Saturday, September 6, 2008

Debt Rattle, September 6 2008: Put the load right on me

Lewis Wickes Hine All earnings go to father May 21, 1910
Joseph Severio, Peanut Vendor. Wilmington, Delaware. 11 years old. Pushing cart 2 years.
Out after midnight. Ordinarily works 6 hours per day.
Works of own volition. Doesn't smoke. All earnings go to father.

Ilargi: After yesterday's focus on the demise of the yen carry trade, the story today is of course the Fannie Mae and Freddie Mac bottomless black hole. Wonder what the connection might be....

I think the best thing to do is simply to provide a range of articles, and -as always- let you make up your own mind. Still, I do have a few comments first.

To start with, someone suggested this morning that Hank Paulson took the job of Secretary of the Treasury in order to earn his place in the history books as the hero who saved the US economy. While that is funny, it's not true.

Paulson's goal has been, all along and from the start, to transfer the losses incurred in the credit markets to the population at large, the taxpayers, and away from his friends and peers, who form a substantial part of the Wall Street banking establishment. It's easy to recognize who is not a friend of Hank: just look at who holds the empty bag.

A lot of questions are out there about the timing of the imminent bail-out, as well as the precise shape it will take.

As for the timing: here's a few thoughts. I read somewhere that the government has frantically tried to stop this from happening on their watch. While that sounds right at first sight, I keep coming back to the notion that if they DO let in happen while they're in charge, they are, well, in charge.

Paulson now controls who gets what and when. He'll be gone in January. That's a lot of power. He may know more than me about who'll follow in his footsteps, but then again, he may not be so sure. Plus, neither of the presidential candidates may want this on their watch either. There's plenty of pressure on Bush to clean up his garbage. Which is also why I expect GM and Ford to go under between the election and the inauguration of the next drone.

More on the timing: Within weeks, Fannie and Freddie have to refinance $225 billion in -mostly short term- debt. There is no guarantee they will succeed, and in fact this is where Paulson may certainly have the edge on us. If he's been told by the CEO's of both firms that they can't get it done, there's a good reason for your timing.

And there's something potentially much bigger. The Federal Accountancy Standards Board, FASB, has announced new standards, a.k.a. FASB-140. It looks like they will be implemented, although they have been delayed. If memory serves, they will now come into effect in January 2009. They will require Fannie and Freddie to take an additional $3.7 trillion of debt on their balance sheets.

And even with the insanely low reserve requirements that they are under as "semi-government" companies, they would need to raise new capital to the tune of $80-100 billion ($46 billion for Fannie alone), in one big whopping step. In view of the fact that the markets have a collective orgasm these days if Freddie manages to raise a mere $3 billion, the potential problems are obvious.

A last point on the timing: Kenneth Rogoff predicted the failure of one of the big US banks within months. If that is about to happen, it would not be a good idea to let it coincide with the Fannie and Freddie bail-out, since this failure would land the FDIC in the ER.

As for the shape and form of the bail-out: It looks like the government will opt to for "conservatorship", a sort of bankruptcy protection that lets them fire all the people they want, and bring in "overseers". Who will then dole out a few billion of your tax money every so often, instead of in one big batch: looks much nicer, even though the result is the same or worse.

While most analysts think holders of common shares will be left with zero, there are some who argue with that. I think it all depends on who's holding it: if they're friends of Hank, they'll be fine. As for holders of preferred shares and junior debt (last in line, unsecured), they will be "made whole" (or lose little), so goes the consensus.

There have been a lot of borderline xenophobic arguments about the Chinese "blackmailing" the US over the GSE-issued mortgage backed securities they hold. But I think that the priorities lie elsewhere (I also despise xenophobia). The Chinese central bank reportedly holds $340 billion of the paper. But Pimco, the US' largest bond investor, has over $500 billion worth. Still, the rant is about China.

Also, as for why the "preffered share"-holders (and perhaps even common shares) will be protected: there is a huge amount of it in US banks, big and small. That means that letting it sink to zip would detonate a whole series of A-bombs inside the US banking system. Which in turn would necessitate an almost instantaneous bail-out of banking deposit insurer FDIC. Since pension funds are the other main holders, many of them would be wiped clean overnight too.

So the whole train is still on track, and it's the taxpayer that will be wrecked. The biggest transfer of wealth in humen history continues on schedule, and it will leave in its wake poverty on a scale that has not been seen in a very long time in the western world.

One last thing: Remember what Nouriel Roubini said: "These GSEs were designed to make losses."

Treasury near plan for Fannie and Freddie
The Treasury Department is close to finalizing plans to effectively take over beleaguered mortgage buyers Fannie Mae and Freddie Mac, according to a report published Friday. Citing sources close to the matter, The Wall Street Journal reported that an announcement could come as early as this weekend. Shares of both companies plunged in after-hours trading.

The government may put the companies in conservatorship and take control of them at least in the short-term, the Journal reported. The plan also may include a capital injection in the government-sponsored entities by the Treasury and changes to senior management at both firms, according to the report.

In a statement, the Treasury Department said it would not "comment on rumors." Representatives for both Fannie Mae and Freddie Mac declined to comment on the report. The two firms, which were set up by the government, own or back about $5 trillion worth of home debt - half the mortgage debt in the country. Since last summer, they have suffered about $12 billion in losses.

Concerns over whether Fannie and Freddie will have enough money to weather future losses in the housing market sent shares sharply spiraling lower earlier this summer. By mid-July, the Treasury Department and Federal Reserve announced steps in mid-July to make funds available to the firms if necessary and Congress approved the sweeping proposals later that month.

The Treasury Department retained Wall Street's Morgan Stanley in early August to advise it on its new authority to prop up the two firms. Morgan will provide advice on capital markets, capital structure, strategy and mortgage-related matters through January 17. It will not be paid for the work, beyond accepting $95,000 for expenses. Morgan Stanley had no comment about the report.

Fannie and Freddie have become virtually the only source of funding for banks and other home lenders looking to make home loans. Their ability to do so is crucial to the recovery of the battered home market and the broader U.S. economy.

The two firms buy loans, attach a guarantee, then sell securities backed by the loans' income stream. They have been badly hurt in the last year by the sharp decline in home prices and the rise in mortgage delinquencies and foreclosures.

Both companies have been losing money for the past few quarters due to the subprime mortgage meltdown and steep declines in housing prices. Bert Ely, an independent banking analyst, told CNN that Freddie Mac CEO Richard Syron could be forced to step down as part of Treasury's plan. Fannie, meanwhile, recently announced that its chief financial officer and chief risk officer were leaving the company.

Ely added that it is a surprise that Treasury may be acting now though because there has not been a lot of pressure on the companies from Wall Street in the past few days. Freddie's stock rose 13% during the holiday-shortened week while Fannie's stock gained 3%. Shares of both companies are still down more than 80% so far this year, however. The ultimate cost to the taxpayer of any Treasury intervention remains unknown.

In any rescue, Treasury would likely have to borrow billions of dollars. Exactly how much it would cost taxpayers is impossible to gauge because of several unknowns. Among them: extreme volatility in the companies' stock prices coupled with falling home values and rising mortgage default rates, which affect the value of the GSEs' assets and debt.

Long-term, the potential downside of a Fannie-Freddie intervention could increase taxpayer costs in other ways. One of them: It could in a slow-growth environment help drag down the government's top-notch credit rating. And that could make it more expensive for the government to borrow, putting pressure on future administrations to raise taxes or cut spending.

Freddie/Fannie Plans In Motion; Why Are They Being Underplayed?
Word all over after the market close is that Treasury is finalizing its Fannie/Freddie bailout/backstop plans. The plans allegedly include changing senior management -- you think? maybe? gosh -- as well as putting taxpayers on the hook for a few deci-billion more dollars.

More broadly, this isn't a big surprise, but the timing of this coming after Bill Gross's missive yesterday really rankles. Does everyone have to hop every time Gross complains? Is he the bond market incarnate, or just channeling its animal spirits?

[Update] The WSJ now has out a story on it. Not much more detail, other than the reminder that Treasury had a series of high-level meetings today, something may come this weekend, and that Morgan Stanley remains one architect of the plan. We all know nothing would ever leak from a classy shop like Morgan Stanley back into the market. No-ooooo.

[Update^2] When asked on CNBC after the close whether he had been approached about buying preferred stock or debt in any bailout deal, Pimco's Bill Gross declined to comment. Take that as a "yes", which makes yesterday's note from Gross even more Treasury bludgeoning. To spend the first half of the interview spitting watermelon seeds and pretending not to know much, only to demur on answering that crucial question at the end is ... well, remarkable TV.

[Update^3] Bloomberg says Hank Paulson, Ben Bernanke, Fannie Mae CEO Daniel Mudd, Freddie Mac CEO Richard Syron and Federal Housing Finance Agency director James Lockhart met today in Washington. More importantly, perhaps, it says Morgan Stanley and Mudd et al., are continue to meet at the FHFA, with catered food scheduled for delivery all weekend. And as we all know, bailout plans run on their stomachs.

[Update^4] The Washington Post has more detail, with a conservatorship -- essentially, a government takeover -- in Fannie/Freddie's future, as well as complete management team and board wipeouts in both companies. The preceding was mostly as expected, but it is disconcerting to read that while common shares will be diluted, and preferred shares and debt will be protected, the common will not be wiped out.

Granted, people who hung on through a near doubling since August 23rd are now in for a pounding, but they should be zapped entirely. The government has no business using my money to bail out lottery ticket holders with my money, which is what FRE/FNM shareholders are at this point.

Is the Freddie/Fannie bailout plan being underplayed? News late today that Treasury plans are likely to be announced imminently strikes many people, myself included, as one of the biggest financial events in modern memory, and yet it feels underplayed.

Why do I say that? Well, until recently, it was the second story on the front page of the WSJ this afternoon, and it hadn't even made the front page of the NY Times site last I looked. Marketplace on NPR, which I listen to most afternoons, shrugged it off in a 15-second drive-by comment as some late-breaking news that the market may have noticed.

