The Sovereign Debt Bubble Will Continue To Expand Until – BANG – The System Implodes

Why are so many politicians around the world declaring that the debt crisis is "over" when debt to GDP ratios all over the planet continue to skyrocket?  The global economy has never seen anything like the sovereign debt bubble that we are experiencing today.  The United States, Japan, and nearly every major nation in Europe are absolutely drowning in debt.  We have heard a lot about "austerity" over in Europe in recent years, but debt to GDP ratios continue to rise in Greece, Spain, Italy, Ireland and Portugal.  In general, most economists consider a debt to GDP ratio of 100% to be a "danger level", and most of the economies of the western world have either already surpassed that level or are rapidly approaching it.  Of course the biggest debt offender of all in many ways is the United States.  The U.S. debt to GDP ratio has risen from 66.6 percent to 103 percent since 2007, and the U.S. government accumulated more new debt during Barack Obama's first term than it did under the first 42 U.S. presidents combined.  This insane sovereign debt bubble will continue to expand until a day of reckoning arrives and the system implodes.  Nobody knows exactly when that moment will be reached, but without a doubt it is coming.

But if you listen to the mainstream media in the United States, you would be tempted to think that this giant bubble of debt is not much of a concern at all.  For example, in a recent article in the Washington Post entitled "The case for deficit optimism", Ezra Klein wrote the following...

"Here’s a secret: For all the sound and fury, Washington’s actually making real progress on debt."

How many times have we heard that before?

About a decade ago, government officials were projecting that we would be swimming in gigantic government surpluses by now.

Instead, we are running trillion dollar deficits.

But right now there is a lot of optimism about the economy.  The stock market recently hit a 5 year high and the business community is loving all of the false prosperity that all of this debt is buying us.
Even Warren Buffett does not really seem concerned about the exploding U.S. government debt.  He recently made the following statement...

"It is not a good thing to have it going up in relation to GDP.  That should be stabilized. But the debt itself is not a problem."

Oh really?

A debt of 16 trillion dollars "is not a problem"?

Perhaps we should all run our finances that way.

Why don't we all go out and open up 20 different credit cards, run them all up to the max, and then tell the credit card companies that we can't pay them back but that it "is not a problem".
Of course real life does not work that way.

The truth is that government debt is becoming a monstrous problem all over the globe.  Just check out how debt to GDP ratios all over the planet have grown over the past five years...

United States
Debt to GDP ratio in 2007: 66.6 percent
Debt to GDP ratio in 2012: 103 percent

United Kingdom
Debt to GDP ratio in 2007: 43.4 percent
Debt to GDP ratio in 2012: 85.0 percent

France
Debt to GDP ratio in 2007: 63.7 percent
Debt to GDP ratio in 2012: 86 percent

Germany
Debt to GDP ratio in 2007: 67.6 percent
Debt to GDP ratio in 2012: 80.5 percent

Spain
Debt to GDP ratio in 2007: 39.6 percent
Debt to GDP ratio in 2012: 69.3 percent

Ireland
Debt to GDP ratio in 2007: 24.8 percent
Debt to GDP ratio in 2012: 106.4 percent

Portugal
Debt to GDP ratio in 2007: 63.9 percent
Debt to GDP ratio in 2012: 108.1 percent

Italy
Debt to GDP ratio in 2007: 106.6 percent
Debt to GDP ratio in 2012: 120.7 percent

Greece
Debt to GDP ratio in 2007: 106.1 percent
Debt to GDP ratio in 2012: 170.6 percent

The Eurozone As A Whole
Debt to GDP ratio in 2007: 68.4 percent
Debt to GDP ratio in 2012: 87.3 percent

Japan
Debt to GDP ratio in 2007: 172.1 percent
Debt to GDP ratio in 2012: 211.7 percent

So how does all of this end?

Well, it is going to be messy, but it is very difficult to say exactly when the system will collapse under the weight of too much debt.  Some nations, such as Japan, are able to handle very high debt loads because they have a very high level of domestic saving.  Up to this point, an astounding 95 percent of all Japanese government bonds have been purchased domestically.  But other nations collapse under the weight of government debt even before they reach a debt to GDP ratio of 100%.  The following is an excerpt from a recent Congressional Research Service report...

It is hard to predict at what point bond holders would deem it to be unsustainable. A few other advanced economies have debt-to-GDP ratios higher than that of the United States. Some of those countries in Europe have recently seen their financing costs rise to the point that they are unable to finance their deficits solely through private markets. But Japan has the highest debt-to-GDP ratio of any advanced economy, and it has continued to be able to finance its debt at extremely low costs.

When a government runs up massive amounts of debt, it is playing with fire.  You can pile up mountains of government debt for a while, but eventually it catches up with you.

Over the past 10 years, the U.S. national debt has grown by an average of 9.3 percent per year, but the overall U.S. economy has only grown by an average of just 1.8 percent per year.  That is unsustainable by definition.

There is going to be a tremendous price to pay for the debt binge that the U.S. government has indulged in over the past decade.  During Barack Obama's first term, the amount of new debt accumulated by the federal government breaks down to about $50,521 for every single household in the United States.  That is utter insanity.

If you can believe it, we have accumulated more new government debt under Obama than we did from the inauguration of George Washington to the end of the Clinton administration.

And most Americans realize that something is seriously wrong.  One recent poll found that only 34 percent of all Americans believe that the country is heading in the right direction, and 60 percent of all Americans believe that the country is heading in the wrong direction.

If we keep piling up so much debt, at some point a moment of great crisis will arrive.  When that moment arrives, we could see havoc throughout the entire global financial system.  For instance, most people don't really understand the key role that U.S. Treasuries play in the derivatives market.  The following is from a recent article posted on Zero Hedge...

This time around, things will be far worse if nothing is solved. If the US loses another AAA rating, then the financial markets could face systemic risk. The reason for this is that US Treasuries are one of the senior most forms of collateral used by the banks to backstop the $600+ trillion derivatives market.

As any trader who trades on margin can tell you, when the value of your collateral is called into question, those on the other side of the trade come looking for you to put up more capital on your trades. This can result in assets being sold en masse (similar to what happened after Lehman failed) and things can get very ugly very fast.

For much more on the danger that derivatives pose to our financial system, please see this article: "The Coming Derivatives Panic That Will Destroy Global Financial Markets".

Once again, nobody knows exactly when the sovereign debt bubble will burst, but if we continue down the path that we are currently on, it will inevitably happen at some point.

And according to Professor Carmen Reinhart, when this bubble does burst things could unravel very rapidly...

"These processes are not linear," warns Prof. Reinhart. "You can increase debt for a while and nothing happens. Then you hit the wall, and—bang!—what seem to be minor shocks that the markets would shrug off in other circumstances suddenly become big."

At some point the global financial system will hit the wall that Professor Reinhart has warned about.
Are you ready?

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New Ruling on Mortgage Putbacks a Potential Huge Win for Banks

Even though, for most people, the housing crisis is a thing of the past, the fight over who should bear the cost of sloppy and openly fraudulent mortgage origination and securities sales continues to grind through the courts.

We’ve written now and again about mortgage putback cases, which are also called representation and warranty, or “rep and warranty” litigation. Investors in mortgage-backed securities were not quite as dumb as the crisis aftermath had made them look. The sponsors of the securitizations made promises in the offering documents (called representations and warranties) about the quality of the loans. It turns out they lied.

Normally, when a loan is found to be worse than the sponsors promised, the remedy is a putback. The originator is required to take the bad loan back and replace it, either with cash or buy replacing it with a loan that was of the quality that the investors were promised. However, the mortgage securitizations put hurdles in front of the investors: it took a minimum level of investors (usually 25%) to demand putbacks and it was hard for any investor to know who else had bought a particular deal. Even then, the trustee (who was the party who was responsible for putting back the loan) almost always ignored and fought investor putback requests. They have ongoing relationships with the sponsors, so they don’t want to ruffle big meal tickets, plus the margins for acting as a mortgage securitization trustee are thin, so they don’t lift a finger unless they absolutely have to.

