Lessons From Modern Economic Crises (Not for the Fainthearted)

Now that the world is in the throes of the mother of all financial messes, economists are scrambling to develop expertise. Carmine Reinhart and Kenneth Rogoff recently had this beat largely to themselves. but in the last two weeks, the IMF came out with a stud of 124 modern banking crises.

The latest addition to this growing body of knowledge comes from Stijn Claessens, M. Ayhan Kose,and Marco E. Terrones at VoxEU.

While we will excerpt the paper at greater length below, here is the key paragraph:

The episodes of credit crunches and housing busts are often long and deep. For example, a credit crunch episode typically lasts two and a half years and is associated with nearly a 20 percent decline in real credit. A housing bust tend to last even longer: four and a half years with a 30 percent fall in real house prices. And an equity price bust lasts some 10 quarters and when it is over, the real value of equities has dropped to half.

More from VoxEU:

The unique nature of the current financial crisis—combining a house price bust, a credit crunch, and an equity price bust—unlike any other one the US has experienced before, makes it difficult to assess its implications for the real economy. Barry Eichengreen recently assessed the lessons from the Great Depression (Vox 2008), but what of the evidence from modern times? However, around the world we have witnessed many such episodes of credit crunches and busts in house and equity prices. In fact, in recent work, we identified 28 credit crunches, 28 house price busts, 58 equity price busts, and 122 recessions in 21 advanced countries over 1960-2007 (Claessens, Kose and Terrones, 2008). These episodes provide some insights on how financial crises evolve and their implications for the broader economy....

How costly are recessions?

As shown in Figure 1, a recession on average lasts about 4 quarters (one year) with substantial variation across episodes — the shortest recession is 2 quarters and the longest 13 quarters. The typical decline in output from peak to trough, the recession’s amplitude, tends to be about 2 percent. For recessions, we also compute a measure of cumulative loss which combines information about both the duration and amplitude to proxy the overall cost of a recession. The cumulative loss of a recession is typically about 3 percent of GDP, but this number varies quite a bit across episodes. We classify a recession as a severe one when the peak-to-trough decline in output is in the top-quartile of all output declines during recessions. These recessions tend to be more than a quarter longer and much more costly than do typical recessions.

Crunches and busts: Often Long and Painful

The episodes of credit crunches and housing busts are often long and deep (Figure 2). For example, a credit crunch episode typically lasts two and a half years and is associated with nearly a 20 percent decline in real credit. A housing bust tend to last even longer: four and a half years with a 30 percent fall in real house prices. And an equity price bust lasts some 10 quarters and when it is over, the real value of equities has dropped to half.

Are recessions associated with crunches and busts worse than other recessions?

Contrary to the view of some commentators, the triple whammy of a house price bust, a credit crunch and an equity price bust has not always led to an eventual recession. What is true is that many recessions are indeed associated with credit crunches or asset price busts. In about one out of six recessions, there is also a credit crunch underway, and in about one out of four recessions a house price bust. Equity price busts overlap for about one-third of recession episodes. There can also be considerable lags between financial market disturbances and real activity. A recession, if one occurs, can start as late as four to five quarters after the onset of a credit crunch or a housing bust.

One of the key questions surrounding the current financial crisis is whether recessions associated with crunches and busts are worse than other recessions. Here, the international evidence is clear: these types of recessions are not just slightly longer on average, but also have much more output losses than others. In particular, although recessions accompanied with severe credit crunches or house price busts last only a quarter longer, they have typically result in output losses two to three times greater than recessions without such financial stresses. During recessions coinciding with financial stress, consumption and investment usually register much sharper declines leading to the more pronounced drops in overall output and unemployment.

Global nature of economic and financial cycles

For some, the global nature of the current crisis has been unprecedented as several advanced economies have simultaneously witnessed declines in house and equity prices as well as difficulties in their credit markets. However, this is not unusual as recessions, crunches and busts often occur at the same time across countries. Recessions in many advanced countries have been bunched in four periods over the past forty years—the mid-70s, the early 80s, the early 90s and the early-2000s—and have often coincided with global shocks. Moreover, when many countries experience a recession, many also go through episodes of credit contractions, declines in house and equity prices.

What are the lessons for the current episode?

The lessons from the earlier episodes of recessions, crunches and busts are sobering, suggesting that recessions, if they were to occur, would be more costly since they would take place alongside simultaneous credit crunches and asset price busts. Furthermore, although the effects of the current crisis have already been felt gradually around the world, its global dimensions are likely to intensify in the coming months.

The main take-away of the past episodes is that some tough times are ahead for the global economy before matters get better. Nevertheless, the nature of a recession in a particular country, if it happens, would ultimately depend on a number of factors, importantly how healthy the financial positions of its firms, banks, and households are prior to the recession, and what policies are being employed. This is high time for policy makers to act swiftly and decisively to undertake the necessary measures at both the national and global levels to meet the challenges of the crisis.

Quelle Surprise! Manhattan Real Estate Prices Drop Sharply

The Financial Times reports that residential real estate prices fell in the third quarter in Manhattan, according to data from a real estate appraisal firm.

Getting good data about Manhattan real estate activity can be a tricky affair, since a big chunk of the market is co-operatives (buyers acquire shares in the co-op corporation, which then give a proprietary lease to the unit) and those sales are not recorded with the city. However, the seemingly favorable comparisons have masked earlier signs of decay. As happened in other markets, demand for the best properties held up well, while the rest of the market eroded, and a higher proportion of big-ticket sales led to rising averages.

The story also does not mention that the city was in the throes of a major building boom, and there are more apartment buildings coming on the market (two large ones within a ten minute walk of my apartment, for instance). That inevitably will have a further price-depressing effect.

From the Financial Times:

Manhattan real estate prices have joined the rest of the US in a downward tumble.

The average sales price of property on the island fell by 11.3 per cent to $1,480,363 in the three months to the end of September according to data from Miller Samuel, a real estate appraiser, compared with the previous quarter.

