Cost Of Default Insurance On Eurobonds Surges To An All Time High

Financial Market Report for December 22, 2010

Cost of Default Insurance On Eurobonds Surges To An All Time High
Ambrose Evans Pritchard of The Telegraph reports: The cost of default insurance on eurozone bonds has surged to an all-time high on reports that Greece is preparing the way for a sovereign debt restructuring after 2013, with tacit support from the EU authorities.

Jim Nelson of Agora Financial:  “A falling currency and massive bailouts are actually helping Germany.” The majority of the supposedly at-risk PIIGS — Portugal, Italy, Ireland, Greece, Spain — bonds are held by foreign governments. Germany’s banking system holds a whopping $394 billion in PIIGS debt. That’s 9.3% of its total foreign debt exposure. So without these bailouts, the German banking system would take a serious hit.

Martin Wolf in the FT documents the disorders of the Euro currency: “the failings of the eurozone have not been fiscal irresponsibility, but macroeconomic divergence, financial irresponsibility, asset price bubbles, and huge shifts in competitiveness. If the eurozone is to work better, it must manage these disorders.”

EU to Issue Eurobonds through Its EFSM and its EFSF beginning In January 2011 The WSJ Market Beat reports that the EU yesterday finalised funding plans for Ireland ‘s bailout. The EU will issue a bond at the beginning of January through its emergency lending fund, the European Financial Stability Mechanism, which has a lending capacity of €60 billion and includes the UK . The eurozone’s bailout fund, the European Financial Stability Facility, will follow in late January. The article notes that the EFSM aims to raise up to €17.6 billion in 2011 and up to €4.9 billion in 2012, while the EFSF aims to raise up to €16.5 billion in 2011 and up to €10 billion in 2012.

OpenEurope reports, without reference, that FT Deutschland looks at German Chancellor Angela Merkel and French President Nicolas Sarkozy’s joint declaration last week announcing that they intend to cooperate more closely in economic and fiscal policy, noting that “ Berlin is working on a new Europe”. The article notes that German experts see the possibility of France and Germany leading a new push for social and economic integration using the EU’s so-called “enhanced cooperation”, which allows a group of member states to move further than other EU states.

David A Smith relates the Euro crisis arises from the fundamental paradox of a single currency being used by multiple financially sovereign states.  Individual states cannot deflate their currencies, an action that would ordinarily have happened year ago to Greece, Portugal, and Italy.  Instead, the Euro’s strength drove Euro interest rates so low that the smaller nations could each act as their own Fannie Mae or Freddie Mac, turbocharging their economies and hyper inflating asset prices.  They could also use the cheap borrowing to over-promise their retirees with wildly unsustainable social-welfare safety nets, all of which are now in tatters.  That’s why the series of Eurozone bailouts must necessarily fail to stem the financial fear – either the subsidiary nations get their finances in line with Eurozone requirements, or the stronger economies, led by Germany, will have to quit the Euro, returning to their original currencies and letting the Euro deflate like a collapsing souffle.

Chart of the Euro, FXE, shows a close of 130.57 on December 23, 2010.

Portugal’s Debt Gets A Downgrade  
Pan Pylas of the Associated Press reports Portugal’s Debt Rating Downgraded By Fitch

Ireland Nationalizes The Anglo Irish Bank
Laura Noonan and Tom Molloy of The Ireland Independent report that the European Commission has approved Irish government plans to pump another €17.5bn into Anglo Irish Bank, AIB, and Irish Nationwide with some cash coming directly from the National Pension Reserve Fund.

The bailout passed the first European hurdle last night when Brussels gave the plans “temporary” approval, subject to full business plans being submitted for all three institutions.

A joint plan for Anglo and Irish Nationwide will detail how they will be wound down, while AIB’s bosses have six months to submit a plan showing how the bank will be restructured.

In a statement, the European Commission said AIB’s long-term plan would only get the thumbs up if Brussels was satisfied it “will be commercially viable in the long term without further injections”.

The Commission also wants guarantees that the bank’s shareholders and its so-called subordinate bondholders (who loaned money to the bank at high interest rates) will make a “significant contribution” to AIB’s rehabilitation

A spokeswoman for Competition Commissioner Joaquin Almunia declined to be drawn on whether Brussels wanted AIB’s shareholders to be entirely wiped out.

