Oh, what a tangled mess we have! The bailout of Fannie Mae and Freddie Mac is the latest attempt to bring stability to the housing and financial markets. But the question remains, is it enough? We have a crumbling housing market and massive financial deleveraging going on at the same time Bernanke, Paulson & Co. are trying to plug all the holes. A friend of mine aptly described the state of the markets in the following quote:
Actually, the situation is more akin to a patient bleeding to death simultaneously being given a transfusion. Every one's hoping the blood going in keeps pace with the blood going out.
In terms of housing, this situation of blood going in and blood going out also applies. Blood going into the housing market is a reduction in supply in the form falling construction to bring demand and supply more in line with each other to arrest falling prices, with the decline in construction being a major positive to the housing market. For example, the number of housing permits relative to the number of households in the US has fallen to 0.8%, tying the second lowest number in 43 years, with 0.8% also reached in 1990. Additionally, sales activity relative to the number of households has also reached a low that has often marked previous housing bottoms.
Figure 1
Source: U.S. Census Bureau
Figure 2
Source: U.S. Census Bureau
While the developments of a reduction in construction relative to households appear to support a claim that housing has bottomed or is near bottoming, construction activity only tells half the picture. The positive development in the housing (declining supply of newly constructed homes) is being offset by rising existing home supply and foreclosures. An example of this can be seen when looking at the number of defaults and foreclosures in San Diego relative to the San Diegan labor force. The breakdown in the San Diego market is truly astounding and worse than the last housing downturn seen in the late 1980s and early 1990s.
Figure 3
Source: Professor Piggington’s Econo-Almanac for the Landed Poor
Rising foreclosures are occurring throughout the nation, swelling the pool of available homes for sale and offsetting declines in newly constructed homes. Rising foreclosures are the symbolic hemorrhaging going on in housing and are prolonging the housing downturn. Perhaps the most disturbing chart is what you see below. Current supply relative to the number of households is nowhere near previous cycle bottoms. In fact, we are still at a 25 year high and have only come down 40% from the peak seen in July of 2006 and need a further 35.5% drop in the ratio from current levels to reach previous housing cycle lows.
Figure 4
Source: U.S. Census Bureau
The big picture message of the chart above clearly illustrates that we are not out of the woods in this housing depression, not by any stretch of the imagination. Supply simply has to come down sharply or we need to import households by the thousands to create new demand to bring down supply. Clearly, the latter isn’t about to happen, and with foreclosures continuing to mount, we could be in for a much longer correction in the housing market than most anticipate. With an ongoing correction in housing and declining home prices, financial losses on mortgages and real estate backed securities will continue to plague financial institutions and the market.
Since the credit crisis began we have seen 1.2 billion in worldwide losses by financial institutions while new capital raised has not completely replaced losses, with 9.5 billion in capital raised worldwide. In terms of the analogy above, the blood transfusions have not been enough to replace the relentless bleeding in the financial markets.
Figure 5
Source: Bloomberg
The financial system is deleveraging on a grand scale, shedding 113,940 jobs worldwide over the past year. The commercial banking system’s loan losses on all categories remain elevated, leading to a substantial number of FDIC member banks becoming unprofitable to levels not seen since the savings and loan crisis (S&L) two decades ago.
Figure 6
Source: FDIC Quarterly Statistics on Banking
Figure 7
Source: FDIC Quarterly Statistics on Banking
What is clearly evident is that the Federal Reserve has tried to revive the economy and stabilize the markets by cutting interest rates drastically and making credit readily available to financial institutions as well as swapping its balance sheet for those of commercial banks, taking on illiquid mortgage-backed securities and exchanging its US Treasuries. Banks are tapping the Fed’s discount window but their borrowings are being used to replace their losses, not to make new loans. The continued losses on all loan categories and fear of more to come are leading the banks to tighten their belts, raising lending standards on all types of loans and reducing overall bank credit, particularly to the consumer.
Figure 8
Source: FDIC Quarterly Statistics on Banking
Figure 9
Source: Federal Reserve Board
Figure 10
Source: Federal Reserve Board: Senior Loan Officer Opinion Survey,
What is going on is that the medium through which the Federal Reserve is able to channel funds into the economy is not operating. The Federal Reserve is pushing on the accelerator (lowering interest rates, making credit available) but the power is not getting to the wheels (economy, consumer) as the transmission (commercial banks) is broken. What do you do when your transmission is broken? You call a tow truck!
