The Government's Moral Hazard with Fannie and Freddie

On Sunday, U.S. federal regulators outlined their takeover plans of the combined $5 trillion giants Fannie Mae (FNM) and Freddie Mac (FRE). The Treasury Department in conjunction with the Federal Housing Finance Agency [FHFA] will use the full faith of the U.S. government to back the two institutions which have been at the core of the illusion of prosperity created by the inflation of real estate.

Reports of overstated equity, upcoming write-downs that exceed the government's estimates and capital market's reluctance to fund Freddie and Fannie, prompted action this weekend. Clearly the rest of the banking system can be assumed to be in the same boat with overstated assets and equity values. In addition, the idea is that nobody has a clue of the value of the falling house of cards called banks

The two companies are now placed in "conservatorship" (in lieu of "receivership") overseen by the FHFA will be run by the government until they are on stronger footing (i.e. five to ten years). Two veterans will replace the outgoing CEOs. Herb Allison ex-Chairman of TIAA-CREF and ex-Merrill will run Fannie, and David Moffett ex-U.S. Bancorp and ex-Carlyle group will run Freddie.

The largesse of the government will provide as much as $200 billion of new capital, and new credit lines. The Treasury plans to buy an unspecified amount of mortgage-backed securities in an attempt to lower mortgage interest costs for homeowners and in addition it is also setting up back up facilities for the 12 Federal Home Loan Banks which provide advances to its 8,000 members.

Dividends on both common and preferred shares will be eliminated, saving about $2 billion per year. And finally the Treasury is acquiring $1 billion of senior preferred stock from each company that include a 10% dividend yield and the right to purchase 79.9% of the common shares at a nominal price. In other words, the common shares are wiped out and preferred shares may follow depending on the level of losses over time. The government took a hard approach to common and preferred shares.

The plan also includes limiting the size of the giants to a maximum of $850 billion as of the end of 2009 (Fannie's own balance sheet size is about $758 billion and Freddie's is $798 billion). Afterwards, the Treasury intends to reduce the portfolio of each by 10% per annum until each reaches $250 billion. It seems as if in the short run there will be an expansion of the portfolios to support housing.

Let's take a look at the upcoming mortgage tsunami, before providing an opinion on the plan. New foreclosure proceedings reached 490,000 in Q2 taking total foreclosures to a record of 1.2 million homes, representing 2.8% of all outstanding loans or double from a year ago. Delinquency rates for mortgages that have missed at least one payment are also in record territory -- that is a staggering 2.9 million delinquent mortgages! Further mortgage losses are unavoidable.

While this "nationalization" will provide a short term relief, the plan at best may only reduce the pace of the price slide in housing in the U.S. while the credit problem is global and continues. Since Mr. Paulson received authority from Congress to do whatever he pleased to support Freddie and Fannie, it has been an anticipated action, hence it has already been discounted by the markets for the most part. It is unlikely that we will see a sustained equity rally as it questions the situation of all other financials.

We are bothered by the government's attempt to stop the credit bubble from deflating and trying to support house prices in a highly politically motivated bail out. The moral hazard of the government's actions will be felt by future generations. Bond vigilantes should be put on alert as a borrower set to keep issuing paper in large amounts should be punished with higher rates -- maybe offsetting Sunday's actions. The U.S. is behaving like an emerging market of the 1980s or 1990s and moving faster than Chavez!

Stock position: None.

Comments

[turkeyeyes:]

With mortgage defaults at a whopping 2.8% or less, it's obvious that the fearmongers at CNBC and the hedgefunds have created enough FUD to tank these institutions. Nice job, fellas! Shorts and other miscreants are destroying what's left of the American Dream.

2008 Sep 09 07:02 AM

[mahesh:]

The American financial crisis is the result of systemattically valuing borrowing over saving. The whole system of credit reporting is incorrect because it values only borrowed money. When I came into this country as a H1B visa / work permit holder, I did not have any credit card, only a savings + checking account combination with a single bank for receiving salary by direct deposit and an ATM card for withdrawing cash, large payments of more than 100 U$D were paid by cheque and smaller amounts were paid cash. I was not interested in credit cards because I come from India where savings is valued over borrowing. Then many people who had been in USA longer told me "If you want to survive in USA and prosper, get a credit card, if you cannot get a credit card, at least get a secure credit card".

My question was "Why".

Their simple answer was "To build credit history. You can never build any credit history by using Savings and Checking accounts, the only way to build credit history is by borrowing and paying back. Borrowing $ 100 on credit card and paying it back would build your credit history much more than saving $1000 in your savings account and leaving it untouched to receive interest."

Then I went ahead and got my first credit card which was a secure credit card from a credit union.

So if the USA government financial bodies want to put an end to future "financial shit", they should reform / modify the present credit reporting system as follows :-

1. Rename "Credit Score" to "Financial score" - ie its telling "all people" this score represents Financial history, not just Credit history.

2. Savings is valued more than borrowings.

3. Bankruptcy fillings say on record longer.

4. Lenders are prohibited from giving Loan to people who have shown no savings ability and have bad credit history. Advertisements like "Bankruptcy no problem, bad credit history no problem" should be outright prohibited.

