The Great GSE Meltdown: Market Adding Fuel to Fire?

As I write this, CNBC (GE) with Jim Cramer, The New York Times, and the “no comment” White House appear to be doing their best to add fuel to the fire of creating a major financial meltdown through the government-sponsored entities Fannie Mae (FNM) and Freddie Mac (FRE).

It is clear to me what the players are attempting to do. The Bush Administration wants to show they’ve got the guts to implement moral hazard by allowing at least one regional bank to fail. Both political parties are angry that the GSEs are not raising more capital. Wall Street is attempting to make up for all their losses through shorting most of the financial sector, the media wants to boost their ratings, and Cramer and former* St. Louis Federal Reserve Bank president William Poole are looking to boost their own star power.

They should all be careful what they wish for. Think about the implications of little or no stock value in the GSEs. These people are in essence telling investors that the moral hazard lesson is to “stay away from equity in financial companies.” This will totally impair the ability for Citigroup (C), Merrill Lynch (MER), and Lehman Brothers (LEH) to raise capital. What the government is implying is that major financial institutions will have to shrink their balance sheets rather than expanding credit. At that point there will be no winners in this game.

*William Poole retired from the Fed on March 31, 2008. He will take up his position as scholar in residence at the University of Delaware, Conrado (Bobby) M. Gempesaw, dean of the Lerner College of Business and Economics, this Fall.

Disclosure: I just bought FNM, FRE. Long C.

Comments

[Ishortyou:]

too late the value of common stock equity is getting so low that is getting useless to raise capital buy common stock sell, so this option is even more and more remote for the banks to use and raise capital, their options are getting smaller.

2008 Jul 13 05:42 AM

[Mbuna:]

"This will totally impair the ability for Citigroup (C), Merrill Lynch (MER), and Lehman Brothers (LEH) to raise capital." These 3 companies were clearly insolvent 6 months ago IMO as a result of the gathering of the perfect financial storm which has cut off any possible escape route. The only drama playing out now is how long they can artfully hide their insolvency. Everyone is in over their heads and Bernanke and Paulson can do little more than put bandaids on to try to protect the interests of their constituents. No one is thinking outside the box they are in. As for the GSE's, they were a convenient vehicle for propping up the housing market for a time but as we all can see that time has ended. I think it better to start thinking about the fact that the US government is well on its way to losing its AAA credit rating. At least you have seen that there is the possibility of there being no winners in this game. For most players that is unthinkable.

2008 Jul 13 05:52 AM

[Bugs:]

I'm tired of all the whine. Fannie & Freddie will be back stopped by Congress, as its their job, if needed. The Bush administration will follow Congressional orders ( legislation ). Screaming from the stands is just noise. I advise small steps into a Citigroup position. I just wish CMB was still around for my bank investing in turbulent times amid cries of insolvency. Chase never let me down through Reagan or Bush.

2008 Jul 13 09:08 AM

[Soccerfanyes:]

Allowing FNM and FRE to go to zero will not eliminate the opportunity for financials to raise capital. On the other hand, it will require that financials pay a lot more attention to the true repayment capacity of borrowers. This whole financial meltdown has been caused by financial engineers living on the edge with leverage to earn the last penny for their companies and themselves. That foolishness has stopped for the good of all.

2008 Jul 13 09:59 AM

[br4711:]

Too big to fail concept is coming home to haunt the USA. Policy has been in force for 25 years and selling securitized off balance sheet products without any regulatory or other risk limitations has been going on for that long period too. Result - literally trillions, possibly up to even 100 trillion, of these unregulated products have been sold to every government and financial institution in the world; AND NOW - everyone knows that it has no real value and trying to unwind the positions is going to cause a huger world liquidity crisis. This tied with commodity price inflation is the debacle of modern financial systems. USA coming down, Europe coming down, Vietnam already collapsing, 70 countries have double digit inflation, Vietnam percursor to China's fall,etc. Bottom line - all paper currencies are worthless - Only hedge GOLD GOLD GOLD GOLD.

2008 Jul 13 12:21 PM

[Silverback:]

It is all chin music and means absolutely nothing. Goldman Sachs is a market massager that manipulates the market for its largest investors, Cramer is the jester.

GSE's - - how many endeavors can you name that the government has managed successfully?

Is you broom ready to be used? After your shot you will be very happy to advance the cause of the state.

I don't want to sound down on the USA. It by far is the best country in the world, but by the collective ignorance and gullibility of our leaders (legislators), we will all be citizens of the third world ruled over by the people who got us here.

2008 Jul 13 01:05 PM

[Financial C...:]

Fannie and Freddie are "well-capitalized." ;)

2008 Jul 13 04:11 PM

[mythoughts:]

Monday mornings's opening price of FNM and FRE stocks should be interesting. Which way are you betting?

2008 Jul 13 07:52 PM

[researcher:]

Im thinking up then down.

freddie is offering X billion tommorow?

what investor in their right mind is going to buy?

2008 Jul 13 08:12 PM

[bearfund:]

researcher, investors aren't going to buy. No investor would ever buy debt that yields less than the rate at which the currency in which it is denominated is losing purchasing power. Speculators might buy them, possibly. More likely they'll be bought by sophisticated traders betting on spreads, but that trade will evaporate quickly once the money is made. Most of this paper, though, will end up at big foreign banks and central banks. You know, the ones Paulson's been calling all weekend. I don't know what he's told them, but I'm guessing it went something like this:

"You know, you have $300b in Treasuries. I know it's been a tough year for those dollars, and I'm really sorry about that, but darn it, America is still the greatest country on earth and I'm sure you're thrilled to be holding them. But gee, it sure would be a shame if we had to bail out Freddie and something bad happened to those Treasuries. Well, that's all; I just wanted to get a better understanding of how tomorrow's auction is likely to go. Nice chatting with you."

While a few central banks and SWFs have stopped throwing good money after bad, we have yet to see anyone start dumping this garbage, even slowly. One wonders if it's really Paulson making these calls and not Gates. Either way, though, there's no reason to think anyone will stop now, not over a paltry $3b rollover.

2008 Jul 13 08:59 PM

[EE:]

I've said it repeatedly, BUY SILVER OVER GOLD AND TAKE DELIVERY AS THE U.S. $ IS DEAD AS WELL AS THE COUNTRY THANKS TO CONGRESS.

2008 Jul 13 10:52 PM