Monday, September 8, 2008

Will Bailout Optimism Lose Stream?

Wall Street loves bailouts. Stocks soared today but the bailout rally lost some steam as the day progressed.

By bringing the hammer down on Fannie Mae and Freddie Mac shareholders, Treasury Secretary Hank Paulson appears to have built a floor under the financial markets, at least judging by today's reaction.

However, investors still do not have the requisite information required to fully understand the impact of this bailout. The major elements of the plan, announced Sunday afternoon, include:

  • Fannie and Freddie being placed under conservatorship administered by the Federal Housing Finance Agency, which was created by this summer's Housing Bill.
  • Treasury has pledged to buy as much as $100 billion each of newly created senior preferred shares of Fannie Mae and Freddie Mac.
  • Treasury will be issued $1 billion in senior preferred stock of both Fannie and Freddie, which will pay 10% annual dividends.
  • Treasury will receive warrants to buy as much as 79.9% of the equity in each firm.

There's a lot of talk about what the plan does or doesn't mean for the housing market and how the new senior preferred shares effectively wipe out the value of existing preferred and common shares.

Scott Bleier, founder of, was on Tech Ticker this morning stating that "all that matters" is $5 to $6 trillion of mortgage-backed securities backed by Fannie Mae and Freddie Mac "won't hit the market." By pledging to buy mortgage-backed securities guaranteed by Fannie and Freddie, the Treasury has taken that risk off the table, Bleier says.

Whether the U.S. government can actually turn a profit on this transaction, as Treasury claims is the plan, remains to be seen; Bleier says it's a "sinkhole" for the first five years.

But he noted the government can hold bad debt for a lot longer than private entities like, says, Pimco, which appears to be the primary beneficiary of this deal, and perhaps its catalyst after Bill Gross' warning of a "financial tsunami" last week.

Indeed, Gross was singing a different tune on CNBC television today: "I think this is the beginning of the end of the potential financial tsunami I talked about."

But is it really the end? Or is the U.S. government just buying some time so banks can shore up their balance sheets?

Interestingly, we saw Fannie and Freddie shareholders get wiped out today but the bailout also triggered $1.47 trillion in credit default swaps.

The Financial Ninja was quick to point this out this morning, stating the following:

Well, this should be fun. Really, equity markets shouldn’t be this excited. By the end of the month a few more dead bodies will float to the surface.

You see, moving Fannie Mae (FNM) and Freddie Mac (FRE) into conservatorship, constitutes a ‘credit event’. Simply put, the rescue counts as if FNM and FRE failed to meet their financial obligations. More importantly, $1.47 trillion in Credit Default Swaps (CDS) just got triggered.

This has NEVER happened before. This is the largest CDS ‘credit event’ ever. Considering that a lot of hedgies thought FNM and FRE could NEVER go ‘bankrupt’, you have to wonder how many of the counterparties are going to be good for their end of the CDS. A favorite game of the hedgies was to write CDSs on these names because they ‘could never fail’.

Fannie, Freddie Credit-Default Swaps May Be Unwound (Update2): “Investors may be forced to unwind contracts protecting $1.47 trillion of Fannie Mae and Freddie Mac bonds against default after the U.S. government seized control of the companies in a bid to bolster the housing market.

So what can we expect from this credit event? According to this FT article, it's too early to tell how the unwinding will proceed in the coming weeks and how it will affect current CDS spreads:

The exact amount of CDS on Fannie Mae and Freddie Mac are not known, reflecting the private nature of the market, but they are part of widely traded indices and the amounts are likely to be significant. Analysts at Lehman Brothers said: “There is likely to be a considerable amount of notional protection outstanding.”

The industry body, International Swaps and Derivatives Association, said on Monday it would launch a protocol to facilitate settlement of credit derivative trades involving Fannie Mae and Freddie Mac and would publish further details in due course.

The uncertainty surrounding the Fannie Mae and Freddie Mac CDS contacts highlights the need for improved settlement and trading procedures. Already, regulators have put pressure on CDS dealers, including all the large financial institutions, to reduce settlement and trading risks.

Interestingly, Time Magazine had warned us of a possible credit default swaps crisis back in March:

A meltdown in the CDS market has potentially even wider ramifications nationwide than the subprime crisis. If bond insurance disappears or becomes too costly, lenders will become even more cautious about making loans, and this could impact everyone from mortgage-seekers to municipalities that need money to fix roads and build schools.

"We're seeing players in all of those spaces being more circumspect about whose credit they're going to guarantee and what exactly the credit obligation is," said Ellen Marshall, partner at Manatt, Phelps & Phillips LLP.

Shimpi admits a meltdown or even a slowdown in the CDS market would affect the amount and cost of liquidity in the market. However, he dismisses concerns that municipalities and others seeking capital could be left in the dust. "Even if the U.S. takes a hit, there are other markets in the world that have different dynamics, and capital flows are international," he said.

Still, most agree the potential repercussions are far-reaching. "It's the ripple effects, the domino effects" that are worrisome, said Pincus. "I think it's [going to be] one of the next shoes to fall" in the credit crisis. Miller said the subprime debacle, rising unemployment, record-high oil prices, and now CDS market troubles "have all the makings of the perfect storm.... There are some economists who say this could be another 1929 — but I don't believe it," he said. "We have a lot of safeguards built into the system that did not exist in 1929 and 1930."

