- -- 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
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
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
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
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.
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.
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.
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.
before Fannie and Freddie begin to feel the full brunt of the
mortgage and recession calamity, their capital had already been
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
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
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
And it's actually worse than
- 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.
- 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
"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
"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
"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."
"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
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
"The answer is that we can
create cash. But we cannot create credit."
"What's the difference?" the
"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
"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
"No, it just convinces them
we're throwing more good money after bad — their good money
"But what about the new
"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
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.
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
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,
For all the details and for your
Good luck and God bless!