Category: government-sponsored entities

Paulson’s gift to the bears

It’s official: The U.S. economy is headed for its worst recession in three decades. Henry Paulson’s scheme to keep Fannie Mae and Freddie Mac on government life support and bail out its creditors (i.e. Wall Street, Big Banks, and Bill Gross at PIMCO) removes any doubt. The only question remaining: Will this downturn rival the Big Kahuna of the 1930s?

Paulson was interviewed today on Bloomberg. Here is the money quote:

“No one likes to put the taxpayer into situations like this. No one does; I certainly don’t. Government intervention is not something I came down here wanting to espouse, but it sure is better than the alternative.”

The alternative, of course, is that Paulson’s friends are actually forced to take huge losses on their reckless, ill-fated loans to Fannie and Freddie. Unthinkable! Paulson assures the naïve interviewer that the taxpayer will come before the shareholder, forgetting to mention the shareholder has already been wiped out, putting the taxpayer last in line behind the creditors. Under Hanky Pank’s scheme, the taxpayer is simply the bagholder of last resort. Paulson was obviously a quick study under former Goldman Sachs CEO and Treasury Secretary, “Mr. Bailout” himself, Robert Rubin.

The initial reaction of the stock market was to celebrate with a 300 point rally in the DJIA. Our guess is the euphoria will fade quickly as investors realize bailout money does not grow on trees, and the cash will either be taxed, borrowed or printed. The only question: How much will the final tab run?

The more pressing concern, however, is the economy. This economy needs to break its addiction to cheap credit, remove the waste of the previous credit binge, shed its political parasites (e.g., friends of Hank), and rebuild on a solid foundation. Every intervention prolongs the process and deepens the malaise. A wholesale government takeover of the mortgage market virtually guarantees the economy will be mired in deep recession for years.

The only winners (besides whiners like Bill Gross)? Those who are short the market.

Note to self: Move those inflation hedges from the attic to the front hall closet.

GSE bailout bill may cost taxpayer over $1 trillion

When President Bush named Hank Paulson treasury secretary several years ago the media welcomed the free market supporter with open arms. Today we see the man’s true colors as both he and Bush have now capitulated by endorsing the most recent GSE bailout bill potentially costing you and I over $1 trillion!

The reversal upends admonitions Bush made starting almost a year ago. “A federal bailout of lenders would only encourage a recurrence of the problem,” Bush said Aug. 31, 2007. No way, he said May 6, would he allow “a costly bailout for lenders and speculators.” The warning was repeated several times this month.

Enactment constitutes “a very important message that we are sending to investors around the world” that would play a key role in “turning the corner” on the housing crisis, Paulson told reporters. “This is about not only our housing markets, but it’s about our capital markets more broadly,” Paulson, 62, said today in a Bloomberg Television interview. “This goes well beyond the two institutions — Fannie and Freddie — it has to do with investors in the United States and investors all over the world.”

In detail the bill added over 700 pages in the past 24 hours, which included several shocking inclusions:

– Fannie Mae and Freddie Mac already own $6.9 billion of foreclosed homes. Almost as much property as the entire rest of the other 8,500 commercial banks – combined.

– Assuming the default rate stops rising immediately, it’s likely that around 10% of Fannie and Freddie’s owned and guaranteed mortgages will end up in foreclosure. Assuming a 50% recovery rate, that’s a $250 billion loss.

– $2.5B line of credit to the Treasury (Fannie & Freddie) is “open-ended”

– Unlimited– Treasury now allowed to buy all ‘F & F’ housing securities

– Congress no longer involved in appropriating funds (Treasury now does)

– New housing trust fund totalling $500-700 billion which resembles a similar proposal submitted by Bank of America months ago.

– No changes in existing GSE model

– Ultimate cost to US taxpayer $1.1 trillion according to S&P

My Comments: The ongoing intervention comes as no surprise yet this bill all but guarantees a nationalization in residential lending. Equity holders and taxpayers will bear the cost while Wall Street benefits. Have the US citizens learned anything from government intervention?

Fannie Mae losses spike

Fannie Mae reported earnings this morning where losses exceeded street estimates by a wide margin.

