FHFA is One Year Old - No Cause for Celebration

FHFA is having a birthday party. They are one year old. There is not much to celebrate. Not surprisingly, the speech by James Lockhart contained nothing new. I doubt there were many Champagne bottles opened for this occasion. There is one aspect to Mr. Lockhart’s presentation that I found interesting. The following is a slide from the speech


There is a message in this slide. The suggestion is that there are three paths that FNM/FRE may follow in the future. The second and third alternatives make no sense. Mr. Lockhart knows that.

The “Improved GSE model” is dead. History will show that the GSE’s were/are the largest systemic risk that we face. The losses at FHFA will far exceed those that AIG will force us to accept. The GSE structure allowed that to happen. A small and insufficient amount of private sector capital coupled with private sector management abused the AAA rating of the United States. The loss of capital by the investors was small by way of comparison to the price the taxpayers will pay. To recreate the structure that is at the heart of our problems is sheer lunacy. If that is the direction that is taken we will deserve the collapse that will surely follow. No foreign investor would trust us if we made that mistake again.

The Private Sector Solution is just a sound bite. The total share of the new mortgage market by all of the D.C. lenders is currently 94%. Together with Ginnie Mae and FHA the government share of the total market is more than 60%. While every effort should be made to privatize as much of this as possible we have to accept the fact that for a minimum of ten years Washington will be substantially more than 50% of this critical market.

So if it is not #2 or #3 it must be #1. Nationalize the Agencies and merge them with Ginnie Mae. It is interesting to note that Mr. Lockhart rains on that idea by suggesting there is a "Moral Hazard" regarding government insurance programs. Mr. Lockhart needs to be reminded that his Agencies have put their guaranty on $3.8 Trillion of paper. To suggest that the FHA model is flawed may be correct. But, the Agencies are the largest insurers of loss in the world. We would not be in this mess if that were not the case.

As the following slides show, the role of the Agencies is already shrinking in favor of an increase role by Ginnie Mae. It would appear that the Agencies are being put to rest in slow motion.

Part of the FHFA Mission Statement is: Support affordable housing. While that may sound nice, it is central to the problem of the GSE’s. Mixing affordable housing and other social objectives inside of the GSE’s is a bad mistake. Their narrow mission should be to support a stable and liquid housing market and to insure that they are sound. To do that it is necessary to abandon the objective of achieving Congress’s social agendas. That must be separated from the credit standards that are set by the surviving government mortgage agency.

We need to re-establish the belief that the mortgage system works. 80+% of the mortgage debt now outstanding is money good. We need to build a gigantic Chinese wall around this and not allow the politicians to pollute it with social objectives that have nothing to do with good lending standards. That will be the challenge for the folks at Ginnie Mae.

I, for one, am convinced that the days of the GSE’s are numbered. The uncertain nature of their guaranty has made them more expensive than they should be. There are redundancies between fre/fnm. At one time they were independent competitors. Those days are over. There are thousand of GSE employees who do an important job on a daily basis. They had nothing to do with the problems we now face. It must be hell for them to live with this uncertainty. That reality will probably hasten and shape the outcome of this.

We would be much better off if FHFA did not have a second anniversary. If they have a fifth anniversary we are going to regret it.



The D.C. lender's share of the new mortgage market is 94%. Note that new mortgage issuance is drying up.



Strong support from the Fed.? About $2 Trillion worth.



These lines have no where to go but up.



The Federal Home Loan Banks aren't doing so well either.



This is the biggest risk that we face.



My favorite. They are reading the Blogs!

Fannie and Freddie Preferred Stock - Update

On July 14th I wrote about the trading activity in FNM/FRE preferred shares. It was clear then that there was a buyer. The buy side interest has continued:




Both fnm and fre have series A-Z preferred’s outstanding. All of these individual shares have appreciated 200-300% in the past 40 trading days. The common stock has not budged.

There are a number of possible explanations for this unusual price action.

-A broad base of ‘punters’ saw the signs that I saw and said, “What the heck”.
I would give this a very low probability.

-A large Prop desk is behind this.
The buying is going on across 40 separate share issues. This is a well organized effort by a large player. This is a good guess, but those ‘desks’ are very close the desks that run the big Agency business that goes on every day. That is a stinky conflict.

-The Agencies are behind the buying.
That can’t be. They are NYSE listed and subject to disclosure. In addition they are owned by the Treasury. As such the must live to a higher standard of disclosure. A ‘sneaky Pete’ buy back just doesn’t fit in with that picture.

-This a completely random event of no significance.
Not.

The market cap of these securities has appreciated by $1.5 billion over the past five weeks. Big money. Someone appears to be wired. If the Agencies and FHFA have a plan for the pref they should share it with the public.

2 Year Note - No Juice for the Carry Trade

I would give today’s 2-year auction a C+. Not a good sign. To get the bid/cover ratio back to a B+ will require more juice to tempt the carry trade.

Consider it on a leveraged basis. If one had $5mm and some friends in town it would not be at all difficult to borrow $95mm at the repo window and buy $100mm of the two-year note*. Assume that the repo cost is the Fed Funds rate.

If the funds rate is stable at .25% for the next 24 months your equity return is 17%. Not bad. However, if the average Funds rate is 1.08% you breakeven. At an average of 2% you are in the hole by 16%.

