Can something be worth less the zero?

I really liked the quote about Merrill Lynch yesterday:

Thain ``is trying to control the mess that he inherited,'' Scott Rothbort, president of Lakeview Asset Management LLC, said in a Bloomberg Television interview. ``I would not rule out at this point their having to write down even more, but you can't write things down beyond zero.''

I beg to differ. You can write ans asset down beyond zero. You buy a gas station, thinking that it is a profit and revenue generating company. Then you find a leaking storage tank. Your business shuts down, the property is now classified by the EPA as a hazardous site any you pay and pay to clean it up. Hence the less than zero valuation.

The same is true for some financial instruments. Let's say you purchased a credit swap derivative. If you bought it for $X, you must think its value is $X+something. You see it become worthless, you write it to zero. But what if the swap goes against you and you cannot hedge effectively due to the markets. You are now exposed to "less than zero" losses and may continue to mount as the underlying security exposes you to increasing losses.

This is a very real possibility so the notion of "you can't write something off below $0" is just no longer true.

We will be discussing exactly that in today's show regarding the great Merrill Lynch Fire Sale of $30B worth of assets at 1/5th their "value".

But did you know that Merrill is financing 75% of the sale? Did you know that a drop of 5% or more in the value exposes Merrill to more risk?

Nothing in the I Bank world is ever quite what it seems. Remember what we said in yesterday's blog, capital is a difficult thing to both create and keep. And, leverage works in both directions.

More on the show today. Join us and call in.

Here is a link to the story:

http://www.bloomberg.com/apps/news?pid=email_en&refer=us&sid=atfHM8sh2xtw

I have always found that an aptitude for mathematics is an essential skill for a financial professional (or talk show host). Captain obvious, at your service!

Let's take the case of a change in value of an asset. Let's say a hypothetical house was purchased for $300,000 and the down payment was 25%, or $75,000. This results in a mortgage of $225,000. This means your debt to equity ratio was 3:1, $225,000 in debt divided by $75,000 in equity.

Now, let's say that same house declines 25% in value, as many markets around the country have. This means that the house is now worth $225,000. Your debt to equity ratio is now infinite. Your house is worth $225,000 and you owe $225,000. You nave no equity and, consequently, you have an incalculable debt to equity ratio, $225,000 in debt divided by $0 equity.

This minor mathematical inconvenience is the root of our financial situation. All typical reserve calculations are irrelevant. All coverage ratios cease to exist. All debt to equity ratios have been decimated and lending capacity reduced, in many cases, to below zero, effectively requiring debt outstanding to be recalled, when possible, and no issuance of incremental debt. This shrinks capital (debt plus equity) and makes the available capital very expensive.

What does this mean? This means that, with fractional banking (and investment banking) that the smaller the equity, the greater the leverage and the greater the effect of any change in equity. On the upside, leverage is your friend, allowing you to feel like a financial Batman.

However, on the downside, your equity disappears faster than Casper in a blizzard. With the unconscionable leverage of many, if not all, financial institutions, this means that your equity has gone from a positive to a negative. We know that a negative equity means that you MUST reduce your lending, unless, of course, you reduce your reserve requirements to $0 or 0%, in which case, there are no rules anymore so let's make up new ideas, laws and controls as we go. This results in bad policies and laws that reduce the ability to short investments and inject huge capital guarantees and cash into zombie companies and industries.

We have now arrived at this financial and economic precipice. You cannot create equity out of thin air. The Government may print more money but money is a debt; it is not equity. The only way many financial institutions can survive is for shadow equity to be created, giving the illusion of real equity. When the FED exchanges good (or relatively good) treasuries for bad Level 2 and Level 3 assets, negative equity was exchanged for positive equity. The bad equity now sits on the FED's books.

At this point, people like me would offer to buy this bad debt of a few pennies on the dollar but as long as the FED does not sell it, it looks like an even swap, treasuries for bad paper, thereby protecting the illusion of a sufficient equity base of the financial institutions.