The first-quarter net loss was $2.57 a share, Fannie Mae said in a statement today. Analysts were anticipating a loss of 64 cents, the average of 12 estimates from a Bloomberg survey.

Based on comments from several analysts many predict losses will actually increase going forward as home price decline estimates were raised for the second time in 4 months today.

Fannie Mae told analysts to expect bigger credit losses in 2009 and said it sees U.S. home prices falling 7 percent to 9 percent this year, up from its previous estimate of 5 percent to 7 percent. Executives see U.S. home prices eventually tumbling by an average of as much as 19 percent before starting to recover.

“There are certain things that we can’t control, like home prices and the overall condition of the economy, and until they improve, they will be a drag on our old book,” Chief Business Operator Rob Levin told analysts during a conference call today. `

`They are now starting to realize the fact that their credit losses will be considerably higher than they were in 2007,” said Ajay Rajadhyaksha, head of fixed-income strategy for Barclays Capital, who is based in New York. “Things in the housing and credit markets are deteriorating very fast.”

Of course none of this matters to OFHEO, the regulatory body for the government sponsored entities, as they lowered capital requirements from 20% to 15% today, assuming Fannie can raise another $6 billion in fresh capital.

Office of Federal Housing Enterprise Oversight said it will lower surplus capital requirements to 15 percent from 20 percent to allow the company to buy and guarantee more mortgages, its biggest source of profit.

Wouldn’t it be prudent to raise capital requirements for the GSEs since balance sheets are actually becoming more precarious?

Fannie Mae boosted estimates for credit losses this year to a range of 13 basis points to 17 basis points, up from a range of 11 basis points to 15 basis points. Every basis point, or 0.01 percentage point, is equivalent to 15 cents of earnings a share, according to Morgan Stanley analysts.

The fair value of assets dropped to $12.2 billion last quarter from $35.8 billion in December. Shareholder equity, which measures how much money would be left to stockholders after Fannie Mae pays all its bills, dropped to less than zero for common stockholders for the first time in at least 15 years, from $20.5 billion in the fourth quarter.

Fannie Mae listed $56.1 billion in so-called Level 3 assets, a category which indicates the holdings are so illiquid that they can only be priced using the firm’s own valuation models.

My Comments: So the playbook is now readily apparent for the mortgage fiasco conclusion: Fannie, Freddie and the FHLB will continue to soak up most of the $12 trillion mortgage market while shareholders will be left holding the bag. Another successful mission for the interventionists.

Fannie Mae on life support

Several weeks ago Fed Chairman Ben Bernanke floated the idea of allowing Fannie and Freddie to temporarily lift loan limits with the assistance of the US taxpayer, I mean government. Charles Schumer of course took to this like a horse to water and immediately worked on a bill to stem foreclosures. Since that time, the ever so punctual Fannie Mae corporation finally filed quarterly financials using some past accounting from ex CEO Franklin Raines. According to a recent Fortune article written by our friend Peter Eavis, Fannie has quietly changed the way they compute their credit loss ratio or the number of bad loans as percentage of total.

In August, Fannie Mae predicted its credit loss ratio would be 0.04-0.06 of a percentage point for all of 2007. A range of four to six basis points may not sound like a big deal for an institution involved in mortgages, but for Fannie Mae it is the norm. What matters is if Fannie Mae goes above that range. And Fannie Mae appears to have already done that this year.

Last week, as part of its earnings report, Fannie Mae revealed that the company had changed the way it calculates the credit loss ratio. Under the new method, Fannie Mae’s annualized credit loss ratio was just 4 basis points in the first nine months of the year.

So what would have happened if the company had compared apples to apples — and stuck with the old method of calculating its loss ratio? Under the previous method, Fannie Mae would have been well outside of its range. The company would have reported an annualized loss ratio of 7.5 basis points in the first nine months of this year.

Management acknowledges that credit losses are mounting. During an analyst call last week, Fannie Mae CEO Daniel Mudd warned that the company’s loss ratio could rise to eight to 10 basis points in 2008, due to a worsening housing market. It’s not clear whether that forecast is based on the old or new methodology.

