The Bear Facts

What is this announcement about the emergence of an American covered bond market? Is it an answer to the housing market’s ills? What is a covered bond in the first place?

First, the announcement as reported in The Wall Street Journal (see here; rearranged for ease of use):

Bank of America Corp., Citigroup Inc., J.P. Morgan Chase & Co. and Wells Fargo & Co. Monday unveiled plans to launch covered-bond programs and become leading issuers of the financial instruments, which date back to 18th-century Europe.

Treasury Secretary Henry Paulson speaks [sic] during a news conference on mortgage finance. “We are at the early stages of what should be a promising path, where the nascent U.S. covered bond market can grow and provide a new source of mortgage financing,” he said.
“We believe a robust U.S. covered-bond market would provide an additional stable and cost effective funding source for banks to originate and hold mortgages on their balance sheet,” the four banks said in a joint statement.
U.S. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke have in recent months been touting the bonds as a way to help revive the nation’s struggling housing market.

OK. So, the four largest banks in the country, at the Fed and Treasury’s prodding, are all agreeing to start a covered bond market to try and revive the housing sector. So what are covered bonds? From Wikipedia (see here):

Covered bonds are debt securities backed by cash flows from mortgages or public sector loans. They are similar in many ways to asset-backed securities created in securitization, but covered bond assets remain on the issuer’s consolidated balance sheet.

[i.e., They are very similar to the securities that have been problematic in the past year but are less risky since the issuer is liable for handing out bad mortgages and they remain of the issuer's balance sheet]

Essentially, a covered bond is a corporate bond with one important enhancement: recourse to a pool of assets that secures or “covers” the bond if the originator (usually a financial institution) becomes insolvent. [Again, much safer that securitization] This enhancement typically (although not always) results in the bonds’ being assigned AAA credit ratings. [I am not sure how this works - anyone? Is it because they have the properties as collateral? Why wouldn't the bonds be assigned ratings the same way as other corporate bonds?]

From the New York Times (see here) and the Wall Street Journal [rearranged]:

Covered bonds, issued by banks and secured by pools of assets like home loans, are widely used in Europe but have only become attractive in the United States since the segment of the mortgage securitization market driven by investment banks dried up last year amid a wave of home foreclosures.
Unlike mortgage securities, which pass all the risk to investors, covered bonds collateralized with mortgages would continue to perform even if the mortgages backing them default — as long as the bank remains solvent. [And what happens if they don't remain solvent? The bond holders get the assets.]

Are covered bonds the answer to the housing crisis?

In one way, covered bonds seem to spread risk more evenly since issuers would continue to be responsible for the losses even if the underlying mortgages default. However, didn’t banks get burned by mortgage securities as well? Didn’t banks loose money by holding the securities they issued? The key difference between covered bonds and the previous batch of mortgage securities seems to be that covered securities have stricter guidelines for what can be included in the portfolio.

Additionally, there is the fact that by making them bank debt, they are somewhat insulated from the underlying housing assets – arguably, making this more attractive. As Felix Salmon wrote in “What is a covered bond” (see here),

Now it’s true that covered bonds are, technically, mortgage-backed. But all the mortgages could default and go into foreclosure tomorrow, and so long as the bank remains in operation, the covered bond will pay out as normal. Similarly, if the bank blows up for some non-mortgage-related reason, investors in the bond will still get paid back in full. Their main risk is that the bank blows up because the mortgages blow up, and they’ll be left holding a bag of damaged loans – but because two things have to happen rather than just one, that risk is relatively low

The WSJ article mentions that previous attempts at creating a covered bond market in the US failed. However, this time the FDIC and the Fed are greasing the wheels. From the WSJ:

The Federal Reserve governor Kevin M. Warsh told the news conference the Fed was willing to consider highly rated, high-quality covered bonds as collateral for banks seeking emergency funds from the Fed.

Nothing like having the Fed help you start a business…

One question is who is going to rate their bonds? Moody’s? What will make this time different from the previous fiascos?

Speaking with very little experience, here is my take. As long as the regulations and guidelines for building covered bonds are conservative enough, I can see this market providing a boost to the housing market. The covered bond market will help by providing more liquidity now that Government Sponsored Enterprises account for over 60% of all mortgages. The private sector might just start getting back in the game. However, housing prices have still not corrected. Even if the covered bond market takes off, it still is unlikely to do much good until the market bottoms out and the economy starts to improve in 2009 or 2010. It is more likely a boon for the banks themselves since they now will have another way of making and borrowing money.

