This is the single best piece I have read to date on Fannie Mae (FNM) and Freddie Mac (FRE) via the Economist:
"After a headlong plunge in the two firms’ share prices (see chart 1), Hank Paulson, the treasury secretary, felt obliged to make an emergency announcement on July 13th. He will seek Congress’s approval for extending the Treasury’s credit lines to the pair and even buying their shares if necessary. Separately, the Federal Reserve said Fannie and Freddie could get financing at its discount window, a privilege previously available only to banks.The absurdity of this situation was highlighted by the way the discount window works. The Fed does not just accept any old assets as collateral; it wants assets that are “safe”. As well as Treasury bonds, it is willing to accept paper issued by “government-sponsored enterprises” (GSEs). But the two most prominent GSEs are Fannie Mae and Freddie Mac. In theory, therefore, the two companies could issue their own debt and exchange it for loans from the government—the equivalent of having access to the printing press…
This model was based on the ability of investors to see through one illusion and boosted by their willingness to believe in another. The illusion that investors saw through was the official line that debt issued by Fannie and Freddie was not backed by the government. No one believed this. Investors felt that the government would not let Fannie and Freddie fail; they have just been proved right.
Oh, and it gets worse . . .
>
Source:
End of illusions
The Economist, Jul 17th 2008
http://www.economist.com/finance/displaystory.cfm?story_id=11751139
~~~
Its a great read Barry. So, let me see here. America defaults on its debt, foreigners stop funding our debt and stop buying treasuries, they call in their holdings, treasury yields go to double digits, and the dollar dives into the crapper.
Fun stuff. Got gold?
An illusion indeed.
Bernanke’s statement: “It’s important for Fannie Mae and Freddie Mac bonds and stocks to rise so they can keep raising capital and aid the mortgage market.”
This is a clear give away as to motive and the intent behind COX exempting primary dealers of the restrictions about naked short selling.
WASHINGTON (Dow Jones)–An emergency order issued by the Securities and Exchange Commission to impose new restrictions on short sales in 19 stocks will not apply to bona fide market makers, the SEC announced Friday.
Desperation abounds to raise capital amongst the financial institutions, and the Fed seems to be in the epicenter now that it has pawned and is holding so much of the bank’s rapidly deteriorating collateral . How could the Fed possibly put this garbage back to the originating institution if they have no capital in exchange. Voila, the Fed, the Treasury and the SEC are manipulating markets trying, orchestrating this short squeeze in GSEs and other financials so they can raise capital. The fact that none of the Presidential candidates are speaking to this clear manipulation is also an outrage. These efforts by Paulson et al to socialize the losses of the GSEs speak volumes as to the dire straights they are in. Poignant post for sure BR. Use this time to sell any remaining financial holdings because when the short squeeze ends, it’s coming down, HARD.
Remaining question I have is what’s worse for the dollar. If Paulson gets his wish or if it is rejected. Either way it’s default or print.
Bernanke and Paulsen know one thing which is that the systemic economic catastrophe that they face is beyond comprehension and therefore they need to do anything and everything to disrupt downward momentum. B&P at least know that much; in contrast to the clueless “the bottom is in” crowd.
The only questions are, how much of this mess will be paid for through an increase in government debt, and how much through debasement of the currency?
This is also connected with the question of whether oil goes up or down from here. I agree with Alan Abelson’s comment from this weeks Barron’s:
“As to oil, mindful of the potential erosion of demand that recession and obscene prices are likely to cause, we nonetheless have every confidence that Ben, with his helicopter, and Hank, with his bazooka, will continue to wreak havoc on the badly wounded dollar, one of the unintended consequences of which will be to bolster crude prices”
therefore, the two companies could issue their own debt and exchange it for loans from the government—the equivalent of having access to the printing press…
and on top of that, the fed would have to print money to buy the GSE paper…
got gold?
I believe one of the more positive developments recently has been the negative wealth effect of rapidly shrinking 401k accounts owned by influential members of the mass media. These Koolaid pushers have suddenly found themselves swiming in it. So we’ve got a pissed off press. Some more financial heads will be rolling soon. The big boys should have known better than to include reporters when they cut their losses.
It it just me, or does this strike anyone as the sort of flawed thinking that got us into this mess.
