Courtesy of Edward Harrison at Credit Writedowns

About a month ago I wrote a post called “The coming wave of second mortgage writedowns” the gist of which was that the big four banks (Citi, JP, BofA, and Wells) had a shed load of exposure to now worthless second mortgages. With many first mortgages now hopelessly underwater, it stands to reason that second mortgages on those same properties have zero value.

The big four are certainly well aware of this problem and are looking for ways to extend the wherewithal of underwater borrowers and pretend they don’t need to take losses on these loans. On paper, these companies are very well capitalized. However, in the real world, the likely losses they must eventually take on loans already on their books would probably render them insolvent. This is what I hinted yesterday in my post on the stress tests.

I said:

I would say the stress tests were a mock exercise to instil confidence in the capital markets. This was important first and foremost because it would induce private investors to pay for bank recapitalization instead of taxpayers. But it was also important for the economy as a whole as the sick banking sector was dragging the whole economy down. The key, however, is that the tests were a mock exercise. Despite the additional capital, banks are still hiding hundreds of billions of dollars in losses in level three, hold to maturity, and off balance sheet asset pools. If asset prices fall and/or the economy weakens, all of this subterfuge would be for nought.

-Geithner: jusqu’ici tout va bien

And when I use the phrase ‘mock exercise,’ by mock, I mean fake. Mike Konczal has done a remarkable job of putting these two concepts – the worthless second mortgages and the stress tests – together.

He writes in a recent post:

Let’s talk specifics: Last June I made a DIY Stress Test, using values reversed-engineered from the public documents, where you could play around with the values online or download an excel spreadsheet yourself (it’s still one of my favorite blogging items). The backbone of the overview of results, page 9 from the Federal Reserve’s document, looks like this:

I’m going to isolate the four largest banks Frank questioned about second-liens, along with their loses as they’ve legally sworn to being accurate during the stress test:

Again, this is data as reported to the government by the major banks during the stress test of 2009. So what’s going on here? The four major banks have about $477 billion in junior liens, either in the form of a second mortgage or a home equity line of credit. If you go to the Fed Funds data online, you’d see that there’s about a trillion dollars of 2nd/Juniors out there, so the four major players have about half the market.

The four major players each report that they expect to have a 13-14% loss on these items under an “adverse scenario”, with Citi reporting a 20% loss under an adverse scenario. That means of the $477bn, $68.4 bn is junk that’ll never be collected on. This, combined with all the other expected losses (see the link to the stress test for the rest) meant that the four biggest players needed around $53bn to be raised.

Notice how Frank’s letter, and pretty much anyone you’d speak to who isn’t working for the four largest banks, assume that second liens in the country aren’t worth 86% of their value (for a 14% loss). You see in Frank’s letter “no economic value.” Huh. Well, that’s a problem.

Let’s look at these values again, assuming that the expected total loss would be 40%, and then 60%.

So the original loss from second-liens, as reported by the stress tests, was $68.4 billion for the four largest banks. If you look at those numbers again, and assume a loss of 40% to 60%, numbers that are not absurd by any means, you suddenly are talking a loss of between $190 billion and $285 billion. Which means if the stress tests were done with terrible 2nd lien performance in mind, there would have been an extra $150 billion dollar hole in the balance sheet of the four largest banks. Major action would have been taken against the four largest banks if this was the case.

See what I mean by fake?  The point is this whole charade is transparent to anyone who actually runs the numbers. Yet, you have people like John Cassidy spreading disinformation in the New Yorker, writing puff pieces of zero negative value with drivel like this:

Other critics dismissed the tests as a sham, arguing that the economic assumptions underpinning them were too benign. As the tests unfolded, however, it became evident that the government’s loss projections were quite high, and that many banks would be forced to raise considerable sums of money—in some cases, more than ten billion dollars.

Baloney. Run the numbers like Mike did, John; and then you wouldn’t make such asinine comments. Of course the stress tests were a sham.  They were a confidence trick to raise more capital and buy time for the banks to earn yet more still. The point was to allow the banks to ease into their losses. And that’s exactly what’s been happening for the past year.

The problem with the stress tests, however, is they gave the banks a way to get from under the yoke of the government’s TARP program. The banks said, “look, we are now well-capitalized even in the worst case scenario of the stress test. We want out of TARP.”

This is bad for three reasons.

