After a big waterfall in the stock prices of Fannie Mae and Freddie Mac, Paulson and Bernanke have taken actions and made announcement before Asia’s opening. They are obviously determined to stop the crisis in confidence to spread further. I think they probably will succeed temporarily.

The markets are due for a rebound, and the rally can be very sharp. Most market participants may think that this is going to be another March low event earlier in the year. However, I beg to differ. I think this rally will last even shorter than the last one, and the eventual fall may be even worse. With the earning season upon us, I cannot see any good to come out of it, until we are all through the worst news.

As I’ve warned last Friday that this coming week is option expiration week. Markets will probably be extra volatile, and I believe the direction will be up. I will probably start covering my out-of-money naked calls, since it’s likely that they may become in-the-money with a strong rally.

But aside from the trading frenzy, remember to keep things in perspective: Indymac (IMB) has just gone under. Downey (DSL) and many others are right behind. Reset of the ARM mortgages is starting in drove, with 300,000 loans to be adjusted. The current state of financial companies is dire. We have 6 months of job losses. State and cities are cutting budget (and jobs and less money for contractors) across the board due to lower property, income, and sales taxes collected. Things are negative, and they won’t turn sunny in a dime. The recovery will take time. In the meantime, one is probably better off staying on the sideline, or just go fishing!

I have been expecting markets to rally towards next week. However, it has been much weaker than I expected. Nevertheless, I see some underlying strength in this market, and therefore I will not short more, but only after July 22nd. The strength is with FNM/FRE falling like crazy, the market is not suffering an outright collapse. I still expect the rally to be short-lived (no more than 2 weeks). And I don’t expect the down wave to be all done until DOW breaks 11000 (preferably going to 10000), and NASDAQ to go towards 2000, and S&P going to 1100 initially (preferably to 1000). That’s your 20% loss right there. After that, maybe markets can get an intermediate term rally. Certainly the next intermediate high will be lower than most would have hoped. So low that majority of them will not sell out in time, and then get all chopped up going towards 2011 “final” initial bottom.

In any case, if markets continue to collapse today, then a rally towards next Friday probably will not happen.

Good luck in trading.

Frugal

Using the data taken from Mish’s article:

The tranche breakdown shows total deal size. Total size is 519.159M, “A” Tranches are 476.069M total, “M” Tranches are 30.112M total, “B” tranches 7.788M total and “C” tranche is 5.19M total.

As of today, tranches A1 through A5 are all still rated AAA . Those 5 tranches constitute $476.069M out of an original pool size of 519.159M. In other words, 91.7% of this entire mess is still rated AAA even though REOs are now up to a whopping 10.48% and 60 day delinquencies are 32.69%. Moody’s and the S&P should be embarrassed by this.

The following is just an estimate based on my understanding and guesses on the bond markets: Based on my observation from going to home auctions, REOs are being sold at prices of about 50% to 75% previously valued. Let me use an average of 60% from previously valued after all the fees and expenses, and that’s only assuming 5% or less are fraudulent loans where the property values can be just 10% to 30% of the loan. Assuming that the average loan-to-value LTV ratio was 92.5%, midway between 5% and 10% down payment, the loss on the loans for REO will be (92.5% – 60% recovered)/(92.5%) = 35% loss. Furthermore, it’s probably safe to assume that 90% of those 60 day delinquencies will go into REO. Assuming the rest of the loan do perform, you will be looking at a total loss of 32.69% * 90% * 35% + 10.48% * 35% = 14% of the principal. Let’s say the average interest rate is 6%. The performing loans are 100% – 32.69% * 90% – 10.48% = 60%. With 60% earning 6% divided for all the A tranches (476.069M/519.159M = 91.7%), the A tranches will only be getting an average of 3.9% interest instead of maybe 5.5% that they “deserve”. To get back to 5.5% yield on a 30-year mortgage bond for the same absolute cash flow, the bond prices must fall by about = (1.039^30/1.055^30) or to 63% of its original value. Of course, that does not include any future decrease on the cashflow. Obviously, when all of those REOs are recovered at 60%, the bottom tranches will experience 100% loss. It will wipe out 100% of all the non-A tranches, and more. A tranches will on the average experience a (91.7%-(100%-14%)) / 91.7% = 6.2% loss. Therefore, that will be a 6.2% forced principal loss, and a (100%-63%)=37% marked-to-market loss. Yeah, and that’s for the terrific AAA mortgage bonds that you buy into.

