The Fannie and Freddie Rescue WELLINGTON LETTER

SPECIAL BULLETIN

The Fannie and Freddie Rescue

THE BIG NEWS EVENT OF THE WEEKEND

STOCK MARKET

The initial “sigh of relief” rally may be much shorter than the bulls would like. Yes, the Fannie and Freddie problems are resolved – for now. The fact that the Treasury took these steps confirms that the liquidity situation of both firms was getting critical. But the rescue had already been built into the markets over the past seven weeks. It was obvious that the government could not let them fail.

So, what’s for an encore? Does it resolve the write-down problems of assets in the banking system? What about the Wall Street firms? And what about the future problems of the private equity firms as their acquired companies have trouble making debt service?

The serious problems are still out there. Everyone knew that these two GSE’s would not be allowed to go out of business. That is no surprise. It only gives a psychological boost, but it will take more than psychology to compensate for trillions of dollars of derivatives melting down.

Its important to remember that everything that the Fed and the U.S. Treasury have done over the past 12 months, which includes the Fed using half its balance sheet, i.e. $400 billion of Treasury securities, has not resolved anything, but only prolonged the inevitable.

The major indices last week started breaking down to new bear market lows, unemployment is soaring, and the economy is in a certain recession which the guys with their Ph.D.’s won’t recognize until next year.

The ill-defined Fannie and Freddie bailouts won’t be any different. It’s like using an aspirin to fight terminal cancer.

While the bullish analysts tell you about the good earnings of companies, and the exciting “widgets” they make, and the virtually unlimited demand for them, they totally ignore the primary driving factor in economies and investment markets, i.e., credit availability. Without credit, economic growth comes to a screeching halt.

And that’s where we are now. Most banks can’t lend because they are close to their capital reserve requirements. They must raise more capital, which is very difficult, or just stop lending and call in loans.

Major firms, such as Lehman, Fannie Mae, Freddie Mac, GM, Ford, etc. are totally unable to raise long-term capital to strengthen their balance sheets. Their preferred stock yields, and yields on long-term debt, are sky high, implying that the market believes they will not be able to survive. The preferred issues yield from 13%-18%. They can’t raise new capital issuing new preferred at these yields, as it would accelerate their demise. GM’s short-term debt is now yielding well over 20%. Investors obviously are not worried about the return ON their money, but OF their money.

Apparently, many investors are being fooled by the $4-5 billion write-offs repeatedly taken by large financial firms. The amounts seem manageable, so they don’t worry. But you have to add them up. For example, MER wrote down $5.5 billion last October. It got a capital injection from Singapore to compensate. However, at this time, the write-offs of MER amount to $48 billion.

Hundreds of billions of dollars in short-term financing used to be conducted in the commercial paper (CP) market. Consider these Federal Reserve figures on commercial paper outstanding: The “asset-backed” CP outstanding has plunged by about $500 billion dollars, or 40%, from last year’s peak of about $1220 billion. That’s the biggest decline of any credit market in history. How can anyone believe that it won’t cause a serious recession?

However, there is a small positive, namely that “non-financial commercial paper” has seen a rise lately. This is the CP issued by large, non-financial companies. It means that someone is able to raise money in the commercial paper market.

But it’s the banks that usually provide credit to smaller and mid-size firms. They are not able to do so now except on a minor scale. And that’s where the problem lies. During the 14-year stagnation in Japan, the banks could basically not lend because they were still loaded up with all the bad loans created during the 1980’s bubble. Their government should have created a mechanism to get those bad loans out of the banks so that they could lend again. The Fed knows the Japanese problem, and is trying to make sure that it doesn’t happen in the U.S. Their answer is “Term Facilities,” where the Fed trades liquid U.S. Treasury paper it holds for the illiquid paper assets held by the banks. But these are loans, not permanent capital infusions.

While the Fed holds these securities, they continue to lose value. Wouldn’t the banks be smarter to just dump them before they become worthless? They probably hope that eventually the Fed, or the Treasury, will just keep them, because reversing the swaps would mean instant bankruptcy for the banks, as they have to write down the value.

