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Surging demand for U.S. Treasuries is causing failures to deliver or receive government debt in the $6.3 trillion a day market for borrowing and lending to climb to the highest level in almost four years."
-- Liz Capo McCormick,
Treasuries' Scarcity Triggers Repo Market Failures, March 20, 2008
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First of all, there is the issue of a problematic dislocation in the massive “repo” market to resolve.
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Not surprisingly, the Fed could not risk a Bear Stearns failure - not with all of its derivative, “repo” and counterparty exposures.
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...in reality, the profound deterioration in the U.S. and global Credit backdrop has greatly altered prospects for the vast majority of companies, industries, and the U.S. and global economies more generally.
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Huge sections of the Credit infrastructures (notably throughout Wall Street-backed finance) are inoperable and disCredited. Prominent Monetary Processes have been broken and the resulting Flow of Finance radically revamped.
...
I simply see no way around it – Nationalization of U.S. mortgages notwithstanding. It is fundamental to my analytical framework that efforts to subvert the Unavoidable Adjustment Process only extend the misallocation of finance and real resources, while adding greatly to the future burden of the financial institutions today aggressively intermediating very risky pre-adjustment Credit (certainly including the banking system and GSEs). ... Nationalization will prove a further blow to already fragile confidence."
NationalizationBy Doug Noland
March 21, 2008
SourceMarch 21 – Washington Post: “To Understand Wednesday’s decision by federal regulators to let Fannie Mae and Freddie Mac set aside less cash to protect against losses, imagine a family that keeps its precious antique silver in a strongbox on a high shelf, beyond easy reach. The regulators have essentially authorized Fannie and Freddie to pawn some of their family silver. Currently, the two firms, known as government-sponsored enterprises, or GSEs, have combined reserves of $82 billion. This includes an extra amount that the regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), required them to hold while they got their books in order after accounting scandals. Now it is reducing that extra cushion by $5.8 billion. The newly freed-up money will leverage the purchase and securitization of up to $200 billion in home loans. The point, however, is not to save Fannie and Freddie themselves but to use the two firms, which buy mortgages and resell bunches of them to investors in the form of bonds, to ease the difficulties of borrowers more generally. It’s as if our hypothetical family pawned its silver to help the neighbors out of a financial jam… This is risky. If all goes well, freeing up the GSEs will buoy mortgage lending, thus slowing or reversing the slide in housing prices… But if housing continues to tank, and the GSEs rack up new multibillion-dollar losses on top of those they have already incurred in recent months, they will have that much less in reserve to fall back on. The GSEs enjoy an implicit federal guarantee, but reducing their capital for a purpose such as this, at a time such as this, goes a fair way toward making that bailout promise an explicit one.”
I found OFHEO director James Lockhart’s interview late Thursday afternoon on CNBC worthy of documentation:
CNBC’s Maria Bartiromo: “Some have been arguing that the blowup in Bear Stearns caused the Administration to reconsider policy responses to this crisis. The deal announced today is basically telling them that that is a fact – that it really was Bear Stearns that pushed the government’s hand. Is that true – was it Bear?”
OFHEO Director James Lockhart: “Not really. We’ve been talking about this for a long time. I’ve been talking for many months about the need for these two companies to raise additional capital. And I’ve talked for over the last year that once they got remediated and fixed their books and got them on a timely basis, we would start looking at removing that 30% excess capital charge we had on.”
Bartiromo: “It seems to have taken a long time. A lot of people – from hedge fund companies to certainly the lenders – have wanted the restrictions eased for some time. What was the biggest barrier and what went away over the last several weeks in order to push your hand?”
Lockhart: “I think the key thing was three weeks ago they did actually produce their ‘07 financial accounts on a timely basis. And we’ve gone through all the consent agreement issues and they’re virtually finished on them as well. We thought it really was the appropriate time. They now have the proper systems and controls - proper risk management. And we think it really is a time they can help the mortgage market in a big way.”
Bartiromo: “We’re talking about a big number, too. Some $200bn in the market. What’s the best case scenario, sir – what would you like to see - what specific mortgages do you want these two guys to buy?”
