At his press conference yesterday, President Bush assured his listeners that he won't do financial sector bail-outs.

President Bush also wanted fast action on his latest proposal to rescue Fannie Mae and Freddie Mac in Congress. He strongly endorsed Treasury Secretary Henry Paulson's plan but asserted definitively that the two companies would continue to be held by private investors. Bush also rejected the notion that the government would bail out any private enterprise.

But, but... government support for Fannie Mae and Freddie Mac that doesn't wash out current equity holders is... ummm, how shall we say this... exactly what a "bail-out" is. If we provide financing to keep Fannie and Freddie up and running but leave the equity holders in place, when their shares are underwater, we are bailing them out!

The best summary I've seen of the Fannie/Freddie situaton -- history and current problems -- is by Tanta at Calculated Risk. As they say, read the whole thing. Looking at the core function of the GSEs (government sponsored enterprises) -- which is to provide liquidity to the mortgage origination markets -- she explains:

They have always been about recycling lending capital and taking long-term fixed interest rate risk off depository (and eventually non-depository) lenders much more than about merely absorbing credit risk. This goes against the grain of much current media over-simplification of "securitization" of mortgage loans that sees laying off credit risk as the main or even the only point of selling loans. The GSEs do take on the credit guarantee obligation of the securities they issue, but nobody sells loans to the GSEs just to offload credit risk--in fact, more than a few lenders work hard to negotiate contracts with the GSEs that leave quite a substantial part of the credit risk with the original lender: recourse agreements, indemnifications, servicing options that put a lot of the cost of default on the seller/servicer, not the GSE. They have historically done this because the credit risk of GSE-eligible loans has always been modest, but the benefits of getting 30-year fixed interest rate loans off your balance sheet has been substantial.

For decades, I have believed that Fannie and Freddie either should not have been privatized or should have been more strictly reined in. They serve, and must continue to serve, a critical function for US (and gobal) debt markets. But they're not ordinary financial institutions. They are public utilities which shouldn't be managed, as private financial institutions are, primarily for the benefit of the holders of their capital base (as currently structured, common and preferred shareholders) and their management.

The backing of the Federal government is the sine qua non of these institutions' existence and successful functioning. Without that implicit guarantee, they would never have fulfilled their public roles -- providing reliable liquidity to the mortgage markets in good times and bad, and setting widely-adopted standards for loan origination and servicing, which made the development of a healthy mortgage-backed securities market possible in the first place.

In recent years, managers and shareholders of the GSEs grew sloppy and forgetful about the real nature of these institutions. They forgot the instiutions were public utilities and that they had a duty to protect the implicit guarantee which made their business possible. Instead, they adopted the same expectations as typical corporate management and equity holders, with a focus on growth, retaining market share in a rapidly growing and increasingly risky market, and pumping up earnings, in order to justify huge executive compensation packages and higher share prices. They also had a lousy corporate governance structure, about which critics on both left and right have complained for years.

When housing market innovations started leaving them behind, instead of sticking to their knitting, they went running to Capitol Hill, where they enjoy enormous power on both sides of the aisle. They were allowed to stray into parts of the housing bubble where they didn't belong while simultaneously ignoring and taking advantage of the implicit government guarantee. Their behavior helped to magnify the overall size of the housing bubble and delay its bursting. (See Tanta for a nice summary of recent history.)

Today, the leverage ratio of Fannie's equity to on- and off-balance-sheet liabilities is, depending on which measure one uses, between 68:1 and 128:1. By comparison, leverage for a healthy private financial institution is likely to be in the range of 10:1 to 20:1, depending on what lines of business it is in. The implications of that excessive leverage are spelled out in a restructuring plan proposed by hedge fund manager William Ackman of Pershing Square Capital Management. (See attached pdf, which is an excellent view of the situation, regardless of what you think of Ackman's proposed solution). As Christine Richard of Bloomberg explains:

Ackman, 42, has his own plan that would see Fannie Mae raise about $86 billion in capital by giving investors in $750 billion of senior unsecured notes 90 cents on the dollar in debt of a new company, with the balance in equity. Investors in Fannie Mae's $11 billion of junior debt would get warrants, while common and preferred shareholders would get nothing, according to Ackman.

