We Drove Our Ships To New Lands

The debate continues over whether or not to save Freddie and Fannie. Although the GSEs should not continue in their present forms, allowing them to falter, or worse, fail outright would do more damage to the economy and place a larger burden on taxpayers in the way of a Resolution Trust-like recovery. The S&L bailout added over $100 billion to the Federal debt.

Permitting the GSEs to default on debt and halt dividend payments would be a breach of investor trust. Allowing investors to be wiped out would be like permitting Titanic passengers permitted because authorities permitted (or ordered) the White Star line to have its ships traverse the ice fields. What needs to be done is to rescue the agencies, protect investors and change how the GSEs do business in the future.

S&P's moving to a negative watch on the GSE subordinated debt and preferreds due to "ambiguity" in the rescue plan appears to be nothing more than a push to have regulators address the subject.

Disclosure: I purchased FREprZ on 7/10/08 and on 7/14/08.

I Can't Stand It

It was bad enough that noted "investor" William Ackman spread panic throughout the financial markets with his plan to restructure the GSEs in which investors of all classes get screwed. This is, unless one is short like Ackman. Today, a news story on Dow Jones News Wire tells several falsehoods about preferreds and the GSEs.

The article stated that most bank preferreds are non-cumulative and could very well have their dividends cut should the banks need capital. First, most preferreds issued sine 1993 are various debt / equity hybrid structures which are cumulative and pay interest. Secondly, because preferreds are used as income vehicles, are not voting and have either fixed coupons or, in the case of floaters, a fixed spread over a benchmark, they trade and are treated as subordinate debt in the capital markets. Secondly, if an issuer suspends its preferred dividends, the capital markets, especially the preferred market will shun that issuer prohibiting it from tapping the preferred market to raise capital.

The article also states that the GSEs could very well suspend their preferred dividends and could be forced to do so by Ofheo if their capital was sufficiently depleted. Although this is true, in theory, in practice it isn't that easy. First, Ofheo answers to Congress. It is more likely that Congress tells Ofheo to have the GSEs get money from the Treasury or Fed (note: Capital rations are nowhere near critical levels, are not expected to reach critical levels and the GSEs can utilize the fed window and soon, the Treasury's rescue plan will be up and running in necessary). Eliminating their preferred dividends will shut the GSEs out from the non-agency bond capital markets needed to replenish balance sheets and would cripple regional banks who hold large quantities of GSE preferreds on their balance sheets.


This article is going to needlessly result in investor angst. Many investors will needlessly lose money by reacting to this story. What a tremendous disservice to the public. I can't stand it!

ABC GSE For You And Me

It appears as though some market participants have a vested interest in beating up the GSEs. It appears as though no rescue plan, no amount of capital, no reassurances from various government officials are enough to stop the slide of GSE common equity and preferreds. Small investors are all to eager to believe the doomsayers. What they do not realize that, by joining in with market participants talking down the GSEs, they are sewing the seeds of their own demise.

You see, the market participants talking down the GSEs are, by and large, short. By panicking investors are creating a self-fulfilling prophecy which could end badly. The government and the GSEs themselves do not want to explore the nationalization option.

We must remember that asset bubbles work in both directions. Irrational exuberance can cause asset prices to rise without being justified by fundamentals. Uncontrollable fear can cause asset prices to fall without being justified by fundamentals. However, fear and short driven selloffs can lead to corporate failures.

This is why the Treasury and the Fed have proposed a plan to lend liquidity to the GSEs. Market participants who deliberately undermine the rescue plans by voicing their opinions in the media to help ensure the success of their trading strategies are detrimental to the markets. For this reason, the SEC is going to restrict shorting shares of the GSEs and certain finanicials. Those wishing to short their stocks would need to borrow shares and the lender would then take the shares out of the market making those shares unavailable for delivery or further borrowing. Needless to say, the shorts are up in arms. All this is, is a return to days gone by. This order is temporary and will be reviewed in 30 days. That could be long enough to stabilize the market.

Read Deep, The Gathering Of The Gloom

It appears as though panic has gripped the investor community regarding Freddie and Fannie. Some investors have been afflicted with selective hearing. Not that we blame them. The media has helped to fuel the panic. Let’s clear the air here.

The first media story which started the ball rolling was a report that former St. Louis Fed President, William Poole stated that he believed that Freddie and Fannie were “insolvent”. Following that announcement, investors began to sell their Fannie and Freddie holdings. What was missed was his comment that the taxpayer would be on the hook for the bailout. He did not say that Freddie and Fannie would not be rescued. What was also missed were comments by Fitch analyst Eileen Fahey that the companies are not insolvent, by Treasury Secretary Paulson that Ofheo informed him that Fannie and Freddie have ample capital and from Ben Bernanke that the GSEs have access to the Fed liquidity programs.

