The Future of the Euro

The fire and brimstone clouding the European sky is not the volcanic ash from Iceland but rather the bleak outlook for a unified currency. To put it mildly the Euro is doomed, it is just a just a question of how the entire scenario unfolds.

Currencies only work for a nation when their own central government has control over the money. A country using a currency while ceding control of the exchange mechanism simply makes the nation a victim of all the other entities using the notes. Germany and other northern European nations recently learned this harsh lesson. The Euro worked while all the economies across the continent were rising, but quickly imploded when a recession occurred. The southern European nations with poor financial controls that that have historically defaulted multiple times are now in a position to collectively drag down the entire collection of economies due to the common currency. Prior the Euro these countries would default and their individual currencies would be devalued.

It is true that the more people that use a currency then the stronger the value. Witness the strength of the deutschemark after the inclusion of East Germany. However a country must have sole control over their currency and not yield power to a central authority in order to be successful. I found that the Germans were very supportive of the merger of East and West Germany despite concerns over the poverty in the East at the time. Today, Germans are outright furious that the country is bailing out Greece and other nations. Most of the people on the street recognize what is going to happen next which is why they are lining up at banks to demand Euro notes with X’s in the serial numbers that are associated with Germany and not other countries.

While the entire situation can play out in multiple scenarios; there are two obvious ones. The first is that the Euro will divide into two segments, the stronger northern European nations with one version of the Euro and the southern European nations with a version of the Euro which is next to worthless. This explains why German citizens are lined up demanding “their national Euro notes”. It is likely that outside notes will soon be devalued.

The second possible scenario involves individual countries withdrawing from the Euro exchange mechanism and reinstituting their own national currencies. A good number of barriers and political negotiations will have to be overcome to allow this type of withdrawal. On the other hand people rioting in the streets generally has the tendency to make central union decision making to move with more haste.

Another likely scenario involving individual nations withdrawing from the Euro focuses on the central union giving countries with debt problems the boot and demanding that they withdraw from the Euro. As the size and scope of the debt issues become more apparent there will be a greater howl across the continent for the offending nations to withdraw.

In the long term where will this leave the Euro? It would be best if it was used as a basket of currencies for international trade as it was originally intended – 23% franc, 34% deutschemark, etc. rather than being used as a universal note in retail trade across the entire EU block. The disbanding of the common Euro is the best solution and the obvious path for continent.

Humor: The Story of the Banks in Iceland

It started with bankers in the U.K. asking 'Where can we find some pansies to sell this CDO crap to?"

UK "We are going to make ourselves rich by selling wothless CDOs dressed up as jewels to your fishermen banks"
Iceland "Yeah we are getting rich.... Big Party."
UK "We will even sell short and bet against the crap we sold you"
Iceland "Hey, this stuff melted down and is worthless."
UK "By the way we expect you to tax all your citizens 3 million dollars each to make up for our 'losses'".
Iceland "FU - stuff it. We voted and ain't paying."
UK "We'll start seizing your international assets till you pay."
Iceland "FU. Enjoy some volcanic ash."
UK "Stop.... you're sinking our economy!"
Iceland "Maybe you should of thought about that before you demanded repayment on the worthless crap you sold us."
UK "Choke....cough.... choke...."

Today's Cartoon

Even a year later - WaMu failure still in the headlines

Washington Mutual was a bank that desperately deserved to fail. Even a year after its demise, WaMu is still making the headlines. One example is is the CNN Money article below...

WaMu: The Forgotten Bank Failure

The biggest-ever bank collapse didn't lead to chaos, but Americans will pay the price for its unsound lending for years to come.

Washington Mutual is long gone, but its lax lending could haunt us for years.

The Seattle-based institution collapsed in the largest-ever U.S. bank failure last September. WaMu ran out of cash after business customers, unnerved by the implosion of Lehman Brothers, withdrew their uninsured deposits.