``We've not yet heard Secretary Paulson's plan but it would be a grave error for the government to invest in the equity of Fannie Mae and Freddie Mac as they are currently capitalized,'' Ackman, who oversees $6 billion at Pershing Square Capital Management in New York, said in a telephone interview.

[snip]

``The good news is that Fannie Mae has all the capital that it needs,'' Ackman said. ``It just has the capital in the wrong form with too much debt and not enough equity.''

Ackman also suggested the government put in place a stand-by purchase commitment for the new common stock for three years. The government is unlikely to be asked to buy any shares as there would be market demand for equity in the better-capitalized companies, Ackman said.

Although much has been made of the declining quality of the GSEs' portfolio, Ackman's plan shows how the structure of their balance sheets is at the heart of their current difficulties. Even if they hadn't wandered into high risk business, given how highly leveraged they are, Fannie and Freddie would today be nearing the point where the government guarantee would be called into play simply because the drop in housing prices nationally has been so large. The rule of thumb for Fannie's plain vanilla mortgage financing is a minimum 80% Loan to Value (LTV) ratio. That means, in some regions of the country, a large number of mortgages will now exceed the current value of the underlying real estate even if they continue to be performing. That's not the "fault" of the GSEs and doesn't suggest they should stop doing business -- as the housing sector continues to collapse, they are needed now more than ever. Being able to ride through periods of large drops in underlying asset values and growth in non-performing assets is one of the reasons why we have the GSEs in the first place.

In effect, the GSEs are designed to be "bailed out" by the government when market conditions demand. When the government steps in, the GSEs require restructuring and new capital, with existing equity being heavily diluted if not wiped out. That didn't really matter when the government owned the institutions. But when they were privatized and the equity in the GSEs was sold to private investors, the share price should have reflected the risk of dilution if the goverment's implicit guarantee was called. Yet that wasn't the case -- the GSEs behaved, and the market priced their shares, as if there was no risk that the guarantee would be necessary even though their balance sheets were built on the basis of the implicit guarantee. The recent plunge in their share prices is simply the market finally pricing the GSE equity to reflect the central fact that defines their business.

As many have observed today, yesterday's prohibition by the SEC against naked short positions in the shares of the GSEs is either simply political theatre or a case of the panics. (See e.g., Dean Baker, Dealbreaker, Felix Salmon). There are other ways than naked shorts for investors to bet, so the objective of the move is unclear. In any event, even if it Cox's game slows the price decline, it isn't going to make those shares worth any more than they already are, which fundamentally is zero.

The only thing which allows the shares to retain any market value is the political optics against "nationalization" of the GSEs. Together with President Bush's comment, the SEC's concern with the declining market price of GSE shares suggests that, although Treasury Sec Paulson hasn't described the conditions under which the government would provide an equity injection, nonetheless a figleaf of private equity will have some sort of role.

By trying to discourage a fall in share price, the government seems to be encouraging investors to believe in fairy tales -- that a restructuring may not be necessary or that current equity holders may not get washed away entirely in the restructuring-to-come. But if leverage ratios are to be brought down to somewhere closer to earth, new private equity won't come in without the existing equity being washed out. If existing equity holders retain a place in a new capital structure, it will be only because, in effect, the government has provided equity financing at rates far below what the private sector would demand.

Contra President Bush, there's going to be a bail-out. The only questions are how and how much. Retaining a role for private investors in the GSEs as Bush and Cox appear to suggest -- without restructuring the roles of the GSEs and their balance sheets -- is the very essence of the worst kind of government bail-out. Privatize the profits and socialize the costs.

Cross-posted at American Fooprints.