The data points to still deeper plunges ahead because it registers closings of sales, which are normally at least three months - and in the case of newly built apartments can be more than a year - after parties agree to a sale.

Real estate brokers say that sales have come to a near standstill since the government takeover of Fannie Mae and Freddie Mac in early September...

“The events of the second half of September in the financial markets and Washington have not shown up in the market data for the quarter aside from the continuation of a lower level of sales activity compared to last year’s record levels,” said Jonathan Miller, who runs Miller Samuel...

Over the year, the picture appeared rosier, with average prices significantly higher, up 8.1 per cent on average. The median price was up 7.4 per cent to $928,263.

The sharp drop in price more recently came as banks tightened lending standards and the number of properties changing hands shrank, but also because initial sales of super-luxury properties costing as much as $40m at locations like 15 Central Park West and The Plaza have nearly completed.

The median price of the top 10 per cent of properties sold fell by 18.7 per cent in the quarter, even as the inventory of these high end apartments and condos soared by 89 per cent.

However, even excluding the sales of properties at these spots the sales price of apartments was down 6 per cent at $1,399,524, according to data from Brown Harris Stevens.

The price of condominiums (which fell by 6.6 per cent to $1,809,684) held up better than that of co-ops ( which dropped by 9.3 per cent to $1,161,302). Condominium prices were stronger.

A litany of other figures underlined the downward slope that the market appeared to be on.

Sales fell 24.1 over the year to 2,654 units compared with 3,499 units sold a year ago.

The inventory of homes for sale was up 34.6 per cent to 7,003 units from the prior year total of 5,204 units.

The average number of days properties waited on the market rose by 11 to134 days.

New Bailout Proposal Costs Estimated at $500 Billion to $1 Trillion

Repeat after me: bye bye the US's AAA rating and the dollar. Although the Paulson's plan is only sketchy, on the surface, it is utterly ridiculous. The authorities propose to save the economy by buying mortgage paper at market prices.

Why do we need the government to create a massive and costly effort to buy paper at market prices? Institutions can sell paper at market prices now. This is clearly ether a massive game of smoke and mirrors (f we are lucky) or a plan to buy bad assets at above market prices but somehow pretend that they are indeed correct.

The latter takes us straight down the Japan path. The government is left holding lousy paper it will have to dispose of at a loss, the banking system gets subsidized not based on triage, on who might it make most sense to rescue, but who gets enough of the crappy assets sold at a high enough price. It's a terrible, inefficient way to recapitalize the banking system. Why should taxpayers underwrite banks without getting some upside and a measure of control?

And as we have said before, Japan had high enough savings that it could manage its crisis internally. We don't. Foreign central banks are already coming under pressure from domestic constituencies over their dollar holdings. It isn't at all clear that they will support these initiatives by buying even larger amounts of Treasuries.

Oh, PS, and who gets to decide if the mortgage prices are fair? Consultants hired by the Treasury. Given how costly and ineffective this Administration's outsourcing has been, I have little faith that this would be implemented well separate and apart from the confused (or more likely misrepresented) objectives.

And the prospect of turning on the spigot has others clamoring for bailouts. There are calls for underwater homeowners to get handouts too.

Pray that this measure does not pass, or better yet, call your Congressman and Senator and raise hell. The importance of these initiatives and the dollars attached says they should not be rushed through in a panic, particularly when the underlying premise is so dubious.

From the New York Times:

The Bush administration, moving to prevent an economic cataclysm, urged Congress on Friday to grant it far-reaching emergency powers to buy hundreds of billions of dollars in distressed mortgages despite many unknowns about how the plan would work.

Henry M. Paulson Jr., the Treasury secretary, made it clear that the upfront cost of the rescue proposal could easily be $500 billion, and outside experts predicted that it could reach $1 trillion.

The outlines of the plan, described in conference calls to lawmakers on Friday, include buying assets only from United States financial institutions — but not hedge funds — and hiring outside advisers who would work for the Treasury, rather than creating a separate agency. Democratic leaders immediately pledged to work closely with Mr. Paulson to pass a plan in the next week, but they also demanded that the measure include relief for deeply indebted homeowners, not just for banks and Wall Street firms.

However, it is not clear that Congress is going to roll over:

As of Friday evening, Mr. Paulson had yet to deliver a formal plan to Congress. House and Senate leaders pledged to work through the weekend, but they insisted that Mr. Paulson bring them a detailed plan rather than just an outline.

An even bigger obstacle was the goal of the plan. President Bush and Mr. Paulson made it clear that their primary, and perhaps only, goal was to stabilize the financial markets by removing hundreds of billions of dollars in “illiquid assets” from the balance sheets of banks and financial institutions....

But Democratic lawmakers insisted that any plan would also have to provide relief to millions of families that were poised to lose their homes to foreclosure.

The House Speaker, Nancy Pelosi of California, said she would insist that the plan “uphold key principles — insulating Main Street from Wall Street and keeping people in their homes by reducing mortgage foreclosures.”

The Wall Street Journal discussed the need to sort out pricing:

However, the government may find itself in a quandary: Does it pay more than fair-market value for hard-to-assess distressed assets, putting taxpayers on the hook for any losses? Or does it drive a hard bargain, buying for pennies on the dollar? The latter approach would further hurt financial institutions, since they would have to write down the losses and take additional hits to their balance sheets. The Treasury department, which hasn't commented on specifics about the plan, is expected to propose issuing debt in $50 billion tranches to fund the purchases.

The SIV rescue plan, the MLEC, did not get off the ground because the objectives of the sellers of bad mortgage debt, did not want to show much in the way of losses, while investors in the Entity, as it was called by some, were only interested in bying fairly-valued assets.

Since ideas along those lines haven't worked, we are now having the taxpayer stand in place of private buyers. And I guarnatee if this program sees the light of day, it will not pay arm's length prices. There'd be no point in doing that. This is a complete charade. But Paulson cannot say that this amounts to a recapitalization of banks, done in a very inefficient fashion. It would be too controversial to admit that. But Congress may figure it out regardless.

