Why Oil Tripped as Fannie & Freddie Survived

Oil's been tumbling sharply for two days in a row. Traders reacted swiftly and brutally to Bernanke’s warnings of “significant risks,” and to OPEC lowering its forecast for world oil-demand growth for 2008 and 2009..

“Signs of economic contraction and financial-market malaise are becoming harder and harder to ignore,” said John Kilduff, of MF Global.

And, as “oil fell to lows we saw at the end of last week [it] probably triggered quite a few automatic sell-stops,” said Nathan Golz, of Wachovia Securities.

In OPEC’s monthly report, the cartel reduced its forecast for world oil-demand growth for 2008 to 1.03 million barrels a day, a drop of 70,000 barrels from its previous estimate. Global oil demand this year is expected to average 86.81 million barrels a day.

“Everyone knows that demand growth has been nonexistent in the U.S. and Europe,” said Jeff Spittel, of Natixis Bleichroeder in Houston. “If things are appreciably worse in the developed world, eventually there will be spillover” to the developing countries.

Energy stocks like ExxonMobil (NYSE:XOM) and ConoccoPhillips (NYSE:COP) responded accordingly as traders waited to see how far oil and natural gas will correct.

At the same time, gold went up one day and then fell on Wednesday, perhaps in sympathy with oil's fall. Perhaps there wasn't a correlation at all, since gold rallied on Tuesday. Now gold stocks are stumbling. Agnico-Eagle Mines (NYSE:AEM) and Yamana Gold (NYSE:AUY) have corrected a bit.

Not that gold isn’t also sensitive to what’s happening with energy, as its fall from its “intraday high … was a result of the massive liquidation that was going on in the crude-oil market,” in the words of Burton Schlichter, of New World Trading.

It’s just that there are few other places to go, as the dollar keeps declining and equities show no signs of stabilizing, other than rallying somewhat on Wednesday.

It’s no wonder that, “People are freaked out,” as Matt Zeman, a metals trader at LaSalle Futures Group in Chicago, reportedly said. “Gold is catching a flight-to-quality bid. People are looking for hard assets to put their money in.”

And Zeman evidently sees more of the same to come. “People weren't as concerned about inflation in March, but that's kind of changed now,” he said.

“The credit-market losses are going to continue, you're going to see more banks failing, and the dollar should continue to lose ground. You'll see a more sustained run on gold.”

Monday's mayhem in the financial sector was stunning. Even after the US treasury department and the Fed announced their dubious bail-out program to save Fannie (NYSE:FNM) and Freddie (NYSE:FRE), big banks like Washington Mutual (NYSE:WM) hitting 52-week lows slightly above $3 a share.

What is this, the start of the horror movie "Great Depression II" or "Nightmare on Wall Street"? The leadership of WM had to assure the public they had enough money and sure enough, Tuesday dawned with the stock rallying a dizzying 25%. It's enough to give an investor or writer a case of vertigo. This is how the chart and stock price of WM looked on Tuesday.

Speaking at a news conference on Tuesday, President Bush also called the U.S. banking system basically sound. Now he lives in a different country than I do or he knows something the rest of us aren't aware of, other than the fact that the US can print money and the Bernanke Fed can drop billions of dollars from helicopters if they want to to say the economy.

Another bank that rose from the dead on Tuesday was First Horizon National (NYSE:FHN) the Memphis, Tenn.-based financial-services holding company, which swung to a second-quarter net loss from a year-earlier profit, increased its capital ratios and named a new chief executive as part of a succession plan.

The loss was $19.1 million, or 11 cents a share, compared with net income of $22.1 million or 17 cents a share in the year-earlier period. First Horizon, the top gainer in the S&P 500 earlier Tuesday, was recently up around 22% so far for this session.

The folks at Alternet (www.Alternet.org), making a Paul Krugman story at the New York Times available in accordance with Title 17 U.S.C. Section 107: "This article is distributed without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes", opens the door for us to share it with you to, citing the same Title 17.

The clever article gives a contrarian view as to why the government (you know, the same people who tell us that "the U.S. banking system is basically sound") will not, and yeah, cannot, allow Fannie Mae or Freddie Mac to expire worthless. Here's the heart of the article for your consideration and education:

The case against Fannie and Freddie begins with their peculiar status: although they're private companies with stockholders and profits, they're "government-sponsored enterprises" established by federal law, which means that they receive special privileges.

The most important of these privileges is implicit: it's the belief of investors that if Fannie and Freddie are threatened with failure, the federal government will come to their rescue.

