Other Commitments

Dear Readers,

I have a few major projects going on right now that will distract my ability to write as frequently as I usually do, which is usually 5 to 8 times per week. Expect far less than that over the next couple of months, but I will try and at least have a few per week.

Banks Low on Blood, Need Capital Transfusion

An important issue has surfaced regarding Fed policy on banking regulation. It has several implications that shall be discussed in a later post, but for now a snippet from Bloomberg, followed by a brief afterthought:Fed Reviews Rules for Investing In Commercial Banks:

"Federal Reserve officials are reviewing regulations that limit investment firms' stakes in banks in an effort to channel more capital into the U.S. banking system. The central bank ``is taking a look at these rules with an eye toward whether there are any provisions that can be modernized

...

Fed Chairman Ben S. Bernanke, Treasury Secretary Henry Paulson and other officials have urged banks to raise capital, helping offset the impact of writedowns and credit losses. Treasury officials have urged consideration of easing limits on private equity firms' purchases of bank shares.

Fed officials have met with the Washington-based buyout fund Carlyle Group, spokeswoman Ellen Gonda confirmed. ``There is an ongoing dialogue,'' she said. ``It's not unusual for regulators to seek private sector input on policy.''

Central bankers have also spoken with J.C. Flowers & Co., Kohlberg Kravis Roberts & Co. and Warburg Pincus, the Journal reported, citing unnamed people familiar with the matter.

KKR spokeswoman Ruth Pachman declined to comment.

Currently, Fed guidelines limit funds to a 9.9 percent voting stake in banks, and funds or individuals have to commit to the Fed that they will remain passive investors if they go above that level, up to a cap of 24.9 percent. If they don't make that commitment, then investment firms or individuals would have to form a bank holding company.

...

Lifting the legal cap on nonbanks' purchases of bank shares ``would be a very major step,'' Fed Vice Chairman Donald Kohn said in answering questions at a June 5 Senate Banking Committee hearing. ``It would be a huge change from where we are today and I'm not sure it's necessary in order to get capital.''

Defaults and delinquencies on mortgage loans and related credit products have hit the financial system with billions of dollars of losses, and resulted in tighter credit conditions for consumers.

Credit losses and asset writedowns worldwide have totaled about $400 billion since January 2007 at banks and financial firms. Financial institutions have raised more than $321 billion of capital over the same period, including through sales of stock and stakes to sovereign wealth funds.

``In the last few recapitalizations where balance sheets have been strengthened for financial institutions, private equity has played an important role,'' Treasury Undersecretary Robert Steel said in an April interview. Changes to the current limit on bank capital purchases is ``certainly something worth considering and looking at,'' he said."

What is the Fed to do?

The Fed is bent over, face down in a pillow, utterly helpless as it sits between Hell and a hard place. The very system that assures the inflationary growth the Fed loves to fuel, is in complete tatters. Reputations are shattered, kaput, deflation.

Banks are so far under capitalized its frightening

Who is going to step up to the plate with no end in sight? After all, with Goldman calling short sales on Citi with almost $9bln in expected write downs to come from just one bank, why would you?

The solution?

This is where I leave off, and my next post will have some history to it since this very topic of brokerage houses mixing together with commercial banking was once put to rest and now in the hour of desperation is being resurrected. Bernanke is in the toughest spot imaginable, I almost feel bad for the mess he inherited. On the other hand he chose to ignore the mess as it plunged to unchecked maddening heights. Stay tuned.

P.S. Don Luskin and Vince Farrell are "Peak Assholes"! They're ignorant, belligerent, egotistically conceited rosy predictions will make they're kind all but extinct once they are proven wrong, and thus the title spawned "peak assholes". For once they're kind of jackassery is figured out, they will vanish....

I hope they are mercilessly chewed by man eating silver backs, and then reincarnated as man slaves to excessively spiteful lesbian dominatrices and flogged for eternity!

MWS: What I've been screening

For your consideration, here are the stocks I find interesting and possibly worth further investigation:

*I do not own, nor am I recommending any of the stocks listed above. This is a "watch list" only of stocks I may or may not be interested in having a position in the future. LYG is a familiar name on this list I've referenced before.

On The Extension of Credit, A Quick Thought

In 1929, margin requirements were only 10%. It's obvious to see this is far too low and only bad results are to come of it. As a part of the Securities and Exchange Act of 1934, Regulation T for the Federal Reserve Board of Governors increased margin requirements to 50% as a result of poor speculation from lax credit requirements. This, was a logical step in the right direction.

Fast forward to 2008, where we are witnessing the consequences of easy credit once again, only this time its through the very financial institutions that our economy relies on. Why is it, that 10% collateral is too low for traders, speculator or investors in stock exchanges, but for banks they can lend out 10x's (the same as 1929 for margin traders) as many deposits as they have in their vaults from customers.

There's a caveat though; with banks incentives play a much larger role. Who sets these incentives? The Federal Reserve. This is the powerful bastard board that sets interest rates. Good ol' Greeny set them at 1% just a short time ago.

Enter the real estate speculator, sub prime loans, liar loans, credit lines and a widely accepted view of using debt to expand operations in the corporate world as a result of negative real interest rates.

And now? The FDIC is awaiting large increases in bank failures, write offs of banks have already exceeded $400bln and rising and not even a whisper as to why our financial institutions are allowed to incur such large debt/equity in the first place. Instead nonsense about placing more regulators over the shoulders of banks and brokerages are the proposals we are hearing.

Extending this farce of an institution more power over our economy is a surefire way to corrupt it further. Not only that, but the Fed is even corrupting the very idea of capitalism by backing the banks and brokerages for their hubris.

TANSTAAFL!

May New Home Sales

UUUGGH! Damn these home builders. They obviously want to bankrupt themselves. Without getting into flaws within the methodology of computing these numbers, here is todays New Residential Sales in May 2008:

"Sales of new one-family houses in May 2008 were at a seasonally adjusted annual rate of 512,000, according to estimates released jointly today by the U.S. Census Bureau and the Department of Housing and Urban Development. This is 2.5 percent (±13.7%)* below the revised April rate of 525,000 and is 40.3 percent (±6.9%) below the May 2007 estimate of 857,000.

The median sales price of new houses sold in May 2008 was $231,000; the average sales price was $311,300. The seasonally adjusted estimate of new houses for sale at the end of May was 453,000. This represents a supply of 10.9 months at the current sales rate."

The definition of new residential sales is for single family units where a contract is signed or a deposit accepted, the latter being optimal because it reduces the likeliness of a cancellation, which aren't accounted for in this data or in revisions.

Now the NAR data of existing home sales, which is yet to be released for May, does not account for new home sales. But there is a terrible similarity between the two data sets; Both are down big yoy and both now have ridiculous inventory levels, the NAR data at 11.2 months and now the Census Bureau at 10.9. Inventory keeps on climbing higher! These home builders should exercise much more discretion in granting building permits of new homes so keep this inventory from building.

Home builders have taken several Chuck Norris roundhouses to the crouch, but continue to exceed demand in their operations. Cancellations must be high is my guess as financing falls through since credit is tough to obtain, which increases inventory. Prices still must fall further, so demand will be hacksawed until reasonable values are obtained. So far there has been a dramatic adjustment to these prices
and a logical possibility is that further price declines will take much longer to unfold, but let's hope it doesn't. Hope though, only leads to disappointment.

The Conference Board Consumer Confidence Index Declines

The Consumer Confidence Index for June was released today....damn!

"The Conference Board Consumer Confidence Index, which had declined in May, declined even further in June. The Index now stands at 50.4 (1985=100), down from 58.1 in May. The Present Situation Index decreased to 64.5 from 74.2. The Expectations Index declined to 41.0 from 47.3 in May.

The Consumer Confidence Survey is based on a representative sample of 5,000 U.S. households. The monthly survey is conducted for The Conference Board by TNS. TNS is the world's largest custom research company. The cutoff date for June's preliminary results was June 18th.

Says Lynn Franco, Director of The Conference Board Consumer Research Center: "This month's Consumer Confidence Index is the fifth lowest reading ever. Consumers' assessment of present-day conditions continues to grow more negative and suggests the economy remains stuck in low gear. Looking ahead, consumers' economic outlook is so bleak that the Expectations Index has reached a new all-time low. Perhaps the silver lining to this otherwise dismal report is that Consumer Confidence may be nearing a bottom."

Consumers' assessment of present conditions grew dimmer in June. Those claiming business conditions are "bad" increased to 32.5 percent from 29.7 percent, while those claiming business conditions are "good" declined to 11.5 percent from 13.0 percent last month. Consumers' appraisal of the job market was also more pessimistic. Those saying jobs are "hard to get" increased to 30.5 percent from 28.3 percent in May. Those claiming jobs are "plentiful" declined to 14.1 percent from 16.1 percent.

Consumers' short-term expectations deteriorated further in June. Those expecting business conditions to worsen over the next six months rose to 33.9 percent from 32.9 percent, while those anticipating business conditions to improve decreased to 8.8 percent from 10.6 percent in May.

The outlook for the labor market was also more pessimistic. The percent of consumers expecting fewer jobs in the months ahead increased to 35.5 percent from 32.3 percent, while those anticipating more jobs declined to 8.0 percent from 9.0 percent. The proportion of consumers expecting their incomes to increase declined to 12.3 percent from 14.1 percent."

I wouldn't get your hopes up for that silver lining or any other shiny trim for that matter (except gold). In fact, watch as this index continues to defy the swines on Wall Street as it hits all time records going forward. Remember, the states haven't cut back yet and consumers have still been walking on their last crutch as debt continues to rise. Once those lurking shadows finally shed light from behind the aura of real estate, that's when the party really gets going.

Home Price History Across Major Cities

Today the S&P Case Shiller Home Price Indices for April was released. Starting with the composite:






















A general observation is that the Pacific Northwest cities have thus far avoided the kinds of home price declines the rest of the country has seen. A look at Cleveland and Detroit show kind of a contagion effect, since neither of these cities had explosive run ups in their prices, but were hit with price declines anyways. Overall, looking at the composite its obvious there is still a ways to go.

Delinquencies Soar

The headline should be of no surprise and neither should the article that discusses it. Americans have all become enchanters over the past decade, but they are casting the illusions upon themselves.

How did we accomplish this?

Through the miracle of spending money that doesn't exist, so in this sense we are also alchemists. Taking on more debt, spending "equity" from inflated home prices and not saving is the scam Americans have pulled on themselves. In the entire course of history, no single group of people have fooled themselves in such splendid form.

To think such destructive behavior would go unpunished in the future is even more delusional than the original act, but the consequences are arriving, a natural correction of unbalanced forces, the retracting of dynamic opposites; yin and yang. This should not be feared, but embraced. The quicker the adjustment is accepted, the sooner this chaotic moment in time will pass and a reversion to the mean can be obtained.

New Crisis Threatens Healthy Banks:

"We are not finished with the mortgage problem, but you are starting to see increased delinquencies in other forms of consumer debt," said Paul Kasriel, an economist at Northern Trust Securities. "We are in the eye of the hurricane. We had the first wave of the credit crisis, and it was quite damaging. But there's another wave coming, and it's likely to be as destructive."

The institutions most at risk in this new phase of the credit crisis are regional and local banks, many of which stayed away from subprime mortgages. These firms are key drivers of economic activity in communities across the country. Without them, consumers would lose a source of personal loans. Small businesses would struggle to stay afloat. Construction companies often can't finance local projects without these banks."

I question the soundness of regional and local banks, for example National City, Keycorp and Fifth Third all proved just as poisonous as any of he money center banks. With regards to home equity lines:

"For lenders, there is little recourse when a home-equity loan defaults or a homeowner declares bankruptcy. They can seize the collateral for the loan, in this case the house, only after the primary mortgage is paid off.

From October to March, $6.7 billion in home-equity loans became delinquent, increasing the total by 45 percent, according to SNL Financial. The delinquency rate is now 2.24 percent, according to the FDIC, which began tracking the data in 1991.

Losses at banks are going up as a result. J.P. Morgan Chase absorbed $450 million of home-equity-loan losses in the first quarter, up from $248 million in the previous quarter. It said its total home-equity losses could double by the end of the year.

Smaller banks have even more exposure to such loans. Overwhelmingly, the institutions that hold the most home-equity loans are regional banks, such as SunTrust Banks and National City, according to Fitch Ratings.

Late payments and defaults in every other major category of consumer debt also rose in the first quarter, the American Bankers Association reported. Auto loans issued through car dealers have a delinquency rate of 3.13 percent, the highest since at least 1990, according the ABA.

"The rise in consumer credit delinquencies is consistent with a rapidly slowing economy," said James Chessen, the ABA's chief economist. "Stress in the housing market still dominates the story, but it's a broader tale of an overall weak economy.""

But this is only one piece of the puzzle and unfortunately equity extraction has accounted for a good bit of consumer spending over the last decade, this trend will not persist much longer.

