GM, Fannie, Lehman: Too big to fail?
Or too big to save?

by Martin D. Weiss, Ph.D.
Money and Markets

Larry Edelson

If you're worried about the IndyMac Bank failure on Friday — America's third largest in history — brace yourself.

This crisis is about to get uglier. And in this double-length issue, I'm not going to pull any punches.

General Motors is now nearer to bankruptcy than at any time since it nearly failed in 1920.

Its bonds are junk. Its sales are in shambles. Its management is in denial — quick to issue statements to stem investor fears, but slow to make decisions to avert financial disaster.

Even Wall Street, which typically sees the world through rose-colored glasses, estimates GM has a 75% chance of going broke within the next five years, based on the actual trading of specialized insurance contracts called credit default swaps. That's 3-to-1 odds the company will not survive!

Meanwhile, the company's shares are down the toilet, the lowest since July 1954. The last time they sold at this level, John Kennedy was a first-year rookie Senator from Massachusetts ... Elvis was a truck driver ... and the oldest of the Beatles was barely 14.

In its heyday, General Motors was a $66 billion company with nearly half of the U.S. auto market. Today, it's a $5 billion company with less than one-fifth of the U.S. market.

Hard to believe, but true: Right now, in terms of the total value of shares outstanding, our country's largest maker of real cars is actually smaller than Mattel, a maker of toy cars.

Moreover ...

GM is not alone. Ford's 5-year probability of failure is 70%, according to the trading of default swaps, and Chrysler's chances of survival seem to be even slimmer.

Result: Nearly one in five auto loans or leases today is subprime. More than HALF of those will end up in default, according to the National Bureau of Economic Research.

Problem: General Motors owns nearly half of the parent, GMAC. Worse, if GMAC has trouble borrowing, it will be unable to dish out easy credit to GM's customers. And if GM's customers can't get car loans, they can't buy cars.

So now do you see why the market sets the odds against GM's survival at 3-to-1 ... why investor speculation about a GM bankruptcy is spreading ... and why the company's shares have lost nearly 89.5% of their peak value?

And mind you: All this has happened before the recession deepens, before interest rates go up significantly and before the consequences of these — or other — corporate failures. But before you ponder those consequences, don't forget ...

Fannie Mae!This supergiant isn't just on a collision course. It's already the subject of government contingency plans for a takeover that would obliterate shareholders and devastate taxpayers.

Here too, high officials have issued denials faster than a spitting spider.

Here too, the talk and speculation have been rampant.

But the bare bones facts are undisputed: Even according to Fannie and Freddie's own, murky year-end 2007 statements ...

Fannie Mae has just 1.6 cents in core capital to cover each dollar of mortgage and debt exposure. Its younger and smaller sibling, Freddie Mac, has only 1.9 cents.

Adequate?

According to government regulators who owe their very existence to the two mortgage giants they regulate, yes.

According to analysts, accountants and auditors who can add two plus two, no.

That's why William Poole, former president of the St. Louis Federal Reserve, declared last week that the two companies were already insolvent.

And that's why investors have driven their share prices down as quickly as they did Enron and WorldCom's six years ago. Damage so far: Fannie Mae is down 88.5% from its peak; Freddie Mac, 89.6%.

So whom should you believe? The high officials or the market wisdom?

Considering the reluctant admission made last week by Treasury Secretary Paulson about home foreclosures — that he expects 2.5 million this year alone, and ...

Considering the no-brainer forecast made by Bernanke — that this crisis will last deep into 2009 ...

It's a moot point — you need not believe anyone. All you have to do is look ahead into the future and you will see that ...

Fannie Mae and Freddie Mac may escape the fate of Bear Stearns — a Wall Street crisis of confidence that delivers instant failure. But can they escape the unfolding reality on the ground — millions of additional home foreclosures this year and next?

It's common sense: By the time a home they've financed is foreclosed, the mortgage has long been in default. And when the mortgage goes into default, Fannie or Freddie is on the hook.

Paulson and Bernanke

So how can Bernanke and Paulson keep a straight face while denying the natural consequences of their own admissions?

The fact is, they can't. In testimony before Congress last week, they were at a loss for words.

They knew that if they spoke the truth, it would only deepen the panic on Wall Street. But they're also beginning to realize that twisting the truth isn't socially responsible either. In the long run, it only foments distrust and more panic.

Lehman Brothers' death spiral is, in some ways, even more troubling: If it fails, it will send the message that all the Fed's horses and all the Fed's men can't put this Humpty Dumpty back together again.

Remember: Ben Bernanke and his cohorts have already put the muscle of America's central bank behind primary broker-dealers like Lehman. If it turns out that even that is not enough to stem an exodus by trading partners and clients, what is?

Many investors aren't waiting around for the answer. By the closing bell on Friday, they had driven Lehman's stock down by 83.3% from its peak, all in less than 17 short months.

Meanwhile, the cost of protecting Lehman Brothers debt from default rose last week to the highest in almost four months, signaling the greatest danger of failure for Lehman since the Bear Stearns collapse.

