The Fed Is Now A Hedge Fund

Actually, thanks to the TALF, it is the Federal Reserve Bank of New York (FRBNY) that is now a Hedge Fund.

You knew this was coming. It was telegraphed last year by Paulson, when he first started to mention “The Super SIV” (think a gigantic Enron). I have been writing about it for months. Geithner’s appointment guaranteed its enactment.

Today the details of The TALF were announced. I want to deconstruct TALF, because it will be the tool used to reflate the Financial System, with the last, epic round of massive leverage.

TALF – Term Asset-Backed Loan Facility
First, an “Asset Backed Security” is created when a bank takes a bunch of loans, pools them together and then turns the pool into a security - splitting it into shares and selling them at a specific price per share. Assets types include mortgages, student loans, auto loans, construction loans, commercial real estate loans, credit card debt, consumer debt …

Asset Backed Securities (ABS) had one glaring flaw – they were priced by the Rating Agencies (S&P, Moody’s) as if the underlying loans were of the highest credit quality, with minimal potential for future defaults. This allowed the banks to issue these loans at artificially low interest rates. It also allowed banks to make loans at artificially low interest rates, relative to the real risk of default by the borrower.

Remember what I told you last week, that banks are pricing this ABS at artificially high prices, so as to make themselves look solvent. But we know that the highest “Rated” stuff is trading at 32 cents on the dollar and the “Junk” stuff is trading at 6 cents.

Bring on the TALF!
The TALF is now under the management of the FRBNY (the bank Geithner used to run). It has been created in the following structure. The Fed will take $20 billion of TARP funds and loan them to the FRBNY. The FRNBY will leverage that money 10 to 1 and buy $200 billion in newly-created loans.

That’s right, the FRBNY is going to invent $180 billion via the Fed (+ $20 billion more via the US Taxpayer) to buy loans that the banks can’t sell, because the yields are too low (prices are too high) to attract any other buyers! We all know that if the banks priced the new ABS to sell at market, then it would be at rates so high, that they could not do any lending.

Remember, the Obama Administration wants to do another round of TARP (TARP II) for $750 billion. That would allow them to buy $7.5 Trillion of loans. They also have at least $200 billion of TARP I funds left. So you would expect to see the FRBNY end up with a pool of about $10 trillion in loans on the books…

The Goal of TALF
TALF is ultimately designed to transfer the junk loans from the balance sheets of banks to the balance sheet of the US Taxpayer.

How
Remember, TALF is only designed to buy newly issued ABS. So the first wave of purchases will be ABS created by refinanced mortgages.

Here is the game they are trying to play -
Bank A has $100 million in a Mortgage ABS
At origination, the average house value was $500k (2,000 mortgages in the pool)
The mortgage was a Neg Am loan, and is now worth $550k
The borrower financed 100% of the purchase price
The minimum payment was made each month
The house is now worth $300k.

The Fed has continued to allow the bank to price the ABS at $100 million
The ABS still holds a AAA rating
The Market knows that the Bank owns this stuff and is factoring the value of the ABS at $6 million

Under TALF, the homeowner will be allowed to refi their mortgage at 4.5% and stretch the term of the mortgage to 40 years. All appraisal requirements will be waived on these new mortgages. You paid $500k for a house and your mortgage is now $550k, but the house is only worth $300k? “No problemo” says Uncle Sam, we will refi the whole balance! No questions asked. Just sign here!

You now have the bank getting repaid $550k cash, on a loan that is about to recast, and put the homeowner into foreclosure. The bank should have to repo the property and sell it at auction for $250k. But the TALF is stepping in to put the Taxpayer on the hook for $550k.

This is a de facto government subsidy to the bank for $300k per mortgage, or $60 million on this $100 million ABS.

The FRBNY will try and buy all of the crap held by the US Banks, European Banks and Central Banks of places like China and Japan.

Why the Urgency?
The Reason this is going on right now, is because there is an enormous wave of Alt-A mortgages recasting in 2009 and 2010. The size of this mortgage recast dwarfs the size of the Sub-Prime default wave of 2007-2008.

The Fed needs to get this stuff out of the banks, credit unions, pension plans and insurance companies before the coming defaults make all of these institutions insolvent.

So I expect to see the Fed soon use the TALF to buy existing ABS loans off the balance sheets of banks at ridiculously high prices, relative to the real value of the paper held in each ABS (100 but worth 32 or 100 but worth 6).

