The Resourceful Bear Blog

Neil Unmack, Abigail Moses and Shannon D. Harrington in Bloomberg article 'CDO Cuts Show $1 Trillion Corporate-Debt Bets Toxic' relate:

Investors are taking losses of up to 90 percent in the $1.2 trillion market for collateralized debt obligations tied to corporate credit as the failures of Lehman Brothers Holdings Inc. and Icelandic banks send shockwaves through the global financial system.

The losses among banks, insurers and money managers may spark the next round of writedowns on CDOs after $660 billion in subprime-related losses. They may force lenders to post more reserves after governments worldwide announced $3 trillion in financial-industry rescue packages since last month, according to Barclays Capital.

``We'll see the same problems we've seen in subprime,'' said Alistair Milne, a professor in banking and finance at Cass Business School in London and a former U.K. Treasury economist. ``Banks will take substantial markdowns.''

The collapse of Lehman Brothers, Washington Mutual Inc. and the three banks in Iceland prompted Susquehanna Bancshares Inc., a Lititz, Pennsylvania-based lender, to lower the value of $20 million in so-called synthetic CDOs by almost 88 percent last week.

KBC Groep NV, Belgium's biggest financial-services firm, which had 377.4 billion euros ($485 billion) in assets as of June 30, wrote down 1.6 billion euros after downgrades on company and asset-backed debt. Brussels-based KBC had 9 billion euros in CDOs as of Oct. 15, primarily linked to corporate debt, according to an investor presentation.

10 Cents

CDOs pooling asset-backed securities have been blamed for losses at the world's biggest banks, from UBS AG to Citigroup Inc. Now, corporate CDOs are starting to be affected as defaults rise and speculation mounts that the world economy is headed for a recession.

Some synthetic CDOs, tied to credit-default swaps on corporate bonds, are trading at less than 10 cents on the dollar, according to Sivan Mahadevan, a derivatives strategist at Morgan Stanley in New York.

CDOs parcel fixed-income assets such as bonds or loans and slice them into new securities of varying risk, providing higher returns than other investments of the same rating.

Credit-default swaps are derivatives based on bonds and loans and used to protect against or speculate on defaults. Should a borrower fail to meet debt agreements, the contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent. An increase in the agreement's cost indicates a deteriorating perception of credit quality.

Private Market

About $254 billion of CDOs tied to mortgages for borrowers with poor credit histories have defaulted, according to Wachovia Corp. Estimating losses on those linked to corporate bonds is difficult because the underlying debt and the structure of the transaction can vary in this private market, said Mahadevan.

Derivatives are contracts whose value is derived from assets including stocks, bonds, currencies and commodities, or from events such as the weather or changes in interest rates.

Downgrades of corporate CDOs will force investors to boost capital, according to an Oct. 17 report from Barclays Capital analysts led by Puneet Sharma in London.

Buyers of deals graded AA by Standard & Poor's and Aa2 by Moody's Investors Service, the third-highest rankings, may have to increase cushions against losses to cover the full amount of the investment, up from 1.2 percent now, Sharma said. His estimate is based on the world economy entering a ``severe'' recession.

Record Lows

Demand for synthetic CDOs helped fuel growth in the credit-default swap market and pushed the cost of default protection to record lows in 2007. That in turn drove down company borrowing expenses. Sales of such CDOs surged to $503 billion in 2006, from $84 billion five years earlier, according to Morgan Stanley.

Bankers loaded the securities with bonds and swaps offering the highest return for a given credit ranking, indicating higher risk. An AA rated European issue offered an average yield of 50 basis points over money-market rates when sold in 2006, according to UniCredit SpA analysts in Munich. Similarly rated corporate bonds paid 9 basis points. A basis point is 0.01 of a percentage point.

``The maths ended up driving the way CDO portfolios were put together,'' said Nigel Sillis, a fixed-income and currency analyst at Baring Asset Management Ltd. in London.

Credit Analysis

The banks that structured the securities and investors both failed to do ``fundamental credit analysis,'' said Janet Tavakoli, president of Tavakoli Structured Finance in Chicago. ``They were using correlation models, they were using spread models, but they weren't doing analysis on the underlying corporations.''

Fitch downgraded 422 classes of CDOs on October 13, 2008 after seven financial companies defaulted or were bailed out since September. The company didn't disclose the total number of classes it rated.

Defaults and so-called ``credit events,'' which can include government takeovers, force payment of the credit-default swaps packaged in the debt. This causes losses for investors or erodes capital.