If we were talking about a single loan with a LTV of 68%, we could talk about the survivability of a 30% fall in house prices. A default would be binary (it would or would not default). The recovery would also be a single outcome.
In fact though, we’re talking about many loans which will carry individual default and recovery outcomes. If even a small cohort of loans default with high LTV’s and low recovery rates, the GSE’s could easily wipe out equity. Unlike a single loan, the value in loans not underwater in a 30% decline scenario can’t be used to offset low recoveries on higher LTV cohorts.
What we really need to know is the distribution of LTV’s, and stress test that against various house price and recovery outcomes.
Last Paragraph: “In the end, the turtle at the bottom of the pile is the American taxpayer. But that suggests that, if Americans are losing money on their houses, pensions or bank accounts, the right answer is to tax them to pay for it. Perhaps it is no surprise that traders in the credit-default swaps market have recently made bets on the unthinkable: that America may default on its debt.”
Last sentence: “Perhaps it is no surprise that traders in the credit-default swaps market have recently made bets on the unthinkable: that America may default on its debt.”
Question from someone who needs to know:
what EXACTLY does this mean: “America may default on its debt”
We are going away for three months travel to Nepal….we are trying to think what to do to avoid possible dollar crisis: we bought full position of international bonds, ETF BWX. Would this help avoid Problem? We are really worried (and think we should be).
As ever an excellent piece of analysis by The Economist. But please, the US is NOT going to default on its debt. I’m not sure if F/F can avoid nationalisation and the accompanying leap in the public debt but for the moment Paulson/Bernanke with a bit of help from the short selling rule change seem to have slowed the bleeding. That said the problem is if they have to raise substantial amounts of new capital, which in itself would necessitate the virtual wipeout of existing stockholders and hence a collapse of the stock price, who the hell is going to subscribe to the new equity whether it’s ordinary or preferred which btw would require a substantial coupon that would impose and enormous debt service burden. Ordinary American investors? Any volunteers? SWF’s who have already been badly burned. American financial institutions whose own balances sheets are vulnerable. The only source is the govt surely. And if they have to do that they might as well nationalize. Or am I missing somenthing here?
There is a saying that goes “sh.t stained on both sides of the stick”. There is no where to hold on to this situation to keep it steady.
What is it going to be? Save FNM/FRE and let the dollar free fall, or let them fail and see the dollar free fall.
I think the time has come for US markets to decouple from the rest of the world.
Barry,
I strongly believe that you are correct in one area but so wrong in your overall thesis expressed in your blog.
This Fannie/Freddie situation is a travesty,—a reflection of everything that has gone wrong in the USA for the past 2 or 3 decades.
BUT the USA will never ever let these two institutions or any other large bank or major brokerage firm default no matter what any one believes. Period. We all have gotten to the panic stage. This is why we have a Constitution, a Federal Reserve, a Treasury Dept, etc. P{lease do not be a callous (Republican)sould who believes in the markets. As we can see by the outrageous and illegal naked shorting, these American companies will disappear overnight if we do nothing. Bravo for Hank and Ben and the others who understand this.
“moral hazard”…gimme a break. The moral hazard is doing nothing. With the trillions of debt in this nation, the depression would look like a walk in the park. don’t we as a country believe in helping the less fortunate. in this case it is Fannie and Freddie. and we all will be better off for it.
I, for one, pray that Paulson stays on into the next administration or Obama finds another Wall Streeter who sees no light at the end of the tunnel if we allow our major financial institutions to fail.
Try to imagine the sheer panic for our citizens and for the rest of the world.
Bob Brandt:
If your concern is that severe, my guess would be to BUY GOLD to protect yourself. If this swings with your thinking and risk tolerance, you can buy DGP or GLD or IAU which track the physical price of gold.
Americans really, really want to prop up home prices, whatever the consequences. Well, wouldn’t it help pricing *more* by:
(a) *not* guaranteeing the existing debt
but
(b) creating a new agency with an explicit guarantee
?
That would bring in “new” money, to help the new agency buy mortgages from issuers.
Existing investors will take a haircut. But, after they “get over it”, what will they do? They’ll invest in the new agency, now explicitly backed.
