Quarter Horribilis

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Published December 02, 2008

| FOXBusiness

Another quarter horribilis is upon us. Fasten your wallets, the next quarter's earnings are going to be a bumpy ride.

Which is why the call to get mortgage rates down much more dramatically, to stop foreclosures, to put money in homeowners' pockets and a floor under damaged mortgage-backed securities, has gained increasing urgency as unemployment rises.

Analysts' estimates for bank losses in the fourth quarter range from as low as $15 bn to as high as $44 bn. The losses come after the credit rating agencies downgraded about $745 bn worth of asset-backed securities for the month of October alone, with $1.2 tn in mortgage assets downgraded in the last three months. Those are record amounts.

Currently, analysts expect Goldman Sachs could report a loss of $5 a share for the quarter ended November 28, about five times prior estimates, its first loss since going public in 1999, says the Wall Street Journal. Shares are down 74% over the last 52 weeks.

And the industrial conglomerate General Electric just jawboned down to analysts its fourth quarter earnings per share estimates to between 50 cents to 52 cents a share, at the low end of its prior estimates, as its levered-up GE Capital unit continues to weigh like an abalone around the neck of the parent. As GE races to pare down its outsized balance sheet, its shares are down 56% over the last 52 weeks.

Has your head exploded yet?

The Problem Spreads

The subprime crisis went viral some time ago, as asset classes of all stripes have been slammed. However, the downturn in leveraged loans, or LBO paper, as well as commercial real estate and credit cards has picked up speed, providing a leaden X-ray blanket on bank stocks over at least the next several quarters.

If you have followed the business coverage for a good period of time, it would be wholly understandable if you get skin hives listening to talking heads who get most of their information from headlines and who predict, with preternatural confidence, where the markets are headed.

Just as you may do when you listen to bearish zealots, notably those who have predicted 10 of the last 2 recessions. I wonder when Congress will pass a new tax on intellectual dark matter, or acid reflux and ankle biters, as doing so may balance the budget. These people know no more than you do about where the markets are headed. 

And instead of windfall taxes on oil companies, how about Congress enacting windfall taxes on all those boats and SUVs and vacation homes borrowers, who had no more sense than a flock of pheasants, bought with their home equity lines of credit taken out on homes they had no business buying in the first place, borrowers now being bailed out by normal, careful, sensible, smart taxpayers who didn't engage in such mindlessness?

Or how about Congress passing a new tax on Wall Street credit rating agencies in the form of a new risk management fee. Maybe then they will stop their drive-by appraisals of nonsensical real estate securities, where they happily gilded the silly by rubberstamping this rubbish as Triple A, lining their pockets as they handed out goldplated ratings like Kleenex.

Not just Wall Street, but US taxpayers will be staring morosely at this mountain of rotting paper for some time to come.

However, I still believe that even dead cats bounce, as one market pundit quipped. But as I wait for it, I notably enjoy reading letter writers, like the one who wrote to the Financial Times, paraphrasing TS Eliot: "This is the way the world ends, not with a bang but an ulcer."

The Circus Mirror of Debt

Both Goldman Sachs and GE have turned to the government to help backstop their corporate debt, a guarantee the government will now provide by, of course, issuing more debt. On November 21, the FDIC voted to approve a bank-debt guarantee program, which is part of the government's financial rescue package. The FDIC has estimated it could insure up to $1.4 tn in bank lending.

Goldman is now a commercial bank, via its ownership of an industrial loan company, and so, it has become the first US bank to issue bonds backed by the FDIC, $5 bn worth.

GE is a special case, as it owns the largest non-bank in the country, GE Capital, now dragging down the parent's profits. Gone are the days when GE Capital fueled half of the parent's profits, instead, it now will (hopefully) provide 40% in future periods.

The Trouble with GE

GE is one of six industrial companies that sport a gold-plated triple-A rating, which allows it to borrow cheaply and buy its way to profits in the credit markets, via its financing unit, GE Capital.

Specifically, GE Capital uses that triple-A rating to help its parent execute its acquisitions and divestitures on the cheap, a just under the wire, limbo game of last-minute moves it has typically executed to grease the way toward meeting or beating quarterly earnings estimates. 

GE Capital also has historically provided cheap financing to customers of its parent to buy all sorts of products, from locomotives to jet engines.

But as the commercial paper market has frozen, GE has hit a wall in conducting its short-term borrowings to run its business and to make its last-minute moves.

GE is the biggest player in the commercial market and has $88 bn in commercial paper, borrowings it needs to fund its day-to-day operations. But it can no longer easily borrow in the commercial paper market as the credit markets went into a blackout. GE's borrowings have steadily risen in cost, zapping its cash flow. GE Capital's operating earnings plunged 33% in the first nine months versus the prior year period.

Government Rides to GE's Rescue

Hoping the government can bring good things to light, the Federal Reserve launched its first ever commercial paper facility for nonbanks, which analysts say was targeted to bail out GE.

GE, which borrowed an estimated $5 bn from the Fed's commercial paper facility, is eligible to borrow up to $96 bn through the program.

GE has already won FDIC insurance for up to $139 bn in debt. GE got the FDIC debt coverage because GE Capital owns a federal savings bank and an industrial loan company, both of which qualify.  

But will GE's government handouts be enough to save its hallowed triple-A rating, given that GE's tangible net worth is slowly submerging under an eye watering debt load?

Despite its claims that everything is fine at the company, GE had to raise $15 bn in equity. GE was forced to sell at a steep price to Warren Buffett's Berkshire Hathaway's $3bn of its preferred stock with a rich 10% dividend as part of its $15 bn equity raise. Berkshire's stake at $22.25 a share is now underwater.

GE also had to stop a stock buyback plan and freeze its dividend, the first time in 32 years it has not increased the annual pay-out.

GE is struggling with a problematic balance sheet that has a sizable debt overhang, at last count $54.7 bn in illiquid securities it can't readily sell, and off-balance sheet vehicles that house another $53 bn in debt securitizations that GE doesn't want hitting its weak balance sheet. Keeping its triple-A rating is vital to its business.

A Smart Fix for Housing

While investors can expect to see problems at GE for some time to come, housing provides a more pressing matter.

To fix housing, to stop foreclosures and to potentially get a floor under damaged mortgage-backed securities, economist Ed Yardeni says the Federal Reserve should "announce that their target is to get the 30-year fixed-rate mortgage yield down to 4%."

Lower mortgage rates may "increase the willingness of lenders to help distressed borrowers work out more affordable loans," Yardeni says. "Of course, lenders will still require higher down payments for both refi's and new purchase loans" a hurdle for reviving housing activity, but the knock-on effect could be dramatic.

"I think there are a lot of home owners and real estate investors waiting for something like this to happen, says Joanne Gregorio, a real estate agent in New Jersey. "People are overcome with fear about the direction the economy is taking. Our perception of wealth is directly affecting our propensity to spend. Decreased homes values, fears of losing our jobs, and concerns over our shrinking retirement funds and stock portfolios all keep us from going out and spending."

Gregorio adds: "A drop in mortgage rates would put more money in our pockets, not just today or this month but for years to come. It would make the consumer more liquid and therefore feel more comfortable about spending. This could have a significant and far-reaching effect on the economy and ultimately the markets."

Yardeni notes that "falling mortgage rates have always revived housing starts and the economy in the past despite high unemployment and depressed stock prices." He adds: "An economic recovery led by housing is the best way out of the Dark Side to the Light Side. Actually, it is the only way. We may be finally on the right path."

Yardeni applauds the Fed's recent move to buy up to $100 bn in debt issued by Fannie Mae and Freddie Mac, as well as another $500 bn in mortgage-backed securities (MBSs).

The move caused yields on MBSs to plunge. In turn, the 30-year fixed-rate mortgage rate dropped by half a point. 

However, Yardeni says this program should expand. He says that the US Treasury "should finance a $1 tn first-come-first-served mortgage sale for qualified buyers of new and existing homes, with Fannie and Freddie holding the mortgages originated by the banks."

Otherwise, the US taxpayer will get pounded. Bloomberg has noted: "The U.S. government is prepared to provide more than $7.76 trillion on behalf of American taxpayers" to fix the mess. That sum amounts to half the country's gross domestic product.

A Fix for the Stock Market

Market critics say the government should temporarily suspend the mark to market rules, which have caused record writedowns that have helped zap trillions of dollars out of investor portfolios worldwide. The rules say companies must price and book securities on their financials against profits as if they were to sell them today in a market that's as frozen over as the two moons of Mars.

If the government can change TARP rules with ease, analysts ask, then why won't the government stop the hammer blow of these rules?

Especially since TARP canceled its initial auction idea for these securities and in turn won't help put a floor price under these securities?

The hope was that the auction idea would put some kind of floor price on these securities. Treasury TARP-edoed that version of the program within the last month or so.

Analysts say that government has been improvising all of the bailout rules, so why not temporarily suspend the mark to market rules?

Especially since the government suddenly did an about face and changed the rules, by resurrecting just for Citigroup a version of the first iteration of the $700 bn Troubled Asset Relief Program [TARP], in which the government would buy at auction bad securities built during the credit bubble?

The government will now backstop $243 bn or so in Kryptonite mortgage-backed and commercial real-estate backed securities at Citigroup. After the TARP auction idea was killed, the Federal Reserve quietly took on $52.5 bn in toxic securities from AIG, along with the $27 bn in securities it inherited from the bailout of Bear Stearns which merged with JPMorgan Chase.

Also, analysts say the Securities & Exchange Commission should bring back the uptick rule, which it suddenly killed in the summer of 2007. Traders and analysts say the SEC's move opened a barn door of bearishness whereby traders could short stocks at prices below prior trades.

Generally speaking, the rule said that when a listed stock is sold in a short sale transaction, it must be sold short at a price above the price of the preceding sale.

But the SEC killed the rule without comment in the summer of 2007, right when the crisis was about to blow. In a short sale, a trader borrows stock and then sells it, and when the price rises, it gives the borrowed shares back, pocketing the difference.

Oh, and remove Citigroup and General Motors from the Dow Jones Industrial Average. Both are acting like twin anvils around the neck of the Dow. The editors of the Wall Street Journal already have yanked Honeywell (HON), Altria (MO) and American International Group (AIG) this year.

Why not these two?

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