Remarkable stuff. Here is the Federal Government backstopping a massive financial services organization; okay, two of them; okay, the whole frickin' financial services industry plus the stock market, with China and the rest of the world watching nervously, and it's being treated as just another day in those nutty ol' markets.

But it isn't just another day in the markets. This is set to be epochal, a true "Where were you when..." moment, a before/after sort of of thing. You can't make these kinds of massive financial commitments -- more than a trillion dollars, at least in notional terms -- with so many contingencies, without imagining the kinds of consequences, financial and political, that come with it. After all, the current U.S. administration desperately wanted to punt this past November elections, and it now seems clear that it can't.

The underlined point in the prior paragraph is important to understand. As much as the Treasury and the Bush Administration didn't want to get saddled with this bailout baggage at all, put that to the umpteenth power and you'll get how desperate they were to move this past election day in November. Bush, Paulson, et al., wanted it to be the next Administration's problem, not theirs; and they didn't want it to be fodder in the current electoral cycle. They failed on both counts, which tells you fast and out-of-control this apple cart is.

So, how much will the total liability be? Any upside will be sold hard, but will there ever be a chance to exercise whatever convertible paper Treasury (i.e., you and me) end up holding? Where does it go from here, and who else -- I'm looking at you, Wachovia and you, Washington Mutual -- is deemed too big to fail? What happens to the dollar with the Fed working overtime to print money? What happens to treasuries? To the dollar? Inflation? Stay tuned.

Paulson Plans to Bring Fannie, Freddie Under Government Control
Treasury Secretary Henry Paulson is preparing to announce plans to bring Fannie Mae and Freddie Mac under government control, seeking to halt the crisis of confidence in the companies that make up almost half the U.S. mortgage market.

Paulson met with Fannie Mae Chief Executive Officer Daniel Mudd and Freddie Mac CEO Richard Syron yesterday to brief them on the decision to put the companies into a conservatorship, where they would be removed from their jobs, according to a person briefed on the discussions. A public announcement is expected this weekend, the person said.

The decision follows the Treasury chief's repeated comments to lawmakers in July that he wasn't likely to use taxpayer funds to prop up the federally chartered, shareholder-owned firms hit by $14.9 billion in losses the past year. The shares of both companies slid since Paulson won powers to inject unlimited funds in the companies, and their borrowing costs rose.

Pacific Investment Management Co., manager of the world's biggest bond fund, and other large investors may put in their own money once the Treasury decides to inject government funds, said Newport Beach, California-based Pimco fund manager Bill Gross, in a Bloomberg Television interview. "They have to open their wallet," Gross said, predicting that the Treasury will act this weekend before the Federal Housing Finance Agency releases an assessment of Fannie's and Freddie's capital.

Paulson gathered with Federal Reserve Chairman Ben S. Bernanke, FHFA director James Lockhart, Syron and Mudd in Washington. The Treasury plans to brief Democratic presidential candidate Barack Obama's campaign team today and has contacted Republican contender John McCain's staff about its intentions.

The meetings come a month after Paulson hired Morgan Stanley to advise on any use of taxpayer funds to recapitalize Fannie and Freddie, which account for almost half of the $12 trillion mortgage market. A government takeover would be the latest attempt to blunt the impact of the yearlong credit crisis, after the Fed provided financing for Bear Stearns Cos.'s takeover by JPMorgan Chase & Co.

Washington-based Fannie and Freddie dropped in after-hours trading. Fannie fell $2.25, or 32 percent, to $4.79 at 5:50 p.m. in New York Stock Exchange trading and Freddie slumped $1.40, or 27 percent, to $3.70.

The Washington Post reported that the government would make quarterly injections of funds as the companies' losses warranted, avoiding a large up-front taxpayer cost, citing sources it didn't name. Debt and preferred shares would be protected, and common stock would be diluted while not wiped out, the Post said. The New York Times said most or all of both the common and preferred shares would be worth little or nothing.

"We are making progress on our work with Morgan Stanley, FHFA and the Fed," Treasury spokeswoman Brookly Mclaughlin said yesterday in Washington, declining to comment on any specific plans. FHFA spokeswoman Stefanie Mullin declined to comment, as did Mark Lake at Morgan Stanley.

Bernanke participated in yesterday's meetings because the central bank was given a consultative role in overseeing Fannie's and Freddie's capital under legislation approved in July. Paulson's decision won the approval of Bernanke and Lockhart, the person briefed on the discussions said.

The FHFA has the authority to place Fannie or Freddie into conservatorships or receiverships under the law. The legislation that President George W. Bush signed July 30 also gave the Treasury the power through the end of next year to extend unlimited credit to or make equity purchases in the firms.

Under a conservatorship, the authorities would aim to preserve Fannie and Freddie assets, rather than dispose of them, the law says. The FHFA was scheduled to release its assessment of the companies' capital levels as early as this week as part of a quarterly appraisal of their finances.

Analysts have speculated that the Treasury would wipe out common shareholders, while seeking to shield preferred stockowners from total loss. Fannie and Freddie preferred shares are typically owned by banks and insurance companies. Their $5.2 trillion of debt outstanding is held by investors including Asian central banks, and would probably be guaranteed, analysts said.

"Treasury's main concern is the debt markets, and if it was to say that it will do whatever is necessary to keep Fannie and Freddie running, the better it is for their funding," said Alex Pollock, fellow at the American Enterprise Institute in Washington and former president of the Chicago Federal Home Loan Bank. The two companies need to sell billions of dollars of bonds each month to pay off maturing debt, and have continued to issue securities this week.

Fannie and Freddie have reported $14.9 billion in net losses for the past four quarters as loan delinquencies rose. Fannie had $47 billion of capital as of June 30, according to company filings. The company is required by its regulator to hold $37.5 billion. Freddie's capital stood at $37.1 billion, compared with a requirement of $34.5 billion, filings show.

Mudd was accompanied in his meetings at FHFA yesterday by Fannie General Counsel Beth Wilkinson and Chairman Stephen Ashley. Last week, he shook up the company's management in an effort to restore investor confidence, replacing three top deputies.

The market capitalizations of Fannie and Freddie slid with their shares this year as investors lost confidence in their ability to offset losses. Fannie's is now $7.6 billion, down from $38.9 billion at the end of last year. Freddie's has fallen to $3.3 billion, from $22 billion over the same period.

Fannie Mae was created in 1938 as part of President Franklin D. Roosevelt's New Deal plan. With the Vietnam War pressuring the federal budget, Fannie Mae was split from the government in 1968, and shares in the company were sold to the public. Freddie Mac was created in 1970 to provide competition for Fannie Mae.

Will Fannie and Freddie shareholders be wiped out this weekend?
Three weeks after Barron's reported that a senior administration official -- my guess is it was Hank Paulson -- leaked details of a "rescue" plan for Fannie Mae and Freddie Mac -- Bloomberg News reports that its implementation could be imminent. And in after-hours, shares of both companies are down 20%.

If what Barron's reported -- wiping out common shareholders and slashing preferred dividends -- proves prescient, both stocks have further to tumble -- as in all the way to 0. Bloomberg reports that Paulson met with Ben Bernanke and the CEOs of Fannie and Freddie and the head of the Federal Housing Finance Agency which oversees the two.

And they have catering set for the entire weekend. I wonder what they are serving? I think PIMCO bond guru Bill Gross knows. He said, "There's probably a 95 percent chance that the moment that something will happen is Sunday or Saturday," according to Bloomberg.

Yesterday Gross called for the government to use $500 billion to bail out the real estate market. As I posted yesterday, this bailout is for the benefit of people like Gross and China's central bank which owns $340 billion worth of Fannie and Freddie mortgage-backed securities. If you happen to be among the holders of their common or preferred stock -- you are going to lose it all.

As I suggested this morning, after the market lost 345 points yesterday, the government needed to announce another rescue plan by Sunday night. And it looks like that's what will happen. Unfortunately, your taxpayer dollars will go to rescue China and poor Bill Gross since "61 percent of Gross's holdings were mortgage-backed securities as of June 30, mostly debt guaranteed by Fannie, Freddie or Ginnie Mae," according to Bloomberg.

Let me repeat -- Bill Gross, who manages $830 billion, has convinced the U.S. Treasury to use your taxpayer dollars to bail him out of his bad investments. And China, which holds $340 billion worth of such securities, will go along for the ride.

U.S. Nears Rescue Plan For Fannie And Freddie
The government has formulated a plan to put troubled mortgage giants Fannie Mae and Freddie Mac under federal control, dismiss their top executives and prop them up financially, federal officials told the two companies yesterday, according to three sources familiar with the conversations.

Under the plan, which could prompt one of the most sweeping government interventions in financial markets in U.S. history, federal officials would place the firms under a conservatorship, a legal status giving the government the option and time to restructure and revive the companies, the sources said. The value of the companies' common stock would be diluted but not wiped out, while the holdings of other securities, including company debt and preferred shares might be protected by the government.

Instead of giving each company a big capital infusion upfront, the government could make quarterly injections as the companies' losses warrant, the sources said. This would be an attempt to minimize the initial cost of the rescue.
The timing of government action remained unclear last night, and the final details were still under discussion.

But as the pace of discussions accelerated, Treasury officials contacted senior congressional leaders yesterday, telling them they might be briefed on the plan this weekend and asking for telephone numbers where they could be reached.

The action would represent a major escalation of the government's role in private lending. The government would be assuming vast obligations it has historically disavowed, potentially using taxpayer money to make up for private business decisions gone wrong.

In an effort to contain the most profound financial crisis in generations, Treasury Secretary Henry M. Paulson Jr., leaders of the Federal Reserve and other government officials have in recent months upended decades of precedent. A bailout of the two mortgage finance titans would follow a Fed rescue of investment bank Bear Stearns in March and earlier steps to provide implicit government backing to Fannie Mae and Freddie Mac.

