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Fiddling! - The Nero-Paulson Doctrine

Fri, Sep 12, 2008 - 11:50am

On 1st September 2008, columnist David Hirst writing in the Australian Fairfax print media, revealed that a former advisor to China’s central bank and one of China’s most highly regarded economists, Yu Yongding, has declared that a failure of US mortgage finance companies Fannie Mae and Freddie Mac could be a catastrophe for the global financial system.“If the US government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic. If it’s not the end of the world, it is the end of the current international financial system.”

Sen. Charles Schumer, D-N.Y. said the intervention was sparked by worries within the Bush administration that foreign governments would stop holding Fannie and Freddie's debt.

The Roman Caesar Nero (Nero Claudius Caesar Augustus Germanicus) is remembered by history for playing the fiddle while the great fire of Rome destroyed much of the ancient city in 64 AD. Hence “fiddling while Rome burns” has become a synonym for a failure to deal with the problem at hand. Whilst Nero probably copped a bad wrap (wrongful statement), as the fiddle or violin was not invented until the 16th century Plaster bust of Nero, Pushkin Museum, Moscow.his memory is forever stamped with this charge.

Much has changed since Nero’s time and the financial Caesar of the USA and hence the world is now Henry Paulson. Much too has changed with the historic bail out of Fannie and Freddie, but it’s not what you think. Fannie Mae and Freddie Mac, have blown up their equity by rapidly expanding assets in 2006 and 2007 through lower and lower quality mortgages. That is, they used their implied government mandate to leverage a vast amount of debt against a relatively tiny capital base and compounded that risk with low quality mortgages that have been stuffed at every opportunity into ostensibly sophisticated investors.

Isn’t it ironic that in the greatest capitalist nation in the world, the credit system has been supported by an implicit state guarantee, and that privately owned institutions use that guarantee to support huge, entrepreneurial risk taking empires. As many have complained, privatizing gains and socializing losses.

Last Sunday’s widely expected announcement has drawn endless commentary on its likely effect on the US housing market and that is how it has been presented in just another disingenuous turn of the screw on whatever credibility US markets had left, but in fact correcting (not crashing) housing markets are only the symptom of the demise of the privately held Fannie and Freddie and not the cause. The essential charge against Paulson is not that he stood by idly as the bonfire of the credit markets continued to burn ever brighter, but that the steps he took merely moved the fire from one part of Rome to another.

The Mindset

We know Bernanke’s mindset. His already published views that the printing press can always stimulate spending and inflation are his hallmarks. That is not of much use in the present inflationary environment (think household inflation if nothing else) but we can turn to the ECB for a recent insight into central banker’s thinking.. Bloomberg reported on 09/05 that ECB President Jean-Claude Trichet reiterated that the governing council isn't ““surprised'' by the slowdown in the second quarter after a ““brilliant'' first three months. Global growth ““is expected to remain relatively resilient, benefiting mainly from sustained growth in emerging economies.''

Paulson for his part understands the dominant position that housing is playing in the US economy. The housing market has become the lynch pin of wealth creation in not only US but most OECD nations. The flow on effects on consumer spending and employment are obvious. Secretary Paulson stated “Our economy and our markets will not recover until the bulk of this housing correction is behind us.” That statement makes housing values central to market behaviour. Peter Costello the long serving Australian Treasurer in the late but unlamented Howard administration is boasting today of his government’s record in wealth creation in recent years. “10% per annum year upon year” he crowed. He neglected to say that like US, UK and much of Europe, almost all of that wealth came from the housing bubble which is now correcting..

But that’s the mindset of central bankers and Treasurers everywhere. They and most commentators are plain incapable of thinking through or more importantly accepting the causes and consequences of the current troubles.

Debt securitization relies on an implicit understanding of the quality of the risk the purchaser is assuming. With Fannie and Freddie buyers of securitized debt got an implicit guarantee from the US government. With other packagers, buyers got a credit rating from an approved ratings agency plus mortgage insurance from a monoline insurer. Since we have come to know that the ratings on this debt were at best wrong (the model doesn’t account for falling home values) and certainly negligent and that the insurers never had the capital to pay the likely ensuing claims, debt purchasers have shunned private label securities and bought only Fannie and Freddie and other GSE paper. Who was doing the buying? Mainly state and national institutions, pension funds and central banks. That puts the US Fed’s fingerprints on these transactions. No central bank is going to load up on paper without a wink and a nod at least from its counterpart central bank. Think that through. China and Japan are the dominant holder of these securities. Do you believe for a moment that those central banks loaded up on billions in US mortgage debt without some comfort from the US Fed?