Investors have thus been going to court to enforce their putback rights. We haven’t been enthusiastic about these suits. It isn’t that the investors weren’t harmed or that the banks really didn’t lie about their wares. But we have always been of the view that ultimately, if these suits get anywhere, the plaintiff would have to show on a loan by loan basis that the default was due not to normal underwriting losses (as in death, disability, job loss) but specifically because the loan was bad (as the loan was so badly underwritten that default was highly likely). That is, the plaintiffs don’t just have to show that their contracts were breached (the loans were worse than they were supposed to be) but that the breach was what caused damages.

What makes these cases potential duds, or at best unlikely to produce damages within hailing distance of investor losses is the fact that they will likely require a loan by loan fight. Imagine the cost of each side doing discovery on a loan, and telling its version of the story as to why the borrower defaulted. Multiply that by thousands of loans and the cost of proving how much you are owed becomes very costly relative to what the plaintiff might recoup. That’s why the people we know who have experience in rep and warranty litigation have expected these cases to settle for comparatively small percentages of likely losses suffered (now having said that, in an important ruling last year in Syncora v. EMC, the judge agreed that misrepresentations about loan quality would increase the risk of an insured loan pools, meaning Syncora would not need to get into a huge analysis of how many loans defaulted and why. But that ruling was based on insurance statues, so that doesn’t help mortgage bond investors).

The cases that are furthest along are those involved monoline insurers, since they had stronger putback rights in their contracts than bond investors. In MBIA v Countrywide, the judge agreed to allow MBIA to construct a sample of the loans (the two sides will now fight over what is an adequate sample) but even within that sample, we’d expect both sides to do a loan level analysis, which would probably include loan level discovery. Ugh.

Alison Frankel of Reuters points to a new ruling which could make this investor-unfriendly picture even uglier. A new ruling has told bond investors to file separate cases on each loan they think was misrepresented. No, I am not making that up. From her post:

I did a double take Wednesday, when I noticed a pair of new suits by Lehman Brothers Holdings in federal court in Colorado. The complaints, which are almost identical, claim that the mortgage originator Universal American Mortgage breached representations and warranties about loans it sold to Lehman, which subsequently suffered losses as a result of those breaches. But here’s the thing: Each suit addresses only one supposedly deficient loan! Lehman’s lawyers at Akerman Senterfitt allege that Lehman sustained about $100,000 in damages on one of the loans and $120,000 on the other — numbers that are light years apart from the multibillion-dollar claims we’ve seen from groups of mortgage-backed securities investors who band together to assert contract breaches in thousands of loans at a time.

The Lehman complaints each also contained a curious paragraph, noting that the claims at issue were previously asserted as counts in an eight-loan put-back case Lehman was litigating in federal court in Miami. The judge in that case, Lehman said, had decided after a pretrial conference last week that “each loan must be filed separately, rather than joined within one action.”

That notation sent me to the docket in the Florida case, and to the order entered by U.S. District Judge James King on Jan. 9. It’s true: King ruled that every allegedly deficient loan has to be addressed in its own suit, not in a block case. “The lack of commonality among the various factual circumstances pertinent to each of the eight individual loans makes them all but impossible to be adjudicated together,” King wrote. “That lack of commonality flows from, among other things, the facts that each of these loans was made at a different time, to different borrowers, in different locations involving different purchases of different real properties; most fundamentally, each loan requires separate proof as to whether a breach occurred, what damages, if any, flowed from any such breach, and what the amounts of any such damages are.”

To add insult to injury, the eight loan case was far enough along that it was scheduled to go to trial in March. And even though this conclusion may seem barmy to some readers, it may have precedential value since few investor putback cases have gotten very far:
Universal American’s lawyer, Philip Stein of Bilzin Sumberg Baena Price & Axelrod, told me Wednesday that if other judges

following King’s lead, the ruling could have profound implications for put-back litigation, since it significantly increases the cost of asserting breach-of-contract claims. (Stein also blogged about the order at Bilzin’s Mortgage Crisis Watch site.) Few put-back cases, Stein said, have reached final pretrial conferences, so few judges have considered the kind of commonality challenges he raised back in 2011 in Universal American’smotion to dismiss the Lehman suit. The judge denied the dismissal motion in order to permit discovery, Stein said, but was receptive when Universal American revived its argument at a pretrial hearing on Jan. 4.

If this ruling does establish what Frankel correctly calls “a new paradigm”, you’d need your head examined to ever invest in anything other than government guaranteed mortgage bonds. And of more immediate import, investors who had hoped they would recover some of their losses will find, yet again, that they’ve spent a lot on lawyers to find out that they don’t have much protection under the law.

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Will New Consumer Financial Protection Bureau New Rules for Struggling Homeowner Stop Predatory Servicing?

The Wall Street Journal gives a teaser, in the form of excerpts from a speech to be made later today, on new rules the Consumer Financial Protection Bureau will be implementing to regulate how servicers treat homeowners who become severely delinquent on their mortgages. Unlike past efforts to stop servicer abuses, the CFPB’s new rules will cover all servicers, as opposed to bank-affiliated ones.

On paper, the proposed changes sound like a big step forward:

Under the rules laid out by the agency, lenders would be barred from starting the foreclosure process until borrowers have missed at least four months of payments, a move designed to give borrowers time to submit applications for help. This requirement would end so-called dual-tracking—starting foreclosure if a borrower has applied for help.

They are required to send a written notice to borrowers within 15 days of a second missed payment that includes examples of alternatives to foreclosure and information about housing counseling. Servicers are barred from completing a foreclosure if a borrower submits an application for aid more than 37 days before the home is scheduled to be repossessed.

The consumer regulator will have the power to police whether loan services are following these mandates.

The article noted that both consumer groups and investors wanted even stronger requirements for servicers to offer modifications in particular circumstances.

I’m highly skeptical that these new measures will make much of a difference unless the CFPB has aggressive monitoring and tough penalties, and those details have yet to be released. The sorry history of the servicing industry is, again and again, various servicing standards have been promulgated and are routinely violated, even with consent orders in place. Look at the state/federal mortgage settlement put in place early last year, which also put in place supposedly improved servicing standards, including an end to dual tracking.

Yet dual tracking still lives. As the Huffington Post reported last October:

The five big banks that agreed in a $25 billion mortgage settlement to reform foreclosure practices have continued to “dual-track” homeowners, an abusive technique that pushes families out of homes they thought their bank was trying to help them save, according to a new report by a monitor overseeing the settlement in California.

And if you think that was because banks were having trouble implementing new procedures, think again. Look at this pathetic bleat from the national settlement monitor, Joseph Smith, on January 4 (hat tip Lisa Epstein):

Translation: the banks are still fucking over borrowers, not sure what we’ll do, but we gotta look like we are doing something, so stay tuned!

Why aren’t these bad practices being stopped? As we discussed at depressing length last year (aided by Abigail Field’s close reading of the often mind-numbing exhibits on metrics), the state/federal settlement was a joke, in that its metrics allowed for remarkably high error rates, including an astonishing 1% wrongful foreclosures. Field estimated that had the rules been in place as of 2008, over 33,000 illegal foreclosures would have been deemed tolerable by regulators. Of course, we had more than that, but with even higher error rates allowed in other categories, it’s not hard to imagine that in the rare event a servicer was subjected to close scrutiny, he’d be able to get away with even more wrongful foreclosures by virtue of artful classification of the abuses (ie, if a foreclosure resulted from forced place insurance, the servicer no doubt would argue that the foreclosure would belong in a category relating to excessive fees rather than “wrongful foreclosure”).

And the bigger reason that regulators for now a full decade have had no success in cleaning up the servicing morass is that servicers aren’t paid enough to service delinquent loans well, let alone do loan mods, which requires even more effort and highly skilled staff. The only way for them to earn decent incomes on delinquent borrowers is by collecting more fees on them when they go into the foreclosure process and otherwise ignoring them. On top of that, servicers have terrible software both as a result of antiquated but widely used platforms like LPS’ Desktop Manager, notes passing through multiple servicers as a result of mergers and bankruptcies, and lousy database management and integration. I’ve asked repeatedly why borrower data can’t be ported into new systems, and I’m told by servicing industry insiders is not just a matter difficulties in resolving data field parameters, but that in the older systems, a lot of data is just not there.

