The First in a Series of Fannie and Freddie Bailouts

The rumors floated on Friday regarding Fannie and Freddie turned out to be true.  This first bailout proposal, released a few hours ago, has three parts.  I say “first” because there is no way that this is going to be enough to save what’s headed our way nor will this be the only time the government will need to “bailout” F&F.

The U.S. Treasury plans to seek approval for a temporary increase in the line of credit granted to Fannie Mae and Freddie Mac. They will also seek authority to buy equity in either company, and the Federal Reserve voted to allow the New York Fed to loan F&F money, if needed, giving F&F access to the Federal Reserve’s discount window.

The Wall Street Journal says the U.S. Treasury and The Federal Reserve are doing this mainly to boost confidence in F&F, not necessarily because any of this is needed, which to me seems to be a flat out lie.

The weekend move means that Fed Chairman Ben Bernanke, who has been steadily accumulating authority as the U.S. grapples with the financial crisis, will have even more power. The Treasury envisions the Fed working with the mortgage giants’ regulator to help prevent situations that could be a risk for the entire financial system. The move builds on Treasury’s broader goal of remaking financial regulation to give the Fed broader influence over financial-market stability.

I’m not sure if we’re suppose to be happy or scared at the thought of Ben Bernanke accumulating more power.  Maybe what’s really going on is some preemptive planning due to known or unknown possibilities that tomorrow’s auction of Freddie Mac debt doesn’t go well.

The Sunday move was designed in part to head off fears about Monday’s auction of Freddie Mac notes. While small, the planned sale had assumed an outsized importance as a test of investor confidence. Freddie should be able to find buyers for its three- and six-month notes, market analysts said. But there is a chance that some financial institutions and investors may demand higher-then-usual yields.

Similar Freddie and Fannie notes that are currently outstanding yield around 2.5%. If weak demand for Freddie’s auction leads to sharply higher yields on the new notes, that could trigger a selloff across a wide range of debt issued by the companies, some analysts said. But most said such a scenario is unlikely.

I’ve been glued to the web, the radio, and my phone since Friday evening reading, listening, and talking about this with friends and colleagues. If the federal government choses to provide (the implied) government backing for bondholders, then the United States increases our national debt by 5 trillion dollars which would have a profoundly negative impact on the value of the dollar and potentially bankrupting the U. S. economy. If the federal government chooses to do nothing and F&F are forced to mark their portfolio closer to market value and sell off assets to accumulate capital, then the true value of what’s in the bag becomes known. The secret will be out and now nobody will be interested in buying our Residential Mortgage Backed Securities, the market will know the true value of the loans currently being held by banks all over the U.S., mortgage lending slows way down, interest rates go way up, and the housing market goes cliff diving.

It seems to me that with this first bailout proposal (I am preparing for more bailouts as should you) everything is just going to be delayed as long as possible, taking us down further into a deeper recession step-by-step.

This bailout proposal is not enough. We have only just begun to see foreclosures rise. We still have the rest of 2008 to get through, when another round of pay option ARMS originated in 2006 begins to adjust, and through 2009 when the ARMs originated in 2007 adjust. Defaults and foreclosures are far from over.

There was a guy who predicted the demise of Fannie and Freddie back in 2006.  His proposal is that we nationalize Fannie and Freddie, quit pretending that they’re a private company, and restructure the debt, thereby forcing the bondholders to take a haircut.

Sniglet asks an interesting question (comment 123): “So what happens to the shareholders? Do any of these plans ensure that there is no dilution of equity if any form of bail-out were to occur? If the GSE shareholders aren’t protected then we could see a complete abandonment of the financial system by investors. Who will want to buy shares in financial firms if the government isn’t going to ensure their investments remain safe?”

From everything I’ve read over the weekend, the government likely will not protect shareholder equity.  Whether or not they should is up for debate.

32 thoughts on “The First in a Series of Fannie and Freddie Bailouts

  1. The message of this government bail-out of the GSEs is quite simple: the US tax-payer will now become the first and last resort for mortgage lending. If the GSEs can’t make money lending with the relatively tough criterion they rely on, then there is NO way any other competitors will be able to succeed with loans with even heavier terms. Who is going to want to get a 30 year fixed at 9%, requiring a 30% down-payment, when the GSEs can offer 6% with only 5% (or less) down?

