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Financial Skeptic Bulletin, July 2007

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It's interesting that many people expected a better 2008.


In 1930, the world was "... as capable as before of affording for every one a high standard of life....

But today we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand."


[Jul 31, 2007] Question of the month: Is stagflation coming ?

Does S&P500 became toxic due to the concentration of financial firms which might be affected by credit crunch and bad loads ?

he head of Nestle see food inflation as a long-term issue, the part of "structural changes" . 

"Core inflation" might be in check, but food and energy is now were the main inflation related action is played. 

[Jul 30, 2007] The possible wave of 401K redemptions of S&P500 and related funds might hurt the quarter.

Most bond funds that specialize on high quality corporate bonds now have yield over 5%. Junk bond funds have yield over 7.25%. Which means 2.25%-3% premium for additional risk.

In view of recent development is this premium too small ? 

[Jul 29, 2007] The Mess That Greenspan Made

It looks like the question is not whether the USA will pay for easy money policy but when. Excess debt and investment build up in the boom years might gradually suffocate the economy. For example housing slump that is particularly caused by reckless/predatory lending is smoothly transitioning into credit crunch and high yield debt (below BB) might be decimated.  If you run an expansionary monetary policy (print money like there is no tomorrow)  and get no inflation, what else do you get? There is no free lunch and asset prices inflation and deterioration of credit are probably two avenues via which such might policy backfire.

Paul Volcker took the reigns as Chairman of the Federal Reserve in 1979. Then came Greenspan to wreck the day.

Under Greenspan’s rule of the Federal Reserve, America became intimately familiar with money supply growth on a double digit scale. The U.S. Federal Government loves this and actually encourages this. When the Federal Reserve creates enough money to match a large portion of the Federal Government’s deficit, we call that monetizing the debt. This is extremely inflationary (even though the dubious government statistics do a pretty good job at hiding it).

The media and the majority of Wall Street elite loved Greenspan and hailed him as a creator of wealth. What Greenspan was actually doing was going against his guns – selling out. A small number of the nation’s elite actually benefit from run-away money creation while the rest of the country suffers from the slow onset malaise. As Ron Paul wrote in his column, Texas Straight Talk:

“In an article entitled “Gold and Economic Freedom,” Federal Reserve Chairman Alan Greenspan wrote that “The excess credit which the Fed pumped into the economy spilled over into the stock market- triggering a fantastic speculative boom…The speculative imbalances had become overwhelming and unmanageable by the Fed… In the absence of the gold standard, there is no way to protect savings from confiscation through inflation.” The irony is that Mr. Greenspan’s words, written in 1966 to describe the era leading up to the Great Depression, could easily have been written in 2003 to describe the consequences of his own Fed policies during the 1990s.”

For someone who could change from his 1966 view that central planning is contrary to free market capitalism, why should we believe him now? He’s just a flip-flopper of the worst kind.

What modern economists believe is that the economy is a rational machine that can be controlled by pulling levers and adjusting dials. What they are actually doing by attempting to control the demand for money is taking the “free” out of “free market.”

[Jul 23, 2007] The Mess That Greenspan Made

Printing fiat money by foreign governments to counter for printing money by the USA might be a new race to the bottom as it defeats inflation targeting. 
Paul Kasriel at Northern Trust explains:
Because Chinese government policy is to manage the Chinese exchange rate, especially with respect to the U.S. dollar, and because the U.S. dollar “wants” to fall in the global foreign exchange market, the PBOC (People's Bank of China) is forced to buy dollars in order to keep the Chinese yuan from rising faster relative to the dollar.

The PBOC pays for the dollars it purchases -- those dollars or the dollar-denominated investment instruments purchased with these newly-acquired dollars – showing up as foreign assets on its balance sheet – with Chinese yuan.

And where does the PBOC get these yuan? The same place all modern central banks get their currencies – they create them with a stroke of a key. (One difference between central bankers and counterfeiters is that counterfeiters actually have to put a little work into creating currency – engraving and physical printing.)
Sounds like a swell system, sure to stand the test of time, but this is what passes for contemporary monetary policy and mainstream economic thought in a global economy that increasing appears to be coming unhinged.

[Jul 22, 2007]  Reviews for Bull! A History of the Boom, 1982-1999 What drove the Breakneck Market -- and What Every Investor Needs to Know About Financial Cycles Books Maggie Mahar

a guided tour of bubbleland, March 26, 2005

By Jeff Lipkes (Tampa) - See all my reviews
_Bull!_ is a riveting and instructive saga about the hazards of rose-colored glasses to anyone's financial health. Unlike the shenanigans detailed in _Liar's Poker_, _Predator's Ball_, and _When Genius Failed_, we all went for the ride Mahar describes. This is a wryly written and well-researched post-mortem. It's almost worth buying for the chapter on CNBC alone. Lots of nice quotes from shrewd market-watchers ("information is not knowledge" and the corollary "always, the promoters who spread the tips sell to those who consume them"; "anxiety motivates people to take risk"-counterintuitively; "the argument that expensing stock options might hurt the share prices was akin to complaining that investors would pay less for shares if they knew that profits were inflated. Of course they would!"; "The unique advantage of gold is that it is no one else's liability"). Some cogent analyses of what was driving the speculation (401(k)s, declining cd and money market yields, etc.) and of the beneficiaries. Among the latter, Mahar is particularly good on the mutual fund industry and the quandaries of conscientious fund managers at the end of the decade. There are plenty of deft portraits of a host of dubious characters-corrupt analysts, criminal CEOs-and of the bubbly companies that fabricated their earnings, or didn't even bother. Naturally the heroes are the lonely bearish analysts and newsletter writers.

