Today's TIDBITS

March 10, 2008   

From Former Fed Vice-Chairman Alan Blinder:  “The problem is not so much liquidity as the unwillingness of anyone to take any risk…The deeper problems with our financial system are not going to be fixed by injecting more and more liquidity into the markets.”

End-of-Day Market Update

From SunTrust:  “Credit turmoil continues to spread, hitting financial stocks especially hard. Thornburg Mortgage's shares have been halted with the last trade printing at 99 cents. Bear Stearns fell almost 14% on concern the dealer did not have enough liquidity to operate. This was vehemently denied by a company spokesperson, but investors took cover. Citi is lower by 5%, WaMu by 4.5% and Fannie shares are worth 12% less. In response, the 3 month bill has rallied 20 bp to a 1.30 discount. 2 yrs hit a new yield low of 1.42, 5 yrs traded at a new cycle low of 2.32. The 2/10 yield curve has held steady at +199 bp. Volume in coupons has not been huge, but liquidity is poor so it takes less size to move markets. Indirect bidders for a third week in a row took a record amount of bills in the auction. Indirects totalled $17.8 bln of the $46 bln total. This amounts to 47% of the 3 month auction and 35% of the 6 month.”

From Bloomberg:  “Crude oil rose above $108 a barrel in New York to a record… surged 80 percent over the past year as the S&P 500 and Dow averages dropped. China, the second-biggest oil- consuming country, increased crude-oil imports by 18 percent last month and halted overseas shipments to meet rising demand….``The grab for hard assets is on due to the lack of confidence in the rest of the markets at the moment.''  Crude oil for April delivery rose $2.77, or 2.6 percent, to $107.92 a barrel at the 2:30 p.m. … the highest since trading began in 1983.”

From UBS:  “Treasuries drifted lower early in the morning before rallying sharply at 11am upon widespread concerns about Bear Stearn's solvency. The market ended 7-11bps  richer across the board…Treasury volume was only 73% of the 30-day average…Swap spreads tightened during the day, then widened back out on the Bear Stearns speculation. We saw very little flows, and spreads went out about 0.5bp across the board. Agencies also had a quiet day, cheapening to Libor by 1bp in the front end and 3-4bps in the long end…Mortgages went from 16 ticks tighter this morning back out to 5 wider versus Treasuries. We saw very little liquidity, and what were once regarded as small trades are moving the basis 3-4 ticks.”

From RBSGC:  “The market rallied to challenge and surpass the levels of last Friday on what started as a quiet Monday, but saw volume accelerate with a bull flattening bid. The move was sparked by continued stress in financing for firms engaged in the credit asset of choice. Rumors were more afoot than facts, but CDS of certain brokers widened sharply with their equities under severe pressure.  That in turn led to the strong bid in the Tsy market, but, and this is notable, the curve did not respond by steepening. This indicates two things to us. One is that the steepening trade is indeed crowded and without the immediate benefit of a traditional ease in the Funds rate, i.e. inter-meeting, a bit of impatience is at hand. The second is more speculation than empirical fact, but that is that investors how have stayed very neutral throughout the rally want to extend -- certainly balk at 2s near 1.40%.  But the story of Monday is really one of the increasing stress on the credit markets, with the latest incarnation that of financing positions. This, in turn, brings the message right to the door of the banks and brokerages who recognize that there are repercussions as they choose not to finance others -- charging higher rates, deeper haircuts, etc.  We are not making a forecast or revealing something of insight, however it seems that the system is being tested to see who will be the first to 'break', or perhaps more prosaically give itself up for sale or go under. Call it a stress test.   Rumors and speculation to take up a lot of this market's attention. The one we feel has some merit is a Fed response that could, perhaps, amount to an idea similar to that of Sen. Dodd's. That is, changing what they can buy to include MBS, as an example. From our perspective, making a direct foray into the asset class -- where current coupon yields have risen some 50-odd bp since the interim cut in late January -- addresses the problem head on and immediately. Plans like Dodd's or ideas like an explicit guaranty for the agencies are far more political and will take a while to work out.  If there is a message in the madness, it's this; the market is looking elsewhere for a 'solution' to the broad mess that started in housing and will presumably end with housing (albeit with some big victims along the way). Meaning someone or something will have to buy MBS, as a starter, to restore liquidity and confidence. WE EMPHASIZE THAT THIS IS WHAT THE MARKET IS SAYING, not that it will happen or won't. We happen to agree. Our concern is that with Funds already at 3%, 2s at 1.44%, the Fed has few traditional tools to use and, in the case of an interim ease or 75 bp cut later this month, and had better use them sparingly.  Overall volumes were modest, but increasing throughout the session…”

