I do not have a new message here; we have known for a long time that advance preparation and a strong balance sheet are the keys to riding out a financial storm. As I have emphasized before, the Federal Reserve can deal with liquidity pressures but cannot deal with solvency issues.
~ William Poole, President,Federal Reserve Bank of St. Louis (February 29, 2008)
The Federal Reserve System announced a new program on March 11. The announcement was not quite gibberish, but it was close. This much was clear: it is a $200 billion program.
The stock market bulls thought, “Wow! That’s huge! That will solve the problem!” They did not read the details of the proposal.
The announcement was an implicit admission of a looming credit crisis of monumental proportions: an unprecedented write-down of bank assets. Why? Because these assets, rated AAA by the big three ratings agencies, are nowhere near AAA. Banks are facing new rules on financial reporting: mark to market, meaning the end of the book value (face value) game that they have played for decades. This is the Financial Accounting Standards Board Rule 157. It goes into effect for banks this quarter, which ends on March 31.
Bankers are going to have to report the truth or else face criminal penalties. Why, they even might turn into Eliot Spitzer! That’s what happens when you play fun and games, as accountants have been allowed to do.
The solution? Sell these promises to pay at market prices. This would have included the promises to pay issued by Fannie Mae and Freddie Mac, the two mortgage-investing companies that account for 40% of the American mortgage market, and which have accounted for at least 70% of new mortgages written over the last six months.
That solution would have brought economic reality to the investment world’s attention: the AAA ratings have been overly optimistic.
The FED rushed to the rescue. It offered to auction off U.S. Treasury debt in its portfolio, which is always AAA-rated, in exchange for AAA-rated private debt. This will allow banks to transfer to the FED questionable assets in exchange for assets that cannot be downgraded in today’s markets: Treasury debt.
The FASB’s Rule 157 does not apply to the FED. It will not have to report a capital loss.
This program was seen by mutual fund managers as an increase in liquidity. It was in fact a last-minute desperation move by the FED to stop a free-fall in the credit markets and possibly even a lock-up of the banking system. If that is the meaning “increased liquidity,” fine. But this was not how the FED or anyone in the media explained the new program. For my explanation, click here.
The FED timed its announcement of this proposed “temporary” $200 billion asset swap just in time for the opening bell of the New York Stock Exchange on March 11. Sure enough, the Dow soared 416 points that day. The next day, it fell by 46 points, after having climbed early in the morning by 150 points.
We have learned that a FED press release can goose the stock market for one day. Then the market sinks.
Stock market optimists who have lost money all year want to believe that the FED can achieve the following with a new program:
1. Overcome the liquidity crisis2. Overcome the solvency crisis3. Overcome sinking residential real estate markets4. Avoid the imminent fall in the commercial real estate markets5. Restore bankers’ confidence in other bankers6. Restore confidence in the credit rating services’ credit rating services7. Reverse the dollar’s slide8. Reverse the falling stock market
If the FED could do any of this, don’t you think it would have done so by now?
We have seen all of this unfold since last August. The stock market recovered its July high by mid-October. In fact, it was even a bit higher. The optimists thought the FED was on top of things when it announced the new, “temporary” Term Auction Facility. It also announced lower federal funds target rate. Happy days were here again. Then reality reasserted itself. Down, down, down the market fell. Take a look at the chart of the S&P 500.
The optimists grab at straws. FED programs are convenient straws.
A LOSS OF CONFIDENCE
We are seeing a broad-based loss of confidence in the American economy. This is affecting just about everything: housing prices (“the great American dream”), the stock market, the international currency market, the commodities market, the municipal bond market, and the banking system. Only the T-bill market seems immune. There has been a rush into T-bills, driving rates below 1.5%. This indicates looming panic in the other capital markets: a flight to safety. This loss of confidence is forcing huge changes in America’s capital markets. We are seeing a move from confidence to doubt. Such a move always has a price: an increased risk premium on loans.
The Friday before the FED’s announcement, a media story appeared on a looming default by the Carlyle Capital Corporation, the legally separate mortgage investment entity of the giant Carlyle Group, whose investors include George H. W. Bush and the Bin Laden family. Carlyle Capital Corp. could not meet margin calls. The margin call was $400 million.
Understand, this was not the total value of the fund. This was just the initial margin call.
On March 13, the bad news came true. The company could not meet these margin calls. The price of the shares fell by 95% in the Amsterdam market, where it is traded. It announced that it had defaulted on $16.6 billion.
When some poor guy in a Fannie Mae-funded home leaves because he cannot make the monthly payment, this is called walking away. When it is done by a corporation set up on the Channel island of Guernsey, it is not called walking away. It is called going bankrupt.
In July, the fund had tapped the public for $300 million in capital. In July, things were still rosy. The Dow was at 14,000. That was then. This is now.
“If Carlyle’s lenders want their money right away, they’ll liquidate the fund,” said Hank Calenti, a London-based analyst at RBC Capital Markets. “That will put pressure on already stressed credit markets.”
It sure will!
“At this point we are exploring all options” for Carlyle Capital, Emma Thorpe, a spokeswoman for Carlyle Group in London, said in a telephone interview. She declined to specify the options being considered.
I think what Ms. Thorpe meant was that she is sending out her résumé to everyone in her Rolodex. But I could be wrong.
The organization at one point held $22 billion in mortgages issued by Fannie Mae. Its debt to equity factor, according to the New York Times (March 7), was 32 to 1.
This seems a tad high to me. I guess I’m old fashioned.
The Carlyle Capital Corporation was confident in its portfolio — confident enough to establish a 32 to 1 debt-to-equity ratio. But why?
