DJIA Reaction to Lehman Bankruptcy

Today the Dow Jones fell 504 points, and this time it has a clear precipitant—the bankruptcy of Lehman Brothers, the 4th largest investment broker, one that heavily bought in to mortgage securities, and has become the largest bankruptcy in history. The issue is broader than that. For the first time credit default swaps are being triggered, and soon the whole patency of the default swap market (in other words, bond insurance) will be tested. Also, for the first time, some magic wand hasn't been waved to get the bond holders in a financial corporation out of hot water, so swap counterparties are finally on the hook. Apparently Lehman wasn't quite well-connected enough, and a giant has been allowed to die.

A Brief Thought on Oil

A year ago, it seemed like any drop of a hat near any oil refinery was enough to cause oil prices to soar—rumors of the possibility of a workers strike, maintenance necessary for one of the plants—any excuse seemed good enough to drive prices skyward. Today, a hurricane slams in to the Galveston coast, and prices are still falling. At this point I'm convinced that refinery circumstances are unrelated to the oil spike, and hardly need to be considered an actual factor in oil pricing. It was probably a commodity run that has exhausted its course. Not that I'm expecting $1.50 gasoline prices again—growing worldwide demand and decreasing expandability of production are contributing. Where this all equilibrates remains to be seen.

Lehman & Merrill Weekend Roundup

The news over the weekend is there was no government bailout for Lehman Brothers, nor was there any private buyout either, after Bank of America and Barclays walked away from the table. So they will be filling for bankruptcy and liquidated.

Since Lehman’s debt does not equal its assets, credit default swaps will be triggered, which I do not recall happening so far in this credit unwind, since failed financial firms have been bailed out or bought out with government backing up to this point. Credit default swaps (of which CDOs are included in the class, discussed in this post) are debt insurance funded by private investors—in this case on Lehman’s bonds. So if Lehman goes bankrupt, their bond holders can be reimbursed for losses by private counterparties, according to prior arrangement.

Merrill Lynch fared better. The brokerage will be bought out by Bank of America for $44 billion.

Distress at Lehman

One firm that may be closer to collapse than even Washington Mutual is Lehman Brothers. For the past few days there has been news of imminent collapse without a bailout or takeover due to capitalization problems from mortgage-related loses. Now, if the Treasury Department via Fannie Mae or Freddie Mac is willing to exchange their mortgage securities for T-Bills, then cries of desperation around Lehman Brothers may be overstated, and they might be a good buy at the right price.

The Shape of the Bailout

Through smoke and fumes, this week we see the outline of the monster that is the mortgage bailout. While measures that exist as of now are not enough to keep housing prices stable or rescue the economy from the deflationary spiral it is in, there is enough at the point to accomplish the fundamental goal of the regulatory effort: that is, saving the banks.

With the conservatorship of Fannie May and Freddie Mac, the Treasury Department will continue to underwrite their traditional economic functions. The federal government will buy troubled mortgages from banks, I imagine at near face value, floating Treasury Bonds as needed to pay for them—such that the Treasury Department holds the mortgage stinkers, bought for with bonds that will be paid off by the taxpayer over time. Banks now have the opportunity to become re-capitalized from recent losses and dump toxic mortgage securities all at once. There is no limit on securities the Treasury Department can buy. I wonder if there are any restrictions at all as to the quality of the loans.

An interesting test of the bailout will be Washington Mutual. All evidence is that they are about to fold. Their bond rating has been cut to junk today. But if in the next week WaMu can dump toxic mortgages on to the treasury department in exchange for T-bills, and survive, then if they can turn around, most likely any bank can. It may still be too late for them. The coming days will tell.

So, does this rescue the economy? It only helps banks that I can see. Congress has given distressed mortgage holders a break, that the Treasury Department will honor, but they will still owe a premium on the properties they bought, that will still consume much of the American consumers' disposable income with high interest and principle payments—that even after the rescue will still be disproportionate to comparable rents.

The only way to stave of the deflationary recession that comes from a credit unwind is to make up for the monetary deficit by printing cash. If the Treasury Department wants to actually stabilize prices, printing is what it will have to do. Hyperinflation would be the consequence. For reasons stated before, that is not what I think they will do. But I would not fully rule out the possibility, and you shouldn’t either if a lot of your money is sitting in the bank. Further bailout policies and any expansion of the base money supply will be reported here as they occur.

Fannie and Freddie Shares Under $1

So, as predicted, this is pretty much it for private ownership of the two mortgage GSEs. Last I looked, both Fannie Mae (FNM) and Freddie Mac (FRE) were trading around a dollar per share each. This is bad news if you bought at Fannies peak at a little over $60 before fall of 2007, or even last Friday at $7/share; or at Freddies Peak of over $60 throughout most of 2007, and $5 as of last Friday. Though the decline from $60 to under $10 per share was due to market activity, and ironically was even slowed down when interventionist measures were passed by congress—this final drop was due to conservatorship of the GSEs by the Treasury Department on Sunday.

This continues a pattern of government intervention first seen with Bear Stearns of rescuing bondholders with desregard to shareholders. I suppose it could be argued that shares were about to bottom out anyway so Treasury actions simply expedited the inevitable, however there was still market play to be had even in the sub-$10 range.

ADDENDUM [9/9/08]: As of tomorrow, Fannie and Freddie will be removed from the S&P 500 index.

Fannie and Freddie Under Federal Conservatorship

In a move anticipated over the last few days, but made official this Sunday morning, in the next major advance in the bailout saga of the financial industry, the Treasury Department has taken over Fannie Mae and Freddie Mac. Basically, the GSEs have lost their capital base through purchasing bad mortgages from banks, and are unable to acquire new capital through the sales of stock. They will continue to repay bonds with income acquired by repayments of the mortgages they service. When that income fails, which essentially it has, any deficit of bonds repayments will be backed through taxpayer money. Worse, Fannie Mae and Freddie Mac will continue to take on Mortgage Backed Securities from struggling banks through 2009. This move appears to allow banks to hand bad mortgages over to the treasury department for at least the next year.

In essence, the banks are being protected from their exhaustive malinvestments over the past 6 years that will cripple the general economy for many more years to come. Clearly, banks have no reason to fear making unwise loans because they can anticipate a taxpayer bailout every time.

Fannie and Freddie are the sacrificial lambs. They are going down such that the rest of the banking industry can live. They are taking it for the team. I think it is fair to say they will not be able to operate with any sort of private underwriting for a long, long time. As always there is political speak about this action preserving the “American Dream” and keeping the American economy strong, but this is unrelated to either of those two goals. It is squarely intended to keep the banking industry afloat.

In the end, this action merely delays a deflationary recession where prices of assets and commodities fall to affordable levels; that outcome is still going to happen, only a little more slowly now. Taxpayer bailouts only slow down the present economic correction in exchange for putting debt that our children will have to pay in to the pockets of the banking industry today.

More will be posted as details unfold.