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In the latest example of financial market madness, the recent government “bailout” of Freddie Mac (FRE) and Fannie Mae (FNM) has perversely resulted in a sharp rise in the value of the U.S. dollar.

If the markets were functioning rationally, the transference of staggering new liabilities to the U.S. Treasury would have been immediately seen as catastrophic for the dollar.  Instead the markets have ignored the obviously negative long-term implications and have remained fixated on the more immediate effects.  However, rather than solving the problems, the government’s actions merely confirm my worst fears, and increase the chances for a hyper-inflationary outcome. 

By transforming $5.5 trillion of suspect mortgage-backed securities into seemingly bullet-proof Treasury bonds, the move has sparked a relief rally in the dollar as foreign investors no longer have to worry about defaults or markdowns. 

In fact, to holders of Fannie and Freddie debt, it no longer matters what happens to the housing market.  Home prices can drop another 50%, every single homeowner can default on their mortgage, and bond holders will not lose one dime.  This has emboldened foreign investors, and temporarily increased demand for both dollars and Freddie and Fannie debt.

Had the government done the right thing and not guaranteed Freddie and Fannie debt, I believe we would now be experiencing an outright financial crisis.  The dollar would be falling sharply along with real estate prices, gold would be soaring and the recession would be deepening.  However, by nationalizing Freddie and Fannie, the government has merely delayed the crisis.  The borrowed time will cost us dearly, as the day of reckoning will now likely involve much steeper losses for our currency.

The Freddie and Fannie takeover does nothing to address the underlying problems that forced the companies into bankruptcy in the first place.  All of the bad mortgage debt still exists.  In fact, based on this bailout, there will be trillions more in bad mortgages insured over the next few years. 

The only thing that has changed is how the losses will be distributed.  Instead of falling solely on bond holders, who had chosen to invest in mortgage debt, they will now be dispersed among U.S. taxpayers and all holders of U.S. dollars, who made no such choices.

Over the next year or two, my prediction is that several trillion dollars of existing mortgages, not currently insured by Freddie or Fannie, will be transferred to the pile.  Going forward the vast majority of new mortgages made to Americans will be bought by Fannie or Freddie. 

Therefore in a few short years the $5.5 trillion of initially transferred liabilities could grow to more than $10 trillion of new obligations for the U.S. Treasury.

The defenders of the bailout claim that Fannie and Freddie debt does not represent true obligations because they are fully collateralized by homes.  But anyone with a casual interest in the current real estate market knows that homes are now only worth a fraction of outstanding mortgage debt. 

And that fraction gets smaller every day.  My guess is that $10 trillion of federally insured mortgages could result in $2 trillion of losses, which amounts to more than $25,000 per American family.

Also, there is no reason to believe that the bailout merry-go-round will end with Fannie and Freddie. Faltering investment bank Lehman Bros. is now positioned to receive the kind of Federal backstop that smoothed the purchase of Bear Stearns back in March.  Bailouts of automotive and airline companies can’t be long in coming.  Once the market perceives a Federal magic wand, it becomes politically impossible to stop waving it.

In addition to adding new sources of debt in the form of mortgage backed securities, the government is also piling on debt the old fashioned way…through budget deficits.  Recent projections put the 2008 deficit at $410 billion, not counting the Iraq war or any costs related to financial bailouts. 

It is my guess that the annual Federal budget deficit will soon approach, and then exceed, $1 trillion, and that the national debt, including actual bonds and guaranteed mortgages, will soon exceed $20 trillion.  When these untenable obligations force Treasury and agency investors to shift focus from default risk to inflation risk, a mass exodus from both Treasuries and mortgage-backed securities (now Treasuries in disguise) will ensue.  The stampede will trample the dollar.

When the dust settles, the Federal government will be left with staggering liabilities that will be impossible to repay with legitimate means (taxation or borrowing).  To make good, they must rely on the printing press to create money out of thin air.  The rapid expansion in money supply will push the dollar down mercilessly.

Right now every asset on the planet is being sold except the U.S. dollar.  To me this rally looks like the last gasp of a dying currency.  Just like a toy rocket ship, once the dollar runs out of fuel it will crash back down to Earth. 

Disclosure: none

Source: Last Gasp of a Doomed Currency