Les Miserables

Age of Wisdom, Age of Foolishness (Part 2)

Written by , KeySignals.com

Those who don’t know history are destined to repeat it.

It is a general popular error to suppose the loudest complainers for the public to be the most anxious for its welfare.

All tyranny needs to gain a foothold is for people of good conscience to remain silent.

You can never plan the future by the past.

Your representative owes you, not his industry only, but his judgment; and he betrays instead of serving you if he sacrifices it to your opinion.

Hypocrisy can afford to be magnificent in its promises, for never intending to go beyond promise, it costs nothing.

If we command our wealth, we shall be rich and free; if our wealth commands us, we are poor indeed.

Edmund Burke

The first report in this series observed:

“The recent evidence shows the emerging scenario in which the financial interest of the asset rich Fed has aligned with the asset rich “City”; at a time when the fundamentals of the housing market continue to deteriorate. The inference is that the Fed must now support the housing market, to which it has become overly exposed, so that it avoids the kind of losses associated with Lehman and Bear Stearns back in 2008.”

The latest evidence suggests that the Fed is now fully committed to the process of trying to save itself at the expense of all other members of the American and wider global economy. The ironic situation has now been contrived in which a continued recession serves the purpose of the Fed; whilst also simultaneously determining that the Fed’s balance sheet can never shrink. An economic recovery is precisely what the Fed does not need; because it will lead to the higher interest rates which will create losses for the Fed’s portfolio and its inability to pay the Leviathan known as the Treasury. Leviathan is going hungry these days, because of the partisan debt negotiations, so the Fed is the chief source of sustenance. The October Employment Report, which surprised with its strength, highlighted the precarious position that the Fed is now in. The stronger data triggered a sudden fear that the “Taper” would be on after all. It took some very noisy market actions by the Fed’s “plunge protection team” to prevent the follow through selling in Treasuries from triggering a panic which would make the Fed’s risk position even worse. The capital markets were at a very dangerous tipping point last week, which reflected a tipping point in the drivers of the behaviour of the Fed. The Fed now finds itself fighting a market which is developing an innate tendency to want to drive interest rates higher. A situation of belief and incredulity is therefore developing in the Fed watching community.

Mindful of this unwinding disaster, Charles Plosser tried to get the Fed to commit to set an upper limit for QE; as a kind of “Taper” redundancy which abides by the edict to provide guidance[i]. Jeffrey Lacker has also come to the conclusion that growth will remain subdued. But rather than concluding that more QE is required, Lacker is implying that QE has reached the limits of diminishing returns; at which more of it will be more risky rather than beneficial[ii]. Lacker’s fear is palpable; he suggests that the Fed doesn’t even fully understand the impacts of its actions[iii]. Thus far, it has been unable to create the growth it expected; so for Lacker this represents an inconvenient truth. Clearly the Fed has too much capital (literally and financially) invested to conclude that it has failed; so that the decision to soldier on regardless has been implicitly made. In order to preserve the integrity of the Fed in the event that this disaster occurs soon, Richard Fisher is squarely laying the blame in advance at the door of the Congress[iv].

Looking in the rear-view mirror, that is the housing market data, one can discern the slow pattern of deterioration.

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CoreLogic reported that the improving foreclosure trend was stalling out in September[v]. There is also a signal that the “Acronyms”, set up by the Government as a kind of creeping housing stimulus, are starting to lose strength. The finger-pointing, in relation to the “Acronym” known as HAMP, has already started. The Special Inspector General of TARP (SIGTARP) recently opined a scathing criticism of HAMP and its custodian the Treasury[vi]. The redefault rate on HAMP mortgages is starting to spike; and the Treasury has no monitors or controls in place to estimate the size of the problem. This implies that the Treasury is either asleep at the wheel or deliberately negligent. Whatever the case, the result is that the rising redefault rate is an unwinding crisis that will undermine the mortgage bond market and hence the Fed’s balance sheet.

Those like the Lender Processing Service (LPS)[vii], who are still cheer-leading the success of the “Acronyms”, focus the debate on the narrow visible signs of falling foreclosures and unchanged delinquency rates.

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This evidence suggests that at least HARP and HOPE NOW are continuing to work their magic. The mantra of these cheer-leaders is that things are back to pre-Crisis levels; and that this is a good thing.

