The Oil Drum: Europe

With economic uncertainty steadily increasing as 2008 approaches, we would like to offer best hopes for peace and a Merry Christmas to all our readers.

Pain Street USA: '08 housing outlook
_{The forecast is for a longer, deeper home-price slump than previously expected, with double-digit declines in many markets.}

The United States is deep in its worst housing slump since the Great Depression, and according to a new report, it's not going to get better any time soon.

In a new survey, Moody's Economy.com says many metro areas will record losses of 20 percent or more during the downturn, with the national median price for single-family homes dropping 13 percent through early 2009. Factoring in discount offers from sellers, the actual price decline would be well over 15 percent....

...."There has been a sea change in seller psychology since the subprime shock this summer," he said. "Sellers now realize they have to drop their prices to make a sale and prices are coming down very rapidly in some markets."

Housing - Simple As That

At this particular moment in time, banks are about as heavily exposed to mortgages (as a total percent of assets) as they have ever been. Further, banks are holding an enormous quantity of commercial real estate loans, especially in the rah-rah areas such as Florida, the Southwest, and in California.

The FDIC reported last year that more than 50% of all the banks in the southeast and west regions had exposure to commercial real estate loans that exceeded their total capital by 300% or more. Holey smokes! ....

....To put it in the simplest of terms, the total amount of bank capital in the entire country is a little over $1.1 trillion while more than $11 trillion in real estate loans exist meaning that a 10% to 15% loss on those loans would translate into the complete bankruptcy of the US banking system. What this all means is that we have a crisis of solvency, not liquidity.

Currently the Federal Reserve has teamed up with a few European central banks to provide vast new sources (unlimited really) of liquidity to the banking system. The central banks will allow specific institutions (big banks) to trade in their piles of dodgy loans for electronic piles of cash for a specified period of time. After a period of time the banks will have to buy those dodgy loans back, at par and with cash, at some point in the future.

If those loans are bad (‘bad’ like a $500,000 mortgage on a $300,000 condo) then this maneuver by the Fed simply won’t work. Instead, we need to quickly recognize that the loans are simply going to permanently underperform or enter default. This means we will probably lose a financial intuition or two (or thirty) along the way, but delaying the inevitable does not change the outcome, only the length of time you spend in pain.

World bankers resort to firebreak

Never before have the central banks of North America, Europe, and Britain, acted together as such a unified phalanx, but never before have transatlantic credit markets seized up with such violent effect.

"This is a drastic action. The central banks want to place a fire-break to stop credit tensions spilling over into the broader markets and becoming the catalyst for a global economic crunch," said Ian Stannard, an economist at BNP Paribas.

While yesterday's joint move was sketched at the G20 a month ago, and fine-tuned in encrypted telephoned calls over the past month, the final trigger seems to have been the spike in the crucial three-month money rates that lubricate finance. Dollar and sterling Libor spreads have vaulted in recent days. Euribor spreads reached an all-time high of 99 yesterday morning....

...."There's a real danger that this may not work. Both the Fed and the ECB have injected a lot of liquidity before, but the banks are hoarding it. We're still seeing all the signs of stress with Libor and the VIX [fear gauge] at very elevated levels. The reason is that people still don't know where the bodies are buried," he said. "This may be a Made-in-America credit crisis but the Americans have cleverly exported their sub-prime cancer to pension funds all over the world. The risk now is a recession on both sides of the Atlantic," he said.

Editorial Note from Stoneleigh: Round-Ups do not always make the front page at TOD. For access to all our work, please check the TOD:Canada site regularly. The last Finance Round-Up (November 29th) can be found here. We intend to publish them twice a week.

It’s not that I was wrong when I said we’d see the US economy propped up for one last good Christmas shopping season. It’s just that accountants, auditors and ratings agencies have started to feel so much heat, they’re afraid they’ll be left sitting all alone on the hot cinders around the tree, with a shaky conscience and nothing in their socks to start the new year but pink slips and indictments.