From Lehman:  “Treasuries rallied sharply once again on Monday… The price action of the past three days has all the feel of a wholesale de-leveraging, as accounts are forced

 out of longs and short positions all across the yield curve, but investors seem  to have their hands full at the moment, and so extremes in treasury RV only merit a passing interest.  Monday marked the third consecutive day of big outperformances for the 10 year sector, but we continued to see much better selling in the sector, particularly from international real money accounts.  We also saw better selling of long bonds today, and only saw good buying in the 5 year sector… Despite …the overall better selling that we saw today, the market continued to surge higher, probably in response to the things

that are becoming the norm - softening stock prices, weaker credit, a surge in oil, you know the routine.  For the second straight day, the yield curve flattened hard from 2s to 10s, and steepened from 10s to 15s.”

From Bloomberg:  “U.S. stocks fell for a third day to the lowest level since 2006, led by a plunge in financial shares, on speculation earnings estimates will prove to be too high as the economy slows and credit losses spread.  The decline in banks steepened as Bear Stearns Cos. Tumbled the most since 1987 on concern the brokerage was facing financial difficulties, even after former Chief Executive Officer Alan ``Ace'' Greenberg said the speculation was ``ridiculous.'' Fannie Mae and Freddie Mac, the largest U.S. mortgage finance providers, both lost more than 11 percent on expectations they face increasing losses as the housing slump deepens.  The Standard & Poor's 500 Index declined 20 points, or 1.6 percent, to 1,273.37 and is down almost 19 percent from its Oct. 9 record. The Dow Jones Industrial Average lost 153.54, or 1.3 percent, to 11,740.15. The Nasdaq Composite Index decreased 43.15, or 2 percent, to 2,169.34. Five stocks fell for every one that rose on the New York Stock Exchange… All 10 industry groups in the S&P 500 dropped today on growing concern that the economy will slip into a recession after banks posted $188 billion in subprime-related losses and analysts forecast earnings for members of the index will decline this quarter and next. The benchmark for U.S. equities is approaching a so-called bear market, which is marked by a decline of at least 20 percent from a peak.  Financial shares in the S&P 500 slumped 3.1 percent as a group today to the lowest level since May 2003 and contributed the most to the broader index's retreat. Producers of raw materials slumped 3.3 percent and industrial companies dropped 1.8 percent as a group.  Bear Stearns, the second-biggest underwriter of mortgage- backed bonds, tumbled $7.78, or 11 percent, to $62.30, its steepest drop since October 1987.       ``There's an insolvency rumor and concerns on liquidity, that they just have no cash,''… Fannie Mae fell $2.96, or 13 percent, to $19.81 after Barron's said solvency may be tested at the largest source of financing for U.S. home loans.  Freddie Mac slid $2.26, or almost 12 percent, to $17.39. The company ``could generate a writedown'' of as much as $5

billion should McLean, Virginia-based Freddie Mac be required to mark to market half of its holdings of subprime mortgages and mortgage bonds, Credit Suisse Group analyst Moshe Orenbuch said today in a report to clients.  Financial companies in the S&P 500 have dropped 20 percent this year, dragged down by the collapse of the subprime-mortgage market.”