Lockhart: “Well, I think they should be a player in many segments of the market. I think certainly, as (Fannie CEO) Dan Mudd just said, the conventional mortgage market has really weathered this storm pretty well because Fannie and Freddie have been there for the last year. But they could do more there. They’re just getting into the ‘jumbo” market next month, and certainly they’ll need capital to do that. And there’s a lot more that could be done in the subprime – refinancing some of these people into safer mortgages. And, also, just loan modifications. So there are a lot of ways that this capital can be used to improve the mortgage market.”
Bartiromo: “Are you expecting the capital at all to be earmarked for some of the passthrough CMOs – I mean the really troublesome securities that really did in Thornburg or Carlyle Capital or Bear Stearns, among others?”
Lockhart: “Carlyle Capital was actually holding Fannie and Freddie’s securities and the spreads widened dramatically – which they’ve probably come back this week. But I think they will be looking at buying their own mortgage-backed securities. They may look at some other mortgage-backed securities as well. I think we need to increase the trading. And as both of them said this morning, they need to be a bid in the marketplace to buy those securities.”
Bartiromo: “And just the idea that they are a bid in the marketplace to buy those securities obviously was really celebrated in terms of investors and the idea that now there is a buyer there. How long do you expect this process to take? And how long do you think it will take to actually get this moving – liquidity back into the market and a feeling of stability?
Lockhart: “Well, it may take awhile. The mortgage market is one issue, but there are some other markets out there as well. I think this is going to be a major step forward. As you said, they can do $200bn in purchases immediately. And to the extent they’re guaranteeing mortgage-backed securities - that could almost get into the trillions. We’re looking at that they would have the capacity – between what we did today and the significant capital raising that they committed to – they could do over $2 trillion in business this year if the market needs that money.”
As long-time readers are all too familiar, I have been a persistent critic of the GSEs. These behemoths of historic Credit excess – instigators of the Mortgage Finance and housing Bubbles – liquidity backstops for the ballooning leveraged speculating community – and instrumental agents for an unparalleled misallocation of financial and economic resources – are proving themselves The Freddie Krueger of Systemic Distortions and Policy Failures.
It would be an outright crime if thinly-capitalized Fannie and Freddie were allowed to increase their Books of Business (mortgages retained on their balance sheets and MBS guaranteed in the marketplace) by $2 Trillion this year – “if the market needs that money.” I was shocked when Mr. Lockhart imparted that they were now in a position to accomplish such a feat. It is certainly a terrible idea to put Fannie and Freddie guarantees on millions of new mortgages created from restructuring loans of troubled borrowers. This would amount to nothing less than a despicable transfer of massive prospective Credit losses directly to the American taxpayer (current owners of this paper should not be bailed out).
I have fully expected the GSEs, at some point, to be taken over by the federal government. It may have been orchestrated subtly, but I can only presume that such a historic endeavor was accepted this week as the only means of averting financial dislocation. And for their regulator to suggest that the GSEs today have any handle whatsoever over their unfolding “risk management” challenge is wishful thinking - at best.
As far as I’m concerned, much of the U.S. mortgage market was this week essentially Nationalized. I’ll take the dramatic narrowing in agency debt and MBS spreads as support for this view. Additional support arrived from comments from Mr. Lockhart, Mr. Paulson, and actions by the Federal Reserve. Having lived contently for years with the markets’ interpretation of the (grey-area) “implied” government backing of the GSEs, our policymakers are surely today satisfied with the inferred market acceptance of mortgage industry Nationalization. To be sure, the Fed’s Splashy “Sunday Night Special” bailout of Bear Stearns is rather trivial in both its implications and consequences when compared to Thursday’s Quiet Coup.
