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Two More Reasons to Sell Treasury Bonds |
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The next half-trillion (with a "T") in losses
to blindside investors,
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A couple more government-sponsored Darwin
Award contenders,
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Plus, Bill Bonner on that Friedman character
and plenty more...
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Joel Bowman, reporting from Taipei, Taiwan...
The markets were closed yesterday in observance of Martin Luther King Day.
We don't know any more than the next guy about the traditions of the
holiday...but we assume it must present the ultimate conundrum for the
racist slacker. Does he stubbornly trudge through a day in a vacant office
in order to stay true to his knuckle-dragging bigotry? Or does he spend
the day on the couch, sipping cheap beer and feeling guilty that he has
betrayed his pointy-hooded brethren?
Who knows? Who cares? Our beat here is finance...
Here in Asia, where workers seem to possess an insuppressible verve for
their toil, trading continued as usual. Markets ended the day relatively
close to where they started it. Japanese measures finished down about one
percent; Hong Kong indexes were up about the same amount. Chinese stocks
bobbed about in more or less the same spot.
Over in Europe, key indexes ended lower by about one percent. Gold and
crude also sagged a bit. The former now sits around $1,130 an ounce; the
latter at $77 and change per barrel.
In other words, things are more or less as we left them last week, when
the Dow dipped 100 points into the weekend. We have no way of knowing
whether this is merely a blip on the way back to "pre-bust" euphoria...or
the start of the next leg down. We certainly suspect the later but, as our
villain, Lord Keynes, himself once famously remarked, "Markets can remain
irrational longer that you can remain solvent."
In today's issue, Strategic Short Report editor, Dan Amoss, joins
us to bolster the case against owning US Treasurys. And, as always,
Reckoner- in-Chief Bill Bonner shares with us his views on the world from
a bus ride in Ireland. Please enjoy...
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The Daily Reckoning
Presents: |
Last week we wrote to Dan Amoss requesting
some fodder for our Financial Darwin Awards. Readers will recall that
we've been celebrating those companies kind enough to have recently
removed themselves from the corporate gene pool. (We prefer the
streamlined, highly-competitive marketplace, the one that once made
America a global powerhouse, to the centrally-planned, "survival of the
weakest" one that continues to grow.)
Dan shot back a couple if ideas, including the following thoughts on two
of the nation's most cumbersome, ill-adapted GSEs...
Two More Reasons to Sell Treasury Bonds
By Dan Amoss
Jacobus, Pennsylvania
Two more reasons to sell US Treasury bonds: Fannie Mae and Freddie Mac.
These two giant mortgage lenders are poster children for the dangers of
wrapping government guarantees around the credit markets. With help from
the state-sponsored banking system, these two government-sponsored
entities (GSEs) perverted the process of credit intermediation and
artificially suppressed the cost of mortgage loans over many decades.
This perversion of mortgage finance explains why house prices grew
faster than household incomes for roughly a decade ending in 2006. With
the broad recognition that the GSEs were insolvent in late 2008, the
artificial suppression of mortgage rates was about to come to an end.
That is, until the Treasury and Federal Reserve doubled down on their
commitments to throw good money after bad. Now, permanent manipulation
of mortgage interest rates has become official government policy. The
cost of this policy will be even higher federal deficits in the future.
Government guarantees temporarily hide risks, which results in foolish
capital allocation throughout the economy. This game can last until the
activity collapses under its own weight (like housing in 2007), or until
the government itself runs out of financing options at affordable
interest rates.
Just like Medicare policies influence the practices of health insurance
companies, Fannie and Freddie mortgage-backed security (MBS) guaranty
policies influenced the underwriting behavior at mortgage brokers.
Therefore, no one should be surprised that mortgage brokers fudged
numbers to shoehorn borrowers into "conforming" mortgages. These brokers
generated huge profits by unloading massive amounts of underpriced
credit risk into the Fannie and Freddie MBS pipeline.
Mortgage expert Mark Hanson described the triumph of automated mortgage
underwriting over prudence in a December 2009 issue of the Mortgage
Pages:
During the bubble years, the GSEs looked at [debt-to-income ratios]
secondarily to credit score, [loan-to-value ratios], and cash reserves
as measured by liquid cash and 70% of retirement [assets]... During the
bubble years, if the LTV was low enough and/or score and cash reserves
high enough, the system would approve virtually anything.
