Agora Financial’s Rude Awakening

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Laguna Beach, California

• Dow slouches another 237 points to new two-year low,
• Fanny and Freddie lead the way, down 13% and 24%,
• 12 trillion reasons to buy gold and plenty more…

Eric Fry, reporting from the land of milk and honeys…

As the risk of stating the obvious: It’s getting ugly out there.

The Dow Jones Industrial Average stumbled 237 points yesterday to a new two-year low of 11,147. After yesterday’s carnage, the Dow, the S&P 500 and the Nasdaq Composite all sit more than 20% below their highs of last October.

Buying stocks isn’t as fun as it used to be.

Crude oil, the enfant terrible of the financial markets, can claim no credit for destabilizing shares prices yesterday. The price of crude barely budged all day. Unfortunately, the shares prices of Fannie Mae and Freddie Mac budged dramatically…to the downside. Fannie dropped 13% while Freddie tumbled 24%. As these two financial bellwethers slumped ever lower, the rest of the stock market followed. Shortly before the closing bell, Freddie dipped below $10 a share – its lowest “print” since 1992.

The proximate cause of this drubbing in the financial sector was the news that Fannie Mae paid a record-high interest rate (relative to Treasury yields) to sell $3 billion of new two-year notes. In bond market parlance, Fannie paid 74 basis points over Treasuries – or triple the spread it paid two years ago. 74 “bps” over Treasuries would not be a newsworthy item, if not for the fact that investors have spent most of the last two decades believing that the bonds issued by Fannie and Freddie were “as good as Treasurys.”

Now that this naïve assumption is eroding away, investors are beginning to fear that Fannie and Freddie might not even be as good as WaMu or Countrywide. Without the U.S. government’s implied backing, Fannie and Freddie scarcely resemble the AAA credits they purport to be. In fact, former St. Louis Federal Reserve President, William Poole, refers to both of these lenders as “insolvent.” As Poole explained yesterday, Freddie owes $5.2 billion more than its assets are worth.

“Congress ought to recognize that these firms are insolvent,” Poole griped, “It is allowing these firms to exist as bastions of privilege, financed by the taxpayer.” Many investors in the private sector seem to agree with Poole’s assessment, as they mark down the value of Fannie’s and Freddie’s shares and mark up the cost of insuring against a bond default by either company.

Fannie and Freddie might not be insolvent, as Poole asserts, but they are certainly in trouble. Since both companies hold trillions of dollars worth of mortgages, balancing assets and liabilities is no small task. One little jiggle here and you’ve got an “adequately capitalized” financial institution. But one little jaggle there and you’re heading to bankruptcy court.

This we know: Fannie and Freddie are both extraordinarily leveraged companies. Both companies live on the razor’s edge between prosperity and disaster. They always have. As long as home prices were rising, extreme leverage posed no problem whatsoever. In fact, it was an attribute. But now that the housing market is imploding, extreme leverage is creating an extreme problem.

A large amount of leverage is almost never a good thing folks, especially not when the asset side of the leverage is losing value rapidly. This simple observation inspired your editor to produce the image below for a 2004 speech he delivered in New Orleans. He did not actually believe that Fannie and Freddie would perish, but neither did he rule it out.

Even now, he doubts that Fannie and Freddie will perish. But he does not doubt at all that they will become two of the newest and largest additions to the Federal budget. Any rescue mission on behalf of Fannie and Freddie will require some form of “monetary re-liquification,” also known as “dollar printing.” So the closer that these two gargantuan mortgage lenders move toward genuine insolvency the more we investors should want to sell dollars and buy gold…At least that’s our best guess.

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The Woes of Fannie and Freddie
By Bill Bonner

Freddie Mac and Fannie Mae are to America’s great empire what the East India Company was to the British Empire in the 19th century…and the Louisiana Company was to France in the 18th. Huge, stupid, and probably fatal.

Freddie and Fannie are huge government-chartered mortgage lenders. In 18th century France, speculators bet on the riches of Louisiana, through the government-chartered Louisiana Company. In the 19th century, they wagered their money on the riches of India, through the government-chartered Eastn India Company. And in the 20th century, they gambled on rising housing prices through Fannie and Freddie.

The immediate problem is that the mortgage lenders are running out of money. They need to raise $75 billion. A few years ago, that would have been no problem. Everybody was ready to put money into America’s go-go, securitized housing market. But then, housing went.

Yesterday’s news tells us that housing prices are falling in 23 out of 25 U.S. metropolitan areas. That, according to Case/Shiller. Foreclosures are still rising at a faster and faster pace. Etc. Etc.

(We’re sparing you the details…we don’t want to upset you too much, dear investor.)

So now, Freddie and Fannie have a problem. They need to raise money - a lot of it. And now it has become “very difficult,” say the experts, to raise that kind of dough. Investors are slowly putting two and three together. The pair of mortgage lenders needs more cash. Their industry is in full flight. Their capital is disappearing. Their collateral gets marked down every month: “Hey, maybe we should sell the stock!” The result of these deliberations was a bad day on Wall Street for the twins, bringing total losses into the billions for remaining stockholders, who were too slow or too dull to sell their shares.

And for the faithful and/or delirious masses who continue to cling to their Fannie and Freddie shares, the bad news has not yet abated. The giant mortgage lenders must still raise even more capital to cover their mounting piles of defaulting mortgage debts. Freddie and Fannie still need to raise money…lots more money. And if a report leaked from Bridgewater Associates turns out to be correct, so will a lot of other businesses…and governments. Bridgewater’s confidential memo - which got out to the Swiss press and then made its way to Ambrose Evans-Pritchard at The Telegraph in London - says that losses from the credit crunch could go as high as $1.6 trillion…four times as high as official estimates from the IMF.

