A Deflating Bubble Can Lift All Boats

It's perhaps the cruelest of ironies that in the U.S. housing market's greatest hour of need, the major entity created during the Depression to bring liquidity to housing, Fannie Mae, may itself soon be in need of bailout. (Jonathan Laing, Barron's)

The new group at the Fed is not equal to the problem that faces it. They need to speak frankly to the market and acknowledge how bad the problems are, and acknowledge their own failures in letting this happen. This is what is needed to restore confidence. There never would have been a sub-prime mortgage crisis if the Fed had been alert. This is something Alan Greenspan must answer for. (Dr. Anna Schwartz, Sunday Telegraph)

Weakness in financial markets accelerated last week as investors became more and more afraid of the systemic implications of the deflating securitization bubble. Unwinding billions of dollars worth of illiquid private label bonds held by leveraged funds and other "weak hands" is putting enormous stress on banks and other intermediaries, including the housing GSEs.

The media feeding frenzy around Citigroup (NYSE:C) reminds us that the best is yet to come in the US credit meltdown. Fact is, loan and lease default rates in 2007 were actually lower than 2005 and flat compared to the year before, even though the trend is clearly higher. Click here to see the chart of gross charge-offs for C and the large bank peer group from our presentation at American Enterprise Institute this Wednesday, March 12th.

We are encouraged to see the Federal Reserve Board moving to increase the amount of liquidity available to the Street, a clear sign that the Fed's leaders understand that the problem is not the official target price of credit, but investor flight from many private asset classes. Hopefully the Fed will stand its ground on March 18th and forgo further rate cuts. Instead, Chairman Bernanke should hold a press conference and make clear that the US central bank is committed to price stability but will provide whatever volume of liquidity is required by the private markets to deal with the unwinding process.

Notice too that the State of California decided not to purchase insurance for its latest municipal bond issue. We expect to see other large, high quality public sector issuers going to market without credit enhancement and even beginning to make markets in their own securities as the Sell Side dealer community crawls under the proverbial rock. Once investors understand the underlying credit and thus the real value proposition, many Muni and even private sector issuers could do the same.

Over the past couple of weeks, we had an email exchange with several CEOs of bulge bracket firms, essentially asking "Where's the plan?" from the private sector to address investor angst over illiquid securitized assets. The response was uniform and limp: we have to fix the ratings agencies first, a reply that basically suggests that Buy Side investors are mindless idiots incapable of making asset allocation decisions without guidance from Moody's (NYSE:MCO) or S&P, a unit of McGraw Hill (NYSE:MHP).

We know different. In fact, we believe that the collapse of the market for private label structured assets presents an opportunity for private issuers and investors who are willing to take advantage of the current market dysfunction. Indeed, the impending insolvency of both Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) may present a way to solve a big part of the problem with the US housing finance sector, namely the hegemony of the US government in mortgage securitization.

Our friend Bob Feinberg likes to quip that the government-sponsored entity or "GSE" is now the favored model in America's supposedly free market economy, a telling comment for those familiar with European history. After all, FDR's inspiration for using the GSE model during the Great Depression came from earlier experiments in fascist Italy and Germany, a model clearly antithetical to a democratic, free society, much less a market-based economy.

As Professor Joseph Mason suggested in our interview last week, the ultimate cause of the subprime mess is the growing government monopoly over the fat middle, low-risk portion of the US housing market. By leaving the least attractive scraps of the mortgage finance sector to the private banks, which mimicked the GSEs securitization template in an effort to compete, Washington actually created the current crisis in subprime securitizations. The Street, however, now has a rare opportunity to recast the current market structure, strike a blow for the national interest and make money at the same time.

The false promise of private "credit enhancement" has distorted investor behavior, but balance is returning. Now that underlying credit quality of collateral in private label securitizations is the focus of investor analysis efforts, the markets are moving toward clearing, but help is needed in order to give investors the comfort they require to get back into the game.

