The first time around, the three-headed federal serpent – the Bush administration, the Treasury Department and the U.S. Federal Reserve – used Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) to “legitimize” trillions of dollars worth of toxic financial waste known as subprime mortgages.

The result was the worst financial crisis since the Great Depression – a mess that was global in nature.

And we’re now headed for a repeat performance.

Some of the players may have changed since the first subprime-mortgage crisis, but the game apparently remains the same. With banks currently unwilling to lend, the new federal triumvirate of the Obama administration, the Treasury and the Fed are trying to inflate the moribund U.S. housing market. This time around, however, the FHA is the weapon of choice.

Obama & Co. are making an all-or-nothing bet that the U.S. economy will recover and bail out the housing market before the final bill for this ill-advised gambit comes due.

When this bubble bursts – and it will – U.S. taxpayers will be on the hook for more than $1 trillion in government-guaranteed debt.

Ginnie Mae: Fannie and Freddie’s Once-Quiet Cousin

As a direct result of the real-estate meltdown, U.S. banks have become reluctant lenders. And they’ve raised their loan standards considerably. Federal officials knew they had to keep the mortgage spigot open, especially to suspect borrowers, so they turned to their new “secret weapon” – the FHA.

The FHA has been cranking out new government-insured subprime loans, which it packages into government guaranteed securities for sale to banks. This frightening reflation of the subprime bubble is being engineered for two key reasons:

• To put a floor under falling house prices.
• And to let banks swap toxic Fannie and Freddie securities for new toxic debt that is 100% guaranteed by U.S. taxpayers.

The almost inevitable insolvency of the FHA could rapidly undermine the fragile recovery of the U.S. economy. And it could plunge stock prices and bank viability to new lows.

Why the FHA?

That’s simple. In an era of increasingly stringent lending standards, the FHA’s standards are laughably lax.

Created by the National Housing Act of 1934, the FHA insures private mortgage lenders against borrower default on residential real estate loans. But its current allure is that it opens the door to prospective homebuyers who almost certainly wouldn’t qualify for a conventional home mortgage. These are buyers with no credit history, a history of credit problems, or not enough cash to cover the down payment and closing costs.

The FHA has quadrupled its insurance guarantees on mortgages in just the last three years, with the bulk of that growth coming in the past two years. Currently, the FHA insures $560 billion of mortgages.

Loans that are FHA-insured are pooled and packaged into mortgage-backed securities (MBS) by the Government National Mortgage Association, more commonly known as Ginnie Mae. Ginnie Mae insures the actual MBS pools composed of FHA loans. Ginnie Mae securities are the only mortgage-backed securities backed by the full faith and credit of the U.S. government.

Two weeks ago, Ginnie Mae proudly announced that it had issued a monthly record $43 billion in FHA mortgage-backed securities, and through the end of July held guaranteed securities with a value of $680 billion. It is on track to exceed $1 trillion worth of guaranteed securities by the end of calendar year 2010.

Ginnie Mae is a cousin of its better-known siblings Fannie Mae and Freddie Mac. Those two mortgage giants are technically insolvent, and were forced into government conservatorship at the height of the financial crisis – ostensibly due to concerns that foreign central banks in China, Japan, Europe, the Middle East and Russia might stop buying our bonds. As “government-sponsored enterprises,” or GSEs, Fannie and Freddie were only supposed to have the “implicit” backing of the U.S. government. But recent events have shown these to be fully backed by taxpayers.

The implosion of Fannie and Freddie severely threatened the mortgage market. It essentially shut down the two giant repositories that bought the loans banks and mortgage originators didn’t want to hold as assets on their own balance sheets.

The FHA and its mortgage-backed securities “factory” – Ginnie Mae – have taken up where Fannie and Freddie left off, and are now the dumping ground for toxic mortgages. Using the FHA is the core strategy in the administration’s misguided effort to prop up mortgage origination and modifications, real estate prices and insolvent banks.

Warning Signals?

Administration officials might want to take heed of some eerie parallels between the current situation and the one involving Fannie and Freddie. They could serve as an early warning system.

First and foremost, the FHA has already started to acknowledge systemic fraud in its business. In the earlier subprime crisis, similar circumstances led to the revelation of massive fraud in the issuance, packaging, ratings and sale of subprime toxic mortgage-backed securities.

On Aug. 4, the FHA suspended Taylor, Bean & Whitaker Mortgage Corp., one of its largest approved independent mortgage originators, from making anymore FHA-backed loans. The suspension came one day after federal investigators raided Taylor Bean’s Ocala, Fla., headquarters.

Since 2007, the value of FHA-backed loan originations underwritten by Taylor, Bean had soared 117%. By contrast, the origination of conventional loans by the firm dropped 34% over the same period. Taylor, Bean subsequently filed for bankruptcy.

Earlier this summer, the U.S. Department of Housing and Urban Development (HUD), which oversees the FHA, raised concerns about FHA practices. On June 18, HUD released an internal inspector general’s report that revealed that the FHA’s default rate exceeded 7% and that more than 13% of its insured loans were delinquent by more than 30 days.

In a “Review and Outlook” piece, The Wall Street Journal reported that the FHA’s reserve fund dropped from 6.4% in 2007 to about 3% today, putting it dangerously close to its mandated 2% minimum. That translates to a “33-to-one leverage ratio, which is into Bear Stearns territory,” the newspaper report stated, referring to the now-failed investment bank that had been a central player in the original subprime mortgage crisis.