The New York Times' Joe Nocera, in "A Hail Mary Pass, but No Receiver in the End Zone" takes a very dim view of recent Treasury moves, including the latest bailout plan. The whole piece is very much worth reading, Key bits:

So rather than help solve the crisis, the Treasury Department has actually contributed to the biggest problem in the market right now: an utter lack of confidence....

Will this latest round of proposals end the crisis? I know the stock market reacted joyously on Friday, 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.

And the third solution — the big megillah — is Mr. Paulson’s plan to create a new government mechanism to buy mortgage-backed securities from big banks and investment houses. Once they are off those companies’ books, life can return to normal — or so Mr. Paulson hopes.

He acknowledged that it would likely cost taxpayers “hundreds of billions of dollars.” I think it will cost more than $1 trillion.

Moody's Revised RMBS Loss Forecasts Threaten MBIA, Ambac Ratings

Just when the worries about AIG have receded from the fore, the longer-standing insurance bugaboos, MBIA and Ambac, may return to center stage. From the Financial Times:

Moody’s Investors Service has increased its projections for losses on residential mortgage-backed securities, a move that could result in “multi-notch” credit rating downgrades for bond insurers such as Ambac and MBIA which have exposure to these securities.

In its latest update on losses expected on mortgages made in 2006, Moody’s said it had increased its projections for cumulative losses to an average of 22 per cent. The losses are expected to increase in every quarter, averaging 17 per cent for the first quarter of 2006 and 26 per cent for the fourth quarter of that year....

“Moody’s updated estimated of 2006 subprime losses represents a significant increase above the level previously projected, and now exceeds the average stress case level that has been used in Moody’s assessments of financial guaranty insurers,” the ratings agency said in a statement.

For securities backed by mortgages made in 2007, loss assumptions are “roughly one-third more severe than for 2006”

Poole: GSE Bailout is "Stopgap", Expects Up to $300 Billion of Losses

It will be interesting to see if this dose of cold water from former Fed governor William Poole will take any sizzle out of the forceful equity rally (the Nikkei is up 425 points as of this writing, and US stock futures say the US markets will also show an impressive move up). From Bloomberg:

``Some of this is a stopgap to try to prevent the mortgage market from falling apart,'' former Federal Reserve Bank of St. Louis President William Poole said on Bloomberg Radio. The federally chartered, shareholder-owned structure, with risks covered by taxpayers, is ``an unacceptable situation,'' he said, projecting the Treasury may need to cover as much as $300 billion of losses..

Bloomberg is running the Poole comment in its headline, so it will catch the eye of traders. The rest of the piece featured mainly positive reactions from the usual suspects. For instance:

``This action should lead to an increased availability of mortgage financing, which will help achieve stability in housing,'' Bank of America Corp. Chief Executive Officer Kenneth Lewis, said in e-mailed remarks...

``Paulson has threaded the needle just right by taking necessary action to stabilize U.S. financial markets while minimizing the liability for taxpayers,'' Schumer of New York, who heads the congressional Joint Economic Committee, said in a statement. ``This plan will be met with broad acceptance in Congress because it doesn't prejudge the ultimate fate of Fannie Mae and Freddie Mac.''

Freddie, Fannie Notable Comments (Mainly Not Pretty)

Not only is the commentary in the blogosphere on the Freddie and Fannie bailout program pretty skeptical, but even some normally staid MSM commentators have an eyebrow cocked.

There is a comprehensive list of links on Freddie and Fannie from Barry Ritholtz. This post serves a different purpose and serves up some choice bits:

Mohamed El Erian of Pimco, who ought to be delighted, instead sounds a sober, unsettled note in the Financial Times:

Unlike New Orleans, the levees of the global economy have broken, one after another.

Also unlike New Orleans, a significant part of the global economy still lies in the path of this hurricane...

First, the success of the action depends partly on whether it “crowds in” capital from both domestic and foreign sources....the US government is already running a growing fiscal deficit and the country as a whole has a current account deficit, its balance sheet must be supported by other capital inflows, especially on the part of foreign holders of US debt who have become increasingly skittish in recent weeks.

Second, the action must be part of a broader policy response that has both a domestic and international dimension.

In this regard I have been impressed by the repeated observations of officials from countries that previously experienced the brutality of deleveraging hurricanes, particularly in Asia in 1997-98. Noting the piecemeal nature of US policies in the past year, they stress the importance of a holistic response from the authorities, including meaningful co-ordination of an often-diffused domestic policy apparatus and explicit, timely and targeted international support. This means, at the minimum, alleviating the housing problem in other stretched jurisdictions.

From Floyd Norris at the New York Times:

Who could have forecast that it would be under the Bush administration, which talked about restraining the growth of these behemoths, that they came to totally dominate the mortgage markets? Now the administration wants to have it both ways in that area as well. Fannie and Freddie are ordered to start shrinking — in 2010, after a new president will be in office. Until then, they are supposed to grow.

From the normally measured Paul Jackson:

This is no longer the worst mortgage crisis since the Great Depression; this is the worst mortgage crisis, period. It’s also the end of an era. The U.S. Treasury on Sunday announced a takeover of both Fannie Mae and Freddie Mac, a move that has nearly no precedent in U.S. history....Under the Treasury preferred stock purchase agreement, the government may purchase an additional $100 billion in preferred interests in each GSE if needed, although FHFA director James Lockhart suggested such a large investment likely wouldn’t be needed.

But after hearing from Lockhart for weeks that the GSEs were in solid financial condition, and that the Treasury had no intention to step in, how much of whatever is said can really be believed at this point?

