Helicopter had a “teaser rate” loan

From Time.com, the extended Bernanke interview.

Q: Do you have a mortgage?

Bernanke: Oh, yes, we refinanced.

Q: Oh, perfect. When?

Bernanke: About 5%. A couple of months ago.

Q: Good time.

Bernanke: Yes. We had to do it because we had an adjustable rate mortgage and it exploded, so we had to.
Q: So, did you get a fixed rate at 5%? I think this might be the most valuable piece of information.
(Laughter.)

Bernanke: Thirty years fixed rate at a little over 5%.

With short term interest rates at zero, how does an adjustable rate mortgage (ARM) explode?

It explodes when you get a teaser rate. So a few years ago, in the housing bubble, Helicopter Ben likely took out a teaser rate (low rate initially/high rate after teasing period is over) and gambled that since his house would appreciate in value, he could refinance at similar or better terms at that time.

Wrong! Just like subprime would be contained.

He refinanced at a 5% 30 yr, a rate that low because of the Fed’s one trillion dollar purchase of Fannie/Freddie junk paper at a premium.

He didn’t go with another straight forward ARM at 4% and then switch to a 30 yr if 30 yr rates go lower. He clearly thinks that the 30 year is going up. It probably will as the Fed is scheduled to stop buying the junk in March and if the 30 year treasury yield goes up, as supply overwhelms demand.

However, given Helicopter’s track record, is it possible that that his 5% 30 year is actually a high rate and that rates are headed lower still?

Not saying it happens, just asking?

The guy can't even get his own mortgage right. Why do we think that he can manage the world's economy?

HT to Minyanville’s Branden Rife for pointing this out.

Dominoes

The dominoes have started falling...

I don't expect them to be contained.

One of the amazing things to me is that after a ton of failures last year (AIG, Lehman, Citigroup, Merrill, Bear, Bank of America, Fannie, Freddie, GM, Ford etc..) and international disasters (Iceland), since March 2009, things have been very calm.

Until Thanksgiving weekend, when Dubai World basically announced a default prior to a four day Eid holiday.

Dubai World is technically not a sovereign, but basically the equivalent of a crown corporation of its government. The government of Dubai has stated that it will not bail out Dubai World. However, most reports have it holding the majority of Dubai's debt ($60 billion minimum of roughly $100 billion for the whole country- who really knows the true numbers?). Basically, a drop in the bucket in the grand scheme of things, but a possible domino in the interlinked global financial system. Losses in one asset class can lead to selling in other asset classes as leveraged investors sell good assets to pay for the losses, particularly in the case of those banks stuck with Dubai World paper.

My knee jerk reaction to Dubai (sorry, didn't get time to publish it) was that it would cause a short term sell-off until the "it's contained" bulls came out and bought. My thesis was that it would at temper the USD carry trade into risky assets by making people at least question default risk, especially in countries where the rule of law isn't quite as strong as in democratic countries. The market would then relax a little as long as the Dubai story stay contained.

And relax it did (much faster than I thought), and the USD completely reversed the flight to quality from Dubai. The S&P hit a new intraday high last Friday.

This week, Greece has been in the spotlight as it is basically running up too much debt after lying its way into the EU. Greece is another domino. Bigger than Italy, Portugal and Spain. The market now is pricing in a possible Greek default. It has a higher credit risk than Columbia or Panama. It is part of the Euro, so it can not devalue or cut rates to get out of its problems. Greece has to refinance or issue 47 billion Euros in 2010. Good luck with that! My guess is that the EU will force Greece to make massive cuts to its spending and increase taxes before even contemplating any bailout. The EU is reluctant to bail out Greece (and it has no official duty to do so) because it would create a moral hazard and the list for bail out candidates is very long.

Here is a list of other potential trouble spots:

1) Latvia is a small country, but it is on the edge of a devaluation of its Euro peg. Devaluation could spread to other Baltic and Eastern European countries, which have mindboggling debt loads. Where does most of the debt reside? European banks
2) Eastern Europe is a big mess. In the boom, credit was flowing to these countries (again European banks). Housing bubbles, euro mortgages for countries that don’t use the Euro, huge deficits. Ukraine may default and has a crucial election coming up in early 2010.
3) Spain has a bigger housing bubble than the US. It has likely yet experienced the worst of the implosion. Add Portugal and Italy to the list of suspects as well.
4) Ireland, the former Celtic Tiger, is in bad shape. It appears to be taking its medicine but you never know about aftershocks.
5) Dubai and the Middle East: Dubai has technically not defaulted, but realistically it has. It is the posterchild for debt excesses. If it can get bailout money from Abu Dhabi, maybe it can muddle through somehow. And all of this is with $75 oil. Imagine what happens if oil goes to $20!
6)Venezuela and Argentina are also possible trouble spots. According to the CDS market, they have a high chance of default.

