Swan Song for Fannie

Eulogy For The "Ownership Society"

By Mike Whitney

18/07/08 "ICH" -- - The Fed's emergency rescue plan for the financial markets is hopelessly flawed. It's a scattershot approach that doesn't address the real source of the problem; an unregulated, unsustainable structured finance system that emerged in full-force after 2000 and spawned a shadow banking system that creates trillions of dollars of credit without sufficient capital reserves. This is the heart of the problem and it needs to be debated openly. The present system doesn't work; it's as simple as that. It makes no sense to provide trillions of dollars of taxpayer money to shore up a system that is essentially dysfunctional. It's just throwing money down a rat-hole.

The Federal Reserve and US Treasury want a blank check to prop up Fannie Mae and Freddie Mac, the two war-horses of the mortgage industry, that currently underwrite nearly 80 per cent of all new mortgages in the US. But by any objective standard both of these GSEs are already insolvent. Thus, the taxpayer is being asked to rescue a failed industry that has been used for private gain so that speculators will not have to suffer the losses. Even worse, Fannie and Freddie have written hundreds of billions of dollars worth of mortgages that have not yet defaulted, but will certainly default within the next two years. This is bound to batter the already faltering economy.

The bad paper held by Fannie and Freddie are mortgages that were made to unqualified applicants who are presently losing their homes in record numbers. Their loans were approved because there was no functioning regulatory body to oversee their issuance and because the mortgages were transformed into complex securities that were sold to credulous investors around the world. The ratings were fixed to meet the requirements of their employers, the investment banks, which marketed these exotic bonds to foreign banks, insurance companies and hedge funds. That puts Fannie and Freddie at the center of a system that needs radical surgery to eradicate the bad paper. If this doesn't happen in a timely fashion, then foreign investors will stop purchasing US debt and the dollar will crash. By creating a backstop for Fannie and Freddie, the Fed is linking US sovereign debt with mortgages and derivatives that are already known to be fraudulent. This is a big mistake. According to Merrill Lynch, the US is already facing a long-term "financing crisis" as the weakening US economy and sluggish consumer spending could signal an end to the $700 billion in foreign investment that covers America's current account deficit. By assuming the GSE's enormous debts, the Bush administration is just speeding this process along and inviting disaster.

Treasury Secretary Henry Paulson has been intentionally oblique about the implications of the proposed bailout. On Tuesday, he delivered a statement in front of the massive stone columns of the Department of the Treasury, a towering monolith that arouses feelings of confidence in rock-solid institutions. He made it clear that Fannie Mae and Freddie Mac would have the "explicit" backing of the US government:

"First, as a liquidity backstop, the plan includes a temporary increase in the line of credit the GSEs have with Treasury. Treasury would determine the terms and conditions for accessing the line of credit and the amount to be drawn.

Second, to ensure the GSEs have access to sufficient capital to continue to serve their mission, the plan includes temporary authority for Treasury to purchase equity in either of the two GSEs if needed.

Third, to protect the financial system from systemic risk going forward, the plan strengthens the GSE regulatory reform legislation currently moving through Congress by giving the Federal Reserve a consultative role in the new GSE regulator's process for setting capital requirements and other prudential standards."

It was an impressive performance from a public relations point of view, but it didn't fool anyone on Wall Street. What Wall Street wants is details not blather. Paulson gave no specifics about how much money the government would provide or what the nature of the new relationship would be; conservatorship, recievorship, nationalization? What is it?

The truth is that Paulson was deliberately vague because he and friend Bernanke would like to have it both ways; they'd like to provide a liquidity backstop and an endless line of credit for the two GSE's without formally nationalizing them. That would avoid the further dilution of stock values while keeping the US government from taking another $5 trillion of mortgage debt onto their balance sheet. It is a delicate balancing act, but Paulson seems to think he carried it off. He's wrong, though, and volatility in the stock market proves it. Investors are clearly skittish about the new arrangement. They want to know the facts about the government's commitment. Paulson is discovering that deceiving investors is not as easy as duping the public about fictional WMD or Niger uranium. Sometimes even the dullest person can grasp the most complex matters when it comes to his own money.

