Free Republic
Browse · Search
News/Activism
Topics · Post Article

Skip to comments.

Going for Broke - In bailing out Fannie and Freddie, the feds up the ante on a bet that they may...
City Journal ^ | 11 September 2008 | Nicole Gelinas

Posted on 09/12/2008 12:30:08 AM PDT by neverdem

In bailing out Fannie and Freddie, the feds up the ante on a bet that they may not be able to cover.

Just days after the White House nationalized quasi-private mortgage companies Fannie Mae and Freddie Mac, all eyes were on Lehman Brothers. The investment bank saw its share price plunge from $70 a year ago to $7 Wednesday—or $3 less than Bear Stearns shareholders got when the feds rescued its creditors from bankruptcy in March. It’s possible that we’re now about to see the real consequences of Uncle Sam’s Fannie and Freddie action, and that the taxpayers’ inn for indigent financial institutions is about to get dangerously crowded.

On Sunday, Treasury secretary Henry Paulson, with President Bush’s support, announced that the White House would put Fannie and Freddie into a government-controlled “conservatorship.” The conservatorship will keep the two firms running and protect creditors while gutting top management. Shareholders, who always take the biggest risks at companies in return for the highest possible reward, will shoulder the firms’ precipitous drop in value, since the government declined to protect them, only guaranteeing the creditors against losses. Shares in each company are now trading below $1. The feds have put their own top officers in charge of the firms and stated that federal taxpayers will provide “unlimited liquidity”—a blank check—to the two companies for the next year and a half or so. The government will also pump up to $200 billion in cash into the companies to stem rising losses, and commit to buying billions in mortgage securities (on behalf of the taxpayer) from them, hoping that this will prop up the mortgage market and give international investors the confidence to keep investing in U.S. mortgage debt.

All are unprecedented steps. Unfortunately, they’re necessary ones: Fan and Fred guarantee more than $5.3 trillion in mortgage debt and have been responsible for three-fourths of recent mortgage approvals, as the private housing-finance market has imploded. Just a few weeks ago, though, the feds had hoped that such dramatic action wouldn’t be needed. Paulson and Fannie and Freddie’s regulators had sought to assuage investors’ fears in July, when Congress gave the U.S. Treasury authority to inject money into the two institutions. At the time, Paulson likened the power to having a “bazooka” but not having to shoot anyone with it.

But the investors who hold the plurality of Fannie and Freddie’s debt—quasi-government agencies and banks throughout Asia, Europe, and the Middle East—weren’t convinced. They wanted Uncle Sam to show them the money, not just promise it, and now he has done so. Further forcing the feds’ hand: Fan and Fred shareholders correctly feared that the government would, if it did intervene, protect only debt, not stock, at the failing firms, as in the Bear Stearns episode. Both existing and potential shareholders were scared off, and Fannie and Freddie couldn’t raise any capital, helping to seal their fate.

The federal takeover of Fan and Fred is troubling not merely because it promises yet more political distortion of the housing market. It’s reasonable to worry that the government’s decision to purchase mortgage-backed securities will prevent the private markets—including funds that specialize in distressed debt—from finding out the securities’ true value, an uncertainty that will keep private investors out of the market even longer than they otherwise would stay put, prolonging the pain we’re in now.

But a more chilling prospect is this: much of the rest of the beleaguered financial world looks, from today’s perspective, similar to how Fannie and Freddie looked six weeks ago. Consider that, after the Bear Stearns rescue in March, the Federal Reserve began allowing the surviving investment banks, including Lehman, to borrow directly from the Fed. This move was also unprecedented, at least in modern times. Unlike commercial banks such as Citigroup, i-banks are supposed to be free-wheeling risk-takers, so the assumption was that they’d be largely on their own if they ran into a crisis.

The Fed’s action in Bear’s case was intended to stop creditors, trading partners, and counterparties of the remaining investment banks from fleeing the company in droves, as they’d started to do at Bear, and setting off even more panic throughout the financial industry. No matter what kind of toxic murk the investment banks had on their books, they could find a way to rearrange it so that the Fed would take it off their hands and give them real money in return, thus ensuring that enough money would be available to keep the BlackBerries working and to pay their remaining employees and lenders.