Here is price chart for a AAA bond maturing in 2038 (30 years) from the ABX-HE-AAA 07-2 series at MarkIt.com. It already has a loss of (70-45)/70=36% since this January 2008.

Very unfortunately, real estates will get worse, not better. I expect that these AAA bonds to experience a horrendous loss, something that if you ever put your retirement money into such “fixed income” investment, you would want to forget about it, and will vow to never buy a single US dollar again in your now shorten retirement life and a shorten lifetime possibly due to the financial stress.

I don’t know who else is holding all these losses besides banks. But eventually someone will find out and puke, and will come back and sue all the credit rating agency and bankers for jail time. Even then, it won’t give you back the lost paper money. Don’t let AAA cheat you out of your retirement. Protect your nest egg carefully. For the first time in history, you could be beter off investing your money in stock markets, rather than “fixed income” in a bear market. And where on Earth and when in human history can someone buy a highly rated bond and experience such a big loss? That is USA under Greenspan & Bernanke’s realm.

The big news this week is obviously the selling panic in the two GSEs (government sponsored enterprise): FNM (Fannie Mae) and FRE (Freddie Mac). The two companies together hold about 3.7 trillions of home mortgage. With increasing defaults on mortgages, sub-prime or prime, the total loss can easily exceed all of their capital reserve for the companies. According to a few GSE watchers, the net worth of FNM and FRE could eventually be negative (if not already).

Markets participants have always assumed that US government will bail out GSE. But since the mortgage portfolio at GSE is in the same order of magnitude as the total debt owed by US government, such actions may easily double the level of current US debt. A big increase in the US debt, I believe, will translate into a lower $US. And a lower $US will probably kick the existing high inflation into the next high gear. Gold in that case should soar.

Of course, this “efficient” but extremely short-sighted market has demonstrated through the subprime mortgage crisis that the market does NOT think ahead much. The initial process of price discovery is quite slow (until lately). Such “gradual” market reaction will mean that being multiple steps ahead of the market will not be immediately rewarded. In fact, with GSE going down, and the stock markets going down, US dollar tends to rise initially like what is happening now. US dollar have just bounced off the support, and may be heading higher in the short term. However, it gives plenty of time for people to heed the cautions and make preparation on what may come to pass.

With more banks and investment firms trying to find the final last fool to take on their toxic mortgages, while GSEs continue to happily loosen their underwriting standards with a low down payment (3% now in some cases), it is only time that separates the GSEs away from a devastation. There are many other reasons why $US will head lower in the longer term. But whether GSEs are bailed out by taxpayers or not, $US should go lower either due to the increase in the total debt, or through selling of GSE debts (in the case of no bailouts). Either case, the loss of confidence in US financial systems is becoming the reality.

Disclosure: shorting markets through combinations of selling/buying calls/puts on IAI, SKF, QID, SDS.

The way IndyMac bank and probably other banks going out of business is unthinkable just one year ago. IndyMac just cuts its staff in half. And it will continue to cut branches and staffs until all money runs out. The bank will simply disappear into nothingness, thanks to all the losses that it ran up in the housing bubble and lending insanity.

And I’m guessing that this will be true or has been true for Downey (DSL), Fremont (FMT), PMI Group (PMI), FirstFed (FED), General Motor (GM), Ambac (ABK), MBIA (MBI), and many others, and potentially for Washington Mutual (WM), FNM (Fannie Mae) and FRE (Freddie Mac) too. For the most part, the enterprise values for those companies are or will be zero, even before the housing market hits the bottom. For the other stronger companies, they will need a hell of some capital because once the housing market hits bottom, it won’t have any significant bounce for quite a long time. Translation: they will need to hold onto the losing mortgages on their book for quite a long time and continue to take losses.

