Conclusion:
The Elliott Wave conclusion is that we are entering a period of extreme risk to both the stock market and the economy. I am using the Nasdaq Composite index for my analysis.
For those who are uninitiated in Elliot Wave analysis. The concept is essentially one of Waves of buying and selling that subdivide into varying degrees.
According to my analysis, we are currently entering into a 3rd of a 3rd of a 3rd wave down, which should provide maximum downside acceleration. Below is the Intermediate and Short Term picture.
Intermediate
Short Term - 5 Minute Bar Chart
Implications For Interest Rates: (All speculation) The implications for the Interest Rate market is actually quite complex. What I see happeneing is a short term implosion of the mortgage markets. In my opinion there is virtually no question that Freddie Mac is a "dead man walking", and that Fannie Mae is not much better off. However, the government will be forced to save one of the two, and they will save Fannie Mae.
In the whole scheme of things, neither Fanne nor Freddie's portfolio quality is all that bad. Not perfect, but not that bad. Their default rates are not terribly bad, considering where we are in the housing market cycle, although if you look at the default rates of loans originated from say 2005 through the summer of 2007, then yes, those loans definitely took on a substantial amount of needless risk. But despite that, at the core of the problems of both Freddie and Fannie, is not loan quality, per se. It is the loan quality GIVEN the amount of leverage they took on. They have taken on an amount of leverage that allows for virtually zero error toleranve regarding default/foreclosure rates. There is no margin for error built into their current system. Both Freddie and Fannie have constructed a portfolio risk profile that is sadly, very similiar to the model used by Long Term Capital Management, in my opinion. In order to chase return, both Fannie and Freddie have over-leveraged their loan portfolios at a time in the economic cycle that they should have been gradually de-leveraging. Simply put, both firms have been grossly mis-managed.
With all this as a background, in my opinion, the mortgage markets are about to enter THE period which the government has tried so hard to avoid...The Great Flush. We are about to see the mortgage markets seize up. We are going to see them seize up because the markets need to unravel this mess.
For example: Banks hold a great deal of Fannie Mae preferred stock in their portfolios, stock that is used to count towards their capital requirements with the Federal Reserve. As the value of this preferred stock gets written down, banks have less capital, thus less money to lend. I use this as an example, but it is truly the tip of the iceberg that we are headed towards.
There is the unwinding of CDOs that will take place. And this is a much more complicated process.
John Maudlin explains it quite well in his email newsletter of August 22, 2008:
Fannie, Freddie, and the Credit Crisis
Let's turn to Freddie and Fannie. There must be some people who think there is some way that the shareholders of Fannie and Freddie will not lose everything, as their shares actually trade. This just simply goes to show that you can fool some of the people some of the time. And as we will see, some of those people are very serious institutions.
It is almost a forgone conclusion that the US Treasury will have to step in and for all intents and purposes nationalize the two government-sponsored enterprises. The estimated losses in these two firms are far beyond what they could raise in a traditional market. And the longer the government waits, the worse the situation is likely to get.
Moody's downgraded the preferred stock in these firms to almost junk level because of the increased likelihood of "direct support" from the US Treasury, which, depending on the nature of the support, could wipe out both the holders of the common and the preferred. The preferred shares have already lost half their value since June 30 on speculation that an intervention would mean a stop in dividend payments (highly likely) and issuance of new preferred that would take preference over current preferred.
Interestingly, this would put more pressure on the banking system, as many banks hold the GSE preferred shares as assets, choosing to get a little extra return over traditional and more conservative assets. But then of course, Fannie and Freddie preferred were considered safe just a few months ago, with the best ratings from Moody's.
"Regional banks including Midwest Bank Holdings Inc., Sovereign Bancorp and Frontier Financial Corp., may have the most to lose. Melrose Park, Illinois-based Midwest has $67.5 million, or as much as 23 percent of its risk-weighted assets, in the preferred stock, while Philadelphia-based Sovereign owns about $623 million and Everett, Washington-based Frontier about $5 million." (Bloomberg)
It is doubtful that banks which hold these assets have written them down yet, but with a downgrade they will almost certainly be forced to do so in the near future. For the record, Fannie Mae has 17 classes of preferred stock, with more than 600 million shares outstanding. Freddie Mac has 24 classes of preferred stock, with about 460 million shares outstanding. The existing shares are trading worse than junk bonds, paying 17-19%.
And it may be a total write-off. It is hard to imagine how Treasury Secretary Paulson, or a new Treasury Secretary next year, could put US taxpayer money into the companies at risk without wiping out the current common and preferred shareholders. The justified outrage would be huge.
The basic problem is that without Freddie and Fannie the US mortgage market would go from crippled to moribund, if not dead. We have created a system that could not function in the short term without them, and the pain of allowing them to collapse would be another 1930s-style Depression, the era in which these firms were first created. They were never designed to take on the huge leverage they did, or to use hundreds of millions in lobbyist money and campaign contributions to create a massive payment scheme for management and shareholders. Congressional estimates are that this could cost US taxpayers $25 billion, a significant multiple of their current market caps.
Fannie and Freddie will not be able to raise capital on their own. At this point, why would any rational investor put that much money into a company with such a convoluted preferred share scheme, without government guarantees? That estimated loss assumes that the housing market does not get worse from this point. Losses could be much worse, or things could get better. Who knows? Why invest in something with so much uncertainty?
But there are more problems. You can't just take someone else's property, and that is what stock is, without some serious reasons. You almost are forced to wait for a crisis, otherwise shareholders would sue, saying that they suffered unnecessary losses. You can certainly expect the preferred shareholders to sue. That is why Paulson hired JP Morgan to figure out how to recapitalize the banks. I don't envy the people who are working on that one. Maybe there is some magic somewhere, but as we saw with Bear Stearns, at the end of the day it is all about adequate capital.
The GSE companies should be adequately capitalized and broken up into much smaller firms that would not be too big too fail in the future, and put under a regulator that would enforce reasonable leverage limits, with the profits going to pay back the US taxpayer before any profits or dividends are paid to any other future owners.
That is, if the government takes the two GSEs and puts capital (probably in the form of loans and guarantees) into them, which puts taxpayers at risk, then allows a public offering of the smaller entities to raise capital to repay the loans, any shortfall should be made up by the issuance of preferred shares, and the common shareowners would wait until the government loan was repaid before they would be eligible for a dividend.
And the people responsible for creating the leveraged systems, the board, et al., should be forced to resign. New top management all around.
The ultimate goal should be for taxpayers to get their money back and any guarantee, implicit or explicit, to be removed. No mortgage bank should ever again be allowed to be too big too fail.
Now, taken as a part of the total credit crisis, which will run to over $1 trillion (at least), $25 billion may not seem like a lot. But I hope this is a wake-up call for better regulations and safeguards.
And before I go, let me reiterate my call for regulators to force banks to move their credit default swaps to an exchange. The potential for a blow-up is serious, and it could dwarf the current credit crisis. I am not saying it will happen, just that it could. Even a low-risk event should be protected against. Credit default swaps are legitimate business transactions. They are very useful. They should just be put on an exchange, like futures or options, where there is 100% transparency as to counterparty risk.
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