Saturday, September 06, 2008

Nationalization Nation - Freddie & Fannie in Conservatorship

Friday afternoon as the US was distracted by four potential hurricanes in the Atlantic and still reeling over the selection of beauty queen, moose hunter, Sara Palin, by John McCain for Vice President, Treasury Secretary Henry Paulson was hammering out the terms of the conservatorship of two more entities that fall into the “too big to fail” category.

A few weeks ago The Cosmopolitan Charlestonian went on a Freddie Mac and Fannie Mae deathwatch, and posted up a very important yet under-reported story related to Fannie/Freddie here. Fannie and Freddie are the two GSEs (government sponsored entities) that support a large portion of the United States’ mortgage market debt. Anyone interested in a housing market recovery, which would extend to a more solid total economic recovery, would be inclined to pay attention to the status of these two giants, whom together currently provide over 50 percent of mortgage financing to US housing markets.

Under the deathwatch, though, we are caught in a quagmire. Free market capitalism is Darwinian in nature. Free markets call for the weak to fail with an understanding that a stronger entity will emerge to fill the void. However, under current market conditions, some economists estimate that Fannie and Freddie are needed to back as much as 80% of mortgage paper generated in U.S markets over the next few years considering the tightening of lending restrictions within the overall banking industry.

At this very moment traditional banks are lending less. They are busy shoring up their fractional reserve balances and transferring bad debt (that was previously held off-balance sheet) back onto their books. The banks’ asset sales and write-downs are covering losses generated by a whole bunch of unregulated financial instruments created throughout the late eighties, nineties and early 2000s designed around maximization and monetization of global leverage. These products indirectly fueled the biggest credit expansion in US history – which also led to quite a magnificent housing bubble. The trouble is these instruments were built upon models that overlooked any potential deflationary downside risk. And since the first hedge fund collapse in the summer of 2007, our economy has been mired in an unwinding (otherwise known as deleveraging) that is feeding the very deflationary cycle the banks didn't count on. At this point a failure of Freddie and/or Fannie is simply an absolute economic nightmare scenario to the Treasury, Federal Reserve and Bush Administration who have relied on credit expansion and consumerism to drive the American economy for far too long.

Despite an overall gain in homeownership, Fannie and Freddie have been on questionable financial ground for years. Although they were supposedly turning things around, the challenging global trading climate that has developed around US financial instruments, compounded by record highs in foreclosure activity are now taking a new toll on the GSEs. Quantified by The Wall Street Journal, “Freddie and Fannie own or guarantee more than $5 trillion of mortgages. They have suffered combined losses of about $14 billion over the past four quarters as they make provisions for a wave of defaults.” Freddie and Fannie will not be allowed to fail. Should they be allowed to travel the way of the Dodo, the housing markets would essentially freeze, with little or no credit extended to even the most worthy of loan customers. So, free market capitalism is off the table. However, Paulson's move in no way equates to complete crisis aversion.

Any move by Treasury would represent perhaps the most significant intervention by the government in the financial industry since the housing bust touched off turmoil in the credit markets a little more than a year ago. From the $168 billion economic-stimulus package in February through the bailout of investment bank Bear Stearns Cos., the Bush administration and the Federal Reserve have taken an increasingly aggressive stance in responding to what has become one of the worst financial crises in decades.
Exactly how Freddie and Fannie are backstopped is the next billion dollar question. Futures trading indicated swift reaction to the news Friday night with everyone wondering how Paulson will treat shareholders.
Investors worried that a government bailout would wipe out the value of existing stock, and those fears have sent the shares down about 90% from a year ago. Many U.S. banks as well as foreign governments own stock or debt in the two giants, meaning their financial woes could cause broad problems beyond the housing market.

Most certainly the news of Fannie and Freddie was rolled out on a Friday afternoon intentionally. Monday morning market commentary will be interesting to say the least. Until then, here are a few links we found:

Bloomberg News

The Economic Populist

Naked Capitalism

Calculated Risk

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