[Here is another article on this subject: Floyd Norris from the New York Times, “A New Way to Generate Mortgages”]

Again on the inflation/interest rate front, here is a really interesting article on inflation in Asia.  I find The New York Times’ “Prices of Food and Gas Take a Toll on Asia” is interesting not because of the headline (not exactly a novelty) but because of the quotes it contains from the Governor of the Bank of Indonesia, Boediono, who calls for international coordination in raising interest rates and fighting inflation.

First, here is the context:

While prices have been rising in the United States and Europe, the biggest increases are being felt in Asia, and countries like India and Vietnam are already having to deal with double-digit inflation.

Sharp rises in global food and oil prices are now spilling over into wages and broader measures of inflation across Asia, as the Asian Development Bank noted in a report released Tuesday.

Workers are demanding higher wages to cover their rising living costs, and companies are imposing higher prices for a wide range of goods to cover accelerating production costs.

Now, enter Boediono:

In an interview Tuesday, Boediono, the governor of the Bank of Indonesia, called for a coordinated international move toward tighter monetary policy, including higher interest rates by the United States, so as to slow inflation.

In an era of global capital flows, so much excess money is now flowing through world markets that no single country can fight the international problem of inflation effectively by tightening its own monetary policy, Boediono said. (Like many Indonesians, he uses only one name.)

“I don’t think any one country, even as big as China or even the United States, would be able to stomach the adjustment” of raising interest rates far enough to slow global inflation, he said.

I haven’t read this yet in any other article on inflation.  I think that it targets the heart of the issue.  If the United States continues to pursue low interest rates and the rest of the world maintains higher rates that still are negative in real terms, that is not exactly a recipe for quenching inflation.  If this continues it seems that the only thing that will correct inflation are longer-term non-interest rate led decreases in consumption or increases in supply.

So, what would happen if there were a coordinated response?  According to Boediono:

World oil prices could fall by 30 percent if countries took coordinated action to reduce liquidity, he said. He attributed much of the recent rise in global commodity prices to excess money in circulation. [This second point is interesting.  I think Soros mentions something similar in his most recent book but he doesn't tie it to inflation]

But Boediono said he was not recommending that Asian central banks sell any of their dollar reserves to put pressure on the United States to raise interest rates. [Again, pretty interesting idea - Asian central banks forcing the US to raise interest rates by lowering their reserves.  Would this work?  Are there other willing buyers that would buoy the market?]  Asian purchases of dollar-denominated securities, led by China’s $1.8 trillion in foreign reserves, have played a central role in financing the American trade and government budget deficits and in holding down interest rates on mortgages during the recent American housing market decline.

Most central banks in Asia have been reluctant to give up any of their economic independence or challenge the United States by coordinating their monetary and currency policies, even as they fret about rising prices.

This last point is the main problem with this proposal.  The sovereignty and independence of central banks around the world is such that they any coordinated responses would be quite unprecedented.  At the moment as far as I can tell, most countries are raising rates except for the United States, so in a sense there is already a coordinated response.  If the United States joined the bandwagon would this quench inflation?

Which leads me to another question: what is causing the current bout of inflation?  Boediono suggests it is greatly due to excess money in circulation.  Others say it is an outstripping of supply by Chinese and Indian demand.  Maybe due to a declining dollar?  Do the central banks know?  Does anyone?  And if not, how can we be sure a coordinated response would be any better than any other?

To see how complicated this is, here is a small section from the article on the interaction between international interest rates, currency appreciation and inflation:

Central banks in the region have been struggling for months to respond to the Federal Reserve’s low interest rates. Low American interest rates are making it harder for the region’s central banks to raise their rates; doing so would make them more attractive for international investors and could produce rapid appreciation in their currencies.

Stronger currencies would lower the cost in local currency terms of importing oil and other goods. But stronger currencies would also reduce the competitiveness of exports at a time when demand for Asian goods is weakening in the United States.

I think these ideas are all interesting and original enough to merit consideration.  Will an international approach be necessary in the end?  If the US raised rates would the second order effects from currency appreciation worsen Asian inflation?  Do we know what is happening?

Ending on a lighter note, how is this for a weird ending to the article [verbatim, I swear]:

Boediono spoke in an interview in his elegant, wood-paneled offices, where the international décor and even the styling of the paneling bear a striking resemblance to the governors’ suites at the Federal Reserve’s headquarters in Washington.

