Wall Street History

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Wall Street History

09/20/2013

A Look Back

Note: I thought we’d take a look at the financial crisis, five years ago, through the use of my “Week in Review” archives. It’s as good a history as any of that immediate period and provides some context on what we were thinking at that time.  You also get to see some hits and misses on my part. Enjoy.

What a year….extreme market volatility, a housing bust, $140 oil, federal bailouts of well-known financial institutions and a crazy presidential election. It kind of makes you wonder if, prior to Americans going to the voting booth, we’ll have an October surprise. 

As noted in a Sunday Times Magazine piece by Dexter Filkins, “Since 2004, six major terrorist plots against Europe or the United States – including the successful suicide attacks in London that killed 52 people in July 2005 – have been traced back to Pakistan’s tribal areas, according to Bruce Hoffman, a professor of security studies at Georgetown University. Hoffman says he fears that Al Qaeda could be preparing a major attack before the American presidential election. ‘I’m convinced they are planning something.’”  

Of course we pray this doesn’t come to pass, but particularly during the next two months caution should be the watchword, particularly if you’re thinking of ‘buying the dips’ in the stock market. It’s not a time to be a hero. 

This past week started out being all about Fannie Mae and Freddie Mac, and by week’s end the story was Lehman Brothers and the eventual disposition of the investment bank. Regarding Lehman, as I go to post the only thing that is certain is the Treasury Dept. is working with prospective buyers to see if a rescue plan can be worked out, though this time, as opposed to the Bear Stearns bailout in the spring, the government is emphasizing it won’t be contributing its own cash. On Wednesday, in attempting to prevent the demise of the firm, following its inability to raise capital, Lehman preannounced it would lose $3.9 billion in the third quarter, as it marked down the value of complex debt instruments by almost $8 billion. Lehman then tried to slow the collapse of its shares by announcing it would spin off commercial real estate assets it pegged as being worth $25-$30 billion, but investors were unimpressed, including the Korea Development Bank, which at one time had been rumored to be an acquirer before coming to its senses. 

As for Fannie and Freddie, I have to admit I was overwhelmed in how best to tackle this one. For today, this is my best shot. 

On Sunday, Treasury Secretary Henry Paulson announced the U.S. government was seizing control of the two mortgage behemoths that not only account for over $5 trillion of a $12 trillion mortgage market, but recently, due to the credit crunch, have comprised 70% of all new mortgage originations. Fannie and Freddie have had combined losses of nearly $15 billion the past four quarters due to surging defaults on the pools of mortgages they either own or guarantee. For example, 47% of Fannie’s losses and 65% of Freddie’s have come from mortgage defaults in just four states; California, Nevada, Florida and Arizona. One can easily project the losses will continue to mushroom, particularly when you have 17% of Freddie’s Alt-A (one level above subprime) mortgages where the loan balance is already greater than the home value. 

“Our economy and our markets will not recover until the bulk of this housing correction [ed. crash] is behind us,” said Paulson. “Fannie Mae and Freddie Mac are critical to turning the corner.” 

The Federal Housing Finance Agency has placed the two under a ‘conservatorship,’ replacing the CEOs of both and eliminating their dividends. Under the bailout, Treasury receives $1 billion of senior preferred stock, with warrants representing 80% of the combined companies, and the government will receive annual interest of 10% on its stake. 

While common stockholders weren’t eliminated, they are last in line when it comes to divvying up any future profits (should the operations eventually turn around), while preferred shareholders are second in line for absorbing losses. Having had their dividends stripped out, the preferred issues lost about 90% of their value in days, a huge blow not just to individual investors, but also many small institutions that held the securities as a significant portion of their assets. There was an ‘implied’ guarantee of some kind of protection, after all, these investors thought, seeing as it was more than just ‘common.’ 

Paulson’s plan, importantly, doesn’t address the question of the eventual final status of Fannie and Freddie, punting a decision on this to the next president and Congress. Many congressmen, though, were undoubtedly bummed to learn all of Fannie and Freddie’s lobbying activities were immediately suspended. 

The goal of the intervention, first and foremost, was to restore some semblance of normalcy to the housing market, and while it’s still very early in the game, mortgage rates did indeed fall sharply (from 6.50% to 6.00% for a 30-year fixed) because the government was making it clear that, while common and preferred shareholders were being abandoned, debt holders were safe as there was now an ‘explicit,’ not just ‘implicit,’ guarantee that the federal government will back it. Recall last week I brought up the example of China and its decision, replicated by many other sovereign governments, to drastically scale back their purchases of mortgage-backed paper. 

To placate the foreign buyers critical to keeping interest rates low in this country, as well as large institutions that regularly buy the paper, the U.S. government has agreed to provide capital injections into both Fannie and Freddie of up to $100 billion, on an as needed basis rather than one massive infusion.  

“Fannie Mae and Freddie Mac securities are held by central banks and investors around the world. Investors have purchased securities of these enterprises in part because the ambiguities in their congressional charters created a perception of government backing. Because the U.S. government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE (government sponsored enterprises) debt and mortgage-backed securities. 

“This commitment will ensure that the conserved entities have the ability to fulfill their financial obligations” regardless of whatever losses or writedowns they might suffer from the housing crisis. 

But what happened? How did this all come about? 

Fannie and Freddie were created in 1938 and 1970, respectively, to increase the supply and reduce the cost of mortgage loans. Through the government’s implied backing (having been created by the government, after all), Fannie and Freddie could borrow at a lower cost and they then used this access to buy loans from banks and other lenders, thus allowing the two to make further loans. 

Fannie and Freddie sold stock to raise money, but over time they issued preferred stock that had a higher dividend and greater protection from bankruptcy. It’s this last category, some $36 billion in preferred shares outstanding between the two, that is one of the many controversies because of what investors saw as the implied backing of the government. $20 billion of the $36 billion was sold just since last November. Now those investors have effectively been wiped out, while holders of $15 billion in subordinated debentures, such as PIMCO and Goldman Sachs, were bailed out in full. This sub debt was only about 1% of senior debt outstanding (that which is held by foreign banks, for example), so as the editorial board of the Wall Street Journal argued, why cut the sub debt a break? Thank Henry Paulson, former head of Goldman Sachs, and read between the lines. 

