Geldpress

The bailout bill failed to gain enough votes yesterday, but all indications predict that a substantial package will pass both houses in the coming days or weeks.  But even if the bailout bill does pass, what’s next?  The Commerce Department recently reported on September 24th, that sales of new homes dropped by a seasonally adjusted 11.5% from July to August.  Year over year sales were down 34.5% from August 2007 to August 2008, and inventory of unsold homes still sits at 10.9 months.

Even if the entire financial industry is wiped clean of all their existing bad debt, they still face the grim prospects of how to garner new business going forward.  The old game is over.  Consumers are wise to the crooked real estate agents, rating agencies, banks, builders, appraisers and mortgage agents.  They are also terrified of continued weakness and falling prices.  The ones not scared are just not qualified to borrow substantial sums of money to buy a house.   Housing prices, especially in past runaway appreciation markets like California, Florida, Seattle, New York, Chicago, Las Vegas and other large cities are destined to see continued weakness.  With weakness comes more foreclosures, more walk aways, more short sales, and more bank losses.

It took a decade or more to get into this mess, and it sure is not going to be over with a single $700 billion check!

I was not at all surprised by today’s 777 point drop in the Dow today.  What I am surprised about, however, is that Jim Cramer still manages to brainwash his viewers into thinking he has a clue.  There are countless examples of Cramer’s ignorance, but the two videos below pretty much sum up his lunacy.  In the first clip, he is kissing up to Ron Paul for his brilliance as the only one in congress that understands the financial issues.  In the second clip he is justifying the bailout, the same bailout that Ron Paul is vehemently opposed to.

The bear market and correction we are facing was a long time in coming.  We have been living on borrowed time in this phantom credit and over leveraged economy for far to long.  The market drops we are witnessing are a direct result of the credit crunch and the de-leveraging it is forcing on the economy, and there will be more blood on the streets to come.  Regardless of whether an amended substantial bailout  is passed, the path of least resistance is DOWN.

Jim Cramer praising Ron Paul for his views on letting the market self correct:

Jim Cramer justifying the $700 billion bailout of the financial markets:

For those interested in learning more about the derivatives market that created the housing disaster, here are three excellent books worth reading:

Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options (The Wiley Finance Series) by Andrew M. Chisholm

All About Derivatives (All About) by Michael Durbin

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation by Richard Bookstaber

There is no shortage of news and commentary on the bailout, so I won’t summarize it here.  Instead, I will offer a few quick and random thoughts of my own, in no particular order:

