Rolfe Winkler

Saving the financial system is probably more art than science. One gets that impression, anyway, when reading today’s Page One profile of New York Fed Governor Timothy Geithner. There are a few very juicy tidbits that suggest TG is driving the Fed’s response to the credit crisis, perhaps more-so than Fed Chairman Ben Bernanke. For instance:

…more than any other government action, it is the Fed’s unprecedented move to save Bear Stearns from bankruptcy, by lending $29 billion to aid its takeover by J.P. Morgan, that bears Mr. Geithner’s personal stamp. Final judgments about that move could make or break his reputation.

More than just the Bear Stearns rescue, it appears Geithner has been a proponent of aggressive Fed action to protect the financial sector:

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This is what investigative journalism should be; it’s disappointing that we may be seeing less of it in the future.

Dogged reporting by Carrick Mollenkamp has shown that some high profile banks have been lying about the interest rates they pay other banks to borrow money. This is important because the rates those banks pay are reported daily and used to compute a reference interest rate called LIBOR, the London Interbank Offered Rate. Trillions of dollars of adjustable rate debt–from corporate bonds to home mortgages to financial contracts like swaps–use LIBOR as the reference rate by which they adjust their rates. (LIBOR + 3.5% = Adjustable interest rate) is one way you might see an interest rate quoted. As LIBOR fluctuates, the interest rate adjusts.

Take for instance, an option ARM. ARM, we all know, stands for ADJUSTABLE rate mortgage. And LIBOR is the input that adjusts.

Here’s what the Journal published back in April:

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Off the wires 10 minutes ago:

NEW YORK – A closely watched housing index shows U.S. home prices dropped at the sharpest rate in two decades during the first quarter.

if(window.yzq_d==null)window.yzq_d=new Object(); window.yzq_d[\\'Wj7ETELEYrg-\\']=\\’&U=13fg3skgv%2fN%3dWj7ETELEYrg-%2fC%3d621585.12711401.13018730.2577455%2fD%3dLREC%2fB%3d5367835%2fV%3d1\\’; Case-Shiller said Tuesday its U.S. National Home Price index fell 14.1 percent in the first quarter compared with a year earlier, the lowest since its inception in 1988.

Its narrower indices also set record declines. The 20-city index tumbled 14.4 percent during the quarter, the lowest since that index was started in 2001. The 10-city index plunged 15.3 percent, a record in its 20-year history.

“There are very few silver linings that one can see in the data. Most of the nation appears to remain on a downward path,” said David Blitzer, chairman of S&P’s index committee.

Yes, low interest rates can keep prices from falling as low as they otherwise might, but sky-high inventories will insure the trend stays negative for some time.

Not long ago, I wrote a post about the dollar’s value and its relationship to interest rates. Part of that piece was concerned with the pressure some countries are feeling to break their currencies’ peg to the dollar, in particular the petro states and China. Their economies are importing dollars by the plane-load, which they receive in exchange for exports to the U.S. These countries maintain a constant–or near constant–exchange rate to the U.S. dollar. This peg enables their export industries to continue profiting from sales to the U.S.

To maintain the peg, they buy up the dollars that flood into their economies with their own currency, flooding their economy with their own currency instead. This maintains the dollar peg, but it sparks inflation in the home currency.

At a certain point, it’s more important to combat inflation than to support export-oriented industry.

And according to the Journal, more hedge funders are making a bet that indeed many of these countries will be forced to break their pegs to the dollar.

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The stock market was down again last week, consumer confidence is at 30 year lows, house prices are declining nationwide for the first time. Is there any good news to report about the economy? Indeed there is: a gallon of gas is approaching $4 per gallon, which I think is just super.

How could I possibly get excited about something that is causing hardship for so many people? Precisely because it is causing hardship for so many people. Hardship, you see, leads to changes in behavior.

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Democratic Congresswoman Laura Richardson has even Hillary Clinton beat for selective memory problems. Remember how Hillary kept repeating the Bosnia story? That she dodged sniper fire, etc.? She always knew it was a lie, but she needed a concrete example of her foreign policy experience. It was telling that that was the only story she could come up with. I hope the Clintons (and the Bushes) disappear from American politics permanently.

But I digress. Here’s what Richardson said of her property in Sacramento in a statement this past Wednesday:

the residential property in Sacramento California is not in foreclosure and has NOT been seized by the bank.

Moreover:

I have worked with my lender to complete a loan modification and have renegotiated the terms of the agreement — with no special provisions. I fully intend to fulfill all financial obligations of this property.

These are bald-faced lies. According to the WSJ:

The Sacramento home of Rep. Laura Richardson was sold in a public auction two weeks ago for $388,000….James York, the Sacramento broker who bought the three-bedroom, 1.5-bathroom home, rejected the idea that the home hadn’t been seized. The sale of the home was announced in March. “She’s walked away from the property,” he said. “I would be happy to resell her the home for the $535,000.”

