Agora Financial’s Rude Awakening

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Dubai, United Arab Emirates

• Who to thank for your dollar’s massive inflationary swoon,
• America’s biggest banks beg for more bucks – what that means for yours,
• A disturbingly long list of adverse consequences and plenty more…

Eric Fry, reporting from Laguna Beach, California…

“I think we’re closer to the end of the [credit crisis] than we are to the beginning,” Treasury Secretary Paulson confidently declared yesterday. Most of the financial experts in and around New York City – or in front of  CNBC television cameras – seem to agree. These experts also assert that the financial sector is recovering and that the “worst has
passed.”

Curiously, however, the “recovering” financial sector looks a lot like the crisis-stage financial sector of last autumn. Top-line revenues are still contracting, while balance sheet assets are still deteriorating. No surprise then that the titans of the financial sector continue to raise titanic quantities of fresh capital. Citigroup, alone, has secured more than $40 billion of new gambling money, while Bank of America, Merrill Lynch, Wachovia and Washington Mutual have raised more than $50 billion combined.

These “recovering” financial institutions seem just as desperate for fresh capital as they used to be during the darkest days of the credit crisis, way back in mid-March. These institutions also seem just as eager to unload mortgage-backed assets on their new best friend, the Federal Reserve. As the nearby charts illustrate, the Federal Reserve has dramatically INCREASED its repo purchases of mortgage-backed securities (MBS) from banks and brokerage firms. The top chart debuted in the October 26, 2007 edition of the Rude Awakening (SIV-Positive).

We remarked at the time:

“Already, the Federal Reserve appears to have absorbed about $25 billion in MBS securities via ‘temporary’ repurchase agreements…Repurchase Agreements, ‘repos’ are also called Sale and Repurchase Agreements. Under these agreements, the seller (usually a bank) sells securities to a buyer (usually the Federal Reserve) for cash. But the seller (bank) agrees to re-purchase the securities from the buyer (Fed) at a later date. Typically the banks use Treasury bonds or Agency bonds as repo collateral. Lately, however, mortgage-backed securities (MBS) have become the collateral of choice.

“In the early part of [2007], the Fed rarely ‘repoed’ an MBS. Weeks would pass between MBS repos. But as springtime [2007] arrived, MBS repos started popping up like so many daffodils. Just a few at first, then a few more, then eventually enough to absorb a money center bank’s entire short-term liabilities…for example…

“The rolling 2-week total of ‘temporary’ MBS repos soared from about zero in June to a whole bunch in August…and the repos are on the rise again, despite the ‘recovering’ credit markets.

“The Fed’s newfound interest in MBS contrasts sharply with the utter disinterest of free market investors. The disinterest of real-world investors comes as no surprise. It is an open secret among many hedge fund managers that the institutional holders of mortgage-backed securities and derivatives have not even come close to marking their assets to market. It is also an open secret that two critical pieces of knowledge remain utterly unknown: How big is the total MBS risk? Who’s holding the risk?

“Until these questions receive credible (and quantifiable) answers, no one will provide financing to [asset-backed] entities, except the Fed.”

Six months have passed since the Fed first ramped-up its MBS repo activity, and the details of the MBS market remain as murky as ever. Still, very few private buyers will finance MBS purchases. Still, the Fed fills the role of “buyer of last resort.” In fact, as the second chart illustrates, the Fed has been increasing its MBS purchases. What a strange sight to see in a “recovering” credit market!

This odd circumstance raises an obvious and troubling question: If the credit markets are truly recovering, why is the Fed increasing its purchases of questionable mortgage assets from financial institutions?

Let the reader decide…

But before deciding, let the reader remember that the health of the housing market largely determines the values of the MBS that the Fed is loading onto its balance sheet. (We know. We know. The Fed is not actually “buying” this stuff; it is just buying it “temporarily.” But if these MBS assets were to decline in value, “temporary” might become “permanent.” Think about it. In the middle of a credit crisis, would the Fed force a struggling finance company to buy back impaired mortgage-backed securities? Doubtful. More likely, these securities would become the property of the Fed and it would absorb the losses). And let the reader also remember that the health of the housing market is none too healthy.

One in every 194 U.S. households, or 650,000 properties, were in some stage of foreclosure during the first quarter of the year, according to RealtyTrac Inc. Meanwhile, home prices continue drop from coast to coast. The S&P/Case-Shiller home-price index plunged 12.7% in February from the same month a year earlier.

Are these the signs of recovery? Let the reader decide…

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Too Small to Succeed
By Eric J. Fry

When the Federal Reserve “rescued” the American financial sector last month, it rescued an increasingly dysfunctional economic system… but not much else.  In fact, the Fed’s blind devotion to the US financial sector and obsession with stock market trends (rather than fundamental economic trends) is creating a disturbingly long list of adverse consequences. 

Some of these consequences are obvious and immediate, like the dollar’s sharp selloff and inflation’s dramatic upswing. But some of the adverse consequences are much more subtle and long-term, like the fact that the Fed’s rescue has enshrined reckless speculation as a favored, government-sponsored activity. The Fed has sent a message that it will coddle the financial sector - i.e., institutionalized speculators – even to the detriment of other economic sectors or subsets of the general population.