The Banks are happy to comply with the Fed’s urging to lower lending standards. Since the Fed is also tightening capital adequacy standards, this gives the banks the out they need. Lending standards can be lowered with reckless abandon, because the loans will be securitised and passed on to private investors and the Fed. The Banks have no skin in the game, so they don’t care about lending standards.

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As a symptom of this symbiosis, between the Fed and the banks, the observer can see the bubble in “Cov-Lite” Loans which is greater than that pre-Credit Crunch[viii]. As the banks water down lending standards, Fannie Mae gradually continues to raise its own standards; and hence reduce its footprint. Its recent footprint shrinkage came in the form of a reduction from 97% to 95% of its Loan to Value (LTV) benchmark[ix]. Commentators opined that Fannie should be using credit scores, rather than the arbitrary LTV bazooka, to set its lending standards by. Fannie’s use of the LTV standard is a direct general tightening of credit, rather than a more holistic use of credit scores which would have kept some credit flowing.

The Banks’ true risk position is based on the fact that they are lending Reserves (under alleged duress) to the Fed and receiving twenty five basis points in interest. As the Fed gets deeper into trouble, banks may decide that these twenty five basis points do not cover the risk they are taking lending to the Fed. The Banks will then reduce their Reserve position; and the Fed will find that interest rates start to rise, even without its own inspired “Taper”. In this situation, the Fed will then have lost control of the interest rate market. This is the situation that the Fed fears most; and it is this situation which means that the banks are in control of the Fed as they have always been. “Bull Dudley’s” recent opining on the wisdom of not breaking up the Too Big to Fail banks was a tacit acceptance of this fact[x]. JP Morgan’s punitive fines and the on-going legal actions against the Banks, create an impression of justice prevailing. As Balzac observed behind great fortune there lies a crime. The new crime creating the new fortune is being perpetrated under cover of the alleged punishment for the last crime. The proceeds of the new crime will more than cover the fines for the last crime. The Fed needs the Banks to accept the twenty five basis points “fee” for allowing the Fed to build its balance sheet. Recent smoke signals out of the Fed suggest that the market is being prepared to accept a “Taper”, even as the Fed’s unemployment target for QE exit is lowered. We would suggest that the banks have told the Fed that they want a higher Rate of Interest on Reserves, based on the greater risk that the Fed represents. The “Taper” has thus been contrived; and bears no relation to economic activity. It does however bear relation to the fact that the risk premium (charged by the Banks) for lending to the Fed is going up, because the Fed’s balance sheet is getting bigger and riskier. The Banks have therefore said that if the Fed wants a bigger balance sheet, which it can unwind without a nasty exit scenario, that it must pay them a higher rate of interest. Throw in for good measure, the Fed’s commitment not to break up the big banks; and the deal looks like it has been done in the total ignorance of the American people once again. The parcel of housing risk has been swiftly passed to the Fed just as the economic music is about to stop. In order to forestall the Fat Lady and keep the music playing, the Fed’s organ grinders are busily at work preparing the case for accommodating the Banks’ ransom demand of higher interest rates for an enlarged Fed balance sheet. William English, a member of the Fed’s Division of Monetary Affairs, published a paper justifying the case for increased liquidity, whilst simultaneously lowering the unemployment QE exit target to below the current 6.5% “Evans Rule” benchmark[xi]. Simultaneously David Wilcox, a member of the Monetary Affairs Committee, published a paper justifying the continuation (and perhaps increasing) of monetary stimulus against the backdrop of lower inflation[xii]. Janet Yellen’s number two, John Williams was swiftly at hand to reinforce the case for more liquidity in the absence of inflation and growth[xiii]. Across the Pond in Europe, Bernanke’s MIT colleague Mario Draghi was busily fighting his Teutonic adversaries over a similar policy move…. and winning. It is clear that the Saltwater School of economics, which remains in control at the Fed and the ECB, intends to apply more “Salty” liquidity as the solution.

The Lender Processing Service (LPS) has already begun to create the smokescreen to conceal this sleight of hand[xiv]. According to the LPS, the recent “Taper” ratchet higher in interest rates will not trigger a wave of delinquencies and foreclosures associated with Adjustable Rate Mortgages (ARM’s). This is because most of the loans have already reset with no adverse (alleged) impact on the borrowers; and also because the remainder of the loans were made at lower interest rates post-crisis. The LPS would have us believe that all is well on the ARM front. All is not however well on the re-defaulting front in relation to HAMP; which suggests that the LPS should be looking into the “Acronyms” rather than just at ARM’s. The Fed is happy to play along with this game of charades. Its recent Senior Loan Officer Survey emphasized that lending standards were being lowered[xv].