A snippet from my blog yesterday:
I think these institutions have outlived their usefulness and should die. Their disappearance may cause some temporary dislocation and “the system” as we know it may never be the same. The wonderful thing about markets though is that they tend to evolve new systems when it makes sense. The only people who should be scared are the Wall Street and Washington big shots who feed on this corrupt and obsolete system. But we shouldn’t let them scare the rest of us into rescuing them, because the destruction of this system and its replacement with something better will only be a minor blip in our lives and in the end will benefit us all. We should rejoice that this detrius may be swept away in favor of something better, newer and more equitable. We should be excited, not scared, that the future can be bright if we don’t insist on preserving the vestiges of the past.
Robert:
On the money. It’s egregious but there’s no option but to rescue these wankers. There are so many nihilists here I’m starting to think I’m in a Dostoyevsky novel. When you read some of this stuff you have to wonder what their motivations are. Left wing students rediscovering apocalyptic Marxism. Democrats who don’t think we don’t need international trade. Market players who think they might make a buck from total chaos. Neanderthal conservatives out to prove a point. I’m sure BR doesn’t subscribe to most of this since he’s part of the system so why egg these people on. We are lucky to have Paulson there, imagine if Snow were still Treasury sec. I also believe a lot of what is happening arises from a desire to avoid the meltdown during a Republican president’s watch, how else to explain that they are throwing overboard just about every conservative tenet you can think of. But since a total meltdown is in no one’s interest it’s hard to disagree with the basic thrust of policy. In the wider sense, as George Will points out in this weeks Newsweek, it demonstrates that conservative tenets are largely movable feasts anyway and therefore, why not vote Democrat. Chill out dudes the end of the world is not going to happen, this is not 1929 although for some bizarre reason some posters here want a history to repeat itself. We’ve got a bumpy two years ahead, America is not going to default, there’s going to be a recession which in fact started earlier this year, unemployment is going to skyrocket, corporate profitability except in few areas is going to suck, the market is going to trade in the 11,000 area for the next year or so, inflation is going to be rampant, some regional banks are going to fail and maybe Wachovia, housing will probably take three years or more to fully recover, and that’s about it. The deluge is not going to happen. Sorry nihilists.
John: Thank you.
Both George Will and i graduated from Trinity College. He was one year ahead and we shared some of the same professors. Perhaps Trinity taught us more than the English History and Samuelson.
I think it is called common sense.
This statement, taken from the Leader of this issue of the Economist, sounds like a reshuffle of the ‘privatize the gains and socialize the losses’ statement yet this re framing of the sentiment shows the failure of the past and the direction we should be taking as we move into the future. Free markets, untethered by regulators, is a mythology that distracts us from a more direct commentary which should be focusing on a system that can be described as a scysophrenic–capitalism, socialism, democracy, globalization…If the 20’s was the Jazz age, we should call this the Hip-Hop age and embrace the mash-up systems that we have created and junk this ideological thinking which plagues our leadership.
Indeed the government had to act, yet the government should have nationalized Fannie and Freddie a week ago. It was the ‘privatized institutions always does it better’ ideology which got in their way. So, the next step is to unwind Freddie and Fannie because this episode exposes the fact that under the present formulation these two institutions can not bare the pressure of propping up 80% of the home mortgage market. Right?
I think that the transition in this last thought points to the risk that the system finds itself presently–the US economy must rebound so that housing prices stop deflating. Yet, before the economy can be saved, the primary job of the Fed today is not to encourage growth or contain inflation, it is to ensure that markets remain liquid and participants are able to access credit. The credit presently being accessed is being extended upon the ‘turtle back’ of perceived receipts of future US tax income. In other words, there is no reason to think that there is a bottom turtle down there due to the pressure that the cost of energy is putting on the consumer and future P&L of business. I’ve come up with other ways of stating this policy: “liquidity ad nauseum for a pro growth society to infinity”–or–”to ensure that there is an American home mortgage market no matter what the markets are saying even if this jeopardizes the existence of America itself.”
Robert,
As for pleading to “Republicans” not to be hard asses, maybe you meant “(r)epublicans” and not “(R)epublicans”. How so? “(R)epublicans” are in cahoots with “(D)emocrats” on bailouts.
>> don’t we as a country believe in helping the less fortunate
You misunderstand the consequences of bailing out investors. Who owns FF debt or stock? The top 1% of this country owns half the financial assets in this country. Those financial assets represent a combination of (a) earnings accumulated from past labor and (b) promises to pay future earnings (debt).