So let’s close the circle, for today at least. The reason why Treasury felt compelled to act this week when there was no immediate, evident crisis in both Fannie and Freddie was twofold. One, advisers from Morgan Stanley that were hired by the Treasury Dept. to scrutinize the books found that Freddie Mac’s capital position was far worse than they were letting on. Their actions may not have been illegal, but they were overstating true value. Fannie was in the same boat but on a lesser scale, however, it was just the right time to take care of both. 

Second, the decision was dictated by the political cycle. To avoid the accusations of partisanship, the Treasury had to act now. Should the final crisis have erupted the last two weeks in October, you can imagine the uproar before the election. 

So what happens now? It remains all about the housing market, as has been the case since I first identified the bubble in this sector and the add-on effects…worldwide. No one can tell you when we’ll hit bottom for certainty (though my guess is early next year), but as to how much the Treasury, and the American taxpayer, have to pony up it is totally dependent on how much further home prices drop and the resultant number of foreclosures. And despite the Fannie and Freddie backstops, even as mortgage rates come down the banks still have to lend and there is little evidence they are prepared to do so. 

But we need to move on. In the case of the world economy, Japan’s GDP fell 3% in the second quarter, owing to slowing global demand, particularly in the U.S., for exporters such as Toyota, while China’s Q2 GDP rose 10.1%. That sounds good, and is, if true, but it’s a comedown from previous figures around 11.5%, and worrisome. China’s industrial production for August also rose, 12.8%; again, good but a sign of a slowdown from the previous pace of 16%+. The real good news on the China front is retail sales soared 23% in August. 

In Europe, the European Commission forecast recessions for Germany, the U.K., and Spain, not that we didn’t already know this, while in Britain’s housing sector, 22% are forecast to be underwater over the coming months and most experts now agree the property market there will stagnate until 2010. 

Here in the U.S., retail sales for August were off a dismal 0.3%, -0.7% ex-autos, but thanks to falling commodities, wholesale prices at the producer level for the month fell 0.9%, helping to confirm my theory of this past spring that inflation is not going to be the issue many felt it would be.  

But I continue to get a kick out of those who believe the Christmas shopping season isn’t going to be that bad. We’ve had 8 straight months of job losses, let alone the collapse in housing. Tell me how Christmas is going to be merry? Because gasoline is a little cheaper at the pump than record high levels of just a few months ago? Hardly. 

Speaking of energy, obviously I am posting as Hurricane Ike slams ashore. It’s a disaster, but too soon for me to comment on the damage to our energy infrastructure. 

For its part, OPEC got together this week and said it would honor its old production targets, which it had been cheating on, so, the press played it up as a production cut but it’s really the same final result. Of more import was non-OPEC Russia making waves that it wants to be invited into the cartel, which will never happen because the Saudis want to be kingmakers and not share the role, though nonetheless OPEC’s secretary-general is traveling to Moscow in October to at least catch a concert and pick up a prostitute or two. 

What I’m going to be focusing on the next few weeks is the debate in Congress over an energy compromise bill that would appease both sides; the drillers and the alternative energy folks. If it doesn’t get through, your editor is going to be one unhappy camper. 

Back to real estate, I do just have to note a headline in the New York Times this week: 

“Real estate markets across China join general slump” 

Now this isn’t new, but it gives me an excuse to show new readers just how prescient your editor was. 

“Remember, the bubble isn’t just a U.S. story, it’s global; whether we’re talking Britain, Spain, Australia, or China.” 

It’s nonetheless amazing how many “smart people” failed to see this; like virtually all of Wall Street and its commercial banking brethren. 

Lastly, back to the leading topic of the week, Fannie and Freddie, and next week a resolution of Lehman Brothers, one must assume this current mess we find ourselves in is all about the fact no one knows, still, the value of everything that is on the investment banks’ books. Derivatives did indeed become “weapons of mass destruction,” as Warren Buffett once put it. 

But another problem these days is that despite all the uncertainty, those of us who like to hold cash aren’t being rewarded for doing so, while at the same time credit has dried up, thus inhibiting our best entrepreneurs and their ideas to a great extent. It’s been a long time since anyone talked of the latest “new thing,” for instance. What is it? Where is it? Laughingly, about seven years ago it was thought to be the Segway.  The iPod? You have to be kidding me. 

Of course the next “new thing” is going to come from all the innovation on the alternative energy front, but this requires government cooperation until economies of scale can be achieved. And that, sports fans, requires leadership. McCain or Obama? We’re about to find out. 

--The Dow Jones rallied for the first time in five weeks, up 202 points or 1.8%, but the S&P 500 rose just 0.8% and Nasdaq managed a gain of only 0.2%. But here’s the bottom line. The overall action was totally irrelevant. 

I’ve said for years the U.S. stock market is nothing more than a casino, and as UBS’ Art Cashin has been pointing out with increasing frequency, one or two days a week, at least, the action is totally dominated by program traders, and/or the hedge funds. This isn’t investing. For the average Joe, especially someone without a lengthy time horizon, it’s nothing more than gambling. Folks, our market is a total joke. I’m only in it myself to the extent I believe, long term, in some individual stories. 

And regarding some select stocks, aside from Lehman, Fannie and Freddie, by week’s end it was all about AIG, which traded at $70 last October and closed the week at $12, Washington Mutual (see below) and Merrill Lynch, $78 just last September and now $17. It’s all about real estate and the idiots who decided to structure over the top products to wrap around it. I long predicted the recession for 2008, specifically, though I said as measured by the GDP figures it would be mild, but there is a fine line between recession and depression, and there are times it feels as if we’re uncomfortably close to the latter. 

Rates were essentially unchanged despite some extreme volatility mid-week amid all the uncertainty, and then you had the dollar. Early Thursday, the euro had fallen to $1.38, its lowest level since Sept. 2007, but by the close on Friday, it was back up to $1.42, a huge move as investors couldn’t be too optimistic about the U.S. financial system, at least until participants saw what happened over the weekend and early next week. 

