Modeling the Mortgage market; it is all in the stars.

Around the time of Christ, Ptolemy the famous astronomer came up with equations and tables to explain the movement of the stars and planets in the night sky. The paradigm being that the earth was the center of the universe and everything else in the night sky revolved around us. His models worked well over the short term but over the long term aberrations occurred. Planets weren't in the exact part of the sky that was predicted but nearby. The modeling computed was a fair approximation and served its need for hundreds of years until the time of Galileo, Copernicus and Kepler when the earth was shown not to be the center of the universe and accurate models could be produced.
Fast forward to modern day advanced mathematics and computer modeling. Computers crunching statistics and advanced mathematics using probabilities come up with explanations and models of market observations. Instead of looking up to the stars, bankers are looking at reams of foreclosure data and debt defaults. Once the data fits the model well enough some brilliant person with a degree in finance figures out how to monetize it in the form of a derivative or rating a bond. Mortgage back securities are rated by bond rating agencies, credit default swaps are priced on over the counter markets and trillions of dollars are underwritten. The only difference now is that unlike the inertia of the universe in the night sky, markets are much easier alter and manipulate. Since the models and equations used become well known it is easy to fit the data for the wanted outcome. If you are are securitizing mortgages you can adjust what you put in to get the highest rating possible. Offsetting toxic mortgages with prime the system can be gamed and profits for the underwriters can be maximized. And if surgical cherry picking wasn't enough to corrupt the market; mathematical models only account for the known unknowns not the unknown unknowns. You set the model to see what the default rate is if we had a housing decline in line with the worst since the great depression and you kick out a value for the security. The models never account for what has never been seen before. How can they. It would be impossible to model all possible contingencies and would require greater imaginations than Hollywood screenwriters.
Credit default swaps are the same way. They "insure" by some estimates $45 trillion in debts. Again models are imperfect. Prices are determined by models and an over the counter market. While they are better indicators of the safety of the underlying debt than the bond rating agencies, they don't factor in a "perfect storm" scenario. Uncle Sam was ultimate guarantor of AIG swaps to the tune of $150 billion so far. A bankruptcy of could have caused a domino effect in debt markets that reverberated around the world possibly creating more Icelands.

The lesson should be to leave complex modeling to NASA and not economics. Instead we are insistent with regulating systemic risk and taking another slug of the hair of the dog that bit us. Financial derivatives may be great for a doctoral thesis in finance but when Wall Street gets ahold of them they become a weapon of worldwide financial destruction.

The Black Swan and Pandemic Flu

From wikipedia: "The Black Swan theory (in Nassim Nicholas Taleb's version) refers to a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations. Unlike the philosophical "black swan problem", the "Black Swan" theory (capitalized) refers only to events of large consequence and their dominant role in history. Black Swan events may also be called outliers.

For instance, a simple model of daily stock market returns may include extreme moves such as Black Monday (1987) but might not model the market breakdowns following the September 11 attacks. A fixed model considers the "known unknowns", but ignores the "unknown unknowns"."

While as the old adages go "history repeats itself" and "those who don't learn from history are doomed to repeat it" The black swan theory gives a valuable lesson on expecting the unexpected. When too much of the world gets explained with mathematical models and complex computer modeling; much is based on the "known knowns" and the "known unknowns". The flaw in the complex models that modern finance operates under is that too much gets boiled down into complicated derivative equations that attempt explain varying amounts of chaos. Mortgages were packaged and then repackaged in complex instruments to reduce risk. The fuzzy math of derivative logic was to assume that we take the worst modern housing decline on record and add a little to it to be safe and use it as our worst case scenario. Little did the mathematical wizards that came up with these instruments realize that they themselves created a bubble of easy credit that would cause the worst housing contraction since the great depression. This was the "unknown unknown".

Now applying this same logic to the current swine flu outbreak, we must wonder what the "unknown unknowns" could be. Computer models are often used in preparation for an outbreak of pandemic flu. In allocating resources to preparedness it is critical that we try to model the possibilities. Most of these doomsday, worst case scenarios are viewed through the prism of the 1918 pandemic. But what are the "unknown unknowns". We know diagnosis and treatment is a quantum leap ahead from 1918. But so is global travel. A tortilla vendor in Mexico City sneezes on a tourist who flies back to Amsterdam that day and the snowball starts rolling down the hill. But that is a "known unknown", and I'm sure some bean counter has factored that into their actuarial table at the insurance firm. We need to concern ourselves with what we are not prepared for, hopefully we will not experience the "black swan" pandemic in our lifetimes.

Chrysler Bankruptcy or just another bailout.

