The Times Online is reporting US Treasury rescue for Fannie Mae and Freddie Mac

US TREASURY secretary Hank Paulson is working on plans to inject up to $15 billion (£7.5 billion) of capital into Fannie Mae and Freddie Mac to stem the crisis at America’s biggest mortgage firms.

The two companies lost almost half their market value last week as rumours of a government bail-out swept the stock markets, hammering share prices around the world.

Together, the two stockholder-owned, government-sponsored companies own or guarantee almost half of America’s $12 trillion home-loan market and are vital to the functioning of the housing market.

The capital-injection plan is said to be high on a list of options being considered by regulators as a means of restoring confidence in the lenders. The move would protect the American housing market, but punish shareholders in both companies.

Under the terms of the proposed move, the US government would receive a new class of shares in exchange for the capital, which would be hugely dilutive to shareholders.

…The funding lines allow Freddie and Fannie to buy mortgages from America’s commercial banks, which it then sells on to bond investors through securitisations. A government guarantee on the company’s debts allows it to raise money cheaply, making mortgages cheaper to finance for US banks.

Some in Wall Street believe a rescue plan may be announced ahead of tomorrow’s US market opening to calm nerves and support the debt auction.

Bloomberg adds Fannie, Freddie in Talks With Treasury About Funding

July 13 (Bloomberg) — Fannie Mae and Freddie Mac are in talks with Treasury, Federal Reserve and White House officials to come up with funding plans should the beleaguered mortgage companies require financing, according to people with knowledge of the discussions.

Freddie Mac is scheduled to sell $3 billion in short-term notes tomorrow. The Treasury Department is expected to make an announcement about the talks later today. Officials are negotiating plans for a possible funding backstop mechanism in case the McLean, Virginia-based company can’t find enough investors for the debt, said the people, who declined to be identified because the negotiations haven’t been announced.

Freddie Mac tumbled 47 percent in New York Stock Exchange composite trading last week and Washington-based Fannie Mae lost 45 percent of its value, forcing U.S. Treasury Secretary Henry Paulson to pledge support for the companies. Fannie Mae and Freddie Mac are critical for the housing market because they guarantee almost half the $12 trillion in outstanding U.S. mortgages.

Treasury is not expected to take immediate action today, these people said. Officials are debating several options and may simply reiterate a July 11 statement of support for the companies while they gauge investor demand for Freddie Mac’s note sale.

Other Options

Other options down the road include injecting billions of dollars in new capital into the companies, though Fannie Mae and Freddie Mac want to limit government involvement, the people said.

The New York Times reports U.S. Weighs Takeover of Two Mortgage Giants

WASHINGTON — Alarmed by the growing financial stress at the nation’s two largest mortgage finance companies, senior Bush administration officials are considering a plan to have the government take over one or both of the companies and place them in a conservatorship if their problems worsen, people briefed about the plan said on Thursday.

The companies, Fannie Mae and Freddie Mac, have been hit hard by the mortgage foreclosure crisis. Their shares are plummeting and their borrowing costs are rising as investors worry that the companies will suffer losses far larger than the $11 billion they have already lost in recent months. Now, as housing prices decline further and foreclosures grow, the markets are worried that Fannie and Freddie themselves may default on their debt.

Under a conservatorship, the shares of Fannie and Freddie would be worth little or nothing, and any losses on mortgages they own or guarantee — which could be staggering — would be paid by taxpayers.

The government officials said that the administration had also considered calling for legislation that would offer an explicit government guarantee on the $5 trillion of debt owned or guaranteed by the companies. But that is a far less attractive option, they said, because it would effectively double the size of the public debt.

…The companies are by far the biggest providers of financing for domestic home loans. If they are unable to borrow, they will not be able to buy mortgages from commercial lenders. In turn, that would make it more expensive and difficult, if not impossible, for home buyers to obtain credit, freezing the United States housing market. Even healthy banks are reluctant to tie up scarce capital by offering mortgages to low-risk home buyers without Fannie and Freddie taking the loans off their books.

Together the two companies touch more than half of the nation’s $12 trillion in mortgages by either owning them or backing them. They hold more than $1.5 trillion of the mortgages as securities. Others are sold to investors in the form of mortgage-backed bonds.