“Economists have predicted 10 out of the last 3 recessions.”  This is what I think of the current crisis and its extended punditry.  I am not sure where this quote comes from, or even if it is correctly quoted, but it speaks to a fundamental truth: if you consistently predict bad things will happen, sooner or latter you are bound to be right.

The United States is going through tough times – there is no doubt.  Simultaneous wars, a housing crisis, and a credit crisis – these are not imaginary.  But undue pessimism feeds on itself and often ignores the facts.  To think that everything that can go wrong will go wrong is a fallacy – Moore’s law taken to the paranoid extreme of an over-newsed population.

What do I mean?  Lately there have been a lot of discussions of all the problems and bubbles that have yet to burst.  The credit bubble.  The unfunded pension liabilities that have accumulated at all levels of our society.  The growing national medical bills.  The collapsing educational system.  Rising inflation.  The list goes on.

Yes, these are problems.  Yes, a lot of them will start to have unfold simultaneously over the next couple of years.  But it’s important to recognize that not all bad things shatter like dot-com bubbles.  Crises unfold in different ways and stock-markets having the quickest and most painful corrections.  Life moves at a slower and more adaptive pace than stock-markets.  People are resourceful.  Governments sometimes help.  And despite what we might think, we haven’t reached some idyllic level of perfection from which we are slowly falling – the country has changed and will continue to change in ways that we can’t foresee.

An example that I have been thinking a lot about lately is consumer debt and U.S. household consumption.  The New York Times had a great piece this weekend on consumer debt in America – see here.  No surprise – the average American household has too much debt, too little in savings and is immersed in an increasingly competitive economic environment.  After reading articles like this I feel like running into the hills of Montana before the imminent collapse of the “system” (I once talked to someone who actually proposed this, in all seriousness, as a solution).  But after taking a few breaths and thinking through the issue, I realize there is no need for anything this drastic.

As housing prices fall and as many sectors of the economy slow people many people will indeed default on their debts. But it won’t be everyone.  Many others will cut back on their debts and increase their savings.  Others will have no problems whatsoever.  Things will change in ways we can’t foresee and no, it won’t happen in a day, or a week.  It will take place over years and despite what you read, nobody knows how or when it will happen.

The problems in consumer expenditure are already happening.  This is from Reuters, “Widespread earnings woes reflect consumer fears”:

“A number of major U.S. companies who rely on consumer spending warned about their results on Monday evening, including credit card company American Express Co, Macintosh computer and iPod maker Apple Inc and cruise ship operator Royal Caribbean Cruises Ltd.

The breadth of the warnings, which also came from makers of chips and carpets, may signal that the credit crisis is quickly moving beyond housing and banks and into mainstream Corporate America.

“It’s understandable that the U.S. consumer would be apprehensive with the circumstances — weakness in housing, gasoline is up, the stock market is down and job insecurity,” said Brian Gendreau, an investment strategist in New York for ING Investment Management Americas. “We may actually have a consumer-led recession — which is rare.”

The wrath of the credit crunch and housing collapse of the past year has largely been felt by middle- or lower-income people. But Monday’s results reflected a broadening of fears.

American Express executives said that even customers with solid credit scores were facing difficulties and even the very affluent have in some cases cut back discretionary spending.

People will cut back on spending – as they do in every recession.  Some people probably – gasp – will have to save money in the future!  But that was the way things once were and it was normal.

The “new economy” might have to look more like an old one.  We might have to start making things and being thrifty.  We might have to change and it just might, not be a bad thing.

After dissing the CPI in one of my previous posts (see here), I am bringing it back today to give it the attention it deserves. There are problems with most statistics but that doesn’t mean we shouldn’t use them only that we should use them with caution.

Today, the Bureau of Labor Statistics released the latest consumer price inflation figures for June 2008 and they are not a pretty sight. The statistic that was used the most in the press today was 1.1% – that is the inflation of headline-CPI-U (i.e., all urban consumers; including food and energy) in the month of June. This works out to a 5% un-seasonally adjusted annual inflation rate for the 12 months ending June 2008 – way above the target rate of close to 2% unofficially set by the Fed.

The markets went up today since Wells Fargo reminded everyone not to throw babies out with the bathwater in times of undue pessimism. However, listening to Bernanke’s comments to Congress today and looking at the inflation figures in more detail, it’s important not to get carried away and think everything is peachy. What do I mean?