So until the industry gets together (and this means, at a minimum, the “sell side” as in the originators, the servicers and investors) and comes up with a new fee structure for servicing, I don’t see how anything changes (I won’t elaborate here, but that would be a massive undertaking, and I’ve not seen this idea floated even as a wild-eyed aspiration). Servicers will abuse customers and argue to regulators that they can’t do better because doing better would lose them boatloads of money, so regulators will continue to enforce only weakly (the threat is they’d abandon the business, although I’m told a servicer can’t abandon its servicing obligation, but I would not underestimate banks trying to argue that parent organizations aren’t liable for the problems in servicing subsidiaries, and if the servicing sub goes broke, no one will take up the servicing rights if all it is is a license to lose money. I’m not sure they will have managed the corporate entities on enough of an arm’s length basis for that legal dog to hunt, but a regulator might also be loath to get into a pigfight that it might lose).

So the test of the effectiveness of these new rules will be whether, when they details are published, they elicit howls of pain from the banking industry, since proper servicing of loans gone bad loses money. If not, rest assured that the most long-suffering borrowers will see is marginal improvement, not badly needed large-scale reforms.

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The Trillion Dollar Trick

The birth, and the apparent death, of the trillion dollar platinum coin idea may one day be recalled as a mere footnote in the current debt crisis drama. The ultimate rejection of the idea (which was to use a loophole in commemorative coinage law to mint a platinum coin of any denomination) by both the President and the Federal Reserve seems to offer some relief that our economic policy is not being run by out-of-touch academics and irresponsible congressmen. In reality, our government has been creating more than one trillion dollars out of thin air every year for the past five. The only difference is that the blatant dishonesty of a trillion-dollar platinum coin is so easy to understand that the public simply couldn't be expected to swallow it.

The American people are more than willing to be fooled, but they won't tolerate so simple a ruse.
People have a long and intimate history with coins. Some of us collected them as kids, and we all touch and see them every day. Unlike currency bills, we know intuitively that a coin's value is supposed to come from its metal content. That's why quarters are bigger than dimes. As a result, most people have viscerally rejected the platinum coin idea. To assign an arbitrary, sky high, valuation to a small piece of metal strikes most people as a deceitful, desperate act. They are right.

However, the same people have no problem with images of thousands of crisp paper notes flying off the printing presses. The acceptance is not impacted by how many zeroes the bills contain. People simply believe that paper money derives value from the numbers, not the paper. This was not always so. Paper money originally entered the public awareness as promissory notes to pay different amounts of gold. Once people got used to the paper, few really cared when the gold backing was finally removed. As a result, the public would likely have been much more accepting of the Fed printing a trillion dollar bill than the government minting a trillion dollar coin. But there was no legal pathway for the Fed to simply give that money to the government.

The government, not the Fed, mints coins, so they did not have to rely on the Fed to create value out of thin air. That is why the platinum coin idea was so seductive, if ultimately unsellable.

But the Fed does the exact same thing all the time using sophisticated accounting and state of the art computing. The Fed "expands its balance sheet" by buying government bonds from private banks. In exchange for these securities, the Fed credits the banks with funds it creates out of thin air. The banks then pass the funds to the general public through loans. But it's important to realize that the Fed does not have any money to actually buy the bonds in the first place. The funds are "created" by a Fed computer. The process is easier (and equally duplicitous) than minting a trillion dollar coin (which at least requires the production of something other than computer code). The only difference is the lack of window dressing. It's a shame that the platinum coin episode did not result in a wider recognition of this brutal truth.

A similarly silly and meaningless distinction is being made with respect to raising the debt ceiling. In his press conference yesterday, President Obama said the Republican reluctance to raise the debt limit was the equivalent of a diner who had ordered and enjoyed a meal who then decides to leave the restaurant without paying the bill. The President is actually arguing that if the diner had no cash on hand, it would be much more responsible to simply use a credit card. In taking this moral high ground, the President ignores the fact that the diner (who has indebted himself through habitual restaurant meals) intends to pay his credit card bill with another card, and then repeat the process until he runs out of cards. So in the end, it's not the restaurateur who gets stiffed, but the issuer of the last card the diner is able to acquire. As with the platinum coin, this is a distinction without a difference.

Currently the Federal Government counts more than $16 trillion in funded obligations. Over the next 10 years we are expected to add another $10 trillion or more. At no point in the foreseeable future are we expected to approach balance in our annual budget. All of our future bills are expected to be paid by future borrowing on a massive scale. Anyone with an ounce of integrity would have to plan for the possibility that an ever-increasing debt rollover is a limited prospect. Such an understanding will mean that eventually someone will get stuck with the bill. How is this any more responsible than dining and ditching?

In truth, a failure to raise the debt ceiling is not a commitment to renege on obligations. It is simply a decision to stop borrowing. The government could still meet obligations by cutting spending, raising taxes, or making reforms to entitlements. But it chooses not to take this difficult step.

More important than that is the message America is sending its creditors. By informing them that the United States will not use its taxing power to repay its debts, but will only rely on its ability to borrow more (ironically from the same creditors), it signals its refusal to tackle our fiscal deficiencies through responsible means. It's a shame that more people can't seem to grasp these very simple truths.

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Goldman Sachs And The Big Hedge Funds Are Pushing Leverage To Ridiculous Extremes

As stocks have risen in recent years, the big hedge funds and the "too big to fail" banks have used borrowed money to make absolutely enormous profits.  But when you use debt to potentially multiply your profits, you also create the possibility that your losses will be multiplied if the markets turn against you.  When the next stock market crash happens, and the gigantic pyramid of risk, debt and leverage on Wall Street comes tumbling down, will highly leveraged banks such as Goldman Sachs ask the federal government to bail them out?  The use of leverage is one of the greatest threats to our financial system, and yet most Americans do not even really understand what it is.  The following is a basic definition of leverage from Investopedia: "The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment."  Leverage allows firms to make much larger bets in the financial markets than they otherwise would be able to, and at this point Goldman Sachs and the big hedge funds are pushing leverage to ridiculous extremes.  When the financial markets go up and they win on those bets, they can win very big.  For example, revenues at Goldman Sachs increased by about 30 percent in 2012 and Goldman stock has soared by more than 40 percent over the past 12 months.  Those are eye-popping numbers.  But leverage is a double-edged sword.  When the markets turn, Goldman Sachs and many of these large hedge funds could be facing astronomical losses.

Sadly, it appears that Wall Street did not learn any lessons from the financial crisis of 2008.  Hedge funds have ramped up leverage to levels not seen since before the last stock market crash.  The following comes from a recent Bloomberg article entitled "Hedge-Fund Leverage Rises to Most Since 2004 in New Year"...

Hedge funds are borrowing more to buy equities just as loans by New York Stock Exchange brokers reach the highest in four years, signs of increasing confidence after professional investors trailed the market since 2008.

Leverage among managers who speculate on rising and falling shares climbed to the highest level to start any year since at least 2004, according to data compiled by Morgan Stanley. Margin debt at NYSE firms rose in November to the most since February 2008, data from NYSE Euronext show.

So why is this so important?

Well, as a recent Zero Hedge article explained, even a relatively small drop in stock prices could potentially absolutely devastate many hedge funds...

What near record leverage means is that hedge funds have absolutely zero tolerance for even the smallest drop in prices, which are priced to absolute and endless central bank-intervention perfection - sorry, fundamentals in a time when global GDP growth is declining, when Europe and Japan are in a double dip recession, when the US is expected to report its first sub 1% GDP quarter in years, when corporate revenues and EPS are declining just don't lead to soaring stock prices.

It also means that with virtually all hedge funds in such hedge fund hotel names as AAPL (the stock held by more hedge funds - over 230 - than any other), any major drop in the price would likely lead to a wipe out of the equity tranche at the bulk of AAPL "investors", sending them scrambling to beg for either more LP generosity, or to have their prime broker repo desk offer them even more debt. And while the former is a non-starter, the latter has so far worked, which means that most hedge funds have been masking losses with more debt, which then suffers even more losses, and so on.

By the way, Apple (AAPL) just fell to an 11-month low.  Apple stock has now declined by 26 percent since it hit a record high back in September.  That is a very bad sign for hedge funds.

But hedge funds are not the only ones flirting with disaster.  In a previous article about the derivatives bubble, I pointed out the ridiculous amount of derivatives exposure that some of these "too big to fail" banks have relative to their total assets...

