Does Paulson’s TARP = TRAP?

For the second day in a row, Federal Reserve Chairman Ben Bernanke and US Treasury Secretary Paulson pleaded to the power players of Washington to pass their request for $700 Billion to implement their Troubled Asset Relief Program (TARP). However if we move the letters around a bit, TARP becomes TRAP and that is exactly how many investment managers, economists, politicians and average Americans view the plan. They are afraid that this is a trap for US taxpayers because they may be paying for a bailout that benefits the private and not public sector. Bernanke argues that a failure of the private sector would have “grave” consequences for the public sector, which is true and Paulson has finally agreed to accept limits on executive pay under the bailout plan. Yet, today’s price action in US stocks and the US dollar suggest that some investors are holding out the hope that Paulson’s TARP does not become the trap that keeps Americans still paying for bailout many years to come.

LIBOR Rates Jump, TED Spread Widens

Other investors on the other hand are more skeptical. Three month LIBOR rates jumped 26 basis points to 3.47 percent, which is the highest level since January. The TED spread, which measures the difference between the interest rates of the 3 month LIBOR and the 3 month Treasury bill hit an intraday high of 311 basis points. Not only is this only the second time in 2 decades that the TED spread has gone above 300bp, but the premium is far above its pre-credit crunch levels of 20 to 30 basis points. The greater the TED spread, the greater the degree of risk aversion and the fear of default in the market. Therefore the jump in the LIBOR and the widening of the TED spread suggests that investors are still hoarding their cash and they are skeptical of whether the government’s efforts will actually restore stability in the financial markets and improve risk appetite.


Paulson’s Plan Could be a Lose-Lose for the US Dollar

Paulson Paulson’s plan is ultimately a lose-lose situation for the US dollar. If it is approved, it would cause a destruction of the US balance sheet by increasing the nation’s debt ceiling by 6.6 percent to $11.315 trillion. If it is not approved or if Paulson and Bernanke only get a trimmed down version of the plan, they would have to go back to the drawing board to come up with other solutions to unclog the mess. If we end up being between rescue plans, the uncertainty would weigh on the US dollar. Therefore I still believe that the US dollar could fall another 5 percent over the next few months.

Home Sales, Durable Goods and President Bush

house Existing home sales dropped by 2.2 percent last month while mortgage applications plunged by 10.6 percent, the largest decline since July. The ongoing turmoil in the financial markets has made it increasingly difficult for even people with money to buy a home to secure loans. House prices continue to fall with the median price declining 9.5 percent from last August, causing more homeowners to pull their houses off market. The inventory of unsold homes dropped 7 percent, which was the largest decline since December 2006. In times of strong growth, a reduction of inventory may be good because it could suggest that demand is strong, but in times of weak growth, it suggests instead that homeowners are giving up on selling their homes now. Durable goods, jobless claims and new home sales are due for release Thursday morning. We continue to expect economic data to confirm that the US economy is weakening. President Bush will also be giving a nationally televised address on the financial crisis on tonight. Although we do not expect any groundbreaking announcements, his comments could nonetheless be somewhat market moving for the US dollar.

IS THE EURO REPLACING THE US DOLLAR IN THIS TIME OF CRISIS?

Oil Continues to Drive the Dollar

The eyes of everyone from investment managers to stock and currency traders were glued to testimony of the 3 biggest players in the latest financial crisis. US Treasury Secretary Paulson, Federal Reserve Chairman Ben Bernanke and SEC Chairman Cox urged the Senate Banking Committee to approve their request for $700B of taxpayer money. Instead of calming the markets, Paulson and Bernanke spent their time warning of the doomsday scenario should the Senators fail to approve their plan. As a result, stocks came under severe selling pressure. Volatility has been vicious in the financial markets today but the one thing that has remained relatively consistent is dollar strength. The greenback traded higher against every major currency. On Monday, the dollar’s weakness was triggered by the sharp rally in oil prices and today, the retracement is leading to a recovery in the US dollar. Since the beginning of the year, the EUR/USD has had a close 70 percent correlation with oil prices. Over the past 3 months, that correlation has become greater than 90 percent.