That is a terrible ‘rate bet’. No one in his or her right mind would do that. Your upside is capped. It is too easy to have short rates average 1% and break even. And if you woke up one morning with a $ problem all of your equity would be lost.

Do the same analysis assuming the two-year is at 2%. The 20 to 1 leveraged return tops out at 35%. While you will not see that return, the downside would seem remote.

Leveraged players at this big casino seem to be absent. They are just one factor in a very big pie. This carry trade is very tempting. At the right ‘price’ leveraged risk capital will create significant demand for the two year. That price is north of today’s auction. 1.5-1.75% is in the cards.



*I describe the ‘carry trade’ as a buy, borrow and hold transaction. That is not how it works. There are many better ways to achieve this risk profile. However, the economics and pricing of those alternatives reflect the interest differentials. The funding differentials are the backbone of the carry trade. 20 to 1 debt equity is not a big deal. To play at this table you have to have an invite, and a few 100 mil.

Debt Repudiation – On the Table

In the Week in Review section the NY Times had a piece by David Streitfeld titled “When Debtors Decide to Default”. I thought it was an important story. The NY Times put the issue of Debt Repudiation on the table. Exactly where it belongs. The author also contributed a new adjective to describe many of America’s troubled borrowers, “Ruthless Defaulters”. This definition comes to us from the “lending” side of the equation. I think that is a misguided definition by the industry. I don’t think they know what they are up against. Yet.

I disagreed with one premise of the article and wrote Mr. Streitfeld.

BK
"I disagree with you that 'a small handful' are involved. I talk with people who have debt trouble every day. More than half of them are going to walk away from their debts. You say there is a downside to this:"

"Ruthless defaulters today face different perils. Delinquency destroys credit scores, can prompt a lawsuit and guarantees a very large number of hostile calls from collection agencies."

"People do not care about credit scores any longer. What does that give you? Nothing. The lenders are canceling lines left and right. Most people do not qualify for a mortgage. Stores are no longer giving out their CCs. There is no more credit available for those that are near the edge. There is no downside to walking away any longer. Debt repudiation is the biggest systemic risk we face. It is staring right at us."

DS:
"I wondered if it might be more than a small handful, but I have to go with the evidence I have -- no one publishes numbers on this. Where are you talking with these people?"

I was going to respond to this privately but thought it might be interesting to throw this out for discussion. Neither Mr. Streitfeld nor I can say conclusively that the number of Ruthless Defaulters is either, (a) A small handful or (b) A significant number that is growing rapidly. In the blog world I can throw out some data and some anecdotal information and draw a conclusion of what it means to me. The readers will make up their own minds. My response:

I follow default rates through Realtytrac. (And others) The numbers for June were terrible. In the first six months of this year there were an additional 1.5mm homes in default. Not all of these borrowers are Ruthless Defaulters. A significant majority were just fed up with the nightmare of home ownership.

The personal bankruptcy rate is also soaring according to aacer (automatic access to court electronic records). They described July 09 as, “The hottest month for filings in three years”. From their report:

Consumer bankruptcy filings also remain on the uptick, increasing by 48% last month over the previous year, reported the American Bankruptcy Institute. Using data from the National Consumer Bankruptcy Research Center, the ABI said the 94,124 new consumer bankruptcy filings in July also marked a nearly 14% increase from the 82,770 filings in June.

A 50% rise year over year has nothing to do with Ruthless Defaulters. For $3,000 you can go chapter 7 and just say, “The hell with it all”. There is no downside. They are not ruthless, they are just defaulters.

I have lived in a small town for 30 years and know a diverse group of people. I give free advice. Business has been booming for the past two years. I spend, at most, one hour with and individual or a couple. By the time they get to me there are typically only two possible outcomes:

-“Your situation is perilous. It is not clear that you will be able to forestall these debts. You can no longer re-fi them away. Your net worth and cash flow are negative. You must renegotiate with all of your creditors. If they do not listen to you, stop paying them. You have six months before you are out of your home. You need to plan for that possibility. You will meet with headaches at every step. Prepare for a very difficult time ahead.”

-“Your situation is hopeless. Do the right thing. Contact the lender and tell them you are vacating the home. Send them the keys and don’t destroy what is left. Sign papers for a “Deed in Lieu” transaction. As for the CCs, you have to walk on those too. You have no assets or excess income to pay those either. You are a cash payer and a renter for the next five-years. Get a pre-paid cell phone and pre-paid credit card. You will need them.”

Admittedly, my narrow exposure to this is not indicative of anything on a broader scale. That said, the data on foreclosure rates and bankruptcy filings coupled with my neighbor's calls, tells me that the default rate on mortgages in excess of $500k is going to explode this fall. That timing is driven by the end of the ‘selling season’. With that, the CC numbers would follow. Broad based debt repudiation is a distinct possibility. It is the biggest systemic risk that we face. There is no fix to this.

BBQ Talk:

Joe: “I just settled with the bastards at Capital One. I owed $50k. Half of that was % and fees. We settled at 50 cents on the dollar:

Lou: “I had a First and Second mortgage with Morgan Stanley. I didn’t pay them for nine months. Then I sent them the keys. They are going to take a bath when they go to sell it. Now I am in a rental down the street at half the monthly cost!”