According to the Comptroller of the Currency, four of the largest U.S. banks are walking a tightrope of risk, leverage and debt when it comes to derivatives.  Just check out how exposed they are...
JPMorgan Chase
Total Assets: $1,812,837,000,000 (just over 1.8 trillion dollars)
Total Exposure To Derivatives: $69,238,349,000,000 (more than 69 trillion dollars)
Citibank
Total Assets: $1,347,841,000,000 (a bit more than 1.3 trillion dollars)
Total Exposure To Derivatives: $52,150,970,000,000 (more than 52 trillion dollars)
Bank Of America
Total Assets: $1,445,093,000,000 (a bit more than 1.4 trillion dollars)
Total Exposure To Derivatives: $44,405,372,000,000 (more than 44 trillion dollars)
Goldman Sachs
Total Assets: $114,693,000,000 (a bit more than 114 billion dollars - yes, you read that correctly)
Total Exposure To Derivatives: $41,580,395,000,000 (more than 41 trillion dollars)

Take another look at those figures for Goldman Sachs.  If you do the math, Goldman Sachs has total exposure to derivatives contracts that is more than 362 times greater than their total assets.
That is utter insanity, but we haven't had a derivatives crash yet so everyone just keeps pretending that the emperor actually has clothes on.

When the derivatives crisis happens, things in the financial markets are going to fall apart at lightning speed.  A recent article posted on goldsilverworlds.com explained what a derivatives crash may look like...

When one big bank faces some kind of trouble and fails, the banks with the largest exposure to derivates (think JP Morgan, Citygroup, Goldman Sachs) will realize that the bank on the other side of the derivatives trade (the counterparty) is no longer good for their obligation. All of a sudden the hedged position becomes a naked position. The net position becomes a gross position. The risk explodes instantaneously. Markets realize that their hedged positions are in reality not hedged anymore, and all market participants start bailing almost simultaneously. The whole banking and financial system freezes up. It might start in Asia or Europe, in which case Americans will wake up in the morning to find out that their markets are  not functioning anymore; stock markets remain closed, money at the banks become inaccessible, etc.

But for now, the party continues.  Goldman Sachs and many of the big hedge funds are making enormous piles of money.

In fact, according to the Wall Street Journal, Goldman Sachs recently gave some of their top executives 65 million dollars worth of restricted stock...

Goldman Sachs Group Inc. GS -0.76% handed insiders including Chief Executive Lloyd Blankfein and his top lieutenants a total of $65 million in restricted stock just hours before this year's higher tax rates took effect.
The New York securities firm gave 10 of its directors and executives early vesting on 508,104 shares previously awarded as part of prior years' compensation, according to a series of filings with the Securities and Exchange Commission late Monday.

And the bonuses that employees at Goldman receive are absolutely obscene.  A recent Daily Mail article explained that Goldman employees in the UK are expected to receive record-setting bonuses this year...

Britain’s army of bankers will re-ignite public fury over lavish pay rewards as staff at Goldman Sachs are expected to reward themselves £8.3 billion in bonuses on Wednesday.
The American investment bank, which employs 5,500 staff in the UK, will be the first to unveil its telephone number-sized rewards – an average of £250,000 a person – as part of the latest round of bonus updates.The increase, up from £230,000 last year, comes as British families are still struggling to make ends meet five years after banks brought the economy to the brink of meltdown.

Wouldn't you like to get a "bonus" like that?
Life is good at these firms while the markets are going up.
But what happens when the party ends?
What happens if the markets crash in 2013?
When you bet big, you either win big or you lose big.

For now, the gigantic bets that Wall Street firms are making with borrowed money are paying off very nicely.

But a day of reckoning is coming.  The next stock market crash is going to rip through Wall Street like a chainsaw and the carnage is going to be unprecedented.

Are you sure that the people holding your money will be able to make it through what is ahead?  You might want to look into it while you still can.

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The Real Interest Rate Risk: Annual US Debt Creation Now Amounts To 25% Of GDP Compared To 8.7% Pre-Crisis

By now most are aware of the various metrics exposing the unsustainability of US debt (which at 103% of GDP, it is well above the Reinhart-Rogoff "viability" threshold of 80%; and where a return to just 5% in blended interest means total debt/GDP would double in under a decade all else equal simply thanks to the "magic" of compounding), although there is one that captures perhaps best of all the sad predicament the US self-funding state (where debt is used to fund nearly half of total US spending) finds itself in. It comes from Zhang Monan, researcher at the China Macroeconomic Research Platform: "The US government is now trying to repay old debt by borrowing more; in 2010, average annual debt creation (including debt refinance) moved above $4 trillion, or almost one-quarter of GDP, compared to the pre-crisis average of 8.7% of GDP."

This is a key statistic most forget when they discuss the stock and flow of US debt: because whereas the total US deficit, and thus net debt issuance, is about $1 trillion per year, one has to factor that there is between $3 and $4 trillion in maturities each year, which have to be offset by a matched amount of gross issuance just to keep the stock of debt flat (pre deficit funding). The assumption is that demand for this gross issuance will always exist as old maturities are rolled into new debt, however, this assumption is contingent on one very key variable: interest rates not rising.

It is the question of what happens to this ~$4 trillion in annual debt creation by the US, as well as other key ones, that Monan attempts to answer in the following paper on what happens to the world if and when the moment when rates truly start rising, instead of just undergo another theatrical 2-4 week push higher only to plunge over fears the Fed may soon pull the punchbowl.

By Zhang Monan, published first in Project Syndicate

The Real Interest-Rate Risk

Since 2007, the financial crisis has pushed the world into an era of low, if not near-zero, interest rates and quantitative easing, as most developed countries seek to reduce debt pressure and perpetuate fragile payment cycles. But, despite talk of easy money as the “new normal,” there is a strong risk that real (inflation-adjusted) interest rates will rise in the next decade.

Total capital assets of central banks worldwide amount to $18 trillion, or 19% of global GDP – twice the level of ten years ago. This gives them plenty of ammunition to guide market interest rates lower as they combat the weakest recovery since the Great Depression. In the United States, the Federal Reserve has lowered its benchmark interest rate ten times since August 2007, from 5.25% to a zone between zero and 0.25%, and has reduced the discount rate 12 times (by a total of 550 basis points since June 2006), to 0.75%. The European Central Bank has lowered its main refinancing rate eight times, by a total of 325 basis points, to 0.75%. The Bank of Japan has twice lowered its interest rate, which now stands at 0.1%. And the Bank of England has cut its benchmark rate nine times, by 525 points, to an all-time low of 0.5%.

But this vigorous attempt to reduce interest rates is distorting capital allocation. The US, with the world’s largest deficits and debt, is the biggest beneficiary of cheap financing. With the persistence of Europe’s sovereign-debt crisis, safe-haven effects have driven the yield of ten-year US Treasury bonds to their lowest level in 60 years, while the ten-year swap spread – the gap between a fixed-rate and a floating-rate payment stream – is negative, implying a real loss for investors.

The US government is now trying to repay old debt by borrowing more; in 2010, average annual debt creation (including debt refinance) moved above $4 trillion, or almost one-quarter of GDP, compared to the pre-crisis average of 8.7% of GDP. As this figure continues to rise, investors will demand a higher risk premium, causing debt-service costs to rise. And, once the US economy shows signs of recovery and the Fed’s targets of 6.5% unemployment and 2.5% annual inflation are reached, the authorities will abandon quantitative easing and force real interest rates higher.

Japan, too, is now facing emerging interest-rate risks, as the proportion of public debt held by foreigners reaches a new high. While the yield on Japan’s ten-year bond has dropped to an all-time low in the last nine years, the biggest risk, as in the US, is a large increase in borrowing costs as investors demand higher risk premia.

Once Japan’s sovereign-debt market becomes unstable, refinancing difficulties will hit domestic financial institutions, which hold a massive volume of public debt on their balance sheets. The result will be chain reactions similar to those seen in Europe’s sovereign-debt crisis, with a vicious circle of sovereign and bank debt leading to credit-rating downgrades and a sharp increase in bond yields. Japan’s own debt crisis will then erupt with full force.

Viewed from creditors’ perspective, the age of cheap finance for the indebted countries is over. To some extent, the over-accumulation of US debt reflects the global perception of zero risk. As a result, the external-surplus countries (including China) essentially contribute to the suppression of long-term US interest rates, with the average US Treasury bond yield dropping 40% between 2000 and 2008. Thus, the more US debt that these countries buy, the more money they lose.

