The U.S. on the Precipice

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 |  Includes: AIG, DIA, FMCC, FNMA, LEH, MER, QQQ, SPY, WFC, WMIH
by: James Quinn

September 7, 2008, the 10th anniversary of the Federal Reserve arranged bailout of the infamous hedge fund Long-Term Capital, is now a more infamous date. This is the day that our government chose socialism over free market capitalism. Our elected leaders increased the national debt from $9.6 trillion to $15 trillion, a 56% increase in one weekend.

Hank Paulson, the U.S. Treasury Secretary, seems to have a penchant for committing U.S. taxpayer dollars on weekends. He previously arranged for the bailout of Bear Stearns (NYSE:BSC) on a weekend and convinced Congress and the President on a weekend to give him a blank check regarding the future of Fannie Mae (FNM) and Freddie Mac (FRE). He spearheaded the takeover of two of the worst run financial institutions on the planet. They hold or guarantee $5.4 trillion of mortgages. James Grant, a keen financial mind, described what we are experiencing today, back in early 2007. “Capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich.”

Skullduggery, Corruption, and Fraud

Fannie Mae was created during the Great Depression in 1938 as part of Roosevelt’s New Deal. Its purpose was to provide liquidity to the mortgage market. For the next 30 years it operated as a government agency, with a monopoly on the secondary mortgage market. In 1968, in the midst of another fiscal budget crisis, Fannie Mae’s activity and debt were removed from the annual balance sheet of the Federal Government and the agency was privatized.

To provide some competition in the secondary mortgage market, Congress chartered Freddie Mac as a private corporation in 1970. This relationship with the Federal Government gave rise to the concept of an implicit guarantee from the government regarding their debt. This allowed these two companies to borrow at much lower rates than the average financial institution.

It wasn’t enough for these two institutions to reap the benefits of their implicit guarantee. They spent $175 million between 1998 and 2008 on lobbyists to influence Congressmen and Senators so that their housing agenda was pushed forward and expanded. These two institutions have bred a culture of corruption, combined with awful internal and accounting controls. Both companies were unable to file legitimate financial statements with the SEC for two years. Fannie Mae has a history of being a playground for former Democratic insiders such as Franklin Raines, James Johnson, and Jamie Gorelick. Franklin Raines, the Director of the U.S. Office of Management and Budget in the Clinton administration, became the first black man to head a Fortune 500 company when he assumed the CEO position of Fannie Mae in 1998.

When Raines assumed command in 1998, he set a goal to double Earnings Per Share in five years. Raines and his top executives reaped huge bonuses by meeting these goals. During his reign between 1998 and 2004, Mr. Raines raked in $90 million. His top lieutenant, Jamie Gorelick, took home $24 million in a four-year period. The only problem with the EPS that was reported is that they were fraudulent. According to an investigative report by OFHEA, “Those achievements were illusions deliberately and systematically created by Fannie Mae’s senior management with the aid of inappropriate accounting and improper earnings management”.

During the investigation Raines lobbied his cronies in Congress to open an investigation of OFHEA and cut off their funding. Ultimately, it was determined that Fannie Mae had overstated earnings by $10.6 billion. In a settlement with OFHEA and the SEC, Fannie Mae paid a civil fine of $400 million for these misdeeds. Raines somehow walked away with a slap on the wrist, sacrificing less than $5 million of his immense wealth.

In 2003, Freddie Mac revealed that it had understated earnings by almost $5 billion, one of the largest corporate restatements in U.S. history. As a result, in November, it was fined $125 million. A 200-page report issued by the Office of Federal Housing Enterprise Oversight indicated that the company's records were manipulated to meet Wall Street earnings expectations. The firm signed a consent order promising to improve internal controls and corporate governance.

On April 18, 2006 Freddie Mac was fined $3.8 million, by far the largest amount ever assessed by the Federal Election Commission, as a result of illegal campaign contributions. Much of the illegal fund raising benefited members of the House Financial Services Committee, a panel whose decisions affect Freddie Mac. Notably, Freddie Mac held more than 40 fundraisers for House Financial Services Chairman Michael Oxley, R-Ohio.

