Default swap spreads on GOVERNMENT debt doubled Friday. That has never happened before.

[link to market-ticker.denninger.net]



Fannie, Freddie, Banks and Government Debt

Ok folks, its time for a long sit-down type of Ticker - the sort that I usually don't write.

Let's start with Fannie and Freddie.

As anyone who has been reading The Ticker knows, I have been saying for quite some time that Fannie and Freddie are in fact "short to zero" candidates for the common stock. This is simply due to the mathematics of their financial situation - they are levered up anywhere from 60 to more than 200:1, depending on what you include and exclude from "capital" and "credit book."

I use the worst-case set of numbers, because in a bad market, that's what you wind up with - therefore, I include all of their credit guarantees, and exclude all intangibles such as "good will" and "tax loss carryforwards", with the latter being particularly important in this case because Fannie, for example, has some $13 billion in deferred tax assets.

That's not money, its an offset against future taxes. But to pay taxes you must first make a profit, and in a bad market, those are worth a big fat zero.

So here we sit with two firms that are running with leverage ratios that make a Hedge Fund look like a convocation of the Girl Scouts.

The Federal Government continues to claim that they are "well-capitalized." Uh huh. And I'm the Easter Bunny. Nobody running with a leverage ratio of 60:1 is "well-capitalized", say much less someone running with a leverage ratio of 200:1.

How did this happen? Quite simple - our government allowed it and in fact prodded these firms into doing it.

Fannie and Freddie began as firms that existed to provide liquidity to the conforming marketplace for mortgages, defined as 80/20 full-doc 30 year and 15 year loans. That is, you put down 20% of the purchase price of the house in cash, limiting your leverage ratio to 5:1, and in addition the typical "back end ratio", or total debt to income, was limited to 36%.

These loans are extremely safe because they have a fixed interest rate, your leverage is limited, and even in a severely-down housing market if you find yourself unable to pay the losses taken by the noteholder are limited or non-existent (you may be wiped out, but the note holder is likely to get most or all of their money back at foreclosure.)

As the 1990s and especially 2000 passed, however, Fannie and Freddie began to loosen standards. They put in place "automated approvals" that were, for the most part, essentially driven by FICO scores - that is, whether you pay your credit cards on time. In addition Congress prodded them to be the "standard bearer" for what was and is a horrible mis-allocation of capital - that is, to push the "American Dream" of homeownership to the maximum possible extent, and to glorify not owning a small bungalow in which you had enough room to sleep and raise a kid or two, but rather the "McMansion" philosophy of building on every square inch of farmland within 100 miles of a population center.

This is a misallocation of capital for a simple reason - a house does not generate GDP. It has utility value as shelter but, unlike a machine, it generates no new GDP by being in existence.

You cannot base an economy on housing for this reason.

Normally a private company could not pursue their end of the "bargain" in this sort of non-GDP-growing enterprise because as they continued to drop credit standards and increase leverage by issuing more and more debt the market would impose discipline. That is, as your gearing ratio went up so would the coupon - or interest rate - that you'd have to pay to issue that debt. The free market works quite well in this regard, and severely punishes those who buy debt that doesn't pay enough to cover their risk - its called "bankruptcy" and tends to result in big capital losses for the bondholders.

But Fannie and Freddie were seen to be "government backed", even though every one of their prospectuses for their debt clearly says it is not. That is, the market has perceived that they would not be allowed to fail irrespective of the amount of risk they took on! Thus, as we went through the 2000s, literally $5 trillion worth of credit was issued and sold off to people - but at a spread to Treasuries - that is, at an implied level of risk that was not equivalent to US sovereign obligations.

But was this marketing reasonable? No. In truth hundreds of billions of dollars worth of mortgages were sold into Fannie and Freddie using automated underwriting systems from firms like Countrywide, many of them refinances, that literally verified almost nothing more than the applicant's credit score! Debt-to-income and even in some cases property appraisals were either done by "automated" (meaning - nobody actually LOOKED at the property) means or not done at all! The former stodgy - and reasonably safe - 80/20 mortgage in fact represented only a fraction of the total "buy" of mortgages during the 2000s.