It’s kind of sad and terrible for those workers at these failing banks, and the real estate owners who lease to the banks. Their workplace will be empty, and probably will stay empty. I seriously don’t know what other businesses will take their place, especially with Starbucks closing 600 stores, and many other retailers to follow, and/or fail. The losses from the housing bubble were just too big. And the banks only have themselves to be blamed. Why in the hell did they want to give (lend) out the money to the home-”renters” who can never pay it back? Money and profits were only based upon a frothy valuation that can never be sustained. Once the home valuation re-adjust, the banks are going out of business in drove.

It’s not Friday yet, on which day FDIC usually shutdown the banks. Better clean out your secure deposit boxes before your local branch disappears. Stick with the strongest bank for now: Citibank, Bank of America, Wells Fargo Bank, Bank of New York, etc. Eventually, the stronger banks may be so weak that you may want to move your money to treasury bonds and/or precious metals.

Looking through charts of financial companies, it’s almost like the dot com replay, with many companies going out of business. But dot com reinvent itself thru Web 2.0. I doubt that extremely few of these financial companies can come out bigger and better, simply because the decrease in the financial leverages directly translates into lower profit margins for banks and brokerage houses.

As I have blogged previously on high dividend stocks (up to 18% yield), you should never invest in a stock only because of its high yields. I excluded financial companies from my dividend stock lists back in 2006 for the now obvious reasons that they are totally scary. Now many of these financials are yielding 8% to 12%, but I still won’t touch them s for the near and intermediate term. Yes, each counter rally will be huge, if you can trade it. But what good will it do to your portfolio, if its long term value is going down and possibly way down from the current level?

I have always thought that Honda has pretty good mpg. But I’m getting about 16 mpg combined on city/highway on my Honda Odyssey. That is quite different from the statements on invoice: 18 in city, and 25 on highway. That just seems awfully low.

I have always driven Toyota, and this is my first Honda car. My mpg experiences with Toyota is much better. The actual mpg comes out to be so much closer to the invoice sticker. My next car will definitely go back to Toyota.

That brings my attention to Toyota’s Prius. According to a UK AutoExpress report, the next Prius will offer 94 mpg!! That is double of the current 45 mpg. At 94 mpg, even if it costs $10 a gallon, you will only spend 11 cents every mile. That is CHEAP. Okay, even at 45 mpg, it is 3 times better than my Odyssey. At $5 a gallon, the difference between 45 mpg and 15 mpg for 7500 miles is about $1700 every year. In 3 years, you can save $5K on gas, and in 6 years, you can save $10K on gas. That’s about 40% to 50% of the cost of a car.

It’s slightly harder to justify between a 25 mpg on my camry and 45 mpg on a Prius, when you have made your investment in the car already. But if Prius does come out with 94 mpg, I’m just going to grab one if I can, and dump my old car. Unfortunately, I think the waiting list will be really long, given a high gasoline price and long commute distance in California.

Today is a holiday and it’s a long weekend. I wish everyone have a nice break.

Regards,

Frugal

The recent big moves by precious metals after US decided to stand pat was more than amazing. Some mining stocks went straight up by 20% in two days. Such is the volatility and the nature of the precious metal investments.

The effect after US Fed meeting was that US dollar was lower, which sent both euros and gold to go up. This Thursday, it is widely expected that ECB is going to raise rate by a quarter point. The question that few are asking is that what if it doesn’t. I think if there is a surprise, it may be a really big one.

European countries are certainly right now are quite split on the new euro with an unfied monetary policy. Many countries, for example, Spain, are suffering the same housing bust in the United States. Others are experiencing more economic slowdown, and cannot afford more tightening. The inflation hawks in ECB so far however have been just talks (like the counter-parties in USA). It’s obvious however that if there is no rate raising on Thursday, this ECB is going to lose its precious credibility.