Fannie Mae and Freddie Mac have backed 70 percent of new mortgages in recent months, but both have incurred vast losses on their loan portfolios as the housing market has tanked. Paulson, the architect of the plan, and other government leaders view the mortgage firms as vital to preventing an even broader financial crisis and economic downturn.

The chief executives of the two companies were called into afternoon meetings yesterday at the 17th Street NW offices of the Federal Housing Finance Agency, their direct regulator, sources familiar with the events said. Executives of the two companies were told to show up without being told of an agenda. Daniel H. Mudd, chief executive of Fannie Mae, was accompanied by lawyers from Sullivan and Cromwell, the company's outside counsel.

He arrived at 3 p.m. for a two-hour meeting. Richard F. Syron, chief executive of Freddie Mac, began his meeting at about 5 p.m., accompanied by several members of the Freddie Mac board and lawyers from the firm Covington and Burling. The boards of Fannie Mae and Freddie Mac both plan to convene today.

Paulson, Federal Reserve Chairman Ben S. Bernanke and James Lockhart, the director of the housing finance regulator, told the executives of the plan, which would strip them of their jobs but not include any broader management shake-up.

The plan was described by three sources: an official, a former official who was told of the plans and a mortgage industry executive with direct information. They spoke on condition of anonymity because its specifics had yet to be announced.

If the plan is enacted, it would bring under direct government control two companies that have a long and complicated history as hybrid public and private entities. In July, with the companies reeling from losses and fears growing that they wouldn't be able to raise new cash privately, Paulson gained the power to invest government money in Fannie Mae and Freddie Mac through unlimited loans or stock purchases.

Although the companies' shares initially soared on that news, their financial positions have worsened in recent weeks, along with their ability to raise money in the markets. The companies' shares are off about 90 percent from their highs in the past year.

"It's clear the market wants some closure on this. Any sort of plan that would get the market at ease would be preferred to what we have right now," said Mario De Rose, chief fixed-income strategist at Edward Jones, a brokerage firm based in St. Louis.

In recent weeks, investors less willing to take risks on debt issued by Fannie Mae and Freddie Mac have demanded higher payments, which has increased costs for consumers taking out mortgage loans. Investor uncertainty over the long-term fate of the companies has left a pall over credit markets. It has been unclear which investors, if any, would suffer should the government intervene to prop up the firms.

The answer, in Paulson's plan, is that holders of preferred shares and subordinated debt, a riskier but higher-paying class of debt, might be made whole. Government leaders were reluctant to allow holders of those assets to incur major losses because they are widely held by banks, and major losses could cause a wave of bank failures.

Placing the companies in conservatorship, rather than receivership, could signal that the government does not intend to nationalize or liquidate Fannie Mae and Freddie Mac. Instead, under the terms of a federal law passed this summer, conservatorship is designed to allow the government to restructure the companies and return them to private control. Treasury officials have previously compared the process to Chapter 11 bankruptcy.

If the government plan succeeds, uncertainty in the markets around Fannie Mae and Freddie Mac could subside, making it easier for the companies to get access to funding at cheaper rates. That, in turn, could have a spillover effect in the overall market for mortgages, lowering interest rates and helping the battered housing market recover.

The move may calm some Asian markets, where central banks and other financial institutions have become among the largest investors in Fannie Mae and Freddie Mac and therefore one of the largest sources of mortgage finance in the United States.

Uncertainty over whether and how Treasury would intervene has caused some major investors to reduce their holdings of the agencies' debt, according to analysts. That threatened to make it more costly for the companies to get financing, increasing mortgage rates and delaying the housing recovery.

Victor Wang, a banking researcher at UBS Securities Asia, said that Chinese banks, the largest foreign holder of agency debt, did not know how to read the possibility of a Treasury intervention. "Very few have full confidence of that," he said. "It's a 'may.' And 'may' means uncertainty. That's something banks don't like."

Government to wipe out Fannie/Freddie shareholders by Sunday
And now what could become history's biggest transfer of tax dollars to bail out bad lending begins. Last month Congress passed a bill that gave the Treasury Department $800 billion to bail out Fannie Mae and Freddie Mac.

And while it is unclear how much money will be used to bail them out, the general outlines of the soon-to-be-announced terms are becoming clearer than they were last night. The New York Times and The Washington Post report on five key features as follows:
  • Government bankruptcy. Fannie and Freddie will be taken under a conservatorship -- which is similar to a bankruptcy wherein a trustee operates the company so it can be fixed and ultimately sold back to public investors. The bailout would reduce the value of their common and preferred shares "to little or nothing," according to the Times.
  • Taxpayers bailout defaulted mortgages. Some share of the $800 billion in taxpayer funds will be used to pay "any losses on mortgages [Fannie and Freddie] own or guarantee," according to the Times.
  • Payouts on a quarterly basis depending on reported results. Treasury is trying to dribble the bailout over time. "Instead of giving each company a big capital infusion up front, the government could make quarterly injections as the companies' losses warrant. This would be an attempt to minimize the initial cost of the rescue," according to the Washington Post.
  • Fire CEOs and replace the boards. At a meeting earlier in the week, on which I posted, Daniel Mudd, Fannie's CEO, and Richard Syron, Freddie's CEO, "were told that they would have to leave. And "the companies boards would be replaced," according to the Times. I can only imagine the firestorm that will ensue if Syron gets another $38 million as a severance package.
  • Announce deal before Asian markets open. As it did with the Bear Stearns bailout, the government caters to Asian markets so it "had been planning to announce the decision as early as Sunday, before the Asian markets reopen," according to the Times.

Why did Paulson decide on this bailout? His bazooka strategy -- merely having the authority to bail out the two companies -- did not alleviate investor anxiety. He measured that by the widening interest rate difference between Treasury and Fannie- and Freddie-backed securities.

And concluded that in order to lower that spread and bring down mortgage rates he would need to use his bazooka rather than merely keeping it in his pocket.

When it was announced in May 2006 that Paulson would take over as Treasury Secretary, I speculated that he did so because he thought he would have a bigger challenge than Robert Rubin -- another Goldman Sachs Group alums -- in cleaning up the coming financial catastrophe created by our dependence on foreign ownership of U.S. debt.

And I thought Paulson would try to make his name in the history books by dealing with that cleanup. It remains to be seen how history will judge him -- but since China owns $340 billion of Fannie and Freddie mortgage-backed securities -- it looks like my guess about the first part was partially right.

U.S. Rescue Seen at Hand for 2 Mortgage Giants
Senior officials from the Bush administration and the Federal Reserve on Friday called in top executives of Fannie Mae and Freddie Mac, the mortgage finance giants, and told them that the government was preparing to place the two companies under federal control, officials and company executives briefed on the discussions said.

The plan, which would place the companies into a conservatorship, was outlined in separate meetings with the chief executives at the office of the companies’ new regulator. The executives were told that, under the plan, they and their boards would be replaced and shareholders would be virtually wiped out, but that the companies would be able to continue functioning with the government generally standing behind their debt, people briefed on the discussions said.

It is not possible to calculate the cost of any government bailout, but the huge potential liabilities of the companies could cost taxpayers tens of billions of dollars and make any rescue among the largest in the nation’s history.

The drastic effort follows the bailout this year of Bear Stearns, the investment bank, as government officials continue to grapple with how to stem the credit crisis and housing crisis that have hobbled the economy. With Bear Stearns, the government provided guarantees, and the bulk of its assets were transferred to JPMorgan Chase, leaving shareholders with a nominal amount.

Under a conservatorship, the common and preferred shares of Fannie and Freddie would be reduced to little or nothing, and any losses on mortgages they own or guarantee could be paid by taxpayers. Shareholders have already lost billions of dollars as the stocks have plunged more than 80 percent this year.

A conservatorship would operate much like a pre-packaged bankruptcy, similar to what smaller companies use to clean up their books and then emerge with stronger balance sheets. It would allow for uninterrupted operation of the companies, crucial players in the diminished mortgage market, where they are now responsible for nearly 70 percent of new loans.

The executives were told that the government had been planning to announce the decision as early as Sunday, before the Asian markets reopen, the officials said. For months, administration officials have grappled with the steady erosion of the books of the two mortgage finance giants.

A fierce behind-the-scenes debate among policy makers has been waged over whether to seize the companies or let them work out their problems. Even after the companies are put under government control, debates will continue over whether they should be independent and how they should operate over the long term.

The declines in the housing and financial markets apparently forced the administration’s hand. With foreign governments increasingly skittish about holding billions of dollars in securities issued by the companies, no sign that their losses will abate any time soon, and the inability of the companies to raise new capital, the administration apparently decided it would be better to act now rather than closer to the presidential election in two months.

Just five weeks ago, President Bush signed a law to give the administration the authority to inject billions of dollars into the companies through investments or loans. In proposing the legislation, Treasury Secretary Henry M. Paulson Jr. said that he had no plan to provide loans or investments, and that merely giving the government the authority to backstop the companies would provide a strong shot of confidence to the markets.

But the thin capital reserves that have kept the two companies afloat have continued to erode as the housing market has steadily declined and the number of foreclosures has soared. As their problems have deepened — and the marketplace has come to expect some sort of government rescue — both companies have found it difficult to raise new capital to absorb future losses.

In recent weeks, Mr. Paulson has been reaching out to foreign governments that hold billions of dollars of Fannie and Freddie securities to reassure them that the United States stands behind the companies. In issuing their quarterly financial statements last month, the two companies reported huge losses and predicted that home prices would fall more than previously projected.

The debt securities the companies issue to finance their operations are widely owned by mutual funds, pension funds, foreign governments and big companies. Officials said the participants at the meetings included Mr. Paulson, Ben S. Bernanke, the chairman of the Fed, and James Lockhart, the head of both the old and new agency that regulates the companies.

The companies were represented by Daniel H. Mudd, the chief executive of Fannie Mae, and Richard F. Syron, chief executive of Freddie Mac. Also participating was H. Rodgin Cohen, the chairman of the law firm Sullivan & Cromwell, who was representing Fannie. Officials and executives briefed on the meetings said that Mr. Mudd and Mr. Syron were told that they would have to leave the companies.