    Investors are right to bail on the GSEs, and every other financial firm that has any real-estate investments whatsoever for one simple reason: write downs are set to continue indefinitely. There really isn’t any floor to how bad things can get. The more US real-estate prices depreciate, the more lenders (GSEs, private investment banks, etc) will have to take write-downs to coincide with the latest price declines.

    The only way this whole train-wreck can get turned around is when real-estate prices begin appreciating again.

    What investor wants to take bets on that happening any time soon?

    That said, I am a big fan of GSE debt. Why not put whatever cash you have under your pillow into government backed Fannie Mae bonds? They are as safe as treasuries (i.e. since they are both backed by the same government) and you get a better yield. In fact, you would be a fool to buy treasuries when GSE debt is so readily available for the taking.

    I don’t see why there has been so much concern about the success of the GSE debt auctions coming up this week. Why would bond-holders care about bail-outs, or a real-estate collapse? They just want to buy high yielding bonds backed by the US government. Who really cares whether the bonds are for GSEs or chicken dung fuel processing schemes?

  2. Jullayne said: “and/or when default rates start falling”

    Aren’t the two really just the same thing? Default rates won’t stop declining until prices start rising again. As we’ve discussed on previous threads, the biggest factor driving foreclosures is price depreciation. Thus, the single thing that would have the biggest impact in reducing the number of foreclosures is price appreciation.

  3. “As the crisis worsens for mortgage giants Fannie Mae and Freddie Mac, Treasury Secretary Henry Paulson is insisting that any potential government rescue plan not benefit the companies’ shareholders, according to people familiar with the matter.”

    If Paulson keeps up this kind of talk he will quickly drive GSE stock prices to $0. And then there will be NO way for the GSEs to raise capital other than via government bail-outs. Who in their right mind would buy GSE stock when the face the very real possibility that the Federal Government will step in at some point and wipe out their equity?

    Keep in mind that raising “capital” is a VERY different thing from issuing debt. Selling stocks to raise money doesn’t tie you down with any liabilities, unlike a bond issue (i.e. you have to pay back the bond-holders).

    To be clear, I think that bail-outs of any sort are the LAST thing the government ought to be doing (i.e. it will just make the problem even worse later down the road). However, if the government is really going to do a bail-out, they’d be better off bailing out shareholders. They should just give cash infusions to the GSEs with no strings attached: no shares of the companies or IOUs in exchange. This kind of government support will wind up being cheaper since it would actually encourage investors to stump up and buy more shares.

    Hey, if you know the governnment will ultimately give free cash to a company you own why not buy shares in it?

  4. Jillayne said: “Bailing out shareholders would equate to a moral hazard.”

    Sure. Bailing out shareholders creates moral hazard, but so does a bail-out of the GSE bond-holders. In reality it is the buyers of GSE bonds who the most responsible for creating the mess these agencies are in. If Investors hadn’t been willing to fall all over each other to buy Fannie and Freddie debt then the housing bubble wouldn’t have gotten off the ground. Unfortunately, bond investors had no reason to really consider the credit-worthiness of the GSEs since they knew the US government would guarantee the debt.

    Is all I am saying is that if the government wants to do some sort of bail-out, they’d be better off helping the shareholders directly. However, the best option is to do no bail-out at all. Investors (both of bonds and equity) need to feel the fear of God for a change, and realize that they really need to take responsibility for putting their money into safe vehicles.

    This is what really angered me about the Bear Stearns bail-out. Bear shareholders took a hit, but the customers of the bank were protected. How does this help anything? It is the immoral customers, and bond-holders, of these institutions who are the root of the problem. It is completely irresponsible to choose the institutions we do business with based merely on price, but since everyone knows the government will bail us out, no one cares about whether a given firm is really safe.