Many lenders, especially the big banks, had...underwriting "trainers"
that would go around to the various mortgage branches and teach
underwriters how to "trip" the systems in order to achieve automated
loan approvals when a declination was certain, or simply get fewer
approval conditions on a loan that was borderline. Getting a loan
approval out of...a borrower with a 100% [debt-to-income ratio] - with
limited documentation required on the automated findings - was not
uncommon.
The poorer-than-expected quality of the mortgages inside of the MBS that
Fannie and Freddie guarantee will lead to hundreds of billions in credit
losses. The frequency and severity of these credit losses over the next
few years will take Wall Street by surprise.
These credit losses will blow huge holes into the GSEs' balance sheets,
overwhelming their thin slices of capital several times over. When this
capital vanishes, the US Treasury Department will float more government
debt and use the proceeds to refill the capital shortfalls.
On Christmas Eve, the Treasury delivered a lump of coal to US taxpayers:
It eliminated caps on future equity injections into Fannie Mae and
Freddie Mac. Let's not kid ourselves. These capital injections are not
"investments." No rational investor would be injecting equity into the
GSEs right now. Rather than demand a reasonable risk-adjusted return,
these injections will just keep the GSEs' loss-plagued balance sheets
solvent.
Consider the situation by visualizing Fannie's and Freddie's balance
sheets. Since the beginning of the financial crisis, the Treasury and
Federal Reserve have teamed up to reinflate the assets and equity of
these institutions. The Treasury pumped new equity (in the form of
preferred stock) into them as needed, while the Fed used newly printed
money to buy up the GSEs' debt and the mortgage-backed securities that
the GSEs guarantee. Thanks to these shenanigans, the market prices of
the assets on the GSE balance sheets appear to be holding up. But make
no mistake; despite the Fed's actions, the real underlying value of
these is being eaten away by credit losses.
On Jan. 12, Amherst Securities published a study on the estimated losses
Fannie and Freddie will absorb as foreclosures flow through the credit
loss pipeline in the coming years. Using a database of 29 million active
prime mortgages from First American CoreLogic, Amherst estimates that
the GSEs will ultimately suffer $448 billion in cumulative
credit losses. Amherst explains the likely distribution of
these losses:
These gross losses will be distributed across four categories -
write- downs already taken by Fannie and Freddie and reflected in their
loan loss provisions, future credit losses to be taken by Fannie and
Freddie, losses absorbed by mortgage insurers, and losses absorbed by
originators through put backs. Fannie's loan loss reserves total $66
billion: $57 billion for MBS guaranty losses, $9 billion for loan
losses. Freddie's loan loss reserves total $30 billion: $29 billion for
MBS guaranty losses, $1 billion for loan losses. The remaining $352
billion of losses will show up across the other three categories (Fannie
and Freddie future losses, mortgage insurers, and originator put backs)
over time.
If Amherst is accurate in its projections - which I expect, given the
quality and independence of its research - then Fannie and
Freddie have built allowances to cover a mere 21% ($96 billion divided
by $448 billion) of the losses they'll ultimately have to absorb from
the housing bubble.
It's no wonder the Treasury Department lifted the bailout caps on
Christmas Eve; it'll be the only entity willing to plug the GSEs'
deepening capital holes.
What does this mean for the markets? It translates into very bad news
for complacent stock market bulls and junk bond junkies.
The lifting of the GSE bailout limits strengthens the case for rising
Treasury yields in 2010. Rising Treasury yields are bearish for the
stock market because higher yields offer better competition for
investors' dollars. Rising Treasury rates also increase the cost of
capital for all companies.
The elimination of limits on Treasury's capital infusion into Fannie and
Freddie is a de facto nationalization. We'll see a gradual
transformation of these hollow zombies into new branches of government.
They'll implement the official agenda for housing, with little regard
for prudent lending standards. This could severely degrade the
creditworthiness of US Treasury securities.
The government will probably stick to its dishonest, Enron-style
accounting; it won't officially consolidate Fannie and Freddie assets
and liabilities onto the federal balance sheet, but many foreign
creditors will. These creditors will demand higher rates to compensate
for the rising risks of investing in US Treasuries...and that means bond
prices will fall...eventually.
Joel's Note: If you'd like to delve a little deeper
into Dan's research - research that has made his readers a small fortune
as the surrounding economy continues its slow-motion collapse - there's
never been a better time to do so.