The meetings reflected the reality that senior administration officials did not believe they could wait for some kind of financial tipping point, as happened with Bear Stearns, which was saved from insolvency in March by government intervention after its stock plummeted and lenders withheld their capital.

Instead, Mr. Paulson has struggled to navigate through potentially conflicting goals — stabilizing the financial markets, making mortgages more widely available in a tightening credit environment, and protecting taxpayers from possibly enormous losses.

Publicly, administration officials have tried to bolster the companies because the nation’s mortgage system relies on their continued ability to purchase mortgages from commercial lenders and pull the housing markets out of their slump. But privately, senior officials have been critical of top executives at the companies, particularly Freddie Mac.

They have raised concerns about major risks to taxpayers of a bailout of companies whose executives have received huge compensation packages. Mr. Syron, for instance, collected more than $38 million in compensation since he joined the company in 2003.

Although Mr. Syron promised regulators earlier this year that he would raise $5.5 billion from investors, he has failed to make good on that promise — even as Fannie Mae raised more than $7 billion. Mr. Syron was slated to step down from the chief executive position last year, but that was delayed when his appointed successor, Eugene McQuade, chose to leave the company.

With the possible removal of the top management and the board, it is no longer clear who would appoint new management. Mr. Paulson had hoped that merely having the authority to bail out the two companies, which Congress provided in its recent housing bill, would be enough to calm the markets, but if anything anxiety has been increasing.

The clearest measure of that anxiety has been the gradually widening spread between interest rates on Fannie- or Freddie-backed mortgage securities and rates for Treasury securities, making home mortgages more expensive. The stock prices of the companies have also plunged.

After stock markets closed on Friday, the shares of Fannie and Freddie plummeted. Fannie was trading around $5.50, down from $70 a year ago. Freddie was trading at about $4, down from about $65 a year ago. With Fannie and Freddie guaranteeing $5 trillion in mortgage-backed securities, and a big share of those held by central banks and investors around the world, Mr. Paulson appears to have decided that the stakes are too high to take chances.

The Treasury Department is required by the new law to obtain agreement from the boards of Fannie and Freddie for a capital infusion. The exception is if the companies’ regulator, Mr. Lockhart, determines that the companies are insolvent or deeply undercapitalized it could take the companies over anyway.

Charles Calomiris, a professor of economics at Columbia Business School, said delaying a rescue would only increase the risks and costs. “The last thing you want to do is give a distressed borrower more time, because when people are in distress they tend to take a lot of risks,” he said. “You don’t want zombie institutions floating around with time on their hands.”

Fannie Mae Investor Sues Citigroup, Merrill Over Stock Drop
Citigroup Inc., Merrill Lynch & Co. and three other banks were accused in a shareholder lawsuit of failing to warn investors about proposed accounting-rule changes that lowered the value of preferred Fannie Mae stock.

Karen Orkin, who bought 600 shares of Fannie Mae's Series T Preferred Stock in May, filed a complaint in New York State Supreme Court in Manhattan in a proposed class-action, or group, lawsuit. Orkin said about 89 million shares of the stock were sold, and the stock dropped 44 percent in value in four months.

"Defendants were negligent in failing to warn plaintiff and other members," Orkin said in the complaint filed yesterday. "The offering circular and other offering materials omitted to state material facts," she said in the complaint. The banks were a syndicate of underwriters to the Series T preferred shares, Orkin said in the complaint.

Proposed changes in accounting rules, known as FAS No. 140, by the Financial Accounting Standards Board, "allowed Fannie Mae to remove certain liabilities from its balance sheet and to put them into trusts," Orkin said in the lawsuit. Morgan Stanley, UBS AG and Wachovia Corp. are also defendants in the case.

FASB is considering changes to Financial Accounting Standard 140 that may require Fannie Mae and Freddie Mac to bring a combined $3.7 trillion in off balance sheet assets on to their books, which would substantially raise their capital requirements.

"When news about these new accounting rules and their possible effect upon Fannie Mae became public, the company's stock dropped substantially," Orkin said. Fannie Mae, the largest U.S. mortgage finance company, and Freddie Mac have posted combined losses of $14.9 billion in the past four quarters as mortgage delinquencies rose.

Orkin said she purchased her preferred stock on May 13 at $25 per share and that it's now trading below $14 a share.
"Should FAS 140 be changed as described above, Fannie Mae could be required to raise up to $46 billion of capital, an amount that would have a substantial impact upon the company," Orkin said in the lawsuit.

Take a Load Off Fannie: Bailout or Nationalization for the Mortgage Giants?
"Take a load off Fanny, take a load for free; take a load off Fanny, and (and) (and) you put the load right on me."
-- The Band, "The Weight" (1968)

Fannie Mae and Freddie Mac own or guarantee nearly half the $12 trillion U.S. mortgage market.  Not long ago, they were the darlings of Wall Street, ranking next to U.S. bonds as among the safest and most conservative investments in the world.  They are called “government-sponsored enterprises” (GSEs), although they are entirely privately owned and specifically disclaim government backing on their prospectuses. 

The market has taken these disclaimers with a wink and a nod and has assumed that the GSEs are “too big to fail,” forcing the government to save them from their reckless investment schemes.  Fannie and Freddie’s preferred shares have been considered so safe that banking regulators let banks count them in the capital required as a cushion against loan losses. 

This is now proving to be a serious problem, because both the common and preferred shares of the distressed duo are suddenly plunging.  Between May 15 and August 25, Fannie’s common shares lost 77% of their value, while its preferred shares lost 58.8% in that short time.  Freddie Mac’s preferred shares plunged even more, down 65.5%.

That could be a disaster for many banks, which are loaded to the gills with these preferred shares.  Banks already reeling from losses on mortgages and mortgage-backed securities are now being hit at the core, shrinking their capital base.  Loss of bank capital works as leverage in reverse: at a capital requirement of 10%, $1 lost in capital wipes out $10 in loans.     
Ironically, the recent plunge in Fannie and Freddie shares has been blamed on the bailout plan that was supposed to save them.  In July, Treasury Secretary Hank Paulson sought and was granted the authority to extend an unlimited credit line to the GSEs, which now have liabilities totaling about $5 trillion; and to capitalize them by buying their stock, effectively nationalizing them. 

At a July 15 hearing in Washington, Paulson assured a group of Senators that Congress probably would not have to go through with the plan. “If you have a bazooka in your pocket and people know it,” he said, “you probably won’t have to use it.”  But bazookas can spook the very people they were supposed to reassure. 

After the plan was approved, foreign central banks slashed their Fannie and Freddie bond purchases by more than 25%, and shareholders rushed to dump their stock.  On August 22, Moody’s downgraded Fannie and Freddie’s outstanding preferred stock by a full five notches, from A1 to Baa3 (or slightly above “junk”), and their Bank Financial Strength Ratings from B- to D+ (a one-half notch above D, something reserved for companies in default). 

Since the private sector isn’t buying, the Treasury is likely to wind up capitalizing the companies by buying new stock itself, seriously diluting the value of existing shares.  A government bailout would be expected to wipe out the common shares, but it is becoming increasingly clear that the preferred stock is in jeopardy as well, jeopardizing the banks that hold it.   There are other aspects of Paulson’s bailout plan that could be giving policymakers Maalox moments.  As noted in a July 17 Economist article: 
“[N]ationalisation . . . would bring the whole of Fannie’s and Freddie’s debt onto the federal government’s balance sheet. In terms of book-keeping this would almost double the public debt, but that is rather misleading. It would hardly be like issuing $5.2 trillion of new Treasury bonds, because Fannie’s and Freddie’s debt is backed by real assets. Nevertheless, the fear [is] that the taxpayer may have to absorb the GSEs’ debt . . . . That suggests yet another irony; the debt of the GSEs has been trading as if it were guaranteed by the American government, but the debt of the government was not trading as if Uncle Sam had guaranteed that of the GSEs.”

The U.S. federal debt is already up to nearly $10 trillion, putting its own triple-A credit rating in jeopardy.  If the U.S. assumes the GSEs’ weighty liability as well, the country could lose its own triple-A rating, causing foreign lenders to withdraw their massive infusion of funds. But if the U.S. does not back the GSEs’ debt, the result could be the same.  China’s $376 billion of long-term U.S. agency debt is mostly in Fannie and Freddie assets.  Yu Yonding, a former adviser to China’s central bank, warned on August 21: 
“If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic.  If it is not the end of the world, it is the end of the current international financial system.”

It sounds pretty grim, but let’s think about that.  Would the end of the current financial system really be so bad?  The international financial system is now controlled by a network of private central banks that print national currencies and trade them with sovereign governments for government bonds (or debt).  The bonds then become the basis for creating many times their value in loans by commercial banks. 

At a 10% reserve requirement, banks are allowed to fan $1 worth of reserves into $10 in loans, effectively delivering the power to create money into private hands.  The price exacted by this private money-creating machine is compound interest perpetually drawn off the top, in a Ponzi scheme that has now reached its mathematical limits. 

The chief role of Fannie and Freddie has been to keep the Ponzi scheme alive by adding “liquidity” to markets, something they do by buying mortgages and bundling them together as securities that are then sold to investors.  Old loans are moved off the banks’ books, making room for new loans, further expanding the money supply and driving up home prices.  As economist Michael Hudson noted in Counterpunch in July: 
“Altruistic political talk aside, the reason why the finance, insurance and real estate (FIRE) sectors have lobbied so hard for Fannie and Freddie is that their financial function has been to make housing increasingly unaffordable. They have inflated asset prices with credit that has indebted homeowners to a degree unprecedented in history.

This is why the real estate bubble has burst, after all. Yet Congress now acts as if the only way to resolve the debt problem is to create yet more debt, to inflate real estate prices all the more by arranging yet more credit to bid up the prices that homebuyers must pay.  

