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Mark's Market Blog

10-15-10: Foreclosuregate.

By Mark Lawrence

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The markets continued trending up on increasing volatility and decreasing volume. The DOW and the S&P are near their high for the year; the technology heavy NASDAQ is at a new high, thanks in large part to Apple.

S&P 500 April 25 2010 to October 15 2010

I've said repeatedly that financials will lead this market, up or down. The graph below gives you an idea of how financials are doing. The S&P is green, NASDAQ (tech stocks mostly) is red, financials are blue. Notice that blue has been flat throughout this entire little mini-bull market we've had for the last 6 weeks or so. Except for taking a little nose-dive the last couple days. We'll talk about that below.

S&P 500, NASDAQ, Financials, April 15 - October 15 2010

Two weeks to the election. What will happen? It's very difficult at this point to imagine that the democrats keep control of the house. In the senate, things are a lot closer. I consider it unlikely that republicans will take the senate. The senate seats most in play are Washington, West Virginia, Nevada, Illinois. That's what you want to watch on election night, if you care about such things. Personally, as I think I've made clear, I no longer believe there's much difference between the two parties: they're both bought off by the same money, they both want to steer the boat over the waterfall. The only difference is which bank they want to hug as we go over. And for those of you who think the republican gains foretell Obama losing his job two years from now: in the last 100 years, every single president who lost big in the mid term elections was re-elected himself. Projecting from history, currently we would expect that after 2012 the senate is republican, the house is strongly republican, and Obama is president for four more years.

The FED has announced QE2. This is not a huge cruise ship named after a popular monarch, it's Quantitative Easing Round II, Bernanke's personal boxing match with the markets. In QE1 he bought a bit over a trillion dollars worth of various securities, which succeeded in recapitalizing the banks to the point where they were no longer technically bankrupt. Today we have a different set of problems: houses continue to get foreclosed, banks don't want to lend to anyone, consumers don't want to consume, businesses aren't hiring. So Bernanke is going to buy another $1T - $1.5T worth of bonds, which will prop up bank profits and the stock market further. He also hopes to get inflation going a bit. Apparently Bernanke doesn't ever buy food, 'cause if he did he would know this is already a done deal. What, you might ask, does QE2 have to do with unemployment, under water mortgages, poor retirement prospects? Sorry, I have no clue. Maybe he hopes that bankers will start buying tons of stuff and hire the rest of us to mow their lawns. Here's the sad truth: no one in Washington has a clue what to do. But they have to be seen as doing something. So, they fall back on what they do best: spend money.

Japan is desperate to lower the value of the yen, which has been going up recently - they're one of the big losers as the Fed erodes the value of the dollar. Japan's central bank made the incredible announcement last week that They've already set up a $61.1 billion fund to buy stocks, bonds and real estate in a bid to fight deflation and lower the value of the yen by blatantly inflating all kinds of asset prices. The director of the Japanese central bank hinted that there may be more when this is used up.

Food prices are skyrocketing, raising recently at 10% per month. What's the government doing about it? The EPA is raising the requirement next year for corn ethanol from 10.5 billion gallons to 12 billion gallons, and raising the gasoline blending requirement from 10% to 15%. AAA and all the car companies are protesting this saying that more than 10% ethanol will mean much faster wear of exhaust systems, catalysts, fuel pumps.

China is getting squeezed hard by the US dollar dropping. As the Yuan is pegged to the dollar, they are finding that commodity prices are shooting up as the value of their currency drops, fueling inflation. The lower Yuan means their exporters are doing well, which drives up their stock prices and fuels their stock and real estate bubbles further. Letting the Yuan continue to drop is clearly risky for them. However, if they let the Yuan rise, then people will buy huge quantities of their currency expecting further rises - this would further fuel their real estate bubble as money pours into China, and also cost them jobs as their goods get priced out of the market. Either way, China is losing.

International Trade Flows

Foreclosuregate - what is it? Sorry, this story is a bit complicated. Several years ago, the banks figured out they could bundle up mortgages and sell them as mortgage backed securities. But that wasn't enough, some bright boys on Wall Street broke the MBSs into slices, "tranches," of varying risk. The low-risk slice went out for a high price, the high-risk tranch went out for a much lower price. But they didn't know which mortgages were high risk - the high risk slices just agree that the first mortgages to default would go on them. So the titles to the houses were assigned to corporations called Real-Estate Mortgage Investment Conduits, REMICS. Fannie Mae and Freddie Mac then formed a corporation called MERS...the Mortgage Electronic Registration System. MERS would move the titles into the correct tranches as time went by, telling everyone who owned what. To get a high rating on the bonds, the REMICS had to be bankruptcy- immune, so they couldn't own the titles. The MERS never owned them, their job was just to move them from A to B. So there was a time when no one owned the title to the houses. If you want to foreclose on a property, you have to prove in court that you own the title, so there has to be an unbroken chain of ownership. But the chains were broken between the REMICS and the MERS. Some attorney noticed this and brought the chain of ownership into question in a particular foreclosure action. Now it's in question for basically every mortgage foreclosed on in the last several years, and most every mortgage to be foreclosed on for the next several.

If the chain of ownership cannot be repaired, the mortgage is void and someone gets a free house. The banks, seeing this, wrote a new law, the Interstate Recognition of Notarizations Act, and paid for it to get through the house and senate, but Obama pocket-vetoed it. The day after the pocket veto BofA announced their "voluntary" moratorium on foreclosures. The banks are now scrambling like mad to try to figure out what went where and how to repair things. Meanwhile, a couple companies sprang up a year ago or so who would "repair" a title chain with forgeries for a fee - this is how some people got their home foreclosed even though they had paid cash. Bottom line: it's possible that in many cases these notes can't be repaired, or previous forgeries mean no judge will accept a repair. It's possible that repairing the chains of title will cost the banks so much money that they can't afford it. Another piece of this issue is when the banks bundled the loans into securities, they made certain claims and promises. It's possible the banks will be forced to buy bank many of these now worthless securities at the original selling price due to the banks making false claims. It's possible the banks are back to bankrupt, back to their state when Lehman Bros went down and the whole financial world nearly collapsed. No one knows. But this issue has the potential to be a game-ender for the large banks.

How serious is this? Many title companies have stopped issuing title insurance, as they aren't sure the documents they get are accurate.

We saw above that financials have been pretty flat for the last several weeks, while everything else has been sky-rocketing. What's in store for the future? After the election, I expect the markets to drop significantly, lead down by the financials. Questions about the banks viability are going to get quite pressing. Bernanke has shown clearly that no big bank will fail on his watch, but that doesn't prove the shareholders will be saved.

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