Bear Stearns is now owned by JPMorgan Chase & Co. (NYSE: JPM).

The HUD inspector general’s report stated that the agency’s growth makes it “vulnerable to exploitation by fraud schemes” and that it may need “Congressional appropriation intervention.”

In a recent article – “FHA Disputes Whispers of Capital Reserve Problems” – on the Mortgage News Daily Web site, HUD Secretary Shaun Donovan said in June that “there’s a better than even chance that we will stay above the two percent reserve threshold. That suggests, not just for the 2010 business, but overall for the portfolio, that we’ll more than likely to stay out of a broader need for any taxpayer funding.”

It may be more than a little disheartening to know that in a very uncertain economic environment, precisely due to fraud in mortgage lending and increasing borrower defaults, that our government is stretching a 50/50 wager on the backs of taxpayers.

That’s only part I of the FHA dilemma story.

Part II is even more frightening.

A Look Ahead

Banks are dumping Fannie and Freddie-backed securities onto the Fed’s balance sheet and replacing them on their own balance sheets with FHA-insured loans packaged into government-insured securities issued by Ginnie Mae. Banks aren’t reducing their net assets, they are aggressively swapping acknowledged toxic securities that no-one wants for a new variety that no one will want in the future. Why?

It’s not just that Ginnie Maes are fully backed by the U.S. taxpayers and Fannie and Freddie’s securities are only implicitly backed. All of them will be covered by taxpayers.

The devil is in the details.

Because Fannie and Freddie securities are only implicitly guaranteed, banks that hold these securities as assets on their balance sheets must “haircut,” or set aside reserves, based on a 20% risk-weighting assigned to the value of those holdings.

Because Ginnie Maes are explicitly 100% guaranteed, they are considered “risk free,” and on par with U.S. Treasury bonds, notes and bills. There is no reserve requirement, or haircut, on Ginnie Mae securities.

By replacing their asset mix and holding Ginnie Maes, banks don’t have to set aside reserves. They can use the money they otherwise would have to set aside to actually leverage-up their balance sheets. And guess what they’re buying?

More Ginnie Maes, naturally.

The effect of the asset swap – basically one toxic pool for a replacement that’s not much better – creates the illusion that banks have healthier balance sheets and that they are meeting their reserve requirements. It’s such a good deal for the banks and actively promoted by the Fed and Treasury, that banks are using Troubled Assets Relief Program (TARP) money to buy Ginnie Maes.

But it’s all a façade.

Capital ratios are being manipulated and insolvent banks are being propped up.

The danger of relying on the FHA to prop up the shaky housing market by facilitating mortgage origination, modifications and refinancing to less-than-stellar borrowers will only result in more subprime loans being stockpiled on the Federal Reserve balance sheet.

Eventually, defaults will overwhelm the FHA. And the hoped-for floor in residential real estate pricing will be pulled out from under us all. The next down-round in real-estate values will expose bank balance sheets for what they really are: Over-leveraged and over-stuffed with junk. Already on the ropes, banks will lose capital and will have to tighten the credit screws on consumer borrowers even more.

We may be headed for another bruising round of real-estate and MBS-related depreciation. Even a mild financial-markets setback could put the economy and the stock market onto the canvas for a 10-count. Further pummelling of shaky consumer confidence accompanied by a couple of major bank failures could easily send the U.S. market down for the financial-system equivalent of a TKO.

Taxpayers, always the lowly cornermen holding the spit buckets, are already in place with the safety nets. We will catch the FHA loans because we insure private lenders against subprime borrowers with no skin in the game. We then will have to catch the buyers of Ginnie Maes, because we guarantee those MBS securities. And we will be forced to catch the falling banks, because we already insure depositors through the Federal Deposit Insurance Corp. (FDIC).

Perhaps our ultimate fate is that of the permanently punchdrunk veteran boxer, who rues his decision to stay in the game, realizing that he fought “one bout too many.” If that’s the case, that “one bout too many” could be Subprime Crisis II, arranged by the very market referees whose job it was to protect us from such beatings.

Source: How the Government is Setting Us Up for a Second Subprime Crisis

Jumbo mortgages — home loans exceeding $417,000 — now have the fastest rising default rates of any mortgage class. According to recent data from First American CoreLogic, 7.4% of these larger-than-life mortgages are currently in some form of default, nearly three times the rate at the start of 2008.

As you can see, when stocks tanked in late 2008, the market for super-sized mortgage loans followed suit:

(Heh, we love the “exclude option ARMs” note… no need to worry about them!)

Is there any reason for this trend to improve? The Obama administration has done plenty to help out their beloved middle-class homeowner… like the $8,000 first-time homebuyer credit, artificially low FHA mortgage rates and several mortgage modification programs. But those programs don’t apply to jumbo loans. Even Fannie and Freddie, masters of mortgage speculation, will no longer stand behind jumbo mortgages.

And the market is blowing jumbo loans a stiff head wind, too. Mortgage rates are roughly 100 points higher for jumbos and inventory — geesh — this is pretty remarkable:

So… an accelerating rate of default; a government cold shoulder; higher-than-typical lending rates; and a huge, growing glut of supply? Could get interesting.

