The Market Ticker

Wow.

Ok, so you saw my rant-rage on Fannie and Freddie and Bloomberg's report this afternoon.

Well, just a bit ago, this came across:

"Under the plan, the federal government would place the firms in a legal state known as conservatorship, the sources said. The value of the company's common stock would be diluted but not wiped out while the holdings of other securities, including company debt and preferred shares, would be protected by the government."

....

"The chief executives of the two companies were called into afternoon meetings today at the 17th Street NW offices of the Federal Housing Finance Administration, their direct regulator, according to sources familiar with the events.

Executives of the two companies were told to show up without being told of an agenda. Daniel Mudd, chief executive of Fannie Mae, was accompanied by outside lawyers. He showed up at around 3 p.m. for a two hour meeting. Richard Syron, chief executive of Freddie Mac, started his meeting at around 5 p.m., accompanied by several members of the Freddie Mac board."

This is very different from what Bloomberg reported.

This, in fact, is effectively an involuntary bankruptcy petition.

Now think about this one folks. 

Under HR.3221 and the previous enabling legislation for OFHEO, in order for the government to step in they must first declare these firms critically undercapitalized.

Now just a couple of weeks ago, we heard Fannie's CEO Mudd tell us that the firm has more capital now than at any other time in its history, and that it is comfortable above minimum capital requirements.

Freddie also stated they were well-capitalized.

So what happened here, exactly?

Three possibilities, all nightmares:

1. The firms both burned through all of their excess reserves and capital in the last few weeks.
2. There was some "event" that was about to happen - like over the weekend - that would have caused the firms to be unable to operate (e.g. someone, perhaps the Chinese, said they were going to intentionally tank GSE paper as an act of economic warfare?)
3. The audit being done by Morgan and Deloitte and Touche found critical misstatements in the firm's capital structure, perhaps similar to what happened back in the early part of the decade when they were caught "cooking the books", and as such what they claimed to have wasn't really there!

There is no other explanation that makes sense.

Now tell this is "bullish" for the market.

How does any of the above scenarios constitute a "buy" for financial stocks - or anything else?

There is much flying about on the news wires this evening on this "bailout" and the specifics, and the distinctions are important.  Here are some of the paragraphs:

NY Times:

"Under a conservatorship, the common and preferred shares of Fannie and Freddie would be reduced to little or nothing, and any losses on mortgages they own or guarantee could be paid by taxpayers."

Note that (1) both common and preferred are essentially wiped out, and (2) the word could in the guarantee of existing debt.

Washington Post:

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

Wait a minute.  Might be protected?  Look at the top of this Ticker.  That first quote is the same paragraph from the same source but earlier it read:

"Under the plan, the federal government would place the firms in a legal state known as conservatorship, the sources said. The value of the company's common stock would be diluted but not wiped out while the holdings of other securities, including company debt and preferred shares, would be protected by the government."

Hmmmmm... maybe someone from Treasury or The Fed saw that would and made a phone call?

Now here's the set of problems, as I see it.

1. Placing the firms into conservatorship (effectively Chapter 11 bankruptcy for them, "prepackaged") is fine.  In fact, it needed to happen a couple of years ago.  That's the good news.
2. Running down the firms' portfolios is both a good idea and is necessary.  We simply cannot have these firms play "hedge fund", and it is clear that the only way to stop it is to strip them of the ability to do so.
3. These firms bought, intentionally, nearly one trillion dollars between them of subprime and "ALT-A" no-doc or reduced-doc mortgages.  These are not prime loans, they are loans made to speculators, and they are the ones most at risk!  We must not and cannot bail these people out.
4. Guaranteeing the existing debt of these firms, which was sold with a black-letter statement on the front of every single prospectus, is unacceptable and exposes the United States Taxpayer to the full $5 trillion in debt that these firms hold and control.  This is equal to the entire public float of The United States Treasury and more than 1 trillion of it is in the hands of foreign central banks in nations such as China and Japan.  They bought this debt with the full knowledge that it was not guaranteed.
5. There is every reason to believe that Treasury Bond Yields will shoot higher in the coming weeks and months.  If this happens it will "take back" any benefit from this so-called "bailout" immediately, and worse, it will hike borrowing costs across the economy - not just in housing - when we are already in a credit crunch.  The result of such an event could be disastrous and it is what I have been warning about for months.

I stand behind my earlier Ticker; this is an outrage.

John McCain, if you are reading this and you really meant any of your speech when accepting the Republican nomination, you need to stand up right here and now and put a stop to this crap, making clear that you will NOT permit it under your administration and will "unwind" anything that encumbers the taxpayer with this garbage paper prior to your taking office, assuming you win.

Barack Obama, you said that these firms were "weird" and that if they were to be public firms they cannot be backstopped, and if government-run, they cannot make profits.  Well?  Where is YOUR outrage?

