Corruptio Optimi Pessima
By Jon Nadler
As mentioned this morning, gold prices were under the potential threat of an outside factor dragging them down to the important $915 support area. That market-moving factor turned out to be the combination of cause and effect fallout from rising US consumer confidence, a strengthening dollar and a fresh drop crude oil on the heels of waning demand. According to one seasoned trader (RBC's own George Gero, who just made it to the ranks of grandfathership) the "pullback in gold from early trading intensified as crude sold off, dollar improved, and the Dow improved accordingly. In addition, [gold] open interest [was] off 16,000 as contract rollovers are almost complete and the "not in the money" options were abandoned. August first notice day is almost here and funds traders reluctant to put up full money on long positions were now sellers as the appeal of gold waned."
Of course, if you were to visit various gold forums, you would once again hear that the yellow metal was the sacrificial lamb as sinister manipulative forces try to prop up Western civilization and its financial instruments. The reality is that thus far, the yellow metal has offered little more than a technical bounce after last week's significant drop and remains range-bound in the absence of larger-scale external market-moving developments. If there was one sacrificial animal today, well, it was oil - it revisited a 14-week low on the surging dollar and on irrefutable evidence of demand destruction in the US. This, despite 'sour grapes' laments/ rhetorical questions from Iran as to why Western nations can be allowed to possess nukes.
Demand destruction appears to have finally caught up with black gold as it was revealed that Americans drove 10 billion fewer collective miles in the month of May, and as gasoline use in the US coincidentally (not) declined for 13 weeks in a row. In yesterday's comment we alluded to oil lobbyists bearing gifts. Turns out such strange men bearing gifts come in large numbers. Today, longest-serving Republican Senator Ted Stevens of Alaska was indicted on seven criminal charges. Among the revelations was the fact that he is alleged to have accepted gifts valued at over a quarter million dollars from...oil services company. So says the DOJ. How the mighty have fallen. Corruption of the best is the worst of all.
A sharply rising US dollar (showing a gain of .76 @ 73.42 on the index) and a major decline in oil (off $3 cents @$121.72 a barrel) underscored the unfavourable conditions in commodities and the yellow metal sold off quite heavily during the majority of today's New York session. Some support was found near $912, in an augmented replay of Monday's action. Much of what little support was indeed found, was related to financial woes over at Merrill Lynch whose $5.7 billion writedowns and $19 billion of losses over the past year have CEO John Thain pedaling harder than anyone in the latest Tour de France to shore up the firm's credit ratings, capital position, and shareholder confidence/patience.
New York spot gold was last showing a $12.00 loss quoted at $918.00 as participants started to fret about the possibility of a sub $900 dip. Bullion futures closed at more than a one-month low. The metal needs to keep above the water line at $915 in order not to induce additional liquidations among position holders. The euro traded much lower at $1.55 but all is not well in Euroland as the contagion from the US housing market is showing all of the signs of a full replay over in another hitherto white-hot market: Spain.
The implosion in that country's formerly soaring real estate has become a headache of first order of magnitude for the ECB's Mr. Trichet. Anyone for (more) covered bonds? Silver fell 19 cents to $17.30 while the noble metals presented a continuing negative picture as platinum fell $21 to $1734 and palladium was off $6 at $381 per ounce. In the background, thousands of unsold SUVs are choking dealer lots and one look at the emerging Kelley Blue Book values was enough to give a firm like Chrysler the final push - they are out of the auto leasing business. How is that for a reality check?
Presidential candidate Mr. Obama met with leaders from the world of money yesterday in Washington as he tackles the economy's challenging issues following his overseas 'foreign policy preview' tour. Though the timing of events was coincidental, the release of a projected deficit of $482 billion for 2009 by the Bush bean counters will have the Democratic contender up at night not only as he chooses monetary and fiscal managers but also as he selects what policies to put into motion (tax hikes, economic stimuli, etc.). Good thing he works out at the gym daily. He will need it. He is next slated to meet with Messrs. Bernanke and Paulson for more mental workouts. Speaking of working out, here is an interesting twist on possibly ameliorating the mortgage situation that has gripped the US and is now spreading to Don Quixote land. Covered Bonds. The NY Times fills us in on a home debt concept that has been quite familiar in Europe for some time now...
"The financial establishment came together Monday in search of a new way for banks to come up with cash for home mortgages. Regulators, bankers and traders, led by Treasury Secretary Henry M. Paulson Jr., all pledged to do their best to get a “covered bond market” going in the United States.
"Covered" seems to be a synonym for collateralized, but it also has other meanings that may be appropriate in this effort to salvage the housing market. Think of covered wagons, which can be circled in times of crisis. With banks reluctant to lend their own money for mortgages, and the private securitization market quiescent if not dead, the cost of mortgage loans has been rising even as housing prices fall, making a bad situation worse. At best, a covered bond market would provide a cheaper source of financing for banks while reassuring investors that their money is safe.