Fannie and Freddie have been insolvent for ages, but it hasn't stopped lawmakers from pushing the envelope and loading more debt on their balance sheets. Here's how Barron's summed it up more than six months ago:

"Fannie's balance sheet is larded with soft assets and understated liabilities that would leave the company ill-equipped to weather a serious financial crisis. And spiraling mortgage defaults and falling home prices could bring a tsunami of credit losses over the next two years that will severely test Fannie's solvency.

But, if the truth be known, a considerable portion of Fannie's losses also came from speculative forays into higher-yielding but riskier mortgage products like subprime, Alt-A (a category between subprime and prime in credit quality) and dicey mortgages requiring monthly payments of interest only or less. For example, Fannie's $314 billion of Alt-A -- often called liar loans because borrowers provide little documentation -- accounted for 31.4% of the company's credit losses while making up just 11.9% of its $2.5 trillion single-family-home credit book. Fannie was clearly looking for love -- and market share -- in some of the wrong places."

Rampant speculation, risky investments, and Enron-type accounting; hardly the stuff of solid portfolios. That's why the two mortgage giants are stumbling headlong towards oblivion despite the Treasury's panicky relief operation. By last Friday Fannie's stock had fallen 47 per cent while Freddie was down 50 per cent. The public may still be in the dark about what is going on, but investors have a pretty good grip on the situation; they can see the great birds are already circling overhead and its just a matter of time before they descend on their prey. Paulson's attempts to muddy the water have amounted to nothing. The fact remains that the two biggest mortgage-lenders in the world are busted and last week's stock sell-off was tantamount to a run on the country's largest bank. Paulson's statement was really nothing more than a eulogy for the mortgage industry; a few heartfelt words over the rigid corpse of a close friend.

When the housing market started to tumble and Wall Street's "securitization" model froze-up, Fannie had to take the lion's share of the mortgages to keep the real estate market hobbling along. In a two year period, between the housing peak in 2005 and 2007, Fannie went from roughly 40 per cent of the market to about 80 per cent. The Congress even enlarged the size of the mortgages they could underwrite from $417,000 to over $700,000. The prospect of bankruptcy never diminished congress's generosity.

Fannie and Freddie currently own or underwrite roughly half of the nation’s $12 trillion mortgage market. Basically, every home mortgage lender depends on them for financing. Their shares are owned by individual investors and banks around the world. Foreign investors have always believed that the GSE bonds were as risk-free as US government Treasuries. Now they are beginning to wonder. (Foreign central banks, led by China and Russia, hold at least $925 billion in U.S. agency debt, including bonds sold by Freddie and Fannie, according to official U.S. statistics)

Whatever happens to Fannie, the loss of investor confidence will send long term interest higher as investors demand bigger returns for the risk they're taking on GSE bonds. That'll put a straitjacket on home sales which are already flagging from soaring inventory and falling prices. Higher rates could bring the whole housing market to a standstill.

The Fed's cheap credit policy under Greenspan created an artificial demand for housing which ballooned into the biggest equity bubble in history. Low interest rates are a subsidy which naturally lead to speculation and asset-inflation. At a certain point, however, the endless debt-pyramiding reaches its apex and the whole mechanism switches into reverse. Now the economy has entered deleveraging-hell where everything is primal blackness and the gnashing of teeth, the flip-side of speculative rapture.

By some estimates, Freddie Mac has a negative net-worth of $17 billion. It's basically insolvent, although Paulson would like to see the charade go on a while longer. Investors purchased another $3 billion of the two GSEs last Monday, but the appetite for failing bonds is diminishing? What's certain is that the collapse of Fannie and Freddie would be a watershed event and a mortal blow to the US financial system. $5 trillion in shaky mortgage-debt can't be easily swept under the rug and ignored. Interest rates on everything would quickly rise; credit would become scarcer, economic growth would shrivel, unemployment would soar, and the dollar will plummet. As the two mortgage giants continue to get whipsawed by higher priced capital and waning investment, US government debt will likely to lose its much-vaunted triple A credit rating. On Friday, credit default swaps on government debt doubled, a sign that investors are losing confidence that the US will be able to manage its twin deficits or pay off its debts. It's the end of the road for Washington's free lunch throng and for a paper dollar that isn't backed by much of anything except music videos, fast food and smart-bombs.

