Thursday, July 10, 2008

Whose Bottom will this Be? Lehamn Brothers (LEH) or Fannie (FNM)/Freddie (FRE)

This is a long post, but it is important to read - so you can tell your neighbors what is happening to the United States of Subprime, and why we are going to be potentially footing the bill in the biggest bailout ever. And how a lax system full of "anti regulation" and cronyism, along with "heads we win/tails we still win" executive compensation has created a disaster.

In January 2008 we had the SocGen bottom (rogue trader doing crazy trades bringing down world markets 5% in 1 day)

In March 2008 we had the Bear Stearns bottom

I had postulated that this time around it might be the Lehman Brothers (LEH) bottom - but Fannie Mae (FNM) and Freddie Mac (FRE) are making a horse race out of it. Who will get bailed out first? Or whose bankruptcy (in the case of Lehman, the other two simply are too big to fail) will mark the bottom? Do we need an "event" to make this bottom?

Frankly if not for the historic changes the Federal Reserve has done (creating massive moral hazard) - [Mar 22: A Historic 9 Days for the Federal Reserve] I believe March 2008 would of marked a major change in our financial markets history with a slew of banking failures - Lehman and Merrill looked like they were heading the same way as Bear. Only historic changes of the rules by our powers that be and the new implicit backing stopped that. In March, we literally changed the rules of free markets in America - and become essentially a socialized market (ironically as we move to socialism, the Chinese move towards capitalism). But it is only corporate socialism in Cramerica - for you peons out there, you are on your own. Safety nets are only for major political contributors.

Now, I believe "they" *want* someone to fail to prove that this is still a (ahem) "free market". It's all about appearances now - we can't have our creditors (the whole world essentially) believe we will just print money to bail out everyone. But it cannot be Fannie or Freddie since that would literally plunge the country into depression - the housing market would literally freeze - as we've outlined on these virtual pages - as the credit system has frozen for mortgages, these 2 quasi government agencies have been doing upward of 70-80% of all mortgages for portions of 2008. Without them - there is no US mortgage market.

But let's take a look at the latest candidates.... first Lehman Brothers (LEH)
  • Lehman Brothers Holdings Inc. shares plunged as much as 19 percent Thursday morning as continued credit fears shook Wall Street, and government officials again reiterated that no bank is too big to fail.
  • Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson both testified before the House Financial Services Committee that the government's overhaul of regulators will help increase oversight. However, they both said that doesn't mean financial institutions are too big to fail.
  • Lehman Brothers, the nation's fourth-largest investment bank, is seen by many analysts to be the weakest of Wall Street's biggest firms. Concerns emerged about Lehman's liquidity and leverage last month after the investment bank reported an unexpected $3 billion loss for the second quarter.
As happened with Bear Stearns, the rumors are now flying fast and furious - it must be good to be a powerful hedge fund shorting these names - you just have to get the media's ear, float rumors that companies have stopped doing business with the bank, and you cause a loss of confidence, and a literal "run on the bank". And you become a very rich firm overnight and your clients laud you for your brilliance - while you just helped kill a firm and unemploy hordes of people. Ah, unregulated (hello SEC) markets. Again no one has investigated who was buying all those massive puts a few days before Bear went down - I wonder why. (Goldman? Nah) I'm sure it was just "good timing".
  • As rumors swirl of hedge funds ceasing to do business with Lehman Brothers, one major trading partner of the embattled Wall Street investment house, SAC Capital said it "is continuing to do business as usual with Lehman."
  • SAC Capital spokesman Jonathan Gasthalter said rumors that SAC, a giant hedge fund with more than $16 billion under management, had stopped taking so-called counterparty risk, where it would no longer lend money Lehman - effectively pulling its credit lines - are "absolutely false."
  • Separately, Pimco, the world's largest bond fund, also said it continues to tade with Lehman. Pimco's comments also came in response to rumors that the bond fund was scaling back its business with Lehman.
On to the twin towers of equity destruction - Fannie and Freddie. I can't take credit for this since the guys at had this thesis before me - but essentially your grandchildren will be paying for the nationalization of these 2 entities. Nationalization is a fancy word for bailout. I've written a lot about this subject in the blog, but not much lately since we have other crisis to deal with on a weekly basis. Our government's solution to the housing problem has been to loosen regulation, allow more risky loans to be taken on by these 2 institutions, and create more lax standards for these two so they can "support" a housing market that needs to crack - creating more and more risk to them (and therefore all of us). As always, SHORT SIGHTED - but what else is new with this bunch. I was typing that for these "solutions" proposed in the late winter and early spring to work, housing needs to turn on a dime and better recover by early 2009 at the latest. Or else these "bright ideas" are doomed, and going to create a new tax expenditure for all of us taxpayers. Well, it looks like it might be coming sooner than I thought (I was tossing around failures of the Big 2 to commence in mid 2009 to late 2009 as the housing market continued to implode)

