Standard & Poors Cuts USA Sovereign Credit Rating to "Negative" from "Stable"

The US ratings agencies, long discredited for kow-towing to the major Wall Street investment houses, as they led a race to the bottom in terms of assigning ratings to sophisticated and complex instruments they themselves were not able to fully understand, finally peered over the fiscal precipice on Monday with Standard & Poors opening the first salvo to admonish the US sovereign credit rating. It cut its long-term outlook on the US to "negative" from "stable." The revision sparked fears that Uncle Sam could soon surrender his coveted "AAA" rating, the cornerstone of "reserve currency" status.

I've always seen these firms as lagging indicators to the machinations in the real economy. Look at what happened in the Eurozone with Greece, Ireland and Portugal. They were late...as usual...in recognising the gargantuan sovereign fiscal risks. Maybe they don't see it as part of their remit anymore to stand up to and ruffle governments' feathers before fiscal road accidents happen. It used to be said the role of the Federal Reserve was to take away the punch bowl just as the party got swinging...with the independent ratings agencies jousting alongside in tandem. However, the pressure within these agencies to search for new sources of income compromised their high ethical standards in the quarterly earnings pressure-cooker that is Wall Street.

For most of 2011, long-term bond yields have been in a trading range between 4.375% and 4.65%. Despite the upward trajectory of QE2 money printing, an endless stream of Treasury bonds issuance and foreign buyers starting to make noises about US fiscal irresponsibilty (Brazil, Russia and China) and the Government's ability to repay, yields have remained stubbornly low.

But interest rates will have to go higher soon...the Treasury has to offer attractive yields to appeal to these overseas buyers to buy ever higher volumes. In February, PIMCO, led by bond king Bill Gross, a conservative bond stalwart, announced its exit from the US treasury market completely. That's akin to Burger King declaring they no longer will use beef in their burgers.

The opportunity to short the treasury bond market is not far off, with yields near the lowest points and pricing near the top of their trading ranges. QE2 ends on 30th June and will open up uncertainty as the market addicts develope cold turkey. Where else can one find the grease to ramp up the markets? A lucrative ETF, ProShares UltraShort 20+ Year Treasury (symbol NYSE: TBT) is a good proxy to brace for a decline in treasury prices, gaining 2% for each 1% fall in price.

2011 Japan Earthquake, Nuclear Accident and Economic Implications

The sixth largest earthquake ever recorded at 9.0 on 11 March in northern Japan and the ensuing tsunami plus nuclear accident at the Fukushima Daicchi is a potential game-changer to the current fragile global economic stability.

With facts still foggy a week after the event, it is not inconceivable fear starts to take over. After all, in the nuclear industry "perceptions" are everything (aka Three Mile Island 1979, Chernobyl 1986). Already some multinational companies have chartered private jets to evacuate their overseas staff from Japan.

This radiation threat can zigzag but I see the economic picture taking shape in the following direction:

1. The world watches rivetted by this destruction in an advanced economy. One reactor may be so catastrophically damaged it contaminates the whole site so rendering the permanent complete shutdown of the entire electricity generating complex. Immediate energy shortages cascade to a grinding slowdown for industries served in the local area. It will take weeks to play out.

2. Japan is a major world player. The smooth cash flows in the global economic system to this financial centre will be disrupted as Japan rethinks the rebuilding programmes for this region which will probably take several years. Initial estimates are this area generates 3% of the national output. Just-in-time manufacturing and logistics patterns can screech to a halt if there are no alternative networks available and the implications can be heavy for domestic exporters and multinational companies. For the financial players, global money movements can be disrupted as their interest rate sensitive strategies and carry trades in the country start to morph into something completely unexpected in an uprooted Japanese landscape. Already we saw drastic and unexpected G7 intervention in the yen this week.

3. Should Japanese exports plunge and imports rise for the reconstruction efforts, Japanese money flows will tend to stay onshore within Japan. They may find they cannot participate in the US Treasury auctions of which they are the world's second biggest holder. US Treasury yields will therefore start to notch up and this can have ominous implications for bondholders and governments in their debt-servicing interest payments.

4. With money ebbing away from the US Treasury auctions, already magnified by fiscal crises in Western Europe PIGS countries, questions will be raised whether another round of quantitative easing be required after the end of June. The current rising oil price due to north African tensions (another potential game-changer in Middle-East oil dynamics) does not help. Is the groundwork being "justifiably" prepared for QE3 based on this Japan crisis?