From the New York Times, September 4, 2005

Connect the Dots. Find the Fees.
Gretchen Morgensen

TO many investors, the collapse of the Bayou Group - a hedge fund company and brokerage firm run by Samuel Israel III - may seem like just another financial mishap, and a calamity only for those who had the bad luck to invest with Mr. Israel or to be steered his way by advisers they were wrong to trust.

But actually, the mess at Bayou, which federal prosecutors are now calling a $300 million fraud, should be a clarion call for caution among the many investors who have been throwing money at hedge funds recently. This is especially true for institutions - endowments and public pension plans - that have flocked to hedge funds with the hope of increasing their returns. Because many of these institutions are having financial difficulties - low interest rates are cutting deeply into their returns - they are too often captivated by investments that seem to promise outsized gains with little risk.

"Our unique multifactor risk model acts as a road map for navigating risk and provides investors with alternative routes to reach their investment summit," Steve Henderlite, a co-founder and principal of Trail Ridge Capital L.L.C., said in a press release from October 2003. Trail Ridge Capital is a hedge fund and fund-of-funds company that had clients in Bayou. Mr. Henderlite did not return a phone call seeking comment.

Trail Ridge is also an adviser to a new investment fund, the Undiscovered Managers Spinnaker Fund, offered to wealthy individuals by the investment unit of J. P. Morgan Chase. The fund, which started last November and had $7.3 million in assets as of March 31, held $662,602 in Bayou. J. P. Morgan says it has written that investment down to zero.

Central to the Bayou story, and to almost every other financial disaster of recent years, are conflicts of interest. At Bayou, these conflicts began in its brokerage unit, which executed trades for the hedge funds. Because the brokerage unit, Bayou Securities, was wholly owned by Mr. Israel, he was able to profit personally from the rapid-fire trading conducted by the funds he oversaw.

But some Bayou investors who got into the funds on the recommendation of investment consultants were confronted with another layer of conflicts. That is, the consultants who recommended the hedge funds to their clients and the funds of funds that bought Bayou shares for their investors often received compensation from Bayou for sending assets its way.

While some investors may not find fault with such an arrangement, institutional investors who have a fiduciary duty to their beneficiaries should definitely steer clear of the deals.

"In my view, if a hedge fund manager wants to pay a particular level of fees to a marketing agent, that's their business," said Orin Kramer, chairman of the New Jersey Investment Council, the oversight board for the state's pension system. "But as a fiduciary, I would be very uncomfortable dealing with a gatekeeper who is being paid on both sides of the trade."

Unfortunately, not all fiduciaries know where these conflicts lie. They are often well hidden.

"Pension consultants frequently have undisclosed financial arrangements with hedge fund managers that create a conflict of interest," said Edward A. H. Siedle, president of Benchmark Financial Services, in Ocean Ridge, Fla., a company that works for pension funds to investigate possible wrongdoing among outside money managers.

Mr. Siedle says the nature of these deals varies. Sometimes the payments come in the form of commissions on trades steered by a hedge fund to a brokerage firm that is affiliated with the consultant; in other cases the payments are fees paid by the fund based on the assets the consultant brings in. In one case, Mr. Siedle said, he found that a pension consultant received a partnership interest in the hedge fund to which it was steering clients.

SUCH payments were a part of the picture at Bayou. According to materials provided by the fund to a prospective investor in 2003, Bayou had several outside marketers that it paid either as a percentage of assets raised or through commissions to the promoters' "designated broker/dealer."

One of the firms that Bayou listed as an external promoter at that time was the Consulting Services Group of Memphis. Bayou also gave prospective investors the name of E. Lee Giovannetti, chief executive of Consulting Services, as a reference and as an institutional investor in Bayou.

Joe Meals, a spokesman for Consulting Services, said that the firm did act as a reference for Bayou in 2003 and that it had recommended Bayou funds to clients. But, he said, "We became uncomfortable with the operations at Bayou and made recommendations to all our clients that they redeem their accounts, and they did so long before any of these issues came to light." He added that Bayou "may have executed commissions through our affiliated broker dealer at one time, but not recently."