Some central banks got nervous and forced the bail out.

Got the message sport? Paulson certainly got it. Hirst says that as of June 30, foreign entities and individuals held over $1,400 billion in securities of US agencies like Fannie Mae and Freddie Mac. Given the huge fall in American housing prices and the $5,000 billion in housing loans that the two companies have guaranteed, there is little doubt both bodies were at least technically insolvent. How auditors have been able to classify these beasts as “going concerns” is just another mystery for shareholders to ponder.

More than 60 global central banks have invested in the Fannie and Freddie securities. The Chinese and Japanese have been enormous investors in the two groups, clearly believing that the Americans would never let them fail. For the Chinese to have invested so much of the rewards of their labor in these and other US securities was a cause of vital concern in China. One of their fears was that the new US president may have turned his back on the verbal undertakings they received from the current administration. There are plenty of precedents. Russia was told by first President Clinton and then by the first President Bush that the US would not incorporate Russia’s former satellites into NATO. But the current President switched strategy. Georgia thought NATO and the US would come to its aid when it launched its attack on the disputed South Ossetia. It was wrong.

Fannie and Freddie both purchase home loans from banks and then repackage those loans as mortgage backed securities which they either hold on their own books or sell to investors around the globe. This process provides banks with more money to make more home loans, greatly expanding home ownership, but also being the prime catalyst for lax lending standards. And this has become the funding model for many banks. The fees that they have earned from these transactions in the past decade have become an ever more important part of their business model. Absent these fees the model doesn’t work.

The real issues which have not been put before you are that the massive funding required to finance the US and almost global property bubble has been siphoned up from all over the world. From state pension funds and authorities not only throughout US but as far away as the tiny Wingecarribee Shire Council which covers my home town of Sutton Forest in rural NSW, west of Sydney, Australia, which last week began legal proceedings against Lehman Brothers for the sale to it of US sub-prime backed CDOs. By banks throughout Europe and Asia and more and more by central banks lead by China and Japan.

The failure to save domestically also results in us having to rely on foreign investors to an increasing extent in order to finance our nation's excess consumption. This may be OK in the short-term; however, it is not in our nation's economic, foreign relations or national security interest over the long-run.
All you need to do is look back to 1956 to see how the United States used its financial leverage against the United Kingdom during the Suez Crisis. When England and France challenged Egypt President Nassar's attempt to take over the Suez Canal, the President of the United States called the Prime Minister of the United Kingdom and advised him to rethink his position. He reminded him how much they relied upon us to support the pound, and within two weeks they were G-O-N-E, and England was an ally! What was our leverage? Loans. David Walker the most recent Comptroller General of the United States, NACO speech (improperly) dated 13 July, 2009.

Banks determine House Prices

Ease and availability of finance largely determine house prices.. If we start with the traditional model, now the old model, a bank would need to see some equity or purchaser’s “skin in the game” before making a loan. Hence 20% equity or down payment was the norm. The buyer also needed to demonstrate an ability to repay principal and interest over the term of the loan. Start with that model and you have a defined number of buyers who might compete to buy a property. As lending models became more innovative (read risky) and the required equity contribution reduced so there were more potential buyers. Keep innovating by offering interest only loans and then teaser loans, and the potential number of buyers and their buying power migrates up the scale.

Eventually you finish up with the ultimate flipper’s mortgage of nothing down and little to pay and suddenly that average house or condo has a serious number of potential buyers and for that time and place demand, created by minimalist lending standards outstrips supply, and competition forces prices higher. Prior to the bailout central banks and institutions were happy to buy complying mortgages. What will the new complying mortgages be? At present that looks like a 3.5% deposit and the lowest interest rates the Fed can manufacture. Here’s the kicker that will come as a surprise to non US readers. Almost all home mortgages in US are non recourse, that is they are not personally guaranteed by the mortgagor, hence, given a level of pressure the mortgagor/home owner has a limited inducement to keep servicing a loan that is underwater and indeed a high incentive to borrow more than they can afford by whatever means, safe in the knowledge that defaulting and having the home go into foreclosure is not likely to be terminal to their economic health. In UK, Australia and most of Europe that is not the case and mortgagors who default in these countries face all of their assets being seized and their wages garnisheed to satisfy the debt. Eventually bankruptcy results. This is a primary reason why the property bubbles outside US will be of longer duration, but eventually just as deadly.