Three month T-Bill yield fell 11 bp to 1.33%  (2003 low yield was .81%)

Two year T-Note yield fell 2.5 bp to 1.49%  (2003 low yield was 1.084%)

Ten year T-Note yield fell 7 bp to 3.46%  (2003 low yield was 3.114%)

Dow fell 154 to 11,740  

S&P 500 fell 20 to 1273  

Dollar index fell 0.06 to 72.96

Yen at 101.8 per dollar 

Euro at 1.534

Gold fell $1 to $972

Oil rose $2.80 to $107.90  (Record High)

*All prices as of 4:30 PM

**********************

I am attaching the full Barron’s cover story on Fannie Mae below-

“Is Fannie Mae the Next Government Bailout?

By JONATHAN R. LAING

IT'S PERHAPS THE CRUELEST OF ironies that in the U.S. housing market's greatest hour of need, the major entity created during the Depression to bring liquidity to housing, Fannie Mae, may itself soon be in need of bailout.

Fannie, of course, occupies a curious middle ground between the public and private sector as a result of its privatization in 1968 as a Government Sponsored Enterprise, or GSE. While owned by its shareholders, Fannie is regulated by a government agency and is able to borrow money cheaply, thanks to an implicit guarantee by Uncle Sam. It uses those funds to buy and securitize home loans -- lots of them. At year end, the company owned in its portfolio or had packaged and guaranteed some $2.8 trillion of mortgages or 23% of all U.S. residential mortgage debt outstanding.

The company's balance sheet appears larded with iffy assets and understated liabilities.

Of late, however, Fannie's prospects have darkened notably. The company (ticker:

FNM) lost $2.6 billion last year as a surge of red ink in the final two quarters more than wiped out a nicely profitable first half. And by late last week, credit-market jitters had penetrated the once-unassailable hushed precincts of the market in Fannie debt.

In the wake of margin calls on collateral at the investment concern Carlyle Capital, yields on guaranteed mortgage securities issued by Fannie and its GSE sibling Freddie Mac (FRE) rose to their highest level over U.S. Treasuries in 22 years. Likewise credit default swaps, measuring market concerns over the safety of Fannie corporate debt, have ballooned out to 2% of the insured amount from 0.5% just four months ago.

Company executives attribute such concerns to what Fannie CEO Daniel Mudd last month called "the toughest housing and mortgage market in a generation." He also said that much of 2007's loss came from reducing to market levels the value of derivatives that Fannie uses to hedge its interest-rate risk. And those accounting moves should reverse and fatten earnings in the fullness of time once interest rates stop dropping.

But, if the truth be known, a considerable portion of Fannie's losses also came from speculative forays into higher-yielding but riskier mortgage products like subprime, Alt-A (a category between subprime and prime in credit quality) and dicey mortgages requiring monthly payments of interest only or less. For example, Fannie's $314 billion of Alt-A -- often called liar loans because borrowers provide little documentation -- accounted for 31.4% of the company's credit losses while making up just 11.9% of its $2.5 trillion single-family-home credit book. Fannie was clearly looking for love -- and market share -- in some of the wrong places.

Likewise, Barron's has found other areas that may bode ill for Fannie's prospects. Its balance sheet is larded with soft assets and understated liabilities that would leave the company ill-equipped to weather a serious financial crisis. And spiraling mortgage defaults and falling home prices could bring a tsunami of credit losses over the next two years that will severely test Fannie's solvency.

Should Fannie or the similarly hobbled Freddie Mac buckle, the government would no doubt bail them out and honor their debt and mortgage guarantee obligations.

Fannie common and preferred shareholders would likely suffer grievously in such a scenario.

Fannie, for its part, insists it's more than adequately capitalized to withstand any future stress. The company also contends that as a result of tightening its standards and making fewer risky loans, the quality of its book of business will improve mightily.