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Slightly less emphasis was placed on the fact that borrowers with good credit standing are not interested in borrowing[xvi]. Some emphasis however was made by Lending Tree to the fact that those who were borrowing in Q3 had a deteriorating ability to repay[xvii]. Private mortgage insurers, who are the real benchmark for credit quality, took a dim view of the situation. The Mortgage Insurance Companies of America (MICA) reported that private mortgage insurance activity slipped considerably in September[xviii]. This all seems to resonate with the stampede of Kyle Bass and Carlyle to exit their private mortgage insurance “venture” enterprise via a premature IPO[xix]. Reading between the lines, the Fed’s survey confirms that money is being thrown at those who have no ability to repay; and that the banks swiftly transfer this risk onto yield hungry private investors. The said yield hungry appetite is of course driven by the Fed’s low interest rate strategy. Another credit bubble is well underway and the banks think that they have neatly dodged the next bullet. The smart money, which had been hitching a ride, is also getting off the gravy-train.

The Fed is increasingly looking like the driver and only passenger on this gravy-train. The signs of the impending train wreck were clear back in July[xx]. Unsurprisingly, they look just like the signs before the Credit Crunch of 2008.

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The Subprime gravy-train steamed out the Credit Crunch again in 2008, after SubPrime Mortgages got modified during the Crunch. It was followed by the Alt A, Option Arm and Prime “modified” locomotives. The “Acronyms” have all added to the velocity of these “modified” trains.

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These trains swiftly hit the buffers as modified mortgages began to default again. The “Acronyms” however kept pushing them through these buffers, as more modifications kept the momentum going.

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Now, the mortgage servicing companies are in the process of stopping paying out the interest payments on seriously delinquent mortgages. These trains have just derailed. It was therefore with great interest that we observed Fitch quietly make its massive Housing Bubble Call this week[xxi]. Fitch’s style was interesting and instructive. Mindful of the opprobrium they earned for being complicit in the scam that preceded the Credit Crunch, they sought to define themselves objectively this time around; presumably to avoid further lawsuits. Also mindful of the chaos that they could trigger, along with the end of healthy business revenues, they decided to make the call with little fanfare. If and when the bubble collapses, they can then show that they were on point and not alarmist.

The gravy enjoyed by the Treasury, which puts the Fed under pressure to cook even more of, was also evident this week.

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(Freddie (left) & Fannie (right) )

Freddie Mac reported that it was within a small dividend cheque of paying the Treasury back; and Fannie May reported that it was nearly there. That was the good news. The bad news is that their “profits” are accounting profits, created by the taking back of charges for future liabilities onto balance sheet[xxii]. In the absence of accounting profits, they are both financially stretched to continue performing and paying back “profits” to the Treasury. The Treasury is thus facing the risk of no earnings from both GSE’s and the Fed, in the event that interest rates ratchet up and the housing market deteriorates further from here.

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The most significant alarm bell in the GSE earnings reports came from the signal that their REO Inventories are building again. Judicial foreclosures are starting to pile up; and there has been a drop in demand for securitised mortgage product because of the rise in interest rates. The GSE’s are experiencing the same risks from rising interest rates that are threatening the Fed’s balance sheet.

At the same time that the housing market fundamentals were deteriorating, sellers bizarrely raised their asking prices[xxiii]. Buyers have however stepped back. The situation forcing Americans to become renters is therefore being driven by both supply and demand factors; which reflects the combination of greed coexisting alongside poverty that is characteristic of this tale of two cities. The next act of “Les Miserables” will be associated with the latest round of Food Stamp cuts[xxiv]. The latest National Association of Realtors (NAR) Profile of Home Buyers and Sellers survey reports that “Les Mis” first time buyers were being crowded out of the housing market; and forced into becoming renters back in June and July[xxv]. The question now arises as to whether this abuse of the renters by the landlords is sustainable.

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Declining rental vacancy data suggests that the landlords maintain the upper hand.

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Renters however have a limited budget, which is presumably under stress from the weak economic conditions that they are in. There is therefore an economic limit to how much the landlords can get away with. There is also the risk from new supply of rental properties. Homebuilders are doing their best to control supply, to boost their own margins, which supports the landlords.