• The big banks all paid back $25 billion in TARP funds. Smaller banks like Northern Trust paid back $10 billion or less. That’s hundreds of billions of capital that they all could have as a buffer against losses. Some of them raised additional capital to replenish the coffers. Nevertheless, net-net, we had less banking capital in the system after the repayments than before.
• Banks free of TARP paid out a lot of cash in bonuses that could have gone to shoring up their capital base.  Every dollar paid in cash compensation to staff is a dollar less of capital.  Had these banks been under TARP, they would have been forced to pay lower bonuses – if only for this year.
• The lower capital – and the fact that banks know that having renewed capital problems would mean the end of the line for them – means that banks are less likely to lend freely.  They understand that now is the time to husband capital. Heads would roll if a big bank or super regional which had repaid TARP had another capital shortfall.

The real question is: why is the Obama Administration running victory laps, unrolling the ‘Mission Accomplished’ banner on the credit crisis, as Mike Konczal describes it? I suspect this is just a political stunt to provide cover in the mid-term elections to somehow demonstrate that the Democrats fixed the problem which the Republicans created.

I think it could backfire if only because the underemployment rate is still 17%. Nobody wants to hear the “I saved the economy routine” when they’re unemployed and losing their home.

Submitted by Nic Lenoir of ICAP-H/T Zero Hedge

The recovery has been uneven around the globe. The US with heavy stimulus has returned rapidly to positive growth (whether we can sustain it is a completely different debate), Swiss real estate was never really affected by the quasi worldwide slide and GDP in Switzerland is expected to be between 1% and 1.5% for 2010, and Canada has not only returned to positive growth but it also has to consider slowing down a bubbly real estate market. Meanwhile Europe’s leading rebounder Germany is not guarantied to post positive GDP for Q1, Greece is wondering whether debt refinancing and what it will take will lead to civil war, Spain’s industrial output is still approximately 30% off of what it was in late 2007, and Japan is discussing extending QE. The least we can say is that the bottoming process is rather uneven based on where you live, and with rates at near 0% everywhere or almost, we look at what relative value opportunities may present themselves as central banks debate how to transition from QE to more “normalized” liquidity environment and finally towards higher rates.

The Fed has constrained itself by stressing the 4 to 6 months meaning of “extended period of time”. Some in fact view it as a moral hazard because it takes away some flexibility in the Fed’s ability to respond to the data should it surprise significantly to the upside. As liquidity is starting to be withdrawn the need for the language and the constraints that come with it are starting to balance each other. While we have not necessarily heard enough from the Fed to believe a change in the statement is coming up necessarily next week, should it happen the sell-off in reds and EDZ0 should be brutal. If this is not the case, I expect the Fed to be at least a lot more vocal in stressing liquidity withdrawal and give details about upcoming operations. The carry remains pretty steep (58bps rolling EDZ0 to EDH0) but policy risk to longs is starting to build up.

The BOC has historically rarely started hiking before the Fed. At the same time, the BAZ0/EDZ0 which was just under 20bps to start the year is now at 60bps. So if history repeats itself and the BOC waits for the Fed to draw first, the spread is probably a bit rich here. I am not sure whether the BOC has the luxury to wait for the Fed, but USDCAD in the lower end of the range between 1.02 and 1.03 is also certain to lead to caution as a strong CAD is not at the top of the BOC’c wishlist. So the Dec BED spread is slightly rich or at best fairly priced we feel.

The SNB has been at the center of many talks in the last few days and it is believed that in the current more risk prone environment the appreciation of the CHF against EUR and USD has been more controlled which may give Switzerland the room to maneuver it needed to consider hikes. Here again outright plays other than for June are carry-expensive and some worry that the overall poor environment in Europe will also make the SNB more hesitant. A relative value play could be to buy ESZ0/ESH1 as a spread against selling ERZ0/ERH1 as a spread. The liquidity normalization in Europe is keeping the Euribor curve relatively steep in the front-end, but at the same time hikes are completely out of the picture. Selling ERZ0/ERH1 rather than buying Euribors outright isolate the liquidity normalization risk while allowing to take a view on a stronger economic environment in Switzerland. (See ERES Z0H1 Chart)

The economic picture in Europe is so obviously bad that rates are completely out of the picture. The ECB is historically a solid year beinh the Fed anyways as the US economy enters faster in recession but also comes out of it a lot faster. However, if the carry to ERZ0 still seems attractive being north of 50bps, a lot of it stems from the expectation of liquidity normalization which would bring Eonia back in line with the 1% target rate. The fact that ERZ0/Z1 is in th mid 80s and EDZ0/Z1 above 140 is already factoring a more aggresive Fed. Still by historical standards more could easily be priced in. We looked at buying EDZ0/H1 against ERZ0/H1 and found that even tough the market could well price more, the box trades already +14bps, so it is a relatively consequent negative carry. Until policy starts physically changing, fighting carry can be a very expensive hobby, so we prefer the SNB/ECB play mentioned earlier when it comes to fading ECB hikes.