Consulting Services did the right thing in advising its clients to exit Bayou before the debacle. Others weren't so lucky.

In coming weeks, federal and state investigators will try to sort out what happened to the money that investors entrusted to Bayou. Because Bayou's minimum-investment requirement of $250,000 was smaller than that of most hedge funds, the firm unfortunately attracted a lot of individual investors. The United States attorney in New York is seeking the forfeiture of all of Bayou's assets, including $100 million seized by authorities in Arizona last May. How much Bayou's investors ultimately get back is anybody's guess.

Larger investors, especially those who are fiduciaries, should take a lesson from the losses at Bayou. Conflicts of interest in the financial world are often hard to uncover. But refusing to do the necessary digging is downright irresponsible.


Copyright 2005 The New York Times Company

That's the question that Buttonwood asks in the Economist. And provides an interesting roundup of evidence that many emerging markets aren't as vulnerable as they were when the Asian crisis hit, with follow-on waves of Russian and Latin American contagion.

In addition to the benefits of having pursued sounder macropolicies, the emerging markets as a group are enjoying a far healthier composition of the money that's been pouring into emerging markets assets recently, attracted by better returns than in more developed markets.

In a study released last week, Christian Stracke of CreditSights, a research firm, compares emerging economies’ dependence on portfolio inflows now and eight years ago. (Portfolio investment—as opposed to foreign direct investment—is generally fast and easy to liquidate, and so includes the sort of “hot money” that travels fast and upsettingly.) Looking at 25 countries, he finds that dependence is generally much lower, but patchily so.

As the table shows, portfolio liabilities in the 18 months to June 2005 for the group as a whole were $118.5 billion, far less than the $170.7 billion that came in before June 1997. This averages out some very different experiences: both Argentina and Brazil have seen liabilities decrease sharply, while India, Poland and Hungary have had just the reverse. What is more, the “hotter” sort of portfolio investment—debt securities—has fallen most (from $116.6 billion to $66.7 billion) while equity investment has stayed almost the same.

On another measure, the ratio of foreign-exchange reserves to recent inflows, things look sturdier still. In June 2005, the median emerging country had enough reserves to cover 529% of the past 18 months’ portfolio inflows, compared with just 222% in June 1997. This average again masks some big differences: oil-rich Russia’s reserves are a staggering 2,093% of flows, while Turkey has either 161% or 249%, depending on how one treats the bulky “errors and omissions” category of its current-account figures.

Buttonwood speculates on what might generate changes in investor sentiment:

But it would not take much to produce that—higher real interest rates in America, for a start (and rate rises look likely to continue). The impact of dearer oil is harder to judge. High oil prices should be a plus for emerging producers such as Russia and Venezuela, while heavy importers such as South Korea have enough other attractions to get away with it. But money managers are beginning to look askance at emerging-market guzzlers who have subsidised energy use and may no longer be able to afford it. [Brad Setser has an interesting post on the differential impact of rising oil prices on various emerging markets]

Paradoxically, globalisation may also dim the appeal of emerging markets by increasing the correlation between developed and developing assets. Mexico, some say, is beginning to pay the price for its lockstep with the United States. A sharp increase in risk aversion would make that matter more: at the moment, investors ask only to be led to the next frontier, but a few more terrorist attacks in big financial centres could change that.

Yet for those of us who have long followed the emerging markets, it's hard not to be hopeful that this time it's different in the sense that hard-won gains in attracting long-term investment won't be wiped out by another round of emerging markets contagion. At the very least, a more mature market for emerging markets assets may produce greater discrimination by investors among countries when the inevitable turn in sentiment arrives. As Buttonwood concludes:

The broad picture is nonetheless revealing, and, within limits, encouraging: a sell-off rather than a rout may be the worst that happens if foreign investors turn tail.

Of course, all bets are off if long-delayed global adjustments -- with the US deficits at the center of the process -- produce the end of the current "Bretton Woods II" regime, as discussed by Nouriel Roubini and Brad Setser. Few emerging markets, regardless of their reserve positions or low portfolio liabilities, will find themselves unscathed in that scenario.

