Poolside at a Howard Johnson's Motor Lodge in Austin, Texas
Ilargi: Please have a seat and strip down to your underwear. The doctor will be with you shortly.
Take a load off Fannie
Ilargi: These days, it takes a trillion dollars to prop up the markets for one single day
Oh wake up
Banks Slammed By Treasury’s Bailout
The Treasury Department’s bailout of Fannie Mae and Freddie Mac could ignite a cascade of sizable writedowns and losses at up to 40 banks around the country, analysts say. The reason is the Treasury did not adopt in its rescue of Fannie Mae and Freddie Mac a plan that would protect the value of the preferred shares, or the common stock, in the two mortgage giants.
Fannie and Freddie own or guarantee about $5.4 trillion in home loans–half the nation’s total, and half the size of the US gross domestic product. Preferred shares are different than common stock, as they carry no voting rights, among other things. As a result, the Treasury Department’s plan now threatens to blow open gaping potholes in dozens of bank balance sheets due to the resulting drops in value in Fannie and Freddie preferred shares.
Because of the bailout, the preferred stock in Fannie and Freddie could eventually be worth just pennies on the dollar, or even zero, according to some analysts. And because of the looming losses, the regionals will be forced to either go hat in hand to, say, the private equity crowd, consolidate, merge, or go out of business–or, ironically, raise capital via more preferred share offerings.
The potential write-downs and losses come after the Treasury Department and the Federal Housing Finance Agency seized control of the mortgage giants, in what is expected to be the world’s biggest government bailout that effectively makes the US government the planet’s largest mortgage finance company.
Anywhere from 25 to 30 regional banks who own their preferred shares will be hurt by the Treasury plan, government banking sources say. Wall Street firms say the number is larger. Big banks including JPMorgan Chase and Wells Fargo could be hurt. Some banks could be battered hard. Losses from Fannie and Freddie preferred stock holdings at Sovereign Bancorp could wipe out up to a year’s worth of profit at the bank, analysts at CreditSights estimate.
A research note from Keefe, Bruyette & Woods identified 38 regional banks, mostly smaller outfits, potentially hurt by the plan. Goldman Sachs says up to 40 banks and financial firms will be hurt. At least eight banks had more than 10% of their capital tied up in the shares, while another six had between 5% and 9%. It’s estimated that $36 billion in preferred holdings in Fannie and Freddie sit on bank balance sheets around the country.
The Federal Deposit Insurance Corp. now has on its watch list 117 problem banks and thrifts, the highest level since the middle of 2003. That’s up from 61 in the year ago period and 90 in the first quarter. The 11th bank of the year, Silver State, failed last week. Many banks included Fannie’s and Freddie’s preferred shares’ dividend stream in their profit figures, and separately, included the shares in their statutory capital cushions required by bank regulators.
The Treasury’s new rescue plan presents a double whammy to the regionals. First, it wipes out the dividends on the preferred shares in Fannie and Freddie. Second, it batters their already slammed preferred shares, which the regional banks included in regulatory capital cushions.
Stocks in the regional banks could plunge even more, as they no longer can report the dividends in profits and as it could leave them without the required capital levels.
Government officials acknowledged the risks from their plans to the regionals on Sunday. “While many institutions hold common or preferred shares of these two GSEs [government-sponsored enterprises, or Fannie Mae and Freddie Mac], a limited number of smaller institutions have holdings that are significant compared to their capital,” Treasury Secretary Henry Paulson said in a statement.
The government is reportedly coming up with a plan to take care of the banks’ capital shortfalls as their preferred holdings potentially get zeroed out, but so far no details have come to light. The Treasury did not state whether the subsequent losses at the regionals triggered by its plan would result in the takeover of troubled banks by other institutions.
Wells Fargo, the nation’s fourth-largest bank by stock market value, said it will take a third-quarter write-down on its preferred securities in Fannie Mae and Freddie Mac. Meredith Whitrillioney, a widely followed banking and brokerage analyst at Oppenheimer Equity Research, estimates that Wells Fargo will report an after-tax charge in its third quarter of $281 million to $297 million, or 9 cents per share.
JPMorgan Chase, the country’s second largest bank in terms of assets, already said it expects to take a $600 million loss on its preferred shares in its third quarter, half of its $1.2 billion preferred share stake in Fannie and Freddie. M&T Bank owns an estimated $120 million in Fannie’s and Freddie’s preferreds, Fifth Third Bancorp owns an estimated $55 million, and National City owns an estimated $10 million.