Right now Dan is offering a one-month trial of his Strategic Short
Report for just $1. This is the same research that retails for
$1,495 per year so, as you might imagine, we can't hold this steep
discount open for long. If you want in,
here's all the info you need.
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And now over to Bill Bonner, who has today's reckoning from
Waterford, Ireland...
Oh happy days are here again. Obama is going to get our money back from
the banks. Jeffrey Sachs is telling Haiti how it can get its economy
back in order (with other people's money, naturally). And Thomas
Friedman is offering investment advice.
This should be fun. We're all on the bus...and it's driven by the blind,
the deaf and the very dumb. Oh, sorry, we meant the visually
impaired...the hearing impaired...and the mentally deficient.
Friedman is, as we all know, full of advice on just about everything. He
advises finance ministers on how to soup-up their economies. He advises
the Arab world on how to update its religious institutions. He advises
whole nations on how to improve the future before it happens.
And here he is now counseling Mr. James Chanos, noted short seller, on
how to make money:
"China's markets may be full of bubbles ripe for a short-seller, and if
Mr. Chanos can find a way to make money shorting them, God bless him.
But after visiting Hong Kong and Taiwan this past week and talking to
many people who work and invest their own money in China, I'd offer Mr.
Chanos two notes of caution."
First, he says: "Never short a country with $2 trillion in foreign
currency reserves."
Typically, investment wisdom evolves over generations of trial and
error. People come to see what works and what doesn't and pass on this
wisdom in the form of cautionary rules. But how many times have
investors shorted a country with $2 trillion in foreign currency
reserves? Where does this wisdom come from? Not from experience. Nor
from any theory we've ever heard. Which makes Freidman's first bit of
advice no better and no worse than every other bit of advice he's given
over the years.
It's his second bit of counsel that causes muscle cramps:
"Second, it is easy to look at China today and see its enormous problems
and things that it is not getting right. For instance, low interest
rates, easy credit, an undervalued currency and hot money flowing in
from abroad have led to what the Chinese government Sunday called
'excessively rising house prices' in major cities, or what some might
call a speculative bubble ripe for the shorting. In the last few days,
though, China's central bank has started edging up interest rates and
raising the proportion of deposits that banks must set aside as reserves
- precisely to head off inflation and take some air out of any asset
bubbles.
"And that's the point. I am reluctant to sell China short, not because I
think it has no problems or corruption or bubbles, but because I think
it has all those problems in spades - and some will blow up along the
way (the most dangerous being pollution). But it also has a political
class focused on addressing its real problems, as well as a mountain of
savings with which to do so (unlike us)."
Get it? Like...China has all these problems...see? And, of course, its
problems developed because of, or with the connivance of its government.
But it's gonna solve these problems...see? Because its political class
is focused on them.
We can hardly type the sentence. Our diaphragm is contracting in such
spasms of delighted cynicism; our fingers shake...our brain recoils.
Yes, dear reader, China's political class - communists, remember - is
going to solve the problems of a dynamic, market economy headed for a
blow up.
That settles it for us. We have friends on both sides of this play. Jim
Rogers is long China. Others are short. But Mr. Friedman has just given
us the Sell Signal of All Time. Every smart investor on the planet - all
two or three of them - should short China now. If Friedman is long; you
have to be short. Heck, even the angels are selling their China shares
and the gods themselves are calling their brokers.
Friedman is long China. What's he short?
"I'd rather bet against the euro," he says.
Well, there you have it. A buy signal for the euro.
Nobody has ever liked the euro. The typical analyst is against it. "The
US government stands behind the dollar," he says, "but who stands behind
the euro? Nobody."
That's as deeply as most analysts care to think about the subject. If no
one stands behind the euro, it must be a weak currency. If it is weak,
it must be weak as compared to something. The dollar, for example.
Here at The Daily Reckoning, we think the typical analyst errs.
As for Friedman, he is beyond error. Mistakes only happen to people who
bother to think about things enough to make the wrong choices. Friedman
thoughts are not that profound. He errs like a squirrel or a donkey
errs, not by thought but by instinct. He is wrong, not by accident, in
other words, but by design; he is made for it.
