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Generational Dynamics Web Log for 9-Sep-2008
Another stunning and historic bailout: Fannie Mae and Freddie Mac

Web Log - September, 2008

Another stunning and historic bailout: Fannie Mae and Freddie Mac

Giddy investors are popping the champagne corks.

As I listened to the pundits talk about the Fannie /Freddie bailout, I was struck, as usual, by how narrow their discussions were.

As usual, pundits were talking about what happened TODAY -- stocks were up 3% on Asian, European and North American markets, "proving" that the problems were solved. These are people who believe that "history always begins this morning." The closest any of them came to a historical view is that some of them said, "See? They should have done this five years ago when I said they should, and then there wouldn't have been any credit crisis."

Har, har.

Returning to the world of reality, we see one emergency measure after another being put forth by the US government (by the Fed or by the Treasury Dept.) to handle the current crisis, with each new bailout larger than the last one.

Can that continue? Does the US Government have infinite resources?

Here's an interesting graphic that Michael "Mish" Shedlock posted on his blog last month:

Analysis of reserves on and off Fed's balance sheet <font face=Arial size=-2>(Source: globaleconomicanalysis.blogspot.com from cumber.com)</font>

Analysis of reserves on and off Fed's balance sheet (Source: globaleconomicanalysis.blogspot.com from cumber.com)

The different acronyms refer to different Fed programs to provide money to banks caught in the credit crunch.

What it shows is that the Fed is running out of liquid assets. Almost all of those other things are illiquid assets, mostly valued at phony market prices. For example, the TAF refers to the Fed's "Term Auction Facility," that allows banks to borrow money from the Fed, posting as collateral mortgage-backed securities that may be almost worthless.

So basically, the Fed has few arrows left in its quiver.

That leaves the Treasury. Theoretically this is a bottomless pit, since the Treasury can "print money." Well, maybe it could print money once upon a time, a century or two ago, but today Treasury can't "print money." What it CAN do is borrow money by issuing Treasury bonds, and selling them to anyone who'll buy them.

The Chinese particularly have been buying them, and we owe China an incredibly large sum of money.

The Chinese have also been buying another kind of bond besides Treasury bonds. Can you guess what, Dear Reader? Yes, they've been buying Fannie and Freddie bonds, also called "GSE bonds." Fannie and Freddie have been borrowing money like mad.

Normally, they borrow money so that they can lend it out again to prospective homeowners who need a mortgage. It's a nice system, as long as it keeps working. Well, it turns out that Fannie and Freddie have been keeping bogus books, not taking into account the fact that there are many, many foreclosures. And if those mortgage loans aren't going to be repaid, then Fannie and Freddie won't get the money they need to pay back the money that China and others lent them by buying GSE Bonds.

And recently, China has been cutting back on buying GSE bonds because -- guess what, Dear Readers -- yes, because the Chinese have figured out that Fannie and Freddie were going to default on those bonds. Those clever Chinese!

And so, the government is now bailing out Fannie and Freddie, essentially by saying that GSE Bonds are backed by the full faith and credit of the US Federal Government.

So now the GSE Bonds are JUST AS GOOD as the Treasury Bonds. And the Chinese can buy GSE Bonds again. And if there's ever any problem with those GSE Bonds and they default, why, the Treasury will pay to back them up. And where will the Treasury get the money to back up the defaulting GSE Bonds? Can you guess, Dear Reader? Why yes, you got it -- Treasury will borrow the money from the Chinese by selling more Treasury Bonds to the Chinese. Do you think those clever Chinese have figured that out, too?

This stuff just leaves me breathless.

And there's another interesting wrinkle to all this. As I understand it, the government is backing the GSE Bonds, but not Fannie and Freddie stock. So if you're a poor schmuck in the stock market whose broker told you that Fannie and Freddie stock was a "good as gold," guess what? You're screwed.

This is how fortunes are made. Bill Gross from Pimco invested heavily in GSE Bonds, and then lobbied Washington hard to get this kind of bailout. Bill Miller of Legg Mason invested heavily in Fannie and Freddie stocks, and is facing financial disaster.

