The worst of the global financial crisis is yet to com

[uobboss]

By Jan Dahinten

SINGAPORE (Reuters) - The worst of the global financial crisis is yet to come and a large U.S. bank will fail in the next few months as the world's biggest economy hits further troubles, former IMF chief economist Kenneth Rogoff said on Tuesday.

"The U.S. is not out of the woods. I think the financial crisis is at the halfway point, perhaps. I would even go further to say 'the worst is to come'," he told a financial conference.

"We're not just going to see mid-sized banks go under in the next few months, we're going to see a whopper, we're going to see a big one, one of the big investment banks or big banks," said Rogoff, who is an economics professor at Harvard University and was the International Monetary Fund's chief economist from 2001 to 2004.

"We have to see more consolidation in the financial sector before this is over," he said, when asked for early signs of an end to the crisis.

"Probably Fannie Mae and Freddie Mac -- despite what U.S. Treasury Secretary Hank Paulson said -- these giant mortgage guarantee agencies are not going to exist in their present form in a few years."

Rogoff's comments come as investors dumped shares of the largest U.S. home funding companies Fannie Mae and Freddie Mac on Monday after a newspaper report said government officials may have no choice but to effectively nationalize the U.S. housing finance titans.

A government move to recapitalize the two companies by injecting funds could wipe out existing common stock holders, the weekend Barron's story said. Preferred shareholders and even holders of the two government-sponsored entities' $19 billion of subordinated debt would also suffer losses.

Rogoff said multi-billion dollar investments by sovereign wealth funds from Asia and the Middle East in western financial firms may not necessarily result in large profits because they had not taken into account the broader market conditions that the industry faces.
"There was this view early on in the crisis that sovereign wealth funds could save everybody. Investment banks did something stupid, they lost money in the sub-prime, they're great buys, sovereign wealth funds come in and make a lot of money by buying them.

"That view neglects the point that the financial system has become very bloated in size and needed to shrink," Rogoff told the conference in Singapore, whose wealth funds GIC and Temasek have invested billions in Merrill Lynch and Citigroup

In response to the sharp U.S. housing retrenchment and turmoil in credit markets, the U.S. Federal Reserve has reduced interest rates by a cumulative 3.25 percentage points to 2 percent since mid-September.

Rogoff said the U.S. Federal Reserve was wrong to cut interest rates as "dramatically" as it did.

"Cutting interest rates is going to lead to a lot of inflation in the next few years in the United States."

 

[uobboss]

Analysis: CDO values in free-fall
By Paul J Davies

Published: August 18 2008 17:12 | Last updated: August 18 2008 17:12

The gloomier outlook for corporate debt in the US and Europe is turning a spotlight on another banking business that exploded during the credit boom, growing from next to nothing into a trillion-dollar industry in little more than four years.

Repackaging credit derivatives to create leveraged investments was a tiny business in the early years of this decade, but between late 2003 and the middle of last year analysts estimate that between $1,000bn and $1,500bn worth of these deals were sold.

The products in question are synthetic collateralised debt obligations. Now, after a year of highly volatile credit markets and with rating agencies under pressure to tighten up their standards across complex structured products, there is growing talk about how to deal with a problem that has the potential to be very expensive.

The systemic increase in risk premiums or spreads in credit derivatives markets means that the values of synthetic CDOs could be less than 50 cents in the dollar, even if the underlying portfolio is relatively high quality, according to analysts at Lehman Brothers.

The bespoke and private nature of the synthetic CDO business makes it near impossible to dig up solid figures for the asset class as a whole, but taking Lehman’s view, investors are easily sitting on unrecognised market value losses of several hundred billion dollars.

This is leading to increasing questions about whether investors – who are mostly banks, insurers and some traditional money managers – should cut their losses and sell, or unwind, such deals or whether they should try to restructure them.

However, specialist bankers in the field say there is relatively little activity tackling this problem asset for two main reasons. First, there is great uncertainty about whether rating agencies will make changes to the way they rate such deals.

Secondly, most of the banks and insurers who bought these CDOs accounted for them as hold-to-maturity assets and so will not have to take any pain until they have to judge such losses as permanent impairments.

Cutting a path through the mezzanine maze
Mezzanine tranches of synthetic CDOs

Synthetic collateralised debt obligations are used to create individually tailored slices of credit risk for investors. They are based on a pool of corporate credit derivatives of individual companies.The investor buys a single slice, or tranche, of exposure to losses from the pool.

For a long time, the most popular were mezzanine tranches, named after their place in the order in which the various tranches of a CDO are exposed to losses.