Nouriel Roubini is not a fan: ". This bailout plan has mostly lousy features that exacerbate the moral hazard of this government intervention and the overall fiscal costs of such intervention." He gives a dozen objections. Some of the more interesting:

...common shareholders instead of being fully wiped out –as they do deserve – will only be diluted and hold about 20% ownership of the GSEs. There is no justification for this even partial bailout of the common shareholders as the two GSEs are insolvent...

the government plan includes the provision of credit lines – of an amount that is not specified but is potentially as high the Treasury wants – to Fannie and Freddie and to the other 12 FHLBs. The Treasury statement does not clarify whether these credit lines will be senior to other subordinated and unsecured agency debt or not. Since this provision of credit is a form of debtor in possession financing – like IMF lending to countries under distress – it should be de jure senior to the debt issued by the GSEs; it should also be senior to the mortgage claims that the GSEs have guaranteed. Instead, the Treasury’s silence about this matter suggests that these credit lines will not have any seniority compared to the unsecured debt of the GSEs.

From Michael Shedlock:

In theory this is a bottomless sinkhole, especially in light of the fact that systemic risk will be increasing over the next 16 months (and probably beyond that).

From Ben Bitroff:

Tomorrow morning equities are gonna fly, especially financials... for how long, I can't even begin to predict. But one thing is for certain. The crash is going to be spectacular.

Yields are screaming higher across the curve as it suddenly becomes very very clear the US debt has at least doubled, if not tripled and more on this bailout. The US dollar is getting whacked across all major FX pairs. Commodities are catching a bid. This is not good for anybody.

You also must read Paulson's Statement on Freddie and Fannie with a Nearly Simultaneous Translation at Jesse's Cafe Americain. Hysterical and on target.

In contrast, Chris Whalen, who had advocated a conservatorship, was positive.

Initial Negative Indicators on the GSE Bailout

Even though the stock markets are over the moon as of this hour (the Nikkei up nearly 440 points, other Asian markets up over 3%, bank stocks up even more), the all-important question is the reaction in the credit markets. It is far less enthusiastic. One might charitably call it underwhelmed.

From John Jansen:

I just spoke with a trader in Tokyo who works for a rather substantial primary dealer. He said that benchmark agency spreads are about 20 basis points tighter than levels which prevailed at 300PM on Friday. Following the Wall Street Journal report spreads tightened about 10 basis points and have moved another 10 basis points in early trading there.

He described market conditions as “illiquid” and “worse than March”.

And this comment from reader and credit market analyst Marshall:

A major bankruptcy can often mark the climactic low of a bear market, but this comes after months of downward pressure, compelling valuation and signs of incipient recovery. And this bailout isn't even a "one-off". Youll probably get rolling bailouts to the GSEs on a quarter by quarter basis and so nobody can quantify the total cost to the taxpayer.

And will the foreign central banks, which have hitherto provided the biggest bailouts to the US economy, continue to play along? They might appreciate the fact that the government's implicit guarantee for the GSEs is now explicit, but you've still got no pricing transparency, as you did in Sweden, so there can be no real confidence in the government bailout, because the government is actively perpetuating subterfuge and offering no segregation of the good assets vis a vis the bad assets. It's another half-assed measure by Paulson, who still doesn't want to hurt his friends on Wall Street too much.

Freddie, Fannie and (Sort of) Federal Home Loan Bank Bailout

The deed is done. Freddie and Fannie are now officially in conservatorship.

Uncharacteristically, I listened to the presentation by Paulson and Jim Lockhart, which was thin on details (particularly size of new facilities and investments). The bombshell was the aside that not only is there to be a new secured lending facility for the GSE as part of the rescue, but also for the Federal Home Loan Banks, which collectively had as of year end 2006, roughly $1 trillion of assets, In interest of getting this post out, I have not yet located the 2007 level, but trust me, since there was a backdoor bailout of Countrywide via the FHLB system (my recollection is roughly $50 billion of assets were offloaded), the total is no doubt bigger now. This was a mere aside, BTW, and I have not seen this detail picked up anywhere in the initial press reports, but is clearly contained in Paulson's speech.

A second noteworthy feature was that Paulson took care to steer clear of saying the US was assuming responsible for GSE debt. The construct was "we created this mess by setting up a conflict between private ownership and public mission, a lot of investors and foreign central banks own this paper, we are responsible to straighten it out." In the end, this winds up being a de facto full faith and credit obligation of the US (there is no way the US can walk from supporting the GSEs having started down this path) but in form, care was paid to set in motion a program that if successful would put the GSEs on a footing to function without life support. Indeed, Paulson said that "Treasury will assure positive net worth" and even though Treasury's authority to act extends only to the end of 2009, there is just about no scenario (absent a Federal debt crisis) that the US can cut back that commitment unless and until the GSEs are radically reformed.

Third was that the program envisions the GSEs expanding their book of business moderately in 2009 to support the mortgage market, then shrinking their portfolios 10% a year starting in 2010 until they reach a size (not specified) where they no longer are so large as to pose a risk to the financial system.

Fourth, not surprisingly, the powers that be indicated that they had studied which banks who held common and preferred would be affected by the measures and ascertained that it was only a small number of smaller banks. They were encouraged to call their regulator to develop a capital restoration plan.

Fifth, Treasury will purchase MBS in an effort to lower spreads. Query how investors will take to the prospect of a less than economically-determined prices. Paulson argued this program may produce gains for the taxpayer (with the spread over funding, that's quite possible)

Sixth, Paulson stressed that Congress needed to resolve the ambiguities in the GSE's charter and it would be a mistake for a new Congress and Administration to neglect this task.

Other key points:

Both Paulson and Lockhart stressed that they had "determined it was necessary to take action" and it was "not in the best interest simply to make an equity investment in the GSE's current form," Lockhart indicated that the issue was capital adequacy, that Freddie and Fannie "cannot continue to operate safely and soundly and fulfill their mission."

As expected,. all common and preferred dividends have been eliminated (note the word was "eliminated" not the more user-friendly "suspended of earlier reports). The government will invest via up to $100 billion of new senior preferred (the figure was not included in the presentations).

All lobbying has been eliminated.

The current CEOs will remain during a transition period. Herb Allison (formerly with Merrill, then TIA-CREFF) is the new CEO of Fannie, David Moffett, former vice chairman of US Bancorp, of Freddie.