Uncle Sam is taking on the role of the commercial banks in channeling funds to the economy. The tip-off to this development was the economic stimulus package announced in the first quarter of the year of roughly 0 billion. There was a positive result seen by the stimulus in the second quarter GDP numbers, with personal consumption expenditures adding 1.24% to GDP growth, double the contribution of 0.61% growth in the first quarter. While commercial bank credit plus commercial paper outstanding has contracted 6 billion from the March 2008 high, the economic stimulus package more than made up for the decline.
Figure 11
Source: Federal Reserve Board
The second attempt to support the economy came over the weekend with the bailout of Fannie Mae & Freddie Mac, with the plan to inject up to 0 billion in each for a total of 0 billion. The move to bail out Fannie & Freddie is just the beginning of what is to be a major role that Uncle Sam is going to play to help turn the deleveraging tide. The FDIC will likely look to the Treasury to replenish its Deposit Insurance Fund (DIF), which is being depleted from bank takeovers of failed institutions. The DIF reserve ratio hit 1.01% in the recent quarter, the lowest ratio seen since March of 1995.
FDIC Weighs Tapping Treasury as Funds Run Low
Federal Deposit Insurance Corp. Chairman Sheila Bair said Tuesday her agency might have to borrow money from the Treasury Department to see it through an expected wave of bank failures. Ms. Bair said the borrowing could be needed to cover short-term cash-flow pressures caused by reimbursing depositors immediately after the failure of a bank. The borrowed money would be repaid once the assets of that failed bank are sold.
The last time the FDIC borrowed funds from Treasury came at the tail end of the savings-and-loan crisis in the early 1990s after thousands of banks were shuttered. That the agency is considering the option again, after the collapse of just nine banks this year, illustrates the concern among Washington regulators about the weakness of the U.S. banking system in the wake of the credit crisis.
"I would not rule out the possibility that at some point we may need to tap into [short-term] lines of credit with the Treasury for working capital, not to cover our losses, but just for short-term liquidity purposes," Ms. Bair said in an interview. Ms. Bair said such a scenario was unlikely in the "near term."
She said she did not expect the FDIC to take the more dramatic step of tapping a separate billion credit line with Treasury, which has never been used.
The FDIC said Tuesday its "problem" list of banks at risk of failure had grown to 117 at the end of June, compared with 90 at the end of March.
The FDIC and Fannie & Freddie aren’t the only institutions in trouble, as the Federal Home Loan Banks (FHLB), another GSE agency, is also looking at establishing lines of credit to tap the Treasury, as seen in an SEC filing by the FHLB of Pittsburgh below:
Federal Home Loan Bank of Pittsburgh: Form 8-K, September 09, 2008
On September 9, 2008, the Federal Home Loan Bank of Pittsburgh (the "Bank"), entered into a Lending Agreement (the "Agreement") with the United States Department of the Treasury (the "Treasury"). Each of the other 11 Federal Home Loan Banks (together with the Bank, the "FHLBanks") has also entered into its own Lending Agreement with the Treasury that is identical to the Agreement entered into by the Bank. The FHLBanks entered into these Lending Agreements in connection with the Treasury’s establishment of a Government Sponsored Enterprise Credit Facility ("GSECF") that is designed to serve as a contingent source of liquidity for the housing government-sponsored enterprises, including the FHLBanks. The Housing and Economic Recovery Act of 2008 provided the Treasury with the authority to establish the GSECF.
Besides GSEs and the FDIC, American industries are suffering from the current economic decline with the auto industry taking center stage. Vehicle sales have fallen quite literally off a cliff and are now down to levels not seen in sixteen years, with the three biggest domestic automakers combined sales down 38% since the peak in 2005 and down 47% since the high in 2000.
Figure 12
Source: BEA
Figure 13
Source: Autodata Corporation
The auto industry has had a tough going this decade as they have lost ground to foreign competitors, with Toyota chief among them. The two big auto giants, Ford and General Motors (GM), have been horrible investments in the past three to four years with a turnaround nowhere in sight. The cumulative earnings-per-share (EPS) for the two automakers is given below showing current losses have erased years of earnings with GM erasing seven years worth of earnings in a little over a year, with Ford fairing a little better.
Figure 14
Source: Bloomberg
The beleaguered financial institutions are trying to shore up their capital by reducing their dividend payments, a move that Ford and GM have used over the years with no lasting result. A timeline of their dividend cuts is given below, with both companies now offering no dividends at all.