Inflation has ramped up significantly over the past three months and unless something changes in interest rate policy, global middle class consumption or some other supply/demand variable, it will not be slowing down soon.

A look at the details is revealing:

In the month of June alone, the energy component of CPI-U increased 6.6%; food increased 0.8%; transportation increased 3.8% and no component grew more slowly than in May 2008.

If you take the past three months and calculate the compound annual rate (April*May*June to the fourth power) – you get an annual headline CPI of 7.9%. Not a pretty picture.

At some point, consumption has to give but 7.9% is quite low by world standards and was common in the U.S. before the mid-80s – nobody knows what will happen in the months ahead, but I am just pointing out that it is not an impossibility. If interest rates don’t rise soon (and in fact, most pundits don’t expect interest rates to rise until the end of the year), I don’t see low inflation on the horizon.

Here are the details from BLS:

Tomorrow the Treasury Department will release its latest figures for foreign nation holdings of Treasury bills (as you already know ). The major change over the past year has been the dramatic increase in ownership taken by oil producing countries that, flushed with new petrodollars, are snatching up Treasuries like its their job.

What I thought was interesting about this article from Bloomberg is that in mentioning this point it makes this fact sounds scarier than it actually is.

Here is the text from Bloomberg, “Oil brings Americans closer to OPEC Debtor Dependence” (July 14, 2008):

“Petroleum-exporting nations from Saudi Arabia to Russia are not only charging Americans record high prices for fuel, they are also poised to become the biggest creditor to the U.S. government

Holdings of Treasuries by oil producers and institutions such as U.K. banks that are proxies for Middle East nations rose 44 percent this year to $510.8 billion through April, four times faster than the rest of the world, according to the Treasury Department’s most recent data. At the current pace, they’ll surpass Japan, which holds $592.2 billion, as the largest owner this month.

While the investment of so-called petrodollars into government debt is helping to temper a rise in borrowing costs as the U.S. finances a record budget deficit, it highlights America’s dependence on foreign money.

“We should be very happy that they’re buying U.S. Treasuries because they’re keeping interest rates low, and that’s a positive for bond investors,” said Gary Pollack, who helps oversee $12 billion as head of fixed-income trading at Deutsche Bank AG’s Private Wealth Management unit in New York. “Whether there’s geopolitical risk is something else.”

The article makes it seem like OPEC is about to become the largest holder of US debt. In fact, the title is called “Oil brings Americans closer to OPEC Debtor Dependence”! However, a look at the data reveals something very different. The article confounds oil producing countries and OPEC for dramatic effect – just look at how they bring in Russia (not a member of OPEC) in the first sentence.

Who is included in the their list of oil producing countries? As far as I can tell from the data – they include Mexico, Brazil, and Norway!   It’s tough to tell exactly who is included since the article includes some of the UK holdings as OPEC-proxies.  However, even if all of the UK holdings are considered as OPECs, the US is still not entirely beholden to OPEC.  Brazil in itself is almost as big as OPEC sans-proxies! I don’t know about you but this doesn’t exactly come across in the title or in the article.

The statistics are more fun and informative. From the Treasury Department, the major foreign holders of treasury securities are listed below. The most striking thing for me is the growth of Brazil as a holder of securities (88% year-on-year, 5th largest holder) – not mentioned anywhere in the article. It’s also interesting for me to see how large Japan and China’s holdings are. They hold 42% of all foreign nation held Treasury securities!

OPEC is still not close to being the largest owner of U.S. Government debt – but for many even its rise to number 4 (or higher with proxies) is problematic. That is a topic for another day.

I’ve been a fan of Kevin Phillips for a long time and haven’t written about him at all on this blog. This is my first step towards rectifying that.

His article in Harpers from May 2008, “Numbers racket: why the economy is worse than we know” is a definite must-read. In it he records how “Washington has been forced to gull its citizens and creditors by debasing official statistics”, specifically GDP, CPI, and the unemployment rate. Phillips argues that economic statistic manipulation has directly led to our current inflation and housing crises by leading us to underestimate our inflation rate and overestimate our economic growth.

Economists I know get very upset when this is mentioned – they defend the new measurements, quote Nobel prizes awarded for these changes and say he is talking nonsense.

