Wall Street Hubris Meet Thy Reward: Insolvency

by Larry Levin


Last week's volatility was in a word: incredible. Lehman Brothers was again feared to be at death's door and oil was on a roller coaster, ending the week at new all-time highs. Fannie Mae (FNM) and Freddie Mac (FRE) were on that same coaster, jumping to the front seat on Friday when it was feared they were going under? Are they insolvent? Only time will tell with FNM and FRE. However, IndyMac bank sure is insolvent - it was closed late Friday when the FDIC took it over. Wall Street hubris meet thy reward: insolvency.

Before we get started on the aforementioned horror show, a potentially big story went unnoticed. A government report on Friday showed us that import prices rose a staggering 20.5% since last year. Not only is inflation here now, but it is being imported every month! When will the Fed do its job and support the dollar by raising interest rates? Don't hold your breath - the Fed doesn't give a rat's a$$ about you or your silly inflation problems.

The government waited until the market was closed Friday to announce its takeover of the Pasadena Calif. Bank, once one of the nation's largest home lenders, IndyMac.

It's possible this will be the most costly bank failure in history, but it's too soon to say, FDIC Chairman Sheila Bair said in a conference call late Friday night. The failure could also affect premiums paid by all banks for deposit insurance, she added.

In the past 15 years, the FDIC has taken over 127 banks with combined assets of $22 billion, according to FDIC records. IndyMac's collapse is a rather big deal when one considers its assets of $32.01 billion dwarfs the combined total of the last 127 bank failures. It is the fifth bank to fail this year and the largest bank collapse since 1984, when Continental Illinois went under with $40 billion in assets. Monday's trade will be very interesting!

This coming week's turbulent volatility will also be greatly affected by the ongoing saga of FNM and FRE. Are these GSEs (government sponsored entities) solvent or insolvent? For every commentator that said it was solvent this weekend, there was another that disagreed. I have no idea what will happen or even should happen, but I do have a few comments on the whole ordeal.

Have you heard anyone suggest that these companies are/were actually part of the housing problem from the outset? In case you don't know what government sponsored entities are, let me break it down for you. That's a euphemism for TAXPAYER sponsored entities, which will once again be bailing out Wall Street's so-called superstars. And that's the problem folks; if your tax dollars are the backstop for failures, the companies could and did act recklessly. This is the very moral hazard that I have warned about for years - on a massive scale.

Another reason why FNM and FRE were part of the problem is that by their very nature - buying 70% of every mortgage ever underwritten - contributed to escalating home prices as every damned fool who asked for a loan received one. Although FNM and FRE are supposed to support affordable housing, in fact they were a main reason why housing became the largest bubble of them all (so far). By the way, what business is it of the government's to promote home ownership over renting?

And another thing, I'd like to know why nobody is looking at the culpability of Congress itself, in particular Barney Frank who continued to support Fannie and its troubled leadership. How many hundreds of millions in bonuses and stock options did this management walk away with while creating this mess? How many millions of dollars of political contributions were paid to Congressmen by FNM and FRE? How many cushy jobs were waiting for Congressmen at said firms when they retired from (cough) public service? Dennis Kozlowski is in jail for an expensive shower curtain and he didn't cost the taxpayers or the financial markets a thing. Where is the outrage?

Not only did Congress support FNM & FRE when they were already bleeding and becoming insolvent on their own portfolios, but Congress has been using these two companies to back stop the entire mortgage market: their portfolio limits were raised, their regulatory capital was reduced and the limits to what conforming mortgages (that the GSE can repackage/insure) are were raised from $420k to over $720k just a few weeks ago. Thanks for making them even MORE insolvent boys! Whenever you hear a Congressman say they do not want to foster moral hazard in the market, tell him or her to just shut up please.

Although Congress is certainly culpable, the ultimate blame belongs on the Federal Reserve. The Fed failed to raise interest rates to cool off the housing bubble when housing prices were growing 1% to 2% faster than the total economy. Greenspan didn't raise rates to slow the tech bubble, so it burst and capital moved to property. The property bubble burst and that capital has moved to commodities. Investing has turned into a follow the pack mentality which is creating one bubble after another thanks to the Fed.

It has always amazed me that the Fed only sees inflation in the prices of goods and wages. Why not in the price of equities and property? The Fed needs to focus on inflation in any form; stock, bond, property, commodity, etc. and raise interest rates to control its growth. The Fed has been too concerned about short-term jobs numbers and Wall Street's profitability (so it keeps rates low) than the long-term economic health of the economy. The SEC also needs to step up and regulate financial vehicles like SIV's & CDO's, and prevent new financial vehicles from being offered until the SEC can access the market risk and establish conservative capital requirements.

I think we can all agree that there is enough blame to go around and that the taxpayer is about to get royally screwed. But who wins? Who gets bailed out? The equity (stock) holders have already been eviscerated and in the event of a government takeover will get zero - so that doesn't help them. However, the bondholders will be saved. Have you wondered who the largest bond holders of FRE and FNM are? I sure did, so I looked it up. The two largest bond holders of FRE and FNM that will be bailed out by your tax dollars are - CHINA and JAPAN !

If you're mad as hell and can't take it anymore - DO SOMETHING ABOUT IT! Call your Congressman and tell him/her that China and Japan speculated (we're supposed to hate speculators for some reason now - right?) when they purchased those bonds and they can twist in the wind with the rest of us.

Real Time Trading Signals*for

Trade Date: 7/11/08

E-Mini S&P Trades*
(before fees and commissions):

1) VA sell @ 8:45am at 1242.50 = -1.5*2

2) 80% buy @ 9:20am at 1242.00 = +1.50 & -1.75

3) OTF sell @ 12:20pm at 1232.25 = +1.50 & -1.25

4) TP sell @ 12:40pm at 1234.25 = -2.5*2

5) Algorithm trades (6)...combined total...-3.75


E-Mini Russell Trades*
(before fees and commissions):

1) Sell @ 10:09am at 662.6 = -1.0 (1 lot)

2) Sell @ 1:43pm at 666.0 = -.9 (1 lot)...-$190

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