After the chaos surrounding Lehman's demise, WaMu was put to rest with little fuss. Regulators seized the nation's sixth-biggest bank on a Thursday night — a departure from the customary Friday — and sold it to JPMorgan Chase for $1.9 billion.

The move wiped out WaMu's 56,000 shareholders of record and left bondholders nursing billions of dollars in losses. But the WaMu deal spared the federal deposit insurance fund and thus was, unlike so many federal actions over the past year, an unalloyed positive for taxpayers.

http://finance.yahoo.com/loans/article/107676/wamu-the-forgotten-bank-failure.html?mod=loans-home >

Today's must read article

One article showed up in my inbox today which is an excellent read. It has some solid information describing the differences between a Recession and a Depression mixed into the overview. Ray Dalio, founder of Bridgewater Associates and manager of what is now the world's biggest hedge fund, believes we are in the middle of a global depression.... or a 'D-process' as he calls it.

Inside the world's biggest hedge fund
http://biz.yahoo.com/hftn/090319/031809_okeefe_bridgewater_fortune.html?&.pf=retirement

"Most people, says Dalio, think that a depression is simply a really, really bad recession. But in reality, the two are distinct, naturally occurring events. A recession is a contraction in real GDP brought on by a central bank tightening monetary policy, usually to control inflation, and ends when the central bank eases. But a D-process occurs when an economy has an unsustainably high debt burden and monetary policy ceases to be effective, usually because interest rates are close to zero, and the central bank has no way to stimulate the economy. To compensate, the value of debt must be written down (risking deflation) or the central bank must print money (a trigger of inflation), or some combination of both."

The Math that Destroyed Wall Street...... and Main Street

Wired magazine recently presented a good article about the underlying math which destroyed Wall Street.

Recipe for Disaster: The Formula That Killed Wall Street

Page 3 actually outlines the basic math of the Copula Function approach which underlies the CDO market.

Important: Funds over the FDIC limit at WaMu

If there is one post to sit up and pay attention to this month - This is the post.

Get your funds over the FDIC limit out of WaMu now! There appears to be a run on the bank forming and one likely end-game will be the FDIC seizing the bank; similar to the situation with another large bank, IndyMac, recently.

Knowledgeable investors have been removing funds for several weeks and now the situation has caught the attention of the mainstream press. A recent report by Gimme Credit cited liquidity concerns with Washington Mutual.

"We won't use the phrase `run on the bank,' but we would be remiss if we did not observe that many creditors have quietly been pulling funds,'' wrote Shanley, based in Chicago. Their actions are "presenting an increasing funding challenge,'' she wrote.'

The bank disputes the findings stating that 7 billion cash infusion led by TPG Inc, cost reduction plans, and a lack of need for commercial paper will help Washington Mutual ride out the storm. Many analysts are skeptical. These restructuring actions are helpful but will not enable the bank to survive a crush of depositors withdrawing funds from an institution that is increasingly looking like a house of cards. Standard depositors are likely to follow the lead of savvy unsecured creditors over the upcoming weeks as more bad press continues.

The second day of WM stock in free-fall is a more telling sign about the challenges facing the institution. While some would state that withdrawing your funds over the FDIC limit does not help the stability of the bank, the other side of the coin states that why should your be out of your funds from a personal finance perspective because you did not take action in the early stages while the crisis was unfolding.

Crushing the American Family

Once in a while a cartoon comes along which really drives home a point. Despite political pundits waving their arms and claiming that we are not technically in a recession, the circumstances facing American families are so dire these proclamations are nearly meaningless.

The credit crunch, housing market, gas prices, job losses, and rising food costs have left consumers in a tough position. Families are having to cut back many activities and purchases simply to cover necessities - this is not good news for the two-thirds of the economy dependent on consumer spending.

Well for the good news - At least we are not technically in a recession!

Is Your Bank Next?

A slew of mainsteam press articles a month back stated that the credit crunch was over. Not so fast! As outlined in articles on HingeFire in May (see Is the Financial Crunch over?) the financial sector is ripe for continued turmoil.

