"There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved."
- Ludwig von Mises

Wednesday, October 6, 2010

Dan Norcini Summarizes the Real Estate-CDO-Foreclosure Nightmare

From King World News, a summary of an upcoming interview with Dan Norcini and Jim Sinclair of Jim Sinclair's Mineset blog emphasis mine:

Dan Norcini:

“Where we are at on the charts with regards to the precious metals is that they are blowing through resistance levels like they are not even there.  If we can clear $23 on silver, there isn’t much resistance until $25 and if silver plows through $25, then you have a realistic possibility of it running up to $35.”

Because we are at new highs in nominal terms on gold, we can’t go back and reference charts so we are projecting levels.  The next technical resistance is at $1,380 with light selling possible at $1,350.

The primary drivers in gold and silver today had to do with concerns over currency devaluation as well as securitized debt problems and the implications associated with it.  Here is what Jim Sinclair had to say:

Jim Sinclair:  “Each time that happens an item of collateral on the securitized debt publicly dies. That is why this is dynamite that people will realize very soon. This is one reason gold is up hard today.”

Norcini continues:

“That collateralized debt obligation is now effectively worthless because the collateral behind the debt can no longer be collected.  The banks cannot go and get it. 

Let’s say you have 10 mortgages at $1 million a piece, the sum total of those mortgages are $10 million.  So, the banks took the 10 mortgages and bundled them together into a collateralized debt obligation or CDO with a face value of $10 million.  

They then sold that new entity that they created to an investment group of some sort, a pension fund, hedge fund, etc. promising them a yield of let’s say 7%.  The sales pitch would emphasize the fact that this CDO was backed by real collateral.  In the event of loan defaults by the borrowers, the banks would tell the buyer of the CDO that the collateral behind the loan could be sold to recapture any potential losses on the part of the purchaser.  

Everything seemed to work fine until the defaults began and the foreclosure process kicked into high gear.  The foreclosure process has exposed fatal flaws in the system and the flaw is that the banks cannot prove clear ownership of the mortgage.  

Consequently, they are then barred from foreclosing on the property.  Because they can no longer foreclose on the properties, the CDO is now effectively worthless. 

The hedge funds and the pension funds cannot now sell these CDO’s on the open market, so how are they going to recover their original investment?  Perhaps you may say that won’t be a problem because these instruments were insured.  The problem is now the credit default swap or the insurance policy that was purchased to protect against default assumes that the insurer has the financial wherewithal or resources to make good on the claim.

If there were only a small number of these problem CDO’s this would not be an issue.  But as the number of the foreclosures continue to skyrocket, and more and more banks are prohibited from seizing the collateral behind the property, the sheer magnitude of the number of claims presented to the insurer will overwhelm their balance sheet.

In effect what you have is an insurance company which doesn’t have enough money to pay off the claims.  Compounding the problem is the fact that the CDO’s and credit default swaps related to these claims form a mass network of interdependence.  This then ripples through the entire system and creates a domino effect which can cause the failure of entities creating the next financial crisis.

Ultimately the Federal Reserve will be asked to step in and buy up the now worthless CDO’s and put those on its balance sheet.  In order to do this the Federal Reserve will have to engage in massive quantitative easing, taking onto its balance sheet the worthless CDO’s in exchange for  newly issued treasuries.

This of course will have a horrific effect on the US Dollar which is why gold and silver are heading much higher.

But keep in mind, this is just one threat of many the current financial system faces.  We have an ongoing currency war, Pension Fund shortfalls, sovereign and local government insolvencies, and high levels of unemployment that depress aggregate demand, but for government deficit spending.  It's extremely complicated and no one knows how all of these factors play against each other, and which will be the tipping point.  Or it could also drag out for years, with increasing "bandages" of debt monetization being "applied" by the Central Banks of the world.  So we have two issues here - weak economies, and weak currencies.  Keynesianism and Monetarism being applied to the extreme to ward off collapse, and in the end it will be Austrianism that will prevail, not because governments like gold, they HATE gold.  But because no government will trust another with anything else but the REAL thing after the system falls apart.  That's why Central Banks keep gold.

Unless of course, there is a global coordinated effort by the world powers to bring into the system the SDR and create through the IMF a global "bad bank" so to speak to sop up all the excess garbage in the system.  And even that seems like a stretch.  What surplus nation will go with a plan that gives the free rider deficit nations a way out?  And in a world of scarce resources no less?  And can all nations agree on the composition of a new currency - when they can't even agree to stop an existing currency war?

This blog will continue to closely follow IMF and G20 developments.  Because in the end, it is through those global institutions that a new system will emerge - whether through conflict or cooperation.  That is the big question.  Understanding history, and watching how nations interact today will give us a clue into the future.

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