OUT OF THE BOX
by Jim Willie CB
September 29, 2006
Jim Willie CB is the editor of the �HAT TRICK LETTER�
For specific detailed analysis of the Gold, USDollar, Treasury bonds, and inter-market dynamics with the US Economy and Fed monetary policy, see instructions for subscription to my newsletter research reports, which include stock recommendations positioned to rise in the commodity bull market.
Once in a while, a worthwhile exercise challenge is to think �out of the box� on an important topic. This article focuses on housing, and in particular Fanny Mae, the weakest among the Govt Sponsored Enterprises (GSE). The last sections describe in minor detail my envisioned metamorphosis for Fat Flanked Fanny. Its seeming permanent state of rigamortis prompts gradually hardening confirmation of bankruptcy, receivership, laundering of its bond portfolio, processing of its massive interest rate swap contracts, and political coercion not to prosecute its corrupt executives. Perhaps its rate swaps have been managed, so as to keep the yield curve flat as a pancake for almost a year. No news on Fanny Mae has graced the winds in over two years. My practice is to distill information for the purpose of making inferences on its true state, and to permit my fertile imagination to develop a creative but credible plan which might easily come to pass. Poor Fanny is stuck in the box, its coffin in my view. Its rotting putrid contents have yet to surface, to see the light of day, and to offend the air with its stench.
Many have embarked upon thinking �out of the box� with respect to the incredibly manipulated energy market, as such unconventional thought has entered the mainstream. Funny thing is, even the public suspects such interference for political gain. This is encouraging, since respect for law seems to have taken a back seat to politically motivated escapades. More accurately, respect for law might have been stuffed in the storage trunk of the car, or the junk yard for old cars, or the sub-basement of the house. The concept of efficient market theory flies in the face to insult those who make such claims, as politics and defense of the indefensible economic system take higher priority.
PREFACE ON THE STATE OF HOUSING
The housing market has justifiable received much attention recently. Both the disastrous war in Iraq and the housing market boom worked to jump start the USEconomy in 2003. They also ignited the commodity bull market. Now both ignition forces are hotly contested for their carelessly crafted corruption. Spin can put a pretty face on a pig, but not this nightmarish civil war and certainly not this housing market. Under-stated is the economic benefit from the military war, especially to commodity demand. Under-stated is the political component involved in the Fanny Mae distribution of mortgage funds. Few analysts seem to properly recognize the upcoming housing market decline, its bear market highly likely to form a gathering storm with vicious momentum. Yet another laughable �Soft Landing� has been forecast. Such an outcome seems far more convenient, politically valuable, delusional wishful thinking, than adept well-founded analytical forecast. The entire concept of Soft Landings would make an interesting chapter in Economic Mythology. We have never seen one, but we continue to have them thrust before us by proclaimed experts. The Soft Landing forecast is a convenient weapon used to deceive, in the wake of busted bubbles and ended trails. Doctored statistics unquestionably aid in the real-time telling of the story. A new fairy tale is needed, and sure as shooting, as a new calamity presents itself.
My Hat Trick Letter in September covered the housing sector from the economic standpoint and also the bond standpoint. The crisis comes in both, but unrecognized yet on the bond and banking side. The recent issue cited numerous statistics which will not be repeated. My September report also identified no less than seventeen deceptive but useful denial statements (constructs) which assist in keeping the public engaged within the current housing bubble. They therefore suspect a stall or reduction to a beneficent plateau, in my view naively. Lower interest rates will do little if anything in preventing a substantial decline. The end to utterly fraudulent lax lending will bite deep into demand for homes. Excessive new home building has exacerbated the supply problem, surely motivated to produce jobs. Builders have added to the supply when demand has been interrupted. Speculators and flippers have grown in size as obstacles within the market, as they take heavy losses and must liquidate. Their carrying costs greatly exceed their income if renters are sought in the interim. The option adjustable mortgage (ARM) have emerged as a vicious vehicle, nay weapon, which will separate homes from owners, only to leave the structure preserved. Some call the option ARM a �neutron bomb� for the housing sector. The housing decline will expose a significant slice of the US population. What was beneficial in home equity extraction for years will turn detrimental in the next couple years. Wages must rise in a big way in order to compensate for free lunch home equity loans. Rising monthly mortgage costs, rising property taxes, rising home insurance costs (especially near coastlines), and high maintenance costs, these all conspire to increase carrying costs, often motivating sale.