Values of all these paper “assets” are shrinking. Merrill Lynch recently dumped its CDO’s, which was a smart move. These CDO’s were declining every day, and finally MER decided to get a dwindling asset off of its books before everyone else decides to dump their own holdings.

Mortgages held by financial institutions are losing their value on a weekly basis. The huge bond investment firm, PIMCO, estimates that $5 TRILLION of mortgage loans are in the “risky asset” category. That’s about 40% of all mortgages. If you are one of the bulls, just think, how can the Fed, or the Treasury, bail out $5 trillion in bad mortgages?

The credit crunch is worsening, yet a number of economists, including some presidents of Federal Reserve districts, are urging the Fed to raise interest rates. This is a great argument for not letting human beings be in charge of something as important as setting interest rates. The markets can do a much better job. The hawks on rates fail to see that the “low” Fed Funds rate of 2% has nothing to do with market rates, which is what the average person, and the average corporation, pay. The low Fed Funds rate creates a steep yield curve, which allows banks to improve their profitability. Higher rates will cause more bank failures. Is that what we want?

This technique of creating a steep yield curve helped resolve the banking crisis of 1990-1991. Banks borrow at the low short-term rates and invest the money into much higher-yielding U.S. Treasury bond rates, thus making a nice profit. That is also the reason that the prices of these Treasuries continue to rise, totally confusing economists who have been saying that bond prices should decline because of higher inflation. These economists just don’t know how the markets work.

The number of business bankruptcy filings rose 42% in the 12-month period through June 30. The numbers are still relatively small, but the trend is definitely negative.

GMAC and its Residential Capital LLC home lending unit announced that they plan to fire 5,000 employees, or 60 percent of the staff, and close all 200 GMAC Mortgage retail offices because of weak real estate markets. Loans originated by outside brokers through the company’s Homecomings unit will cease and business lending will be curtailed, the company said.

And that’s how credit becomes tighter.

Ford reported that domestic sales fell 27% in August. That’s the 21st decline in 22 months. Ford is reducing its planned second-half production in North America by 50,000 vehicles. In July, sales of U.S. carmakers declined to the lowest sales rate in 16 years.

Meanwhile, Nissan of Japan reported that its sales gained 14%. What’s wrong with Detroit management?

We are now coming to the phase of the bear market and recession where there is a realization by the majority of the investment establishment that the credit crunch is accelerating. Such an acceleration acts like an avalanche, where the lenders and other sources of liquidity suddenly realize that their previous “bargain hunting” has resulted in big losses and they are no longer willing to provide capital.

Banks shut their lending windows for two reasons: they don’t have the capital, and they don’t want to take the risk.

Bill Gross, founder of PIMCO, the largest bond firm in the world, and a very astute analyst of the credit markets, was very candid and revealing last week on CNBC. He admitted that PIMCO had been too quick to provide capital to financial firms early this year when they thought the worst was over.

Obviously, they don’t subscribe to our WELLINGTON LETTER, where we warned last year that the bargain hunters were much too early. He said that currently, they and other investment firms are no longer willing to provide capital.

He said that, to resolve the current crisis, the financial markets need $500 billion of capital. This is huge.

No one can provide that except the government. Remember, the investments by the large, foreign “Wealth Funds,” which invest in governmental surpluses, have been investing the amount of $4-6 billion. And they now hesitate to invest more. Well, the $500 billion required is nowhere to be found, except at the U.S. Treasury printing press.

Late last year we said that a capital infusion of that much by the Federal government was the only way to restore confidence, not the small amounts of $20 billion and $50 billion which the Fed actually did provide. Paulson had it right a few months ago when he said that when everyone knows you have a bazooka, instead of a little pistol, you don’t have to use it.

Of course, at that time, most of the policy makers in Washington didn’t even think there was a crisis. Our leaders in Washington are reactive. When the meltdown really gets going, they’ll start scrambling. But wouldn’t it be better for them to come up with a program now, totally avoiding the next crisis?