Sure, the rest of us own the other half. But, we earn a living by selling our labor; not by living off financial assets.
So, what happens when you write off all those financial assets? The present value of future labor *increases* as a percentage of overall wealth. (That’s right. The poor become richer.) The gap between rich and poor would nosedive. And, even though I’d have less nominal money in my 401(k), the NPV of my labor would rise as a percentage of all the wealth in the world. And with the credit destruction, any old or disabled people living on the bogus CPI-indexed Social Security payments would see the real value of their payments increase.
So, you want to help the poor? Don’t hand out welfare to the rich. That will help the poor.
If you “can’t sit still” to wait for the market to adjust on its own and want to do more to help the poor, then what you want instead is “bankruptcy reform”, to undo the 2005 act written and passed by credit card lobbyists. I.e., if you want to help borrowers and not the banks, then give everyone a chance to more easily renege on their debts and start over. If you let houses fall in price quickly (rather than slowly), business activity will pick up again *quickly*. And fewer jobs will be lost.
What you’re supporting instead is a proposal for Americans to remain “sharecroppers” in their houses for as long as possible.
Feel free to disagree or point out flaws. This is the first time I’m articulating some of these ideas.
John and Robert, you are, IMO, both unknowingly indenturing average Americans to pay debts to investors who chose to invest their money poorly. You are impoverishing average Americans. You are not helping them.
Even if you somehow *think* bailing out bond holders will help the end borrower sitting upside-down in his/her home, remember that the people who “own” a home are on average RICHER than the people who RENT.
If you *think* you’re being “compassionate” and helping people who need help, you’re doing it ONLY by hurting people who didn’t even have two nickels to rub together to buy a home.
Maybe kill two birds with one stone?
Just allow FNM/FRE to trade their debt for Zimbabwe dollars? Then they can run the printing presses all they want…
=)
” ‘therefore, the two companies could issue their own debt and exchange it for loans from the government—the equivalent of having access to the printing press …’
and on top of that, the fed would have to print money to buy the GSE paper …” — m3
————
There must be an economic law which holds that Bubbles are infinitely nested, one layer upon another, in an ever-unfolding pyramid.
Consider: the Federal Reserve — a creature of Congress, whose board members are appointed by the president — monetizes Treasury debt via the primary dealers. All of this is purely for the sake of appearances. One arm of government is buying and monetizing the debt of another, via ‘private-sector’ middlemen, in a sort of monetary auto-fellatio.
Now appear Fannie and Freddie — also government-sponsored creations — who as the Economist points out, can effectively monetize their own paper at will. Or, like the Treasury itself, Fannie & Freddie can issue their paper to third parties, who in turn can redeem it for cash liquidity at the Fed. And so the widening circle becomes a vast galactic spiral.
Sadly, none of this squalid fiat-currency check kiting provides any access to SPECIE, the ultimate and unimpeachable source of bearer liquidity. SPECIE is as remote a concept to Ben Bernanke as the Ark of the Covenant; shrouded in the mists of pre-history. That don’t mean it can’t still bite his ass, though.
One more point to the bailout advocates:
Do you ever wonder what the quality of life of “homeowners” would be if they chose to RENT in an apartment or smaller home instead of a McMansion at TWICE the price? How much extra health care or education could they have bought? What would the price of oil be if we didn’t blow this bubble? How much extra stress are they suffering from now, from having that big mortgage hanging over their heads?
You we-need-another-bailout-after-the-bust-of-the-last-bailout advocates need to recognize the hole we’re in, thanks to people who the last time reacted as you do now. Please stop digging!
As one who shorted real estate early, I want those prices back where they belong.
Let them all go bankrupt!
Elst pay me too!!
“But please, the US is NOT going to default on its debt.”
What you are claiming is that U.S. Treasury debt service could not possibly be delayed during a systematic banking collapse resulting in an unplanned bank holiday. That is … optimistic. It does seem unlikely, but it is possible to turn off Fedwire if a computerized meltdown starts.
“It’s egregious but there’s no option but to rescue these wankers.”
Indeed. By hook or by crook, the GSEs must be rescued to avoid systematic catastrophes.
But why must their stockholders be given a handsome reward? The stock of a high-leverage financial company is essentially a derivative tied to the business cycle. How does the taxpayer benefit by rewarding the speculators who made a losing bet in such stocks?