But the government hasn’t made clear just how far its support for the investment banks will go, just as it wasn’t clear, until this week, about what it would do to back Fannie and Freddie. And creditors of the remaining investment banks fear that the Fed will stop its lending. After all, its cohort across the ocean, the European Central Bank, last week implemented much stricter rules on its own investment-bank lending program. These investment-bank creditors now want the government to show that Bear wasn’t a special case, and that it would rescue all big investment banks from potential bankruptcy. The financial environment has deteriorated substantially since March; it’s less likely that the government today could find a white-knight company like JPMorgan to step in and purchase a flailing company like Bear, even with federal guarantees against certain losses.

So just as was the case with Fannie and Freddie this weekend, the markets seem to want clarity about what, exactly, Uncle Sam would do to protect more investment banks from bankruptcy. The markets are looking for a more explicit guarantee that creditors won’t suffer from their firms’ folly—as such creditors would and should—in a real free-market economy. Further, freshly reminded of what happens to shareholders in a financial failure, shareholders of investment banks are jumping ship. Without new investors to shore up capital, investment banks and other financial institutions, including big hedge funds, are extremely vulnerable.

Unfortunately, the feds could justify making explicit government guarantees and injecting capital into investment banks, and taking similar actions at huge commercial banks that have the potential to overwhelm the FDIC’s reserves, with the same rationale it used in the Fannie/Freddie and Bear Stearns cases.

For starters, there’s the housing market. President Bush and both presidential candidates all seem to agree that it’s the government’s job to slow the slide in housing prices. They might think their chances of succeeding here are slim unless they also prop up the investment banks, which, supported by Fannie and Freddie, have run the mortgage-market infrastructure for the past two decades. And perversely, they might even think that propping up the investment banks is their only chance to give Fannie and Freddie some competition in a few years, thus providing the government with an exit strategy to wind down those two behemoths.

Then, there’s the “too big to fail” rationale. The feds said back in March that Bear’s creditors needed protection because if they didn’t get it, they’d swamp the financial system, selling off the collateral that they had demanded in return for lending to Bear Stearns. The same could happen if another big firm failed.

The weightiest justification the feds could cite, however, is the health of the dollar. In Fannie and Freddie’s case, the feds acted partly because, if the Chinese and the Japanese and the Kuwaitis and our other creditors had stepped up their sales of Fannie and Freddie bonds, it could have ignited a run on the U.S. currency. It’s hard to quantify the exact risk of this scenario. But it certainly was a real possibility. Another investment-bank failure or a shattering commercial-bank failure—despite all of the efforts the government has made to prevent such occurrences in the past six months—could heighten the same risk.

So there’s a very real possibility—again, impossible to quantify—that within the next year or so, the American banking sector will be a wholly owned subsidiary of the U.S. government. In such a case, just as China calls itself a socialist economy with market characteristics, we’d have to call ourselves a market economy with socialist characteristics—and that’s putting a positive spin on things.

But even that’s not the most chilling scenario. The real nightmare would be if the government did all of these things—under the same perfectly reasonable-seeming justifications that it has used over the past six months—and still failed to stem the banking crisis, instead turning it into a national fiscal and monetary crisis. It’s perfectly conceivable, for example, that the government could take on hundreds of billions of dollars of new risks on behalf of the taxpayers, and find that there’s simply not enough money in the U.S. treasury to stem the fall in housing prices and thus end the banking crisis. The open-ended risk here is already startling. If Fannie and Freddie suffer losses in their mortgage portfolios of just 10 percent, it would cost taxpayers $500 billion. Losses of 20 percent would cost taxpayers more than $1 trillion.

The possibility of such losses is real. Between 2000 and 2006, home prices across 20 urban areas from Las Vegas to Cleveland more than doubled, on average. They’ve fallen by less than 20 percent since then—meaning we could have a long way to go before we hit bottom. Last week, the Mortgage Bankers Association said that nearly 9.2 percent of mortgage borrowers are at least a month behind on their payments, the highest rate since the association started keeping records four decades ago. More foreclosures mean lower prices—and that in turn means more foreclosures, and still-lower prices. People who borrowed based on bubble prices may get tired of throwing money down a black hole every month. In the U.S. economy’s previous bubble—tech stocks—the Nasdaq stock market reached a high of 4,959 points eight years ago. It hasn’t recovered since, closing at 2,210 this past Tuesday.