1. Main street vs Wall Street bailout - The politicians are posturing about how the bailout only helps wall street and does nothing for main street folks struggling to pay their mortgages.  In reality, main street is just as guilty as wall street for creating the mess.  Anyone who does not fully understand the terms of a $500,000 loan document (or any size loan document!) should not have signed it in the first place.  Also, let’s not forget how many people have walked away from their mortgage obligations as soon as they went underwater.  If they were willing to accept the leveraged potential appreciation in their home values, then they need to accept that leverage can also work against you and it sure stings when it does!  The very fact that banks are allowing people to walk away in mass - without paying the banks for the lost equity - is evidence enough of the bailout helping a large part of main street.
2. Bailout market prices - If the bailout is approved, it’s unclear how Paulson would handle purchasing the toxic mortgage waste of the financial firms.  Warren Buffet suggests selling a small percentage of the toxic waste into the open market just to determine a market price, and then using that as a gauge for all the toxic bailout.  But rumor on the street suggests that Paulson is going to pay full face value for all the toxic assets.
3. Limits on executive compensation - Unfortunately, Paulson and Bernanke are right that this crisis is very serious and could very well bring down the entire world economy.  That is the justification for wanting a quick rubber stamp of the 3 page $700 billion bailout.  But every executive of the financial, building and rating sectors have proven their complete incompetence over the last 10 years.  Congress is absolutely right for wanting a little extra time and a few more conditions.  If the idiots who caused this mess want taxpayers to bear the burden for their lunacy, then they need to accept any mandates we shove down their throat for giving them the money.  Limiting future executive compensation is a small price to pay for saving their firms!  If they think they can get a better deal somewhere else, then by all means, they should go get it.  But if they want the taxpayers to bail them out, then they should accept whatever mandates the taxpayer representatives come up with!
4. Robert Willumstad, who was only at the helm of AIG for a few short months before the government canned him and took over, kindly refused his $22 million contractual severance pay.  Perhaps other former and current financial executives should take his example, and donate their past fraudulently earned bonus payments to the general ledgers of their failing companies.  I know, wishful thinking, but it’s worth a thought.
5. Collapses prior to the mega bailout - If this mega bailout passes, how will the ex-morons in charge of Netbank, Indymac, Bear Sterns, and others reflect on the timing of their own implosions?  I guess if they had concealed their losses just a few more months, they would still be around to benefit from the taxpayer handouts.
6. 
7. Foreign bailouts - What is it with all this talk about bailing out foreign purchasers of our toxic waste known as mortage pools, tranches, etc.?  Have they not heard of the term “buyer beware”?  The United States can not afford this massive bailout even if it is limited to US corporations.  We certainly can not afford to bailout foreigners who lost money on the toxic waste.  Let them eat their own losses!
8. Jail time for rating agencies? - The blame for this financial crisis is certainly wide spread, but at the center of the mess is the rating agencies whose job it was to sound the alarm bells at the first sign of trouble.  Instead, they looked the other way and rubber stamped everything that crossed their desk as “AAA”.  If that doesn’t warrant jail time, then I don’t know what does.
9. McCain vs Obama - Let’s face it.  The financial problems we face are complicated.  I’ve listened to each of them over the last few weeks and although they each make legitimite criticisms of each other, it’s fairly obvious that neither one of them has any clue of what the problem is, how it was caused, or how to get out of the mess.  And that comment also applies to at least 90% of the members of congress.  Proposed solution: We need standardized financial/economic aptitude tests for presidential candidates and every member of congress.  If they don’t know what a derivative is, then their votes pertaining to regulating them will not count!
10. Gregory Meeks, representative of New York recently stated to Paulson and Bernanke that his biggest fear is that the banks will still hoard money after the bailout, preventing affordable loans from being available.  Just what exactly does Gregory Meeks want?  More easy and stupid $500,000 loans to unqualified borrowers?!?!?!
11. We need lower housing prices, not 100 year mortgages - The financial mess we face is directly related to artificially high housing prices.  Even if we bail out all the financial institutions, it does not change the fact that housing prices need to come down a lot more.  But beware of the coming lunacy from the financial markets after the bailout.  They will likely follow Japan’s “solution” of artificially high real estate and create new 100 year mortgage products to lower the monthly payments and make houses appear to be cheaper.  Wake up America!  The 100 year mortgage is coming, and it needs to be resisted!
12. Foreclosure moratorium - This is not an acceptable provision of any bailout plan.  If you can not afford to pay your mortgage, then stop stressing out about it, and move into an apartment that you can afford.
13. When Paulson was asked who would manage the purchased toxic waste, Paulson stated that the details were still being worked, but it he is looking to private enterprise to help manage the toxic waste.  Doesn’t he realize that the private financial sector are the ones who caused this mess, and can not be trusted?!?!?!

Proshares and Rydex are ETF providers that offer Inverse or double inverse funds.  The short ETF’s offer a convenient way for investors to short the market, or individual sectors of the market.  And both of them have double inverse financial ETF’s that have serious implications due to the SEC ban on short selling financials.  Proshares release a short statement on their website this morning related to the uncertainty:

Due to the emergency action announced by the Securities and Exchange Commission on September 18, 2008, temporarily prohibiting short sales of shares of certain financial companies, Short Financials ProShares (SEF) and UltraShort Financials ProShares (SKF) are not expected to accept orders from Authorized Participants to create shares until further notice.  Unless notified otherwise, shares will be available for redemption by Authorized Participants as normal. The shares of these ProShares are expected to trade in the financial markets. As disclosed in the prospectus, ProShares may at times trade at prices that are not in line with their intraday indicative values.

The SKF got absolutely hammered last Thursday in anticipation (SEC LEAK ANYONE??) of the short sale ban, and again on Friday when the ban was officially announced.

So what does all this mean for SKF and other ultra short investors?