When we begin to talk about systemic risk, and being not only to big to fail but too interconnected to fail, we barely seem to scratch the surface.
During President Obama's press conference today on the bankruptcy of Chrysler we heard the familiar talking points of shared sacrifice. But under the veil, the real sacrifice is from the tax payer.
Chrysler bond holders would not except the deal the government was pushing an getting less equity in the company than the union. Why would they. Large bond holders purchase insurance on their holdings using a complex derivative instrument called a credit default swap. If the company cannot repay the debt the credit default swap will make bond holders whole. So with a hedge why would you agree to smaller equity stake when you can go to bankruptcy court and get better terms.
Here in lies the rub. One of the largest issuers of credit default swaps was AIG also J.P. Morgan (TARP recipient) is a major player. The US government is on the hook for over $150 billion of them. Many of them that cover both Chrysler and GM. So essentially the government is on the hook for guaranteeing the Credit default swaps and negotiating an equity stake in the new emerged Chrysler with the creditors. And who are the creditors? Many of them are the usual suspects, large money center and regional banks that have already taken TARP funds. Don't expect things to get better anytime soon. GM still has to negotiate with it's creditors.
When institutions get to big or interconnected to fail all that is left to fail is the government and the tax payers are left with the bill.

Fireside chats are full of hope and change too.

I came across this video from 1933 and it was striking how much is similar to what we hear today. FDR calls for a moratorium on foreclosures. Just like what is called for by many states in the last year and what TARP recipients have agreed upon for the next few month while the government tries to work out a new plan to help home owners.
While FDR referred to buying up more gold with his newly formed agency to prop up the dollar; the Fed and the Treasury have the same conversation now with issuing too much debt dropping the value of the dollar. Luckily for us with a global economy we are all in the same boat and with simultaneous stimulus packages and increased government spending we haven't seen the dollar plunge yet.
History does repeat itself and usually when most of the people who have live through it and able to pass on the lessons have passed on themselves. Policy makers will be just as served watching the History channel as watching CNN, CNBC and Bloomberg.

The lost decade part two.

President Obama released his budget today with tax increases to boot. All we have been hearing from policy makers is that we won't repeat the mistakes of the past. I thought raising taxes during a recession was one of them. It didn't work for Herbert Hoover in 1932 and didn't work for the Japanese in the 1990's tax cuts did.
From Bloomberg:
"Obama’s 2010 budget proposal, released today, would reinstate the top two Clinton-era tax rates of 36 percent and 39.6 percent in 2011, up from the 33 percent and 35 percent the richest Americans now pay. It would raise taxes on capital gains and dividends to 20 percent for top earners, up from the 15 percent set by former President George W Bush in 2003."

We could get in a class warfare argument that the rich don't pay their fair share, but looking at history raising taxes during a severe down turn has only had negative results. And using the rationale that during the Clinton era the rich got richer is a fine argument if we are talking about taxing 1993 dollars, but while a family bringing in $250,000 a year these days is comfortable it is nowhere near what type of affluence that was in 1993. So saying that you are bringing back tax rates to where they were when $4.50 would buy movie tickets and $1.30 could purchase a gallon gasoline is disingenuous.
Anyone that will have their taxes raised or more importantly think that they will have their taxes raised will think long and hard on how they will spend their discretionary income. Having the stock market go down 40% last year and down so far this year fear is in the air and capital preservation in going to be in the front of everyone's mind no matter what your marginal tax bracket is. Small business will lay people off or just not rehire when someone leaves.
Large segments of the middle class are already concerned about some of the Bush tax cuts expiring. A middle class retired couple relying on a pension, anemic bank interest and dividend income are concerned about the dividend taxes going back up. That is money out of the consumer economy.
People are scared now. Now is not the time to scare the people with money no matter it is right or wrong how much money they bring home in their pay check. Let's save this discussion for when things start to turn around.

Gold; not just for the "end is near" crowd anymore.

As a store of wealth, gold has been coveted since the beginning of civilization. Fear and uncertainty have played their role in driving the most recent rally in the metals, but very rational arguments can be made for holding gold. First, the stock market has been tanking and no real visibility in sight. Uber-safe
U.S. treasuries have rallied to the point that they don't pay a return or the yield is so low that it gives little protection for coming inflation. A money market or CD often doesn't break 2% return for the year. With the specter of higher taxes and more robust auditing from the IRS for upper income folks gold is looking like a good place to park money. Swiss bank accounts aren't even safe anymore from the watching eye of the IRS.
It is easy to say that the old 1980's mantra of putting 10-20% of your portfolio into the metals may come back. And with a more interconnected global economy, citizens of smaller country may do the same, being worried that they may be living in the next Iceland. Adjusting for inflation the old high of gold would now be around $2300. With the current gold price between $900 and $1000, there is more upside than downside in the long term.

Rick is right, we all need a bailout.

Looking back at history, whenever you have pundits telling you that things have changed it is time to think critically. I remember during the dotcom boom when "analysts" said that dot com stock shouldn't be valued on earnings but business model; that the rules have changed. No they haven't! Several years ago the talking heads were saying that you should get a ARM or a interest only mortgage if you were only planning to stay in your home for a few years, because you would just sell it at a profit. Trees grow to the sky you know. ARMs are now readjusting and we are expected to bail them out with taxpayer dollars. Why? If people got in over their head that is their own fault. If they were taken advantage of by a less than reputable mortgage lender that is different. If government wants to subsidize the gullible and greedy that is wrong. Why not subsidize all of us with lower interest rates. If you were conned by a bad mortgage lender you can refinance into a lower rate and be fine. If you had a credit rating in the 500-600 range you are still struggling. But if you"played by the rules" as Obama likes to say, you get a lower mortgage. We all win. A refi is as good as a tax cut. Saving $100 a month or saving your house is a huge boon for the economy. I don't care of all of my neighbors are being foreclosed upon if they were irresponsible, saving several hundred dollars a month will do alot more for me than keeping my home value propped up if I am not selling.
A quanitative easing to subsidize interest rate will do alot more to jump start the economy than subsidizing the daydreaming affluent want-a-be's. Give us low interest rates and the wheat will seperate from the chaff and the responsible and the exploited will be rewarded.