The bailouts could thus pose a substantial danger to our national fiscal health. A trillion-dollar loss at Fannie and Freddie would represent more than 10 percent of our national debt. Such a hit, protracted over several years, would discourage foreign governments’ banks and investment agencies from investing in our Treasury bonds, pushing up interest rates and mortgage rates, too.

In going further down this path, we risk a slow desertion of our currency and government bonds that could be just as devastating as the rapid desertion the feds were trying to prevent with the Fannie and Freddie action. What would have been a painful economic adjustment would become tortuous. We’d have to bring back our economy after having lost the world’s confidence and having hampered, through massive government intervention, our markets’ ability to recover slowly on their own. The government and its supporters could wind up wishing that Bear simply had been allowed to declare bankruptcy in March. Had the feds taken this course of non-action, they would have shown clearly where they draw the line in giving protection to the creditors of supposedly private, risk-taking companies.

Granted, this is a worst-case scenario. But a year ago, people would have said the same thing about a government takeover of Fannie and Freddie.

Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst.


TOPICS: Business/Economy; Editorial; Government; Politics/Elections
KEYWORDS: fanniemae; freddiemac; govwatch; socialism

1 posted on 09/12/2008 12:30:08 AM PDT by neverdem
[ Post Reply | Private Reply | View Replies]

To: neverdem

This what happens when the Federal Government becomes Big Brother or Big Daddy. Law makers doing anything and everything to protect their reelection with their pork, ear marks etc. Passing laws that insure that people who should never be given loans for homes they cannot afford and bailing out people that make their living buying and selling property.


2 posted on 09/12/2008 12:42:06 AM PDT by Dustbunny (Freedom prospers when religion is vibrant and the rule of law under God is acknowledged. The Gipper)
[ Post Reply | Private Reply | To 1 | View Replies]

To: neverdem

Plus
the RATS have been trying their dammest to put us in another depression. So they can rescue us.


3 posted on 09/12/2008 1:10:52 AM PDT by Waco ( G00d bye 0'bomber)
[ Post Reply | Private Reply | To 1 | View Replies]

To: neverdem
I am certainly not a financier but it doesn't take much more than a few Goggles to see what was happening.

The Congressional liberals were using the banks, Freddie and Fanny for nothing more than a giant piggy bank to subsidize low income housing loans and affordable housing. Freddie and Fanny both had on their web pages that they were proud to help provide "unconventional" loans. Yet they were criticized by Congress for not doing more to help the lower income people "like the banks". They were ask to raise their affordable housing commitment which they did from 50% to 54%. These lower rate loans spilled over into the prime market. People have responsibilities to manage their finances and I'm not making excuses for those who fell into this trap; but legislative fingerprints are all over these unconventional loans and this housing mess that now has left tax payers with billions of dollars of extra debt.

Why would the liberal Congress do this? In Virginia, if you have a resident and (presumably) a valid driver's license, you can vote.

Where are the Congressional hearings by the Senate Banking committee who is suppose to oversee this sort of thing? Apart from a few minor hearings, they are strangely silent these days.

Senate Bank Committee Members

Christopher J. Dodd Chairman (D-CT), Tim Johnson (D-SD), Jack Reed (D-RI), Charles E. Schumer (D-NY), Evan Bayh (D-IN), Tom Carper (D-DE), Robert Menendez (D-NJ), Daniel K. Akaka (D-HI), Sherrod Brown (D-OH), Robert P. Casey (D-PA), Jon Tester (D-MT)

Richard C. Shelby Ranking Member (R-AL), Robert F. Bennett (R-UT), Wayne Allard (R-CO), Michael B. Enzi (R-WY), Chuck Hagel (R-NE), Jim Bunning (R-KY), Mike Crapo (R-ID), Elizabeth Dole (R-NC), Mel Martinez (R-FL), Bob Corker (R-TN)

4 posted on 09/12/2008 1:47:07 AM PDT by HarleyD
[ Post Reply | Private Reply | To 1 | View Replies]

To: neverdem

To repost my take on the whole financial mess:

Plenty of stupidity all the way around. The buyers who lied about their incomes were stupid. The lending agents who encouraged/ outright told buyers to lie were stupid. The banks who didn’t verify anything were stupid. The bank’s investors who packaged the mortgages together, called it “equity” and borrowed against it to issue more mortgages were stupid. The investors who bought derivatives too complex for human comprehension were stupid. The ratings firms who blessed the whole flea circus with AAA ratings were stupid. And regulators were stupid for not stopping it much earlier (even congress was stupid for pushing hard for banks to make more high-risk mortgages).