"Businesses are also feeling the pain of relying too much on credit. Construction and development loans, a specialty of regional and local banks, hit a delinquency rate of 7.18 percent at the end of March, the highest in 14 years, according to the FDIC. In October, the rate was 3.22 percent.

The trend worries regulators. "Right now, too many community bankers are having too hard a time coming to grips with the problems that have emerged in their commercial real estate portfolios," Comptroller of the Currency John C. Dugan said in a speech last month.

In the Washington area, home-equity and commercial real estate loans represent a significant share of the banking business, and the trouble in these two areas is a source of deep concern, said Peter Fitzgerald, a former U.S. senator from Illinois who founded Chain Bridge Bank in McLean.

"The banks around here all have an extraordinary concentration in real estate," said Fitzgerald, adding that his bank has followed conservative lending practices since opening in August. "And what will happen is you will have some economic Darwinism. The banks with the strongest balance sheet will not only survive but will go on to prosper."

Consider these CMBX Loss Estimates for a better idea of where CRE is headed. Given that defaults are already so high and a "stressful environment" is only in its beginning phases, those loss estimates quite potentially not high enough.

The Week Ahead

A lot of activity this week in economic data releases, Economic Calendar: Bloomberg.

Bond Insurers Making Plenty of Headlines

Rather than reiterating what others have already labored very well over, here are links to the plethora of information that has been developing recently on the bond insurers, specifically MBIA and Ambac. For a recap of all of my writing on bond insurers see Debating the Monolines. A heads up, today Moody's finally gave in and downgraded MBIA (harshly), which completes the trifecta of downgrades and now countless write downs will ensue from money center banks.

First up is from Mish, Bloomberg: Ackman Was Right on MBIA Ambac

Absctract:

"Clearly the S&P stress scenario is a farce. Ambac (ABK) set aside a mere $2 billion for $47 Billion of guarantees on CDOs backed by subprime mortgages. MBIA (MBI) set aside a mere $2 billion for $51 Billion of guarantees.

A stress test loss in the current environment would have to assume losses of at least 33% or ($15.7 billion minimum each)."

Naked Capitalism has done a whole series on this, extremely detailed and well worth your time. In chronological order from oldest to most recent:

First, MBIA Refuses to Downstream Cash, Uses CDS Fears to Defy Regulators

Abstract:

"Let me tell you, if we have a revolution in the next decade, one of the triggers will have been the flagrant disregard shown by big players like MBIA for regulations, legal commitments, and fair dealing. I'm not surprised to see financially oriented sites calling for mass protests (but not yet against bond guarantors).

The latest bit of MBIA chicanery manages to sink far beneath the already low standards set by the bond insurer. Readers may recall that MBIA had refused to downstream $900 million raised in highly dilutive equity offerings to its insurance subsidiaries (note it had raised $1.1 billion, all of which was initially slotted to go to the subs, then when it was revealed that the money was still in the holding company, said in early May that they would remit $900 million to the insurance ops, then in early June basically said that they had changed their mind)."

Next, Ambac Tells Nasty Fitch to Go Away as Shorts Vindicated

Abstract:

"Well, Ambac seems to be resorting to a strategy popular among those in denial:rather than admit you need to lose weight to stave off a heart attack, throw away the scale instead.

Ambac has decided to fire Fitch as one of its rating agencies. And why is that? Well, Fitch had the bad taste to bite the hand that feeds it (remember, fees are paid by the companies) by issuing ratings that are somewhat more candid than Standard & Poor's and Moody's. Fitch was the first to downgrade Ambac to AA (although the newly-established Moody's indicative rating scale, which shows the rating implicit in credit default swap spreads, shows both MBIA and Ambac to be junk credits)."

Then, MBIA Lies in Attack on NY Times

Abstract:

"Let's get real here. Dinallo was worried enough about the future of the bond insurers to try to organize a rescue in the amount of $15 billion total for MBIA and Ambac, and their subsequent fundraisings fell vastly short of that number. The fact that he has looked into the swaps issue in this level of detail says he still sees risks. If MBIA has not been able to persuade either its regulator or its rating agencies, who presumably see more detail than the monoline presents in its public filings, that all is well, why should the greater public believe their assertions?"

Continuing, More on the MBIA/NYT Slugfest

Abstract:

"Most observers believe the monoline business model is dead, between the changes in muni bond rating procedures that are being forced on the rating agencies (ie, no more free lunches by insuring credits that were better than the rating agency marks suggested they weret) and the entry of Warren Buffet, who has an uncontested AAA, vastly more capital, and unlike the monolines, has very successful insurance operations that take real risks. Buffett will cherry pick the best risks (that's Ajit Jain's the head of his insurance op's MO); good luck to anyone who'd go up against them (and that's even assuming a new MBIA sub could get an AAA, particularly if required to reinsure the existing exposures on the current muni book, which Dinallo indicated was something the wanted)."

Almost there, On the MBIA, Ambac Downgrades; Regulatory Comments on MBIA

Abstract:

"As readers probably know by now, Moody's, the last holdout on the AAA rating for the two big monolines MBIA and Ambac, downgraded both companies earlier today, and more harshly than Standard & Poor's. And even with this downgrade, it underscored that more cuts are likely to be in the offing"

Finally, MBIA Downgraded Increases Collateral Requirements; Clarification on CDS Acceleration in Insolvency/Custodianship

Abstract:

"Did MBIA's downgrade impair as much as 25% of its claims-paying resources? Consider these statements, the first from a letter from MBIA yesterday on the Moody's downgrade of its insurance sub from Aaa to A2 (hat tip to Jason for a useful question):"

I highly recommend reading all of the NC articles to really get an understanding of the intricacies.

This one from Merkel more on the ratings system and the destruction of business that results from downgrades, Downgrades Come Easy, Upgrades Come Hard, Upgrades to AAA? - Forget About it

Abstract:

"We’re not quite to the endgame yet, but the jig is up for MBIA and Ambac, after the downgrades from Moody’s at the holding companies to Baa2 and A3 respectively. Wait, why I am I mentioning the holding companies? Isn’t it the operating subsidiaries that matter?

Well, yes, for sales and regulatory purposes, but the ratings at the holding companies matter for a different reason — notching. But let me tell a story first."

...

"Once your insurance operating subsidiary is downgraded below AAA/Aaa, there are many classes of business that cannot be written anymore. Revenue dries up. What’s worse, is that the rating agencies no longer have any practical reason to not downgrade further; the revenue model is broken for the rating agencies, and if there are highly rated new entrants, there is no reason to care about the company; the industry will survive, and the rating agencies will get fees."

So there you have it, the monoline recap.

Bear Stearns Hedge Fund Managers Indicted; A Red Herring

I was astounded when I heard Charlie Gasparino report on famous cheerleader Larry Kudlow's show (in all fairness to Kudlow, I am an avid watcher of his show). You can view the video here, but it is only referenced for its topic, hardly any discussion worth hearing from this particular one. So why was I astounded?

The Blame Game

Ralph Cioffi and Matthew Tannin, former hedge fund managers at Bear Stearns, are being indicted on criminal charges for having "inside information" with regards to the sub prime collapse in 2007 and still allocated client funds to these investments.

I'll agree with Kudlow, these two are scapegoats. Somebody has to pay so we can all move forward with our perfect lives. However, they've got the completely wrong guys. The real culprit has been in the headlines for years now and is the sole proprietor responsible for the real estate/credit crisis, in fact there is a blog partially devoted to his injustices:

The Mess That Greenspan Made:
How Eighteen Years Of Easy Money Have Changed The World

Greenspan was the cheerleading architect of this whole mess. He is the "official" who left interest rates at 1% for far too long, which by the way was too long before they even got there. Keeping nominal rates below the inflation rate was incredibly dangerous, and now were facing the consequences. To say the least, if you give a mouse a cookie, he's gonna drink your freakin milk dumb a$$. And that's exactly what happened. He condoned adjustable rate mortgages and the "ownership society", brushing aside the hazards of large deficits. The worst part is he fully understood the consequences of his actions, but was manipulative and unethical not to at least warn about it. From Empire of Debt, in a Scotland speech he gave in 2005:

"The growth of home mortgage debt has been the major contributor to the decline in the personal saving rate in the United States from almost six percent in 1993 to its current level of one percent,"
...
"The rapid growth in home mortgage debt over the past five years has been "driven largely by equity extraction,"
...
"Approximately half of equity extraction shows up in additional household expenditures, reducing savings commensurately and thereby presumably contributing to the current account deficit...The fall in U.S. interest rates since the early 1980's has supported the home price increases," (p.258-259)

So there you have, just as good as a signed confession. The crime(S):

• Masked inflation, the likes of which this world has never known
• Malinvestment from artificially low interest rates
• The cheerleading of home ownership, even for those who had not the income
• The deception, for knowing all this and keeping quiet
• Dodging the business cycle, eventually it catches up and it's consequences will be worse than before
• Lax oversight of financial firms and innovation, from which the Maestro surely saw the danger, but instead chose to cheer, like with the use of derivatives
• Now negative personal savings thanks to Greenspan's disincentive to save
  

The list could go on, but I fear carpal tunnel might bestow me. Why is it that two numskull hedge fund managers are being indicted when it is clearly Greenspan who was the mastermind of America's disastrous policies over the past 20 years. It should be him facing criminal charges for this terrible injustice, which should immediately be followed by the abolition of the Fed and immediately a move back to the gold standard should be made.

Real Personal Income

State personal income for Q1 2008 which was released today and this chart eye candy came along with it:

"U.S. personal income grew 1.1 percent in the first quarter of 2008, after growing 1.2 percent in the last quarter of 2007, according to estimates released today by the U.S. Bureau of Economic Analysis. Across states, personal income growth ranged from 7.6 percent in North Dakota to -1.9 percent in Arkansas.

The unusually wide range of state growth rates is largely a consequence of rising grain prices. Corn prices jumped 22 percent in the first quarter, while wheat prices rose 18 percent and soybean prices 17 percent. This added 6.4 percentage points to personal income growth in North Dakota where the farm sector is predominantly crop production. At the same time, the higher grain prices, which raised expenses for livestock growers, reduced personal income by 1.0 percentage point in Arkansas where the farm sector is predominantly poultry.

Nonfarm growth. Nonfarm personal income growth rates ranged from 2.5 percent in New York to 0.9 percent in Arkansas. Performance bonuses for 2007 (paid in 2008Q1) in the finance industry accounted for New York's strong personal income growth, more than double national nonfarm growth. Because many of the recipients of the bonuses live in Connecticut and New Jersey, personal income of those states was boosted slightly as well.

...

Nonlabor income. Property income grew 0.5 percent in 2008Q1, down from 1.5 percent growth in 2007Q4. The deceleration reflects a combination of lower interest rates and a tapering off in federal subsidies for reconstruction related to Hurricane Katrina in Louisiana and Mississippi.

State unemployment insurance benefits grew 6.9 percent nationally in 2008Q1, following a 2.1 percent increase in 2007Q4. Geographically the picture is mixed: unemployment insurance benefits fell 0.2 percent in the New England Region and rose 18 percent in the Rocky Mountain Region. Two states, Florida and Nevada, stand out from the rest. Unemployment benefits rose 25 percent in Florida and 23 percent in Nevada in 2008Q1 and have now reached a nominal level comparable to that which prevailed in those states during 2002-03 when the U.S. was recovering from the last recession."

A definition of,

"Personal income is the income received by all persons from all sources. Personal income is the sum of net earnings by place of residence, rental income of persons, personal dividend income, personal interest income, and personal current transfer receipts. Net earnings is earnings by place of work (the sum of wage and salary disbursements (payrolls), supplements to wages and salaries, and proprietors' income less contributions for government social insurance, plus an adjustment to convert earnings by place of work to a place-of-residence basis. Personal income is measured before the deduction of personal income taxes and other personal taxes and is reported in current dollars (no adjustment is made for price changes)."

An obvious observation is that real personal income is negative even using the absurdly low BLS data. All items compounded over the last 3 months add up to 4.9% inflation (May CPI), and that doesn't even count the whole quarter, in which personal income grew at 1.1%. Americans are losing purchasing power big time. I'm curious to know if stimulus checks were factored in that income observation, but negative real wages is no recent development, Disposable Personal Income (I know, I switched up metrics on ya) and CPI All Urban Conumers:



Since 2000, even the BLS's "mildly" understated CPI index has outpaced disposable personal income over the same time period. If you're wondering why CPI is so understated (outside the obvious exclusion of food and energy), a single word can explain it; hedonics,

"In CPI calculations hedonic regression is used to control the effect of changes in product quality. Price changes that are due to substitution effects are subject to hedonic quality adjustments."

For example, computers are often used in hedonic adjustments. Even though the price of computers may be rising, hedonics say the quality is now improved, so price increases are adjusted down. The same concept is used in productivity, where it gets increased (dramatically) because of improved computing ability.