Hundreds of thousands will be forced to leave their homes and sell out, some of whom with negative equity. In fact, a new subclass will reveal itself, the homeowner who is bankrupt, in full ownership, but with negative equity. Wow, the homeowner in poverty! In time at a later date, they might actually gain bargaining power with their lenders, overwhelmed by foreclosures. Imagine occupying a home, enjoying its shelter, its opportunity for comfort and privacy, a place to raise a family, but being unable to make payments which have risen monthly by 30% to 50%. Imagine for these unfortunados that they must produce tens of thousand$ in order to sell and depart. In 1990 following a divorce, an experience of mine left me with a mere $180 check (one hundred eighty dollars) at closing of a property sale in the western suburbs of Boston, waving bye-bye to our $23,000 down payment. The wench did not even show up, regarding invective from the jackass as not worth the $90 in split proceeds. This class of negative equity folks will suffer a plight surely to be covered by our hound dog press. Initially the mortgage lenders, the title holders, will seize the properties when payments fall into arrears, all within the prescribed legal process. Later on though, they will be overwhelmed. In 2003, the Boston area suffered the ignominy of a record high abandonment of cars with underwater equity. They simply �walked away� and left the cars at the bank lots with keys. Adept analysts expects walk-aways from underwater houses in the near future. This will be shocking.
THE GREENSPAN DECEPTION
In 2001, former US Federal Reserve Chairman Greenspan urged the long-term Treasury Bond yield to come down. He cheered a housing boom led by cheaper mortgages. This clearly covered his tracks in promoting and killing a stock bubble. Later, in 2004, Greenspan urged homeowners to switch into adjustable rate mortgages. He argued that ARM�s enabled lower monthly costs, sufficient to further the consumption boom, which offered some relief to household budgets. The unspoken deceit is how Greenspan urged homeowners to embrace the interest rate risk, to relieve that risk from bankers, and to proceed as rates on ARM contracts continued upward from his own USFed rate hikes. He encouraged the shift in rate risk from bankers to households, in keeping with his role as the bank sector salesman, policy maker, and representative of their interests. Greenspan did not keep the interests of the US middle class high as a priority. His #1 priority was to bankers. He openly served as the bankers� whore. He acted as a traitor to the middle class.
�BIG MO� IS POWERFUL, HIDDEN, NOT MENTIONED
Momentum is not discussed much at all in the housing market. We hear of stalled prices, a mild decline to remove the froth, even a reduction and flattening to a more stable level. Pure poppycock! However, we hear nothing of fast developing momentum in housing to careen downhill in price. The items for denial in the last two years are actually key points in favor of downward momentum. In 2004 and 2005, my forecast was for a stall and the onset of a housing decline. It did not happen. Careful analysis reveals without any question the reasons why. Lending turned insane. No documentation loans allowed lying about income on loans. Minimal down payments permitted 0% equity (100% loan to value) loans. Fully 25% of those who purchased with 0% down payments now have negative home equity in their properties, to make for an initial nightmare for first-time buyers, one never forgotten. Second mortgages were routinely granted to cover the down payments, so as to sidestep private mortgage insurance. Force fed appraisals approved the claimed values, or else the appraiser was cut out of the mainstream. Deceptive option ARM�s tricked people into forfeiting their excellent lovely low fixed rate mortgages, in favor of temporarily lower rates, lower monthly carrying costs, but with rising balance on loans. Now many such ARM deals are higher in rates than the forfeited old fixed loans. Refinances are much more costly, many over $10 thousand, whereas REFI�s costs used to be under $1000. New home builders have offered free cars, free swimming pools, and no payments for initial months. There was no end to the insanity.
