The Market Ticker

"Here I sit all broken hearted....."

Oh I cannot tell a lie - NOT.

The sell-off yesterday was predicated by not only the Barrons' article I cited in the weekend Ticker, but also by a Reuters follow-up and, when queried, Treasury confirmed that it had no intention of immediately bailing out Fannie and Freddie.

Now of course that wasn't Paulson who said that, and we know the game by now, right?

That is, you let the market get frothed up good on the short side, all the Bears come out and sell the beJeezus out of anything Financial, and then, out of the blue, after you call certain "friends" to tell them in advance you suddenly "JamJob" the market with some sort of "news" that you're going to fix it.

Of course you can't fix it, but the goal is really to just kick off a furious short-covering rally and give a knee in the nuts to the shorts.

How many times have we seen this?  And how many times do I believe that certain "favored people" were told in advance?

Oh, on the latter, all of them?

So what, precisely, was that nasty little rally late this afternoon, on heavy volume too?  Do you really expect me to believe it was all organic?  That there was no "whisper in the breeze"?

Uh huh.  I've gotten wise to you Paulson, you snake.

I don't trust these guys as far as I can throw them.

With that said, the credit market says that Fannie and Freddie are toast.  Nothing that the crooners have done can (or will) change that.

Let's get something straight here.  This isn't just liar loans.  Its everything securitized.  That's why nothing Paulson can do will fix it, and if he has an ounce of common sense he will not throw the taxpayer to the wolves trying to do that which is futile.

Again, our friend the CMBX, with the glorious deterioration of just the last few days:

What planet are you on if you don't think this is a big deal?  The AA and A spreads have blown out by 150 basis points over the weekend!

Something is blowing up.

Actually, that's a lie.  A lot of things are blowing up in the credit world.  In fact, its easier to list the things that aren't blowing up instead of the ones that are.

The ones that aren't blowing up (thus far) are:

• Treasuries

That's it.  A list with one item in it.

Most everything else is either at historical wides or is very close to it.

That's bad.

Paulson, of course, can remove Treasuries from that "safe" bullet list if he's stupid enough to actually try to bail out Fannie and Freddie.  That is, if instead of doing what I recommended over the weekend, throwing them into receivership and then running down the portfolio, forcing people to take whatever medicine they have coming, he could try to "buy out" $800 billion in bad paper, or worse, decide that he's going to paper over the problem (with your tax money) and hide it.  Either of those attempts has a high probability of drawing a big black line through "Treasuries" on the list above.

I hope he's smart enough not to do it, because Lord knows, we haven't got enough people in this country who "get it" and will raise hell in our streets, towns and in protest in DC to make clear that we the people will not tolerate such nonsense being offloaded onto the 80% of America who were prudent and did not make one dime in profit from this fanciful fraudulent credit binge from which all these "wonderful" Wall Street institutions - and their executives - extracted billions for themselves.

You want to know what's worse?  Inflation expectations are totally "off the reservation."  Forget about them being reasonable; there is nothing reasonable at all about what consumers expect.

After all, why should they?  Gasoline poking around $4, egg, dairy and cereal prices doubling over the last couple of years, $5/gallon heating oil "locked" pricing for the upcoming winter.  But as Bernanke says, "inflation expectations remain well-anchored."

Bullcrap.

Now we have a cute little problem.  See, Bernanke has spent the last year throwing literally half his $800 billion balance sheet into the system to intentionally drive short-term interest rates below where they should trade on a "fair value" basis, into one of the largest commodity bull markets of all time.

But just like his predecessor Greenspan, who whined repeatedly that long term rates aren't coming down as I think they should, Bernanke is seeing the same thing.

What's worse, as spreads blow out for anything but Treasuries the cost of credit over longer periods of time is ramping to insane levels.  To put this in perspective, the cost of "AA" Commercial Real Estate Credit is implied at 900 basis points (by the chart above) over the 10 year swap rate, which is currently around 5%.  This means that the actual cost of that credit is close to 14%!

How much has lowering the Fed Funds target to 2% done for those people?  NOTHING!  If anything the excess liquidity and allowing people to continue to lie about their exposure and credit risk has caused spreads to blow wider and as a consequence the real cost of money, which is all that matters to people like you and I, has gone up, not down.

The market controls the real cost of money, not The Fed, and the market says "nuts" to Bernanke!

Want a mortgage? It costs, according to Bloomberg, 6.37% right now.  A year ago?  6.24%.  But what was the Fed Funds Target a year ago?  5.25%.  So The Fed throws $400 billion into the pot to drive down short-term interest rates, and you see mortgage costs go upward, not down.

Who gets the extra?  Bernanke's buddies, who are trying furiously to get you to take out that mortgage so they can steal that extra "vig" from you and not go bust. 