Today, in early December, it’s still possible that the worst decay remains buried till 2008, but we can’t be sure anymore. What we see is America’s largest mortgage lender, Countrywide, hanging on by a thread, while America’s, and the world’s, biggest bank, Citigroup, may be beyond redemption. After recent securities losses, and $40+ billion more predicted, Citi now admits to a $17 billion write-down on its SIV’s, which still leaves another $66 billion of braindead “assets”.

Ratings agencies are trying to stay afloat, and increasingly, in the face of congressional investigations, out of prison. To show their good will, they’ve started downrating companies, bonds, and all sorts of securities. This’ll likely be the end for many bond insurers. Is that so bad? Ambac carries $620 billion in structured paper, with $9 billion in cash. ACA insured $61 billion in assets, with $326 million in cash. Isn’t it just good riddance?

Well, Ambac are underwriters for paper issued by the likes of Countrywide, GMAC and Lehman Bros, and Ambac’s demise will drag down, way down, all the paper they insured, and the clients that issued it.

And it gets worse, with the forced sale of E*Trade’s mortgage-backed securities. E*Trade got $2.5 billion from Citadel, a hedge fund, under condition that they sell their MBS. Since nobody trades that stuff these days, for fear of finding out the true value, this sale is a rare glimpse behind the veil. The price they got is 11 to 26 cents on the dollar, a potential 89% loss.

Why is that important? It sets a new rule, law, value, for all remaining mortgage-backed securities, trillions of dollars “worth”, that remain in vaults all over the world. For all of them, it just got a whole lot harder, if not downright impossible, to get more than 11 cents on the dollar. Moreover, E*Trade was the only offer in the market when they had to sell. If more, and bigger, parties are forced to unload simultaneously, the price’ll go down, so says the free market.

March is when we realize that the dollar doesn't come back

_{Arlington Institute issues a Financial Alert based on M·CAM Analytics}

The Chinese currency wild-card may become relevant far sooner than expected. An effort by China to convert its $1.4 trillion U.S. Treasury holdings into euros is not viable for many reasons -- not the least of which is the European Central Bank's inability to absorb such an event.

When February comes, the Chinese are going to do something as they will have to decide what the exposure is going to be with the treasury. As I see it they have to just dump the treasury. They only keep it because they can use it -- they have 43% direct/indirect of US treasuries so they'll dump them on the market.

OPEC price with the whole fluctuation of oil futures presages the event. They are going to run the price of oil as high as they can get it on the dollar, while buying US treasuries from China with the money. When the dollar does collapse, they'll flip denominations.

The wild card is long about March when the OPEC cuts spot oil off the dollar to the euro. One can look at the current oil price at close to $100/barrel and fail to see that, as this premium price is currently turning around and investing in a weakening dollar, the effective price (less the dollar investment hedge) is probably closer to $50/barrel than the spot price reflects. Currency problems will change the game -- they are financially structuring themselves to take the hit.

When we can't afford to buy oil commodities on a spot market -- it compounds the problem however the consumer that Saudi Arabia ships to is liquid (China). In the US it is a big problem. There is still a market for oil; it just changes.

When you come out of Straits of Hormuz, turn left.

People increasingly ask us what they should do in face of the financial quicksand we’re in. Unfortunately, as with all of today’s global riddles, there are no easy answers. The views we quote here vary from inflation to deflation, from buying gold to buying goats. The writers we link to often make their living tracking markets, and still there is nothing remotely resembling consensus.

According to Gregory Peters, head of credit strategy at Morgan Stanley:

There's a greater than 50 percent probability that the financial system will come to a grinding halt. You have the SIVs, you have the conduits, you have the money-market funds, you have future losses still in the dealer's balance sheet in the banks [..] That's all toppling at once.

Financial institutions are acknowledging that the losses could reach over $400 billion, and that is before an additional several hundred billion dollars worth of residential real estate enters foreclosure, leading to additional losses in the derivatives market of many times that figure due to leverage.

Over the next few months, major impacts will be felt.

First, the gargantuan bond insurance industry is teetering on the brink of the abyss, with rating agencies threatening downgrades of 14-18 notches (from AAA to deep junk). That could leave trillions of dollars of bonds uninsured, and therefore no longer able to borrow a triple A credit rating independent of their true worth. Those bonds would lose much of their value, and many large investors, such as pension funds, would be obliged by law to sell anything below investment grade.