The top headline news today outlined the shares of U.S. banks plummeting amid stability fears. Sizeable regional banks such as Wachovia, WaMu, and National City are near the top of the list that investors believe have the likelihood to fail.

‘"It's the cockroach theory. You don't just have one bank failure -- when you have a big bank go under, there's always more than one," said James Ellman, president of hedge fund Seacliff Capital, who is short some financial stocks.’

The failure of IndyMac in many ways was a standard run on a bank. Panicked depositors lined up outside the doors pulling out $100 million a day causing what regulators called the second-largest bank failure in U.S. history. It was clear to regulators, politicians, and investors that IndyMac was in trouble, leaving only the question of degree. This type on depositor driven panic could easily happen to other struggling regional-type banks.

'One woman leaned on the locked doors, pleading with an employee inside: "Please, please, I want to take out a portion." All she could do was read a two-page notice taped to the door.'

At some point the FDIC will not be able to handle the level of defaults. While the FDIC has staffed up expecting more failures, the federally sponsored insurance agency is primarily focused on merging banks in trouble. The FDIC does not have deep pockets to bail out a chain of sizeable cascading failures.

Regional banks are not the only concern. Fannie Mae and Freddie Mac are in deep trouble. To avoid total financial market panic, the White House administration has ask Congress this past weekend to approve a plan that would provide a credit line of some $300 billion to the troubled GSEs and buy their stock. The Fed passed measures to allow both Freddie Mac and Fannie Mae to borrow at its discount window. Clearly, the government's hand was forced by a $3 billion Freddie auction scheduled for today that would have revealed the extent of the disaster without government intervention.

Is your bank next?

Will you be lined up at the door of your local institution begging to get your money out while the door is slammed in your face?

This is a time to carefully evaluate the safety rating of your local bank where you have deposited your money. If the bank looks the least bit shaky then your should get your funds out before a wide-spread panic develops.

Who wants to buy Circuit City?

An earlier summary regarding Circuit City outlined how all of the vultures that have been sitting on the sideline would be drawn out once Blockbuster started bidding. It is time to either fish or cut bait for all other potential suitors.

An article from Reuters today stated that Circuit City has received buyout interest from several strategic and financial bidders. A sale is expected to be announced over the next month.

The only question at this point is how much the carcass of this poorly managed electronics retailer will go for? I believe that many long suffering stockholders will be sadly disappointed at the price.

Is Lehman Next?

Lehman Brothers has plunged over the past few days as Wall Street is speculating if it is the next Bear Stearns. The bank has fought these allegations with a string of press releases and appearances stating that it is properly capitalized and reducing debt. (Wait a minute, this sounds familiar – didn’t Bear do the same thing).

A string of major articles outlining Lehman’s woes has not helped the situation. The Wall Street Journal stating that the bank’s “balance-sheet troubles threaten to harm the wider financial system unless the bank takes decisive action”. The paper went on to say the firm will be forced to sell all or parts of itself to stay above water. Naturally this news has LEH stock targeting 52 week lows.

Lehman’s has not taken the press sitting down; it has come out swinging at parties that portray the bank in a negative light. At the top of the list is head fund chief, David Einhorn, who runs a $6 billion hedge fund called Greenlight Capital. (Lehman Battles an Insurgent Investor). He has been a vocal critic of Lehman’s and has profited on their pain by shorting the stock. According to most market watchers, “Mr. Einhorn instigated the latest dive in Lehman’s stock price two weeks ago when he encouraged other investors to short the stock at a large conference in New York”. He followed this up by agitating for a reduction in debt ratings for Lehman Brothers.

The firm is trying to portray Mr. Einhorn as a short-seller who is simply trying to pad is pocket by spreading negative news about Lehmans. Many on Wall Street simply point to the many times he has been correct in the past. In any account, the situation will play itself out over the next few weeks. It is unwise to underestimate the headwinds facing Lehman Brothers, their eroding mortgage portfolio represents a systemic risk not only to themselves but other Wall Street firms. The media is most likely right on target when stating that a merger is needed and the bank is at serious risk.