The pie in the sky crowd will get their just desserts.

Is Silver actually more rare than gold?

The case for silver has been made for over a decade that production has not been able to keep up with demand for years and the gap has been filled with stockpiles of bullion and government selling. Silver has rallied with gold and the silver ETFs have had a spike in inventories as well. The silver ishares SLV have had an astounding near 50 million ounce jump so far this year. Other increases have been seen in other ETF's based in Switzerland and London. Most research points to only about 1 billion ounces being above ground in a usable form. Most silver has been used in photography and electronics making it very difficult to recover at current prices if at all.
Spikes in bullion buying has driven up the mintage of silver eagles last year by 50% to 20 million ounces. At the current pace the U.S. mint should exceed that with the current interest in physical silver. This is taking more silver off the market and putting it in investors vaults.

Assuming the ETF's actually do hold all silver that they say they do and not just enough for reserve requirements to handle redemptions for physical delivery, we are quickly running out of silver to fill their vaults.

SLV 260 million ounces
Swiss ETF 50 million ounces
CEF 50 million ounces
COMEX 100 million ounces in inventory
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total 460 million ounces


Not including other smaller ETF's and the possibility of another out of Dubai, we are quickly tying up a majority of above ground stockpile.

Due to a world wide recession demand for silver other than investing will be down this year. But since by many estimates 60-70% of silver that is mined is a byproduct of mining zinc, copper and lead, declines in those metals production will reduce the amount of silver pulled out of the earth. Doing a quick google search of zinc mining cut backs it looks as though some of the larger miners and zinc producing countries are cutting back anywhere from 10-30% . Copper production should be about flat and lead production should be down.

My forecast is that silver production will be down 5-10% versus last year and demand erosion will be more than made up for with from investors. If the numbers from SLV are true and about 50 million ounces have been added this year, put it in to prospective; that is more than many of the major silver producers mine in an entire year. If demand keeps up at this current pace for a few more months we could be looking at a significant shortage resulting in an upward spiral that brings even more money in. With losses in the stock market and a presumed bubble in the treasuries market with anemic yield, investors will look to diversify and protect themselves from the coming inflation in a few years.

Gold on the other hand has had even more interest and the inventories of the ETFs have skyrocketed. Gold on the other hand is kept by many central banks and most of the gold that has ever been mined is still easily recoverable or in a form that is in demand like jewelry. It is doubtful we would ever have a supply squeeze with the European central banks capping their annual sales of gold to not effect the price.

Iraq withdrawl will drive unemployment higher.

One dirty little secret not mentioned by politicians nor the press is that following every war the unemployment rate; not surprisingly goes up. The two plans in the works now are a 16 or 23 month withdrawal from Iraq. Up to 30,000 troops may go to Afghanistan but many more Americans are leaving Iraq as contractors and will not be needed in Afghanistan due to a lack of size and developed infrastructure. The Congressional Budget Office estimates that unemployment will go to 9%. Look at the chart above and you can see that at the end of the Vietnam war in 1975 there is a spike and in 1991 at the end of the first Iraq war there is a spike, so look for a marginal increase of at least 1/2% to 1% on the unemployment rate. There is a better chance than not that we exceed the unemployment rate of the early 1980's especially when only $30 billion of the near $1 trillion stimulus is for infrastructure. Clean energy is a nice idea but creating "green collar" jobs results in the loss of "black collar" dirty fossil fuel jobs. Just remember we had a $160 billion stimulus package in February 2008 that failed to do what was intended, though I am sure that everyone that advocated it would throw out the red herring that things would have been worse with inaction just like we hear now.

Keynesian Stimulus or Swinging at a pinata blindfolded

The lessons learned during the 1970's were that Keynesian stimulus resulted in stagflation. Why would it work now? The economic stimulus checks mailed out last year did not pull us out of the tailspin. Why will more work? Keynesian "priming the pump" has never been proven; but the Fed is out of "bullets", no more room to drop interest rates, so what else do you do?

True believers in stimulus can only point to WWII. While GDP did rise and employment did improve, the quality of life did not. The jobs created involved millions of Americans dying in the European and Pacific Theaters while America at home endured rationing of gasoline, meat, nylon, rubber, etc.. While it is possible that stimulus works in this scenario it is doubtful that most Americans will want to endure this level of pain while the economy improves.

I don't have the answers but I do have children that will have to pay for the rapid growth in our level of debt. Throwing close to $1 trillion into an experiment sounds risky when you think what can be done with that type of money; we put a man on the moon with less than that you know.