Here's a message board post (click here for original) by InvestorVillage's Northbeachfl2000 that summarizes things well (my clarifications are enclosed in italicized [square brackets], MontyHigh):
Please pay attention. This might be the most important post you read for a while (even though it does not involve energy directly).
The level of understanding about how our capital markets work in this country (including these talking heads on CNBC and in the media) is pathetically inadequate. For those here, I'm going to try and correct that. The basis of my understanding of this subject did not come from a book. It came from working at Salomon Brothers during the 1970's (a firm - now part of Citibank - that dominated the taxable fixed income markets during that period). I started out as a money market and government securities salesman. My next to last job there (before I left to start my own firm) was as their global money market and government securities sales manager. As a result, I think I know what I'm talking about.
Following the concept of KISS (keep it simple, stupid), I'm going to try and walk you thru what exactly is going on right now as it pertains to Freddie Mac and Fannie Mae. I'm going to go slowly and keep it as simple as I can (at the possible cost of exact technical correctness). Hopefully I will be able to tie everything together at the end in a way that makes this complicated financial situation understandable.
(1) What role does the Treasury Department play? - It is the role of the Treasury to make sure that the U.S. government has enough money to fund the obligations of the U.S. government. Whether the government is running a fiscal surplus or deficit, it is their responsibility to determine how much money should be raised and when. It is also their responsibility to determine what the maturities of this debt should be. The amount of each offering is set by the amount of debt maturing (thus requiring refinancing) as well as any additional debt that may be needed above and beyond that (i.e. to fund that year's deficit). If you check, this is done thru weekly Treasury Bill auctions, quarterly refundings and other periodic treasury auctions such as the monthly two year note. These auctions are not conducted by Treasury. They are conducted by the Federal Reserve Bank of New York thru their network of recognized government securities dealers. The important thing to note here - these Treasury financings have absolutely no impact on the money supply. They simply determine how much Treasury debt is outstanding (i.e. the national debt).
(2) What role does the Federal Reserve play - Besides facilitating the Treasury's effort to fund the operations of the government, the FED is charged (along with many other things) with determining how much money is in the system. So how does the FED expand or contract the money stock? SIT DOWN AND PAY ATTENTION. All they have to do to create more money is to buy a Treasury bill, note, or bond from one of the recognized government securities dealers (i.e. $1MM treasury security goes to FED, $1MM is released into the system as payment). IT IS JUST THAT SIMPLE. It is from this money stock creation/contraction (that can be raised or lowered at will by the FED simply by buying or selling treasury or GSE agency securities), that then gets circulated throughout the financial system, that is the starting block for determining such things as M1, M2, and M3. POINT TO REMEMBER - only the FED can monetize debt and THIS IS HOW THEY DO IT.
(3) With (2) above in mind, The FED right now has a portfolio of around $800B (my numbers are probably off, but the magnitude isn't). That means that they have created $800B of "money" (which gets multiplied many times over as it winds its way thru the banking system thru the mechanism of bank deposits and bank loans (less reserve requirements)). Up until the Bear Stearns bailout, all of this $800B of "money" was backed by a portfolio of U.S. Treasury and Agency securities. With all of these "clever" new financing vehicles that were created by the FED to bailout Bear Stearns and to keep the IB's and money center banks afloat, roughly half of this $800B AAA+ portfolio has been loaned out thru the Discount Window in exchange for toxic waste garbage (sub prime MBS, etc.). [It should be noted here that the FED does not own this garbage. It is simply financing it for the street since no one else will. The hope is that they will be able to get their original securities back (and get the garbage off their books) when the credit markets normalize.]
(4) What role does FNM and FRE play? - These two GSE's [government sponsored entities] are the only reason that we have a functioning 30 year fixed rate mortgage market. Reason? As government sponsored enterprises, they have long enjoyed a competitive advantage in terms of how they can fund themselves. They have historically paid only a slight premium over the level of treasury (i.e. risk free) interest rates (for any given maturity) for their money. As a result, they have been in a much better position than any private sector mortgage provider to be able to "lend long" and "borrow short". It should also be noted that FRE/FNM are the bedrock of the secondary mortgage market in the country (since they own roughly half the residential mortgages in the country and process many others in one way or another). I haven't looked in a long time, but it is my guess that the average duration of FRE and FNM's 5T of debt is under 3 years (REMEMBER THIS POINT).