Having overseen the lenders creating the housing bubble, Paulson now acknowledges that markets won’t recover until the bulk of the housing crisis is over. That means house prices stabilizing and buyers coming back to the market. I told you at the beginning of the year that house prices would fall 35% and that now looks optimistic. The best comparable data we have is the UK housing bottom in the 90s where the average house price bottomed out at 3.3 times average earnings. Let’s acknowledge that there is a lot more competition likely to survive in the US lending system and say that the bottom will come when average prices equal 4 times average earnings. There is still a long way to go.

Consequences and likely outcomes.

US Treasury is now the guarantor of US housing debts. The market for asset securitization without substantial guarantees is dead. The Fannie/Freddie model of implicit government guarantees has now been made explicit. Criticism of this model always was that eventually it encouraged privatization of gains and socialization of losses and that is what has just happened.

And it is going to continue. As well as shifting the GSEs funding requirements to Treasury, Paulson announced a new “secured lending credit facility” that has been made available as well, not just to Fannie and Freddie, but also to the 12 Federal Home Loan Banks, which is the first time these institutions have been mentioned as being in trouble. These 12 federal banks are the largest borrowers in the US after the federal government, with $US1.25 trillion in debt and holding $US1.35 trillion in assets, largely loans to credit unions, thrifts and small banks to support their lending.
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One of the levers cited by regulators in their decision to pull the trigger on the bailout was a shock horror discovery that these worthies had been cooking their books. The Morgan Stanley advisory team acting for Treasury found that “the companies may have mischaracterized their financial health by relaxing their accounting policies on losses. For years, both companies have effectively recognized losses whenever payments on a loan are 90 days past due. But, in recent months, the companies said they would wait until payments were TWO YEARS late. As a result, tens of thousands of loans have not been marked down in value.”

This is a material change in accounting policy that should have been released to the markets. If the regulators, directors, executives and auditors all failed in their duty to keep markets informed and the listing and compliance authorities, NYSE and SEC don’t care, then investors have literally no hope. If Freddie and Fannie, amongst the largest corporations in the world are not accountable and actively conspire to ensure that markets are not fully informed of material changes to their balance sheets, then investors are entitled to ask “Who else?”

These companies, which together own or guarantee about $5 trillion in home loans, half the nation's total, have lost $14 billion in the last year and are likely to pile up billions more in losses until the housing market begins to recover. Paulson’s stop gap rescue is silent on who pays existing losses and future losses.

Paulson’s plan envisages that under government control, the companies will be allowed to continue to expand their support for the mortgage market over the next year by boosting the holdings of mortgage securities they hold on their books from a combined $1.5 trillion to $1.7 trillion. These guys are unable to survive without the fix of more, more and more. In addition, officials said the Treasury Department plans to purchase $5 billion in mortgage-backed securities issued by the two companies later this month, the first of a series of purchases planned by the government in an effort to bolster demand for these securities.

Starting in 2010, though, they are required to drop their holdings by 10 percent annually until they reach a combined $500 billion according to the announcement. Rubbish. It will never happen. This pyramid can’t stop. Absent mortgage securitisation in some form or other a whole lot of banks and lenders are going to find as most already have that their model stops working.

For the biggest financial failure in history there is apparently no blame and no loss. The CEOs were terminated with all their benefits but at the same time retained as consultants to work with the new leaders. Paulson was careful not to blame Daniel Mudd, the outgoing CEO of Fannie Mae, or Freddie Mac's departing CEO Richard Syron for the companies' current problems. If these guys are not to be blamed then who is?