Somewhere between the fantasy land idea of "AAA" ratings for subprime debt (defined as paper that routinely throws of 20-30% defaults over say three to five years) and default is a price where such deals get done, without credit enhancements or third-party ratings. Incidentally, that's why we subject US banks to a 1,000 basis point or 10% default tolerance threshold in the Economic Capital model in The IRA Bank Monitor. Finding that market clearing price level is the start of a true solution - maybe even a revolution.

When, not if, the wave of defaults and foreclosures in conforming mortgage paper hits the GSEs, the Congress and a new President will confront a huge public sector bailout. But rather than watching Washington further nationalize the housing finance market, the true underlying cause of the subprime crisis, both sides of the Street should organize and be prepared to bid against a re-nationalization of FNM and FRE. If investors could stop worrying about what the Fed is going to do or whining for a bailout from Congress, we might actually solve this problem and then some.

"Do you think Wilbur Ross would pay 5x tangible book for Freddie," asked our friend Josh Rosner during the weekly yak on Friday. Rosner figures that "tangible" book for FRE is $0.46 per share, so figure $2.50 per share including the tip, about 10% discount from the $19 and change Friday close. Remember that the bond holders are the true shareholders of both GSEs. GSE equity is just an option. By election day, defaults and mounting OREO could see both GSEs trading in single digits - if they are trading at all.

By being prepared to float a private rescue of FNM and FRE, an organized, coherently led consortium of private banks, dealers and investors could be in a position to propose to the Congress a grand concordat, a systemic fix to the current mess that also could help restore free market discipline to America's increasingly managed financial markets. The executive summary reads like this:

• Repeal of fair value accounting treatment for illiquid financial assets
• Standardization of terms and structure of all private label securitizations.
• Registration with the SEC of all securitizations to be sold to banks/pension and/or mutual funds.
• Public disclosure of secondary market prices for all securitization and OTC derivative transactions.

The Street would bid for the assets and guarantee portfolios of FRE and FNM, and use this vast corpus of deeply discounted "conforming" assets as the foundation for a much larger, purely private securitization market that includes all manner of collateral. A new definition of "conforming" paper would be established for all private securitizations, which may or may not carry ratings or enhancements. The Congress would codify the new standard into law, extinguish the corporate charters of FRE and FNM, and refocus public policy on the subprime area via Ginnie Mae where there is arguably a role for direct government assistance.

Why now for such a bold plan? Well, for starts Uncle Sam is broke. Given current Fed interest rate policy, the war in Iraq and a widening recession, the mere suggestion that the Congress is considering a public bailout of the GSEs would send the dollar into a free fall that makes recent market weakness seem leisurely by comparison. Fears of inflation and growing state-intervention in the US economy would turn the dollar's slump into a rout. How does $3 per Euro strike you?

When the market value of the GSEs begins to approach "tangible book," the Street has a rare opportunity to roll back Washington's intervention in the US mortgage market and eliminate one of the worst socialist excesses of the New Deal. The missing ingredient, at the moment, is leadership and imagination from the captains of Wall Street, who have been far too comfortable with the status quo. Even usually conservative voices like Barron's incredibly call the prospect of nationalization of the GSEs "a good thing."

The good news, though, is that there's plenty of private capital on the sidelines waiting for direction. Can the heads of the major Buy and Sell Side houses summon the necessary courage, brain power and attention to suggest a private sector solution to the subprime crisis? Such an audacious course could reduce the role of government in mortgage finance, takes financial pressure off our spendthrift government and may even help the battered dollar. But most important, it will revive a financing mechanism that is vital for US economic growth, namely the market for private label structured assets.

Comments

[bluesmoke]

Excellent article! Desperate times call for desperate measures. Letting the free markets fix this is a much better solution. Getting all the "experts" with their big egos to agree on anything as practical as this is a tall order I'm afraid. Seems to me it's easier for them to watch the country go bankrupt.