“The Commission does not have a level of pain-sharing for shareholders but we are careful that when a state acquires shares in a new bank, the state does not overpay . . . because this would be an undue benefit for shareholders,” she added.

Spain Having No Money, Declines To Pay Enel’s Spanish Subsidiary Endesa’s Utility Bills
Alessandra Migliaccio and Ben Sills of Bloomberg: “Europe’s spreading sovereign debt crisis is making it tougher for Spain to pay electricity bills, and that’s infecting corporate bonds beyond its borders. Enel SpA, the Italian owner of Spanish power company Endesa SA, was put under review for a possible downgrade last week by Moody’s Investors Service because the Spanish government’s surging financing costs led it to freeze plans to repay 14.6 billion euros ($19.2 billion) owed to its utilities. Enel bonds were the worst performers this month among the 50 biggest non- financial issuers in Bank of America’s EMU Corporate Index. “The contagion between corporate and sovereign is already happening,” said Tom Sartain, a fund manager at London-based Schroders Plc, which oversees $245 billion of assets. “The instability of the sovereign is filtering through.” Chart of Enel and Endesa.

US Banking Sector Troubles Grow
Martin Z. Braun and Jeff Bliss of Bloomberg Bank of America in Municipal Bid-Rigging Case Tip of Iceberg Band of America’s, BAC, agreement to pay $137 million in restitution for taking part in a nationwide bid-rigging conspiracy for municipal-investment contracts may soon be followed by more settlements to repay the scheme’s victims, the Justice Department’s Antitrust Division head said. “Stay tuned to this channel — I think you will see a lot more activity in the coming weeks and months,” Christine Varney,  the antitrust chief, told reporters yesterday. “We are committed to getting restitution, full restitution, to all the municipalities that were victims of this scheme.” Bank of America, which has assisted the government probe of the $2.8 trillion municipal-bond market since at least 2007 in return for leniency, has provided documents, e-mails and recordings of phone calls, according to court records of civil suits. In September, Douglas Lee Campbell, formerly employed by the bank’s municipal derivatives group, pleaded guilty to taking part in a conspiracy to pay state and local governments below market rates on investments purchased with bond proceeds. Chart shows Bank of America, BAC, falling lower on December 23, 2010.

EPA To Issue New Greenhouse Gas Policy
Politico reports EPA to Double Down on Climate. “The Obama administration is expected to roll out a major greenhouse gas policy for power plants and refineries as soon as Wednesday, signaling it won’t back off its push to fight climate change in the face of mounting opposition on Capitol Hill.

The Environmental Protection Agency has agreed to a schedule for setting greenhouse gas emission limits, known as “performance standards,” for the nation’s two biggest carbon-emitting industries, POLITICO has learned.

Under the schedule agreed to by EPA, states and environmental groups, the agency will issue a draft greenhouse gas performance standard for power plants by July 2011 and a final rule by May 2012. The agreement – which comes after states and environmentalists challenged the George W. Bush administration’s failure to set the standards – requires EPA to issue a draft limit for refineries by Dec. 2011 and a final rule by Nov. 2012.”

The current regulatory framework and forthcoming EPA mandate from EPA Chief Lisa Jackson is an example of authoritarian federal regulation of industry and commerce. It is similar in scope to the power invested in the Financial Regulator, that being the person of the Secretary of the Treasury, under the Dodd Frank Legislation. Of note, the environmental protection mandate comes after the recent November election. It is a mandate; it  is not a law that has been debated and passed by the representatives of the people. This is a decree. Such EPA action should have been done under the Bush Administration when utilities and the economy was in good shape. We are an inflection point. With the announcement of the EPA Clean Air Mandate the world will pass from democracy and into the age of authoritarian rule. American Environmental Policy under Obama is toxic to the manufacturing sectors. Responsible environmental policy is now precluded. Concern over industrial emissions has morphed into the ideological cornerstone for the advocates of Social Justice. Jobs and capital investment will leave America. The EPA mandate coming at this time will result in greater utility costs and cause much societal and economic destruction.