What kind of protective action is Lehman taking? Not much. Nearly all of the ticking time bombs on its books at the end of its first fiscal quarter — mortgage-backed securities that are hard to value and harder to sell — were still on its books at the end of its second quarter, according to the firm's own statements.

It seems the most Lehman could do was to get rid of 2.7% of the stuff. Worse, in proportion to the firm's total assets, these high-risk securities, called "Level 3" assets, actually rose from 5.4% to 6.5%.

You'd think the smart folks at Lehman — the same people who warned us about the dangers at Fannie Mae early last week — would have the brains and guts to run for cover. Instead, the mindset seems to be:

"Why bother? If we mess up, Uncle Ben Bernanke is ready to pick up after us. Yeah, we lost another $2.87 billion in our second quarter. But so what? With the almighty Fed as our backstop, we were actually able to raise $6 billion of fresh capital in the very same week we announced the loss."

Dear Subscriber — therein lies the true tragedy of our times:

Our entire financial system is at risk. But the biggest risk-takers, largely shielded from the pain, are being encouraged to dig us into a still deeper hole.

I just hope you've been reading these Money and Markets emails regularly. Because if you have, you know that ...

The Climax of This Tragic
Screenplay Was Largely

Foreshadowed in the First Act

It wasn't hard to see. The main challenge was just opening your eyes. That's how ...

Over a year and a half ago, in our Money and Markets of October 2, 2006, I was able to write:

"America's two largest auto giants, Ford and General Motors, are on a collision course with bankruptcy. Yet most American investors don't seem to care.

"Instead, they're buying up big Dow stocks like American Express, AT&T, Citigroup, DuPont, General Electric, Hewlett-Packard, Merck, JPMorgan Chase and Microsoft ...

"Some are even bidding up the shares in the auto companies themselves. That's how General Motors has managed to recover from $19 per share in April to as high as $33.64 on Thursday. That's how Ford also rose from just over $6 per share in July to as high as $9.48 on September 13.

"It's a classic case of complacency despite overwhelming evidence of darker clouds."

I went on to describe "the horror story of rapidly declining sales," "the horror story for auto workers and their towns," "the horror story for shareholders" and the "horror story for the future."

Now, that future is here. And my conclusion this morning is the same as my conclusion then: "If you own GM or Ford stocks or bonds, what are you waiting for? It doesn't matter what you paid for them ... get out."

Missed that issue? Then how about our warning of March 12, 2007 that the "torrent of red ink at Detroit's Big Three is NOT ending" — or the alert Mike Larson and I put out November 20, 2007 that GM shares were about to break down?

Ditto for Fannie Mae ...

September 6, 2005, "The Great, the Awful and the Scary" — "Fannie Mae ... typifies what I see happening now and in the future with financial stocks. It has plunged from over 89 in late 2000 to as low as 49.20 ... [and now] it remains perilously close to a major new breakdown."

Martin D. Weiss, Ph.D.

January 6, 2006, "Two Urgent Questions" — "Did you follow our recommendation last year to get the heck out of stocks that sank — like Delphi, Delta Airlines, Fannie Mae, Ford and General Motors? If so, great. If not, the lesson learned could still save you a fortune in the months ahead."

Fannie Mae and Freddis Mac's domination of mortgage industry is very worrisome!
Martin Weiss and Mike Larson
Fannie Mae crashes to lowest level in decade!

June 12, 2006, "The Cycle of Debt and Energy" — "Two shaky companies now control the mortgage market ... and the larger of the two — Fannie Mae — is in deep doodoo. Its accounting stinks to high heaven. Its leadership is mentally constipated. And its entire business model is in danger, especially as Americans begin to default on their mortgages. The big concern: A sudden shortage of money in the mortgage market. An even bigger worry: A panicky reaction by the Fed to pump in even more money and credit, causing still more inflation."

June 25, 2007, "Mortgage Meltdown" — "This crisis is expanding in concentric circles. First, it affected just the niche players in the non-prime mortgage business. Then, it spread to mid-grade mortgages. And now it's hitting Wall Street in the gut. Next, don't be surprised to see investors snub higher quality mortgage-backed securities like those backed by Fannie Mae ... where underlying default rates are also rising."

October 20, 2007, "News flash: Dow breaking down!" — Mike and I wrote, "Most important, as the housing bust wipes away the profit gains of the 1990s, look how much further Fannie Mae could fall — to $20 per share, even $10 per share."

November 26, 2007, "The Next Big Bankruptcy" (about Countrywide Financial) — "What happens when Fannie Mae and Freddie Mac, now cited as agencies that could help ease the pain for many homeonwers, find that they're in the same sinking boat? ... What happens when the U.S. sinks into a recession?"

Lehman Brothers? We also warned you of its troubles — in "Dangerously Close to a Money Panic" (December 3, 2007) ... "Lehman Rumored on the Brink. What Next?" (March 30, 2008) ... "Judgment Day for Wall Street" (March 31, 2008) ... and "Wall Street's Next Titanics" (April 1, 2008).

