Federal Reserve & Interest Rates

The settlement brokered by New York Attorney General Andrew Cuomo with investment banks to buyback billions in auction rate securities will only help a fraction of the investors that bought into the trouble market.

The deals so far announced total about $56 billion of the auction-rate securities market — but there are $210 billion of such securities unredeemed, according to research firm Restricted Stock Partners.

Basically unless you were a client of one the brokers running the auctions you could be out of luck.  Investors that bought from discount brokerages could be stuck holding the bag, since their brokers had no knowledge of the breakdown in the auction rate market and for the most part have not been considered liable.

The investment banks that underwrite the actual auctions are only agreeing to take care of their own clients and even then there are still some gray areas.  Short of legal action it will be unlikely the majority of investors will see any of their money anytime soon.

With investment banks desperate for capital they will probably fight tooth and nail to buyback as little as possible.  However, these investments aren’t really in danger of failing, as much of it is made up of relatively safe municipal bonds.

The sticking point and the crux of the government’s argument with investment banks is that auction rate securities are in actuality long term investments but they were marketed as “like cash”.  Interest rates reset on the securities usually every 7 or 28 days so that investors were able to quickly get into and out of the market until auctions started to fail back in February.

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 $300 billion 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.