Feature Stories | Sep 09 2008
By Greg Peel
When the markets in the US opened on Monday morning, equities shot up, the US dollar and US government bonds were sold off, and the prices of commodities, including that of gold, rose. It was text book stuff – just what one might expect from the about the biggest public bail-out of the private sector in US history, funded by a government that is still battling with an enormous current account deficit (an enormous debt).
Equities rose, led by the financial sector, because the government’s “back-stopping” of Fannie Mae and Freddie Mac removed the uncertainty surrounding the troubled lenders, and all things being equal, offered the prospect of lower mortgage rates and relief for homeowners hanging on the brink of foreclosure. The US dollar fell because the US Treasury has been once again forced to commit money it doesn’t actually have, further diluting the value of existing dollars. The gold price rose on the flipside of that equation. US bonds were sold as investors reversed the “flight to quality” of previous months.
At this time the Global Investment Strategy analysts at UBS were sitting down to write a report on the implications of the bail-out, and were unsurprised by the markets initial movements. “A reversal was to be expected,” the analysts suggested, “given how far and fast markets had moved in recent weeks. Look for sharp rallies in global equities and credit, equally sharp sell-offs in government bonds and the US dollar at the beginning of the week”.
The report nevertheless went on to argue why such moves were not necessarily sustainable. But by the time the report was being sub-edited, already initial reactions had begun to turn around. The stock market faltered at its highs. The bond market eventually closed slightly higher. The US dollar turned around and made even further ground against the euro. And the rally in gold evaporated. Gold traded above US$817/oz early in proceedings, but by the end of the session was actually slightly down at around US$801/oz.
The central linchpin here is the US dollar. Those looking at buying equities in New York on Monday were doing so on the argument that the bail-out meant a stabilisation of credit markets, thus cheaper mortgage rates, thus a stabilisation of the housing market, thus a return to consumer spending, thus a stabilisation of the US economy. Money flowing out of US bonds, the bulls would argue, is simply money moving out of the temporary protection of the safe haven to be put back to work in stocks now that fear has abated. A stable US economy implies a stable to stronger US dollar.
The bears would argue, however, that money flowing out of US bonds represents a step-down in the credit-worthiness of the US Treasury following the hundreds of billions committed to propping up Fannie and Freddie. The risk inherent in the lenders’ mortgage portfolios has not suddenly gone away, it just now belongs to the US taxpayer rather than private investors. The additional dollars required to be “printed” to provide the rescue funding only dilutes the value of existing dollars, hence the US dollar should be weaker.
Gold’s response to the bail-out thus depends on whether the bulls are right or the bears are right. The winners on Day One were the bulls, although it was far from an emphatic victory.
On a more microcosmic level than the world’s reserve currency, one might say the true linchpin is US mortgage rates. Despite the Fed having cut the cash rate from 5.25% to 2% over the course of the last year, the 30-year fixed mortgage rate in the US has dropped only marginally from the higher sixes to the lower sixes. This is because credit markets have been frozen with fear, and securitisation markets defunct. The only lenders to march merrily on have been Fannie and Freddie, funding some 70% of mortgages issued since the credit crunch began, albeit on a higher funding cost and a skinnier margin.
Fannie and Freddie could do this when others couldn’t because they had the implicit backing of the US Treasury. That the Treasury has been forced to step in gives us some indication of just how big a hole the two had dug for themselves.
Now that the government owns the lenders, their cost of funding for future mortgages will come down. That is because buyers of F’n’F paper know that this time they really are dealing with the US government and not quasi-private entities. Hence the cost of mortgages will come down for the “conforming” loans F’n’F issue, which in turn should allow the fully private mortgage lending market to begin to relax and ease its own lending rates. Or so the story goes.
The flipside, however, is that US bonds still provide a benchmark rate, such that mortgage rates fluctuate as as spread over the bond rate. Were the bond rate to rise, then it would act as an offsetting force to the reduction in risk spreads in mortgage rates. What could force bond rates to rise?
Initially bond rates could rise as investors parked in the safe haven shift funds back out into equities – the bull story. But in the bigger picture bond rates could rise because the world perceives a US government carrying Fannie and Freddie as a more risky proposition than it was previously. The last thing the US government wants is a crisis of confidence across the globe in the value of US government paper. For that would cause a run on the US dollar.