Secondly, US accountancy rules changed November 15, affecting the upcoming financial year. "FASB 157" dictates that banks and securities firms can no longer hide their worst assets as Level 3, which allowed them to be kept off balance sheet. Trade in classes of commercial paper theoretically worth more than entire countries will have to be valued using observable inputs for the first time (where possible), rather than mark-to-make-believe.

In addition, as of January, banks can no longer indemnify their auditors for signing off on accounts they cannot verify, leaving the auditors potentially liable over the virtually unquanitfiable exposure of their clients to the derivatives market. Auditors are therefore likely to make every effort to verify valuations where evidence of true value can be found.

A cascading failure of financial institutions is all too possible.

The credit crunch that has been unfolding in slow-motion all year appears ready to make headlines again as equities experience a sharp sell-off. As Ambrose Evans Pritchard says, the evidence that something serious is underway is already present in abundance. Losses and writedowns are mounting, and problems seem to be spreading to bond insurers, which will further impact on the value of insured bonds.

Trillions of dollars of off-balance sheet activities are increasingly coming back to haunt the banking system, as downgrades come in thick and fast. 'Discounted' is the new 'contained', but these losses are neither fully discounted nor contained.

Ambrose Evans-Pritchard: The sky has already fallen

If you are a bear, you must accept that you will always be wrong in polite society, and you will continue to be wrong all the way down to the bottom of recession. That is the cross that bears must bear.

Over the last three months we have seen a rolling collapse of speculative debt and real estate across half the global economy, yet friends still come over to my desk at the Telegraph, with that maddening look of commiseration on their faces, and jab: “so when is the sky going to fall then, eh”?

Well, excuse me. The sky has fallen. The median price of new homes in the US has crashed from a peak of $262,6000 in March to $238,000 in September. (Commerce Department). This is a 9pc drop nationwide.

The slide in existing homes is catching up. They have come down from $229,200 to $211,700 in three months. (National Association of Realtors). Yet we have barely begun to see the default hurricane as Teaser rates contracted in 2005 and 2006 on floating mortgages kick up venomously over the winter, peaking around in the Spring of 2008.

Merrill Lynch has just confessed to a $7.9bn write down on CDO subprime debt and assorted follies, nearly double what it suggested three weeks ago....

....It is true that stock markets have once again decoupled from the realities of the debt markets. But they did this in the early summer, when the Bear Stearns debacle was already well under way. They caught up famously in August.

Nobody I talk to in the City credit trenches believes for one moment that the crunch is safely over. Indeed, they think that we are edging back to extreme stress levels, and the longer it goes on, the worse the damage.

Big banks continue to try to put together a rescue fund in order to avoid a firesale of the assets backing off-balance-sheet structured investment vehicles, but the voices of the critics who would like to see an 'orderly repricing' of these asets grow louder. Alan Greenspan , who now says the credit crunch was "an accident waiting to happen", is notable among them.

It remains to be seen how orderly such a repricing of such assets would be, as well as how broadly and how quickly financial contagion could spread the fallout.

UPDATE:

You Tube: The lighter side of the subprime fiasco from a British perspective

Give it up for the Long Johns

This 8 min. movie both explains subprime better than we could, and has us rolling off our chairs.

In the US, as one door has closed on subprime lending, another has opened on credit card debt. Actually living within one's means doesn't always seem to be an option, for some due to poverty and for others due to greed. Either way, the debt hole Americans (and Canadians, and the British) are collectively digging themselves into is getting deeper by the day, and they start young.

As losses mount, the role of mortgage fraud, by both borrowers and lenders, and also potential securities fraud, is being revealed. The litigation is only just beginning, but be prepared for a storm of legal action and recriminations. The ratings agencies are looking vulnerable to European action as their ratings enabled the sale of bad loans to European institutions, under conditions of conflict of interest.

Signs of stress are spilling over from the world of high finance to the real economy, where trucking and shipping are feeling the slowdown. Meanwhile Canada (several months behind the US) is still seeing a booming housing market, but for how long?