The Bank of England has a tough task ahead, but not as tough as fixing the budget gap is. England seems to have the will compared to other countries to balance the budget to avoid a refinancing crisis like what is happening in Greece (claims that the crisis is over today by the way or not only ludicrous but also moronic as there is a huge tranche of refinancing coming up in April and May, and only successful issuance will allow politicians to claim victory). As long as those issues aren’t addressed, and the consequences of the austerity required on the economy are evaluated, an extension of QE could well be more likely than talks of hikes. This is why we view a relative value play between ED and short sterling as the best way to express the economic outperformance of North America over Europe. The chart shows that buying EDZ0/H1 against L Z0/H1 allows us to express the view without barely any carry, we would buy the spread around -2/-3 in order to play +10/+15. For those who prefer using options, this morning we priced that selling the EDZ0 99.50 calls to buy the L Z0 99.125 calls could be done receiving 3bps for the structure. If both markets sell-off a gain of 3bps is realized, and the only real downside scenario would be a case where the Fed is on hold through 2010 and the BOE hikes. We view this scenario as very unlikely.

The last central Bank we want to quickly mention is the Bank of Japan. Most market participants expect the BOJ to extend QE and continue to pump liquidity into the system in a desperate 20 year in the making attempt at creating inflation. Whether they succeed or not, it should undermine the vlaue of the JPY. As I have stressed out on many occasions I believe USDJPY is grossly mispriced. The trade is hard to keep on because of risk aversion flight to JPY which can be rather painful, but if one aligns market timing with fundamentals it is a good trade to play from the long side. Watch closely a break past the 91.50 and 92.80 resistances which would confirm an exit outside of the bearish channel and lead to a strong move upward.

Courtesy of John Carney at Clusterstock/Business Insider

The news that the Securities and Exchange Commission’s top economist is leaving should highlight huge blot on the record of Chairman Mary Schapiro.

James Overdahl, the economist, run the unit of the SEC charged with evaluating the economic impact of proposed rules. In 2008 his office evaluated the impact of short sellers.

What the economists found is that a lack of evidence for the so-called “bear raids” in which short sellers were allegedly piling onto distressed stocks. Rather, short sales increased when stocks rallied. They concluded that there is no evidence that “episodes of extreme negative returns are the results of short-selling activity.”

But the SEC went ahead and adopted rules restricting short sales anyway, voting 3-to-2 to to limit short sales  when a company’s stock falls 10 percent from the previous day’s close. Overdahl’s departure highlights how much this is political pandering rather than good policy making based on empirical results.

Overdahl will step down March 31 to join NERA Economic Consulting, according to Bloomberg.

By David Galland, Managing Editor, The Casey Report

The concept of entropy is one of the most useful terms for understanding just about everything. While it has its origins in natural law – thermodynamics, specifically – the concept holds true pretty much across all closed systems.

In the simplest of terms, every closed system will ultimately degrade toward a state of maximum entropy.

I’ll use the current political system of the U.S. as a convenient example. When American democracy was first shoved out of the nest by the founding fathers, it was new, fresh, and energetic. It took the world’s breath away at its boldness and unlimited promise, and set the wheels turning on tangible change across much of the world.

Before the ink dried on the Constitution, however, the degradation began. From the beginning, the country’s political operations fell into the hands of a strictly limited number of parties, which quickly coalesced into just two. Since then, they have essentially shared power, with only minor differences in policies between the two. Simply, absent a disruptive external force, the closed political system quickly matured into an institutionalized “sameness” that all but assures no serious challenges – leading, ultimately, to the certainty it will degrade to only a shell of its former self.

It was, perhaps, because of his own understanding of natural law that Thomas Jefferson was heard to remark, “The tree of liberty must be refreshed from time to time with the blood of patriots and tyrants. It is its natural manure.”