But Mahar wants to be more than a historian; the book's subtitle is "What 21st Century Investors Need to Know About Financial Cycles." Apparently, they don't need to know much about their relation to business cycles or to geopolitical events. There is no reference in the discussion of the bear market of the 1970s to the huge boost in the capital gains tax in 1969 or to surging oil prices. The market seems to cycle in a vacuum. You almost have the impression that personal computers are the tulips of the late 20th century. That people were willing to pay $400 for a share of Amazon and throw billions at dotcons that had no prayer of making a profit doesn't detract from the fact that there was a technological revolution in the 80s and 90s that has totally changed the way we live our lives and run our businesses. There's a reason why Intel and Msft have the market caps they do; the bull market of the 80s and 90s was more than just a frenzy of irrational exuberance.

As a bear, Mahar naturally goes after the philosophy of buy and hold, but her numbers belie her biases. She cites a study looking at 10 year periods between 1926 and 1998 and notes, triumphantly, that there was a 4% chance that you'd make nothing by holding for 10 years. But every investment is a bet and 19:1 are pretty good odds. And b and h means more than 10 years. After 40 years, your chance of earning greater than 10% annualized return is "just" four in five, says Mahar dismissively. An investor could be excused for thinking that was not bad. There were positive annual real returns in all the bear markets she graphs at the beginning of her chapter on cycles, save for 2000-2004.

Her bearishness colors her story. Magellan's Jeff Vinik is supposed to be a seer for dumping tech stocks in fall of 1995; Gail Dudek is a heroine for repeatedly calling a market top starting in 1997. But it's not particularly prescient-or profitable-to be four years early. From 1/1/96 to 12/31/04 the Nasdaq had an 11.86% annualized return, w/o compounding. If there are paper gains, there are also paper loses. Had you bought shares of the Prudent Bear fund run by David Tice, another hero, you'd have been down about 3.4% p/a over the same period.

Still, Mahar's distinction between secular and cyclical markets is valid, and there may be another leg down to the bear market that began early in 2000. Maybe the S&P500's P/E never got low enough and the despair never got high enough. The twin trade and budget deficits are worrisome as is the extent to which the recovery in 2003-4 was driven by consumer debt. A lot of readers will find the author's bear case pretty compelling. But whatever your take on the next quarter or next decade, there's a lot to savor and learn from in _Bull!_.

[Jul 21, 2007] Trapped in a Government Spending Spree

We should not believe those despicable cowards who refuse to buy stocks and predict recession each year including supposedly forthcoming slump in 2007 as everything is fine: inflation yes, recession no ;-). Government will save us from recession.

...since annual Gross Domestic Product of the USA is about $12 trillion, total government spending is fully half of GDP! Half! Half of the entire yearly output of goods and services of the whole freaking country equals total government spending! The government IS the economy!!!!

... ... ...

... news item about the Labor Department reporting,

 "Prices paid to factories, farmers and other producers rose 0.7 percent after a 1.0 percent gain in March."

 Today's report showed food prices rose 0.4 percent in April, after the previous month's 1.4 percent increase."

 "Costs of intermediate goods, those used in earlier stages of production, rose 0.9 percent last month, after rising 1 percent the prior month."

Inflation is everywhere! I can't even afford to write my stupid Congresspersons ("Dear Morons, You let the Federal Reserve destroy our money by creating so much of it!") as first-class postage is going from 39 cents to 41 cents, which is an increase of 5.1%. In case you were wondering, other classes of mail will have newly altered rates, too, and the average rate is going up 7.6%.

***** [Jul 20, 2007] The Flirting Mistress of Prosperity By Bill Bonner

07/17/07 One man's Crack-Up Boom is to another man "The Greatest Economic Boom Ever." That is what Fortune magazine calls it on the current cover.

And now everyone is coming to see that we are in the midst of a huge, worldwide credit boom. And most recognize it's prominent features:

Our old friend Steve Chapman writes in the Chicago Tribune that the U.S. economy is in great shape. The stock market is near record levels; unemployment is down to 4.5%; inflation is running below 3%. "Recessions used to come along every four to five years, but since 1991 we've only had one mild downturn, back in 2001." Americans have grown so accustomed to prosperity that we take it for granted," says Steve.

Ah, that's the trouble with prosperity. It is like a mistress; as soon as you take her for granted, she begins to pout and flirt with strangers.

And that is the fundamental difference between a Crack-Up Boom…and The Greatest Economic Boom Ever. Here at The Daily Reckoning we don't think you can take mistresses or prosperity for granted. Instead, they need to be handled carefully, given proper respect, shown appropriate appreciation…and, occasionally, allowed a tantrum.

That the U.S. economy has had only one minor recession since 1991 we take as cause for alarm…like a teenager who is unusually polite; we figure he's up to something. But most economists, and sensible people too, regard the lack of a major correction as a good sign; they believe it signals that the economy is so healthy it needs no correction.

The economy is not really healthy at all - especially not in America.

The latest report from the New York Times tells us that the rich are doing better than ever. It's a new "Gilded Age," says the gray lady. Wealth is once again being concentrated at the top - just as it was before the Great Depression. Then, it was the great men of industry - the Vanderbilts, the Rockefellers, Carnegies and Fords - who controlled vast wealth. Now, it is the great men of finance - the Schwarzmans, the Petersons, the Kravises, and the Kolhbergs - who get the dough. According to the TIMES, only 15,000 American families now collect 5% of total national income - equivalent to $9.5 million per year each.