The gap between rich and poor would nosedive. And, even though I’d have less nominal money in my 401(k), the NPV of my labor would rise as a percentage of all the wealth in the world.
w, i think you underestimate the extent to which the leveraging of the last 30 years has helped you. it’s perhaps true that the gap between rich and poor here would close if the worst came to pass. but it’s also true that the gap between the united states and, say, zimbabwe would narrow considerably. being closer to the rich folks was no consolation to those standing in soup kitchen lines in 1932 — and shame on anyone who does not yet grasp from the data that that is in fact the appropriate context period.
we are in deep trouble in any case, but it behooves the government of any society so unfortunately endowed to mitigate the pain which must eventually come. this is not a morality play.
You guys are all so negative. Geez!
Overall it’s really not anywhere as bad as people are making it out to be. House prices could fall by 50% and still have been a great investment over the past couple of decades.
Speculators may be getting reamed but that’s the risk.
I also agree with the poster that said we should never let the GSEs go out of business. The chaos caused by letting the economy swing too far isn’t worth the repricing that is probably needed in some areas. Better to slow things down and keep people from starting a revolution (where no one wins)
Preach it wunsacon! Your arguments are much better articulated then I could have made them (and yet I’ll feebly attempt below…)!
You can have your free market, or you can eat your free market. Want financial innovation? Cool, but you also get to eat the losses. Why else were the GSE’s paying a premium over Treasuries? This “too big to fail” and “it’s best if we bail them out for all of us” types irk me to no end. We’re hear BECAUSE we did that last time.
For the love of god, STOP DIGGING! Will that hurt you? Yep, but you did it to yourself. Will it also hurt me? Yep, but it’s the only way to keep you from screwing up even bigger next time for even more hurt for me! We already tried this after DotBOMB, it didn’t work (as is evidenced by this latest bubble/debacle). So why if we bail you out again will it work this time? It won’t, it’ll only grow ever bigger and ever more hurtful for you and me.
Cn
The underlying reason for all of this failing financial chicanery is that the US does not produce amywhere near its share of wealth, period. Hence, no matter what is attempted by financiers and other suit-wearers whose only contribution to world production consists of methane ejected through their suits and into their chairs, the US and its financial institutions are going to utterly fail within 18 months.
One thing I can say is…I hope me and my family and our tax dollars as well as those of every other responsible American who lives within his means are spared the kind of “common sense” espoused by the Johns and Roberts of this world.
this is not a morality play.
Umm, yes it is. And the moral is this: We should fix this mess now, or at least begin to, and eat the cost ourselves instead of passing it on to future generations via more government debt along with absurd fairytales about future economic growth taking care of everything. As if the Treasury has the money to bail out FNM and FRE in the first place: if you extrapolate from the rate of debt issuance in May, the federal budget deficit is on course to top $1 trillion this fiscal year.
And I cannot think of anything more immoral than dumping all of that off onto our children.
Wunsacom:
I’m not being compassionate, in fact I’m not an awfully compassionate guy. I’m being pragmatic. The failure of Fannie/Freddie would cause a complete seize up of the US housing market, home sales would literally virtually halt for several months until the situation sorted itself out. The effects of this alone would be unforseable but traumatic. In the wider arena there would be the collapse of equity markets around the world, bank runs, a seize up of wider credit, a dollar run etc etc. You seem to view with total equanimity a meltdown of the US economic system in order to avoid a notional bill for our children which is largely in your head. I wonder if you have the faintest idea of what the consequences would be. Personally I think the govt should have nationalized F/F and started a long slow process of reducing it’s size, even the most crazy free market nuts at the WSJ ed page realize you couldn’t let them or BS for that matter fail because the consequences would be largely unpredictable but potentially catastrophic. Fortunately Paulson and not you is the treasury sec and he will have to continue putting together this jury rig. It’s not pretty but preferable to the boat capsizing.
The failure of Fannie/Freddie would cause a complete seize up of the US housing market, home sales would literally virtually halt for several months until the situation sorted itself out.
And that would be a bad thing?! IMO this just means we’d get back to the days when mortgage originators didn’t sell the risk off into a securitization black hole where it got rated ‘AAA’ by some outfit that’s immune to prosecution for its malfeasance, no matter how egregious. Or stamped with some ‘implicit’ guarantee, which is absolutely worthless due to the leverage employed. And that’s exactly where we need to go and be: lenders again being careful about who they lend money to because they hold the risk. Imagine that.