But you, for your part, still can't afford the house.  Why not?  Because its too damn expensive, that's why.  It costs more than 3x your annual income, and all the "liar loans" and "exotics" that used to be available are gone, as the Ponzi schemes that were being run that made them possible have imploded and buried their proprietors.

You want to fix housing?  Drive prices down to no more than 3x incomes on average in a given area.  Period.  The quickest and easiest way to do that is to provide federal support for only 30 year fixed mortgages with 20% in cold, hard cash (no games) down and a maximum 36% DTI.  Intentionally cut off ALL other mortgages from ANY SORT of Federal support, implicit or explicit.  Poof.  House prices come back to affordable levels because nobody will pay more and people can afford houses again with SUSTAINABLE and AFFORDABLE mortgages.

On to our next point, are you enjoying getting it in both holes as a consumer, while our government and The Fed continue to lie about the state of the economy and what's being served up next for you behind Door #1?  There's something back there making noises suspiciously like a credit collapse monster and his name begins with a "D".  While there are plenty of people who say you "can't" get either of those "D" things with price inflation screaming higher like this, they are wrong.

The way it happens is really quite simple.  First you overlever the consumer with hopeless levels of debt, telling him that his balance sheet is "strong" and his house is the center of his "wealth", when in fact you're lying to him relentlessly for your own personal profit (as a "money man" or "broker", whether of stocks or mortgages.)  You run media campaigns trying to get people to "live Richly".

Then reality strikes - the Ponzi scheme runs out of suckers.  A Ponzi scheme the bankers and government intentionally constructed and let build to knowing unsustainable levels.  At the same time, the intentional "loose money" policies of the government and banking system, from The Fed to the "fog a mirror" mortgages, create tremendous froth in commodity prices.

When it all comes apart the consumer gets it in both holes, as his purchasing power is utterly destroyed at the same time his so-called "wealth" is proven to be a phantom - but the debt he was encouraged to take on is still there!

And see, The Consumer is 70% of the economy; as a consequence when the consumer's balance sheet gets lit on both ends of the page and burns towards the center the entire economy goes in the toilet all at once.  Suddenly, credit cards (which of course the consumer was encouraged to "lever up" with too!) and car loans (125% of sticker price anyone?) implode. 

The only company left that makes money is the guy selling plywood to board up the once-busy storefronts.

Why do we, as Americans, tolerate this sort of crap? 

This was not an accident - it was an engineered scheme devised for the explicit purpose of goading you into spending money you didn't have on things you didn't actually need so the bankers and lobbyists could make BILLIONS while literally BANKRUPTING YOU, and you fell for it!

Oh, and they passed "bankruptcy reform" at the same time so if you have an "above-average income" you can't get out from under the debt either; you're stuck with wage garnishment, preventing those who gave you credit they knew you couldn't repay on the original terms from being forced to take the loss that resulted from their intentional scheme.

Now let's think about our fine Presidential candidates for a moment.

Are you enjoying Obama and McCain spar in a Church over matters religious and snipe back and forth about "tax cuts for the rich" .vs. "tax cuts for the middle class", when in fact The Federal Government is currently turning the largest budget deficits in history, and doesn't have the money to provide a tax cut to anyone!

Are you enjoying McCain claim that Obama "tried to legislate Iraqi failure", while at the same time John McCain has ignored the fact that he was in Congress during the time Glass-Steagall was repealed, he was involved in the genesis of the credit bubble and willful regulatory blindness and even today he refuses to call for the fraudsters to be indicted, tried and jailed?  How about focusing your "legislative" complaints on things like fraud throughout our financial system and Congressfolk who got $70,000 in benefit from "friends of important people" mortgages, while that same firm screwed millions of Americans out of their house?  Mr. Jefferson of Lousiana was caught with an alleged $90,000 in cold hard cash (literally - in his freezer) and is under indictment - isn't $70,000 worthy of the same treatment?

Are you enjoying Obama spending his time attacking McCain for "pandering to the rich" while he himself is ignoring the fact that States attempted to stop the subprime mess in the early part of the decade (before it got out of control) and both Congress and the Administration sat back while regulators over which BOTH have control intentionally overrode state regulators and prevented them from putting a boot on the neck of those who were preying on low-income families?

You want to talk about religion?  How about having a discussion on what the candidate's faith - or for that matter any faith - says about honest and fair dealing?  You know, what we haven't gotten from Washington DC over the last 20+ years, irrespective of whether it was a Democrat or Republican sitting in a particular chair?  Do we now have a pair of snakes from The Garden of Eden running for the White House, where all we're really choosing between is which head is on the snake and whether that head has hair or is bald?