Longer term dominoes:

1) China: I am not a believer in the China story. China’s economy is supported by exports and fixed investment. Exports are getting killed, obviously. However, consumer stimulus and fixed investment has more than picked up the slack. There is an investment bubble of epic proportions. Fixed investment is up 50% (!!!) over already inflated levels. Banks are lending with no realistic chance at a decent return. I see a lost decade coming for China at some point. With a rapidly aging population, China is rapidly becoming yesterday’s story and not tomorrow’s as 99.9% of the mainstream media would have you believe.
2) Japan has almost 200% government debt to GDP and is locked in the throes of severe deflation. It has been saved by rock bottom interest rates. If the market ever gets scared that Japan will not be able to pay its debt, interest rates would soar, making Japan’s debt load completely unaffordable. Japan has a ton of domestic savings, you say? Yes, it does, and that has saved it thus far. However, savings are dropping to near zero as its population ages while debt grows exponentially. This is a longer term domino but worth keeping in mind.

3) UK is in bad shape right now. If you get another financial crisis like 2008, good luck!
4) In the US, there is a huge reset in Alt-A and Option-ARM mortgages that is JUST STARTING. Combined with 10% unemployment, I expect foreclosures and defaults to soar in 2010, and house prices to continue to fall. Commerical real estate is a big mess. Budget deficits and growing intolerance for any new bank bailouts are going to make 2010 challenging for the bailout kings if things unravel once again.

Most of these dominos involve the same story. Too much debt, not enough savings.

What does this mean for 2010?

I have been looking for trouble abroad to be the next catalyst. I have laughed at those who have blamed the Americans for all of the world's problems. I even heard one analyst in Dubai blaming the US as the originator of the world financial crisis that has now washed up on its shores. Gimme a break! Dubai has built up a fantasyland in the desert with excess leverage. It was bound to fail eventually.

These dominos are likely to strengthen the US dollar especially versus the Euro, and tank commodity prices and stock prices as we go forward from here. I expect many sovereign defaults in 2010/2011 in addition to big problems with provincial and state debt loads in Canada and the US.

I am not sure how it plays out but I suspect that credit spreads are going to widen for most countries and it could even infect the safer credits of Japan, the UK, Germany and the US. The Dubai and Greece experience are going to make many bond investors look at the details of what they are holding (not sure why the experiences of 2007/08 didn't do that, but I digress). In addition, credit losses on defaults are going to hit, what else, the financial sector, with unknown further dominoes, including derivatives and/or bank runs.

In recent days, the US dollar has strengthened due to this return to risk aversion (and a strong employment report on Friday). The US dollar is the most hated asset class and everyone thinks it is going down. I think the dominoes are likely to send the Euro down to par over the next few years, and the US dollar is likely to be very strong in 2010 (target 1.15 to 1.25). This will unwind the carry trade with a steep drop for stocks and commodities. In addition, stocks are overvalued so a move to new lows in 2010 is very likely.

This does not even factor in the effect that an Israeli attack on Iran would have. That has a much higher chance of happening in 2010 than most are contemplating, I believe. (I will need to cover this in further detail at some point).

I suspect that with only a handful of trading days left in 2009, the bulls will keep things afloat for year end bonuses. Perhaps a move to new highs in January even. I fear that 2010 is looking to be a repeat of 2008.

Meanwhile, the useless mainstream economists (not Rosenberg or Krugman) will tell you that it is going to be a slow but steady recovery with GDP growth in 2010 & 2011 of 2 to 3%. When the catalysts hit, they will say "no one predicted X, no one could have seen Y" as their models can't cope.

Winds of Change in USD and SPX?

I have warned about premature celebration regarding the economy.

What does this mean for an investor or a trader?

It is not crystal clear yet for me.

Personally, 2008 was relatively straightforward. As I warned many times over 2008, we were heading a lot lower. However, by late 2008 and early 2009, once we had crashed, the future was looking a big murkier to me. The problems are still there, but a 60% move in 17 months means that at least some of it was priced in. I correctly saw the potential for a bear market rally but I completely messed up the trading of it and did not allow the rally to run its course.

In recent months, now that the “easy" money (it is never easy) had been made on the short side in 2008, I realized that I needed to adjust my approach.