5. There could be spill-over effects into the enormous derivatives arena. This is a fast-changing financial landscape for the international big boys and any changes in the economic assumptions that underpin these assets can quickly turn them toxic.

6. Everything changes. Faster than you can believe.

The baseline is starting to shift this week. We cannot foretell whether the resulting market turbulence (Nikkei down 16.5% in two days, worst performance since 1987 crash) was just a temporary hiccup or the harbinger of bigger moves to come over the the next two months, as the economic consequences of the guargantuan task ahead for the world's leading creditor nation are digested. Japan recovered relatively quickly from the 1995 Kobe 6.9 earthquake.

After the stunning market rebounds over the last two years, it may be time to hit the sidelines by paring down the non-core holdings and move to cash.

Dagong Global Critique of Federal Reserve QE2 Quantitative Easing Measures

A China credit rating agency, Dagong Global, the equivalent of Moody's and Standard & Poors, came out with a blistering critique of the latest US$600bn quantitative easing manoeuvre by the U.S. Federal Reserve announced on 3rd November.

"Though it is likely for the current loose monetary policy to postpone the occurrence of difficulties, yet in the long run, it will be proven to be a practice resembling drinking poison to quench thirst."

Timed for the Seoul G20 meeting, the drumbeat of anti-American economic policy management is building. Germany weighed in this week with their finance minister pronouncing the U.S. Federal Reserve "clueless".

Based in Beijing and founded in 1994, this is the same agency which in July announced credit downgrades to several western nations stripping them of their AAA status (Germany AA+, USA AA, Britain AA-, France AA-).

Watch for further announcements from Dagong...it is demonstrating to be a robust counterweight to the systemic biases embedded within the western ratings agencies who totally failed to anticipate the risks that unfolded leading up to the 2008 financial crisis.

Time will tell whether it proves to be a good leading indicator of the Chinese government's thought processes on western monetary policy management.

US Foreclosure-gate: Subprime 2 housing crisis coming?

The news broke this week on foreclosure-gate. It has been evident for a while the U.S. banks are drowning in foreclosures and this current crisis is just going to make things a lot worse. Back in 2005, there were approximately 100,000 home repossessions in the United States. In 2009, there were approximately 1 million home repossessions in the U.S. and RealtyTrac is now projecting that there will be an all-time record of 1.2 million home repossessions in the United States this year.

Vast numbers of foreclosures across the United States could be invalid because the securitization process has muddied the chain of ownership. In fact, an increasing number of judges have ruled that the "owners" of the mortgage have no right to foreclose on a property because they lack clear title. This has giving rise to a "Show me the Doc" (document for tile deed) movement to help householders restrain the banks' actions.

8 Investment Implications:
House Buyers

• Foreclosure bargains currently on the market may not be the bargains they appear if legal title is not clear.
• How will this affect the middle-upper of the property market with recent social trends to "trading-up"?

• Americans that have recently purchased foreclosed homes may now be facing some serious problems themselves enduring the uncertainty of where legal title actually resides. Managing household budgets will be thrown awry.
  

House Sellers

• Millions of Americans may now "own" homes that they do not have clear title for. When it comes times to sell those homes, many Americans may find themselves unable to do so, thereby restricting labour mobility.

Householders with Foreclosure Notices Served

• For a typical under-water US householder, there may be an incentive to just stay in one's property until a bank or "someone" turns up with the full and proper paperwork to evict. The "Show-me-the-doc" movement is now gaining traction as survival instincts are triggered with social mores thrown out.
• By not paying the mortgage, a householder may gain a "temporary reprieve" to transfer mortgage spending elsewhere.

Banks

• It will make it much more difficult for the banks to sell the massive backlog of foreclosed properties they have accumulated.
• Under current FASB accounting regulations, such loans (assets) should be marked to zero if there is no eligible legal title or in the absence of market validity. Massive write-offs could be looming. It distracts management attention from running the core business.
• How will this affect the ability for banks to sell mortgage-backed-securities (MBS) into the market?
  
• Will banks continue to hoard money and not lend as they consider all conservative means at their disposal to shore up their capital base?
  