You want to talk about national security?  Good.  So do I.  How do we accomplish it when our economy and thus our source of government funds (remember, government in the end only exists fiscally because it has taxing power, and that requires a strong economy) is impaired by reckless overextension of credit, lying, fraud and rampant thievery up and down both wall and main streets, none of which either candidate is willing to take on?

Maybe we as Americans are asking the wrong questions this election season.

"I told you so, months ago."

Barrons put a nail into the coffin in an article due to show up on newsstands on Monday (subscription required)

"It is growing increasingly likely that the Treasury will recapitalize Fannie and Freddie in the months ahead on the taxpayer's dime, availing itself of powers granted it under the new housing bill signed into law last month. Such a move almost certainly would wipe out existing holders of the agencies' common stock, with preferred shareholders and even holders of the two entities' $19 billion of subordinated debt also suffering losses. Barron's first raised the possibility of a government takeover of Fannie and Freddie in a March 10 cover story, "Is Fannie Mae Toast?""

Yep.

But before I put forward a prescription for how I believe the government should act (and act it will, in due course), I want to take a look at how this all happened up front.

Let's look at an article in the International Herald-Tribune entitled "How Banks Sold Home Equity Loans":

"Still, "Live Richly" won out. The advertising campaign, which cost about $1 billion from 2001 to 2006, urged Americans to lighten up about money, and helped persuade hundreds of thousands of Citi customers to take out home equity loans - that is, to borrow against their homes. As one of the ads proclaimed: "There's got to be at least $25,000 hidden in your house. We can help you find it.""

"Ads for banks and their home equity loans often portrayed borrowing against the roof over your head as an act of empowerment and entitlement."

"Bankers defend home equity loans by saying they merely give customers what they want: easy credit to buy things they otherwise might not be able to afford." (Ed: you mean "can't afford but we'll make you think you can, right?")

"Live Richly" eh?

Hmmmm.

But back to Freddie and Fannie.

A large part of the trouble they're in is due to the more than half-trillion dollars worth of "ALT-A" - or liar loans - that they bought or guaranteed in the last few years.  The GSEs claim that their mission statement is to promote "affordable housing" targets and this is why they got in trouble.

What part of buying loans from people who lied to get them and were demonstrably unable to afford the payments at their full level is about "promoting affordable housing"?

None.

These loans were made to real estate speculators in Florida, Las Vegas and California, in the main, along with pseudo-wealthy "middle class" Americans trying to "Live Richly."  There was exactly no connection of any kind to low-income borrowers in the cities, where this mandate does in fact exist.

Nor is there a hint of prudence in Freddie and Fannie's recent actions since the stress became declared in their public statements (never mind that Freddie's CEO disclosed recently that their risk manager warned of this very problem quite some time ago.) 

In the last quarter Freddie Mac's growth of on-balance sheet exposure exploded higher by 11% - all out of proportion to the declared "risk" they claim they now see, and in addition, they have taken down hedging costs, which means they're now even more exposed to interest-rate changes than they were before.

What prompted that?  Both Fannie and Freddie went to OFHEO and The Bush Administration early in the year and told them they'd raise more capital in exchange for loosening their "excess capital requirements" and removing portfolio size caps.  Fannie did raise the capital, but then lost nearly all of the additional capital in just one quarter; Freddie welshed on the deal and still hasn't raised jack, citing "market conditions", but they still got their loosened capital requirements and used the expanded capacity to lever up even higher!

This amounts to walking into a Casino, betting (literally) half your house, losing, and then doubling down.  You either are a zero or hero, and the odds favor the zero. 

Why is such behavior tolerated? 

Because management believes they can blackmail Congress and Paulson into bailing them out - in short, they believe they can take these sorts of risks on purpose, not for their chartered and proper reasons in helping Americans but to enrich their shareholders and management, and get away with it - "heads we win, tails you lose."

Then there's the issue of exactly how they're valuing things.  I've written about this many times in the past, and now Barrons is blowing the whistle on it as well.  Is there any reason to believe that their "marks" reflect trading reality?  No. 

I believe both firms are intentionally overstating the marks on their assets, thereby making them appear to be in much better health than they really are, not to mention counting "deferred tax assets" that can't be spent (they're only "assets" to the extent you have taxable income in the future!)  As written about in The Ticker in the past, this isn't my opinion alone - many have opined that under any sort of real "Fair Value" assessment both of the GSEs are insolvent right here, right now.

In addition we now know from both firms filings that they are intentionally refusing to take repurchases of defaulted mortgages from securitizations they guaranteed, instead choosing to make the interest payments themselves on those bonds.  This is simple chicanery in that these defaults will not cure themselves; the GSEs are doing nothing more than pushing forward the day of recognizing the impact of these losses, which have already in fact happened.  This sort of artifice and accounting trickery is an outrage.