Hey, good for them. But while the Carnegies and Fords boosted real incomes for the whole population, the Schwarzmans and Kravises seem to keep it to themselves. The average American is increasingly trapped between the Scylla of stagnant income…and the Charybdis of increased expenses. He has a bigger house, a bigger mortgage, more cars and a more expensive living standard. But he has no more money to pay for it.


From Houston comes word that more and more Americans - already the hardest working race on the planet - are giving up old-fashioned vacations. Either they don't want them…or they can't afford them. And even when they do go off for a while, they take their portable phone and portable computer with them so they can keep up with work while they're away.

And now oil prices are rising again. They're just pennies away from the record high set last August…and Goldman says a barrel of oil may go to $95.

Meanwhile, analysts are now projecting that the housing slump could last for years - that there is a 'second wave' of housing hurt coming our way. This wave could not only affect the equity you have in your house…but all of your investments. The Survival Report's Mish Shedlock shows you three solid hedges against the coming bust here:

The Housing Tsunami

Our friend and colleague, Porter Stansberry reports:

"The number of U.S. home foreclosures rose 87% in June year over year. There were 164,644 loan default notices, scheduled auctions, and bank repressions, led by California, Florida, Ohio, and Michigan. If you assume that each of these homes is worth the median U.S. home price, that's $36 billion in defaults. And if you assume the banks, hedge funds, and bond managers that own these debts will recover 75% of this value, that's an estimated $9 billion in losses…in one month."

"We're trying to sell our old house in Maryland," said an associate in Baltimore, "because we bought a new house and have already moved in. Right now, we're paying two mortgages, so we want to get rid of the old place as soon as possible. So far, we've had a few people look at it. And we've actually had a couple of offers…but they were both contingent on the buyers being able to sell their houses. So we looked on the Internet to find out what the odds of them being able to sell quickly really were…and we found, in both cases, that they were trying to sell houses in areas where there were hundreds of houses just like theirs for sale. It didn't look good for them…and it doesn't look good for us. For us it's not too much of a problem, because we bought our house many years ago. We have a lot of equity and a small mortgage. But I don't know what other people do in this situation…"

We don't know either…but, as always, we'll find out.

[Jul 18, 2007] IMF expects U.S. economy to pick up into 2008

Anemic growth below inflation for the rest of the year (aka stagflation)... It might be a bad time to turn your focus to top-performing stocks :-) The fact that the U.S. economy has had only one minor recession since 1991 might be a cause for some concern…
June 22, 2007 | IMF/

U.S. economic activity should pick up for the rest of this year and into 2008 as the drag from a decline in the housing market dissipates, the International Monetary Fund said Friday.

But the IMF warned that growth is uncomfortably close to the 2 percent "stall speed" associated with past recessions even if other accompanying factors - rising unemployment and high interest rates - are not evident.

[Jul 17, 2007]  (Bloomberg) -- Goldman Sachs Group Inc., JPMorgan Chase & Co. and the rest of Wall Street are stuck with at least $11 billion of loans and bonds they can't readily sell.

Big banks might gamble too big.  JP Morgan in up to a neck in derivatives.

The banks have had to dig into their own pockets to finance parts of at least five leveraged buyouts over the past month because of the worst bear market in high-yield debt in more than two years, data compiled by Bloomberg show.

[Jul 14, 2007] Credit-Card Use Lifts Consumer Borrowing -

Credit cards as the lender of the last resort for consumers

Borrowing by the nation's consumers increased at an annual rate of 6.4% in May as credit-card use climbed sharply, the Federal Reserve ...

[Jul 13, 2007] More employers doing away with pensions, study finds - Los Angeles Times

The new survey found that 25% of employers questioned had closed their pensions to new hires within the last two years, whereas 12.9% had frozen their plans for all employees. The survey found that more than 30% of employers expected to make similar changes in the coming two years. The survey questioned 162 employers, including some of the nation's largest companies, according to the study's statistics.

The acceleration of pension freezes and closures raises anew the question of whether the 77-million-strong baby boom generation is financially ready to retire.

Some recent studies have suggested that baby boomers are not as ill-prepared as previously suggested, and that a combination of pensions, 401(k)s and home equity, together with Social Security, would see them through old age.

But EBRI analysts suggested those studies might need to take a fresh look in light of the new survey's results.

"It appears that any careful analysis of retirement income adequacy … must be modified substantially to factor in the extraordinary plan changes among [pension] sponsors in the last few years," analysts said.

"What you're seeing is the slippage of the middle class," said Certner of AARP. "Their retirement benefits are much smaller than those of the previous generation that had traditional pensions."

[July 11, 2007] Banks seen pulling back lending to loan buyers Reuters By Elena Moya

LONDON, July 11 (Reuters) - Banks are pulling back from lending to hedge funds and others who invest in leveraged loans, raising the spectre of more problems syndicating debt packages behind private equity deals, restructuring specialists said.

Rising corporate debt levels of almost 10 times profits, compared with 6.5 times three years ago, according to Standard & Poor's data, will also make some companies struggle to refinance during times of trouble, they said at a Corporate Restructuring Conference in London on Wednesday.

"We're seeing a withdrawal of liquidity by prime brokers, mainly the big investment banks lending to hedge funds, and by lenders to parties willing to buy leveraged loans," said Robin Doumar, managing partner at Park Square Capital, a London-based fund with 2.25 billion euros ($3.09 billion) under management.

