Government by Stealth: the GSE affair continues

David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in NYT, WSJ, Barron’s, and other publications. He is a frequent contributor to CNBC. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).


December 25, 2009

Merry Christmas to all and best of holiday wishes. We didn’t plan on writing today but are doing so to be sure our clients and readers and the especially the 300 worldwide journalists on our list see the action just taken by the Treasury Department under Secretary Geithner. It was clearly designed to minimize the press coverage of the changes in the GSEs.

This item was released after the closure of the healthcare debate and after the extension of the debt limit passed and after the president left for his Hawaii trip. Sent out on Thursday afternoon, Christmas Eve, the press release outlines the many changes that Treasury is making because of the worsening conditions of Fannie and Freddie. And it paves the way for the recognition of losses in the hundreds of billions in the GSE mortgage pools where the face amounts of the mortgages exceed the property market values or foreclosure amounts.

This action also moves things one step closer to full nationalization of the GSEs and full specific guarantee of the GSE debt by the US Treasury. That would put official GSE debt on the US government’s sovereign debt balance sheet. That is also where it belongs since this has been a game of deception over the implied guarantee and it is time for it to stop. Technically the GSEs are still operating under an ”implied” guarantee. Because of that the foreign sources and domestic US institutions have been reluctant to buy GSE debt and the Fed has had to step in with over $1 trillion to bolster the US housing market.

We believe this action confirms the seriousness of the GSE problem and is another reason why the Fed must stay on hold with low interest rates for an ”extended period” and why there may even be an extension and enlargement of the Fed’s holdings of GSE paper. If markets do NOT reprice GSE debt at very tight spreads to Treasury debt, the home mortgage interest rate in the US will rise and the nascent housing recovery will be choked off. The Fed knows this and is watching these spreads closely.

The full text of the Wall Street Journal online report and the Treasury release is below. When will Mr Geithner and his colleagues learn that there are no secrets and that transparency and explanation is much better than release of details in the middle of the night. Probably never but there are some of us who will leave our holiday time for a few minutes and keep reminding them. We are scheduled to remind them again on CNBC Closing Bell at 4:30 PM on Monday. CNBC Squawk Box Asia and on CNBC Power Lunch on December 30.

We again wish our readers best wishes for the New Year. Our earlier comments on GSEs are archived on our website. We again commend Barclays for its excellent report on the GSE situation. The text is below.

Wall Street Journal

DECEMBER 24, 2009, 4:05 P.M. ET.

U.S. Uncaps Support for Fannie, Freddie

WASHINGTON — The U.S. Treasury said it would provide capital as needed to Fannie Mae and Freddie Mac over the next three years, effectively opening its checkbook to the government-controlled companies in a bid to reassure investors in their debt.

Treasury also will end its purchases of the companies’ mortgage-backed securities and terminate a never-used short-term liquidity facility set up for the firms and the Federal Home Loan Banks.

And it moved to allow the companies to shrink their giant portfolios of mortgage securities more slowly, though it said it was still “committed to the principle” of reducing the portfolios.

Treasury announced the moves in a Christmas Eve press release, a week before its authority to change the terms of its agreements with the companies was set to expire. After Dec. 31, Treasury would need the consent of Congress to make such changes.

So far, the government has pumped $60 billion into Fannie Mae and $51 billion into Freddie Mac to keep each company solvent since it seized the firms in September 2008 under a legal authority known as “conservatorship.” The companies, threatened by mounting mortgage defaults, were headed toward collapse.

At the time, the Treasury pledged to inject up to $100 billion of capital apiece as needed into the companies in exchange for preferred stock paying a 10% dividend. The Obama administration earlier this year doubled that commitment to $200 billion.

The new terms announced Thursday would allow the cap on Treasury’s support to increase by the amount of the total net loss the firms experience over the next three years, beginning on Jan. 1. The cap in place at the end of 2012 would apply thereafter.

The changes come as Fannie’s and Freddie’s regulator, the Federal Housing Finance Agency, on Thursday approved multimillion pay packages for the firms’ top executives. The pay announcement and the sweeping increase in the government’s commitment to backstop the companies are certain to stoke anger from the companies’ critics on Capitol Hill.

“The Obama administration’s decision to write a blank check with taxpayer dollars for the continued bailout of Fannie Mae and Freddie Mac is appalling,” said Rep. Scott Garrett (R., N.J.). He argued the timing of the announcement, on Christmas Eve, was “designed to try and sneak the bailout by the taxpayers.”

A senior Treasury official said he didn’t expect either company to need the additional authority Treasury is creating by ending the caps on its support. Rather, the changes would provide reassurance to investors in Fannie’s and Freddie’s debt and mortgage-backed securities so that they would continue to invest, the official said.

The companies’ top regulator, Federal Housing Finance Agency Director Edward J. DeMarco, said in a statement that the changes provide “further protection against adverse conditions in the mortgage market.”

The administration, in a midyear review of the 2010 budget, estimated the taxpayer exposure to the companies at a combined $170 billion over 10 years.

Treasury also on Thursday moved to relax a requirement that the companies shrink their portfolios of mortgage securities by 10% per year beginning next year. Treasury will allow them to base the 2010 reduction on the maximum limit on the size of the portfolios — $900 billion — rather than their actual size at the end of 2009.

The move would allow the companies flexibility to avoid selling off securities next year just as the Federal Reserve and Treasury are ending programs to purchase mortgage-backed securities, a senior Treasury official said. Currently, each firm’s portfolio stands at more than $700 billion.

Treasury also said it would waive for one year a fee charged the companies in exchange for the government aid. The Treasury official cited the poor conditions in the mortgage market.

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