Shenandoah

by John Galt

December 15, 2009

I shall start this part by reminding everyone where to find the OCC Report on Derivatives Activity by providing a link to the .PDF file which is not issued on a timely basis in my opinion, but when it is released the news usually tells the tale of where we are at as a nation regarding the risky behavior of the institutions that so many of us have taken for granted in our lifetimes. The risks that are being flashed by the markets are nothing insane but do provide a warning to those who wish to dig and the following is my opinion and my opinion only and should not be used for investing or financial decisions; seek a professional certified financial adviser (C.F.A.) should you wish such considerations. The problems that I am outlining are not too different from those warnings I started to find out about in 2006 and writing about at that time. The actual financial crisis started in last 2006 but was brought to the forefront in February of 2007 when New Century Financial Corporation went Tango Uniform with a warning announcement on February 7, 2007.  As the second largest subprime lender in the United States at that time, the implications of the news hit the markets immediately but not in such a severe manner as to bring the world to a screaming halt. On February 27th of 2007 though, people began to realize that if they had problems, everyone had issues with the real estate securitization ponzi scheme as constructed and that meant banks on up to the GSE’s.

A BRIEF BIT OF TIME TRAVEL TO FEBRUARY 2007

A funny thing happened on the way to the subprime crisis.

Well, so much for that 1-3-6 rule, right? The announcement after the market close didn’t do squat on February 7th or 8th and in fact the yield climbed. This rule must be total nonsense as there is no way the markets would react without the cratering of yields on the 1 month Treasury, right? Well, WRONGO BEETLE BREATH! Let’s visit the other two “longer” short term Treasury notes from that time period:

While 5 bps may not seem like much, well it is telling everyone that something is amiss. Let’s go even longer in the yield, all the way out until 6 whole months:

Of course all you will hear in reaction is that “well, you can’t invest based on this rule” and “this guy’s a historian, what the bleep does he know about the world of high finance” or worse. The reality is that I stumbled on this thanks to a sage and actually researching what has been happening from 2007 forward. If you look at where we are at now, we are hundreds of basis points away from this era and that using the idea of “Common Sense” you might perceive that this historian is not a blind, drunk, ignorant, Libertarian, system-hating malcontent and just might be on to something. Think about those graphs above and check out the Dow from the same time period; you know, the Dow when GM and Citigroup were still somewhat functioning entities:

Either the “smart money” knew what was going on or the dumb money panicked. If I remember correctly, some of the smart money did make a move:

Wow, an almost $15 move in gold. Maybe it was just “dumb” money chasing yields like the clowns who sold stocks and bought very short term Treasuries in the 3 to 6 month time frame because they were scared of what was next. Perhaps I’m wrong. Perhaps we should listen to Jim Cramer’s “buy” Mad Money In-Depth Stock Picks on February 8th when the markets started to break down and buy Bank of America! Let’s see how that has done in the “flight to safety” trade from February 2007 until Monday, December 14, 2009:

Cool Beans! If you bailed in March of 2009 at $3.13 you only suffered about a 94% loss! Of course the rebound up to $15 per share and the announcement that you will have the opportunity to BUY BUY BUY more shares as they flood the markets to cover the Countrywide and Merrill Lynch fiascoes should give you as much stimulus as Tiger Woods in a Vegas disco! Let us compare the same time period with that barbaric relic, gold:

So the bottom line is you could be down 60+% on many “expert” pieces of advice or have enjoyed an almost 100% increase in a  piece of safety if you watch what the smart money DOES and not what they SAY. Now that this little lesson is over, and yes, there are more examples, I shall take a stab at the dangers of 2010.

THE 2010 WARNINGS, RISK AND POTENTIAL FINANCIAL DISASTER

The Dubai market crater test was just a warning. Please return to your normal ignorant bliss as all systems are go and people are buying all of those empty homes near you and builders are going to continue to insure that we maintain that magical 19 million vacant units number that assures we have sufficient locations for any and all future Americans, potential Americans, or illgeals we wish to count as Americans in the 2010 Census Survey.

Funny thing, I did not hear that announcement from our beloved Department of Propaganda, aka, Bubblevision, aka the Comcast/GE cable family of channels. There is a new reality that I see for 2010 and sadly, it is the same as that of February 2007. They tell you the “all clear” has sounded but the potential for so many disasters to coalesce at once in one time frame, at one moment, in one nation, is so large, so terrifying, that is why I think we are seeing very short term Treasuries, aka the 1-3-6, hovering at record to near record lows. Why? Let’s start with the derivatives exposure and/or liabilities of some of the largest regional banks.

