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   I’ve been writing a bit over the last few months about the financial mess we’re about to fall into and an event I’ve been expecting for a while came to pass late last week – a foreign bank wrote down all of their U.S. CDOs to $0.10 on the dollar.

  This event, the long dreaded "mark to market" for CDOs, has implications for all bonds, both commercial and municipal, due to the exposure monoline bond insurers have. This matters for stocks as commercial bonds are often the offerings of publicly traded companies, it matters for the pensions that will have to fire sale all bonds that stop having a AAA rating if the monoline insurers implode, and it’s happening against the backdrop of the first of what promise to be somewhere between 900 and 2,200 bank failures that will result in an FDIC bailout to match the recent Fannie Mae/Freddie Mac bailout.

  Grab a bottle of scotch and your teddy bear, ‘cause you’re gonna need both before this is done.

 A CDO is a collateralized debt obligation. All those ‘for sale’ signs on your street? The mortgages of those foreclosed houses are part of a CDO somewhere. The repossessed car that belonged to the people that lived there? That loan was part of a CDO. The credit cards they defaulted on? Part of a CDO. Starting to see how this works?

 A CDO has a credit rating – the underlying issuing entity pays a monoline insurer an insurance premium for which they receive a "AAA" or investment grade rating on the instrument. The monoline insurers used to be the most boring sort of business in the world, taking a little slice of each bond issue and loaning out their AAA rating in exchange. The risks were well known, they scored consistent, unexciting profits, and life was good. They got seduced by the dark side, began insuring make believe financial instruments, are now on the hook for CDO performance, and now the two in New York, AMBAC and MBIA, are under intense scrutiny from the New York insurance commission and will certainly fail.

 This stuff is all like a pile of discarded California Christmas trees on February 1st. One little spark and the whole business will go whoooosh in a puff of flame. Bank of America purchasing Countrywide? Totally and completely about not having to fess up to what their mortgage bundles were worth; it would have taken down both companies and the rest of our economy along with it. J.P. Morgan buying Bear Stearns? More concealment in action with the hand of the U.S. Treasury guiding the event.

 Pension plans have rules – they can’t own crap. They own a lot of CDOs which are crap in their own right and they also own lots of other bonds which will become crap due to the loss of their AAA rating when a run on the monoline insurers begins. They'll have to sell, sell quickly, and that means prices for all of these sorts of securities will tumble.

  The triggering event for the run on the monoline bond insurers could not come from within the United States; the Federal Reserve, the U.S. Treasury, the Congress, and the White House have all shown a willingness to do whatever was necessary to head off this day of reckoning. It was always obvious the trigger for the meltdown would come from a "mark to market" occurring outside the control of these entities.

   National Australia Bank’s decision to value the CDOs it holds at 10% of their face value (this is what got me started on this diary) may very well be the event that will trigger the destruction of the monoline insurers, the revaluing of CDOs from their "mark to model" to "mark to market". If you prefer to be more direct you can call it "mark to meltdown".

  These synthetic securities or derivatives (Just call ‘em funny money) were valued via computer models that purported to express the percentage of debtors who’d fail to pay. No one actually sold these things in the open market, they just bought and held them, taking the payments that came and trusting the investment banks that were bundling up and selling these things. Financial innovation, they called it. This was true until two Bear Stearns funds imploded fifty four weeks ago.

   Bankers were terrified that this would trigger an overall "mark to market" event.

Well, the bonds just aren't worth what most people are carrying them on their balance sheet for. If Merrill sells, it's admitting whole huge chunks of mortgage-backed assets should be revalued to reflect market pricing. "No one in the subprime business wants to ask the question of whether they need to re-mark all the assets. That would open the floodgates," says Janet Tavakoli in the Journal article. "Everyone is trying to stop the problem, but they should face up to it. The assets may all be mispriced."

- Dan Denning, Australia’s Daily Reckoning.

   Consider just what this means. Municipalities are already under stress due to declining property tax revenues and that source of funding is about to get reset bigtime due to declining home values. Corporations are under stress due to declining consumer confidence and the recession we’ve already entered which threatens to turn to depression in the third quarter of 2008 and will certainly be there by fourth quarter(!)

 Many of the CDO issuers are mortgage making banks. I’ve written here and here regarding the coming storm in the banking business. Executive summary? One eighth to one quarter of our banks will die very shortly. The FDIC has $51 billion in assets and a failure of any one of the top eighteen deposit holders alone will exceed that amount. Wachovia is widely seen as being marked for death and their insured deposits are ... $392 billion. Bank of America is on the list, too, and their deposits are $600 billion.