The U.S. Treasury has broad powers under a $700 billion rescue plan enacted on Oct. 3 to purchase an array of distressed assets. While Treasury Secretary Henry Paulson has said that home loans and related securities are the main focus of the plan, CDOs or other non-mortgage-related derivatives could qualify under the law. Congress would have to be notified of their inclusion.

Treasury spokeswoman Michele Davis didn't immediately respond to a request for comment.

Barclays Capital estimates that 70 percent of synthetic CDOs sold swaps on Lehman. Swaps on Kaupthing Bank hf, Landsbanki Islands hf and Glitnir Banki hf were included in 376 CDOs rated by S&P. The company ranks almost 3,000.

Fannie, Freddie

About 1,500 also sold protection on Washington Mutual, the bankrupt holding company of the biggest U.S. bank to fail, according to S&P. More than 1,200 made bets on both Fannie Mae and Freddie Mac, the New York-based rating company said.

The collapse of Lehman, WaMu and the Icelandic banks, as well as the U.S. government's seizure of the mortgage agencies, will have a ``substantial'' impact on corporate CDO ratings, S&P said in a report Oct. 16.

The government in Reykjavik seized Kaupthing Bank, the country's largest lender, earlier this month. Assets and liabilities from Landsbanki Islands and Glitnir Banki were transferred to state-owned entities, triggering default swaps.

Default Forecasts

Nonpayment on speculative-grade corporate bonds may rise to 7.9 percent worldwide in a year, from 2.8 percent at the end of the third quarter, as the credit crisis deepens, Moody's said Oct. 8. Those in the U.S. may rise to 7.6 percent, said S&P.

``As there are credit events, you'll have losses in portfolios and marking down of other assets,'' said Claude Brown, a partner at law firm Clifford Chance LLP in London.

Investors may sell the CDOs back to the banks that structured them, which will unwind protection they wrote to hedge swap transactions, Barclays said. The chain of events will push up the price of default protection and company borrowing, according to Barclays.

Banks unwinding hedges helped double the cost since April of default insurance on the lowest-ranking equity portion of the benchmark Markit CDX North America Investment Grade Index, to 75 percent upfront and 5 percent a year. That equates to $7.5 million in advance plus $500,000 annually on $10 million of debt for five years.

For European investment-grade company debt, as shown by the Markit iTraxx Europe index of credit-default swaps, the price for protecting against nonpayment may climb 50 basis points to a record 200 next year, Barclays forecasts.

Buy Now

Some investors are choosing to buy protection and determine their losses now, according to Edmund Parker, head of derivatives at law firm Mayer Brown LLP in London.

National Australia Bank, the country's biggest lender by assets, paid A$100 million ($67 million) this year to hedge the risk of loss on six company-linked CDOs totaling A$1.6 billion. It will pay a further A$60 million annually for the next five years, according to company filings.

``The upside is that you've now drawn a line on those assets and you know you're not going to lose more than your hedging costs,'' Parker said. ``Unless, of course, your counterparty goes under.''

Still, investors don't have to unwind CDOs. They could hold on until the debt instrument matures if they judge defaults won't be bad enough to prevent them getting their money back, according to Barclays Capital analysts.

Radian, CIT

Companies most frequently referenced in synthetic CDOs include Philadelphia-based Radian Group Inc., RDN, the third-largest U.S. mortgage insurer, whose stock fell 68 percent in New York trading this year. Another is CIT Group Inc., CIT, an unprofitable commercial lender in New York that dropped 83 percent. The company faces about $2.4 billion in debt repayments by the end of 2008, according to data compiled by Bloomberg.

``We feel very strongly that we have adequate claims-paying capabilities for both our financial-guarantee business and our mortgage-insurer business,'' said Radian spokesman Richard Gillespie.

CIT spokesman Curtis Ritter declined to comment, pointing to the company's statement last week that it will meet funding needs for the next 12 months.

Forecasts for ratings downgrades are ``going to force a lot of activity'' in unwinding CDOs, said Rohan Douglas, former director of global credit derivatives research at Citigroup. He now heads Quantifi Inc., a provider of valuation models for the debt. ``Buy-and-hold investors suddenly find themselves in a situation where they will have to sell these assets.''

Commentary
The authors report: "About $254 billion of CDOs tied to mortgages for borrowers with poor credit histories have defaulted, according to Wachovia Corp. Estimating losses on those linked to corporate bonds is difficult because the underlying debt and the structure of the transaction can vary in this private market, said Mahadevan."

While the banker claims "estimating losses ... is difficult"; I disagree. I have a BS Degree in accounting, common sense, business acumen, and lots of balance sheet and income statement preperation experience.