Sally: “But doesn’t that hurt your credit rating?”

Lou: “So what? The banks cut our lines to zero. There is no credit to get anymore so who cares about FICO scores for the next five years?

Joe: “I never had any credit. I was a no doc. borrower. They deserve what they get.”

Sally: “So how do we get in on this?”

Joe/Lou: “It’s easy. Just stop paying for six months. The lenders will roll over.”

Chorus: “Yeah! Down with the banks. We are going to stop paying next month too!”


This is by no means a joke on my part. I was at the party.

The Growth Trade Vs. The Bond Calendar

Over the past few months market psychology has gone from enthusiasm to dismay in the course of a fortnight. Back on June 12 the talk was,"China’s roaring back, load up on copper!”. “The 10 year’s at 4%, it’s going to 5!” “There will never be a down week in the market for the rest of the year!” Just four weeks later, on July 8th, the talk was, “Oils going to 20, the commodities trade is dead!”

As of last Friday the overall market sentiment was back on the ‘Growth Trade’. The ‘investors’ on TV were talking about their longs and a big shot, Warren Buffett, said, “Short bonds, buy stocks”. Even Alan Abelson at Barron’s had something positive to say in his weekend piece, “It Could Be Worse”.

There are a lot of ways to make a bet on the growth trade. One could; move equity money away from health care and back to growth, play commodities long, position for a steepening of the curve, short bonds outright, get leveraged long in equities, get short the Yen and long the Aussie. The list goes on and on. The following chart tracks oil, S%P and the 10-year note yield for the past three months. Directionally they match. There is some divergence during the June 14- 29th period. There can be little doubt looking at this, that from July 10-24th the markets have been directionally converging on the growth trade.


A market sentiment that is biased to growth is a lousy market to sell bonds into. Treasury has a bundle on offer in August. The auctions next week come to a very lumpy $240 billion. $120b. in short date, $120b in coupons and TIPs. The balance of August has tons of additional fixed rate paper coming. Prior year increases in Treasury IOUs for the month of August were: 2006=$68b, 2007=$100b, 2008=$79b. Based on the following schedule from Treasury, the August 09 total issuance could exceed $400b. Keep in mind this is August, a month when a lot of bond folks are out at the Hamptons.


It is not an easy task for the dealers to position for this supply. At their level the cost of being short the ten-year overnight is = (3.6% -. 25%) / 365. Based on that, you’re average $500mm overnight short position will cost you $50,000 in carry. The street has learned the hard way that being short bonds can be a very costly trade. The drop in yields for the ten-year from 3.98% to 3.32% was a doozy. It cost the shorts a bundle. The result has been a spike in volatility. That increase just adds to the hedging costs.




The convergence of the August calendar, the current market psychology and the high cost of shorting sets up the possibility that the upcoming auctions will put significant upward pressure on bond yields. We may be headed back to the 4% level that was touched on July 8th. Should that happen, the talk will revert to, “Mortgages are pushing 6%. Housing is dead! The financials will get killed!”

The last month of summer is setting up to be an important one. Possibly by the end of August we will have learned something. If the economy is in recovery mode the ability to finance the $2T deficit issue has to resurface. The question will become, “Can we fund the deficit at a price we can afford?” In my opinion this question is going to be answered before the end of September. That answer will be, “No, at these costs the deficit will overwhelm us. The growth trade is dead!”

This market sets up well for people who can go both ways. For the buy and hold crowd, look out, you’re going to get hurt.

Red Berries – Brown Shoots

I live in a pretty quiet area north of NYC. For some reason wild raspberries grow here in abundance. On side roads the stuff grows untamed. For years I have been picking the berries at this time of year. Most of the fruit got eaten by the birds, some just rotted. Not this year.

There are a dozen folks from Ecuador and Guatemala picking the bushes clean. I talked to them.

-“So are you folks going to eat all those berries?”

-“No. We sell at farmers market.”

-“Where were you last year?”

-“Working”.

-“You have no work?”

-“I have no work for 6 weeks. We sell fruit for money to live”

How big a brown shoot is this? There is a social side that is impossible to quantify. A shot at the economics:

The press uses a number of 12mm illegals as of 2007. At that time the unemployment rate for these workers was near zero. (That fact is what kept them coming) Today that number around NYC is at least 50%. Around here the day rate was $100. Assume an average of $75 and a four-day workweek. These are conservative assumptions.

Well that number comes to $100 billion of lost wages. It also means that there are another 6mm workers who are unemployed versus two years ago. They are not in the headline numbers. If they were, the unemployment rate would be nearing 20%.

Where might this $100 bil. have gone?


These are small numbers in our big economy. However, this hidden drop in income is equivalent to nearly 1% of GDP. That extra 1% would come in handy. It is not going to happen.

Maynard Keynes would say that a drop in private consumption must be offset by an increase in public sector demand in order to re-establish economic expansion. Following that logic one could conclude that about a quarter of the existing stimulus plan is offset by the drag from unemployed illegal workers.

From that perspective it is a big deal, and I have no berries.

Fed Mortgage Report – What’s Ginnie Mae Up To?