Some market participants became panicked after reading an editorial in today’s Wall Street Journal. The Journal stated that if the U.S. government took responsibility of Freddie’s and Fannie’s combined $5.5 trillion of outstanding mortgages, when combined with the government’s own $9.5 trillion, the government’s AAA rating would be in jeopardy. Reader apparently missed the Journal’s solution to the problem. The Journal states:

“Our own proposal, made months ago, is to require a more honest form of socialism by injecting taxpayer money now into both companies (say, in the form of subordinated debt or preferred stock) to recapitalize them enough to weather the current storm. This would help prevent a U.S. balance sheet debacle, and it would force the politicians to acknowledge the mess they have created. Then as the crisis passed, the taxpayers would at least get something for their money, while regulators could work to unwind Fan and Fred's liabilities and shrink these monsters to a less dangerous size.”
This is in line with my opinion that the government will keep the GSEs from failing, not by placing their debt on its own balance sheet, but by helping the GSEs to weather the storm by ensuring their abilities to raise capital in the capital markets.

This is a good segue into the preferred securities discussion. It is true that there is an implied government guarantee for FNMA and FHLMC debt, but that guarantee does not necessarily extend to their preferred securities. It is possible that in a very dire situation, in which Freddie and Fannie were struggling to service their debt (yes it would have to be that bad), they could suspend preferred dividends. However, let’s look at reality. If the plan to fix the agencies is similar to what the Journal and I believe and new preferreds would be issued, who in the world would invest in preferreds which had their dividend payments in jeopardy from the very beginning. Sure, one is speculating that the dividends will be paid when one invests the GSE preferreds, but given the reality of their situations, wouldn’t investing on many (any) bank and finance preferred is a bigger dividend speculation? We won’t even get into the auto sector or junk bonds in general.

Many investors may be curious just how important the mortgage agencies are to the U.S. economy. Let’s shine a little light mortgages in the U.S. According to many sources, there are approximately $12 trillion of outstanding U.S. mortgages. Of that amount, the GSEs are responsible for about 46%. Throw in GNMA (which carries a full faith guarantee of the U.S. government) and the amount guaranteed by some kind of government agency increases to 70%.

If the mortgage agencies are responsible for 70% of mortgages, who is on the hook for the other 30%? It is mostly investors who hold private label mortgage-backed securities. However, as any mortgage trader or salesperson will tell you, the demand for such securities has waned as investors demand some kind of agency guarantee when investing in mortgage backed securities. If this trend holds true for the foreseeable future, the U.S. housing market may be relying almost completely on the mortgage agencies to provide the necessary mortgage liquidity to encourage a housing recovery. This is why regulators have pushed the GSEs to increase the size of their balance sheets and guarantee larger mortgages. No GSEs would be, not only catastrophic but, possibly, cataclysmic for the U.S. economy.

Disclosure: I am long FREprZ.

Say, Say, Say.

The debate continues to rage over whether the Fed should tighten or leave the Fed Funds rate unchanged. There are many market participants who espouse the opinion that the Fed needs to keep rates low. I will concede that keep rates low help troubled banks by keeping Fed and interbank borrowing costs low.

Although that would be a valid argument, many of these easy money advocates go as far as saying that the Fed is not keeping rates low to help banks (some insist that higher rates would help banks - yeah right), but to help consumers. Their argument is that it keeps credit card rates, ARM rates and HELOC rates low.

My argument is that borrowers are tapped out and banks are not lending. Besides, more consumers are feeling the effects of higher food and energy prices than would be affected by higher rates. The easy money apologists have an answer for that too. They claim that food and energy prices are not being affected by low rates and a weaker dollar, only supply and demand. I will concede that supply and demand is the primary driving force between higher commodity prices, but to say that the weaker dollar is not significantly affecting the price if IMPORTED oil is a bit disingenuous. What would make so many smart people say stupid things? Agenda!

Nearly all of the pundits who clamor for continued easy Fed money work for banks or investment banks. Analysts, economists and strategists, whose firms depend on easy financing. Consider the source of the opinion as well as its message. I do work for an investment bank, but the cloak of anonymity provided by this blog permits me to tell the truth.

My readers should also read the blog posted by bondguy1824.

