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Benton D Struckcheon

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Member since: Fri Jan 18, 2013, 09:06 PM
Number of posts: 2,347

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Five Year Anniversary of Sept 15: What Actually Happened

It'll be five years since the crisis really began this coming Sunday, the fifteenth. The below is my personal opinion, which I held in real time as it was happening five years ago, on what the causes were.
Or, actually, the singular cause: the total screwup of the bailout of Fannie and Freddie, specifically, the failure to bailout the preferred shares of these two.
What follows is a series of links with commentary that are the timeline, as I see it, of what caused the crises. Posting it here in the Economy group because I don't think the knowledge required to understand the below would be general.


In the first part of 2008, the government sold preferred shares of Fannie and Freddie to banks around the country. This was a way of putting more equity into these two, and therefore providing them with more reserves against losses in their mortgage portfolios.
As the summer of 2008 wore on, it became obvious that the two would need an outright bailout. What began to be debated was the structure of that bailout.

John Dizard of the Financial Times on the preferred shares of Fannie and Freddie, August 31, 2008:

In the now overcrowded world of investing in distressed securities, the standard strategy is to pick the “pivot” issue...In the past couple of weeks it seemed that the entire US economy had a pivot security, or set of securities: the preferred stock issued by the government-sponsored entities, or GSEs. Fannie and Freddie, the Sodom and Gomorrah of “public/private partnerships”, sold about $36bn (£20bn, €24bn) of non-cumulative preferreds to the banks and the public, with the aggressive support and encouragement of the US Treasury and the GSEs regulator...The banking system needs to raise several hundred billion dollars of equity, and preferred stock is the lowest-cost way to do that in the public markets. While some sophisticated investors could distinguish between preferreds issued by a sound bank holding company, and preferreds issued by the overleveraged F&F, international investors and domestic retail investors would not have the data or analytics to draw the distinction.
The alternative, as I see it, to recapping the US banking system with preferreds is some form of direct government investing in the equity of banks or bank holding companies. That would be even more expensive to the taxpayers – as in at least 10 times more expensive.
As a reality check I called Jim Grant, of Grant’s Interest Rate Observer, and the author of the forthcoming “Mr Market Miscalculates”. He comments: “The alternative to preserving the value of the GSE preferreds? Prayer? Remember that a lot of that paper is held by the same banks the authorities would love not to fail.”

So, on August 31, John Dizard of the Financial Times and Jim Grant, a very well known Wall Street bond market guru and editor of his own (very expensive) Grant's Interest Rate Observer is of the opinion that if the preferred shares of Fannie and Freddie aren't bailed out - as in their dividends being continued - it would cost ten times their market value of 36 billion dollars, or 360 billion dollars, to the taxpayer for the subsequent bailouts of failed banks. At least.

Fannie and Freddie Bailout

Hank Paulson did not share Dizard's opinion. Apparently, he opted for prayer. The below is from the statement issued on Sept 7, 2008, detailing the terms of the bailout of Fannie and Freddie:

Similarly, conservatorship does not eliminate the outstanding preferred stock, but does place preferred shareholders second, after the common shareholders, in absorbing losses. The federal banking agencies are assessing the exposures of banks and thrifts to Fannie Mae and Freddie Mac. The agencies believe that, while many institutions hold common or preferred shares of these two GSEs, only a limited number of smaller institutions have holdings that are significant compared to their capital.

The agencies encourage depository institutions to contact their primary federal regulator if they believe that losses on their holdings of Fannie Mae or Freddie Mac common or preferred shares, whether realized or unrealized, are likely to reduce their regulatory capital below "well capitalized." The banking agencies are prepared to work with the affected institutions to develop capital restoration plans consistent with the capital regulations. Preferred stock investors should recognize that the GSEs are unlike any other financial institutions and consequently GSE preferred stocks are not a good proxy for financial institution preferred stock more broadly.

The fallout from their failure to bailout the preferred shareholders of Fannie and Freddie was immediate. Despite the date you see now, this story is on events that happened on Sept 8, the day after the above statement:

Fannie, Freddie Takeover Jolts Preferred Stock Market

Sept. 10 (Bloomberg) -- Treasury Secretary Henry Paulson's takeover of Fannie Mae and Freddie Mac is roiling the market for preferred securities.

Prices of fixed-rate preferred stock fell an average of 11 cents to 69.8 cents on the dollar this week, including the biggest one-day drop in a decade on Sept. 8, according to Merrill Lynch & Co. index data. The 13 percent decline compares with a 0.8 percent drop in the Standard & Poor's 500 index in the same time.

In putting Fannie and Freddie in conservatorship, Paulson scrapped dividends on the mortgage-finance companies' equity securities and said the U.S. would buy as much as $200 billion of preferred stock ranking ahead of existing issues. Investors are more hesitant to invest in similar securities of other financial institutions on concern that Paulson set a precedent for issuers. Unlike common stock, preferreds typically carry fixed dividends.

Paulson's ``actions have damaged the preferred market,'' said Thomas Hayden, the investment strategist for Liberty Bankers Life Insurance in Dallas. ``Somebody is going to be looking at an issue of Fannie or Freddie preferred shares that were rated AA up until a few months ago. If that's not money good then what about the small regional bank in some part of the country?''

