Two Hurricane Ike for Every State or Financial Implication on the Commodities Markets

It is hard to understand large numbers. They are so big that we do not have a reference point. Yahoo had to headline on their home page that went something like this: ‘Bailout package to cost over a half a trillion dollars’ and ‘Hurricane Ike to cost Texas over Five billion Dollars’. They had the picture of the hurricane damage which was relatable. Then the realization hit that the bailout was going to be 100 time more expensive than the hurricane. A hundred times - that is two hurricanes per state. That too was relatable. The numbers for both have since change but the magnitude of the financial stress is now very real.

As we understand it, the bailout package is designed to relieve the effects of the sub-prime mortgage market in a weak housing market. It looks like the sub-prime market started in the mid 1990’s and accounted for about 13.1% of the mortgage written in 2006. Their default rate was 8.4 time that of prime mortgages at about 3.1% of the mortgages written in 2006. These default rates have risen with higher short term rates (ARM’s made up over 50% of the sub prime market) and lower home values (people lost their equity in their homes and walked away). That is what brought AIG down (at least our understanding). One of their companies insured sub-prime mortgages against default. When the rate of defaults exceeded their projection they started losing money till the whole company was bankrupt. Now the purchasers of the sub-prime mortgage have lost their insurance coverage and are subject to the loan defaults the AIG was paid to take.

Our understanding is the bailout (This bailout is over and above the $900 billion dollar the government has allocated to the housing bubble with over half going to Fannie Mae, Freddie Mac and Federal Housing Administration (prime loans) according to http://enwikipedia.org/wiki/Unidted_States_housing_bubble.) is to provide liquidity to the financial system by purchasing these sub-prime mortgages. The government buys these mortgages from the financial markets so they can use the money they receive from the sale to finance other projects. (The promoters of the bailout say that financial capital will “dry up” without it.) We are not sure how that will work if the “talking head” on TV have it right. They are indicating that those sub-prime mortgage will be marked to the market (priced at the going rate of similar risked assets) when purchased by the government, thus creating a potential loss for the seller but giving the Government a chance to breakeven on the purchase if the price is discounted more than the future repayment history of the sub-prime mortgage holders. The home owners would still be subjected to foreclosures. If the government is buying them at face value that would be create a loss to the tax payers of $150 billion dollars ($500 billion at a 30% foreclosure rate (or whatever default rate for whatever time frame you want to use)) and a gift to sub-prime mortgage purchasers. (That is only 30 man made hurricane Ikes.)

Agriculture needs financial capital, especially with rising input cost. Some suppliers are looking to the farmers to finance their operations. (Prepayment of fertilizers and margin calls on hedge to arrive contracts come to mind.) (We are not sure how to protect ourselves from financing the next AIG of Agriculture.) Other suppliers use more traditional debt (bank) or equity (sale of stock) financing. Most local banks are not investors in the sub-prime markets but their correspondent banks or their holding company may be. Should these institution be required to liquidate their holding because of the down grade of the quality of their holdings (AIG is no longer around to insure them), we would suggest that the bank regulator wave the quality requirement for those assets for a period of X years (whatever time you want). This would give the market time to develop a more transparent market place for the sale of these sub-prime assets. This would keep the government out of the bailout and let the market work out the problem. These are “big” boys playing in the sub-prime market. They should know what they are into. Either way, market work out or government bailout at a discounted price (hair cut), the market is going to have the same amount of capital. Then it comes down to time. The government would be quick. We do not understand why one in the need of money (liquidity) would invest in mortgages prime or otherwise. They are longer term investments. They could be buying derivatives of the sub-prime market but those boys are not agricultural lenders. The equity houses have changed forever. (The money from commodity speculators is still there. They may need some time to get their money in the right house (solvent brokerage/clearing firm).) Time is required before equity offerings will be viable. That may be more a sign of the market place’s attitude than the number of players.

To change our view; again, we would need to understand why one that needs liquidity is purchasing long term mortgages, how is the government bailout any better for “all” than a haircut from the market and if a liquidation is required to meet regulatory requirements why can’t those requirements be put on hold till a market is developed for those sub-prime assets. This housing issue will have a recessionary impact with or without a government bailout. The government bailout would be inflationary. The bailout may be a short term positive for agriculture with the dollar declining and higher inflation. This “Stagflation” environment, in the long run, did not turn out very well for agriculture in the past. We needed the bailout hurricanes of the 1980’s.

Excellent observation
~Stu

We Freeport IL almost had it right and may be making it more “wronger”! We regretfully say this is not the First Time Either.

The reason for the problems is the accounting procedure of investment banks (brokerage).
--------------------------------Sub-Prime--Sub-Prime---Cash--------Govt
--------------------------------with Insur--Insur Gone—Needed---Bailout
-----------Time Frame-----------A---------B-------------C-------------D
-----Face Value Asset -------$1.00-----$1.00--------$0.61---------$0.75
-----------Price % Face-------100%-------20%-------100%--------100%
Market to Market Value-----$1.00------$0.20-------100%--------$0.75
----% Risk Adjustment--------75%-------70%-------100%--------100%
-Asset Reporting Value------$0.75------$0.14-------$.061--------$0.75
----------Asset % Capital------3.0%-------3.0%-------3.0%---------3.0%
---------------------Capital---$25.00-------$4.67-----$20.33-------$25.00

Time frame A shows our investment bank (IB) holding sub-prime mortgages with insurance an AAA (highest credit value) rated investment. The price is marketed to the market at 100% of face value. The regulator require a discount on this type of investment of 75% (not sure of the percentage – use as example of the mechanism only). So our IB reports the value at $0.75. If the Asset to Capital ration is 3.0% (again not sure of value – example only) then IB can have $25.00 in Capital.