I add that the world passed from the age of investment leverage and into the age of investment deleverage of December 15, 2010, as the European Leaders met and decided to kick the can down the road as John Mauldin relates, by not coming to a comprehensive solution to the European Sovereign Debt and Bank Debt Crisis. It was at at that time that sovereign debt interest rates rose globally and World Government Debt, BWX, and major currencies, DBV, and emerging market currencies. CEW, fell lower.  

And finally I add that the world will be passing from the age of care and assistance and into the age of disrespect and disregard in January 2010, when Medicaid austerity cuts stop funding of foot care and eye care as well as elimination of TANF.

EPA Takes Over Texas Pollution Permits
RG Ratcliffe of Chron reports EPA Takes Over Texas Pollution Permits. The EPA officially took away from state regulators the permitting process for air quality on major industrial facilities. The move was praised by environmentalists, but, criticized by industry and Gov. Rick Perry’s office. EPA Regional Administrator Al Armendariz in a letter to industry said that as of Jan. 2, 2011, all greenhouse gas air quality permits that are pending at the Texas Commission on Environmental Quality or may be filed in the near future will now be reviewed and issued by the EPA. Armendariz said the TCEQ has estimated that 167 projects in Texas will be affected

Derivatives Oligarchy Meets In Secret
Louise Story of The New York Times: A Secretive Banking Elite Rules Trading in Derivatives: On the third Wednesday of every month, the nine members of an elite Wall Street society gather in Midtown Manhattan. The men share a common goal: to protect the interests of big banks in the vast market for derivatives, one of the most profitable, and controversial, fields in finance. They also share a common secret: The details of their meetings, even their identities, have been strictly confidential. Drawn from giants like JPMorgan Chase, Goldman Sachs, and Morgan Stanley, the bankers form a powerful committee that helps oversee trading in derivatives, instruments which, like insurance, are used to hedge risk. In theory, this group exists to safeguard the integrity of the multi trillion-dollar market. In practice, it also defends the dominance of the big banks.

Mortgage Cartel Massively Unloads In Subprime Neighborhood
David Schepp in AOL Daily Fiance article The Housing Mess Hits One New York Town Hard reports dramatic price drops in working class and minority town Mount Vernon, NY, such as that of 27 Harrison St Mount Vernon, NY, 10550 which is now listed for $125,000.

Tim Murphy wrote on August 7, 2007 in the New York Times: “Reflecting statewide and national trends, there has been a steep rise in the number of Westchester County homeowners experiencing or facing foreclosures. In the first half of 2007, foreclosure filings in Westchester rose 32 percent and actual foreclosures increased 62 percent over the same period last year, said the county clerk, Timothy C. Idoni. Like Ms. Moore, the vast majority of those homeowners obtained so-called subprime mortgages, given to people with less-than-perfect credit, often at high interest rates, or rates that start low and then rise sharply after a year or two. In Westchester, the majority of people with subprime mortgages are black or Hispanic and live in communities like Yonkers, Mount Vernon, New Rochelle and Greenburgh.

Municipal Betting Agency Shuts Down
James T. Madore of Newdsay reports that the New York City Off Track Betting Bailout Vote Fails In State Senate Vote) The New York City Off -Track Betting Corp.  began shutting down wagering parlors and stopped taking bets over the telephone and Internet last night after a bailout failed in the State Senate. Lawrence Schwartz, OTB chairman and a top aide to Gov. David A Paterson  said he expected all operations to cease by midnight. He predicted the closure of harness tracks across the state and possibly no horse racing at Belmont Park next spring without NYC OTB, which took in $840 million in bets last year. More than 1,000 OTB employees were expected to be out of work. “We are out of cash,” Schwartz said. “We are out of business today because the Senate didn’t act.” The bailout needed 32 votes to pass but garnered only 29: all Democrats and two Republicans.

Mortgage Refi Activity Takes A Big Hit
Tony Alvarez reports “The jump in mortgage rates since early November continues to take a heavy toll on refinancing activity, as the math no longer works for many homeowners. The Mortgage Bankers Assn. said Wednesday that its seasonally adjusted index of new refi applications plunged 24.6% last week compared with the previous week, the sixth straight weekly decline.”