Some very curious points are made in bold and italic from the personal income release. Despite all the woes of the financial sector, bonuses are still out of control. I questioned the impact of bonuses in The Leverage Factor once already, some validation is made here.

It surprises me how well California and especially Florida are doing considering the monstrous real estate mess they're in.

Come 2009, deleveraging will be in full swing, possibly complemented with an Obama office Keynesian style recovery attempt and that map will turn more orange.

In summary, in the end we're all dead.

Debating the Monolines

It went away for awhile but now its back in the headlines, will the monolines survive? It's a worthy question to pose because their downfalls would be a major blow to banks. For regular readers of this blog, they know fully well I am predicting The Death of the Bond Insurers and The Consequences of Short Term Memory Loss can be severe. To make matters more complicated, MBIA Debt is Setting Up a Quandary:

"MBIA has written $137 billion in swaps, which are privately traded insurance contracts that let people bet on companies’ financial health. Most of these contracts stipulate that if MBIA’s bond insurance unit becomes insolvent or is taken over by state regulators, buyers can demand payment immediately.

But if that were to happen, MBIA would have far less money to pay policyholders and owners of municipal bonds backed by the company. So the swaps give MBIA significant leverage over Eric R. Dinallo, the commissioner of the New York State insurance department, who wanted the company to bolster its insurance unit with the $900 million in cash.

In the case of Bear Stearns, the Federal Reserve feared that credit default swaps might unleash a chain reaction of losses if the bank were allowed to collapse. Given the threat that similar swaps may pose to MBIA, Mr. Dinallo is unlikely to push for a regulatory takeover of the subsidiary even if Joseph W. Brown, MBIA’s chief executive, refuses to recapitalize the unit.

...

“I am trying to think carefully of what is the right use from a regulatory perspective for that $1 billion,” he said. “If they intend to take the billion and do some cut through reinsurance for the municipal side, I’d be very open to it.”

MBIA said it was working closely with Mr. Dinallo’s office and “would consider selected reinsurance opportunities” for its new subsidiary.

But others are not so sure. John Miller, chief investment officer at Nuveen Asset Management, a big municipal bond fund manager in Chicago, voiced skepticism about MBIA’s plans to start a new insurance subsidiary that could reinsure its existing portfolio.

“It would be surprising to me if it would be successful,” Mr. Miller said. “It will still be an MBIA-insured bond and then reinsured also by MBIA, but MBIA as a new company.”

The premise is simple; MBIA and Ambac are doomed. Considerations for losses tied to subprime investments have for the most part already passed and the bulk has been written off. The larger worries are ahead still. First off, Think Things Are Bad? Wait till the States Cut Back. That's right, municipals are in trouble, which will surely increase claims to that $670 municipal bond insurance business. If you don't believe me just look at the facts; Muni Defaults Triple:

"The amount of municipal bonds that have defaulted this year is already more than triple what it was for all of 2007.

And who could doubt there's more bad news on the way?

So far this year, $736 million in municipal bonds have defaulted. That doesn't necessarily mean they didn't pay investors; they may have just drawn down reserves. That's what happens just before they stop making payments to bondholders."

There's no sugar coating this one, losses will increase to the already capital hindered and highly leveraged MBIA. Tom Brown thinks otherwise, he's a bull on bond insurers. I've brought up Brown before in The Great Real Estate Debate, in which he was right, sub prime is not the biggest issue anymore, but he misses the big picture and what lies in the road ahead, and that is Alt-A, Option ARM's and HELOC's, in which Brown recognizes the insurers huge exposure, just not the potential losses; from The Bond Guarantors Need $200 Billion? No Way?:

"That leaves the insurers’ structured finance exposure at $900 billion. Of that, remember that not all insured paper is mortgage-related securities. And remember, too, that of the mortgage-related paper, not all is subprime. Again, no one is looking for a crackup of structured finance paper in general. The problems are with bonds backed by subprime mortgages, Alt-A loans, home equity, and closed-end seconds. The combined par value of that paper that’s backed by the guarantors came to $489 billion at the end of the third quarter, according to BCA Research.

So the guarantors’ subprime truly at-risk exposure is considerably less than $900 billion. And regardless, in the event of default, the subordination—extra collateral—already embedded in the securities will take the first loss. Beyond that, the guarantors will generate some recoveries in foreclosure.

But even if all the subordination in all the securities gets burned through in a heartbeat and recoveries are a pittance, guarantors exposure still won’t be anywhere near $200 billion. Here’s why: when an insured CDO goes into default, the insurer is not obligated to repay its principal immediately. Rather, it simply has to make interest and principal payments over the CDO’s remaining life. In many cases, that could take decades. Between now and then, the insurers’ payouts will consist of relatively modest annual payments spread out over many years. The present value of those payments is a tiny fraction of the face amount of the defaulted securities."

Refer back to all of my previous posts on the insurers and reference the Pershing loss estimates cited. MBIA and Ambac have to deal with losses on CDO's, ABS, HELOC and second mortgages, CMBS, reinsurance and below investment grade exposures, coming to a combined $13.5bln in estimated losses. That figure is only 2.8% of that $489bln Brown cited, so losses could even be worse. Many of these losses have only begun to mount in 2008 and will continue most likely through 2011. How many times will investors come to their rescue with new capital? Most importantly, their credibility to obtain new business is completely shot! How is $900mln going to be adequate?

All of my previous bond insurer posts for your convenience:

The Death of the Bond Insurers

The Consequences of Short Term Memory Loss

Ambac "Surprises" with Huge Loss, Bond Insurers Revisited

The "Earn and Burn" Managment Style

A definition of the titled phrase will ensue, but first a primer; AIG Ex-CEO Severance Seen As High $68mln: Analyst,

"American International Group Inc's (AIG.N: Quote, Profile, Research, Stock Buzz) former chief executive, Martin Sullivan, who stepped down on Sunday amid large subprime losses, could receive up to $68 million in severance pay and benefits, according to an estimate compiled by an outside research firm.

Corporate governance firm The Corporate Library on Tuesday said Sullivan -- who was replaced by Chairman Robert Willumstad as CEO on Sunday -- could receive up to $2.5 million in salary, $26.6 million in bonus payments, $14 million from a defined contribution plan, $21.9 million worth of stock awards, $3.3 million in pension benefits and $32,316 in medical and life insurance coverage, according to a report by research analyst Alexandra Higgins."

This is not a new topic, exorbitant CEO compensation has been making headlines for a very long time now, and it is certainly not the regulators job to chime in and dictate what a man should or should not earn and I will never favor that kind of proposal. However there is a point of ill contempt. Since when should any man be exponentially rewarded for failure?

What is lacking in executive compensation is a fair system of performance based incentive; instead the performance metric was wiped from that concept. After all, isn't performance this man's primary function? Does he not have an obligation to the shareholders of his enterprise to respond to? I've pondered into this issue before in Say on Pay, where shareholders were given consideration on deciding pay, however there are problems with that system as well.

I can't help but imagine a corporate world in which there existed great consequences for its governance. Imagine big execs that only earned a small fraction of the colossal earnings they are now racking up while simultaneously having to work damn hard to earn them. Positive consequence of this:

• The "earn and burn" CEO would most likely disappear. This is the exec that earns a big pile of income over a relatively short period of time usually on "cooked" earnings that makes him look much more effective than in reality. This...
• short term "earn and burn" tactic matters not in the long run the the short lived CEO, since he already robbed shareholders blind on poor performance and left on favorable terms compensation wise. But if...
• executive compensation were not initially already so generous, despite the prevailing business conditions (good or bad), incentives would be aligned much differently and extra capital would be freed up, in some cases enough to pay a fairly respectable dividend. And...
• management would now be fighting for long term viability of their position, which is in the shareholders interest, because now the exec can no longer retire most comfortably from his losings and instead would have to build an empire like it were his own company to achieve the ultimate glory. Finally,
• Only after a reasonable and proven tenure with a business should a CEO be rewarded with such princely jewels and by that time he will most likely have a very definite emotional attachment with the firm since it was his hands that laid the brick. His mane will ruffle with pride.
  

Returning to the article:

"Sullivan is the latest in a line of executives who have resigned from their firms after large losses from subprime investments. AIG has, over the past two quarters, written down more than $20 billion in assets linked to subprime mortgages."

$20bln in write downs and a stock that has performed as such over the past year. Yeah I'd say he earned that generous termination benefit (biting sarcasm).

CMBX Loss Estimates

I recently came across a Global CMBS Newsletter from DBRS and since I've been diligently following commercial real estate and CMBS, I'll share their findings. You can reference the newsletter for how they contrive the data, but here I'll only display the tables I found rather striking, following indices from 2005 to 2008:

This first chart assumes moderately stressed economic factors (click on image for larger picture)

It's stunning how great the losses are for low rated trenches. But the next table adjusts for an environment of increased stress


A final note from DBRS:

"As borrowers continue to report and servicers spread YE2007 financials, it will be interesting to see how lengthy the watch lists become with cash flow shortfalls and DSCR declines. DBRS expects that upticks in delinquencies and perceived declines in performance from not meeting underwritten projections will prompt additional ratings volatility in these transactions. Just how severe and broad-brushed will the downgrades be? In a subsequent newsletter, DBRS will report on the perceived downgrade risk given DBRS’s loss results and help navigate the early warning signs of a downgrade."

My guess is, cash flows will continue to significantly decline parallel to rising delinquencies.

Hoover Reincarnates

It's very sad to report, but this from Mish's blog:

"In the wake of the housing crash, "tent cities" have been springing up in several places in California. The story is not that new. However, it has not received much mainstream press. Therefore, many are unaware this is even happening."

I encourage everyone to read the entire article and watch the videos. The likes of this has not been witnessed since "Hoovervilles" were common during the Great Depression, which is a frightening thought to entertain.

The Employment and Real Earnings situation is far worse than BLS numbers suggest in their unreality reporting.

Stock Yields are Low

I've already warned once The Market is Overvalued, and with 2008 Q1 Corporate Profits coming in at low levels with anemic capital investment and bloated inventory, the "P" is only going to get larger relative to the "E".

The market will eventually catch on to this and vote against the "P", sending it more in line with historical P/E levels. I gave a Friday 13th CPI Breakdown, in which I tried to explain how imports and their prices have ballooned since 2007, which have for the most part been reflected on the producer side and now Stocks In US Show Negative Return on Inflation Gain:

"Surging commodity prices have eroded earnings and spurred the Federal Reserve to consider raising borrowing costs just as equities are trading at their most expensive in four years. Standard & Poor's 500 Index shares yield 0.22 percentage point more in profits than the interest on 10-year Treasury notes, the smallest advantage since 2004, data compiled by Bloomberg show. The last time corporate earnings returned less versus bonds, the index posted its first quarterly decline in more than a year.

The 44 percent advance in oil, 72 percent jump in corn and 41 percent climb in rice pushed the UBS Bloomberg Constant Maturity Commodity Index to a record this year. That's squeezing profits as raw-material costs outpace consumer prices by the largest margin since the 1970s. Companies in the S&P 500 will earn 7.7 percent less in the second quarter than a year ago, according to analysts' estimates compiled by Bloomberg.

...

The S&P 500 has slid 7.6 percent since December, the biggest year-to-date decline since 2002. Almost $400 billion in losses tied to subprime assets and the collapse of Bear Stearns Cos. sent the gauge to its worst tumble in seven years in the first quarter. After rebounding in April, the index fell 4.7 percent on concern record fuel and food costs will force the Fed to lift interest rates even as the economy sputters. Yields on 10-year Treasuries jumped on June 13 to the highest level this year.

Rising bond rates make the payout from fixed-income investments more competitive with stocks. S&P 500 companies yielded 4.28 percent in reported profit versus their share prices last month, compared with 4.06 percent from 10-year Treasuries, data compiled by Bloomberg show. The last time the gap between the so-called earnings yield and government bonds was narrower was in May 2004. A quarter later, the S&P 500 lost 2.3 percent.

...

In the U.S., valuations have climbed as earnings of S&P 500 companies fell faster than shares."

Samuel L. once said "Hold on to your Butts"; heed his advice. Why?

MWS's Periodic Economic Reality Report:

• The consumer is dying and Option AMR's are beginning their what will be legendary rampage of resets during the Drying of the Credit Well where federal recognition of the coming Commercial Real Estate problem was finally addressed

• The Consequences of Short Term Memory Loss teach us not to forget our dear friends the monoline insurers, as their downgrading from rating agencies will trigger a wave of massive write offs

• Thanks to the GSE's, potential home buyers still have the opportunity to have No Money Down Now, No Money Later
  

• Consumer Debt Carries Ahead, ignoring completely the coming Gloom, Doom, and Despair that truly sends shivers down my spine as our "great" nation's debt obligations have grown to completely absurd and unrealistic levels that will one futures day mark the end of an empire, an inevitable fate (it does not mark the end of the US, just its role as an imperial power)

• Think the Economy is Bad? Wait Till the States Cut Back. This happens in July, and the Unemployment and Real Eearnings, that were so Abysmal for May will be much worse towards the latter half of 2008

• The Twilight in the Desert leaves little slack for a pullback in oil prices, although the Fed raising interest rates (unlikely), slowing global growth and the recent subsidy cuts in China should (in theory) ease demand and upward pricing pressure in a tight environment

• Finally, Existing Home Sales are terrible and inventory is still rising
  

That's a lot to worry about...stocks will be voted upon harshly over the next year, with bears dining on USDA prime beef.