The question remains of how much LEH will sink below $31 in the next couple of months. Will the firm regain investor confidence or is it doomed for a big fall?

Wall Street’s Graveyard

Bear Stearns was not the first firm to implode and float belly up on Wall Street. Portfolio.com takes us through the colorful history of other firms that have gone kaput since 1970.

Greed and lack of risk control is not a new story. However the danger in the modern era is that many of the firms are built on a mountain of derivatives and the collapse of one can lead to a cascading failure of others. Increased regulation of the derivatives market is needed to prevent this type of event.

Venezuela: The slide continues

Hugo Chavez is still running amok in Venezuela. Despite voters rejecting a referendum giving the president sweeping power over the economy a mere few months ago, Chavez has taken steps over the past weeks to seize more businesses.

Chavez is driving the take-over of Sidor, a large, Argentine-controlled steel maker; cement companies owned by Mexican, Swiss and French investors; more than 30 sugar plantations; a large dairy products company; and a sprawling cattle estate on the southern plains…and these firms are just a component of overall list.

As expected these moves have spooked foreign investors and infuriated neighboring countries (whose public companies own many of the assets). The compensation offered by the Venezuelan for these companies is under 20 cents on the dollar. Foreign investment in Venezuela has hit record lows, with only $500 million investing in 2007 as Chavez nationalized electric, telephone, and oil companies.

All this socialist exploitation has tanked the Venezuelan economy, which is now beset with foot shortages, building supply problems, and a lack of many other staples. At a time where many other South American economies are booming, the Venezuelan bolivar currency is in free-fall with the black-market rate climbing over 20% in the past couple of months to 3.4 per dollar. The government moves to prop up the currency have failed miserably. One can only expect that the name-sake of the currency, Simon Bolivar would have been shocked at government policies that are so destructive to the people, if he was alive today.

Only high oil prices are propping up the centralized economy of the nation. Of course this is only a short-term situation because oil production is drastically declining at the oil wells seized by the government. The entire government house of cards will fold as oil prices or production fall, further illuminating the reality of why centralized economies do not work. It is one thing to have social programs in countries that aid the poor, homeless, aged, and disadvantaged; it is another thing entirely to seize companies that your entire productive economy is built upon.

Looking ahead one can only expect further unrest and economic turmoil in Venezuela. This situation is unfortunate since the country is rich in natural resources and formerly endowed with a rising economy prior Mr. Chavez’s administration.

Chávez Seizes Greater Economic Power

Tax Cut leads to surge in Chinese Indexes

Attempting to tackle a sharp decline in the indexes over the past months, the Chinese government reduced the tax on equity trading. In response the Shanghai Composite index surged 9.3% - an increase that is almost certainly temporary. The broader issues with lofty valuations, lack of transparency, and macro-economic issues driving the fortunes of companies in Asia remain unaddressed by this regulatory action.

Investors were delighted with the government action; however it did not boost the long term confidence in the stock market for most individuals. Smart investors will take advantage of the surge to exit their positions over the next week. Slower earnings growth and higher costs do not bode well for company results in upcoming quarters.

“The government is clearly concerned about the meltdown,'' said James Liu, Shanghai-based deputy chief investment officer at APS Asset Management, which oversees $1 billion. ``It's positive for the market in the short run.''

The primary words to focus on are “short run”. Simply reducing the stamp duty on stock trading to 0.1 percent from 0.3 percent will not eliminate the headwinds facing the market, nor change the primary trend of the stock market which is down.

Despite the optimism expressed from financial pundits, the proclamations that this denotes the market bottom are likely to backfire within the next couple of weeks. Certainly the government is pleased with this cheerleading from the financial sector, because after all markets are in reality a confidence game.

