It’s a financial quagmire out there. Getting into a credit bubble is so much easier than getting out of it. What is your exit strategy?
The story is moving fast. We can barely keep up with it. But we’ll try to break it down for you piece by piece, and tell you what it might mean for Australian banks and shares. First, what IS the story?
Normally, the second largest bank failure in U.S. history would be your lead story. But these aren’t normal times. For the record though, Federal Regulators in the U.S. seized control of Indy Mac, a US$32 billion California-based mortgage lender. They did it Friday night, after the markets were closed, to avoid spooking Wall Street.
Indy Mac (Independent National Mortgage) was spun off from Countrywide in 1997 and in 2000 got full time into the business of originating Alt-A loans, a category between prime and subprime. It’s also a category of loan that doesn’t require much documentation at all. And that is what proved to be the bank’s downfall.
As defaults on its loans rose, Indy Mac struggled to raise new capital to make more loans. Depositors began a run on the bank in early June. And by the end of business Friday, regulators from the Office of Thrift Supervision (OTS) stepped in and seized control of the bank, whose operations had ground to a halt.
Personal deposits up to US$100,000 are insured by the Federal Deposit Insurance Corporation (FDIC). Early estimates are that the takeover of Indy Mac by the OTS will cost the FDIC between US$4 and US$8 billion, or 10% of the FDICs insurance reserve. The trouble is, this could be the beginning of a new phase in the credit crisis where we see a lot more bank failures.
Indy Mac is the fifth FDIC-insured bank to fail this year. The more that fail, the more worried depositors become, the greater the pace of withdrawals. But failing confidence in the banks is not even the biggest problem.
The biggest problem is that this is not a liquidity crisis now. It’s a solvency crisis. An institution is solvent as long as it can pay its debts with cash. The trouble with leverage is you finance the asset side of your balance sheet with borrowed money. You borrow to buy. That means you have to pay interest (to bondholders in this case) on the borrowed money, and hope you continue to receive interest (on the loans you’ve made).
Only it’s not happening that way now. As U.S. housing prices continue to fall, more and more homeowners are defaulting are their loans (and even more will, we reckon). These loans, remember, are assets on the bank balance sheet (when they are not securitised and sold as bonds). Thus, the quality of bank assets is now a front-and-centre issue with smaller and regional U.S. banks.
There are many commentators who would like to sayy this is all matter of sentiment and temperament and mood. But the real issue is the quality of the assets on so many bank balance sheets. The most heavily levered financial institutions will find themselves insolvent. The rest will be forced to make a massive write down on their assets. More on that in a moment.
Here in Australia, Westpac and NAB are expected to follow the Commonwealth Bank, ANZ, and St. George in raising interest rates on variable loans. St. George raised rates by twenty basis points on July 4 to 9.67%. Commonwealth Bank and ANZ raised by 14 and 15 basis points respectively. NAB and Westpac will probably raise by the same amount, leaving all five major banks with variable rates above 9.5%.
With a shocking weekend like we’ve had, it’s bound to be a shocker for shares as well. But wait, before the market’s opened today we had big news from U.S. Treasury Secretary Henry Paulson. Paulson announced a three-step plan to restore confidence in the two big government sponsored mortgage lenders, Fannie Mae and Freddie Mac.
First, let’s report what Paulson said, in case you missed it. Paulson denied last week any support for a shareholder bailout of the two companies. But it’s not the shareholders he’s worried about. It’s the bondholders. You can tell that from how Paulson began his statement.
He pointed out the importance of the GSEs to keeping the American housing market going. This, of course, is true. While non-bank lenders collapse and other banks tighten up, Congress expanded GSE lending powers earlier this year to keep the mortgage market from going into deep freeze. The result is that GSEs wrote 80% of the loans originated in the first half of this year. If they cease operating, the American mortgage market ceases to function. Imagine what that would do for house prices?
Scary as this, it is not even the biggest concern. Here is what Paulson said early in his statement: “GSE debt is held by financial institutions around the world. Its continued strength is important to maintaining confidence and stability in our financial system and our financial markets.”
-There is some US$7 trillion in GSE debt sloshing around the world’s financial system. Non-American investors own about US$1.5 trillion of it. The Treasury Department desperately wants to assure investors that Fannie and Freddie will not default on that debt. But it does not want to explicitly “guarantee” the debt. Instead, it has taken three steps, with the Fed taking a fourth.
First, the Treasury Department will increase the line of credit the GSEs have with it. Currently, that line of credit is a pretty miniscule US$2.5 billion. If the financial markets know the Treasury is willing to loan billions more to the GSEs, it might calm things down a bit. Or not.
Second, the Treasury Department will ask the U.S. Congress for permission to purchase equity in the GSEs. You can be sure it will not be common stock, but some kind of preferred shares that give the Treasury and the U.S. Taxpayer some special benefits. Both this and the first measure are designed to be temporary and not last more than 18 months.
Third, the Treasury will ask the Congress to craft legislation that gives, “the Federal Reserve a consultative role in the new GSE regulator’s process for setting capital requirements and other prudential standards.”
The Federal Reserve’s Board of Governors also met this weekend and agreed to give the New York Fed “temporary authority” to lend to the GSE’s “should any such lending prove necessary.”
That’s the policy response crafted t comfort markets ahead of a week of trading. Now, shall we translate it for you?
The Treasury gives the GSEs a new line of credit. But will it matter? Freddie Mac is set to auction a relatively modest US$3 billion in bonds this week. It’s short-term debt, 3-6 months. If yields blow out at the auction, we’ll know the market is treating the GSEs like lepers.