- GM: Has erased seven years of cumulative earnings
- Cut quarterly dividend by 50% in 2006 from __spamspan_img_placeholder__.50 to __spamspan_img_placeholder__.25
- They discontinued quarterly dividend on 07/15/2008
- Ford: Has erased four years worth of earnings
- Cut dividend 40% in 2000, from __spamspan_img_placeholder__.50 to __spamspan_img_placeholder__.30
- Cut dividend 50% in 2001, from __spamspan_img_placeholder__.30 to __spamspan_img_placeholder__.15
- Cut dividend 22% in 2002, from __spamspan_img_placeholder__.15 to __spamspan_img_placeholder__.10
- They discontinued quarterly dividend on 09/15/06
Both Ford and GM have negative rating outlook with Standard & Poor’s rating of GM and Ford both at B-, whose bonds are trading at a significant discount to par and yield-to-maturities (YTM) more than 10% higher than US Treasuries. Along with their continued deterioration has been a surge in their 5-year credit default swaps (CDS), with GM’s currently at 2462 basis points and Ford’s at 1788 basis points. This implies that it costs .462 million and .788 million annually to protect million in GM and Ford notes respectively from default. The credit markets are clearly factoring in the possibility of default in these two companies.
Figure 15. GM Bonds Maturing in 2015, YTM =19.18%
Source: Bloomberg
Figure 16. Ford Bonds Maturing in 2018, YTM =16.03%
Source: Bloomberg
Figure 17. GM & Ford 5-Yr CDS Spreads
Source: Bloomberg
With their bonds trading at significant discounts to par, a negative credit watch and roughly junk rating, the cost of insurance against default at high levels, Ford and GM are going to have a tough time tapping the markets, which is exactly what Ford is going to be doing. Ford has millions of debt maturing in the next few years and will likely have to issue debt at much higher interest rates to entice investors to the table, further hurting its profitability as its interest expense is likely to increase.
Figure 18
Source: Bloomberg
With such a dark outlook for both Ford and GM, it is not surprising to hear of talks about a bailout or other supports for these American icons, with presidential candidates keeping their options open, as highlighted in the article below.
If GM's situation worsens, McCain open to "every option" (07/18/2008)
In the wake of GM's Tuesday press conference detailing its plans to have enough cash on hand through 2009, politicians have been eager to voice their thoughts regarding the possibility of a government bailout. President Bush gave the possibility a strong no, but the two guys in line for his job have taken a different route.
Senator Obama has said that he supports automaker's attempts to restructure without outside help, but says he's willing to work with the companies on fuel saving tech. Republican Senator John McCain took an even stronger pro-automaker stance, saying "if it looks like it is approaching that, everyone has to consider every option." The Arizona Senator and presumed Republican nominee has stated in the past that he wouldn't support a buyout, but would instead provide tax breaks and infrastructure support to create more fuel efficient vehicles. McCain's "every option" comment may not sit well with his party, but it could sound good to Detroit automakers.
In addition to the US auto industry, the airlines aren’t fairing any better. Like the auto industry, they have suffered this decade, though even more so. The eight-year cumulative EPS for both American Airlines and Continental Airlines are decidedly negative. Like Ford and GM, the 5-Yr CDS spreads for the airline industry have skyrocketed this year with the cost of oil being the major factor as the CDS spreads on Southwest, who hedges their oil costs, is far below that of its peers. Though the fall in oil prices has been a major positive for the industry, the credit markets are still pricing in a high probability of default with credit spreads higher on the airlines below than on Ford and GM.
Figure 19
Source: Bloomberg
Figure 20
Source: Bloomberg
As mentioned above, with the mechanism of credit transfer from the Fed to the economy via the commercial banks broken, Uncle Sam is going to be playing a bigger role. We have already seen the bailout of the Fannie and Freddie and further bailouts cannot be ruled out, particularly for the auto and airline industries. What is also likely to be seen is another economic stimulus package, which has already been proposed by Barack Obama.
What we are seeing is no different than what occurs as the economy enters into a recession. Federal debt as a percentage of GDP increases during recessions as seen below. What is likely to be different this time around than in the prior two recessions is a reduction in consumer debt as a percentage of GDP as the US consumer is simply tapped out. If we can not count on increased debt to fuel the economy from the consumer, we can expect the increase in Federal debt to play a larger role than in the past.