The equity takes the first 3 per cent of credit losses from a portfolio then comes the mezzanine tranches, the first of which commonly covers the next 3 per cent of losses up to the 6 per cent mark. Others can also be created to cover losses up to the 12 per cent mark, beyond which come the senior, triple A rated tranches.

Restructuring options

If investors do not want to sell out either back to the bank that first sold them the deal, or to a specialist investor looking to create value through their own unwind strategies, they have two main strategies.

First, they can make substitutions in their portfolios to swap riskier credits for safer ones. This costs money, but can be paid for in a number of ways, such as reducing the overall coupon of the deal, or extending its maturity and giving up the extra yield this would have granted.

Second, they can make structural changes, such as adding subordination, or moving their tranches higher up the capital structure so that they only take losses after say 4 per cent of the portfolio has already gone.

The less investors do, the less likely their deal would have to be rerated, but the more likely it is to be almost as risky as before.
“Investors are in a quandary,” say Gaurav Tejwani and Fabien Azoulay, analysts at Lehman. “Even those who expect to hold these instruments to maturity and are less sensitive to mark-to-market movements have been struck by the poor valuations and the sense that the dislocation in marks no longer appears temporary.”

The main reason why valuations have been so hard hit is that a large proportion of the outstanding deals were structured and sold when credit conditions were at their most benign and so spreads were at historic lows.

Analysts at Dresdner Kleinwort estimate the majority of deals were done in 2006 and the first half of 2007. “Issuance in 2006 and 2007 accounted for 70 per cent of total volumes to date and was one of the factors that led to the historical credit spread tightening seen prior to the credit crunch,” says Domenico Picone, analyst at Dresdner.

In the intense hunt for higher yields during that period, deals were structured with increasing levels of leverage, longer maturities, less diversification and lower rated credit, Mr Picone adds, with financial credits being particularly favoured.

However, financial debt has been the hardest hit in the past year’s turmoil due to the exposure of banks’ and insurance companies’ to mortgage related bonds and other structured credit.

Analysts at Morgan Stanley say this is one reason why such deals have performed worse than credit broadly. “Levered exposure to certain financials and housing related credits is partly why many such mezzanine tranches [synthetic CDOs] have today underperformed the corporate credit markets broadly,” they say. Mezzanine tranches were long the most popular form of synthetic CDOs because they offered very high returns for a BBB or sometimes A rating. They are called mezzanine because of their place in the order in which the various tranches of a CDO are exposed to losses (see box).

“For banks, insurers and long-only money managers, mezzanine CDO tranches were used as a proxy to get diversified credit exposure,” says one experienced structured credit banker. “All these deals are most likely held at cost and if investors don’t want to take the hit, then they should restructure.”

The banker adds, however, that most of the restructuring strategies being touted are defensive moves that allow investors to buy themselves some protection, though not much if defaults tick up to anywhere near what credit spreads are predicting.

One problem for investors who do want to restructure is the uncertainty surrounding how deals will be rated in the future. Fitch has already reworked its system for synthetic CDOs and now has much more conservative models, which have led to a wave of downgrades.

Moody’s and Standard & Poor’s are much more important to the market and rate a far higher proportion of deals, according to bankers and analysts.

While they have not yet made any changes, bankers insist it remains impossible to restructure a deal to the extent it would need re-rating while all three agencies are either simply not taking on the work, or where their future ratings practices are still uncertain.

Other bankers are more sanguine about the synthetic CDO problems, however. Vaibhav Piplapure, global head of CDOs at Credit Suisse in London, says that of all structured credit assets, investment grade single tranche synthetics are among the least affected from the view of long-term credit losses and are often the smallest part of structured credit portfolios by notional value.

”The fact that most holdings are not mark-to-market means investors are much more able to put the problems in perspective because credit spreads are implying losses far greater than most expect to see in their investment grade credit portfolios,” he says.

"Most investment grade CDOs are managed and most allow various forms of portfolio rebalancing to substitute riskier credits.”

Mr Piplapure says that for banks especially the bigger picture is more important,

“Banks have finally come to the realisation that they need a system-wide solution for their structured credit portfolios, which are made up mainly of dollar-based ABS [asset backed bonds], CLO and CDO assets.”

Another London-based structured credit banker says the reason there is not much restructuring yet is partly because there have been few CDO downgrades and partly because there have been almost no bond defaults. “ But we do expect a very busy fourth quarter,” he says. “As credit continues to deteriorate, people will come back from holiday with year-end concerns and that will provide a big new impetus.

 

[hughgrant]

overall a very gloomy picture. dont know how

 

[madmansg]

world bank economist talk cock lar. Crisis over then he come out and shout ? Where was he two years back ?

 

[SIFU]

when PAP says overall economy still doing well, we have to start to worry liao..