Source: The New Credit Crunch Victims

It’s not just guilt by association. Most banks with loans in construction, commercial real estate, corporate loans, and of course residential real estate, are dealing with a deteriorating loan book.

Credit was too easy for too long and now they’re paying the price.

The Canadian bank has more or less followed the S&P down. In the same period, Citigroup and Bank of America have lost over 80 percent of their value.

That Canadian bank was the last bank I recommended. And I got out while we were still ahead. I’ve since shorted banks (and made a lot of money), but generally I’ve stayed away from banks for two reasons:

1. I don’t trust them.

1. Their balance sheets can be deceiving. There are so many places banks can tuck away their money.

Banks are once again making the news. JP Morgan beat expectations last week. But Bank of America had to go to the government (again!) with its hands out. It got a $20 billion infusion plus another $118 billion to backstop their bad assets. Of course, that’s on top of the $25 billion they got last year.

The last bank rally of note began last July when four out of the five biggest banks beat earnings expectations for the second quarter. Had a bottom been reached? Many investors thought so.

Citi’s CFO said at the time that “the company was well-capitalized to weather further turbulence.” But major writedowns continued and bank shares dropped precipitously.

That didn’t stop analysts from calling more bottoms.

In September, during a mini-rally, North Carolina State economist Mike Walden said, “The bottom was reached with the Citi deal. And now Wells Fargo is looking at the financial-services sector in a positive way. This deal may represent a turning point in the industry.”

He was referring to the generous price that Wells paid for Wachovia compared to the much lower price Citi was offering. As it turns out, Citi was the more realistic player. Wells paid too much for Wachovia just as Bank of America paid too much for Merrill and way too much for Countrywide.

Wall Street’s propaganda machine was having none of that. Bank of America was saying that Countrywide would add to earnings in 2008 and Wall Street was agreeing. Listen to this: “Countrywide will go down as a good, bold acquisition.”  The company drinking the kool-aid held 55,000 shares in Bank of America.

Banks actually thought that they could make risk go away by engaging in some fancy financial engineering. Failing that, they thought that they could talk their way out of their mess. And, as a last resort, they suspected that the government would come to their rescue.

Bankers and politicians – hard to say who’s more arrogant. Politicians think they can legislate away economic cycles. The U.S. was in an economic recovery stage for the entire century. We were due for a pullback. But the government wants to cut it short and make it as painless as possible.

And the way to do that is to “save” the banks.

These may be good intentions. But in this case that old saying applies, “the road to hell is paved with good intentions.”

Massive government intervention hasn’t worked so far. But it will certainly bring another wave of bottom-calling this year. Don’t believe it.

The banks and the executives who lead them aren’t complaining. Amazingly, the government hasn’t forced the CEOs of the banks out.  They are leaking tens of billions of dollars. They’re still making obscene salaries, and that’s unacceptable.

Much worse is that, after handing banks $271.7 billion of TARP money on a silver platter, the government is still letting them play their little game of “hide the bad assets.”

The one thing that bothers banks more than losing money is everybody finding out about it.

Banks are the least shareholder and investor-friendly sector in the U.S. We have no idea how many billions of dollars worth of bad assets they’re parking with the Fed. They won’t tell us and the Fed is keeping mum. Fox and Bloomberg are suing to get this public information.

Hey, banks, you’ve got to come clean. Tell us the value of the toxic assets you’re holding directly or indirectly. What is their market value and how did you calculate it.

No more off-the-book special purpose vehicles or buried derivative holdings. And give us realistic projections of how much more of your portfolio will go bad next quarter and into the following year, and how that could impact your need to raise more capital.

Without this transparency how can we begin to invest in banks again? How can banks figure out which other banks to lend to? How can the government figure out how to disburse their hundreds of billions of dollars?

Instead of increased regulation, the new Obama administration should push for increased transparency. The government may not be able to legislate the banks back to health, but it can certainly make laws requiring them to give us more detailed information.

The weak or “bad” banks won’t like it. It would scare the last of their investors away. Other banks would stop lending to them. The government would have no choice but follow their lead and let those banks die. That’s the way it should be.

The government can’t save all the banks anyway. Let the private sector show the government what to do. It won’t stop the pain in the banking sector. But it’s the fastest way to get banks to lend to each other. And that should loosen up credit.

In the end we’ll have a smaller but stronger banking sector.

Source: Banks Need More Transparency, Not Regulation

This from Sovereign Society:

In a previous A-Letter, we talked about the three attributes necessary to make a portfolio successful in this kind of market. One of those attributes was yield…something that’s become easier to find as equity markets take more and more of a beating. But you have to be careful, because yield isn’t always the mark of a high-value investment. Sometimes it can be the siren’s song that lures you – and your portfolio – onto the rocks.

Doubting Those 16% Yields

On October 7th, Investment Director Eric Roseman wrote to you about Real Estate Investment Trusts (REITs), one of investors’ favorite asset classes, “One of the biggest casualties of the global financial crisis is the big bust now underway in REITs, or real estate investment trusts. Until mid-2007, U.S. REITs dominated global investment performance in the post-2000 tech stock “bubble” era with eye-popping 25% annualized returns.”

If they’re new to you, then think of a REIT as an index fund for real estate. Instead of holding a bucket of commodities or currencies, REITs – as their name implies – hold a variety of real estate titles and allow shareholders to profit from the appreciation of said real estate. And since 2008 was a bad year for real estate, you can imagine how these trusts are faring today.