The proshares prospectus clearly outlines their method of obtaining double exposure to the inverses.  They do not actually short the market.  Instead, they use multiple financial instruments, in an attempt to mimic the inverse performance of the underlying.  Per the prospectus, those instruments are:

• Futures contracts and options on futures contracts
• Swap agreements -  In a standard “swap” transaction, two parties agree to exchange the returns (or differentials in rates of return) earned or realized on particular predetermined investments or instruments.  The Funds are subject to credit or counterparty risk on the amount each Fund expects to receive from swap agreement counterparties. A swap counterparty default on its payment obligation to a Fund may cause the value of the Fund to decrease.
• Forward contracts - two-party contracts entered into with dealers or financial institutions where a purchase or sale of a specific quantity of a commodity, security, foreign currency or other financial instrument is agreed upon at a set price, with delivery and settlement at a specified future date.”
• Options on securities and Stock indexes and investments covering such positions

Proshares does not disclose the specifics of which of the above instruments they utilize at any given time to seek their double inverse returns.  My personal hunch tells me that most or all of the double inverse returns were coming directly from the two party counterparty swaps - at least until the SEC short sale ban last Thursday anyway.  The scenario is usually pretty simple.  Proshares would agree to pay a fixed amount of interest in exchange for a counterparty paying the return on an inverse index.  It is the counterparties, and not proshares, that actually does the shorting of the market or index.  And the counterparty risk associated with proshares ETF’s is the risk that these counterparties will become insolvent and not be able to pay the agreed upon inverse returns.

After the collapse of Bear Sterns, there was significant speculation around proshares, and whether they had any exposure to Bear Sterns as a counterparty.  Proshares in that case did come forth with additional details on their counterparties.  They still would not state clearly who their swap counterparties were, but they at least admitted that Bear Sterns was NOT one of them.

With the ban on short selling, the landscape and risk exposure of proshares inverse ETF’s changes completely.  Counterparty risk is still a concern on existing swap contracts, but by far the biggest counterparty risk is the US Government, and their under analyzed short sale ban. In the new environment, it does not really matter who the proshares swap counterparties are.  If those counterparties are unable to short the market, they have two choices, and neither of them are good for proshares:

• Discontinue counterparty swap agreements with proshares
• Assume near infinite, and unhedged risk (agree to pay inverse returns, but don’t short the market to hedge those risks)

In all liklihood, the proshares inverse funds will continue to exist in the short term, but the mechanisms they use to achieve their results will significantly change, and the risks to shareholders will go up as well.  Don’t expect full disclosure on what changes proshares implements, but it will likely be to utilize more options and futures and a lot less third party swap arrangements.  But with the spreads on options and futures increasing significantly over the last few days, it will be increasingly more difficult for proshares to come close to the desired performance.  The proshares prospectus explicityly lists correlation risk, but in the new landscape, that correlation risk could become much more significant.

The Geldpress bookstore has a new category titled “BAILOUT NATION”:

Books related to reckless economic policy, failed policies of the past, housing bubbles, financial crisis, bank failures, long term capital management, other insane bailouts, the great depression, the national debt, savings and loan crisis, and more.  The latest round of financial bailouts are nothing new.  These reckless ideas have been going on for decades, and will continue indefinitely as long as we let it.

Just click on the BOOKSTORE tab to get started.  There are 5 pages of bailout books to choose from.  Among those I recommend most are:

Everyone knows you can’t squeeze blood from a turnip, but it hasn’t stopped Paulson and Bernanke from trying.  The American economy today is built entirely on speculation and irresponsible consumer spending.  Housing prices, especially on both coasts, and in large cities (Chicago, New York, Baltimore, California, Florida, and more) will continue to go down no matter what the intervention is.  The consumer is tapped out, and the easy credit days are over.  Perhaps one day in the future everyone will realize again that it is just a market sum game, but until that time we will continue looking for blood in the turnips.