But some financial leaders aren't so sure. At a conference several weeks back, William Poole, president of the St. Louis Federal Reserve Bank, said that the GSEs (clearly a reference to Fannie and Freddie) appeared to be insufficiently capitalized to handle the kind of losses suffered by U.S. major banks in the past six months. "I do not have any information on the GSEs that the market does not have," he said. "Nevertheless, in assessing the risk of further credit disruptions this year, I would put the GSEs at the top of my list of sources of potentially serious trouble."

And, in commenting on the government's "too big to fail doctrine" for financial institutions, he said: "First, firms in trouble ought not to be bailed out, unless the bailout takes a form that imposes heavy costs on managers and shareholders."

POOLE HAS LONG BEEN skeptical -- correctly it turns out -- of Fannie and Freddie's ability to serve both God (their social mission of promoting liquidity and affordability) and Mammon (the shareholder and lush management compensation). At Fannie, a generation of Democratic Party insiders, such as James Johnson, Jamie Gorelik and Franklin Raines, made substantial fortunes in Fannie's executive suite. As Fannie Mae's top regulator, James Lockhart, pointed out in recent congressional testimony, the absence of debt-market discipline (the government guarantee makes Fannie and Freddie all but impervious to credit downgrades) makes pell-mell growth irresistible to shareholders and managers.

Have a hunch, bet a bunch.

The Bottom Line:

The stock down 65% since last fall, may well fall a lot farther. As capital declines, the company could issue more stock. But that, too, would hurt shareholders.A major scandal erupted at Fannie earlier in the millennium when the company was found to be cooking its books to hide a multibillion-dollar loss it had incurred when massive interest-rate bets went awry. Freddie got nailed at the same time for setting hedging profits aside in a cookie jar to boost results in subsequent years. Yet, the recent lending bets made by Fannie are likely to prove far more damaging.

On the surface, Fannie's balance sheet looks fine. At year end, the company reported regulatory net worth of $45.4 billion, some $3.9 billion higher than the expanded minimum capital of $41.5 billion required by federal regulators.

But with its extreme leverage -- assets stand at 20 times net worth -- Fannie has little room for error. And there appear to be significant problems with the way Fannie has valued both its assets and liabilities.

For example, some $13 billion of its $45.4 billion in net worth consists of deferred tax assets that have value only if Fannie can earn enough money in the near future (say $36 billion) to employ them. That hardly seems likely. During the housing boom of 2002 to 2006, this tax asset only climbed -- from zero to $8 billion as Fannie reported $23 billion in income from 2003 to 2006.

Last year's $2.6 billion loss compounds the problem, pushing the tax asset to

$13 billion. At a minimum, accountants may require the company to sharply write down the value of this asset, thus slashing net worth. Bank regulators, for example, limit the amount of deferred tax assets for regulatory purposes to the lesser of the amount expected to be used within one year or 10% of regulatory capital. So if Fannie were a bank, this entire asset would be wiped out. Fannie maintains the value of the asset will be realized over time.

Another soft asset is Fannie's $8.1 billion of Lower Income Housing Tax Credit partnerships. The partnerships' only value, other than helping fulfill Fannie's housing affordability requirements, are the rich tax credits they generate from their intended operating losses. The problem is that Fannie hasn't made enough money to employ these tax credits. Thus the asset is apt to dwindle away to zero without providing Fannie any benefit. Fannie makes no predictions on the future values.

The story is much the same for the liability side of Fannie's balance sheet.

There's an item called guaranty obligation, which represents the company's best estimate on what it will have to pay out to make good on any mortgage defaults in its $2.4 trillion guaranty book. On its regular balance sheet, Fannie carries the item at $15.4 billion, but on its "fair value" balance sheet, which attempts to mark every asset and liability to current market value, the guaranty obligations are pegged at $20.6 billion. The problem was, as Morgan Stanley analyst Kenneth Posner discovered, Freddie went through the exact same drill with its guaranty obligations' fair value and chose to mark them much more aggressively. It valued them at 1.5% of its guaranteed book, double the 0.74% of total book that Fannie saw fit to use, even though Freddie's delinquency rate is lower than its rival's.