 

[Sammael]

world bank economist talk cock lar. Crisis over then he come out and shout ? Where was he two years back ?

Well you know how these closet experts are. Bet you that 2 years back he was probably singing the praise of the same tools.

 

[sun-x]

Better start to save money...less bonking:o

 

[Lentor]

when PAP says overall economy still doing well, we have to start to worry liao..

they said 'more good years ahead' ok!

 

[xdecepticon]

Better start to save money...less bonking:o

Dont talk abt bonking. A plate of chai png already cost me $3/-. Mthly salary oso less than $2k. How to save??

 

[uobboss]

US regulators shut Kansas bank

August 23, 2008: 8:16 AM EDT


WASHINGTON (AP) -- -- Federal regulators on Friday shut down Kansas bank Columbian Bank and Trust Company, which was struggling with losses on soured real estate loans.

The Federal Deposit Insurance Corp. was appointed receiver of Columbian Bank of Topeka, Kan., which had $752 million in assets and $622 million in deposits as of June 30.

The FDIC did not give a reason for the closure, but Columbian reported $92 million in delinquent loans in the second quarter, citing a "volatile real estate market." The bank set aside $9.2 million for loan losses in the first quarter, up nearly 30 percent from the $7.1 million it set aside in the first quarter of 2007.
5 problem borrowers

A financial statement for the bank shows $482.3 million in real estate loans in the first quarter, including $439.4 million in construction and development and commercial real estate loans. Columbian has said that five borrowers represented nearly half the $92 million in problem loans.

Construction and development loans are areas that have been under greater scrutiny from federal examiners, the FDIC has said, and a growing number of banks have cited weakness in those areas of their loan portfolios.

The agency said Columbian's deposits will be assumed by Citizens Bank and Trust of Chillicothe, Mo. Its nine offices will reopen Monday as branches of Citizens Bank. Depositors of Columbian Bank will continue to have full access to their deposits, the agency said.

It was the ninth failure this year of an FDIC-insured bank.

That compares with three failures in all of 2007. More banks are in danger of failing this year, agency officials have said.

The FDIC estimated the resolution of Columbian Bank will cost the deposit insurance fund around $60 million.

Regular deposit accounts are insured up to $100,000.

There were about $46 million in uninsured deposits held in 610 accounts at Columbian Bank that potentially exceeded the insurance limit, the FDIC said.

Concern has been growing over the solvency of some banks amid the housing slump and the steep slide in the mortgage market. The pressures of tighter credit, tumbling home prices and rising foreclosures have been battering many banks, large and small, across the nation.

The FDIC has been beefing up its staff of examiners to handle the anticipated spike in bank failures this year.
IndyMac Bank

The largest bank failure by far this year has been that of savings and loan IndyMac Bank, which was seized by regulators on July 11 with about $32 billion in assets and deposits of $19 billion.

The seizure of Pasadena, Calif.-based IndyMac, which was the largest regulated thrift to fail in the United States, prompted hundreds of angry customers to line up for hours in Southern California to demand their money. IndyMac also was the second-largest financial institution to close in U.S. history, after Continental Illinois National Bank in 1984.

The FDIC has been operating the bank, now called IndyMac Federal Bank, under a conservatorship.

On Wednesday, the FDIC announced a program under which thousands of troubled home borrowers with loans from IndyMac will be able to switch into 30-year, fixed-rate mortgages with interest rates capped at around 6.5 percent in what could be an important test case for future bank resolutions.

FDIC officials have said the agency expects to raise insurance premiums paid by banks and thrifts to replenish its reserve fund after paying out billions of dollars to depositors at IndyMac. The fund, currently at $53 billion, is expected to take a hit from IndyMac of $4 billion to $8 billion.

FDIC Chairman Sheila Bair said recently she expects turbulence in the banking industry to continue well into next year, and more banks to appear on the agency's internal list of troubled institutions.

Of the 8,500 or so banks in the country, 90 were considered to be in trouble in the first quarter. The FDIC doesn't disclose the banks' names.

Only 13 percent of banks that make the list fail, on average, and most are nursed back to health or acquired by stronger institutions, according to Bair.

Federally insured banks and thrifts set aside a record $37.1 billion to cover losses from soured mortgages and other loans in the first quarter, when profits were nearly halved.

 

[uobboss]

Goldman Sachs says half of the world economy faces recession

Posted online: Friday , August 22, 2008 at 00:14 hrs
Updated On: Friday , August 22, 2008 at 00:14 hrs


Goldman Sachs Group Inc said countries that account for half of the world's economy face a recession a year after the credit crisis began. The US, Japan, the 15-nation euro area and the UK are "either in a recession or face significant recession risks in the months ahead," Goldman's London-based international economist Binit Patel said in a report to clients on Thursday.

