Financial Contraction Phase II

Look at this chart and you will see the reason most folks are predicting the end of the world as we know it.  We have two years of underwater mortgages to be reset and likely refinanced.  The bad news is that it actually cannot be done so it largely will not be done.

The reasons are simple. The subprime wave has passed through the system and the banks discovered they are the end buyers of millions of homes.  The original borrowers were all normally not credit worthy, so their exit while damaging merely changed seats on the home ownership titanic.  The end result is a badly depressed marked in which the sellers are the lenders who are unable to sell at all.  That is why pricing has stabilized.

The next wave is actually credit worthy people who will be forced to make a strategic investment decision.  They bought a house priced at say $500,000 with little down usually and an attractive monthly payment that they could afford.  The house has lost $250,000 and shortly their monthly payment must double at least.  Until now they have been paying close to market rent for the property.  Paying double is not in the cards.  Yet continuing the program locks in a $250,000 loss.

The last time I checked, that is a bone stupid investment decision.

The foreclosure laws provide no meaningful escape hatch forcing banks and creditors to engage in a work out and this past year has seen no progress toward doing such.  The banks are about to learn that if you destroy your customer’s assets by reckless lending, that your asset base must shrink.

Most of these borrowers will be exiting their obligations. The good news is that they  can move next door and pay rent on an equal house to another bank happy to receive rent on their recently acquired foreclosed home.  There is no bad news if they do this.  The banks still have to lend to earn and your new friendly bank manager will see to it that such a fine earner such as you does not go without appropriate lines of credit.  After all, without that large mortgage the ratios are wonderful and you certainly did not lose your job with the house.

Smarter things might have been done, but that did not happen.  It does mean however that consumer cash liquidity is stable as consumers take charge of their lives and shed massive household debt.  It will be a fabulous time to create household wealth by buying houses on the basis of their rental income.  What an old fashioned idea.

Yes the banks are getting hammered, but who said you should be rolling the dice with the money of widows and orphans.  All this funny paper was financed with floods of excess cheap credit.  It got lost and this is what a financial contraction looks like.  Banks get much smaller.

What is so bullish is that the true engine of economic growth, the American consumer will swiftly get over the hangover and reenter both the housing market and durables and smart cars. 

The financial industry will contract back to pre bubble size which will be about a two thirds reduction.  It has well begun.

This collapse was and is a financial collapse that disturbed the main street economy to the extent of making Main Street financing difficult.  That appears to be ending.  The remaining problem is to carry the massive mortgages been forced on banks through so called foreclosure.

There will still be lots of noise and when it is over, our banking system will be back to been boring with a 12 times multiple.  I wonder who bought all that funny paper flogged by the boys into the Eurodollar market.  There are a lot of walking dead out there that will show up.

My sense is that the Eurodollar market has been contracting and that this will continue, but I do not know for sure.

The American consumer is in a position to walk away from the lenders and this is bullish for Main Street.  Those same consumers will be buying all that foreclosed housing and restoring their balance sheets.  This is all bullish news.  A massive amount of misplaced credit has disappeared and the next tier of financial institutions is emerging from the shadows to carry on as capital flows back in.

Six Theories On Why the Stock Market Has Rallied

By Washington's Blog

There are at least 6 theories about why the stock market has rallied some 70% off its lows a year ago, even though nothing has been done to actually address the root causes of the financial crisis.

What The Dumb Money Believes

The dumb money believes what CNBC and their trusty stock churner ... er, broker ... says: that the government has fixed the economy but it just has to "kick in" (and that unemployment is just a lagging indicator, nothing important. See thisthisthis andthis).

Therefore, these folks believe that stocks are hugely undervalued, and that if they buy while most people are still afraid, they'll make a killing when the market goes to the moon.

Temporary Juice

Others believe that it is the quantitative easing, low rates, bank bailouts, stimulus spending, and other portions of the "wall of money" which the feds have thrown at the economy are creating a temporary pump to the stock market.

But they think that - when the spigot is turned off - the market will tank.

The Situation is Inflation 

Others believe that - regardless of continued loose monetary and fiscal policy or real stock valuations, we're in for some serious inflation.

Stocks tend to preform well during inflationary periods.

For more on inflation versus deflation, see this.

Machines Run Amok

Tyler Durden explains that all of the stock market gains have occurred after hours when mystery buyers purchase stock futures in low volume environments (and seethis).

Vincent Deluard - a strategist for TrimTabs Investment Research (25% of the top 50 hedge funds in the world use TrimTabs' research for market timing) - said last month:

We've never seen this before – such a huge rally, and the little guy is out.

Some argue that it is high-frequency trading or momentum-chasing trading algorithms doing the buying, and that the market will tank when they change their game.

Fed Futures

Others argue that the government is itself buying stock futures.

Some believe that the Feds aren't buying, but that they have intentionally showered the big banks with money, and encouraged the banks to buy. In other words, they argue that the Feds are indirectly promoting a stock market rally.

Fraud Central

Karl Denninger believes that the market has rallied due to the systemic, fraudulent overvaluation of assets.

As Denninger wrote yesterday:

[A reader wrote] the FDIC to ask about [allegations of fraudulent valuations]. This was their response:

That’s the value the bank had them on their books on their year-end financials, but the true value is much less. It is similar to someone in Las Vegas saying that their house is worth $300,000 because that’s what they paid for it three years ago, but the reality is, if they had to sell it in today’s market, they’d only get $250,000 for it. The FDIC has to sell assets in today’s market...

Or tomorrow's market.

The simple fact of the matter is that there it is, right in front of you.

A raw admission that the banks are carrying these loans at dramatically above their actual value.

Yes, this means that essentially all balance sheets must now be considered fraudulent, and thus the valuations assigned by the market to them are also fraudulent.

Extending this to the stock market as a whole you now have a market that is intentionally overvalued as a direct and proximate consequence of fraud, permitted and endorsed by the government, of somewhere between 25-40%.

Now you know why the market rallied off the SPX 666 lows to where it is now. 1139 (where we are now) * .60 (a 40% haircut) = 683.40, or awfully close to that 666 bottom.

Of course this "valuation" expressed in the market can only be maintained for as long as the fraud is. If the ability to maintain that fraud is lost for any reason then values will instantly collapse back to reflect reality.

Note: Obviously, I believe this is a bear market rally which will eventually fizzle out. If the bulls are instead right, then that will make me the dumb money. But I think it much more likely that the rally will change direction in the not-too-distant future.

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