Ominous signs of the house of cards built by former CEO Franklin Raines?

The company may already be exceeding that 2008 guidance. Based on the old methodology for calculating the loss ratio for the third-quarter alone, the company’s annualized loss ratio is already at 14 basis points.

So what could a soaring loss ratio mean for Fannie Mae? Consider these numbers: At Sept. 30, Fannie Mae had exposure to $74 billion of loans with a FICO credit score below 620. Loans scored below 620 are generally classified as subprime. In addition, Fannie Mae has exposure to $196 billion of Alt-A mortgages, home loans for which the borrower doesn’t have to submit complete documentation for basic criteria like income. At the same time, Fannie Mae has only $40 billion of capital.

My comments: This week Deutsche Bank analyst Mike Mayo estimated a default rate of 30-40% and a loss rate of 40-50% on subprime mortgages. Using the midpoint of both ranges, this implies a realized loss rate of 15.75% of principal (0.35 x 0.45). If Mayo is accurate the subprime/Alt-A exposure alone wipes out Fannie Mae’s equity.

Lenders of last resort

Since the implosion of asset backed commercial paper market 11 weeks ago lenders have implemented contingency plans for future funding requirements. According to a recent Bloomberg article, the 12 regional Federal Home Loan Banks came to the rescue as other government sponsored agencies moved to the background.

Countrywide Financial Corp., Washington Mutual Inc., Hudson City Bancorp Inc. and hundreds of other lenders borrowed a record $163 billion from the 12 Federal Home Loan Banks in August and September as interest rates on asset-backed commercial paper rose as high as 5.6 percent. The government-sponsored companies were able to make loans at about 4.9 percent, saving the private banks about $1 billion in annual interest.

Of course the funding was subsidized by the American taxpayer…

To meet the sudden demand, the institutions sold $143 billion of short-term debt in August and September, according to the FHLBs’ Office of Finance. The sales pushed outstanding debt up 21 percent to a record $1.15 trillion, an amount that may become a burden to U.S. taxpayers because almost half comes due before 2009.

The government is “taking a lot of risks through the Federal Home Loan Banks that are unnecessary,” according to Peter Wallison, a fellow at the American Enterprise Institute, a Washington-based organization that analyzes public policy, and general counsel at the Treasury Department from 1981 until 1985.

More moral hazard?

A loss of confidence in the companies could prompt investors to dump FHLB debt, potentially causing the collapse of one or more banks, according to Wallison and lawmakers including Representative Richard Baker of Louisiana. If others were unable to meet the liabilities, taxpayers would be on the hook, they said.

U.S. lawmakers need to ensure “the institutions don’t blow up in the taxpayer’s face,” Representative Christopher Shays of Connecticut, a Republican on the House Financial Services Committee that is responsible for oversight of the system, said in an interview.

My comments: Where will the marginal mortgage companies go for future funding since all government entities have hit a wall? Looks like Bernanke will be fielding lots of phone calls this holiday season.

Fannie Mae to the rescue

Senator Charles Schumer, Democrat from New York, introduced a bill that would lift the cap on the mortgage portfolios of Fannie Mae and Freddie Mac by 10%, which he says will free up about $145 billion to purchase new loans, reports MarketWatch.

The measure “will deliver a shot in the arm that could make refinancings possible for tens of thousands of Americans trapped in the subprime mess,” Schumer said in a statement.

“Times like these reaffirm the need for Fannie Mae,” Fannie’s executive vice president Thomas Lund told attendees Monday at a Lehman Brothers conference.

My comment: The Dems are oblivious that Fannie is part of the problem, not the solution. Apparently, they missed Milton Friedman’s lecture reminding “there’s no free lunch.”

The trouble with lending to the poor

An op-ed titled, “A Wall Street Trader Draws Some Subprime Lessons: Michael Lewis,” appeared on Bloomberg today:

So right after the Bear Stearns funds blew up, I had a thought: This is what happens when you lend money to poor people.