[July 11, 2007] No end in sight for U.S. housing slump by Barrie McKenna

Twenty thousand new condos are under construction in Miami… That's a lot of 'see throu" condos...  Also housing is not 2% of the economy; it is more then 20% of the economy if you factor in landscaping, insurance, heating/air conditioning (and heating in North East is mostly running on oil -- Heating Oil Use in American Households) and other businesses that serve directly to houses owners.

July 11, 2007 | Globe and Mail (Canada)

Grim profit warnings yesterday from three companies whose fortunes are closely tied to housing - Home Depot Inc., Sears Holdings Corp. and D.R. Horton Inc. - suggest the trough may not come until next year.

Home prices are still falling, the glut of unsold homes remains ominously high, mortgage rates are creeping up and the mess in the subprime market is worsening.

And that, economists predict, could keep a lid on the U.S. economy for months. The economy grew at its slowest pace in four years in the first quarter - a miserly 0.7-per-cent annual rate.

Summer Rerun: Has the Credit Contraction Finally Begun?

This post first appeared on July 11, 2007

Readers of this blog know that I have been concerned about the state of the credit markets for some time. We’ve had (until the last month or so), rampant liquidity feeding asset bubbles in virtually every asset class except the dollar and the yen, tight risk spreads (that means inadequate compensation for risk assumption), lax lending standards (that helped create the aforementioned bubbles), and increasing inflation pressures.

Now what inevitably happens when credit gets too cheap is that borrowers go and buy stupid things, like housing they can’t afford or illiquid faith-based paper or overpriced companies, and at some point enough of this speculation, um, investment, turns out badly that lenders get nervous and start turning off the liquidity spigot. And the wilder the party has gotten, the worse the hangover.

Now heretofore, I have merely fulminated about this situation, because at some point, the correction will begin. But it’s very easy for people like me to expect things to get rational way before they do (look how long the 1980s LBO wave, the Japan bubble, and the dot com mania lasted).

So as much as I have felt for a long time that these conditions were not sustainable, and were likely to end badly, I have refrained from making a call. Smarter people than me, like Martin Wolf of the Financial Times, have similarly pointed out that the global equity markets are considerably overvalued and are certain to mean-revert, but he pointedly refused to say the markets were near a peak.

But the few times I’ve made a specific investment call (and it’s been very few times, believe me), I’ve been proven correct. So as a mater of public service (and doubtless ego as well), I’m making one now.

The bear credit market has begun.

Why do I think now is the turning point? There has been considerable nervousness over the last few weeks, due first to the Bear Stearns meltdown and the parallel development of a sharp, pattern shattering rise in Treasury yields that many felt was the sign of a fundamental change in sentiment. And if I am right and the contraction has begun, many will legitimately see the Treasury break as the starting point.

But I see the following as the signs:

Liquidity is falling on a widespread basis. Bond yields are rising in all major bond markets (hat tip to Michael Shedlock for the chart) below):

Investors are increasingly reluctant to shoulder risk. A number of LBO financings have either not gone forward or have had to offer improved terms

The reaction to the downgrades by Moody’s of 399 subprime bonds from 2006 and another 52 from 2005, about $5.2 billion in face value, and the announcement by S&P that it will likely downgrade 612 issues, representing $12 billion in original issue price and about 2.1% of the market, has precipitated a reaction that at first blush is way out of proportion to the event. After all, $5 billion or even $12 billion worth of bonds isn’t much at all, even if there are forced liquidations (any pension funds or insurance companies holding formerly investment grade paper that has been downgraded to junk will in most cases have to sell for regulatory reasons).

Now as we go through the rest of this post, skeptical readers will doubtless think, “But this is mainly about subprimes. This is contained.” Yes and no. Forced sales. losses and general embarrassment (if not loss of capital) will create new found sobriety, which will lead to less liberal credit terms across the board. As we said yesterday, nearly all participants have been playing a game of musical chairs, trying to stay in the game until the last possible minute so as to extract maximum profits, under the cheery assumption that there won’t be a rush for the exits.

Now contrast that fact set with this Bloomberg story, “Subprime Losses Drub Debt Securities as Credit Ratings Decline“:

On Wall Street, where the $800 billion market for mortgage securities backed by subprime loans is coming unhinged, traders are belatedly acknowledging what they see isn’t what they get.


As delinquencies on home loans to people with poor or meager credit surged to a 10-year high this year, no one buying, selling or rating the bonds collateralized by these bad debts bothered to quantify the losses. Now the bubble is bursting and there is no agreement on how much money has vanished: $52 billion, according to an estimate from Zurich-based Credit Suisse Group earlier this week that followed a $90 billion assessment from Frankfurt-based Deutsche Bank AG.

Even the world’s second-largest company by market value must “triangulate” the price of an asset-backed bond when it gets bids from traders, said James Palmieri, an investment manager at General Electric Co.’s Stamford, Connecticut-based GE Asset Management Inc., which oversees $197 billion.

“We do not foresee the poor performance abating,” Standard & Poor’s said yesterday as it threatened to downgrade $12 billion worth of securities backed by subprime mortgages. Losses “remain in excess of historical precedents and our initial assumptions,” S&P said.

Moody’s Investors Service went further, lowering the ratings on $5.2 billion of subprime-related debt.

Why Now?

More than a few investors would like to know what took the New York-based rating companies so long to discover a U.S. liability of Iraq-sized proportions.

“I track this market every single day and performance has been a disaster now for months,” said Steven Eisman, who helps manage $6.5 billion at Frontpoint Partners in New York, during a conference call hosted by S&P yesterday. “I’d like to understand why you made this move now when you could have done this months ago.”