Carlyle’s fund has said its so-called agency debt has an “implied guarantee” from the U.S. government.
I believe the appropriate phrase here is this: “There’s a sucker born every minute.” P. T. Barnum never said it, but it’s true. Some of them are (or were) rich.
There will be similar events. Count on it.
“This is not only a problem for Carlyle,” Jochen Felsenheimer, the Munich-based head of credit strategy at UniCredit SpA, wrote in a note to clients today. “We expect a further flood of downgrades especially of higher-rated securities, putting enormous pressure on the system.”
Now, we must get to the famous bottom line. Carlyle Capital Corp. was not acting alone. There were “counterparties.”
Carlyle’s counterparties are a dozen Wall Street firms including Citigroup Inc. and Deutsche Bank AG, according to the fund’s annual report. The banks use repurchase agreements to lend money and require securities be put up as collateral. As the perceived creditworthiness of asset-backed bonds declined, the amount of money that can be borrowed using them as collateral fell.
Who else? The New York Times (March 7) listed these lenders: UBS, Merrill Lynch, Lehman Brothers, JPMorgan Chase, ING, Deutsche Bank, Credit Suisse, Citigroup, BNP Paribas, Bear Stearns, and Bank of America.
Do you begin to get the picture? This was why the FED announced its credit swap plan in March 11. The economists saw what is obviously coming.
“Carlyle won’t be the end of it,” said Greg Bundy, executive chairman of Sydney-based merger advisory firm InterFinancial Ltd. and a former head of Merrill Lynch & Co.’s Australian unit. “There’s more to come. The problem is no one can give you an educated guess about how much.”
If you go to the Carlyle Capital Corporation’s website (act now — this offer is limited!), you will read the following: “Quality diversified assets, steady current income.” Diversified? Did they think that $22 billion of Fannie Mae debt was diversified? Then we read this:
Carlyle Capital Corporation Limited (“CCC”) is a closed-end investment fund domiciled and registered as a limited company under the laws of Guernsey, Channel Islands. CCC invests in a diversified portfolio of fixed income assets including high-grade mortgages and credit products. CCC’s day-to-day activities and investment portfolio are managed by Carlyle Investment Management L.L.C., whose investment professionals have extensive experience in the areas of mortgage finance, leveraged finance, capital markets.
These were clever people — too clever by half. They are now overseers of a stricken company, which was incorporated so far away, so distant from lawsuits. The best and the brightest put their money in this company, which was the financial equivalent of the Hindenburg.
In January, 2005, William Poole, the President of the Federal Reserve Bank of St. Louis, gave a speech on the GSE’s: Fannie Mae and Freddie Mac. He sounded a warning.
An understanding of the risks facing Fannie Mae and Freddie Mac — which I will sometimes refer to as “F-F” to simplify the exposition — is important from two perspectives. First, investors should be aware of these risks. Although many investors assume that F-F obligations are effectively guaranteed by the U.S. Government, the fact is that the guarantee is implicit only. I will not attempt to forecast what would happen should either firm face a solvency crisis, because I just do not know. What I do know is that the issue is a political one, and political winds change in unpredictable ways.
A second reason to understand the risks is that sound public policy decisions depend on such understanding. To reduce the potential for a financial crisis, risks need to be mitigated.
He ended with a strongly worded warning that the managers of Carlyle Capital Corp. did not take seriously enough.
One thing I think I know for sure is this: An investor who ignores the risks faced by Fannie Mae and Freddie Mac under the assumption that a federal bailout is certain should there be a problem is making a mistake.
THIS WILL GET MUCH WORSE
We are in the early stages of a write-down of assets not seen since the Great Depression. This is going to go into the history textbooks.
The man who predicted this most eloquently was Dr. Kurt Richebächer. He died on August 24, 2007, two weeks after the events he had long predicted began. He regarded the expansion of credit under Greenspan as laying the foundation of the worst post-World War II economic contraction. He seemed like John the Baptist, crying in the wilderness. He seems today more like Jeremiah, the author of Book of Lamentations.
These stories of busted investment companies will continue for the rest of 2008 and well into 2009. My fear is that the stories will get worse as time goes on. Because the financial industry is at the center of this recession, the economy is at great risk. It is one thing for manufacturing firms to go bust in a recession. There are fewer of them these days inside the United States.
We are now seeing huge banks in trouble. When they cease lending, the economy will topple. Declining capital due to credit market defaults will cause banks to reduce lending. They will not be operating on a 32-to-1 ratio.
Economic growth comes mainly from small companies that get big. So does employment. These are the companies that the capital markets generally ignore. Local banks are their source of loans. They will find that when local banks are in the middle of an international credit crisis, loans become very difficult to obtain. I saw this in Texas in the S&L crisis, 1984—87.
If this recession lasts only a year, I will be pleasantly surprised. The recovery will be weak. Why? Because this time confidence in the FED will be at rock bottom. Confidence of the Federal government is already low. Congress is impotent. There will be a new President. None of the candidates inspires confidence in people with money to invest.
We hear the phrase “systemic crisis” too often. Systemic crises are real, but they rarely manifest themselves until after time has run out. In the interim, nothing is done to correct them.
The FED is facing what appears to be the early phase of a systemic crisis. The stock market has not reflected this yet. It is slowly declining, with fits and starts. It is not collapsing.
My suggestion is that you do not pay much attention to upward moves in response to new programs offered by the Federal Reserve System. If it could do anything other than inflate the money supply, it would not be coming up with late-night emergency bailouts to be announced just before the opening bell of the New York Stock Exchange.
March 17, 2008
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