Figure 21
Source: Standard & Poor's/BEA
Figure 22
Source: FRB/BEA
To fund the bailouts and economic stimulus packages the Treasury is going to have to issue more debt. Sources of buyers will either be domestic or foreign investors and the Fed through debt monetization. We have been lucky enough to have foreigners recycle their surpluses back into this country, but with foreign economies also slowing, that door may begin to shut as their foreign reserves begin to slow. Moreover, the mess that our current financial system is in may also weigh on foreign investment. While the foreign community has been saved in terms of their debt investments in Fannie & Freddie, will the move by the government shake their confidence in our overall financial soundness? What will be the cost? Commentary on the subject and the bailout of Fannie and Freddie are provided below by Brian Pretti from ContraryInvestor.com
ContraryInvestor.com: Market Observations (09/09/2008)
The Ultimate Conservationists?...We can remember during the pre-convention campaign when the story broke about Hillary lying about her adventures disembarking on the Bosnian plane flight, her handlers vehemently denied she had lied. Rather, they said, she "misspoke". Well, over the weekend, Fannie and Freddie didn't implode, they didn't go bankrupt, they weren't exposed for the frauds that they were, they simply slipped into "conservatorship". Spin, spin, spin, spin and spin. What else is there these days in the US? We simply don't know any more. To be honest, in the world of legal definitions applied to individuals, a person can become "conserved", or be placed under "conservatorship" when they are deemed no longer able to make decisions for themselves. We guess that applies, and maybe in spades…
You'll remember that last month we penned a discussion called "Fun With Funding", describing what we believe is a very problematic cost of funds issue facing the US longer term. For the financial markets to make the leap of faith that all is well now, and we've saved the financial markets for the second time in six months (Bear being the first), housing prices better bottom, and soon. Is that really realistic, despite the fact that we've further burdened our children and grandchildren with more US taxpayer liabilities over which they have had zero say? Sorry to be so redundant, but ahead, monitoring global flows of capital into the US will be critical. How will the foreign community respond to what has taken place? Yes their bond bacon has been saved, but what about their forward level of trust and willingness to fund a financial system constantly in need of governmental bailouts? Correct answer being? We're going to find out. Stay tuned.
That level of trust is beginning to be shaken, while modest, it still shows a change afoot. For example, just as CDS spreads have widened for the auto and airline industry, they are doing the same for Euro-denominated 5-Yr CDS on US Treasuries as highlighted in the article below.
U.S. Treasury Credit-Default Swaps Increase to Record, CMA Says
The cost of hedging against losses on Treasuries rose to a record on concern the U.S. government faces higher liabilities because of its rescue of mortgage companies Fannie Mae and Freddie Mac, credit-default swaps show.
Contracts on U.S. government debt increased 3.5 basis points to a record 18, up from 6 basis points in April, according to CMA Datavision prices for five-year credit-default swaps at 5 p.m. in London. Credit-default swaps on German government bonds cost 8 basis points and Japanese bonds 16.5 basis points…
"The bailout of Freddie Mac and Fannie Mae is weakening the balance sheet of the U.S. and that is causing a deterioration of creditworthiness,'' said , a credit strategist at BNP Paribas SA in London. "The market is anticipating there might be more bailouts...”
Contracts on Treasuries are quoted in euros and a basis point on a credit-default swap contract protecting 10 million euros (.2 million) of debt from default for five years is equivalent to 1,000 euros a year.
The 5-Yr Euro denominated CDS on US Treasuries spiked in July when Treasury Secretary Henry Paulson said the Treasury was seeking expedited authority from Congress to expand its current line of credit to the two companies and to buy shares of the companies if needed. The announced bailout of the two led to a further spike in CDS to the highest level of the year, with any further announced bailouts or stimulus packages likely to send spreads even higher.
Figure 23
Source: Bloomberg
While trust in the US government by foreigners still remains high and the foreign community may still have an appetite for US Treasuries, Federal Reserve Chairman Bernanke may yet increase the Fed’s balance sheet to help stem the massive asset deflation currently underway. In fact, we may just be seeing the early signs that he is doing just this as the St. Louis adjusted monetary base has increased by 7.15% on a three month annualized basis, the highest rate since 2006. Moreover, the declining trend in the year-over-year rate in the adjusted monetary base is being assaulted currently and we may have a change in trend, which wouldn’t be surprising as the monetary base exploded to the tune of a 10% YOY rate to pull us out of the 2001 recession.
Figure 24
Source: Federal Reserve Bank of St. Louis
Figure 25
Source: Federal Reserve Bank of St. Louis
While bank credit is contracting the stimulus package and GSE bailouts have more than offset the decline. We may begin to see the same turn of events if Chairman Bernanke begins to load up the helicopters for deployment to offset the asset deflation underway. We are seeing bleeding on several levels from contracting bank credit as well as falling asset prices. However, Uncle Sam and Helicopter Ben are giving the blood transfusions to stem the hemorrhaging and turn the economy and markets around. We have yet to see who the victor will be in this tug-of-war, though a determined government can accomplish near anything as Chairman Bernanke has said.
Deflation: Making Sure “It” Doesn’t Happen Here
Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of dollars in circulation, or even credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is the equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
Bernanke, Ben S.
November 21, 2002.
Time will tell, and you can be sure we will be checking on the data ahead and report any new developments.