    Why not get CDs from the lenders offering the best rates, despite the fact those companies are usually the ones with the most trouble? Heck, my wife bought IndyMac CDs earlier this year because she got a great rate! She isn’t even batting an eye due to the bank failure since she knows her money is guaranteed by the government (the totals are far below $100,000). My wife was acting rationally, but it is this type of moral hazard that is the rot at the core of our system. Unfortunately, I haven’t heard anyone talk about trying to rectify this (exept Roubini, maybe).

  5. Just nationalize the suckers. If it’s the taxpayers taking the risk, they should be reaping the bene’s in the good times.

    Now I have to go find Roubini’s proposal.

  6. From the looks of this morning’s trading, it would appear that Skeletor just threw a hanging curve with the bases loaded. Apparently, the overnight traders of equity futures didn’t read past the headlines and now realize that this is no bailout, but rather a way to let the air out slower than it was before.

    The problem with the GSEs descends from the very model they use. They can only sustain so many defaults before they implode. Given that they were modeled on a 1% default rate, it doesn’t take much to tip this over.

    I’m not sure socialization of the mortgage market is going to be healthy for the economy, or even the housing market. At the end of the day, whatever a homeowner will save on interest, he will lose in taxes, overhead, and the inability to originate other forms of debt at working prices.

    Also, contrary to popular myth, Uncle Sugar doesn’t have an endless supply of money. Even if we eliminated the Defense Department, we still can’t pay out the Boomers’ retirements on Social Security, much less the far larger Medicare. Add in interest on the existing debt, and you have a government that is going to default on entitlement spending to save its credit rating.

    I know people might think that is a nutty prediction, but people also thought it was nutty that the real estate market would ever shift into reverse. Economic reality trumps sugar-plum dreams.

    Now, how does the backstop all the mortgages? Even more pressing, how does the take on enough mortgage paper to keep the present market from spiraling downward?

    In engineering terms, this is what we call “dynamically unstable.” (the more something moves out of equilibrium, the greater the propensity to continue to move out of equilibrium)

    If $15B and a stock buyback was all that was needed to fix the financial system, Skeletor would have done this months ago. The problem is in the trillions of dollars and the fact that tens of millions of Americans overbought their home, and there is not a single thing we can do to paper-over that reality.

  7. BTW, Jillayne…

    That’s a first rate summary on where we find ourselves. I’m glad people are starting to understand this for what it is.

  8. Speaking of potential bailouts…

    Check out the stock price on WaMu today. Down 32%, and the option traders are pricing in a price below $2.20 before Friday.

    I think the FDIC shot about 20% of its arsenal on IMB. Food for thought.

  9. Jillayne:

    Re the Option ARMS adjustments, I think we will see the biggest adjustments in POA’s between 4 and 5 yrs from date of origination. The peak of the Option ARMs originations was 2006.

  10. A little off topic, but perhaps the perspective of those with no need to care.

    I called my Mom yesterday. She said “how are you?…I was worried when I heard that Fannie and Freddie were getting a government bailout and IndyMac went under.”

    Put that into perspective. She is turning 78, raising a handicapped “child” who is 50 and two of her grandchildren. Owns her home free and clear and has enough money to live on. And yet she is that aware of what is happening.

    No talk about how she’s doing, how the kids are doing, aches and pains…all about F&F and IndyMac.

    For people who lived through the depression, as she did, IndyMac going under is significant news as is the F&F story. Though she had no clue who IndyMac was…she being in PA.

    She was pretty spot on except when she said “X bank is doing good because my bond there is worth more than the others”. I explained that was because of the 7.5% rate on that bond vs. the 6% rate on the other ones. That concerned me, because she used to know that. Then she asked me what she should do when it matures in 2011 🙂

    I told her it was a long way away. She said “not really”. I said in this market environment, 3 years away is way too far away for any of us to predict where the markets may be by then, especially the stock and bond markets.

    With no need to push rates lower, since no one can buy a house just because rates are lower these days, I think we are going to see interest rates rise. Lowering them is not going to help anything, since the impediment to buying is about cash in hand and credit scores.

    Sorry to be off topic, but when phone chats with Mom turn to things not mundane…those thinking this is not BIG news are just being ostriches.

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