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MarketThoughts Special Commentary: GSE Bailout

(September 6, 2008)

Dear Subscribers and Readers,

I hope this email finds you well. As I alluded to in our weekend commentary last week, I had planned to take this weekend off unless something "unforeseen" occurred in the financial markets this week. Aside from the 90% downside day (a 90% downside day occurs when both the declining volume and the number of downside points equal or exceed 90% of the total volume and the total number of points, respectively, as defined by Lowry) on Thursday, the trading week was relatively uneventful, although it was clear to both professionals and the laymen that the global financial markets were still mired in a deflationary/deleveraging phase. After the market closed on Friday, everything changed - as the WSJ reported that a Treasury-led "bailout of the GSEs (Fannie Mae and Freddie Mac) was imminent.

We will probably not know the terms of the bailout until Sunday. Preliminary reports indicate that the Treasury-led bailout will be announced before trading opens in Asia on Sunday evening. The Washington Post (with the more optimistic view) asserts that both the debt and the preferred shares will be made whole (this is a very big deal as the preferred shares were trading at a >20% effective yield late last month), while common stock shareholders would merely be "diluted." The NY Times indicated that common stock holders would be wiped out, and that preferred shareholders may be diluted, but the debt holders would be made whole.

At this point, there is no point in speculating what the details are - given that the Treasury will most likely announce the plan before the S&P 500 futures start trading on Sunday evening. Obviously, the best scenario for the global financial system would be a bailout that makes the preferred shareholders whole - as many banks and insurance companies have been holding preferred shares (approximately $36 billion on a par value basis) on their balance sheets without yet writing them down. In any case, I expect the Treasurly-led bailout to result in a net liquidity injection into the financial markets. This is the best news for the financial markets since the 25 basis point cut ("Greenspan put") on October 15, 1998 in the midst of the LTCM bailout. All the prior FFR cuts over the last 12 months, special facilities, and the Bear Stearns rescue were done without a net addition to liquidity - as indicated by the stagnant growth of the monetary base over the same timeframe The bailout of the GSEs should be very different, as the Treasury will be directly injecting liquidity into the market place and (unlike the recent fiscal stimulus) to where it matters most - the US mortgage market. All the cash on the sidelines will piggy back on this on Monday.

It is also likely that the Treasury commitment will remain open-ended going forward. That is, should a further need for capital arises, the Treasury will consider further liquidity injections. This will go a long way to reestablishing the global appetite for risk - not to mention directly bringing in agency MBS and agency debt spreads. Not only will mortgage rates subsequently decline, but the availability of mortgage loans should also jump in the weeks ahead. Goldman Sachs yesterday asserted (before news of the bailout emerged) that if the GSEs adopts a cautious stance for the rest of this year, the US economy could very well lose about 3% of growth (on an annualized basis) over the next 15 months. Even should the GSEs continue to grow their balance sheets at the same rapid pace ($600 billion in the last 12 months), the US economy could still lose 1.5% to 2% in annualized GDP growth in the next 15 months, assuming the ABS and commercial banking systems remain challenged.

A Treasury-led bailout at this juncture, however, will change the game. Not only will this bailout allow the GSEs to expand their balance sheets at a more rapid pace, this will also give a "signal" to sovereign wealth funds, institutional investors, mutual funds, hedge funds, and retail investors alike to take more credit risk on the long side - at least for the foreseeable future. While this may not totally "open up" the ABS market, this will at least stem the recent declines in ABS issuance and commercial bank lending. As credit spreads narrow, banks will most probably not have to endure any further writedowns - and in some cases, may even be able to "write up" their balance sheets (which will allow them to start lending - albeit cautiously - again). This should go a long way to breaking the current "logjam" in the financial markets.

Assuming the initial liquidity/equity injection is sizable, and assuming the Treasury's commitment remains open-ended, my sense is that we should see a tremendous rally in the stock market and virtually all credit instruments next week. In such a scenario, I would not be surprised to see a Lowry's 90% upside day next Monday - and potentially a 1,000-point rally in the Dow Industrials over the next ten trading days. For now, however, we can only wait.

Have a great weekend, everyone.

Yours Sincerely,

Henry To, CFA

MarketThoughts Special Commentary: GSE Bailout (Part II)

(September 7, 2008)

Dear Subscribers and Readers,

The Treasury has just announced the terms of the GSE bailout. Please read the full text of Paulson's statement at the following link:

Following are several key take-away points:

  1. The Treasury's position would be senior to both the preferred and the common shares - although it is not clear how the latter will perform once trading starts on Monday;

  2. The GSEs will moderately increase their portfolios next year. Starting in 2010, the GSEs will reduce their portfolios by about 10% a year, largely through run-off;

  3. The Treasury will directly invest in GSE MBS. Most likely, Paulson decided to go this route so as to ensure the size of the GSEs' portfolios won't get too much bigger. This will go a long way towards bringing in mortgage and credit spreads in general. As a result, mortgage rates will decline and mortgage loan availability will increase significantly;

  4. Establishment of a new secured lending credit facility which will be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks in order to ensure these entities can continue to fund their operations.

As I mentioned in our commentaries over the last couple of weeks, I believe the US stock market made a significant bottom in mid July. The bear market is now over as a result of the immense liquidity that the GSE bailout will add to the financial markets starting on Monday.

Yours Sincerely,

Henry To, CFA

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