Also vulnerable are Gateway Financial Holdings, Midwest Banc Holdings , Farmers Capital Bank Corp. and Westamerica Bancorp.
E-Trade Financial Corp. and American International Group also own preferred shares in Fannie and Freddie as well. Among the banks with the greatest exposure to the preferred shares of Fannie and Freddie is Sovereign Bancorp , which held $623 million in preferred shares or about 9% of its tangible capital, according to the research firm Keefe, Bruyette & Woods.
Sovereign recently raised $1.9 billion in capital to shore up a balance sheet battered by credit losses. “In the event that Sovereign was required to write off this entire investment, and was not able to record a tax benefit for the loss, Sovereign’s capital levels would still exceed the levels required to be considered well-capitalized,” the bank said in a regulatory filing.
Under the Treasury’s plan, dividends on both common and preferred shares in Freddie and Fannie will be eliminated, saving about $2 billion per year. The Treasury is also buying $1 billion of senior preferred stock in each company that include a 10% dividend yield and the right to buy 79.9% of the common shares at less than $1 a share.
Under the new regime, the preferred shareholders are second in line behind existing common shares to absorb any losses at Fannie and Freddie. As a result, preferred shares in Fannie and Freddie have plunged in value, as Moody’s and S&P have slashed their ratings now veering towards junk status. The benchmark Freddie Mac Series Z preferreds now trade at about $2.50, and Fannie’s Series S preferreds trade at around $2.04.
Letting the existing preferred shares drop in value are among the tough choices being made. Treasury’s rescue plan protects Freddie and Fannie’s mortgage-backed securities instead of the equity holdings in Freddie and Fannie, in order to appease central banks and commercial banks around the globe.
The dollar amount of Fannie and Freddie’s senior mortgage-backed debt obligations that the two hold on their own books now approaches about $1.5 trillion. The two have also guaranteed about trillions of dollars in mortgage-backed securities scattered around the globe, in portfolios held by central banks and other institutions around the world.
Central banks have threatened a buyer’s strike unless Treasury explicitly guaranteed new issues from Fannie and Freddie, economist Edward Yardeni notes. Central banks overseas have cut their holdings in Fannie and Freddie debt securities by $18 billion sine July 15.
According to CreditSights, the majority of US banks own sizable holdings in their mortgage-backed securities, on average about 50% of the total securities portfolio for most banks. That compares to the $36 billion in preferreds owned by the regionals and other banks. Zeroing out the common and the preferreds and preserving Fannie’s and Freddie’s debt securities was the Hobson’s choice Treasury made.
But don’t expect the really tough choice to be made-forcing Fannie and Freddie to dial back their $1.5 trillion securitization portfolio, as there is little political will and resolve in Washington to do so.
Since the two are intrinsic to the $300 billion housing bailout bill, the Treasury says it will let them temporarily expand their mortgage-backed securities holdings to $1.7 trillion from about $1.5 trillion. Fannie’s balance sheet portfolio here is about $758 billion and Freddie’s is $798 billion.
A plank in the Treasury’s bailout has it that the two companies must then cut the size of their high-risk mortgage-backed securities portfolios starting in 2010 by 10% a year, to $250 billion from $850 billion each (or to a total of $500 billion down from $1.7 trillion).
But do the math. Depending on how seriously Fannie and Freddie take this new rule–and who enforces it–it could take five to ten years to reach that $250 billion level, or even longer. Will a future Congress and the Treasury still have the political will to cut Fannie and Freddie down to a manageable size?
Even Rep. Barney Frank (D-Mass.), for years an enabler of the reckless management of Fannie and Freddie, was quoted on Monday about this condition, “Good luck on that,” and that it would “never happen.”
U.S. Pending Home Resales Decline More Than Forecast
Fewer Americans signed contracts to purchase previously owned homes in July as harder-to-get financing kept would-be buyers from taking advantage of lower prices.
The index of pending home resales fell 3.2 percent after rising 5.8 percent in June, the National Association of Realtors said today in Washington. A separate report showed inventories at U.S. wholesalers piled up twice as fast as forecast in July as their sales slid.