The SEC has thrown the fair value accounting rule out the window, and the accountants have withdrawn the mark-to-market standard of FASB 157, and replaced it with mark-to-fantasy assumptions of bank and real estate management; I estimate losses that need to be taken today in the range of 40% to 90%; a charge should be taken on the income statement of at least 40% immediately.

It is commendable that KBC Groep NV took write downs as they did; unfortunately for investors, the Belgium stock market has took a harder hit for this than other stock markets. Since synthetic CDOs are trading at 10 cents on the dollar, 90 cents on the dollar losses should be taken by the affected companies.

The authors report: "downgrades of corporate CDOs will force investors to boost capital, according to an Oct. 17 report from Barclays Capital analysts led by Puneet Sharma in London"; this cannot be done as no one trusts balance sheet statements based on current SEC and FASB principles.

The authors report: "Buyers of deals graded AA by Standard & Poor's and Aa2 by Moody's Investors Service, the third-highest rankings, may have to increase cushions against losses to cover the full amount of the investment, up from 1.2 percent now". I believe that cushions will only be increased by a fraction of what is needed. What is more likely is that 'corporate mutual bond funds' and 'municipal bond mutual funds' will be forced to sell securities effected by the announcement of S&Ps and Moodys resulting in a drop in their net asset value which will further cause credit gridlock, that is lending gridlock, and evaporation of liquidity from the world wide financial system.

The authors relate: "Defaults and so-called credit events. This causes losses for investors or erodes capital". This also causes evacuation, that is evaportion of liquidity from 'debt ETFs', 'corporate mutual bond funds' and 'municipal bond mutual funds', which in turn is one of two factors turning down the world wide stock markets, the other being the unwinding of the Yen Carry Trade, that is the EUR/JPY, as well as other carry trades which come from currency traders short selling the currency pairs using 0.5% interest from the Bank of Japan.

I conclude that from what the authors present Fannie Mae and Freddie Mac will be affected; these organizations should write down their "assets" significantly; as they do so, raising capital will become more expensive, and the interest rate on home loans can only go up in price.

Banks that have issued credit default swaps are walking dead men; and are walking dead men as their customers are exposed to default events.

It is unlikely that CIT Group will be able to raise capital to pay off it's existing debt and unlikely it will be able to raise capital and be a conduit of lending. This means that capitalism is dead, dead and dead since capitalism cannot exist without funds obtained by the lending organizations such as CIT Group and the Banks.

Radian Group, RDN, and CIT Group, CIT, are walking dead men; they will fail soon, causing a domino loss of investment globally.

The authors relate "Buy-and-hold investors suddenly find themselves in a situation where they will have to sell these assets"; well there is no market for the assets; this is going to cause a continuing fall in financial organization value, and in US real estate, IYR, value, and in REIT Value, RWR, and world real estate value, DRW.

Yes, since capitalism is dead, dead and dead, I ask two questions: Got gold, and do you have it in under your personal ownership in a multiplicity of secure places?

Keywords
Syntheticcdos

By Dawn Kopecki of Bloomberg reports that federal regulators directed Fannie Mae and Freddie Mac to start purchasing $40 billion a month of underperforming mortgage bonds as the Bush administration expands its options to buy troubled financial assets and resuscitate the U.S. economy, according to three people briefed about the plan.

Fannie and Freddie began notifying bond traders last week that each company needs to buy $20 billion a month in mostly subprime, Alt-A and non-performing prime mortgage securities, according to the people, who asked not to be identified because the plans are confidential. The purchases would be separate from the U.S. Treasury's $700 billion Troubled Asset Relief Program, TARP.

The Federal Housing Finance Agency, FHFA, which placed the two companies in conservatorship on September 7, 2008, directed them last month to start increasing their purchases of loans and mortgage-backed securities as the Treasury seeks to absorb underperforming and illiquid assets from financial companies.

Adding underperforming assets to Fannie and Freddie's combined $1.52 trillion mortgage portfolios would come at a time when the two mortgage-finance companies already hold as much as $210 billion of bad debt that may be eligible itself for the Treasury's relief program, their regulator said October 5, 2008.

``The overall goal of the program will be to contribute greater stability and liquidity in the mortgage market, which should enhance consumers' access to mortgage financing and ultimately result in reduced mortgage interest rates,'' FHFA Director James Lockhart said in a September 19, 2008 statement.

Non-agency, or private-label, bonds are issued by banks and don't carry guarantees by Fannie, Freddie or government-agency Ginnie Mae. Freddie held about $207 billion in non-agency debt in its $760.9 billion portfolio as of August, according to its latest monthly volume summary. Fannie had about $104 billion of such securities in its $759.9 billion portfolio in August.