There was also talk of new federal budget deficit projections. Suffice it to say that with plunging tax receipts (at least one would think so…the government certainly isn’t getting anything from me this year), the deficit for F2009 (which begins Sept. 30) will be in the neighborhood of $500 billion, depending on how much Treasury has to cough up for Fannie and Freddie. 

--And speaking of bailouts, I could have easily put the proposed bailout of the U.S. auto industry in my opening remarks, but other events frankly took precedence, at least for now. What is being discussed in Congress, however, is a $50 billion or so loan guarantee program for Ford, GM and Chrysler. Now excuse my French, but what truly sucks about this, even more so than Fannie and Freddie’s bailout, if that is possible, is the fact U.S. automakers already make highly successful cars in Europe…highly fuel efficient ones, to boot.  So while I understand they have massive pension and health benefit issues to take care of, the business itself should be more than viable, yet the Big 3 wants help retooling for a ‘new era’ that is really an old one, by overseas standards. 

[There was some bad news on the car front in Asia, as preliminary data for August shows that sales in China have declined by as much as 10% year over year, not good for the likes of GM, which are counting on continuing strong overseas sales to cushion the depression in the U.S. And as further proof the slump in this industry like almost everything else is global, Spain’s sales for August were off a whopping 41% from year ago levels.] 

9/20/2008

For the week 9/15-9/19

[Posted 7:00 AM ET…Avalon, N.J.]

PANIC

Wall Street 

I’ve been at the Jersey shore this week, but like many of you was glued to CNBC and the historic movements in the financial markets and the application of the heavy hand of government. Thankfully, I rented a house that was 100 yards from the beach and I took solace in my daily walks. Levity was provided by the flocks of sandpipers that humorously run around in packs, or solo, depending on the waves or an approaching figure. They constantly look befuddled, as has been the case with market participants recently, both here and abroad for that matter, as we watched daily price actions that by some measurements had never been seen before. And as I walked the beach part of me also wished George Washington had originally accepted the offer to be king. Suffice it to say our politicians have done little to distinguish themselves during this period, going back years as the great housing bubble sprang forth. 

I have long railed that when it came to foreign policy and our policy regarding Israel and the Palestinians in particular, the United States has not been an honest broker. And today, we have now proven that when it comes to the global financial system, the U.S. has been a dishonest broker. We peddled our garbage all over the world, and seeing as we are supposed to have a monopoly on financial genius, the world ate it up. This week, collectively, the world spit it all out. It was as if the U.S., as is the case in China today, laced its financial instruments with melamine, a chemical used in fertilizer that some Chinese infant formula producers substituted for protein in an attempt to cut costs. Wall Street’s mavens thought they could get away with their skullduggery, and indeed for years many did, but in the end everyone gets caught.

Before I get into some basic explanations, every single one of which has been long covered in these pages, let me tell you what I did with my own finances this week. 

For starters, I made three statements last week that bear repeating. 

“Caution should be the watchword, particularly if you’re thinking of ‘buying the dips’ in the stock market. It’s not a time to be a hero…. 

“I’ve said for years the U.S. stock market is nothing more than a casino, and…the action is totally dominated by program traders, and/or the hedge funds. This isn’t investing. For the average Joe, especially someone without a lengthy time horizon, it’s nothing more than gambling. Folks, our market is a total joke. I’m only in it myself to the extent I believe, long term, in some individual stories…. 

“I long predicted the recession for 2008, specifically, though I said as measured by the GDP figures it would be mild, but there is a fine line between recession and depression, and there are times it feels as if we’re uncomfortably close to the latter.” 

If you didn’t understand that last sentiment when I first wrote it, you do now, and in keeping with all the above this week I did nothing. In fact, as I’ve noted before, I haven’t done anything with the few stocks I own in at least five months, except to round out my China position. For a long spell I have been guided by the late, great Sir John Templeton and his example of buying shares at the height of the Great Depression and then just waiting things out. In my case I can afford to do this because I have a solid cash position and don’t need to do any panicked selling, at least not yet. I also remain satisfied with what I own, as long as the credit crisis eventually resolves itself and I catch a break on the alternative energy front.  Believe me, I take the advice I dish out to the rest of you, and my portfolio of mostly microcaps did surprisingly well the past five days. But enough about yours truly. 

So what happened this week, or rather the past few weeks and months, going back to the collapse and bailout of Bear Stearns in the spring? It’s really incredible how the landscape has changed. No more Bear; Fannie Mae and Freddie Mac, bailed out; 158-year-old Lehman Brothers, gone; 94-year-old Merrill Lynch, no longer independent; the world’s largest insurer, AIG, bailed out. And the fate of stalwarts such as Goldman Sachs and Morgan Stanley, as well as the biggest savings & loan, Washington Mutual, and powerhouse regional Wachovia, at one point or another hung in the balance. 

If you’re new to StocksandNews and this column, just understand that I correctly identified the tech bubble and yelled “Crash” in April 2000. I called the housing bubble, long before 99% of the “experts” did, and, just as importantly beat everyone to the punch in identifying housing as a global problem. I railed about derivatives virtually since the start of this site in Feb. ’99, and on more than 100 occasions, by my best estimate, said “Wall Street is not as smart as you think and these guys don’t understand what they own.” 

So for me it’s always been about lack of transparency, and, through my own extensive Wall Street experience, where I was in positions in the fund industry subject to regulation, the lack of same when it came to many of the Street’s practices. 

It’s been about leverage, massive amounts of it, not just on the part of our financial institutions, but at the individual level as well. It’s also been about accountability, again, both institutionally and individually. 

This week, New York City Mayor Michael Bloomberg slammed the “I want it now society,” adding “We lost the moral compass of saying no to the people who did not have the earnings capacity to support a mortgage.” 