I Remember The Fourth Of July

The economy has many Americans depressed this Independence Day. Although this may be justifiable compared with the U.S. economy of Independence Day's of the recent past, let us put our current plight into a proper perspective.

How bad is it really for the majority of Americans? Is it so terrible because may of us no longer easily afford to drive our gas-guzzling SUVs to the corner store? Is it so terrible because many of us can no longer afford a 4,000 square-foot "McMansion"? Is it so terrible because many of us can not afford the latest electronic gadget? Be thankful if you are only inconvenienced by higher commodities prices.

Be thankful that the majority of Americans own their own homes. Be thankful that, even though we are in a mild to moderate recession, nearly 95% of Americans are employed. The grand social democracies of Europe (never mind the rest of the world) wish they had such a low unemployment rate. Be thankful that taxes are not so high that the government confiscates more money than you take home (speak to a European about that). Be thankful that an unelected despot is not planning to destroy your town, business of farm.

The fact is that, even during this economic downturn, life in America is better than ANY place else in the world. Keep that in mind when you are voting this year. Some candidates wish to emulate the very countries who lag behind us.

Have a Happy Independence Day and God Bless America.

The Battle of Evermore

I have been having a running battle with a colleague (financial adviser) regarding Fed policy. He states that the real reason the Fed has eased and why it should continue to ease is to save the banks by steepening the yield curve thereby enabling banks to borrow cheaply and profit from lending. Although my dear colleague would have been (simplistically) correct during the Greenspan years, he has not accepted the current reality. I fear that many of my readers may also be living in a fantasy world. Here is a splash of cold water to shock you all back to reality.

The Fed has indeed eased to help the banks, but not to help them generate profits via their lending businesses. The Fed has made a cornucopia of capital available to banks so that they may stave off catastrophic failures. Banks are not lending most of the capital they are raising. They are using it to offset writedowns, most of which will never be written up appreciably if at all, so as not to fail. This is about basic survival

Traditionally the Fed lowers rates to make capital affordable to spur consumer spending (homes, cars etc.). The result is usually somewhat inflationary which causes long-term rates to rise which makes the so-called carry trade (borrowing short-term and lending or investing long-term) profitable. The Fed would do a group cartwheel of it could pull this off now. Not only is this not happening now, it is not going to happen for quite some time.

The Fed wantsto tighten. It knows it needs to tighten, but it cannot as long as troubled banks threaten the viability of the U.S. financial system. The Fed and the Treasury Department have been working to find a way to get the banks off of the Fed nipple. Treasury Secretary Hank Paulson may have found a way. Rather than bail the banks out, create a moral hazard which encourages poorly thought-out risk taking (the function of Fed easing for every crisis), Mr. Paulson is working on a way to permit financial institutions fail in an orderly fashion.

Mr. Paulson suggests SWAT teams which would administer the asset sales of troubled financial institutions. The FDIC has a similar mechanism in place for commercial banks. This would apply to investment banks. This way the Fed can manage inflation and growth without screwing the remainder of the economy wiping up after imprudent investment bankers.

The sooner the Fed tightens, the sooner food and energy prices begin to stabilize and, hopefully, decline somewhat. Consumers, less burdened by higher food and energy prices, will begin spending in other areas of the economy, maybe even buying homes (when financing is available) and economic growth will resume. Imagine that, raising rates to promote growth. Seem like I have seen this before, eh Paul?

Little Darlin' It Seems Like Years Since Its Been Clear

It should be clear to all but the most delusional Pollyanna that higher food and energy prices, which are squeezing consumers and businesses alike, are beginning to drag the economy into a significant slowdown if not an outright classical recession. Companies from nearly every sector are reporting reduced revenues, facilities closures and job cuts. Even Starbucks is closing "underperforming" stores, blaming slower sales as consumers have less disposable income.

The U.S. automakers are teetering on the precipice of bankruptcy. They cannot sell their most profitable vehicles ( trucks and SUVs) and do not have the production to meet demand for small cars (which are marginally profitable at best).

The Wall Street Journal stated in an article that investors are surprised that banks are not taking advantage of a steep yield curve to lend profitably via the carry trade. Get it through your thick heads, banks to not have much spare capital to lend. They need nearly every cent they can raise to stay afloat.

It is the troubled banks which are prohibiting the Fed from tightening. We are all suffering to bail out the banks. Of course, if the banks were permitted to fail, we would have 1930 / 31 all over again. The Fed is truly in a bind.

I see now immediate end in sight. The Fed will stay on the sidelines and dollar hedgers and speculators will use oil as their investment of choice. This could change if and when the Fed begins a tightening policy.