What’s the immediate impact. Shareholders lost out but their shares were worthless anyway given a true valuation without the government intervention, the Federal Reserve and other federal banking regulators said in a joint statement Sunday that "a limited number of smaller institutions" have significant holdings of common or preferred stock shares in Fannie and Freddie, and that regulators were "prepared to work with these institutions to develop capital-restoration plans’, code for “we’ll swap them for you guys”.

Other notable beneficiaries included PIMCO who reportedly had a huge bet on GSE bonds and who got a record pay day when Paulson made their bets good. PIMCO have been quite open and consistent in their support of the bail out. Bill Gross on 09/04 called for an even broader bailout of the housing market, calling on the Treasury to use funds to bail out mortgages as well as financial companies. And he was betting on that bailout, saying that PIMCO finds distressed mortgages an attractive investment.

So far as I can ascertain, nobody asked Bill the pertinent question-Why?

No Outrage

Strangely there were no outbursts of outrage over this $100 billion slug to taxpayers. The few who understood knew that Paulson was just making good on the promises that the Bush administration had made when borrowing the lolly from China, Japan et al. All the present players supported the bailout.

In a statement, President Bush said, "Americans should be confident that the actions taken today will strengthen our ability to weather the housing correction and are critical to returning the economy to stronger sustained growth."

Democratic presidential nominee Barack Obama issued a statement agreeing that some form of intervention was necessary, and promised, "I will be reviewing the details of the Treasury plan and monitoring its impact to determine whether it achieves the key benchmarks I believe are necessary to address this crisis."

Republican presidential nominee John McCain also voiced support. The Fed released a letter from Fed Chairman Ben Bernanke to James Lockhart, the director of the Federal Housing Finance Agency, in which the Fed chief said he concurred in Lockhart's decision to take control of Fannie and Freddie saying the action "will help ensure the safe and sound operation of the enterprises."

A look at the current housing and mortgage related current sub-prime crisis portends a much larger and more disruptive outcome from what I'll call our potential super sub-prime crisis. Namely, the very real risks imposed by our nation's poor financial condition and irresponsible fiscal practices. In fact, the current sub-prime crisis and our nation's fiscal situation share at least four key characteristics. First, both involve a disconnect between those who benefit from current policies and practices and those who will bear the risk and pay the price in the future. Second, both involve inadequate transparency relating to off-balance sheet and other risks. Third, both serve to demonstrate the importance of maintaining lender confidence and adequate cash flow, as well as the limitations of credit rating agencies. Bear Stearns and investors in certain mortgage-backed securities recently found this out the hard way. Finally, both involve a lack of adequate ongoing oversight, risk management and timely action to prevent a crisis. David Walker the most recent Comptroller General of the United States.

So the deal is first , conservatorship; second, a guarantee of positive net worth by Treasury through new preferred stock; third, the new lending facility for them; and fourth, buying mortgage backed securities.

Before the ink has even dried on the press statement, Consumer advocates and some Democrats are starting to call for Fannie and Freddie to help more borrowers facing foreclosure by modifying more loans and halting foreclosures. "That's one advantage of the takeover," said Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee. "They were being torn between their private activities and their public mission. Now that's finished - it's the public mission." And, someone might remind Mr Frank, it’s the public purse. Not that cost is an item seriously on the Congress agenda.

Most of these things have not been spelled out in detail, so ambiguities and therefore uncertainties remain about the future operations of the GSEs themselves. Finally, the administration, who like Congress haven’t a clue about anything more exotic than presents from lobbyists and earmarks, made sure that they distanced themselves from this disaster "It is really an assent to Hank's direction, guidance and judgment," said a senior administration official. Obviously Hank won’t be around after this year so he might as well carry the can for all. What mates!

Markets’ Reaction

There is always something to be learned from financial events and the lesson is especially worthy in times of market stress. Paulson’s historic announcement came on Sunday evening US time so many everyday traders were caught unaware until they read their papers on Monday morning. As usual, the Gnostics, those that know, were out of the box faster than the average punter. The deal was widely known as Paulson and his team undertook the inevitable and necessary consultations. With not only significant inside knowledge (insider trading seems the fruit de jour these days rather than an indictable offence) but a widely telegraphed plan that an announcement was imminent, insiders used the Danielcode numbers to put in the market turn on Friday in the S&P at 1217.23 on SPX, just 3 points through the nearest Daniel number sequence. On Monday with all the emotion following Sunday evening’s announcement and as unwary shorts were again being eviscerated by insiders, the futures contract gapped 36 points at the open but both the futures and the cash followed their DC numbers with precision.

