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Jim Cook



Every once in a while I switch the TV channel from Fox to CNBC to see what the liberals are saying.  After listening awhile I get a deep sense of hopelessness and foreboding for our country.  The most important thing for the left is giving money to people.  They are happy to see the growth of food stamps, disability payments, housing subsidies, free healthcare and all the other welfare benefits.  They utterly fail to see the damage it is doing to the recipients.  Whole cities that once flourished have deteriorated into rotting eyesores populated with shambling hulks of chemically dependent drones.  These people are no longer employable.  They have become incompetent and helpless and the liberals can’t see that it’s their doing.

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The Best of Jim Cook Archive

Commentary Of The Month
September 17, 2008
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GSE Bailout: This is Bad News not Good

  • by Rob Lee

Rob Lee is an economist who has been involved in investment markets for 30 years, the last few in nominal retirement

Initial market reaction to the Fannie Mae (FNM)/Freddie Mac(FRE) "rescue" has been positive. Mortgage rates are expected to come down and mortgage availability improve, helping to stabilise the housing market and thus the financial system and economy. Are these expectations realistic?

This depends on the longer term impact of the bailout on US bond yields. The spread between yields on FNM/FRE mortgage bonds and Treasury bonds will clearly narrow sharply as the government guarantee becomes explicit (or at least seems to). Therefore if long term US bond yields hold steady or fall then mortgage costs WILL come down. However, if long bond yields rise substantially the impact on housing and the economy will make a bad situation even worse.

A sharp rise in bond yields is much the more likely scenario, for the following reasons:

* The tale of how the two GSE’s got to this point is a long and sorry one. It is a story of quite staggering ineptitude on the part of company management, the financial regulators, the Federal Reserve, the US Treasury, and the US Congress. I believe it is a seminal moment in the ongoing demise of the US Dollar as the world’s reserve currency.

* The man now in charge of FNM/FRE is none other than Federal Housing Finance Agency Director James Lockhart - the same regulator that consistently failed to track what was really happening there. On March 19th this year Mr Lockhart, easing restrictions on how much capital they were required to hold, said " The actions we have taken today make the idea of a bailout nonsense in my mind". You can’t make this stuff up!

* The sudden move to rescue is highly instructive. It is clear that when Treasury Sec. Paulson asked Congress for the powers now used, he did not expect to have to use them. Why the change? Firstly, it is obvious that the capital position of the two was far worse than previously revealed. Secondly, a recent buying "strike" by foreigners of agency securities made it clear that upcoming large scale auctions of new agency debt would fail. The fact is that this dramatic rescue was prompted by fear of imminent and severe crisis - on reflection not something investors should regard as cause for confidence.

* Conservatorship raise more problems than it solves. The ultimate fate of these institutions is still highly uncertain and politically charged. Imagine the wrangling in Congress over the next eighteen months, especially if there is a President McCain but a heavily Democratic Congress? It is not clear to me that the issue of a formal government guarantee for agency securities is finally resolved. What if the agencies are re-privatised in some way, or dissolved?

* More broadly, the state has become still more heavily involved in the financial system and the housing market. If the housing downturn is prolonged this involvement will become deeper and more complex. Conflicts of interest will multiply. For example, the rescue package as it stands has been very damaging for holders of the preferred and common stock but advantageous for holders of agency securities. Some banks have a considerable portion of their "core" capital in the preferred stock and may now need bailing out themselves. Conversely, PIMCO is a major holder of GSE bonds and thus a winner (coincident with recent strenuous advocacy on their part of a bailout). Issues like these are a minefield of future litigation. Many such pitfalls lie ahead for investors and policymakers.

* The Federal Reserve already has around $400bn of dubious assets on its balance sheet as a consequence of its liquidity assistance to the banking system. The US Treasury is now effectively adding $5.4 trillion to the public debt by backing FNM/FMC bonds. Of course they also then have the mortgage assets of FNM/FMC. What losses are likely on those? Bill Poole, ex-Fed Governor reckons about $300bn.

*The recession (yes, there is a recession) is already rapidly widening the federal deficit. The time when the baby boomers start adding big time to government spending is fast approaching. The auto companies are requesting $50bn in loans to develop alternative energy engines. The Federal Deposit Insurance Corporation (FDIC) will need a major injection of funds as the number of banks that go under grows. The list goes on. As the saying goes, ‘a million here and a million there and pretty soon you’re talking serious money’.

* Increased state involvement in the economic system in general, and bailouts and subsidies in particular, are usually regarded by investors very negatively. So are large and growing fiscal deficits. They have usually led to currency crises in emerging markets, and always when large current account deficits are also present. The IMF is then typically drawn in to restore financial sustainability.

If the US were an emerging market such a crisis would have already erupted, but the US is still protected by the dollar’s reserve currency role and its superpower status. The IMF is not going to be called in. Instead, foreign investors will do the job by withholding or withdrawing capital. The recent sharp upturn in the Dollar (which has all the hallmarks of a bear market rally) will reverse as dollar holders take full stock of what has happened. In defiance of low Fed-managed short rates, US Treasury long bond yields are going higher. In time probably much higher. The present market euphoria is nothing but a mirage.