08/09/08 "ICH" - -- With yesterday's announcement of the most massive federal bailout of all time, it's now official: Fannie Mae and Freddie Mac, the two largest mortgage lenders on Earth, are bankrupt.

Some Washington bigwigs and bureaucrats will inevitably try to spin it. They'll avoid the "b" word with vengeance. They'll push the "c" word (conservatorship) with passion. And in the newspeak of 21st century bailouts, they'll tell you "it all depends on what the definition of solvency is."

The truth: Without their accounting smoke and mirrors, Fannie and Freddie have no capital. The government is seizing control of their operations. Their chief executives are getting fired. Common shareholders will be virtually wiped out. Preferred shareholders will get pennies. If that's not wholesale bankruptcy, what is?

Some Wall Street pundits and pros will also try to twist the facts to their own liking. They'll treat the bailout like long-awaited manna from heaven. They'll declare that the "credit crisis is now behind us." They may even jump in to buy select financial stocks. And then they'll try to persuade you to do the same.

The reality: This was the same pitch we heard in August of last year when the world's central banks made a coordinated attempt to rescue credit markets with massive injections of fresh cash. It was also the same pitch we heard in March when the Fed bailed out Bear Stearns. But each time, the crisis got progressively worse. Each time, investors lost fortunes.

Together, both Washington and Wall Street are trying to persuade you that, "no matter what, the government will save us from financial disaster." But the real lessons already learned from these events are another matter entirely:

Lesson #1. Each successive round of the credit crisis is far deeper and broader than the previous.

• In 2007, the big news was big losses; in 2008, it's big bankruptcies.
   
• In March, the failure of Bear Stearns shattered $395 billion in assets. Now, just six months later, the failure of Fannie Mae and Freddie Mac is impacting $1.7 trillion in combined assets, or over four times more. And considering the $5.3 trillion in mortgages that Fannie-Freddie own or guarantee, the impact is actually thirteen times greater than the Bear Stearns failure.

Lesson #2. Despite unprecedented countermeasures, Washington has been unable to stem the tide.

Yes, the Fed can inject hundreds of billions into the banking system. But if banks don't lend, the money goes nowhere.

Sure, the Treasury can inject up to $200 billion of capital into Fannie and Freddie. But if their mortgage portfolio is full of holes, all that new capital goes down the drain.

And of course, the U.S. government has vast resources. But if the $49 trillion mountain of U.S. debts and the $180 trillion pile-up of U.S. derivatives are beginning to crumble, all those resources don't amount to more than a band-aid and a prayer.

Lesson #3. Shareholders are the first victims.

Bear Stearns shareholders got wiped out. Fannie and Freddie Mac shareholders are getting wiped out. Ditto for shareholders in any of Detroit's Big Three that go belly-up, any bank taken over by the FDIC or any insurer taken over by state insurance commissioners.

The Next Lesson:
The Primary Mission of the Fannie-Freddie
Bailout Will Ultimately End in Failure

Most people assume that when the government steps in, that's it. The story dies and investors shift their attention to other concerns. In smaller bailouts, perhaps. But not in this Mother of All Bailouts.

The taxpayer cost for just these two companies — up to $200 billion — is more than the total cost of bailing out thousands of S&Ls in the 1970s. But it's still just a fraction of the liability the government is now assuming.

Why?

First, because the number of home foreclosures and mortgage delinquencies has now surged to a shocking four million — and a substantial portion of the massive losses stemming from this calamity have yet to appear on Fannie's and Freddie's books.

Second, because the U.S. recession is still in an early stage, with surging unemployment just beginning to cause still another surge in foreclosures and mortgage delinquencies.

Third, even before Fannie and Freddie begin to feel the full brunt of the mortgage and recession calamity, their capital had already been grossly overstated.