Today's housing figures help explain why the government took over Fannie Mae and Freddie Mac two days ago. Policy makers are aiming to stem the increase in mortgage rates triggered in part by the turmoil that engulfed the two companies, which make up almost half the $12 trillion U.S. mortgage market. Rates have dropped since Treasury Secretary Henry Paulson's intervention.
"The market is still showing a lot of fragility," said Jeffrey Roach, chief economist at Horizon Investments in Charlotte, North Carolina, who forecast the pending sales gauge would drop 3 percent. "The credit crunch is causing some of these borrowing costs to remain higher and that's part of the reason people are hesitant to jump in."
The Commerce Department said that wholesale inventories rose 1.4 percent, led by higher stockpiles of automobiles, machinery and petroleum, after an increase of 0.9 percent in June. Sales dropped 0.3 percent, the most since February.
Economists had projected the home-sales index would fall 1.5 percent, according to the median of 39 forecasts in a Bloomberg News survey.
Thirty-year fixed-rate mortgages averaged 6.29 percent in July, up from an average of 5.81 percent in the first half of the year, according to Bankrate Inc. Rates fell to 5.88 percent yesterday.
As home-loan losses mount, banks are reducing lending. Wachovia Corp. in June stopped offering option adjustable-rate mortgages, which let borrowers skip part of their payment and add the balance to principal. Chief Executive Officer Robert Steel said today the Charlotte, North Carolina, bank next year will cut $1.5 billion of expenses as it's "tapping the brakes" on risk.
Pending resales were down 6.8 percent from July 2007, reflecting declines in every region except the West, today's housing report showed. Compared with June, resales dropped the most in the West, where they were down 10.6 percent. They fell 7.5 percent in the Northeast and were unchanged in the South. Pending sales increased 2.8 percent in the Midwest.
Pending resales are considered a leading indicator because they track contract signings. Closings, which typically occur a month or two later, are tallied in a separate report from the Realtors.
"The housing correction poses the biggest risk to our economy," Paulson reiterated on Sept. 7 when he announced the takeovers of Fannie and Freddie. The Treasury will also start purchasing mortgage-backed securities issued by the two companies to "support the availability of mortgage financing for millions of Americans," he said.
Figures on August existing home sales are due from the NAR Sept. 24. Purchases in July rose 3.1 percent to a 5 million annual pace, with at least one-third of the purchases coming from foreclosed properties.
At the July sales rate, it would take 11.2 months to sell all the houses on the market, about twice the supply that reflects a balanced market, according to the agents' group.
Other measures also show how bank seizures may push down home prices and suppress sales. Foreclosures increased to the fastest pace in almost three decades during the second quarter, the Mortgage Bankers Association in Washington said in a report last week.
Home prices in 20 U.S. metropolitan areas fell in June by 15.9 percent from a year earlier, the most on record, the S&P/Case-Shiller home-price index showed on Aug. 26. Homebuilders are struggling to maintain profits as they compete with a glut of unsold properties on the market. Toll Brothers Inc., the largest U.S. luxury homebuilder, reported its fourth straight quarterly loss last week.
"Weak consumer confidence has kept many potential buyers from taking advantage of the current buyers' market," Chief Executive Robert Toll said on a conference call with analysts Sept. 4. "Once the supply of foreclosed inventory is exhausted, we believe that favorable demographics will kick in and the housing market in general will begin to recover."
US federal budget deficit runs out of control
The federal government will run a near-record deficit of $407 billion this year, according to the latest Capitol Hill estimates.
The Congressional Budget Office released figures Tuesday that indicate the red ink will spill over into next year, when the deficit would reach a record $438 billion — and could go even higher as the government takes over mortgage giants Fannie Mae and Freddie Mac.
The worsening deficit is largely due to continuing weakness in the economy, high energy and food prices, and the slump in the housing and financial markets, the CBO said. And the economy could still slide into a recession, according to the forecast.
"The economy is likely to experience at least several more months of very slow growth," the new report said. "Whether this period will ultimately be designated a recession or not is still uncertain, but the increase in the unemployment rate and the pace of economic growth are similar to conditions during previous periods of mild recession."
The economy will grow 1.5 percent this year in real terms and slip to just 1.1 percent growth in 2009, CBO predicts. The nonpartisan agency, which makes economic and budget estimates for Congress, also sees unemployment averaging 6.2 percent next year.