A year since the US housing slump sparked about $500 billion in credit market losses for banks globally, the world's largest economies are all stumbling as rising borrowing costs combine with record commodity prices to sap growth. The US is close to a recession and France, Germany and Japan all contracted in the second quarter.

Economists at UBS AG led by Larry Hatheway this week cut their forecast for global growth next year to 2.9% from 3.1%, close to the 2.5% deemed a world recession, while those at JPMorgan Chase & Co say this quarter's estimated 1% expansion will be the slowest since mid-2001.

Patel estimates the chances of a global recession at no more than 20% given his expectation that China's economy will continue to grow about 10% this year and next.

"Continued robust, albeit slowing, growth in China and the rest of the emerging markets" will deliver world growth of 3.6% next year after 3.9% in 2008, said Patel, who estimates emerging markets account for the other 50% of the world economy.

—Bloomberg

 

[ahbengsong]

The golden era has just started.... global financial crisis or not.... it apparently did not stop Lee from saying the golden era is here in sgp....

 

[uobboss]

Warning: Worldwide wipeout ahead

Warning: Worldwide wipeout ahead
Think US stocks are on a life raft? Look around the globe, where seas are much rougher. This is serious, folks. Brace for a brutal riptide of more economic upheaval.

By Jon Markman
It barely seems possible that anyone is more pessimistic about corporate earnings prospects than American shareholders right now, with the U.S. stock market down almost 15% for the year and the banking system coming unglued before our eyes.

Yet if you take a moment to look around the world, you may be surprised to learn that U.S. stocks are the picture of health compared with their counterparts worldwide. And measured against the gloom in bonds, U.S. stocks are like a sunny day in spring.

Time to gloat? Not on your life. For if there's one thing we know about global markets these days, it's that they seldom diverge for long. So while it might be tempting to look with pity at investors across the seas and in other asset classes, it's more likely that U.S. equities will plunge than that foreign equities will float higher toward our perch.

Just spin a globe to see a few examples from the world of truly Olympian value destruction:

The British stock market has been harried down the rabbit hole to the tune of 22%, or about half again as bad as we have it. Blame energy, banking and telecoms, because those are the downside leaders for the Europeans, particularly basket cases such as wireless giant Vodaphone Group (VOD, news, msgs), down 30%, and Royal Bank of Scotland (RBS, news, msgs), down 44%.

The French market is also une grandestinque-bombe, down 22%, led by energy and banks. The Belgian market is worse, down 30%, with Germany down 24%, Austria down 23%, the Netherlands down 21% and Spain down 23%.

Elsewhere on the Continent, the news does not improve. Sweden is off 23%, Russia is down 23%, Turkey is down 25%, and Greece is down 36%.

How about Asia, the crown jewel of global growth? It's a wet noodle. The Chinese market is down 31%, South Korea is down 27%, once-hot Malaysia is down 29%, and India is down 43%. The best in the region are down half as much but still a lot, as Japan has lost 16% of its value this year. Taiwan is off 14%, Australia is off 21%, and Singapore is down 19%.

And Latin America, that bastion of energy, metals and grains? Well, the bear market in Brazil has only just begun; it is down just 12% so far after being up as much as 22% in mid-May. Mexico is hanging in there at 5%, probably propped up by the narco-trafficking biz. But Argentina has fared a lot worse, sinking 20%.

Most of the European and Asian countries' biggest companies are banks that have suffered the same fate as U.S. financial institutions. Gullible and desperate for income at a time of record-low yields in the mid-2000s, they were suckered by Wall Street investment banks into borrowing to the hilt to buy high-yielding mortgage-backed securities that were mislabeled as high-quality, low-risk investments.

It takes only a 4% loss to wipe out your capital when you're at leverage levels of 30-to-1 -- a measure of how much capital you have at risk compared with how much capital you have before borrowing -- as many banks around the world were. And add to that a crash in metal and energy prices in the past two months, plus a slowdown in industrial growth, and you have a conflagration of capital that knows no borders.

The global dominoes fall
You need read only a single day's worth of headlines to gather that a global, synchronized economic wipeout is under way. On Aug. 18, Bloomberg reported that:

French manufacturing confidence fell in July to the lowest level in five years.

New Zealand's services industry contracted in July for the fourth straight month.

Sales at Japanese department stores fell in July for the fifth straight month.

Singapore's overseas shipments dropped in July for the third straight month as companies shipped fewer electronics and drugs to customers in the West.

In many places, a perfect wave of growth has reversed into a brutal riptide. Indian information-technology companies such as Cognizant Technology Solutions (CTSH, news, msgs) and Wipro (WIT, news, msgs) swelled in importance by helping U.S. companies fix the "millennium bug" in the late 1990s and then went on to grow at 40%-plus rates as the tech outsourcing fad exploded.

