The "in your face" signs of the continuing U.S. financial crisis that we have seen this summer (major bank failures and record stock price declines for financial institutions), received a temporary reprieve following the government's decision to prop up Fannie and Freddie. This seems like a temporary patch of the hole in the hull of the Titanic.  Everyone knows that ultimately the ship may sink, but if we can just cover up the hole for awhile and not inspect the hull too closely, it will be smooth sailing.  (Or, as noted in a commentary authored by Tom Millon:  "Welcome to the Titanic.  Would you like a refreshing drink while I rearrange your deck chair?").

The major investment banks - like Citicorp, Goldman Sachs, Morgan Stanley and Lehman Brothers - appear focused on turning around prior bad business decisions by shedding unprofitable investments, recognizing losses and cutting employees. While the Wall Street firms are not quite poised to soar like an eagle, the steps taken by many major commercial banks are more reminiscent of an ostrich.

While we continue to see meteoric rises in loan defaults and the FDIC's "Watch List" no longer fits on a single sheet of paper, there is, as yet, no industry-wide strategy for a permanent repair of the U. S. S. Banking System.  Bank analyst David Ellison, who runs the FBR Small Cap Financial Fund, recently pumped up the cash levels in his two funds to as much as 50% of assets, noting that "too many financial executives remain in denial."  From last week's Wall Street Journal:  "While he is heartened by the industry's recent upturn, he remains wary of chronic woes such as weak loan demand at banks.  The timing of a sector turnaround is impossible to predict," said Mr. Ellison.  His downbeat themes:  No one has any idea how much worse things will get amid poisonous debt lurking inside financial outfits, and this is just the beginning of a complete regulatory overhaul needed to eventually fix the problems."

What is interesting to note is how, from a global perspective, the current crisis differs from prior recessions. (When it costs $110 to fill up the SUV and $250 to purchase groceries and the stock portfolio is oozing red, one can't help but use the "R" word.) 

In days of old, as the U.S. goes, so goes the world.  Financial trends generally started here and then circled the globe.  This time around, in the financial sector, that doesn't appear to be the case. Leading European, Asian and Canadian banks have shown relatively strong performance over the last couple of years, and a certain degree of immunity from the crisis facing U.S. financial institutions.  As a result, their stock prices are, for the most part, hanging on fairly well. 

Contrast U.S. banks Corus (CORS) and Wachovia (WB), with Canada's Bank of Nova Scotia (BNS) and Europe's HSBC (HBC). Two years ago, Corus was trading at $23/per share and Wachovia at $55/share.  At press time, those prices were, respectively, $3.80 and $14.50, declines of 74% to 83%. Meanwhile, up north, BNS traded two years ago at $42/share and closed last week at $48; while, across the pond, HSBC was at $91 two years ago and closed last week at just under $84. These are just a few of many examples here and abroad. 

Why the difference? In a nutshell, U.S. banks are being pummeled for their aggressive lending practices.  During the past five years, many U.S. banks abandoned their Brooks Brothers suits in favor of trendy American Apparel outfits. Conservative 70% loan-to-value ratios were abandoned in favor of 80% loans with a 15% mezzanine piece grafted on. Underwriting based on historical data was abandoned in favor of underwriting based on future pro formas. Geographic restrictions gave way to broader regional measures. 

This did not occur everywhere, of course, and a fair number of well-managed U.S. institutions stuck to their tried and true ways.  Although those "stodgy" institutions "suffered" in the context of limited deal flow over the last few heady years, today those banks are avoiding massive write-offs and enjoying relatively healthy balance sheets. 

Most overseas banks didn't quite see the world like the maverick U.S. banks. Many leading international banks appear to have come through the current crisis relatively unscathed. Generally, foreign lenders appear to have stuck to their tried and true lending practices - underwriting borrowers on their abilities to repay; not over-leveraging deals, not betting that increased values would rescue bad business decisions. Certain hyper-aggressive foreign lenders, who bought into the new U.S.-style financial alchemy, are now taking their lumps. UBS, abandoning its centuries-old, staid approach to underwriting, joined the hoopla in the U.S. and was rewarded with tens of billions in write-downs in the past year.

A second dynamic was at work as well.  The eroding value of the U.S. dollar strengthened the relative financial positions of foreign lenders. The Euro, Pound and Canadian dollar have soared to unprecedented levels, relative to the U.S. dollar, increasing the relative position of foreign banks from a cash and collateral perspective. Even those foreign lenders who made risky U.S. real estate loans are buffered by the strength of their currencies.

The likely result: a dramatic increase in the failure rate of U.S. banks and a corresponding likelihood of increased foreign investment into U.S. financial assets at knock-down prices. Don't be surprised if today's troubled U.S. banks and floundering American commercial real estate assets are tomorrow's German-owned international financial institutions and Saudi-owned trophy properties.

It's interesting that so many of these present day issues hearken back to lessons I learned during my freshman year of college.  Lesson #1, from Econ 101: the Law of Supply and Demand - too much money chasing a finite number of good investments drives investment in marginal (or worse) projects. Lesson #2, from Physics 101: Newton's Laws of Motions - what goes up must come down.