I think he brings up issues that are not mentioned enough. The devil is in the details and he contends that by slowly manipulating them, governments since the 60s have been slowly using the statistics to provide a rosier view of the economy. Why? In order to:

1. Pay less in federal pension and Social Security obligations (both tied to official inflation figures)
2. Maintain artificially low interest rates (by underestimating inflation)
3. Boost the “borrower-industrial complex” (Phillips’ term taken from the New York Times)
4. Hide weak economic growth (by underestimating inflation and unemployment while overestimating GDP)

The article mentions the details of how the manipulation was done. Briefly:

CPI was manipulated downwards by:

Focusing on core inflation vs. headline inflation (first implemented during Nixon in 1973 and 1974)

Using “owner equivalent rent” instead of homeowner costs (implemented under Reagan in 1983). This move replaced the investment aspect of housing from the CPI. This allows a housing boom to happen without it affecting the tracker rate of inflation. Phillips says that this move alone has “served to understate or reduce inflation during the recent housing boom by 3 to 4 percentage points.”

Product substitution (changing the base used to calculate inflation – assume people shift from “flank steak to hamburger” if prices rise), geometric weighting (goods whose costs are rising most rapidly get a lower weighting), and hedonic adjustment (adjust prices based on quality improvements – but never increased based on declining quality)

The unemployment rate has been estimated downwards by:

• Classifying the military as employed instead of outside the labor force. Implemented under Reagan. Increases the denominator of the unemployment rate making the percentage smaller.
• Redefined the workforce as people seeking work for less than a year. Implemented in 1994 under Clinton. People looking for work for more than a year – the “long-term discouraged” – about 4 million people – were no longer included in the most frequently used statistic (U-3).
• Thinned the household economic sampling from 60,000 to 50,000 by dropping mostly inner city households. Done during Clinton. Is thought to have reduced black unemployment and poverty levels.

And finally, Gross Domestic Product was estimated upwards by modifying the formula through “imputations” and “the birth/death of businesses equation” – both of which I don’t really have a good grip on (any comments on this would be very helpful).

They are all small details but they add up to big changes.

I think that his points are powerful and add another dimension to the unfolding housing crisis. Did it all really start with statistics? If we still used the old measurements would the current liquidity bubble and inflation spiral have been avoided?

From the article (emphasis added):

“The real numbers, to most economically minded Americans, would be a face full of cold water. Based on the criteria in place a quarter century ago, today’s U.S. unemployment rate is somewhere between 9 percent and 12 percent; the inflation rate is as high as 7 or even 10 percent; economic growth since the recession of 2001 has been mediocre, despite a huge surge in the wealth and incomes of the superrich, and we are falling back into recession. [...]

Undermeasurement of inflation, in particular, hangs over our heads like a guillotine. To acknowledge it would send interest rates climbing, and thereby would endanger the viability of the massive buildup of public and private debt (from less than $11 trillion in 1987 to $49 trillion last year) that props up the American economy. Moreover, the rising cost of pensions, benefits, borrowing, and interest payments—all indexed or related to inflation—could join with the cost of financial bailouts to overwhelm the federal budget. As inflation and interest rates have been kept artificially suppressed, the United States has been indentured to its volatile financial sector, with its predilection for leverage and risky buccaneering.

Arguably, the unraveling has already begun. As Robert Hardaway, a professor at the University of Denver, pointed out last September, the subprime lending crisis “can be directly traced back to the [1983] BLS decision to exclude the price of housing from the CPI. . . . With the illusion of low inflation inducing lenders to offer 6 percent loans, not only has speculation run rampant on the expectations of ever-rising home prices, but home buyers by the millions have been tricked into buying homes even though they only qualified for the teaser rates.” Were mainstream interest rates to jump into the 7 to 9 percent range—which could happen if inflation were to spur new concern—both Washington and Wall Street would be walking in quicksand. The make-believe economy of the past two decades, with its asset bubbles, massive borrowing, and rampant data distortion, would be in serious jeopardy. The U.S. dollar, off more than 40 percent against the euro since 2002, could slip down an even rockier slope.”

[For more details on these statistics, see Phillips' sources: Shadow Government Statistics by John Williams and The Index of Missing Economic Indicators by Austan Goolsbee]

In my post from Friday I said that the denial over a government bail out had been too much for it to remain untrue (see here). Today, the Secretary of the Treasury, Henry Paulson, confirmed the first steps in this direction.