Regulators initially restricted Fannie and Freddie's growth when they seized control of the government-sponsored enterprises Sept. 7. To ``promote stability'' and lower mortgage costs to borrowers, Treasury Secretary Henry Paulson said the two would be allowed to ``modestly increase'' their mortgage portfolios to as much as $1.7 trillion through the end of next year and said they would no longer be run ``to maximize shareholder returns.''

Less than two weeks later, Fannie and Freddie were told to ramp up their mortgage bond purchases as the financial crisis deepened and credit activity came to near standstill.

Fannie and Freddie which own or guarantee almost half of the $12 trillion U.S. home loan market, were given access to $200 billion in emergency Treasury financing as part of their rescue package.

There are a number of troubling issues here
1) The authority for the purchase of the assets apparently comes from the director of FHFA, and not from the authority granted by Congress: the action of FHFA goes beyond the mandate of law.
2) This announcement of purchase is another framework agreement like the Security and Prosperity Partnership, the SPP, which was announced by the leaders of the North American continent on March 23, 2005. Thus a usurption of law for the purpose of greater state corporate control, that is for state corporatism; this evidences that capitalism is no longer the basis for the operation of America's economy.
2) There is no revelation as to where the assets are being purchased from, they could be from insurance companies as well as banks.
3) The financial organizations should be allowed to go bankrupt. The banks are walking dead men; the action of purchasing the assets, only temporarily postpones the bank's death.
4) One has to ask why the Federal Government is postpoing the bankruptcy of the financial organizations. Part of the answer as to why is that by purchasing troubled assets, and providing cash, or Treasury debt, or FHFA debt in exchange, the financial organizations lifespan is extended, financial system stress decreased and liquidity sustained, but the day of collapse and accounting still is coming when the organzations will fail, and credit default swaps will have to be settled, causing financial system strain as the companies that underwrote the derivaties will have to pay; only they do not have the monies to pay.
5) All payments, that is all purchases is going to cause destruction to the value of US Government bonds, and will eventually cause hyperinflation as the value of the US Dollar and government debt falls.
6) The SEC and the Finanancial Accounting Standard Board's decision to abandon fair value accounting of FASB 157, that is to abandon mark-to-market, receives extra strength by Lochart's mandate. Thus a nontransparent lending marketplace abides where genunine value is not presented. Distrust between lender and debtor continues, and hence credit gridlock, that is, lending gridlock remains. The only lendng that will take place in the United States is through the Fed's CPFF; and that lending is still weeks away from getting going, and will be too small and inefficient to meet the demand. With the result that corporations, lacking short term credit cannot meet payroll costs, and will have to immediately layoff, and have to shutter because they lack operating funds for onging purchases of supplies, services and raw materials. The credit granted through CPFF will be only those corporations whose functioning is deemed critical to the homeland.
7) The mandate of Lochart enslaves Americans to debt, and the most toxic of debt. The level of that debt is increasing day by day. Mr. Lochart is a stakeholder in state corporate rule. He with Paulson, and Bernanke are task masters of indebtedness.
8) There has been a bloodless coup where the finance officer of a private corporation, James Lochart, was appointed by Congress, to form and lead a state enterprise: government, housing and banking have been merged so that state corporatism has replaced capitalism as the driving eoconomic principle in America.

The political and economic coup is a fulfillment of bible prophecy found in of the First Horseman of the Apocalypse. The horse is white signifying conquest over mankind, and the fact the rider has a bow with no arrows, foretells a bloodless coup.

The Scripture reference is Revelation 6:1-2 where the NIV relates: "I watched as the Lamb opened the first of the seven seals. Then I heard one of the four living creatures say in a voice like thunder, "Come!" I looked, and there before me was a white horse! Its rider held a bow, and he was given a crown, and he rode out as a conqueror bent on conquest".

Here is one artist's rendition of the four horsemen of the apocalypse.

Arlen L Chitwood relates the Greek word "crown" here is "stephanos" or "conqueror's crown"; a number of leaders have conquered capitalism and replaced it with state corporatism.

God is Sovereign, and as such from eternity past, foreknew, foresaw, and worked out today's events; everything is working out according to his foreordained plan.

Introduction
There are a number of threats to financial stability that I have addressed in my blog. These include treasury repo fails in interbank lending, the failure of the insurance company AIG, the level two assets and level three assets at banks and investment bankers, the debt carried off balance sheets at a number of organizations, commercial lending gridlock where companies seeking to refinance debt as it comes due are unable to do so and go out of business, and the dearth of liquidity caused by the impact of FASB 141.

I am reporting that a liquidity vacuum has formed and is intensifying, and that as a result a liquidity event may occur where the world's financial system seizes up and break down.