NO NO NO ! The extra mile that housing went in 2004 and 2005 and 2006 provided the initial downward momentum to housing. Harken back to the days as a youth in the playground. On a swing, if pushed higher on the back stroke, the swing would surge downward much faster in speed, to attain more force on the down stroke. The same is true for the housing sector. It went farther up than it should have, and for much longer than it should have. Its early momentum is unquestionable on the down side from that artificial extension. The current momentum is from flippers selling out, from option ARM holders selling out, from the wise veterans selling out to the new fools. Next will be those with negative equity selling out, along with those who will not tolerate a 50% rise in their monthly mortgage payment. The many layers of irresponsible lending will unravel, one stage at a time. Few realize that ARM mortgage terms were often dictated by hedge funds headquartered in London. As the USFed might cut short-term rates in the future, it might not have an effect on ARM holders. The hedge funds tied the adjustable rate to the LIBOR overnight rate in London. Read the fine print. In the midst of enthusiasm, most people do not. Very few will probably lay blame on Greenspan, as is deserved. Bankers smile with glee.
My forecast is for the current housing decline, which is several months along, to become the worst housing bear market in modern history, just as the lending abuse was the most insane in modern history. We arrogant over-indulgent Americans love to boast on our innovation. However, when it comes to housing, our innovation is for kooky devices which enable people to purchase houses who should not. The promotion went so far as to have Fanny Mae advertise on television for minority families of color to participate in the dream of homeownership. This unfortunate group will stand as the last buyers, the suckers. No, the housing market will become a living breathing monster which cannot be reined under control, which will refuse to respond. Its momentum will grow too powerful. A new hobby among writers will be to recount the horror stories. One friend reported that his realtor agent friend in Chicago claims that bids in September simply disappeared. My friend has a brother in the Miami home building sector who reports that people are canceling new purchases since they cannot sell their other homes in transition. In resort locations such as the Outer Banks of North Carolina, banks will not provide mortgage funding unless a property can demonstrate a positive cash flow. My own eyes saw a plethora of �for sale� signs during a brisk bicycle ride on a road bike. No truck-like sluggish mountain trail bikes for me.
The home builders have benefited from a rally in their stock shares, one without merit. A pure short covering rally in my view, as their fundamentals worsen. The HGX approaches the 20-week moving average, the next resistance boundary. Their August new home inventory level grew from 6.5 months supply to 6.6 months supply. Their reported land lease abandonments have grown, with large claimed losses. Sadly and tragically, the housing market bear market has only begun. With each passing month, the denial will continue in the investment community and among the economist charlatans. They will never mention downward momentum, but rather newfound stability at a lower level. Just as upward momentum was critically important, so is downward momentum. Lower property values will encourage people to sell out, to avoid being a victim of negative home equity. Rising carry costs to the homeowner will motivate round after round of selling, until the 1999-2000 level is reached in prices.
A DEAD FANNY MAE ???
Is Fanny Mae dead? A great question. My simple answer is �yes of course, check for a pulse, since it has none� which can be argued. The argument can be easily made or given with some distilled inference. Two big reasons dominate my center argument for dead and not yet buried. First, it has not provided an annual financial statement since 2003, and has promised none. This constitutes a free pass, when its trading stock should have been delisted two years ago, and surely immediately. We were amused by stories of 1500 accountants working like so many eager beavers in determining its balance sheets and recent earnings. No such luck. Forget their profit and loss, since current health status is more over-riding. My personal view is that the 1500 bean counters are assisting in the bond laundering, probably converting in full illicit fashion a scad of mortgage backed securities (MBS) into more stable USTreasury Bonds. Does anyone connect the absent M3 Money Supply dots to Fanny Mae�s books? Quarter after quarter has passed without a peep on Fanny Mae�s financial status. Nobody even asks anymore, and nobody expects any word. Conclusion: dead kaput, in bankruptcy receivership.