Most importantly, take every word financial CEO's, Fed chairman, prominent political figures and other worthless cheerleaders have to say with a grain of salt as not one prediction they have made has been in line with reality.

Hidden Gems

There has been a whole lot of noise in the market over the past year, which may be the understatement of the century, just look at volatility in crude for God's sake. I write about much of this noise mostly in a fundamental sense and the tone anyone reading will get is less than optimistic, but don't get the wrong impression, investing in stocks that represent excellent quality companies with a long term emphasis is my motto.

The Fallen Shall One Day Rise Again

For example, a close friend of mine brought to my attention Lloyds TSB Group plc LYG* (thats right, this is in the banking sector). Here is a snippet from the key statistics:

(click on image for clearer picture)

Positive Stats (somewhat generic, but useful):

Forward Div Yield of 14%
Low P/E of 6.09
More cash on hand than total debt
ROE of 22.46%
High profit and operating margins

Makes for an intriguing starting point


From the LYG 20F Annual Report:

"US sub-prime mortgage Asset Backed Securities (ABS) and ABS Collateralised Debt Obligations (CDOs)

Lloyds TSB continues to have no direct exposure to US sub-prime mortgage Asset Backed Securities and limited indirect exposure through ABS CDOs. During the first quarter of 2008, the market value of our holdings in ABS CDOs was written down by £5 million, leaving a residual investment of £125 million net of hedges.

The Group’s residual investment of £125 million is stated net of credit default swap (CDS) protection totalling £406 million purchased from a ‘triple A’ rated monoline Financial Guarantor. At 31 March 2008, the underlying assets supported by this protection had fallen in value, leaving a reliance on the CDS protection totalling £187 million. During the quarter, the Group has written down the value of this protection by £58 million. In addition, at 31 March 2008, the Group had £1,972 million of ABS CDO’s which are fully cash collaterised by major global financial institutions. During April 2008, this exposure reduced by £566 million, or 29 per cent, following the sale, at cost, of an ABS CDO."

"Available-for-sale assets

At 31 March 2008, the Group’s portfolio of available-for-sale assets totalled £23.2 billion. A significant proportion of these assets (£7.9 billion) related to the ABS in Cancara, our hybrid Asset Backed Commercial Paper conduit. Over 99 per cent of these ABS remain ‘triple A’ rated by both Moody’s and Standard & Poor’s. Cancara, which is fully consolidated in the Group’s accounts, comprises £7.9 billion ABS and £3.9 billion client receivables transactions and is managed in a very conservative manner, which is demonstrated by the quality and ratings stability of its underlying asset portfolio. Cancara has continued to fund itself satisfactorily without having to utilise the Group’s liquidity backstop facility.

The balance of the Group’s available-for-sale assets includes £3.1 billion Student Loan ABS, predominantly guaranteed by the US Government, £7.4 billion Government bond and short-dated bank commercial paper and certificates of deposit and £4.8 billion major bank senior paper and high quality ABS. These available-for-sale assets are intended to be held to maturity and as a result, under IFRS, they are marked-to-market through reserves. During the first quarter of 2008, a net £740 million reserves adjustment has been made to reflect the fact that, whilst not currently impaired, there has been a reduction in the value of these assets. This adjustment has no impact on the Group’s capital ratios."

"Trading portfolio

In the first quarter of 2008, Corporate Markets saw a reduction in profit before tax of approximately £278 million as a result of the impact of mark-to-market adjustments in the Group’s trading portfolio, reflecting the market-wide repricing of liquidity and, to a lesser extent, credit. At 31 March 2008, the trading portfolio contained £200 million of indirect exposure to US sub-prime mortgages and ABS CDOs."

"Valuation of financial instruments

Within our Wholesale and International Banking business, exposure to assets held at fair value through profit or loss using unobservable market inputs totaled £1.3 billion, at 31 March 2008, of which £0.7 billion related to the Lloyds TSB Development Capital portfolio of investments."

I'd like to think of that as their equivalent of level 3 assets, but the good news is its share of total assets is under 1%, rather minuscule, which lessens uncertainty.

"Ratio of net write-offs during the year to average loans outstanding during the year 0.7%"

"Risk asset ratios (unaudited) 2007

Total tier 1, 8.1%

Total tier 1, excluding innovative capital instruments* 7.3%

Total capital, 11.0%"

Summary

This is not a comprehensive analysis, but only an analysis of certain problem areas that have persisted among major banks and brokerages specific to LYG, and the results seem to indicate that LYG maintained conservative and prudent investment and underwriting. They had the good sense to invest little in the sub prime sector that so many other financial institutions have been plagued with, only £125 million after hedging is relatively small and not of too much concern if those investments deteriorate. What is of concern though, is that £470 million is hedged by monoline insurers (which ones aren't disclosed) and as I've mentioned before, The Consequences of Short Term Memory Loss can be great, in which I discussed the impact of write downs from the down grading of the monolines. Yet, this still is only a small portion of their overall business and the "bath" would be quick and it's effects short run.

A bit of concern may rise over their Alt A and CMBS exposure, and you all know how much I've been warning about CMBS in the coming future. However, once again, this business has over £350bn in assets, and LYG so far has proven wise judgment in their investment exposure , so I will give them the benefit of the doubt here that their ABS exposure here, which is almost 100% AAA/Aaa quality (taken with a grain of salt), is safe going forward, though it is certain at least some write downs will be incurred going forward, but still this area is a relatively small part of their business.

Without a doubt, personal mortgages are the largest business line with respect to overall assets, clocking in at about 30% of total assets. But again, unless LYG is being dishonest in their reporting, the quality of issuance seems superb. I must rehash:

"Ratio of net write-offs during the year to average loans outstanding during the year 0.7%"

This is very low and satisfactory. Total write offs during 2007 were £1,542mn, which applies to the £209,814mn of total loans outstanding. However, what I could not find as of yet were 30, 60, and 90 day delinquency rates for these loans, which would most definitely provide some clarity with regards to how honest management is being about write offs they are taking now relative to what they should be taking.

Author's Opinion

As stated before, this is an incomplete analysis specific to risky controversial current market conditions for LYG. In my opinion if surprises do arise in the future, the impact will be light and more debt issuance or capital raising efforts most likely won't be necessary. LYG appears to have an excellent and prudent business model and has thus far exercised fine judgemtn with their limited exposure to problem real estate areas . The (generic) valuation metrics suggest this company is on sale and high yielding. Fortunately for the investor interested in the financial services and banking sector, the market has no love here, only fear. So waiting a bit longer to see how financial conditions of LYG progress as more economic disasters of the present market unfolds and how and if it affects LYG most likely wouldn't result in a missed opportunity.

*I do not have any position in this stock, nor is this a recommendation to buy shares of this company. The purpose of this is for discussion purposes only and any decisions made as a result of the information of this article are at your own risk, I recommend seeking professional investment advice for any investment considerations.

Friday 13th CPI Breadown

Before I get started in analyzing today's May CPI release, consider this chart from The Big Picture:

Also consider what Scott Black President of Delphi Management commented on inflation and banks and their books:

CPI -

"im not a big believer in core inflation, that was a manifest created in the Johnson Administration"

Banks & Brokerages -

"Overall the financial services sector is still expensive...we don't know what the "E" is...we don't really know mark to market what the books are...another $200 - $250bn to go (in write downs)"

"Triple Edged Sword"

"Leveraged loans marked to low"

He's referring to rising delinquencies and foreclosures in regular mortgages and credit card defaults. Any investor who suspects deceit in CPI number is on my list of people's who's opinions I respect.

(click on image for video)

Ok, back to May CPI, here's the headline release, which is complete absurdity:

"On a seasonally adjusted basis, the CPI-U advanced 0.6 percent in May, following a 0.2 percent increase in April."

"The May level of 216.632 (1982-84=100) was 4.2 percent higher than in May 2007."

Since I don't trust this blasphemy, I'll use imports and exports indexes to try and supplement more on price inflation, all data from:

U.S. International Trade in Goods and Services, APRIL 2008

U.S. Import and Export Price Indexes


Upon first glance of these charts the pattern is easily visible, imports exceed exports, especially in 2007 - 2008 as far as prices are concerned. Just looking at the huge jump in petroleum prices year over year should signal to the Fed that CPI is complete hogwash.

Also, when you hear commentators or economists cheerleading how much our exports have risen relative to a year ago then just bring up how much more our imports have risen relative to the same time frame.

In summary, inflation in the CPI is very much understated, but this is hardly a new revelation.

Drying of the Credit Well

Shocker...

Big U.S. Banks Have Tightened Loan Standards: Survey:

"The survey, covering a 12-month period ended March 31, examined trends in lending standards and credit risk at the 62 biggest banks regulated by the comptroller's office.

After four consecutive years of eased underwriting standards, the majority of the banks surveyed tightened underwriting standards for both commercial and retail loans," the survey said."

Well now, if this survey has been in place for that long, why no public announcement of illegitimate lending standards?

"Notwithstanding the recent overall tightening of standards, examiners anticipate that the relaxed underwriting standards of the past, coupled with current economic weaknesses, will result in increased credit risk and losses over the next 12 months," it said."

12 months is highly optimistic, this will continue into 2011 at least as 5-yr ARM's begin to reset, just look:





















Both of these chart are courtesy of Mish's blog, though the above graph I do not have a link to at the moment. I think these graphs seal the fate that credit tightening will persist for longer than 12 months.

But the following quote is the one that interests me the most as it foreshadows what I've been blabbing about since I started this blog and it was issued directly from the U.S. Comptroller of the Currency:

"Commercial real estate loans remain a "primary concern" for federal bank examiners because of the bank's significant concentrations in this area relative to their capital, the survey said."

Please see Commercial Real Estate Continued for details. Think sub prime was rough, wait until overweight commercial exposure crushes banks from the consumers that are being reduced to the walking dead (only relative to their previous out of control spending that persisted for far too long). Speaking of the dying consumer, Raising rates would be crazy, forecaster says, of interest...

""They've been ovespending for 10 years," he said. "It's wildly implausible" that consumers will be able to resume their previous standard of living now that the flow of cheap credit has been cut off.

Most U.S. recessions have been centered in the corporate sector, where millions of jobs can be slashed quickly to restore companies to profitability. "Companies correct quickly and painfully," he said. "Consumers correct slowly and painfully."

Shepherdson says the U.S. has never experienced this kind of consumer-led slump before. The closest parallel was the three-year recession in Sweden in 1990, which was three times deeper than the U.S. recession of the same time, he said."

Finally, as proof of this, Calculated Risk reported on Real retail Sales:

"Although the Census Bureau reported that nominal retail sales increased 2.1% year-over-year (retail and food services increased 2.5%), real retail sales declined 0.8% (on a YoY basis).

So despite the strong sales in May, the YoY change in real retail sales is still negative."

They point out this is all while much of the stimulus check has already been disbursed, which should have acted to bolster retail sales, but need a remind you of the University of Michigan Consumer Sentiment Survey:

"The University of Michigan consumer sentiment index dropped 2.8 points in May, according to final data. The index came in at 59.8, the lowest reading since June 1980."

Please fasten your safety belts we seem to be experiencing some turbulence...er wait it's technically not a recession since GDP is still positive (DOH!).

Retail Investors Are Finally Getting Wise to the Game

I have a gripe with mutual funds apparent from my article A Sea of Funds, a brief overview to for your consideration:

“There is a profound conflict of interest built into the industry’s structure, one that grows out of the fact that the management companies are independently owned, separate from the funds themselves, and managers profit by maximizing the funds under management because their fees are based on assets, not performance.”

"Over the 25 years from 1980 to 2005, the S&P 500 index returned an average of 12.3% a year. Over the same period, the average equity mutual fund returned 10% and the average mutual-fund investor (thanks to his regrettable tendency to buy the hottest funds at the top of the market) earned just 7.3%, five percentage points below the index."