In recent weeks, the companies have spiraled downward, undermined by declining confidence in their future and shaken by sharp declines in their assets as the housing markets have continued to slide and foreclosures have risen.

Minyanville adds Fannie, Freddie Expecting Bailout

The US Government will not explicitly guarantee the debt of Fannie and Freddie, but rather will either inject capital (super senior preferred stock subordinated debt a la a Continental Illinois style bailout) or provide a “make-whole” guaranty on the assets of both companies (a la an FDIC/RTC style failing bank resolution). The choice of the former suggests a “going concern” for the GSEs, while the latter suggests an orderly wind-down.

In either case there’s considerable historical precedence. And either choice implies that the common stock of both companies is worthless and the preferred stock value is at best uncertain.

If Freddie and Fannie are placed into conservatorship and are wound down (the second choice), I expect that the US mortgage market will move quickly to the covered bond format that is common to the Europe mortgage market. (And for a quicker primer click here.)

…Finally, I have no doubt that both the Treasury Department and the Federal Reserve have been working on a contingency plan for the GSE’s for some time. I further believe that key members of Congress are already poised to act with whatever legislation is necessary for a quick, but more importantly certain, resolution of this issue.

Which, given that today is Friday, will come Sunday night before the market open Monday morning in Asia.

Bloomberg reports IndyMac Seized by U.S. Regulators Amid Cash Crunch

July 11 (Bloomberg) — IndyMac Bancorp Inc. became the second-biggest federally insured financial company to fail today after a run by depositors left the California mortgage lender short on cash.

The Federal Deposit Insurance Corp. will run a successor institution, IndyMac Federal Bank, starting next week, the Office of Thrift Supervision said in an e-mail today. Customers will have access to funds this weekend via automated teller machines.

The Pasadena, California-based bank specialized in so-called Alt-A mortgages, which didn’t require borrowers to provide documentation on their incomes. Its home state has been among the hardest hit by foreclosures.

…IndyMac becomes the largest OTS-regulated savings and loan to fail and second-biggest financial institution to close behind Continental Illinois in 1984, according to the FDIC.

Bloomberg reports Bank of America’s Lewis Expects Recovery in Mid-2009

July 9 (Bloomberg) — Bank of America Corp. Chief Executive Officer Kenneth Lewis expects the economy to begin recovering from the housing crisis in the middle of next year.

“Until then, depending on what sector of the economy you’re in, it will feel slow and may feel like a recession,” Lewis, 61, said today in prepared remarks in Los Angeles.

Bank of America last week became the biggest U.S. mortgage lender after completing the $2.5 billion acquisition of Countrywide Financial Corp. It plans to rework at least $40 billion in troubled loans over two years to keep more than 250,000 families in their homes, Lewis said. Foreclosure filings rose 48 percent from a year earlier in May as banks repossessed twice as many homes, RealtyTrac Inc. said in a June 13 report.

Deteriorating housing prices, rising unemployment and record oil prices pushed U.S. consumer confidence to a 28-year low last month. Lewis said that’s the “challenge we’re facing as we work to revive our housing markets and our economy.”

Bank of America, the second-biggest U.S. bank, fell $1.48, or 6.3 percent, to $22.06 as of 4:10 p.m. on the New York Stock Exchange. The Charlotte, North Carolina-based company has lost more than half its value in the past year.

JPMorgan Chase & Co. CEO Jamie Dimon said yesterday that buyers are returning to some types of mortgage products and the crisis in the capital markets will ease.

People with a horse in the race will always have an agenda. Does anyone believe these guys? If anyone did, surely someone would be buying financial stocks right now. Hmmm.

BKX Index

Bank of America

JP Morgan

Citigroup

Fannie Mae

Freddie Mac

Indymac Bank

Wells Fargo Bank

Washington Mutual

Merrill Lynch

Wachovia Bank

SunTrust Bank

Morgan Stanley

Goldman Sachs

General Motors

Lehman Brothers

 There you go. A few talking heads may say that they feel the credit crisis is over, but, clearly, nobody is buying it. Literally.

These programs were born from the Great Depression, to help breath life into the ecomony by providing affordable mortgages.  In 1960, Fannie Mae was privatized, though popular belief was that there has always been an inherent Government backing.  The agencies say that they are well capitalized, but are leveraged 50-to-1…meaning that for every dollar of cash, they have loaned out $50. You can see that it doesn’t take too many loan defaults to make them insolvent. Now, the stage has been set for both Fannie Mae and Freddie Mac to once again become Nationalized.

