30x Leverage from the FHA

A scary paper was recently made available to the public by Joseph Gyourko from Wharton about the sad state of affairs at the Federal Housing Administration (FHA). The organization has been rapidly increasing it's risk profile as it insures mortgages to borrowers many of whom normally would have a tough time getting a standard mortgage. Many of these borrowers are highly leveraged under this program. Getting some tax money back next year? You can get the FHA to insure your mortgage with a downpayment as low as 3.5% (roughly 30x leverage).   Some people can even use future tax refunds as collateral and put no downpayment at all.

The FHA has been rapidly growing its portfolio as more borrowers end up needing their help in obtaining a mortgage. At the same time the payouts on the insurance "claims" have been rising, depleting FHA's capital. The graph below shows the amount of insurance on mortgages the FHA has outstanding per dollar of capital they hold (based on Gyourko's paper).  This is effectively the organization's risk profile.
 

Rather than requesting that Congress strengthen its capital resources as the housing bust deepened, FHA decided to pursue a strategy of growing out of its problems beginning in 2008. Aggregate insurance-in-force more than tripled since then, from $305 billion at the end of the 2007 fiscal year to just over $1 trillion according to the latest data available from July 2011.

Gyourko had suggested that the agency will ultimately need a capital injection from the US Treasury of $50 - $100 billion to cover future payouts.

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Sectoral financial balances and the 2012 US elections

Guest post: PonziFinance
 

As 2012 election season is on us, Republicans of all sorts keep harping on the need for government to reduce spending (at the very extreme Ron Paul would eliminate $1 trillion in fiscal spending!) in order to “balance the country’s budget”.

What is not understood (even by trained economists and strategists and investors) is an accounting identity that follows from basic double entry book keeping (invented in the 14^th century AD and the basis for all book keeping in the world now), which rearranged states the following:

(I-S) + (G-T) + (X-M) = 0 where I = Investment, S = Savings, G = Government Spending, T = Taxes, X = Exports, M = Imports

Said another way, domestic private sector balances (I-S), government balances (G-T) and foreign sector balance (X-M) cannot all be positive. Indeed, if the US private sector (households and businesses) want to save, as they are doing so now under the burden of overleveraged balance sheets, and the US almost always runs a current account deficit (as the largest importer of goods and services in the world, also as a direct function of having the world’s reserve currency but that’s a topic for another day), the ONLY way for accounting identity to hold is that the government MUST run a deficit to accommodate this requirement.

Looking at the attached chart for the US over the past 60 years confirms this (watch the changes prior to and after 2008 carefully). Over time, we will look at other conditions and constraints that are attached to this basic accounting identity (before you ask, no, the US government cannot run deficits into eternity without other consequences!).

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Rupee's Recent Correction

Indian Rupee continues to weaken to post-08 lows.

USD/INR (source Bloomberg)

There seem to be a number of explanations beyond the Europe-driven macro stress. India's current account deficit of some $150 billion/year, convertibility issues, and RBI's lack of appetite to raise rates above the already high levels seem to be some of the reasons. There is also some speculation that this devaluation is meant to stimulate growth by giving a boost to the exporters. Indian papers provide generic explanations:

Sustained dollar demand from banks and importers in view of the higher dollar in the New York market mainly affected the rupee value against the American currency, a dealer said.

Really? The danger here is that this devaluation will exacerbate India's already high inflation, particularly given the recent run-up in fuel prices. India is an economic powerhouse, and a significant slowdown there will have global implications.

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Europe's Unsustainable Markets

The situation in Europe feels unsustainable. The volatility comes and goes in waves, and each consecutive wave is worse than the previous. This morning Spain had a fairly bad bill auction (felt like Spanish banks ended up buying most of the paper) and European government bonds started unraveling. Spanish and Belgian bond spreads (to Bunds) hit new records. The most troubling is the selloff in French bonds. This is no longer the "fringe" of Europe, but the core. Below is the spread for 5-year French bonds - a new record.

Source: Bloomberg 

Simultaneously the interbank lending indicators continue to show stress. Below is a chart of the 2-year EUR Swap Spreads. We are now at levels not seen since late 2008.

Source: Bloomberg 

As scary as Europe looks, the US may be following a different path. More on that later on.

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A Tale of Two Forecasts

Let’s take a quick look at the probability of a US recession in 2012. Here are forecasts from two sources that have little to do with one another. The first one comes from the FRBSF Economic Letter (the San Francisco Fed). Using a set of leading economic indicators (LEI) they put the probability of a recession close to 55% at the peak this coming January. 

"The combination of these two recession coins, shown in the combined risks line of Figure 2, is quite disconcerting. It indicates that the odds are greater than 50% that we will experience a recession sometime early in 2012."

Source: FRBSF

That’s in two months!

The competition for the Fed's forecasting prowess is Intrade, the event betting site. Its a market implied probability of a recession in 2012, forecasting 38% probability. 

In the past one could observe the LIBOR futures curve dipping down or the inverted treasury curve as market implied evidence of an impending economic downturn. These days the Fed is keeping short-term rates near zero and is “twisting” the treasury curve. Thus these markets no longer function as an indicator, and something like Intrade becomes one of the few remaining market based forecast tools. One may argue that those betting just don’t know what they are doing. If that is so, go ahead and bet against them.

So who is right? We should know within a few months.


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The Big Picture (aka the dollar as the key indicator)

Guest post: PonziFinance

It is the author’s firm view that currencies, especially the $ hold the key to all risk assets. It wasn’t always like this as the attached chart of the trade weighted dollar index (DXY) versus S&P 500 index (SPX) shows. DXY (as a proxy for the US Dollar) USD and S&P 500 moved in tandem from 1994 to about 2003 as the country’s fortunes rose and fell in sync with underlying rise and fall in economic growth and productivity. Following the 2002 NASDAQ (and stock market) crash, the Fed began engineering what I view as a “fake” recovery based on proactively weakening the US Dollar. This helped hide the underlying structural stagnation by building the foundations for a debt fueled recovery. As this process came to a head in the subprime debacle in 2008, the dollar rallied hard as risk assets crashed.

Since then, the Fed has tried to engineer the same “fake” recovery by printing countless trillions that have buoyed all risk assets since the “recovery” began in March 2009. It is my view that this is yet another “fake” recovery and therefore unsustainable. This theme will stay with us throughout my posts as we explore the ramifications of a weak $ recovery that the Fed tries to engineer (yet again!).

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Trouble for Republicans?

Looks like Republicans may be in trouble for 2012 presidential bid.  Intrade, the Irish betting site has Obama above 51% odds of victory with an upward trend.   Seems the Republican presidential debates and the “personalities” lineup didn’t help much.  There is also some evidence the Democrats' performance (probability) is correlated to the equity markets.  But more on that later.

When people bet money on a candidate, they are not saying this is who they would vote for, but who is more likely to win.  That makes this process a better predictor than traditional polling.

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Sober Look is Back

After a two-year hiatus, we are going to fire up the old Sober Look again. The goal this time around is to have less frequent postings but with more than one contributor. With all the macro fun that’s been shaking up the financial markets and all the hype that surrounds it, the time is right.

We start off with a simple chart of the USD 2-year swap spread. For those who are not familiar with the term, it’s the fixed rate on the current 2-year fixed-for-floating swap vs. the yield on a 2-year treasury note. This is basically the expectation of future LIBOR spread to treasuries. Today we’ve hit a new recent high, indicating concern about the health of the interbank lending markets. This is one of the key indicators of stress in the overall financial system. 47bp is no big deal relative to 08, but it’s something to watch closely.

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