"Yet fund managers profit margins are approximately 42% according to the Boston Group Consulting survey referred to in the article, hardly justified for the above lackluster performance for the mutual fund owners. And yet investors still flock to mutual funds, availing funds to unsustainable dollar amounts of assets under management, which can increase the chance of dismal performance"

It seems this trend is changing as the little guy finally catches on. According to Bloomberg Magellan Shows Peril of Active-Managed Stock Funds as Fees Bite:

"Outflows from these once best-selling U.S. mutual funds underscore the increasing reluctance of individual investors to pay managers to pick stocks, especially for subpar returns. Established names such as Magellan or Bill Miller's Legg Mason Value Trust are no longer enough to attract billions of dollars of investors' cash.

...

The pace of investments in index and exchange-traded funds run by firms such as Vanguard Group Inc. of Valley Forge, Pennsylvania, and London-based Barclays Plc has been accelerating since 2006. The funds carry fees that are at least 45 percent below those of traditional funds.

Actively managed funds attracted a net $88 billion in the 10-month period ended April 30, compared with $178.6 billion for index funds, data compiled by Boston-based Financial Research Corp. show. ETFs took in $127.9 billion in the same period, according to the Investment Company Institute, the industry's Washington-based trade group.

...

Index funds have average fees of $76 per $10,000 of invested assets, compared with $137 for actively managed funds, according to Morningstar. ETFs, which trade on an exchange like stocks, charge an average of $49 per $10,000."

It's a long article, but the big picture is easy to catch. In essence, the actively managed mutual fund industry has performed tremendously better than their clients, back to my article:

"IMAGINE a business in which other people hand you their money to look after and pay you handsomely for doing so. Even better, your fees go up every year, even if you are hopeless at the job. It sounds perfect.

That business exists. It is called fund management. Charley Ellis, a veteran observer, explains that fees in the industry tend to grow at around 15% a year because markets rise by an average of 8% and savings grow by 5-6%. This growth is being maintained despite the industry's vast size. According to a report by Watson Wyatt, a consultancy, the value of all professionally managed assets at the end of 2006 was $64 trillion."

I cheer retail investors for switching to the lower cost peers of mutual funds. Though myself choose to invest rather in individual stocks over mutual funds, I have and actively spent (loads!) of time learning and researching the art form, which for most people is too enterprising.

It is a sad day when greed trumps pride and ability, but that is exactly how actively managed funds have operated for far too long despite their years of experience and vast education. It is a positive sign to see the masses catch on, maybe this will spark a revolution among fund managers (I'll keep my fingers crossed).

Commercial Real Estate Continued

In keeping up with the commercial real estate story the Moody's Real Commercial Properties Price Index (CPPI) finally was updated for May.

Latest Results

"May 30, 2008 update: The latest results of the Moodys/REAL CPPI show a decrease of 2.3% in March for the all properties national index. All four national property sectors are down from their peak prices of 2007 (with peaks in different quarters of last year for different property types). Retail is down the most from its peak, -5.7%, while offices and industrial are down the least, by -2.0% and -2.3% respectively. Apartments are in the middle, with price declines of -3.4% since that asset type's peak a year ago in the first quarter of 2007."

Declines across the board, not surprising. Refer back to CMBS Are Next To Tumble and it is there you can learn of the imbalances of supply vs. demand in this market. I also predicted a rise in unemployment and since then the Data Extravaganza - Unemployment & Real Earnings disasters have come true.

Look back on the NY Times chart here. High unemployment is going to spur this commercial real estate drop big time; consumer spending will go on further and deeper life support, all negative for commercial space, especially the retail space.

Since banks and other financial institutions hold and trade CMBS, they will incur mark to market losses.

Cash Rules Everything Around Me (C.R.E.A.M)

From this title I will indulge in the complementary uses of financial statements, in this case the use of cash flow from operations (CFFO) to determine the quality of earnings. CFFO can be defined as:

Net Income + accumulated depreciation and other non cash flows +/- the change in net operating assets (NOA)

It is from this metric we can determine the quality of reported profits. The reason is that accruals can mask cash exchanges while reporting bloated profits at the same time. So if a company is consistently reporting large profits while at the same time reporting small or negative CFFO, there is most likely a disaster in the mix when a shortage of actual earnings comes to surface. To check:

Quality of Earnings = CFFO/Net Income

However, this does not mean earnings are to be completely mistrusted, but it involves much more in depth research to uncover their true potential, as using cash flows exclusively is less then optimal. The process I outlined in an article on another site called The Concept of Residual Earnings, keep in mind however that this valuation process is determined from using reformulated GAAP statements, where operations are separated from finances:

Discounted Cash Flow Analysis:

Free cash flow (FCF) is calculated easily by finding the difference between Operating Income (OI) and the change in Net Operating Assets:

(^NOA or NOA1 - NOA2) or FCF = OI - ^NOA

The FCF forecast model uses FCF now and estimates into the future discounted by the Required Return on Capital (RC). The RC is calculated using the stock's Beta, the risk free rate of return (usually 3 mo. t-bill), and a market risk premium (expected return on the market - risk free rate). This calculation is made however many years out the forecast is intended to extend to, maybe 3-5 years. So it looks like:

Value = FCF/RC + FCF2/RC2 + ..... + FCFn/RCn + CV

The last part of the formula, CV, is the continuing value, is an estimate of value for a finite forecast horizon of FCF's. It is calculated as follows: FCFn+1/(RC-1) or if you forecast FCF to grow at a constant rate then FCFn+1/(RC-g), where g is 1 plus the forecasted rate of growth in FCF.

The problem with using discounted FCF is that it does not measure value added. FCF is a measure of stocks and flows. The analysis charges this flow of money with the required return on capital. Assume a company makes a large investment and as a result ends a quarter with negative cash flow. Value is not derived from this figure and cannot be accurately forecasted, but in the long run there is potential value added from the cash investment. FCF does not measure this.

The Residual Earnings Forecast Model:

First, let's define residual earnings (RE); RE = Return on Common Equity (ROCE) - [RC * Common Shareholders Equity (CSE)]

So what does this measure exactly? This measures the return to shareholders above the required return on capital. The discounting process is the same as with FCF, where a CV is used at the end, but RE is used instead of FCF;

V = CSE + RE/RC + RE1/RC1 + ... + REn/RCn + CV.

One important note must be accounted for; this model can only be used when there is no debt recorded on the books. Otherwise debt acts to lever up ROCE, distorting real value added.

So here we have a cleaner forecast, one that determines whether value is being added in earnings. You can tell by the difference in ROCE and RC. If it is positive, RE will be positive and value is added. The opposite is true if ROCE is less than RC.

Again, debt distorts this forecast, in which a different formula will be needed, but I will not cover in this particular article. Also, beware of long forecasts, the longer the time horizon the more speculative in nature it becomes. For this reason, I do not forecast out beyond the current year and scrap the CV.

The point is financial statements are like a system of checks and balances, they must all be analyzed together to show where value is being derived from or if it is being manufactured by holes in GAAP accounting.

Without further ado, C.R.E.A.M:

The Consequences of Short Term Memory Loss

It wasn't too long ago that markets were in utter fright when news of the capital impaired bond insurers surfaced. I recently revisited the coming Death of the Bond Insurers, and the death will be painful, but markets have been smokin that stuff again and have paid no attention. The terms of the death was outlined today in the FT where Banks Face $10bn Monolines Charges:

"Citigroup, Merrill Lynch and UBS, the banks most exposed to Ambac and MBIA, could face further writedowns of up to $10bn after the bond insurers last week lost their fight to retain their triple A credit ratings.

Wall Street executives said they had been wrong-footed by the timing of the downgrades by Moody’s and Standard & Poor’s, saying they had not expected the rating agencies to take action for several months after affirming the triple A ratings of Ambac and MBIA in February and March.

“I think Moody’s jumped the gun,” a Wall Street executive said. “They and other credit rating agencies have been under pressure to anticipate developments, rather than lag behind the curve, and this looks like an attempt to do just that.”"

Excuse me Mr. Wall Street Executive, but you've obviously never read a financial statement or report in your life, I'll do you a favor and give you an example of what a financial hurricane looks like post quote.

"The banks have used the bond insurers to hedge holdings of complex bonds such as collateralised debt obligations and other mortgage-backed securities.

The prospects of further writedowns related to bond insurers, also known as monolines, could deepen concerns over the financial health of US and European banks.

Ambac and MBIA, which guarantee more than $1,000bn of bonds, raised cash earlier this year to prop up their capital bases, damaged by exposure to mortgage-backed bonds. Al-though concerns have eased that bond insurer downgrades could damage the entire financial system, there remains the potential for individual banks and investors to suffer further pain from Ambac and MBIA’s problems."

Ok, one final time we will revisit this death:

"Approximately $5.5 billion of MBIA’s on-balance-sheet debt will come due before year-end 2008, $8.5 billion before year-end 2009"

The following chart explains all:

If MBIA only raised $1.1bn this year and only plans on funneling $900bn of that into its bond insurance subsidiary, then death is imminent and it's about time the rating agency finally owned up to their alleged testicles.

Continuing with the article below...

"UBS, Citigroup and Merrill Lynch declined to comment.

Meredith Whitney, analyst at Oppenheimer, said in a report this week that UBS had the largest exposure to monolines of $6.3bn, Citigroup came second with $4.8bn and Merrill Lynch followed with $3bn.

The value of CDOs and mortgage-backed bonds has plunged amid soaring foreclosure rates in the US. This week, CDOs in default crossed the $200bn mark, according to specialist publication Total Securitization. Many of these bonds had triple A ratings when they were issued and large amounts were retained by banks.

S&P cut Ambac and MBIA to double A; Moody’s expects to downgrade Ambac to double A and could cut MBIA to single A."

From MBIA May 2008 10Q the company shows only $290ml in cash. Analyzing their assets and liabilities though is a bit trickier, which shows plentiful investment assets. But let's take a closer look, starting with a definition of level 3 assets:

"Level 3—Valuations based on inputs that are unobservable and supported by little or no market activity and that are significant to the overall fair value measurement. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. Assets and liabilities utilizing Level 3 inputs include certain MBS, ABS and collateralized debt obligations (“CDO”) securities where observable pricing information was not able to be obtained for a significant portion of the underlying assets; and complex OTC derivatives (including certain foreign currency options; long-dated options and swaps; and certain credit derivatives) and insured derivatives that require significant management judgment and estimation in the valuation."

and now...

(click on image for larger picture)

The note on the bottom of this picture is small, but very important;

"Level 3 Analysis

Level 3 assets were $7.3 billion as of March 31, 2008, and represented approximately 22.5% of total assets measured at fair value. Level 3 liabilities were $8.7 billion as of March 31, 2008, and represented approximately 90.7% of total liabilities measured at fair value."

MBIA doesn't even know what its liabilities are. There may be some disclosure, but its late and it would take considerable time to find (most likely not find). But my guess is these entries may serve as the debt MBIA guarantees.

This table only represents assets and liabilities of investments, debt and other liabilities is actually much closer to the value of assets, with little remaining in equity.

On a sidenote, Meredith Whitney is as intelligent as she is hot, if only every financial analyst was more like her;

No Money Down Now, No Money At All Later

After everything that has shed light on our battered housing and mortgage market, the Washington Post reports Mortgages With No Money Down Still Available:

"Despite the bursting of the housing bubble, it's still possible to buy homes with no money down. In fact, it's possible to borrow up to 105 percent of the purchase price, leaving the buyer with more debt than the house is worth.

It might sound like a pitch from a late-night infomercial. But the offer comes from Freddie Mac and Fannie Mae, two government-chartered companies with potentially conflicting mandates to uphold prudent lending standards and make homeownership more attainable."

Now that Freddie and Fannie are able to carry lower capital requirements and carry more debt I guess they figure everyone should.

"Without equity in their property, buyers could end up unable to refinance at lower rates or sell their homes if they need to move.

Although borrowers are sometimes required to show they have money in the bank to draw upon in a crunch, Freddie Mac said people can qualify for its no-money-down purchases with no cash reserves. However, borrowers must undergo homeownership education. Such programs can reduce delinquency rates by about 34 percent, the company said.

Freddie Mac allows home buyers to borrow more than the purchase price if they use a second loan, sometimes called a piggyback, from special lenders such as government housing agencies, nonprofit groups and employers.

Fannie Mae typically applies a similar requirement when home buyers borrow more than 97 percent of the price. The lender on the second loan may forgive that debt if the buyer stays in the home for five years, said Gwen Muse-Evans, Fannie Mae vice president of credit policy and controls.

The loans have performed well, she said.

Neither company provided delinquency rates for borrowers who put no money down."

Here's a thought, buyers who cannot afford a down payment should not own homes, period. This is just setting the already capital impaired GLE's up for even more failure. Read on, the two lenders even recognize housing prices will decline more and still have the balls to put low income people in homes with no money down and in some cases >100% leverage.

Pay special attention to comments from the article in bold, these are important highlights. Also, homeownership education is not going to help a borrower's financial situation, in which buying a home with no equity in a declining market will surely prove.

Finally,

"Even as it eased the requirement, Fannie Mae said in the news release that down payments "are a critical success factor in homeownership.""