Now, The Wall Street Journal reported this week, the Western credit crunch and capital expenditure slowdown have sapped sales, and the cheaper dollar has shrunk Indian tech company profits. At the same time, rising labor costs have permitted competition to emerge in lower-cost countries in Eastern Europe and the Philippines. The big Indian tech companies' shares are down 30% in the past 10 months versus a negative 18% for U.S. techs.

Meanwhile, fear has gripped corporate bond investors by the throat in ways that make stocks' problems look tame. Surely you remember bonds, those widows-and-orphans instruments that were once considered the market's equivalent of a boring IOU, paying a percentage point or two above U.S. Treasurys? Well, now many are trading like penny stocks.

You can call your broker to buy debt by the mortgage unit of blue-chip GMAC Financing at crash-landing prices that would give you a 50% annualized rate of return over the next three months when they mature in November. Or perhaps you'd prefer bonds of privately held plastics giant Pliant that mature in September 2009 and are going for 45%. Or bonds of car-parts maker Dayton Superior (DSUP, news, msgs) that mature in June 2009 for a yield of 40%. Or maybe Washington Mutual (WM, news, msgs) bonds maturing in January that trade around 35%.

I could go on and on. Credit analyst Brian Reynolds has sent clients a list of 60 major companies with bonds maturing over the next 12 months that trade with yields over 10% at a time when the federal funds rate is at 2%, adding in a note: "And these are just the bonds that have been able to trade!"

The Merrill Lynch Corporate Master Index, which tracks the performance of investment-grade-rated corporate bonds, shows 72 of them trading in "distressed" condition, or more than 10 percentage points over Treasurys -- 28 of them issued by banks such as regional giants National City (NCC, news, msgs) and Washington Mutual. That means corporate bankruptcies are virtually inevitable over the next 18 months. Chris Whalen, the managing director of Institutional Risk Analytics, has told Dow Jones Newswires that he expects 110 banks with $850 billion in assets to fail by next July, which is eight times the Federal Deposit Insurance Corp.'s reserves.

A spate of bankruptcies of this breadth is incompatible with a rising stock market even if the next president gets in front of the problem by creating a new government entity that buys failed banks, much like the Resolution Trust Corp., which closed 747 thrifts starting in 1989. So either the pessimistic credit guys and global-equity investors are terribly wrong right now, or the relatively optimistic U.S. equity investors are wrong. They can't both be right, as both depend on assessments of global earnings potential, with small variation for currency values.

Since credit has led the recent cycle down, and since the rest of the world's vote is overwhelming, I think we have to give a nod to the pessimists this time. The latest bounce should persist a little longer, but once the Dow Jones industrials ($INDU) climb to around 12,000 by early fall, watch out below.

 

[smoothnsleek]

Live within your means. Throw your credit cards away...jus have one on standby. Use cash, NETS or bank cheque. Tell those pte banking officers "Thanks but no thanks" when they offer Balance Transfers for your holidays, pay off credit cards or for investments. The admin fee or "low" int charges reeks of conmanship. No such thing as free lunch.

Our economy may do well but prob restricted to certain sectors. This is not a 'doomsday' message but jus be prudent. Like a tsunami, Asia may still be in the US grip of falling asset dominoes. The waves do not recede overnight.

Avoid advance purchases of things that will be delivered only in the future....like booking holidays. Think discounted present values. Think job security. Think cash flow.

We are all rich if in earning 100 we still have 90 at mth's end after spending and saving. The doghouse is for those who have -1 at mth's end.

It's not how much we make; it's how much we save.

 

[madmansg]

Re: Warning: Worldwide wipeout ahead

all these talk cock people. the global GDP is 50 Trillion. So 1 trillion loss will be forgotten in a year or two. Dont be fool by all these chicken sky is falling articles.

 

[panama]

That's why must save up for rainy day

 

[jw5]

smoothnsleek
Your post is very sensible, but unfortunately not relevant to this topic.
On the contrary, the worry now for those common folk depositors in the US is that they may have been prudent and save most of what they earn, but the bank closes down because of their lack of prudence with relation to housing securities.

 

[uobboss]

Why The Fannie-Freddie Bailout Will Fail
by Martin D. Weiss, Ph.D. 09-08-08


Martin D. Weiss, Ph.D.

With yesterday's announcement of the most massive federal bailout of all time, it's now official: Fannie Mae and Freddie Mac, the two largest mortgage lenders on Earth, are bankrupt.