Even worse, Fannie and Freddie, who guarantee their own bond issues, started buying their own paper. That is, they are writing insurance on a hurricane when they are both the writer of the insurance and the loss payee. This looks brilliant in that the "expense" of providing that insurance effectively disappears, thereby making the entirety of the spread they get from their source-of-funds to their paper issue theirs to keep, but that's the wrong way to look at it.

In fact that paper is uninsured, because the money comes from one hand goes to the other, attached to the same body.

Where were the regulators? Congress? Intentionally asleep. Remember that back in 2003 and 2004 both firms were found to have improperly accounted for their results. This should have led to an immediate clampdown and forced deleveraging to no more than 10:1 on an audited basis.

It did not, and in fact neither firm timely filed accounting statements until last year, more than three years after the "errors" were discovered.

But for Congress, The Fed and OFHEO looking the other way on purpose most of the Housing Bubble could not have happened, as the money necessary to fuel it simply would not have been available.

Now we are faced with the reality - Fannie and Freddie, under fair value accounting rules, are insolvent (if you listen to Bill Poole.) What does that mean? It means that if Fannie and Freddie were to sell their assets and net it out today, you'd wind up with a negative number. That is, its assets are less than its liabilities.

The question now comes down to "what do we do about this?"

There are several choices, all of which will have bad side effects. It is critical, however, that we understand those side effects and choose the path forward that represents the least risk to the broader economy and to the government, not just the most expedient or the one that the people who would lose will scream most loudly about.

Here are the options:

1. The Fed "decides" to "open the discount window." This is a non-starter, right up front. Fannie and Freddie need longer-term - years in length - money. Repos for 28 or even 90 days don't do them a damn bit of good and in fact destabilize them further as the rate and thus cost of that money makes hedging their portfolio against interest risk extremely difficult. Forget this one.
2. The Fed "decides" to essentially backstop Fannie and Freddie by exchanging what's left of their balance sheet (longer-term bonds and notes) with GSE paper. Down this road lies the immediate implosion of the Treasury market. If they attempt this the dollar will instantaneously implode as The Fed will have converted the "backing" of our currency to houses declining in value while people's jobs and thus incomes necessary to pay the mortgages on same are being lost! If Bernanke is stupid enough to do this (and note that from Friday's Ticker, Ben said he will do whatever he wants unless Congress explicitly passes a law to stop him) you are very likely to need steel and lead, not gold or dollars, as this would almost certainly provoke an immediate currency and treasury market crisis.
3. The Federal Government steps in and decides to "formally" guarantee Fannie and Freddie's debt. This is an unmitigated disaster as it does nothing about the risk management policies and procedures in these firms. In fact, The Senate has just passed a bill that will increase, rather than decrease, the risk on Fannie and Freddie's book via their funding of the "mortgage bailout bill." The threat of this possibility is why, on Friday, the risk of default on US Government Debt doubled! In my years in the market I have never seen this kind of bond market dislocation - the spread moved from 9 to 20 basis points in one day. Further, the 10 year bond moved 15 basis points higher on yield on a day when people were scared to death and should have been demanding Treasuries, not selling them. "Risk free" was partially removed from the description of Treasuries and if this path is taken much more damage will accrue to US Government debt. ALL debt costs will rocket higher if this happens as everything is referenced, with a spread, off US Treasuries.
4. The government could attempt to prop them up without actually formally assuming control, by, for instance, forcing them to issue preferred stock which the government then buys. This would also impact treasury funding costs but not as severely as (1-3) above, and it also likely does little or nothing to stop the problem, because deleveraging to reasonable levels (e.g. 10:1) would require a literal $500 billion worth of capital! It would also destroy equity holders (stockholders) of their shares immediately by diluting them to an insane degree.
5. The government can decide to do nothing. If Fannie and Freddie are unable to fund, they go under. Period. This would produce a monstrous dislocation in the housing market, but it would not cut off all mortgages. It would, however, have a fairly dramatic impact on funding costs, probably adding 300 basis points to the cost of a mortgage - in other words, 30 year money would immediately go to about 9%. However, other forms of credit would be largely unaffected, including and most importantly, US Government debt.
6. OFHEO could step in and declare Fannie and Freddie "severely undercapitalized" and put them into "conservatorship." The next obvious step would be to place them into runoff, where they slowly divest their bond portfolio as it matures over the next 30 years. This would have the same impact on mortgage money as (5) above, but current bondholders would see different amounts of damage depending on exactly where they are in the capital structure and what and when they bought. Those who bought "trash paper" backed by what amount to no-doc loans would get creamed, while those who bought paper backed by 80/20 loans would likely lose nothing.