Eisman was referring to the rise in borrowing costs that has forced thousands of Americans to default on their mortgages.

A total of 11 percent of the loan collateral for all subprime mortgage bonds had payments at least 90 days late, were in foreclosure or had the underlying property seized, according to a June 1 report by Friedman, Billings, Ramsey Group Inc., a securities firm in Arlington, Virginia. In May 2005, that amount was 5.4 percent.

Investors depend on guesswork by Wall Street traders for valuing their bonds because there is no centralized trading system or exchange for subprime mortgage securities. Credit rating companies supported high prices because they failed to downgrade the debt as delinquencies accelerated.

Headed Lower

While there’s no consensus on prices, traders agree that the bonds are headed lower. Some of the securities have already declined by more than 50 cents on the dollar in the past few months, according to data compiled by Merrill Lynch & Co.

One subprime mortgage bond, Structured Asset Investment Loan trust 2006-3 M7, is valued at about 91 cents on the dollar to yield 9.5 percent, according to the securities unit of Charlotte, North Carolina-based Wachovia Corp. Merrill Lynch in New York puts the price of the same security at 67 cents to yield 18 percent…..

The downgrades may force sales, giving investors who have relied on estimates real prices to value their own holdings. That would be novel in the market for asset-backed bonds.

The securities, backed by everything from student loans to auto payments to mortgages, almost doubled to about $9 trillion outstanding since 2000, according to the Securities Industry and Financial Markets Association.

Masking Swings

At least a third of hedge funds that invest in asset-backed bonds pick and choose values for their investment that help mask wide swings in performance, according to a survey of 1,000 funds worldwide by Paris-based Riskdata, a risk management firm for money managers.

“If you have five different brokers you will get five different quotes, so if you don’t have an objective valuation process you can choose the quote which for you is the most interesting,” said Olivier Le Marois, chief executive officer of Riskdata. “There’s no consensus on where the market price is.”….

Wall Street has benefited from keeping the so-called structured finance market opaque. Securities firms collected $27.4 billion in revenue from underwriting and trading asset- backed securities last year alone, according to Kian Abouhossein, an analyst at JPMorgan Chase & Co. in London.

Investors struggle when they need to set values for subprime and lower-rated debt because the bonds trade infrequently, said Dan Shiffman, vice president at American Century Investment Management in Mountain View, California.

“If it’s a bond that requires a lot of credit work and if that bond hasn’t traded for some time, it’s very difficult to assess,” Shiffman said. American Century manages $5 billion in mortgage-backed and asset-backed bonds….
Trace system. Levitt is a director of Bloomberg LP, the parent of Bloomberg News…

Traders in subprime and low-rated asset-backed securities may resist any move to shine a light on the trades because they benefit from having their moves kept under wraps, said American Century’s Shiffman. “They might get better execution rather than having the bonds flagged all over the market,” he said.

So what do we have here? We have a fairly large amount of bonds in aggregate, and for many of them, even the most sophisticated players didn’t know what they were worth in a good market. A bid of 91 from one dealer and 67 from another on the same security is a staggering difference. And now we are having forced liquidations, and it’s unlikely there will be enough buyers because more downgrades are in the works. Speculators are likely to wait till the carnage gets worse.

But the real news isn’t these immediate downgrades. It’s the fact that the rating agencies have finally gotten religion and are going to start going through these instruments with a much more jaundiced view. Mind you, they’ve started with subprimes, but they will get around to CDOs, so this is the beginning of a long and painful process. And even if they are cautious and late to the game, this process is going to force more trading, and the price discovery is going to be very painful.

And most important is that Standard & Poors has announced it is changing its methodology (and we imagine Moodys and Fitch will have to follow). Tanta of Calculated Risk was good enough to post the bulk of S&P’s lengthy press release. Let me give you a few of the high points:

Many of the classes issued in late 2005 and much of 2006 now have sufficient seasoning to evidence delinquency, default, and loss trend lines that are indicative of weak future credit performance. The levels of loss continue to exceed historical precedents and our initial expectations.


We are also conducting a review of CDO ratings where the underlying portfolio contains any of the affected securities subject to these rating actions…On a macroeconomic level, we expect that the U.S. housing market, especially the subprime sector, will continue to decline before it improves…

Although property values have decreased slightly, additional declines are expected. David Wyss, Standard & Poor’s chief economist, projects that property values will decline 8% on average between 2006 and 2008, and will bottom out in the first quarter of 2008.

It’s pushing 3 AM, so I will be terse in my comments here. An 8% decline is a much bigger number than most mainstream forecasters have put forth (although some specialists have put forth even grimmer estimates). That in turn has nasty ramifications for the economy, and frankly seems inconsistent with a bottom in 1Q 2008.
Back to S&P:

Data quality is fundamental to our rating analysis. The loan performance associated with the data to date has been anomalous in a way that calls into question the accuracy of some of the initial data provided to us regarding the loan and borrower characteristics. A discriminate analysis was performed to identify the characteristics associated with the group of transactions performing within initial expectations and those performing below initial expectations. The following characteristics associated with each group were analyzed: LTV, CLTV, FICO, debt-to-income (DTI), weighted-average coupon (WAC), margin, payment cap, rate adjustment frequency, periodic rate cap on first adjustment, periodic rate cap subsequent to first adjustment, lifetime max rate, term, and issuer. Our results show no statistically significant differentiation between the two groups of transactions on any of the above characteristics. . .