I can only imagine how hard the Fed and the Treasury must have been working this weekend trying to figure out what to do. After IndyMac was seized by the FDIC on Friday (see here), and while this is not directly related to Freddie and Fannie, it does mean that the markets are not likely going to be very happy on Monday (to say the least). The news on Fannie and Freddie will likely crowd out that of IndyMac and probably keep markets a bit calmer.

What exactly is the Fed proposing? There are three main points as listed in Sunday’s statement by the Treasury:

First, as a liquidity backstop, the plan includes a temporary increase in the line of credit the GSEs have with Treasury. Treasury would determine the terms and conditions for accessing the line of credit and the amount to be drawn.

Second, to ensure the GSEs have access to sufficient capital to continue to serve their mission, the plan includes temporary authority for Treasury to purchase equity in either of the two GSEs if needed.

Use of either the line of credit or the equity investment would carry terms and conditions necessary to protect the taxpayer.

Third, to protect the financial system from systemic risk going forward, the plan strengthens the GSE regulatory reform legislation currently moving through Congress by giving the Federal Reserve a consultative role in the new GSE regulator’s process for setting capital requirements and other prudential standards.

In summary, Fannie Mae and Freddie Mac will soon have the options of tapping allegedly temporary Government lines of credit, equity investments while also having some sort of Fed oversight. Oh, and don’t forget, they maintain their GSE status, owning or guaranteeing half the mortgages in the country – i.e., they won’t be allowed to fail by the U.S. Government.

In other words, Fannie and Freddie are becoming more and more integrated into the US Government. The major difference between them as far as I can tell is that being GSE’s their liabilities don’t count towards those of the Federal Government – at least not as far as most people are concerned. In reality, since the Government will absorb the companies if they go bankrupt, the GSE’s liabilities should count as those of the Federal Government. When people say the Government only has $9 trillion in debt, they should add in Freddie and Fannie’s $5+ trillion as well.

As I see it there are three major take aways from today’s announcement.

The first is the increased role the Fed will have over the financial markets after this recession is over. As the WSJ writes:

The weekend move means that Fed Chairman Ben Bernanke, who has been steadily accumulating authority as the U.S. grapples with the financial crisis, will have even more power. The Treasury envisions the Fed working with the mortgage giants’ regulator to help prevent situations that could be a risk for the entire financial system. The move builds on Treasury’s broader goal of remaking financial regulation to give the Fed broader influence over financial-market stability.

What exactly this means over the long-term is unclear but as banks continue to fail, the housing market deteriorates and as emergency arrangements continue to be made, the regulatory bodies are becoming much more hands on than they’ve had to be in a long time.

The second major issue is the Government’s increasing role in providing liquidity over the biggest credit markets in the country: home mortgages and student loans. As the New York Times writes, “Government as the Big Lender” (emphasis added):

Two years ago, when commercial banks were still jostling for fatter slices of the housing market, the share of outstanding mortgages Fannie and Freddie owned and guaranteed dipped below 40 percent, according to an analysis of Federal Reserve data by Moody’s Economy.com. By the first three months of this year, Fannie and Freddie were buying more than two-thirds of all new residential mortgages.

A similar trend is playing out in college loans. As commercial banks concluded that lending to students was no longer quite so profitable, the Bush administration promised in May to buy their federally guaranteed student loans, giving the banks capital to continue lending.

In short, in a nation that holds itself up as a citadel of free enterprise, the government has morphed from lender of last resort into effectively the only lender for millions of Americans engaged in the largest transactions of their lives.

Before, its more modest mission was to make more loans available at lower rates. Now it is to make sure loans are made at all. The government is setting the terms and the standards of Americans’ biggest loans.

Again, what the mortgage and student loan markets will look like after the crises are over is anyone’s guess.

Tangentially, would government backing of credit card debt ever be an option? Sounds ridiculous but as the lifeline of the American consumer, if this house of card fails something will have to be done. How big is credit card debt? From the New York Times this weekend (emphasis added):

According to a new report from the Federal Reserve, revolving [consumer] credit, which includes credit cards, increased at an annual rate of about 7 percent in May [to $2.57 trillion of which credit cards are $962 billion]. In April, by contrast, it had shown a slight percentage decline.

The increase is notable because May was the first month when rebate checks from the federal government really started to kick in. So even with some extra financial padding, many consumers still turned to their credit cards.