The only sane path forward, folks, is option #6.

Here's why.

#1 through #4 simply transfer the risk of loss, all of which was taken by Fannie and Freddie as private companies, to the taxpayer, in either whole or part. It potentially doubles the Federal Public Debt from $5 trillion to $10 trillion (there is another $4 trillion in Federal Debt that is "not publicly held".) Depending on which path and what combination of "pieces" are done, the impact would change, but none of this actually addresses the issue, which is that the credit book is too-highly leveraged and needs to be cut back.

#5 is a bad choice as well. Doing nothing will lead to these firms destruction. They are incapable of publicly offering equity at these stock prices and with this volatility - nobody in their right mind is going to buy, and the amount of equity they need is insane. Trying to raise $500 billion is simply not going to happen, but its what needs to happen in order to restore their leverage ratios to sane levels (e.g. 10:1)

So this leaves one with #6, conservatorship and forced runoff.

Where does that leave us as an economy?

1. A return to sound mortgage standards. 30 year fixed money on an 80/20 basis (you put up 20% of actual cash as a down payment) will likely blow out by 100-200 basis points from where it is now - that is, 1-2% higher. 8% rates with 20% down will become the norm, with somewhat-lower rates, say, 7%ish, for those who are very well capitalized and can prove it.
2. Low-doc, higher ratio loans will remain available but they will be extremely expensive, as they should be.
3. House prices will contract immediately to where the average American will be able to afford the average house in a given area under a 30/fixed, 80/20 loan at 8%. For many parts of this country this means a further huge decrease in home "values" - back to actual historical norms of 2.5-3x incomes.
4. The people who bought those Fannie and Freddie bonds thinking they were "risk free", while getting a premium over Treasuries, will take some losses. We cannot allow those losses not to be suffered, as that will, in effect, have allowed $50 billion per year to have been siphoned off by the buyers of these bonds, or nearly a half-trillion dollars over the last decade!

By the way, rumor is that Treasury is going to try to step in for $15 billion of preferred stock and access to the discount window. The latter means nothing and the former is like trying to take a leak on a forest fire to put it out - at best it buys them a small cushion against losses for a quarter or two.

The market already gave you its opinion of any such "recapitalization" on the back of The American taxpayer. Default swap spreads on GOVERNMENT debt doubled Friday. That has never happened before. Clearly there is a LOT of nervousness about the impact on the fiscal stability of The United States (as a whole!) should this attempt be made.

Now let's talk about IndyMac. You have to have been in a cave not to know that they were seized yesterday.

The good news is that the FDIC covers you up to $100,000.

The bad news is that the FDIC took a huge charge on this one, somewhere between 10-20% of their total balance sheet - they think. Unfortunately the damage will only stop there if people don't show up Monday to take all their money out, and if it does not spread to the other similarly-situated banks that also wrote scads of Option ARMs in California.

Both of these beliefs are, if the public has one lick of sense, the sort of magical thinking we should not tolerate from lawmakers and regulators.

Who else is on the list? As I said before, pick any bank with substantial real estate exposure in California and/or Florida that offered Option ARMs - that is, negative amortization loans.

Most of them are already near zero in their stock prices; here's a partial (very partial!) list - Downey, First Federal, Wachovia and Washington Mutual.

Not all of these are "modest regional" banks. Washington Mutual, in particular, is one institution that I highlighted last spring when their 10Q showed they were effectively paying dividends out of capitalized interest (that is, money they hadn't received yet as it was "increase" in loan value on Option ARMs.) I predicted then that this would end badly for them.

OTS was out complaining about Chuck Schumer "causing" IMB to fail by inciting a bank run.

OTS, you're wrong - you are the reason that IMB failed, and you, Congress, The Fed and OCC are the reason that all other institutions similarly situated are likely to fail as well!

OTS and OCC (not to mention The Fed or Congress) could have stepped in last spring when that 10Q from WaMu was released and started going through all of these banks, hitting every one of them with enforcement orders demanding that they stop that crap and divest themselves of that paper immediately.

They did not.