The second factor is more technically complex, as it pertains to what is called �mortgage convexity� in the trade. Back in 2002 and 2003, Fanny openly boasted about beneficial convexity. When long-term interest rates were in constructive and useful decline, the rush of refinanced mortgages created a surplus in Fanny cash flow. With extra funds, Fanny saw fit to invest in USTBond futures contracts. This pushed down rates even further, which ignited round after round of refinance activity. The convexity worked in the favor of lenders, in the favor of borrowers, and surely provided a jet assist to property values. Fast forward to 2005 and 2006, when the USFed had ratcheted up seventeen consecutive 25 basis point rate hikes (the same number of housing denials in my report, not a coincidence). The first six or eight or ten rate hikes were relatively harmless, as the USFed effectively removed their easy money policy. However, the last several rate hikes have hurt households. ARM rates have inched up enough to cause pain. Refinanced deals are harder to come by, require more documentation, must overcome the appraiser hurdle and a more rigorous inspection. They even cost ten times more. Mortgage convexity has turned from harmless to harmful, without report of pain. The absence of REFI activity, the rise of delinquency, the tragedy of foreclosure, these all work against Fanny Mae cash flow. They might actually sell into their bond hedge book, but not openly discuss it. What did we hear from Fanny on the detrimental side of convexity as rates unfortunately rose all year long? Not a peep. Fanny is dead kaput, in bankruptcy receivership. It is an election year, so any reform is out of the question. The Office of Federal Housing Enterprise Oversight (OFHEO) has shrugged its duty, with no reform likely, even as Fanny continues to rest like a smelling rotten putrid cadaver in the USGovt agency basement. Its tissue rots in the nether chambers of the agencies outside the public view. The corporation, or agency, or clearing house, or whatever the heck Fanny Mae is, it is a certain subject for autopsy. Its holdings is another matter altogether.
FINANCIAL SEWAGE TREATMENT PLANT
SEWAGE TREATMENT PLANT
Warren Buffett called derivatives generally �financial sewage� after he was forced unwillingly to process bond derivatives in a blind side undertaking (a pun on funerals). His Berkshire Hathaway assumed the hedge book for General RE, a reinsurance outfit. Fanny Mae stands apart in a critical manner. Not only does it possess a mountain of financial sewage, but its core holdings are the worst quality in the industry. A bank or mortgage firm might hold 20% of its originated loans in portfolio, but it sells Fanny Mae its worst quality and retains its best quality. Fanny, with due disrespect, exercises absolutely zero diligence or discrimination. They will purchase willy nilly your most pathetic, lowest quality, total garbage loans, tied to the most unqualified jokes of borrowers. One landlord owning multiple properties last spring proved to be a homeless man without income living on the streets of St Pete Florida !
Fanny Mae therefore qualifies as what some have called a �financial centrifuge� in their eyes. This image requires an alteration. They accept refuse and garbage which serve as bank sector excrement. They return to the banks (who originate the loans) the cash for the recycled loan, regardless of its value. Fanny Mae routinely sells �repackaged loans� in mortgage bonds, which by law cannot be audited on an individual basis. This is a reckless sewage treatment process, a one-way street.
A NEW FANNY MAE REIT ???
In 1989 through 1991, the Resolution Trust Corporation (RTC) took center stage in the news. Its head was Bill Seidman, who expertly liquidated hundreds of thousands of foreclosed properties under the guise of the Federal Deposit Insurance Corp. An expected $800 billion loss turned out to be in the neighborhood of a $260 billion loss, when the dust cleared, properties were sold, and recovery was complete. The FDIC is the insurance underwriter for Savings & Loan institutions. Fanny Mae has no such underwriter. Their underwriter is the USGovt, whose political motives outweigh business considerations. Criminal fraud is permitted, when the violations are done by friends of the USGovt, either the current or previous administration. Thus the label for our economy of �Authoritarian Free Capitalism� or �Crony Capitalism� fit. Fanny Mae will never be subjected to a resolution of any kind, no way, no how, not gonna happen.