Here is the real problem. This is nothing more than a guarantee without equity or substance. It is no different than the Department of Education backing Sallie Mae bonds, the Federal Government finally explicitly backing Fannie and Freddie or the FDIC backing IndyMac. There comes a point in time when all of the guarantees of all these institutions are finally recognized to be vapid assurances. Investors finally accept the fact that each of these guarantees will be honored but with no change in equity backing them. That will, indisputably, lead to massive inflation.

I believe that this is the real message we must take from the current market.

Buy gold, buy silver, short the market, take a closer look at puts, research ETF's that are inversely related to the market. Remember, you can make money in a market like this. Just bet on any investment that prospers during this "inconvenient asset revaluation period".

Should anyone disagree with this conclusion, call the show and take away our WWF ("World Wide Financial") tag team championship belt that was awarded (by us to us) for understanding the current situation better than any other host or team of hosts.

I hope that you win and take our belt. That means that we are wrong and we all live to fight another financial day. If we win, we really all loose.

Pop quiz.

Did anyone read the news late Friday that the new housing assistance bill passed?

Did you wonder why a bill of this "significance" and "importance" was so ill-reported?

For those of us that believe and know that deficits and debts do matter, while the bill does provide some $300B in mortgage "assistance", did you notice that the national debt ceiling was raised to $10.6T?

Essentially, our recognized national debt as nearly doubled in 7 years. Let's not forget that this amount does NOT include the now explicit guarantee of Fannie and Freddie of $12T. Nor does it include the unfunded liabilities of...who really knows...but estimates run from $40T to $60T.

First, thanks to several shy but pretty creative monks many years ago, we have a double-entry method of accounting. That means nothing is created out of thin air. For every debit there is a credit. Therefore, in order for the U.S. to spend, it must first borrow, as we have a national debt, a massive and growing deficit and no reserves. This is neither a new nor a unique thought. It is fact. If this were not true, then why track the national debt - for kicks?

If we could create wealth and "money" (in any form) out of electronic bits and bites, then why not just create a million dollars for everybody in the U.S. and eliminate poverty? BECAUSE YOU CAN'T!!!

The current postulation is that as long as we create this whole transaction in our own currency, then we can create as much "money" as we like. Unfortunately, this is partially true...but...the effect would be the ultimate end-game of "Helicopter Ben" and it would create massive inflation. That would be bad enough but we continue to import things and those things will become massively more expensive as we debase our currency. The real race is to see which country can debase their currencies faster.

If we accept this as true, and I defy anyone, anywhere to challenge this statement with even a whiff of a fact, then we must consider the burden of this deficit and why it matters. Right now, our national budget is about $3T annually (not including huge amounts of "off-budget" things such as war). Of this $3T, 1/6th or $500B is interest on our debt. The debt ceiling just increased by about $1T. Interest on this additional borrowing alone will be about $40B, at our current borrowing costs. That is a huge increase in the annual deficit, a deficit that must be financed by borrowing.

Come on, folks, this has to matter to you at some point.

Look at the "what-if's. What if the U.S. incremental cost to borrow increases? The deficit and the debt increase. As the debt increased, the interest carry increases and the deficit increases. What if the FED needs to be re-financed by the Treasury? When the FED craps out on the last of the $1T or so of capital it has (and it has already committed $500-$600B), it must go to the Treasury and ask for more securities. The Treasury must then float these securities (borrow) and give them to the FED. What if we give away another stimulus package? Where do you think that money comes from? What if we need another mortgage bailout? What if the FDIC, with about $53B of capital (before the $8B it spent on IndyMac or the two bank failures this weekend) needs more capital? What if $300B just isn't enough to save the 3-5 million homes already in or expected to enter foreclosure within the next year?

Time for the comic relief of the chart above, thanks to our friends at The Sovereign Society. Banks have borrowed nearly $200B through January of 2008. Other borrowings have brought the total amount borrowed from the FED to $500-600B. The FED has taken instruments of completely unknown value and exchanged them for still relatively valuable Treasury securities. Yes, this is old news, but the national debt ceiling now exceeding $10T is new news. And it matters. Just like it matters to you when you have more debt than you can service.

