[Rhodes22-list] Bush Speech

[Brad Haslett]

Another "you heard it first on the Rhodes List" - today, the Wall
Street Journal finally got around to dealing with FASB 157 and "mark
to market" accounting (see attached). Four years of sitting through
the most boring classes known to mankind and this is all I have to
show for it - spotting the leak in the machine first.

Brad

----------------------------

    * SEPTEMBER 25, 2008

The Paulson Plan
Will Make Money
For Taxpayers
By ANDY KESSLER

    * Article

more in Opinion »

    * Email
    * Printer Friendly
    * Share:
          o Yahoo Buzz more
          o MySpace
          o Digg
    * smaller Text Size larger
    *

In 1992, hedge-fund manager George Soros made $1 billion betting
against the British pound. In 2007, John Paulson's Credit
Opportunities fund correctly bet against subprime mortgages, clearing
$15 billion for the year and $3.7 billion for him. Warren Buffett is
now hoping to make big money on Goldman Sachs.
[Chad Crowe] Chad Crowe

But these are small-time deals. My analysis suggests that Treasury
Secretary Henry Paulson (a former investment banker, no less, not a
trader) may pull off the mother of all trades, which could net a
trillion dollars and maybe as much as $2.2 trillion -- yes, with a "t"
-- for the United States Treasury.

Here's what's happened so far. New technology like electronic trading
meant that Wall Street's bread-and-butter business of investment
banking and trading stocks stopped making much money years ago. So
investment banks took their enormous capital and at first packaged
yield-enhanced, subprime mortgage loans into complex derivatives such
as collateralized debt obligations (CDOs). Eventually and stupidly,
these institutions owned them for themselves -- lots of them, often at
30-to-1 leverage. The financial products were made "safe" by insurance
products known as credit default swaps, a credit derivative from
companies such as AIG. When housing turned down, the mortgages and
derivatives were worth a lot less and no one would lend Wall Street
money anymore.

Then the piling on started. Hedge funds could short financial stocks
and then bid down the prices of CDOs stuck on Wall Street's balance
sheets. This was pretty easy to do in an illiquid market. Because of
the Federal Accounting Standards Board's mark-to-market 157 rule, Wall
Street had to write off the lower value of these securities and raise
more capital, diluting shareholders. So the stock prices would drop,
which is what the shorts wanted in the first place. It was all legit.

There is a saying on Wall Street that goes, "The market can stay
irrational longer than you can stay solvent." Long Term Capital
Management learned this lesson 10 years ago when it got its portfolio
picked off by Wall Street as its short-term financing dried up. I had
thought the opposite -- hedge funds picking off Wall Street -- would
happen today. But in a weird twist, it's the government that is set up
to win the prize.

Here's how: As short-term financing dried up, Fannie Mae and Freddie
Mac's deteriorating financials threatened to trigger some $1.4
trillion in credit default swap payments that no one, including giant
insurer AIG, had the capital to make good on. So Treasury Secretary
Henry Paulson put Fannie and Freddie into conservatorship. This
removed any short-term financing hassle. He also put up $85 billion in
loan guarantees to AIG in exchange for 80% of the company.

Taxpayers will get their money back on AIG. My models suggest that
Fannie and Freddie, on the other hand, are a gold mine. For $2 billion
in cash up front and some $200 billion in loan guarantees so far, the
U.S. government now controls $5.4 trillion in mortgages and mortgage
guarantees.

Fannie and Freddie each own around $800 million in mortgage loans,
some of them already at discounted values. They also guarantee the
credit-worthiness of another $2.2 trillion and $1.6 trillion in
mortgage-backed securities. Held to maturity, they may be worth a lot
more than Mr. Paulson paid for them. They're called distressed
securities for a reason.

Now Mr. Paulson is pitching Congress for $700 billion or more to buy
distressed loans and CDOs from the rest of Wall Street, injecting
needed cash onto balance sheets so that normal loans for economic
activity can be restored. The trick is what price he will pay. Better
mortgages and CDOs are selling for 70 cents on the dollar. But many
are seriously distressed (15-25 cents on the dollar) because they are
the last to be paid in foreclosures. These are what Wall Street wants
to unload the quickest.

Firms will haggle, but eventually cave -- they need the cash. I am
figuring Mr. Paulson could wind up buying more than $2 trillion in
notional value loans and home equity and CDOs for his $700 billion.

So the U.S. will be stuck with a portfolio in the trillions of dollars
in bad loans and last-to-be-paid derivatives. Where is the trade in
that?

Well, unlike Mr. Buffett or any hedge fund, the Treasury and the
Federal Reserve get to cheat. It's not without risk, but the Feds,
with lots of levers, can and will pump capital into the U.S. economy
to get it moving again. Future heads of Treasury and the Federal
Reserve will be growth advocates -- in effect, "talking their book."
While normally this creates a threat of inflation and a run on the
dollar, and we may see dollar exchange rates turn south near term,
don't expect it to last.

First, with Goldman Sachs and Morgan Stanley now operating as
low-leverage bank holding companies, a dollar injected into the
economy will most likely turn into $10 in capital (instead of $30 when
they were investment banks). This is a huge change. Plus, a stronger
U.S. economy, with its financial players having clean balance sheets,
will become a safe haven for capital.

Europe is threatened by an angry Russian bear. The Far East,
especially China, has its own post-Olympic banking house of cards of
non-performing loans to deal with. Interest rates will tick up as the
economy expands -- a plus for the dollar. Finally, a stronger economy
driven by industry instead of financials means more jobs, less
foreclosures and higher held-to-maturity payouts on this Fed loan
portfolio.

You can slice the numbers a lot of different ways. My calculations,
which assume 50% impairment on subprime loans, suggest it is possible,
all in, for this portfolio to generate between $1 trillion and $2.2
trillion -- the greatest trade ever. Every hedge-fund manager will be
jealous. Mr. Buffett is buying a small piece of the trade via his
Goldman Sachs investment.

Over 10 years this could change the budget scenario in D.C., which can
also strengthen the dollar. The next president gets a heck of a
windfall. In the spirit of Secretary of State William Seward's
purchase of Alaska for $7 million in 1867, this week may be remembered
as Paulson's Folly.

Mr. Kessler, a former hedge-fund manager, is the author of "How We Got
Here" (Collins, 2005).

On Thu, Sep 25, 2008 at 9:53 AM, Lowe, Rob <rlowe at vt.edu> wrote:
> Hank,
> I had not read through this when Ed first posted.  Sure was a lot of
> talk and no action by Congress.  Wonder why? Both parties and control of
> Congress at one time or another during these events.  - rob
>
>
> -----Original Message-----
> From: rhodes22-list-bounces at rhodes22.org
> [mailto:rhodes22-list-bounces at rhodes22.org] On Behalf Of Hank
> Sent: Thursday, September 25, 2008 10:20 AM
> To: The Rhodes 22 Email List
> Subject: Re: [Rhodes22-list] Bush Speech
>
> Rob,
>
> According to a white house press release previously posted by Ed, Bush
> warned congress of this 17 times since 2001 and asked them to act, so
> yes, I
> believe that he would have signed the bill had congress passed it.
>
> Here was Ed's original post.
>
> Hank
>
>
> __________________________________________________
> To subscribe/unsubscribe or for help with using the mailing list go to http://www.rhodes22.org/list
> __________________________________________________
>