Some Washington bigwigs and bureaucrats will inevitably try to spin it. They'll avoid the "b" word with vengeance. They'll push the "c" word (conservatorship) with passion. And in the newspeak of 21st century bailouts, they'll tell you "it all depends on what the definition of solvency is."

The truth: Without their accounting smoke and mirrors, Fannie and Freddie have no capital. The government is seizing control of their operations. Their chief executives are getting fired. Common shareholders will be virtually wiped out. Preferred shareholders will get pennies. If that's not wholesale bankruptcy, what is?

Some Wall Street pundits and pros will also try to twist the facts to their own liking. They'll treat the bailout like long-awaited manna from heaven. They'll declare that the "credit crisis is now behind us." They may even jump in to buy select financial stocks. And then they'll try to persuade you to do the same.

The reality: This was the same pitch we heard in August of last year when the world's central banks made a coordinated attempt to rescue credit markets with massive injections of fresh cash. It was also the same pitch we heard in March when the Fed bailed out Bear Stearns. But each time, the crisis got progressively worse. Each time, investors lost fortunes.

Together, both Washington and Wall Street are trying to persuade you that, "no matter what, the government will save us from financial disaster." But the real lessons already learned from these events are another matter entirely:

Lesson #1. Each successive round of the credit crisis is far deeper and broader than the previous.

* In 2007, the big news was big losses; in 2008, it's big bankruptcies.

* In March, the failure of Bear Stearns shattered $395 billion in assets. Now, just six months later, the failure of Fannie Mae and Freddie Mac is impacting $1.7 trillion in combined assets, or over four times more. And considering the $5.3 trillion in mortgages that Fannie-Freddie own or guarantee, the impact is actually thirteen times greater than the Bear Stearns failure.

Lesson #2. Despite unprecedented countermeasures, Washington has been unable to stem the tide.

Yes, the Fed can inject hundreds of billions into the banking system. But if banks don't lend, the money goes nowhere.

Sure, the Treasury can inject up to $200 billion of capital into Fannie and Freddie. But if their mortgage portfolio is full of holes, all that new capital goes down the drain.

And of course, the U.S. government has vast resources. But if the $49 trillion mountain of U.S. debts and the $180 trillion pile-up of U.S. derivatives are beginning to crumble, all those resources don't amount to more than a band-aid and a prayer.

Lesson #3. Shareholders are the first victims.

Bear Stearns shareholders got wiped out. Fannie and Freddie Mac shareholders are getting wiped out. Ditto for shareholders in any of Detroit's Big Three that go belly-up, any bank taken over by the FDIC or any insurer taken over by state insurance commissioners.

The Next Lesson:
The Primary Mission of the Fannie-Freddie
Bailout Will Ultimately End in Failure

Most people assume that when the government steps in, that's it. The story dies and investors shift their attention to other concerns. In smaller bailouts, perhaps. But not in this Mother of All Bailouts.

The taxpayer cost for just these two companies — up to $200 billion — is more than the total cost of bailing out thousands of S&Ls in the 1970s. But it's still just a fraction of the liability the government is now assuming.

Why?

First, because the number of home foreclosures and mortgage delinquencies has now surged to a shocking four million — and a substantial portion of the massive losses stemming from this calamity have yet to appear on Fannie's and Freddie's books.

Second, because the U.S. recession is still in an early stage, with surging unemployment just beginning to cause still another surge in foreclosures and mortgage delinquencies.

Third, even before Fannie and Freddie begin to feel the full brunt of the mortgage and recession calamity, their capital had already been grossly overstated.

Indeed, right at this moment, while Wall Street analysts are trying to evaluate the details of a bailout plan that's supposed to save them, regulators and their advisers are poring over the Freddie-Fannie accounting mess they're supposed to inherit. According to Gretchen Morgenson and Charles Duhigg's column in yesterday's New York Times, "Mortgage Giant Overstated the Size of Its Capital Base" ...

* Freddie Mac's portfolio contains many securities backed by subprime and Alt-A loans. But the company has not written down the value of many of those loans to reflect current market prices.

* For years, both Freddie and Fannie have effectively recognized losses whenever payments on a loan are 90 days past due. But in recent months, the companies saidthey would wait until payments were TWO YEARS late. As a result, tens of thousands of other loans have also not been marked down in value.

* Both companies have grossly inflated their capital by relying on accumulated tax credits that can supposedly be used to offset future profits. Fannie says it gets a $36 billion capital boost from tax credits, while Freddie claims a $28 billion benefit. But unless these companies can generate profits, which now seems highly unlikely, all of the tax credits are useless. Not one penny of these so-called "assets" could ever be sold. And every single penny will now vanish as the company goes into receivership.