This defies all logic and common sense, desperation is an ugly vehicle.

NAR April Pending Home Sales

Home Sales May Rise Modestly Before Broader Upturn In Second Half of 2008:

"The Pending Home Sales Index,* a forward-looking indicator based on contracts signed in April, rose 6.3 percent to 88.2 from a reading of 83.0 in March. It’s the highest index since last October, but remains 13.1 percent lower than April 2007 when it stood at 101.5."

Definition of The Pending Home Sales Index:

"The index measures housing contract activity. It is based on signed real estate contracts for existing single-family homes, condos and co-ops. A signed contract is not counted as a sale until the transaction closes. Modeling for the PHSI looks at the monthly relationship between existing-home sale contracts and transaction closings over the last four years."

Further elaboration into the PHSI:

"When a seller accepts a sales contract on a property, it is recorded into a Multiple Listing Service (MLS) as a “pending home sale.” The majority of pending home sales become home sale transactions, typically one to two months later.

...


Since pending home sales measure actual existing-home sales, the PHSI provides an accurate and reliable indicator of future home sales activity. Our sample shows that over 80% of all pending home sales go to settlement within a 2-month time-period (and a significant share of the rest close in month 3 and month 4).

...

Not all pending home sales go to closing. A certain percentage of properties that go under contract are cancelled (or fallout) before ever going to settlement."

The index goes back to 2001, which is why this increase may not be as predictive as previous years have shown, when home prices were rising and buyers and builders were flooding the market. My assumption is that cancellations will be higher because financing is harder to come by as lending standards have severely tightened and many banks are slow to lend since they will surely need the capital to weather further blows to their balance sheets.

More importantly, let's revisit the April Existing Home Sales; Inventory is now over 11 months supply and existing home sales are down over 17% year over year. Inventory rose last month from already preposterous levels as builders refused to quit building and buyers are scarce; this will only lead to further price declines. Add in record foreclosures and there exists a huge problem, never mind a few buyers in the West, the scope of whether or not these are speculators or home buyers is subject to suspicion.

This NAR headline is a joke! To predict an upturn in the housing market based on an increase in an uncertain number in one particular month is complete ignorance. Corrections on scale as large as this one don't happen this fast.

Lehman Raises Pricey Capital

As discussed before in Capital Raising Follies Continue, Shareholders Still Lose and Management Sounds Idiotic, Lehman is now confirming losses and capital raising efforts in excess of their previous estimates...odd for a company that doesn't even need to raise capital yet Lehman to Post $6.8 Billion in Quarterly Loss :

"The company (LEH 29.84, -2.45, -7.6%) said it expects to report a second-quarter loss of $2.8 billion, or $5.14 a share, compared to a profit of $489 million, or 81 cents a share, in the year-ago period.

...

Net revenue, representing total revenue less interest expense, is expected to be negative $700 million for the latest quarter, down from $5.5 billion in the year-ago period. The decline reflects negative mark-to-market adjustments and principal trading losses, net of gains on certain debt liabilities, Lehman said."

I already discussed these Accounting Shenanigans before, where companies report earnings from declines in the market value of their debt, when in fact no money has been earned.

"Lehman said Monday that it has priced $4 billion of that public offering of 143 million shares of common stock at $28 a share, with the remaining $2 billion coming from 2 million shares of 8.75%, three-year non-cumulative mandatory convertible preferred stock.

The offering figure also came in at the high end of estimates, according to recent reports heralding the efforts by Lehman to raise capital as its grapples with spillover from the credit crunch. See full story.

Analysts began taking aim at the size and quality of the offering early Monday, raising questions about what could potentially be a major dilution for shareholders and what further write-downs the bank might see.

"Management credibility is shot in our opinion." said Douglas Sipkin, an analyst for Wachovia Corp., in a research note. "The dilution from the offering is material and should pressure returns for a long time. The outlook for their credit likely improves."

Proceeds from the offerings will be added to Lehman's capital and used for general corporate purposes."

Damn right credibility is shot, they never should have had any in the first place since this is not the first time Lehman has been in the woods and every other major investment bank hasn't escaped these follies, why should Lehman have?

And come on, 8.75% convertible preferred! I can tell you straight up, corporate purposes might be the most vague, bullsh%t capital allocation I've ever heard of in my life. That's like saying I bought a Blue Ray for entertainment purposes... WTF else would it be for! No, this capital will shore up losses that are certain to continue as credit keeps on deteriorating and at a high price to both Lehman and existing shareholders.

Consumer Debt Carries Ahead

Bloomberg reports Consumer Credit Increases $8.9 Billion in April:

"Total consumer credit rose $8.9 billion for the month to $2.56 trillion, the Federal Reserve said today in Washington. In March, credit rose by $13.1 billion, previously reported as an increase of $15.3 billion. The Fed's report doesn't cover borrowing secured by real estate.

Consumers used their charge cards less and personal loans more in April, in the aftermath of the credit-market collapse and the deepest housing slump in a quarter century. Weaker consumer spending, which accounts for two-thirds of growth, could send the economy into recession.

...

According to the Fed, total consumer borrowing rose at a 4.2 percent annual rate in April after increasing at a 6.2 percent pace during March.

Revolving debt such as credit cards gained $300.4 million during April, the smallest increase since May 2005. Non- revolving debt -- including car, school and holiday loans -- jumped by $8.6 billion for the month, the biggest increase since August.

Tax Rebates

The Treasury Department earlier today said it has sent consumers a total of $57 billion in tax rebates between April 28 and today. President George W. Bush signed the $168 billion stimulus package into law in February to try to shore up consumer spending.

...

Foreclosures Rise

The number of U.S. homes in foreclosure last quarter rose to the highest in almost three decades as did late payments on home loans, according to a report issued yesterday by the Mortgage Bankers Association.

Overdue debts at the six largest credit-card lenders declined for the first time in 10 months in April, according to data compiled by Bloomberg from American Express Co., Bank of America Corp., Capital One Financial Corp., JPMorgan Chase & Co., Citigroup Inc. and Discover Financial Services."

Stimulus Fail

Remember folks, a massive Fiscal Stimulus - Fail package has and is being sent out and consumer credit still manages to expand. I already predicted that these checks would be mostly used to pay down current debts, which appears to be true as credit card lenders saw a decrease in overdue debts. Unfortunately, consumers only leveraged themselves more in despite of the costly checks, which adds to the problem at the worst time if you consider the Data Extravaganza - Unemployment & Real Earnings numbers that came in today.

The checks have only helped consumers pay down their credit cards a bit now (or maybe buy a tank of gas), but I guarantee that once the stimulus flow ends, consumers will revert right back to charging. This all comes at a cost of our already out of control deficit, which hurts our dollar more.

We are not even close to out of the woods in the credit crisis, consult The Great Real Estate Debate for more clarity on that, not to mention excess housing inventory that will continue to wreak havoc on housing prices.

On a final note, I'm actually amazed consumers were able to secure more personal loans. This issue concerns me highly in this environment as credit deterioration has certainly taken place, banks are as far as I'm concerned capital constrained and job uncertainty in the future is rising. This smells bad.

Data Extravaganza - Unemployment and Real Earnings

The Employment Situation in May 2008:

"The unemployment rate rose from 5.0 to 5.5 percent in May, and nonfarm payroll employment continued to trend down (-49,000), the Bureau of Labor Statistics of the U.S. Department of Labor reported today. In May, employment continued to fall in construction, manufacturing, retail trade, and temporary help services, while health care continued to add jobs. Average hourly earnings rose by 5 cents, or 0.3 percent, over the month."

Please consider May 2008 NFP Preview from The Big Picture. Some point to outline:

• The trend in job growth since 2001 has been slower relative to job growth before 2001.
• trends have been negative in private sector employment, real wage gains and hours worked.
• See the article for an explanation of Business Employment Dynamics.
  

"The index of aggregate weekly hours of production and nonsupervisory workers on private nonfarm payrolls fell by 0.1 percent in May to 107.1 (2002=100). The index has decreased by 0.6 percent in 2008."

The May number differs from the reported BLS number. This is my estimate of May preliminary data once May CPI is reported, which I am assuming will come in hotter than previous numbers since producers are beginning to pass on costs. Weekly average hours have been on the decline and the average trend since last year is negative real hourly earnings. Might I add though, that if you Think The Economy Is Bad? Wait Till The States Cut Back. This will surely affect June unemployment going forward.

To be fair, also see Unemployment Seasonal Aberration to learn why 5.5% unemployment is most likely slightly overstated for May, but at the same time is most likely right in line with the overall trend.

Jim Rogers - Takin Ya Back Ta Skool!

Jim Rogers on Bloomberg discusses shorting Citi and Fannie, the Fed printing our way to the inflationary conditions we're in, as well as th Fed taking worthless assets in on their balance sheets.
He even brings up buying airlines. It looks like great minds think alike as I wondered whether The Ill Fated Airlines might present an excellent opportunity.

Finally, Jimmy talks about oil inventories not getting any larger, and that commodities are not in a bubble.



(click on image to watch video)

Death of the Bond Insurers

Moody's May Downgrade Ratings of MBIA & Ambac Units as reported by the NY Times:

"Moody’s Investors Service said on Wednesday that it was likely to cut the top ratings of the bond insurance arms of MBIA and Ambac Financial, in a move that may cripple their ability to write new insurance.

The companies, which are No. 1 and No. 2 in the business, have been struggling to raise capital to shore up their AAA ratings, which are under pressure on concern about losses from mortgage-backed debt."

But just wait, MBIA plays ignorant...

"Moody’s said it was likely to cut the ratings on MBIA Insurance and Ambac Assurance to AA. Mr. Dorer said that a drop to A is possible for MBIA, because its capital position is weaker.

A downgrade would effectively end both insurer’s business, analysts said, because the quality of their guarantee was contingent on holding the top ratings.

In a statement, MBIA said that it was surprised by Moody’s action and that its capital position had improved.

Ambac also said that it believed its capital position was adequate for an AAA rating and added that it had no plans to raise additional capital.

MBIA, the world’s largest bond insurer, had guaranteed $668 billion in debt as of the end of the first quarter of 2008, while Ambac, the second-largest insurer, has an insurance portfolio of $511 billion."

Now to add a little more flavor, from MarketWatch What will MBIA do with $900 Million?:

"MBIA Inc. raised $1.1 billion selling new shares in February and was planning to funnel $900 million of the cash into its main bond insurance subsidiary by next week to salvage its crucial triple-A ratings.

...

MBIA Chief Executive Jay Brown said during a conference call on Wednesday that using the $900 million to set up a new insurance business is an option that the company's board of directors will have to consider.

...

However, regulators, including the New York State Insurance Department, may not approve.

"We are in active discussions with MBIA regarding the company's fulfilling its existing publicly announced commitment by the stated June 11 deadline," Eric Dinallo, New York State Insurance Superintendent, said in a statement.

Dinallo was referring to MBIA's plans to send the $900 million to its bond insurance unit by June 11.

Insurance regulators try to make sure that policyholder claims are paid. They're less interested in helping public insurance companies generate future returns for shareholders.

That means the New York State Insurance Department may require at least some of MBIA's $900 million to be sent to its current bond insurance business to help it pay big claims on guarantees it sold on mortgage-related securities that are going sour.

...

MBIA's Brown said on Wednesday that the company had planned to send the $900 million to its bond insurance unit if that extra cash would have supported its triple-A ratings.

"This cash was never needed to pay claims," he stressed in a statement.

However, Rosner noted that MBIA told a slightly different story in an 8-K regulatory filing on May 12 with the Securities and Exchange Commission.

In the filing, the company said that, after consulting with the New York State Insurance Department, it decided to funnel the $900 million to its insurance subsidiaries to support "existing and future policyholders" as well as its triple-A rating.

"Nowhere in the May 12th 8-K is the support of the Triple-A stated as the sole reason they agreed to downstream the money," Rosner wrote. "In fact, they agreed to do so in support of 'existing and future policyholders.'"

If MBIA has written any new business since May 12, policyholders would want there to be enough capital in the company's insurance subsidiary to pay any claims and the state insurance regulator is responsible for making sure this happens, Rosner added."

Is MBIA out of their minds completely? Let's take a look back at Ambac "Surprises" with Huge Loss, Bond Insurers Revisited:

"Bond Insurers will likely soon need to fund significant claims. In our view, their capital resources are grossly insufficient to meet these demands

Applying Merrill Lynch and Citigroup valuations to guarantors’ Super Senior CDO exposure would eliminate 45%-107% of their statutory capital"

"Approximately $5.5 billion of MBIA’s on-balance-sheet debt will come due before year-end 2008, $8.5 billion before year-end 2009"

MBIA is flat out living in denial. They are basically saying F%ck off to policyholders. To start a new business line when you're other business units are severely under capitalized is madness, who do they think they are fooling, themselves obviously. $900 million in capital is nowhere near sufficient compared to estimated losses. Look for capital raising attempts in the future.