Recall from the original story:

The Southern California Democrat bought the house for $535,000 with no money down in January 2007 and owed nearly $575,000 to Washington Mutual when the mortgage was sold earlier this month at a significant loss to Red Rock Mortgage Inc.

And there is additional irony here:

Richardson didn’t vote on the housing rescue deal that passed the House of Representatives two weeks ago and in a statement attributed her absence to her father’s funeral. But Richardson did vote last fall in favor of the Mortgage Forgiveness Debt Relief Act, which passed and prevents the federal government from charging income tax on debt forgiven as a consequence of foreclosure.

Let us pause for a moment of silence in memory of the institution that WAS the Wall Street Journal. As a long-time subscriber to the paper, I’ve noticed it’s devolution since Rupert Murdoch took over. Here’s a clue from the paper itself:

News Corp. Chairman Rupert Murdoch named Wall Street Journal Publisher Robert Thomson as the paper’s new managing editor, succeeding Marcus Brauchli, who left under pressure last month….The move is expected to speed the pace of change at the nation’s second-largest newspaper, creating a more direct pipeline from News Corp. to the paper’s editors….

For the first few months under the new ownership, Mr. Brauchli ran the operations of the paper. Mr. Thomson remained in the background….

Mr. Brauchli presided over a number of changes — more general news, a more urgent and splashy front page, shorter stories — but Mr. Murdoch decided that change wasn’t happening as quickly as he would like…..

Indeed. Now the news page is littered with “general interest” stories: daily updates on the Myanmar Junta refusing aid for cyclone survivors, multiple articles per day about the recent Chinese earthquake. We get it, the Burmese Generals don’t want aid and an earthquake killed lots of Chinese.

I don’t mean to make light of those stories. But the fact is, if I wanted daily updates on those topics, then I’d read the New York Times.

And that’s the point: Murdoch wants to move the Journal away from its roots covering all-things business so that it can compete with the Times more effectively in general interest news.

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FT is reporting that banks are pressing their case to have fair-value accounting rules relaxed.

The world’s leading banks have stepped up pressure to relax controversial accounting rules with a new plan aimed at breaking the “downward spiral” of huge writedowns, emergency fundraisings and fire-sales of assets.The proposals on “fair value” accounting by the Institute of International Finance, an alliance of 300-plus companies chaired by Josef Ackermann, Deutsche Bank’s chairman, would enable financial companies to cushion the blow of financial crises by valuing illiquid assets using historical, rather than market, prices.

Of course banks would prefer to carry the value of their illiquid assets at “historical” rather than “market” prices. If they’re allowed to do so, they can carry billions in paper losses without actually writing down any assets.

Kudos to the various “accounting standard-setters” who are resisting this pressure. Allowing banks to carry toxic trash on their balance sheet at values they determine themselves threatens to turn the American and European financial sector into Japan circa 1995. Bank writedowns, and even some failures, may be painful in the short-run. But the long-run health of the economy depends on efficient capital formation. It depends on creative destruction to eliminate economic rot.

Democratic Congresswoman Laura Richardson of California was recently the victim of foreclosure, according to Capital Weekly. She quickly issued a statement “clarifying” the story; she says the house is not in foreclosure and that her loan has now been modified.

Reading her statement, which begins with a non-denial denial, it seems to me she probably moved to “modify” her loan only after this news hit the papers.

I just find the facts hilarious. She managed to get a zero-down mortgage, likely an Option ARM given the Neg Am that’s piled up, in January 2007….just as the housing bubble began bursting.

100% LTV on a $535k house; the report says she now owes $578k in total.

The story would be even MORE ironic if she’d voted in favor of the various House measures to aid “distressed” homeowners. Sadly, no: she claims to have been absent from the House when the crucial votes were taking place.

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Today’s top NYT editorial is full of socialism and sophistry. House prices are falling but buyers aren’t yet returning to the market. This means prices may continue to fall. That could compound recessionary pressures that the housing sector is putting on the economy as a whole.

There’s only one solution: “foreclosure prevention.” And there is “no excuse for delay.”

Personally, I would argue there is a case for outright neglect. Let’s call “foreclosure prevention” what it really is: a bailout by taxpayers for homeowners and lenders that made bad decisions over the last few years. I don’t even know where to begin to pick this editorial apart. Perhaps I’ll leave it to my critical thinking readers to find all the holes in this argument.

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This blog is dedicated to more than the deterioration of Fannie and Freddie, I promise. I think the reason I devote so much space to the topic is the sheer size of these two entities and the risk they pose to taxpayers.