Either way, the Taxpayer is going to get royally hosed.

What to Do?
If TALF works the way I think it will, then you should see an enormous rally in the stocks of the banks that survive the next few weeks.

This will be the greatest theft of taxpayer money in the history of mankind. But it will put a bottom in on the stock market and lead to a multi-year rally before the US Dollar and US Treasury Bond collapse.

This Chart Says It All

Here is a chart of the rally in the Dow from August 1982 – October 2007
The rally took 25 years. The Dow gave back more than half of those gains in 17 months. 17 MONTHS!!

The Dow has now taken out the key 50% retracement level at 7504. I think the most likely scenario is at least a test of the 62% retracement line, at 5,919. If it occurs, I would expect to see price overshoot 5,900 and test the 5,200 - 5,500 range. But I would then expect to see The Dow close the month above 5,900. We’ll see how it plays itself out.

Bottoms occur in emotional panics. The last few days should be sharp, violent plunges. You do not want to be guessing on the bottom during these days, because you can be a day away from price in time and still be 10-15% away from the bottom in price.

Here is a chart of the Dow from 1996 – Present. You can see how many times the 50% retracement line (Black Solid Line) was tested (Black Arrows).

The last test led to a quick rally (Green Arrow) up into the 38.2% retracement line (Dashed Black Line). This rally failed quickly and the Dow has now taken out the 50% line (Blue Arrow).

Next stop sure looks like the Orange Box.

Weekly Bands
The first big drives down stopped at the -35% Band (Orange Line). That line is currently at 625.7 on the S&P 500. That is a long way below here.

Obama Nukes Healthcare

Healthcare
On February 18 I wrote the following about Johnson & Johnson (JNJ) –

“Johnson & Johnson (JNJ) is the single scariest chart in the stock market. If I shorted individual stocks, I would have a BIG short position in JNJ. I would be looking to add on a rally into the $62 range and a retest of the highs near $70. But I don’t short individual companies, so this is an academic exercise.”

I wrote this because I was not only concerned about the company, but I am terrified of the fundamental prospects for the industry. For months, I have been wondering how anybody could invest in Healthcare, when you know that Obama is on the warpath to nationalize it…

JNJ was down -8.4% the last two days.

This week Obama released his Budget proposals and he crashed the Healthcare stocks. Healthcare is the second largest group in the S&P 500 (15.3%), so when it crashed, the market took another leg down too.

Here are a few charts to show you what the Institutions think about holding onto Healthcare stocks –

US Healthcare Index ($DJUSHC)

US Pharmaceuticals & Biotechnology Index ($DJUSPN)

Health Insurance
Humana (HUM)

Review some of these charts if you want to see how bad the damage is to the Healthcare this week –
Amgen (AMGN), Abbott Labs (ABT), Pfizer (PFE), Celgene (CELG), Covidien (COV)…

Continue to focus on Preserving Capital!

The Actual Pricing of "Shovel Ready Bank" Assets

There is an article today on the actual pricing of Mortgage-Banked Securities (MBS). The numbers are scary. I want to tie it into the “Shovel Ready Bank” post from the other day.

In the post from the other day, I wrote about the disconnect between the way assets are being priced by Banks and the way they are being priced by the Markets. The Banks are pricing the high-quality mortgages in the mid-90s (90% of the maturity prices) and the Sub Prime mortgages at 100 (100% of the maturity prices).

Of all the mortgages originated since 2002, 42% of all securities have seen some level of default in their portfolios. Of the late 2005 – 2007 originations ($450 billion), $305 billion of them are in some state of default.

$102 billion have already been liquidated. The actual recover rates on defaulted paper are 32% on AAA paper (Top Quality Mortgages) and 5% on Sub-Prime (junk) paper.

http://www.ft.com/cms/s/0/ddaa47f4-f79b-11dd-a284-000077b07658.html

Regulators and Banks pretending that assets are worth more than they are really worth, helps nobody. It actually hurts confidence and paralyzes lending. The markets figured it out long ago.

This is becoming a replay of the “Lost Decade” in Japan (1992 – 1998).

A Shovel Ready Bank

A buddy of mine asked be about a small bank today and I wanted to go through the numbers to illustrate the problems the banks face. I’m not going to name the bank or show a chart.

I wrote him the following –
Something isn’t working in their numbers for me. This is all from the 10Q dated 9/30/08, but you can extrapolate it into the latest 10Q which has not yet been filed.