You can see Monday’s high in the cash just one tick off its proprietary Daniel sequence retracement.

SPX

If you were lost, clueless or panicked by the markets foreknowledge of the weekend’s events still to come (for most) on Friday or gasping to find Monday’s high as gut shot shorts were squeezed, then you didn’t have a market map. The Danielcode is the market map and 85% of market turns come at the DC numbers or within our allowable variances. The DC numbers on the $SPX chart above were posted for subscribers at the Danielcode Online on Sunday night US time. From Monday’s high, we got Wednesday’s intraday low to within 1 point and on Wednesday night I posted new charts for the December contract which added to the confusion by becoming the front month on Thursday.

Below is that chart. Thursday’s dramatic gap down low was 1212.50. Again the DC black line, the last level of Danielcode support for the major swing at 1214.20, stopped and turned this huge, ostensibly panicked market right where it should. FSO readers will have seen this mysterious black line turning many of the markets we cover in a variety of different examples in recent months.

500 Index

If you didn’t have the Daniel numbers you were caught unaware. They are always available for those who seek knowledge. Equity markets are trying to be bullish but have not yet got traction from the bailout although as the Fed has practiced on a number of occasions this year, slaughtering shorts with out of hours intervention is a sure way to take the sting out of market adjustments, at least temporarily.

Currencies take Charge

Floating currencies are the shock absorbers of major markets. They take and release pressures in the system that are not clear in other views. EUR-USD is making a strong statement that Euro land’s troubles are worse than US. It is trying to turn within our standard variance at two degrees of DC targets at 1.3840.

EUR

And the DX has continued its magnificent rally to within 12 ticks of a DC target at 80.50. The DC black line at 80.87 or a bit above that will probably measure this first leg up of DX resurgence.

DX

Yesterday’s funny story (and the financial media exists to entertain more than it informs), was that the widely expected interest rate cut by the New Zealand Reserve Bank had caught the carry trade off balance and was blamed by a talking head broker for the negative tone of Wednesday’s S&P open. Fancy that. A country of 3 million people and 14 million sheep even being mentioned in the same breath as the mighty S&P index. What a joke. Our commentator friend must have been the only person in New York who hadn’t actually seen the chart which has been in sell off mode for months. Those of you who follow the Danielcode Report will recall my earlier articles about the NZD and the perils of its ubiquitous Uridashi trade, the spillage from which is occurring but to date not being disclosed by either the Four Pillars or the Reserve. You can refresh your memory at my FSO archives.

NZD

Gold as protection against fiat currencies

The list of GATA and its fellow travelers’ litany of misdirection is crumbling. First, the “Gold is money” mantra is looking thin. If Gold was money at $1033 it is still money at $758, but it’s only a quarter of the money now. That of course can all change, but if ever there was a time for Gold to prove its worth as a hedge against fiat currencies, this week was it as $5 trillion was added to US taxpayer obligations by the Fannie and Freddie bailout. Gold didn’t rally and Silver sold off all week to be at $10.71 at lunchtime on Friday. That’s a loss of over 50% for Silver since the Danielcode called the March highs to a matter of ticks.

Tell me how that “Gold and Silver are money” story goes again.

Here is the weekly DC chart of Comex Gold. You can see it stair tripping down its Daniel number sequence. Having bounced just above 777 for a few weeks, this week’s low has gone like an arrow to its next DC target at 740.20. The week’s low to date is 739.80 just 4 ticks from the weekly DC number. Was that worth knowing for Gold traders? The cartel knew. It always does. You could have known as well.

COMEX

I must admit that I expected to see a reaction from Gold on Monday. I also expected a sell off in the long Bond. That neither event occurred is testimony to Paulson’s mastery of markets. This coup was deeply planned.

The DC Gold Trend Charts, free for FSO readers have continued to keep you on the right side of the trends in Gold and HUI. Over 4000 Financial Sense readers viewed them last week. They are updated before the US open each Monday.

Copyright © 2008 John Needham

About the Author

Lawyer and Financial Consultant
jneedham [at] thedanielcode [dot] com ()