From Main Street to Washington, No One is Happy with Paulson’s Plan

Based upon the criticism by the Senators, the backlash from economists, commentators and average Americans, no one is happy with Paulson’s plan. The big question on Main Street is whether Paulson is putting the private interest ahead of the public. This is certainty a heavy debate and one that we will not take up in this column. Instead, we acknowledge the fact that no other viable solutions have been offered and instead Paulson has simply relented to more oversight. This lack of confidence or clarity in Paulson’s plan is a big reason why the US dollar could fall by another 5 percent. Like banks, investors from around the world are pulling their money out of high risk investments and hoarding their cash. According to The Independent, hedge funds are suffering mass redemptions. Foreign investors continue to lose confidence in dollar denominated investments, which is reflected in the sell-off in the stock market and rally in US Treasuries. For currency traders, this means that the US dollar is headed lower.

The Problem is Counterparty Risk

Paulson’s argument is that by freeing up capital for the banks, they can resume making loans for individuals and businesses. However the problem that lenders face is not necessarily a lack of cash, but the fear of couit’sitnterparty risk. The only encouraging thing that came out of the statement was a peculiar comment from Fed Chairman Ben Bernanke. Rather than stick to his prepared testimony, Bernanke spent his time talking about buying assets at their value if held to maturity over buying them at fire sale prices. If this is what they actually do, we could see banks revise up their write-downs. Unfortunately this is another band-aid that masks some of the troubles in the financial crisis and not a new solution aimed at boosting lending, reducing risk aversion or stimulating growth. Unless these problems are tackled head on, the US economy could be in for more trouble.

More Signs that Mr. Scrooge is Coming this Holiday Season

The Richmond Fed manufacturing Index and the report on house prices were both weaker than expected, but the big disappointment came from the National Retail Federation’s warning that spending this holiday season could be the slowest in 6 years. More consumers may be forced to think like Mr. Scrooge which will lead to weaker growth and slower hiring. Existing home sales are due for release on Wednesday. We expect sales to continue to slow because even if homeowners have money to buy, lenders are making it very difficult for them to take out a loan in excess of their down payment.

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US: Forget About a V-Shaped Recovery, Maybe a W or L

The volatility that we have seen in the currency, stock and bond markets this past week has not been for the faint of heart. The Dow Jones Industrial Average fell 500 points on Monday, but instead of continuing lower over the course of the week, it staged the biggest 2 day rally in 5 years. Three to four hundred point swings in the stock market have become the norm this week as surprises and disappointments from the US government keeps traders on their toes.

The current Administration has thrown everything but the kitchen sink at the markets and based upon the recovery that we have seen over the past 2 trading sessions, something has worked. The most powerful of which is probably the Securities and Exchange Commission’s temporary ban on short selling and the hope that Paulson and Bernanke will deliver a new groundbreaking rescue plan that will include a bail-out fund that sops up all of the troubled paper. This has forced a massive short squeeze that drove stocks up more than 750 points in 2 days. Although there could have also been some genuine buying, the rise in gold prices suggests that some investors are still nervous. With no details disclosed at his press conference on Friday, it will certainly be another long weekend for US Treasury Secretary Paulson.

Don’t Expect a V-Shaped Economic Recovery, Maybe a W or L

The main take away from the recent developments is that we will not see a V shaped economic recovery. According to the data released this past week, the housing market and the manufacturing sector are still in trouble. Durable goods, the final numbers for second quarter GDP, new and existing home sales are due for release in this coming week and we expect the data to confirm the weakness of the US economy. Layoffs will rise, consumer spending will slow and corporate profitability will decline for at least the next 3 to 6 months. A recovery usually comes in one of four forms – U, V, W or L. We believe that in the current case of the US economy, we will probably see a recovery that looks more like a W or an L.

Investment Banks: 3 Down, 2 to Go

Of the top 5 investments banks on Wall Street, 3 have disappeared this year – Merrill Lynch, Lehman Brothers and Bear Stearns. The last ones standing are Morgan Stanley and Goldman Sachs (Citigroup and JPMorgan are considered universal banks since they have commercial banking divisions). With Morgan in merger talks, there could end up only being one independent player left in the market. For banks to consolidate is not a surprise but their consolidation now is more of an act of desperation than anything else.

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How Does the Fannie / Freddie Announcement Impact the FX Market?

This weekend, the US government announced that they have seized control of Fannie Mae and Freddie Mac, also known as the Government Sponsored Enterprises (GSEs). The sharp rally in the Asian and European stock markets as well as the move in Dow futures suggest that we will see similar strength in US stocks. There is no question that US Treasury Secretary Paulson’s announcement has carved out a bottom in equities but for currency traders, it will be another reason to buy dollars.