  You heard it here first, folks. The treasury bailed out Bear Stearns, they bailed out Freddie Mac, and they bailed out Fannie Mae. The first one showed Wall Street a failing investment bank would get the keys to the treasury and the two Government Sponsored Entities, Fannie and Freddie, had already been put to work as collecting points for toxic mortgage securities, transferring private troubles to you and I. Call it Welfare for Wall Street. The FDIC bailout will be next and right after that, I fear, we’ll see a terrible need for addition funds for the Pension Benefit Guaranty Corporation, with the failure of Chrysler, GM, and Ford being one of the driving factors.

  So where does all of this bailing get us? Nowhere. Fast. When a single institution or a region of the country has trouble we spread the losses around and pull them out of it. When every institution and every region has trouble there isn’t anywhere to bail to. What we face now is a systemic crash tied to the deflation that has been in motion since the Bear Stearns funds collapsed last year. The Federal Reserve "printing money" isn't going to help in the face of a systemic problem; a doubling of dollars would just cut the value of all of them in half.

  If I sound like I know what I’m talking about it’s only because I’ve been religiously reading the work of Kossack Stoneleigh regarding the credit crunch. Stoneleigh and Ilargi broke away from The Oil Drum:Canada a while back to run their own thing - The Automatic Earth which is a daily, in depth read for me.


Good sources for bad news? These are the ones I use:

and I really like this new one of which I was just informed ... a time line for the whole mess.


Originally posted to Stranded Wind on Sun Jul 27, 2008 at 01:47 AM PDT.

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Comment Preferences

  •  Hasn't IndyMac's fall soaked up (3+ / 0-)
    Recommended by:
    Samwoman, KenBee, Stranded Wind

    a pretty good share of the FDIC funds?

    •  Indymac got 10% of the total (9+ / 0-)

      Indymac got 10% of the total, but should this one gain visibility today someone will come along and give a three paragraph lecture about how the FDIC will raise rates on the banks and do some other stuff to shore up their ability to respond. I am not yet educated in that area ...

       It should be noted that brokered deposits are already experiencing some new restrictions - you can deposit more than the $100k limit somewhere, it'll get "brokered" for a higher rate, and thusly a lot of folks got sucked in to Indymac's drama.

  •  Thank you for your insights on this--you might (5+ / 0-)

    also appreciate this blog:

    A friend of mine who's pretty smart, says it's great--I am not in much of a position to say as I have very little knowledge of economics, but what I DO read and understand makes a lot of sense. She's been correct in essentially all her forecasts so far....and I'd love to see her get some traffic!

    Thanks again for posting something about this situation in a way I can actually understand!

    HOPE: It's the new black. And it's WINNING!!

    by Samwoman on Sun Jul 27, 2008 at 02:36:32 AM PDT

  •  kangaroos (2+ / 0-)
    Recommended by:
    Overseas, Stranded Wind

    while everybody's so worried about the US housing market disaster, I prefer to send money to help the kangaroos who are losing their homes as we write. Their  homes are only worth 10 percent of original mortgage value, and worse than California Christmas trees blazing out of control is a kangaroo's grassy home up in flames. Currently, these angry bounders are boarding boats and immigrating to America for opportunity and to grab some housing while the prices are low. At least that will help alleviate the abundance of for sale signs in my neighborhood.

    •  bounding (1+ / 0-)
      Recommended by:

      Shouldn't you be out bounding around a hay field somewhere?

    •  It is the deer in our area (2+ / 0-)
      Recommended by:
      Stranded Wind, Peacerunner

      Houses have been built near our woods and there are less and less places for them to live.  

      A group of them come to a thick tree area every night behind our house. We see them from inside the house, we never go near them. We don't want them to trust people.  We have a spring that has a trickle of water that goes into a low solid rock area that catches water. That is where they drink from.  

      My husband puts out a salt block for them.  We want them to know they have somewhere to hide.

      November is deer season here. I dread it.

  •  Grim (6+ / 0-)

    The Bush economy drunk was based entirely on cheap mortgage money. We have not been creating living wage jobs, people have been getting squeezed from local and state taxes to offset the loss of federal funds. Then the energy and food costs went through the roof as the house as ATM dried up.

    Injustice anywhere is a threat to justice everywhere. - Martin Luther King, Jr.

    by DWG on Sun Jul 27, 2008 at 03:17:34 AM PDT

  •  'No angry lines of customers after bank takeover' (2+ / 0-)
    Recommended by:
    side pocket, Stranded Wind

    yet. Story here
     Wait til the FDIC runs out on the 100,000$ accounts.
     That'll be exciting.