None of them, though, are directly targeted at CDS. On Wall Street, innovators are always ahead of regulators. And that can sometimes have a very steep price.

As for the bailout optimism, I point your attention to this article in Minyanville, Freddie and Fannie Rescue Not a Cure-All.

I quote the following:

As a patriotic American, I hate to say this, but we have the blind leading the blind.

Do we cheer this move, as it could be the savior of our markets? Should we cheer as it will reduce the unemployment rolls? Should we cheer when GSE preferred and common shares gap down near zero? Will credit spreads magically come down? Will mortgage delinquencies magically decrease? Will banks magically return to "business as usual"? Will retailers find their stores full of shoppers? Will gas and oil fall in price to help consumers? Will credit card debt just disappear? Will the savings rate turn positive?

I could go on. But my answer, objectively, after considering every fact I know, every concept I understand, is that we should be jeering this move, not cheering it.

Warren Buffett was interviewed by Fox Business News today stating that the bailout was wise:

“The government really had no choice,” Buffett said. “For years, they have encouraged the belief that there is an implicit guarantee behind Freddie and Fannie’s guarantee of mortgage instruments.”

Buffett said that belief was being tested in the marketplace as the spread widened between Freddie and Fannie mortgage-backed securities.

A crisis in the mortgage market was inevitable, Buffett said, but has been averted by the government’s action. Buffett said that the bailout would “improve the mortgage situation and reduce any eventual losses to the U.S. Treasury--although there could well be losses.”

Buffett likened the bailout of Fannie and Freddie to that of Bear Stearns, saying that the government is going to be there to “swoop in and save the day on the really large institutions.” Like Bear Stearns, Buffett said, Fannie and Freddie were big-enough potential problems that they could have caused “ripples throughout the world, or maybe tidal waves”--so the government had to step in.

One big distinction Buffett made was that he believes the government won’t step in to help common or preferred shareholders, but rather will intervene to assist with debt problems that could lead to the bankruptcy declaration of a very large institution.

Buffett said the government would never let a very large investment bank fail in terms of debt. However, he said the government would not help shareholders. “They are going to let the equity fail for sure; they have done that even in these cases,” Buffett said.

Buffett cautioned that the Fannie-Freddie bailout wouldn’t solve the problems of homeowners who owe more on their houses than the houses are now worth--but in terms of new loans, people may pay less. He said he guessed that people may pay half a percentage point or so less than would have been the case if the Treasury hadn’t acted.

Buffett said the bailout won’t change the fate of automotive, airline, or retail companies hit hard by the mortgage crisis. “I don’t think Linens-n-Things can go down to Washington and say, ‘it’s in the national interest to bail us out.’”

When asked to estimate the overall cost of the bailout, Buffett said nobody knows if it’s going to take, say, $20 billion or $200 billion--and it all depends on what the housing market does.

“If house prices go down another 20% it’ll be a big loss. If they go down another 5% from here, it may not be any loss at all, and I just don’t know the answer to that,” Buffett said.

If Robert Shiller is right (see my previous blog entry), house prices will correct by a lot more than 5% and the total cost of this bailout will end up costing U.S. taxpayers billions of dollars.

Lastly and most importantly, the bailout may bolster the markets for now but it will not solve the crisis:

"This euphoria might fade, because Fannie and Freddie are not the problem," said Christopher Low, chief economist at FTN Financial. "Their woes are a symptom of a worldwide contraction in credit that may not be cured by the decision."

This insightful comment from Michael E. Lewitt of Harmonic Capital Managment (HCM) sums it up well:

And indeed that is the point that HCM has been making over the past several months. The credit collapse can be laid directly at Wall Street's door. We do not say this because we like sounding churlish, but because what has occurred has real, negative long-term economic and political consequences.

The cost of our unwise and corrupt policies has already been very high and it will continue to rise unless we act now to do better. Confidence in the American model of capitalism has been shaken with good reason. Despite the rally of the dollar (mostly against the Euro, another compromised currency), the U.S. currency has been battered largely due to a loss of confidence in American economic policies and leadership.

We continue to shift hundreds of billions of dollars out of our own coffers into those of countries that do not share our beliefs because we have moved too slowly to develop sound energy policies. In large part this is because our politicians remain indebted to an automobile industry that is on the verge of insolvency and to an energy industry that places its own interests ahead of the country's and the world's.

We have allowed our derivative markets - specifically those related to credit (i.e. credit default swaps) - to grow in a completely unregulated manner to the point where everybody is basically holding their breath and praying that a financial accident won't occur.

This has occurred largely because it has been in Wall Street's interest to limit regulation of derivatives. But the time has come to stop allowing the fox to patrol the chicken coop. Just as it was completely foreseeable that Freddie and Fannie would fail, it is a certainty that we will face future crises if we continue to avoid difficult and unpopular choices or refuse to speak truth to power. How many wake-up calls do we need?

For now Wall Street loves this bailout but we shall see once the party dust settles and reality sinks in whether or not this rally has enough steam to last. I wouldn't count on it.

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