Since peaking in 2008, Real Estate Investment Trusts have fallen in value by as much as 70%, and many investors are wondering whether it’s time to start picking up the pieces. And with distributions as high as 16% or more on some commercial-property-based REITs, it can be a pretty tempting proposition.

Having already declined 70%, wouldn’t you expect that a rebound might be in the works? Not necessarily…

Commercial Real Estate goes “Subprime”

Most Commercial Real Estate (CRE) in the U.S. is financed and developed by large REITs. And conversely, many REITs are dominated by CRE holdings, so one could say their fates were relatively intertwined. So what’s in store for CRE?

Close watchers of the mortgage market and insider experts have been warning about problems in CRE since before the subprime bubble gained critical mass. And as the subprime mess started to unfold, they continued to warn of the hazards in CRE loans.

To be sure, the underwriting standards weren’t as lax as they were for subprime paper, but there are different psychological factors at play here too. While a homeowner is likely to fight tooth and nail to keep a roof over their heads, small business owners are more likely to throw in the towel when they know they’re faced with a losing proposition. Some can set up shop at home, consolidate their operations, or even just sell off for fear of losing even more – like their house – in such a terrible marketplace.

That we’re already seeing a “terrible marketplace,” is painfully clear. In the words of one anonymous web-poster, Q4’s retail sales “jumped off a cliff, hit the ground and started digging.” The Baltic Dry-Shipping Index – an esoteric indicator of the levels of total demand, measuring the total number of containers shipped overseas – sustained a horrifying and unprecedented 93% drop this past autumn.

Businesses & consumers are already starting to gear up for the worst. Granted, you might not be able to call it “Depression Mentality” just yet, but “Bubble-based Optimism” is wearing off quickly. As a result, the CRE sector is rapidly deteriorating.

CoStar – one of the best sources for information on CRE – is reporting an alarming rise in the number of CRE loans being moved into “special servicing.” According to CoStar, this is “generally an indication of a delinquency or failure to pay off a mature loan.”

Looking at data like this, you can’t help but think CRE – and in turn, the REITs holding Commercial Real Estate – have still got a ways to go before putting in a bottom. Despite the fact that they’ve already taken a serious blow in the last year and some of the trusts are yielding double-digit dividends, it’s likely still too dangerous to go bottom-fishing.

But Eric believes there might be some handsome deals for individual investors on the way there, “The United States can expect more government auctioned foreclosures in 2009, and that means big bargains for speculators and investors alike. Banks are desperate to remove non-performing loans from their clogged portfolio of real estate deals.”

We’ll give all this a few months to unwind and then re-visit it mid-year. Eric believes that the U.S. REIT sector could lead the rest to recovery. It’s also possible that real estate could lead market recovery in general. If that’s the case, then REITs could offer a windfall opportunity to cash in on a recovery, or even just a short-term bounce. Just not yet.

Source: WARNING: The 16%-yielding Asset that You Should NOT Invest In

Off we went to the store where he had scouted out the best price on the unit he wanted. Wow, these things are expensive. As he stared in wonder at this digital behemoth, the sales person dutifully came up to close the deal.

As is always the case, numbers started flying back and forth between the sales person and myself; cables, warranties, delivery costs, you know the drill. The once affordable unit was now a much bigger number.

Glancing at Guy, that’s his name, he had completely glassed over during the rapid exchange. There was literally a haze over his eyes and he had obviously lost the flow of the conversation. The big numbers had done their work on him. It was too much for him to manage. This is how most big-ticket items are sold to the uninitiated.

At that moment, I flashed back to the first time I went with my father to buy my first car. The exact thing happened to me. I clearly remember glassing over and losing all sense of what was happening. I was in over my head. This was new territory and it owned me. I was lost in the particulars and I did not fully grasp all the details. In fact I remember Dad explaining to me what had just happened as we drove home.

Since President -Elect Obama started his push for an economic stimulus package I have had this bad feeling that the glass over affect has kicked in. That’s not unusual. Anytime Washington claims to be fixing anything I get that, “not again” feeling. I entered the work force in the mid 70’s and remember too well the last big push by D.C. to make a bad situation better. Boy, do I remember!

It isn’t that I don’t think an infusion of cash or any investment in infrastructure is a bad idea, I know we need it. There has just been something out of place or not quite right about it. I attributed it to my genetic rejection of anything that comes out of Washington as bad and probably exactly the wrong thing at the wrong time, or worse, just another political payoff with my money.

Then it hit me. Putting cash into a broken banking system is like having a hole in a water bucket. We can’t possibly expect this money to have its maximum affect on the economy if the banks are still broken. How can he be missing this?

Banks must be recapitalized and made healthy first, if any stimulus package is to have any chance of producing the desired affect of shocking the economy back to some degree of normal functioning.

As things stand now, banks are literally hoarding as many assets as they can just to stay above water. They have been crushed by the collapse of the mortgage market.

It isn’t realistic to expect them to say suddenly, “Oh, this is stimulus money, lets get back to normal lending.” If you know any bankers, you know how much of chance this has of happening.