• Should another raising of capital arise to boost their Tier 1 and 2 reserve ratios, this will cause dilution to existing shareholders.

Ratings Agencies

• Do they have any credibility left? What checks did they do to validate any of the paperwork before they issued their ratings on the mortgage-backed securities (MBS)?
  
• Warren Buffett has sold down a large proportion of his holdings in Moodys over the last 18 months.

Government

• Another test of the big banks are too big to fail may not be far off depending on the size of write-offs and how market confidence is affected.
• Is there political appetite for another bailout?
• The Federal Reserve is holding US$ trillions of MBS on its balance sheet when it bailed out these banks. One day, it has to divest itself of these. Who will want to buy them and at what yields?
  
• FDIC reserves may not be enough to absorb a wave of smaller bank failures that result from foreclosure inertia. This may necessitate more federal spending to boost their reserves and so further increase the growing fiscal deficit.
  

Lawyers

• Attorneys general in 50 states will be working together on a joint investigation into this foreclosure crisis. It is going to become much harder to get a mortgage. It is going to become much harder to buy a home. It is going to become much harder to sell a home.
• For a bank, this must be a nightmare. Loans on the books are backed by inadequate documentation. Employing low paid back-end staff to sign off mortgage approvals and which were subsequently "re-packaged" without thoroughly questioning any of the paperwork or ensuring completeness of due legal process. At best it's carelessness, at worst negligence. Defective documentation has created millions of blighted titles that could plague the nation for the next decade. Lawyers smell blood!

Economic

• This probably explains why the recent consumer spending indicators have not been worse in the downturn. Is it possible what some foreclosed householders don't pay in mortgages has been "transferred" to other items eg Walmart, iPads etc
• Over time, if this is not quickly resolved, the U.S. housing industry is likely to suffer a significant downturn due to all of this uncertainty. Consumers consume. Housing expenditures and their flow-through to related support industries (eg furniture and furnishings) transmit to the general economy.
  
• To assess if consumers hold back, Thanks-giving and christmas spending over the next two months will be key indicators to watch.

In a litigious society like the U.S., lawyers will have a field day. 2008 subprime could now morph into subprime 2 making tobacco litigation seem like a picnic.

A healthy property market is pivotal for any economy. It promotes labour mobility, greases social development and drives a steadfast flow of consumer spending.

Shorting the US banking sector (symbol:XLF, Financial Select Sector SPDR) seems a reasonable bet until clarity is achieved with this tangle of legal spaghetti. Imagine the financial equivalent of BP having many many small wells gushing oil out into the Gulf all at once and getting confused as to which ones to plug immediately. We know what happened to BP's share price in the first two months of that saga.

An explanation of how bubbles happen...

This is the most simple and straightforward explanation I've come across on how and why asset bubbles occur. It comes from Thomas Woods, the author of Meltdown which digs into the real causes of the 2008 collapse. He had this to say at a recent speech at Indiana University:

… Asset bubbles, like the housing bubble we’ve just lived through, do not occur spontaneously. If people bought lots of houses on the free market, interest rates would rise as the banks’ loanable funds were depleted. That would put an end to speculation in real estate.

But thanks to the Federal Reserve System, which is no part of the free market, large infusions of money created out of thin air kept interest rates low, and thus perpetuated the bubble. During an asset bubble, demand for the asset in question rises, as does its price. Where would people get the money to keep buying an increasingly costly asset if the government’s officially approved money machine weren’t there to flood the economy with cash?

It was this interference with interest rates, pushing them well below where the free market would have set them, that set in motion the classic boom-bust cycle we’ve just witnessed. F.A. Hayek won the Nobel Prize for showing how central banks like the Federal Reserve, by interfering with interest rates and not allowing them to tell entrepreneurs the truth about economic conditions, divert the economy into unsustainable configurations that inevitably come undone in a crash. (Hayek belongs to a tradition of free-market thought called the Austrian School of economics.)

Adding fuel to the fire was the so-called Greenspan put, the unofficial policy of the Greenspan Fed that promised assistance to private firms in the event of risky investments gone bad. What kind of incentives do you suppose that created?...

Concise, logical and accurate. That's in the USA and they've just learnt a harsh lesson. Let's hope more consumers in China and Hong Kong start paying attention and dispense with the "but this time it's different here" attitude. Nations do not succeed by strenuously defying economic gravity.