The CBO figures for this fiscal year, which ends Sept. 30, are slightly worse than White House predictions released in July. The White House foresees a $389 billion deficit for 2008, growing to $482 billion in 2009.
If Congress fixes the alternative minimum tax, or AMT, next year's deficit could rise another $80 billion, according to CBO. The numbers represent about 3 percent of the economy, which is the deficit measure seen as most relevant by economists. That's considerably smaller than the deficits of the 1980s and early 1990s, when Congress and earlier administrations cobbled together politically painful deficit-reduction packages.
Still, the new dollar figures are so eye-popping that they may restrain the appetite of the next president, who takes office Jan. 20, from adding expensive spending programs or new tax cuts. Pressure may build to allow some tax cuts enacted in 2001 and 2003 to expire as scheduled at the end of 2010, with Congress also feeling pressure to curb spending growth.
The deficit for 2007 totaled $161.5 billion, the lowest number since an imbalance of $159 billion in 2002. The 2002 performance marked the first budget deficit after four consecutive years of budget surpluses. "Today's estimates provide the latest evidence of the fiscal legacy of Republican policies: record deficits and a weak economy," said House Budget Committee Chairman John Spratt Jr., D-S.C. "It's another reminder of the dismal economy and budget that Republicans are leaving others to sort out."
Under the promises of Democratic presidential nominee Barack Obama and Republican nominee John McCain — who both say they want to extend most of the tax cuts passed in 2001 and 2003 at the urging of President Bush — the deficit is likely to remain high.
Even if all of the Bush tax cuts were allowed to expire at the end of 2010, the budget would still run a considerable deficit of $325 billion in the following year, CBO says. The cost of extending the Bush tax cuts and other expiring pieces of the tax code, along with making sure the AMT doesn't trap more and more middle class families, would reach more than $400 billion a year by 2012, CBO says.
Budget deficits tend to bounce around, and the CBO's long term projections likely inflate the cost of ongoing military operations in Iraq and Afghanistan. The agency assumes current war costs — Congress approved $186 billion for Iraq and Afghanistan for this budget year — continue indefinitely.
The agency's latest estimate of total appropriations since 2001 to fight terrorism and for operations in Iraq and Afghanistan is $858 billion.
Newsflash! Citi and Lehman Downgrade Fannie And Freddie
The Fly on the Wall reported this morning that "Lehman downgraded shares of Fannie Mae and Freddie Mac to Equal Weight from Overweight after the U.S. government said it will place Fannie and Freddie into a conservatorship.
Citigroup also downgraded shares to Sell from Buy following the federal government's plan to place the GSEs into conservatorship as they believe both Fannie and Freddie will no longer be managed to maximize common shareholder returns."
Well isn't that wonderful? Lehman and Citi were telling investors to buy shares at $7 last week and now the stock is at $1 -- and they're kind enough to let us know that we should sell now that they aren't being run for the benefit of shareholders. That kind of hindsight is truly priceless, or at least valueless.
Given that Fannie was presumably being run for the benefit of shareholders all the way down from $68 to $1 (and hopefully 0), it may be interesting to see what happens now that shareholders aren't the top priority.
But there's a larger message here about the value of Wall Street's sell-side research: when you add the long history of analyst research being flawed by conflicts of interest to the fact that companies like Citigroup and Lehman can't even keep track of their own balance sheets, it might be worth ignoring completely -- if Lehman doesn't understand Lehman, how could it possibly understand Fannie and Freddie? Obviously it didn't.
Lehman in free fall again
The way things are going, shares in Lehman Brothers may be trading at parity with Fannie Mae and Freddie Mac by the time the brokerage firm shows Wall Street its new strategic plan next week.
Shares in Lehman plunged as much as 44% in heavy trading Tuesday after Dow Jones reported that Korean regulators said talks between Lehman and the state-backed Korea Development Bank had ended. “There will be other opportunities,” Financial Services Commission Chairman Jun Kwang-woo told Dow Jones.
Lehman declined to comment, but investors fled the company’s shares, sending them to their biggest one-day drop since Bear Stearns collapsed in March. The true state of the discussions was further muddied when Reuters reported that KDB Chief Executive Min Euoo-sung - a former top exec at Lehman - declined to comment on the prospect of an investment in Lehman.
“I’d believe no comment would be the best strategy for us,” he told reporters at a venture capital forum, Reuters reported.