After 2009, GSEs will pay a fee to government for support.

Further commentary comes from Bloomberg:

Morgan Stanley, hired by the Treasury to probe the companies' finances, concluded the accounting, while legal, enabled Freddie, and to a lesser extent Fannie, to overstate the value of their reserves, according to the people who declined to be identified because the findings were confidential.

From the Wall Street Journal:

The Treasury said its senior preferred stock purchase agreement includes an upfront $1 billion issuance of senior preferred stock with a 10% coupon from each GSE, quarterly dividend payments, warrants representing an ownership stake of 79.9% in each firm going forward, and a quarterly fee starting in 2010.

Bye Bye Banks: Freddie and Fannie Preferred Holders to Take Big Hits?

The reporting on the main elements of the Freddie and Fannie rescue plan is converging as the content of official briefings leaks out.

The stunner, which contradicts preliminary reports, is that the preferred shareholders in the GSEs will take losses. The Wall Street Journal reports that dividends on common will be eliminated and those on preferred will be suspended (Bloomberg, Reuters, and the New York Times were less specific, but indicated that preferred shareholders would suffer).

Justin Fox summarized why this outcome, of wiping our or otherwise damaging the preferred shareholders, had been considered highly undesirable:

Lots of small and mid-sized banks in the U.S. have, with encouragement from regulators, built up big holdings in Fannie and Freddie preferred stock, which they use to satisfy their capital requirements. If Fannie and Freddie preferred shares become worthless, a lot of banks will become insolvent. Which, with the FDIC insurance fund already being depleted by bank failure, could end up costing taxpayers a ton.

Now admittedly, the preferred shares have already inflicted sizable losses to those who bought them when issued. For instance, Freddie Mac's Z preferred was sold for $25 and has traded in the $10 to $14 range recently. But even at that level, its rich dividend (at these level, the yield is 15%+) is a support for the price. Adjustable rate preferred is trading at a bigger discount, 80+%. Where do they go once that prop is removed? Readers who can provide insight are encouraged to speak up.

In the meantime, let's do some first-cut back of the envelope calculations. The face value of GSE preferred was $36 billion. While the market values have taken a beating with the bailout talk, most banks would have end of June prices reflected in their latest financial reports. Since I don't have access to historical prices or the mix of adjustable versus fixed rate, let's assume market value across all issues was $18 billion as of end of June. Even with the dividend suspension plan, the preferred will still have some option value. This is a complete stab in the dark, but say the shares fall to 1/4 their current price. So the incremental damage is $13.5 billion. Now that doesn't sound all that bad across a whole lot of banks (boy, have we gotten inured to big numbers). But one can of course argue the contrary case, that an equity hit of that magnitude reduces bank lending capacity by roughly $180 billion.

Now to do this analysis correctly, not only do you need better numbers on 1) what losses have the banks taken already on Freddie and Fannie preferred and 2) how much more of a hit is likely, but you also need to know 3) which banks have a significant exposure relative to their capital. Even if the aggregate losses are not awful in a macro sense, they could have the effect of tipping a seemingly disproportionate number of banks over the edge.

Nevertheless, inflicting damage on the preferred sharholders was seen as so unlikely that John Dizard of the Financial Times devoted his last two articles to the merit of investing in GSE preferred shares. He regarded a cram-down as a non-starter (this is one reason we steer clear of discussing investment ideas here. You can do good analysis and still have your head handed to you. But in fairness, if you had taken his advice as a trade and gotten in and out fast, you would have made a very nice turn).

From the Financial Times:

In the now overcrowded world of investing in distressed securities, the standard strategy is to pick the "pivot" issue...that is the problematic part of the capital structure. Securities with seniority above that of the pivot get paid out, securities below that get wiped out or have their value seriously impaired. The idea is to buy the pivot at a good price.

In the past couple of weeks, it seemed that the entire US economy had a pivot security or set of securities: the preferred stock issued by the government-sponsored entities, or GSEs. Fannie and Freddie, the Sodom and Gomorrah of "public/private partnerships", sold about $36bn of non-cumulative preferreds to the banks and the public, with the aggressive support and encouragement of the Treasury and the GSEs regulator.

Last week I wrote about these preferreds; my position was that if or, rather, when the Treasury had to recapitalise the GSEs with new, senior preferred issues, it would be a really good idea from the taxpayers' point of view to leave the old preferreds in place while wiping out the value of the outstanding common stock.

I thought that saving Fannie and Freddie's preferreds would support the entire asset class of preferred stock. The banking system needs to raise several hundred billion dollars of equity, and preferred stock is the lowest-cost way to do that in the public markets. While some sophisticated investors could distinguish between preferreds issued by a sound bank holding company, and preferreds issued by the overleveraged F&F, international investors and domestic retail investors would not have the data or analytics to draw the distinction.

The alternative, as I see it, to recapping the US banking system with preferreds is some form of direct government investing in the equity of banks or bank holding companies. That would be even more expensive to the taxpayers - as in at least 10 times more expensive.......

I called up Andrew Senchak, the vice-chairman and co-director of investment banking at Keefe Bruyette & Woods, which specialises in bank securities...

As he says: "It is true that there is no direct link between the GSE preferred issues and that of the banks, but they are in the same galaxy. Given that, there is almost no incentive not to keep the GSE preferreds in good shape. If there is a recapitalisation of the GSEs [by the Treasury], you can achieve the public policy end [of limiting 'moral hazard' by wiping out the value of the common]. I am not sure how much new bank equity has to be issued . . . it could be anywhere from $200bn to $400bn."...

And yes, I agree that it is likely, if not certain, that if the GSE books were marked to market, the asset value would not be there to support the preferred issues. There is, though, a real value to clapping to keep Tinkerbell alive here: you get a banking system that can finance a recovery.

As a reality check I called Jim Grant, of Grant's Interest Rate Observer, and the author of the forthcoming Mr Market Miscalculates . He comments: "The alternative to preserving the value of the GSE preferreds? Prayer? Remember that a lot of that paper is held by the same banks the authorities would love not to fail."