Priceless

Presidential Run 2008

So it's down to two...finally! What will ensue here then, is not a political, but an economic comparison of the two candidates, most likely in a several part series. Some of the key topics to discuss:

• Tax policy and spending budget, which will of course touch on Iraq/military spending and health care
  
• Cap and trade/energy policy
  
• Trade policy and theories on deficit spending (if any thoughts on deficits at all)
• Social entitlement programs (social security, Medicare, etc.) refer to Doom, Gloom and Despair (YIKES!) for a background of this massive problem
• Any other subjects I think of along the way

Bottom line is this country has been heading down a destructive path and though Ron Paul was the ideal candidate, these two are what we're stuck with so it's time to analyze and reason.

Doom, Gloom and Despair (Yikes!)

Readers, this may be the most gloomy article I will post yet, which is considerable if you take a look back, not to mention long and most shocking, it's the FED DALLAS PRESIDENT (gulp)! Without further ado, Richard Fisher presents Storms on the Horizon cut down for your convenience:

"Today, our fellow citizens and financial markets are paying the price for falling victim to the complacency and recklessness Martin warned against. Few scanned the horizon for trouble brewing as we proceeded along a path of unparalleled prosperity fueled by an unsustainable housing bubble and unbridled credit markets. Armchair or Monday morning quarterbacks will long debate whether the Fed could have/should have/would have taken away the punchbowl that lubricated that blowout party. I have given my opinion on that matter elsewhere and won’t go near that subject tonight. What counts now is what we have done more recently and where we go from here. Whatever the sins of omission or commission committed by our predecessors, the Bernanke FOMC’s objective is to use a new set of tools to calm the tempest in the credit markets to get them back to functioning in a more orderly fashion. We trust that the various term credit facilities we have recently introduced are helping restore confidence while the credit markets undertake self-corrective initiatives and lawmakers consider new regulatory schemes.

I am also not going to engage in a discussion of present monetary policy tonight, except to say that if inflationary developments and, more important, inflation expectations, continue to worsen, I would expect a change of course in monetary policy to occur sooner rather than later, even in the face of an anemic economic scenario. Inflation is the most insidious enemy of capitalism. No central banker can countenance it, not least the men and women of the Federal Reserve.

Tonight, I want to talk about a different matter. In keeping with Bill Martin’s advice, I have been scanning the horizon for danger signals even as we continue working to recover from the recent turmoil. In the distance, I see a frightful storm brewing in the form of untethered government debt. I choose the words—“frightful storm”—deliberately to avoid hyperbole. Unless we take steps to deal with it, the long-term fiscal situation of the federal government will be unimaginably more devastating to our economic prosperity than the subprime debacle and the recent debauching of credit markets that we are now working so hard to correct.

You might wonder why a central banker would be concerned with fiscal matters. Fiscal policy is, after all, the responsibility of the Congress, not the Federal Reserve. Congress, and Congress alone, has the power to tax and spend. From this monetary policymaker’s point of view, though, deficits matter for what we do at the Fed. There are many reasons why. Economists have found that structural deficits raise long-run interest rates, complicating the Fed’s dual mandate to develop a monetary policy that promotes sustainable, noninflationary growth. The even more disturbing dark and dirty secret about deficits—especially when they careen out of control—is that they create political pressure on central bankers to adopt looser monetary policy down the road. I will return to that shortly. First, let me give you the unvarnished facts of our nation’s fiscal predicament.

Eight years ago, our federal budget, crafted by a Democratic president and enacted by a Republican Congress, produced a fiscal surplus of $236 billion, the first surplus in almost 40 years and the highest nominal-dollar surplus in American history. While the Fed is scrupulously nonpartisan and nonpolitical, I mention this to emphasize that the deficit/debt issue knows no party and can be solved only by both parties working together. For a brief time, with surpluses projected into the future as far as the eye could see, economists and policymakers alike began to contemplate a bucolic future in which interest payments would form an ever-declining share of federal outlays, a future where Treasury bonds and debt-ceiling legislation would become dusty relics of a long-forgotten past. The Fed even had concerns about how open market operations would be conducted in a marketplace short of Treasury debt.

That utopian scenario did not last for long. Over the next seven years, federal spending grew at a 6.2 percent nominal annual rate while receipts grew at only 3.5 percent. Of course, certain areas of government, like national defense, had to spend more in the wake of 9/11. But nondefense discretionary spending actually rose 6.4 percent annually during this timeframe, outpacing the growth in total expenditures. Deficits soon returned, reaching an expected $410 billion for 2008—a $600 billion swing from where we were just eight years ago. This $410 billion estimate, by the way, was made before the recently passed farm bill and supplemental defense appropriation and without considering a proposed patch for the Alternative Minimum Tax—all measures that will lead to a further ballooning of government deficits.

In keeping with the tradition of rosy scenarios, official budget projections suggest this deficit will be relatively short-lived. They almost always do. According to the official calculus, following a second $400-billion-plus deficit in 2009, the red ink should fall to $160 billion in 2010 and $95 billion in 2011, and then the budget swings to a $48 billion surplus in 2012.

If you do the math, however, you might be forgiven for sensing that these felicitous projections look a tad dodgy. To reach the projected 2012 surplus, outlays are assumed to rise at a 2.4 percent nominal annual rate over the next four years—less than half as fast as they rose the previous seven years. Revenue is assumed to rise at a 6.7 percent nominal annual rate over the next four years—almost double the rate of the past seven years. Using spending and revenue growth rates that have actually prevailed in recent years, the 2012 surplus quickly evaporates and becomes a deficit, potentially of several hundred billion dollars.

Doing deficit math is always a sobering exercise. It becomes an outright painful one when you apply your calculator to the long-run fiscal challenge posed by entitlement programs. Were I not a taciturn central banker, I would say the mathematics of the long-term outlook for entitlements, left unchanged, is nothing short of catastrophic.

Typically, critics ranging from the Concord Coalition to Ross Perot begin by wringing their collective hands over the unfunded liabilities of Social Security. A little history gives you a view as to why. Franklin Roosevelt originally conceived a social security system in which individuals would fund their own retirements through payroll-tax contributions. But Congress quickly realized that such a system could not put much money into the pockets of indigent elderly citizens ravaged by the Great Depression. Instead, a pay-as-you-go funding system was embraced, making each generation’s retirement the responsibility of its children.

Now, fast forward 70 or so years and ask this question: What is the mathematical predicament of Social Security today? Answer: The amount of money the Social Security system would need today to cover all unfunded liabilities from now on—what fiscal economists call the “infinite horizon discounted value” of what has already been promised recipients but has no funding mechanism currently in place—is $13.6 trillion, an amount slightly less than the annual gross domestic product of the United States.

Demographics explain why this is so. Birthrates have fallen dramatically, reducing the worker–retiree ratio and leaving today’s workers pulling a bigger load than the system designers ever envisioned. Life spans have lengthened without a corresponding increase in the retirement age, leaving retirees in a position to receive benefits far longer than the system designers envisioned. Formulae for benefits and cost-of-living adjustments have also contributed to the growth in unfunded liabilities.

The good news is this Social Security shortfall might be manageable. While the issues regarding Social Security reform are complex, it is at least possible to imagine how Congress might find, within a $14 trillion economy, ways to wrestle with a $13 trillion unfunded liability. The bad news is that Social Security is the lesser of our entitlement worries. It is but the tip of the unfunded liability iceberg. The much bigger concern is Medicare, a program established in 1965, the same prosperous year that Bill Martin cautioned his Columbia University audience to be wary of complacency and storms on the horizon.

Medicare was a pay-as-you-go program from the very beginning, despite warnings from some congressional leaders—Wilbur Mills was the most credible of them before he succumbed to the pay-as-you-go wiles of Fanne Foxe, the Argentine Firecracker—who foresaw some of the long-term fiscal issues such a financing system could pose. Unfortunately, they were right.

Please sit tight while I walk you through the math of Medicare. As you may know, the program comes in three parts: Medicare Part A, which covers hospital stays; Medicare B, which covers doctor visits; and Medicare D, the drug benefit that went into effect just 29 months ago. The infinite-horizon present discounted value of the unfunded liability for Medicare A is $34.4 trillion. The unfunded liability of Medicare B is an additional $34 trillion. The shortfall for Medicare D adds another $17.2 trillion. The total? If you wanted to cover the unfunded liability of all three programs today, you would be stuck with an $85.6 trillion bill. That is more than six times as large as the bill for Social Security. It is more than six times the annual output of the entire U.S. economy.

Why is the Medicare figure so large? There is a mix of reasons, really. In part, it is due to the same birthrate and life-expectancy issues that affect Social Security. In part, it is due to ever-costlier advances in medical technology and the willingness of Medicare to pay for them. And in part, it is due to expanded benefits—the new drug benefit program’s unfunded liability is by itself one-third greater than all of Social Security’s.

Add together the unfunded liabilities from Medicare and Social Security, and it comes to $99.2 trillion over the infinite horizon. Traditional Medicare composes about 69 percent, the new drug benefit roughly 17 percent and Social Security the remaining 14 percent.

I want to remind you that I am only talking about the unfunded portions of Social Security and Medicare. It is what the current payment scheme of Social Security payroll taxes, Medicare payroll taxes, membership fees for Medicare B, copays, deductibles and all other revenue currently channeled to our entitlement system will not cover under current rules. These existing revenue streams must remain in place in perpetuity to handle the “funded” entitlement liabilities. Reduce or eliminate this income and the unfunded liability grows. Increase benefits and the liability grows as well.

Let’s say you and I and Bruce Ericson and every U.S. citizen who is alive today decided to fully address this unfunded liability through lump-sum payments from our own pocketbooks, so that all of us and all future generations could be secure in the knowledge that we and they would receive promised benefits in perpetuity. How much would we have to pay if we split the tab? Again, the math is painful. With a total population of 304 million, from infants to the elderly, the per-person payment to the federal treasury would come to $330,000. This comes to $1.3 million per family of four—over 25 times the average household’s income.

Clearly, once-and-for-all contributions would be an unbearable burden. Alternatively, we could address the entitlement shortfall through policy changes that would affect ourselves and future generations. For example, a permanent 68 percent increase in federal income tax revenue—from individual and corporate taxpayers—would suffice to fully fund our entitlement programs. Or we could instead divert 68 percent of current income-tax revenues from their intended uses to the entitlement system, which would accomplish the same thing.

Suppose we decided to tackle the issue solely on the spending side. It turns out that total discretionary spending in the federal budget, if maintained at its current share of GDP in perpetuity, is 3 percent larger than the entitlement shortfall. So all we would have to do to fully fund our nation’s entitlement programs would be to cut discretionary spending by 97 percent. But hold on. That discretionary spending includes defense and national security, education, the environment and many other areas, not just those controversial earmarks that make the evening news. All of them would have to be cut—almost eliminated, really—to tackle this problem through discretionary spending.

I hope that gives you some idea of just how large the problem is. And just to drive an important point home, these spending cuts or tax increases would need to be made immediately and maintained in perpetuity to solve the entitlement deficit problem. Discretionary spending would have to be reduced by 97 percent not only for our generation, but for our children and their children and every generation of children to come. And similarly on the taxation side, income tax revenue would have to rise 68 percent and remain that high forever. Remember, though, I said tax revenue, not tax rates. Who knows how much individual and corporate tax rates would have to change to increase revenue by 68 percent?

If these possible solutions to the unfunded-liability problem seem draconian, it’s because they are draconian. But they do serve to give you a sense of the severity of the problem. To be sure, there are ways to lessen the reliance on any single policy and the burden borne by any particular set of citizens. Most proposals to address long-term entitlement debt, for example, rely on a combination of tax increases, benefit reductions and eligibility changes to find the trillions necessary to safeguard the system over the long term.

No combination of tax hikes and spending cuts, though, will change the total burden borne by current and future generations. For the existing unfunded liabilities to be covered in the end, someone must pay $99.2 trillion more or receive $99.2 trillion less than they have been currently promised. This is a cold, hard fact. The decision we must make is whether to shoulder a substantial portion of that burden today or compel future generations to bear its full weight.

Now that you are all thoroughly depressed, let me come back to monetary policy and the Fed.

It is only natural to cast about for a solution—any solution—to avoid the fiscal pain we know is necessary because we succumbed to complacency and put off dealing with this looming fiscal disaster. Throughout history, many nations, when confronted by sizable debts they were unable or unwilling to repay, have seized upon an apparently painless solution to this dilemma: monetization. Just have the monetary authority run cash off the printing presses until the debt is repaid, the story goes, then promise to be responsible from that point on and hope your sins will be forgiven by God and Milton Friedman and everyone else.

We know from centuries of evidence in countless economies, from ancient Rome to today’s Zimbabwe, that running the printing press to pay off today’s bills leads to much worse problems later on. The inflation that results from the flood of money into the economy turns out to be far worse than the fiscal pain those countries hoped to avoid.

