Bonds

You have to wonder....

Nov. 12 (Bloomberg) -- Goldman Sachs Group Inc. paid off at face value some junior-ranking slices of two collateralized debt obligations at the potential expense of more-senior classes that now are likely to default, according to Fitch Ratings.

Goldman Sachs, the most-profitable securities firm, applied its “sole discretion” to ignore standard payment priority and use cash in reserve accounts for the Abacus 2006-13 and Abacus 2006-17 CDOs to retire lower-ranked notes, Fitch said yesterday in separate statements.

....

“We are not aware of the use of this feature in other transactions we rate,” Trebach said in a telephone interview.

Let me guess - the inclusion of such a feature didn't factor into the ratings originally issued either, right?  Yet this "feature" is, apparently, quite common?

From what I can discern from the article Goldman had every right to do this - even if it was due to their owning the paid-off pieces (thereby receiving full "par" value where other people would get screwed.)

The better question here is why anyone would ever buy something that includes a "feature" that allows the manager to exercise their discretion to screw more-senior holders at any time they wish.

Who, if I may ask, is dumb enough to buy trash like this?

Well, obviously there are some "someones", as it appears that this trash was sold and traded, and now Fitch has blown down the ratings of these un-redeemed tranches to "CCC", well below investment grade.

Some of the debt was originally rated "AAA".

One wonders how, given the presence of this "discretionary" clause in the original deal, since the premise of said "AAA" rating is the presence of excess coverage for the senior tranches provided by the subordinated components!  If the manager has full discretion to remove that coverage at any time (as occurred in this case) then the original "AAA" rating, which envisions performance to maturity, was severely flawed at best.

Put bluntly, the so-called "credit enhancement" propounded to be present in the deal was fictitious and any "rating" predicated on same was false.

What did Turbo Timmy and Bendover Bernanke think they were trying to pull?

The Fed's "Quantitative Easing" is now basically defunct, with about $6 billion left out of the original $300.  Of course the scam of buying Fannie and Freddie Paper (even though it is not full-faith-and-credit, as I have noted repeatedly) will continue through the first quarter of next year.

But there looms a larger and more immediate problem for Treasury - their incessant "rolling down the curve" activity over the last few years has led to some real trouble, although Treasury has started to recognize this issue.  Currently average maturity is approximately 50 months (down from 70 months in 2000) and is starting to edge back upward.

But this belies the underlying reality - all of the debt, on average, must be rolled every four years, or about $3 trillion a year that must be rolled over PLUS net issuance!

How Treasury thinks they will be able to continue to do this on "favorable" terms is simply beyond comprehension.  Indeed, I'd go so far as to suggest that it is highly likely that there is only one way to avoid a major coupon spike upward - intentionally crash the stock market, just as was done last fall.

And do not be confused about the consequences of a coupon spike - something as "mere" as a 2% increase in the average interest rate on Treasury debt could result in a near-doubling of interest owed, sticking more than $300 billion of additional red ink into the budget instantly.  That in turn could result in a perception of inability to pay which in turn could provoke another coupon spike!  This ends the same way it does if you miss a credit card payment.....

Nobody likes to talk about the insane amount of interference between Treasury, The Fed and the equity markets, but to deny it is present is to deny reality - liquidity games played at "critical" times in the market in order to get a desired outcome from Congress or the marketplace.

Nobody has called Bernanke to account over that, just as they won't this time around.  Today these machinations are better-hidden due to the alphabet soup that The Fed and Treasury are maintaining - but hiding something doesn't mean that the effect doesn't happen, it just makes anticipating the effect harder.

Unless, of course, you're one of the chosen few who is tipped off in advance (cough-goldman-cough), as John Crudele (and I) have documented repeatedly.

The problem with all of this is of course timing and the madness of crowds.  The "get up and dance while the music is playing" meme is back out in force, with mutual fund managers now chasing returns lest they be fired for not being invested.  This is the perversion of Fraud Street writ large, as what happened last month or quarter is of no relevance to what is going to happen next quarter.  All prospectuses contain "past performance is no guarantee of future results", but what is a foregone conclusion is that while past performance may not guarantee future results it is a certainty that fund managers will chase past performance and thus, when mean-reversion happens, under-perform the market.

We continue to see no or little evidence of actual improving business conditions in terms of top-line revenues.  Alcoa beat only on an insane per-ton price increase; shipped volumes fell.  Johnson & Johnson saw net up a percent but revenue fell 5.3%.  More ominously the company was hurt, not helped, by the dollar's destruction, with about half of it coming from currency effects.  US Sales fell 8.1% - not the sign of an improving economic picture.  Drug sales were down 14% with most of that coming from generic competition, but consumer health care was also off - in this case, 2.7%, and was hurt by dollar devaluation (can you say "import sensitive"?)

Then there is the mysterious case of the SDRs.  As Zerohedge pointed out there was a sudden and unexplained "boost" in the Treasury's "International Reserve Position", with essentially all of it ($50 billion or so) comprised of a huge increase in IMF SDRs.