Indeed, right at this moment, while Wall Street analysts are trying to evaluate the details of a bailout plan that's supposed to save them, regulators and their advisers are poring over the Freddie-Fannie accounting mess they're supposed to inherit. According to Gretchen Morgenson and Charles Duhigg's column in yesterday's New York Times, "Mortgage Giant Overstated the Size of Its Capital Base" ...

• Freddie Mac's portfolio contains many securities backed by subprime and Alt-A loans. But the company has not written down the value of many of those loans to reflect current market prices.
  
   
• For years, both Freddie and Fannie have effectively recognized losses whenever payments on a loan are 90 days past due. But in recent months, the companies saidthey would wait until payments were TWO YEARS late. As a result, tens of thousands of other loans have also not been marked down in value.
  
   
• Both companies have grossly inflated their capital by relying on accumulated tax credits that can supposedly be used to offset future profits. Fannie says it gets a $36 billion capital boost from tax credits, while Freddie claims a $28 billion benefit. But unless these companies can generate profits, which now seems highly unlikely, all of the tax credits are useless. Not one penny of these so-called "assets" could ever be sold. And every single penny will now vanish as the company goes into receivership.

In short, the federal government is buying a pig in a poke — a bottomless pit that will suck up many times more capital than they're revealing. My forecast:

Just to keep Fannie and Freddie solvent will take so much capital, there will be no funds available to pursue the primary mission of this bailout — to pump money into the mortgage market and save it from collapse. That mission will ultimately end in failure.

The Most Important Lesson of All:
As the U.S. Treasury Assumes
Responsibility for $5.3 Trillion in Mortgages,
It Places Its Own Borrowing Ability at Risk

The immediate reason the government decided not to wait any longer to bail out Freddie and Fannie was very simple: All over the world, investors were beginning to reject their bonds, refusing to lend them any more money. So the price of Fannie and Freddie bonds plunged, and the yields on those bonds went through the roof.

As a result, to borrow money, Fannie-Freddie had to pay higher and higher interest rates, far above the rates paid by the U.S. Treasury Department. And they had to pass those higher rates on to any homeowner taking out a new home loan, driving 30-year fixed-rate mortgages sharply higher as well.

Now, with the U.S. Treasury itself stepping in to directly guarantee Fannie-Freddie debts, Washington and Wall Street are hoping this rapidly deteriorating scenario will be reversed.

They hope investors will flock back to Fannie and Freddie bonds.

They hope investors will resume lending them money at a rate that's much closer to the Treasury rates.

And they hope Fannie and Freddie will again be able to feed that low-cost money into the mortgage market just like they used to.

In other words, they hope the U.S. Treasury will lift up the credit of Fannie and Freddie.

There's just one not-so-small hitch in this rosy scenario: Fannie's and Freddie's mortgage obligations are just as big as the total amount of Treasury debt outstanding.So rather than the Treasury lifting up Fannie and Freddie, what about a scenario in which Fannie and Freddie drag down the U.S. Treasury?

To understand the magnitude of this dilemma, just look at the numbers ...

• Mortgages owned or guaranteed by Fannie and Freddie: $5.3 trillion.
  
   
• Treasury securities outstanding as of March 31, according to the Fed's Flow of Funds (report page 87, pdf page 95): Also $5.3 trillion.

If Fannie's and Freddie's obligations were equivalent to 10% or even 20% of the U.S. Treasury debts, the idea that they could fit under the Treasury's "full faith and credit" umbrella might make sense. But that's not the situation we have here — Fannie's and Freddie's obligations are the equivalent of 100% of the Treasury's debts.

And it's actually worse than that:

• Foreign investors, the most likely to dump their holdings if they lose confidence in the United States, hold an estimated 20% of the Fannie- and Freddie-backed mortgages outstanding. But ...
  
   
• Foreign investors own 52.7% of the Treasury securities outstanding (excluding those held by the Fed).

So based on the above stats, Treasury securities are actually more vulnerable to foreign selling than Fannie and Freddie bonds.