It is thus not surprising that Hank Paulson’s rescue plan propped up only F’n’F’s debt, and not its common or preferred stock. For at the height of the US housing boom and beyond, foreign central banks and sovereign wealth funds saw Fannie and Freddie’s own bonds – issued to fund their mortgage portfolios – to be as good as government bonds but with a slightly better yield. The world was financing half the US housing boom.
The London Financial Times this morning quoted US Treasury figures, which note that foreign holdings of US “agency” debt, which includes to a great extent that issued by F’n’F, rose from US$107bn in 1994 to US$1,304bn in June 2007. The rate of growth of agency debt investment outstripped that of either US corporate debt or government bonds.
Paulson has justified his actions by claiming that Fannie and Freddie were too big to be allowed to fail. The reason this is the case is summed up nicely by Michael J. Kosares of USAGOLD:
“A well-oiled and functioning market for paper instruments depends in the end on faith and trust. Value in one financial house depends upon performance from another financial house which depends upon performance from still another – a seemingly infinite web of interlocking counterparties fully dependent upon each other for their existence. A breakdown in one major institution, we are told, could lead to a domino effect and collapse the entire system.”
And there are few institutions bigger than Fannie and Freddie. But while this might be the immediate problem, the wider problem of allowing F’n’F to fail would also have meant rendering foreign agency debt investments worthless. That is something that would not have gone down to well with the governments of China, Russia and the Middle East who hold most of the paper. It would have meant the end of the US dollar.
Allowing F’n’F to fail by themselves would have had the same result, so Paulson’s only choice was to use US taxpayer money to protect foreign investments (debt-holders) while sacrificing the holders of common and preferred stock. The latter group consists mostly of US regional banks. So Paulson has had to sacrifice his own countrymen to keep the enemies at bay.
For the moment, the plan has worked. The US dollar actually closed stronger on Monday. But for how long will this temporary back-stop work?
The opinion of UBS analysts is that “while the news is to be welcomed, it is only a necessary, but not sufficient step in restoring credit market allocation, confidence and growth”. As welcome as the bail-out might be, “quick fixes are improbable,” the analysts suggest. “Policy makers and consensus thinking have both repeatedly underestimated the depth of balance sheet problems and the impact of the attendant deleveraging process. The reality is that balance sheet repair is far more widespread than just [Fannie and Freddie]”.
One is immediately prompted to recall the euphoria that exploded on the day the Fed saved Bear Stearns. Bear Stearns, said Fed chairman Ben Bernanke at the time, was too big to be allowed to fail. Bernanke was hailed as a hero, half the market declared the credit crunch now over, and the stock market rallied solidly into May. Until it became apparent the Bear Stearns bail-out had not fixed anything at all.
And if a survey had been conducted early in 2008 that asked “If the Fed cuts the cash rate to 2%, do you believe that would prevent the collapse of Fannie Mae and Freddie Mac?”, a resounding majority would have said “Yes”, and probably “Why even ask?”. Clearly the Fed’s rate cut slashing has not fixed anything at all either.
But the rate cuts were necessary. As was the bail-out of Bear Stearns. As was the bail-out of Fannie and Freddie. As will be the bail-out of Lehman Bros in the next month or so. Oh but wait – the rescue of institutions as truly large as Fannie and Freddie implies that this time it’s different.
Again.
There has already been collateral damage from the rescue. Despite Fannie and Freddie’s debt being largely underwritten by the US government in the deal, the “conservatorship” move triggers a technical bankruptcy of the two as far as the credit default swap market is concerned. In reality, CDS positions on F’n’F must now be closed out. The London Financial Times calls it one of the largest defaults in the history of the US$62bn credit derivatives market.
The exact amount of CDS positions on F’n’F in the market is unknown, for the CDS market is an over-the-counter closed shop. The Times notes that actual payments on default swaps are expected to be limited, given the debt is still valuable, but in reality the CDS market has grown so rapidly that it has outpaced regulation. It could take some time while all parties now sit down and unravel the mess.
More ominously, some commentators are suggesting that as the government rescue package has effectively wiped out preferred stock holders in F’n’F, the value of the mere existence of preferred stock as an asset class must come into question. Preferred stock, which despite being called “stock” is really a form of debt with a fixed coupon and a maturity date, is a primary means for banks and dealers to raise capital. Investors are safe in the knowledge that preferred stock ranks above common stock and also above some levels of subordinated debt in the event of a wind-up, as hence are prepared to pay more. But will they continue to pay more if they know the government can jump in and impound their investment, while honouring lower ranked debt? It may now become somewhat more difficult to raise funds through preferred stock issues.