In short, the federal government is buying a pig in a poke — a bottomless pit that will suck up many times more capital than they're revealing. My forecast:

Just to keep Fannie and Freddie solvent will take so much capital, there will be no funds available to pursue the primary mission of this bailout — to pump money into the mortgage market and save it from collapse. That mission will ultimately end in failure.

 

[uobboss]

part 2

The Most Important Lesson of All:
As the U.S. Treasury Assumes
Responsibility for $5.3 Trillion in Mortgages,
It Places Its Own Borrowing Ability at Risk

The immediate reason the government decided not to wait any longer to bail out Freddie and Fannie was very simple: All over the world, investors were beginning to reject their bonds, refusing to lend them any more money. So the price of Fannie and Freddie bonds plunged, and the yields on those bonds went through the roof.

As a result, to borrow money, Fannie-Freddie had to pay higher and higher interest rates, far above the rates paid by the U.S. Treasury Department. And they had to pass those higher rates on to any homeowner taking out a new home loan, driving 30-year fixed-rate mortgages sharply higher as well.

Now, with the U.S. Treasury itself stepping in to directly guarantee Fannie-Freddie debts, Washington and Wall Street are hoping this rapidly deteriorating scenario will be reversed.

They hope investors will flock back to Fannie and Freddie bonds.

They hope investors will resume lending them money at a rate that's much closer to the Treasury rates.

And they hope Fannie and Freddie will again be able to feed that low-cost money into the mortgage market just like they used to.

In other words, they hope the U.S. Treasury will lift up the credit of Fannie and Freddie.

There's just one not-so-small hitch in this rosy scenario: Fannie's and Freddie's mortgage obligations are just as big as the total amount of Treasury debt outstanding.So rather than the Treasury lifting up Fannie and Freddie, what about a scenario in which Fannie and Freddie drag down the U.S. Treasury?

To understand the magnitude of this dilemma, just look at the numbers ...

* Mortgages owned or guaranteed by Fannie and Freddie: $5.3 trillion.

* Treasury securities outstanding as of March 31, according to the Fed's Flow of Funds (report page 87, pdf page 95): Also $5.3 trillion.

If Fannie's and Freddie's obligations were equivalent to 10% or even 20% of the U.S. Treasury debts, the idea that they could fit under the Treasury's "full faith and credit" umbrella might make sense. But that's not the situation we have here — Fannie's and Freddie's obligations are the equivalent of 100% of the Treasury's debts.

And it's actually worse than that:

* Foreign investors, the most likely to dump their holdings if they lose confidence in the United States, hold an estimated 20% of the Fannie- and Freddie-backed mortgages outstanding. But ...

* Foreign investors own 52.7% of the Treasury securities outstanding (excluding those held by the Fed).

So based on the above stats, Treasury securities are actually more vulnerable to foreign selling than Fannie and Freddie bonds.

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.

 

[uobboss]

part 3

A Fictional Scenario
That's Coming True

In my book, Investing Without Fear: Protect Your Wealth in All Markets and Transform Crash Losses Into Crash Profits, I anticipated this very scenario. In a fictional scenario about the not-too-distant future, I warned what might happen if the U.S. Treasury tried to bail out the bonds of a giant corporation, just as it's doing for Freddie and Fannie right now.

In my scenario, a few days after the bailout is announced, the Treasury secretary calls the president of the United States on the phone to bring him up to date with the impact in the financial markets. Here's the dialog that follows, quoted from my book verbatim [with any additions in brackets]:

"It's no good. The benefit of our plan to the stock market is a spit in the ocean. On the other hand, to the government bond market, it's a potential hydrogen bomb. The quality spreads are narrowing — and in the wrong direction."

The president didn't know much about quality spreads. "What are the causes and what are the consequences of changes in quality spreads?" he asked.

"I am referring to the difference in yield between a Treasury bond and a corporate bond. A big corporation [like Fannie or Freddie] always has to pay more than the U.S. Treasury to borrow money. Typically, the difference has been about one full percentage point.

"Then, several months ago, when the full threat of corporate bankruptcies was first apparent, the yield on medium-grade corporate bonds went up by 2 1/4 percent, but the yield on the governments went up only 1/4 percent. In other words, the spread increased by two full percentage points. It was a red-hot flashing signal of trouble. It revealed that confidence in all corporations — no matter how creditworthy — had collapsed. But that was before our rescue package was announced."

"And now?"

"Now the opposite is happening. Corporate bond yields [like Fannie's and Freddie's] are back down sharply, but government bond yields are actually up sharply. The spread between them has narrowed to practically nothing — a very bad sign." The Treasury secretary felt satisfied that he had put forth a very clear and straightforward explanation.

"Well, isn't that what we had said we wanted — to bring up the corporate bond market, to get it back up toward the level of government bonds?"