Credit channels are loosening up. There are signs that the crisis, while not over, is improving. The LIBOR rate is down significantly and mortgage rates have dropped to the point where in some markets houses are selling again and there are signs of a real estate bottom. Granted these are very early signs, but it’s the first sunshine in a very dark year. Let’s enjoy it.

The first infusion of cash into the banks seems to have evaporated. Businesses are still having trouble borrowing for their day-to-day cash flow needs and the average Joe is still being rejected for car and major purchase loans because he doesn’t have perfect credit. Has anyone thought about how injecting more cash into the system will work if the banks hoard it again?

As Obama has stated, and I agree, time is of the essence, but there are just as many people asking for a rationally paced approach to this decision as are pushing for instant action.

If you have read my column before, you know I hold congress responsible for the bulk of this credit mess. When they mandated FNMA and Freddie accept loans from people who would never otherwise qualify for a mortgage, they opened the floodgates and almost destroyed the world economy.

Some of my colleagues at IDE are on the other side of this argument; they hold the banks and Wall Street responsible. From my perspective what congress really did was put piles of money on the street, unguarded, and assumed people wouldn’t steal it. Huh?

This decision, to give away money for mortgages, smacked of not having a full understanding of the mortgage markets.

So, here we are again. Another effort by the government to fix a problem, and a noble effort indeed, and once more they seem to have missed something. Just as they didn’t fully understand the long-term ramifications of making money available to deserving but credit risky buyers, they seem also to have a limited understanding of what needs to happen for a stimulus package to work.

The glass over affect could be kicking in here to some degree. Has Obama really had the time to think through all the implications of this move? I don’t think so, and it’s too much money and there’s too much at stake to have another government decision be almost right.

Action now must be slow, deliberate and right on the money. Let’s hope the system does its usual slowpoke routine and there is time to fine tune it and get the full benefit from this effort.

Source: There’s A Hole In The Bucket

“What an awful year. And 2009 doesn’t look like it’s going to be any better.”

Our neighbor, Pierre, was describing the state of the agricultural industry in Europe…and, indirectly, why he couldn’t pay the rent. He leases some land from us at a price of about $150 per acre. He’s now far behind on his rent payments. Elizabeth had asked for a meeting to try to collect. Your editor sat off to the side, listening.

“Of course, I’d like to pay,” Pierre explained. “And I’m sorry I’m so far behind. But this is just a terrible time for us. I have to feed the cows. That’s the first priority. I have to feed them…and buy medicines and fertilizers…even though nobody is buying them. The meter turns over pretty fast – even though I’m not going anywhere. I’m not a meat producer. I’m a breeder. We’ve been breeding Limousine cattle here for more than a hundred years. These cows can trace their ancestry better than most people. But when farm prices fall, people stop investing in the quality of their herds.

“Normally, I sell about 20 top breeding bulls per year. This year, I’ve sold 5. There are many people who want to buy, but they don’t have any money. They don’t have any money because they can’t get good prices for their cows…and can’t get credit from the bank. So they don’t buy my bulls…so I can’t pay you.”

“Well, the publishing business is no picnic either,” Elizabeth replied. “Your customers don’t have any money…you don’t have any money…and now I don’t have any money either,” she added with a laugh.

We wondered how many conversations like this were taking place all over the world. The world’s money machine has broken down.

Yesterday, the Dow fell 31 points. Oil rose to $40. The dollar held steady at $1.40 to the euro. Gold rose $4 – giving it a nice gain of about 6% for the year.

Everything else is losing money. This will go down in history as the worst year for investors of all time. Oil, copper, and most financial stocks are down 2/3 from their highs. Stock markets generally are down 40% to 60% all over the world. Housing markets are down in most places too – with prices in Britain and America off about 20%.

Bloomberg reports that holiday sales were so bad it will “force store closings, bankruptcies.”

And USA Today reports that global trade is expected to shrink by 2% in ‘09, after rising at nearly 10% per year for the last decade. Smoot? Hawley? Who needs those knuckleheads? Global trade is collapsing without trade barriers. Because Americans aren’t buying.

And here, we can trace the breakdown in the entire world money machine…from the pistons that don’t fire to the crankshaft that doesn’t turn. Like the farming business in France, one man doesn’t have any money…so the next man is a little short…and so on all up and down the line.

And here, for the benefit of new readers, we offer a simple schema of the machinery of the Bubble Epoch: Americans bought stuff from the Chinese. The Chinese printed up yuan to buy dollars from Chinese merchants. Then, the nice Chinese financial authorities lent the money back to America. What else could they do with it?

So, you see, everyone had plenty of money. And the more Americans bought…the more money they had to spend. And the more they spent, the more the Chinese had to lend!

Of course, it didn’t take a genius to see that a system that depended on people buying things they didn’t need with money they didn’t really have couldn’t last long. In the event, it lasted longer than we expected. But still, not forever.

It broke down under the strain of its own absurdity.

But wait a minute. How come all of a sudden Americans don’t have any money? Won’t anyone lend any money to them? And why not?

Oh dear reader, throw us a bone!

The financial authorities are clumsily turning screws and tightening valves. They think they can fix the machine by simply getting more credit into consumers’ hands. But this machine is not that simple. In fact, it’s not a machine at all…but a living, organic thing. It has emotions as well as a brain. It is capable of self-delusion, deceit, corruption, wishful thinking, and extravagance.