A Liquidity Event appears imminent as liquidity has simply evaporated.
The Libor is a measure of liquidity, and it rose sharply today suggesting that liquidity has simply vanished. Gavin Finch of Bloomberg reports on September 16, 2008 in article Overnight Money-Market Rate for Dollars Doubles, BBA Says that the cost of borrowing in dollars overnight more than doubled to 6.44 percent, its biggest jump, according to the British Bankers' Association. The London interbank offered rate, or Libor, increased 333 basis points from yesterday, the BBA said today.

And today the Ted Spread, another metric of liquidity, closed at 2.17 up from just over 1% last week. Calculated Risk in September 15, 2008 article Credit Crisis: The Fourth Wave, relates that this is close to the highs reached in August 2007, late 2007 and in the spring of 2008, the three previous waves of the credit crisis. Note: the TED spread is the difference between the three month T-bill and the LIBOR interest rate.

Sam Mamudiin Market Watch article Money Market Giant Freezes Redemptions reports that "One of the first and largest money market funds has put a seven-day freeze on redemptions after the net asset value of its shares fell below $1. Primary Fund, RFIXX ... RFIXX, a $62 billion fund managed by money market fund inventor, The Reserve, said Tuesday afternoon that its $785 million holding of Lehman Brothers Holdings debt has been valued at zero. As of 4 p.m., the value of the fund's share is 97 cents. The Reserve said that redemption requests received before 3 p.m. Tuesday will be paid out at $1 a share.

Catherine Belton, Charles Clover, and Rachel Morarjee of FT. com report September 16, 2008 Russian Stock Market Crashes, Russia Halts Trading After 17% Share Price Fall.

Gavin Finch and Kim-Mai Cutler of Bloomberg in September 16, 2008 article Money-Market Rates Double Amid Global Credit Seizure relatesThe cost of borrowing in dollars overnight more than doubled to the highest since 2001 as the collapse of Lehman Brothers Holdings Inc. and credit downgrades of American International Group Inc. led banks to hoard cash.

The London interbank offered rate, or Libor, that financial institutions charge each other to borrow soared 3.33 percentage points to 6.44 percent today, its biggest jump in at least seven years, according to the British Bankers' Association. The rate was as low as 2.07 percent in June.

Banks are driving up short-term lending rates on concern that AIG, the biggest U.S. insurer, will follow Lehman into bankruptcy and leave financial institutions with losses on $441 billion of credit derivatives. Central banks around the world pumped more than $210 billion into the financial system as they sought to alleviate the credit-market seizure.

``It's fear,'' said Imke Jersch, a senior money-market trader in Hanover at Norddeutsche Landesbank Girozentrale AG, Germany's fourth-biggest state-owned bank. ``You don't know who has exposure and who might not be getting their money anymore. It's a domino effect. You never know who might fall next.''

The yield on the 10-year Treasury note fell to the lowest level in five years as investors sought the safety of government debt. Average yields on overnight U.S. commercial paper backed by assets such as credit cards and car loans jumped 54 basis points to 3.45 percent, the highest since March.

``I have never seen anything remotely like this. The money market was typically the one thing that always worked,'' said Luca Jellinek, head of interest-rate strategy in London at Royal Bank of Scotland Group Plc. ``It's the cardiovascular system of the financial body. When this happens, it's like a heart attack.''

The Fed added $50 billion in temporary reserves to the banking system today through overnight repurchase agreements, or repos. The European Central Bank offered 70 billion euros ($100 billion) in a one-day refinancing operation and the Bank of England injected 20 billion pounds ($36 billion). The Bank of Japan added 2.5 trillion yen ($24 billion) and the Reserve Bank of Australia injected A$1.85 billion ($1.5 billion)".

My analysis is that a Liquidity Event is very likely imminent, where the financial system, lacking liquidity simply freezes up and breaks down.

The Federal Reserve moved to prevent a disorderly failure of AIG, but has not addressed the risk to financial stability posed by Washington Mutual.
Associated Press reports on September 16, 2008, in Government Announces $85 Billion Loan To Save AIG that "In a bid to save financial markets and economy from further turmoil, the U.S. government agreed to provide an $85 billion emergency loan to rescue the huge insurer AIG. The Federal Reserve said in a statement it determined that a disorderly failure of AIG could hurt the already delicate financial markets and the economy."

While the Fed acted after market close, as referenced in their announcement, to prevent a disorderly failure of AIG, it has done nothing as of yet, to address the potential of a liquidity event, and financial system breakdown, associated with the counterparty risk associated with the credit default swaps and depletion of capital at Washington Mutual, WM.

