Paulson's Bazooka

 |  Includes: FMCC, FNMA, SPY
by: Dr. Duru

As much of the nation mourns a potentially season-ending injury to New England Patriots star quarterback Tom Brady, it might miss the fact that this weekend also marked a sad milestone for American "free-market" capitalism. The Federal government finally did what almost everyone surely assumed as a foregone conclusion: the Feds seized Freddie Mac and Fannie Mae and placed them into the conservatorship of their regulator, the Office of Federal Housing Enterprise Oversight [OFHEO]. Treasury Secretary Henry M. Paulson, Jr. threatened the market with a "bazooka" in the hopes that he would not actually have to use it, and the market instead pressed the pedal to the metal in calling the bluff.

And of course the market called the bluff. Over and over during America's on-going financial crisis, we have had to suffer through claim after claim by the people that run and regulate our financial institutions that either all is well and sound, no additional capital is needed, liquidity is adequate, the bottom is at hand, and/or the entire kitchen sink of broken plumbing has been thrown into the write-off garbage bin - only to hear sooner than later that the exact opposite is the case. Here we go again. As late as July 11, Paulson claimed that "Today our primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission." Bloomberg went on to report that "Paulson's remarks indicate he wants to reassure shareholders they won't be wiped out by any government efforts to ensure the stability of the firms..." Fannie Mae spokesman Chuck Greener chimed in that Fannie Mae "...has access to ample sources of liquidity, including access to the debt markets, and Freddie Mac added that it was "...adequately capitalized, highly liquid..." Let's not even mention the analysts who declared July's swoon to be an excellent buying opportunity (which it was - for short-term traders). How little is the understanding of so many people "in the know" about what is going on - Meredith Whitney has been a breath of fresh air although her dose of hard reality checks have been hard for folks to swallow.

This is a sad day for American capitalism because, despite rhetoric that may suggest the contrary, the hard-earned taxes of the American people will be put to work to socialize the risks of speculators who over-reached in search of private profits. (kudos to Paulson for at least appearing to try to protect the interests of taxpayers by spreading the pain to Freddie and Fannie stockholders...who probably will also feel like victims here. Paulson has also made it clear he is not happy about what he has "had to do").This intervention will occur on a massive and historic scale. We also must wonder how much better can the government manage this mess than the private market did?

The main advantage that the government has over the private sector is its power to tax the people and its power to print more dollars. This conservatorship has confirmed for me that both are in play in a major way. Thus, this has confirmed my continued lack of faith in the U.S. dollar. I am also disappointed to read the Wall Street Journal report that the current CEOs of Fannie and Freddie may walk away from this disaster with attractive exit packages: "Mr. Syron may walk away with an exit package that could total as much as $15 million, says David Schmidt, a senior consultant at James F. Reda & Associates LLC, a compensation consulting concern in New York. That includes a pension and deferred compensation, about $3.7 million in severance pay and a possible payment of $8.8 million to compensate for forfeiting recent equity grants. Mr. Mudd's exit package, including stock he already owns, could total $14 million, Mr. Schmidt estimates. That includes $5 million in pension and deferred compensation, $4.2 million in severance pay and $3.4 million of restricted stock, based on Friday's closing price. That value of that stock could fall sharply, however."

With these kinds of potential pay-offs for achieving such poor results, can we honestly say there was enough incentive to do well? Yikes... Anyway, a good outcome from all this might be a simpler tax code that discourages the abuse of leverage in financing homes, and a social ethos that re-focuses on owning a home outright (home security) and frowns upon staying indebted to a house for a lifetime (home insecurity).

Now, is it any accident that the government's latest market intervention comes just as we are staring again at 1200 on the S&P 500, and the major indices threaten fresh 52-week lows? I think not. Since last Fall, every bounce we have had from climactic lows has come after the government announced some surprise intervention. The small difference this time is that the market seems to have anticipated the intervention in time to buy into the close on Friday ahead of the government's move.

Financials and housing stocks were especially strong beneficiaries of the bounce after the morning despair from another horrible jobs report - this time showing the unemployment rate has popped up to 6.1%, the highest rate in five years. (And for all of you "lagging indicator" people, I finally have to agree that this number is apparently cannot keep up with the real decline in the economy!). Another difference is that this intervention has come after the failure of a very weak rally from the last government-induced bounce in July.

I now find myself torn on what to do next. I suggested buying into the July lows for the S&P 500 because the selling had reached historic proportions. Less than a month later, I found myself backing off given the weakness I saw in the ensuing rally. Both recommendations proved timely on the S&P 500. This time around, I have a lot less confidence in guessing at the market's next moves. On the one hand, I think I made a decent case for a bear market rally that takes us back to the May highs before year-end. On the other hand, the rally off July's low was tepid and unconvincing while the sell-off that began post-Labor Day trading was sharp and quite convincing. Before Friday, I was getting ready to write an extremely bearish missive, but after Friday I still wonder just how many times government intervention will "work" to prop up the stock market.

If I believed that the remaining financial problems in the world come from Fannie and Freddie, I would have to bang the table ever more loudly for another bear market bounce that finally takes us to the May highs in less than four months. But we can have little comfort that Freddie and Fannie are behind us. Additionally, global stock markets have sold off hard for months not because of Freddie/Fannie fears but because the global growth story has been slowly unraveling.

Even worse, from a technical perspective, we are nowhere close to a selling climax. As faithful readers know, I keep my eye on the T2108 indicator, and it tells me we have a lot further to fall before reaching a new climactic low. TraderMike, as usual, puts together a good story on this and includes the T2108 indicator. His September 5th recap is also good reading for those of you with a technical eye. Essentially, the markets are primed for a nice short-term bounce that short-term traders will love, but the sustainability of such a bounce is highly doubtful. Overhead resistance should prove tough to break, and only such a break would bring back my confidence (for example, a high-volume move over 1300 on the S&P 500). So, if I was forced to make a conclusion, I would say sell this rally until "further notice." Alan Farley has a good related piece called "Wait for Proof of a Turnaround."

Be careful out there!

Full disclosure: Long S&P 500 in an index mutual fund.