That pretty well sums up the accident that was waiting to happen on the housing front when it came to Mr. and Mrs. Jones, who were offered subprime, Alt-A, and option adjustable-rate mortgages that in so many cases the homeowner didn’t have a clue as to how it would impact their financial future. But when it then came to Wall Street, it was about packaging each and every home in America, including beaver and bear dens it would seem, into some kind of structured product; product that Archie Bunker, were he still alive, would have properly described as “crapola.” But we bought it…and then for this past year or so it’s been a game to see who’s the last one left holding the bag. Despite all the action taken by the federal government this week, when it comes to the likes of the defunct Lehman Brothers, or Morgan Stanley, for that matter, we are far from knowing where all the bodies are buried. And through it all, the regulators and boards of directors were asleep; in the case of the latter gorging themselves on foie gras at the meetings, one can assume, while the CEO had maidens feeding his hand-picked buddies grapes and supplying other tender favors. 

For its part, Washington wasn’t any better, a veritable plethora of buffoons, as best exhibited by those striding before the microphones this past week, including John McCain. It is utterly amazing how a McCain or Joe Biden can reside in such a position of power, for decades, and with access to the best experts in the world, yet emerge from the experience with a brain full of nothing but air when it comes to financial matters. 

It was also amazing that Sen. McCain said the American economy was fundamentally sound. Oh, I know, this is a typical Republican talking point, but in the span of 24 hours on Thursday in particular we learned that not only was the U.S. economy not sound, but the entire financial system was on the verge of total collapse. 

You see, credit – the mother’s milk of economic activity, right down to those new microcredit programs for the poor in India and Africa one man won a Nobel Prize off of – had totally seized up.  Interbank lending, the first step, had ceased to exist and if the banks wouldn’t lend to each other, suffice it to say you and I wouldn’t be able to obtain a car loan, or my favorite microcaps a business loan, or some large corporations the ability to finance their payrolls on an ongoing basis through what were once simple commercial paper transactions. 

And it is those very commercial paper instruments that are the lifeblood of money market funds (that and short-term Treasury and other corporate securities). Suddenly, with all the uncertainty created by a seized up credit market, institutions, first, and then individuals, launched a near run on the bank; those very same, safe money market funds you and I never gave a second thought to when gauging our financial security. It all started when the father of the money market fund himself, Bruce Bent of the $62 billion Reserve Fund, realized, ‘Omigod, we have Lehman paper in our fund!’ and in marking it to zero caused the net asset value to break the cherished buck. FIRE!!!! 

Institutions began to flee a Putnam institutional money market fund that was then forced to close, others were pulling their money from other offerings, fleeing in panic, as money then moved into one and three-month T’bills, with the cascading demand for the safest paper imaginable, at least for the moment, causing yields to approach 0.00%. But at least it was safe. Capital was preserved. [Personally, I was secure in the knowledge I had my ten coffee cans of coins stored in my laundry room should worse come to worse. Plus a gold class ring, proceeds from which I could have purchased some pasta, tuna fish and cheap wine and beer to ride out the coming revolution.] 

Amidst the near stampede, however, came word that Hank Paulson, Goldman Sachs alum and Treasury Secretary, had seen the light and it was now time to save the Free World, and the authoritarian one for that matter, seeing as Russia, China and a bunch of shady Middle Eastern nations hold a ton of our debt, the rapid selling of which would only exacerbate the problem, by offering to bail out everyone from every obligation he or she ever had in their lives. It wasn’t just pure coincidence that Alex Rodriguez and wife Cynthia reached a divorce settlement the same day, you understand. Paulson swooped in to clean up that mess as well. 

OK, strike this last one from the record, and the bit about any obligation us schleps ever had in our lives. What Paulson did do was bail out the banks, first and foremost; offering to take in all their toxic crapola under his great robe, like the Ghost of Christmas Present. ‘Come here, my children, and I’ll shelter you from the storm.’  

Of course under Paulson’s robe already resided the remnants of Bear Stearns, some $29 billion worth, and $85 billion from the just rescued AIG, and perhaps up to $200 billion for bailing Fannie and Freddie. What will be the cost of taking on all the other bad paper, plus insuring the lion’s share of money market funds, yet another of his steps? We’ll learn over the coming weeks… and here I’m invoking my 24-hour rule. Suffice it to say it’s a lot, as in $100s of billions, though the Fed and some experts can legitimately argue the government could make money on many of the rescue projects. Let’s hope so. 

But at least in the short term the bills for the taxpayer are going to be humongous, this on top of a Fiscal 2009 federal budget deficit that Paulson’s own Goldman cronies have estimated to be in the $565 billion range. In fact, the potential add-on cost is truly unfathomable. Let us hope the result of Paulson’s war on the free markets isn’t like that in “The Christmas Carol,” where in our case the Ghost of Christmas Yet to Come shows us a tombstone with a simple inscription… “Here lies Adam Smith, author of ‘The Wealth of Nations,’ model for the American Dream, 1776-2008.” 

For the archives and my running history of our times I need to get down some other thoughts before advancing to Street Bytes. 

What does all of the above have to do with the economy, here and now? If we take out our three-legged stool, the consumer, housing, and capital spending, clearly, even if some form of confidence returns, especially if Wall Street continues to rally and housing bottoms, as I see early next year, the consumer has been dealt a severe body blow and to compound matters corporate America is continuing to retrench, save some tech sectors it would appear (see SAP’s and Oracle’s recent performance), so spending is bound to remain punk. [Lower energy won’t bail us out in this regard.] The house, once a piggy bank, is no longer. The Christmas season will be a disaster and my recession forecast holds. 

And, sports fans, I have not changed my tune one bit regarding the stock market. I have been steadfast we would finish the year down 3 to 5 percent as measured by the major indexes. The market moves on sentiment far more than on fundamentals.
 

--The Federal Reserve actually met this week and opted to keep its target funds rate unchanged, expressing an ongoing concern with inflation even as the economy teeters, a stance that PIMCO’s Bill Gross called “otherworldly,” as in the Fed is clearly on another planet in holding this view. 

--Lehman saw its shares tumble to zero amidst the largest bankruptcy filing in our nation’s history, down from $85 in early ’07. Despite up to 10,000 employees in the capital markets and investment banking divisions being rescued by Barclays, and perhaps more employees out of a total 26,000 by other outfits, the fact is a staggering amount of wealth was wiped out. This, like in the case of Bear Stearns, and massive layoffs in the industry overall, has a ripple effect that is in some respects the true heartbreak…the dry cleaner, the waiter, the driver for the car service, the coffee cart guy.  