We have two Presidential Candidates and this is the issue for November folks. 

You can claim all you want that we should have an election about The War, about national security, about health care or about energy independence.

None of this matters if our economy and government funding mechanisms are damaged or destroyed due to the irresponsible and outrageous bailing out of TWO GIANT HEDGE FUNDS that happen to be called "Fannie Mae" and "Freddie Mac", and THE PRESENT GOVERNMENT just took FIVE TRILLION DOLLARS onto its balance sheet!

You're worried about Medicare, Social Security, our nation's infrastructure, or our energy needs?

Well what the HELL are you doing then sitting on your butt this weekend sirs, while UNELECTED Ben Bernanke and Hank Paulson TAKE FIVE TRILLION DOLLARS WE DON'T HAVE, FIVE TIMES THE AMOUNT WE HAVE SPENT IN TOTAL ON THE IRAQ WAR, AND BLOW IT ON BAILING OUT TWO GIGANTIC HEDGE FUNDS AND THEIR "INVESTORS"?

GET OUT IN FRONT OF THIS ISSUE NOW - THIS WEEKEND - IF YOU WANT AMERICAN'S VOTES!

That didn't take long.

The Republican Party adopted a platform that said:

"At the same time, government action must not implicitly encourage anyone to borrow more than they can afford to repay. We support energetic federal investigation and, where appropriate, prosecution of criminal wrongdoing in the mortgage industry and investment sector. We do not support government bailouts of private institutions. Government interference in the markets exacerbates problems in the marketplace and causes the free market to take longer to correct itself."

You lied.

"Fannie dropped $2.25, or 32 percent, to $4.79 at 5:50 p.m. in New York Stock Exchange trading after the Wall Street Journal said the Treasury is close to completing a plan to help the mortgage-finance companies. Freddie slumped $1.40, or 27 percent, to $3.70.

The plan may involve a ``creative use'' of the Treasury's new authority to pump capital into the companies as well as changes to senior management, the Journal reported on its Web site today, citing a person it didn't name."

So you adopted a platform earlier this week which said you wouldn't bail anyone out or support practices that involve unsustainable loans which is exactly what Fannie and Freddie have done over the last eight years.

But by the end of the week, you have already, by the officials in your own party, who currently occupy Treasury and The White House, made clear that you are rank LIARS.

Absolutely nothing in your platform - not your stand on foreign policy, not your stand on human rights, not your stand on trade, not even your stand on abortion and family values can be taken at face value.

YOU HAVE JUST DECLARED THE ENTIRE PLATFORM TO BE ONE GIGANTIC DOCUMENT OF LIES.

By extension, I must take every promise that McCain and Palin made at the Convention to be lies, when you are unable to avoid going back on your word for even one calendar week.

Attention RNC - you have just lost my vote, and any person with more than two firing neurons in their head that votes for John McCain and Sarah Palin this fall is both certifiably insane and is voting for the intentional destruction of our nation's financial security.

If your party does not step in prior to this "fait accompli" being announced and squelch it, I will burn in effigy my Gingrich Speaker's Gavel, make a Youtube video making clear how I feel about The Republican Party, and will be filing a party affiliation change Monday morning.

That's a promise.

Foreign policy and military prowess is immaterial if you have no money; The Republicans have spent the last eight years practicing fraud and theft upon the public, and now, less than one week after saying that it was antithetical to the party principles your standard-bearers go do exactly what you said is unacceptable.

Irrespective of what the "change" is you get from Obama (and how good or bad it might be) at least you're being told up front what they're going to do, instead of being lied to so blatantly that your party can't even wait one week to go back on its word in a way that can bankrupt our children and grandchildren.

Republicans disgust me.

Yesterday I wrote on Pimco's latest "scream", and Cramer, along with others, have picked up on it and are now doing their usual "attention whore" deal trying to drive ratings.

I want to focus, instead, on the underlying issue - the truth about credit, its purpose in an economy, why we really do need it and fractional banking isn't "the evil mess" some thing it is - and how it got abused.

Many people believe that credit is some evil thing that nobody should ever utilize at all, because it will ultimately "drag you into the abyss."

In a word, baloney.

Consider this - I, along with a lot of other people, use credit almost every day.  I walk up to the gas pump, fill my car full of fuel, and charge it.

But at the end of the month, I pay the bill in full.

Let's say I'm a businessman.  I come into your office and sell you some of my "mystic frobozz cleaning dust" to clean your shop floors.  You buy a pallet of the stuff for your manufacturing operation.

Ok, I now have an order for $5,000 worth of "mystic frobozz", but I don't have any cash.  I want to produce the stuff for you, but I also have an office to pay the rent on, I have salaries (including mine!) and I have electricity to buy so I can keep my books up to date.