The New York Times reports Mortgage Fears Cast Shadow Over 2 Agencies

As home prices decline and Washington struggles to end the economic malaise, Wall Street is starting to send a sobering message: The worst is yet to come.

One of the strongest warning signs came as the week began, when shares of the nation’s most important mortgage companies, Fannie Mae and Freddie Mac, plummeted. After falling almost continuously over the past month, Freddie Mac tumbled another 18 percent and Fannie Mae lost 16 percent on Monday amid concerns that the companies would need to raise billions of dollars in fresh capital.

With renewed prospects for turmoil in the financial markets, global stocks fell Tuesday from Sydney to Stockholm.

“Across the board, there are probably more write-downs to come,” said Florian Esterer, a fund manager at Swisscanto Asset Management in Zurich. Investors need to look beyond the subprime problems, he said, and consider the decline in the quality of home-equity loans, credit card debt and commercial real estate — problems associated with the end of a “traditional credit cycle.”

Banks seem to be “in denial” about the degree of problems, he said, adding, “I think there is much more pain to come than they are telling you.”

Fannie Mae and Freddie Mac are the nation’s largest buyers of home mortgages, and traditionally the government’s backstop for the housing economy. But with the plunge Monday, each of these “government-sponsored enterprises” has now lost more than 60 percent of its market value this year. The declines, along with a falling stock market and growing unease about the possibility of more losses at big banks, reflect a growing consensus among investors that the current housing slump will last longer, and prove more severe, than initially feared.

…“If Fannie or Freddie ever became critically undercapitalized, their regulator would have no choice but to put in place a taxpayer rescue,” said Karen Shaw Petrou, managing partner of Federal Financial Analytics, a consulting company.

To ward off that possibility, in recent weeks, Mr. Bernanke and Treasury Secretary Henry Paulson Jr. have both urged Freddie Mac and Fannie Mae to raise additional capital from investors.

But as share prices at the companies have declined, raising new funds has become increasingly difficult. Freddie Mac, for instance, said May 14 that it intended to sell $2.75 billion in new common stock to investors. Since then, the company’s stock price has declined by 56 percent.

As a result, Freddie Mac will have to issue more than twice as many shares to raise the new funds. When those new shares hit the market, they are likely to further push the company’s stock price down, and make it even harder for Freddie Mac to recover when the market eventually rebounds.

Similar problems are likely to plague investment banks and other financial firms also hoping to raise new money. So, as the housing market declines, there are new concerns that the financial spigot that keeps Wall Street and the economy afloat may be closing.

It is unclear precisely why Fannie Mae and Freddie Mac suffered so greatly Monday. Early in the day, analysts at Lehman Brothers estimated that a proposed change in accounting rules would require the companies to raise about $75 billion in additional capital — an enormous sum for two companies that have already asked investors for $25 billion since December.

Bloomberg reports Freddie Mac, Fannie Mae Plunge on Capital Concerns

As mortgage delinquencies grow at a record pace, the companies likely will take further losses, Tierney said. Banks repossessed twice as many homes in May as they did a year ago and foreclosure filings rose 48 percent, according to RealtyTrac Inc., a real estate database in Irvine, California. Home prices in 20 U.S. metropolitan areas fell 15.3 percent in April by the most on record, S&P/Case-Shiller home-price index.“There’s probably an accumulation of events today that has focused investor selling,” said Christopher Sullivan, who oversees $1.3 billion as chief investment officer at United Nations Federal Credit Union in New York.Fannie Mae and Freddie Mac were both trading at more than $60 as recently as October as they distanced themselves from accounting frauds that caused more than $11 billion of restatements. Then defaults on subprime mortgages caused the credit markets to seize up and credit losses to rise. The companies, which own or guarantee almost half of the $12 trillion in U.S. residential mortgages, were so integral to boosting the housing market that Congress lifted restrictions on their buying power to help revive the economy.

…The new FAS 140 rule that seeks to stop companies keeping assets in off-balance sheet entities may force Fannie Mae and Freddie Mac to bring mortgages back onto their books, requiring them to put up capital, Lehman analysts led by Bruce Harting wrote in a note to clients today.