Essentially investors would buy into a pool of mortgages that would be kept on the balance sheet of the bank that made the loans. These would be high-quality loans, and at the first sign of trouble in the underlying mortgages, those mortgages would be replaced in the mortgage pool. Thus, investors would be assured of repayment unless the underlying mortgages suffered major losses and the issuing bank failed. That might make investors burned by existing mortgage securities more willing to return to the market.
At best, a covered bond market would provide a cheaper source of financing for banks while reassuring investors that their money will be safe. It is highly unusual for the government to take such a major role in getting a market established, but Treasury officials said their action was needed to get more money into housing loans.
"We spoke to 50 or 60 market participants," a senior Treasury official said, speaking on condition of anonymity because he was not authorized to describe the process publicly. "It became clear that if we took the lead, we had a real chance to kick-start this market."
In Washington, Mr. Paulson said that "as we are all aware, the availability of affordable mortgage financing is essential to turning the corner on the current housing correction. He was joined by officials from the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Office of Thrift Supervision.
“We are at the early stages of what should be a promising path, where the nascent U.S. covered bond market can grow and provide a new source of mortgage financing," Mr. Paulson said. Four major banks — Bank of America, Citigroup, JPMorgan Chase and Wells Fargo — said they hoped to issue such bonds, and a larger group of investment banks and brokerage firms pledged to establish desks to trade the securities.
What remains to be seen is if there will be buyers. Mr. Paulson said the bonds appeared to be attractive to major banks, which would be able to pledge them to obtain loans from the Fed, and to some institutional investors. The F.D.I.C., which takes over failed banks, promised to respect the terms of the bonds, so that bondholders would be repaid from the value of the mortgages, even if other bondholders in the failed bank suffered major losses.
Covered bond markets exist in many European countries. In some of them, laws make the legal standing of such bonds clear, but Mr. Paulson and the other agencies concluded that no legislation was needed, and that policy statements by regulators would suffice. It is expected that Bank of America will be the first issuer. Bank of America has issued such bonds in Europe, and did one $2 billion American offering of covered bonds in June 2007, before antipathy to mortgage securities intensified.
The covered bond markets in some European countries have suffered to some extent from house price declines, but the markets have not closed down as the private-label securitization market has in this country. In the United States, those securities were backed by mortgages that were not guaranteed by either the federal government or by Fannie Mae and Freddie Mac, the two government-sponsored housing finance enterprises. Fannie and Freddie became the principal buyer of mortgages after the private securitization market closed down, but their own financial health has deteriorated, and provisions for their own bailout, if necessary, are pending. In normal times, an American covered bond market would bear little resemblance to traditional mortgage securitizations, in which the investors are paid from the interest and principal payments on underlying mortgages (and thus suffer all the risks involved in such loans).
Instead, a bank that issued such bonds could do so on any terms it and investors agreed on. The bond payments would come from general corporate funds, and would not have to be tied to terms of the mortgages. Under a set of "best practices" issued by the Treasury and rules issued by the F.D.I.C., the bonds could have maturities from one year to 30 years. The mortgages securing them would be of high quality, and for no more than 80 percent of the home’s market value. That market value would be adjusted according to regional trends in home prices; if home prices declined, mortgages covering those homes might have to be replaced in the pool.
Any mortgage on which payments were at least 60 days overdue would also have to be replaced, so at least in theory the pool would always include good loans, and their value would have to total at least 105 percent of the outstanding bonds. The mortgages would remain on the books of the bank that issued them, and the bank would stand to lose if the loans went bad. That was not the case in recent years when mortgages were sold to securitization pools. That led to an erosion of lending standards because the lender profited when the loan was made and sold, whether or not it was eventually repaid.
For the covered bond market to become a major source of mortgage money in the United States, investors will have to be willing to buy the bonds, accepting interest rates at least a little lower than the banks could get by borrowing money directly. The banks also will to need to be comfortable in making mortgage loans that they will keep on their balance sheets, tying up capital. In past decades, banks took for granted that they would do that. But in recent years fewer loans were kept on balance sheets. They were sold off as mortgage-backed securities, freeing up capital and enabling the banks to report higher profits.
Many of the risks of those mortgages stayed in the banking system, however, as banks kept some of the securities they issued or bought from other banks. That led to multibillion-dollar losses, which have made it harder for some banks to raise money and have made virtually all banks less willing to make mortgage loans. The covered loan market could bring in cash for mortgages, if both the banks and the investors are willing to cooperate. Those are not exactly sure things. "There’s not 100 percent certainty that it ever will become very significant," Mr. Paulson said.
Sector rotation out of commodities and into whatever bargains may abound in other sectors (the Dow was ahead 210 at last check) continues to manifest itself as the summer rolls on. We cautioned about the dollar. This time, it rose without jawboning, on a bad day for Merrill. Not a sign to take lightly. Something is clicking. Or, could it be...ticking?
