Where We Are, How We Got Here and Where to Next?

by Rob Kirby, Kirby Analytics. July 2, 2007

Of late, in the media, a great deal of attention is being paid to the sub-prime debt markets. These markets consist of a fangled assortment of "engineered" alphabet-soup-sounding securities like MBS and CDOs.

In layman's terms, what these "engineered" financial products do is "bundle income streams or payments" giving folks and institutions access to credit [loans]. By "re-packaging" traditional debt instruments, through the wizardry of investment banking, folks and entities who previously couldn't get a loan now can.

Investment bankers make generous fees for re-packaging the debt and placing it with institutions such as pension funds, insurance companies and the like.

To make everyone "feel good about the whole thing" [the marketing process whereby buyers are found for debt secured by someone / something who formerly did not qualify for a loan] – the professional services of Credit Rating Agencies are used. As Wikepedia explains,

"A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations. In most cases, these issuers are companies, cities, non-profit organizations, or national governments issuing debt-like securities that can be traded on a secondary market. A credit rating measures credit worthiness, the ability to pay back a loan, and affects the interest rate applied to loans."

When this process is repeated MANY TIMES OVER, a picture like the one below begins to take shape:

Source: Federal Reserve : Flow Of Funds

So, what you end up with is a grossly overvalued real-estate market – all fueled by cheap credit:

Now, if we stop to consider for a moment just how many things we experience in life that adhere to BELL - SHAPED distributions – like those depicted below:

Have We Crested?

Recent developments in the CDO market – as it relates to Bear Stearns - prompted an investigative article by Ambrose Evans-Prichard last week titled, Banks 'set to call in a swathe of loans'.

Mr. Evans-Prichard cites a report by Charles Dumas of Lombard Street Research to reveal that,

"the fast-moving crisis at two Bear Stearns hedge funds had exposed the underlying rot in the US sub-prime mortgage market, and the vast nexus of collateralised debt obligations known as CDOs."

I'd like to say, "hats-off to Mr. Dumas and to Mr. Evans-Prichard too." Firstly, for properly identifying the malady [rot] and secondly, for reporting on it.

The Rot Is Becoming Impossible To Ignore

Rot generally, scientifically and perhaps most widely refers to the decomposition of organic objects. I liken the world's U.S. Dollar-centric-fiat-money-system to a living organism.

Credit / money creation is this organism's life-line.

But how far has this "rot" already spread?

Let's see:

The official "un-employment" rate in the U.S. has been re-jigged so as to be meaningless. As John Williams of Shadow Government Statistics reports,

"The popularly followed unemployment rate was 5.5% in July 2004, seasonally adjusted. That is known as U-3, one of six unemployment rates published by the BLS. The broadest U-6 measure was 9.5%, including discouraged and marginally attached workers.
Up until the Clinton administration, a discouraged worker was one who was willing, able and ready to work but had given up looking because there were no jobs to be had. The Clinton administration dismissed to the non-reporting netherworld about five million discouraged workers who had been so categorized for more than a year. As of July 2004, the less-than-a-year discouraged workers total 504,000. Adding in the netherworld takes the unemployment rate up to about 12.5%."

The inflation indexes [CPI and PPI] have also been reworked so as to "exclude" ANYTHING that actually rises in price. Again deferring to John Williams of Shadow Government Statistics,

"Inflation, as reported by the Consumer Price Index (CPI) is understated by roughly 7% per year. This is due to recent redefinitions of the series as well as to flawed methodologies, particularly adjustments to price measures for quality changes. The concentration of this installment on the quality of government economic reports will be first on CPI series redefinition and the damages done to those dependent on accurate cost-of-living estimates, and on pending further redefinition and economic damage."

Anyone who has taken an introductory level economics course would [or should] know that using severely compromised inputs outlined above result in hideously flawed GDP reporting.

"The Gross Domestic Product (GDP) is one of the broader measures of economic activity and is the most widely followed business indicator reported by the U.S. government. Upward growth biases built into GDP modeling since the early 1980s, however, have rendered this important series nearly worthless as an indicator of economic activity. The analysis in this Installment will indicate that the recessions of 1990/1991 and 2001 were much longer and deeper than currently reported, and that lesser downturns in 1986 and 1995 were missed completely in the formal GDP reporting process. Furthermore, the current economic circumstance is suggestive of an early-1980s-style double-dip recession.
The distortions from bad GDP reporting have major impact within the financial system. For example, Alan Greenspan's heavy reliance on productivity gains to justify some of his policies is equally flawed, since the methods applied to GDP estimation influence the numerator in the productivity ratio. As with the CPI distortions discussed in Installment III, the Federal Reserve Chairman knows better.
With reported growth moving up and away from economic reality, the primary significance of GDP reporting now is as a political propaganda tool and as a cheerleading prop for Pollyannaish analysts on Wall Street."