Homeowner Bailout Boondoggle

Nicholas Taleb while writing his book, The Black Swan in 2006, foreshadowed what was to come for Fannie Mae and Freddie Mac.

Banks are now more vulnerable to the Black Swan than ever before with ‘scientists’ among their staff taking care of exposures. The government sponsored institution Fanny Mae, when I look at their risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deemed these events ‘unlikely’.

Democratic Representative Barney Frank, Chairman of the House Financial Services Committee, chose to blame short-sellers for Fannie and Freddie’s problems  when he made the following statement on April 25, 2008. Between 1989 and 2008, Fannie & Freddie contributed $42,350 to Mr. Frank’s re-election campaigns.

I believe Fannie and Freddie are better off than the market thinks. Over the long term the market is a very rational distributor of resources, but in the short term it can fall prey to hysteria. Sometimes you need to deal with that. Part of the problem is rumor mongering by short-sellers. Our hope is that just by making U.S. financial support available, we'll quiet the fears and eliminate any need for that support.

Democratic Senator Christopher Dodd, former candidate for President, revealed his grasp of the situation on July 11, 2008 when he strongly defended the financial condition of Fannie & Freddie. Between 1989 and 2008, Fannie & Freddie contributed $165,400 to Mr. Dodd’s re-election campaigns.

"This is not a time to be panicking about this. These are viable, strong institutions," Sen. Christopher Dodd, D-Conn., said at a Capitol Hill press conference. "The economics are fine in these institutions and people need to know that," Dodd said. There's no reason "to talk about failure," he added. "These two institutions are fundamentally, fundamentally strong," Dodd said. "There's no reason for the kind of reaction we're getting."               

Mr. Dodd’s analysis proved to be somewhat deficient. President Bush signed the Housing Recovery bill on July 30, 2008. This bill gave the Treasury authority to put the U.S. taxpayer on the hook for all of Fannie Mae and Freddie Mac’s bad decisions.

It appears that our political leaders believe in capitalism when there are obscene profits that benefit their hand picked cronies, but prefer socialism when it comes to sharing the losses with taxpayers. The Congressional Budget Office estimated that the American taxpayer would end up paying $25 billion for their mistakes, with a 5% chance that it would reach $100 billion.

The major problem with the bill was that it gave the Treasury the ability to provide an open ended guarantee. In July, former Fed governor William Poole said that Fannie Mae was technically insolvent. Their shareholder equity was $35.8 billion at the end of 2007. It plunged by $23.6 billion to $12.2 billion as of March 31, 2008. If their balance sheet had been marked to market as of June 30, 2008, they would have been insolvent. Congress passed this plan but provided absolutely no mechanism to pay for these future commitments.

At the end of the day, two public companies that had lost a combined $13 billion in the last 9 months were given a blank check to lose billions more. The CEOs of these two institutions “earned” a tremendous amount of compensation while their companies have plummeted to worthlessness. Daniel Mudd, CEO of Fannie Mae, took home $46.7 million in compensation between 2003 and 2007. Richard Syron, CEO of Freddie Mac, took home $58.1 million over the same time frame. In the last year, stockholders of these “fine” institutions lost $98 billion. They should be appreciative of the tax loss carry forwards they can use for decades. 

Representative Ron Paul voted against the $325 billion homeowner bailout bill. His view of this bill hits at the heart of the issue:

It is neither morally right nor fiscally wise to socialize private losses in this way. The solution is for government to stop micromanaging the economy and let the market adjust, as painful as that will be for some. We should not force taxpayers, including renters and more frugal homeowners, to switch places with the speculators and take on those same risks that bankrupted them. It is a terrible idea to spread the financial crisis any wider or deeper than it already is, and to prolong the agony years into the future. Socializing the losses now will only create more unintended consequences that will give new excuses for further government interventions in the future. This is how government grows – by claiming to correct the mistakes it earlier created, all the while constantly shaking down the taxpayer. The market needs a chance to correct itself, and Congress needs to avoid making the situation worse by pretending to ride to the rescue.