Hayden, whose $1.5 billion fixed-income portfolio contains preferred shares of Fannie and Freddie, said he's ``not interested'' in buying any more preferred securities.

Rising Costs

The market's tumble is making it more expensive for banks and brokers trying to raise fresh capital after taking $506 billion of writedowns and losses on the collapse of the subprime-mortgage market.

Dizard on Paulson's trashing of the preferreds:

“When they get in trouble, they send for the sons of bitches.”
Admiral Ernest King, on being appointed commander of the US Fleet by President Roosevelt after Pearl Harbour.

In the Bush Administration, when they get in trouble, they send for the hacks and yes-men. Ernest King did not go along to get along. He did not think his job was to make other members of the nation’s leadership feel good about themselves; he was, as he said, a SOB. On the other hand, Roosevelt wanted somebody who knew how to win the war in the Pacific, and that’s what he got.
Hank “The Plank” Paulson, US Treasury secretary, now has his place in history, but it’s not one the rest of us should envy. He will be in the book on the same page as his counterparts in the latter days of the French Third Republic. The Admiral Kings, or the people who organised the rescue of New York City in the 1970s, will be on different pages.
I wrote that the alternative to saving the value of the preferred would be direct Federal capital support for the banking system, and that this would be 10 times as expensive.
One financial commentator thought that I had a point, but that the 10 times estimate was“snatched from thin air.” Actually, no. To get the banking system back to something close to balance sheet health will require capital raises in the order of $400bn. The preferred stock value that disappeared with Mr. Paulson’s “rescue” was around $36bn. There you are.
Now, if Mr Paulson and his team had an alternative plan that made sense, some creation of structured finance magic that would leave us gasping at the genius of it all, that would be different. But no.
In his statement on the Fannie and Freddie actions, he said: “Preferred stock investors should recognise that GSEs [government-sponsored enterprises]are unlike any other financial institutions, and consequently GSE preferred stocks are not a good proxy for financial institution stock more broadly ... the broader market for preferred stock issuance should continue to remain available for well-capitalised institutions.”
Not true, Mr Paulson. The market for bank preferred stock is effectively closed. It is not immediately obvious now how the banks can raise the Tier One capital they need to finance a recovery ... scratch that, not a recovery, just the present level of economic activity.

Lehman Downgraded, then Bankrupted

Lehman had already been known to be in bad shape. They were one of the banks looking to go out and issue new shares to recapitalize themselves. But of course now the preferred share market was closed off; no one was going to buy new preferred shares in any bank after what had just happened to Fannie and Freddie. On Sept 9, Fitch downgraded Lehman. The link is gone now, but Fitch's reason for the downgrade was the difficulty Lehman would have raising new capital now that the preferred share market had been hit.
The downward spiral of Lehman's stock really took off after this downgrade. The next weekend the Fed and the usual suspects gathered again, as they had in March for Bear Stearns, to see if they could find a way to rescue Lehman. No way was found.
The events of the Lehman weekend, during which BOA decided to buy Merrill instead:

NEW YORK — Transforming the face of Wall Street, two major securities firms succumbed Sunday to the country's long-running mortgage crisis as Merrill Lynch & Co. agreed to a hastily arranged, $50-billion takeover by Bank of America Corp. and Lehman Bros. Holdings Inc. spiraled into bankruptcy...The crumbling of Lehman and buyout of Merrill came only one week after the government committed up to $200 billion to shore up home-loan giants Fannie Mae and Freddie Mac.

The run begins: money market fund breaks buck, freezes redemptions:

Primary Fund , managed by New York-based money market fund inventor The Reserve, said late Tuesday that its $785 million holding of Lehman Brothers Holdings debt has been valued at zero.

As of 4 p.m., Eastern, the value of the fund's share was 97 cents. The Reserve said that redemption requests received before 3 p.m. will be paid out at $1 a share. The company said Primary Fund will continue to accept new money.

While Primary Fund's Lehman holding was small compared to the fund's overall size, the fact that it froze redemptions reflects a surge in redemption requests by investors.

The size and speed of the withdrawals was stunning. At 3 p.m. on Tuesday, Primary Fund's assets stood at $23 billion, a $40 billion hit from the $62.6 billion in the fund on Friday, a spokeswoman for The Reserve told MarketWatch late Tuesday.

The Crisis

After this, the Fed backed up all money market funds, Paulson went to Congress for the TARP, AIG went belly up, and on and on.
But the sequence of falling dominoes began with Paulson's failure to back up the 36 billion dollars of preferred shares issued by Fannie and Freddie. Dizard's original estimate of 360 billion for the cost of that mistake was, as it turned out, low: the TARP cost a trillion in up front money. There are varying estimates of how much the government has received back from that money, but the entire bloody mess could have been avoided by simply continuing to pay the dividends on those preferred shares, thereby keeping the market for banks' preferred shares open, which would have allowed Lehman and Merrill to muddle along the way Citi eventually did (it issued tons of new stock as a result of the TARP, diluting its existing stock by 90%, but it survived) and avoided the subsequent collapse of the money market.

But they chose not to, opting instead, apparently, for prayer. And so it went.

Posted by Benton D Struckcheon | Fri Sep 13, 2013, 07:44 PM (4 replies)
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