“. . . The economy has reached its debt limit and is entering its insolvency phase.  We are not in a cycle but the end of an era. The old world of debt pyramiding to a fraudulent degree cannot be restored . . . . The class war is back in business, with a vengeance. Instead of it being the familiar old class war between industrial employers and their work force, this one reverts to the old pre-industrial class war of creditors versus debtors. Its guiding principle is ‘Big Fish Eat Little Fish,’ mainly by the debt dynamic that crowds out the promised economy of free choice. 

“. . . No economy in history ever has been able to pay off its debts. That is the essence of the ‘magic of compound interest.’  Debts grow inexorably, making creditors rich but impoverishing the economy in the process, thereby destroying its ability to pay. Recognizing this financial dynamic most societies have chosen the logical response. From Sumer in the third millennium BC and Babylonia in the second millennium through Greece and Rome in the first millennium BC, and then from feudal Europe to the Inter-Ally war debts and reparations tangle that wrecked international finance after World War I, the response has been to bring debts back within the ability to pay.  

“This can be done only by wiping out debts that cannot be paid. The alternative is debt peonage. Throughout most of history, countries have found again and again that bankruptcy – wiping out the debts – is the way to free economies. The idea is to free them from a situation where the economic surplus is diverted away from new tangible investment to pay bankers. The classical idea of free markets is to avoid privatizing monopolies, such as the unique privilege of commercial bankers to create bank-credit and charge interest on it.”

Under current law, if the GSEs’ capital falls too far below required levels, the Office of Federal Housing Enterprise Oversight (their regulator) is authorized to take control of the firms and impose a conservatorship, a form of bankruptcy.  As former Federal Reserve consultant Walker F. Todd explained in a July 23 article: 
“Traditionally, conservatorship freezes existing bank accounts and then allows limited withdrawals until authorities determine how much of those frozen accounts may be distributed pro rata to the claimants. After the appointment of a conservator, new deposits and other funds received as well as new investments would be fully protected.”
Prior claimants satisfy their claims against available assets according to seniority, with lenders being senior to shareholders.  The proceeds from any new business are kept separate.  Fannie and Freddie investors would take some losses, but the available pot for settling claims is quite large.  As Hudson observes: 
“[N]ot all the mortgages that these two agencies have bought or guaranteed are junk.  Most are genuine and are being paid. . . . Let these mortgages continue to back the existing FNMA and Freddie Mac bonds to the degree that they actually receive mortgage debt service.  If there is a shortfall, let the bondholders take the usual haircut that is supposed to go hand in hand with risk. . . . That is the law for all other bondholders when their investments go south.  Why make an exception for participants in the real estate bubble? . . . To keep their activities current, let Fannie and Freddie issue a new series of bonds – the ‘we won’t fake it anymore’ series.” 

Nouriel Roubini is Professor of Economics at New York University and has a popular website called Global EconoMonitor.  He estimates that the haircut for securities holders would be a modest 5% ($250 billion on $5 trillion).  Securities holders are getting a subsidy of $50 billion a year over what they would earn if they had invested in U.S. Treasuries, specifically because Fannie and Freddie carry more risk; and risk means the occasional haircut.  Roubini concludes: 
“It is . . . time to put a stop to the coming ‘mother of all bailouts’ starting with a firm stop to the fiscal rescue of Fannie and Freddie, institutions that have behaved for the last few years like the ‘mother of all leveraged hedge funds’ with their reckless leverage and reckless financial activities.  . . . [L]et’s call a spade a bloody shovel: nationalise Freddie Mac and Fannie May. They should never have been privatised in the first place. . . . Increase taxes or cut other public spending to finance the exercise. But stop pretending. Stop lying about the financial viability of institutions designed to hand out subsidies to favoured constituencies.”

Roubini suggests that nationalizing Fannie and Freddie would require an increase in taxes or cuts in other public spending, but there are other possible funding solutions, ones with quite successful historical precedents.  If the multiple layers of profiteers, speculators, derivatives, commissions, bonuses, fees and general fraud were eliminated from the mix, a nationalized Fannie/Freddie could finance itself. 

This was proven in the 1930s with the Home Owners’ Loan Corporation (HOLC), a government-owned agency set up to reverse a disastrous wave of home foreclosures.  The HOLC was funded by the Reconstruction Finance Corporation (RFC), another wholly government-owned agency that performed the functions of a public bank.  The RFC successfully funded not only the New Deal but America’s participation in World War II. 

In a February 2008 article in The New York Times, Alan Binder recommended a return to the HOLC model as a way out of the current mortgage crisis.  He wrote:  
“The HOLC was established in June 1933 to help distressed families avert foreclosures by replacing mortgages that were in or near default with new ones that homeowners could afford. It did so by buying old mortgages from banks . . . and then issuing new loans to homeowners. The HOLC financed itself by borrowing from capital markets and the Treasury.   

“The scale of the operation was impressive.  Within two years, the HOLC granted over a million new mortgages. (Adjusting only for population growth, the corresponding mortgage figure today would be almost 2.5 million.) Nearly one of every five mortgages in America became owned by the HOLC. Its total lending amounted to $3.5 billion. . . . (The corresponding figure today would be about $750 billion.)  

“As a public corporation chartered for a public purpose, the HOLC was a patient and even lenient lender. . . . But times were tough in the 1930s, and nearly 20 percent of the HOLC’s borrowers defaulted anyway.  So the corporation eventually acquired ownership of about 200,000 houses, nearly all of which were sold by 1944. The HOLC closed its books in 1951, or 15 years after its last 1936 mortgage was paid off, with a small profit. It was a heavy lift, but the incredible HOLC lifted it. 

“Today’s lift would be far lighter. . . . Given current low interest rates, a new HOLC could borrow cheaply and should find it easy to earn a two-percentage-point spread between borrowing and lending rates, for a gross profit of maybe $4 billion to $8 billion a year.”
The RFC initially capitalized the HOLC by buying all of its stock for $200 million.  The HOLC was then authorized by statute to issue ten times that sum (or $2 billion) in tax exempt bonds.  In the same way, in 1937-38 the RFC created and funded Fannie Mae as a wholly government-owned agency, for the purpose of injecting money into the banking system so that banks could increase the volume of home mortgages. 

The RFC and its agencies funded their operations by selling bonds at a modest interest to the Treasury and the public, then relending the acquired funds at a slightly higher interest.  The “spread” was sufficient to cover operating costs and losses from default and still turn a modest profit.  

How did the HOLC manage to reverse a far worse foreclosure crisis than we have today and still turn a profit, when Fannie and Freddie – which also raise their loan money by selling securities to investors – have become hopelessly bankrupt in that pursuit?  The difference seems to be that the HOLC was a public institution operated as a public service. 

Fannie and Freddie are private, profit-making ventures designed to make money for their investors and political exploiters.  As Professor Roubini observes, “These GSEs were designed to make losses. They are expected to make losses. If they don’t make losses they are not serving their political purpose.”  When the profiteering is taken out and the business is run as a public service, the math works.   

There is another American model that is even older than the HOLC, which presents even more exciting possibilities.  In the first half of the 18th century, the province of Pennsylvania completely funded its government without taxes or debt, through a publicly-owned bank that issued paper currency and lent it to farmers.  The bank did not have to borrow capital before it made loans; it just created the currency on a printing press. 

The money was lent rather than spent into the economy, so it came back to the government in a circular flow, avoiding inflation; and interest on the loans was sufficient to fund the government’s operations without taxation.  Such a public bank today could solve not only the housing crisis but a number of other pressing problems, including the infrastructure crisis and the energy crisis.  (See E. Brown, “Sustainable Energy Development: How Costs Can Be Cut in Half,”, November 5, 2007).   

Once bankrupt businesses have been restored to solvency, the usual practice is to return them to private hands; but a better plan for Fannie and Freddie might be to simply keep them as public institutions.  In the August 8 London Tribune, British MP Michael Meacher proposed this alternative for Northern Rock, a major British bank that was recently nationalized after becoming insolvent.  He wrote:  
“[W]hen the banks have failed the public interest so badly and still even now continue to pursue so single-mindedly their commitment to privatise their gains whilst socialising their losses, would not a publicly owned bank be the most effective way of changing the current corrosive financial culture of short-termism, lower investment, house price inflation, and insider enrichment at the expense of systemic fragility for everyone else? Perhaps we should not return Northern Rock to the private sector after all.”

Perhaps we should not return Fannie and Freddie either.

FDIC Press Release: Nevada State Bank Acquires the Insured Deposits of Silver State Bank, Henderson, Nevada
Silver State Bank, Henderson, Nevada, was closed today by the Nevada Financial Institutions Division, and the Federal Deposit Insurance Corporation (FDIC) was named Receiver. To protect the depositors, the FDIC entered into a Purchase and Assumption Agreement with Nevada State Bank, Las Vegas, Nevada, to assume the Insured Deposits of Silver State Bank.

The branches of Silver State Bank will open on Monday as Nevada State Bank in Nevada and National Bank of Arizona in Arizona. Depositors of the failed bank will automatically become depositors of Nevada State Bank or National Bank of Arizona. Deposits will continue to be insured by the FDIC, so there is no need for customers to change their banking relationship to retain their deposit insurance coverage.

Over the weekend, customers of Silver State Bank can access their money by writing checks or using ATM or debit cards. Checks drawn on the bank will continue to be processed. Loan customers should continue to make their payments as usual.
As of June 30, 2008, Silver State Bank had total assets of $2.0 billion and total deposits of $1.7 billion. Nevada State Bank agreed to purchase the insured deposits for a premium of 1.3 percent.

At the time of closing, there were approximately $20 million in uninsured deposits held in approximately 500 accounts that potentially exceeded the insurance limits. This amount is an estimate that is likely to change once the FDIC obtains additional information from these customers. Silver State Bank also had approximately $700 million in brokered deposits that are not part of today's transaction. The FDIC will pay the brokers directly for the amount of their insured funds.