I have my own hunches about The Rise and Inevitable Fall of the GSEs. I’ve always assumed that the Greenspan Fed was pleased (relieved?) to watch Fannie and Freddie morph in the early nineties from conservative mortgage insurance providers to aggressive bank-like lending institutions and market operators. GSE Credit creation (and timely market interventions) worked greatly to alleviate the forceful economic headwinds created by an impaired banking system. I also (admittedly, rather cynically) pictured President Clinton, Treasury Secretary (and former Goldman Chairman) Robert Rubin, and Budget Director (and former Fannie vice chairman and so-to-be CEO) Franklin Raines behind the closed doors of the Oval Office plotting the exploitation of the GSEs, Wall Street finance, system mortgage Credit, and housing inflation for the orchestration a politically expedient economic boom. After beginning the nineties with assets of $454bn, the GSEs ended the decade with balance sheets that had swelled more than three-fold to $1.723 TN.
In the latter years of the nineties, global financial crisis coupled with political foible – not to mention Wall Street’s rapidly growing power and influence - granted the GSEs carte blanche. And then there was the market hysteria surrounding Y-2K, followed by the bursting of the technology Bubble, the terrible terrorist attacks, and then the 2002 corporate bond dislocation. By the time accounting irregularities surfaced in 2004, GSE assets had almost reached $3.0 TN.
I also have a hunch with regard to Greenspan’s now infamous prodding of households into adjustable-rate mortgages. I think he recognized clearly the degree to which the impaired GSEs (and their scantily capitalized counterparties) had become acutely vulnerable to a rise in market yields. As the Maestro, his interest-rate policies (market manipulations) orchestrated a massive shift of interest-rate risk from the financial sector to the household sector. In the process, however, recklessly low interest rates spurred unprecedented mortgage lending and speculative excesses that today imperil borrower, lender, leveraged speculator and system stability alike.
Somewhere along line, I think the Fed came to appreciate the extent to which they had relegated monetary (mis-) management to the agencies (and their Wall Street enthusiasts). Meantime, some politicians belatedly came to recognize what an affront the GSEs had become to the pricing and allocation of system Credit, as well as to the functioning of free markets more generally. Especially after the 2004 revelation of massive fraud and gross system inadequacies, a consensus developed in Washington that the GSEs needed both restraint and a powerful regulator (although the legislative details were much too slow to materialize). Apparently, all these justifiable concerns were chucked out the window this week in the name of “system stability”.
After first reaching $2.0 TN in 1999, Fannie and Freddie’s Combined Books of Business surpassed $5.0 TN in January. This “Book” increased $638bn, or 16%, last year, in what will surely be the greatest transfer yet of risky mortgage Credit to the GSEs (only to be greatly outdone in 2008). Interestingly, OFHEO, Washington politicians, and Wall Street analysts are keen to play a dangerous game pretending that there is limited risk in guaranteeing MBS (as opposed to the obvious risk associated with mortgages retained on their balance sheet). The absurdity of Mr. Lockhart stating that the GSEs will be in a position to take on an additional $2.0 TN of mortgage risk this year is simply incomprehensible. Keep in mind that the GSEs are on the hook for the “timely payment of principle and interest” on more than $5 TN of American mortgages – and counting… Such obligations will, in the Post-Bubble Era, prove untenable.
I remember when my old “analytical nemesis” Paul McCulley would refer to himself as a “populist” (I still prefer my “inflationist” characterization). Well, where are our “populist” statesmen today? The “average American” is getting slammed by rapid inflation in the prices for fuel, food, healthcare, education and other basis necessities. He was duped into various dangerous mortgage products to purchase homes with, in many cases, grossly inflated market values. Millions are in the process of losing virtually everything. He was also duped into various risky investment products, while the bursting of Bubble markets will leave him dreadfully unprepared for retirement. Now, he is seeing the returns from his savings crushed by the melee to bailout Wall Street “money changers” and speculators. Over the coming months, millions will lose their jobs with the inevitable adjustment and realignment to cope with post-Bubble realities. And now, apparently, the American taxpayer is to sit back and watch his contingent liabilities balloon (even further) with the Nationalization of the U.S. mortgage market.