They show Common Equity at $1.214 Billion
On 126 million shares, that is a Book Value of $9.36 per share
Yet the stock is trading at under a dollar a share.
Common Equity is essentially Assets - Liabilities

Why? Because something on the Asset side of the Balance Sheet is not properly priced and the markets know it.

Here is what I think it is –
Under Assets, you will find a position called “Securities Held for Sale, at Fair Value” $2.019 Billion

If you look at Note 4 of the 10Q, you see the breakdown and pricing of these securities.

$484 million CMOs priced at 96.4 cents on the Dollar
$745 million Mortgage Backed priced at 101 (above Par!)
$538 million Municipal Bonds priced at 100
$249 million Agency paper at 102 (implied backstop)

Some CMOs (Collateralized Mortgage Obligations) are trading at 6 cents.
Private origination Mortgage Backed Securities are trading way below Par (20 - 30 cents)
Try selling a Muni for Par right now. You will be lucky to get 68 cents.

So the disconnect between reality and the pricing of positions in the Balance Sheet is being reflected in the stock price.

The bottom line is this –
(the bank stock) is now a Call Option on a massive transfer of wealth from Taxpayer to Shareholder. That is what it would take to allow (the bank) to sell their holdings at the fantasy prices they show on their balance sheet.

If you think the Government will bail out this bank at Taxpayer expense, then buy the stock. If you don’t think so, then don’t buy it.

This bank’s “Balance Sheet” is “Shovel Ready”!

So You Had a Bad Day...

The markets rallied at the open and then got crushed all day long.

I thought the markets would bounce, so I bought a little FAS (+300% the Financial Index) for me at $4.65. It was the classic setup – the markets were testing a low, CNBC had another leak via Gasparino and Obama was set to speak in 10 minutes. So I bought FAS near the lows for the day. FAS rallied hard for about 20 minutes and then rolled over hard. I got stopped out at $4.87.

The Markets were crushed, because the government insists upon playing financial accounting games, rather than fix the obvious problems.

Tangible Common Equity
This is the new “Stress Test” that the Government will use to determine which banks are solvent and which banks are insolvent. The idea is that the value of the Common Equity (Stock) must be worth at least 3% of the Total Assets held by the bank.

Let me explain what the Government is trying to pull with Citigroup to get them in compliance with this definition, so that they can get more handouts from the Government.

Under TARP, the Government invested $45 billion in Citigroup, by buying Preferred Stock. Preferred Stock is basically a bond, so it is classified as Debt. The Government is looking to convert their $45 Billion in Preferred Stock into a pile of Common Stock worth 40% of Citigroup. The total value of Citigroup stock is now worth about $11 Billion. So the Government would get $4.4 Billion worth of stock.

Nice trade!!

The reason why they want to book this $40.6 Billion loss for the taxpayers is as follows. Converting the Preferred Stock into Common Stock increases Citigroup’s “Tangible Common Equity” ratio to a level high enough to justify the Government throwing more Taxpayer money into the sink hole that is Citigroup.

Even better, the Preferred Stock would have paid the US Government $2.5 Billion a year in Dividends. The conversion of Preferred to Common benefits nobody but the Shareholders of Citigroup.

Yesterday I wrote the following –
“No doubt there will be another round of leaks about how the banks will not be nationalized and how Timmy Geithner will invent some new math to prove that banks are indeed solvent and don’t need to be taken over or stuffed full of another $2 trillion to be able to keep their doors open under their current ownership.”

I had no clue that this was their version of “New Math”. The market crashed today, because the Big Boys know that these accounting games do not fix the real problem.

More
In his Press Conference today, President Obama told us how his Administration would focus on Financial Responsibility. A week after he wasted $800 Billion in Taxpayer Money, Obama told us that his new Budget would be structured under the “Pay-Go” principle, where you pay as you go. Where was his fiscal conscience last week?

The markets are sick of the hypocrites. They will keep crashing until the Government takes actions to solve the real problem – Insolvent Banks Are Not Lending Money. That has paralyzed the economy and we are now in Depression, with imploding economic activity and imploding pricing.

Is this a retest of the November Lows?
Maybe.

Remember how much time I spent late last year telling you not to get antsy, because I never saw a Bear Market end without a retest of the first lows? This may “The Retest” of “The Bottom” or we may just get a bounce.