Liquidity continued to evaporate today as the Counterparty Risk Index went critical
FT.com in September 16, 2008 article Counterparty Risk Goes Critical reports that counterparty risk in the market for credit default swaps, as measured by the CDR Counterparty Risk Index, CRI, hit an all-time high on Tuesday as traders reacted to Lehman Brothers’ bankruptcy and the unknown future of AIG.

The CRI hit 389.33bp this morning, compared with its previous record wide of 250bps during the Bear Stearns-induced market panic.

Washington Mutual, the home loan lender to the low income, sees share price fall and credit default swaps rise as the liquidity crisis unfolds
The MSN Finance chart of Washington Mutual from August 8, 2008 to September 16, 2008, shows that WaMu has lost 50% of its stock market value ... Chart of WM from 08-08-08 to 09-16-2008

A part of the force feeding the intensifying liquidity vacuum as well as WaMu's share price fall is the organization's portfolio of Option ARMs
Bob Ivry and Linda Shen in Bloomberg article Washington Mutual Hobbled By Increasing Defaults on Option ARMs reports on September 15, 2008 that Washington Mutual Inc., the thrift that lost 92 percent of market value in the past year, is being dragged down by a mortgage product once hailed by former Chief Executive Officer Kerry Killinger as a boost to profit.

As many as 45 percent of borrowers with payment-option adjustable-rate mortgages issued from 2004 to 2007 and bundled into securities may default, according to Fitch Ratings analysts Roelof Slump and Stefan Hilts. Washington Mutual held $52.9 billion of the mortgages, also called option ARMs or negative amortization loans, on its books in the second quarter, with defaults doubling to $3.2 billion from the end of 2007, according to a filing with the U.S. Securities and Exchange Commission.

``You look at all the major players in the option ARM market and they're all on their knees,'' said Andrew Laperriere, Washington-based managing director at the International Strategy & Investment Group research firm. ``These companies have changed their stance on these loans dramatically. They were defending them as late as a year ago. They said these loans would be fine.''

Two of the top five option ARM lenders, according to a ranking by industry newsletter Inside Mortgage Finance, are no longer in business and the other three have ousted their CEOs and seen their market value erode in the worst housing recession since the 1930s. Seattle-based Washington Mutual, the largest U.S. savings and loan, fired Killinger on Sept. 8 after 18 years as CEO, citing his failure to stem losses from home mortgages.

Payment Spikes

Option ARMs allow borrowers to skip part of their payment and add that sum to their principal. Monthly payments increase after five years or once the loan balance reaches a predetermined limit, usually 110 percent to 125 percent. Introductory interest rates can be as low as 1 percent.

For the average option ARM borrower, payments will rise 63 percent, or an additional $1,053 a month, when their rates reset, according to a Sept. 2 report by New York-based Fitch.

Because typical option ARM borrowers make less than the full payment each month, according to Fitch, they don't build equity in their homes. When house prices fall, they owe more than their home is worth. That leaves lenders facing losses if the loan defaults and they foreclose.

About 83 percent of the option ARMs issued from 2004 to 2007 were underwritten without full documentation of borrowers' incomes, Fitch said.

``For most borrowers, once their loan resets, there's no place for them to go,'' said Hilts of Fitch. ``A high percentage of them don't have equity, so they can't refinance, and they don't have the income to withstand the payment shock.''

Four percent of Washington Mutual's option ARM portfolio probably will reset in the second half of this year and 13 percent, or $7.1 billion, will reset in 2009, according to the SEC filing.

Home Price Declines

With home prices falling 18.8 percent nationally from their peak in 2006, according to the S&P/Case-Shiller Home Price Index, almost one-third of borrowers who bought their homes in the past five years now owe more on their mortgages than their properties are worth, real estate valuation Web site Zillow.com said.

Washington Mutual issued half its option ARMs in California, according to the thrift's second-quarter regulatory filing. One in 130 households there were in some stage of foreclosure in August, making it the state with the second-highest rate, data compiled by Irvine, California-based RealtyTrac Inc. show. Nevada is No. 1.

The thrift made 13 percent of its option ARMs in Florida, the state with the fourth-highest foreclosure rate, according to RealtyTrac.

``It's not the product, ultimately, it was how it was administered,'' said Gary Townsend, chief executive officer of Hill-Townsend Capital LLC in Chevy Chase, Maryland, referring to Washington Mutual.

`Nice Gains'

Killinger said in a July 22, 2004, conference call with analysts that option ARMs were a product that would boost Washington Mutual's profit margin.

``We will emphasize origination of higher margin product such as option ARMs and we will emphasize originations through our retail and wholesale channels,'' Killinger said.