It is just incredible that Lehman CEO Richard Fuld couldn’t see the coming train wreck and, having had six months since the collapse of Bear Stearns to address his firm’s problems, did nothing. But it’s no surprise the Lehman board did an equally poor job. 

--Merrill Lynch, with 60,000 employees, was rescued by Bank of America in a deal initially valued at about $29 for Merrill shares, stock that was once $98 in ’07. Many layoffs on both sides are a certainty here. 

--In Britain, HBOS, the largest savings & loan in the country, was forced into Lloyds TSB’s arms owing to its massive mortgage exposure. 40,000 layoffs could be the result here. 

--AIG, with a presence in 130 countries, and counterparty risks in same, and with 80% of its life insurance and retirement program premiums from overseas sources, was given an $85 billion “bridge loan” by the federal government in exchange for what seems to be a good deal for the Treasury, 8% plus interest (currently about 11% as based on LIBOR), plus 80% ownership in what eventually remains of the company. 

--Housing starts for August were at their lowest level in 17 years and with 4.7 million unsold homes still on the market, the inventory level has to fall considerably before homes are affordable again. 

--Short-selling was banned in Britain until January, while in the U.S., the SEC banned it in 800 financials until Oct. 2 in an attempt to stem bear raids on the likes of Morgan Stanley and Goldman. As the veteran Jack Bogle put it Friday morning, the attempt to rein in the shorts “borders on insanity.” Far more on this next time as the rules are still evolving, which is a big part of the problem. 

--There is a ton of revisionist history going on with regards to Hank Paulson, as I will address in my next “Wall Street History” column to be posted Tuesday. For now, understand your Fed and the Treasury, once seen as a lender of last resort, is now an investor of last resort. 

--China holds $376 billion in Fannie and Freddie debt, Japan, $228 billion, in case you were wondering the real reason why those two agencies were bailed out….admittedly, a slight exaggeration, but not that much of one. 

--State and local economies will continue to see their tax revenues dry up. And as one London trader put it, when it comes to high-rollers, “The bling is gone.” 

--And two editorial opinions, for the archives and the record.
 

“To those who would like to see more punishment and less help meted out by Washington, we say: Be careful what you wish for. 

“Executives who won fat bonuses by behaving in colossally stupid ways, investing in junk mortgages and willfully ignoring risks, deserve neither help nor sympathy. But that is not the point. 

“Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson are not in charge of law enforcement, ideological purity or consistency. Nor should they pass judgment on the few in ways that could harm the many. Their job is to prevent a dramatic drop in lending, which would threaten the entire economy.”

“Perhaps Secretary Hank Paulson was right that AIG had to be rescued to avoid a broader financial collapse. We aren’t privy to what he and the New York Fed were hearing about AIG’s credit default swaps or its insurance ‘wraps’ for the commercial paper market; maybe unraveling those would have smashed the corporate debt market or caused a run on money-market accounts. So maybe he had no choice but to rescue the part of AIG that was a hedge fund wrapped around the world’s largest insurer…. 

“The danger is that we will get these financial melodramas every week, if not more frequently. Each one only frightens the public more and extends the panic. The two surviving big investment banks, Morgan Stanley and Goldman, continue to operate with enormous leverage yet profess to have enough capital to survive. That’s also what Lehman and AIG thought. Markets are also punishing Washington Mutual, the big savings bank, and Wachovia, the regional bank, with others to follow if housing prices keep falling. 

“Sooner rather than later, the Fed is going to run out of money to pull off these government takeovers. Its balance sheet was designed to finance open-market operations, plus serve as the occasional lender of last resort for regulated banks.  Its assets have long been mainly Treasuries or currency. 

“Since last December, however, the Fed has made creative use of its discount window with the result that its balance sheet looks uglier all the time. The Fed has guaranteed $29 billion in dodgy Bear Stearns paper, opened its window to ever more colorful collateral, and as of Monday even agreed to accept equity. With its AIG stake, the Fed now owns an insurance company. By our calculations, the Fed has committed some $380 billion of its $888 billion in assets to these mortgage rescue operations. That’s nearly half. And yesterday the Treasury announced it will issue new debt to lend to the Fed, not merely to fund government operations. 

“These are all taxpayer obligations, and as such they pull the Fed ever more deeply into political decisions that compromise its independence. The Fed has been pushed into that situation because Treasury lacks the legal authority for such takeovers (except in the case of Fannie Mae and Freddie Mac)…. 

“We’re told Treasury has a proposal ready to send to Congress [ed. Friday’s announcement], but that the Members have told Mr. Paulson they don’t want to see it until after Election Day. Mr. Paulson fears that if he does call for action and Congress refuses, then the contagion would be even worse. Well, how much worse can it get than a failure or two a week of a major financial institution? The sooner a resolution agency is up and running, the fewer banks will fail and the lower the ultimate cost to the taxpayer. 

“Mr. Paulson ought to tell Congress that this authority is essential to stopping a panic, and that the need is urgent. If Harry Reid and Nancy Pelosi say they can’t do it until December or later, then they can take responsibility for the nationalizations to come.” 

And so Congress is now working this weekend to prevent this from happening.

*Before I continue, I recognize there are some issues I didn’t totally address above, such as short-selling. I’ll expound further next time as we glean more details about the various plans in play, including any debate in Congress, as well as any further changes in the rules, which can be expected. And with the proposed bailout of the banks and their mortgage portfolios, now there is some question as to the finality of the AIG rescue plan and Merrill’s takeover by Bank of America. We’re just getting started, in other words. 

--Monday’s 504-point drop in the Dow Jones was the largest since 9/11, but we then had rallies of 142, 410 and 368 points in the average, sandwiched around Wednesday’s sickening 449- point slide. When it was all over, the Dow was off just 0.3% to 11388, while the S&P 500 gained 0.3% and Nasdaq 0.6%. If you only looked at the final box score, you never would have known the real tone of the game. For example, the S&P’s two-day gain of 8%, Thursday and Friday, was its best performance since the aftermath of the 1987 crash. Meanwhile, the global rally over the same two days was the sharpest in 38 years as many markets on Friday registered their best point gains ever. 