Also schools all over the country should include in their curricullum a small course for senior students (Grades 10, 11, 12) - "being financially responsible", this course does not need an examination and may be handled by requesting senior staff from neighbourhood banks to volunteer to give presentations, informal discussions & question/answer sessions.

I am reminded of a message that I had seen in most shops in Chennai - "Kadan anbai murrikkum" meaning "Loans spoil friendship". Its time the great American economists learn from time tested Wisdom.

2008 Sep 09 07:15 AM

[SouthernBea...:]

I don't see a bailout was necessary yet. Most companies are allowed to work their way out when financial problems occur. Home prices have been too high for several years this seem to be a good way to correct that, but the Gov't says, you don't have enough reserves. More time should have been given FRE & FNM. Now all of these Retirement Funds that had millions of shares of those companies stocks loose. In essence the Gov't said, "You people that acted irresponsibaly and took out dumb loans will get help, all of you people that saved and did the right thing............ tuff". You saved and invested in the country and you loose you money so the Gov't can help stupid people.

2008 Sep 09 07:35 AM

[Sirilover:]

Mahesh: your perspective makes about the most sense I've read on any of these sights in a long time.

2008 Sep 09 08:22 AM

[Sirilover:]

beach7: yep...so much for living responsibly, how can we expect anyone in america to respect that when our leaders in DC behave just the opposite. What a country!

2008 Sep 09 08:26 AM

[wetwillie:]

Mahesh you are right on the point. about "credit scores". But I'd also like to point out with the takeover of Freddie and Fannie the is an implied timetable to get loans off their books. And what do you think that means? What I forsee happening is the politically friendly institutions (most of them) will buy these loan portfolios for pennies on the dollar and this will be the next fleesing of the taxpayer.

2008 Sep 09 08:28 AM

[radiowaver:]

We're reversing roles with China: As they industrialize, we de-industrialize. And as they shed their state-owned companies, our government is building them. In 5-10 years, most of us (the "poorest" 90% of the population) will all have to go to the government to borrow money to pay for things! And that'll probably be everything, like food, clothes, cars, as well as houses.

2008 Sep 09 08:44 AM

[John Preston:]

It is interesting that with unemployment up 35% in 18 months or so (4.5 to 6.1)... "under-employment" (a job with less income) common.... with state and local governments struggling with budget short-falls...that everyone thinks housing and mortgage issues do not affect them...

And, this is not about "stupid people"....its about the housing and mortgage environment that was created over a 10-15 year period of time....99% of those who looked at the market didn't the hidden risks lurking in the economy...jobs..income...

I saw falling income in 2006...people in construction..laborers... also retail workers getting less OT.....now its a mess....

Now, I am not saying that mistakes weren't made...I have some very strong feeling on the root causes of the current crisis...the top of the financial and regulatory food chain really screwed up....and the root of the problems go back to the mid-to-late '90's...

Still, F/F needed to be stabilized and straightened out...housing health and the health of the economy go hand-in-hand....

There has been a lot of fleecing in the past...there will probably be some more....I wish I was a "fleecer"....

We'll see how this is handled....

Personal Disclosure: I do not comment on stocks or the various financial markets. My focus is on real estate and mortgage lending. My background is 30+ years in mortgage lending and real estate.

2008 Sep 09 10:31 AM

[leegee:]

I think that you have all missed the purpose of the Federal "Bailout," which in my opinion had little to do with the housing crisis. China and other countries were begining to slow down or stop their purchases of Government securities; this step by Paulson, et al, was necessary to demonstrate the presence of the US Government in this current crisis.

2008 Sep 09 10:52 AM

[DCM:]

"The moral hazard of the government's actions will be felt by future generations." How many voters agree with this statement? What will you do about it this November? Trickle down economics and encouraging spending (through easier credit) hasn't worked - is not ever going to work. The fact that half the country thinks it will and will probably vote for politicians that will continue those policies tells me this country is doomed to fail.

For the record, I agree with the statement and the premise set forth in this article. I for one am not going to pay another tax dollar to a government that takes my money to protect and bailout the wealthy elite. Make no mistake - the wealthy pay billions to Washington politicians (primarily Republicans) to protect and grow their wealth into the trillons. Wake Up America! I was going to say before its too late but I think it already is.

2008 Sep 09 10:53 AM

[kurt walter:]

On November 4, we will see if Americans really want socialism.

2008 Sep 09 01:09 PM

[User 258588:]

I grew up in a time and place where debt was non existent. People saved to buy what they needed, and bought only what they could afford. Most people in my country build their own homes and they build the homes they can afford. My parents built our home when I was 8, but my Dad announced that we wouldn't have central heat for some years until we had saved enough to install it. There was so much pride in getting ahead in life.

Who needs these McMansions that we see everywhere? People have less children and bigger empty homes.

When I bought my first home, I had more savings than the value of the house, but they were invested. I asked my bank for a short-term loan with my stocks and bonds as collateral. They wouldn't do it, just because they couldn't pull a credit report on me. If I had been Joe-6-Packs living from paycheck to paycheck, I would have had the loan.