Investors, businessmen, householders and consumers are all now reacting to the madness of the Bubble Epoch. They lent, spent, speculated and borrowed wildly – as if there were no tomorrow. Now, every day is tomorrow. And they’re afraid. After the sub-prime bubble popped, all the bubble delusions began to fall from their eyes. While once they looked through the glass rosily, now they look darkly:

Wall Street was not making them rich, after all – it was ripping them off! Houses didn’t go up forever – sometimes they went down! Things didn’t get better and better all the time; often, they got worse! Prominent analysts and economists often have no idea what they’re talking about! Alan Greenspan wasn’t such a genius after all!

Suddenly, they looked at their balance sheets and realized that they were in danger. Investors have lost half their money in 2008. Homeowners have lost about $4 trillion in America alone. They read the news. They talk. They know the whole thing is imploding. How are they going to pay their bills? How are they going to keep up their standards of living? How are they going to be able to retire?

Instinctively, reflexively, they cut back their spending. And when the pistons stop pumping, the drive shaft stops spinning, and the wheels stop turning. Americans don’t go to the stores, the stores don’t order more stuff, the ships don’t bring more stuff, the Chinese merchants don’t make money, the Chinese central bank doesn’t have to buy it from them, and then the Chinese have less money to lend back to Americans – who aren’t borrowing in any case.

The machine is busted. It can’t be fixed.

*** “The Undeniable Shift to Keynes,” begins a piece in the Financial Times.

Why the shift? Because Friedman has let us down. The Fed kept the supply of money and credit fairly constant, just as it was supposed to. Then, when credit got tight, it cut rates…all the way down to zero, just as it was supposed to.

Did that solve the problem? Nope. Because the economy is not a simple machine. It’s a complex, organic system. It cannot be controlled. It can only be survived. Tolerated. Enjoyed.

Let’s imagine that the Fed’s key lending rate was zero all year long. Even so, if you’d borrowed money directly from the Fed and used it to buy stocks, your rate of return would be about MINUS 50%. Or suppose you bought a house with a zero-interest mortgage? Your rate of return would be about MINUS 20%. Or, it could have been worse. You might have invested your money with Bernie Madoff, in which case your rate of return would be MINUS 100%.

What business…what investment…what durable consumer item is worth borrowing for under those conditions? Not many.

Besides, once the Fed gives away money at zero interest, what more can it do? Well, it still has some tricks up its sleeve, but its main monetary tool is worthless. It can’t cut rates further.

So, it turns to another great economist – Keynes. Instead of colluding to fix the price of money, Keynes said governments should make up for the lack of private spending with public spending. That is, instead of allowing consumers to use their resources as they wished, politicians should divert resources to their own pet projects. In its idealized form, if the private sector found no use for a working man, for example, the feds should put him to work on some socially-useful project – such as building a bridge or picking up trash.

Of course, if there are idle hands in an economy it’s because the feds have already distorted it. Typically, various government rules and safety nets make it difficult to adjust the price of labor downwards. So, when prices fall, labor rates become disproportionately high. Who’s going to pay a man $25 to make a gadget that sells for $15? No one. That is what causes unemployment. But rather than allow labor prices to fall, Keynes came up with a trick. Government should spend money, thus causing inflation. The rising prices will make labor seem relatively affordable again.

But like all the tricks and quick-fixes in economics, Keynesianism causes more problems than it solves. Governments rarely have any genuine savings. So, in order to spend, they either have to take money away from other spenders …or print it up. If they take it from other uses, the net gain, in theory, is zero. In practice, it is much less than zero, since most government spending is wasted. If it prints up the money, on the other hand, the inflationary effect is much greater…and ultimately ruinous. As we shall see…as the reckoning continues.

Source: The Breakdown of the World Money Machine

This from Whiskey & Gunpowder:

Under Bernanke’s direction, the Federal Reserve has completely rewritten its mission. Many articles in the International Speculator and The Casey Report have reported the strange growth in the loans they have made and explained that Bernanke has, for a long time, espoused unconventional actions to avert deflation and to expand the economy. So the charts below tell that story, and it is truly amazing.

The Federal Reserve was never envisioned to be lender of last resort to a whole slew of investment banks, money market mutual funds, and commercial paper issuers.

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The situation is not easy to sort out, for the simple reason that the extent of their actions is not presented by the Fed via clear and concise data. Instead, the data is complex and hard to analyze, partly because of the piecemeal way the actions were taken, but also probably due to a desire by the Fed to avoid public scrutiny and criticism.

Digging into the details of the Fed’s balance sheet reveals, however, the complete change of composition and direction of the Fed. The most obvious change is that they have doubled the size of their assets and liabilities. A year ago, the Fed’s assets consisted almost entirely of government Treasuries and a little gold.

That is a clean, safe balance sheet.

The only important liability was the currency they issued (our paper dollars). They also had a small reserve of deposits from all the banks. When Greenspan wanted to give the economy a boost by lowering short-term interest rates, he would create some money and buy Treasuries. He could also do the reverse.

Bernanke has turned this upside down. Initially he made focused loans to big banks. But then the loans became bigger than the reserve deposits, leaving the banks in total as net borrowers. The concept of a fractional reserve no longer applies when the reserve is net negative.