Today, it seems that U.S. banks which employed the most aggressive lending practices appear to display the least responsive reaction times in dealing with their defaulted loan portfolios. As loan volume plummets, loan losses rise along with restructuring costs. Many of these institutions appear poised to fail, both because demand has dramatically eroded and their costs (from write-offs and workouts) are escalating. The root cause, though, was poor lending practices. As Darwin postulated, the strong survive and prosper and the weak will be absorbed by more efficient domestic or foreign buyers or rescued by the government and, ultimately, taxpayers. Profits will be made by those with conservative but opportunistic positions. 

The current financial downturn looks like it will be steeper than the last one, in the 1980s. But, if foreign financial institutions remain healthy and larger U.S. investment banks continue to take their lumps, the cycle may be shorter this time around.

Lorne Polger is a co-founder and Managing Director of Pathfinder Partners, LLC.  Prior to founding the company in 2006, Lorne was a partner with the law firm of Procopio, Cory, Hargreaves & Savitch in San Diego, where he headed the Real Estate, Land Use and Environmental Law group.

That's the biggest drop since 2002, the end of the last recession. How's that for a recessionary indicator? According to a recent Federal Reserve report, total household worth declined 3% in the March quarter, to $56 trillion. During the 2000-2002 recession, American net worth dropped 6.2%. So, if the current crisis is of any comparison to the tech bust, we're halfway through.

And, the primary culprit? You guessed it - home equity fell to 46% by the end of the quarter, the lowest amount since the Fed began keeping records in 1951.

Here's a bombshell from über-analyst Marc Faber, long-time member of the venerated Barron's Roundtable. Readers of this newsletter will recall earlier mentions of this category of extremely illiquid balance sheet asset, which since the spring must be specifically reported. Not only are level three assets hard to value, they're also notoriously difficult to sell. With the deterioration in the mortgage market, more mortgages now must be categorized as level three.  Care to guess what types of businesses have the highest proportion of level three assets? Here's Faber's top ten list, ranked by percentage of total shareholder equity:

And a big trend today in California is recession. House prices have fallen more in California than anywhere - down 29%, according to the usually ebullient California Realtors Association. A thousand foreclosed homes are auctioned every day in California. And joblessness in the Golden State hit 6.8% in May.

Californians' response? "Cutting back on spending," says James Saft in the International Herald Tribune. "Besides causing woes for state and local government, the cutback is giving California's economy another knock and makes further job losses, home repossessions and banking problems more likely."

Nordstrom, with a third of its sales from California, says sales were down 6.5% in the first quarter. Starbucks isn't selling as many lattes in California as before. Jack-in-the-Box says Californians aren't buying as much of its fabulous food either.

In the central valley, cities like Modesto, Stockton and Merced have 60% of their homeowners "upside down" on their mortgage. Unemployment rates in these towns are north of 10%. And Vallejo, a city in Northern California, has declared bankruptcy.

And, that's putting it kindly. Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSE's) which hold more than 80% of all U.S. home loans, are running out of money. At the end of 2007, the two firms held $83 billion in cash reserves underpinning a staggering $5 trillion (with a "T") in debt and mortgages. 

Fannie's stock price is at a three-decade low; Freddie's stock is down 90% during the past year. As mortgage defaults have risen and home prices have fallen, the firms have reported billions in losses. The value of the firms' collateral continues to be marked down monthly. Analysts report Fannie and Freddie need to raise $75 billion. A few years back, before the housing market tanked, that would not have been a problem.

The ostensible reason for their woes was the news that Fannie paid a record-high interest rate (relative to Treasury yields) in July to sell $3 billion of two-year notes. To be precise, Fannie paid 74 basis points over the Treasury bill rate; triple the spread it paid just two years ago. This is newsworthy because 74 bps over Treasuries doesn't jive with the story the two GSE's have spun for two decades that their bonds are "as good as Treasuries."

Now that the cat's out of the bag, investors worry that Fannie and Freddie might be the next Bear, Countrywide or WaMu. Absent the Federal government's backing, Fannie and Freddie ain't the AAA credits they have appeared to be. Former St. Louis Federal Reserve President, William Poole, has been predicting a meltdown in the two GSE's since March, calling the two lenders "insolvent".  

According to Poole, Freddie owes $5.2 billion more than its assets are worth. That's significant, since the two bought 80% of new mortgages in the U.S. this year from banks and mortgage lenders. "Congress ought to recognize that these firms are insolvent," Poole says. "It is allowing these firms to exist as bastions of privilege, financed by the taxpayer."

While Fannie and Freddie might not be insolvent, they are both highly leveraged firms - leverage ratios in the neighborhood of 60-to-1. While home prices were heading north, that was just hunky-dory. But, now that the housing market is in free-fall, big leverage creates big problems.

Peter Schiff, president of Euro Pacific Capital, predicted that the companies would have trouble raising capital from private sources. "That's like selling tickets for the Titanic after it's already hit the iceberg," he said.

While we doubt Fannie and Freddie will go under, it's a safe bet they will become two major new line items in the Federal budget. Witness recent statements from NY Senator Chuck Schumer ("too important to go under; Congress will act quickly, if necessary.") and John McCain ("They must not fail"). There's a solution only a politician would dream up: How to solve a problem caused by too much credit? More credit, of course.

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