What happens if the international mistrust and fear afflicting Fannie and Freddie bonds infects U.S. Treasury bonds? Foreign investors would start dumping Treasury securities en masse. They'd drive Treasury rates sharply higher. And they'd wind up forcing Fannie and Freddie to pay much higher rates for their borrowings after all.

How will you know? Just watch the all-critical spread (difference) between the yield on Fannie-Freddie bonds, considered lower quality, and the yield on equivalent government bonds, considered high quality. Then consider these two possibilities:

• If that spread narrows mostly because Fannie and Freddie interest rates are coming down toward the level of the Treasury rates, fine. That means the immediate goal of the bailout is being achieved. BUT ...
  
   
• If the spread narrows mostly because Treasury rates are going up toward the level of Fannie's and Freddie's rates, that's not so fine. It not only means a failure to achieve the immediate goals, but it will also imply that the entire Fannie-Freddie bailout is backfiring on the Treasury.

A Fictional Scenario
That's Coming True

In my book, Investing Without Fear: Protect Your Wealth in All Markets and Transform Crash Losses Into Crash Profits, I anticipated this very scenario. In a fictional scenario about the not-too-distant future, I warned what might happen if the U.S. Treasury tried to bail out the bonds of a giant corporation, just as it's doing for Freddie and Fannie right now.

In my scenario, a few days after the bailout is announced, the Treasury secretary calls the president of the United States on the phone to bring him up to date with the impact in the financial markets. Here's the dialog that follows, quoted from my book verbatim [with any additions in brackets]:

"It's no good. The benefit of our plan to the stock market is a spit in the ocean. On the other hand, to the government bond market, it's a potential hydrogen bomb. The quality spreads are narrowing — and in the wrong direction."

The president didn't know much about quality spreads. "What are the causes and what are the consequences of changes in quality spreads?" he asked.

"I am referring to the difference in yield between a Treasury bond and a corporate bond. A big corporation [like Fannie or Freddie] always has to pay more than the U.S. Treasury to borrow money. Typically, the difference has been about one full percentage point.

"Then, several months ago, when the full threat of corporate bankruptcies was first apparent, the yield on medium-grade corporate bonds went up by 2 1/4 percent, but the yield on the governments went up only 1/4 percent. In other words, the spread increased by two full percentage points. It was a red-hot flashing signal of trouble. It revealed that confidence in all corporations — no matter how creditworthy — had collapsed. But that was before our rescue package was announced."

"And now?"

"Now the opposite is happening. Corporate bond yields [like Fannie's and Freddie's] are back down sharply, but government bond yields are actually up sharply. The spread between them has narrowed to practically nothing — a very bad sign." The Treasury secretary felt satisfied that he had put forth a very clear and straightforward explanation.

"Well, isn't that what we had said we wanted — to bring up the corporate bond market, to get it back up toward the level of government bonds?"

The secretary shook his head, trying to hold his voice steady so that his feelings of frustration with the president's lack of knowledge of bond markets would not be picked up over the phone. In the past, he tried several times to explain to the president how interest rates and prices moving in opposite directions always meant the same thing, but that spreads, although moving in the same direction, could mean a variety of different things.

How does one make such things simple for a president to understand without sounding condescending? The secretary certainly didn't know how. He spent the next half hour going over the events in the marketplace until finally, after considerable effort, the president developed an image of bond markets that looked similar to the chart below.

"Now I see," the president said finally. "We wanted to bring the corporate bonds up to the level of the government bonds. What's happening is precisely the opposite. The 'governments,' as you call them, are falling down to the level of the 'corporates.' In short, we are not lifting them up; they are dragging us down."

"Yes, Mr. President. We bent over, we bent all the way over, to pull them out of the quicksand. Instead, they pulled us down with them, and now we're sinking in the quicksand too."