To fund yet more loans, Bernanke then sold off half of the Fed’s Treasuries. And he traded Treasuries for toxic waste of poor-quality mortgage-backed securities. And he encumbered half of the remaining Treasuries with “off balance sheet” swaps of about $220 billion. (Does this sound like Enron accounting?) The balance sheet started with $800 billion of mostly reliable assets and now has about $250 billion of unencumbered Treasuries.

The biggest source of funding is from the Treasury. Banks are leaving deposits in the Fed now that the Fed is paying interest.

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The important conclusion is that the paper dollars are now issued by a far less soundly structured Fed, an organization that is more interested in bailing out the financial community than defending the dollar.

This chart below compares last year’s assets, which were mostly Treasuries, to this year’s twice-as-large and far more questionable mix:

The other side of the balance sheet shows that the Fed has borrowed and taken in deposits to fund the loans that are as big as the issuance of currency. In effect, the Fed has doubled its footprint and doubled its responsibilities. Mostly under the covers, they added almost $1 trillion in new credit to the financial world in about two months.

There are additional important Fed actions not included in their balance sheet. For example, they invented a Money Market Investor Funding Facility (MMIF) to guarantee up to 90% of $600 billion of loans to that sector. They do this through special-purpose vehicles established by the private sector (PSPVs). The latest Commercial Paper Funding Facility (CPFF) started October 27 and has issued $143 billion so far. These are both in addition to the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility initiated September 19. The programs are beyond keeping up with.

Nothing like this has ever been done before by the Federal Reserve. In time, the consequences in terms of confidence in the dollar will be bad.

Source: Backfield in Motion at the Fed

Fannie and Freddie, the nation’s two-largest mortgage holders, will target loans in which borrowers are 90 days or more delinquent, and have high loan-to-income ratios, Bloomberg News reported. The companies may offer homeowners reduced interest rates and longer terms of as much as 40 years to trim monthly payments. By rewriting the terms on some overdue loans, homeowners won’t have to pay more than 38% of their monthly income on housing payments, officials from the U.S. Treasury Department and the Federal Housing Finance Agency said at a news conference in the nation’s capital yesterday.

It’s the government’s most aggressive move yet in its battle to reverse the rising tide of mortgage defaults and home foreclosures, MarketWatch.com reported.

“Foreclosures hurt families, their neighbors, whole communities and the overall housing market,” said James B. Lockhart III, director of the Federal Housing Finance Agency. “We need to stop this downward spiral.”

The plan centers upon Fannie and Freddie because they are than operating under a government conservatorship, and because the two entities own or back roughly $5 trillion in loans, CNNMoney.com reported. The federal government took over the two government-sponsored enterprises back in September – not because of worries about the fading U.S. housing market, but because of concerns that foreign central banks in China, Japan, Europe, the Middle East and Russia might stop buying our bonds, a Money Morning investigative report showed. Fannie Mae on Monday reported a third-quarter loss of $29 billion.

The initiative expands efforts by the Hope Now Alliance, a group that U.S Treasury Secretary Henry M. “Hank” Paulson Jr. helped create last year. Hope Now is made up of investors, advocacy groups, and mortgage lenders and servicers such as Citigroup Inc. (C) and Wells Fargo & Co. (WFC). The past success rate for “curing” delinquent loans with modifications similar to what was proposed yesterday was about 50% for both prime and subprime mortgages.

“With such broad adoption, this new protocol will be a standard for the industry to quickly move homeowners into long-term sustainable mortgages,” Neel Kashkari, the U.S. Treasury’s interim assistant secretary, and the architect of much of the housing legislation aimed at easing the U.S. real estate crisis, said in a prepared statement.

MBA Chief Economist Jay Brinkman conceded that “we realize that a number of those can’t be saved because of the borrower’s situation. But if we can save half of them, that’s a good result.”

While a number of major banks – including Citigroup, JPMorgan Chase & Co. (JPM) and Bank of America Corp. (BAC) – have announced loan-modification programs in recent weeks, those financial institutions hold only a fraction of the nation’s mortgages compared with Fannie and Freddie.

Federal agencies have been slow to present their own plans to modify the loans of millions of “at-risk” homeowners – despite calls from congressional representatives and harsh criticism from housing advocacy groups. Those critics want the government to take a more direct role in preventing foreclosures.

Under the new program, mortgages on owner-occupied homes that are at least 90-days past due with a loan-to-value of 90% or more will be eligible for the streamlined modification, MarketWatch reported. Homeowners who are “underwater” – owe more on their home than it is worth – will be eligible. However, homeowners who purposefully default on their mortgage to get a modification will not be eligible. Borrowers who want to know if they qualify should contact the company they make their payment to each month – called the “servicer.”

To encourage them to take part in this program, these servicers will be paid a fee of $800 to modify loans.

Even with this program, the borrower ultimately still will be responsible for paying the full amount of the principal borrowed. The program is only designed to defer payment on part of that principal to make the monthly payment affordable, experts say.

Lockhart said the program would apply to loans guaranteed by Fannie or Freddie, including prime, Alt-A and subprime mortgages. Other kinds of loans may also be covered. Lockhart urged the private-label mortgage industry to adopt the modification plan as well, MarketWatch reported.
The program will start by Dec. 15.

Moody’s Economy.com (MCO) forecasts that even with loan modification programs, 1.6 million Americans will lose their homes this year either in a foreclosure or distressed sale, and another 1.9 million are projected to lose their homes in 2009, CNNMoney.com said.

