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Bailout Battle Raging Between US Government and Financial Markets

Stock-Markets / Financial Crash Jan 26, 2008 - 02:39 AM GMT

By: Money_and_Markets

Stock-Markets

Best Financial Markets Analysis ArticleMike Larson writes: Pardon me, but am I the only one suffering a serious case of whiplash here? I mean, the financial sector developments over the past few days have been amazing ... simply amazing.

Coming into the week, the global markets were in a freefall. While U.S. markets were closed for Martin Luther King Day, stock indexes from Hong Kong to London were collapsing on fears of a bond insurance market meltdown.


Then in the early morning hours on Tuesday, the Federal Reserve took emergency action, slashing interest rates by 75 basis points. That was the single-largest interest rate cut going all the way back to 1984, and the first inter-meeting cut since right after 9/11.

It kept U.S. markets from plunging into the abyss, but they still finished lower.

On Wednesday, it looked like we were set for another disastrous session. The Dow tanked 326 points by lunch.

But before you could say "government bailout," the market suddenly reversed course. The Dow actually closed UP nearly 300 points, capping a wild 5% intraday swing!

Why? News leaked about more possible federal intervention in the mortgage market and a potential rescue package for the bond insurers. Specifically ...

Senator Dodd wants Washington to buy up distressed mortgages and sell them back to strapped borrowers.
Senator Dodd wants Washington to buy up distressed mortgages and sell them back to strapped borrowers.

Connecticut Senator Christopher Dodd floated the idea of creating a "Federal Homeownership Preservation Corp.," which would buy the most troubled mortgages out there and offer new loans — with lower balances — to the borrowers stuck with them. Those new loans would be backed by Fannie Mae and Freddie Mac, or insured by the Federal Housing Administration.

The corporation would be capitalized with $10 billion to $20 billion, and its goal would be preventing more foreclosures. If the idea of the government stepping in and buying up crummy assets sounds familiar, that's because it's a tried-and-true response to financial panic.

During the S&L crisis, for example, the government set up a company called the Resolution Trust Corporation. The RTC bought up distressed assets (commercial loans, mortgages, and so on) from failing thrifts and tried to sell them over time, using the recovered money to reimburse depositors and other creditors of the failed institutions.

Meanwhile, New York insurance superintendent, Eric Dinallo, reportedly sat down with bank executives and urged them to help bail out the bond insurers. According to the Financial Times ...

Eric Dinallo is trying to get banks to bail out bond insurers.
Eric Dinallo is trying to get banks to bail out bond insurers.

"The largest U.S. banks are under pressure from New York State insurance regulators to provide as much as $15 billion in fresh capital to support struggling bond insurers, people familiar with the matter said.

"Eric Dinallo, New York insurance superintendent, has met executives at the banks and has strongly urged them to provide $5 billion in immediate capital to support the bond insurers, the largest of which are MBIA and Ambac, and to ultimately commit up to $15bn."

Then yesterday, we learned that more government and quasi-governmental intervention in the mortgage markets is coming. The economic stimulus package includes a provision that would temporarily raise the jumbo loan limit, which caps the size of home mortgages that Fannie Mae and Freddie Mac can buy.

The current cap is $417,000. If the Senate and White House sign off on the plan, the cap will climb to as much as $625,000 in certain higher-cost markets (Think New York, California, etc.) for one year.

The proposed package will also boost the size of mortgages that the Federal Housing Administration, or FHA, can insure. Both moves are aimed at lowering borrowing costs for mortgage hunters who don't qualify for conventional financing.

In other words ...

A Titanic "Government Vs. Market" Battle Continues to Rage!

In one corner, you have huge profit declines across the board in the financial sector ... gigantic write-downs ... falling home prices ... and rising delinquencies on everything from mortgages to auto loans to credit cards.

Just in the past few days, subprime auto lender AmeriCredit (ACF) joined the list of companies warning of crummy credit conditions. It lost $19 million in the December quarter, a huge swing from a year earlier, when it earned $95 million. The firm's provision for loan losses roughly doubled to $357 million, too.

Regional bank SunTrust (STI) said it earned just $3.3 million in the fourth quarter, down 99% from a year earlier. Bank of America (BAC) and Wachovia (WB) saw profits shrink 95% and 98%, respectively.

In the other corner, you have increasingly aggressive attempts by the government to combat those market forces.

The same Fed that a few months ago said everything was fine and the problem is "well-contained" is now cutting rates by the biggest margin in two and a half decades.

Last summer, Treasury Secretary Paulson said housing was at or near a bottom!
Last summer, Treasury Secretary Paulson said housing was "at or near a bottom!"

And the same Treasury Secretary who said the housing market was "at or near a bottom" last summer, and who maintained that the subprime meltdown "will not affect the economy overall," is now jumping in with both feet. He's trying to push and prod lenders into modifying mortgages, and working with Congress to deepen the government's involvement in mortgage lending.

This pitched battle is leading to colossal — and I do mean colossal — moves in financial stocks. Ambac Financial Group, the bond insurer, plunged 38.7% one day last week and 51.9% the next, only to surge 28.6% this Tuesday and 71.9% on Wednesday!

Or how about JPMorgan? It couldn't get out of its way starting in mid-December, falling more than 20% from intraday high to low. Then on Wednesday, the bank's shares shot up almost 12%. That's the biggest one-day gain this mega-cap bank has seen in years — and it came on the highest volume I can find.

Is It Time to Bet on a Winner in this Epic Battle?

This week, a lot of big money was bet on a bottom in the banks. You could see it in the price action and the trading volume.

The scenario being envisioned by the bulls: A 1991-1992-style dramatic rebound in banking shares, which followed a deep plunge brought on by the S&L Crisis.

This time around, the bulls are counting on a rebound in the economy and a boost in profit margins brought about by aggressive Fed interest rate cuts.

Here's the problem I have with that idea: The last major banking crisis was largely driven by souring commercial real estate loans. This time around, there was dumb lending everywhere. It was most visible and most egregious in the residential mortgage arena. But you also saw it in commercial mortgage lending ... in leveraged buyout financing ... in auto lending ... you name it.

As a result, there are signs of credit stress in several loan categories. Moreover, the value of many of these loans is falling in the secondary markets, according to various derivatives indices and data services. That raises the risk of further multi-billion-dollar write-downs across the banking sector.

And I should point out that almost every step of the way, the federal government and the Federal Reserve have been reacting to the market problems, rather than getting ahead of them. The economic stimulus package ... the mortgage restructuring initiatives ... even the Fed's rate cuts were all apparently cooked up AFTER the crises hit the front pages. That doesn't exactly make investors feel warm and fuzzy inside — or confident that the government is on top of the problem.

The ongoing "blow ups" that keep coming out of left field are another confidence killer. Heck, the second-largest bank in France, Societe Generale, just announced that a rogue employee managed to rack up $7.2 billion in losses by placing unauthorized bets on stock index futures. The 30-year-old trader reportedly made less than $150,000, but managed to wipe out almost two years of pre-tax profit at the firm's investment banking arm. It'd almost be comical if it weren't so disturbing!

Frankly, this looks like classic bear market behavior to me. You typically see big, waterfall declines, followed by major, snapback, short-covering rallies.

In 2000-2002, the sector at the center of the crisis was tech. This time around, it's anything related or tied to the financial and housing industries.

I'll let you know if I see a lasting turn in the fortunes in these areas. But I just don't think we're there yet.

Until next time,

Mike

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