If Fanny Mae were to act like a responsible corporation, subject to the rules and regulations of legitimate corporations, then it would proceed through a liquidation phase. It continues to hold property titles, as collateral tied to the mountain of mortgages under service, mortgage bonds, Treasury Bonds, interest rate swaps, and linked exotic contracts (e.g. TBond to Euro, TBond to Gold) as well as other absurd geared contract devices which defy logic or reason. They surely cannot be adequately or properly accounted for in an honest exercise. Thus its business is either dead or beyond calculation, probably both.
Fanny Mae cannot proceed to liquidate either its MBS bonds or its foreclosed properties. To do so would pummel the housing prices, and threaten the low mortgage rate environment. Besides, its property titles serve as loan collateral. The property value declines have only begun. They must wait for the upcoming slaughter of trillion$ in home stock values nationwide. Fanny holds the mortgages for 40% of the nation's mortgages. Banks and mortgage firms hold the mortgages for only 20% of the nation's mortgages, but they have made a critical error. Banks and mortgage firms have recycled the money obtained from recycled Fanny funds into mortgage backed securities, even some Fanny Mae corporate bonds, and ridiculously some Fanny Mae stock. They recycled sewage into their own private firm balance sheets. Fanny will liquidate and seek resolution of its properties and bonds only when taken to the woodshed, kicking and screaming. Expect it after the November elections at the earliest.
My future �out of the box� view is that Fanny will NEVER liquidate its properties under foreclosure. It cannot avoid the writedowns in their MBS bonds, to the tune of 20% to 40% easily. My future view is for the creation of a new Fanny Mae Real Estate Investment Trust (REIT). The market crisis will demand it. A flood of one million foreclosed properties for sale under distress would wreck havoc on housing values. So forget that! You think one million is too high a number? Get back to me in 2008. Instead, a foreclosed property must acknowledge its potential income source from rental. Poof! We have the new �Fanny Mae rental homes� which can be obtained as relief to the shortage of rental homes. Unlike 1990, the RTC will not be a repeated exercise. To repeat the RTC, which makes good business sense, unfortunately would create a disaster in an already overloaded supply situation where unsold inventory grows each month. The new Fanny Mae REIT invites new ownership.
ARISTOCRATS & LIMITED PARTNERSHIP
Two avenues can be taken, one corrupt and one within the shadow of the RTC experience. Nobody knows what evil lurks in the minds of US financial engineers, those crafty little innovators of disastrous machinery. Heck, this is our national advantage. Nobody outside of USGovt circles, beyond the syndicate inner workings, can know what is truly in progress.
The first route would involve USGovt acceptance of all Fanny Mae and other GSE losses, in a hidden taxpayer bailout, or a hidden flood of greater USDollar monetization. The government would essential offer guarantee of all derivative losses, in a complete whitewash of criminal fraud and colossal mismanagement. If rich enough or connected, the player is a partner, not a criminal. The derivative losses would be kept hidden and undisclosed, much like a backroom sewage treatment plant. Lack of monetary accountability would offer a giant assist to the process. The unencumbered properties held under foreclosure would next be fashioned together within a limited partnership Real Estate Investment Trust (REIT). It would collect rather impressive rental income, paid as dividend to the Fanny Mae REIT shareholders, not Fanny Mae share holders. My guess is only connected insiders would be invited to participate in this REIT, since the repossession from the middle class would constitute a transfer to the aristocrats. They would not choose to share. Call it a second phase to the confiscation of middle class pension funds in 1999 and 2000 with the stock bust, whose vehicle was the 401k and IRA accounts. The hedge fund liquidation has a stench of more confiscation, since many pension funds have pursued hedge funds for higher returns than the paltry bond yield offerings.