Source: Government Rolls Out Long-Sought-After Anti-Foreclosure Program

This from Today’s Financial News:

If you thought lending in the home-mortgage lending industry was tight, you will be shocked by the woes in the auto-lending world. This subprime debacle is destroying one company after the other.

Just this morning, GMAC (NYSE:GJM) announced it has stopped issuing car loans in seven European countries. October 31 will be the last day for folks from Finland, Norway, Greece, the Czech Republic, Portugal, Spain, and Slovakia to get loans from General Motor’s (NYSE:GM) finance arm. The news proves the desperate situation the entire industry is in.

This is far from the first news we have heard from the gigantic lender. GMAC recently announced it was drastically raising its lending standards and its borrowing rates. Now, if you are going to get a loan from the company you are going to pay an exorbitant price and you had better have squeaky-clean credit.

Spreading the pain

It is the same situation across the auto-loan industry. Look at companies like AmeriCredit Corp (NYSE:ACF), United PanAm Financial (NASDAQ:UPFC) and Consumer Portfolio Services (NASDAQ:CPSS). These companies have given their shareholders terrible nightmares over the past twelve months.

Just yesterday, AmeriCredit took its investors for a wild ride as share price tumbled by over 50% at one point during the trading day. Shares hit five-year lows as Wall Street dealt with the very real chance this company may have some liquidity issues capable of dealing a death blow.

As the economy turns sour, AmeriCredit, and its large stance in the subprime auto-lending industry, may not have the cash it needs to pay its future obligations. For instance, the company has a $2.5 billion payment due early next year that it has no idea how to deal with.

With its credit losses piling up higher and higher, the company’s chances of finding the cash to ensure the multi-billion dollar check will not bounce are getting smaller by the day. Right now, it has just $244 million in reserves.

With news like that, it is hard to believe share price has found the support that it has. Look for more price drops over the next few weeks.

For options investors, AmeriCredit offers some profit potential. While options are fairly expensive across the board, this company’s impending doom gives put buyers and call sellers a chance to make some money. Options with a January expiration are looking particularly appetizing, especially for sellers.

With fewer folks willing to re-purchase the debt of companies in the auto-financing industry, the future will be tight. GMAC has a shot at success thanks to help from the Federal Reserve and the multiple life preservers it has tossed into the stormy sea. But for smaller companies like AmeriCredit, Consumer Portfolios Services, and United PanAm, the good times may be permanently over.

As these companies struggle, there will be plenty of investing opportunities. Pay attention to their actions and you can win no matter which way the industry moves.

Source: Look out below: AmeriCredit (ACF) and GMAC (GJM) are falling fast

This from Today’s Financial News:

It is a fact that the real estate industry has historically been a leading indicator of the American economy. When it falls, Wall Street falls. When home prices rise, so does the Street. If that continues to be the case, the American economy is on the rebound.

For proof, look at today’s new-home sales figures released by the Commerce Department. Compared to sales in August, the amount of new homes that sold in September rose by an unexpectedly high figure of 2.7%.

Over 464,000 freshly built houses traded hands across the country. Three years ago, that number was nearly three times higher. But that is all in the past. What matters is that this month’s figure marked an end to the real-estate landslide.

So what has caused buyers to return to the markets? Two things, falling prices and fear of the stock market.

As for falling prices, take a look at these figures. One year ago, the average new home sold for $240,300.  Right now, that figure is just $218,400.  Buyers smart enough to realize home prices are not going to drop any further are getting an instant 10% discount on their homes.

Next, there are plenty of folks unwilling to take a leap into the stock market right now. With the nation facing a deep recession, the equities market is a scary beast for the uninitiated. They figure if they invest in real estate, their investment will always hold at least some value. After all, a piece of land cannot go bankrupt and disappear overnight. Smart idea. Instead of burying their money in their backyard, they are making it work for them.

News you can use

Even with the strong selling last month, inventory levels are still near record-high territory. Over 390,000 new homes remain unsold across the country. According to the experts that calculate such things, that is a 10.4-month supply. Inventories dropped by over 7%.

With prices falling and such a high inventory of homes still on the market, few builders are willing to raise a new house unless it is already sold. That simply means the market is correcting itself and the free economy is working.

As long as the government stays out of the industry, it should recover in short order.

So where is the investment potential? It depends on how much you have to invest.

If you have plenty of cash and have access to the markets along the western coast, buy all the deeply discounted properties you can afford. Rent them now and sell them in a few years. Your investment will pay off handsomely.

If you don’t have a few hundred thousand dollars lying around, you can reap equally large gains by investing in a few choice real estate investment trusts (REITs). Trusts like Post Properties (NYSE:PPS), which is involved in apartment rentals and condo sales, and American Campus Associates (NYSE:ACC), which is taking advantage of the shortage in student housing and a real-estate industry bottom, will do well. And just as almost all REITs do, they both pay nice dividends of 9.7% and 5.5%, respectively.

The facts are obvious. The real estate market is turning around, proving the American economy will be on the rebound fairly soon. We have seen the worst of this crisis.

Now is the time to re-allocate your portfolio and ensure you are properly positioned to take advantage of the bull that lies just over the horizon.

Source: Last Chance for Deep Discounts In Post Properties (PPS) and American Campus (ACC)