The latest measure from the government is to ban short selling in 799 financial securities, and to expand the purchase of toxic securities from all of the incompetent financial firms that got us into this mess.  The full details and the exact wording of the far reaching bailout plan is yet to be released, but it does seem to have bipartisan support, and the support of the biggest moron on Wall Street, Jim Cramer.  Jim Cramer’s philosophy, if you remember, is to celebrate the counterfeit boom in the housing bubble based economy, and then scream and cry for interest rate reductions and bailouts when the house of cards comes falling down.  Jim Cramer apparently never saw the mess coming 5 years ago when he pumped up the stock prices of every bank, brokerage and homebuilder during his nightly shows.  Despite the obvious warnings, in the form of minimum wage workers everywhere receiving $500,000 home loans, the ignorance of the “experts” and “leaders” is purely astonishing.    The list of those “experts” and “leaders”, in random order includes:

• Alan Greenspan - After 911, he aggressively jacked down short term interest rates to 1%, and encouraged everyone to take loans they could not afford.
• George Bush - Utterly clueless.  Up until yesterday, he was still in denial of the financial crisis, and wondering how much more of those phantom surpluses he should give back to taxpayers.
• Phil Gramm - Completely gutted the Glass-Steagal act in 1999, and replaced it with the Gramm-Leach-Bliley act, allowing commercial banks, investment banks, and insurers to merge, and setting the stage for the largest bubble in world history to occur without oversight.
• Suze Orman - She claimed on national TV that “nobody could have seen this crisis coming”, and urged homeowners nationwide to move to Seattle to buy even bigger houses they could not afford.
• Henry Paulson - Worked for Goldman Sachs as they helped create the mess, and now the biggest sponsor of the largest bailout of Goldman Sachs and other financial institutions.
• Moody’s corp - They are called a rating agency, but in reality they only have one rubber stamp, with three letters on it - “A A A”.
• Jim Cramer - He is famous for his arrogant “They Know Nothing” rant, when in reality he has been completely ignorant of the housing bubble since its beginnings.  He preached for years on how the idiotic investment banks and homebuilders were the best investments.  And when they got in trouble for insanely stupid loans and ridiculous leverage, he cried how the “Feds know nothing”.  And now he supports the largest bailout in history to save his buddies at Goldman Sachs, at your taxpayer expense!

The additional details of the current bailout will likely be apparent in the coming days.  But don’t expect it to be the last bailout, or the last set of rule changes to the market.  Housing prices are still extremely unaffordable, and need to come down, and come down A LOT!  But these very necessary collapsing housing prices will wreak additional havoc on the economy.  More jobs will be lost.  Consumers, who surprised everyone by spending what they didn’t have over the last decade, will suddenly be cut off from easy credit.  Federal, State and local tax revenues will plummet.  Everyone will feel the pain of the idiotic economic policies of yesterday.  And the ranting over the bailouts will continue for years:

From the Daily Reckoning,

They’re missing the point completely. It is not “flaws” that are being exposed - it’s the whole consumer economic model and the whole generation of jackass economists who created it. They rejected the insights of classical economics. Instead of encouraging saving and capital formation, they thought they could nurture growth by luring consumers to spend more money.

From the UK Telegraph:

What is causing widespread anger is that those who should have exercised greater caution have already banked the gains from the good times and have a nest egg to sustain them even if they do lose their jobs….Perhaps most of us, at some point or other, have dipped our hands in the pool. Where did we think all that cheap money was coming from? With people borrowing 10 times their salaries, there was always going to be a settling of accounts.

Professor Bennet Sedacca

The Federal Government just declared war on short sellers.
Will it help the real economy? No sir.
Will it help the value of my house? Nope.
Will it blow up hedge funds? Yep.
Is it a selling opportunity? You betcha.
Will the rally last ? No.
Will earnings increase? Actually I think they will fall.

From Lea Pickard, former SEC official:

The securities and exchange commission can blame itself for the current crisis.  The SEC allowed five firms — the three that have collapsed plus Goldman Sachs and Morgan Stanley — to more than double the leverage they were allowed to keep on their balance sheets and remove discounts that had been applied to the assets they had been required to keep to protect them from defaults.

English Al Jazeera:

The roots of the panic in financial markets around the world are deep and complex but they lie in the convergence of three factors. Millions of people pursuing the “American dream” of home ownership, politicians and regulators who dismantled a system of financial safeguards and then ignored warnings of impending disaster and financial markets and institutions disregarding risk in their headlong pursuit of profit.