Fannie Mae would need to add $46 billion of capital and Freddie Mac would need about $29 billion, the Lehman analysts wrote. 

Mish asks…Fannie Mae holds or guarantees over $5 trillion in mortgages. A mere 1% decline would wipe them out. Is that adequately capitalized?

Watch this Video on Yahoo Finance We’re All Homeowners: Nationalization of Fannie, Freddie Unavoidable

Fears about Fannie Mae and Freddie Mac retreated somewhat Tuesday after their federal regulator, OFHEO Director James Lockhart, said new accounting rule changes should make “no difference in the risks of the two firms.”On Monday, Freddie and Fannie shares plummeted after a Lehman Brothers analyst said a new FASB rule could require the two firms to write-down as much as $75 billion.

Rather than the accounting rules, what’s really got investors spooked is a growing realization the government will have to nationalize Fannie and Freddie, says Kevin Depew, executive editor of Minyanville.com.

The two mortgage lenders are simply too big to fail and too critical to the housing market, Depew says. Given Fannie and Freddie own or guarantee 50% of all housing debt, according to the WSJ, continued stress on their balance sheets means higher borrowing costs for the firms, and ultimately higher mortgage rates for individuals. It also means another round of write-downs for the battered financial sector generally, which owns a lot of Fannie and Freddie-backed paper.

But nationalizing the firms, each created by an act of Congress, would mean a wipeout for equity holders, who have already seen their holdings decimated in the past year.

The nationalization of Fannie and Freddie and would put U.S. taxpayers on the hook for the socialization of the housing market, but Depew says we’re already there whether we know it or not.

The National Association of Realtors reports Home Sales to Vary in Narrow Range, Then Rise in Second Half

WASHINGTON, July 08, 2008

Modest near-term movement is expected in existing-home sales, with a recovery in sales seen during the second half of the year, according to the latest forecast by the National Association of Realtors^®.

The Pending Home Sales Index,* a forward-looking indicator based on contracts signed in May, fell 4.7 percent to 84.7 from an upwardly revised reading of 88.9 in April, and remains 14.0 percent below May 2007 when it stood at 98.5.

Lawrence Yun, NAR chief economist, said some pullback after a sharp increase in the previous month was expected. “The overall decline in contract signings suggests we are not out of the woods by any means. The housing stimulus bill that is still being considered in the Senate is critical to assure a healthy recovery in the housing market, jobs and the economy,” he said.

The PHSI in the West slipped 1.3 percent to 97.5 in May but is 2.0 percent higher than May 2007. In the Northeast, the index declined 2.9 percent to 77.0 in May and is 16.4 percent below a year ago. The index in the Midwest fell 6.0 percent to 78.6 and is 13.8 percent below May 2007. In the South, the index dropped 7.1 percent in May to 84.5 and is 22.1 percent below a year ago.

Yun said location has never mattered more than in the current market. “Some markets have seen a doubling in home sales from a year ago, while others are seeing contract signings cut in half. Price conditions vary tremendously, even within a locality, depending upon a neighborhood’s exposure to subprime loans.”

Double-digit pending sales gains in May from a year ago were noted in Colorado Springs, Colo.; Sacramento, Calif.; and Spartanburg, S.C.

NAR President Richard F. Gaylord, a broker with RE/MAX Real Estate Specialists in Long Beach, Calif., said the current market offers immediate benefits and long-term value for many buyers. “Home buyers are getting a great deal right now,” he said. “Although inflationary expectations appear to be under control for the time being, sharper consumer price gains could lead to notably higher mortgage interest rates in 2009.”

Based on current indicators, the 30-year fixed-rate mortgage is forecast to rise gradually to 6.5 percent by the end of this year, and then hold at that level for most of 2009. NAR’s housing affordability index is improving this year and is likely to rise 15 percentage points to 127.0 for all of 2008.

Existing-home sales are expected to grow from an annual pace of 5.01 million in the second quarter to 5.75 million in the fourth quarter. For all of 2008, existing-home sales should total 5.31 million, and then increase 5.0 percent next year to 5.58 million.

“The speed at which home prices has declined in a few select markets is unprecedented, but the large price declines in those areas have enticed bargain hunters back into the market,” Yun said. “Interestingly, there have been reports of multiple bidding after the large price cuts, so it is possible that most of the price declines have already occurred in those markets.”

