Enzio's Clock

Background

1. Extent and Timing of the Bungee Jump

An extremely supportive client in Texas sent me a fabulous article by F. William Engdahl (www.engdahl.oilgeopolitics.net) of 25^th November 2007. I do not have its title, except that it alludes to “Deutsche Bank Shock”, so do visit Mr. Engdahl’s useful website! Praise where praise is due.

What follows is perhaps old news to our U.S. subscribers. But perhaps not to our non – U.S. subscribers. I openly cite Mr. Engdahl’s erudite comments, hoping to add value of my own to them. Here we go.

Extent of collateral damage

First of all, let’s get an idea of what is going on in America’s sub–prime jungle. What follows is a road map of what Mr. Engdahl discusses:

a) Big banks like Citi or Deutsche Bank buy reams of mortgages from local lenders;

b) Thereby, these big banks become “trustees” for a securitization pool, meaning that they may have bought the mortgages off the small local banks, but they do not have the actual legal title to the mortgage (see below);

c) These Trustees now bundle these reams of mortgages into jumbo securities, “Collateralized Mortgage Obligation Bonds” (CMOs), and

d) The Trustees sell these CMOs to pension funds and individual investors seeking to earn more than US Treasury Bond rates.

“A chain is as strong as its weakest link”, and in this case, that “weakest link” is what Mr. Engdahl points out under b): once borrowers start defaulting on their mortgages, it is seriously unlikely that the Trustees will be able to take possession of the homes that are meant to be the collateral backing the mortgage.

Why so?

Because recently, a U.S. Federal Judge, CA Boyko, ruled in the Federal District Court in Cleveland, Ohio, that Deutsche Bank (DB) could not take possession of the 14 homes of Cleveland residents in order to claim these assets in order to on-sell them in the hopes recovering DB’s 14 mortgages. Mr. Engdahl notes that “The Judge asked DB to show documents providing legal title to the 14 homes. DB could not. All DB attorneys could show was a document showing only an ‘intent to convey the rights in the mortgages.’ They could not produce the actual mortgage, the heart of Western property rights since the Magna Charta…”

Should the U.S. Supreme Court uphold Justice Boyko’s ruling, “…millions of homes will be in default but the banks (could be) prevented from seizing them as collateral assets to resell.” And that is because “…no one is yet able to identify who precisely holds the physical mortgage document” because “…the Trustee never got the legal document known as the mortgage.” Got it? I had to chew through this stuff myself…

So what magnitudes of collateral damage are we discussing? Here are guesstimates gleaned from Mr. Engdahal’s rich treatise (all figures in US dollars):

• How much securitized mortgage debt (SMD) is outstanding? $6.5 trillion.
• Of this total SMD, how much is in “interest–only”? Adjustable Rate Mortgages (ARMs)? $1.4 trillion (i.e. 22% of all SMD).
• Of this total SMD, how much faces higher interest rates from January – July/August, 2008? $690 billion (i.e. 11% of all SMD);
• Of this total SMD, how much could default from January – July/August, 2008? $325 billion (i.e. 5% of all SMD).

Why am I taking your time to digest Mr. Engdahl’s article with you? After all, only five percent of total SMD are at risk! So what is the big deal? Seems to me like there are at least three “big deals”.

First, because I have an inkling that what I am giving you is incomplete: I don’t know what I don’t know, so if anything, what I have gleaned from Mr. Engdahl’s rich article – perhaps – is incomplete, at best.

Secondly, what I do know is that nobody can know the extent of the domestic, U.S collateral damage. How much of this SMD stuff has been “collateralized” and then on– sold by (totally justified) bonus–hungry sales executives at avaricious banks?

Finally, I also know is that nobody can know the extent of international collateral damage. How much of this SMD stuff has been on–sold to banks outside of America? We got whiffs of this when one German bank’s exposure was aired in the press right at the outset of these crises (yes, plural they are), and in Hong Kong, Central Bank boss Joseph Yam warned of various Asian banks’ exposure to such collateral damage.

What we do know is that banks don’t trust each other – and therefore don’t want to lend to each other. In the jargon of The Economic Clock: this mistrust is creating an excess demand for money, this time in the Gestalt of an excess demand for credit…

When will assets become liabilities?

Mr. Engdahl’s guess is January – July/August, 2008: financial markets already now are staring into headlights.

Here is another fuzzy road-map depicting how he arrives at his timing:

• 9/11/01: Fed Chairman Alan Greenspan creates an excess supply of money in order to offset the tragedy of 9/11, and to replace the dot.com bubble with more real estate lending;
• 2005-2006: this is the peak period of the U.S. real estate bubble. This is when “the most sub-prime mortgages were written with (interest-only) ARMs" (see section 2 below), and
• December 2007 – July/August, 2008: “Now a whole new wave of mortgage defaults is about to explode onto the scene…Between December 2007 and July 1, 2008, more than $690 billion in mortgages will face an interest rate jump according to the terms of the ARMs written two years before.”

2. The Crash and The Clock

So why are we suggesting that Wall Street has to cave-in over the next nine months? Because sub-prime borrowers – home owners with wobbly, if any income sources – will see the interest portions of their interest-only ARMs explode in their faces. Just when their wages either tank or implode due to rising unemployment.

For some time we have been warning you of America’s looming stagflation: growth will stagnate and inflation will rise. This has to kill U.S. corporate profits - and thus catalyze a major de-valuation of American stocks, no?

This implies that The Economic Time™ in America must morph into an even more pronounced -

• Excess demand for money, and thus an
• Excess supply of goods. (Currently, America is still in this cycle's last vestiges of an excess demand for goods...)

So the American, sub-prime borrower will be stuck between a rock and a hard place. As Mr. Engdahl states, “That means (that) market interest rates for those mortgages will explode just as recession drives incomes down.”

How can profits of quoted U.S. companies rise when The Economic Time is deteriorating? Truly, things are not so “different” this time. We wrote an earlier piece outlining Prof. Charles Kindleberger’s four stages of a crash, and we truly are entering stage four. Once the bungee jump has occurred, marvelous buying opportunities will present themselves. But first, here goes the bungee jump...

3. How to Make Money Off This Idea

• Always talk with your financial adviser first!
• Short the US stock market. For our Economic Time Fund we are using the Pro Share Tracker short. Its Bloomberg Code is SDS:US.
• Short particularly the US financial sector, for instance the Financial Select Sector SPDR Its Bloomberg code is XLF:US.
• Short non-American financial stocks or indeed the whole sector, if possible. As a band-aid, just short major overseas banks where you smell trouble.
• Cash is king, and for some time we have suggested the Australian dollar as well as the Euro.

How to Make Money Off This Idea