Then there’s all the banks and other investors who are specifically holding F’n’F preferred stock, now almost worthless. JP Morgan, for one, had admitted to having to write down US$600m after stock prices in the two fell some 95%. They have since fallen another 95%. But it will be certain US regional banks who will be the hit the hardest – those small operations who invested their customers’ deposits in good faith in government-sponsored agency debt.
And will it all just end with Fannie and Freddie? No.
Lehman Bros has already been mentioned, although Lehman may yet get an eleventh hour reprieve from a risk-hungry investor. But investment banks are one thing. US federal authorities are now looking at how to tighten loans in the credit card industry, as the Wall Street Journal notes, and are being asked to double the US$25bn in loans already made to the US auto industry in exchange for developing fuel efficient cars, ten years too late. And all this time the Fed’s “discount window” remains open to just about all comers, with just about any piece of worthless paper, and will remain so indefinitely. “Whatever it takes” is the new motto of both the US Treasury and the Fed.
The Wall Street Journal notes that a year ago, about 90% of the Fed’s US$875 billion in assets were US government securities. But now, “after a year of interventions aimed at mopping Wall Street of its complicated and illiquid assets”, those government security holdings have fallen to 50% of the Fed’s assets.
Just where is all of this leading the US dollar?
The world’s reserve currency has recently found strength after a year of battering, but this is misleading for in reality the US dollar’s strength is only representative of the sudden weakness of economies around the world, not of the strength of the US economy. One is reminded that in order to survive an attack from a savage lion, one must only outrun the slowest member of the group.
And to return finally to the topic of this article, what does it all mean for gold?
USAGOLD’s Kosares makes a few interesting observations. As a dealer in gold bullion and coins, Kosares relates that the dealer logged its biggest single week of sales in its 35-year history back in July, in the week when IndyMac went under. By mid-August global demand for gold coins had become so strong that both the US Mint and South Africa’s Rand Refinery ran out. There was a “shortage”. Kosares expects this demand to remain strong, “no matter what the price does”, if systemic risk remains in the headlines.
Kosares also voices his concern over either of the candidates to be the next president, noting neither party conventions featured speeches pertaining to the future of the US dollar, or even the plight of Fannie and Freddie. “It’s one thing to make promises about the economy and taxes,” Kosares suggests, but “it’s quite another to deliver, especially when those promises involve increased military commitments overseas and bigger an better social programs at home”.
Also noted is the fact George W. Bush was elected with a promise to retire US$1 trillion of debt in his first four years of office. Over eight years he has managed to add a further US$4 trillion.
Then there’s Fannie and Freddie’s rescue. Another day, another bail-out. “It is important to keep in mind though, “Kosares suggests, “that Fannie and Freddie are only part of the problem. There are other credit landmines buried about this economy that could be tripped at any moment”. And the bad news is that there is a “significant downside risk to the Fed’s Magic Money Machine”. Runaway stagflation becomes a distinct possibility”.
All of the above are implicit reasons why Kosares, gold dealer or not, sees gold as a rather sensible longer term bet. And as he notes, he is not alone.
Chinese officials are reportedly very resentful about the amount of institutional losses they had suffered through investing the country’s reserves in US securities. Kosares notes they feel they have been deliberately lured by the US into investments that were bound to fail. While the Fannie and Freddie rescue might alleviate some tension, it is expected the officials will now see gold as a sensible alternative. “Keep a close eye on China,” says Kosares, “because it now holds the key to the US Treasuries market. It’s decisions could become a major influence on US interest rates, as well as to what degree the US budget deficits will need to be financed with printing-press money”.
And finally, while many of the member states of the European Union have been selling gold in the past couple of years, either to fund massive deficits (eg Spain) or rebalance reserves (Switzerland), Germany has held fast and not used up any of its allotted gold sale allowance under the Washington Agreement. Most recently, the Bundesbank has stated:
“National gold reserves have a confidence and stability-building function for the single currency in a monetary union. This function has become even more important given the geopolitical situation and the risks present in financial market developments.”
The world’s third biggest economy is also a supporter of gold.
What does all this mean?
At present, the US dollar is rallying because the economies of the rest of the world are weakening. But just how valuable is that dollar, outside of the relative relationships of currencies? How long can the US government keep diluting the value of the world’s reserve currency?
In the shorter term, the price of gold will fall if the US dollar continues to rally and fund managers continue to deleverage positions. But in the longer term…