Translation: they lied to us. Remember, rating agencies don’t do due diligence. Back to the press release:

In addition, we have modified our approach to reviewing the ratings on senior classes in a transaction in which subordinate classes have been downgraded. Historically, our practice has been to maintain a rating on any class that has passed our stress assumptions and has had at least the same level of outstanding credit enhancement as it had at issuance. Going forward, there will be a higher degree of correlation between the rating actions on classes located sequentially in the capital structure. A class will have to demonstrate a higher level of relative protection to maintain its rating when the class immediately subordinate to it is being downgraded. . . .


OK, now they will be quicker to downgrade higher rated tranches if the lower graded tranches that were providing credit support get whacked. That only makes sense, and one has to wonder at how they could have justified their old posture. To S&P:

Given the level of loosened underwriting at the time of loan origination, misrepresentation, and speculative borrower behavior reported for the 2006 vintage, we will be increasing our review of the capabilities of lenders to minimize the potential and incidence of misrepresentation in their loan production. A lender’s fraud-detection capabilities will be a key area of focus for us. The review will consist of a detailed examination of: (a) the overall capabilities and experience of the executive and operational management team; (b) the production channels and broker approval process; (c) underwriting guidelines and the credit process; (d) quality control and internal audits; (e) the use of third-party due diligence firms, if applicable; and (f)secondary marketing. A new addition to this review process will be a fraud-management questionnaire focusing on an originator’s tools, processes, and systems for control with respect to mitigating the potential for misrepresentation.


Oh, so they are going to do due diligence? Tanta doesn’t think so; she envisages a questionnaire. But that’s still progress of a sort.

As MarketWatch noted:

Standard & Poor’s just drove a huge harpoon into the heart of the mortgage credit bubble, and it’s going to take a long time to clean up the mess once the beast finally dies.


S&P, one of the three main credit-rating agencies that served as enablers of the subprime-mortgage boom, announced Tuesday that it would lower its ratings on 612 bonds, a small portion of the mortgage-backed securities it had given its seal of approval to.

But the bigger news is that S&P isn’t going along with the charade anymore. S&P said it would change its methodology for rating hundreds of billions of dollars in residential-mortgage-backed securities. And it would review its ratings on hundreds of billions of dollars in the more complex collateralized debt obligations based on those subprime loans.

A lot of debt will be downgraded to junk status. A lot of that debt will have to be sold at fire-sale prices. A lot of pension funds and hedge funds that once thrived on the high returns they could get from investing in subprime junk will now lose a lot of money.

S&P’s announcement is a death warrant for the subprime industry. No longer will mortgage brokers be able to help buyers lie their way into a home. Fewer stressed homeowners will be able to refinance their mortgage, thus extending and exacerbating the housing bust.

“We do not foresee the poor performance abating,” S&P said.

Prices will fall, and foreclosures will rise. More mortgage fraud will be uncovered as the tide goes out.
And hedge funds will have to find another way to beat the market — if they survive this blow, that is.


Now that may sound terribly melodramatic, but consider this tidbit from (of all places) the UK’s Telegraph:
When creditors led by Merrill Lynch forced a fire-sale of assets, they inadvertently revealed that up to $2 trillion of debt linked to the crumbling US sub-prime and “Alt A” property market was falsely priced on books.


Even A-rated securities fetched just 85pc of face value. B-grades fell off a cliff. The banks halted the sale before “price discovery” set off a wider chain-reaction.

“It was a cover-up,” says Charles Dumas, global strategist at Lombard Street Research. He believes the banks alone have $750bn in exposure. They may have to call in loans.

The reason I take this seriously is that I heard rumors after the Feb 27 global selloff, in which subprime related paper took a bit hit, that if the downtrend had continued much longer, the margin calls to hedge funds would have forced a larger wave of selling that would likely have damaged dealers.

The rest of the Telegraph piece is sobering reading:

Not even the Bank for International Settlements (BIS) has a handle on the “opaque” instruments taking over world finance.


“Who now holds these risks, and can they manage them adequately? The honest answer is that we do not know,” it said.

Markets have been wobbly since the surge in yields on 10-year US Treasuries, the world’s benchmark price of money. Yields have jumped 55 basis points since early May on inflation scares, the steepest rise since 1994. It infects everything; hence that ugly “double top” on Wall Street and Morgan Stanley’s “triple sell signal” on equities.

Wobbles are turning to fear. Just $3bn of the $20bn junk bonds planned for issue last week were actually sold. Lenders are refusing “covenant-lite” deals for leveraged buy-outs, especially those with “toggles” that allow debtors to pay bills with fresh bonds. Carlyle, Arcelor, MISC, and US Food Services are all shelving plans to raise money. This is how a credit crunch starts.

“This is the big one: all investment portfolios will be shredded to ribbons,” said Albert Edwards, from Dresdner Kleinwort.

The BIS had warned days earlier that markets were febrile: “more risk-taking, more leverage, more funding, higher prices, more collateral, and in turn, more risk-taking. The danger with such endogenous market processes is that they can, indeed must, eventually go into reverse if the fundamentals have been over-priced. Such cycles have been seen many times in the past,” it said.

The last few months look like the final blow-off peak of an enormous credit balloon. Global M&A deals reached $2,278bn in the first half, up 50pc on a year. Corporate debt jumped $1,450bn, up 32pc. Private equity buy-outs reached $568.7bn, up 23pc. Collateralised debt obligations (CDOs) rose $251bn in the first quarter, double last year’s record rate.