Chinese stocks soar after tax reduction

Few analysts believe share prices will reach a new high this year, but many investors and analysts are hoping the worst is over. Hoping and reality normally run on diverging tracks.

Come Watch the Death of a Bond Insurer

This week the market gets front row seats in the death of a bond insurer. In February, the forebearance for ACA Capital Holdings was extended to April 23rd. This date approaches in a couple of days and is unlikely to be extended. The outcome at this point is obvious according to most pundits, the complete implosion of the bond insurer.

The open question remains of what impact this event will have on the municipal bonds which are insured by ACA. In most cases, the expectation of the bond insurer failure is already priced into the munis. However this can not be a good sign for the jittery auction rate or municipal markets.

At minimum, mid-week will be the time to pull up a chair, grab a drink, and see how the entire situation with ACA unfolds. Will some firm magically step up and save the bond insurer? Will regulators from New York State step in? The flak from the implosion splatter across the Wall Street landscape? Will it give CNBC something to talk about instead of the mediocre first quarter earnings?

One recent BusinessWeek article outlines how Wall Street used ACA to hid loads of subprime risk with the eventual unintended consequence of sinking the entire business, including the bond insurance operations.

An associated story outlines the failure of S&P, the only credit-rating agency to follow ACA, to properly cut the companies rating in a timely manner. On December 19th, the rating agency cut ACA’s grade from A down to CCC overnight; immediately turning gems into junk.

Chinese markets plunge 50% in six months

Earlier HingeFire articles outlined the risk of the Chinese stock market (see The Plunge Continues – China, Shanghai Index Double Top, ETFs to short China) and the probability of the bubble would implode. A summary from early April outlined the rapid deflation of the Chinese indexes. In the past week, the Shanghai index dropped another 11%.

The deteriorating situation has caught the eye of the mainstream press. The WSJ outlines the 50% fall of the Chinese market in a mere six months as a front page article. With the P/E ratio of the composite Shanghai index still at a frothy 35, the market still has plenty of downside. To reach a nominal P/E of 20, the index would slide to 1700; a 72% crash from the Shanghai market peak. A situation that is very reminiscent of the NASDAQ in 2002.

What is that sound? It’s the market bubble bursting in China

Previous Hingefire articles in 2007 outlined the increasing risk in Chinese stock markets and how the Chinese indexes were not strongly correlated with other world markets. The Plunge Continues – China in June 2007 warned of the risk that the Chinese markets were in a bubble and it was just a matter of time till they burst. The lack of correlation to the world markets was discussed in August. A HingeFire article in November recommended ETFs to short the Chinese market.

Fast-forward the clock to April of 2008, the Chinese stock market has become the world’s leading example of a bursting bubble. The Shanghai composite index has plunged 45 percent from its high, reached in October 2007. While markets world-wide have been down since this time, other major world indexes have all dropped less than 20% in the same time period.

The frenzy that surrounded the upside of the market in China has now dissipated leaving many investors angry and demanding that the government take action. A good number of the speculators lost their entire savings. Many have learned a harsh lesson in how quickly a bubble bursts.

To See a Stock Market Bubble Bursting, Look at Shanghai

“Look,” he said, “it took two years to go from 1,000 to 6,000 but two months to go from 6,000 to 3,500.”

Enjoy the Haircut

The Muni Auction Rate market continues to decline. Firms have been scrambling for a solution, but so far none has appeared. The next step is to ask for a Federal government bailout to put liquidity back into the muni auction rate market. If Bear Stearns can effectively be bailed-out for $30B then how about a few billion for the auction rate market?

If this trend continues soon the Fed will be providing liquidity in every sector to hold off financial calamity. This brings up an image of a carter greasing the wheels of the wagon to keep it moving, while in actuality the entire wagon is collapsing without him noticing.

