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Thursday, September 11, 2008 3:14 AM

Slope Of Bailouts Is Slippery And Expensive

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Inquiring minds are asking "What has Paulson Wrought?"

That's a good question. So let's see what we can find starting with a look at the unintended consequences of the Fannie Mae (FNM) and Freddie Mac (FRE) taxpayer sponsored bailout forced down our throats by Treasury Secretary Paulson.

Unintended Consequences

Bloomberg is reporting Fannie, Freddie Takeover Jolts Preferred Stock Market.

Treasury Secretary Henry Paulson's takeover of Fannie Mae and Freddie Mac is roiling the market for preferred securities.

Prices of fixed-rate preferred stock fell an average of 11 cents to 69.8 cents on the dollar this week, including the biggest one-day drop in a decade on Sept. 8, according to Merrill Lynch & Co. index data.

Paulson's "actions have damaged the preferred market," said Thomas Hayden, the investment strategist for Liberty Bankers Life Insurance in Dallas. "Somebody is going to be looking at an issue of Fannie or Freddie preferred shares that were rated AA up until a few months ago.

The takeover was "unambiguously bad" for preferred investors and "likely set a precedent for any future rescue transactions," Kathleen Shanley, an analyst at bond research firm Gimme Credit LLC in Chicago, wrote in a Sept. 7 report.

Preferred shares of Washington-based Fannie and Freddie of McLean, Virginia were cut to the second-lowest rating by Standard & Poor's and Moody's Investors Service on Sept. 7. The grades were slashed 11 levels by S&P to C and 10 rankings to Ca by Moody's. Moody's rated their preferred stock Aa3, the fourth- highest grade, until July.

"In the primary market it's going to be much more difficult for financials across the board," Hayden said. "If Lehman Brothers thought they needed to go to the market and had any chance at all of issuing preferred stock to raise capital, it is now three times more difficult than it was last Friday."

Investors will be "gun-shy" about buying preferred shares, said Thomas Houghton, who manages $2 billion of corporate bonds at Advantus Capital Management in St. Paul, Minnesota.
Intentional or not, another consequence of the structure of the Paulson bailout was a $1.7 billion payday for PIMCO. Given that Bill Gross bet the farm (62% of his $132 billion fund was riding on agency bonds) a very good case can be made that the bailout was purposely structured to protect PIMCO.

Mother Of Year-Ends

Inquiring minds may wish to consider Fed May Expand Funding Aid to Banks in a "Mother of Year-Ends".
Six bank failures in the past two months and rising concern about Lehman Brothers Holdings Inc.'s capital levels pushed lenders' borrowing costs to near a four-month high yesterday. They may climb further as companies rush for cash to settle trades and buttress their balance sheets at year-end.

"This could be the mother of year-ends," said Brian Sack, vice president of Macroeconomic Advisers LLC in Washington, who used to serve as head of monetary and financial market analysis at the Fed. "The markets will need extraordinary actions to get through it."

Traders in the forward markets, where financial instruments are sold for future delivery, are pricing three-month cash from December to March at 90 basis points over expectations for the federal funds rate. That's up from 85 basis points at the start of the week and an average of 7 basis points average in 2006.

"If banks are unwilling to lend to other banks, then they are unwilling to lend to you and me," says Stan Jonas, chief executive officer at Axiom Management Partners LLC, a New York investment firm. "The market anticipates that we will be in a heightened state of credit risk."

"Liquidity tools by definition can only have so much impact," said Dino Kos, former head of financial markets at the New York Fed and now a managing director at Portales Partners LLC, a New York research firm. The Fed "can alleviate the problem by helping institutions finance these bad assets," Kos said. "But by itself, that doesn't lift the price of these assets. You still have an underlying solvency problem."

"Why would anyone inject equity capital into a financial institution if a few weeks later the government comes in and renders it worthless?" said Axel Merk, president of Merk Investments, a Palo Alto, California-based fund manager. "The slope of bailouts is slippery and expensive."
Slope Of Bailouts Is Slippery And Expensive

Not only are taxpayers on the hook for $200 billion dollars, but the Paulson sponsored bailout has caused even more mistrust and resentment of the system.

A quick check of my calendar shows next week is options expirations week. What stunt might Bernanke and the SEC pull now? Eliminate naked shorting across the board through the end of the year? Conduct a séance? Howl at the moon?

I vote for the séance. There are many dead banks with whom Bernanke can communicate.

But a séance will not change the fact that banks do not want to lend to each other for good reason. No one knows who is next, and besides they are all short on cash anyway.

Bernanke is clearly running out of options. The TAF, PDCF, and TSLF have all failed. The reason they all failed is this is a solvency issue not a liquidity issue. However, there is one thing Bernanke has not tried yet so be prepared for it.

Printing Presses Are Ready To Roll

Eventually Bernanke is going to start printing in an effort to shore up banks. Borrowed bank reserves will soar. But hardly a penny of that will get lent. With collapsing consumer demand and rising unemployment, businesses will not want to borrow and banks will not want to lend.

The zombified banks will sit there pretending they have cash to lend and the Fed will pretend that banks are well capitalized. Inflationists will be screaming inflation and they will still be wrong. Bank credit marked to market will continue to collapse at a rate far greater than the printing for quite some time.

Most will miss the credit collapse for the simple reason banks will resist marking their assets to market. However, the bond market will sniff this out as treasury yields continue to sink, corporate bond yields skyrocket, unemployment soars, and asset prices collapse.

Welcome to Deflation American Style. You are in it now.

Mike "Mish" Shedlock
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