Leveraged deals are running at 5.4 debt/cash flow ratio, an all-time high. As the BIS warns, this debt will prove a killer when the cycle turns. “The strategy depends on the availability of cheap funding,” it said.

Why has such excess happened? Because global liquidity flooded the bond markets in 2005, 2006, and early 2007, compressing yields to wafer-thin levels. It created an irresistible incentive to use debt.

What is the source of this liquidity? Take your pick. Goldman Sachs says oil exporters armed with $1,250bn in annual revenues have been the silent force, sinking wealth into bonds; China is recycling $1.3 trillion of reserves into global credit, a by-product of its policy to cap the yuan; Japan’s near-zero rates have spawned a “carry trade”, injecting $500bn of Japanese money into Anglo-Saxon bonds, and such; the Swiss franc carry trade has juiced Europe, financing property booms in the ex-Communist bloc. And, all the while, cheap Asian manufactures have doused inflation, masking the monetary bubble.

The deeper reason is the ultra-loose policy of the world’s central banks over a decade. They “fixed” the price of money too low in the 1990s, prevented a liquidation purge to clear the dotcom excesses, then kept rates too low again from 2003 to 2006. Belated tightening has yet to catch up.

Don’t blame capitalism. This is a 100pc-proof government-created monster. Bureaucrats (yes, Alan Greenspan) have distorted market signals, leading to the warped behaviour we see all around us.

As the BIS notes tartly in its warning on the nexus of excess, this blunder has official fingerprints all over it. “Behind each set of concerns lurks the common factor of highly accommodating financial conditions” it said.

Rebuking the Fed, it said Japan and Europe have turned sceptical of the orthodoxy that central banks can safely let asset booms run wild, merely stepping in afterwards to “clean-up”.

The strategy leads to serial bubbles, creates an addiction to easy money, and transfers wealth from savers to debtors, “sowing the seeds for more serious problems further ahead”.

If you think we are too clever now to let a full-blown slump occur, read the BIS report.

“Virtually nobody foresaw the Great Depression of the 1930s, or the crises which affected Japan and south-east Asia in the early and late 1990s. In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a ‘new era’ had arrived,” it said.

The subtext is that you bake slumps into the pie when you let credit booms run wild. You can put off the day of reckoning, as the Fed did in 2003, but not forever, and not without other costs.

So the oldest and most venerable global watchdog is worried enough to evoke the dangers of depression. It will not happen. Fed chief Ben Bernanke made his name studying depressions. He will slash rates to zero if necessary, and then – in his own words – drop cash from helicopters. But his solution is somebody else’s dollar crisis.

On it goes. Perhaps governments should simply stop trying to rig the price of money in the first place.


Topics: Banking industry, Credit markets, Derivatives, Economic fundamentals, Federal Reserve, Investment outlook, Macroeconomic policy, Private equity, Real estate, Risk and risk management, Summer rerun


[Jul 10, 2007] Will big U.S. job gains raise inflation risks - Eye on the Economy -

US does face inflation risks, but not from Mac-jobs creation ;-). 100K $10 per hour jobs is just equal to salary of 167 executives earning each 10 millions a year. And those executives are pretty far from the top "earners". As MarketWatch noted "The managers of the private-equity funds have the best compensation deal you've ever heard of. As a management fee, they take 2% of the assets they control right off the top, plus 20% of the profits made from other people's capital that they put to work. It's known as 2-and-20. And it added up to an estimated $14 billion last year for just the top 25 managers."

The latest data showing strong job growth are good news for anyone looking for a job or angling for a raise. But with the Federal Reserve still keeping an eagle eye on inflation, the news makes it unlikely the rate-setters will lower their guard — or interest rates — anytime soon.

The latest official jobs data from the government confirmed that, after barely breaking even in the first quarter, the U.S. economy is rebounding convincingly; some 132,000 new jobs were added in June, according to the Labor Department. That kept the unemployment rate at a historically low 4.5 percent. Workers also posted gains in their paychecks last month.

Friday’s report also showed that that the economy added more jobs in April and May than the government previously thought. Revised figures Friday showed that payrolls grew by a strong 190,000 in May, up from the 157,000 reported last month. And in April the total job pool expanded by 122,000, better than the 80,000 previously reported.

***** Worldwide

There is a danger that "increasing mortgage delinquencies will drag down the U.S. economy and drive debt-laden companies into default." Investors withdrew $502 million from high-yield mutual funds in the week ended June 20, the most since September 2005

Bonds that allow companies to pay interest in extra securities instead of cash, including toggle notes, accounted for almost 9 percent of high-yield debt sold this year, compared with less than 1 percent three years ago

In 2004, there were just $100 million of such loans. But the total rose to $2.4 billion in 2005, $23.6 billion last year and $103.9 billion in the first half of this year. Exclusive LBO Debt Alarms Fidelity, Lehman, TIAA-CREF Managers (Update2) By Cecile Gutscher and Caroline Salas

Did junk bond generated by LBOs became the most dangerous the class of investments that now hold the risk equal or higher then stocks?

Regulators crack down on subprime-lending abuses - MarketWatch

Damage is contained but a lot of people were hurt and a lot of money lost.  It’s in addition of approximately a $200-billion plus tidal wave of losses from LBO that will crash ashore in the next six months. So we are talking about approximatly half trillion damage right now.  Financial Katrina?  Also why all the increasingly large private equity deals, which results in huge money creation not properly accounted for within monetary aggregate measures?

Americans will lose up to $164 billion in home-based wealth due to foreclosures in the subprime mortgage market, according to a study from the Center for Responsible Lending, a nonprofit research and policy organization.