Don’t get me wrong: I have nothing personally against the poor. To my knowledge, I have nothing personally to do with the poor at all. It’s not personal when a guy cuts your grass: that’s business. He does what you say, you pay him. But you don’t pay him in advance: That would be finance. And finance is one thing you should never engage in with the poor.

After the subprime debacle, a small, but growing minority is questioning the wisdom of two decades of public policy promoting home ownership for low-income families. In an August 22 WSJ op-ed titled, “Payback,” Holman W. Jenkins, Jr. recalls how a number of these bad seeds were planted during the Clinton administration:

Everybody talks about moral hazard. A wisp of memory came to mind last week. Then-Fannie Mae chief Franklin Raines visited The Journal years ago and entertained himself by mocking editorial writers who assume that establishing that a policy is economically inefficient is enough to establish that it’s unwise.

He yukked it up quite a bit, in fact, noting that voters are perfectly entitled to assert values other than those of the market, namely that homeownership is a social blessing and should be encouraged with subsidies. And so we’ve done with tax subsidies, lending subsidies and a concerted set of policies by Bill Clinton’s HUD to move low-income people out of rental units and into homes they own. His goal, which was achieved, was to lift the homeownership rate from 64.2% to 67.5% of households.

This brings to mind an interview of Raines that appeared in the June 30, 2003 issue of BusinessWeek:

What Fannie Mae does is important to the country and to home buyers. And we do it, I think, very well.

(Btw, the interview is a classic with such quotes as “We are compulsive about managing risk,” right before fessing up to an accounting mess that cost over a billion dollars to clean up, three years of financial statements not provided investors, and eventually Franklin Raines his job. Don’t shed any tears for Raines: For his troubles he made nearly $100 million in 8 years of running the ship at Fannie Mae.)

In “Payback,” Jenkins goes on to cite a study questioning the wisdom of a policy that ignores basic economics:

A home financed by a mortgage is not just an asset. It’s also a liability. We owe thanks to Carolina Katz Reid, then a graduate student at University of Washington, for a 2004 study of what she dubbed the “low income homeownership boom.” She considered a simple question — “whether or not low-income households benefit from owning a home.” Her discoveries are bracing:

Of low-income households from a nationally representative sample who became homeowners between 1977 and 1993, fully 36% returned to renting in two years, and 53% in five years. Suggesting their sojourn among the homeowning was not a happy one, few returned to homeownership in later years.

Even among those who held on to their homes for 10 years, the average price-appreciation gain was 30% — less than if their money had been invested in Treasury bills. This meager capital gain was about half that enjoyed by middle-income homeowners.

A typical low-income household might spend half the family income on mortgage costs, leaving less money for a rainy day or investing in education. Their less-marketable homes apparently also tended to tie them down, making them less likely to relocate for a job. Ms. Reid’s counterintuitive discovery was that higher-income households were “twice as likely to move long distance if they’re unemployed.”

Almost needless to add, the great squarer of circles for middle-income homeowners, the mortgage-interest deduction, won’t turn a house into a paying proposition for those with little income to shelter.

His conclusion:

Bottom line: Homeownership likely has had an exceedingly poor payoff for millions of low-income purchasers, perhaps even blighting the prospects of what might otherwise be upwardly mobile families.

Yet in the political realm, bad ideas never seem to die, but instead are embraced and expanded by future politicians. President Bush took ownership of the “American dream” concept with the euphemism “ownership society.” And when that dream turned to nightmare, he pandered to the peasants with bailouts and an increased role for Fannie Mae and Freddie Mac. As Jenkins wrote in a September 5 WSJ op-ed:

You’ll know Washington is doing for housing what it did for New Orleans (subsidizing uneconomic decisions) if it now heeds countless pleas to expand the mandate of Fannie Mae and Freddie Mac to refloat the housing market and refinance underwater loans. Their lending already has grown much faster than the economy, much faster than housing demand, channeling a current $1.5 trillion in artificially cheapened capital into the housing market.

The underlying problem in the housing market is that, after two decades of easy credit funnelled into the home, prices are too high for the expanded pool of homeowners to afford. More of the same – promoting home ownership at any cost for those least able to afford it – can only exacerbate the current mess.

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