So, with the market's affirmation, and the agreement of one of the Street's flintiest sceptics, I'm sticking to my position: the GSE preferreds should survive.

Narrowly, Dizard is 100% correct. The GSE preferreds will indeed be preserved. But if the news stories pan out, that will be cold comfort to their owners.

NY Times: Freddie Overstated Its Capital

The New York Times, in "Loan Giant Overstated Its Capital Base," sets forth an interesting bill of particulars as to where Freddie deviated from what one might consider a full and fair statement of its financial condition. Indeed, the article says that the widely-expected Sunday intervention was triggered by the GSE's regulator determining that the firms' capital was short of the reported level (note that Fannie's practices were not as aggressive as Freddie's). Bloomberg had indicated yesterday that the rescue was being announced prior to a FHFA [Federal Housing Finance Agency] evaluation of their capital. We noted:

... it seems likely that there was something due to be released [in the report] that either gave James Lockhart, the head of FHFA, the smoking gun to intervene, or was sufficiently troubling to run the risk of an adverse market reaction...

Yet, as Calculated Risk pointed out, the Times had an artfully worded comment (emphasis ours)

The company had made decisions that, while not necessarily in violation of accounting rules, had the effect of overstating the companies’ capital resources and financial stability.

CR said, "I doubt Freddie violated any accounting rules this time" without explaining why. I'm cynical enough that the powers that be would like to tone down any suggestion that questionable accounting treatments might have been fraudulent (that opens up all sorts of cans of worms, including litigation, which are distractions that would make the job of any new conservator all the more difficult.

But his view may be based on this accounting contretemps with Freddie reported in the Washington Post earlier this year:

Years after Fannie Mae and Freddie Mac were found to have misrepresented their earnings by billions of dollars, a federal regulator is warning them to follow both the spirit and the letter of a new accounting rule.

The Office of Federal Housing Enterprise Oversight said it would consider taking action against the government-sponsored mortgage funding companies if their handling of the new rule raises concerns, even if their conduct "technically complies with the accounting standard."

The OFHEO statement came less than a week after the regulatory agency said it found "certain issues" in Freddie Mac's implementation of accounting standards which "raise concerns" about the company's capital...

Sounds familiar, no? Nevertheless, the Times' list of, shall we say, items of note, is striking, with the biggest surprise last:

For years, both companies have effectively recognized losses whenever payments on a loan are 90 days past due. But, in recent months, the companies said they would wait until payments were two years late. As a result, tens of thousands of loans have not been marked down in value.

Another bone of contention was the inclusion of deferred tax credits in assets. When Jonathan Weil of Bloomberg had suggested that the use of tax credits might produce an unduly rosy balance sheet; some dismissed it, arguing in effect that the tax assets would have value because 1) the GSEs would at some point be profitable, so the tax shield did have value, and in any event, a successor could use the assets were the GSEs reorganized.

The Times addressed some of these issues:

....such credits have no value unless the companies generate profits. They have failed to do so over the last four quarters and seem increasingly unlikely to the next year. Moreover, even when the companies had soaring profits, such credits often could not be used. That is because the companies were already able to offset taxes with other credits for affordable housing.

Most financial institutions are not allowed to count such credits as assets.

The Times also contends:

Freddie has not written down many of its subprime and Alt-A exposures to market value

Both companies appear to be managing earnings by delaying increases in loan loss reserves

As the search for the guilty continues, expect to see more post mortems of strategy (were the GSE's doomed to run aground due to their conflicted public/private charter?) and management decisions.

NY Times: Fannie, Freddie Nationalization (aka Conservatorship) Imminent

Guess the powers that be were unwilling to risk playing chicken with the markets and losing.

So much for the theory espoused by some that the government couldn't put the GSEs into custodianship absent a breaching of statutory minimums (technically, by being insolvent under the "fair asset" valuation method, Freddie is already on plenty thin ice). Nevertheless, this is quite a Friday night bombshell, particularly since the plan, as the Times appears to have garnered a few more details beyond the initial reports, is not minimalist (say an preferred equity purchase with no management changes). Conservatorship officially makes the GSEs wards of the state.

However, the rumors have not yet converged on the shape of the plan, The New York Times says that not only wouldthe existing chiefs and likely the board will be given the heave-ho, but that the preferred shareholders would suffer as well as the common equity holders (note the details of the recapitaliztion were not reported). That was surprising and may not be correct. Most observers had assumed that preferred shareholders would be spared, since many banks hold significant slugs of Freddie and Fannie preferred, and a big writedown would be a direct hit to the bottom line.

A report from the Washington Post gives a skeletal outline of the financial and legal arrangement; the Times has a more background (note the post has been updated to include the WaPo information and reflect the divergence of reports). Per the Times, a formal announcement is expected before the Asian markets open Sunday.

From the Washington Post:

The government has formulated a plan to put troubled mortgage giants Fannie Mae and Freddie Mac under federal control, dismiss their top executives, and use government funds to prop them up, government officials told the two companies yesterday, according to sources familiar with the conversations.

Under the plan, the federal government would place the firms in a legal state known as conservatorship, the sources said. The value of the company's common stock would be diluted but not wiped out while the holdings of other securities, including company debt and preferred shares, would be protected by the government.

Instead of giving each company a big capital infusion up front, the government plans to make quarterly infusions as the companies' losses warrant, the sources said. This would be an attempt to minimize the initial cost of the rescue.

From the New York Times:

Senior officials from the Bush administration and the Federal Reserve on Friday informed top executives of Fannie Mae and Freddie Mac, the mortgage finance giants, that the government was preparing to seize the two companies and place them in a conservatorship, officials and company executives briefed on the discussions said.

The plan, effectively a government bailout, was outlined in separate meetings that the chief executives were summoned to attend on Friday at the office of the companies’ new regulator. The executives were told that, under the plan, they and their boards would be replaced, shareholders would be virtually wiped out, but the companies would be able to continue functioning with the government generally standing behind their debt, people briefed on the discussions said.