PAULSON'S POWER GRAB

What Paulson is really wants is for congress to allow the Fed to regulate the financial system without congressional oversight. Paulson's so-called blueprint for financial regulation is a blatant power-grab meant to expand the authority of the banking oligarchy giving them unlimited power over the markets. Journalist Barry Grey sums it up like this in his article on "US Bailout of Mortgage Giants: The politics of plutocracy":

"The plan outlined by Treasury Secretary Henry Paulson would give him virtually unlimited and unilateral authority to pump tens of billions of dollars of public funds into the mortgage finance companies. At the same time, the Federal Reserve Board announced that it would allow the companies to directly borrow Fed funds... The Democrats...now march in lockstep with the minority party to rush through laws demanded by Wall Street... The buying of legislators and their votes by corporate interests is carried out openly and shamelessly. Members of Frank’s House Financial Services Committee received over $18 million from financial services, insurance and real estate firms this year. Frank himself raised over $1.2 million, almost half of which came from finance and related industries...Senator Dodd’s top contributor in the 2003-2008 election cycle was Citigroup, followed by SAC Capital Partners. He raised $4.25 million from securities and investment firms.
Senator Schumer’s top contributor was likewise Citigroup. He raised $1.4 million from securities and investment firms, his most lucrative corporate sector."

The smell of political corruption is overpowering, and yet, the plan is moving forward regardless. Even if Paulson's plan worked in the short term, the damage would be enormous. It would place the country's regulatory powers and purse-strings in the hands of the same amoral banksters who created this mess to begin with. It is the fast-track to corporate feudalism on a nationwide scale.

PITFALLS FOR THE GSEs

The biggest problem facing Fannie and Freddie is that wary investors will not roll over the debt of the two companies which will precipitate a collapse. This is where it pays to have people who can be trusted in positions of power. Henry Paulson is the worst thing that ever happened to the US Treasury. Paulson is to finance capitalism what Rumsfeld is to military strategy. To say that Paulson is lacking in credibility is an understatement. Nothing he says can be taken at face-value. When Paulson says "the worst is behind us" or the "subprime crisis is contained" or the Bush administration "supports a strong dollar policy"; most people know it is a fabrication. Besides, Paulson is completely out of his depth in the present crisis. His appearances on TV, with the beads of sweat glistening on his forehead, and his foolish repetition of the same stale mantra is eroding confidence in the financial system and sending waves of panic rippling through Wall Street. Enough is enough. He needs to go.

If the administration was serious about changing direction they would dump Paulson and reinstate Paul Volcker. Whatever one thinks about Volcker, his presence would calm the markets and send a message that the adults were back in charge. But that won't happen. The Bush team still thinks they can finesse their way through the thicket of investor skepticism. That means that catastrophe is inevitable as more and more investors pick up their bets and head for the exits.

TIME IS RUNNING OUT

Whatever the administration decides to do; time is short and they have one chance to get it right. The Treasury needs to find a way to ring-fence the garbage bonds and pray that the investing public won't dump their holdings in a panic run on the market. Either way, it's a gamble and there's no guarantee of success. The Wall Street Journal outlined the doomsday scenario if Paulson's plan fails:

"Falling house prices and nonpaying homeowners cause the value of the trillions of dollars in outstanding debt held by these government-sponsored enterprises (Fannie and Freddie) to plunge. Many banks have balance sheets stuffed full of this paper. They face huge losses, which some can't survive. They and other investors, such as foreign central banks, then dump the GSE paper.