I began to distinguish my intellectually bearish stance (where I believe this entire rally to be false and doomed to fail) from trading on the bear side. Since August, I have been a lot more selective about waiting for confirmation of the bearish case to show up. I believe we at least have a bearish set up here and I am trading quite heavily from the short side (note that my stance could change tomorrow).

Since the September 23rd Key Reversal Day and more recently, the October 21st Key Reversal Day, the market has looked toppy. A number of technical indicators are at least flashing caution, and since September 23rd, I have played the short side carefully, with small positions and with small gains. We have had a bunch of double tops in key indexes (transports, Russell, SOX) and poor action in key sectors such as financials and homebuilders. Good news is no longer leading to gains, and bad news is met by selling. Volume has been heavy on down days and poor on good days.

In the past week, I have ramped up my short positions as confirmation of at least a correction have shown up. We may be in a selling stampede (Jeff Saut’s term) that normally last 17 to 25 days, and are interrupted by 1.5 to 3 day countertrend moves. By my calculation, we are likely in Day 12 on Thursday, and today’s FOMC reversal might have been the end of a 3 day counter trend move.

The setup is here, and I believe a move below recent lows of 1029 should lead us to 950/956 by around November 20th.

The bull case, in my opinion, is that we bottom around those levels and then rally back by year end or early 2010 to 1100 or higher.

The bear case is that we are going much lower than 950 and will take out the March lows, albeit not in 2009.

I believe in the bear case, but if we get to 950ish, I will pause and see the quality of any rally that develops.

Everybody is now discussing a new US dollar financed bubble (we covered this 2 months ago). If the dollar soars, as I think it might, S&P 950 is a slam dunk. However, to get the bear case to actually happen (beyond the current move to 1030ish), the US dollar needs to take Tuesday’s spike high and take out 77. A USD spike should kill the resilience that commodities have been showing and shave points off the TSX and S&P.

In addition, we need to see further strong selling (similar to what happened between 3pm and 4pm today) show up again this week. That will confirm to me that we are in a selling stampede that is about to get really chaotic.

Note that gold/silver, credit spreads, US long bonds and weakness in financials are all potentially warning of coming problems. Offsetting those signs are resiliency in oil, commodities and China.

I suspect that the market will decide this very soon. If we don’t go sharply lower soon, I will probably have to put away the bear case (again).

Positions in USD, CAD, Euro, QID, SKF, HMD, JPM, BMO, CM

While you were out celebrating the end of the recession…

There have been a series of articles touting the end of the recession this week.

ECRI calls it the giant error of pessimism (the pessimism prior to a recovery)

ECRI and pretty much everyone now, thinks that we are going to see a stronger than expected recovery and that the recession is over. Q3 GDP came in at 3.5% (caused 100% by government spending, per Dave Rosenberg and others) and I would not be surprised to see positive Q4 GDP. However, this is not enough to declare an end to the recession. A quarter or two of positive GDP, especially with an avalanche of government stimulus, is not enough. The key, in my opinion, will be Q1 2010.

Bernanke and his clueless cohorts continue to cheerlead the recovery from a recession that they did not see coming.

Call me a realist.

I am wondering, where is continuing growth going to come from? The stock market is not always good at giving us guidance on the economy but in a post-bubble credit contraction, when it turns down or up, it can give us immediate clues to the health of the economy. In October 2007, the market topped and so did the economy a month later. In September 2008, the market tanked and so did the economy. Remember, until that point, all the so-called experts were not even conceding that a recession had started! In March 2009, the market rallied and the economy began to improve from a -6% clip to 3% in Q3 2009.

The same thing happened in 1929 when the economy shrunk in August 1929 and the stock market peaked in September 1929. Ditto for 1873 (hat tip Bob Hoye)

Let’s look at some important sectors that are not joining the celebration:

1) Restaurants: Most US based restaurants bottomed ahead of the market in November 2008. They led the rally since March. Many are down sharply in recent weeks. McDonalds, which is doing well and benefitting from the dropping USD, has said that customers are in retreat mode.
2) Housing: Sure, Case-Schiller is up for 3 straight months. Then why are housing stocks down almost 20% in the past month. There is a ton of foreclosed housing that is not even on the market yet. I believe that this recent rise in Case-Schiller is a blip.
3) Semiconductors: Again, another leading group that led the rally this year. Down about 12% in recent weeks.
4) Transports: A key sector, that has really stunk it up in recent weeks. Down 12%.
5) Russell 2000: Down 10%. This represents smaller companies that have little international exposure, and therefore, a good proxy for the US economy.
6) Financials: Key financials such as Bank of America, Citigroup, Wells Fargo are down over 20%. Also, credit continues to contract at alarming rates as consumers pay down debt and banks cut credit. Again, this is not your father’s typical recovery playbook.