The president thought for a moment before he spoke. "The question is, Why? Don't they believe we're serious? Why haven't we restored confidence? At the meeting, it was said that we can create cash, that the law gives us the authority to funnel this cash wherever we please."

"The answer is that we can create cash. But we cannot create credit."

"What's the difference?" the president queried.

"There's a very big difference. To create more cash, all we have to do is speed up the printing presses at the mint — or, actually, pump it in electronically. And when we dish it out, no one is going to turn us down. But to create credit, we have to convince investors and bankers to make loans — and in this environment of falling confidence, I can assure you that this isn't easy. If it were so easy, we could have saved Bethlehem Steel or Enron or Kmart or Global Crossing or WorldCom or any of the other giants that have failed. But we didn't, and for good reason."

The president was getting impatient. "So what's the point?"

"The point is that you can create cash; you can't create confidence."

"It would seem to me that the more money we give 'em, the more confidence they'd have."

"No, no! It's exactly the opposite. The more we spend the government's money recklessly, the less confidence they have and the more they fear our government bonds will go down in value."

"Oh? But why can't we just buy more corporate bonds? That should convince them we mean business!"

"No, it just convinces them we're throwing more good money after bad — their good money after bad."

"But what about the new law?"

"The law gives us the on-paper authority to buy private securities. It does not give us the actual power to create real economic wealth."

"Why didn't we recognize this when we discussed the rescue plan?"

"We did. But you overrode us, and we consented. We hoped that the marketplace might swallow it. We seriously underestimated the sophistication of U.S. and foreign investors — very seriously underestimated."

Still the president sounded perplexed. "You're saying the market is sensitive. You're saying the market is smart. I see that now. But ..."

The secretary's irritability was becoming more apparent. "Let's say I'm a foreign investor and I own U.S. Treasury bonds. This implies that I trust the U.S. government; that I loaned you my money for the purpose of running your government. Now you take my money and pass it on to a third party, a private company. So I say to you, 'What did you go and do that for? If I wanted to loan the money to that company, I would have done so myself — directly — in the first place. But I didn't. I didn't do it because I don't trust the company. I trusted you. But now I can't trust you anymore either. Now you're just one of them.' So the investor stops buying our bonds or, worse, dumps the government bonds he's holding, and then we are in trouble. Then we can't sell our government bonds anymore to pay off the old ones coming due. Then we, the United States government, default."

The president hesitated for a few seconds before responding, but it seemed like hours as the tension built.

"Then what?"

The secretary could not believe his ears. The president of the United States had treated the government's default with levity, utter levity. He could no longer control his boiling frustration — and fear. "Do you want to allow the entire market for U.S. government securities to shut down? Do you want to be the one who has to lay off hundreds of thousands of government employees because you can't raise the money to meet the government payroll? Do you want to be the last president of the United States? Do you want to risk a new republic with a new constitution? Do you want to destroy, in one fell swoop ..."

The secretary's voice broke with emotion. Silence reigned.

"[Hank], I appreciate the sincerity of your emotions, but you misunderstood me. What I said, in fact, was 'then WHAT,' indicating to you my surprise and disbelief that our country could ever reach the point you've described so dramatically just now."

Back to the Present

In my book's future scenario quoted above, the government ultimately decided to abandon its plan to rescue large private corporations like Fannie or Freddie. It was the only way it could save its own credit and its own ability to continue borrowing from domestic and foreign investors.

In the real world of the present, however, the government is going forward with its bailout plan — and the plan is even more ambitious than the one contemplated in my book.

But for the same reasons I've outline above, the Treasury will ultimately have to effectively abandon Fannie and Freddie: It will set a cap on the resources it will commit. It will not write a blank check. In the final analysis, it must save its own neck first.

The same applies to you. Follow our instructions to get your money to safety. And even use this crisis as a unique opportunity to build your wealth. To learn exactly how, join us online one week from today, Monday, September 15.

For all the details and for your free registration, click here.

Good luck and God bless!

Martin