Six months later, Chief Financial Officer Thomas Casey told analysts that the lender would ``push that option ARM as hard as we can.''

``We believe that the option ARM is a differentiating product for us, and we're continuing to see nice gains on that compared to some of the other products that are out on the market right now so that will be a continued focus for us,'' Casey said Jan. 20, 2005.

Killinger's departure from Washington Mutual came as the thrift signed a memorandum of understanding with its regulator requiring the bank to improve its risk management.

Washington Mutual was the second-biggest provider of option ARMs in the second quarter, behind Charlotte, North Carolina-based Wachovia Corp., which held $122 billion of the loans, according to a company filing.

Countrywide Financial Corp., formerly the biggest U.S. mortgage lender, had $25.4 billion of the loans on its books in the second quarter. Bank of America Corp. bought the company on July 1. The Calabasas, California-based lender had the third- highest amount of option ARMs.

Downey Financial Corp., a savings and loan based in Newport Beach, California, held $6.9 billion at the end of the second quarter, according to a filing, making it the fourth-largest U.S. option ARM lender, according to Bethesda, Maryland-based Inside Mortgage Finance.

Downey, with second-quarter assets of $12.6 billion, has lost 95 percent of its market value since the beginning of the year. It replaced its CEO, Daniel Rosenthal, on July 24.

Seized by Regulator

In July, IndyMac Bancorp Inc., the Pasadena, California-based lender that began as a spinoff from Countrywide, became the third- largest bank in U.S. history to be seized by its regulator, the Federal Deposit Insurance Corp., after depositors withdrew more than $1.3 billion in 11 business days. IndyMac held $3.5 billion of option ARMs, the fifth-largest amount.

Wachovia, the fourth-largest U.S. bank, lost 71 percent of market value in the past year. In July, the bank ousted CEO Kennedy Thompson, whose $24 billion purchase of Golden West Financial Corp. in 2006 came with a portfolio of option ARMS.

Robert Steel, the former Treasury official who replaced Thompson as Wachovia's CEO, said at a Sept. 9 investors conference in New York that he approached the option ARMs ``as if we were a distressed investment manager.''

Brock Davis, a broker with U.S. Express Mortgage Corp. in Las Vegas, calls option ARMs ``neutron loans'' because ``three years later the house is still there and the people are gone.''

Mike Mish Sheldon in recent article Thoughts On Credit Default Swaps relates that Credit Default Swaps, CDS, on Lehman, LEH, and Washington Mutual, WM, were soaring on Tuesday September 9, 2008. This should not be surprising given that both stocks were hammered today Wednesday September 10, 2008.

OptionArmageddon in article WaMu (& BKUNA, & DSL) On The Brink? reports on September 8, 2008 that "Basically, OTS just put WaMu on notice. Remember, WaMu has about $120 billion worth of toxic mortgage assets sitting on its balance sheet. Subprime, Option ARMs, Home Equity Loans, etc. Taken together, these securities are likely worth 50 cents on the dollar. It’s not easy deciphering their balance sheet, but WaMu probably has in the neighborhood of $40 billion of capital backstopping these losses. So if they actually write down their assets to reflect their current value, it could wipe them out.

Is it any wonder WaMu is desperate for capital?

With $140 billion in insured deposits, any prospect that WaMu might fail has to be stressing regulators, especially the FDIC. Remember, FDIC has only $45 billion in its reserve fund, meaning that a failure the size of WaMu could come close to wiping THEM out."

Just one of many causes for the liquidity vacuum, is the inability of banks and investment bankers, such as WaMu to obtain capital as documented by Jonathan Keehner and Linda Shen, in September 11, 20008, Bloomberg article, WaMu May Lose Suitors on Accounting Rule; Stock Plummets 30%: "At least three potential acquirers ended negotiations to buy either Seattle-based WaMu or Cleveland's National City Corp., the bankers said. One sticking point, they say: a rule change that will force acquirers to compute a target's assets at market prices instead of deriving values from measures including the purchase price. WaMu is in "a tough place," said Jaime Peters, an analyst at Morningstar Inc. in Chicago. "The revised rules will create additional hurdles for WaMu, and there are already plenty of hurdles."

Sara Lepo of the Associated Press and Orange County Register reports that Washington Mutual Removes CEO Kerry Killinger on September 8, 2008. Washington Mutual, the nation’s largest thrift, replaced Kerry Killinger as chief executive on Monday, as it continues to grapple with large losses from sour loans, reports the Associated Press. Killinger is being replaced by Alan H. Fishman, the former president and chief operating officer of Sovereign Bank and president and CEO of Independence Community Bank.