What's even worse is that banks are and have been offloading paper to the GSEs as fast as they can, and the GSEs are still more interested in flooding their balance sheet than scrutinizing what comes in the door for sustainability and payment capacity.  Anyone care to take a guess at what sort of real credit quality is behind that recently-acquired paper?

It is clear that both of the GSEs will and must fail.  

I believe their failure from a market perspective is unavoidable as a consequence of their conduct and the resulting "quality" of their book.

I also believe they must be allowed to fail to set an example for all the banks, brokerages and others who have engaged in similar conduct - to point out that such sort of willful abuse of the taxpayer will not be permitted.

Here is what must happen now:

• The government must force full, public, outside audits.  The recently-announced Treasury action in this regard is a nice start, but not having access to the GSE's internal books is an outrage.  Give us a full, public accounting.
• All marks must be documented and defended.  This, I believe, will force both firms into immediate receivership (bankruptcy.)
• To the extent that management is implicated in intentionally falsifying reporting (if any), they need to be indicted, tried, and if convicted locked up.
• The Government should then step in and forcibly purchase a large (~$10 billion each) interest in super-senior preferred stock, granting them the right to:
  • Replace the board of directors and management
  • Supersede all other classes of stock, suspending dividends across the board.
  • Support the super-senior and senior coupon to the extent possible, until that capital is depleted.
• The government then places both firms in rundown, fires management, and brings in outside parties to operate this process.  All acquisition and forward funding ceases.  The debt in the non-originated portfolio is sold off for whatever it brings and each class of debtholder is retired as the portfolio runs off, category-by-category.  End of GSEs.
• To take over the GSE's former function, Ginnie is authorized to guarantee the issue of mortgages to the general public (not just VA and FHA), but under strict, 20% down, 36% DTI, 30 and 15 year fixed term underwriting criteria.  These notes are issued with the Ginnie explicit government guarantee.  Note that Ginnie has never engaged in the sort of "hedge fund" nonsense that got the other two GSE's in trouble.  This provides the mortgage liquidity function that Paulson and others believe is "critical."  It puts the desired "floor" under housing, but at an actual sustainable price, which is, incidentally, quite a ways down from where we are now.

Most bondholders under this action would take no or very little loss.

Those who bought bonds from the far-riskier hedge-fund like activities, or the open-market purchases of ALT-A "assets" that are in fact worth far less than they're being carried at would be partially exposed, but this was a choice - if you look at what sorts of debt Fannie and Freddie have issued, it is not just single-family residential mortgage-backed debt, it is many different classes of bond linked to many different sorts of retained, purchased and guaranteed assets.  You choose what you want to buy, and each has a very nice prospectus detailing what's in there. 

If you bought bonds backing ALT-A liar loans to speculators in Nevada, then expecting the taxpayer to back up your bad purchase is beyond ridiculous and into the realm of theft and, if you threaten someone (like Paulson) over it, blackmail.

The preferred stockholders in this scenario would be in serious trouble while common equity holders would be just plain wiped out.  Preferred holders might be able to (depending on how the quality of that retained portfolio actually works out over time) to recover some of their investment, but almost certainly not all.

The important point here is that the longer the government waits to do this the worse the losses will get for everyone, as housing prices remain in decline and they will continue to do so until they reach 3x incomes, on average, in each market area. 

It is now CLEAR to anyone who has even a double-digit IQ that Bernanke and Paulson's ideas from last year of allowing financial institutions to lie, cheat, and try to borrow their way around telling the truth and selling off this debt to deleverage has only led to more losses as the value of the collateral has continued to decline.

As I said originally last summer the right move was (and still is) to force these people to sell off the debt NOW for whatever it will bring, because its value today is higher than it will be tomorrow.

We must force resolution of this problem now as we are headed straight for the result that Japan got by allowing their institutions to lie and fail to report their losses honestly, declaring their "marks" by fantasty, wish and dream instead of the market. 

Today, more than ten years on, the Nikkei stock market has still not recovered from the loss of 2/3rds of its value, and the Japanese economy still has failed to bottom and recover.

Goodbye Fannie and Freddie, it was nice knowing 'ya.

Oh, and for my fellow Americans?

Exactly what will it take before you will get off your butts and start demanding that The Government stop allowing people to lie to you about matters financial? 

Go back and read this whole thing.  This mess did not happen in a day and you have consistently sat on your tush and bought your plasma TVs and iPODs, without regard to whether you could afford them. 

You listened to those who intentionally deceived you for their profit and your loss, and you still are.

Do you hear the alarm clock in your head yet? 

If not, how much more of your standard of living do you have to lose before you do?