The reports come a day after Lehman said it would report its fiscal third-quarter earnings, and reveal other so-called strategic initiatives, in a conference call after the market closes next Thursday. Lehman shares dropped 12% in trading Monday even as the financial sector staged a relief rally following the government’s decision to take the big mortgage firms Fannie and Freddie into temporary custody.
On Tuesday, shares of Fannie were up 8 cents at 81 cents, while Lehman was down $4.55 at $9.57 - a level last seen in the wake of the 1998 collapse of Long Term Capital Management.
Freaking Out About Lehman
The vise continues to tighten on Lehman Brothers Holdings Inc., as shares are down by 30% and the cost of insuring against default has risen sharply. Larded up with bad positions in subprime mortgages, the brokerage is facing the very real scenario of selling lots of assets before the investors are comfortable with the stock again.
Earlier today it was reported that the Korea Development Bank ended talks with Lehman; the state-owned bank was flirting with an acquisition of some of the firm’s assets. Several analysts have cut earnings estimates on the company in the last 24 hours, and there are concerns that the company will find itself out on an island after the Treasury has already bailed out the more-important institutions of Fannie Mae and Freddie Mac.
“My guess is Lehman is stuck being Lehman, rather than a domino [the Fed and Treasury] have to prevent from falling,” says George Feiger, president of Contango Capital Advisors, the wealth management arm of Zions Bancorporation.
Equity shares of the other brokerages are getting hit, but none so much as Lehman. And the company’s credit-default swaps, a measure of the cost of insurance against default on debt, have widened to $450,000 from $320,000 Monday, according to Phoenix Partners Group. However, five-year Treasury CDS have risen to $18,000, a record, and the CDR Counterparty Risk Index has widened to $162,900, suggesting real concerns across the credit spectrum.
Now, the speculation centers around when Lehman will sell its Neuberger Berman asset management unit, which Sanford Bernstein analysts estimate to be worth $7 billion to $8 billion (a pre-tax gain of $4 billion to $5 billion for Lehman).
Brad Hintz, analyst at Sanford Bernstein, lays out a scenario that would value Lehman’s shares at around $15 each, with current leverage taken into account. This would involve a sale of Neuberger Berman, another write-down on mortgage positions, and a sale of commercial real estate assets.
“We believe that LEH will be able to avoid a forced ’shotgun marriage,’ like the one Bear Stearns and its stockholders endured,” he writes. “In the meantime, investors will have a difficult period ahead.” Michael Schwartz, options strategist at Oppenheimer & Co., says the activity reflects a re-pricing of Lehman’s shares without Neuberger.
The activity is heavily weighted in favor of put buying, even out-of-the-money September put options that expire on the 19th. More than 16,000 September put options at a $7.50 strike price have changed hands, and there’s also significant action in the $10 call options (the option to buy a stock at a later date). However, the price of those calls is falling, down $2.43 lately to $2.27 each.
In such a scenario, an investor could sell the calls and collect a $2.27 premium, while buying the $7.50 puts at $1.33 each, and still have the possibility of making money as the stock deteriorates.
Oil Nears $100 — On the Way Down
For a time, it looked as if the next round number of significance for oil was $200 a barrel, but unless something quite spectacular occurs, investors will see oil drift below $100 a barrel within the next few days.
The sharp reversal in crude prices in the last several weeks, carried by a strengthening dollar and weakness in worldwide demand for energy products, continued Tuesday even as Hurricane Ike approached the U.S. mainland and OPEC ministers suggested they will keep production steady.
To analysts, the decline represents an ongoing revision of views on economic growth. Somewhere around $120 a barrel, oil flipped from being a detriment to consumer spending to a sign that consumers just weren’t spending. “Consumers started to change their habits a bit,” says Scott Magnuson, commodity trading advisor at MF Global.
David Aleman, senior trade analyst with Grand Central Trading Co. in Newport Beach, Calif., says the equity market’s weakness is partially responsible for leading crude lower in recent days — sort of the reverse of what transpired several weeks ago, when crude rallies were hurting equities. “Psychologically, I think it’s significant,” he says. “I wouldn’t be surprised to see it hit $90 or $95 a barrel.”
Folks like to focus on the round numbers, but Ashraf Laidi, analyst at CMC Markets, points out that the more nondescript $99.66 level might be the true “support” level, representing the halfway point between the high of $148.50 and the low of $50.82 in 2007.
Where is the money going to come from?