From Bernanke's speech today....

""They have taken a lot of losses. They are also being very protective of their liquidity because they are unsure of the possibility of additional off-balance sheet assets coming onto their balance sheets and therefore they are being rather conservative in making new loans which has implications for the broader economy," Bernanke said."

There 'ya go.

What did I post this morning?

Yep.

See, the banks know the game.

They have an alleged "wrap" on all these "assets" which allows them to "claim" that their credit book is all "money good."

Same deal for places like Fannie and Freddie that have roughly $5 trillion of mortgage paper in their "credit guarantee" book, with a fair bit of it at LTVs over 80%. They claim "money good" because the mortgage insurers wrote policies (swaps, effectively) against the potential failure to recover the full loan balance.

The problem is that essentially none of these swaps are any good.

That's the bad news.

The worse news is that the situation is going to get worse over time, not better, because home prices are going to continue to fall, not rise, for at least another one to two years, and before they bottom we will see the long end of the interest rate curve start to rise too, which will put further downward pressure on prices.

The NAR (which has been all pollyannaish until recently), Fannie and Freddie are all predicting double-digit additional percentage declines, and Case-Schiller is on board with that too.

As this occurs it "uncovers" more and more exposure in the insurers (swap writers) which in turn results in more degradation of the credit book, which in turn causes the real cost of mortgage money to rise.

This in turn causes more home prices declines which........

Yeah.

Here's the thing - in "normal times" being a MI company is a license to print money, just like writing swaps is. If the "base case" is that only 1% of all prime mortgages default, and you only insure the top 20% of the note, then you only lose if the default happens before the note drops below the principal value.

In a normal market this is unusual - you might only have to pay on 1/2 of 1% of the loans you write. Same thing applies to swaps - in the recent past we had a year where there were essentially no corporate defaults!

But in this market it is anything but normal, because the default percentage rises to 2 or 3%, and you have to pay on most of them, and corporate defaults are rising too!

The underlying model that firms have used to price this risk is mathematically unsound in a declining home price marketplace.

Specifically, the model relies on the assumption that you will only experience losses on 1% or so of the loans and for the most part price appreciation will prevent you from having to pay as the foreclosure sale will recover most or all of the deficiency.

Neither of these assumptions are valid in today's market!

Here's the proof (click for a larger view):


Note that we have $142 billion worth of exposure "off prime" with 21% of it delinquent 60 days or more yet it was all rated "AAA" at origination.

Most 60+ delinquencies will foreclose. The 2nds and HELOCs are essentially total wipeouts in an environment where home prices are declining as foreclosure nets you nothing since the balance exceeds equity.

Now take a look at the real losses likely to be seen here. Assume we're talking that most of the 21% delinquent on the $142 billion goes "boom", we have $30 billion in exposure. Being nice and allowing a recovery of 50 (hopelessly optimistic) we have $15 billion in losses.

The problem is that MBI, Radian and Ambac's market cap combined is less than $4 billion.

So we have $11 billion in "forward, unrecognized and uncovered" losses but Freddie is going to raise $6 billion? Yes, I know, they have some capital cushion, but is it really wise to invade that when the problem is nowhere near over?

We also haven't accounted for losses in the prime book - at all. And how much of that "prime" is really prime and not "Fast and Sleazy" paper that was sold to them as prime but in fact is Alt-A?

See, this is at today's home prices and loss experience - but both Freddie and Fannie are predicting further home price declines, which will feed into more delinquencies.

The bottom line is that the claimed "credit guarantees" are crap and this is only Freddie, which has less exposure than Fannie (they were nice enough to publish a pretty table that made this pretty easy to put out there for 'ya.)

You can extend this problem to both the investment and commercial banks; the basic problem remains the same - the so-called "guarantees" represented by these OTC swaps and other "derivative devices" are worth nothing as the money simply is not there to make the payments.

Once the first blowup bankrupts the guarantors everyone else is immediately running uncovered.

There is no way out of this box. We have had a nearly-10-year run where all this paper was written in a mispriced environment under the premise that the music would never end.

Bernanke has admitted that he knows this in that the banks are "hunkered down" and unwilling to put more exposure out in the market because they know what is coming.

But Bernanke is compounding the error by not forcing institutions to take down their leverage.

You force them to take down leverage by demanding that they either prove their swap and "insurance" counterparties can pay against the most pessimistic assumptions in the current environment or those policies must be declared "worthless" and your assets then have to trade on their underlying credit quality.

If he was to do so then we would find out who is swimming naked (and there would be plenty of people who are) but the bleeding would stop in the banking system because once the trash paper is sold it's not your problem any more - it is now owned by whoever bought it.

Remember folks - if hedge funds want to bet on recovery of this paper and buy it for 80 cents on the dollar on alleged "money good" paper, and they're wrong, we do not get a systemic failure.

People who are risking their own capital get to either make or lose money.

But if the banks continue to hold this paper trying to get "par" for it rather than take the losses now and they are wrong we all get screwed because Bernanke has literally loaded over $400 billion dollars of this trash on The Fed's balance sheet, and to bail that out, if it becomes necessary, will require transferring that bad debt to the United States Treasury with catastrophic results.

Worse, if this blows up in our faces you'll find that you suddenly need 50% down to buy a house, because nobody in their right mind will loan on more than half of the underlying collateral value.

This happened during The Depression for this exact reason - what do you think a development like that will do to house prices?

Bernanke is gambling with our future by refusing to act to force the deleveraging to take place now through recognition that these swaps and "insurance" policies are, in aggregate, worthless.

Congress, for its part, is sitting back and fiddling instead of insisting that the truth of these firm's financial positions be recognized and the underlying credit quality be the basis upon which they trade.

It's time for you to either stand up and raise hell or shut up, because come the July Recess, which is only about a month and change away, there will be no further Congressional action of consequence until after the Inauguration in January of 2009.

We don't have that long.