Customers with accounts in excess of $100,000 should contact the FDIC toll-free at 1-800-523-8177 to set up an appointment to discuss their deposits. This phone number will be operational this evening until 9:00 p.m. PDT; on Saturday and Sunday from 9:00 a.m. to 6:00 p.m. PDT; and on Monday and thereafter from 8:00 a.m. to 8:00 p.m. PDT.

Customers who would like more information on today's transaction should visit the FDIC's Web site at Beginning Monday, depositors of Silver State Bank with more than $100,000 at the bank may visit the FDIC's Web page, "Is My Account Fully Insured?" at to determine their insurance coverage

In addition to assuming the failed bank's insured deposits, Nevada State Bank will purchase a small amount of assets comprised of cash and securities. The FDIC will retain the remaining assets for later disposition. The transaction is the least costly resolution option, and the FDIC estimates that the cost to its Deposit Insurance Fund is between $450 and $550 million. Silver State Bank is the second bank to fail in Nevada in 2008. First National Bank of Nevada, Reno failed on July 25, 2008. This year, a total of eleven FDIC-insured institutions have been closed.

Regulators Shutter Silver State Bank
State and federal regulators on Friday shut down Silver State Bank, the latest in a series of bank failures and one that could ripple through the presidential campaign.

Until recently, the son of Republican nominee Sen. John McCain sat on Silver State's board and was a member of its three-person audit committee, which was responsible for overseeing the company's financial condition. Andrew McCain left the Henderson, Nev., bank July 26 after five months on the board, citing "personal reasons." He is Sen. McCain's adopted son from his first marriage.

There is no evidence that Mr. McCain, 46, committed any wrongdoing. Nor are there signs that Sen. McCain, the Arizona Republican who on Thursday accepted his party's presidential nomination, had any knowledge of or involvement in Silver State's problems. A spokesman for the McCain campaign couldn't be immediately reached for comment.

The lender, the 11th bank to fail in the U.S. this year, was overexposed to risky real-estate loans, a problem that's vexing many banks amid the worst financial crisis in a generation. Silver State had nearly $2 billion in assets and 17 branches in Arizona and Nevada.

The Federal Deposit Insurance Corp. had been preparing to shut down Silver State late last month, but the agency encountered resistance from the Nevada Division of Financial Institutions, according to people familiar with the matter. The Nevada regulators had final say over whether to pull the plug on the state-chartered bank, and wanted to keep it open.

Founded in 1996, Silver State specialized in construction and land-development loans to finance real-estate projects in Nevada and Arizona. In July 2007, Silver State raised about $30 million through an initial public stock offering. Its shares debuted at $20.

The business unraveled this year. By June 30, borrowers had fallen behind on about $252 million worth of loans, compared to about $11.5 million six months earlier, according to the Federal Deposit Insurance Corp. The bank's capital ratios, which represent the bank's cushion to absorb losses, have dropped sharply.

Mr. McCain's ties to Silver State date to 2006, when he became a director of Choice Bank, a small Scottsdale, Ariz., lender that Silver State acquired that year. Mr. McCain's family was an early investor in Choice, according to people familiar with the matter.

Choice was smaller than Silver State, but its finances deteriorated just as quickly and hurt the parent company. As of March 31, 2008, Choice was facing $7.9 million worth of delinquent loans, up from $1.6 million three months earlier. Silver State recently logged an $18.8 million write-down, representing the full remaining value of its investment in Choice, to reflect the "continued deterioration" of the franchise's credit quality, according to securities filings.

In June, Silver State planned to raise up to $40 million through a stock offering. As a way to entice investors, the company's 10 directors each agreed to participate. Mr. McCain, who at the time owned 1,126 shares of Silver State stock, pledged to buy another 170,648 shares, according to regulatory filings. At the $3.26-a-share offering price, it would have cost him $556,312.

A successful stock offering could have bought Silver State some time. But the offering never was consummated, in part because Silver State couldn't drum up interest from investors. If Mr. McCain had remained on Silver State's board another four days, his position on the audit committee would have required him to sign off on the company's second-quarter financial statements.

Three weeks after Mr. McCain quit, Silver State had to revise those second-quarter numbers to reflect a loss of $72.3 million, which was larger than previously reported. It warned in the Aug. 15 regulatory filing of "uncertainty about the company's ability to continue as a going concern," a sign the bank's survival was in doubt.

Silver State said at the time its insurance carrier planned to cancel policies protecting Silver State's directors and executives from liability due to the bank's elevated risk profile, effective Oct. 7. Mr. McCain's public role in his father's presidential campaign has been mostly limited to appearances at several events last month. A person close to Mr. McCain says he left Silver State's board because his busy schedule meant he wouldn't be able to devote enough time to the struggling bank.

Mr. McCain was a quiet presence on Choice's board, say former associates. He would occasionally ask executives about how the bank's loan portfolios were holding up, but rarely pressed for details. William Robert, a co-founder of Choice, says Mr. McCain didn't play an active role on the boards of either Choice or Silver State. "He got on [the Silver State] board, he looked around, and he decided he shouldn't be on it," Mr. Robert said. "There's nothing suspicious here."

Highway Fund Shortfall May Halt Road Projects
An important account in the federal Highway Trust Fund will run out of money this month, a situation that could hamper completion of road and bridge construction projects across the country, Transportation Secretary Mary E. Peters said on Friday.

Because the trust fund’s highway account is draining away, the Transportation Department will have to delay payments for projects, Ms. Peters said at a news conference. Since money from Washington typically pays 80 to 90 percent of the cost of federally aided road work, states with shaky finances may have to consider curtailing projects.

Ms. Peters said her department would begin to dole out money from the fund each week on a prorated basis. For instance, if there is enough money to cover only 80 percent of the payment requests the department receives for federally financed local projects, the agency will pay only 80 percent of each request initially, making up the difference later.

“Time and again, the president has warned Congress of the pending shortfall and submitted fiscally prudent budgets to close the gap,” Ms. Peters said, in remarks that reflected the political nature of the long-running debate over how to pay for road building.

The fund is financed by federal excise taxes on motor fuel, 18.4 cents a gallon on gasoline and 24.4 cents a gallon on diesel. But the fund’s highway account is being rapidly depleted because for months Americans have been reacting to the high price of gasoline by driving less, Ms. Peters said. In May, for instance, vehicle-miles were down 3.7 percent from a year earlier.

Not many months ago, federal officials expected the highway account to have about $4 billion by Sept. 30, the end of the federal fiscal year. Last Oct. 1, the trust fund had $8.1 billion in the bank, transportation officials said, but by Sept. 30, its expenses will have exceeded its income by $8.3 billion, creating a $200 million gap. (The Highway Trust Fund also has a much smaller account to finance mass transit projects, but it is in surplus at the moment.)

The Transportation Department expects to have enough money to make all payments to the states for the second week of September but enough for only about 64 percent of the payments the third week, said Brian Turmail, an agency spokesman.

Then, with a regular infusion of two weeks’ worth of gasoline-tax revenue from the Treasury, the Transportation Department will have enough money to make 88 percent of its payments in the fourth week of September — except that it will have to first make up payments it could not meet earlier in the month.

Thus, as states wind down the busy summer construction season, their transportation officials can anticipate longer and longer delays in getting payments from Washington, Mr. Turmail said.

State transportation officials expressed alarm. The money shortage will have “grave repercussions for the states, for hundreds of thousands of workers in the construction industry and the driving public,” said John Horsley, executive director of the American Association of State Highway and Transportation Officials.

Contractors were also worried. “Each week that it goes on, it gets more serious,” said Brian P. Deery, senior director of the Associated General Contractors of America’s highway and transportation division. At some point, he said, some states may have to tell road contractors that they cannot pay them and that “we’d like you to continue working, but we understand if you have to stop working.”

In July, the House passed a bill that would use $8 billion of general federal revenue — from income and other taxes, not the dedicated motor fuel tax — to finance highway projects. The measure has not gained much support in the Senate, and until Friday the White House had been hostile to it. But Ms. Peters said the administration now endorsed the measure because “immediate action” was required to ensure that the states did not suffer.

Another possible solution would be to transfer money to the highway account from the account that the trust fund maintains to finance mass transit. But lawmakers from large cities that rely on trust-fund aid for their transit systems could be expected to resist such a move.

For the moment, Republicans and Democrats were blaming each other for the problem, which comes as the economy is in trouble and the election season is intensifying. The administration has accused the Democratic-controlled Congress of loading transportation bills with pork barrel projects that virtually invite President Bush’s veto.

But Democrats accuse the Bush administration of “nickel and diming our degrading roads, bridges, highways,” as well as mass transit, as Senator Charles E. Schumer of New York put it on Friday. The issue is likely to be on a front-burner when Congress returns, as Representative James L. Oberstar, the Minnesota Democrat who heads the House Transportation and Infrastructure Committee, signaled on Friday.

“Given that the United States has lost more than 600,000 jobs this year, and the unemployment rate is the highest it has been in five years, we cannot afford to lose one more family-wage construction job,” he said in a statement.

Whatever Congress does in the short term, some profound policy issues will have to be addressed at some point. The shift to smaller, more fuel-efficient cars in an era of expensive gasoline is the very trend that is helping to deplete the highway fund.

Ilargi: Shiller has some good observations in this video, but then he concludes with an estimate of another 10% drop in US home prices (in the cities the Case/Shiller index covers), based on futures markets. The problem I have with that, and many other similar predictions, is that nobody ever explains what would halt the decine at that point.

Shiller’s own index indicates that prices are down by 24% already (which by the way takes the loss to homeowners well over $5 trillion so far), and thus indicates, when limiting further losses to 10%, that we are two-thirds through the crisis.

Based on what? I have not a clue. Futures markets are nice and all, but show me the first one that figures in the demise of futures markets.

U.S. House Price Decline Could Be Worse than Great Depression, Economist Shiller Says

U.S. Must Buy Assets to Prevent 'Tsunami,' Gross Says
The U.S. government needs to start using more of its money to support markets to stem a burgeoning "financial tsunami," according to Bill Gross, manager of the world's biggest bond fund.

