Wednesday, July 30, 2008

Fannie, Freddie, Mortgage Rescue Bill Passed

In an avalanche of hugely relevant bailout news, we get the mortgage rescue bill, with Fannie Mae and Freddie Mac provisions, signed in to law by President Bush today.

Relevant features of the bill with commentary on their effect on the credit market and value of the dollar—as well as who benefits, who will not, and who pays—will be posted in a day or two.

Expansion of the Feds Emergency Liquidity

The basic premise of the TAF (Term Auction Facility) has been discussed here before, where the Federal Reserve Bank issues short term bonds to banks at low interest rates, which they use to back higher interest loans or investments—all in a borrow-low and lend-high carry trade principle. Two other related programs have been the PDCF (Primary Dealer Credit Facility) and the TSLF (Term Securities Lending Facility) for investment banks.

TAFs began in September 2007 with the onset of the credit freeze, and had expanded steadily to $75 billion by March, and now recently have expanded by another $25 billion with 84-day cycles. TSLFs were made available on March 11, 2008 after the fall of Bear Stearns, which offers $200 billion of liquidity; they are available to "primary dealers," are offered weekly, and have a 28-day maturity, where treasury securities are borrowed with mortgage-backed securities as collateral. Like TSLFs, PDCFs are available to primary dealers, but have overnight terms, with outstanding loans in the $15-30 billion dollar range.

A "primary dealer" is an investment bank with access to the Fed's discount window; the link has the list of them. Bottom line, banks and investment banks have expansive lines of credit through the Federal Reserve Bank.

The news today is the expansion of TAFs by another $25 Billion, and the extension of TSLFs and PDCFs from mid-September 2008 to January 2009.

With these emergency lending systems enacted by the Fed, the U.S. taxpayer accepts the risk when banks default on their capital base due to the origination of bad loans. By my math, the amount at stake is somewhere between $300-400 billion, with seemingly little resistance by the Fed to expand this amount as is convenient.

Speaking of which, the other major financial event is the bailout of the GSEs and troubled mortgages, now tied together in the same bill and moving briskly through the house and senate. Material details will be reported once it gets to the White House and is signed in to law, which could be any day now.

Saturday, July 19, 2008

Short Sales Restrictions of Select Banks

Amid the turmoil of a collapse of Fannie Mae and Freddie Mac stock, discussions of their bailout, and the FDIC takeover of IndyMac, we get a piece of humorous news: the SEC has placed limits on the shorting of select bank stocks. Now, what exactly it hopes to accomplish by that is anyone's guess. Basically it is more government intrusion into a flailing financial industry. The list of banks that are covered by this ruling, which include many of the major banks in America, as well as some notably excluded—namely Wachovia and Washington Mutual—has been covered by Mish in a series of posts on the subject.

The DJIA did rebound 500 points this week, possibly reacting to slightly cheaper oil prices, and a general air of increasing government protectionism of the financial industry. Nothing set in stone yet about either the bailouts of Fannie and Freddie or passage of the mortgage rescue bill.

Tuesday, July 15, 2008


On June 21 the DJIA crept under 12,000, and I was dubious of any turnaround like the two times prior this year it fell to that level; around those two times the Fed announced bailout programs (decreased rates and increased TAFs) that kept things afloat for a brief spell. Now, less than a month later, it is below 11,000, despite significant bailouts proposed for Fannie Mae and Freddy Mac. Fortunately, it seems investors see such talk as indicative of the failure of these institutions, rather than opportunities to profit from the U.S. tax base. The market uptick from these announcements was lackluster to say the least.

So it appears bailouts for Fannie Mae and Freddy Mac are underway, and I'll report more once the specifics have been finalized. Government bailouts come in differing levels of intensity with different benefits to different classes of investors, and there is a lot of hot air and speculation flying around, but probably within the week concrete information about the bailout program will be announced, and quite possibly a mortgage bailout plan from the house and senate will be sent to the White House very shortly.

All of this was anticipated, but still disheartening for anyone who believes in the concept of personal responsibility that inevitably goes along with freedom—as well as preferring the free market over ongoing and pervasive government regulation.

Saturday, July 12, 2008

China holds $376B in Fannie

Apparently the truth is starting to come out about China and American lending institutions, as it appears that China would be the biggest foreign beneficiary of a bailout of Fannie Mae, were that to happen. Reasons why China would be interested in Americans borrowing had been discussed by me before in this post.

