Michael Gracie

As the press goes, last week Fed Chairman Ben Bernanke told ‘congressional leaders’ that the US faced an imminent meltdown. We heard from the horses’ mouths that this was scary. It couldn’t have been written any better for a movie. Surprise - now we have yet another bailout plan.

You can find the full proposal (for now) at the end of this post. The first thing you’ll notice is that it is pretty short, and the second thing you’ll notice are some of the egregious terms. The press and the blogosphere were quick to point out the latter, and various conspiracy theories were quickly generated around Section 8, which deals with the Treasury’s unilateral and unobservable authority, included protection from litigation. Amateurs, each and every one of them.

You don’t go to the negotiating table with a proposal, particular one that outlines to a country full of people how weak they’ve become without a game plan. And you especially don’t bring such a proposal to a band of lawmakers that you know have a penchant for changing things to directly benefit themselves, and who, while complicit in the problem to begin with, will do everything in their power to try and convince said country’s people that they are there to help them. The sticking points in the proposal are nothing more than “throwaways” - terms purposely put there only to create a little unrest and be caved on later - terms designed specifically to make those on the far side of the negotiating table think they won something.

Will it work?

I’m going out on a limb here…no. First and foremost, we are talking about the purchase of fairly complex mortgage instruments, including but not limited to the over-the-counter insurance which backs them in case of default. It’s that insurance that is causing most of the problems - a market of many 100’s of trillions of dollars - and if it collapses at one point it sets off a ripple of defaults elsewhere in the transaction chain. So while this move is probably quite necessary, the problem has been known for years. The Treasury really doesn’t have a clear idea of how much these assets are worth because the bankers that presently own them don’t - the market for these assets has become extremely inefficient, with few buyers asking very low prices, and the bankers demanding higher because they paid much more just a few years back. Sound familiar?

Now a new buyer steps into the fray - this buyer has well-publicized, deep pockets, and has publicly stated it is willing to pay more. How do you expect these sales are going to go? The Treasury is going to wind up paying entirely too much for these assets, and when the obligations finally sell taxpayers are going to be looking at a loss. The cap on purchases has been initially set at $700 billion, but I say that’s a drop in the bucket - the Fed injected roughly $150 billion into the system just last week to prevent a money market meltdown. As a result of this cap, the Treasury will be forced to liquidate positions prematurely in order to buy additional product. The result - more losses. They’ll be back at the national debt trough in no time, which brings up the second problem, borrowing capacity.

It isn’t just the US markets that are roiling - this is a worldwide financial crisis. Even China, who until now has had an unquenchable thirst for US Treasury securities, is getting tired. And with the US economy slowing, even they are going to see their need for dollar-denominated government securities wane. Either they (and every other foreign creditor still standing) starts getting bonds at deeper discounts, or interest rates have to rise - either way yield is headed up. If the former happens, Congress is going to be mighty busy raising that debt ceiling. If the latter, nobody is going to be able to afford domestic credit.

This is all a temporary fix just like the last three (or is that four) bailout proposals presented over the last year, including the one which laughably sought to have Fannie Mae and Freddie Mac doing the bailing (those GSEs are now being bailed out themselves, in case you’re just joining). It’s just that this one is bigger.

Regardless of its merits (or lack thereof), I suspect this proposal will pass. There will be oversight, and there will be further help for struggling homeowners.

And there will be more proposals.

UPDATE: It looks like the proposal may now include auto loans, student loans, revolving credit lines, and other ‘troubled assets’. The price tag is getting bigger already.

UPDATE 2: Congress seems to be biting on the wrong stuff.

Read more »

No government assistance this weekend

As Lehman Brothers, one of oldest names on Wall Street, appeared to unravel on Sunday, anxiety over the bank’s fate — and over what might happen next — gripped the nation’s financial industry. By late afternoon, Merrill Lynch, under mounting pressure, entered into talks to sell itself to Bank of America.

While the New York Times waxed on about spoiled cocktail parties and canceled weekends in the Hamptons, Bloomberg noted that Lehman’s lawyers were prepping Chapter 7 paperwork and the Wall Street Journal said the Merrill Lynch board was nearing a vote on a $29/share sale to Bank of America.

After reviewing chatter around the web, I’ll say the consensus expectation is that Washington Mutual is a foregone conclusion, and that Wachovia and AIG are not far behind.

I guess the powers that be in the United Socialist State Republic of America figured they’ve already bitten off a century’s worth of meals with Fannie and Freddie.

UPDATE: The Fed has been clocking some overtime - according to their now regular Sunday press release, they are “broadening” the Primary Dealer Credit Facility and the Term Securities Lending Facility (i.e. the emergency conduits for the printing of money in return for collateral of declining value). In particular…

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities.