That is especially true of China, the world’s second-largest creditor country (and America’s largest creditor). But this arrangement is quickly becoming unsustainable. China’s far-reaching shift to a new growth model implies major structural and macroeconomic changes in the medium and long term. The renminbi’s unilateral revaluation will end, accompanied by the gradual easing of external liquidity pressure. With risk assets’ long-term valuation falling and pressure to prick price bubbles rising, China’s capital reserves will be insufficient to refinance the developed countries’ debts cheaply.

China is not alone. As a recent report by the international consultancy McKinsey & Company argues, the next decade will witness rising interest rates worldwide amid global economic rebalancing. For the time being, the developed economies remain weak, with central banks attempting to stimulate anemic demand. But the tendency in recent decades – and especially since 2007 – to suppress interest rates will be reversed within the next few years, owing mainly to rising investment from the developing countries.

Moreover, China’s aging population, and its strategy of boosting domestic consumption, will negatively affect global savings. The world may enter a new era in which investment demand exceeds desired savings – which means that real interest rates must rise.

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Inflation Propaganda Exposed

Economists who hold the popular view that expanding the money supply will provide the best medicine for our ailing economy dismiss the inflationary concerns of monetary hawks, like me, by pointing to the supposedly low inflation that has occurred during the current period of rampant Fed activism. In a recent blog post aimed specifically at me, Paul Krugman noted that the sub 2.5% increases in the Consumer Price Index (CPI) over the past few years are all that is needed to prove me wrong. In fact, Krugman and others have even suggested that the CPI itself overstates inflation and that the Fed would be better able to help the economy if less strict methodologies were used. However, there is plenty of evidence to suggest that the CPI is essentially meaningless as it woefully under reports rising prices.

Magazines and newspapers provide a good case in point. The truth has not been exposed through the economic reporting that these outlets provide, but in the prices that are permanently fixed to their covers. For instance, from 1999 to 2002 the Bureau of Labor Statistic's (BLS) "Newspaper and Magazine Index" (a component of the CPI) increased by 37.1%. But a perusal of the cover prices of the 10 most popular newspapers and magazines (WSJ, Washington Post, Time, Sports Illustrated, U.S. News & World Report, Newsweek, People, NY Times, USA Today, and the LA Times) over the same time frame showed an average cover price increase of 131.5% (3.5 times faster than the BLS' stats). This is not even in the same ballpark.

Some defenders of the BLS may conclude that prices were held down by the availability of free online news content or the convenience of digital delivery. But that is beside the point. Prior to the digital age, the BLS could have claimed that newspaper costs were held down by public libraries that provided free access. It's also true that online publications deliver less value on some fronts. Not only do many people enjoy the tactile process of reading physical newspapers or magazines, but they offer the secondary value in helping to kindle fires, housebreak puppies, pack dishes, and line birdcages.

Another stunning example is found in health insurance costs, which is a major line item for most families. According to the BLS we can all breathe easy on that front because their "Health Insurance Index" increased a mere 4.3% (total) in the four years between 2008 and 2012. Interestingly, over the same time, the Kaiser Survey of Employer Sponsored Health Insurance showed that the cost of family health insurance rose 24.2% (5.5 times faster). But even if the BLS had reported higher costs, it wouldn't have made much of a difference in the CPI itself. Believe it or not, health insurance costs are assigned a weighting of less than one percent of the overall CPI. In contrast, the Kaiser Survey revealed that in 2012 the average total cost for family health insurance coverage was $15,745, or almost one third of the median family income.

If the BLS could be so blatantly wrong in reporting the prices of newspapers and health insurance, should we believe that they are more accurate on all other sectors? If the inaccuracy of these two components were consistent with the rest of the CPI's components, inflation could now be reported in double-digits!

Even more egregious than the manner in which prices are currently reported is the way that CPI methods have been changed over the years to insure that most increases are factored out. Since the 1970's, the CPI formula has changed so thoroughly that it bears scant resemblance to the one used during the "malaise days" of the Carter years. Main stream economists dismiss criticism of the changes as tin hat conspiracy theories. But given the huge stakes involved, it's hard to believe that institutional bias plays no role. Government statisticians are responsible for coming up with the formulas, and their bosses catch huge breaks if the inflation numbers come in low. Human behavior is always influenced by such incentives.

The newer CPI methodologies are designed to report not just on price movements, but on spending patterns, consumer choices, substitution bias, and product changes. In other words, the metrics have been altered to track not so much the cost of things, but the cost of living (or more accurately, the cost of surviving). But if you simply focus on price, especially on those staple commodity goods and services that haven't radically changed in quality over the years, the under reporting of inflation becomes more apparent.

As reported in our Global Investor Newsletter, we selected BLS price changes for twenty everyday goods and services over two separate ten-year periods, and then compared those changes to the reported changes in the Consumer Price Index (CPI) over the same period. (The twenty items we selected are: eggs, new cars, milk, gasoline, bread, rent of primary residence, coffee, dental services, potatoes, electricity, sugar, airline tickets, butter, store bought beer, apples, public transportation, cereal, tires, beef, and prescription drugs.)

We know that people do not spend equal amounts on the above items, and we know their share of income devoted to them has changed over the decades. But as we are only interested in how these prices have changed relative to the CPI, those issues don't really matter. We chose to look at the period between 1970 and 1980 and then again between 2002 and 2012, because these time frames both had big deficits and loose monetary policy, and they straddle the time in which the most significant changes to the CPI methodology took effect. And while the CPI rose much faster in the 1970's, the degree to which the prices of our 20 items outpaced the CPI was much higher more recently.

Between 1970 and 1980 the officially reported CPI rose a whopping 112%, and prices of our basket of goods and services rose by 117%, just 5% faster. In contrast between 2002 and 2012 the CPI rose just 27.5%, but our basket increased by 44.3%, a rate that was 61% faster. And remember, this is using the BLS' own price data, which we have already shown can grossly under-estimate the true rate of increase. The difference can be explained by how CPI is weighted and mixed. The formula used in the 1970's effectively captured the price movements of our twenty everyday products. But in the last ten years it has been quite a different story.

If these price changes in our experiments had been fully captured, CPI could currently be high enough to severely restrict Fed action to stimulate the economy. Instead, the Fed is operating as if inflation is extremely low. As a result, they are making a huge policy mistake that will come back to haunt us. During the last decade the Fed spent many years denying the existence of a housing bubble, even as a mountain of evidence piled up to the contrary. That error caused the Fed to hold interest rates too low for too long, blowing more air into the bubble and imposing enormous negative consequences on the economy. The Fed, now similarly blind to the inflation threat, is repeating its mistake, only this time the negative consequences will be even more dire.

Apart from the statistical problems that hide inflation, there are also macroeconomic factors that have helped keep prices down despite the quantitative easing. Massive U.S. trade deficits and foreign central bank dollar accumulation mean that much of the printed money winds up in foreign bank vaults, not U.S. shopping centers. As foreign consumer goods flow in, and dollars flow out, a lid is kept on domestic prices. In effect, our inflation is exported as foreign central banks monetize our deficits and recycle their surpluses into U.S. Treasuries. The demand has pushed down bond yields which has allowed the U.S. government to borrow inexpensively. Of course, when the flows reverse, bond prices will fall, yields will climb, and a tidal wave of dollars will wash up on American shores, drowning consumers in a sea of inflation.

Unlike Krugman and the Keynesians, I would argue that it is impossible to create something from nothing. I believe that printing a dollar diminishes the value of all existing dollars by an aggregate amount equal to the purchasing power of the new dollar. The other side takes the position that the new money creates tangible economic growth and that real economic value can therefore be created by putting zeroes onto a piece of paper. I think that those making such absurd claims should bear the burden of proof. For more on the interesting topic of hidden inflation, see my video that I just posted.

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Former Deutsche Bank Employee Claims Bank Took Big Libor Bets During Crisis Because It Could Influence Rates

The Wall Street Journal has an exclusive story based on a whistleblower leak, apparently with supporting transaction records.
In 2008, Deutsche Bank made very large bets instruments linked to one, three, and six month dollar, euro, and sterling Libor, that differential between one month rates versus the three and six month tenors would widen as the crisis became more severe. The German bank reportedly made over €500 million on these trades.
What is significant is that these were very large wagers, particularly at a time when most banks were desperate to shed risk. This is the guts of the story:

The documents from the former Deutsche Bank employee set out how traders in London and New York working for the German bank’s global-finance unit successfully bet that borrowing costs in euros, U.S. dollars and British pounds over three- and six-month periods would rise faster than one-month interest rates because of deepening stress throughout the global financial system.
The interest-rate bets included an estimated potential profit of €24 million for each hundredth of a percentage point that the three-month U.S. dollar Libor increased compared with the one-month U.S. dollar Libor, according to the documents.