Had Fannie taken a similar hit, its fair-value net worth would've shrunk by some $20 billion to a paltry $16 billion, compared with its juiced-up regulatory capital of $45.4 billion. Fannie stands by its estimate and says it doesn't know how Freddie arrived at its own.

Finally, Fannie seemed to have been inordinately easy on itself when, in the fourth quarter, it wrote down its $74 billion holdings of privately packaged, non-agency subprime and Alt-A mortgage securities by a mere 6%, or $4.6 billion.

In addition, Fannie declared that only $1.4 billion of the write-down constituted a permanent impairment, something that penalized both Fannie's profits and net worth. The remainder of the write-down was deemed a temporary mark-to-market loss that had no such negative impact.

Had Fannie charged off the remaining $3.2 billion that would have torched most of the $3.9 billion in excess regulatory capital that it held at the end of the fourth quarter. Nearly all the major banks, from Merrill Lynch to UBS, have taken much larger percentage write-downs on their holdings of similar mortgage paper, and ran virtually all the losses through their income statements.

In any event, continued deterioration since year end in indexes like the ABX triple-A index indicate that Fannie, based on the different vintages it owns, should conservatively take another $14 billion charge, according to Barron's estimates. Fannie Mae says that since it's a long-term investor, it should incur no permanent decrease in asset value beyond what it has recognized.

The very survival of Fannie as a going concern hinges on the size and speed of the credit losses it faces in the years ahead. Merrill Lynch's Kenneth Bruce sees Fannie suffering losses on its current book of around $32 billion over the next decade. Yet, he still expects the company to manage recovery earnings per share of between $2.50 to $4 between 2009 and 2011.

His forecast, however, is based on spirited 8% average annual growth in Fannie's credit book over the decade. Although Fannie has just been cleared to deal in mortgages of up to $700,000, from $420,000 now, 8% growth could be hard to come by if the company's capital remains stretched.

Pillars in Peril? Problems at Fannie Mae and Freddie Mac can have big implications. The agencies support some 55% of all mortgage originations, after a dip in 2004-2006, and account for half of all outstanding mortgages.

IN OUR VIEW, THE RAPID DECLINE in home prices and soaring level of foreclosures might cause the wave of credit losses to hit far sooner and with greater ferocity than many imagine, potentially submerging the income Fannie is expecting to harvest from volume growth and higher lending fees.

A new phenomenon of widespread negative equity -- homeowners owing more on their mortgage than the underlying property is worth -- has wrought a sea change in borrower behavior. Borrowers, whether subprime or prime, financially stretched or flush with cash, are walking brazenly from their l obligations in stunning numbers.

To be sure, Fannie has a better book of mortgages than most institutions. Fannie requires a layer of credit insurance on much of its high-loan-to-value mortgages. The GSEs have long insisted on higher underwriting standards on the loans they purchase in the secondary market.

Yet using conservative default rates of 40% on its $133 billion subprime book, 12.5% on its $314 billion of Alt-A mortgages and 4% on its remaining $2 trillion of prime home mortgages, Fannie could well be facing cumulative credit losses of over $50 billion. That's after assuming Fannie will realize recoveries of 60% on its subprime and Alt-A loans and 70% on its prime loans. Should Fannie founder over the next couple of years, the government would have no choice but to step in and back all of its debt and guarantee obligations. Too much of the paper is owned by our major creditors, such as China and Japan.

Perhaps, both Fannie and Freddie can go back to the capital markets to raise more equity, as they did last fall when both sold a combined $13 billion of preferred stock. Both have said they may take such action should circumstances demand it. But with both stocks in steep decline -- Fannie's is down 65% since last fall -- offerings would bring punishing dilution and growing investor skepticism.

Just maybe a bailout of Fannie, in effect a nationalization, would be a good thing. A retooled Fannie could pursue its important social mission without the distraction of trying to please Wall Street. Of course, it's doubtful if this happens that the shareholders would be along for the ride.”