I understand perfectly the motivation Wall Street, the Administration and the Fed have in blindly throwing the “kitchen sink” at this unfolding Crisis. These are indeed scary times bereft of solutions. I am certainly familiar with the view that bailing out Wall Street and the speculators is medicine necessary to stabilize the system. But not only is this approach both inequitable and unethical on moral grounds, it is my view that such endeavors will prove only further destabilizing for the system overall.
Many are this weekend undoubtedly relieved by the market's strong rally. The Fed and Administration finally are said to have discovered the right antidote – crisis resolved – buy financial stocks! I will caution, however, that U.S. and global markets this week had “dislocation” written all over them. First of all, there is the issue of a problematic dislocation in the massive “repo” market to resolve. We all should hope and pray that this is not the next “contemporary” financing market buckling under the forces of contagion. And to see commodities break down while financial stocks go into spectacular melt-up mode forebodes only greater losses for leveraged speculators in the troubled “market neutral” and “quant” arenas. The short financials and long commodities “pairs trade” was quickly added to the list of favorite trades gone sour. And those (and there were many) using March options (especially financial sector derivatives) to hedge market risk saw this strategy go up in flames as well. Speculators that were long international markets against shorts in the U.S. were similarly crushed. And speculators hedging with short positions in agency, agency MBS, and many other fixed-income derivative indices quickly found themselves on the wrong side of hasty developments.
Surely, policymakers were keen to mete out some punishment on the increasingly destabilizing “systemic risk trade” (shorting stocks, bonds, Credit derivative indices, buying bearish derivative products, etc.), but the upshot was only further destabilization. News that the GSEs were Back in the Game in a Big Way added to an already highly unsettled situation for myriad sophisticated trading strategies. But before getting too excited about the spectacular short-squeeze, keep in mind that shorting has become an instrumental facet of leveraged speculator trading strategies – and, really, “contemporary finance” more broadly speaking. And the disintegration of an ever increasing number of hedge fund and Wall Street strategies, as I’ve written previously, remains at the Heart of Deepening Monetary Disorder.
Not surprisingly, the Fed could not risk a Bear Stearns failure - not with all of its derivative, “repo” and counterparty exposures. It really was not a difficult fix. Yet the rapidly lengthening line of vulnerable non-bank lenders (Thornburg, CIT Group, and Rescap come immediately to mind) and hedge funds will pose a greater challenge. There are some very substantial balance sheets at risk and significantly more “de-leveraging” in the offing - and the big banks will have no appetite.
The S&P500 is down a modest 7% from the much changed financial and economic world of one year ago. While having little impact on the Unfolding Credit Crisis (or home prices), policymakers have thus far largely succeeded in sustaining inflated U.S. stock prices. But, in reality, the profound deterioration in the U.S. and global Credit backdrop has greatly altered prospects for the vast majority of companies, industries, and the U.S. and global economies more generally. Despite any number of policy actions and all the good intentions imaginable, there is absolutely no way that the U.S financial system will now be capable of sustaining either the (pre-bust) quantity of Credit or the uniform flow of finance that levitated Bubble Economy asset prices, household incomes, corporate cash-flows, “investment” spending or consumption. Huge sections of the Credit infrastructures (notably throughout Wall Street-backed finance) are inoperable and disCredited. Prominent Monetary Processes have been broken and the resulting Flow of Finance radically revamped.
Prospective Credit and financial flows will prove insufficient for scores of companies, as well as for state and local governments and various entities all along the economic food chain. Enormous numbers of business downsizings and failures – many by companies that thrived during the Bubble Era – will lead to huge losses of jobs and incomes (many at the “upper end” where the greatest excesses transpired). I simply see no way around it – Nationalization of U.S. mortgages notwithstanding. It is fundamental to my analytical framework that efforts to subvert the Unavoidable Adjustment Process only extend the misallocation of finance and real resources, while adding greatly to the future burden of the financial institutions today aggressively intermediating very risky pre-adjustment Credit (certainly including the banking system and GSEs). And I certainly don’t believe this week’s rally in the dollar should be viewed as a vote of confidence for the direction of U.S. policymaking. Nationalization will prove a further blow to already fragile confidence.