Global Banks Borrow A Zero Percent Interest At The Fed
Shahien Nasiripour of the Huffington Post reports Money For Nothing: Wall Street Borrowed From Fed At 0.0078 Percent:  For the lucky few on Wall Street, the Federal Reserve sure was sweet. Nine firms — five of them foreign — were able to borrow between $5.2 billion and $6.2 billion in U.S. government securities, which effectively act like cash on Wall Street, for four-week intervals while paying one-time fees that amounted to the minuscule rate of 0.0078 percent. That is not a typo. On 33 separate transactions, the lucky nine were able to borrow billions as part of a crisis-era Fed program that lent the securities, known as Treasuries, for 28-day chunks to the now-18 firms known as primary dealers that are empowered to trade with the Federal Reserve Bank of New York. The program, called the Term Securities Lending Facility, ensured that the firms had cash on hand to lend, invest and trade. The market was freezing up. Effectively free money, courtesy of Uncle Sam, helped it thaw. The European firms,  Credit Suisse, CS, (Switzerland), Deutsche Bank, DB, (Germany), Royal Bank of Scotland, RBS, (U.K.), Barclays, BCS, (U.K.), and BNP Paribas, BNPQY, (France) — borrowed $5.2-6.2 billion in Treasuries 20 different times. The one-time fees they paid on each transaction ranged from $403,277.78 to $481,110. Deutsche Bank led the way with seven such deals.

Build America Bonds Trade Lower
Michael McDonald and Brendan A. McGrail of Bloomberg report Build America Bond Yields Climb to 11-Month High Build America Bond, BABS, yields rose to the highest in 11 months as the federal program subsidizing state and local government borrowing costs is set to expire at year- end unless lawmakers extend it. The average yield on the taxable securities climbed to 6.35 percent yesterday, the most since Jan. 7, as investors demanded a larger premium to buy the debt, according to a Wells Fargo index.

Wheat Prices Remain Elevated
Luzi Ann Javier of Bloomberg reports U.S. May Have ‘Problem’ Meeting Surging Wheat Demand. Chart of the Grains, GRU.

Borrowers Default On First Mortgage And Keep Second Mortgage Current
Irvine Renter reports Borrowers Default On First Mortgage And Keep Second Mortgage Current: Perhaps borrowers really do recognize that second mortgage debt is just like a credit card that follows them after they leave the house. If people accept that they can’t escape the debt without bankruptcy, and they are unwilling to give up access to credit, then they will keep paying their second mortgages to keep the credit lines alive.

Forint Plunges As Fitch Downgrades Hungary To BBB-
Tyler Durden reports Hungary was just downgraded by Fitch to BBB-, and still kept its rating outlook negative, meaning the country is about to enter junk territory. And what is sure not helping is the record strength of the CHF, which is making life for borrowers in Hungary a living hell, whose debt is denominated primarily in Swiss Francs, FXF.

In December 2009, currency traders started to massively go long the Swiss France, FXF, and Short The Euro, FXE. This probably turned out to be the best carry trade investment of all time as there has been no successful central bank intervention nor any currency swaps by the US Fed to blunt this strategy, such as the Dollar Swap Facility recently extended once again by the US Federal Reserve.  On December 21, 2010, Stanh reports in the Forex Trading System Blog Euro Hits Record Low Against Swiss Franc. Many became very wealth through this currency trade.

Shaun Richards relates: “After writing on Tuesday about how many borrowers in Eastern Europe had taken out mortgages in other currencies with the Swiss Franc to the fore because of its history of low interest-rates I thought that I would highlight the impact this must have on housing markets there. The Euro/Swiss Franc exchange rate is now 1.2495 so the Swiss Franc has extended it rise even further. If we look at the specific case of Hungary then those with Swiss Franc mortgages have seen their debt rise by nearly 2% since then and their debt is now 10% higher than a month ago. These sort of figures must be a millstone around the necks of the mortgage and housing markets in this area.”

I ask what if the FXF:FXE carry trade unwinds? Would that not be a winner for those invest short the pair? Of course, I do not trade currencies.  