The payoff of this column, since our entire BizRadio and Wall Street Shuffle teams are committed to giving you the tools to make a better financial decision, is that you should take inflation very seriously. In fact, the only treatment for the problems we have right now (notice I did not say "cure") is inflation. Bet on it, bank on it, invest accordingly. Bernanke is praying for it and he is pulling out all the stops to create it. He knows the alternative is massive deflation, and that is something no one wants or knows how to cure.

The U.S. is nothing more that than the collective earning and borrowing capacity of its citizens based upon the opinion of those that would lend to us. At some point, these numbers matter. It is at that point that we will really understand the term "defend the dollar".

The very uncomfortable reality is that our dollar is strong only as long as the world believes we will defend it. That defense could have been with a sound fiscal and monetary policy but it will depend, ultimately, upon the lenders' perception of our military strength and their perception of our willingness to use it.

Maybe that this the real reason Cheney said that "deficits don't matter". I respectfully disagree.

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I believe in the "End of Days" concept for the American Consumer. While I'm not sure exactly what the signs are or what the final sign will be, I can say with certainty that we are managing to leverage every valuable asset we have. When we have run out of things to borrow against, that will be the last sign. Until then, for the American Consumer, these will have to do (and these are pretty darn close to the final act):

The Seven Signs of The Financial Apocalypse of the American Consumer
1) Reverse mortgages
2) Life settlements (for the sellers)
3) Negative am, Alt-A, sub-prime, cash-back mortgages
4) Property tax loans
5) Payday loans
6) Debit cards for your 401K
7) Paying your mortgage with your credit card

I have friends in the property tax lien business. It is huge in Texas. If you cannot pay your property taxes, you can go to a firm that lends you the money at 18% interest over 48 months. They take a lien on your home. In Texas, this lien jumps to the head of the priority line, even jumping in front of your first mortgage holder.

Even people that own $3 million homes are borrowing the $90,000 of property taxes due.

You would think this is almost an entirely risk free investment, as property taxes are about 3% of the value of your home annually. A lender lends 3% of the value of your home to you and pays your taxes for you and they take a first lien.

Know what is slowing this lending practice right now?

The lack of qualified applicants!

Can you imaging? You are so concerned about the borrower paying back your puny 3% loan and worried that the property that you have taken as collateral won't sell that you won't lend 3% against the property. AND you have a first lien?

That, my friends, is truly amazing. And just a weeeee bit concerning.

Our next post will list the Seven Signs of the Financial Apocalypse of our federal government.

The big question is whether this is a permanent consumer buying shift.

If it is, this is a big problem for an economy that prides itself on being more than 70% consumer driven.

Also, as you drive through familiar neighborhoods, have you noticed browner and slightly less manicured lawns? And, in the evenings, have you noticed that many homes are dark that were previously lighted at night?

Think this has anything to do with your July power bill was up more than 50% from July of 2007? How do you think increased water prices are affecting the average American?

A better question is what do you think winter heating bills will do to consumption?

Does anyone think this is just a small problem with middle America? I have friends that have what once were considered to be great middle class jobs. They now have problems just meeting their monthly obligations. And they have no wage pricing power. And they face increased commodity costs. And their home value is declining. And their 401K's and retirement plans are shrinking.

This is not just your neighbor's problem. If the average American consumer is struggling, the nation struggles. If the nation struggles, the exporters of the world struggle. If that happens, your choice of investments, no matter where they are in the world, face challenges.

Never was there a better time to remember Will Rogers when he said that he was more concerned with the return of his investment rather than the return on his investment.

And just one more thing. In that Freddie and Fannie have contributed some $170 million dollars over the last few years to campaigns and lobbying...

Can they still do it if the U.S. Government REALLY is backing their paper now? Or if the FED REALLY makes an investment into some new class of preferred stock in either or both of these companies?

At what point does a private company become a GSE then become a ward of the country?

Can we at least stop them from now using our tax dollars and guarantees to lobby our Congress?

You heard it on "The Wall Street Shuffle" weeks before this release. And we have no inside information, just a lot of common sense...and we read everything.

NEWS ALERT
from The Wall Street Journal


July 17, 2008

J.P. Morgan Chase posted a 53% fall in net income to $2 billion, or 54 cents a share, from $4.2 billion, or $1.20 a share, a year earlier. The decline in earnings was driven partly by a higher provision for credit losses. Items related to the acquisition of Bear Stearns amounted to a net loss of $540 million. The firm beat analysts' expectations of on average 44 cents a share.