Speculation Economy book, by author Lawrence Mitchell:

American businesses today are obsessed with the price of their stock, and no wonder. The consequences of even a modest decrease can be so dire that some executives would rather damage their corporation’s long-term health than allow quarterly returns to fall below projections. But how did this situation come about? When did the stock market become the driver of the American economy? Lawrence E. Mitchell identifies the moment in American history when finance triumphed over industry. He shows how the birth of the giant modern corporation spurred the rise of the stock market and how, by the dawn of the 1920s, the stock market left behind its business origins to become the very reason for the creation of business itself.

The Speculation Economy: How Finance Triumphed Over Industry (BK Currents (Hardcover)) by Lawrence E Mitchell

The drastic new rules prohibiting short selling in financial firms have been ordered. The full text of the SEC statement is available here. In summary:

IT IS ORDERED that, pursuant to our Section 12(k)(2) powers, all persons are prohibited from short selling3 any publicly traded securities of any Included Financial Firm.  Similar to the Amended July Emergency Order, we are providing a limited exception for certain bona fide market makers. We believe this narrow exception is necessary because such market makers may need to facilitate customer orders in a fast moving market without possible delays associated with complying with the requirements of this Order….This Order shall be effective immediately and shall terminate at 11:59 p.m. EDT on October 2, 2008, unless further extended by the Commission.

This statement begs the question of how the inverse funds will handle the new rules.  There are two major competing ultra short financial ETF’s, the Proshares ultra short (SKF), and the Rydex 2x Inverse financials (RFN).  As of the time of this writing, neither of these firms has issued a statement on their website.  I called each of them this morning and they both stated that they are unaffected by the new rules.  They achieve their results not through actually shorting the markets, but from derivative swap contracts with counterparties.  Unfortunately, neither of them disclose who those counterparties are, and thus each of them do have counterparty risk of default.

On a side note, proshares and rydex list their holdings completely different.  It is crystal clear that proshares is using derivative swap contracts in their ultra short funds.  But from the Rydex holdings, it appears as though they are double short the indexes.  But despite how Rydex lists the holdings, they contend that they are actually using derivative swaps, and not actually shorting the indexes.

What a crazy day in the markets.  The rules are changing, and nobody seems to understand exactly what the rules are.  Just when you figure it out, they will certainly change on you again.  Capitalism is dead.  We are now a cross between socialism and communism.  Bernanke and Paulson just announced the largest government bailout in history, and sparked an enormous short squeeze market rally.  It’s way to early to determine the cost of this insanity on US taxpayers.   And whatever the new rules seem to be (more bans on short selling), they are sure to change again next week.

All of this uncertainty has managed to drive share prices higher, although it will likely only be temporary.  The markets seem to realize this, as evidenced by the huge BID/ASK spreads in virtually all of the option markets.  Take a look at the BID/ASK spreads below for the Russell 2000 October call contracts.  Anyone placing a MARKET order today on anything is practically begging the market makers to rip them off. Use limit orders, now more then ever!

I wouldn’t touch AIG 6 months ago or even 6 weeks ago, but with the shares as low as they are today, at the same time of such incredibly high implied volatility, there is one AIG play worth looking at.  AIG closed today at 3.75, after bottoming out for the day at 1.25, and AIG shares are likely to be just as volatile over the next few days.  But take a look at the October options for AIG: (option chain from end of day)

AIG may very well be completely insolvent.  It’s just to hard to tell what is really going on, and you are not likely to get any straight answers from former CEO Martin Sullivan or current CEO Robert Willumstad.  But a covered call on AIG at the October 2.50 strike may very well be worth a gamble, based on the risk to reward ratio.  From today’s closing price and closing option chain, here is the scenario:

• Buy 100 shares of AIG for $375
• Sell to open (1) contract of the October 2.50 AIG strike for a $275 credit
• Initial total net debit is $100

The risk of this trade, based on the above prices is just $100, and the maximum loss only occurs if AIG tumbles to ZERO prior to October option expiration.  If AIG stays above $2.50 at October expiration, then the shares will be called away for $250, and the profit is $150 ($250 for shares called away, minus the $100 initial net debit).  Having the covered call exercised would result in a 150 percent return on risk for a covered call held just barely over one month, not counting commissions.

Special Notes: Check the disclaimer and trade at your own risk!  Also note that tomorrow’s prices will likely fluctuate greatly for both AIG and the October options.

New Insights on Covered Call Writing: The Powerful Technique That Enhances Return and Lowers Risk in Stock Investing by Richard Lehman