The former employee has told regulators that some employees expressed concerns about the risks of the interest-rate bets, according to documents. He also said that Deutsche Bank officials dismissed those concerns because the bank could influence the rates they were betting on.

Naturally, Deutsche Bank officials deny the allegations. So as damaging and plausible as the charges seem (who would take such a big bet then if they weren’t confident they had some sort of advantage?), unless the source can provide some sort of supporting evidence, this is “he said, she said,” and the matter will shake out in the German bank’s favor.

One has to wonder why the bank is going to extreme lengths to disprove a conspiracy to manipulate rates. Again from the Journal:

Deutsche Bank hopes to persuade regulators to delay talks on a potential settlement until the bank completes its internal probe later this year, according to the people close to the bank.

Regulators have ordered banks to trawl through emails, chat messages and phone records dating back at least several years. The internal probe by Deutsche Bank began in May 2011, about three years after U.S. regulators began probing Libor.

The internal probe has been arduous because Deutsche Bank is inspecting thousands of trades between 2005 and 2011, including the big interest-rate bets detailed in the documents from the former employee.

The internal inquiry goes beyond looking for “smoking gun” emails or messages such as those exposed by regulators in their settlements with UBS and Barclays. Deutsche Bank is trying to match traders’ emails and chats with messages from clients and outside brokers, aiming to detect any subtle conspiracy to fix rates, said the people close to the bank.

The hunt to essentially prove the negative—that a specific person wasn’t trying to rig rates—explains why the bank-led internal probes are taking so long, said one of those people.

Deutsche seems unusually concerned about liability, which gives the impression they have something to hide. Firms also vary a fair bit in terms of how openly staffers express themselves; one of the reasons that Congressional investigations of particularly toxic Goldman CDOs turned up comparatively little dirt is that Goldman has a very buttoned-down culture. The same deals at other firms would have had a lot more in the way of sniggers and trash talk about the deals and the clients dumb enough to buy them in the records. Libor diddling seemed to be sufficiently widespread in 2005 to 2007 that it seems unlikely that any Deutsche trader would have been careful about covering his footprints….but if one had wanted to be, I can imagine it would not have been hard (limiting discussions to face to face meetings, not using the firm phones, etc And that’s the easy stuff. I had a probably deservedly paranoid buddy who did business in Russia go on about how to leave messages on Usenet groups in ways that no one could figure out the hidden communication).

So as much as the pattern of Deutsche’s activity looks sus, the whistleblower’s claims are likely to be stared down by the banks unless others come forward reporting that they heard the same thing from managers in a position to know . Then, of course, the German bank would simply change course and try to depict them as simply being wrong, or if that failed, painting them as rogue actors. In other words, I don’t see the odds as high that the source will be deemed to have the goods, even if what he is saying is completely accurate. I’m expecting these times to generate a new cliche, along the lines of “you can’t beat City Hall” to describe the futility of trying to prove that a major bank really did engage in bad behavior.

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Bank Outlook 2013: Lower Mortgage Volumes, Higher Interest Rates

As 2013 begins, the US economy is facing higher taxes and an uncertain outlook in terms of jobs and growth. As one senior GOP staffer told The IRA over drinks in Washington last week, we took a European approach to the crisis - namely bailing out the largest banks, etc. This is why there is no traditional recovery in terms of jobs and capital formation.


"We used to shake out all of the losers and start again," notes the veteran Washington financial services operative. "This time we bailed out everyone and there is no job growth. We may already have seen the 'recovery' in 2012."


The other aspect of the refusal by Washington to impose pain on the stock and bond holders of the TBTF banks, for example, is that the Fed is still entirely focused on fighting deflation. Since the US refused to get the process of restructuring done quickly and painfully, the adjustment is ongoing - now six years since the subprime crisis began -- and the US central bank is still trying to avoid a reset in asset prices.


Thus when we look at the US banking system, the outlook seems to be flat to down earnings and revenue for 2013. Mortgage refinancing volumes are likely to be down significantly, creating a significant negative bias in bank revenue and earnings this year.


The Mortgage Bankers Association is expecting new loan origination volumes to fall from $1.7 trillion in 2012 to $1.3 trillion this year, but few Sell Side analysts on Wall Street have taken notice of this fact as yet. The culprit is a drop in mortgage refinancing volumes. As we have noted in previous missives, the US banking sector is going through a serious structural change in terms of sources of new revenue.

"Reduced expenses for loan losses and rising noninterest income helped lift insured institutions' earnings to $37.6 billion in third quarter 2012," reports the FDIC in the most recent Quarterly Banking Profile. "Net interest income was $746 million (0.7 percent) higher than a year ago, even though the average net interest margin (NIM) fell from 3.56 percent to 3.43 percent. The increase in net interest income was made possible by a 4.6 percent increase in interest-earning assets. Two out of every three insured institutions (67.8 percent) reported year-over-year NIM declines, as average asset yields declined faster than average funding costs."


So the good news from the perspective of the FOMC is that banks are putting on more assets. The bad news for banks is that the earnings per dollar of asset are falling with NIM. This trend is due to the other negative factor for US banks in 2013 besides lower mortgage origination volumes, namely the Fed and its zero rate policy.


As we noted in our last comment, net, net the impact of the Fed's purchases of RMBS and zero rates more generally is decidedly negative for banks. Many observers are focused on the continuing fiscal disarray in Washington as the explanation for economic troubles in the year ahead, but we see the FOMC as perhaps the biggest single negative for both banks and consumers.


The impact of financial repression c/o the Fed has been widely noticed for years now, but the members of the FOMC refuse to change their policies. In 2013, however, we see the negative impact of ZIRP on banks and consumer activity becoming even more pronounced. And we also look for some unexpected surprises from the TBTF banks in terms of legacy mortgage exposures.


Once the FOMC finally relents and allows short-term interest rates to rise, we expect to see asset returns at banks improve. Consumers and savers will also start to see their cash flow rise after years of financial repression. But the adjustment process will take years, so for 2013 we think it is safe to assume that margins at US banks will continue to compress under the pressure of ZIRP and constrained consumer activity. So long as the Fed penalizes savers and subsidizes debtors via zero rate policy, there will be no meaningful recovery in the US economy.


But once the Fed does let US interest rates rise -- perhaps as early as the middle of 2013 -- the pressure on Washington in terms of fiscal reform will start to escalate dramatically. For the past six years, the FOMC has given Congress and President Barack Obama a free ride in terms of fiscal issues. As the Treasury starts to see the cost of borrowing rise and Fed purchases of collateral subside, the true dimensions of the fiscal crisis in Washington will become the central concern for global markets and financial institutions. That's when the fun really begins.

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$8.5 Billion Foreclosure Fraud Settlement: Yet Another Loss for Homeowners Touted as a Victory

It’s bad enough to see long suffering homeowners take it once again in the chin, thanks to the way the bank regulators prostrate themselves before their supposed charges. It adds insult to injury to see this type of ritualized sellout yet again presented as a boon for consumers.

The latest case study is the $8.5 billion foreclosure fraud settlement announced today. This agreement came out of a consent decrees among 14 servicers, the OCC, and the Fed entered into in April 2011. This was never a good faith effort to change bank behavior; the OCC was using this ruse to try to undermine the (then) 50 state AG-Federal regulator negotiations (which looked like they might be serious because Elizabeth Warren was informally advising the government side).

There were two major elements of the consent decrees, also known as cease & desist orders. One was a list of servicing standards, which were a partial recitation of what they were supposed to be doing already under current law. The second was a Potemkin review of foreclosures. The cover story was that this process was to identify wrongful foreclosures and compensate harmed borrowers. The real purpose was to whitewash servicer behavior.

