Wednesday, September 19, 2007

An Issue of Confidence

I was sitting watching today's trading activity and starting thinking about the bank run over at Northern Rock in England, the issue of confidence and how fragile it truly is. Like good health, no one appreciates it until it is taken away. Everything is A-okay until one morning you wake up and it isn't anymore. Everything here is not A-okay. I consider the U.S. housing market to be the straw that has broke proverbial camels back. What it comes down to is this, the housing market charade is over. It is dead. Rate cuts are going to be completely ineffective as the damage is irreparable. To hear the politicians and pundits wax on about how the cuts are for the homeowner is disingenuous at best. They are instead a feeble, futile attempt to bail out hedge funds and Wall St. from their mistakes.

The housing bubble was spawned via an artificially low interest rate environment which was the result of a futile attempt to mitigate the fallout of out a prior bubble (tech, do you see a pattern here?) The housing charade was fostered by non-existent to completely fabricated borrower documentation environment which created phenomenal yet artificial demand. Now some may argue how could it be artificial? It was real, I saw the prices paid, the transactions are recorded and a matter of public record. Yes on all counts, but the wealth that was supposedly being created was and is fictional. Worse, all the economic growth this bubble fostered via mortgage equity withdrawals and job creation via home building is now working in reverse.

The slicing, dicing, packaging and offloading of this paper permitted abuses beyond compare. The mortgage originators had no skin in the game so they encouraged their representatives to aggressively pursue clients. Borrowers who would never have been given the time of day by a conventional lender under traditional normal circumstances were now shown the red carpet, aided and abetted by fraud laden paperwork, and deceit driven appraisals. Unwittingly the average homeowner has become participants in what I believe in hindsight will be considered the greatest swindle in financial history. Charles Ponzi would be proud.

This paper having been cycled through the Wall St. meat grinder was now given a AAA credit status by the ratings agencies, bought and paid for by the same firms the operate the meat grinder. How nice! This toxic paper now resides in hedge funds, off balance sheet investment vehicles, overseas pension, endowment and state sponsored institutional accounts. There is no market for this garbage, with many of the holders steadfastly refusing to mark to market, stubbornly still marking to fantasy. The tectonic nature of this chain of events cannot be overstated. The U.S. financial system considered premier has put the screws to their global bankers. To think they will let this slide is naivete of the first order.

Much like the Chicago 'Black' Sox throwing of the 1919 World Series this has now become an issue of confidence. Legitimate companies in need of financing have been shut out of the commercial paper market. No one trusts anyone right now and 50, 100 or 300 basis points will not change that. As evidenced by the LIBOR rate continually rising. LIBOR is especially important as it is the rate that banks will lend to one another. The Bank of England is stepping in to guarantee "all deposits" at Northern Rock and other banks. Will the government become the lender of last resort when all refuse to lend similar to how government has become insurer of last resort in Florida leaving taxpayers on the hook.

The Fed's cutting of rates will not solve this predicament but what it will do is seal the coffin on U.S. dollar. This rate cut means open season on the U.S. dollar. This will be the result of a short sighted, politically expedient decision to bail out bad investment decisions. I sure wish the fed would bail out my bad trades. The fed's actions to cut are the complete opposite of everything free market capitalism stands for. It is unjust and it is wrong. I believe the U.S. financial markets are at a crossroads. They are at a point where an overhaul of the U.S. financial system, including ratings agencies, banking rules, etc. is necessary so that confidence can be restored. Market participants need to be able to believe that no matter what document they read, it is true and accurate. Like I have said before, where the heck is Paul Volker when you need him, and believe me, the U.S. financial markets in particular the dollar needs a man like him now more than ever. Good trading to you all.

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