And WaMu said it has entered into a memorandum of understanding with its regulator, the Office of Thrift Supervision. WaMu has committed to provide the OTS with an updated, multiyear business plan, and does not have to raise capital or increase liquidity.

The New York Times, on May 20, 1999 in article Washington Mutual to Buy California Mortgage Lender reported that: "Washington Mutual, a financial services company, said yesterday that it had agreed to acquire the Long Beach Financial Corporation, a California mortgage lender, for $350.4 million, or $15.50 a share, expanding its presence in the residential mortgage market. Washington Mutual, based in Seattle, has 2,000 offices and assets of $174 billion. Long Beach Financial, known as a subprime lender, makes mortgage loans to customers with spotty credit records, usually at high interest rates, then packages its loans and sells them to institutional investors. Shares of Long Beach jumped 16.8 percent, gaining $2.0625, to $14.375. Shares of Washington Mutual climbed 75 cents, to $39.75."

Washington Mutual has been a consistent provider of home loans to the low income
Bakersfieldbubble on May 3, 2007 reported in article $14,000 Per Year Field Worker Buys $720,000 Home that: "Despite making only $14,000 a year, strawberry picker Alberto Ramirez managed to buy his own slice of the American Dream. But his Hollister home came with a hefty price tag - $720,000.

A year and a half later, Ramirez has defaulted on his loan, and he's hoping to sell the house before it's repossessed. And according to many housing advocates and civil rights groups, Ramirez is not alone. As mortgage foreclosures rise, many minorities are suffering.

Brown said the language barrier (Ramirez, a native Spanish speaker, is not fluent in English, and spoke to the Free Lance through a translator) can also play a big role.

"When you go into Washington Mutual ... you can't always get someone to speak your language," she said.

"The real estate boom covered a multitude of sins," Simmons said. "Once the market started depreciating, the rug was pulled back to show the rot underneath."

Investment Application
I have to relate that I am a blogger who holds forth the Liquidation Thesis and one who encourages investing in gold. I am not a licensed investment professional and do not take any compensation for things related in this blog. I am currently invested long in the ETF SKF and have a few small gold coins. I always suggest that one consult a licensed investment professional before making any investment decision.

Herb Greenberg in article How To Keep Your Investments Safe suggests the use of a trust account for investing.

I recommend that one buy gold immediately at GoldMoney and BullionVault as well as a limited number of Krugerands from Kitco.com.

Be advised that currently the price of gold, GLD, is a function of oil, USO. The gold ETF, GLD, traded yesterday at 77.56; it is currently trading at 76.62

The Yahoo Finance ongoing chart of oil, USO, relative to gold, GLD shows that oil has fallen twelve percent in the last two days to 74.19.

I fully expect gold to move lower in price; gold traded yesterday at $786: today it is trading at $780; strong support for gold is found lower at $750; 700 and $675.

The one year chart of Gold, GLD, compared to natural gas, GAZ, and silver, SLV, as well as Silver Standard Resources Inc, SSRI, and Barrick Gold, ABX, proves how speculative the latter four have been -- they got run up by the yen carry traders using the Bank of Japan lending window, and investors who went along believing these had real value got burned very badly. Their fall shows the absolute chaos that has come to the world from using the neoliberal Milton Friedman floating exchange currency system.

Keywords
mortgage backed securities, financialization, securitization, mortgage loans, cdo, cdos, liquidity crisis, liquidity evaporation, liquidity vacuum, evaporation of liquidity, counterparty risk, implosion, systemic risk event, financial system meltdown, financial system breakdown, ofheo, wamu, wm, real estate loans, financial stabililty threatened, means, meaning, implosion,

Mike Mish Sheldon is reporting that Option ARM Time Bomb About To Explode HousingWire is reporting Fitch Warns on Option ARMs; “High Defaults Await”.

Fitch Ratings on Tuesday released a wide-ranging look at option ARMs that paints a decidedly negative picture for the mortgage markets over the next 36 months. In fact, the picture is a downright scary one: the bottom line is that most outstanding neg-am mortgages won’t get out of 2011 alive, thanks to forced recasts.

Fitch analysts said they now expect roughly $29 billion in option ARMs to recast to higher monthly payments by the end of 2009, and an additional $67 billion to recast in 2010; of this, approximately $53 billion is attributed to early recasts.

“Though recent declines in the 12-month Treasury average rates have mitigated some risks, the majority of option ARM borrowers have elected to make the monthly minimum payment over the past 24 months,” Fitch said in the report. “As a result, a large number of these loans, especially those with 40-year amortization and 110% principal caps are expected to reach their recasts before the end of the five-year mark.”

TraderMark provides insight into option ARMS.