So let me cut to the chase and try to tie all of the above together as it pertains to the current crisis that FNM and FRE and the FED and the Treasury now face and what options the government really has at its disposal to attempt to solve this problem..
So as we sit back this weekend and try to figure out what the government's options are in regards to Fannie Mae and Freddie Mac, let's look at some of the options being proposed by some of these financial, talking head bozos on CNBC and elsewhere:
(1) Open the Discount Window - This ranks as the dumbest idea ever. Why? Simple. The FED's balance sheet is only $800B. Half of that has already been exchanged for toxic waste to keep Wall Street afloat. They are probably going to need the other half when Lehman Brothers or someone else starts to seriously sink (which will most certainly happen). In addition, how is opening the discount window going to solve the GSE's problem of rolling over their $5+ TRILLION in debt when it matures? Keep in mind that this massive debt also has a very short duration. The ONLY way the FED could do this would be to MONETIZE whatever the $ amount the GSE's came to the discount window for by going into the market and buying massive amounts of treasury securities. We're talking potentially TRILLIONS here since this action (i.e. the GSE's going to the discount window) would in all probability shut them out from issuing any additional debt into the debt markets at anything close to a reasonable spread to treasuries.
LESSON LEARNED - No way is the FED going to open the discount window to the GSE's.
(2) Nothing changes - business as usual. According to Paulson, the government has no current plans to "takeover" the GSE's. They're just going to monitor the situation closely. This might work. It might not. HERE'S THE TEST the GSE's have to pass. As long as they can continue to issue debt on a timely basis and in the amount that is required to fund their business at a REASONABLE INTEREST RATE SPREAD over treasuries, then things will be okay (no matter what the financial media says). If they can't, then the sh#t will truly hit the fan. Here's an example of what I'm talking about. Let's say that 5 year FNMA paper historically has traded at 50 basis points over 5 year treasuries. If that spread blows out to 150 -200+ basis points because the bond market vigilantes no longer trust the implied government guarantee that historically has supported it, then the game is over. The government will then have to step in.
(3) The government steps in - The options here are numerous.
(A) The government puts an explicit government guarantee on all of the GSE's outstanding debt. The benefit to this is that it will insure that the GSE's can continue to fund themselves in the debt market (which is ABSOLUTELY crucial). The downside is that it will officially add this debt to our national debt. [The national debt is currently nearly 10 trillion$. Adding the GSE debt instantly increases the national debt by 50%.]
(B) Congress authorizes the Treasury to raise $100B (for example) in additional debt and to invest those funds into the GSE's (in some form or fashion, you're guess is as good as mine). The good news is that this will preclude all of the GSE's debt from landing on the national debt. The bad news is how big are the real losses that the GSE's will face going forward? Will this $ amount (whatever it is) be enough? Will they still be able to fund themselves at a reasonable spread over treasuries?
(C) Some sort of convoluted public/private bailout scheme that might be attempted by the government in order to save face. This could come in many forms, and I'm not smart enough to figure out which ones (if any) might make sense.
The bottom line to all of this is that whatever happens in regards to FRE/FNM, it won't be a quick easy fix. The problems the government now faces in this regard makes the Bear Stearns bailout look like a walk in the park.
In conclusion, I saw something like this coming. That is why I'm so heavily overweight in gold stocks (38% of my portfolio). Having said that, I never dreamed that the GSE's fall from grace would either be as swift or as stunningly complete as it has turned out to be. We could very easily be looking at a "Black Monday" market situation if the government doesn't get its act together quickly.
JMO. I hope this helps others here understand exactly what is going on in terms of the GSE's.
Northbeach2000
Every time I see the chance of a "black" Monday, and prepare for the shock, the markets bounce and gold takes a hit. I suspect a bit of jawboning and a few $billion injected here and there will have the same effect tomorrow, but then as this is the first time I am anticipating a counterintuitive kick up the butt, maybe things will proceed as they should, and gold will rise to the occassion.
Either way, I'm more patient than the markets. I am only 30% in gold, but I'm unleveraged and can wait as long as it takes.
Posted by: john east | July 13, 2008 at 10:00 AM