The aggregate median existing-home price is projected to fall 6.2 percent this year to $205,300, and then rise by 4.3 percent in 2009 to $214,100.

New-home sales are likely to fall 32.3 percent to 525,000 in 2008 and decline another 3.4 percent next year to 507,000. “In light of high inventory conditions, rising commodity prices and construction costs will curtail new home construction deep into 2009,” Yun said. Housing starts, including multifamily units, will probably fall 28.7 percent to 966,000 this year, and then drop another 9.0 percent in 2009 to 879,000.

The median new-home price is expected to decline 3.2 percent to $239,300 this year, and then rise 5.3 percent in 2009 to $251,900.

Growth in the U.S. gross domestic product (GDP) is seen at 1.6 percent in 2008 and 1.4 percent next year. The unemployment rate should average 5.4 percent this year and 5.8 percent in 2009.

Inflation, as measured by the Consumer Price Index, is forecast at 3.7 percent this year and 2.4 percent in 2009. Inflation-adjusted disposable personal income is projected to grow 1.5 percent in both 2008 and 2009.

The National Association of Realtors^®, “The Voice for Real Estate,” is America’s largest trade association, representing 1.2 million members involved in all aspects of the residential and commercial real estate industries.

Today, Indymac Bank joined the list of imploded mortgage lenders.

Here is the letter from the CEO to it’s shareholders:

Indymac Issues Stakeholder Letter
July 7th, 2008
Dear Indymac Stakeholders:

In this very difficult and challenging environment, any of the actions that we take to keep Indymac safe and sound unfortunately have negative consequences to some important constituency. As we stated in our financial update on May 12, 2008, we have been working with our investment bankers to raise additional capital. To-date, we have not been successful with these efforts, and, while we will continue these efforts with our bankers and others, we don’t expect to be able to raise capital until there is more stability and less uncertainty in the housing and mortgage markets. While some shareholders may believe it is in their best interests that we not raise capital right now given the significant dilution that it would cause, there are consequences of not being able to raise more capital and, therefore, actions that we now must take.

Given the continued downward trend in home prices and a resulting increase in our forecasted credit losses and the related downward trend in the pricing of all mortgage related assets in the capital markets, especially mortgage-backed securities where we have experienced significant rating agency downgrades this quarter, we expect our loss for the second quarter to be larger than Q108, but it is difficult at this time to be more precise given the significant uncertainty surrounding accounting estimates, fair value accounting and other accounting matters.

In light of the current environment and related deterioration of our financial position since last quarter, we have been working closely with our federal banking regulators with respect to the actions that they and we must take to meet our mutual goal of keeping Indymac safe and sound through this crisis period. In that respect, based on information we have provided to our regulators, they have advised us that we are no longer “well capitalized”, which we stated on May 12 was a possible scenario. Our regulators have also asked us to submit to them a new business plan for their review and approval, something on which we have been working with them for some time. We have agreed on the basic elements of the plan, and the regulators have directed us to begin executing on it. An important element of our plan is to improve our capital ratios. Without an external capital raise, the traditional way to improve safety and soundness is to sell assets and shrink the balance sheet, which in normal times generally has the effect of improving capital ratios and bolstering liquidity. Yet in this environment, where either there are no bids for most of IMB’s mortgage loans and securities or the bid/ask spreads are abnormally wide, “fire-selling” assets would actually deplete capital further. As a result, the most realistic and cost-effective way to shrink both our balance sheet and our servicing rights asset (which, as discussed in previous communications, is up against the regulatory cap limit), is to curtail most new loan production.

In addition to needing to shrink our assets to improve our capital ratios, we also need to do so to ensure that we maintain prudent operating liquidity. A consequence of falling below well-capitalized is that we are no longer permitted to accept new brokered deposits or renew or roll over existing ones, unless we get a waiver from the FDIC. While we have submitted a waiver application, it is uncertain as to whether such a waiver will be granted.

As a result of the above, we have made the difficult decision, effective July 7, 2008, that we will no longer accept any new loan submissions or rate locks in our retail and wholesale forward mortgage lending channels, except for our servicing retention channel. We plan to honor all of our existing rate-locked loans and will continue to fund these loans in the coming weeks. While the managers and employees in these units have worked incredibly hard, these units are not currently profitable due to the continuing erosion of the housing and mortgage markets. At the same time, these operations take up significant balance sheet capacity and “feed” growth in the servicing asset, an asset we need to shrink given its size relative to our existing capital.