And it only gets worse…

One trillion, six hundred billion dollars is a lot of money. If Bridgewater is right, the whole financial sector will be gutted. You’ll remember, dear investor, after manufacturing pulled out of America, the financial industry was left. And retail. Housing. Services. And not much else. The center of economic power shifted from Detroit and Trenton - where they made things - to Manhattan, where they financed them. Mothers ceased wanting their babies to grow up to be CEO of General Motors; they wanted them to go to Wall Street. That’s where the real money was. Finance was the key not only to huge profits itself, but also to the growth of the retail and housing sectors. People bought durable goods and consumer goods on credit. No credit; no purchases. No purchases; no consumer economy.

Well, now GM has lost 75% of its value…and the financial industry is not far behind.

Well, Bridgewater goes on to say that a $1.6 trillion loss in the financial industry will mean a loss of $12 trillion in credit to the economy as a whole. When the lenders don’t have capital, they can’t lend it out. Typically, they lend $10 for every dollar of capital. So if a dollar of capital is wiped off their balance sheets, as much as $10 of credit is erased from the economy.

Here in Europe, we’re used to high prices. One billion? Heck, we spend that much on lunch. But $12 trillion begins to sound like real money. And $12 trillion taken out of the U.S. consumer economy begins to sound like the Great Depression. Like Japan, 1990-2006…only worse. Collapsing asset prices. Rising unemployment. Bankruptcies. Defaults.

Of course, no central bank or government will go into that good night without a fight. The Fed will cut rates…and lower reserve requirements…and probably intervene directly in markets. Banks will be effectively nationalized…The federal government will increase borrowing and spending to try to offset the money disappearing from the markets and the economy.

What about the foreigners? What about Sovereign Wealth Funds? They’ve got a lot of money. Couldn’t they help recapitalize the credit system? Alas, the SWFs have only $3 trillion currently. And the foreigners? Our guess is that when they realize what is happening they will be desperate to get rid of dollars and U.S. paper of all sorts. Instead, they’ll want real resources, factories, brands, concrete and land. And they will have a great opportunity. As asset prices fall, they will be able to buy more valuable properties in America at bargain prices. Already, Abu Dhabi bought the Empire State Building. A Belgian brewery, run by Brazilians, is buying Budweiser. More to come…

How’s our “Trade of the Decade” doing? Eight years ago we suggested you sell stocks and buy gold. The bull market on Wall Street was over, we thought. A bull market in gold was just beginning.

As far as we can tell, we were right.

The S&P is down about 20% from its high…which puts U.S. stocks barely lower than they were in 2000. But adjusted for inflation, the loss has been spectacular. Remember, oil has gone from around $10 a barrel to around $140 a barrel. Everything else has gone up too. Even by official CPI numbers, the year 2000 buck is worth only about 80 cents. And the dollar against the euro is down about 40%.

Real bear markets typically last 10-15 years. This one has another few years to go. These should be the most interesting ones. Commentators are already looking for a bottom in the stock market. They may have to wait a long time.

An ounce of gold would buy the whole Dow in 1926…again in the 1930s…and once again in 1980. If gold stays where it is, the Dow would have to drop below 1,000 for the gold/Dow ratio to return to one. More likely, the Dow will drop and gold will rise to meet it. In 1999, gold bottomed out at around $260 an ounce. Since then it is up nearly 5 times. The U.S. money supply, however, has gone up 11 times. So, our guess is that there’s plenty of upside left for the stuff they make dental fillings out of. If it were to equal the increase in M3, its price could rise to $2,700 or so.

This is all guesswork, of course. But the Trade of the Decade still looks good to us. Gold and the Dow will probably come together somewhere north of 3,000….

[Joel's Note: The road to $3,000 gold, as its progression from $260 to $1,000 testifies, will not be a smooth one. There is bound to be pullbacks, selloffs, rallies and spikes along the way. To ensure you benefit from all the ups and downs on the way up, we suggest you take a look at Ed Bugos’ Gold
& Options Trader. Ed’s service portfolio is stacked with junior mining plays, options on the metal and in depth research into short and long-term price movements. This way, you can profit from every dip and, eventually, realize the maximum value of the world’s only true and enduring store of wealth.

If you’d like to learn more, read on here: The Gold & Options Trader.

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[Rude Endnote: Searching for that elusive bottom in the market has caught many off guard in recent months. We asked the Rude folk what their take on the matter was…

Reader Frank reckons, “The DJIA seems to have made a temporary bottom at around 11100. The RSI was at or near 20. My take - and I’m just an amateur- Dow rallies to 11700/12000 and then heads south again.”

Reader Carl reckons, “The averages recently broke into “bear market territory” (-20%). I’m guessing we’re ’bout HALF WAY THERE - sometime in the next two to three years. We’ll see a good-sized run-up in the mean time, maybe two, but it won’t last. I have no real basis for this call - I just think we have a long way to go. I’m glad I’m not an index investor!”

And Reader John reckons, “According to the “authorities” I have some confidence in, the sub prime mess is only about 1/3 liquidated. Thus there is not one, but two more ’shoes’ to drop. And that is assuming that the meltdown does not precipitate a further downdraft in things like credit card debt, and also government debt, as the tax take will be negatively affected by the downdraft. Bottom line, the bottom is not close. This ’step’ is just a pause to give false hope, on the way down.”

We leave you today with the Dow sitting on a new two-year low and gold back up over $930. Anyone care to guess which way this train is heading?

Until tomorrow…

Cheers,

Joel Bowman
Rude Awakening

aussiejoel@the-rude-awakening.com