The secretary shook his head, trying to hold his voice steady so that his feelings of frustration with the president's lack of knowledge of bond markets would not be picked up over the phone. In the past, he tried several times to explain to the president how interest rates and prices moving in opposite directions always meant the same thing, but that spreads, although moving in the same direction, could mean a variety of different things.

How does one make such things simple for a president to understand without sounding condescending? The secretary certainly didn't know how. He spent the next half hour going over the events in the marketplace until finally, after considerable effort, the president developed an image of bond markets that looked similar to the chart below.

"Now I see," the president said finally. "We wanted to bring the corporate bonds up to the level of the government bonds. What's happening is precisely the opposite. The 'governments,' as you call them, are falling down to the level of the 'corporates.' In short, we are not lifting them up; they are dragging us down."

"Yes, Mr. President. We bent over, we bent all the way over, to pull them out of the quicksand. Instead, they pulled us down with them, and now we're sinking in the quicksand too."

The president thought for a moment before he spoke. "The question is, Why? Don't they believe we're serious? Why haven't we restored confidence? At the meeting, it was said that we can create cash, that the law gives us the authority to funnel this cash wherever we please."

"The answer is that we can create cash. But we cannot create credit."

"What's the difference?" the president queried.

"There's a very big difference. To create more cash, all we have to do is speed up the printing presses at the mint — or, actually, pump it in electronically. And when we dish it out, no one is going to turn us down. But to create credit, we have to convince investors and bankers to make loans — and in this environment of falling confidence, I can assure you that this isn't easy. If it were so easy, we could have saved Bethlehem Steel or Enron or Kmart or Global Crossing or WorldCom or any of the other giants that have failed. But we didn't, and for good reason."

The president was getting impatient. "So what's the point?"

"The point is that you can create cash; you can't create confidence."

"It would seem to me that the more money we give 'em, the more confidence they'd have."

"No, no! It's exactly the opposite. The more we spend the government's money recklessly, the less confidence they have and the more they fear our government bonds will go down in value."

"Oh? But why can't we just buy more corporate bonds? That should convince them we mean business!"

"No, it just convinces them we're throwing more good money after bad — their good money after bad."

"But what about the new law?"

"The law gives us the on-paper authority to buy private securities. It does not give us the actual power to create real economic wealth."

"Why didn't we recognize this when we discussed the rescue plan?"

"We did. But you overrode us, and we consented. We hoped that the marketplace might swallow it. We seriously underestimated the sophistication of U.S. and foreign investors — very seriously underestimated."

Still the president sounded perplexed. "You're saying the market is sensitive. You're saying the market is smart. I see that now. But ..."

The secretary's irritability was becoming more apparent. "Let's say I'm a foreign investor and I own U.S. Treasury bonds. This implies that I trust the U.S. government; that I loaned you my money for the purpose of running your government. Now you take my money and pass it on to a third party, a private company. So I say to you, 'What did you go and do that for? If I wanted to loan the money to that company, I would have done so myself — directly — in the first place. But I didn't. I didn't do it because I don't trust the company. I trusted you. But now I can't trust you anymore either. Now you're just one of them.' So the investor stops buying our bonds or, worse, dumps the government bonds he's holding, and then we are in trouble. Then we can't sell our government bonds anymore to pay off the old ones coming due. Then we, the United States government, default."

The president hesitated for a few seconds before responding, but it seemed like hours as the tension built.

"Then what?"

The secretary could not believe his ears. The president of the United States had treated the government's default with levity, utter levity. He could no longer control his boiling frustration — and fear. "Do you want to allow the entire market for U.S. government securities to shut down? Do you want to be the one who has to lay off hundreds of thousands of government employees because you can't raise the money to meet the government payroll? Do you want to be the last president of the United States? Do you want to risk a new republic with a new constitution? Do you want to destroy, in one fell swoop ..."

The secretary's voice broke with emotion. Silence reigned.

"[Hank], I appreciate the sincerity of your emotions, but you misunderstood me. What I said, in fact, was 'then WHAT,' indicating to you my surprise and disbelief that our country could ever reach the point you've described so dramatically just now."

Back to the Present

In my book's future scenario quoted above, the government ultimately decided to abandon its plan to rescue large private corporations like Fannie or Freddie. It was the only way it could save its own credit and its own ability to continue borrowing from domestic and foreign investors.

In the real world of the present, however, the government is going forward with its bailout plan — and the plan is even more ambitious than the one contemplated in my book.

But for the same reasons I've outline above, the Treasury will ultimately have to effectively abandon Fannie and Freddie: It will set a cap on the resources it will commit. It will not write a blank check. In the final analysis, it must save its own neck first.

Good luck and God bless!

Martin