The total size of the mortgage market has been flat for a year. In its June report the Federal Reserve reported that the total market had declined from $14.68 trillion at year end 2008 to 14.60t. in March of 2009. The following looks at the moving deck chairs on this Titanic. The data comes from the June FRB Mortgages Outstanding report. This is March data. I have reviewed individual data from June 30th. I believe that the trends evident in the FRB report are continuing today.


The following looks at the outstandings for One-Four and Multifamily residences. Note that the total outstanding is down by $400b. year over year. The current total is equal to the levels of year-end 07.


The commercial lenders have kept their outstandings stable. The 4% increase over 18 months is probably not a reflection of their willingness to lend new money. This is a consequence of having to put old mortgages back on their balance sheets as a result of blown up SIVs and CMOs.


The following looks at the holdings of the Federal side of the equation and some of the components. Not surprising is that the balance sheets of the D.C. lenders has been growing. But, a year over year change of less than 10% is only an increase of $70b in increased funding requirements. The total of ‘on book’ residential mortgage assets is only $800 billion.


The Pool, or securitized, section is the more significant category. Of note is that the FNM/FRE side of this represents a combined increase on a year over year basis of just $100b. At the same time the much smaller Ginnie Mae has increased by $250b. That the Private Participants has declined by $500b or 20% over the past year and a half should be no surprise. That trend has continued in the past three months. The absence of private participation in the securitized market speaks for itself. The Shadow Banking system is taking a bank holiday. It is likely to be a long time before that holiday ends.


The following is a summary that looks at the private/public percentage of the residential mortgage market. The government already owns too high a percentage. That percent share has no-where to go but up.


The compound average growth rate of the mortgage market in the ten years that preceded 2007 was 12%. The total outstanding grew during that period from $6.8T to $14.6T. That $8 trillion increase in credit was the gas that fueled the trend-line GDP growth of 3%. It was also the gas that caused the costly fire in 2008.

I can’t imagine a return to 3% growth unless credit creation from mortgages resumes an upward trend. The Fed, Treasury and the D.C. lenders have done everything they could do to boost demand with historically low interest rates and 125% LTV loans. They have barely succeeded in keeping the total at a stable level. The higher interest rates that must come at some point will just add to the problem. Washington is running low on arrows.

The positive economic signs that keep popping up suggest that the economy has stabilized. We should not mistake that to believe that strong positive economic growth is around the corner. It is not. The implications on the future social costs (Medicare and Social Security) should be debated in light of the reduced long-term growth prospects.

NOTES:

-The rapid increase of Ginnie Mae’s participation in the mortgage market is worth highlighting. Ginnie is a private company owned by HUD. It is not a GSE. It has never been a public company. Unlike FNM/FRE the debt and guaranties of Ginnie are direct obligations of Treasury. There are no ambiguities on their status. As a result they can issue MBS with a guarantee at a lower cost than the old Agencies. Ginnie Mae did not fall into the trap of bad credit in the 04-07 period that killed FNM/FRE. Net-net Ginnie did what a government mortgage agency should have done. They supported the mortgage market and protected the taxpayer’s interest. Look for Ginnie Mae to assume much broader responsibilities in the future.

-In a report to Congress HUD contrasted it’s superior credit performance to the GSE’s (fnm/fre). The following is from that report. In D.C. this kind of talk is like shooting a bazooka. I doubt they like each other very much.


-One hitch that I can’t understand is that there are very specific limits on the size of Ginnie. The Fed report put Ginnie at $680b. in March. They have been growing (and bragging) about increasing that number by $40b. a month. Therefore an estimate of their current guarantees outstanding is near $800b. As far as I can determine their current limit is only $640b.

The request for an addition $300 billion ceiling for 2010 is a 'tip' of what is in store for the folks at Ginnie Mae. It is also an indication that the GSE's days are numbered.

Mega Jumbo Loan Defaults on the Rise in Florida

Mortgage defaults in Florida are nothing new. My four-year old niece is aware that there is a problem with condos in Miami. However a call from a friend prompted a closer look.

This fellow owns a house in a 600 home gated community in Collier County Fl. This place has all the amenities and has been around for fifteen years. Two years ago the minimum house was $1mm and the max was $3mm. Because of the relative age and the stability of the members it was believed that values would not be impacted as they were in newer and more speculative communities.

No such luck. All involved were shocked to learn that 6 homes had gone into foreclosure from June 1, to July 15 of this year.

The selling season for these types of properties ends on June 1st. It’s too hot and the ‘snow birds’ have gone back north after that. Demand disappears until the following November. What must have happened this season was that there were some owners who were in payment default. The lenders said, “We’ll give you to July 1, and then we will move on you”. These owners were ‘upside down’. If they had any realizable equity they would have dropped the price to flush out a buyer or held off the lender with some cash. That did not happen. There were very few sales this year. At the end of the season the lenders acted and filed papers.

I reviewed data from RealtyTrac. I looked at the numbers of recorded defaults on properties with a “value” greater than $1mm. I narrowed the time period from June 1 to July 16. Just 45 days. I compared the data from 2009 to 2007. The numbers are for recorded defaults only.

I believe that RealtyTrac does a good job of compiling this information. I am also sure that there are errors in this data. There are some significant changes over the two-year period. This can’t all be dismissed as bad data. The following chart looks at various Florida counties.