But all that's water under the bridge. Now, what counts most are these two urgent questions:

Urgent Question #1
Are GM, Fannie and Lehman Too Big
To Fail? Or Are They Too Big to Save?

Wall Street would have you believe they're too big to fail.

They point out that GM still employs more than a quarter million people; and the entire auto-related industry, over four million.

They argue that without Fannie and Freddie, most of the U.S. mortgage market would be toast.

They warn that the demise of a company like Lehman Brothers, so close on the heels of the Bear Stearns collapse, could precipitate an oft-feared Wall Street meltdown ... or worse ... a traumatic shock to the $596 trillion global market for derivatives.

And they conclude that each and every one of these consequences is unthinkable. "The U.S. government," they say, "will simply never let it happen."

Yes, that's certainly the government's intent. And that's likely to be the pattern we see for quite some time.

But it's not quite that simple. Nor is it just a matter of the moral hazard — the concern I voiced earlier that companies under the protective arm of the Fed have a lesser incentive to clean house. The bigger and more immediate issues boil down to these:

Issue #1. Yes, the U.S. government will be able save some of the big companies going bankrupt. But can it save them all? At approximately the same time?

Issue #2. We know the government has vast resources and will print more money out of thin air, as needed. But ultimately, can it do so fast enough to hold back the tide?

Issue #3. If the U.S. government assumes direct or indirect — full or partial — responsibility for Fannie and Freddie's $5 trillion in mortgages, including hundreds of billions that are going sour, what's going to happen to the credit of the U.S. Treasury?

The assumption is that the credit of U.S. Treasury is strong enough to prop up the likes of GM, Fannie and Lehman. But what makes people so sure these sinking companies aren't heavy enough to pull down the credit of the U.S. Treasury?

A far-fetched question requiring a far-fetched answer? Not exactly ...

You may not know this, but General Motors, Fannie Mae and Lehman aren't the only ones sharing the shame of surging premiums for insurance contracts on their possible or probable demise. There are also actively traded credit default swaps on U.S. Treasury securities — bets that the United States government itself may default some day!

As remote as that possibility may be, it doesn't stop institutional investors from seeking protection — or placing bets — on that highly unlikely event.

But here's the clincher: Last week, the cost of those tiny premiums surged far higher than their average levels.

Why? Primarily because of speculation that the U.S. government might assume at least some responsibility for the giant debts of Fannie and Freddie.

This is not what Treasury Secretary Paulson — or anyone in government — wants to hear. But it's an undeniable fact of life: If I'm one of the millions of investors worldwide who have loaned trillions of dollars to the U.S. Treasury, I have a very serious gripe for Mr. Paulson.

My gripe can best be expressed like this: "Mr. Paulson, I lent you my money to run your government. That's what you pledged you'd do with it, and I trusted your pledge. But now you are turning around and diverting my money to third parties — to finance massive, private enterprises on the brink of failure. So I simply cannot trust you any longer. I want my money back. Now!"

My unequivocal forecast: Ultimately, after many rescues, much money pumping and much more inflation, this complaint will be heard from millions of investors. And on that day, the U.S. government will have to make a choice: Save the world or save itself.

The final outcome: There's no question whatsoever in my mind that our nation's leaders — whether elected or appointed, Democrat or Republican — must and will opt for the latter. They will save the U.S. government first and, if push comes to shove, they will let failing companies fail.

Urgent Question #2
What Should You Do Right Now?

My recommendations:

1. If you haven't done so already, shed most of your non-resource stocks. Too late? No. The Dow is still near 11,000. It could easily go to 7200.

2. Build cash. Treasury bills are still the safest haven and Treasury-only money funds are among the most convenient vehicles. Examples: American Century's Capital Preservation Fund, U.S. Global's U.S. Treasury Securities Cash Fund, or our affiliate's Weiss Treasury Only Money Market Fund. They're not insured by the FDIC. But in my opinion, the securities they buy offer protections that are still better than any insurance — the direct backing of the U.S. Treasury Department.

Important: The same cannot be said for bank deposits — let alone for those that are uninsured. A prime, current example: When IndyMac Bank failed on Friday, it had an estimated 10,000 customers holding $1 billion in potentially uninsured deposits. And on the uninsured portions, the FDIC says the depositors will get only 50 cents on the dollar at this time.

Plus, all these vehicles (even including Treasury bills) suffer one disadvantage: They are denominated in sinking U.S. dollars. So you will need to offset that risk by allocating a portion of your money to the world's strongest foreign currencies with instruments like Everbank's WorldCurrency CDs or Rydex's CurrencyShares ETFs. And needless to say, continue to use other contra-dollar investments — such as gold.

3. Protect the remainder of your stock portfolio from stock market declines — or go for significant capital gains — using our favorite inverse ETFs.

4. If you have a personal adviser or money manager, ask if they offer programs specifically designed for protection and profit during bear markets. If not, consider moving your money to one who does.

Good luck and God bless!

Martin

Monday, July 14, 2008. This investment news is brought to you by Money and Markets. Money and Markets is an investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit www.moneyandmarkets.com.
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