Unless I am completely off base, this means that the PDCF will now accept equity securities in return for short-term loans. The tri-party repo system is run primarily by Bank of New York and JP Morgan Chase - this is the kind of move that would reflect either 1) declining confidence in their ability to continue clearing the transactions or 2) something done with their prodding in order to reduce their own counterparty risk.

Big stuff.

UPDATE 2: Lehman files Chapter 11.

Bill Gross of bond fame has been whining for some time. Reason: his portfolio at the PIMCO Total Return Fund is full of GSE bonds and he knows it’s going down, down, down.

His latest blathering is veiled in an attempt at humor (more like an inane distraction, but bear with me) - the entree is some ludicrous poll comparing Louis Rukeyser with Jim Cramer. I don’t much care for “investment media”, mostly because I believe they are nothing but stock shills being compensated somewhere, someplace. In other words, a lot are frauds, skirting securities law for the dis-benefit of the gullible investing public. Added…Gross thinks Cramer is a daring pundit (because he was once a money manager himself). Sure - and a money manager that blew up (but saved his own ass via his oft-touted ‘trust’) just like Bill Gross will probably do. But Cramer does have a house on the beach with oil under it - some are impressed so I guess that makes him okay.

Bottom line - Fannie Mae and Freddie Mac were the closest thing to socialized medicine for the housing sickness of the late 80’s/early 90’s as anyone could imagine who lived through the New Deal Era. Gross became the famed bond investor while riding the wave of easy money - now management ineptitude (and basic economics) are coming back to haunt the GSEs and their investors, and Gross is begging for the US Treasury to bail him out.

If I was the CIO of an insurer or pension fund, I’d be running from the GSE-overweighted bond portfolios like you might if approached at a cocktail party by someone that was recently busted cheating on their spouse with a farm animal.

And after reading Bill Gross’s diatribe, which at once beckoned for a new bull market in bonds while simultaneously putting the onus on the Fed to make it happen, maybe he should think about a new poll - that which decides whether investing in GSE paper is more like running with bulls…or sleeping with sheep.

MORE: Barry Ritholtz asks “WTF is up with PIMCO?” and notes that the “quasi-homage to Cramer” was just plain “weird”.

Peter Bernstein pits Mellon against Keynes (and Greenspan and Bernanke against the tide). The tome is shutting off the open bar to prevent the hangover.

(h/t to The Big Picture)

Editor’s Note:

Bernstein is author of two books I’ve read, The Power of Gold: The History of an Obsession and Against the Gods: The Remarkable Story of Risk. They are both quite worthy, and both certainly relevant to our “inflation ex-inflation” (quote pilfered from Barry Ritholtz) times. However, I found The Power of Gold more enlightening than the latter - Bernstein waxes poetic on the history of the metal, and concludes its worth is only in the eyes of the beholder. Against the Gods, on the other hand, won’t hit you like a Louisville Slugger unless you have some minimal exposure to elementary statistics. I’ve long since passed “Gold” on to a commodities trading friend, but Against the Gods still sits on the shelf. And if someone can develop a salient, but not necessarily completely risk-averse, argument as to why the Fed (and Congress, and the Treasury, and the rest of the Administration) should play hands off here, invariably allowing the meek to inherit (or at least take full economic advantage of) the scraps, I’ll send them my un-abused copy of Against the Gods for their reading pleasure.

Post your thesis in the comments, or put it on your blog and post a link down yonder. In addition, rationale to the contrary (why governmental bodies should step in and start paying your neighbor’s mortgage) will also be accepted, although taking that path may be fraught with risk.

Derivative headline for a derivative world.

Was discussing the same idea with a colleague just this morning…

And if another investment bank were to fall like Bear Stearns, there are no more J.P. Morgans to pick up the pieces. In addition, counting on foreign countries’ investment funds may be problematic, as many politicians balk at the fact that all but one sovereign wealth funds are from countries without a democratic system.

For the better part of a year there’s been play with banking shorts. Now there seems to be a lot of money sitting on the sidelines, persistent chatter that the bottom has been reached, and yet continued resistance towards the upside. Uncertainty is the prevailing wind.

The take over here is there are still a lot of writedowns left to go, and even more balance sheet games which will eventually exacerbate the situation. The Fed and the Treasury seem to have “blown their wads” too early. More obvious taxpayer funded/direct bailouts could create downright insurrection (or at least there are going to be a lot of pissed off renters rioting in the streets). The WSJ is correct in their assumption - there just aren’t many J.P. Morgans left to do the bailing. Then there is the offshore money. Politics aside, you have to wonder how much of it will be willing to chase financial assets of a dollar denominated nature - said assets may look cheap to them now, but may get a hell of a lot cheaper in the year to come too.

At the very least I suspect it is going to be an interesting summer.