Hat tip to Smita Sadana of Minyanville.com who has been tracking these groups.

So what is holding the market up here in the stratosphere?

1) US dollar. The sinking greenback has been giving fuel to commodities and the large sectors in the S&P. In addition, it props up the earnings of the multinationals that dominate the Dow and S&P. Finally, it is the fuel for the carry trade in which traders borrow USD at near zero and invest it is risky assets. In particular, corporate bonds have done very well, and I suspect that if the USD has put in a bottom, look out corporate and junk bonds. If the credit markets go, so will the stock market.
2) Large cap tech. Apple, Google, Microsoft and Amazon have had great runs of late keeping the Nasdaq strong. Any breakdown in the overall market will force these names to play catch up to the downside.

What is going to lead the recovery?

It does not look like restaurants, housing, rails, semis, domestic companies or the banking sector are going to lead 2010 growth, at this moment.

The sectors that are still holding on?

Energy/Commodities?
Multinationals?
Tech?

If the US dollar has put in a bottom, then I would expect commodities, multinationals and tech to enter a downleg, as revenues would fall and cost-cutting will not generate a recovery.

How about pharmaceuticals? These are a fairly steady sector of the economy that is unlikely to generate a strong recovery or start a recession at this time.

How about manufacturing and autos? Boeing and the automakers are struggling and don’t see a big near term pickup. This leaves the 3M, Duponts and Caterpillar. Jury is still out on these, and if the US dollar turns, good luck!

How about the consumer (70% of the economy)? See comments above on restaurants and hosuing. Unlikely, that retail will lead with housing and credit very tight and 10% unemployment.

How about government? This has been the single largest contributor to growth as stimulus and printed money have found their way in to the economy this year. Sustainable recoveries need more than government spending. And with $1.5 trillion dollar deficits as far as the eye can see, even if the Obama administration is somehow able to cobble another stimulus package for the economy, I believe investors are not going to be fooled again.

For a recovery to happen, you will need some participation from retail, banking and housing in my opinion.

Conclusion:

I understand the logic of ECRI's giant error of pessimism. I also understand the logic of the message of the stock market and the logic of an aging undersaving, tapped out consumer who is getting foreclosed. I also understand the logic that there is too much debt out there that needs to be extinguished once the banks "extend and pretend" shenanigans are "discovered".

If the US dollar has bottomed and the stock market has peaked, then I believe it is telling us that there was no sustainable recovery. Canada and the UK’s recent disappointing GDP reports only further confirm my suspicion.

$100 Billion: Not yet a tipping point

Ontario $25B
Canada $55
Quebec $10 (I’m not using their fudged numbers- I’m using the increase in debt)
BC $3
Alberta $7

Total $100 billion (Let’s count the big guys for simplicity).

I warned about a return to deficits almost 2 years ago, when everyone was talking surpluses.

$100 billion is a lot of money. This represents about 7% of GDP. Similar deficits in the 90s caused a lot of belt tightening that was well absorbed by the economy during the booming 1990s. In the 1990s, the population was much younger (baby boomers moving into their peak spending and earnings), the technology bubble was just starting and credit was flowing freely as consumers were just getting started on the shop ‘till you drop mentality. In addition, there was a wave of deregulation hitting the Canadian economy. Remember Wal-mart only came to Canada in 1994, and you had no choice but Bell Canada for your wireline phone.

Now, we are an older population with a looming health care crisis. Health care spending is now almost 50% of most provincial government spending. Education is about a quarter. Consumers need to deleverage and start saving (unlike 1994), and housing is overvalued (unlike 1994).

TD Bank assumes that about $30 billion of this is one-time stimulus. However, to remove this, GDP would drop by 2%. To grow 3% next year as the BoC is expecting, the Canadian economy will need to grow 5% organically. Good luck with that! Therefore, expect the one-time stimulus to mostly remain for 2010 and maybe onward.

If one is optimistic and assumes that this is not a L shaped recovery, then some of this deficit will disappear as the economy grows and new spending is restrained.