Banks, securities firms and hedge funds are dumping assets, driving down prices of bonds, real estate, stocks and commodities, Gross, co-chief investment officer of Newport Beach, California-based Pacific Investment Management Co., said in commentary posted on the firm's Web site today.

"Unchecked, it can turn a campfire into a forest fire, a mild asset bear market into a destructive financial tsunami," Gross said. "If we are to prevent a continuing asset and debt liquidation of near historic proportions, we will require policies that open up the balance sheet of the U.S. Treasury."

The government needs to replace private investors who either don't have the money to buy new assets or have been burned by losses, Gross said. Pimco, sovereign wealth funds and central banks are reluctant to fund financial firms after losses on investments they made to support the companies, Gross said. The world's biggest banks and brokers have raised $364.4 billion in new capital after more than $500 billion in writedowns and credit losses since the beginning of last year.

Since financial markets seized up a year ago as the subprime-mortgage market collapsed, the Standard & Poor's 500 Index has fallen 13 percent and home prices are down more than 15 percent. Yields on investment-grade corporate bonds, debt backed by commercial mortgages as well as credit cards reached record highs last month relative to benchmark rates.

Gross cast a bleaker view for the prospects of the world's financial markets than in previous notes to clients. The fund manager has previously called on lawmakers to support housing with legislation passed in July that allows lenders to forgive some of homeowners' debt and then refinance them into government-insured loans.

Pimco, a unit of Munich-based Allianz SE, is seeking to take advantage of declines in home-loan bonds. The firm is raising as much as $5 billion to buy mortgage-backed debt that has plunged in value, according to two investors with knowledge of the matter. The Distressed Senior Credit Opportunities Fund will invest in securities backed by commercial and residential mortgages, said the people, who asked not to be identified because the fund is private.

Treasury should support not only mortgage finance providers Fannie Mae and Freddie Mac, but also "Mom and Pop on Main Street U.S.A.," by subsidizing rates on home loans guaranteed by the Federal Housing Administration and other government institutions, Gross said. A new version of the Resolution Trust Corp., which bought assets from failing institutions during the savings-and-loan crisis of the 1980s, may also work, he said.

U.S. Treasury Secretary Henry Paulson arranged a rescue package for Washington-based Fannie and Freddie of McLean, Virginia as concern escalated the government-chartered companies didn't have capital to withstand the housing slump. Treasury pledged to pump unlimited debt or equity into the companies should they need it.

As Fannie and Freddie, banks, securities firms and hedge funds shrink, yields on all debt assets will rise compared with benchmark rates and volatility will increase, Gross said. The declines will end once sellers have depleted their assets and sufficient capital has been raised, Gross said. Unless "new balance sheets" emerge, prices of almost all assets will drop, even those of "impeccable" quality, he said.

The extra yield demanded on Ginnie Mae's 30-year, current- coupon mortgage-backed securities over 10-year Treasuries has climbed to 1.75 percentage points, from 0.87 percentage points at the start of last year, according to data compiled by Bloomberg. Bonds guaranteed by the U.S. agency are backed by the U.S. government. Spreads on 2-year AAA rated bonds composed of federally backed student loans have climbed to 0.95 percentage points over benchmark rates, from 0.01 percentage points below, Deutsche Bank AG data show.

"There is an increasing reluctance on the part of the private market to risk any more of its own capital," Gross said. "Liquidity is drying up; risk appetites are anorexic; asset prices, despite a temporarily resurgent stock market, are mainly going down; now even oil and commodity prices are drowning."

The decline in home prices hasn't been seen since the Great Depression, Gross said. That drop translates to an even bigger decline in overall wealth as the effects ripple through markets, Gross said. Home prices in 20 of the largest U.S. metropolitan areas fell 15.9 percent in June from a year earlier, according to an S&P/Case-Shiller index.

Fannie and Freddie 30-year fixed-rate mortgage bond yields, which influence the rates on most new home loans, have probably risen 75 basis points because of the waning demand, Gross said. A basis point is 0.01 percentage point. The Pimco Total Return Fund returned 9.8 percent in the past 12 months, beating 97 percent of its peers in the government and corporate bond fund category as of Sept. 3, according to Bloomberg data. The returns are 5.76 percent annually over five years. Pimco has about $830 billion of assets under management.

About 61 percent of Gross's holdings were mortgage-backed securities as of June 30, mostly debt guaranteed by Fannie, Freddie or Ginnie Mae, according to data on Pimco's Web site. "In a global financial marketplace in the process of delevering, assets that go up in price are rare diamonds as opposed to grains of sand," Gross said.

U.S. wants "substantial" prison terms for Gen Re, AIG execs
U.S. prosecutors on Friday asked a Connecticut judge to sentence five former executives of Berkshire Hathaway Inc's General Re Corp and American Insurance Group Inc to "substantial" prison terms for misleading investors about AIG's financial condition.

In a sentencing memorandum filed late on Friday, prosecutors argued that sentences for the five defendants should be stiffer than the range of 168 months to 210 months calculated in a pre-sentence report. The government also said losses to AIG investors could be estimated at more than $400 million -- with the government's expert calculating fraud-related losses as much as $1.4 billion -- a factor that should enhance the defendants' sentences.

"(T)he Court should sentence the defendants to a substantial period of incarceration," prosecutors wrote in the memo. Attorneys for defendants Chris Milton, AIG's former vice president of reinsurance, and ex-Gen Re senior vice president Christopher Garand pleaded for leniency for their clients in sentencing memos filed on Friday.

The sentencing memos for both men contained testimonials from friends and family members who attested to their good deeds and characters. "This is who Chris Milton is: a man who sees people in distress and seeks to restore them to dignity," his attorneys concluded in their memo.

Garand's lawyers argued that the judge should be lenient because Garand was "a bit player in a transaction conceived of and directed by others," and that, at age 61, a lengthy prison term would amount to a life sentence.

Sentencing memos were not available for the remaining defendants: Ronald Ferguson, former Gen Re chief executive; Elizabeth Monrad, Gen Re's former chief financial officer; and Robert Graham, former Gen Re senior vice president and assistant general counsel.

Garand was senior vice president and head of Gen Re's finite reinsurance operations in the United States.
In February, a federal jury in Hartford, Connecticut, found the five guilty of conspiracy, securities fraud, making false statements to the SEC and mail fraud.

The defendants were convicted in connection with a reinsurance deal that prosecutors said misled AIG investors because it enabled the company to improperly inflate its loss reserves, painting an artificially bright picture of its financial results.

AIG previously acknowledged accounting improprieties and restated $3.8 billion in earnings from 2000 through 2004 and agreed to a $1.64 billion regulatory settlement in 2006.

Emerging Markets Face Earnings 'Recession,' Morgan Stanley Says
The earnings "recession" in emerging markets may be the worst in at least six years based on valuations and profit estimates are overly optimistic for this year and next, according to Morgan Stanley strategists.

Earnings may rise an average 5 percent this year, driven by energy and telecommunications companies, compared with the consensus forecast of 13 percent, strategists including Jonathan Garner wrote in a note to clients dated yesterday.
Morgan Stanley's profit growth forecast for next year is 7 percent compared with the 18 percent consensus estimate, they wrote.

"Valuations now suggest an earnings recession in emerging market at least as bad as the 2001/02 cycle when emerging market earnings fell 18 percent peak to trough," they wrote. The MSCI Emerging Markets Index has declined 30 percent this year to the lowest since March 2007, trimming multiples to 11 times earnings from 19 in late October.

Emerging market stocks have fallen to "very compelling" levels as earnings sources are more diverse and mining may be still at a midpoint of a super-cycle, they wrote. "The market is very close to pricing in our bear case scenario," the strategists wrote. "We think that risk-reward is very compelling at these levels."

World financial system in state of dysfunction: RBC's Nixon
The global financial system has been “pushed to the brink” in its most severe downturn since the Great Depression, although the actions of American policy makers have averted disaster, the head of Canada's largest bank said Friday

“Not since the (Second World War) has the financial system itself been in such a state of dysfunction,” said Royal Bank chief executive Gordon Nixon told a roundtable of prominent business leaders. However, “decisive actions” such as the bailout of investment bank Bear Stearns, which was bought by JPMorgan in a deal orchestrated by the U.S. central bank, prevented a potentially disastrous ripple effect from taking place.

Scotiabank CEO Richard Waugh said regulators in Canada have also played an important role in stemming the effects of the credit crisis. Because regulators set such a high bar for bank capitalization ahead of the unravelling of credit markets, Canadian banks went into the storm in relatively good shape, Mr. Waugh said. But there are some things that the financial institutions themselves can do better in the future, he added.

“We are accountable and we've got to do something about it,” Mr. Waugh said. For instance, he said “terrible things happen” when liquidity is not priced properly — in other words, when it's too easy to borrow money at low interest rates or sell equity at high prices. The chair of Deutsche Bank said there is reason to be optimistic in the current economic gloom.

While financial markets remain “volatile and fragile,” the underlying economic environment is “relatively benign,” Deutsche Bank's Josef Ackermann said. Bank writedowns related to the credit crunch are continuing but investment and clients are beginning to return to the industry, he said. While challenges remain, the “market is not dead.”


Anonymous said...

Ilargi - Your expanded commentary of late and your and Stoneleigh's responses to comments are very much appreciated! A big thank you to you both! GSJ

OuttaControl said...

In yesteday's DR, Anonymous Reader asked : I rolled my IRA into a mutual fund consisting entirely of short term Treasuries (Vanguard VUSXX). Could you explain how and why this type of fund could become wallpaper and might disappear?

Suppose Vanguard itself is in a precarious financial position and becomes insolvent. How long will it take until FDIC is able to bail out all of the individual accounts (note: FDIC doesn't actually insure account holder directly; they insure the institution). Or will FDIC be able to do that at all? IndyMac customers, ironically, are the lucky ones in that FDIC still has capital and they will get their money quickly. It will get complicated in the months ahead when the FDIC itself needs to be bailed out.