But in the case of the action against the shorts, the covering of whose positions created much of Friday’s advance, there was one universal cry as a finger was raised to Hank Paulson. “You’ve changed the rules in the middle of the game!”

Again, if you only looked at the final above yields vs. a week earlier, you never would have known the full story, like the virtually zero percent T’ bills at one point. On the week, Treasuries hardly moved except on the very short end. 

The interbank lending rate this week exploded from the Fed’s target of 2% to 8%, and even then no bank wanted to loan to another when they didn’t know what the other side had hidden on its books. [Would they get their money back? Lehman’s London office says it’s owed $8 billion by its own now bankrupt parent, for example.]

9/27/2008

For the week 9/22-9/26

I was golfing with three friends who work in the financial industry this week and we were talking about the mess Wall Street and Main Street find themselves in when Jude said “We really need a revolution…the system is old. Just freshen it up a bit.” It’s a sentiment I would guess almost every single one of you has had, joking at a cocktail party, the golf course, or in the line at the grocery store in small talk about this or that, but if you watched Washington in action this past week the thought of a big shake up certainly would have crossed your mind more than once. There are virtually zero honest politicians and the system has been long corrupted. Then you have Wall Street, also corrupt, with financial markets that often are little more than a casino. Yet, despite all this we still have the best, most dynamic market economy in the world and somehow we’ll get through this period…really. 

This week our leaders, including of the unelected variety, strode forth to scare the hell out of us. Federal Reserve Chairman Ben Bernanke said our nation faces “grave threats” to our financial stability. President Bush spoke of the “serious financial crisis” and how we risked a “long and painful recession,” adding we could see a true “financial panic.” In a joint statement early in the week, presidential candidates Barack Obama and John McCain spoke of the need to prevent “an economic catastrophe.” 

Investor Warren Buffett, perhaps the most respected figure in America today, said “We can’t take another week like the last one,” meaning two weeks ago, though in the end this past week was just as bad. Bernanke said, “Economic activity appears to have decelerated broadly.”  

That’s what happens when the credit spigot is turned off. Every business in America is already being impacted. In a highly-publicized item, even the best corporation in the world, McDonald’s, told its franchisees that Bank of America, savior of Merrill Lynch, declined to extend credit so the franchisees were on their own in terms of obtaining financing for store improvements. Of course it trickles on down from there. The system is frozen, and confidence on both the part of corporations and individuals has dried up. 

In Newsweek, Treasury Secretary Paulson said “We can spend a lot of time talking about how it happened and how we got here. But we have to get through the night first.” Then in congressional testimony, Paulson added this whole episode is “embarrassing for the United States of America,” echoing my favorite statement from years ago; the securities that helped cause the crisis “are overly complicated and complex” and the firms peddling them “didn’t understand (what they had created) themselves.” 

Ah yes, Hank Paulson. King Henry I. Through his bailout/rescue plan he is asking for a ton of power and a lot of us aren’t comfortable with this. But there is no time to debate this particular topic. We need action. 

I come at this job from a unique perspective because of my Wall Street background and at times like these, in my own small way, I’d like to think I can bridge Main and Wall.  

There is no doubt Wall Street is deserving of the opprobrium being cast on it. Many of its leaders should be strung up in the public square and it’s the hope here that those guilty of outright fraud receive life in prison, not 6-12 months in Club Fed. 

But when it comes to Paulson’s rescue plan, yes, the details of the proposal are vague at best. And, should the plan go through in its basic form, there are zero guarantees that once the bad paper is stripped out of the banks and put into the marketplace, the lending institutions will in turn go back to lending. 

What, though, is the alternative? As Bernanke and Paulson have said on countless occasions, you don’t want to know. 

So, friends, this is about you and me. Wall Street played no small role in getting us into this mess, but at the same time many of us didn’t fulfill our own end of the bargain in living well beyond our means. One point that hasn’t been made enough in the debate over the crisis is ‘personal responsibility.’ Personal responsibility is not just a key to democracy, it’s a key to capitalism, and many of us failed the test. Those of us who feel we did everything right, including corporations and financial institutions who did act responsibly, and there are many, have a right to be frustrated, and angry, but that doesn’t solve the problem of today. Access to credit. 

Many times in life you have to take a leap of faith. This is one such moment.  Let’s pray not only that Congress gets its act together soon, but that our admittedly waning faith in King Henry and our system in general is warranted. Otherwise we’re headed towards that revolution, only this time it won’t be a joking matter. 

Some outside commentary for the record.
 

“The leveraging-up in this cycle is reversing, and we are now deleveraging. When a huge system – that is, the global credit system dominated by the investment bank giants that have been the major creators of credit in the last cycle – turns down, the fallout is going to be terrible. 

“Deleveraging is a very painful process, and will run longer and deeper than anybody can imagine. I’ve been fearful of this. 

“So far, what we’re seeing is the pain in the financial system. Later on, we’ll see the echo effect of the pain in the real economy. I can’t understand economists talking about no recession or mild recession. This is the worst financial crisis since the 1930s. It’s different than the 30’s, but is the worst since then, and the consequences will be very, very painful for virtually everybody in our economies.” 

Brazilian President Luiz Lula da Silva: “We must not allow the burden of the boundless greed of a few to be shouldered by all.” 

U.N. Secretary General Ban Ki-moon: “The global financial crisis endangers all our work. We need a new understanding on business ethics and governance, with more compassion and less uncritical faith in the ‘magic’ of markets.” 

Mark Malloch Brown, British cabinet minister: “What you are seeing here is the letting off of some political steam. They are all remembering the very hard, unforgiving advice that they got from American financial institutions” to “deflate your economy, let your banks go to the wall. There is a resentment at what they would see as a further evidence of double standards.” 