The second route would involve the explosion blowup of the Fanny Mae hedge book, and perhaps chain reaction blowups of the Freddy Mac hedge book as well. My firm belief is that the mortgage bond crisis would trigger an uncontrollable chain reaction which would threaten the entire bank sector. The banking sector owns too many MBS bonds. Their writedown comes soon, like a dreaded procedure which threatens the system. Under this scenario, a Fanny Mae REIT would struggle to get off the ground. Who would invest in such a REIT when the financial balance sheet is horribly damaged? Well, surely some dimwitted investors.
The first route of complete coverage of losses, kept fully undisclosed, is more likely. The objective is for Fanny Mae to process the foreclosures and earn a yield on its properties. Full liquidation of a mountain of lost properties is not an option. Full realization of its gigantic corroded hedge book loss is not an option. However, the potential income stream from home rental creates an opportunity which will not be bypassed or overlooked. One must think out of the box.
NEW HOUSING FROM 2008 TO 2010
This is a nasty topic, replete with political overtones, with a hint of the harsh heavy hand of state power directed to exert control during upwardly escalating chaos within our society. Expect creation of debtor prisons in future years, without any doubt whatsoever in my mind. With a collapsing housing market, removed piggy bank with home equity, rising mortgage costs, and struggling wages, our American Dream will fade into memory. The loss of the critically important manufacturing sector has rendered our nation as incredibly vulnerable to a housing decline, one which is at our doorstep. Housing prevented a recession and nourished the sick USEconomy, but now housing has turned into sour milk for that nourishment. The need will arise to house people who have lost their homes. The need will be acute to prevent bands of people invading the wealthy suburbs, to seek assets in survival mode. The more pressing national need will be to create a new renaissance of a manufacturing sector. With forward vision, one can see debtor prisons with paired mfg sites, ready cheap labor, and worker reinstatement programs so as to exit the dire straits of bankruptcy. Its laws have changed, much less liberal nowadays.
THE BOND CRISIS
The upcoming bond market crisis will launch gold. Many in the gold community regard price inflation and monetary inflation as the levers which will send the gold price upward. The past three years has taught us that the US monetary inflation apparatus has been abused and contorted into a twisted mess of redirected flows. We export inflation and import cheap Asian products, essentially importing deflation. Domestically, we build asset bubbles which break, only to unleash more deflationary forces. The case in point is the housing sector, now in full deflationary bloom. NO, the gold price will respond favorably to the bond crisis underway. USTreasury Bonds might actually benefit from the massive leak of financial sewage extended from damaged loan portfolios, as mortgage bond spread trades unwind. New USTBond demand will come to the market, just like it did in June 2005 when General Motors and Ford Motors corporate bond spreads unwound. The 10-year TNote yield fell below the 4.0% mark temporarily.
One cannot regard inflation as an aggregate concept. That is the principle failing among analysts in the gold community. Not here! Not for Hat Trick Letter members. This has been on ongoing topic of analysis, one made painfully clear in previous articles. To ask whether deflation will overtake inflation is the wrong question. Rather, the issue is to what degree inflationary forces grow at the same time of growing deflationary forces, and which groups flip flop into deflation like housing is now. Banks own too many mortgage bonds. Their MBS portfolios is soon to endanger the banking system. At that time, watch gold fly, and soar like a sleek beautiful bird. My forecast is for the USTBond 10-yr yield to fall to the 4.0% level. The bank distress will initially present USTreasurys once again to be a safe haven. When the USEconomy suffers mightily from the USDollar decline, written in stone, gold will rise without interruption.
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© 2006 Jim Willie, CB
Jim Willie CB is a statistical analyst in marketing research and retail forecasting. He holds a Ph.D. in Statistics. His career has stretched over 24 years. He aspires to thrive in the financial editor world, unencumbered by the limitations of economic credentials. Visit his free website to find articles from topflight authors at www.GoldenJackass.com.
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