And besides, the GSEs may have credit with the Treasury, but the real question now is how much longer the Treasury has credit with the rest of the world. Watch gold and oil. They will tell you exactly what the market thinks.
As for the equity stake, this is pretty intriguing. It’s going to be nearly impossible for the GSEs to raise capital in the private sector. And don’t count on a Sovereign Wealth Fund to save the day. These companies have massive liabilities. The U.S. government doesn’t want to explicitly guarantee GSE obligations, though.
Instead, what we see is a back-door capital raising through a rights issue. That is, the Feds hope that talking is enough to stabilise things. But if it doesn’t turn out that way, we see the GSEs taking on the Feds as preferred shareholders and then doing a rights issue, offering the American taxpayer a large stake in the companies in exchange for billions in capital to shore up the balance sheet.
Call it what you’d like, but it’s a backdoor nationalisation. If it’s done cleverly, the Feds hope it will prevent a run on the dollar and run away oil and gold prices. If it’s done clumsily, it will still result in run-away inflation without solving the solvency problem for the GSEs.
The last option is to get Congress to change the rules so the Fed can change the rules. While technically insolvent, the Fed and Congress could simply change the definitions and waive the capital requirements for the GSEs until some muddle-through policy mess is sorted out. When in doubt, change the rules!
The stock market will see all this and sell the GSE shares from here to Friday and back again. One way or another, common equity shareholders are doomed. But again the issue here is the bond holders. Why does that matter? Because there are so many people in the world who own GSE debt and simply cannot afford a default. There are even quite a few here in Australia.
As we mentioned above, most of the debt issued by the GSEs and other U.S. lending agencies is owned by American investors. This is debt sold to finance other lending operations. Because this debt yields more than government bonds but enjoys an implied government guarantee, many investors have loaded up on it.
In fact, according to data from U.S. Treasury, Australian entities own US$32 billion in long-term agency bonds, and US$6.6 billion in short term agency bonds. The Chinese have the biggest exposure at US$376 billion in long-term agency debt and US$10 billion in short-term debt. Japan and the Cayman Islands (hedge funds) own a tidy sum too. Check out the spreadsheet here:
If you check the Reserve Bank’s balance sheet, it sure doesn’t look like it owns too much GSE debt. So who does? If that figure is correct at the link above, there is US$32 billion worth of agency debt on balance sheets in Australia. We’re not suggesting all of it is dodgy. But we sure would like to know who owns bonds issued or guaranteed by Fannie and Freddie.
In the meantime, there are two other things worth thinking about. One, the U.S. government does not want to aggravate its creditors. That means China and Japan. You can be sure the Chinese are aware of what’s going and are watching carefully to see what happens. Geopolitically speaking, it’s a target-rich environment.
Another consideration is that this is all simply a strategic devaluation of long-term U.S. liabilities. That this is all by design, a way of deflating the value of U.S. obligations to foreign bond-holders. While intriguing, we thing this unlikely for a simple reason: while non-U.S. investors would lose a bundle on a GSE default, American firms and savers stand to lose even more.
The latest Federal Reserve Flow of Funds report tells you where the GSE bodies are buried in the American financial system. On page 96 (table L.21O) of the most recent report, we find out who is loading up on GSE debt. To remind you of what this means, these are bondholders who are expecting a regular stream of income (and principal) to be delivered by the same American homeowners who are struggling to pay the mortgage.
What do we find? Remember, there’s over US$7 trillion in GSE debt out there on the books that other investors are treating as assets. A casual glance at the Fed date shows us who owns it:
- Household sector: US$843
- State and local governments: US $431 billion
- Rest of the world: US$1.5 trillion
- Commercial Banks: US$962b
- Savings institutions: US$166b
- Property Insurance Companies: US$126.9b
- Life Insurance Companies: US $390b
- Private Pension Funds: US$268b
- State and local government retirement funds: US$323b
- Money Market Mutual Funds: US$309b
- Mutual Funds: US$586b
- Government sponsored enterprises: US$702 billion
We will leave you today with a series of simple calculations that tell you how bad this mess might yet become. To fund the housing boom, the GSEs increased their liabilities from US$4.9 trillion in 2001 to US$7.5 trillion by the end of the first quarter 2008. That’s a 51% increase, and remember, they borrowed that money by selling bonds to investors (the folks above).
During that same time, the household net worth of Americans soared. According to the Fed, it went from US$40.6 trillion 2001 to a peak of US$58.1 trillion by the third quarter of 2007—an increase of 43%.
The biggest single component of household net worth—real estate—soared by 65%, from US$13.6t to US$22.4 trillion. Since then, however, total net worth has fallen by 3.8% to US$55.97 trillion. Mutual fund shares have fallen by 9.5% from US$5.2 trillion to US$4.7 trillion, just to rub salt in the retirement dreams of many investors.
And how does it stand now for America? The value of the assets purchased with that borrowed money are falling. The value of the debt is not—at least not yet. But the further house prices fall, the worse it is for bonds backed by American mortgages.
If U.S. policy makers cannot stem the flood of defaults and foreclosures, the result could be a default by Fannie and Freddie, tantamount to a default on sovereign U.S. debt, with inevitably negative consequences for the greenback. That is such an undesirable result for so many people what it’s tempting to say it could never happen. And perhaps it won’t.
Instead, the value of those liabilities will be inflated away by a massive money printing campaign that savages the U.S. dollar and sends gold to US$1,500 or higher. We will be keeping an eye on how resource shares behave in this potential hyper-inflationary melt-up scenario. Until tomorrow.
Markets and Money