It is not possible to calculate the cost of any government bailout, but the huge potential liabilities of the companies could cost taxpayers tens of billions of dollars and make any rescue among the largest in the nation’s history....

Under a conservatorship, the remaining common and preferred shares of Fannie and Freddie would be worth little, and any losses on mortgages they own or guarantee could be paid by taxpayers. A conservatorship would operate much like a pre-packaged bankruptcy, similar to what smaller companies use to clean up their books and then emerge with stronger balance sheets.

The executives were told that the government had been planning to announce the decision as early as Sunday, before the Asian markets reopen, the officials said...

Officials said the participants at the meetings included Mr. Paulson, Ben S. Bernanke, the chairman of the Fed, and James Lockhart, the head of both the old and new agency that regulates the companies. The companies were represented by Daniel H. Mudd, the chief executive of Fannie Mae, and Richard F. Syron, chief executive of Freddie Mac. Also participating was H. Rodgin Cohen, the chairman of the law firm, Sullivan & Cromwell, who was representing Fannie.

Officials and executives briefed on the meetings said that Mr. Mudd and Mr. Syron were told that they would have to leave the companies.....

he meetings reflected the reality that senior administration officials did not believe they could wait for some kind of financial tipping point, as happened with Bear Stearns....

With the possible removal of the top management and the board, it is no longer clear who would appoint new management.

Some interesting tidbits from Bloomberg:

The meetings come a month after Paulson hired Morgan Stanley to advise on any use of taxpayer funds to recapitalize Fannie and Freddie, and before the FHFA [Federal Housing Finance Agency] releases an assessment of their capital....

Mudd and Syron must approve of any government intervention under the law, unless the FHFA declares that either firm has insufficient capital. The legislation gave the Treasury the power through the end of next year to extend unlimited credit to or make equity purchases in the firms.

Given that this meeting with Mudd and Syron appears to have been a one-way communication. it seems likely that there was something due to be released that either gave James Lockhart, the head of FHFA, the smoking gun to intervene, or was sufficiently troubling to run the risk of an adverse market reaction, which would at a minimum raise the GSE's cost of funding, which is already high enough to create worries that it might interfere with fulfilling their charter.

Update 11:20 PM. This comes via e-mail from James Bianco of Arbor Research:

As of this writing (Friday night, 10:14), it appears no one has a clue as to how the Fannie/Freddie Government bailout is going to work. I guess will have to wait for the now common Sunday night/Monday morning press releases to save the financial system from ruin....

If you’re are keeping score at home we had Sunday night/Monday morning “save the world” press releases in August 2007 (cut of the discount rate), December 2007 (TAF), January 2008 (ease 75 bps), March 2008 (Bear) and July 2008 (first Fannie/Freddie rescue) and now September. Anyone want to believe this is the last one (which will be the sixth in 14 months) will be the one that finally works and saves the world?

Bianco went further than we did above, and listed what the Times, Wall Street Journal. WaPo, Financial Times, and Bloomberg had to say. No convergence. Nada (looking at Bloomberg, it quoted WaPo on some matters and cited earlier "analyst opinion').

It's possible that inconsistent information is being leaked deliberately. The first time I saw that happen on a deal I was close to was on Goldman's acquisition of commodities trading firm J. Aron. It may be that the powers that be assume they cannot prevent information getting out, and prefer to muddy the waters until an announcement is ready to go.

Update 12:05 AM. A key bit from the Wall Street Journal:

The meetings Friday were in part aimed at getting Messrs. Mudd and Syron to agree to the plan, though their approval was not necessary, these people said.

Foreclosures and Delinquencies Reach Record Highs

More cheery news on the housing front. The rise in foreclosures wasn't unexpected, since there are widespread, albeit anecdotal reports of banks being backlogged on foreclosures, either by virtue of design or understaffing. But notice how prime mortgages are a significant component of new foreclosures.

From Bloomberg:

New foreclosures increased to 1.19 percent, rising above 1 percent for the first time in the survey's 29 years, the Mortgage Bankers Association said in a report today. The total inventory of homes in foreclosure reached 2.75 percent, almost tripling since the five-year housing boom ended in 2005. The share of loans with one or more payments overdue rose to a seasonally adjusted 6.41 percent of all mortgages, an all-time high, from 6.35 percent in the first quarter.

Tumbling home prices are making it difficult for even the most creditworthy owners with adjustable-rate mortgages to sell or get a new loan as their financing costs rise, said Jay Brinkmann, MBA's chief economist. Prime ARMs accounted for 23 percent of new foreclosures and subprime ARMs were 36 percent, he said.

More commentary from Reuters:

"The national foreclosure numbers continue to be driven by the hardest-hit states continuing to get much worse," Jay Brinkmann, the association's chief economist and senior vice president for research and economics, said in a news release.

The increases in foreclosures in California and Florida overwhelmed improvements in states such as Texas, Massachusetts and Maryland, he said.

"It is unsurprising that mortgage delinquencies picked up further in the second quarter," John Ryding, chief economist, and Conrad DeQuadros, senior economist, at RDQ Economics in New York, said in commentary.

"However, the increase in delinquencies and foreclosures up to this point is most likely predominantly the product of poor underwriting standards. Going forward, we have to overlay the weak economy and labor market picture as this more traditional driver of delinquencies will probably become more of a factor," they said.

Lehman May Put $32 Billion of Dubious Debt in "Bad Bank"

Although there have been rumors of various Lehman Hail Mary passes (the number of companies allegedly interested in investing in the troubled bank seems to grow on a daily basis), the one involving it spinning off less than choice debt into a liquidation vehicle appears to have some substance. A Bloomberg story today gives details that suggest, at a minimum, the idea has been fleshed out in some detail.

Lehman-watchers will no doubt find the provisional name of the new entity a tad Freudian: Spinco.