Andra Marinescu writes in Metrolic: “The total volume of loans denominated in Swiss francs, contracted by both the banking and non-banking sector increased from 228 billion Swiss francs in 1999 to 558 billion francs in the third quarter of 2008, before slightly declining to 488 billion francs (378 billion) in the first quarter of 2010, according to the report “Loans in francs could become a threat to Switzerland”, conducted by UBS Wealth Management Research. To properly assess their actual size it should be taken into account that the total volume of loans in Swiss francs is ten times the value of all Swiss francs banknotes in circulation and is almost equivalent to the nominal GDP of Switzerland (535 billion Swiss francs in 2009).”

“Loans in Swiss francs have become attractive due to lower interest rates compared to interest rates practiced by loans contracted in other currency. Moreover, the Swiss currency depreciation between 2003 and 2007 also fueled a strong demand for loans in francs in Eastern Europe. Since June, however, the franc had a strong appreciation against almost all currencies, which means that the foreign currency denominated loans have, become increasingly expensive. Largest holders of loans in Swiss francs are the Austrians, who “owe” 81 billion Swiss francs (62.7 billion euros), followed by Germany with loans of up to 60 billion francs. Outside the euro area, the Poles are leaders on the podium, with loans worth 53 billion francs, followed by Hungarians with loans worth 36 billion francs. The central bank tried to intervene on the market in summer, spent 80 billion francs a month, but so far their actions have not had lasting impact. And while the number of investors placing capital in Switzerland is growing, Berne officials fear that the Swiss economy is too small to safely absorb massive capital inflows.”

China Stocks Fall As Chines Interest Rates Rise
Shaun Richards continues: “Chinese 7 day repo interest-rates have surged this morning by 1.5% to 5.67% as a liquidity squeeze hit home. So in a way China may well be getting a rise in interest rates without an official announcement. The increase in reserve ratios combined with a year-end liquidity squeeze may mean that markets will do the job for now, a slightly unusual position for a command economy to adopt perhaps but the facts are simply thus.” Chinese Financials, CHIX, fell, taking Chinese shares, FXI, lower.  

Ireland To See A Rise In Its Outstanding Sovereign Debt Through Nationalization Of Allied Irish Bank
Shaun Richards adds:  “It seems that this suggestion was well founded because today the Irish Times has announced  that the Irish government has drawn up plans to put a further 3.7 billion Euros into AIB. This will need to be followed by another 6.1 billion Euros next year if she is to met the new capital requirements. I do not know about you but suddenly the 85 billion Euro rescue package seems a lot smaller. Also the 3.7 billion will be provided by the National Reserve Pension Fund which in my habit of sometimes addressing economic issues with song titles has me imagining Irish pensioners singing “What have I done to deserve this?” by the Pet Shop Boys. Also the law of unintended consequences may have an impact here too. So far Ireland has managed to keep the debt issued by its bad-bank NAMA off its sovereign debt but as it is about to in effect nationalise AIB which is a NAMA shareholder then this piece of Eurostat approved financial alchemy is likely to come to an end which will raise Ireland’s national debt by some 30 billion Euros.

Moneyness Has Come To Financial Shares Globally From Those Seeking Safe Haven From Sovereign Debt Crisis   
I comment that there has been not only an increase in value in the United States as is seen the Small Cap Revenue Shares, RWJ, but also in Financial Shares Globally, IXG, with the exception of China Financials, CHIX, Bank of Montreal, BMO and some South American Banks, such as BBVA

Leveraged Buyout Firms, PSP, such as Solar Capital, SLRC, and Gladstone Capital, GLAD, have risen.  Nasdaq Community Banks such as Community Bank Systems, CBU, have gone parabolically higher as have Wall Street Financial Services, IYG. Those at Goldman Sachs, GS, and the Chicago Mercantile Exchange, CME, should have a good bonus this year.    

The European Financial Institutions, EUFN, entered into an Elliott Wave 3 Down on December 13, 2010 at a price of 21.84 immediately before the European Leaders Met In Summit and unfortunately were unable to come to a comprehensive solution as to the sovereign crisis: as John Mauldin relates they simply “kicked the can down the road”.  It was at this time that the major currencies, DBV, and the emerging market currencies, CEW, turned lower also in an Elliott Wave 3 Down as sovereign debt interest rates rose and world government bonds, BWX, turned lower.