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I know to some the chart above might just look a wee bit awkward. But start to review the numbers. What I did was take the latest OCC numbers and BankRate.com Safe and Sound Ratings plus the Bauer financial ratings (for “balance”) all of which are only up to date through June 30, 2009 and compile the data into a basic spreadsheet to give everyone some idea what might happen should we see further deterioration in the commercial or residential real estate markets and the performance of their balance sheets.

Why is this important?

First of all, most of these banks have interests in the states either via acquisition or direct activity in the highest risk states for foreclosure, mortgage delinquency or outright default (Namely AZ, CA, FL, GA, OH, MI, etc…)

Then start to put together a series of news items with the train of thought that I am following. Commercial delinquencies, residential delinquencies, and let’s bury the turd under the litter are the rule of the day as the bankers and politicians want your “Animal Spirits” to attempt to take over the recovery using psychological influence rather than admit to economic reality. The banks are still in very dire straits. If everything was so wonderful in late 2008 and early 2009, then why did Morgan Stanley and Goldman Sachs get a historic exemption to become “commercial banks” to fleece the taxpayers when they have yet to open one branch in my community or yours? If the crisis is “over” why haven’t 1, 3, and/or 6 month Treasury yields returned at least to a 1.0% level? And what is the sudden urgency in the past 90 days for those yields to crater as we approach not just year end, but the 1 year anniversary of a historic and sinister low of 666 on the S&P which was indicative of a Great Depression era blunder by the wisdom filled Keynesian “experts” who proclaimed what happened in 29 to 39 would never happen again?

The derivatives factor and unwillingness to acknowledge the disasters that are on the horizon is why. If you review the news headlines it tells the tale of the tape in just the last several weeks:

Citigroup Bailout Exit Clouded by $617 Billion of Assets at Citi Holdings

CMBS Loan Defaults Rose to Record in Third Quarter

Loan Resets Projected to Cause Mortgage Crisis in 2010

Lender Processing Services’ November 2009 Mortgage Monitor Report Shows Loan Deterioration Ratio Climbed above 3:1

CMBS Delinquencies Grow 504% since ‘08: Realpoint

I could go on and on and on but I think you get the picture. So how does this relate to the entire structure of those banks listed, of which I could probably add 100 more?

Take any 1, 2 or 5 of those banks on the list. Compile a mistake made by the Federal Reserve (as was made in August of 2007 and what I called in an ancient article title “The Blunder” where they failed to cut rates fast enough to stave off a massive recession) and excessive and foolish behavior by the politicians. Then consider overseas liquidity issues and foreign powers quietly continuing their exodus from the dollar.

The perfect storm, part two, where the eye crosses the shoreline. A 1.5 to 2.0% rise in 10 and 30 year yields as the Option ARMs and various other instruments resets starting in February 2010 wold create a massive wave of defaults which fits with some of the forecasts that I have seen of 8-10 million residential foreclosures in 2010.  Add that massive deviation in a short time period to the reset rates or applicable rates for commercial real estate attempting to refinance without adequate capital for a down payment due to a collapse in the C&I and retail sector and you have the formula for a wave of regional bank failures along with issues at Citigroup and Wells Fargo which would not only terminate the statistical recovery but probably implode the equity markets and create a flight to “safety” away from all asset classes that do not offer 100% safety with regards to a return of the investment as opposed to a return on the monies invested.  Thus the consequences of a series of massive defaults impacting the DERIVATIVES market and creating a dysfunctional insurance or CDS market which starts a new wave of financial institution defaults.

That is the danger I see and why I fear that the yields have cratered in conjunction with the first and second quarter of 2010 and thus the dangerous consequences for the Federal Reserve to begin or even hint at a tightening or conclusion of any serious Quantitative Easing programs. If they do elect do “blunder” again, and start the process of draining from the system, they might well save the fiat dollar for a very short period of time, but in return create a spiraling deflationary depression that creates a political situation unseen in American history since the Great Depression of 1837. Which of course was created by a fiat money crisis and real estate speculation.

Funny how history repeats or hums a similar tune.

As predicted on these pages some two years ago.