From Bloomberg:

Lehman Brothers Holdings Inc. may shift about $32 billion of commercial mortgages and real estate to a new company that will be spun off in a move similar to the good-bank-bad-bank model used in the 1980s banking crisis...

The bad bank, nicknamed Spinco for now, would have about $8 billion of equity coming from Lehman, the people said, speaking on condition of anonymity because the plan is one of several under consideration. Spinco would borrow the remaining $24 billion from Lehman or outside investors. The New York-based bank would replace capital put into Spinco, whose shares would be owned by current Lehman shareholders...

The Spinco proposal would enable Lehman to dispose of 80 percent of its commercial mortgages, the people said. Under another plan, the firm would establish a company capitalized and managed by outside investors to buy some of its mortgage assets. The Spinco plan would enable Lehman's shareholders to benefit from a turnaround in the mortgage market...

Lehman's $65 billion mortgage-related portfolio has spooked shareholders...The bigger portion of the portfolio, or $40 billion, is tied to commercial real estate.

Even though defaults of commercial mortgages are still below 1 percent, speculation that delinquencies will jump in that market has pushed down the prices of the bonds backed by commercial real estate loans.

Setser: "If trends continue.....Agencies won’t be able to rollover their debt"

Brad Setser is thoughtful and data driven, but he also isn't shy about saying what numbers portend, even if he runs the risk of sounding a tad alarmist. We've had so much complacency, followed by concerted efforts to keep asset values and confidence aloft that an unvarnished presentation can come off as a dousing of cold water.

Specifically, some have argued that the hand-wringing about Freddie and Fannie is overdone, claiming that their expected losses do not threaten their statutory capital levels (or if worst came to worst, they could shrink their balance sheets, although that could be deemed to be a violation of their charters). Other analysts have looked at the same data and reached different conclusions, forecasting more serious losses that make a rescue necessary.

Setser puts himself in the "bailout is probable" camp, but for different reasons. Foreign central bank purchases of GSE debt is essential to their business model. Freddie and Fannie need ongoing access to cash at very favorable prices, otherwise their mortgages become too costly to appeal to customers and enable them fulfill their mission of facilitating transactions. We've written before about falling central bank purchases versus a large calendar between now and the end of September for GSE sales (see here, here, and here for more evidence of softening demand). While Freddie and Fannie may muddle through September, credit conditions look likely to deteriorate through the end of the year, keeping the agencies in a vulnerable position.

Setser shows that foreign central banks are shifting away from agencies into Treasuries, which is no doubt contributing to freakishly low yields (the ten year was at 3.74% today). Korea would very much like to sell dollars to support the won, but a good deal of its remaining FX reserves is in GSE paper deemed to be not-very-liquid. Any central bank aware of Korea's plight might find that another reason (beside the open questions of how the US proposes to backstop Freddie and Fannie) to choose other vehicles.

From Setser:

In August, central banks added close to $46 billion ($45.92b) to their custodial holdings of Treasuries at the New York Fed. In August, they reduced their holdings of Agencies by a bit over $13 billion ($13.33b).....

Yves here, Note that the decline in demand in January-February corresponded to the spike up in GSE spreads that led, among other things, to the creation of new liquidity facilities and the Bear Stearns rescue.

No wonder that the options market is now implies a significant probability that the Agencies existing common equity will be worth zero; look at this chart produced by Paul Swartz, a colleague of mine at the Center for Geoeconomic Studies.

If these trends continue for much longer, US Treasury Secretary Paulson will be forced to show his hand. The Agencies won’t be able to rollover their debt — at least not at a spread that works for them. The US government will then either have to step or let the Agencies fail. And, well, letting the Agencies fail, in the sense of default on their debt, is probably more than the US government is willing to consider right now.

....the world’s central banks have a fairly clear alternative to buying Agencies: buying Treasuries. Shifting from Treasuries to Agencies cost them a few basis points, but it didn’t require a wholesale change in the currency regimes. It doesn’t require any big policy decision on their part. It is just a technical decision about reserve management – and probably a prudent one at that....

The impact of such a shift, by contrast on the US is far more pronounced. Without central bank financing, the Agencies cannot exist in their current form. They certainly cannot be a conduit between the large pools of savings in the hands of emerging market governments and the US housing market. And right now, that is exactly what the US government wants them to do. Private demand for mortgages – and most other forms of household receivables – has dried up. The Agencies are the mortgage market......

Call it a buyers strike by central banks on assets other than Treasuries.

There's more good material in the post; read it here.

"UK home sales boosted by desperate vendors"

Today's Financial Times describes a new sign of how bad things are in the real estate market in London. People are so desperate to keep their deals alive that they are buying houses they do not want (yes, that sounds completely barmy, but the piece explains how it works). The net effect is that not only are sellers having difficulty exiting the real estate market even with a nominally successful sale, but as the example shows, some are increasing their exposure.

From the Financial Times:

The London property market, once one of the most buoyant in the world, is now so stagnant that desperate vendors are spending hundreds of thousands of pounds buying houses they don’t want in order to sell their homes.

The extreme measure arises from the growth of the so-called property chains that often frustrate home sales in the UK, where houses are normally sold by one party to another, rather than by auction.

The chains occur when a line of buyers and sellers all rely on each other’s transaction to go through. If one deal falls through, because someone pulls out or cannot get a mortgage, for instance, the rest are delayed or fail.

In the increasingly difficult London market, where estate agents say prices have been falling or weak for most of the year, there are fewer cash buyers so vendors are facing longer chains that break down more often as buyers fail to obtain mortgages or try to negotiate discounts.

Rather than waiting for chains to clear, agents say vendors have begun to buy the properties of people further down the chain to clear the way for their own home to be sold.

One homeowner engaged in such a process told the Financial Times she had only been able to sell her house for £450,000 – in order to upgrade to a £700,000 home – by buying an apartment at the bottom of her chain for £200,000...

Hamptons International, one of London’s biggest agents, says it has a number of clients who have sold properties worth between £2m and £3m after buying homes in the region of £300,000 further down the chain. These properties are then being rented out or given to children.