FDIC Takes Over IndyMac

Interesting to see how the FDIC operates... in any case amid all the news of Fanny Mae and Freddy Mac, Southern California-based mortgage lender IndyMac has been taken over by the FDIC as of late Friday evening and is now IndyMac Federal. They were unable to sell shares to raise private capital, as WaMu, Wachovia, and Citigroup have done before. One can still make withdrawals and deposits and from a customers perspective should not be operating much differently than before.

Those with insured deposits (less that $100,000) should see essentially no changes as the bank transitions to FDIC conservatorship. Those not insured (with deposits over $100,000) can make a deal next week to recover half of the non-insured amount. Better than nothing. Still a hard lesson if this amount is significant.

Thursday, July 10, 2008

Fannie and Freddie

Fannie Mae and Freddie Mac have been in the news lately over a precipitous decline in stock values, plunging sharply toward near-worthlessness from a relatively stable plateau as late as fall '07 (FNM and FRE). Given their sizable role in the credit industry, it deserves comment here.

The two companies are part of a collection of Government Sponsored Enterprises (GSEs) that exist to facilitate credit to certain markets, in this case low-to-moderate income houses. They were chartered into existence by congress, however operate as a private corporation with shareholders and profits, and explicitly no government guarantee of their securities, however an implicit one is up for debate. Essentially they buy loans from banks, package them as securities, and sell them to private investors.

This is not an unreasonable business model, so long as everybody pays their mortgages with only a trickle of foreclosures, which has been the case for years—until the subprime crisis. My Internet seach on their degree of subprime exposure turned up plenty of contradictory statements from various news sources, which to my mind leaves the matter inconclusive. Apparently the market is suspicious of either subprime exposure or oncoming Alt-A exposure. In any case, Freddie Mac has admitted to $12 billion in subprime losses, and support of low- and moderate-income home ownership is part of Fannie Mae's mission statement.

Their accounting scandals of a few years ago suggest they do not operate in a culture of honesty, so, all things considered, their exposure to shaky mortgages is probably high, they are facing serious capitalization problems, they are probably having difficulty arranging privately funded bailouts like WaMu and Wachovia, and so a market exodus is probably sensible. Talk of a bailout has begun but is diffuse and vague. No doubt there will be more to say as this drama unfolds.

Monday, July 7, 2008

The Freeze of ‘07

So in the last couple of posts I have reviewed the origins of how credit came to exceed what banks have in capital reserves: either by selling debt to investors to free the balance sheet (in the case of securitized loans), or attracting capital from short-term bond investors through structured investment vehicles (SIVs).

To review, securitized loans came to an end when the credit default obligation (CDO) market dried up and banks could no longer insure their riskiest unrated tranches of subprime securities. That happened as subprime adjustable rate mortage loans began to re-adjust en masse, borrowers foreclosed, and subprime CDOs quickly became worthless. They went so sour I doubt there is a market even for prime CDOs nowadays.

SIVs came under distress when buyers of commercial paper went elsewhere. Why they did that is not as apparent; however if banks have mortgages at 6%, and the Fed overnight rate is over 5%, and treasuries and other bonds follow the Federal funds rate, AND (according to the principle of the carry trade) banks need to borrow-low and lend-high, perhaps commercial paper was no longer competitive. Perhaps banks could no longer sell commercial paper at rates low enough to profit.

These events happened in the Fall of 2007, and created a sudden and urgent situation where banks could not find the capital to generate new loans and were barely able to manage the ones they had.

Now, the Fed cannot increase deposits by making people save more. But the Fed can, and is, managing a government variant of the commercial paper market. First, they enacted a series of striking cuts that brought the overnight rate from 5.25% in September 2007 down to 2% in April, which makes commercial paper again a more feasible source of capital to banks—naturally at a cost to bond investors who suffer lower returns. Second, they instituted term auction facilities (TAFs), which essentially behave as a government-sponsored replacement for commercial paper buyers. So, instead of going to bond investors, banks can go to the Fed and buy the government’s equivalent of commercial paper at rock bottom rates, and up to $75 billion of it, cycling, is where it now stands. Even more, the Fed has been accepting questionable debt as collateral for this money. So if banks default the Fed is holding on to unrated subprime debt packages; while U.S. taxpayers are still liable for the treasury bonds the Fed handed out in return.

So now we have the Fed accepting the role traditionally held by bond investors, and insured by the United States tax base. What this means is that for people who want to save their money, interest rates they can get for it are being actively suppressed by government, all for the benefit of the banking industry. Saving money is not as appealing as it would otherwise be, thanks to the Fed.

However, these interventions only stopped the financial market from collapsing—it still remains under stress. As discussed before, as people borrow less, and the inventory of goods for sale remains approximately the same, the value of cash will strengthen.