Fannie and Freddie would end up unable to lend, or at least to take up anything like their current 80% share of the U.S. mortgage market, further punishing the reeling housing market. This would add another twist to the spiral of falling prices, credit losses and failing lenders.

What should they do? First, devise a plan -- and fast. There is no time to dither." (Wall Street Journal)

If foreign banks and investors ditch their GSE debt; it will send shockwaves through the global economy. But if the Treasury provides unlimited funding for a sinking operation, it's likely to trigger a sell-off of the dollar. It's a lose-lose situation. For now, bond holders are sitting-tight even though the stock is tanking, but for how long? They've already been taken to the cleaners on hundreds of billions of dollars of mortgage-backed garbage; now there are rumors that the US government won't back agency debt. What kind of shabby shell-game is the US playing anyway?

New York Times:

“If people lose faith in Fannie and Freddie, then the whole system freezes up, and nobody can buy a house, and the entire housing market can crash,” said Paul Miller of the Friedman, Billings, Ramsey Group in Arlington, Va. “There’s a fine line between having faith and losing it, and sometimes it’s unclear when it has disappeared. But when investors cross that line, bad things happen very quickly.”

And it affects more than the housing market, too. The bond and equities markets are handcuffed to real estate and they're already listing from the slowdown in investment. The Fed thought they could keep the whole mess from going sideways by opening up "auction facilities" where the banks could get low interest capital in exchange for their mortgage-backed junk. But the banks have curtailed their lending and there's bigger trouble ahead. Bridgewater Associates issued a warning last week that losses to the banking system would exceed $1.6 trillion, four times original estimates and enough to crash the entire banking system. So far, banks have only written down $450 billion, which means that they are only 25 per cent of the way through the current credit storm. Defaults are liable to skyrocket as hundreds of undercapitalized banks turn to a grossly underfunded FDIC ($52 billion in reserves) to cover the losses of their depositors. The prospect of a humongous taxpayer bailout seems nearly unavoidable.

What's most disturbing is that nothing has been done to restore the markets to a functional model. The Fed's strategy is still to try to keep the relatively new "structured finance" model (with all it's bizarre-named debt instruments and derivatives) in place even though it failed its first stress-test and has demonstrated that it cannot withstand even moderate downward movement in the market. The current model is kaput; there needs to be a Plan B or the Fed is just wasting its time.

Fannie's demise comes at a particularly difficult time for the banking system. According to a report by Paul Kasriel, Chief Economist at Northern Trust:

"The sharpest 13-week contraction in bank credit” since data were first available in 1973. Banks simply don’t have the capital on hand to avail “themselves of the cheap credit the Fed is offering to fund them at.”....This is what it means to be in a “credit crunch.” Banks have suffered hundreds of billions in losses, forcing them to pull credit out of the economy. Every time you read an article about banks cutting credit lines, exiting lending businesses, or eliminating mortgage products it represents more bank credit drying up." (Option Armageddon, "Understanding Bernanke")

Bank credit is drying up because the capital is being destroyed (from foreclosures and downgraded assets) faster than anytime in history. We are just now feeling the first stiff breezes from a Force-5 deflationary hurricane set to touch down in 2009. Fannie and Freddie are teetering towards insolvency while the country is entering the most vicious downward cycle since the Great Depression. Higher interest rates, negative home equity, mounting credit card debt, auto loan debt, commercial real estate debt and tightening lending standards will only curtail consumer spending more putting greater pressure on the dollar.

The Fed will have to be selective; not everything can be saved. Significant parts of the financial system will be reduced to ashes. It would be wiser to clear the brush away from as many of the solvent institutions as possible and prepare for the worst. Otherwise, the whole system is at risk of contagion. Hundreds of local and regional banks are expected to go under. (the average small bank has 67% of its assets in real estate) It can't be avoided. They are holding too much bad paper and no way to make up for the losses. They're following the same path as the 250 mortgage lenders that vaporised in the subprime meltdown. They couldn't be saved either.