Philosophically, I believe very strongly in a free-market economy. And that means that I believe stupid people and corporations should lose their money, homes, corporate assets, etc. So philosophically, let the buyers lose their homes, the agents lose their jobs, the banks end up with a house worth 1/3 of the mortgage, the investors lose their shirts, the ratings agency lose their credibility, and various corporations declare bankruptcy and/or merge.

But I can accept that I am wrong. I can accept the claim that this would devastate the entire US economy, drive us into recession, and cause Republicans to lose more seats in the next election.

The government can intervene in several ways, but if we are talking about a government ‘bail-out’, then that explictly means that the government is going to give (large) sums of money to entitites that have done nothing to deserve it.

And if we do that, we have two choices of targets — we can give money to the stupid lying homebuyers. This would allow them to continue paying their mortages, avoiding foreclosure, which means the bank has a valuable steam of payments instead of a less valuable house. Fewer fire sales on houses means a more controlled rate of devaluation, making non-distressed home-owners happier if they have cause to sell a house. And the various investments will likely pay at least face value until they are properly closed out.

Alternatively, we can give money to the stupid lying bank investors. That way, when they foreclose on a house worth only 1/3 the mortgage and default on the bogus investment offers and crash the housing market encouraging more people to default on under-water mortages, they won’t quite go out of business.

If we are to intervene at all, I’m not at all sure that the bail-out money is appropriately targeted. I see no principled argument explaining why investors but not homeowners should be rescued.


5 posted on 09/12/2008 1:54:18 AM PDT by TennesseeProfessor
[ Post Reply | Private Reply | To 1 | View Replies]

To: neverdem
Isn't Jamie Gorelick, the Clinton administration harpie who established a 'legal wall' which blocked Clinton administration hacks from being properly vetted for security clearances, and prevented the cia from divulging info about known terrorists to the fbi?

She is one of the many CLinton era looters who destroyed Fannie MAe and Freddie Mac in the name of diversity....

The debacle of 50billion down the drain is the result of the CLintonistas cashing in on the percs of high office.

We are going bankrupt on their pilfering.

If we don't stop the dems in November, you can say hello to the next great depression that will topple the word's democracies.

6 posted on 09/12/2008 2:12:50 AM PDT by x_plus_one (Muhammed and Allah = memes destined for the ashheap of history.....)
[ Post Reply | Private Reply | To 1 | View Replies]

To: HarleyD
Well put.

It was probably a mistake, but yesterday morning I was listening to NPR on the way to work. NPR reported, with glee, that the bailout caused a drop in 30 year mortgage rates and that the institutions were gearing up to write a lot of new ones. I found myself yelling at the radio, "How can you be so ignorant of basic economics? Don't you understand that this rate underestimates the true risk of these loans? Because of the gov't backing, we just cosigned every one of them!"

The real problem here is that the people writing these mortgages and the people obtaining them don't have enough "skin in the game." The execs of the financial institutions get big bonuses when their revenues grow and golden parachutes when the whole thing tanks. Bubba Bumpkin gets a larger home than he can prudently afford, then probably furnishes it with credit card debt, and finally just lets the bank foreclose when he can't make the payments. Senator Payout gets votes and PAC contributions to his campaign.

What really irritates the wife and me is that we have tried to work hard and make prudent financial decisions all our lives. These politicians want to tax us to pay for the foolishness and scheming of others. I want to see every mortgage company exec involved bankrupt and the pensions of the senate banking committee and Andrew Cuomo confiscated to pay the debt before that happens. But you know these pandering politicians and schemers will live large while we foot the bill. My only solace is that the Lord sees the hearts and deeds of these folks and vengeance is His!

7 posted on 09/12/2008 4:53:55 AM PDT by RochesterFan
[ Post Reply | Private Reply | To 4 | View Replies]

Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.

Free Republic
Browse · Search
News/Activism
Topics · Post Article

FreeRepublic, LLC, PO BOX 9771, FRESNO, CA 93794
FreeRepublic.com is powered by software copyright 2000-2008 John Robinson