In closing our forward mortgage business, we will refocus our lending efforts on supporting and building within regulatory constraints Financial Freedom, our reverse mortgage unit (FHA production only), and on continuing the retention activities associated with our servicing portfolio. Combined, we currently expect these units to produce roughly $5 billion to $10 billion per year of new FHA/GSE loans. Thus, our core business model will include (1) Financial Freedom, one of the largest reverse mortgage lenders in the Country; (2) a top ten mortgage loan servicing operation, with a solid retention production unit; and (3) a Southern California retail bank branch network, including 33 branches and roughly $18 billion in deposits, of which over 96% is fully covered by FDIC insurance. In addition, when this housing and mortgage crisis abates and we return to health, we would also hope to be an investor in mortgage loans and mortgage-backed securities and might re-enter the national forward mortgage production business with a low-cost, non-commissioned-based business model.

Unfortunately, the above actions will necessitate the reduction in our present workforce from approximately 7,200 to roughly 3,400 or so over the next couple of months, which should reduce our operating expenses by roughly 60%. We will retain about 1,100 employees in loan servicing in Kalamazoo and Austin; 350 in our servicing retention group in Irvine and Kansas City; 800 at Financial Freedom, primarily in Irvine, Sacramento, and Atlanta; 400 in our Southern California retail and web bank; 500 in portfolio management and administration, largely in Pasadena; and 250 in discontinued businesses. In building Indymac up from 4 employees in 1993 to its present size, we have had to retrench and then rebuild several times over the past 15 years, but clearly these are the largest and most difficult staff reductions we have ever had to make. If we had another alternative, we clearly would have chosen it, as we understand how painful these workforce reductions can be for the affected employees and their families. Given Indymac’s current financial position and these significant layoffs, I strongly believe it is appropriate that I further materially reduce my own compensation. As a result, I have requested of Indymac’s Board of Directors that they reduce my base salary by 50%.

With respect to severance, our policy has always been that the fair and right thing to do is to provide our departing employees with a generous severance program to ease their transition to the next stage of their career. Our severance program, which provided one month of pay and one month of Indymac-paid COBRA insurance coverage for each year of service, was clearly the most generous in the mortgage industry, if not among most of the Fortune 500. I very much regret that the reality today, however, is that we can no longer afford this program given our need to preserve capital and return to profitability. Therefore, we will be providing employees with a minimum 30-day notice of the termination of their employment (effectively, 30 days severance), with employees covered under the Federal WARN Act and similar state statutes (“WARN”) receiving 60 days of advance notice prior to the effective date of the their termination. Affected employees with five or more years of service will receive a minimum $20,000 severance, including any compensation payments made during the notice period.

With all of the above said, in this environment plans can change often and quickly (e.g. ability to raise capital and/or liquidity, regulatory actions, etc.). All we can do is continue to work hard and do our very best to keep Indymac safe and sound, so that we can rebuild our workforce and shareholder value when the housing and mortgage markets stabilize. We will be providing more information on our plans and prospects when we release Q208 earnings.

Very truly yours,

Michael W. Perry
Chairman and Chief Executive Officer

Minyanville explaines Inflation and Deflation in How the Bubble Bursts

Now that we’re getting a taste of what deflation is, it’s easier to talk about. Before, I tried to describe what to expect and how to deal with it, but in a way that was difficult for the average person to understand - especially when the government, the Fed, and Wall Street continue to misrepresent it.

Now that we’ve seen the beginning stages of deflation, it’s becoming clearer what’s going on and what’s important: to conserve capital. To save.

So let’s review what inflation and deflation really are.

People who had no business borrowing took money from people who had no business lending. This drove the prices of the cars and house they bought with that money up, while the debt drove the value of the currency down. This doubles the pressure on the prices of things we get from other countries - like oil.

So it isn’t hard to convince people that inflation means rising prices, because rising prices almost always occur when the money supply’s inflated with debt.