Here's a related catch 22 for you. I actually own put options on the financial institution that holds my RRSP (IRA). The puts will become very valuable when my financial institution approaches insolvency. However, if it does actually cease normal operations, I may very well have a tough time converting my paper gain into money I can use.

Why am I worried about my bank? Even in good times, my conservative Canadian bank has been known to make stupid bets on, for example, natural gas prices. They are undoubtedly up to their eyeballs in 'AAA' Canadian and US "prime" mortgages. And, frankly, they won't be decoupling from global chaos any more than any other country's banks.

Having said all that, I googled Vanguard and it doesn't seem to be a publicly traded corporation so it's difficult to know what risks it may have assumed (other than in the managed funds themselves).

But, if we could all be customers of Global Century Investments, we'd have it made.

FB said...


Seeking Alpha writes of deci-billions. I assume they mean deca-billions.

You know, the ones without any cafeine content.

So that you can sleep while the hecto-billions creep up on you.


P.S. You may have to be European to understand that one.

OuttaControl said...

ilargi: Regarding FASB 140, it starts for companies whose fiscal year begins Nov 2009. I would think that the first fessin' up would be 3 months after. FASB Postpones Off-Balance-Sheet Rule for a Year

Anonymous said...

Thank you for explaining Paulsons role so succinctly.Socialize the loss,bail out his buddies.I am wondering if B. Gross is his buddy,w/what you said,60%investment?He reminds me of those hilarious English comedians that were linked awhile back w/the punch line about the pensions....

With the new fed guidelines coming into play,do you see many more shoes dropping during that time frame?.That is if we avert a complete meltdown of the system by that time.It does not surprise me that the "Mark to Market"requirements were left ,as a cute little time bomb for the new administration.It would not surprise me to find out the actions of Paulson have consisted of a delaying action,primarily to give the administration time to "Get out the door with the goods"before all hell breaks loose.

I am thinking this blog would be a good "History of the Collapse" [to be taught children, in economics classes,by candlelight,a generation from now....]


freddie freeloader said...

Todays MarketTicker from Dennigers site doesnt mince words either.

"We are quite literally facing the possibility of a government funding cost ramp, which can lead to the collapse of government financing. Tax receipts are already way down and will go much lower. Corporate profits, from which are taxed, are also in decline. Add to this a doubling of the public float and we could easily find ourselves unable to fund any of the social programs, infrastructure, or other spending that you think Government owes you.

Down this rabbit hole lies a Greater Depression, worse than the 1930s, or, if the government were to panic (and it will - see the recent examples in Bear Stearns and now Fraudie and Phoney), an all-on hyperinflationary explosion that renders everyone's savings and investments worthless occurs overnight, followed shortly by the collapse of the government.

No government in the history of mankind has managed to engineer a hyperinflation and get out of it intact, but there is a mathematical point beyond which debt service exceeds income + spending necessary to maintain life (of the government) and at that point such an implosion becomes inevitable. This is mathematics, not politics.

In each and every case where that line was crossed and hyperinflation ensued a dictator or fascist state has risen and overthrown the previous government, frequently by force, and the people's wealth has been destroyed. All of it.

I repeat for emphasis: History says that this has happened every single time a government has attempted to walk this path.

While there are those who say that we "can't" have deflation because it would be horrible and we "must prevent it", if the government continues down its present path what we will get is far worse.

Yes, folks, we are headed for a Depression. It is unavoidable and both political parties are responsible - along with, ultimately, you."
I&S, Denniger is very knowledgable and respected (you also include a link to his site). He makes it sound that hyperinflation is a distinct liklihood in the U.S. sooner rather than later, however Stoneleigh, at least, maintains that deflation will take hold for a significant time before hyperinflation were a risk.
In your opinion ,what factors can we look for to determine the onset of a hyperinflation once youre on the deflation path (other, of course, than a slice of cheese already costing $100). The timing on these things is important for all of us to know.

Thanks in advance, ff

webjazz said...

I'm suprised by Denninger's reference to hyper inflation. He is definitely in the deflation camp for the most part. I guess he is now seeing the possiblity that a complete change of government could lead to a printing of money to try to escape the jaws of deflation.

Ilargi said...

For inflation to ensue, you would need to print enormous amounts of money, and not only that, you would have to be able to make it enter the money supply and flow.

Robert Shiller says that the loss in US home prices has reached 24%. On an estimated -former- total "value" of $23 trillion, that means $5.5 trillion is gone. And that's just housing. Losses in money markets, even just those that are mark-to-market recognized, add a large amount to that.

So just to get back to where the credit and money supply started, in, let's take a year, 2005, you'd have to print that much. Still, there'd obviously be no inflation.

What the Fed has "injected" is perhaps half a trillion dollars. But that's in temporary loans. Even if they can thus far be rolled over, it's still no real increase in money supply. Moreover, all that credit serves only purpose only so far: it's used to temporarily cover the Wall Street banks' previously incurred losses, the ones shaped like bottomless manholes.

It's all sucked inwards, none of it can stay at the surface.

If the US government would try to print the financial system "out of all their losses", the international bond markets would make short shrift of its monetary standing.

Therefore, we will see an enormous expansion of the deflation we are already in. It's being hidden through denial, both in home prices and in the values of various sorts of paper that lies tucked away in vaults.

Once the international bonds system has imploded, there is a chance to attempt (hyper-)inflation. But that is a long way off, and when the time comes the world will have undergone so much change in so many ways, it'll be hard to even remember what you are looking at today.

OuttaControl said...

Once the international bonds system has imploded, there is a chance to attempt (hyper-)inflation. But that is a long way off...

And yet, isn't the several $trillions absorbed by the Treasury for F&F just such an existential threat to the international bond market, at least the portion denominated in $US? If not, how many more bailouts can occur?

Anonymous said...

Ilargi, thank you for your incisive analysis of what's transpiring in this predatory system.

The first time I heard that the Great Depression was a transfer of wealth was from Michael Ruppert. Now I understand. How right you are!


Anonymous said...

I think Vanguard is owned by the shareholders, not private or publicly held.

Bogle Heads

generic beer said...

Thanks everyone for great comments and ilargi for some clarification of why the impending move by Treasury will not likely produce hyper-inflation in the near to medium term.

I wonder if this move is more impression management than anything else ... to calm the markets a little longer, to encourage everything to unwind a little more slowly. Certainly, no one in these negotiations wants a financial panic before early November.

Seems to me that this is a global meltdown ... Freddy and Fannie are important to be sure ... but how much so relative to the whole global financial system and its collective problem of massively over-leveraged investments?

Anonymous said...

ilargi - why the international bond market can still exist long after the US implodes and a worldwide depression ensues? who will be there to continue buying the US bonds?


Greenpa said...

Oh, the theater we live in! This is from Forbes; regarding the imminent news conference at 11AM -

"As I understand it, whatever proposal Secretary Paulson is going to make is a proposal to get us over this hump of instability and uncertainty," said Vice Presidential hopeful Sen. Joe Biden on NBC's Meet the Press television program on Sunday.

"It's not an official reorganization. It will be left to next administration and Congress to make those judgements," he added."

Translation: Paulson et all know for a fact F&F are unfixable, no matter what- and want the responsibility for that to go to the next administration.

Stoneleigh said...

The international bond market is extremely powerful, as it hold the power of the collective. It isn't going to disappear overnight, although I wouldn't count on it existing in anything like its current form in ten years from now.

I'm surprised to see Karl Denninger mention hyperinflation. What I see is desperate attempts to inflate not being able to keep pace with credit destruction, especially when the pace of the latter picks up, as I think it will shortly.

Inflation would require banks not to hoard whatever liquidity comes their way, which I think is a vain hope considering that they're already doing exactly that even before things get really difficult. Cash hoarding greatly reduces the velocity of money, causing even more acute difficulties for those who are trying to hang on 'until conditions improve'. It will push many more over the edge, compounding debt defaults and the collapse of asset values in a downward spiral of positive feedback.

Once such a cascade picks up enough momentum it is impossible for anyone to stop, although it will eventually stop by itself once deleveraging has proceeded to the point where the (small amount of) remaining debt is acceptably collateralized to the (few) remaining creditors. We're a very very long way from that point.

Anonymous said...

“As my friend's book points out, there's nothing wrong with leverage at modest levels, like the 20% down conventional loans to buy a home - that's still a great use of leverage. But 2% (and less) to control huge financial abstractions? That's coming to an end. Painfully.
What's hard for people to conceptualize is that a sell off of one commodity (or stock) generates margin calls in others, which in turn drives selling in non-related markets, and those in turn cascade in slow motion which might more properly be called a "Crashcade" although I haven't spied that term (or "Debtberg" in my friends book, yet.

But, before the Second Depression becomes apparent, I'm betting the Oil Party will start another international distraction going and we'll all be blaming some group in another country and getting all whipped up into a frenzy to carpet bomb there. Late October, maybe?

The distractions to come may serve to blame-shift, but I think you can see now that the "PowersThatBe" might readily be described as hedge fund managers reacting to market forces at work.”
The Great De-Levering, Redux

Anonymous said...

“What happens if the international mistrust and fear afflicting Fannie and Freddie bonds infects U.S. Treasury bonds? Foreign investors would start dumping Treasury securities en masse. They'd drive Treasury rates sharply higher. And they'd wind up forcing Fannie and Freddie to pay much higher rates for their borrowings after all.

How will you know? Just watch the all-critical spread (difference) between the yield on Fannie-Freddie bonds, considered lower quality, and the yield on equivalent government bonds, considered high quality. Then consider these two possibilities:

 If that spread narrows mostly because Fannie and Freddie interest rates are coming down toward the level of the Treasury rates, fine. That means the immediate goal of the bailout is being achieved. BUT ...

 If the spread narrows mostly because Treasury rates are going up toward the level of Fannie's and Freddie's rates, that's not so fine. It not only means a failure to achieve the immediate goals, but it will also imply that the entire Fannie-Freddie bailout is backfiring on the Treasury.”

Rob said...

good post