There is however a large grey area, of all the existing foreclosed and derelict properties, which is visible in the real world but seems to have been made invisible on the charts that show supply. This grey area is known as the Shadow Inventory. So far, commentators have looked at the rising price dynamic of this missing Shadow Inventory. There are signs that we have reached the tipping point, at which it is time to look at the impact of this supply coming onto the market. Foreclosure rates are just starting to rise, which suggests that this supply is increasing. The previous report in this series also suggested that a new “Acronym”, known as “FHA 203(k)”, may be bringing this inventory back onto the market soon; once a fiscal incentive for the renovation involved in the strategy occurs. It was left to the Census Bureau to say that the Emperor of the Housing Market has no clothes. In its latest Housing Vacancies and Homeownership report[xxvi], the Census Bureau stated clearly that there is a latent bubble of oversupply in the existing home market. Inventory that has been withheld, pending renovation for ultimate resale or renting, represents this latent supply bubble. According to the Bureau household formation has been so weak, during the recovery, that the demand does not exist to clear all this latent supply at the current level of sale prices and rents. Basically, if young Americans stay at home with the parents (and grandparents!!!), demand is effectively stripped away at this current level of market prices and rents.

Fannie Mae’s October National Housing survey provided further evidence that the housing market had passed a tipping point. The survey shows that post Government Shutdown consumer attitudes have changed significantly.

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The economy is now viewed to be heading in the wrong direction.

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House sellers are more disappointed than buyers.

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House prices and rents are expected to fall.

What the Fed, the Treasury, the GSE’s and the Banks want to hear is also evident in the survey. Consumers do not expect interest rates to fall. In fact, consumers expect the Fed to step up to the plate with even more liquidity. Thus we have a situation in which America in general is rooting for economic weakness, because of the pecuniary incentives such weakness provides to all those with a financial axe to grind. A self-fulfilling prophecy born out of misguided self-serving pecuniary behaviour is thus achieved. The American Dream is one in which Americans dream of a nightmare scenario.

The Fed lowers its unemployment QE exit target, yet further to a level that will never be reached, so why even bother? The reason to bother is that it justifies the raising of the “fee”, paid to the banks by the Fed in terms of Interest on Reserves, in order for the Fed to finance all this economic misery in the absence of real government and leadership. The US Dollar (and the energy it purchases) is backed by the creation of debt. The “fee” for this privilege has just gone up.


  1. US Federal Reserve’s Charles Plosser floats setting a cap on QE3
  2. Foreclosure Improvements Held Back by Judicial States
  3. What does the Fed’s bank survey tell us about mortgage origination?
  4. Mortgage REITs: Last Chance to Exit?
  5. Lawler on Fannie and Freddie Results, REO Inventory Increases in Q3
  6. First-Time Home Buyers Losing Market Share
  7. Fed’s Lacker Says Cautious Consumers Restraining Economic Growth
  8. Fed President Lacker: ‘We’ve got tinder on the books of the banking system’
  9. Dallas Fed’s Fisher Says U.S. Economy Hog-Tied by Government
  10. HAMP’s Redefault Rate at 27% and Likely to Rise
  11. LPS on Mortgages: New Problem Loan Rates Close to Pre-crisis Levels
  12. Covenant-light loans on the rise
  13. What Does Fannie Mae’s New LTV Threshold Accomplish?
  14. Bill Dudley On Breaking Up Too Big To Fail Banks: “Don’t”
  15. U.S. Economy Slack Justifies Stimulus, Top Fed Staff Papers Show
  16. U.S. Economy Slack Justifies Stimulus, Top Fed Staff Papers Show
  17. Fed’s Williams Says Economic Data Disappointing With No Pickup
  18. Report: New Wave of Delinquencies from ARM Resets Unlikely
  19. U.S. Banks Ease Business-Loan Standards, Fed Survey Shows
  20. Borrowers Deemed Less Healthy in Q3 as Prices and LTVs Rise
  21. September Sees Drop in New Private Mortgage Insurance
  22. Bass-Backed NMI Prices IPO at Top of Range in Mortgage Wager (1)
  23. Report: Housing Bubble Fears May Not Be Unfounded
  24. Home Price Increases Widen in September, Sales Weaken
  25. US emergency food providers brace as $5bn food stamp cuts set in
  26. Low Inventories Conceal Hidden Vacancies, Threat Looms Nonetheless

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