And I can’t stress enough that the outcome was not only predictable, it was predicted as soon as the consent orders were published: that the OCC had deliberately devised a process that the servicers could exploit to claim that nothing bad had taken place. For instance, Georgetown professor Adam Levitin wrote:

By far the most interesting bit in the draft C&D order is the bit requiring the banks to engage independent foreclosure review consultants to review “certain” foreclosures that took place in 2009-2010. There is no specification as to which foreclosures are to be reviewed or precisely what the standards for review are. But that’s all kind of irrelevant. Who do you think the banks are going to engage to do these reviews? Someone like me? Not a chance. They’re going to find firms that signal loud and clear that if they get the job, they won’t find anything wrong. It’s just recreating the auditor selection problem, but without even the possibility of liability for a crony audit.

Frankly, this sort of regulatory outsourcing is pretty astounding–the OCC has resident examiner teams at the major servicer banks. Shouldn’t they be the ones auditing the internal controls and performance, not a third-party compensated by the bank? (Oh wait, I forgot that the OCC is paid by the banks–it’s budget comes from chartering fees and assessments on the banks is regulates. Indeed, I was struck in some places by the linguistic similarities between the proposed C&D order and the banks’ counterproposal to the AGs. It’s impossible to know who was cribbing from whom, but the similar language is revealing.)

So here’s what’s going down. The bank regulators are going to provide cover for the banks by pretending to discipline them very hard, but not really doing anything. The public will see a stern C&D order, but there won’t be any action beyond that. It’s as if the regulators are saying so all the neighbors can hear, “Banky, you’ve been a bad boy! Come inside the house right now because I’m going to give you a spanking!” And then once the door to the house closes, the instead of a spanking, there’s a snuggle. But the neighbors are none the wiser. The result will be to make it look like the real cops (the AGs and CFPB) are engaged in an overzealous vendetta if they pursue further action.

It turns out we were not cynical enough. We recounted in a post last week in gory detail that the information that leaked out as the reviews were underway showed not only that the review process was every bit as corrupt as we expected. It was also, peculiarly, turning out to be (per the banks) very costly. We couldn’t fathom the latter (we discussed how implausible the hours claimed to have been spent per borrower file were). The only explanations we can fathom are 1. that the banks were doing a lot more than OCC file review (as in they were bundling in “file remediation” as in cleanup/document fabrication) and 2. people were being paid to do nothing (we’ve gotten reports from insiders that some high-skill temps were kept “on the beach” at the start of the process).
Fast forward, and what happens? The banks bitch about the costs and use that to persuade the OCC and the Fed to shut the process down (they may also have become concerned that with so many people involved in file reviews, many of them temps and hence with no loyalty to the banks, that if they let the process continue to completion, they would have been exposed to enough leaks to get Congresscritters interested). Plus the banks were going to such lengths to suppress any unfavorable findings that the result, that pretty much no one was hurt, would be so ludicrous as to open the process up to unwanted scrutiny.

The excuse was that the money spend on performing the reviews would be at the expense of payouts to wronged homeowners. Huh? We are not talking about parties with strained budgets. The homeowners were supposed to be recompensed. That has squat to do with the expense of figuring out who was wronged.

Nevertheless, the banks and the Feds started negotiating in secret (homeowner advocates and Congressmen were not appraised), with the settlement total rumored at $10 billion for 14 servicers. It turned out to be $8.5 billion for 10. We get the party line and some commentary from Ben Hallman at Huffington Post:

Under the deal, announced by the Office of the Comptroller of the Currency and the Federal Reserve, the mortgage companies will make $3.3 billion in direct payments to “eligible borrowers” whose foreclosures were handled improperly, and will make $5.2 billion available in other assistance to struggling borrowers, such as loan modifications.
“The OCC and Federal Reserve accepted this agreement because it provides the greatest benefit to consumers subject to unsafe and unsound mortgage servicing and foreclosure practices during the relevant period in a more timely manner than would have occurred under the review process,” the regulators said in a joint statement….

The new settlement Monday replaces a deal struck in April 2011 that established the Independent Foreclosure Review, a program that was supposed supposed to give homeowners an opportunity to have an unbiased third-party review their foreclosure and determine whether they might qualify for a cash payout of up to $125,000. Scrapping a previously agreed-to legal deal, especially one as high-profile and complex as the Independent Foreclosure Review, is highly unusual, and a tacit acknowledgement of the program’s failure.

“[It] has become clear that carrying the process through to its conclusion would divert money away from the impacted homeowners and also needlessly delay the dispensation of compensation to affected borrowers. Our new course of action will get more money to more people more quickly, and it will speed recovery in the nation’s housing markets,” said Comptroller of the Currency Thomas Curry in a statement.

If you think this deal was about helping borrowers, I have a bridge I’d like to sell you. The New York Times reported that servicers were eager to wrap the deal up so they could say in their soon-to-be-published 2012 financial reports that the matter was behind them. The Federal Reserve held up the deal briefly, wanting the banks to pony up an additional $300 million. The sense of urgency on behalf of the banks gave the regulators negotiating leverage. But the Fed inexplicably caved.

Now remember, we don’t know how the money will be divvied up, and the bank record on modifications in the deal struck in February of last year shows that they consistently gone for the cheapest route, which is modifying big ticket mortgages (bigger mortgages gets you to a dollar total with the minimum number of mortgages, and the costs are pretty much the same no matter how large the mortgage is). So the odds are high that mortgage mods will go to a comparatively small number of high income (but overleveraged) borrowers.

As for the part of the funds that goes to people who suffered wrongful foreclosures, how the hell are the servicers gonna do that now that the reviews have been aborted? Divide the funds among those that requested a review? Pro-rate it among them, adjusting for mortgage amount? Or divvy it among everyone they can find who was foreclosed on in 2009 and 2010 that they can locate (note they’ve had trouble finding the addresses of former customers who lost their homes) whether they think they were wronged or not? Gretchen Morgenson went through the math using the somewhat bigger numbers (starting with the rumored $10 billion) over the weekend:

Some back-of-the-envelope arithmetic on this deal is your first clue that it is another gift to the banks. It’s not clear which borrowers will receive what money, but divvying up $3.75 billion among millions of people doesn’t amount to much per person. If, say, half of the 4.4 million borrowers were subject to foreclosure abuses, they would each receive less than $2,000, on average. If 10 percent of the 4.4 million were harmed, each would get roughly $8,500.

This is a far cry from the possible penalties outlined last year by the federal regulators requiring these reviews. For instance, regulators said that if a bank had foreclosed while a borrower was making payments under a loan modification, it might have to pay $15,000 and rescind the foreclosure. And if it couldn’t be rescinded because the house had been sold, the bank could have had to pay the borrower $125,000 and any accrued equity.

Let’s look at the the paltry less than $2,000 to perhaps $8,500 compared to the harm some borrowers have suffered. Consider this example from a report posted here from one of the file reviewers:

For example, in one case I reviewed the borrower paid approximately 25K to reinstate his mortgage. Then he began to make his mortgage payments as agreed. Each time he made a payment the payment was sent back stating he had to be current for the bank to accept a payment. He made three payments and each time the response was the same. Each time he wrote and called stating he had sent in the $25K to reinstate the loan and had the canceled check to prove it. After several months the bank realized that they had put the 25K in the wrong account. At that time that notified him that they were crediting his account, but because of the delay in receiving the reinstatement funds into the proper account he owed them more interest on the monies, late fees for the payments that had been returned and not credited and he was again in default for failing to continue making his payment. The bank foreclosed when he refused to pay additional interest and late fees for the banks error. I was told that I shouldn’t show that as harm because he did quit making his payments. I refused to do that.

So the bank basically scammed the borrower out of an additional $25,000 before foreclosing as originally planned. Under the old formula, he’d be owed $15,000 plus his house back or $125,000 plus accrued equity. Instead, he’ll get an insultingly small amount. Oh, and he’ll almost certainly also be asked to release the bank from any liability as a condition of getting the dough.
This is what passes for justice in America: the authorities are all too happy to paper over what any sensible person would consider to be criminal conduct.

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"The Magic Of Compounding" - The Impact Of 1% Change In Rates On Total 2022 US Debt

They say "be careful what you wish for", and they are right. Because, in the neverending story of the American "recovery" which, sadly, never comes (although in its place we keep getting now semiannual iterations of Quantitative Easing), the one recurring theme we hear over and over and over is to wait for the great rotation out of bonds and into stocks. Well, fine. Let it come. The question is what then and what happens to the US economy when rates do, finally and so overdue (for all those sellside analysts and media who have been a broken record on the topic for the past 3 years), go up. To answer just that question, which in a country that is currently at 103% debt/GDP and which will be at 109% by the end of 2013, we have decided to ignore the CBO's farcical models and come up with our own. Our model is painfully simple, and just to give our readers a hands on feel, we have opened up the excel file for everyone to tinker with (however, unlike the CBO, we do realize that when calculating average interest, one needs to have circular references enabled so please do that before you open the model).

