You Have Been Warned

Take one Chinese credit bubble, and add the total destruction of US housing...

SOMEONE is going to be voted off the island in America, says Dan Denning in his Daily Reckoning Australia.

It will either be the bankers or the borrowers. Or maybe a giant debt default/amnesty is coming in which both negligent lender and delinquent borrower are let off the hook. Hmmm...

But how about let's look at the can't-miss metal of the moment, copper! Our friend and Diggers and Drillers editor Alex Cowie was all over the copper story a few months ago. And now the metal has reached a mainstream tipping point. Dr. Copper is trading near a 27-month high of US$8,360 per tonne.

Delegates to the Macquarie/London Metals Exchange conference in London predicted a 17% rise for copper in the next twelve months and a 35% rise in the weighted average price of all base metals. If there were any base metal/China bears at the conference, they were probably shot and served as a delicacy, with their pelts used as doormats.

"I think we're in phase two of the super cycle," Alex told us over coffee yesterday. "Of course these smaller projects are always risky. But there are a lot of great stories out there to tell and if metals prices keeping going up, there's money to be made."

In today's Australian Financial Review, a representative of an Aussie firm attending the LME show said, "As long as the world economy keeps going strong and China keeps developing, there doesn't really seem to any other way that copper can go [than up]."

You've been warned. But then again, we could be wrong. And who are we to argue with Alex at the moment. He's recommended copper and tin and Gold Mining stocks this year. And they all seem to be doing well.

But keep in mind that about $30 billion got sucked out of the Chinese banking system yesterday. Granted, that doesn't seem like so much money these days. But it's not a small amount, either. The People's Bank of China lifted reserve requirements by half a percentage point at six Chinese banks yesterday.

The banks in question are the Industrial & Commercial Bank of China Ltd., China Construction Bank Corp., Bank of China Ltd., Agricultural Bank of China Ltd., China Merchants Bank Co. and China Minsheng Banking Corp. Goldman Sachs followed that report with its own analysis that the increase in reserve ratios would remove about $30 billion from the banking system.

For a banking system that pumped nearly US$1.4 trillion in new loans into the economy last year, $30 billion really is chicken feed. The People's Bank of China reports that new loans this year currently tally around 5.7 trillion Yuan – which is a lot less than last year's figure of 9.6 trillion. But there are still three months to go...

Bottom line? Raising reserve requirements is one way to try and contain China's property bubble. That property bubble is what influences the demand for Australian coal and iron ore. That demand is what generates large export earnings for Australia and royalty revenues for the Australian government. Without that demand, the budget probably doesn't stay in surplus and unemployment probably goes down.

That demand is the result of a credit bubble. And what happens to credit bubbles?

To be fair, the Chinese have nothing on America when it comes to bubbles. We probably failed to clearly make our point about the American housing market in yesterday's letter. We'll be clear today: the American housing market is headed for total destruction.

The issue with the robo-signing scandal is that clear title could disappear in the American mortgage market. Part of the outrage is that US banks have been foreclosing on mortgages which they don't even own. Part of the reality is that the convoluted process of securitization means banks may not be able to prove at all they actually do own the mortgages.

Already large unions in the US are encouraging borrowers to challenge banks to prove they won your mortgage. They've set up a website asking the question, "Where's your note?"

You can see where this is headed. No one in America wants to own a failure. The banks want to foreclose on homes and sell them and avoid taking losses. Borrowers (some of them, and some of them rightly) want to avoid paying a debt for an asset that's worth less. No one wants to be responsible anymore because the most lucrative and least painful route is to abandon responsibility and your word.

This is a serious breakdown in one of the most basic elements of a functioning market: contract (doing what you said you'd do). People at every level appear to have cheated and lied during the housing boom. The borrowers who lied on their loan applications...the mortgage originators who made the loan without any documentation of work or income...the securitizer who packaged it up and sold it to investors...the ratings agency that rated the debt investment-grade...the insurance companies who sold default insurance against the bonds multiple times...and the government that encouraged home-ownership and subsidised the fraud with an implied guarantee on the bonds of Fannie Mae and Freddie Mac, the government-sponsored enterprises that bought a lot of the garbage bonds.

What is really at stake though? Well, if borrowers challenge foreclosure proceedings, and if banks (as they have already begun to do) halt foreclosure proceedings nationwide, the process of establishing a market-clearing price in the US house market is frozen. Buyers can't buy and sellers can't sell if the ownership of the underlying collateral – the house itself – is in doubt. What sane person would enter a market like this with prices effectively having completely broken down?

As if that's not bad enough – and it's nearly as bad as it gets – don't forget that that there is a whole universe of financial instruments whose value derives from the underlying collateral. Mortgage backed securities...collateralized debt obligations...the value of any instrument whose value is derived from the underlying asset is now suddenly in doubt.

It's hard to understate what this could mean for financial markets. It could mean another capital crisis in the financial world. It would make 2008 look quaint.

This is why this problem is rapidly escalating into another contest between the banks and the borrowers. The US Congress chose to side with the banks by passing a law (H.R. 3808) which would have made it easier for the banks to foreclose on properties without having to go through the usual process of documentation. But US President Obama – less than a month away from an election that's become a referendum on his policies – simply ignored the resolution (a pocket veto). Who wants to be seen siding with bankers right now?

Now you have a situation where US banks again face massive losses on their exposure to residential real estate. You have a growing popular movement to challenge the banks through the legal system – raising bank costs and eating into bank earnings (which are already pretty flimsy when you take away the boost to the net interest margin from low short-term rates).

But the biggest problem by far is that you have a growing ethos in the American mortgage market that everything is so upside down and backwards that the best thing to do is just stop playing by the rules and stop paying your mortgage. The whole market is on the verge of breaking down. Trust has evaporated. The rule of law itself now seems irrelevant.

Who is the government going to side with in this dispute? The banks, who will claim (perhaps correctly) that the crisis threatens their ability to loan, and perhaps their very existence? Or will it choose an increasingly angry populace who doesn't want to again get sacrificed on the altar of saving the financial system?

Our guess is the government won't choose either. It will choose both!

The easiest way to deal with debt – if you have no intention of paying and don't want to inflate it away right away – is to simply repudiate it. A great debt amnesty is required!

Bankers must be allowed to sell everything they don't want to the government, and probably at a price that suits the bank, even if it wouldn't be borne by the market. And distressed homeowners must be allowed to refinance at a fixed-rate for 50 years through a government lender that will never foreclose on them, and is probably statutorily prohibited from doing so. No one takes a loss. No one loses a house. Voila!

Of course it can't work that way. Huge amounts of capital have been misallocated in a credit boom. The recovery begins when the losses are taken and household and corporate balance sheets are returned to sanity. But no one wants to deal with that pain. So insanity ensues and a completely zombified mortgage market looms.

Australia has housing problems of its own, but not quite on this scale. The only question now is what the total destruction of the US mortgage market means to global capital flows and interest rates.

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