In fact, Wachovia didn't stop offering PayOption Mortgages (albeit "fixed rate" ones) until just a week or so ago, and Downey announced they were going to stop doing so just this last week!

So OTS, I think you need to shut up. While Mr. Schumer and I could probably count the things we agree on using the fingers of one hand, the fact remains that in this he was absolutely right, and you were absolutely wrong.

Your job is to guarantee the safety and soundness of our thrifts. That means paying attention to what they're doing and the embedded risk of loss and default in each of those scenarios and programs. You seem to think this is some sort of game, where you can simply "hope and pray", while fostering whatever sort of bubble economy the banks wish to dream up, and it will all be ok.

That of course is pure nonsense.

As for The Fed, OTS and OCC generally, you put the banks into an impaired capital position in the first place by allowing them to play games with sweeps and such, thereby destroying the usual 10% reserve requirements. This degradation of reserves means that much smaller problems destroy the bank than would otherwise be the case.

This too is intentional; The Fed could have hiked reserve requirements going into this mess and in fact could have done so when the property markets started to overheat. It did not and you did not raise any warnings about this, nor have you been out there pounding the drum for raising more capital and taking down leverage.

I have no sympathy - at all - for your position at this time. Zero. This is a crisis of your own manufacture and you deserve what you get.

CNN is reporting that there are ninety other banks on the "troubled" list. Yoo hoo - do 'ya think the $50 billion the FDIC has will be enough?

That's what I think too.

Again, to Americans, I say:

* If you have more than $100,000 in a bank, get under the FDIC limits immediately. Like Monday. How many times do you need to hear this before you figure it out? While nearly $200 million was cleared out of IMB before it blew up the fact remains that nearly a billion dollars of uninsured deposits remained, and those people are very likely to lose at least some of their money, perhaps as much as half.
* Consider getting all your liquid cash over immediate expenses into Treasury Direct and buying T-bills with it. If the government goes down you will need steel, lead and brass, not money.
* Get away from a reliance on debt. Immediately, if not sooner. You simply cannot afford to be in debt in this environment. Period. The odds are very high that any callable line will be called as stress continues to increase, or interest rates, if adjustable, will be ramped significantly.

Look folks, OTS and OCC are not doing their jobs and haven't been since 2003 when the housing bubble began. IndyMac bank was spun off by Countrywide to take paper that they couldn't sell to Fannie and Freddie!

This very same bank has been offering way-above-market CDs in an attempt to attract deposits. How were they intend to pay the coupon on those CDs? Isn't this like doubling down every time you lose at Blackjack? Do you know what the Pit Boss in Vegas calls someone who does that? BROKE. Again - the regulators saw all this as it was advertised - where were they and why didn't they stop it?

The Fed has sat on its hands as well through all of this, and in fact instead of forcing people to deleverage they have made more liquidity available since August, just like, as I've noted, giving heroin to an addict instead of forcing him or her to detox and suffer withdrawals.

Finally, Congress has refused to step in. In fact, their latest "Housing Bill", which The Senate passed last night and which a whole bunch of Senators didn't even have the gonads to vote on, attempts to continue the party for the drug addicts by further increasing the leverage in the FHA and pouring yet more liquidity - dope - into the addicts veins!

Unfortunately at this point the addict is about to suffer heart failure and can't survive another hit. In fact, he may not survive the hits he's already taken!

How much more of a warning do you need folks?

I have been saying that the clock is about to expire for over a year.

The alarm just rung.

Wake up.

Every American who reads this needs to understand that you must choose now whether you are going to sit idly by while Congress and the regulatory agencies put their fingers in their ears and allow the blasts to continue to occur at ever-increasing rates and sizes, including those that engulf and destroy you financially, or whether you are going to, right now, get every one of your neighbors and friends together and organize to shut down your local city and/or Washington DC in peaceful protest until Congress, OCC, OTS and The Fed cut this crap out.

Believe me folks, the French know how to do this. Spontaneously, 5,000 people will appear and literally block the streets, effectively closing them until their complaints are heard.

We as Americans either act now or you are giving consent.

Do you need a bigger warning than the possible implosion of the mortgage agencies that hold more than half of all outstanding mortgages today? Does not the failure of a large regional bank in California - the second largest failure in FDIC history - wake you up?

If not, you're beyond hope.

If so, its time to act.

NOW.