The answer to this age old African proverb is:

“One bite at a time!!”

And so it has come to pass that the US Government has finally owned up to what many of us have known for several quarters if not years: Fannie and Freddie are bankrupt. (You can check the posts on our blog for our earlier views in this regard.) It appears to us that the timing of this move was heavily influenced by the growing realization within the US Government that these entities, if left to fend for themselves, would shortly face insurmountable refinancing problems stemming from the need to roll over massive maturing term borrowings over the next several months.

The stock market roared ahead in the wake of the nationalization of the two GSE’s, the relief rally sending the Dow Jones index up over 300 points. Unfortunately, it is not immediately apparent that the socialization of the losses associated with these organisations represents a great day either for free markets or democracy.

What has changed we ask? The Fannie, Freddie announcement merely enables a needed liquidation process to commence; it will not speed up the process or make it any less painless.

Several key question marks remain following the announcements on the weekend that include but are not limited to:

• The size of the liability assumed by the US Government in this latest fire drill. We will not know the scale of the meltdown at these two institutions for many months, and we are extremely sceptical that it will be limited to the figure of “only” USD 200 Bn. that is being bandied about;
• The willingness and ability of the Federal Government to assume the obligations of other bankrupted or severely impaired corporates. This resolve will be severely tested over the next few months and quarters because a growing jumble of zombie companies is piling up like broken forest timbers in the wake of a meteor strike. Notable names include:
  • AIG
  • CitiGroup
  • Fifth Third Bank
  • Ford/Ford Credit
  • General Motors/ GMAC
  • KeyCorp
  • Lehman Brothers
  • Merrill Lynch
  • National City
  • Regions Financial
  • United Airlines
  • Wachovia
  • Washington Mutual
  • Zions Bancorp

  Watch Out!!: the cumulative liabilities of these firms rival those of the GSE’s in size; 

• The effect of influences stemming from a worsening economy, a large external deficit that needs to be financed amid the threat of accelerating inflation, and a FED and Treasury that are rapidly running out of ammo to deal with the various problems that beset them;
• The growing risk of a sell-off in Treasuries sparked by heightened inflationary expectations that would bring more pain for mortgagees and borrowers carrying high debt loads.

Following the activities of the last few months and this weekend, what seems to be less questionable at this moment is the US Government’s chosen approach to dealing with the Credit Crunch. Five defining behavioural characteristics seem to be emerging:

1. Buy Time: delay action and deny the existence of problems until the bitter end;
2. Shield the Problems: internalize the risk on the FED’s or the US Government’s balance sheet;
3. Spend Other People’s Money: aggressively use the public purse to fund and paper over mistakes made in the private sector;
4. Jawbone with Style: with the aim of keeping the markets relatively orderly during what will be a very long process of unwinding the excesses, so that the FED and Treasury, and by connection, the USD, will continue to enjoy the confidence of domestic and overseas investors; and finally,
5. [Try and] Keep some Powder Dry.

One bite at a time…Hmmmm…..Sounds OK and it Might even be Doable (but not likely) …In that case maybe all we need to do is to keep watching the FED……

* We gratefully acknowledge and thank, Ray Williams, Managing Director, Derivatives, National Bank Financial for suggesting the use of the Proverb.

This entry was posted on Wednesday, September 10th, 2008 at 1:13 am and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.