'Intelligent discontent is the mainspring of civilization.' -- Eugene V. Debs

Tuesday, September 09, 2008

The Black Box: the Mysterious Bailout of Fannie Mae and Freddie Mac 

On Saturday, I posted an alert that the Federal Government was about to take control of the two mortgage giants, the government sponsored entities (hereinafter "GSE"), Fannie Mae and Freddie Mac. Despite much media coverage, it is difficult to understand what the government is actually doing, and the financial consequences for American taxpayers.

For a good summary, I recommend this article by Hal Bonddad Stewart. In the article, he highlights four major aspects of the seizure;

(1) The government is going to shrink the size of Fannie Mae and Freddie Mac by selling off mortgage backed securities (hereinafter "MBS") held by the institutions, starting in 2010.

(2) The government is going to ensure that Fannie Mae and Freddie Mac maintain a positive net worth by purchasing preferred stock from the two institutions as required. Shareholders will take the losses while the holders of Fannie Mae and Freddie Mac debt will be protected.

(3) The government is additionally providing a secured line of credit in the event that the issuance of preferred stock is inadequate to address the liquidity needs of the institutions.

(4) The government is going to buy, on a temporary basis, MBS from Fannie Mae and Freddie Mac in an attempt to reduce the spreads (difference in interest rates) between treasuries and MBS that has constrained the ability of people to purchase homes.

The plan for salvaging Freddie and Fannie is extremely controversial because of the reason that the Treasury Department provided to justify the infusion of government funds into them:

These Preferred Stock Purchase Agreements were made necessary by the ambiguities in the GSE Congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS. Our nation has tolerated these ambiguities for too long, and as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free. Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS.

Let me translate: it is essential that American taxpayers assume the risk of debt previously issued and guaranteed by Fannie and Freddie, instead of the entities that purchased them, such as mutual funds, hedge funds and the central banks of foreign governments, because they were lead to believe that they were risk free as a result of government support. Now, mind, you, they didn't get risk free returns over the years, because the market priced them as having a higher risk of non-payment than treasuries, so they pocketed those higher returns, probably somewhere in the range of half a percent to a full percent, depending on market conditions. No, they were just lead to believe that they were entitled to higher returns because of market risk without assuming that risk because of ambiguities created by the government.

Of course, this is absurd. Here is a typical example of what a prospectus for these securities said:

The Debt Securities, together with interest thereon, are not guaranteed by the United States and do not constitute a debt or obligation of the United States or of any agency or instrumentality hereof other than Fannie Mae.

It's pretty ambiguous, isn't it? Fear not, American taxpayers are still going to guarantee the survival of Fannie and Freddie, and interest payments upon their debt securities, because investors persuaded themselves that they were backed by the US government despite clear language to the contrary in the prospectus. The possible cost of these measures?

William Poole, former president of the Federal Reserve Bank of St. Louis, said taxpayers may face a $300 billion bill to revive Fannie Mae and Freddie Mac, the mortgage giants being taken over by the Federal government.

``I would not be surprised if their total losses aggregate about 5 percent of their obligations'' of about $6 trillion, Poole said today in an interview on Bloomberg Radio. ``Five percent does not seem to me to be an outrageous guess.''

Poole welcomed the decision to put the companies into conservatorship by the Federal Housing Finance Agency, calling it preferable to action by the Federal Reserve. He said financial fallout from Fannie and Freddie was likely to be a long-term drain on the Treasury.

``It's extremely healthy that it's now the Congress and the Treasury and not the Federal Reserve putting funds in,'' he said. ``It's not the purpose of a central bank to put funds in to save or bail out failing companies.''

Exactly! It's not the responsibility of the central bank to rescue investors from their greedy mistakes, it's yours and mine. The regulators of late stage capitalism are so brazen that they don't even bother to conceal that its operation is dependent upon requiring the politically and economically powerless to subsidize the speculative activities of global investors. Such self-assurance arises from the knowledge that both political parties will acquiesce in whatever the finance sector and financial regulators decide to do. And we should not forget that $300 billion may well be a conservative estimate of the exposure, as the risk is dependent upon the extent the institutions are stabilized and the prospect for favorable economic conditions going forward. You may recall how often Treasury Secretary Paulson, the initiator of this rescue operation, told us that the subprime mortgage crisis had been contained last year.

Indeed, the remarkable aspect of these actions by regulators is their complete lack of transparency. As with the purchase of Bear Stearns by J. P. Morgan, subsidized by the Federal Reserve, this decision was announced over the weekend. Details were provided through press conferences conducted by government officials, and there was nothing, other than the assurances of these officials, that the plan would stabilize Fannie and Freddie and reduce the cost of funds for the provision of home mortgages.

Meanwhile, there is the impolite question of fraud at the two institutions. Federal regulators decided to take action to seize them after encountering serious accounting irregularities. According to Gretchen Morgenson and Charles Duhigg of the New York Times, the government decided that the seizure of Fannie and Freddie was unavoidable because Freddie, and to a lesser extent, Fannie, had overstated their capital base, creating a more serious risk of default than either had acknowledged. Furthermore, Fannie and Freddie already had a history of manipulating earnings through questionable accounting practices, such as here and here and here and here. To date, I haven't heard any reports of a criminal investigation.

All of this raises the question, why is such aggressive action so important? Why is such a blatant bailout and nationalization of the market for home mortgages and MBS, a repudiation of the neoliberal economic principles of the last 30 years, necessary? Bonddad Stewart, giving due credit to the Angry Bear, provides some insight with the title of his article on the subject: Freddie and Fannie Bailout: Our Foreign Masters Have Spoken. In case you have forgotten, China and Japan, among others, hold a lot of these securities with their central banks. Economist Michael Hudson also has some interesting things to say about it, and I will post some excerpts from a recent interview of him by Mike Whitney in the next day or so.

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