Debt deflation is the future. Debt deflation is the contraction and crisis that follows credit expansion.  One of the most famous quotations of Austrian economist Ludwig von Mises is from page 572 of Human Action: “There is no means of avoiding the final collapse of a boom brought about by credit expansion.  The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency involved.”

As most are painfully aware banks will need to revive, that is renew their balance sheets soon with new debt issue. No one, nada, absolutely no one, is going to buy bank debt. Investors are short selling European bank debt and buying credit default swaps on the banks

Regulatory Capture Seen At Its Worst: Derivatives Lobbyist To Oversee Derivatives Regulation
Russ Douthat relates in article Capturing the Government:  Regulatory capture is the principle that over time, regulators become more responsive to the goals of the regulated entities than to the interests of the general public.

Peter Orszag’s well-remunerated transition from the White House to one of the banks that our federal government recently bailed out provoked a thoughtful post from Will Wilkinson, who suggested that the revolving door between Wall Street and Washington illuminates a “tension within the progressive strand of liberal thought.” No matter how ingeniously or idealistically progressives deploy government power “as a countervailing force against the imagined oppressive and exploitative tendencies of market institutions,” he wrote, “it seems that time and again market institutions find ways to use the government’s regulatory and insurer-of-last-resort functions as countervailing forces against their competitors and, in the end, against the very public these functions were meant to protect.”

It’s also worth noting that not all “captures” of government programs look like textbook cases of regulatory capture. (They aren’t all as straightforward and egregious as, say, the exploitation of certain alternative-energy tax credits by some clever paper manufacturers.) Where the big programs that Chait is defending are concerned, it’s usually more complicated than that. The capturer isn’t usually some completely mercenary corporation that’s figured out how to game the system. Instead, it’s often a group or organization that’s integral to the purposes the government is trying to pursue, but (all-too-understandably) ends up putting its own interests, or those of its members, ahead of the common good. Read more…

A ..Kate Burne of the Dow Jones News Service reports Chamber of Commerce Derivatives Expert To Join House Ag Committee … “Ryan McKee, a senior director focusing on derivatives regulation at the U.S. Chamber of Commerce, has been appointed as a professional staffer at the House of Representatives Committee on Agriculture under Frank Lucas (R., Okla.), the committee’s incoming chairman”

Ms. Burne continues: “The Chamber of Commerce is a business lobbying group. McKee was best known for defending corporations against harsh new financial regulations that could raise their costs of hedging. McKee begins her new post in early January. Her role will be to liaise with the Commodity Futures Trading Commission, which is working to implement the Dodd-Frank financial overhaul law with respect to over-the-counter derivatives. The rules will become effective in the latter half of next year. The Dodd-Frank law, which was enacted over the summer, left a lot of specifics undecided, which the CFTC and Securities and Exchange Commission are working to clear up. One key aspect of the law that worries big business is the lack of a clear grandfathering provision exempting existing swap trades from the derivatives overhaul. “Just about everyone agrees that you shouldn’t undo existing swaps,” said David Hirschmann, the Chamber’s president and chief executive of capital markets. “Regulators say they have no intention of doing that. But no one knows for sure. It’s hard to run a business on ‘probably.'”

B … Regulatory capture has resulted in an integration of the mortgage GSEs, Freddie Mac and Fannie Mae, into the lending whereby these entities have failed to se risk-sensitive prices and have become the lender of first and last resort imposing cost and risk onto the taxpayers.

Global Intersection News Blog reports: “ Because of their implicit federal guarantee, Fannie Mae and Freddie Mac could borrow to fund their portfolio holdings at much lower interest rates than those paid by fully private financial institutions that posed otherwise comparable risks, and investors valued the GSEs’ credit guarantees more highly than those issued by fully private guarantors. Some of those benefits from federal support flowed to mortgage borrowers in the form of greater availability of credit and somewhat lower interest rates. The GSEs’ other stakeholders (shareholders, managers, and employees) also reaped some of the gains. The advantages of implicit federal support allowed Fannie Mae and Freddie Mac to grow rapidly and dominate the secondary market for the types of mortgages they were permitted to buy (known as conforming mortgages). In turn, the perception that the GSEs had become “too big to fail” reinforced the idea that they were federally protected.