Prudent credit-card carriers may well be vowing to pay off their balances in full. But with food and gas prices soaring, more people must lean on plastic for the necessities of life, and it becomes harder and harder to keep that balance from ballooning.

Gives me chills.

The third and final takeaway from this weekend’s statement is that the dollar will continue its descent. The credibility of the Federal Government is in free fall. If as many people said, the Government’s absorbing Fannie and Freddie’s liabilities would have hurt the dollar, why should their current backing in all but name do anything different?

The markets this week will be very interesting.

Breaking news: IndyMac has been seized by the FDIC (Federal Deposit Insurance Corporation) becoming the first major bank to fail since the mortgage crisis started. The other banks that have failed have been small and local.

IndyMac was once part of Countrywide Financial (recently acquired by Bank of America at a firesale price) and is now owned by the government.

This is the largest bank failure since the savings & loans crisis in the late 80s when close to 3,000 financial institutions failed; it is the third largest bank failure in U.S. history.

The Wall Street Journal reports that it will likely cost the FDIC between $4 and $8 billion.

IndyMac and the government (the Office of Thrift Supervision, O.T.C.) blame Senator Schumer from New York for its downfall. As the New York Times reports (emphasis added):

The run on the bank came after a critical letter about the bank from Senator Charles E. Schumer, Democrat of New York. Federal regulators said on Friday that Mr. Schumer’s letter had prompted the collapse by causing the run and scaring away potential acquirers.

“The senator made comments in his letter questioning the viability of the institution,” John M. Reich, director of the Office of Thrift Supervision, said in a phone call with reporters. “When a member of the United States Senate makes such a statement, it frightens depositors.

In the days after Mr. Schumer’s letter was released on June 26, IndyMac customers withdrew an average of $100 million a day from the bank, or a total of $1.3 billion, the government said. Before Mr. Schumer’s letter, the bank had been receiving net inflows of money from depositors, Mr. Reich said. [...]

“IndyMac’s troubles, like Countrywide’s were caused by practices that began and persisted over the last several years,” he [Schumer] said. “If O.T.S. had done its job as regulator and not let IndyMac’s poor and loose lending practices continue, we wouldn’t be where we are today.” [...]

IndyMac was being shopped to potential investors this summer, but their interest disappeared after Mr. Schumer’s comments, said Timothy T. Ward, deputy director of examinations, supervision and consumer protection at the O.T.S.

Economic reality is directly fed by our perceptions as George Soros would say (see here).

After Sen. Schumer said the bank was in trouble the bank couldn’t find anyone who would shore up its balance sheet.

This does not bode well for Fannie Mae and Freddie Mac in the weeks ahead. Not because anyone will run on the bank (as far as I know they don’t take deposits), but perceptions will feed a credit reality that will make their operations increasingly unstable and make capital increasingly out of reach.

For an in-depth look at exactly what the FDIC does when it takes over a bank, check out this article in the Wall Street Journal from a couple of months ago, “Backstage at a Bank Funeral.” Here’s a tidbit:

“In its role as receiver for failed banks, the FDIC acts as a SWAT team, playing equal parts secret agent, medical examiner, salesman and grief counselor. The first 48 hours are typically the most frantic, as the agency must turn a failed bank inside out and oversee its sale — or its orderly burial.”

[To see the updated post after the Treasury Secretary's statement, see here]

At lunch today a friend was saying how the current wave of denial over Freddie and Fannie being “nationalized” was eerily similar to the Board of Directors vote of confidence for the CEO. It is usually followed by the CEOs dismissal two weeks later.

Needless to say, Fannie Mae and Freddie Mac’s stock went down again today. Fannie fell 19% (75% this year) and Freddie lost 4% (also 75% down this year). But scarier was the sudden urge to deny bankruptcy. From the WSJ, here are a couple of the denials:

The Treasury Department is “not talking about nationalizing” struggling mortgage giants Fannie Mae and Freddie Mac, according to a person familiar with the administration’s thinking.

In an unusual move, Treasury Secretary Henry Paulson issued a written statement Friday saying that the Bush administration’s “primary focus is supporting Fannie Mae and Freddie Mac in their current form.” (See the text of Paulson’s statement.)

The person familiar with the matter said the statement was intended to discount reports suggesting that the government was considering a takeover of mortgage giants.

Friday afternoon, Sen. Christopher Dodd (D., Conn.) said Fannie and Freddie are “fundamentally strong” and questions about their capital are unwarranted. “This is not a time to be panicking about this. These are viable, strong institutions,” Sen. Dodd said at a Capitol Hill press conference.

