and had good credit history. Subprime loans, by contrast, were to borrowers of poor credit quality and spotty job histories.

    The bigger problem is that the mortgage bubble infected a number of areas beyond just subprime. The subprime crisis was the first to drop, like a marathon dancer that falls to the floor exhausted. But there are still other dancers on the floor ready to topple over too.

    Take a look at this next chart, which has gained some currency in the worried circles of financial people. It's worth a bit of study. It shows you the other dancers on the floor.


    The first thing to jump out at you is that subprime is only about a $1.5 trillion market - not anywhere near the biggest of the risky loans. There are other layers here.

    Subprime is only one slice of low-grade bologna. It sits at the bottom. Alt-A is the next riskiest slice of mortgages above subprime. Alt-A are mortgages to people who are better credit risks than subprime, but still not prime. Documentation is still spotty as far as verifying income, and loan to values are high. Plus, about a quarter of these mortgages went to nonowner-occupied homes - which were subject to even greater speculation.
    "The bigger problem is that the mortgage bubble infected a number of areas beyond just subprime. The subprime crisis was the first to drop, like a marathon dancer that falls to the floor exhausted. But there are still other dancers on the floor ready to topple over too."

    The scary thing is that this mortgage market is 50-100% bigger than subprime. Unlike subprime, Alt-A loans typically have five-year resets - meaning, the interest rates adjust to higher rates. The Alt-A reset surge doesn't really get started until 2010! It continues through 2012.

    You'll also see something called "option ARMs" on that chart. These loans usually have ultra-low teaser rates and often were interest only. Again, the reset surge for these loans only starts in 2010.

    You'll also see something called "jumbo prime." These are big loans - on average about $750,000. These were common in the most inflated bubble states, such as California and Florida, and were often made to poor credit risks. This is a market of $1-1.5 trillion - about as big as subprime.

    Then there are home equity lines, which you'll see just below jumbo prime. As Tilson and Tongue write, home equity lines funded "in 2007, 30% of new car purchases in California and 20% in Florida." These loans are second loans, behind all the garbage I mentioned above. That means that many home equity loans will be a total loss for the lenders, as housing prices have collapsed and can't support the junk loans in first position, much less junior liens like home equity lines. (See nearby chart for a look at the housing price index collapse.)

    I won't go into all of these loan categories, but I think you get the picture.

    Moreover, the pattern for all of these loans was the same. You see rapid growth in the bubble years, roughly from 2000-2007.

    In fact, the riskiest loans grew the most. You also see skyrocketing delinquency rates beginning in 2007 and continuing today - and massive losses for banks. Subprime was only the first wave.


    Through March of 2009, banks had taken only $1.1 trillion in write- downs to date. Even the most conservative estimates put total credit losses at $2.2 trillion. Tilson and Tongue make a convincing case that the losses will be far worse than that - more like $3.8 trillion. And these numbers seem only to grow over time. I remember sitting at a Grant's conference over a year ago when John Paulson, the fund manager who saw all this coming and profited mightily, tossed out $1 trillion as the number for total losses. That number induced gasps at the time.

    So I think Tilson and Tongue will be closer to the mark. It may well be even more than that when it is all said and done. The fallout from all of this is that the banks will have to raise a lot more capital. They've raised only $1 trillion so far - yes, only. Given the high leverage in the banking sector, they may yet need to raise at least another $1 trillion. I don't see how that is possible in today's market. Where is the money going to come from?

    Take a look at the nearby chart to see how leverage has increased over time. As banks' assets got riskier - with subprime, Alt-A and all the rest - they actually borrowed more to hold these assets. The typical bank has only 4 cents of tangible equity for every dollar of assets. That means a 4% drop in asset value wipes out the equity - making the bank insolvent. As you can see, the banking system is vastly undercapitalized.


    And this, then, answers the great fundamental question that seems to baffle so many market commentators. Why aren't the banks lending? People point to the trillions of dollars the government pumped into the economy, including on bank balance sheets.

    The answer is that the bankers know they will need the money to cover losses from their toxic loan portfolios. The banks are clearly not lending. Banks are cutting lines of credit to consumers - and to businesses, too. New loans in various business categories are down 60- 80% from where they were a year ago.