Daniel:
For some reason I can’t copy your money comments. But:
1.The US isn’t going to default because there isn’t going to be a systemic collapse of the banking system.
2.Where do you get the idea that the stockholders of F/F (which btw are major parts of the portfolios of most vanilla mutual funds including probably ones with your pension money if you are old enough) are going to be rewarded. The stocks of both of them are in the tank relative to a year ago despite a modest uptick. They need to raise oodles of new capital and wherever it comes from (govt most likely) it’s going massively dilute existing stockholders. All this activity is being done to shore up their role as credit creators and protect the debt holders.
All this hyperbole about debt loading our children is bs. Probably 95% of the paper they are holding is ok and even if the 5% is only worth 60 cents on the dollar it’s a manageable. What you’re losing sight of is that the only gainers from a fire sale of all the F/F debt, good and bad, would be insiders in hedge funds and the like.
Eh.
“And that would be a bad thing?!”
Yes Eh it would be a very bad thing, badder than you can possibly imagine. Even in it’s current depressed state new and existing home sales total approaching 6 million, if because of credit disruptions this dropped by say half to around 2.5million the effects would be volcanic. Unfortunately your prescription might remove the cancer from the patients body but would kill him in the process.
Probably 95% of the paper they are holding is ok and even if the 5% is only worth 60 cents on the dollar it’s a manageable.
So why do they need a “rescue” then?
It’s egregious but there’s no option but to rescue these wankers.
Do you actually read the stuff you write? And I guess you pull those numbers out of your own black hole.
But at least you agree with me: We shouldn’t do a damn thing.
…this dropped by say half to around 2.5million the effects would be volcanic.
Love those adjectives — it’s “volcanic” this time. Ooh, now I’m even more convinced by your, ahem, arguments.
That’s right, we have to ASAP get right back to getting rich by churning/selling each other ever more expensive houses with money created out of nothing. Otherwise the country will go right into the crapper.
Unreal.
Eh:
Why don’t you counter with a few facts instead of your opinions and rather juvenile critiques of my terminology. If you don’t think the consequences of a fall in the sale of homes to around 2.5 million would be traumatic what can I say.
“So why do they need a “rescue” then?”
We need to rescue them because they are overleveraged and this has caused a crisis of confidence. We can argue about why or how they reached this state but that’s where we are but the fact that the Treasury sec a former head of the most revered investment bank in the country agrees suggests that there is at least an intellectual case to be made for rescue even if seems beyond your understanding.
“Do you actually read the stuff you write? And I guess you pull those numbers out of your own black hole.”
I am of course speculating when suggesting that 95% of their paper is ok although many others have suggested similar numbers. But you are doing the same if you suggesting their situation is much worse. Ahh…yes you didn’t actually provide any facts, preferring to opinionate in the abstract.
” But at least you agree with me: We shouldn’t do a damn thing.”
Do you read. This is absolutely the opposite of what I said and indedd what appears to have provoked your irrational ire. We have no option but to take action. I would of preferred full nationalization and an orderly liquidation of their book which is essentially what is going to happen to the BS inventory of paper. It will probably cost a few billion but that’s chump change set against the consequences of a BS failure.
complicated stuff this shakedown cruise
WHO’s checking account (built with derivatives) is going to STAY in the black via those credit cards LONGER?
Can a debtless person even survive the storm? Doubtful.
Soverign funds eschewing GSEs
http://themortgageinsider.net/mortgage-news/foreign-sovereign-funds-turn-their-backs-on-the-gses/
And what exactly is the dynamic-duo plan for F&F?
“The US isn’t going to default because there isn’t going to be a systemic collapse of the banking system.”
You mean there need not be a systematic collapse, because the necessary interventions to prevent one are straightforward and obvious. The regulators have planned for it and know how to do it.
If that were true, the IndyMac cleanup would have been a successful dress rehearsal. Whoops. Small businessmen watched IndyMac and learned a lesson: be early on the next run or lose half your payroll account. One or two more IndyMacs and systematic runs become likely.
“Where do you get the idea that the stockholders of F/F … are going to be rewarded.”
The Bear Stearns jackpot and quotes like this: