Federal Reserve & Interest Rates

Merrill Lynch is raising capital once again, despite statements to the contrary just last week.  The company will sell $8.5 billion in new common stock further diluting the shares of existing investors.

Merrill said it expects to take a $5.7 billion pre-tax write-down during the third quarter. Most of this — $4.4 billion - stems from the sale of its CDOs. The rest is from the termination of its Security Capital guarantees and possible terminations of guarantees bought from other bond insurers, the firm explained.

This is definitely a bitter pill for the proud investment bank but it may well be the right move for the long run.  They probably didn’t need to make this move at this time but the  worsening credit conditions would have weighed down the firm in upcoming quarters.

With Merrill dumping their illiquid CDOs in a virtual fire sale, their profit numbers will look extremely bad this quarter.  However, with the housing slump getting worse, reducing exposure to the residential mortgage market is never a bad thing.

No one knows when the credit and housing crisis will end, financial firms have already taken nearly $500 billion in writedowns in the past year.  Many experts think that number could reach $1 trillion before all is said and done.

It will be interesting to see if investors react to this move favorably in the upcoming weeks.  After this move, the company should be in a much better relative position in upcoming quarters and it wouldn’t be surprising if they tried to reduce their exposure even further.

From the beginning Merrill was a big player in the CDO market and they would have had to pay the price sooner or later.  Better to make this move now while they still have willing investors to shore up their capital position.

Earlier today, the Senate approved a controversial housing bill that would in effect provide a federal backstop for government sponsored enterprises(GSE) Fannie Mae and Freddie Mac.  Expected to be signed into law early next week by President Bush, this represents a sharp policy shift for the administration that has for the past few years tried to instill the perception that GSE’s were operating under free market conditions.

The bill gained momentum as worries about the health of Fannie and Freddie spread. Some House and Senate Republicans were skeptical of a plan unveiled by Treasury Secretary Henry Paulson on July 13 that extends a line of credit to the two and allows the government to buy their stock if necessary.

The rescue plan would extend an unlimited line of credit to the two mortgage-finance giants for 18 months and give the Treasury the authority — also for 18 months — to buy Fannie and Freddie shares if the Treasury deems the companies’ capital to be inadequate.

The government acted abnormally quick on this legislation, which goes to show the true severity of the problem.  It hasn’t been three weeks since the story broke about the possible insolvency of the two troubled GSEs.

The two companies own or guarantee about half the loans of the $12 trillion mortgage market and their importance to the market has actually grown since the subprime crisis surfaced.  With many lending institutions struggling, the two companies have been involved in over two thirds of the new mortgages written over the past year.

The other provisions in the bill could also help alleviate some pressure in the slumping housing sector.  Included are tax breaks for first time home buyers and about $3.9 billion in housing aid to local communities.

The Fed has pretty much fired their bolt already during this current economic crisis and it’s actually good to see the government taking a more active role with fiscal policy.  Although the economy is still benefiting from the effects of the economic stimulus package, it was pretty obvious something needed to be done to help the housing market.

The slumping housing market sent financial stocks tumbling today for their worst drop in nearly a decade.  The National Association of Realtors issued a report that stated sales of existing homes fell 2.6% in the month of June.

“We are faced with a considerable excess of housing units that is only likely to worsen over coming quarters, and for which there is no quick solution,” wrote Richard Moody, chief economist for Mission Residential.

About a third of sales are distressed sales, either foreclosures or short sales, in which homeowners accept less than they owe on the house, with the lender taking the loss. Many foreclosures aren’t included in the data at all because they are not sold through the Realtors’ multiple-listing service.

At this point no one knows when the housing slump will end.  A number of factors have combined to make it quite difficult for a recovery to happen.

The amount of surplus homes on the market have kept prices falling for an extended period of time.  While this would make it seem like a buyer’s market, demand remains depressed as the general economy worsens and lenders are much more careful about who they loan money to.

The financial sector has been locked in a downward spiral with the housing market as rising default rates have caused hundreds of billions in writedowns as firms have had to scrambled to raise capital.  Before it’s all said and done the final tally could reach $1 trillion.

Mortgage markets are struggling, from originators to insurers and rising interest rates are the result.  The Federal rescue plan for Fannie Mae and Freddie Mac have stopped some of the bleeding for now but while many in the government were hoping they would be an integral part of a housing turnaround that seems farfetched at the moment.