Was that 100 point rally before the open all we will see for the bounce from oversold conditions? Are the Big Boys just running for the hills at any price?? Today, the gap up Open was sold hard. That is not a good sign.

I figured that 2009 would be a difficult year to make money. Because I know full well that there will be a lot of potential set ups that must be played, but only the last one will pay off in a big way.

The problem is that nobody knows which one will work. So I will buy small probing positions at logical places, with tight stop loses. This is another one of those high-probability setups. So I need to nibble a little, just in case this is a meaningful low. I bought a little SSO today (200% the S&P 500).

If the November lows fail, then potential support for the S&P 500 lies at 710, 660 and 609. It would be a selling capitulation if we reached those numbers. I will be looking to nibble there too if the set ups occur.

Oversold and Due for A Bounce

On 2/05/2009, Senator Chris Dodd (Dem Conn) (Head of the Senate Finance Committee) told us, with a laugh, that Bank of America would not be nationalized. Then on 2/20/2009, he told us that they “may have to be nationalized for a short period of time”.

http://nbcharts.blogspot.com/2009/02/rumors-from-con-men.html

When will these guys just shut up and start taking action, executing the laws on the books. The markets are pricing in nationalization. The talk of politicians is proving to be folly and is eroding public confidence in our nation’s institutions and leadership – sort of a financial Hurricane Katrina…

Nationalizing the largest, insolvent banks is the first step in restructuring the World’s Financial Markets. That is the job of the FDIC! Their role is to protect depositors from the irresponsible actions of bank management. But they are nowhere to be found.

Counterparty Risk
Banks are afraid to lend to one another, because they know that the guy on the other side of the trade is insolvent. If the government nationalizes your counterparty or they go bankrupt, then you lose all of your money. So banks aren’t lending to one another. This has the economy paralyzed. All the talk is to try and keep confidence game going just another day longer.

The only way to get lending going again is to get the risk out of the system by removing the insolvent banks. My story has not changed since October. Unfortunantely, the economy has crated since then, as the politicians and regulators have been paralyzed from doing what is needed and right.

This week, the big boys sold banks with abandon. Take a look at the Index for the Preferred Stocks of Banks (PFF). It took out major support on massive volume. That isn’t grandma and Aunt Betsie selling, that is Fidelity and CALPERS running for the hills!
I feel bad for those little old ladies who have been chasing yield and buying Preferreds. Just wait until Corporate Bonds roll over yet again…

Very Short-Term Oversold
That said, the markets have been pounded since February 9th and they are now very stretched and can rally sharply at any time.

No doubt there will be another round of leaks about how the banks will not be nationalized and how Timmy Geithner will invent some new math to prove that banks are indeed solvent and don’t need to be taken over or stuffed full of another $2 trillion to be able to keep their doors open under their current ownership.

We may be entering another crash leg, so I want to revisit the indicators I use to determining how oversold the markets are and from where they may bounce.

Daily Moving Average Envelopes
This chart plots lines for each 5% +/- the 150-day moving average. It worked very well in the 2000-2003 Bear Market and has done a decent job defining activity of the last few months.

I use the S&P 500 Index (Cash Price, Not Futures or SPY) as my proxy for stock market activity. You can see how the S&P 500 have been bound between the -15% Line (Green) and the -25% Line (Thick Blue). See how rallies have failed at the Green Line and the 50-day (Black Line). See how selloffs have stopped at the Blue Line (Black Arrows).
30-Minute Standard Deviation Chart
I use this chart to define oversold and overbought conditions in the shorter-term. When price stretches to + or – 3 Standard Deviations from the 50-day moving average (Black Arrow), then I expect at least a short-term reversal. We are now there, so I am looking for a bounce.
A bounce from here would be normal. I think this bounce will be aggressively shorted. I think the markets are broken and the governments around the world are in panic mode. I expect MASSIVE government intervention in the next few days of trading.

I would not be surprised to see the announcement of either explicit government support of stock prices or some new multi-trillion dollar transfer of money from taxpayer to shareholder. Nothing else will stop this market from crashing.

The potential for intervention is why I am not interested in shorting. Even on a bounce.

Scorecard
The S&P 500 was down -38.5% in 2008. I was +2.8%. In 2009, the S&P 500 is -13.76% and I am down about -0.50% (1st Quarter Fee Included). So I am 54.6% ahead of the market the last 14 months. So I have plenty of time to wait before I deploy money into stocks again.