     I think we're pretty much see no/hear no/speak no lalalala monkeys and expect the Feds to just keep things humming along. Until we feel Grover's little cloven hoof on our necks.
    "These things happen".

    I hope you and your 'Automatic Earth' pals are out to lunch. Reading there, I can delude myself that I can actually understand economics eventually, they write really well, and thanks for the linx.

    Obama...Hope McCain...Nope

    by KenBee on Sun Jul 27, 2008 at 03:46:29 AM PDT

  •  Nope (1+ / 0-)
    Recommended by:

    The GDP will be up between 1 and 2%.  Unemployment will be at about 5.6%.  This isn't earthshattering bad news.

    Most of the money in the alphabet soup world of CDOs came from overseas.  Indeed it was the selfish investors from the EU, China and Japan, in collusion with the greedy and unscrupulous American brokers who caused this mess.  The overseas investors are the ones who got really hammered.  After all, it was the American brokers who sold them the garbage, and they got very fat on it.  If you earn .1% on a trillion in CDOs you've done well.  Those brokers fees on all of those junk home mortgages weren't that bad either.

    The historical level of home values vs. GDP are now back in line with current values.  After a 6 year where they went way over the line, they are now back at historical parity.  Home building is slowly bouncing back- still a long way to go- and home remodeling is being enhanced by people preparing for winter heating costs.  And the mortgage bill about to be signed by Bush will not hurt either.

    •  Oh really? (3+ / 0-)
      Recommended by:
      SarahLee, unclejohn, Stranded Wind

      The impact the credit crunch on the economy has only just begun to be felt, as economic fallout is a lagging indicator of financial turmoil. Also, we are still in the very early stages of the credit crunch, so credit deflation has yet to seriously impact liquidity. By next year, that impact will be huge. I won't see even the most modest economic growth, and unemployment will go through the roof. People don't realize the extent to which the entire economy relies on the credit that is disappearing - slowly at first, but at an accelerating rate, as is the nature of positive feedback.

      Overseas investors have indeed been hammered by losses on worthless CDOs, but the losses to domestic US investors are huge as well. Pension funds were a favourite dumping ground for the 'toxic waste' of the investment world for instance. They were chasing yield without realizing they were chasing risk, while issuing banks were engaged in a feeding frenzy over fees while selling on the risk through credit default swaps. The counterparty risk on those is now overwhelming, and as that market is 'worth' approximately $62 trillion, the coming meltdown there will hurt far more than anything we've seen so far. The crisis is global, and overseas investors will suffer just as badly.

      I'd like to see your data on home values vs GDP as I'm skeptical to say the least. Even if it were true, we wouldn't expect this housing debacle to end in the normal range. For every overshoot there is a substantial undershoot, and in this case that will be driven by lack of access to credit. In a few years time, I doubt if many houses will be worth much more than the cost of the building materials they are composed of, reflecting the fact that much of the building boom was an exercise in negative added value.

      During the Great Depression, some of the best farms in the country were auctioned following foreclosure and received no bids. The problem then, as it will be again, was a lack of purchasing power thanks to a collapse of the money supply (deflation). Just what is something worth if there are no bids?

    •  GDP (0+ / 0-)

      And those are what, govt numbers. good luck
      with that.

      They dont adjust for inflation,
      real inflation over 10% per year.
      GDP has to be over 10% to keep up with the
      collapse rate.

      inflation is cooked in all those numbers.

      Inflation is a loose term, it really currency

      Most companies reporting higher earnings
      on lower unit sales, inflation is cooked in.
      No consumer/retail companies report inflation
      adjusted numbers, inflation growth cooked in.

      How's your income inflating? lol.

    •  The unemployment rate (1+ / 0-)
      Recommended by:
      Stranded Wind

      doesn't count those who are a one man business that works for the same company all the time. They don't get unemployment when the companie lays them off.  

      They also don't count those who have been laid off and not rehired.

      Those who are 62 that get laid off usually go on Social Security. They should go on unemployment, but most can't afford to do that.

  •   transferring private troubles to you and I. (1+ / 0-)
    Recommended by:
    Stranded Wind


    James Howard Kunstler is also a good site for horse pill sized depression.

  •  Self-serving question: (2+ / 0-)
    Recommended by:
    SarahLee, Stranded Wind

    I have a checking account in Wachovia, solely for the purpose of automatic utilities and other bank draft payments. I only keep enough in it to satisfy my creditors. When Wachovia goes belly up will I have to go elsewhere for this service, or will FDIC ensure that my account continues to serve this purpose?  My nest egg is in our local county bank, that is, so far, rated well at bauerfinancial and
    Thanks for diarying in plain English on this topic. I checked out Automatic Earth last week, and it is too in depth and over my head, so I really appreciate your updates, and look forward to reading your work.