Earlier I mentioned the Fed’s dual mandate to manage growth and inflation. In the long run, growth cannot be sustained if markets are undermined by inflation. Stable prices go hand in hand with achieving sustainable economic growth. I have said many, many times that inflation is a sinister beast that, if uncaged, devours savings, erodes consumers’ purchasing power, decimates returns on capital, undermines the reliability of financial accounting, distracts the attention of corporate management, undercuts employment growth and real wages, and debases the currency.

Purging rampant inflation and a debased currency requires administering a harsh medicine. We have been there, and we know the cure that was wrought by the FOMC under Paul Volcker. Even the perception that the Fed is pursuing a cheap-money strategy to accommodate fiscal burdens, should it take root, is a paramount risk to the long-term welfare of the U.S. economy. The Federal Reserve will never let this happen. It is not an option. Ever. Period.

The way we resolve these liabilities—and resolve them we must—will affect our own well-being as well as the prospects of future generations and the global economy. Failing to face up to our responsibility will produce the mother of all financial storms. The warning signals have been flashing for years, but we find it easier to ignore them than to take action. Will we take the painful fiscal steps necessary to prevent the storm by reducing and eventually eliminating our fiscal imbalances? That depends on you.

I mean “you” literally. This situation is of your own creation. When you berate your representatives or senators or presidents for the mess we are in, you are really berating yourself. You elect them. You are the ones who let them get away with burdening your children and grandchildren rather than yourselves with the bill for your entitlement programs.

This issue transcends political affiliation. When George Shultz, one of San Francisco’s greatest Republican public servants, was director of President Nixon’s Office of Management and Budget, he became worried about the amount of money Congress was proposing to spend. After some nights of tossing and turning, he called legendary staffer Sam Cohen into his office. Cohen had a long memory of budget matters and knew every zig and zag of budget history. “Sam,” Shultz asked, “tell me something just between you and me. Is there any difference between Republicans and Democrats when it comes to spending money?” Cohen looked at him, furrowed his brow and, after thinking about it, replied, “Mr. Shultz, there is only one difference: Democrats enjoy it more.”

Yet no one, Democrat or Republican, enjoys placing our children and grandchildren and their children and grandchildren in harm’s way. No one wants to see the frightful storm of unfunded long-term liabilities destroy our economy or threaten the independence and authority of our central bank or tear our currency asunder.

Of late, we have heard many complaints about the weakness of the dollar against the euro and other currencies. It was recently argued in the op-ed pages of the Financial Times [3] that one reason for the demise of the British pound was the need to liquidate England’s international reserves to pay off the costs of the Great Wars. In the end, the pound, it was essentially argued, was sunk by the kaiser’s army and Hitler’s bombs. Right now, we—you and I—are launching fiscal bombs against ourselves. You have it in your power as the electors of our fiscal authorities to prevent this destruction. Please do so."

Capital Raising Follies Continue, Shareholders Still Loose and Management Sounds Idiotic

Lehman Brothers announced today that they may plan to raise capital, most likely though common stock offering. Statements from any bank management in this environment shouldn't be trusted, nor their strategies, from Reuters:

"Lehman Brothers Holdings Inc has no need to raise capital and would only do so if the right market opportunity presented itself or if the firm thought it would help investor perceptions, a source familiar with the situation said on Tuesday.

The source said a move to raise capital was only one of "dozens" of options for the bank.

Some analysts agreed there was no urgent need for Lehman to further bolster its balance sheet.

"In our view, there is no immediate need to raise equity capital, and the company would only take this painful step in an effort to cease the drumbeat of negative perceptions," David Trone, an analyst for Fox-Pitt, Kelton, wrote in a research note.

But Lehman shares were down nearly 6 percent in morning trading, making it the top decliner among brokerage stocks and bringing its fall so far this year to about 50 percent. By comparison, the Amex Securities Broker Dealer index is down 21 percent in 2008."

Sure, there's no need to raise capital and dilute the sh$t out of shareholders after our shares have plummeted almost twice as much as our competitors, but they might do it anyway...complete blasphemy! Remember in Capital Raising, Shareholders Lose:

"Bill Blain at KNG Securities provides the counter-argument:

NO NO NO! There is only one thing worse than a bank that is short of capital - and that’s one that has too much! Capital strapped banks are careful and cautious, and look after their shareholders. Banks with too much capital do silly things like lend to people who can’t possibly pay back or they go and buy Dutch banks for absolutely no perceivably good reason.

Short-term, banks have to continue the deleverage process, and yes they do need to raise capital selectively. And those guilty of hubris - come on down Fred, Chuck, Stan, Marcel, and Jimmy - pay the price. Some banks will/have be forced into rights issues. But to make a virtue of raising capital is not a good thing - it’s bad bad bad! Running efficient banks well on the right amount of capital is the path of virtue. Running fat lazy banks on the amount of capital a regulator tells to you to have is not."

Blain stakes us to church here, no need to dilute shareholders more if not necessary, it makes no economic sense. Continuing with the Reuters article:

"Second-quarter losses from asset write-downs and ineffective hedges are likely to top $2 billion, the Journal said. The bank will also realize losses tied to job cuts, it said, citing a person familiar with the matter.

Lehman in May decided to cut around 1,300 jobs, or nearly 5 percent of its work force, a person briefed on the matter said. It had laid off more than 5,000 people since the middle of 2007.

...Two months ago, Lehman sold $4 billion of preferred shares, a stock-bond hybrid. In early May, it sold $2 billion of 30-year bonds."

However, my intellect prevails here and Lehman is out of line. Why raise capital when you are still paying a dividend of 1.80%, or $130 million last quarter?

Well maybe because their debt to equity ratio is is 30.65! Cutting the dividend of $130 mill is redundant with so much capital needed. They raised $6 billion already, but losses will continue to stack and with so much debt on hands....don't listen to Lehman, they need capital dammit!

Make no mistake about it, this is not a maneuver just to reassure investors' perceptions, this is a blood and plasma transfusion with chemotherapy. On a final note, banks and brokerage houses aren't out of the woods yet as The Great Real Estate Debate evolves and heavy "surprise" losses mount in 2009.

Think the Economy Is Bad? Wait Till the States Cut Back

I've been forecasting doom and recession since I opened this blog, but it appears I've been outdone; Gloomy, but realistic article from the NY Times:

"State and city governments have yet to shrink the economy; indeed, they have even managed to prop it up. They have quietly maintained their spending at pre-crisis levels even as they warn of numerous cutbacks forced on them by declining tax revenues. The cutbacks, however, are written into budgets for a fiscal year that begins on July 1, a month away. In the meantime the states and cities, often drawing on rainy-day savings, have carried their share of the load for the national economy.

That share is gigantic. At $1.8 trillion annually in a $14 trillion economy, the states and municipalities spend almost twice as much as the federal government, including the cost of the Iraq war. When librarians, lifeguards, teachers, transit workers, road repair crews and health care workers disappear, or airport and school construction is halted, the economy trembles. None of that, or very little, has happened so far, not even in California, despite a significant decline in tax revenue.

“We are looking at a $4 billion cut to public schools and deep cuts that will result in thousands of Californians losing their health care,” said Jean Ross, executive director of the California Budget Project, offering a preview of coming hardships. “But the reality is we have not pulled money off the streets yet.”

Quite the opposite, the states and municipalities have increased their spending in recent quarters, bolstering the nation’s meager economic growth. Over the past year, they have added $40 billion to their outlays, even allowing for scattered spending freezes and a few cutbacks in advance of July 1. Total employment has also risen. But when the current fiscal year ends in 30 days (or in the fall for many municipalities), state and city spending will fall, along with employment — slowly at first and then quite noticeably after the next president takes office."

Not only is unemployment going to get worse, Barry Ritholtz has taught us about Cutting Hours Aggressively instead of job losses. It would also be wise for interested readers to refer to Bracing for NFP Data and Reviewing NFP Data to learn about birth death model errors and the weak job growth since 2001 that masks how significant job losses now are. Continuing with the NY Times article:

"Sometime next year, the decline will reach an annual rate of $50 billion, Goldman Sachs estimates. “It is a big reason to expect a weak economy in 2009,” said Jan Hatzius, chief domestic economist at the firm.

The $90 billion swing — from more spending to less — could be enough to push down a weak economy to zero growth or less, because state and city spending has accounted for as much as half of total economic growth since last fall. (A robust economy has a growth rate of 3 percent to 4 percent, compared with the 0.9 percent or less of the last two quarters.) The $90 billion would certainly offset most of the $107 billion stimulus package now going out from the federal government to millions of Americans in the form of tax rebate checks. The hope is they will spend this windfall on consumption and in doing so sustain the economy. That might happen — for a while. But with the cutbacks in state and city outlays canceling out the consumption, the next president, struggling to revive a weak economy, will almost certainly have to consider a second stimulus package."

Mish has been warning about state and local governments for some time and just today he reports Muni Defaults Triple and also refer to Grim News For State Budgets.

News just keeps pouring in sealing the fate of the coming recession. A quick review:

• The Market is Overvalued with oil producers accounting for more than half of profits

• 2008 Q1 Corporate Profits reveal inventories are high and investment is low
  

• Commercial Real Estate Delinquencies Rise the beginning of another huge problem

• April Existing Home Sales show inventory is getting worse, not better

• Peak Oil is Scary!, enough said

• Looking Into the Eye of the Fed shows Fed policy has been and will continue to be ineffective in alleviating market tension and is only proving to exacerbate price inflation
  

• Stay Seated, Credit Crunch Seventh Inning Stretch Is Not Close and time has no yard stick in this arena

• Fiscal Stimulus - FAIL

• When Ambac "Suprises" with Huge Loss, Bond Insurers Revisited and second lien mortgages predict large losses in the future

• Sub prime is only the beginning in the The Great Real Estate Debate, losses will only grow from liar loans

• Banks are Trapped as demand for credit lines increase at a time when banks are strapped for capital. Small business lending, America's bread and butter growth is falling

Well that's not all that bad (overly sarcastic tone)

Accounting Shenanigans

Featured book of the day, "Financial Shenanigans". For every financial sleuth out there, this book is a must read to catch companies "cheating" GAAP, usually in an unfortunately quite legal way. Like most regulation it doesn't keep up with innovation, even when gimmicks are known for long periods of time.

Shenanigan headline in question, recording profit from loss in value of debt, in particular bonds. Bloomberg reports Wall Street Says -2 + -2 = 4 as Liabilities Get New Bond Math:

"Leave it to Wall Street to profit from its own distress.

Merrill Lynch & Co., Citigroup Inc. and four other U.S. financial companies have used an accounting rule adopted last year to book almost $12 billion of revenue after a decline in prices of their own bonds. The rule, intended to expand the ``mark-to- market'' accounting that banks use to record profits or losses on trading assets, allows them to report gains when market prices for their liabilities fall.

The new math, while legal, defies common sense. Merrill, the third-biggest U.S. securities firm, added $4 billion of revenue during the past three quarters as the market value of its debt fell. That was the result of higher yields demanded by investors spooked by the New York-based company's $37 billion of writedowns from assets hurt by the collapse of the subprime mortgage market."

These profits are only on paper, but in the real world are FALSE. Oh by the way from MER's most recent quarterly filing on April 29, 2008, Merrill Lynch issued $2.7 billion of new perpetual 8.625% Non-Cumulative Preferred Stock. In January and February 2008, Merrill Lynch issued issued 9% Non-Voting Mandatory Convertible Non-Cumulative Preferred Stock (the “convertible preferred stock”), for an aggregate purchase price of approximately $6.6 billion. With such high interest, recording profits from mark to market decreases in value is lunacy, besides the full debt amount is still there:

"Here's how it works, according to Richard Bove, an analyst at New York-based Ladenburg Thalmann & Co. A company decides to designate $100 million of its subordinated bonds as subject to mark-to-market accounting. The price of the bonds drops to 80 cents on the dollar from 100 cents. So the firm books $20 million on the ``presumed savings that you have on your liabilities,'' Bove said.

``In the real world you didn't save a dime,'' he said. ``You still owe the $100 million. It's another one of these accounting rules that basically takes you further and further away from reality.''"

Howard Schlitt, the author of Financial Shenanigans uses a slightly different example, as the time the book was written was before this new GAAP rule was implemented, but very similar. The shenanigan is retiring old debt and marking a gain, this is how it looks:

(Click on image for larger view)

The example illustrates the same conclusion, gains that are never actually earned are recorded.

"The Federal Reserve, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency and Office of Thrift Supervision objected to the rule before its passage, saying in a joint 2006 letter to the FASB that it would ``have the contrary effect'' of increasing a bank's net worth at the same time its ``financial condition is deteriorating.''"

I'll concede that point, this is just another flawed loophole in our brilliant regulatory system.