Moving on to interest rates – let's now consider the enormity of J.P. Morgan's derivatives book. It weighs in at 68+ TRILLION in notional. This "beast" of financial engineering [flim-flammery] is largely comprised of interest rate swaps. With the lions' share of interest rate swaps being naturally "hedged" with a duration weighted amount of bonds [imbedded in the trade] – this affords J.P. Morgan [nothing less than an "extension" of the Federal Reserve] complete mastery of the bond / interest rate curve. The upshot – interest rates no longer fulfill their historic function of rationing or "efficiently" meting out capital. The result – savers are punished and holders of fixed income securities are irreparably harmed [witness the state of the largest "holders" of fixed income securities - our private pension system].

So now – Mr. Dumas feels that a CDO "meltdown" is FINALLY going to upset the proverbial apple-cart and provoke a liquidity slashing credit crunch? I'm going to make a rather "bold statement" and say "NOT SO QUICK."

When Mr. Dumas states in his report that "God knows what the true value of CDO's really are since banks have shut down the marts where they trade" – I find this reminiscent of today's Gold Market.

Historically when inflation rears its ugly head – the price of gold rises. Nowadays, the gold market is "rigged" through machinations [outrageously concentrated shorting] in the futures markets by agents of the U.S. Government and / or Federal Reserve. People like me who like to point this out are affectionately referred to as Conspiracy Theorists. A "low" gold price instills "faith" or gives foreigner's willingness to continue holding U.S. dollars as official reserves. So long as the mis-pricing of the asset in question is "sanctioned" by government or agencies charged with "oversight" – no-one flinches. The gold price of today is as MISPRICED as [or perhaps more] than CDO's selling at 35% of face.

Once again, "hats off" to Mr. Dumas to make the statement that the "shuttering" of the mart where CDO's trade REEKS of "BLATANT COVER-UP". Kudos to Mr. Dumas for stating that this has ALL OCCURRED with the complicity of those charged with Regulatory Oversight [the Ratings Agencies]. You see, GOLD market "rigging" is only possible with the complicity of the FED, Treasury and CFTC – along with an assorted rag-tag group of foreign Central Banks too.

You see, "IF" economic laws were actually allowed to assert themselves – FALSE REPORTING of employment numbers, inflation numbers, GDP numbers and larcenous interest rates may very well have already toppled the U.S. fiat-hegemon.

It Slips But It Never Falls

But things are changing. An increasing number of countries are beginning to REFUSE accepting U.S. Dollars. Of course, few people even notice this because the U.S. Dollar index doesn't seem to budge in spite of these developments. Ask yourself this, "Given the indebtedness of the U.S., both fiscally and from the standpoint of the Current Account along with the hollowing out of U.S. industry – why would a rational human being want to hold dollars?"

The answer to that question, "Increasingly, they haven't."

But Mr. Dumas should be warned of drawing too much attention to "the lack of a transparent mart for CDO's" – he runs the risk of being intellectually ghetto-ized and "fitted" for a tin-foil hat if he keeps this up.

Could the developments in the CDO market be the proverbial "straw that broke the camel's back"?

Perhaps, but don't bet the fiat ranch on it. Do not under-estimate Mr. Bernanke's stated belief that he can solve all the world's problems with money creation. We are living in an "Alice and Wonderland World" and until the tea-cup and saucer say, "no-mas" [or someone takes the proverbial joy-stick out of Bernanke's / Paulson's grubby hands] – this hallucination can and likely will continue.

Today's Market

Overseas equity markets began the week on a sluggish tone with Japan's Nikkei Index gaining 7 points to 18,146. North American markets began the week very strong with the DOW ahead 126.80 to 13,535.40, the NASDAQ up 29.07 to 2,632.30 and the S & P gaining 16.10 to 1,519.45. NYMEX crude oil futures gained .46 to end the day at 71.14 per barrel.

Canadian markets were closed today in observance of the country's 140^th birthday [July 1].

On foreign exchange markets the U.S. Dollar index "slipped" .51 to 81.19.

Interest rates were about 4 basis points easier across the curve with the benchmark 5-year bond ending the day at 4.89% while the 10-year bond finished at 4.99%.

Precious metals were stronger with COMEX gold futures ending the day up 8.80 to 658.80 per ounce while COMEX silver futures added .30 to close at 12.70 per ounce. The XAU Index gained 2.87 to 138.82 while the HUI added 7.88 to 337.23

On tap for tomorrow, at 10:00 a.m. May Factory Order data is due – expected -1.3% vs. prior + .3%. Then at 5:00 p.m. June Auto sales data is due – expected 5.2M vs. prior 5.5M. June truck sales for the same period expected 7.3M vs. prior 6.8M.

Wishing you all a very pleasant evening and a safe and happy 4^th of July!

Rob Kirby

Contact Information

Rob Kirby | Proprietor, Kirby Analytics Newsletter - Proprietary Macroeconomic Research
Toronto, Ontario, Canada | Observations | FSU Editorials | E-mail