The bigger investment banks are in trouble too. That's why the SEC has finally decided to act as a regulator and go after short-sellers:

"The Securities and Exchange Commission announced an emergency action aimed at reducing short-selling aimed at Wall Street brokerage firms, Fannie Mae and Freddie Mac, and will immediately begin considering new rules to extend new requirements to the rest of the market."

The SEC never took an interest in naked shorting of stocks (or commodities speculators) while its fat-cat friends in the big brokerage houses were raking in billions. Now that many of these same institutions, including Fannie Mae and Freddie Mac, are in the crosshairs, SEC chief Christopher Cox is rushing to their rescue. It is utter duplicity, but it illustrates an important point; the system is cannibalizing itself just like Karl Marx predicted over 100 years ago. Unchecked greed is inevitably self-destructive.

A growing number of market analysts are beginning to notice the storm clouds forming on the horizon. The Royal Bank of Scotland has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months. The Bank of international Settlements (BIS) made a similarly ominous warning that the credit crisis could lead world economies into a crash on a scale not seen since the 1930s. The bank suggests that government officials and market analysts have not fully grasped the financial turmoil that could result from the mortgage crisis and its effects of the global economic system. The body points out that the Great Depression was not anticipated because people ignored the implicit danger of "complex credit instruments, a strong appetite for risk, rising levels of household debt and long-term imbalances in the world currency system."

Ron Paul (R-Texas) is one of the few members of congress who has shown that he has a grasp of the impending economic disaster now facing the country if corrective action is not taken swiftly. In a speech he gave last week on the floor of the House, he said:

"There are reasons to believe this coming crisis is different and bigger than the world has ever experienced...The financial crisis, still in its early stages, is apparent to everyone: gasoline prices over $4 a gallon; skyrocketing education and medical-care costs; the collapse of the housing bubble; the bursting of the NASDAQ bubble; stock markets plunging; unemployment rising;, massive underemployment; excessive government debt; and unmanageable personal debt. Little doubt exists as to whether we’ll get stagflation. The question that will soon be asked is: When will the stagflation become an inflationary depression? "

The troubles at Fannie and Freddie are symptomatic of more deeply rooted problems related to abusive lending and the unsustainable expansion of credit. We've now reached our debt limit and the bills must be repaid or written off. The Bush administration is hoping to reflate the bubble by (stealthily) recapitalizing the GSEs, but it won't be easy. As one blogger put it, we have reached "peak credit" and have nowhere to go except down.

Economist Michael Hudson summed it up like this:

"The reality is that Fannie, Freddie and the FHA gave a patina of confidence to irresponsible lending and outright fraud. This confidence game led them to guarantee some $5.3 trillion of mortgages, and to keep $1.6 trillion more on their own books to back the bonds they issued to institutional investors." It was a scam of Biblical proportions and now it is all starting to unravel. Bush's "ownership society" was a cheap parlor trick engineered by the Fed's low interest rates to trigger massive speculation and shift wealth from one class to another. Now, the housing bubble has crashed and the excruciating reality of insolvency is beginning to sink in.

Michael Hudson, again:

"All one hears is a barrage of claims that the government must preserve the financial fictions of Fanny Mae and Freddie Mac in order to 'save the market.' The usual hypocrisy is being brought to bear claiming that all this is necessary to 'save the middle class,' even as what is being saved are its debts, not its assets...The “way of life” that is being saved is not that of home ownership, but debt peonage to support the concentration of wealth at the top of the economic pyramid.
Mortgages are the major debts of most American families. In this role, real estate debt has become the basis for the commercial banking system, and hence the basis for the wealthiest 10 percent of the population who hold the bottom 90 percent in debt. That is what Fannie Mae, Freddie Mac and “the market” are all about." (Michael Hudson; "Why the Bail Out of Fannie Mae and Freddie Mac is Bad Economic Policy", counterpunch.org)

The housing boom never had anything to do with Bush's Utopian-sounding "ownership society". It was always just a swindle to enrich the banking establishment and divert middle class wealth to ruling class elites.