I don’t know what financial reports Sen. Dodd has been looking at but I am willing to bet he is basing this comment on his gut. Looking over the latest quarterly reports from Freddie and Fannie today I finally realized why there is so much panic.

The financial statements are extremely convoluted and not easy to read. However, it doesn’t take much to look at the balance sheet and find that assets are nearly outweighed by liabilities – excluding equity. As the housing market collapses their assets are worth less and less as is their corresponding equity. By some estimates they already have negative equity and if I understand this correctly, unless they can raise new capital pretty soon, then that means they are technically bankrupt.

[For a discussion on different capital calculations from the Wall Street Journal see here]

On top of this, under a section in the financial statements by the name of off balance-sheet liabilities, you can find that they each are ultimately liable for a couple of trillion dollars under the worst of circumstances -they don’t really elaborate on this as much as you’d think they would.

So when Sen. Dodd says they are financially sound or to paraphrase former Senator Phil Gramm, all the critics are just a bunch of whiners, that is not exactly true.

So what is going to happen?

They will be nationalized or there will be a large government bail out. Despite the denial of everyone involved. Just as in every other crisis and recent firing, their denials, unfortunately, are not to be trusted.

Some estimate they need to lose $77 billion before the government will absorb them / nationalize them (placing them under conservatorship if you will). Everybody has a theory about how it will play out. What seems certain is that the stock will be worthless. Their debt will likely be respected (or at least somewhat respected). The CEOs will be fired and the housing market will suffer in the short-term.

This is a big deal.

[Here is a link to some visuals from the New York Times on Fannie and Freddie]

[For more on the lack of credibility of the financial regulators, see Gretchen Morgenson's article from this Saturday, July 12]

[For the latest post on Fannie and Freddie, see here or further below in this same post]

Portfolio.com’s Odd Numbers blog has a great post today on previous bear markets and their trends – see here. Thanks Gaurav.

Here is their chart. How many days did it take to go from the peak of the S&P 500 to Bear (i.e., -20%), from Bear to low and low to next peak.

While it’s tempting to say that the new Bear market will be like that of 2000 given the extent of economic damage that is happening, it doesn’t mean much if we ignore the periods in between. From 1987 to 2000 the market went up significantly more than 1973 to 1987. The market is not nearly as overvalued as it was in 2000 and the bear market will not be as prolonged. That doesn’t mean it has hit bottom but comparing it to 2000 is a bit much.

From Yahoo! Finance:

In other news – anyone know what happens if Freddie Mac and Fannie Mae go bankrupt?

[For the latest post, see here]

Background from Fortune:

Fannie Mae and Freddie Mac are government-sponsored enterprises that help the mortgage market function by purchasing pools of loans and packaging them into securities. If one or both couldn’t function, the result would be chaos.

At the end of last year, Fannie alone had packaged and guaranteed about $2.8 trillion worth of mortgages, approximately 23% of all outstanding U.S. mortgage debt. And these securities are highly rated and sold to investors all over the world.

“If Fannie or Freddie failed, it would be far worse than the fall of [investment bank] Bear Stearns,” says Sean Egan, head of credit ratings firm Egan Jones. “It could throw the economy into depression or something close to it.” [...]

The possibility of government aid looms because it’s hard to see how the private market can help the companies. Their stock market values have dropped so low that it would be difficult for them to raise money. For example, Egan estimates that Freddie alone will need to raise $7 billion over the next two quarters due to writedowns and losses. But the company’s market capitalization – the number of outstanding shares times the share price stands at $8.7 billion. [...]

What’s more, both companies have already raised a total of $13 billion by issuing preferred stock at the end of 2007; and they reduced their dividend payments to conserve cash.

What’s going to happen? If the Fed couldn’t let Bear Stearns go bankrupt, could it ever possibly let Freddie and Fannie do so? Any guesses?

Here’s a bit from today’s Wall Street Journal:

One possible scenario if Fannie and Freddie’s financial position worsens: Under existing law, if either company were severely low on capital, it could fall under the control of their government regulator, which would then be responsible for the firm. That step — known as placing it in a conservatorship — would allow the mortgage company to continue operating, but the extent of its abilities in such a distressed situation remains unclear

The article has a ton of great information. If you’re interested in this issue, it’s a great source.