Chairman and Chief Executive Officer Jamie Dimon said, "Our expectation is for the economic environment to continue to be weak -- and to likely get weaker -- and for the capital markets to remain under stress. We remain conscious that since substantial risks still remain on our balance sheet, these factors will likely affect our business for the remainder of the year or longer."

FLASH - Bernanke admits that inflation is both a hidden tax and a monetary phenomenon.

Watch the video.


http://www.house.gov/paul/index.shtml

Care to watch the CEO of Indymac, the second largest bank failure, at a press conference this weekend?

Listen to the words carefully. You will hear something that is entirely untrue but it is carefully scripted to suggest that your deposits are safe and secure.

Let me know if you pick it up.

http://www.youtube.com/watch?v=YWObzm9O1Nc

By the way, THIS is what you have been seeing as the "OFFICIAL" unemployment rate.

Please read on...

I can't make this up, folks. Hot off of the Bureau of Labor Statistics ("BLS") press.

FLASH : REAL UNEMPLOYMENT NEAR 10% - and that is our own lying number (I added for effect).

And, guess what? It was over 8% for May of 2007 - LAST YEAR! Did you read that anywhere? Noooooooo. You read unemployment at historical lows - 4.5%.

These definitions are real and also from the BLS. Please focus on the hitherto unmentioned crazy relative locked in the basement - U-6.

Definitions of U-1 to U-6:
U-1: Persons unemployed 15 weeks or longer, as a percent of the civilian labor force
U-2: Job losers and persons who completed temporary jobs, as a percent of the civilian labor force
U-3: Total unemployed persons, as a percent of the civilian labor force (the official unemployment rate)
U-4: Total unemployed persons plus discouraged workers, as a percent of the civilian labor force plus discouraged workers
U-5: Total unemployed persons, plus discouraged workers, plus all other “marginally attached” workers, as a percent of the civilian labor force plus all “marginally attached” workers
U-6: Total unemployed persons, plus all “marginally attached” workers, plus all persons employed part time for economic reasons, as a percent of the civilian labor force plus all “marginally attached” workers

U-6 IS the real unemployment, as bad as it gets. It is still a lie but it's now more like a really, really big white lie.

No more needs to be said.

This is a lot like the FED no longer publishing the M-3 measure of the money supply because it so, so, so massively disturbing. They know what it is but they no longer publish it. Best guess of folks that try to continue to calculate it...in excess of 20%...per year.

Or consider the insulting "core" inflation numbers of 3%+/-. Does anybody actually live without energy or housing or any other "adjusted-out" items?

Are you now beginning to understand why you feel like you have been in a recession?

Of course you do because you've been in one one for more than a year.

Wait until the next post for a discussion of Greenspan's ultimate bonehead thought. This one, if we un-correct his correction, would reduce GDP by nearly 2%. Sooooo, for as long as our "reported" GDP has been less than 2%, we have actually been in a recession.

So, we have understated unemployment, understated inflation and understated growth in the money supply. And these are just the first three crazy relatives!

Ah, I feel so clean now. Now we can talk about ALL of the other relatives in the basement. It's actually a small compound down there. We'll bring them up one at a time to get you used to them...slowly.

Hell, some one left the basement door open...they are all coming out...they're hideous...derivatives, Alt-A mortgages, negative am mortgages, consumer loans, real government deficits, real government debt, unfunded government liabilities, Level 3 assets...AAARRRGGGHHH!

By the way, check out the June 22nd blog. Very prophetic.

You don't have to be smart. You just have to read a lot and think like a sneaky bastard...just like a Central Banker or the head of the Treasury.

To make money, you don't need a lot of warning. I think 19 days was enough.

Did anyone else short Freddy or Fannie or think Indy would fail?

An you call yourself "Shufflers"!

What do you think will fail next?

To the tune of the intro to "The Rockford Files":

"Eh, yo, Danny Boy. This is your buddy, Fat Sally…Sal Minela. You still bustin’ knee caps? I gotta couple of stugotts been a little light recently and I need some persuasive collections. Names Skinny Fannie, Fast Freddy and their pal Mini Indy. It’s about $6 trillion with the vig. U interested? Call me."