The stocks have been in free fall for days, and now even William Poole (ex Fed head) is saying out loud what many know, but don't want to say. Technically these are both insolvent.
  • Fannie Mae and Freddie Mac, the two biggest providers of financing for U.S. home loans, tumbled to the lowest levels in 17 years in New York trading after a former Federal Reserve president said the companies may need a government bailout.
  • Fannie Mae tumbled as much as 24 percent and Freddie Mac slumped as much as 34 percent in New York Stock Exchange composite trading after UBS AG analysts said in a report today that Freddie Mac's decline creates ``challenges'' for the company's plan to raise $5.5 billion.
  • Chances are increasing that the U.S. will bail out Fannie Mae and Freddie Mac because they don't have enough capital to weather the worst housing slump since the Great Depression, former St. Louis Federal Reserve President William Poole said in an interview. Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules. The fair value of Fannie Mae assets fell 66 percent to $12.2 billion, data provided by the Washington- based company show, and may be negative next quarter, Poole said.
  • ``Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer,'' Poole, 71, who left the Fed in March, said in the interview yesterday.
  • The companies, created to boost homeownership and promote market stability, own or guarantee about half the $12 trillion in U.S. home loans outstanding.
  • Senator John McCain, the presumptive Republican presidential nominee, said the federal government can't allow them to fail.
  • ``I worry about those institutions,'' retired Richmond Fed President Alfred Broaddus said. ``They are huge. They dwarf the Bear Stearns issue. In the very worst case scenario, I don't know how you do it other than extend money and the public takes the loss.''
The Wall Street Journal chimed in this morning (obviously leaked by those in power) to assure us we have nothing to worry about because the government has it covered.
  • The Bush administration has held talks about what to do in the event mortgage giants Fannie Mae and Freddie Mac falter, according to three people familiar with the matter, as the stock prices of both companies continue to fall sharply
  • The talks have become more serious recently given the financial woes of the shareholder-owned, government-chartered companies, whose stability is vital to the functioning of the nation's housing market, these people say.
  • The government doesn't expect the entities to fail and no rescue plan is imminent, these people said. Government officials and market analysts expect both companies will be able to raise large amounts of capital relatively easily. (from whom?)
  • The shares of the two companies have plummeted for several reasons. Investors are worried they will suffer bigger losses as housing prices continue to fall and mortgage defaults rise. Stock-market investors are also worried they will need to raise significant amounts of capital to cover those losses. For stock investors, that means the value of their ownership stakes in the company will be cut.
  • The current credit crisis has prompted some unprecedented thinking from national policy makers about how to maintain the integrity of the financial system.
  • Any move to prop up the mortgage giants would likely set off a political firestorm. The two companies have long been a target for some Republicans who contend that Fannie and Freddie have profited from an implicit backing they receive from the government.
It's a long story - you can click the link to follow the rest. This is not surprising to long time readers of the blog... here are some warnings
  1. [Nov 20: Freddie and Fannie Trading Like Chinese Small Caps]
  2. [Feb 27: OFHEO Increases Allowance for Fannie Mae] Instead of limiting risk, to "save" the mortgage market the regulators told these companies they will allow them to take even more risky loans
  3. [Mar 10: Barron's Cover Story - is Fannie Mae the Next Government Bailout?] Even Barron's saw the writing on the wall - politicians of course, could not
  4. [Mar 19: Fannie, Freddie Layered with MORE Risk] We bemoaned the "solutions" the politicians were coming up with for the housing problem - all of which added even more systematic risks on the back of these 2 institutions
  5. [Apr 15: Could the US Lose It's Triple A Rating] We discussed the United States of Subprime losing its Triple A rating if it had to bail out these 2 institutions - think our dollar is a joke now? Just wait.
  6. [May 7: Some Things I'm Reading] 2 articles from Wall Street Journal and NY Times warning about this
I thought I'd be writing this piece 1 year from now; not today. In my February entry (above) I wrote

And on a serious note, Fannie is only surviving due to the government's implicit backstopping (it won't fail) and you - the tax payer have a good chance of bailing out this company if things continue down this path for another 18 months. Also, remember Congress' bright idea to stuff this institution with even bigger loans since those markets are frozen, and what do you do when the market is frozen? The government rides to the rescue.

So this is where we are now. If I can figure this stuff out sitting on a computer and reading/researching how can all these intellects in Washington miss the whole boat. In fact they've exaggerated the problems by heaping more systematic risk on an already broken business model. Because they want to get re-elected, and as long as they could kick the can through another election season - then this is the way of D.C.

So if/when it happens the politicians will once again drag executives up to the Hill to grill, when instead they should be looking in the mirror. Our regulators were asleep at the wheel. Our Federal Reserve was asleep at the wheel (or better yet CELEBRATED because housing prices can go up 20% a year in our new paradigm). Our executives in banks not only were asleep at the wheel, they became ultra rich, even those that were "fired". And they have been getting bailed out with interest rates slashed solely to save their bacon, but causing massive inflation problems for the proletariat. Heads they win, tails they win. For you? Heads you lose, tails you lose. Cramerica - for the corporation, by the corporation. It might not happen this week or this month or this quarter. But housing will continue to degrade. And this problem might get put to the back of the shelves for a few months - but it will re-emerge later. Get your wallets ready for the biggest bailout imagined. And please send your grandchildren the I.O.U.

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