Three facts to chew on:

• At $5.3 trillion, the combined debt of Fannie and Freddie is half that of the entire Federal Government
• “Core capital” at the two companies is less than 2% of that combined total of $5.3 trillion….less than $90 billion.
• The companies’ exposure to subprime and Alt A mortgage loans (i.e. the most risky ones in the market), exceeded $700 billion at the end of last year.

A 20% fall in the value of their risky assets alone, would be enough to push them towards bankruptcy, forgetting for the moment that there may be billions of losses yet to take in their “prime” portfolios.

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Does anyone remember when Fan and Fred were still thought to be “prudent” lenders? Relative to the CFCs and WMs of the world they may always have been, but they still have far more risk in their portfolios than they should given the taxpayer guarantee backstopping their balance sheets.

The WSJ reported two days ago (sorry I’m getting around to this late) that Fan and Fred have decided to scrap a rule that required higher down payments for mortgages in markets that were experiencing especially large price declines.

Why the change in policy?

The change comes in response to protests from vital political allies of the government-sponsored provider of funding for mortgages, including the National Association of Realtors, the National Association of Home Builders and organizations that promote affordable housing for low-income people.

Those various groups have said the policy is hurting an already feeble housing market by shutting out too many potential buyers.

Too many overlevered and unqualified borrowers were the problem that expanded the housing bubble in the first place. When lenders require no down payment and are offering low teaser rates, it makes sense for borrowers to take on debt to buy a house. Their mortgage amounts to a free call option on continued house price appreciation.

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Gretchen Morgenson’s column in tomorrow’s NYT is a decent discussion of the creative lending facilities to which the Fed has resorted to help out troubled banks.

SAVING the nation’s financial system from reckless banks and brokerage firms is an enormous job, heaven knows. But somebody’s got to do it, so the Federal Reserve Board, with its taxpayer-funded balance sheet, stepped in.

To grease the gears of the nation’s seized-up credit markets, the New York Fed in recent months created three new lending entities. Together, they allow banks and financial firms to swap up to $350 billion of securities they cannot sell for cash or United States Treasuries.

The entities will stay in business as long as the markets for mortgage securities and other orphaned “investments” are closed, the Fed said. This allows institutions to exchange their trash for cash that they can turn around and lend to corporations or individuals.

The nature of these new Fed lending facilities is not without risks, of course. One of those risks is that taxpayers may have to cover losses if a firm or bank fails to repay a loan.

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If Ben Bernanke keeps his present course, former Fed Chairman Paul Volcker warns we could repeat the 70s. “Core” inflation is still within the Fed’s “comfort zone,” but at a certain point, rising food and energy costs may pull other prices along with them. That’s the opposite of what the Fed is assuming will happen. The Fed appears to believe that food and energy costs will come back down as the economy slows.

But that may give the U.S. a lot more credit that it deserves for driving oil demand. What if demand growth outside the U.S. is enough to offset declines here at home, keeping oil prices high? It’s not far-fetched to believe that can happen:

Despite China’s fantastic growth, and very inefficient use of fossil fuels, the U.S. is still the largest consumer of oil worldwide. The stats at that link are from 2007, and China’s economy has probably grown another 10% since then. So figure we consume 21 million barrels of oil per day and China consumes 7.2 million. I confess I don’t know enough about the dynamics of the oil market to know the impact of, for instance, a 2% decline in U.S. GDP would do to oil demand. But for simplicity figure oil demand growth matches economic growth.

To offset a 2% decline in U.S. demand for oil, Chinese demand would merely have to rise 6%. They’re certainly on track to grow faster than that the next few years.

Herein lies the problem with the Fed’s plan I think, and the reason people ignore Paul Volcker at their own peril:

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Following up on yesterday’s post regarding credit losses, here is an interview with Carlyle’s David Rubinstein from Bloomberg. The article notes that while credit losses have totaled $329b worldwide, banks have been able to raise $247b to offset those losses. Such capital raises dilute the shit out of common shareholders, though to the extent that those shareholders risk losing everything in bankruptcy if banks DON’T raise capital, a smaller share of ownership in the banks’ continuing earnings is an acceptable price to pay.

Incidentally, I was at the Credit Sights subprime conference two weeks ago (had big plans to live blog it, but there was no WiFi connection!) and heard an interesting tidbit from a hedgie:

You may have noticed that banks forced to raise capital see a temporary boost in their share price. See the uptick in WM from $10 to $12 a couple months back, for instance.

I wondered why that always happens since common stock is clearly worth less after being diluted so substantially. Sure capital raises are positive to the extent they help banks survive, but the guys trading in volume aren’t betting that these banks are threatened with bankruptcy just yet. So why the huge (20%?!) uptick in price?

“Because it’s an elegant way to cover your short.” All the guys short the financials have an opportunity to cover their positions buying newly issued stock at a slight discount to market. Interesting.

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