Governmental meddling in the private sector wears many faces, but it goes by only one name: Inflation. Every interventionist action is certain to cheapen the value of paper money and to produce an inflationary effect. Therefore, every interventionist action is certain to benefit a minority of favored individuals or companies, while punishing the majority.

For example, the Fed’s easy-money response to the recent crisis has contributed to the dollar’s massive inflationary swoon. The greenback has lost a whopping 14% of its value against the euro since the Fed’s first rate cut last August.  The gold price has jumped more than 33% over the same timeframe, while crude oil has soared 57%. In other words,
American purchasing power has plummeted - a phenomenon that has distributed economic hardships far and wide. Any intellectually honest assessment of the Fed’s bailout campaign, therefore, must not ignore these towering liabilities on America’s macroeconomic balance sheet. And these liabilities fall directly – and painfully – upon the millions of companies and individuals who are trying to succeed…even without preferential treatment from the Federal Reserve.

When the Fed rescued the financial sector last month, it did not also rescue Aloha Airlines. Nor did it rescue the thousands of anonymous sole proprietorships that also failed during the last few months. These unfortunates belong to America’s growing population of companies that are “too small to succeed.”  These are the companies that lack the “systemic significance” to attract multi-billion-dollar intervention from the Fed and Treasury.

But the Fed does not merely ignore these faceless non-entities; it abuses them with inflationary monetary policies. In other words, America’s non-financial companies are the collateral victims of the Fed’s policies. For example, the inflationary effects of the Fed’s intervention in the finance sector may have sped the demise of companies like Aloha Airlines. ($120 oil is no friend to an airline company, we must remember).

Governmental coddling of investment banks rewards the rich and the reckless, while punishing the poor and the prudent. America’s investment banks do not manufacture tractors or jet engines or solar panels; they manufacture bonus checks. So why should the Federal Reserve have used its resources to finance J.P. Morgan’s takeover of Bear Stearns?

Where were Bernanke and his private equity partner, J.P. Morgan, when Aloha declared bankruptcy?  Where was the Fed’s unlimited lending facility when Aloha decided to ground its jets on the tarmac of Kahului Airport? Why did the troubled financial sector receive round-the-clock care and nourishment from the US government when the troubled airline sector did not?  Is a flight attendant’s job less valuable than a bond trader’s?  Or to rephrase the question from a lender’s perspective: Is a $200 million CDO better collateral than a $200 million airplane?  (We’ll take the airplane, thanks).

The Federal Reserve and US Treasury seem to believe that they can steamroll whatever regulations they wish; obliterate whatever free-market precept they wish; and collude to manipulate any financial markets they wish, as long as the goal is to manipulate financial markets for the “greater good” - loosely defined as whatever the CEOs of America’s investment banks would applaud.  But what is this greater good that the Fed meddles to advance?  And is it really any good at all?

Most of the same finance company executives who guided their companies onto the shoals of bankruptcy and/or near-bankruptcy continue to draw 7-, 8- and 9-figure pay packages. But who else has benefited?  Bear Stearns shareholders?  Nope.  They were wiped out.  Bear Stearns employees?  Nope.  Thousands of them will be hitting the pavement to look for new jobs.

Well, okay, let’s broaden our perspective. Have the actions of the Fed and the Treasury to date provided any aid whatsoever to struggling homeowners or low-level Wall Street employees or food stamp recipients?  Nope.  That didn’t happen either. Millions of families will still lose their homes; 30,000 Wall St. employees will still lose their jobs; and a record 28 billion Americans will still go on food stamps this year.

The numerous defenders of the Fed would argue vociferously that Chairman Bernanke has halted the credit crisis in its tracks and prevented deepening economic crisis and hardship.  Maybe so, but probably not…and here’s why:

The Fed did not cure the credit crisis; it merely pumped the financial system full of pain killers and stimulants. The folks at the top of the system are feeling no pain – literally. But the sickly financial sector is as sick as ever.  The “worst” of the credit crisis may be over, but don’t bet on the “better” appearing anytime soon.

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Rude Endnote: “Everyone loves to go against the trend…as long as everyone else is doing it too.”

We offered these words (borrowed from the Daily Reckoning’s Bill Bonner) to a fund manager we met earlier in the week for coffee. The fellow was chatting about how every investor and their dirham account is jumping into property investing here in the UAE.

“And do you know what happens when we see this sort of herd mentality?” the gentleman asked your editor.

“Tears?” we offered.

“Exactly.”

Similarly, when every talking head on CNBC is seen declaring the end of the financial crisis, we think perhaps the herd is on the move.

“Let the reader decide…” wrote Eric in today’s column. Now, here’s your chance. Is the crisis over? Or are we in for another round or two of pain yet?

Send your ponderings to us here at the address below and keep an eye out for a selection of Rude responses, due to appear in future issues.

Until tomorrow…

Cheers,

Joel Bowman