Fannie Mae and Freddie Mac were profitable in most years until recently, when the United States experienced its most severe financial crisis since the Great Depression of the 1930s. As housing prices dropped nationwide and foreclosures increased, the two GSEs suffered large losses on various investments in their portfolios, such as subprime mortgages (loans made to borrowers with poorer-than-average credit) and “private-label” MBSs (securities issued and insured by private companies without government backing). The GSEs also faced heightened uncertainty about the magnitude of the ultimate decline in housing prices and increase in unemployment and thus about the size of credit losses on their outstanding guarantees (which in September 2008 totaled $3.8 trillion). Those factors impaired the GSEs’ ability to issue low-cost debt to fund their mortgage purchases, and doubts arose about whether they had enough capital to cover potential losses.

The enactment of the Housing and Economic Recovery Act of 2008 (Public Law 110-289) established the Federal Housing Finance Agency and gave it the authority to place Fannie Mae and Freddie Mac in conservatorship– a step it took in September 2008. The Treasury was granted the authority to provide the GSEs with unlimited capital (by purchasing their stock) in order to maintain their solvency through 2012. Those actions gave the government control over the two institutions and effectively made the government’s backing of their debt securities and MBS guarantees explicit.

As a result of that aid and the explicit federal guarantee, Fannie Mae and Freddie Mac were able to continue channeling funds to the mortgage market, even as private financial institutions were faltering. Consequently, in 2009, the two GSEs owned or guaranteed roughly half of all outstanding mortgages in the United States (including a significant share of subprime mortgages), and they financed three-quarters of new mortgages originated that year. Including the 20 percent of home loans insured by federal agencies, such as the Federal Housing Administration (FHA), more than 90 percent of new mortgages made in 2009 carried a federal guarantee.

The implicit federal guarantee concentrated market power in Fannie Mae and Freddie Mac by giving them lower funding costs than potential competitors in the secondary market. As a consequence, the GSEs grew to dominate the segments of the market in which they were allowed to operate. Because of their size and interconnectedness with other financial institutions, they posed substantial systemic risk–the risk that their failure could impose very high costs on the financial system and the economy. The GSEs’ market power also allowed them to use their profits partly to benefit their other stakeholders rather than exclusively to benefit mortgage borrowers.

The implicit guarantee created an incentive for the GSEs to take excessive risks: Stakeholders would benefit when gambles paid off, but taxpayers would absorb the losses when they did not. (Financial institutions that lack the benefit of a federal guarantee have less incentive to take risks because doing so can increase their financing costs, although some still act imprudently at times.)

One way that Fannie Mae and Freddie Mac increased risk was by expanding the volume of mortgages and MBSs held in their portfolios, which exposed them to the risk of losses from changes in interest or prepayment rates. Over the past decade, the two GSEs also increased their exposure to default losses by investing in lower-quality mortgages, such as subprime and Alt-A loans.

Because the federal guarantee was implicit rather than explicit, the costs and risks to taxpayers did not appear in the federal budget. That lack of transparency made it more difficult for policymakers to assess and control the GSEs’ costs and risks. Lack of transparency also made it difficult for policymakers to evaluate whether the GSEs were effectively and efficiently meeting their affordable-housing goals; several studies have questioned the effectiveness of the GSEs’ affordable-housing activities.

Weak regulation was a further shortcoming of the pre-crisis model. For instance, until 2008, the GSEs’ regulators lacked the power to increase capital requirements for Fannie Mae and Freddie Mac or to place them in receivership–powers that regulators have long had over banks.

Finally, as private companies with a public mission and implicit public backing, Fannie Mae and Freddie Mac faced an intrinsic tension in balancing the objectives of maximizing profits for their shareholders, maintaining safety and soundness to minimize potential costs to taxpayers, and supporting affordable housing. For example, efforts to help low-income households tend to involve targeting loans toward borrowers who generally pose more risk than borrowers of traditional conforming mortgages do, thereby putting taxpayers at greater risk of loss. The affordable-housing goals and the pursuit of profit may have encouraged Fannie Mae and Freddie Mac to purchase subprime MBSs that were expected to generate high returns but that involved excessive risk for borrowers and taxpayers alike.