German Finance Minister Peer Steinbruck: “The U.S. will lose its status as the superpower of the world financial system” with the emergence of stronger, better-capitalized centers in Asia and Europe. “The world will never be the same again.” Steinbruck emphasized it was “irresponsible” for the U.S. government to oppose stricter regulation even after the subprime crisis broke out. 

“The dangers, as Bernanke and Paulson see them, are in the liabilities. Who knows where they might lead? They include AIG’s obligations to pay off credit-default swaps – private contracts in which AIG promised to support billions of dollars of bonds if their issuers defaulted. These were developed to comfort speculators and make them believe they were investing. 

“It was a delusion: At the worst, credit-default swaps on Lehman Brothers Holdings still were quoted at about 5% of the face value of the bonds being protected less than five days before the firm went under. It was like selling flood insurance on Galveston Island, while Hurricane Ike was in the Gulf of Mexico. 

“Credit-default swaps created a nation of speculators who don’t want to take their losses. The financial establishment has been afraid to start unwinding these swaps. They know that when you pull on a loose bit of yarn dangling from a sweater, you never know how much sweater you will have left at the end. So the government is buying the sweater. As President Bush declared in the Rose Garden Friday, ‘These are risks America cannot afford to take.’ Too bad. The risks have already been taken. Now: Can America afford to cover its bets?.... 

“Listen carefully to the cries of ‘chaos’ on Wall Street: Some of those shouting loudest are trying to make others pay for bankers’ and borrowers’ mistakes. Finding no others willing to step up, the Fed and Treasury are becoming the nation’s stand-in speculators. 

“The Treasury will borrow to buy mortgages and the Fed will print money to buy Treasuries. The danger is that they are igniting a great inflation to stave off a great depression. If so, this week will enshrine President Bush with President Carter, and Ben Bernanke with G. William Miller. 

“Just as the Weimar Republic printed money to pay war reparations that the Germans couldn’t afford, the United States of America is putting its full faith and credit – until neither remains – behind mortgages that its citizens can’t afford. All investors can do is hope that the ultimate sacrifice of capital destruction won’t be necessary."

“Nobody understands who owes what to whom – or whether they have the ability to pay. Counterparties have become afraid to trade with each other. Sovereign wealth funds are no longer willing to supply badly needed capital because they no longer know what they are investing in. The crisis continues because nobody knows what anything is worth. You simply cannot have a functioning market under such circumstances. 

“Will this latest round of proposals end the crisis? I know the stock market reacted joyously on Friday [9/19], but I’m not hopeful. One solution being promoted by the Securities and Exchange Commission – to make life more difficult for short sellers – is a shameful sideshow. A second solution, which Mr. Paulson announced Friday morning, requires money market funds to create an insurance pool to cover themselves against losses. 

“That may provide comfort to investors who equate money funds with savings accounts, but it is fraught with moral hazard.” 

Anuj Gangahar / Financial Times 

“It is no easy task to deal with a crisis that, in spite of its similarities to previous ‘financial gales’ is unprecedented because of the complexities of today’s capital markets. We must hope for all our sakes the U.S. government’s solution works and that it is not too late. It was the economist John Kenneth Galbraith who said: ‘One can relish the varied idiocy of human action during a panic to the full, for, while it is a time of great tragedy, nothing is being lost but money.’ Unfortunately, it is not just money, but the lives and hopes of ordinary people that are increasingly likely to be damaged after this week.” 

Anatole Kaletsky / London Times 

“The Emperor has no clothes. If you want to know why American capitalism is on the brink of disaster, but also want to understand what will save it, then log on to the C-Span congressional website and watch the interrogations of Henry Paulson, the U.S. Treasury Secretary, by the Senate and House banking committees. 

“Until last week, I was in a minority of one in arguing that Mr. Paulson was personally responsible for suddenly turning the painful but manageable credit crunch that had been grinding away 18 months in the background of the U.S. economy into a global catastrophe. Mr. Paulson’s appearances on Capitol Hill, marked by the characteristic Bush-era combination of arrogance and incompetence, are turning my once-outlandish view into conventional wisdom: Henry Paulson is to finance what Donald Rumsfeld was to military strategy, Dick Cheney to geopolitics and Michael Chertoff to flood defense. 

“Mr. Paulson may be a former chairman of Goldman Sachs, but as U.S. Treasury Secretary he does not know what he is doing. His recent blunders, starting with the ‘rescue’ of Fannie Mae, have triggered unintended consequences around the world, resulting in the death-spiral of financial values. But last Friday Mr. Paulson outdid even these Rumsfeldian achievements, when he demanded $700 billion from Congress for a ‘comprehensive and fundamental’ solution to the global financial crisis, without apparently having any idea of what he would actually do.” 

Meanwhile, the FBI announced it has been investigating AIG since last March for hiding losses (flat out fraud in manipulating earnings), while it is now looking into the activities of executives at Fannie, Freddie, Lehman and a host of others. 

Eric D. Hovde / Washington Post 

“What is even more remarkable is that (while) firms such as Goldman Sachs and Lehman not only made billions of dollars packaging and selling toxic loans, they also wagered with their own capital that the values of these investments would decline, further raising their profits. If any other industries engaged in such knowingly unscrupulous activities, there would be an immediate federal investigation. 

“Why is Washington so complicit in this intricate and lucrative affair? First, the Fed laid the groundwork for both these asset bubbles by lowering interest rates to historic lows. In an attempt to protect his legacy after the Internet-bubble collapse, Greenspan provided unprecedented stimulus to re-inflate the economy and maintain his popularity with Wall Street. (Remember the ‘Greenspan put’?) But in doing so, he spawned the largest debt and asset bubble in U.S. history. 

“At the same time, federal regulatory agencies such as the SEC stood idly by as Wall Street took advantage of the investment public during both the Internet and the housing bubbles. The SEC took almost no action against Wall Street after the dot-com implosion. And in the midst of the housing bubble, in 2006, only the Office of the Comptroller of the Currency pushed for any level of regulation to address subprime lending. 