Earlier HingeFire articles discussed the Auction Rate fiasco (see More Credit Turmoil: The Muni Auction Rate market freezes and Auction Rate Stress Continues: Muni Bond Funds Impacted). Today UBS placed a stake in the heart of customers holding auction rate securities when the firm marked these securities to market giving many holdings a 20% haircut. Customers had been told previously that these securities could not be sold at the regularly scheduled auctions but they retained full value.

So much for integrity in the markets, customers were sold these investments by brokers who promised they were a safe alternative to cash offering a slightly higher yield. This markdown of auction rate securities is expected to spread to other Wall Street firms this coming week, leaving a trail of furious wealthy investors in its wake.

Consumer Confidence Expectations hits the lowest level since 1973

The Consumer Confidence Expectations measure by the Conference Board dropped to 47.9 from 58.0. This is the lowest reading since 1973. Many will remember that 1974 was a very painful downside year for the U.S economy.

Consumer confidence crumpling proclaims the headlines in many papers across the U.S. today. The commentary from analysts adds a sense of despair to most of the press.

"Yes, weaker than in the last four downturns," BMO Capital Markets analyst Sal Guatieri said of the latest expectations number. "Ouch!"

Consumer confidence, he said, is "now buried deep in recession territory" and it is now "only a matter of time before personal consumption follows suit."

Of all the headwinds facing the economy -- faltering consumer confidence, which will drive a drop in retail sales representing two-thirds of the overall economy, is the largest threat. This has driven the federal government to take tax rebate measures to boost the consumer. However in an environment with a credit crunch, falling home prices, rising unemployment, high fuel prices, and increasing necessity costs --- it is not likely the government action can stop the downward spiral.

Weak Local Banks Retreating

Earlier HingeFire articles outlined the financial pressures facing weaker local banks as commercial real estate loans have soured. By no means is the crisis over, in fact the action over the past month is simply the start of the slide.

Building on a earlier article (see Local Banks: Time to Short) which outlined the threats facing these local institutions; the “Just how bad is the situation with local banks?” article presented a list of potential candidates to short. The difficulty in trading many of these stocks is that most are thinly traded and listed on the OTC.

Now that a month has passed, it is time to quickly re-visit these selections and evaluate their performance over the past four weeks.

Bank and one month performance (%)
------------------------------------------------------------
Friendly Hills Bank (FHLB.OB) -3.4%
Fresno First Bank (FSNF.OB) 0%
Folsom Lake Bank (FOLB.OB) 0%
Fremont General Corporation (FMT) -77%
Focus Business Bank (FCSB.OB) -14.3%
Discovery Bancorp (DVBC.OB) -23.3%
Desert Commercial Bank (DCBC.OB) -13.0%
Coronado First Bank (CDFB.OB) -0.5%
Cornerstone Commercial Bank (CRSB.OB) -2.7%
Commerce Bank Folsom (CBFM.OB) -10.0%
Bank of Santa Clarita (BSCA.OB) -2.7%
Charter Oak Bank (CHOB.OB) -10.5%
Bank of Napa (BNNP.OB) 14.3%
Atlantic Pacific Bank (APFB.OB) -13.5%
Americas United Bank (AUNB.OB) 4.3%
Marco Community Bank (MCBN.OB) -1.1%
Old Harbor Bank (OHBK.OB) -6.1%
Gold Canyon Bank (GCYO.OB) -0.8%

As a group these local banks have dropped an average of 8.9% in price over the past month; a time period in which the S&P500 has dropped 1.7% and the KBW Bank Index has declined 2.8%. This is a signficant under-performance for a set of stocks that are not normally volatile and is an example of generating excess alpha from proper stock selection on the short side of the market.

Some of the local banks suffered significant drops; long-suffering Fremont is down over 77% and Discovery Bancorp stock lost nearly a quarter of its value. Only two of the eighteen stocks rose in value.

In the opinion of most local banking analysts the pressure from faltering commercial real estate loans is only going to increase. The drop over the last month is probably just the starting point for the stock price demise for many financially weak banks.