Now I may be missing something here but Treasury doesn't appear to have that power without an explicit act of Congress.  To wit, The US Constitution Article I, Section 7 provides:

To coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures;

CONGRESS has sole authority to approve (or not) the acquisition and disposal of SDRs, which are nothing more or less than a foreign currency - in this case, one comprised of a basket of other currencies.  The Executive has no power to engage in this sort of transaction on its own initiative.

But it did, and thought it wouldn't be noticed.

Well, it was.

The dollar continues to rattle around at key support.  If it breaks then our import-based economy will be decimated.  Oil will skyrocket and so will input costs to American business.  Bye-bye profits - and businesses.

Congress, Treasury and The Fed are all counting on not only you being stupid but everyone in the International Markets being stupid.  That's a bad bet, and I believe the time to buckle up is close at hand.  While the "can kicking" of the last six months might seem to have been a good thing at the time, and might even look good now, I suspect that when we look back on it in a year or two we will recognize it as the disaster that it in fact was.

Let me guess - record levels of junk bond defaults are positive for the economy going forward?

Ambrose Evans-Pritchard writes the following:

Democrat leader Yukio Hatoyama, who won a landslide victory over the weekend, has pledged that there would be no increase in debt to fund his $180bn boost for child allowances and social policy by 2013, but his advisors are already back-tracking as they examine the dire tax figures.

While Japan pulled out of recession in the second quarter, it has barely begun to make up for the 11.7pc contraction of its economy over the preceding year. Industrial production was still down 23pc in July. Exports were down 39pc to the US.

Uh huh.  These are great promises, but Japan's tax receipts are down 27% over the last year.   This sounds oddly familiar.... our government's tax receipts are down huge as well, as are the tax receipts of the states.

Michael Taylor from Lombard Street Research said Japan made a strategic error during its Lost Decade by waiting too long to pull the monetary levers. "They failed to boost money supply the way the Fed and the Bank of England are trying to do through quantitative easing. Their fiscal packages led to a massive deterioration in public finances."

Oh nonsense.

Japan tried to avoid the truth.  They tried to sweep the bad debt under the rug instead of forcing it out of the system.  They attempted to apply the Keynesian "fix" that seems to be the tonic to all that ails the economy - spend spend spend and loosen loosen loosen monetary policy.

Did it work?  No. 

Nor will it work here, because just like in Japan the lies have not been flushed from the system and those who have hidden boluses of garbage have not been forced to admit to and clear them.

"IMF studies show that as public debt rises above 60pc of GDP fiscal stimulus loses it effect. People anticipate the consequences: higher taxes, and eventually higher interest rates. The bond vigilantes will always get you in the end," he said.

Hmmm.... Public debt in the US is about $11 trillion, GDP 14ish, so where does that leave us?

Here's a hint: But for Bernanke's machinations, we'd be forcing the bad debt into the open and clearing it now.  Since we have refused for political purposes (read: bribes in the guise of "lobbying" and "campaign contributions") to force the exposure and resolution of bad debt, and instead have chosen to "extend and pretend" (lie), "mark to model" (tell damned lies) and not close banks immediately that are demonstrably insolvent (stick your head in the sand like an ostrich) we have a clogged credit system that is incapable - not unwilling - of properly performing its function in the economy.

Buffett, iStockanalyst, PIMCO and of course myself....

“No government, or central bank, is bigger than the bond and currency markets. Foreign bondholders aren’t going to sit idly by while any government … even the government of the U.S. … openly decides to trash its currency by printing it with reckless abandon. And they aren’t going to sit by while the government manipulates prices higher.

Yep.

Look, I'm no fan of Buffett and PIMCO, as anyone who's read my column for more than a week knows.  Both have been the subject of many a barb, with both profiting mightily from what amounts to unbridled Government Largess and the intentional overlooking of fraudulent activity in the financial markets.

Profiting from Fannie being backstopped, for example, is obscene.  Its not illegal, but it is obscene.  So is profiting from banks that are allowed to jack interest rates to 30% to cover their own sin of writing loans without a prayer in Hell of the borrower being able to pay.

But this belies the point here, which is that as I have outlined in today's treatises we as a nation are at a crossroads.

We can defend the dollar which will cause interest rates to rise significantly, choking off false growth and forcing the defaults being hidden to the surface, or we can continue an economic policy that fosters fraud and deceit.  If we do the latter we will continue to see revulsion for all forms of dollar-denominated debt and like a creeping case of gangrene it will travel from the corporate and agency space, eventually infesting US Treasuries as well.

The only remaining question is whether the monetary and fiscal authorities will amputate the gangrenous hand or whether they will allow sepsis to set in and kill the entire nation - including its currency and potentially the government.

Before you dismiss me as some off-the-wall Internet kook, you might want to consider that in addition to those of us who have been pounding the table for the last couple of years on these points, we now have both PIMCO and Warren Buffett adding their voices to our chorus.

These individuals may not be someone who you like, but they are people who appear to have come to the same conclusion - even if they got there via a different, more-circuitous route.