I could run on an entirely cash basis, starting small, selling a bit, using that money once it has been collected and product delivered, expanding with it, etc.

Or I could take that order and immediately spend it on production - that is, use credit.

By using credit in this situation I increase the velocity of money, and the velocity of commerce.  That is, it is now possible for me to solicit a second customer to buy some of my Frobozz Magic Dust before I produce - and collect on - the first order.

This use of credit is beneficial to business function and comes with some, but not much, risk.  After all, while Customer #1 might go bust, if he does before I deliver the cleaning supplies I haven't lost money - just the order.  I can go find another business-owner who needs to clean his shop floor.  It is only if the first customer goes under after receiving (and using) the product, but before he pays me, that I take a hit. 

That risk is relatively small, although its certainly not zero.

Now let's look at the next use of credit - to expand operations. 

Let's say that I don't have any orders at all right now.  But I go ahead and produce a metric ton of this cleaning stuff anyway, all using credit - borrowed money. 

Now I am taking on much more risk - but it still may be reasonable.  Now, the success of my bet depends on my being able to make more money on a net profit margin basis than the money costs me to borrow.  The leverage allows me to expand much faster, but my margin for error narrows significantly - and if my operating margin falls below the cost of my funds, I will go under even though the business itself is profitable!

But this use of credit can rapidly morph into something far more pernicious - and ugly.  That's the model that many Americans, and many financial companies, fell into over the last eight to ten years.

That is, you borrow to finance your current operations, but when the bill comes due you borrow from someone else to meet the obligation, effectively rolling forward the debt and increasing your leverage.

Look at, for example, the people who practice "rolling over" so-called "zero-interest" balance transfers. 

They claim this is "sound money management."

Its not, because they were never able to meet the original financial obligation in the first place; they had no plan to retire the debt from existing cash flow.

That's where the problem lies. 

For homeowners, this model relies not on current earnings capacity but rather on expected home price appreciation.  For the businessman, this model relies not on current sales but on expected business expansion, or even worse, an expectation that there will be yet another bigger sucker.

The problem is that these projections are literally a crap-shoot in the short term, but in the longer term you will always - I repeat - always - lose.

Why?  Because all Ponzi-based finance schemes must lose in the fullness of time.  This is why should you decide to try to send out "Make Money Fast" letters you will go to jail; it is guaranteed as a mathematical certainty that all but a very few will lose money in such a scheme because there are a limited number of people in the world and as the scheme (debt) grows in the size so do the number of suckers (investors) necessary to support it. 

It is a mathematical certainty that you will run out of suckers (investors), and it is for that reason such schemes are, for "ordinary people", unlawful and will result in big fines and prison time.

ALL financial schemes that rely on being able to increase leverage to make them work are doomed to suffer this fate.

ALL.

Every one of them is a fraud and every one will eventually collapse. 

We are simply arguing over when, not what or if.

That we allow this sort of crap to take place in the markets, where you or I would go to jail for setting up such a pyramid scheme, is an outrage.

And this, my friends, is why we must not bail any such "scheme" or "investment" out. 

We can't bail them out and have them succeed. 

We can only transfer the loss from one person to another, and those who originally set these schemes up knew full well that they couldn't possibly survive on their own on a perpetual basis.

People point to Chrysler as an example of a "bailout" that worked.  But Chrysler used the money to actually build cars, that they then sold.  They did not use the money to cover a bad leveraged position that had exploded on them.

IF Paulson "draws his bazooka" he will be in effect trying to "roll forward" one of those zero-interest balance transfer deals with Fannie and Freddie. 

This is a bet that cannot pay, because there is no realistic model under which Fannie and Freddie can use those funds to reduce leverage and continue to meet their claimed objective, which is the purchase and guarantee of residential mortgages.

Therefore, Treasury must not act in this fashion.

Instead, should Fannie and Freddie become unable to meet their obligations via the marketplace, which is entirely possible, Treasury must step in not to "rescue" them but to force them into conservatorship and, ultimately, to run down their portfolios.  Through this process the firms themselves will likely fail, but the bonds they wrote that are asset-backed - that is, not "pure" obligations of the firm, but rather backed by mortgages and actual property, will suffer modest loss.

Those people who loaned Fannie and Freddie money to pay the light bill - literally - on a "forward" basis - will lose much more of their investment.  They should lose, because it is only through forcing that loss into the marketplace that we will curtail people from buying issues like this in the future - and curtail it we must if we are to stop this sort of stupidity in the credit markets in the future.

PS: The Unemployment rate spiked to 6.1% from 5.7%.  Nasty, and revisions to past months added to the malaise, with the job losses in June being revised down to double what was reported (Credibility?  Honest reporting? What's that?)  And of course we have people chattering once again about The Fed "easing" - that is, stoking yet more irresponsible use of credit even though that's the root cause of the problem in the first place.