OK, let's go over this again.

1. You can't lend money to people that can't pay it back.

2. You are not a government that can print money so you must either earn it, borrow it or have someone buy your equity.

3. Contrary to some folk's opinion, money is not just digital bit and bites created at the Treasury's or the FED' whim.

4. If you leverage your equity 30:1 (or even 220:1 ala Bear Sterns), just a weeeee little decline in the market wipes out your equity and, therefore, your capital structure.

"What we have here is a failure to communicate."

Let's remember just what our government is. It is nothing more than the collective capabilities of all of its citizens. That's it. We, as productive citizens, produce value in excess of what we consume, after tax (or at least that is what we are supposed to do). This is called savings.

Then there is the government. It is funded by our taxes. These taxes may be invested in things that last, such as bridges, roads, utilities, etc. We can spend it on social requirements such as the military. We can spend it on the necessary expenses of our country (though you and I might differ on the definition of "necessities"). Then, after all of this investing and spending, we still don't have enough, the country may use our collective ability to service new debt and we can borrow. To support that debt, we must pay interest, but that interest must be paid out of our taxes UNLESS you have a giant governmental negative-am economy.

That is it! We have a giant negative-am country!!!

We tax, we spend more than we tax, we borrow to spend and we borrow to pay the interest on the debt we borrowed. How do we get away with it? We have a giant printing press. The world uses our currency and they have wanted our dollars. Also, it helps that we have 13 or so aircraft carriers, a large number of "boomers" (submarines that break things, not you and me), an even larger number of warheads and the demonstrated ability and desire to use them to defend liberty and capitalism (OK, not really but it sounds good). This is the real meaning of "defending the dollar".

But, you and I do not have a trigger in our hands so our debts must be paid and serviced. We don't have a personal printing press.

Another truism: Most people think that assets are fixed in value and debt is variable. It is quite the opposite. Assets vary in value and debt is fixed.

As an example, you buy a house for $500,000 and borrow $475,000 (a very generous, by current standards, 5% down). If, just if, the value of your home declines by 25%, as they have in many parts of the country, your home is now worth $375,000 BUT you still owe $475,000. You must pay that off somehow and you must service the debt while you owe it.

If you don't pay this debt, the bank looses money. That loss reduces their equity and they can now lend less. Less lending, less growth capital, higher rates, etc.

This is right where we are now. Over valued assets everywhere supported by too much debt and too little income to service the debt. This is true for individuals and for the country.

And for Fannie and for Freddy and for Indy. And the "ands" just keep on coming!

Yes, I know that I have always been inspired by Ross Perot's charts (he has a new web site with new charts "perotcharts.com").

This chart, however, is a real game changer.

For everyone who thinks the consumer may return soon, therefore driving stocks back up, think of this. For our Texas listeners, most of whom heat their homes with natural gas, see what impact natural gas prices will have on your disposable this fall and winter.

Let's round for effect. Last fall, natgas spot was about $7. Today it is about $14. Assuming that it does not go up any more this year, your home heating bill will more than double, after taxes and fees.

Soooooo, if my monthly home heating bill was $700 last year, this year it will be $1400.

We pause for effect...

Did anyone out there plan to spend $500-$1000 more each month to heat their homes? What effect do you think this will have upon disposable incomes? Think this will make consumers spend more or less? And this is just the heating bill. This does not include the increased cost of virtually everything else.

Just food for thought when deciding upon whether we have a bottom in sight anywhere. Especially financials. If financials are struggling with write-offs, what do you think this massive decrease in disposable income will have on the propensity of consumers to pay their outstanding obligations? My bet is that write-offs and foreclosures will continue to increase dramatically. And this is if the natgas prices just don't go up any more.

Cash, puts, shorts, precious metals seem a whole lot safer right now. Obviously, if you believe that the tops are in for energy, then take another tack. If you believe that energy is flat to increasing or if you think some further conflict is probable in the Middle East, this chart might be conservative by the end of this year.

Pull out your crystal ball and take your choice.