  •  "Does Wall Street come apart next week?" (3+ / 0-)

    This we can't know.  Even if you're right that the inevitable trajectory of the financial situation is towards meltdown, the timing of said meltdown is bound to be elusive.  One savvy Wall Street billionaire had the 2000 NASDAQ crash totally sussed out and bet it to the hilt.  Only problem was he was two years too early.  For two years he got his teeth kicked in.  Fortunately for him, he had deep pockets and was able to hang on until the collapse.  He made skads of money.  We're not him, though, and the adage that applies to us goes something like "the market can stay wrong longer than I can stay solvent".

    •  Wall street is already coming apart (2+ / 0-)
      Recommended by:
      SarahLee, The Wizard

      It's still early days, but Wall street has already been coming apart for a long time. The credit boom disguised a collapse in real values that has been going on since 2000, and even in nominal terms the market peaked last October. We are now stair-stepping lower in a series of stomach-churning lurches. Although the current rally may last until early August (as an initial short squeeze seems to have sparked some buying interest from the buy-the-dips crowd), the next phase of the decline should then be longer and stronger than what we have seen so far. By autumn, we may well be in crash territory, and the deleveraging should continue for several years. We are well on our way to a rerun of the Great Depression.

  •  When the banks in my country had a (2+ / 0-)
    Recommended by:
    side pocket, Stranded Wind

    similar problem - after the fall of socialism they held an enormous amount of bad debt and inflation was very high - there was only one sensible thing to do to retain a nationally-owned banking system (very important in a small country):

    Buy debt. A bank always juggles with money: It always has to have enough on hand for the depositors. When it becomes illiquid it collapses, by law and because of the broken trust. The state, on the other hand, can take its sweet time with extracting bad debt.

    The state bought the bad debt in exchange for government bonds. Welfare, you might say. And it was. But it also happened to play a major part in saving an economy in a depression. And the state slowly recouped a third of the bad debt with very little pain.

    I would suggest the US do the same to alleviate the crisis.

    Omne malum nascens facile opprimitur, inveteratum fit plerumque robustius. - Cicero

    by Dauphin on Sun Jul 27, 2008 at 05:20:45 AM PDT

    •  No one has deep enough pockets for that this time (1+ / 0-)
      Recommended by:

      There won't be a lender of last resort this time. The scale of the losses will be too large. The derivatives market has gone from essentially zero to $750 trillion in a little over 20 years. It's a leveraged house of cards - a giant Enron waiting to implode.

      •  But there is a big difference (0+ / 0-)

        between a slow, controlled collapse, and chaos. Besides, the government can always inflate its way out of the problem and be sure that they will come out on top since the rest of the world will be afflicted much more severely.

        Omne malum nascens facile opprimitur, inveteratum fit plerumque robustius. - Cicero

        by Dauphin on Sun Jul 27, 2008 at 07:54:17 AM PDT

        [ Parent ]

  •  Yep (1+ / 0-)
    Recommended by:

    down hard to Aug 20-21.

    Because of these naked short sellers?


  •  August (1+ / 0-)
    Recommended by:
    Stranded Wind

    Here's my time and price projection.
    It's about 8% down, 1145-1120 SP500.

    Cyclic study has Aug 20-21 but that adjusts
    as we go and is not exact yet.


  •  There are a couple (2+ / 0-)
    Recommended by:
    Clzwld, Stranded Wind

    of reference points that I did not see in your diary Stranded Wind.  

    1.  Any discussion of CDO's, the Monoline Insurers, the Bear Stearns hedge funs implosions and later Bear Stearns itself, Countrywide & Bank of America  and the rest needs to include the  the market for Credit Default Swaps.  Its structure of party/counter party risks, total market capitalization and the import of actually holding the bonds that are being insured through the Monoline's or the CDS market.
    1.  In discussions of Monoline Insurers loss of their AAA ratings impact upon local governments through the CDO/ property tax base must also include a reference to the in progress implosion of the municipal bond markets and the student loan markets.

    Stranded Wind,  your assessments of the inherent risks to the financial system do to the ongoing implosion of structured finance in general and CDO's and like products specifically are timely.
    I include these points simply because the process of unwinding of global structured finance has and is ongoing and is accelerating.  
    One only needs to take a look at the market for Auction Rate Securities over the past 12 months, including the pending legal actions announced by the Attorney's General's of Massachusetts and New York  to obtain a good feel for how many of these other markets are unwinding as well and their effects on the broader market.


  •  Triple Witching season (1+ / 0-)
    Recommended by:
    Stranded Wind

    Three major factors will change things forever this Fall/ early Winter.