On the assumption that this data accurately reflects what went on during the past 45 days in Fl. there are some significant conclusions that can be drawn:

-Lenders are going to get hurt. This is not a FNM or FRE problem. This is the banks. To my knowledge there has not been much provisioning for losses of the mega jumbo loans that are now going into default.

-As with lower end communities the defaults will lead to foreclosures and auctions. The result will be that high-end homes will lose value. If the average ‘value’ in the 600 home example I provided was $1.5mm two years ago, it just went down by a 1/3. That implies an asset loss of $300mm. Multiply that by a few hundred of these places and you get some real money. This wealth effect will impact consumption.

-The lower home values that will be realized over the next six months will, no doubt, force more leveraged borrower to walk. The number of defaults on $1mm+ mortgages has no-where to go put up.

- The reduction in RE taxes is going to kill the local communities. These homes were a big component of the tax base. (Approximately 1.8% of purchase price)


I did check a few other areas in the country to see if the phenomenon of jumbo mortgage defaults was popping up elsewhere. In Maricopa County, AZ the numbers went from 1 to 26. In San Bernardino County, CA the number went from 1 to 23. This again, is just for the last 45 days.

These numbers could trump the green shoots. It may reopen the door on the issue of the stability of the banks. The stress test did not contemplate the implications of broad based jumbo mortgage default. I can’t envision a plan that would result in assistance to high-end homeowners that are underwater. There is no obvious solution to this one.

07 RealtyTrac



09 RealtyTrac

Agency Preferred Stock – Who’s Buying?

It is now nine months since the Agencies were put into receivership. It is pretty clear that there is $200-400 billion of embedded losses. By any reasoning and analysis the common stock of both FRE and FNM are worthless. But they still trade actively in the 50-60 cent range. This is a different situation than the old GM common. Old GM shares are worthless. The courts say so. The status of FRE/FNM common is not as clear. Technically the shares still represent a claim on the companies. The claim is valid and worthless at the same time. As with any bankruptcy this matter must be addressed at some point. If for no other reason than to eliminate the voluminous public disclosure requirements of the NYSE, the common stock’s status should be resolved. It should be de-listed.

To do this you must address all of the pieces of the Agencies balance sheets. The status of the senior debt obligations was addressed nine months ago. All of the Senior debt is money good and functionally guaranteed by Treasury. The status of the Subordinated debt is also now clear. As of July 13, 2009 Goldman Sachs is buying in all the sub debt for FRE in a tender offer. Incredibly, the terms are that the subordinated creditors end up money good with a fat premium. No doubt but that FNM will announce a buy back of its subordinated notes in the near future. The only unresolved liability category is the Preferred stock that is outstanding.

Freddie Mac currently has 20 different categories of preferred shares outstanding. FNM has a similar number. Both companies relied heavily on Preferred stock issuance to support their capital ratios. There is approximately $60 billion of par value securities in the market. The original investors mistakenly thought the Pref. stock was functionally ‘guaranteed’.

In the last week of June someone started buying the Agencies Preferred stock. A few graphs:






The following is a more detailed chart of the Fannie Mae Preferred S compared to the FNM common. Note again that the prices more or less tracked until June 26. What is clear is on that day someone started buying the pref. and shorting the common.



It has been my contention that it is not legally possible for the Sub debt to be paid in full while the Pref. gets nothing. There is no equity to that. It opens the door to lawsuits.

The tender offer for the Sub debt was agreed to weeks before last Friday’s official announcement. GS is running the books on that deal so they and the others in the deal (Bank of America and Citicorp) were well aware of the move by the Agencies to resolve the status of their balance sheet components. It is not a great leap to think that the timing of the jump in the Pref. value was consistent with the finalization of the terms for the Sub debt buy back.

My guess is that by the end of the year the status on the Agency Common and Preferred stock will be legally resolved. The common stock will be worthless. The Preferred stock is going to be tendered for. My guess on that price is in the $5-10 range.

Should that come about, the “smart money” that started buying the Pref. and shorting the Common on June 26 will be getting fat. I wonder who that could be?

A list of the FRE Pref. outstanding:



A copy of the offering document for Fannie Mae’s last Preferred offering, Note:

-$2 bil. of this swill was sold to the public five months before going into receivership. They offered 8.25% to the suckers. This deal was sold with a wink and a nod. (“the governments behind it and the yield is super!”)

-Note the underwriting fees, .7874%. That came to $63mm for Wall Street. Two years prior FNM sold Pref. with a .25% fee. That $63mm is big bucks for a Pref. deal that was rated A+ at the time.

-Goldman Sachs is on the middle bottom of the list of underwriters. This means they were the smallest takers of this (crammed down) deal. They did not keep what they got stuck with. They probably did not sell what they got to in-house customers. They knew this was toxic.

GE - Big Numbers This Week

GE is to release its earnings on Friday. The consensus is for 23 cents (Down 57% from a year ago). GE has so many ways to move this number that I would look for it to be the standard 1-2 cents ahead of expectations. This will give Mr. Immelt’s cheerleaders at CNBC something to crow about. More important will be the forward guidance. It is hard to imagine that the folks at GECC are doing very well. A competitor, CIT, is looking at a chapter filing in the near future. The industrial side is no doubt doing better than that, but there can’t be much good news on that front either. Locomotives, jet engines and wind turbines are just not hot businesses to be in today. Ask T.Boone about wind.