2008 Sep 09 02:16 PM

[OnW:]

Everybody is now aware of the mortgage mess and how it came about. I, not a trader but a long time buy-and-hold investor, depended on guidance by the expert analysts and rating services. I now wonder at the many levels of stupidity and/or irresponsibility that brought this about. The banks knowingly write fraudulent mortgages. They then sell these bombs to Fannie and Freddie. Don't F&F know that this is junk? Don't the rating services know how F&F operate? How can so many highly paid people/businesses be so stupid or careless? So a handful of overpaid execs lose their jobs and the miillions of innocent investors lose lifelong savings.

2008 Sep 09 04:40 PM

[specks:]

I am Canadian. I am also close to retirement.
I am afraid that what has been created by the best educated minds in the world, attending some of the finest halls of education lead by the wisest professors will be discovered to exist worldwide.
If my government and business leaders, as yours, has lost our money because of their incompetence, how are we old folks going to survive, do you think?
Two things are for sure. But I'll live for probably another 30 years. And that means me along with the other 33% of the population, unless you dispose of us, will have to survive on tax money.
Or, the fixed income level we are guaranteed, at least for now, will have the purchasing power necessary to pay for our needs!
Are any of you economists out there?
Is this talk DEFLATION??

2008 Sep 09 05:01 PM

[Did U Think...:]

151885 wrote:"I am afraid that what has been created by the best educated minds in the world, attending some of the finest halls of education lead by the wisest professors will be discovered to exist worldwide."
"If my government and business leaders, as yours, has lost our money because of their incompetence, how are we old folks going to survive, do you think?"

My dear canadian friend, I don't know where to start with you. You are so confused. I say that because you make true statements without understanding them. Yes these guys are smart and well educated. In fact they are so smart that they did not make any mistake!! They are rich by stealing from you, and you are poor because you believed them. It all went exactly as planned.

"They lost our money because of incompetence..."
I could just cry when I hear things like this. First of all, they didn't lose it, they stole it. They flim flammed you into believing in a ponzi scheme fiat currency system. The only incompetence was on your part. While the scam seemed to be working you were glad to accept the socialistic benefits - you got something for nothing and you knew other people were too. You never stopped to care that there is no free lunch and thus something must be wrong. You didn't care that there is no fountain of wealth coming from gov't even though they made it SEEM to be like that with the magic trick they call inflation. You just followed blindly and now they have you bent over a log and are ramming away. AND YOU STILL don't seem to understand that the educated elitists are laughing their little illuminati asses off at people like you. They do not care that you will be poor in retirement any more than you care that people starve in Africa each year.

What are you to do? You are to do the one and only thing that they are afraid of. You are to band together and harness the power of the people. You are to educate yourself on this scam and then teach all of your friends and their friends and all of the children. You are to NEVER believe a single word coming from the pie holes of gov't and corporate thieves again. You are to make your voice heard and throw the bums out. You are to AVOID the temptation of letting them print more funny money in order to appease you. You are to return your country to hard currency based on commodities like gold and silver. You are to disband any parts of your military that have conspired with America's Northcom to create an international "peace keeping" force which can be used to cross the US-Canada border to put down civil unrest. You are to find the Canadian counterparts to the USAs CFR and publicly expose their plan for the north american union and to reject it in whole EVEN THOUGH the liars will soon be telling you that it's for your own good.

You are to remember what it used to mean to be a Canadian patriot just like all Americans who now also need to understand the word because they could not or would not see this coming even when told to their faces years ago.

You are not to dispair. You are to take courage that you are helping to save the next generation. You are not to complain about diminished quality of life as you perform all of the above because you were the one that got yourself into the mess.

Sorry if this is hard to hear, neighbor, but tough love is what the sheeple, even the retiring ones, of the USA and Canada need to hear. It's still not too late to stop these elitists from completing their nefarious plans.

Either that or just go back and watch the tube as you wither and fade.

Good luck.

2008 Sep 09 11:38 PM

[elwind45:]

This action will lead to the need to add treasury obligations to drain liquidity. The true treasury will be hoarded. The mortgage paper will make its way to the treasury, and never be sold to reduce liquidity. This priced-in action has forced the fed to limit credit growth.(economy is being sufficated) This is limiting investment growth at a time when needed most. The treasury will have to suck clean the toxic waste in the system and hold it. When the fed needs to drain liquidity it buys treasuries(which will be hoarded) and will have to make its inventory available to buy back excess reserves. This type of money growth will be counter productive to investment and itself will be hoarded on bank balance sheets. The elimantion of interrest and principle from the MAC,s debt obligations is further going to restrict growth. The scarcity of money, and treasuries will continue the dollar rally and lead to higher interest rates on new offerings. This will restrict growth and further the downturn. A higher dollar will cripple exports. Higher interest rates(growth in treasury obligations) will force up rates. This story ends in massive unemployment, my friends. Gold is being naked shorted by couple banks and physical gold cant be found at this nights price.

2008 Sep 10 04:17 AM