Wall Street Got Drunk

At a recent closed-door fundraiser in Texas, where he thought it was safe to tell the truth, President Bush summed up the financial crisis in his usual understated way:

There’s no question about it, Wall Street got drunk, that’s one of the reasons I asked you to turn off the TV cameras. It got drunk and now it’s got a hangover.

This is an excellent analogy of what developed in the last few years. The sad part is that the American taxpayer is left to clean up the mess after the party. Meanwhile, George Bush will depart for his Texas ranch on January 20, 2009 knowing that his “no financial regulation” agenda has resulted in the greatest financial catastrophe in the United States since the Great Depression. Luckily, he should be able to muddle through on his $10 million net worth and the millions he will rake in writing his memoirs and making inspiring speeches.

Secretary Paulson failed to mention how much this would cost the American taxpayer during his speech announcing the takeover of Fannie Mae and Freddie Mac. Two distinguished financial analysts, who have been correct on this issue for the last two years, Dr. John Hussman and former Federal Reserve governor William Poole, have concluded that the tax bill will be $250 billion to $300 billion on the existing $5.4 trillion debt portfolio.

This fails to account for the $20 billion per month of new loans that these awful institutions will be making. Count on at least $1 billion of losses per month on these loans.

Murky Dangerous Future

To put $250 billion of losses in perspective, the tax bill of every household in America just increased by $2,300. You will not get a bill from the IRS because our politician leaders find it easier to choose the immoral route of shifting this burden to our children and grandchildren. The U.S. Government is broke. The $250 billion will be borrowed from China, Japan and the Middle East, with an annual interest charge of at least $10 billion.

This is $250 billion that will not be spent on education, infrastructure, or energy independence. It is the cost of financial recklessness of banks, greedy CEOs, governmental incompetence, Alan Greenspan’s loose policies and average Americans who thought they deserved something for nothing. Future generations will pay a steep price of this greed and malfeasance. 

The following passage from Nicholas Taleb’s brilliant book, The Black Swan, describes the potentially dire situation that we are facing at this moment in time:

Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial Institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks – when one fails, they all fall. The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur ….I shiver at the thought.

The recent actions by our politician “leaders” will not solve this financial crisis. They are a weak attempt to keep this finance Ponzi scheme going until they are re-elected in November. These actions have propped up essentially insolvent financial institutions.

The question is, how many more financial firms can be bailed out or fail before the entire system collapses? Lehman Brothers (LEH) goes bankrupt this weekend, Merrill Lynch (MER) bought by Bank of America (NYSE:BAC) before its collapse, AIG (NYSE:AIG) barely alive, Washington Mutual (NYSE:WM) about to wipe-out the FDIC fund, Wachovia (NASDAQ:WB), and many more in the future.

The economic situation has gotten worse. There are 4.7 million homes for sale representing an 11.2 month supply, the highest in history. Home prices have fallen 16% in the last year according to the Case Shiller Index. Prices are expected to fall through 2011 according to John Burns, a real estate analyst who has been correct for the last five years. Foreclosures totaled 1.2 million in the 1st 6 months of 2008, a 100% increase over the prior year, and are accelerating at the fastest pace in three decades. Option ARM mortgage and Alt A mortgage delinquencies will be accelerating in 2009 based upon their date of issuance. This will lead to more foreclosures and much lower prices. Unemployment is accelerating and will not peak until 2009, probably north of 7%. People without jobs can’t make mortgage payments or buy HDTVs at Best Buy (NYSE:BBY).

We have entered a recession that is being driven by consumers with vast amounts of debt. This recession will be deep and long. The greatest debt bubble in history does not pop without making a huge mess. Credit is getting to be scarce. Forced consumer spending reductions will bankrupt overleveraged retailers, mall developers, and commercial developers. A slow soft depression is a distinct possibility.

The continued bailout of the reckless financial firms by the taxpayers, while their top management received titanic pay packages borders on immorality. The average American has the right to ask for a similar response. If you are in danger of losing your house to foreclosure, can’t meet your monthly obligations, or make the minimum payment on your credit card, just call Hank Paulson at 1-800-BAILOUT.

Disclosure: I have no position in any of the stocks mentioned in the article.