The next day (Time Frame B) the insurer of the sub-prime mortgage pool has it financial rating reduced from Highest Quality to Barely Investment Quality. The price of sub-prime mortgage pool goes from 100% of face to 20% (actual numbers). IB's regulator requires it to report the market to market value of $0.20 and reduced Risk Adjustment (again not sure of value – example only) to 70% because the quality of your holding has been reduced. The regulator says; "Reduce the size of your company by 81% (($25.00-$4.67)/$25.00 = 81%) or find some more capital."

Time frame C is an example of how much cash our IB would need to find ($0.61 on 61% more). IB does not have $20.33 of its Capital covered ($25.00 - $4.67). At a 3.0% ration it needs $0.61 ($20.33 x 3.0%) of reporting asset value. Cash has no risk reduction (100%) and price to face of 100%. So in one days time our IB went from things are going OK to either reducing the company size by 81% or find 61% of the Face Value of his asset in additional cash. Other companies are not willing to lend to IB because either they need the cash themselves or they do not want to risk investing in IB (repayment risk).

Time frame D is an example of how much cash is need to replace (by selling to government bailout) the sub-prime mortgage held in the portfolio to make IB “whole or hole (you choose)” again. If they are to hold $25.00 in capital and Asset to Capital requirement ratio is 3.0% then $0.75 in reporting asset value. Cash is not discounted and is at par with face value. So the $1.00 worth of sub-par mortgages would have to be purchased for $.075 or 75% of Face value. That would be 3.75 times more than market value. At that price the government might get its money back in 5 years if 50% of the non-prime mortgages made timely payments, 30% default after 3 years of timely payment and only 20% should be foreclosed now. There are a lot of assumptions including the homes could be sold at a 33% discount to mortgage principal value.

Newsletters “Market to Market Now Mark to-Taxpayer” on September 8, 2008 and “Here’s A Plan to Avoid a New RTC” on September 22, 2008 by Brian S. Wesbury were most helpful in discovering our error. They can be found at http://www.ftportfolios.com.

United States of America, Incorporated

Emergency Economic Stabilization Act of 2008 is trying to sell USA as a for profit business. That is not the purpose of Government. If a bailout is needed, a profit motive should not be part of the equation. Wall Street and the President are all saying there is money to be made for the public in this bill. (The bill even issues stock warrants, in companies sells assets to the government.) It is hard to believe that hedge funds or others would not be stepping in to purchase these assets if there was a “good” return in them. If one looks at the characteristics of the non-prime (sub-prime and Alt-A) loan characteristics, one could see that a return of principal (maybe not return on principal) is likely in a five year time frame. The problem is the bill can purchase other assets. Those assets have not been defined. (Does a pig in the poke describe this purchase?) There are articles available on the web that talks about derivative that are been constructed from the non-prime mortgages. These derivatives can be very safe or very risky but were dependent upon credit swaps (insurance); which is no longer available, to remain viable. A real question has to be asked if the government can properly value these assets.

Another solution may be to open a second widow that the Federal Reserve. That widow would lend money on non-prime mortgages that 50% of face value (or any number you wish less than par and would somewhat reflect value). Make it available for mortgages only and have a very structured repayment schedule. In return the company would provide collateral of the mortgages and senior preferred debt for the amount of the loan in the company. That way if and when the company is declared insolvent and/or is sold the Government is paid out first. This approach only works if the problem is liquidity. If the problem is solvency than injection of cash is the solution; USA Inc. will need to be created. In this case why not make the process as simple as possible; have the Government buy dividend paying preferred stock (like Mr. Buffets investment in Goldman Sachs) in the institutions at book value. That would eliminate the need of asset (non-prime and/or derivatives) evaluation and for an agency to manage the purchased mortgage for the Government. The Government should not be in the foreclosure business and some of the mortgages need to be foreclosed.

Bank consolidation has the potential of matching or exceeding the rate and score that occurred in the 1990’s. The current bill would allow the acquiring institution to purchase a lot of liquidity (non-prime mortgages and/or derivatives are converted to cash), which could accelerate the consolidation process. It is not to saying that consolidation is all bad, it just seems that the Government should not be funding the process. Golden Parachutes were designed as an anti-takeover measure. The talk of executive pay limits and removing golden parachute will make a buyout easier. The bill had a mechanism which enabled the Government to recoup any gain in institution may derive from assets sold to the government. That however does not apply if the institution is sold.

There is something happening that has not been shown or declared. The economy should not have a liquidity problem (The Fed pump in $620 billion on Monday). It may have a solvency problem. The non-prime mortgages themselves do not appear to warrant the total blame. Those mortgages as report by the Kansas City Fed were lent out at 82 % of value. The Office of Federal Housing Enterprise Oversight (OFHEO), the ones that monitor Fannie Mae and Freddie Mac, indicate the US Housing Prices picked in the second quarter of 2007 and have declined by less than 7.0% annualized rate since than. The S&P Case-Shiller US Nation Home Price Index (20 metropolitan regions) peaked in the second quarter of 2006 and has decline by a total of 18.25% to the second quarter of 2008. There is a real concern that massive foreclosure in a recessionary environment could accelerate the decline in home values.

If liquidity is the problem buys bonds – If solvency is the problem buy dividend paying preferred stock, let’s make this as simple and as transparent as possible.

PS Thanks for the format to release our frustration. This is our last comment and change of mind on this subject.