However, just remember that during the recovery (again, assuming that there a recovery right now and indeed the recession is over), government revenues have to organically increase by $100 billion more than expenses over the next decade to arrive at a balanced budget. It is possible, as we did it in the 1990s (from about 10% of GDP) but as I mentioned, things were different then. Also, interest rates are historically low right now. Any increase in interest rates (something that should happen if the economy recovers) is going to make that task harder. In the 1990s, interest rates fell despite the boom. Those interest savings were passed on to taxpayers via tax cuts, as well as used to balance the budget and increase spending. Don’t expect that to happen this time!

If I am right and this recession is longer and more severe than most expect, we are going to go beyond $100 billion ($150, $200?) and we are going to reach a point of no return, where we can’t simply pretend that everything will go back to the way things were (I think we are still doing that, case in point the housing market).

There will then need to be draconian spending cuts, where the medicare system as we know it will no longer exist, tuition increases, large cuts to the payments to the poor & elderly and to the bureaucracy. In addition, tax increases and higher user fees will probably be attempted. If lenders do not wish to pay for our spending habits, long term rates could increase despite being in a deflationary world.

I believe we are heading a 21st century New Deal, where due to the current crisis, government will be forced to step away from the nanny state and focus on a few key services. The rest will be left to the private sector and regulated or managed by the government. It will not be ideology driven. It will be driven by realism. Ultimately, this will lead to a better Canada, but the next decade will be unpleasant.

All this with the shortest recession….

Horn tooting

Mish-Krugman-ECRI

Last week, blogger extraordinaire Mish put out an excellent critique of ECRI’s recent record. As I was reading it, I thought to myself: this is very similar to what I wrote back in the summer (original and with ECRI comment). Then, I saw that Mish gave a hat tip to this blog (thanks!). He went even further than I did, and did an excellent analysis.

Apparently, Paul Krugman thought so too. While I often disagree with Krugman’s interventionist approach, I can not deny that he is a brilliant person and a Nobel prize winner. To see Krugman, the leading Keynesian of our day, agree with Mish, a strong proponent of the Austrian school is quite unusual.

Once the Mr. Krugman got into the game, ECRI had to do damage control, as it is doesn`t want Nobel prize winners questioning its calls or model. Any doubts about its calls or model can seriously hurt ECRI’s business, especially when that doubt it sowed by one of the preeminent economists of our day.

So ECRI put out a statement contradicting Krugman.

The Big Picture then commented.... Not sure, how it happened, but this little blog managed to write a piece that got the ball rolling and indirectly caused comment by a Nobel winner, 2 top bloggers and a top economic forecaster.

The funny thing is ECRI should be sitting pretty right now, as its April call for a strong economic recovery is being corroborated by the stock market which hit a new high this week. This doesn’t mean that it will ultimately be a good call, or that I agree with it. To ECRI`s credit, they came out boldly and early with the pronouncement.

Also, notice how none of this discussion took place in the mainstream media (unless you count Krugman’s NYTimes blog).

Questions on US dollar

Question: is it the USD to watch or the Euro? Just that there appears to be an
inverse correlation between the EURUSD and US equities, gold, etc. I looked at
JPYUSD and didn't see the same correlate, and the 'commodity currencies' like
CAD, AUD, etc seem to rise & fall with commodity prices rather than what the
USD is doing specifically. While I agree that a spike in USD will likely
coincide with a drop in equities would a EURO sell-off coincide with that or
precede it?Does that make sense?

Also, I'm convinced this 'dollar doomism' that seems to be popular these days is rooted more in ideology than reality. Do you think perhaps, without getting into tinfoil hat territory, that there's a deliberate ploy to force the Fed to raise interest rates prematurely?

Not a stupid question at all. Euro is over 50% of the USD index (comprised of a basket of currencies including the loonie). Yen has been the strongest currency since the credit crunch started in mid 2007. I have been long it at times, but not sure if it will do as well in the next phase. Big movements in commodity currencies can influence USD. I watch the Euro religiously. It needs to break down for any sell-off to be meaningful in my opinion (as a sign of unwinding of the carry trade). The Euro is very, very overvalued in my opinion.

I agree that the doomism is more rooted in ideology than reality. Don`t see a ploy. Only ploy is borrow in USD, go long risky assets. A classic carry trade. I believe that since everyone hates the USD and likes the Yen, and there is no difference in interest rates between the two, the USD has replaced the Yen as the carry trade currency of choice. This will result in a soaring US dollar if asset prices drop once again. I no longer think that the Yen will soar the way it did last year, although I think the Euro and commodity currencies will take the biggest hit.

Disclosure: Positions in US, Canadian and Euro cash.