I follow the global capital markets broadly but not closely. Like the Brads (Setser and DeLong), Tyler Cowen and General Glut (or for that matter, Warren Buffett), I've been increasingly concerned for more than a year about the unsustainability of foreign central bank financing of the US current account. But I don't bother to comment on the problem -- there are far more knowledgeable folks out there doing an excellent job tracking and analyzing both the macro and the micro numbers, and they agree in some areas and disagree in others.

Although I'm an enthusiastic reader of all this stuff, when it comes time to sort it all out for myself, I find I fall back on some far simpler heuristics. It's a kind of informal "severe storm warning" indicator system that the world is in fact awash in liquidity, and the shake-out is coming sooner rather than later. Unfortunately, I've just seen the final signals flash.

Here's what I said in mid-January, in a comment on the blog Investor's Diary:

My simple rule of thumb used to be: the moment you see the investment banks trot out something that looks like a "perpetual" and they find someone to buy them, it's time to run for the hills because a bubble is about to burst in the debt markets spread across most classes of financial assets. There is no way that risk is being priced in -- the premium is too skinny. When spreads are too skinny means the world is awash in excess liquidity looking for returns. And none of the monetary authorities in the major countries has the incentive or disciplined to mop it up that liquidity.

Over the past 2 decades, the new harbingers of a financial crisis are the spreads on junk and emerging markets sovereigns.

I know it hardly seems fair to those emerging markets that have worked hard to clean up their act since 1998. They hope to ride out the next crisis and avoid excessive contagion. But they're going to have a hard time not being whipped sawed again.

The big problem this time is that the instability is sitting in the world's biggest market and its reserve currency, not in some offshore banking regime in the Thai baht. The bubble isn't Bangkok real estate but most of the housing sector in most of the Anglosphere. And I could go on.
[...]
And I also think the financial sector is going to take a major hit, even though they think they've cleaned up their balance sheets to avoid or ride out a crisis. I think we'll see a reexamination of the BIS rules when people realize that "capitalization" doesn't protect you if the assets are built on sand and the liabilities are real.

And now come the clinchers in my personal severe storm warning system:

• Perpetuals (or their practical equivalent) have returned to the sovereign sector. As I indicated in my comment above, this has been the signal that the party's finally over.
  

  WSJ -- Fed 24 2005: France Finds Big Appetite for 4% in 50-Year Bonds
  
  The stellar response to a very "long bond" with a Gallic flavor illustrates the strong desire among global investors to reach out for what are very low yields on long-maturity debt.
  
  In the first issue of its kind, France attracted tremendous demand in a sale of 50-year bonds that carry a fixed-rate coupon of just 4%. The majority were scooped up by euro zone investors, but 22% went to investors based in the United Kingdom. The U.S. accounted for 7%.



• And today, via Barry Ritholtz's The Big Picture: The art market is going crazy. Although Barry focuses on what that signifies for equities (very bad news indeed), his analysis is equally applicable to the capital markets more broadly.

  Wanton disrespect for money as an asset class, as depicted by mad bidding wars for unknown artists, typically only occurs when there is too much of a good thing around; I.E., when the Fed has cranked up money supply (think M2); That condition gets easily rectified by the Fed merely turning the spigot off, which I suspect is 6 months to 1 year away; It takes a little less than a quarter (2 months or so) for weak money supply to be felt by the market

Fundamentally, all of this is a sign of way, way, way too much liquidity. It's going to get wrung out of the system one way or the other, and it's going to be the debt markets where the contagion (across asset classes and across currencies) is going to happen. I'm afraid this time around that this is not simply going to be a case of a "condition [that] gets easily rectified by the Fed merely turning the spigot off" because of the various policy traps the Fed finds itself in.

If those thoughts haven't made you lose your appetite for thinking about the capital markets, here are some other links of possible interest, including some further perspectives on what's maintaining the gravity-defying asset bubbles we've been witnessing. But warning, even the experts who see the global financial system entering dangerous waters don't agree on what it all signifies let alone what's going to happen.

