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We
are at a critical point in the economic history of the United States.
I know of no other way to put it. The events of last week were of a character
that we've never seen before. On Friday mortgage lender IndyMac
Bancorp became the second largest federally insured financial company to fail
after it got hit by a bank run. The Federal Deposit Insurance Corporation
took it over. That news may be a big story, but is totally overshadowed right
now by the teetering collapse of Fannie Mae and Freddie Mac. Both are in
danger of going under and the Bush administration, Federal Reserve, and
Treasury Department are now meeting on a daily basis to figure out what to
do.
On Sunday the
Federal Reserve and Treasury Department announced that they were going to
allow the Federal Reserve Bank of New
York to lend to Freddie and Fannie at 2.25% - the
discount rate that Wall Street Commercial banks receive. They also said they
are going to seek authority from Congress to expand their current $2.25
billion line of credit to each company.
According to
Reuters, "Sunday's announcements are likely to raise anew criticism that
the government should have moved sooner to rein in the two companies,
especially since investors widely assumed they would be bailed out if they
got into trouble."
"The
government denied it, but what was seen by investors as an implicit guarantee
of support allowed Fannie and Freddie to borrow at rates only slightly higher
than the Treasury -- and lower than what their banking competitors had to
pay."
"This really
blows away the notion of an implicit guarantee," independent banking
consultant Bert Ely said of the Treasury's plan to ask Congress to allow it
to make equity investments in Fannie Mae and Freddie Mac. "It suggests a
greater concern about how these companies are doing. It says the problems are
deeper. It gets to the solvency of the companies, not just the
liquidity."
There is no news
that would be worse than the collapse of these two institutions and such an
event if it happens will have ramifications for the economy and stock market
for years to come. Fannie and Freddie buy mortgages and then package them
into bonds, which they guarantee. They then sell the bonds to investors,
including mutual funds, hedge funds, pensions, annuities
- just about any institutional investor you can think of. Odds are that if
you own a mutual fund or annuity that you indirectly own a security backed by
one of these two institutions. The two of them combined own half of America's
twelve trillion in outstanding mortgages and their failure would be the
implosion of the entire financial system.
People have
worried about problems in these two institutions for years. Five years ago
Armando Falcon, the head of the government agency that overseas Freddie and and Fannie wrote a report that said that the two
companies would experience a "financial calamity" if real estate
prices were to fall at all due to excess leverage and poor accounting
standards. His report took two years of research and was controversial at the
time. The day it came out housing stocks had a temporary drop on huge volume.
In response to the report the Bush administration fired Falcon. Don't think
for a second though that the Bush administration is somehow solely
responsible for this mess. There is plenty of blame to go around and one
would have to start at the Senate and several powerful Senators on the
Banking Committee that are literally owned by the banks. "Angelo's
Angel" being one of the worst. If these politicians had done their job
the country wouldn't be in the fix it is in now.
Others have
warned about what a collapse of Freddie and Fannie would mean. Warren Buffett has made statements in the past that he feared
the failure of Fannie and Freddie could set off a "derivatives time
bomb" that would implode the whole financial system. By insuring over
half of the mortgages in the country they are two big to fail. This is
serious situation folks. We've never seen anything like it before.
Earlier last
week former St. Louis Federal Reserve President William Poole said the
companies are basically "insolvent" and may need a government
bailout. The falling housing prices and foreclosures have caused Fannie alone
to lose $6.85 billion in the past year, which in turn is eating away at its
balance sheet. Both Fannie and Freddie closed on Friday at a combined market
cap of $15 billion and thanks to massive leverage own over $5 trillion
dollars worth of mortgages. In comparison the largest US commercial
banks such as Bank of America and JP Morgan have market caps of around 10% of
their total assets. Congress encouraged Fannie and Freddie to over leverage themselves - and so has the Federal Reserve in the past 10
months - to try to cushion the collapsing real estate market.
Of the $5
trillion that sits on Fannie and Freddie balance sheets only $1.6 trillion is
listed on its balance sheet. The rest of it is listed "off" the
balance sheet in much the same way that Bear Stearns listed its "Level
3" assets on its balance sheet. The two companies must constantly borrow
money just to operate. If borrowing costs rise or they have to make good on
the securities they insure than they can fail. Of course this is exactly what
has been happening.
According to
Bloomberg, "Freddie Mac owed $5.2 billion more than its assets were
worth in the first quarter, making it insolvent under fair value accounting
rules... The fair value of Fannie Mae's assets fell 66 percent to $12.2
billion, data provided by the Washington-based company show, and may be
negative next quarter."
 
Both companies
need to raise billions of dollars to stay afloat and that is where their
problem lays. Because both shares are in collapse it is impossible for them
to raise the money they need by issuing stock or by issuing bonds.
On Thursday the
New York Times reported that the Bush administration is meeting around the
clock to come up with plans to deal with this crisis. They have a plan
outlined for the government to directly bail out the two companies by taking
them over if necessary. The government would then insure their bonds and
securities with taxpayer money or by raising money through the issuance of
Treasury bills. A report by Standards and Poors
projects that such a scenario would cost the government $1 trillion dollars
and would force the agency to lower the creditworthiness rating for the
Federal Government, because it would mean a huge increase to the national
debt.
In other words
you and I through higher taxes and higher inflation thanks to the money
printing that will be necessary to bail out these two companies would be
forced to suffer the consequences to pay for the mistakes of the bankers. To
get a size for what $1 trillion means it amounts to about $30,000 for every
man, woman, and child in the United
States.
The
ramifications of such a scenario would be dire. We've seen inflation explode
thanks to the Fed lowering interest rates at the fastest rate ever to try to
stem the credit crisis it helped create by keeping rates too low for too
long, which created the real estate bubble and whole mess we are in right
now. Now imagine the rate of inflation accelerating even more as up to a $1
trillion dollars gets printed in a Fannie and Freddie bailout.
Foreigners would
lose confidence in the bond market and gold prices would skyrocket. The stock
market would continue to drop as a side effect. On Friday, as talk of such a
bailout floated all over Wall Street and the media, bonds did indeed sell
off. There is no news or event that could be worse than a government bailout.
It would send a message to the entire world that the Federal Reserve and the
US government will print any amount of money or do anything to protect the
interest of bankers the dollar be damned. Such a bailout would put the
government directly in the mortgage business. It's a kin to communism. Or
communism for the rich and well connected.
Of course neither the Bush administration or anyone else wants
things to get that point. No one wants the government to take over the two
companies and become responsible for their liabilities, but preparations are
being made by those in charge to do this if things get to that point. My take
is that this crisis is going to continue for the next several weeks and we
are going to see repeated assurances by officials that everything is fine.
They are trapped
in a confidence game where all they can do is make statements to make
everyone think that everything is ok while they work behind the scenes to try
to raise enough money for the two companies to keep them in business in the
form of special loans or a preferred stock deal with the government or a
foreign government or sovereign fund like Citigroup did with Abu Dhabi.
The problem is
will it work? Fannie Mae and Freddie are suffering from the nationwide
decline in real estate prices, which shows no sign of coming to an end over
the next year. Can they survive another year of losses?
If the market
thinks not then the market is likely to punish them right now. Attempts to
keep them glued together over the next few weeks will then fail. I pray it
doesn't come to that.
The gyrations in
these two stocks and repeated statements that all is fine will dominate the
markets and news for the weeks to come. The credit crisis has moved to Defcon one and there is simply no way out now.
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Mike
Swanson
Editor, Wall
Street Window
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