    First is the cost of oil. This Winter the heating shock will be huge and will hit hard. Consider that it will cost just under $1000 to fill your oil tank and you'll need it every two to three weeks in the coldest part of Winter. On top of that you'll pay $100 to fill your tank in your SUV/Pickup Truck.

    The second is the financial crisis. There is no security behind much of the invested wealth. Banks will fail, mortgage companies will fail and the stock market will deflate. This was inevitable as there has accumulated too much debt and too much wealth. Your debt is someone else's wealth. Their wealth is dependent on you being able to pay your mortgage and your credit cards. And guess what, easy credit has allowed you to borrow way beyond what you can pay. Stranded Wind is right-on in this diary.

    The third is the consumer economy.  It's dependent not only on consumer debt, but increasing consumer debt. The last eight years have seen a 50%increase in GDP, but a very small increase in median income. Yet the broad base consumer market continues to grow. This makes almost no sense at all, and the end of this year brings an end to that. The consumer market will screech to a halt as wealth and income get clobbered and fixed expenses sky rocket. The housing market will completely crash as that's the last thing that consumers are going to think of, if they could qualify with tightened requirements. The housing market will not stabilize until housing is about 40% below pre-bubble prices.

  •  From the little man. (1+ / 0-)
    Recommended by:
    Stranded Wind

    Till we see   firings  and admittance of the frauds that have and are taking place we will not be at a turning point.
    Down elevator. All on board.

    Looking for Good Reason

    by Clzwld on Sun Jul 27, 2008 at 08:00:35 AM PDT

  •  An old man told me (1+ / 0-)
    Recommended by:
    Stranded Wind

    that during the last great depression the local bank failed. He said the banker said he lost all his money, too, but no one believed him. His life didn't change at all.

    One bad thing about the subprime loans was the way the poor sometimes traded in affordable homes, mostly not very good homes, but they were a roof over their head.

    Why is gold and silver going down?  

    Knowing the problem is only half of solving the problem.  What should people do with their money?

    •  Gold and Silver (1+ / 0-)
      Recommended by:

      Technical trading action. Why are they
      still buying stocks? Why are there still
      violent bear mkt rallies in the stocks?
      It's just a technical condition.

      When the stock market surged last week
      money moved out of all commodities. That's
      a technical action, taking off their hedge
      because of external interventions of non
      open nor free market activities by the central
      command planners ( communists ) is hard to
      measure and value.

      Gold hit a high level in the spring,
      dropped back to test $850 support level
      during the stock mkt recovery Mar-June.

      It's also called a wave 4 action which are
      volatile time consolidations.

      Once gold goes over the spring high will
      be a permanent support, they stair step.
      Gold is relatively high and there is apprehension
      and time involved to accept this trading level
      and move to a higher range over the spring high. All market psychology and trading phenomenon.
      No one really understands it but we try.

      I work in a supplier to truck manufacturers,
      truck manufacturers stopped ordering parts and our
      factory has regular shut downs, curtailments,
      temporary layoffs. But you know those truck manufacturer stocks havent crashed yet. Now some of that is inflation, they can report higher $ earnings on lower unit count and hide some damage. But in any case markets are not
      necessarily linear and are more a psychological
      phenomenon but eventually reprice to reality.

  •  So as usual (2+ / 0-)
    Recommended by:
    CitizenOfEarth, Neon Vincent

    I see diaries like this, and I think, 'sure, that all makes sense, but what do I do?'

    I have some money, it's currently all in short-term CDs.  I'm not trained enough to know what's coming, deflation or inflation, safety in bonds or not, so I haven't been able to decide what the hell to do with it.

    In a depression-level economy, none of my skills are marketable.  If I lose my job and my nest egg, I either end up on the dole (if the government can afford one) or dead.

    None of the advisers I've talked to have said anything other than 'oh, stocks are bound to go back up, buy them'.  I say I'm worried about a real recession or even depression and they look at me pityingly, like I'm perhaps someone out of the local mental hospital.  The places that do offer information on how to avoid these problems all universally read like quack doctors offering colored grain alcohol as a remedy for your leprosy... for a small fee, of course.

    I feel like this is coming, and I feel like I'm in a position to prepare, but I have no idea how.

    I feel like I am so, so screwed.


  •  Great diary. And with two brand, spanking new (3+ / 0-)

    bank failures   this is sounding prophetic.

    Anyone for a quick game of Chess.

    by CitizenOfEarth on Mon Jul 28, 2008 at 10:59:59 AM PDT

  •  Rich will get richer. Poor will starve. (0+ / 0-)

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