Friedman's pensée is not prone to error; it is fundamentally flawed,
like a kitchen sink that is plumbed backward. You turn on the cold
water, and it comes bubbling up out of the drain. You turn on the hot
water and you hear Frank Sinatra.
How else could a walking, talking human being believe such preposterous
and foolish things? Don't bet against China because its political class
is focused on its problems? Oh stop...our stomach muscles can only take
so much... Economic problems, meltdowns, and crises can be caused by
politicians; there is not a single example in the historical record
where they have cured these problems. (The only exception is when they
stop doing damage...temporarily, like a boxer who lets an opponent get
up from the mat before slugging him again.)
Which brings us back to the euro. The continental currency is despised
for the wrong reason: because no nation is actually capable of beating
it up. All the world's other paper currencies are controlled by people
intent on weakening...or destroying them. The euro's out of the
ring...controlled by...well, no one in particular. It's run by a group
of countries that can't agree on how to ruin it. The euro benefits from
eurosclerosis. The Irish and Greeks want a weaker currency. The Germans
want to keep it strong. The French can't decide what they want. Result:
paralysis. No one will rush to save the euro. But no one will rush to
kill it either.
Besides, if Friedman is agin' it...we're for it.
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And more opinions...thoughts and reckless reflections...
Markets were closed in America yesterday. In the rest of the world nothing
much happened. This leaves us free to talk about whatever we want.
What do we want to talk about?
Let's talk about Japan. You remember, Japan? It's the country with the
20-year on-again, off-again depression. You could have bought stocks in
Tokyo 20 years ago...held onto them...and guess what you'd have today?
Well, for every dollar you invested two decades ago, you'd have about 25
cents. How's that for 'stocks for the long run?' How's that for capital
appreciation? How's that for getting rich from investing?
Stocks in Japan are back to their levels of the mid-'80s. So, an investor
who was 40 in, say, 1984, is now 66. He's retired. During his 'investing
years' he made zero...nada...rien...zilch...from his money.
What to make of it? Is the whole promise of investing nothing but a Wall
Street fantasy? The idea is that you can give your money to Wall
Street...put it in a fund...in stocks...in some sort of investment...and
it will grow larger. You will pay Wall Street a fee for this service. In
fact, you could pay a lot of money...trading in and out of various
investments.
And where would you end up? Well, if you were the typical Japanese
investor you'd end up with less than what you started with.
The lesson we draw from that is that you only make money from investing
when you buy assets that are cheap and sell them when they are dear. 'Buy
and hold' doesn't work. 'Stocks for the long run' is a trap.
But what about Japanese stocks now? We thought you would ask. Since we
announced our new 'Trade of the Decade' - sell US Treasury bonds/buy
Japanese stocks - we have gotten nothing but grief on the subject.
Everyone thinks he knows what will happen to Japanese equities over the
next 10 years; and everyone thinks they will go down.
Here is Ambrose Evans-Pritchard in London's Daily Telegraph:
"...2010 will prove to be the year that Japan flips from deflation to
something very different: the beginnings of debt monetization by a
terrified central bank that will ultimately spin out of control, perhaps
crossing into hyperinflation by the middle of the decade.
"Once a country embarks on such policies, the game is nearly up. The IMF
says Japan's gross public debt will reach 227pc of GDP this year. This is
compounding at ever faster speeds towards 250pc by mid-decade.
"The only reason why this has not yet blown up is because investors
(mostly Japanese) have not yet had the leap in imagination required to
understand their predicament, and act on it. That roughly is the argument
of Dylan Grice from Societe Generale in his latest Popular
Delusions note released today. 'A global fiasco is brewing in Japan.'"
We don't doubt it. Evans-Pritchard is right. So is everyone who thinks
Japan is going to meltdown or blow up. A global fiasco is brewing. But it
will not necessarily be bad for Japanese companies. Investors will leave
Japanese debt and buy Japanese equities. Inflation will reduce the real
cost of operation for Japanese companies. Frugal, solvent, efficient
Japanese companies will prove to be a refuge, not a trap.
More on this subject as the decade progresses. We will be proven
right...or wrong... Geniuses...or idiots... Visionaries or hallucinaries...
Depending on how the chips fall.
Regards,
Bill Bonner,
for The Daily Reckoning
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Here at The Daily Reckoning, we value your questions and
comments. If you would like to send us a few thoughts of your own, please
address them to your managing editor at
joel@dailyreckoning.com
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