Our assumptions are also painfully simple:

i) grow 2012 year end GDP of ~$16 trillion at what is now widely accepted as the 'New Normal' 1.5% growth rate (this can be easily adjusted in the model);

ii) assume the primary deficit is a conservative and generous 6% of GDP because America will never, repeat never, address the true cause of soaring deficits: i.e., spending, which will only grow in direct proportion with demographics but as we said, we are being generous (also adjustable), and

iii) sensitize for 3 interest rate scenarios: 2% blended cash interest; 3% blended cash interest and 5% blended cash interest.

And it is here that we get a reminder of a very key lesson, one that even the CBO admitted on Friday they had forgotten about, in what compounding truly looks like in a country that is far beyond the Reinhart-Rogoff critical threshold of 80% sovereign debt/GDP.

The bottom line: going from just 2% to 3% interest, will result in total 2022 debt rising from $31.4 trillion to $34.1 trillion; while "jumping" from 2% to just the long term historical average of 5%, would push total 2022 debt to increase by a whopping $9 trillion over the 2% interest rate base case to over $40 trillion in total debt!

Sadly, this is no "magic" - this is the reality that awaits the US.

And for those more curious about that other critical economic indicator, debt/GDP, the three scenarios result in the following 2022 debt/GDP ratios:

• 2% interest - 169%;
• 3% interest - 183.5%; and 
• 5% interest - 217%, or just shy of where Japan is now.

Which reminds us: in the next few days we will recreate the same exercise for Japan's ¥1 quadrillion in total sovereign debt, which will show why any more "exuberance" arising from Abe's latest economic lunacy, will promptly send the country spiraling into that twilight zone where every dollar in tax revenue is used only to fund interest expense.

Once again, it is not our intention to predict what US GDP or debt/GDP will be in 2022: only the IMF can do that with decimal level precision, apparently, and not just with anyone, but Greece. The whole point is to show that when dealing with a debt trap lasting a decade, even the tiniest change in input conditions has profound implications on the final outcome. We invite readers to come up with their own wacky and wonderful projections of what the futures of the US may look like.

And that one should, indeed, be careful what one wishes for.

The results summarized for the three scenarios:

Total debt: 2013-2022.

The Zero Hedge open source model, for everyone to play around with, can be found here. Remember: don't be a CBO, enable circs!

P.S. don't even think of modelling a recession: everything Refs up then.

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Pimco's El-Erian: Divided US Government No Longer Good for Economy

A divided government no longer benefits the U.S. economy as it did in the past, said Mohamed El-Erian, CEO of fund giant Pimco. In the past, indecisiveness and political stalemates in Washington prevented policymakers from passing laws that got in the way of the private businesses, which were otherwise free to go to work with Washington out of their hair. "It was once fashionable to argue that a divided government was good for the economy," El-Erian wrote in an OpEd appearing in The Huffington Post. "The view then was that politicians would be too busy with political brinkmanship to get in the way of a dynamic private sector. As a result, unfettered by government interference, the private sector was more likely to invest, hire and prosper ... It is hard — very hard — to make this argument today." – MoneyNews

Dominant Social Theme: Government needs to get back to work.

Free-Market Analysis: Presumably, this is an emergent dominant social theme that Mohamed El-Erian is giving voice to. Perhaps it is a subdominant social theme, as well.

The dominant social theme is, of course, that government is good and among humankind's most necessary inventions. The subdominant social theme could be that government has never been more necessary than NOW.

Why? Well, as El-Erian suggests, the world in general, and the US specifically, has a need for a steady hand on the tiller. What he doesn't indicate, of course, is that it is government and central bank monetary policy that has placed Western economies in jeopardy in the first place.

To some degree, of course, El-Erian is "talking his book." He manages US Treasuries and it is not in his interest if the US as an entity and its fixed income instruments are downgraded. He wants the US – and government in general – to be responsive and make necessary changes.

For this reason, he's made this statement – which certainly goes against what has often been repeated in the business community. The idea that a divided government is good for the economy and the private sector has been a favorite truism of political analysis as well.

For the powerful El-Erian to reverse this perspective is a fairly significant event in mainstream financial circles. Here's some more from the article:

"Our self-inflicted fiscal cliff drama may be the most visible illustration of Congressional political dysfunction, but it is unlikely to be the last one or the most challenging," El-Erian wrote.
"It would also undermine the country's longer-term growth potential and, with that, the ability of many citizens to realize the American dream."

Lawmakers themselves say they understand anger on the part of voters when it comes to the fiscal cliff, a potentially recessionary combination of tax hikes and spending cuts due to take effect at year end.

"I don't blame people at home for wondering what in the heck is going on in the nation's capital," said Sen. Mary Landrieu, a Louisiana Democrat who is up for reelection in 2014, according to Politico. "It's hard to explain. ... I don't think it looks good for either party."

Now Mary Landrieu may believe people are wondering what in heck is "going on" in DC (like El-Erian) but we would tend to believe such statements are disingenuous. Did Ms. Landrieu not notice what has become known as the Tea Party? This constituency is not "wondering" about the US government. In aggregate it wishes to dismantle much of it.

It is perhaps unfair to suggest that El-Erian, too, is ignoring what has taken place, but his solution – to utilize current sociopolitical tools more energetically than ever – is perhaps not feasible long term. The system, we would argue, is dysfunctional on purpose.

This is, in fact, the preferred method of the top elites, for whom El-Erian works. Business as usual is the order of the day. In fact, the just resolved (for the moment) Fiscal Cliff is a good example of how these things occur.

Nothing changed for the US as a result of the agreement to avert for the moment the Fiscal Cliff. The debt remained the same, the regulatory structure, the endless fiat money printing of the central bank.
El-Arian may want focused government officials to make necessary changes in the US and throughout the West. But one has to ask, what is it that modern government is to do?

Certainly, El-Erian wants a return to a previous status quo in which government debt was seen as properly apportioned and not overwhelming and in which US consumers – buoyed by easy money – pursued a virtually endless buying spree.

But the trouble is that the current economic system is set up to gradually fail. Central banking creates booms and then gigantic busts and economies both centralize and subside as a result. Eventually, the plan seems to be for world government to gradually emerge. Those who have created the current system have built an environment that like a shark only moves in one direction, forward.

For a number of reasons, then, what El-Erian is asking for may not be realizable. Government officials shall continue to overspend. The culture of corruption will grow. Sooner or later (and probably sooner) El-Erian's US bond market will experience a precipitating event that will burst what some have called the biggest fixed-income bubble ever.

This is no doubt what El-Erian really fears, a destabilizing element that crashes bond prices and causes rates to rise hard and fast. But he is looking at these issues narrowly and obviously does not sense how much the larger sociopolitical conversation has changed in the US.

The dissatisfaction that created the Tea Party has not gone away. While many are proclaiming a US recovery, any real economic advance will generate considerable price inflation. That's because the tens of trillions printed by central banks will surely start to circulate, causing rates to rise and choking off "green shoots" once again.

When it becomes clear to people that this greatest recession since the depression of the 1930s is not really over at all but is destined to go into yet another phase, as it did in the 1970s, whatever patience remains is likely to be exhausted.

El-Erian and others may wish to turn to renewed government activism to "solve" the 21st century problems that government has caused. But those who have set up the current system did not apparently intend for it to remain stable. And what we call the Internet Reformation is likely to continue to undermine people's willingness to put up with the status quo.

For more about what people are learning about the economy thanks to the Internet, see this Daily Bell Special Report: " The Best Free-Market Economics and Pro-Liberty Educational Resource on the 'Net and Why I Use It Religiously."

Conclusion: We are not at all sure that El-Erian's plea for a renewal of activist big government is line with what realistically can – and will – occur. He and others in his position may wish for such an event but we would guess that the opposite may be in the offing, more divisiveness rather than harmony. The 21st century will be nothing like the 20th, in our view.

 

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