“One has to wonder why Treasury secretaries under Presidents Clinton and Bush – Robert Rubin and Hank Paulson, respectively – took no action to curb these abuses. It certainly was not because they did not understand Wall Street’s practices – both are former chief executives of Goldman Sachs. And why has Congress been so silent? The Wall Street investment banking firms, their executives, their families and their political action committees contribute more to U.S. Senate and House campaigns than any other industry in America. By sprinkling some of its massive gains into the pockets of our elected officials, Wall Street protected itself from any tough government enforcement…. 

“Wall Street’s actions are now profoundly hurting American families, communities and the entire U.S. financial system. People are being thrown out of their homes. Once seemingly indestructible financial entities are succumbing to the crisis they have created and have jeopardized the stability of the global financial system. Isn’t it ironic that the same firms that preached free-market capitalism are now the ones begging for a taxpayer bailout?” 

Lastly, regardless of how successful any rescue plan proves to be, the federal budget deficit, and thus the national debt, is obviously going to soar. Commentator George Will summarizes one aspect of this problem. 

“This crisis has arrived during the ninth month of a vast demographic deluge – the retirement of 78 million baby boomers. As the population ages, the welfare state – primarily, a transfer-payments pump providing pensions and medical care for the elderly – requires more rapid economic growth to generate increasing revenue. To the extent that today’s crisis results in large amounts of capital being allocated by considerations other than those of economic efficiency, the nation will be consigned to less-than-optimal economic growth. 

“The next administration, but especially an Obama administration, will chafe under severely narrowed economic restrictions. But subsequent generations will pay the radiating costs of the rising role of the state in allocating financial resources.” [Washington Post] 

--The Dow Jones fell 2.2% to 11143, while the S&P 500 lost 3.3% and Nasdaq declined 4% to 2183, the latter’s lowest weekly close in over two years.   Aside from all the uncertainty, General Electric didn’t help matters when it slashed guidance for the third quarter and the full year owing both to the global slowdown as well as a reassessment of prospects at its financing arm, GE Capital.   And BlackBerry maker Research In Motion warned on its prospects, sending the stock down a whopping $26.50, or 27%. 

The short end of the curve continued to convulse on every rumor of another bank failure or other sign of financial instability. There was also some straightforward economic news and it wasn’t good, with existing home sales plummeting further, and durable goods (big ticket items) tumbling 4.5% for August. The weekly jobless claims number was also atrocious and didn’t augur well for the next monthly payroll report. Finally, 2nd quarter GDP was revised for a final time and it slipped to 2.8%. 

--The 6th-largest bank in America, Washington Mutual, became the biggest bank failure in U.S. history, though in this case no taxpayer dollars were expended. Instead, JPMorgan Chase acquired the deposits, judged to be in the $180 billion neighborhood (as of June 30, though depositors were beginning to walk with their cash the past month in particular), for all of $1.9 billion, while acquiring a loan portfolio of some $300 billion, of which it will immediately write off $31 billion. Bottom line, a total steal for JPM.  [WaMu stock and bondholders were wiped out.]

And Goldman Sachs received a shot in the arm from Warren Buffett, $5 billion in the form of a perpetual preferred, at 10%, plus the right to buy another $5 billion in Goldman stock at a future date, priced at $115. [Goldman finished the week at $137.] 

--Goldman Sachs, Morgan Stanley, and Raymond James are all transforming themselves into bank holding companies, subjecting each to greater federal regulation, significantly reduced leverage, and, particularly in the case of the first two, the end of an era on Wall Street as Goldman and Morgan sought to avoid the fate of Lehman Brothers. 

[Morgan Stanley then received an investment of between 10 and 20 percent from Japan’s Mitsubishi UFJ, details of which are sketchy, while Goldman got the infusion from Buffett.] 

--Barclays Plc, the U.K. bank that bought parts of Lehman Brothers, initially talked of retaining 10,000 employees from Lehman’s trading and investment banking business, but now there is word they may still cut up to 5,000. 

--Ireland and New Zealand are officially in recession as denoted by two consecutive quarters of negative growth, while growth estimates for the U.S., Japan, and Europe in 2009 are all between 1.0 and 1.5 percent, far from good. [And not boding well for corporate earnings.] 

--Energy: Monday saw the biggest jump in history for crude oil, up $16 to $120, but the move had to do with a short squeeze, brought on by the SEC rules on same, as well as the normal volatility associated with a contract expiration. The next day it traded back down. 

--Remember the ban on short-selling? You remember, it was a big deal a week ago? There was virtually zero talk on the topic this week, even as the SEC stepped up an investigation into hedge funds and possible manipulation involving the financials, while the SEC also continued to change the rules of the game, including allowing short selling for those involved in hedging activities, as well as changing some of the disclosure requirements. 

Short seller James Chanos, in an op-ed for the Wall Street Journal. 

“I believe the SEC has every right to obtain and review information about short positions for market surveillance purposes, but forcing public disclosure will have serious consequences for the market. Companies may retaliate against short sellers. Fund managers will lose their ability to manage assets without revealing their strategy. Other traders will ‘pile on,’ and may trigger panicky selling if an investor sees that noted short sellers have shorted the stock…. 

“Economists have long believed that market prices are best set by a variety of viewpoints, including by those with no previous ownership interest. In the financial markets, that latter group is the short sellers. As a former SEC chief economist aptly observed, ‘To ban short selling is to in effect say that the government is going to try to determine what stock prices should be.’ 

“For our investors and our country to emerge with strength from these extraordinarily difficult times, it is imperative that our regulatory bodies respond in a way that appropriately balances vigilant protection of investors with open, vigorous competition. Closing down short sellers will not work to help the U.S. maintain the freest, strongest and most liquid capital markets in the world.” 

--Panic amidst the hedge fund crowd after the collapse of Lehman Brothers led to massive movements of cash from the prime brokerages through which the funds conduct business. The Financial Times reports that Morgan Stanley “lost close to a third of the assets…amounting to hundreds of billions of dollars, as hedge funds…moved to rival banks.” Once markets stabilize, the money could return. 

The hedgies moved their funds to commercial banks, perceived to be safer, a situation exacerbated by the fact $billions is to this day tied up in the Lehman bankruptcy. 

Editor: So that was our world five years ago. 

Wall Street History returns in two weeks.

Brian Trumbore

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