I’m not going to venture to bet on an otherwise outcome of no rate raising. Based on the levels of the currency markets, with Euro going up much higher after US Fed stood pat, most bets seemed to be on a ECB rate raise. A lower dollar has been very good to precious metal-related investment. However, if ECB doesn’t raise rate, I think it’s probably going to lit up fire in the precious metal complex. When one of the most hawkish major central banks stopped at the real actions, who else is going to put a lid on the inflation, and therefore on the gold price?

Gold currently is trading near its next resistance level at around $950. A break through here will certainly be huge. I personally believe that the likelihood of that the precious metal correction is already over is quite high, possibly in the 75+%. Both the time duration and the magnitude of the HUI correction has been about 50% of the seven month rally since last August. My biggest worry has been a sharp pullback in crude oil, pulling down precious metals together. However, it looks like gold is ready to move up already. And there is no sign of a lower crude oil, which is still in its Elliot wave 3 of 3. The Elliot wave 3 of 3 could be anytime now for precious metals. I highly recommend buying if any dips come along.

Disclosure: I own lots of precious metal and mining stocks.

From about 1980 to 2000, global economy (especially US) enjoyed unprecendented steady growth without the inflationary pain that often comes with it. There were three primary trends:
1. Technology advancement has lowered real costs associated with production of goods and services.
2. International trades and globalization faciliated capitalism to find the lowest cost structure through a combination of variables in global wage arbitrage, tax, and transportation costs.
3. Just-in-time inventory systems through information technologies have reduced the inventory needs to the lowest level required.
4. Inflationary effects from monetary and fiscal policy are negligible when it is averaged on a global economy that has increasing number of low wage work forces without much end-user demands for basic commodities in third world countries.

Everything was all good, but all good things have an end. Going forward, I believe the following factors and trends will increasingly shape the global economic landscapes:
1. Technology advancement is hard-pressed to lower most of the real costs for goods and services in a significant way (let’s say 10+% improvement on an inflation-adjusted, annualized basis, and weighted by its monetary contribution). In another words, the fruits left are the low-hanging fruits.
2. International trades and globalization only work in a low transportation cost environment. High energy prices may reverse the gear on globalization into de-globalization. High inflation will also cause higher trade barriers for crucial commodities.
3. Just-in-time inventory is causing and and will continue to cause extremely high price volatility for prices of commodities and goods. From a mathematical point of view, a feedback system with less buferring capabilities is usually less stable than the one with more
buffers. The buffers act as a low-pass smoothing system to smooth out the magnitude of changes from the input to the output. Using laymen’s terms, a low inventory system speeds up the the price changes from the input to the output. Furthermore, it excerbates the volatility in capitalism which hinges on the real-time dynamic balances between supplies and demands.
4. Rising living standards in third world countries put the capitalism to test. Yes, the textbook is correct in stating that increase in money circulation will result in higher inflation. The statement applies in a closed economic system. US domestic inflation is continued to be held down via global trades for now temporarily. However, increase in US money supplies have been “sterilized” by foreign governments via printing of their own currency and buying up of US debts. The end result is that the labor workforce of Asian and Middle-Eastern countries are not enjoying the fruits of their hard work through an appreciated currency to bring a higher living standard. Rather, the labor are suffering the majority of the inflationary effects from the US, while the businessman pockets loads of money primarily not through a more efficient company, but through a wage arbitrage mechanism due to the currency exchange rates held down by foreign governments.
5. An aging demographics is going to exert its inflationary effects on mature economies. Less active labor and more demands for services from elders is the formula to drive wage inflation, if all other factors hold the same.

Whether my observation and interpretation on global economy is correct or not, it is always important to understand the past on how we came to where we are, in order to project the future and find where we may be going. What was achieved from 1980 to 2000 may not be achievable anymore. It’s easy to say that human innovation always triumphs. But unbounded optimism is best to check against with realities once in awhile.