That doesn’t mean I am advocating revolution – just pointing out the fact that any closed system, no matter how well constructed, will degrade. To expect the United States of America to avoid this fate is to expect the impossible.

Switching to a corporate example, I used to be a regular buyer of Toyota cars. They were well made, innovative, and suited my changing needs over the years. And I wasn’t alone – in 2007 they became the world’s largest automobile maker, with a global manufacturing and distribution system that made them appear dominant. Behind the scenes, though, entropy was at work.

In 2008, when the time had come to lease a new car, I reflexively headed over to the local dealer fully expecting to drive off with yet another Toyota, just as I had done several times over the previous decade or more. But as I walked around the showroom, it was impossible not to notice that the company had lost its edge. The cars on offer were not only more expensive than the competition, but even the newest models had that “so yesterday” look about them.

Surprising even myself, I walked out and ended up leasing from another company. I remember vividly at the time saying to my wife that we should short Toyota’s stock. Of course we didn’t – but if we had, it would have been a good play, as you can see in the chart of the company’s stock price here. Note that Toyota’s share price peaked in 2007, almost concurrently with it becoming the world’s largest car company.

As I said at the onset, you can see entropy at work in virtually every closed system. Consider the U.S. dollar, which became the world’s de facto reserve currency as a result of Bretton Woods. What an amazing advantage for the United States – this unique ability to provide the world’s central banks with their primary reserve component! And to have all the world’s commodities dealt in dollars. In short, the dollar became the centerpiece of the global economic system.

It was, of course, damned to entropy, with Nixon’s ending the dollar’s gold backing just being part of the natural progression. And if he hadn’t done it, one of his successors would have – due to some “emergency” or as a “temporary” measure, or some other flimsy political cover. Regardless, the degradation of the currency gained speed and, systematically, it’s been all downhill since.

You may also want to think about entropy when pondering the Chinese miracle. No question, China is having a heck of a run. As James Quinn writes in his article “Is China’s Recovery a Fraud?” in the February edition of The Casey Report, in 1970 that country’s GDP was just $92 billion. Today it is $4.9 trillion!

“Unstoppable!” cheers the punditry. The Chinese leadership, whose capable hands are very much on the levers of the macro-economy, are cut from special cloth, they add.

In answer to that, Quinn points out that despite China being an export-based economy, purpose-built to supply goods to a U.S. population engaged in a mad rush to spend themselves into debt and default – which is to say, an economy now only a memory – there is currently 30 billion square feet of commercial real estate under construction in China.

I’m not sure if bowling is popular with the Chinese, but with all that spare space, some enterprising individual might want to consider promoting it as the coming thing. Roller rinks? Indoor laser tag centers?

Meanwhile, back in the U.S., we the people are no longer content with a free-market system that embraces periodically burning down the house in order to rebuild stronger and better – a system which has been proven to create wealth, and lots of it. Instead, we are hell bent on adopting the closed economic system of a socialist model where everything and everyone is tightly controlled.

On that point, a recent article in the Wall Street Journal titled “No Exit in Sight for U.S. as Fannie, Freddie Flail” sheds light on the continuing degradation in the free market that used to underpin the nation’s hugely important housing sector…

Fannie and Freddie, for their part, remain at the core of a housing-finance system that inflated a dangerous housing bubble. After prices collapsed, sending shock waves around the world, the federal government put America’s housing-finance system on life support. It has yet to decide how that troubled system should be rebuilt.

On Dec. 24, Treasury said there would be no limit to the taxpayer money it was willing to deploy over the next three years to keep the two companies afloat, doing away with the previous limit of $200 billion per company. So far, the government has handed the two companies a total of about $111 billion.

(Full story here.)

Can’t you just smell the entropy? The results are not just predictable, they are evident – just look around.

As investors, it is, I would contend, important to understand the notion of entropy – and to watch for it in your portfolio companies, in your bureaucracies, and, on a more personal level, your relationships and your health. On that last point, the human body is very much a closed system and so, as we all are too painfully aware, will degrade until it ceases to exist.

You can slow the degradation by taking care of yourself. But it’s also worth remembering that it’s a one-way slope, so enjoy yourself while you are fit and able to.

While it’s impossible to halt entropy, what you can do is take action to protect yourself and your assets from its effects. That’s what the editors of The Casey Report do best: recognize and examine emerging trends in the economy and markets, and help investors take advantage of the opportunities that arise from them. And profits are everywhere if you know what to look for – even in the worst economic crises. Click here for more…