This sets up the possibility for another run below $10 for the stock in the near future. The following chart shows GE’s performance versus the S&P. Sure the stock made a great bounce off the $6.66 March 5, lows. But it has clearly lagged the broad market recovery.



The March low had nothing to do with GE. At the time the global economy was falling at a 15% annual pace. It looked like Citi was going out of business. The lights were going out. All of that proved to be a head fake and the market quickly responded. GE’s V shaped March low should be exclude from the chart.

A share price around $10 is a problem. It limits GE’s ability to sell new equity without murdering the existing shareholders. A big increase in the share float at this time would drain cash because even the new lowered dividend is double the historic (2%) yield. Preferred stock would be very expensive. This implies that there will have to be more debt.

Then there is the market capitalization issue. I look at the Market Adjusted Debt to Equity ratios (“MADE”). There is so much hype in the balance sheet it is hard to really look at how much equity there is. I let the market determine how much the equity is worth. The following comparisons are based on current market cap data. The liabilities are net of preferred and common. The liability numbers are 3-6 months stale. I do not think there is much change in those numbers.


GE is neither beast nor fowl. There are no ‘good’ comps. Clearly GE is leveraged 3Xs the other industrials but well less then a strong financial like GS. The comparison to Sears is irrelevant but interesting nonetheless. The GE competitor CIT is headed into a black hole. It is notable that their MADE ratio is the same as Citi’s. That BAC is 10Xs better than C is also an eye opener.

I believe that GE’s corporate debt level is going up. I am concerned that some of their off balance sheet stuff comes back on the balance sheet. This happened with the banks and their SPIVs last year.

GE is 1/3rd a financial and 2/3rd an industrial. Based on that it should have a MADE of 5. It is 25% above that now and that ratio has nowhere to go but up.

Freddie Buys in its Sub Debt – Heinous!

After the bell on Friday (ahem) Freddie Mac announced that it would buy in $4.4 billion of its Sub Debt. This deal is another coup for our pals at Goldman Sachs who got the Lead Manager slot on the deal. No doubt but that GS has a ton of these bonds in portfolio. Some details:


“We’re doing it to provide liquidity to this market, and retiring these high-coupon bonds also reduces our cost of funding,” Lisa Gagnon, a company spokeswoman, said. (Bloomberg)

That statement is malarkey. They are doing this to provide liquidity for sub debt holders? Why on earth would they care about that? Do they think they can sell new sub debt? Certainly not. They are bailing out the sub debt holders and that does give those holders liquidity but this has nothing to do with supporting a market. As for reducing their funding cost, that is bunk too. They are paying a big premium over par to buy in this paper. They have to borrow another 10% to get the deal done. It will take years for them to amortize this premium.

The money for this deal is coming straight from Treasury. So it will be cheap money. But this is not a fair comparison. They are arbing the Treasury/taxpayer AAA once again. These bonds are not now and never were guaranteed by Treasury. The conservatorship allows continued payment of interest but does not make these bonds money good. This buy back just puts more taxpayer money at risk to the Agencies.

There may be an interesting ‘unintended consequence’ from this move. I think there is a great lawsuit based on this. I am not a lawyer, so I would love some comments on this from those that are.

Freddie has $14.1 billion of preferred stock outstanding. In the conservatorship this was wiped out. The Pref. stock is now changing hands around $1 versus the $25 offering price. There are always layers to a corporate balance sheet. Broadly they include:

-Senior Secured
-Senior Unsecured
-Subordinated
-Preferred Stock
-Common Stock

In a bankruptcy the assets are distributed to theses classes of creditors by a judge. The higher you are in this layer cake the better off you will be. Typically the secured and senior guys get out more or less whole. The sub debt gets something and the pref. is usually converted to new common. The old equity ends being heavily diluted or worthless.

Preference is the guiding principal in dividing this up. But equity comes into the equation as well. In the case of the FRE sub debt buy back there is neither adherence to the rules of preference, nor is their any consideration as to the equity or fairness of this. How can the sub debt that is one notch above the pref. be money good++ while the pref. gets nothing? There is nothing fair about that.

If you do not like that legal argument try this approach. Sixty days prior to the Agencies crashing into conservatorship the President of the United States, The Treasury Secretary of the United States and the chief regulator of the Agencies Mr. James Lockhart all made the same public statement: “The Agencies are Adequately Capitalized”. Bush, Paulson and Lockhart knew at the time that those statements were both false and misleading. Those statements were intended to calm down the nervous creditors, including the Pref. holders. If this had been a true public company there would have been hell to pay. The SEC would have been involved.

So what could this look like? There are 560mm $25 preferred shares outstanding. I think one could clear the whole lot at a $10 price. That implies a settlement of less than 35 cents on the dollar. That would be more than fair given that the sub debt is money good. Well, that settlement would be worth a cool $5 billion. A 20% payout would make for a $1 bill payday for the lawyers. No bad for a lay up case.

These rules are simple. There is a hundred years of court cases in support of that. D.C. is breaking them.

