I’m becoming even more bearish than I already was.
The U.S. Treasury will ask Congress to allow an unspecified amount of equity injections into Fannie Mae and Freddie Mac. The Treasury has already asked to increase the current $2.25 billion credit line for each of the government-chartered banks.
Meanwhile, the Federal Reserve has created a lending facility for Fannie and Freddie for loans collateralized with their own debt and with Treasuries.
JPMorgan analysts — prompted by the U.S. Treasury’s move on the banks on Sunday — see no respite for structured finance.
Quoting those analysts:
Unlike the Russian default crisis, failed hedge fund Long-Term Capital Management or the technology, media, and telecom stocks crises, "we are unable to see a 'club' structure with the ability to make industry-wide decisions to resolve the issue and hence proactively rather than reactively intervene."
"We conclude, the Fed action could trigger a short-term rally but with what we see as a lack of leadership, the structured credit crisis is spilling into 2009."
JPMorgan thinks three "curve balls" remain unresolved: U.S. "pure" investment banks, monolines, and highly leveraged banks.
I think the big issues remain the following: banks are overleveraged, and notwithstanding government support (which can’t go on forever) fears about counterparty risk and liquidity are still pervasive.
Fear has spread from commercial paper markets to repos, credit default swaps, and will continue — say JPMorgan’s equity research team — to eat right into traditional credit.
How many bailouts can the U.S. government manage? First there was the superSIV, the fund to back the structured investment vehicles. Then there was the Bear Stearns bailout with JPMorgan. Hot on the heels of that, the monoline insurers, MBIA and Ambac Financial.
And now, Fannie and Freddie. Not to mention, via the Federal Deposit Insurance Corporate late Friday, home lender Indymac, which got taken over by regulators.
Straws? Camel? Back?
So, the big, unanswered question becomes, will foreign governments keep buying U.S. agency debt?
Consider these potential "straws" hovering over our already stumbling camel:
• Central bank holdings of agencies (including those of Fannie Mae and Freddie Mac) have soared over the past two years and likely exceed $1 trillion. China accounts for half that total, Japan has over $250 billion (split between private and official sector holdings), and Russia holds about $100 billion (especially short-term). The implicit government guarantee means that the agencies could run out of equity before central banks lose their willingness to buy agency paper.
• Potential serious repercussions of a flight of foreign capital if there is a sudden perception that agency debt entails heavy risks.
• Government-backed entity bonds, like those of Fannie Mae and Freddie Mac, are not officially backed by the U.S. government and trade at a significant risk premium to Treasury bonds, but the implicit guarantee made them attractive to many investors, including governments like China. Chinese and Russian holdings of agency bonds nearly doubled in the year ending June 2007, according to U.S. Treasury data.
• Exposure to U.S. government agency bonds more widespread than that to subprime-related mortgage-backed securities among emerging markets. With concerns about the solvency of Fannie and Freddie and the chance that they might be nationalized, holders are worried.
• The widening of the agency debt spread relative to Treasuries — from 10 basis points to about 100 basis points — has reduced the mark-to-market value of such agency debt.
• Foreign investors own $1.3 trillion in agency debt. Among them, China, Japan, the Cayman Islands, Luxembourg, and Belgium hold the highest shares of long-term debt. Havens like the Caymans may reflect the holdings managed on behalf of other holders.
• China and Japan had the largest total exposure to the U.S. mortgage market, though unlike European markets it was more clustered among higher-rated securities.
• In mid-2007, the Chinese central bank portfolio included as much as $100 billion in U.S. mortgage-backed securities.
• The acceleration in Chinese reserve growth coincided with an increase in China's risk appetite. The purchase of debt securities by China's banks also picked up in the course of 2006. Many of these securities were financed using funds borrowed from the People's Bank of China through foreign-exchange swaps.
• In 2007, foreign investors bought 55 percent of $32 billion in new Fannie Mae benchmark notes. Their share shot up from about 49 percent of the $39 billion of new notes in 2006 and from the 37 percent share in the past decade.
So, I’m becoming even more bearish than I already was.
Why? Because now the Fed and Treasury seem to be aiming for an explicit government bailout guarantee for Fannie and Freddie, which in fact will be a guarantee of a guarantee.
For the moment at least, I’ve lost my confidence. Given all of the straws over our quivering camel, what kind of guarantee will be allocated to the other government-backed entities? Who's is going to trust those guarantees?
I’ve put the dollar on "negative" watch and will act, that is, sell on pure technical signals. We aren’t there yet. I remain, however, in energy, “serious" inflation-fighting currencies, agriculture, and physical gold kept in always-accessible places.
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