This implicit guarantee means that profits are privatized but losses are socialized. If Fannie and Freddie do well, their stockholders reap the benefits, but if things go badly, Washington picks up the tab. Heads they win, tails we lose.

Such one-way bets can encourage the taking of bad risks, because the downside is someone else's problem. The classic example of how this can happen is the savings-and-loan crisis of the 1980s: S.& L. owners offered high interest rates to attract lots of federally insured deposits, then essentially gambled with the money. When many of their bets went bad, the feds ended up holding the bag. The eventual cleanup cost taxpayers more than $100 billion.

But here's the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago, an explosion that dwarfed the S.& L. fiasco. In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.

Partly that's because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn't do any subprime lending, because they can't: the definition of a subprime loan is precisely a loan that doesn't meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.

So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works.

In that case, however, how did they end up in trouble? Part of the answer is the sheer scale of the housing bubble, and the size of the price declines taking place now that the bubble has burst.

In Los Angeles, Miami and other places, anyone who borrowed to buy a house at the peak of the market probably has negative equity at this point, even if he or she originally put 20 percent down. The result is a rising rate of delinquency even on loans that meet Fannie-Freddie guidelines.

Also, Fannie and Freddie, while tightly regulated in terms of their lending, haven't been required to put up enough capital -- that is, money raised by selling stock rather than borrowing. This means that even a small decline in the value of their assets can leave them underwater, owing more than they own.

And yes, there is a real political scandal here: there have been repeated warnings that Fannie's and Freddie's thin capitalization posed risks to taxpayers, but the companies' management bought off the political process, systematically hiring influential figures from both parties. While they were ugly, however, Fannie's and Freddie's political machinations didn't play a significant role in causing our current problems.

Still, isn't it shocking that taxpayers may end up having to rescue these institutions? Not really. We're going through a major financial crisis -- and such crises almost always end with some kind of taxpayer bailout for the banking system.

And let's be clear: Fannie and Freddie can't be allowed to fail. With the collapse of subprime lending, they're now more central than ever to the housing market, and the economy as a whole.

© 2008 The New York Times

So perhaps the mortals who comprise The Federal Reserve Bank and The US Department of the Treasury will be able to prop up the financial sector before the rest of the "cock roaches" start to come out of the wall.

From this author's perspective, it will be a difficult and arduous process to restore confidence when the reputation, integrity and stability of the biggest financial companies in America, including the likes of Citigroup (NYSE:C) and Merrill Lynch (NYSE:MER), has been so badly damaged.

I agree with Paul Krugman that the problems at FNM and FRE won't take down the financial system of the USA, but it would be a mistake to think that the "all clear signal" has been sounded. Now's a good time to avoid being one who tries to catch "falling knives" and to get our roach bait near at hand.

Another question to be asking is "How does a citizen know when a politician is lying?" If you don't know the answer to that question please let me know and I'd be happy to give you the fool-proof answer.

Oh by the way, gold is still below a $1,000 an ounce and silver, last I checked, was still below $19. Hint, hint, hint.

Comments

[User 223602]

So - How do we know for sure a politician is lying? Is it that by definition that is always the case?

[TommyG]

His/Her lips are moving. Mark to Market is killing the financials, don't see why it has to be. An asset (loan) is impared if it's not performing, not because someone decides not to buy it. Look at how large corps value their A/R and reserves for bad debt. Fannie and Freddie have performing portfolios and could raise large sums by reducing the amount of loans they make.

[madeconomist]

This is a great explanation of the event. I tend to be a little bit of conspiration theorist. So, I believe on the other hand that some kind of deal was struck between the Chinese government and ours. That we use our good sources to hold the oil prices low for a while, as China helps us investing in Fannie and Freddie. Hence, Fannie Freddi are saved and oil falls. Order restored.

[A.S.D.]

Any Comments on Banro (BAA)?

[iThinkBig]

Here's my conspiracy theory Madeconomist: Nations are opportunists. They also now have supercomputers and can now crunch U.S. data analytics compared to our social patterns. This was and is a massive wealth transfer, coordinated by Russia, the GCC and China. Useful idiots nations serving as puppets are Iran and North Korea and Pakistan. They drain our resources directly and divert our intention indirectly. Again, the objective in my mind is wealth transfer, but unfortunately history in the last 100 years has shown world wars are spawned from such things.

[MarcCourtenay]

Yes, the punchline is "They're moving their lips". Should be a lot of this going on in a presidential election year. Sure wish politics wasn't such a toxic game