Note: Fannie Mae has sub debt outstanding as well. Look for them to make an announcement of a sub debt buyback within a month . This means the lawyers can win twice. Double the fees to $2 bil. That should provide the proper incentive.

FHFA Five-Year Plan – No Changes!

The FHFA released its five-year plan today. There are no surprises in this report. There are no innovative plans to change the troubled mortgage giants FNM and FRE. The five-year plan by FHFA calls for them to do what they have been doing for the past year as FHFA and for the past decade as OFHEO. Not much in the way of supervision or control. Just business as usual.

The primary goal set forth by FHFA is as follows:


How are they doing in their Primary Goal? Not so good. On page 29 of the report is the following:

“The GSEs have not met and may continue to be unable to meet many regulatory standards”

A critical component of the report is missing. Where is the exit strategy for American taxpayers? There is none in the five-year plan. This topic is glossed over with a reference to the requirement by the Conservatorship Agreement that a) limits the maximum balance sheet of the GSEs and b) a requirement that those aggregate limits be reduced in a significant manner over a number of years. This sounds like a way out. But it is not. It is misleading to leave the reader with that impression.

Any balance sheet caps by the Agencies are worthless. The other wing under the FHFA is the Federal Home Loan Banks. They are ramping up their balance sheets to adjust for the limits at the Agencies. There are no effective limitations on assets under the FHFA umbrella.

In addition, there are no restrictions on the amount of MBS that either FNM or FRE can guarantee. So the amount of mortgages they can have at risk is unlimited. This open-ended guaranty is a backdoor way to maintain and expand the Agencies position in the mortgage market. So far this year their balance sheets have been stable. But they sold nearly $1 billion of newly issued guaranteed MBS to the Federal Reserve. This is just moving the deck chairs. The end result is the same. The taxpayers are at greater risk to the mortgage market today then ever. The systemic risk is continuing to be concentrated exactly where it should not be. In the hands of the government.

A five-year plan should have at least addressed this problem. Even I understand that there are no quick fixes to the mortgage mess. Our feet are stuck in this cement. It would have been refreshing if Mr. Lockhart had included as one of his goals that FHFA would create a Blue Ribbon type panel to take on this very serious topic. The panel should include academia, existing and former Fed and Treasury folks, the private sector financial side and some people who do not have an axe to grind. There should be a bulldog running this.

If we let the FHFA set the five-year plan for the FHFA then in five years we will have accomplished nothing. The government’s role will be bigger than ever. One FHFA goal should be:


FHFA puts the following sentences at the bottom of its correspondence. They are very proud of this big number. The folks at FHFA want this number to grow every week and month forever. If we are not careful that number will grow to $10 Trillion in five years.


I did like the cover and all the other pictures of the happy home owners.

Swiss Government/UBS-Versus-The USA and Me

The ever-escalating story of the Swiss accounts and Swiss banking secrecy took a turn toward the absurd this week. Here, here and here.

The net of this is that in an attempt to protect the matter of banking secrecy in Switzerland the Swiss government is going to expropriate the data from UBS. This puts the Swiss and US governments eyeball to eyeball in a fight that no one can win.

I believe that this is complete theater. I am sadly an insider to this story. My facts do not jive with the story that is in the press. A detailed explanation:

I am a Swiss citizen. I am also a US citizen. As a Swiss living abroad I have the right to participate in the Swiss health system and the Swiss Social Security. Follows is a notice from the Consul General of Switzerland regarding my eligablility for SS Swiss style.


Now a copy from a Swiss health insurer regarding my status. Note that a requirement for eligibility is that one must have a bank account in Switzerland.



I provide this personal information to provide credibility to the following tale of woe.

I opened up the required Swiss account with, you guessed it, UBS Zurich. I was not trying to avoid or evade taxes. I was just trying to get a better deal on some health insurance. Because of the account with UBS I became one of the 52,000 losers you keep reading about.

In December of 2008 online banking for this account was disrupted. I called. I was told that the account was to be closed. That all of the US resident accounts were to be closed. I was told further that if I did not provide alternative payment instructions a check for the balance of the account would be sent to my US address on 12/31/2008.

I complained bitterly. To no avail. The account was closed. I got the following email from UBS.


I deleted the sender names and some private stuff but the words are very clear. The image from the email is not. I will repeat them:

I am absolutely aware of the fact that you have dual-citizenship, unfortunately all these issues with the US Government concerns all clients based in the US and having domicile in the US. For the US Government it makes no difference whether you have second passport or note. I wish we wouldn't have to close the business with US clients. It is totally unsatisfactory for all our clients and us as well.

From this email one must conclude that the vast majority of US account holders at UBS had their accounts closed and money sent back to the US. The NY Times reported on this aspect of the story on 1/9/2009. This NY Times story confirms what I have been describing.

So what does this mean?

Any wire transfer or bank draft from a foreign financial institution to a US bank account that is greater than $10,000 is an automatic Red Flag item for both the bank and the computers that monitor these flows. The minimum balance on the UBS accounts was $150,000. Therefore anyone who had an account was automatically caught. The quote from the Times was:

“You can either take that check and throw it in the woods, or deposit it somewhere and get busted,” “There’s nowhere to hide.”