Small Cap Revenue Firms: Annaly Capital Management — NLY

Mortgage Finance: iStar Financial — SFI

Financial Firms: Mortgage REITS —REM

US Mortgage Bonds — MBB

Moneyness Has Come To The Stock Market From Anticipation Of QE2 And A Flight To Safety In US Based Small Cap Shares.
A … Coming out of the subprime and commodities crash of  2007 and 2008, for the last two years, up until the 30-10 US Sovereign Debt yield curve, $TYX:$TNX, flattened on October 20, 2010, with the widespred conviction of the coming of QE 2, investing in Michigan closed end municpal debt fund MIY provided better returns than investing in gold and the small cap reveune shares, RWJ. It was anticipation of QE 2 tht provided moneyness to the small cap revenue shares as well as a perceived flight to safety away from the sovereign crisis in the Euro, the European Financial Institutions, EUFN, and in the European Shares, VGK. This being seen in the chart of MIY, RWJ, GLD, and EUFN, from 1-1-2009 to 12-22-2010.

B … Mark Jewll of the Associated Press reports that it wasn’t just closed end municipal bond funds, but also the a total attraction to bond funds that snapped in November 2010 as investors de-risked: The appeal of bonds may be dimming, as investors took more money out of bond mutual funds than they put in last month. The pullout snapped a two-year string of positive monthly flows into bonds, where investors have sought refuge after the financial crisis soured many on stocks.

Fund tracker Strategic Insight said Friday that investors pulled $1.3 billion from bond funds in November, the first outflow since December 2008 during the credit crunch.

Last month’s outflow stems largely from a sharp increase in the amount pulled out of municipal bond funds. The net withdrawal of $7.4 billion came amid fears about the financial health of state and local governments.

The overall shift out of bond funds marked an about-face from October, when bond funds attracted a net of more than $22 billion.

“As financial confidence slowly rebuilds, U.S. equity funds should benefit in the coming years,” said Avi Nachmany, research director with New York-based Strategic Insight.

Overall, the November flow into stock funds was $8.2 billion.

The recent surge into bonds has been global, with bond mutual funds attracting more than $1 trillion of new money since early 2009, according to Strategic Insight.

Although last month’s withdrawals from U.S. bond funds weren’t huge, bonds are clearly becoming less appealing to investors. Many are worried about rising interest rates and long-term inflation, which can erode bond returns.

Some of this concern was evident as investors pulled out a net $1.9 billion last month from the world’s largest mutual fund, Pimco Total Return, according to Morningstar. As with bond funds overall, it was the first monthly outflow in two years at Pimco Total Return. Still, the $256 billion fund run by star bond investor Bill Gross has seen a net $80 billion added since 2008.

Last month’s movement came as Pimco Total Return suffered a 1.5 percent investment loss in November, its worst month since September 2008, Morningstar said. By comparison, a broad measure of bond market performance, the Barclays Capital U.S. Aggregate Bond Index, fell nearly 0.6 percent for the month.

Bond investors now face substantial long-term risk from an inevitable rise in short-term interest rates, currently near zero. When the Federal Reserve raises rates, prices for bonds with locked-in rates will drop. That’s because investors will be able to buy newly issued bonds paying higher interest.

Prices of muni bonds, which are issued to build such public projects as roads and sewer systems, dropped last month at one of the fastest paces since the credit crisis. That decline has also hurt returns at funds that trade the bonds.

C … The small cap revenue shares, RWJ, such  as DLLR, NICK, NEWS, FCFS, CSE, CCRT, EZPW, WRLD, saw a terrific rally beginning Friday December 17, 2010 … chart of DLLR  NICK, NEWS, FCFS, CSE, CCRT, EZPW, and WRLD. NewStar Financial, Inc., NEWS, is a commercial finance company, provides customized debt financing solutions in the United States and it rose to a new high on December 23, 2010.

Inverse Volatility Fell And Volatility Rose
Inverse Volatility, XIV, fell
Short Term Volatility ETN, VIIX, rose
Mid Term volatility ETN, VIIZ, rose
Volatility, VXX, rose

The Investment Demand For Gold In Foreign Currencies Remains Strong
Chart shows gold priced in terms of currencies remains strong

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