In 2007, we reached a point where there was just too much debt; no one could take on any more. This is where the Fed’s inflation machine breaks down: If no one can borrow or lend on the credit they offer the banking system, the money supply stops expanding. In fact, as people try to pay off all that debt (retire it) or default on it (destroy it), the money supply, bloated with debt, begins to shrink.  Hence deflation.

What does the Fed do then? Why, they buy that debt themselves, to try to keep the money supply from deflating. This leads to those TAF (term auction facility) auctions you’ve heard about, where the Fed exchanges new capital (t-bills) for bad debts with banks.

Despite these efforts, the money supply has probably deflated by the amount of write-offs — by now, approximately $400 billion — that banks have incurred. Strict measures of money supply, like M3, haven’t fallen - but that doesn’t include the most important broad sources of new money, like derivatives and securitized loans. As the money supply deflates, people borrow less and spending goes down. The deflation thus feeds on itself, because lower spending means lower income and debt becomes even harder to support. Prices in stocks begin to fall as the money supply dwindles.

The traditional definition of inflation (rising prices) and deflation (falling prices) don’t make sense in today’s world. That’s why people are confused. Ironically, the Fed wants you to be this confused, because it’s actually they who create inflation - which plants the seeds for eventual deflation.

Inflation’s just the expansion of the money supply, almost always through the expansion of debt. This is what the Fed does: They create debt out of thin air and pass that debt on to the banking system by extending credit; banks then extend it to consumers.

From 1993 to 2006 the Fed created massive inflation by creating massive debt, keeping real interest rates negative and supplying plenty of credit to keep them there. This was particularly true from 2001 to 2006; in 2006 alone the Fed expanded the money supply by creating $4 trillion in new debt.

…When a bank takes a write-off, debt gets smaller - but we still have a long way to go. How long? Well, the level of debt’s currently four to five times greater than is normal for our economy; the natural level of income and savings aren’t enough to support the debt. Debt will get destroyed — and the money supply will deflate — until debt and actual savings are more balanced.

If you understand inflation and deflation in this way, our current crisis makes more sense. Now we’re seeing deflation (a shrinking money supply and lost liquidity), which is causing havoc in markets.

…For decades, but especially over the last seven years, central banks have “solved” any and all market dips, slowing economies, and financial problems by creating debt. If the stock market declines, just make it easy to borrow, so people can buy stocks. If the economy slows, just make it easy to borrow, so people can consume more. This methodology may work on occasion, but doing it systematically leads to crisis.

PMI released their latest Economic Real Estate Trends Report: Accelerating Housing Price Declines

And, The Wall Street Journal suggests that Congress is debating if Indymac is too big to fail

Minyanville adds IndyMac?

Spun out of Countrywide (CFC) in the late 1980s, IndyMac is a Southern California thrift and mortgage originator specializing in loans a couple of notches above subprime. Known as “Alt-A,” these mortgages thrived during the credit boom, when verifying a borrower’s income was considered due-diligence overkill.

IndyMac aggressively issued these loans, along with billions in option adjustable rate mortgages, or option ARMs, to become the country’s second largest private mortgage lender. Countrywide is was number one.

Since the mortgage market stumbled last year, however, IndyMac’s shares have plummeted. They now sit at just 70 cents per share, down from over $47 in December 2006.

Thanks to Senator Chuck Schumer, the Federal Reserve may need to decide whether IndyMac’s potential demise is too great a risk for the fragile financial system to bear.

…By orchestrating a bailout of Countrywide by Bank of America (BAC), as well as of Bear Stearns by JP Morgan (JPM), the Fed set a dangerous precedent. While there may have been sound arguments for saving these firms to prevent outright financial panic, can the same be said about IndyMac, a bank with a market capitalization of just $70 million?

And what about KeyCorp (KEY), Fifth Third (FITB) or Zions Bancorp (ZION), all of which have recently gone to the rapidly closing financing window?

These are questions regulators must answer, and soon.

Struggling companies — especially banks — need to go bust, in order to stimulate healthy new growth. The Fed’s propping-up of doomed institutions only forestalls or hampers this process.

The financial system is bloated with firms that should go out of business - and it’s time that it went on a diet.

Sales in June have grown to the highest levels in sometime, lead by strong REO sales in the hardest-hit areas. The same trends that we’ve been watching are continuing: a growing share of distressed homes for sale and increased sales among that demographic.

 Inventory Watch Report