    It is hard to imagine any economic recovery when the banking system has such gaping funding holes it needs to fill. As it is, banks are failing and the losses are severe - on average, the losses amount to more than 40% of assets. The data coming in on foreclosure recoveries are bleak. In California, recovery is often less than 35 cents on the dollar. It's not supposed to happen like this. It's like the hogs broke free and skinned the butchers. If this crisis is anything like previous cycles, we've got a long way to go on bank failures.


    How do we invest in this environment? We'll take a more detailed look later in this letter. But an early conclusion would be to still avoid banks and leveraged financial institutions in general. And don't expect the banks to start lending so freely again anytime soon. That means you should also avoid businesses that depend on regular access to credit to grow - such as real estate investment trusts. I would also say that the housing market is not due for any recovery anytime soon. There is still enormous inventory to work through. So homebuilding stocks and related investments also face stiff head winds.


    Chris Mayer
    for The Daily Reckoning

    P.S. At the right price, I might buy almost anything. But investing is hard enough without also taking on problems as big as the ones I've outlined here. There are plenty of other great places to fish...see my latest special report to learn where you should be heading.

    Editor's Note: Chris presented yesterday at the Agora Financial Investment Symposium - and even if you weren't able to join us this year, you can still be privy to all the investment advice that Alan (and all the rest of this year's presenters) have to offer. That's because we are recording all of the main session presentations, and you can get them delivered straight to your front door at an amazing value.

    But this offer is only good while the conference is going on. So you have until Friday, July 24, to get these CDs at this low price...after that, the price will jump by at least $100. Get them now.

    Chris Mayer studied finance at the University of Maryland, graduating magna cum laude. He went on to earn his MBA while embarking on a decade-long career in corporate banking. Chris is the editor of Capital and Crisis and Mayer's Special Situations, a monthly report that unearths unique and unconventional opportunities in smaller-cap stocks. In 2008, Chris authored Invest Like a Dealmaker: Secrets From a Former Banking Insider.

    --------------------- Special Offer ---------------------------

    The "Forever Oil Crash" Has Already Begun

    The era of "cheap oil" is long gone...but there are two investments that could give you a powerful shield against the fallout ahead - and have the potential to soar, despite the current market turmoil.

    Keep reading...
    The Daily Reckoning - Special Reports:

    Gold: The Truth About Gold

    Fiat Currency: Using the Past to See into the Future

    Introducing the Single Best Way to Make Sure You'll Never Run Out of Money...

    AGORA Financial Resources: The Daily Reckoning Is:

    Economics & Politics
    Crisis & Opportunity
    Gold, Oil & Energy
    Growth, Tech & Medical
    Options Investing

    Founder: Bill Bonner
    Editorial Director:
    Addison Wiggin
    Publisher: Rocky Vega
    Managing Editor: Kate Incontrera
    Web Editor: Greg Kadajski
    About The Daily Reckoning: Now in its 10th anniversary year, The Daily Reckoning is the flagship e-letter of Baltimore-based financial research firm and publishing group Agora Financial, a subsidiary of Agora Inc. The Daily Reckoning provides over half a million subscribers with literary economic perspective, global market analysis, and contrarian investment ideas. Published daily in six countries and three languages, each issue delivers a feature-length article by a senior member of our team and a guest essay from one of many leading thinkers and nationally acclaimed columnists.

    For additional articles and commentary follow The Daily Reckoning on Twitter and Facebook.

    Agora Financial

    To end your Daily Reckoning e-mail subscription and associated external offers sent from Daily Reckoning, cancel your free subscription .

    If you are you having trouble receiving your Daily Reckoning subscription, you can ensure its arrival in your mailbox by whitelisting the Daily Reckoning.

    © 2009 Agora Financial, LLC. All Rights Reserved. Protected by copyright laws of the United States and international treaties. This newsletter may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the World Wide Web), in whole or in part, is strictly prohibited without the express written permission of Agora Financial, LLC. 808 Saint Paul Street, Baltimore MD 21202. Nothing in this e-mail should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investment advice.We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication or 72 hours after the mailing of a printed-only publication prior to following an initial recommendation. Any investments recommended in this letter should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

    No comments:

    Post a Comment

    Note: Only a member of this blog may post a comment.