It takes a lot to shock me these days. Yesterday I watched Hank Paulson and Ben Bernanke come up to Capital Hill armed with a two to three page proposal to spend $700 billion on the "Troubled Asset Relief Act". They told Congress that they planned on paying something that Bernanke called, "Held to Maturity Value", and I started getting real nervous. Senators pushed back on Hank and Ben and maybe for the first time since I was eight, I was on the side of the Senators! Chairman Bernanke and Secretary Paulson see the tidal wave coming. It is a tidal wave that some of us have seen for some time now. I think that in the first week of September, Paulson and Bernanke finally saw what we saw. The defaults and losses in residential mortgages were just in first-gear. A whole bunch of subprime, Atl-A, and Alt-A Option ARMS are going to reset over the next twelve months and hundreds of billions of mortgages are going to default at a time when Loan to Value ratios where soaring to 120-130%. Here is something we wrote back on September 7, 2008. It was titled "Freddie & Fannie Bailout: Why Now and Why You Should Be Scared"
Today, the Government of the United States took over Fannie Mae and Freddie Mac. It was a move that Treasury Secretary Henry Paulson and The White House desperately did NOT want to make on their watch. Hence, all the talk about bazookas in pockets. As most have predicted, Treasury now will begin a series of preferred stock purchase agreements, adding capital to Freddie and Fannie as needed. Each time Treasury buys in, existing common and preferred share holders get pushed further and further down the capital structure until the losses Freddie and Fannie will take consume them. It sounds right out of an "Animal Planet" documentary. Dick Syron and Dan Mudd can now leave to "pursue other interests" or "spend more time with family."
What you might be asking is, "Why now?" After all, Paulson has been talking right up until the middle of last week that he's confident he won't have to use his Treasury preferred purchase powers (the bazooka). What changed his mind so suddenly? Paulson is claiming that based on discussions with his advisors at Morgan Stanley (I still laugh every time I think about Paulson bringing them in as "advisors") he now sees that both Freddie and Fannie are essentially insolvent. I'm not sure why he needed Morgan Stanley to tell him that. After all, It's not rocket science or fifty little line-items that may or may not add up to insolvency. It's the "Tax Deferred Asset" and the "Temporary Loss on Securities" entries. The Tax Deferred Asset alone is $35 billion for the combined entities! The Temporary-Loss item is at least $20 billion. I'm assuming Paulson took a couple of accounting courses when he attended The Harvard Business School. He really didn't need an advisor to tell him these guys were cooked.
Here's what scares the crap out of me;
- The Mortgage Bankers of America put out their monthly delinquency and foreclosure data on Friday. Serious delinquencies (90 days or greater) and foreclosures on BOTH PRIME AND SUBPRIME continue to increase unabated. With the rise in unemployment, continued deterioration of real estate prices, and the specter of billions of negatively amortizing option ARMs hitting their principal caps, (thus driving more mortgagees into default), the housing situation is getting worse at an increasing rate.
- Former Federal Reserve Chairman Paul Volcker said on Friday, "This bright new system, this practice in the United States, this practice in the United Kingdom and elsewhere has broken down. Growth in the economy in this decade will be the slowest of any decade since the Great Depression, right in the middle of all this financial innovation. It is the most complicated financial crisis I have ever experienced and I have experienced a few."
- Finally, Secretary Paulson, a man who seems to increase the frequency of his "all is well" speeches right when we are on the brink of something really bad, said in his statement today, "Nothing about our actions today in any way reflects a changed view of the housing correction or the strength of other U.S. financial institutions."
I don't know about you, but if numbers one and two didn't get you, number three has to clinch it! Stock up on the bottled water, canned foods and ammo because things are about to get a whole lot worse.
Bernanke and Paulson have got religion now and they are trying to say it in any way possible without having to just come out and say it. They need that $700 billion to get the assets that are going to take catastrophic hits off the bank books and on to our "non-public" books. We know this because if Paulson and Bernanke truly believed that market prices are purely based on fear and illiquidity and that many of these assets are going to return their original cost (some combination of principal and interest), they would just wave the mark to market accounting on these assets and let institutions hold them at cost. In some cases, this would allow for write-ups. You might be saying, "Eric, that's stupid. Do you know how difficult and damaging it would be to get everyone on board with that type of accounting methodology change?" My answer would be, "Is it harder than raising $700 billion to buy these assets at cost from the banks and convince tax-payers that it has to be done?" The government knows that if it just lets banks carry these assets at cost, the defaults and losses coming will force them to take huge writedowns as the assets become impaired. If they are on "OUR" books, who is going to notice?
Finally, after Congress pushed back hard yesterday and most probably today, Goldman Sachs raises $5 billion of perpetual preferred from Warren Buffett, with a 10% coupon, and gives him $5 billion of five-year warrants to buy more Goldman shares at $115 (GS closed at $125 yesterday) at 6PM! Goldman also plans to raise $2.5 billion of common stock. Morgan Stanley and even Goldman Sachs found themselves staring into the abyss last Thursday as a run on money market mutual funds intensified. Hence, the bank charters and the capital raises. Do you think Goldman makes a sweet, sweet deal with Buffett yesterday if Congress just rolled over and gave Hank and Ben their $700 billion? I don't think so. The Buffett deal was, in my opinion, Plan B.
Hang on to your hats.
**AND JUST NOW Goldman has doubled the $2.5 billion of Common Stock they were raising to $5 billion!
The entitlement (medicaid, medicare, social security, prescription drugs,..) problem is now. The can has been kicked down the road by the beltway buffoons forever. There was always time to fix it, leave it to someone else to deal with in the future. Pete Petersen's Concord Coalition been trying to shine light on it since the '80s. Read his book from 2004, "Running on Empty" and you'll get the picture.
All the bills are coming due at once. Downgrade is just the beginning of the pain if changes aren't made. People will actually have to prioritize needs vs desires and make some sacrifices for the next 5-10yrs if this country is to remain great. Nothing we can't do, and clearly we must do for the sake of our kids, but it requires an enormous national mentality shift.
Entitlement should be a four-letter word (and probably will be soon).
Posted by: fletch | September 24, 2008 at 11:22 AM
Yup. We had a big freaking problem with the baby boomers coming due BEFORE we dropped 1 or 2 trillion new debt on ourselves. One of our friends, Fletch has been talking about U.S. Tsy downgrade for about a year now. I think he's going to be proven right.
Posted by: eric | September 24, 2008 at 09:40 AM
I hope that Volcker's predictions about the economy are incorrect. Do you see that dark cloud looming over the horizon? That's an aging baby-boomer population with a net savings rate of below zero. We are going to see a retirement crisis even without a slow market. If we experience a negative real growth rate over the next ten years we are in serious trouble.
Posted by: RPB | September 24, 2008 at 09:36 AM
maybe these jokers are reading your blog--as they should be!
Posted by: mike | September 24, 2008 at 09:01 AM