Restoring Confidence Among Sovereign Wealth Funds

Risk aversion surged last week, sending the US dollar higher and carry trades lower. Even though the dollar has rallied more than 10 percent against the Euro and British pound since July, we have argued that the dollar’s strength is not over. With the government taking over Fannie Mae and Freddie Mac, it will shore up confidence amongst foreign investors and sovereign wealth funds in particular. Paulson took a look at China’s $4.6 billion reduction of exposure to Fannie and Freddie debt and realized that something needed to be done to prevent a further exodus of foreign investment.

Positive for Carry Trades and the US Dollar

For the past month and a half, the dollar has been rallying on slower growth outside of the US and the expectations for interest cuts abroad. None of those macro drivers that have been propelling the dollar higher have changed and if anything, the GSE announcement restores confidence and helps to alleviate risk aversion. For the currency market, this means more dollar strength and a recovery in the Japanese Yen crosses. We are still looking for the EUR/USD to hit 1.40 and the GBP/USD to hit 1.75 over the next few weeks. There will be nothing to celebrate when it comes to Eurozone and UK data and because of that, the dollar will have a much better time holding onto its gains than the Yen crosses.

M&A Flow
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The ABCs of the Fannie Mae and Freddie Mac’s Problems

A.

First of all, who are Fannie Mae and Freddie Mac?

Fannie Mae: Is the nickname for the Federal National Mortgage Association

and

Freddie Mac: Is the nickname for the Federal Home Mortgage corporation

Collectively, they are know as GSEs or Government Sponsored Enterprises and their job is to provide local banks and mortgage lenders with liquidity to finance home mortgages.

These GSEs are not government owned, only government sponsored. This means that they are privately held and operated by shareholders but receive a line of credit from the US Treasury and an exemption from taxes. Fannie was privatized by Lyndon B. Johnson in 1968 to remove it from the national budget. Freddie was created in 1970 to prevent monopolization of the secondary mortgage market by Fannie. Both GSEs are exempt from SEC oversight.

Fannie Mae and Freddie Mac are very important entities within the US economy. They guarantee approximately $US 6 trillion in outstanding home loans and service 50 million mortgage customers. The value of their loans is equal to 2/3 of the current national debt!

With a triple A credit rating and a $2.5 billion credit line with the Treasury, many investors have long considered Fannie and Freddie the safest of the safe.

B.

So What’s the Problem?

As owners of the lion share of mortgages, Fannie and Freddie have not been immune to the subprime mortgage crisis. However unlike the other Fortune 500 companies, Fannie and Freddie are not forced to disclose their financial difficulties. Investors fear that they will suffer more losses than the $11 billion that has already been reported.

Not too long ago, the Justice Department and the SEC discovered accounting errors in the amount of 4.5 to 4.7 billion dollars. The current fear is that the sheer size of Fannie and Freddie’s potential losses eclipses their lifeline.

Fannie and Freddie’s shares have fallen to the lowest levels in 19 years. Speculators believe that not only could they be insolvent, but based upon the comments from US Treasury Secretary Paulson and President Bush, the US government does not think that a bailout is needed.

Yet liquidity problems can be compounded by market fears. Remember how Bear Stearns’ credit lines were all pulled on speculation that the bank would go under, which of course exacerbated their demise. Selling of government bonds can lead to higher bond yields and pricier borrowing costs for the GSEs.

C.

Too Big to Fail?

The biggest question in the financial markets right now is whether or not Fannie and Freddie are too big to fail? I certainly think so. If the government stepped in to prevent the Bear Stearns meltdown from crushing the market, they will step in to prevent a collapse in Fannie Mae and Freddie Mac because if these 2 GSEs fail, Americans will have to shoulder the burden. Fed Chairman Ben Bernanke has already announced that the GSEs can have access to the discount window, which would allow them to borrow money directly from the Federal Reserve rather than the markets.

Bernanke Opens the Discount Window, But Will that Be Enough?

If Fannie and Freddie’s problems are not solved and they still have difficulties borrowing, this means that they will have difficulties lending, which is something that the US government can not gamble with at this moment.

It would send a much stronger mess to the markets if the US government:

1. Guaranteed Fannie and Freddie’s Loans
2. Nationalized the GSEs
3. Infused Government Funds into Fannie and Freddie (Equity Investment)
4. Encourage Further Investments from Private Investors

China, Japan, the Cayman Islands, Luxembourg and Belgium are the top 5 foreign holders of Fannie and Freddie’s debt.

For the currency market, it is a lose-lose situation for the US dollar. Further problems at Fannie and Freddie would push stocks lower once again, which would trigger another flight to safety out of US dollars. A bailout would essentially double the public debt, risking a downgrade in the US credit rating.

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