Two of my favorite reads on the markets -- one daily, one monthly -- are at the opposite end of the size spectrum. One has more of a trader's view, the other a portfolio manager's view. Investor's Diary is a recent blog by an individual trader in Bunds who writes about the other markets he follows closely but doesn't trade in (especially these days FX, treasuries, financials and oil). The other is the monthly column by the chief bond guy at the big portfolio manager PIMCO, Bill Gross -- BTW the other articles and publications on the PIMCO site are also worth a read.

• If you're interested in the "conundrum" recently identified by Alan Greenspan (the fact that the yield curve hasn't just been flattening but that the long end has actually been going downwards), Bill Gross's most recent column has lots to chew on, together with his previous critique of Greenspan's limited approach to managing the speculative bubbles.
  
• Investor's Diary on the "conundrum" has a somewhat different take on the implications for trading and portfolio management, and offers this look at why at least one bond specialist is bullish on the long end.
  
• A further interesting post from February 1 Investor's Diary on banks and financials, and why the Investor thinks they've hit a secular peak.
  
• For more details on the excess global liquidity problem, the Economist from last week has numbers.
  
• PIMCO also has an interesting analysis of the difficult policy tradeoffs facing central bankers and governments in those emerging markets that have successfully fought hard over the past few years to achieve credibility; these hard won gains will be significantly eroded if there's global contagion, especially if the dollar isn't the automatic safetyzone.

---

Just found that General Glut thought the French 50-year bond noteworthy as well when it was announced last month.

I guess that's the last time Bill Thomas goes on Meet the Press ... this was in my inbox today (below the jump):

{UPDATE 1-25-04} by nadezhda: Also after the jump, my response to what was a perfectly civil and innocuous query from praktike. Just in case anyone was losing sleep over what I think about Social Security and how it fits more broadly into "what should be done" in the economic and social policy arena, you can learn everything you ever wanted to know and were afraid to ask.    more »

Courtesy the Washington Post, another installment in the saga of the shift in the balance of economic risk away from capital and toward labor. This time brought to us by the Pension Benefits Guaranty Corporation.

A significant portion of the skyrocketing deficits is due to declared or likely-to-be bankruptcies in the airlines and steel industries. Deregulation of airlines may have expanded services and reduced the price of flying for us as consumers, but it looks like we may be picking up some of the tab as taxpayers.

Oh, and perhaps we should consider this little item when we're figuring out how to fund the transition cost of privatizing part of Social Security. Although it must be admitted, $20+ billion is easy to overlook when you're talking in fractions of a trillion.

Struggling under a cascade of bankruptcy filings in the airline and steel industries, the government's pension insurance agency said yesterday that its deficit has more than doubled in the past year -- to $23.3 billion.

The figure is so large that an overhaul of the way traditional pensions are funded and insured has become essential, several experts said. Pensions of about 44 million workers and retirees are insured by the Pension Benefit Guaranty Corp.
[...]
"The bottom line seems to be that there really is a PBGC crisis, though to date neither Congress nor the [Bush] administration has been treating it as such," said Dallas L. Salisbury, who heads the Employer Benefit Research Institute in the District.

There are three basic ways that the deficit can be made up: (1) revaluation of assets through a bull market (combined with some "aggressive" portfolio management); (2) increasing revenues through larger premium payments from employers; and (3) taxpayers making up the difference.

Door Number 1 isn't what you'd want to bet the farm on, as hopefully someone learned in 2000.   more »

So says Steve Pearlstein, and he assembles a pretty long list of troublesome points. I don't know about you, but between oil prices likely to remain at over $50 a barrel and a current account deficit on an upward path toward 6% of GDP , I'm starting to get a little antsy about, say, interest rates and growth rates going in the opposite (wrong) directions in the medium-term that don't have anything to do with the business cycle.

[UPDATE 10-31-04] by nadezhda
Seems I'm not the only one fretting. See below the fold.   more »