And there's more: It appears that US regional banks were heavily invested in Fannie and Freddie stocks, while foreign banks were more heavily invested in Fannie and Freddie bonds. So the foreign banks will make out better than the US regional banks in this bailout although, let's face it, it's all just Chinese money anyway.

Third quarter earnings estimates

For months, Treasury officials were claiming that Freddie and Fannie were doing well, and would not be bailed out. No one really believed that, but still, that's what the officials were saying.

Then on Monday, I saw Steve Liesman on CNBC interview Treasury Secretary Hank Paulson. Here's one exchange:

"Liesman: I think we have to talk about some of the charges out there about the politics relative to the timing. Some people say, hey, wait a second, this followed the Republican convention and it is very far from the election. Did that play a role in when you decided to move?

Paulson: Oh, absolutely, no role. Steve, we have been working around the clock for weeks. People say to me, you always do these things on the weekends. We have been working every weekend. The amount of work that has been done here by the Federal Reserve, the OCC, FHFA, my team here at Treasury, we have been analyzing data, looking at the situation, getting ready. And we moved as quickly as we could move and as was appropriate. If we could have moved quicker, we would have done that."

And so, guess what? When Treasury officials said that they weren't planning any Fannie/Freddie bailout, they were lying. They were working "around the clock for weeks," taking breaks only to tell the public that they weren't doing anything.

Of course this is a "good lie," as opposed to other kinds of lies, called "bad lies." But I tell you again, Dear Reader, you should not believe anything about finance that any journalist, analyst, executive, politician, or government official tells you. The norm today, on the right and the left, is to lie openly. And it's ok because everyone knows that everyone is lying (except for the people who don't know, and therefore get screwed).

And that brings us to corporate earnings. This is a game we've been playing for several quarters now. We keep track of the estimated earnings growth for each quarter, and see how the estimate changes from week to week.

Back in March, Thomson Financial was providing the following earnings growth estimates for 2008:

  Period  Earnings growth estimate as of 3-March (Thomson Financial)
  ------- --------------------------------------------
  Q1 2008       2.6%
  Q2 2008       3.5%
  Q3 2008      20.0%
  Q4 2008      50.0%

Actual Q1 earnings growth was -17.5%. Actual Q2 earnings growth was -22.1%.

We're now able to begin posting the table of third quarter S&P 500 average corporate earnings estimates, based on figures from CNBC Earnings Central supplied by Thomson Reuters:

  Date    3Q Earnings growth estimate as of that date
  ------- -------------------------------------------
  Mar  3:              25.0%
  Apr  1:              17.3%   Start of previous (2nd) quarter
  Jul  1:              12.6%   Start of quarter
  Sep  5:               0.8%

We're playing the same game that we've been playing for several quarters, with the same results. Each week, analysts give bloated earnings estimates that they have to lower in the following weeks, as actual earnings start coming in.

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 5-Sep-2008. <font face=Arial size=-2>(Source: MarketGauge ® by DataView, LLC)</font>

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 5-Sep-2008. (Source: MarketGauge ® by DataView, LLC)

As earnings estimates fall, price/earnings ratios go up, and they're really skyrocketing these days, as shown in the above diagram, which is Friday's version of the graphic that appears on the bottom of the home page of this web site.

Investors pushed price/earnings ratios up because they actually BELIEVED the 25% figure that was coming out in March.

Investors and pundits today just CAN'T BELIEVE that the bubble is still leaking, and that the bubble isn't going to start growing again. They are going to be shocked beyond belief.

On Monday, the Fannie and Freddie bailout caused investors to push up stock market indexes by several percentage points in Asia, Europe and North America. The reasoning is as follows: "The Fannie and Freddie bailout is so huge that it must be the end of all the financial problems." Doesn't that make sense to you, Dear Reader? It doesn't to me either, but that's what investors are telling themselves.

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (9-Sep-2008) Permanent Link
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Generational Dynamics Web Log for 9-Sep-2008 Another stunning and historic bailout: Fannie Mae and Freddie Mac

Third quarter earnings estimates

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Generational Dynamics Web Log for 9-Sep-2008
Another stunning and historic bailout: Fannie Mae and Freddie Mac