It is possible that a portion of the account holders were able to direct the payment to other offshore accounts prior to the 12/31/2008 deadline. But that would not have worked either. Say that one of the account holders wanted his money to go to Panama, Cayman or Macao. It is possible that UBS would have made the payments to the new secret account. But this activity would clearly come to the attention of senior management at the UBS Head Office. The Swiss laws are clear. They do not sanction tax evasion. The Swiss banks participate with a variety of international law enforcement agencies. They do not want illegal activity on their books. UBS can provide information on account holders if they deem the activity to be suspicious. To do so is not a violation of Swiss banking laws. It is an obligation of the banks to provide information on possible illegal activity.

UBS and the Swiss government ‘gave up’ the bulk of the 52,000 names when the money went back to the US accounts. Those that avoided that way of getting caught could have been turned over long ago based on the ‘suspicious’ activity of avoiding the funds being returned to the host country.

So if UBS has a valid reason to expose those that it has not already exposed and the Feds knew the bulk of the names by mid January and has a strong case for the others what the heck is going on here?

We are about to go to war with Switzerland. Switzerland is building walls that it does not want to build. If all these names are actually available what is the big deal?

The only possible explanation I can think of is that a small amount of the accounts were not closed. The woman who wrote me that “all clients based in the US” could have been wrong. These would be big accounts. Fat cats. If that were the case then UBS and the Swiss government would have something to hide. If that is not the case then both sides of this story are making something from nothing.

Social Security Trust Fund June Report – Continued Deterioration

It is my contention that the Social Security Trust Fund is experiencing a slow motion ‘Tipping Point’. The surpluses of the SSTF are invested back into the economy through purchases of Treasury securities. At $2.4 Trillion the Fund is America’s largest single creditor. The annual surpluses that have funded our deficits since WWII are rapidly drying up. This could not be happening at a worse time. Our deficits are exploding. Our need for investors is rapidly increasing. The SSTF is on track for reducing its purchases of Treasury debt by 6% this year. That is the first YOY decline in history. In 2007 the Fund provided the liquidity for half of the entire federal deficit. That number will be less than 10% this year. It is possible that as early as 2010 the remaining surpluses will be eliminated.

June is a very big month for the SSTF. All long and short-term holdings mature on June 30th. They roll these funds along with the current year surplus into new Treasury IOU’s. The new investments have a maturity ranging from 1 to 15 years. The June report contains information that confirms that the tipping point has been reached.

The interest rate is set on these new long-term holdings by an arcane formula that was developed in 1960. The formula establishes a single yield for all of the maturities. The June 2009 reset yield is 3.25%. The lowest level in over 30 years. The effective and average return on the portfolio over time is as follows:


That interest rates have been steadily falling is a reflection of Macro conditions and Fed policy. The unfriendly interest rate environment coupled with the slow down in employment has had a significant impact on the SSTF. Some numbers:




As you can see the year to date comparisons show a significant deterioration in the critical surplus number. The surplus is down 40% from 08 and 35% from 07. This number should be rising not falling based on the Funds projections. Note the negative months. May (the most recent report) is yet another. These negative months began occurring in 2008. Negative months significantly impair the Future Value of the portfolio. Based on the YTD numbers my forecast for the full year 2009 surplus is $115 billion. If that proves to be correct it would represent a fall of 50% from the 2007 peak.

The other revenue component for the Trust Fund is tax receipts. The following chart shows the first 7 months results for 07-09.


Tax revenue is meaningfully lower in 09 over 08 in all of the months other than February. It may be that there was some ‘special’ adjustment to explain that monthly pop in receipts. Even with the February number the Fund is running at a rate that is equal to 2008 and only 1% higher than 2007. The Fund is supposed to be collecting ever-higher amounts of tax income. That is not happening. The tax receipt side is being impacted by unemployment. This negative factor is not going away anytime soon. It is unlikely that there will be any meaningful increase in employment before 2010.

The expense side is exploding. After years of growing at 6% the 2009 increase is at 10%. This is the impact of the baby boomers. Their numbers are just kicking in. The number of beneficiaries will double in the next decade. More numbers:




The June SSTF reports clearly show the deterioration in the footings of the fund. Their interest income is declining. The tax receipts are falling. The disbursements are soaring. The annual surpluses are dwindling and will continue to do so. The engine that stoked the economy for 60 years is failing.

It has been easy to forestall the debate on Social Security while the Fund has been purchasing 50% of our annual deficits. By 2010 their purchases will be approximately 5% of the funding requirement. By 2011 they will be a non-factor in financing the deficit. This changed status should accelerate the timetable for confronting this issue. If it is no longer a positive, it is most certainly a negative.

NOTE: The June SSTS purchase of new T notes came to a total of $312 billion. The yield on the entire 15-year strip was set at 3.25%. That is a very good deal on the one-year piece. (A pick up of 270 basis points on $11.5 billion). However, pricing the fifteen-year piece at 3.25% puts it underwater to the market by 65bp. The 15-year piece is for $153 billion so this costs the Fund $1 billion each year. The net of all flows comes to an NPV of $11 billion in favor of Treasury and at the expense of the Fund. With the numbers involved that is a rounding error. It does raise the question as to how many other 'rounding' errors there are.