Due in part to adjustable-rate mortgages, one out of five subprime loans issued during 2005 and 2006 will fail, according to CRL.

The Mess That Greenspan Made When the savings and liquidity gluts end

Buried within an otherwise fascinating tour of the last few decades of financial history, Martin Wolf of the Financial Times raises a particularly insightful question that was surely lost on all but a few of his readers.

In The new capitalism, come these gems:

Two further long-term developments help explain what has happened. The first is the revolution in financial economics, notably the discovery of options pricing by Myron Scholes and Fischer Black in the early 1970s, which provided the technical underpinning of today's vast options markets. The second is the success of central banks in creating a stable monetary background for the world economy and so also for the global financial system. "Fiat" (or government-created) money has now worked well for a quarter of a century, providing the monetary stability on which complex financial systems have always depended.

Yet there is also a shorter-term explanation for the explosive recent growth in finance: today's global savings and liquidity gluts. Low interest rates and the accumulation of liquid assets, not least by central banks around the world, has fueled financial engineering and leverage. How much of the recent growth of the financial system is due to these relatively short-term developments and how much to longer-term structural features will be known only when the easy conditions end, as they will.
Left unstated here is the obvious relationship between "fiat" money and the two "gluts" that are integral parts of today's financial world - the "savings glut" and the "liquidity glut".

You don't normally get too many "gluts" (or the resulting asset bubbles) when the creation of money and credit are subject to some kind of restraint. That is, the kind of restraint that you see when money and credit are not simply created by government "fiat" or Wall Street "fiat" (e.g., securitized debt, etc.) and are then subject to some reasonable bank reserve requirement.

It is more than interesting that Mr. Wolf can be so sure of the fate of the gluts - "when the easy conditions end, as they will" - yet apparently unaware or uninterested in their causes.

The Mess That Greenspan Made The lonely vigil

The Washington Post reports on Mr. Walker's continuing efforts:

Walker is the tour's rock star, profiled on "60 Minutes" and interviewed by faux-pundit Stephen Colbert. A former Arthur Andersen accountant, Walker heads the Government Accountability Office, a legislative agency that aims to improve government performance through audits and investigations.

With six years to go on a 15-year term, Walker has the stature and independence to say what he wants. For the past five years, since Congress ignored his advice and created a hugely expensive prescription-drug program for Medicare beneficiaries, Walker has put the looming fiscal crisis at the top of his agenda.

"People are on the beach having a beach party while you can see a tsunami of spending on the horizon. And you've got people saying, 'party on,' " Walker said in an interview. "We're headed for very, very rough seas, like we've never seen before in this country."
With his Southern-fried accent and flair for apocalyptic turns of phrase, Walker's job on the tour is to breathe life into the dry details of the federal budget. By his reckoning, the heart of the problem is this: The annual budget deficit, which is the difference between revenue and spending, was $248 billion in fiscal 2006, down from a high of $413 billion in 2004. It is expected to decrease further in the fiscal year that ends in October, and both the White House and Congress are projecting a balanced budget by 2012.

But the numbers hide massive cracks in the budget's structure. First, they rely on borrowing from the Social Security trust fund, which today collects more in taxes than it needs to pay benefits. As the baby boomers retire, demands on the trust fund will grow, and the yearly surplus will likely disappear by 2017. Without that surplus, last year's deficit would have been $434 billion. Eventually, the money the government has borrowed from Social Security will be needed to pay retiree benefits, and it will have to come out of general revenues.

Which gets to the larger problem: More than half the federal budget is on autopilot, eaten up by interest payments and entitlement programs that provide benefits to anyone who qualifies. The biggest entitlements are Social Security, Medicare and Medicaid, which together account for about 40 percent of federal spending. Interest on the national debt accounts for another 9 percent and is the fastest-growing budget category at $227 billion, or nearly twice what was spent last year on the war in Iraq.

Congress created the big entitlement programs, and it can change or limit them at any time. But the programs are so popular that in practice, Congress rarely tinkers. Unlike such other government functions as education and transportation, known as discretionary programs, entitlement spending grows more or less automatically. That makes it easy to project spending, and the outlook is sobering.

***** BIS warns credit spree could produce 1930s-style depression - MarketWatch

More people will realize that the government's inflation numbers are bogus. And they not happy about such a finding. " Years of loose monetary policy have fuelled a dangerous credit bubble"

NEW YORK (MarketWatch) - The Bank for International Settlements is warning that years of loose monetary policy have fuelled a dangerous credit bubble, leaving the global economy more vulnerable to another 1930s-style slump is than generally understood, the U.K.'s Telegraph newspaper reported on its website.

Virtually nobody foresaw the Great Depression of the 1930s, or the crises which affected Japan and Southeast Asia in the early and late 1990s. In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a 'new era' had arrived", the bank was quoted as saying.

The BIS, the ultimate bank of central bankers, pointed to multiple worrying signs, including:

the report said.

Still waiting for the tax-cut boost

Economist Paul Kasriel is still twiddling his thumbs, waiting for the predicted good results in the economy from the major tax cuts of 2001 and 2003.

In an analysis a month ago for his bank, Northern Trust Co. in Chicago, he referred to the famous Samuel Beckett play, "Waiting for Godot," in which Godot never shows up.

Last week, Mr. Kasriel said he still can't detect the promised big boost in national output, investment, and savings from what economists call "supply side" tax cuts made by a GOP-led Congress and approved by President Bush.

"The data don't seem to support the hypothesis," he said in an interview.



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The Last but not Least

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