"I told you so, months ago."
Barrons put a nail into the coffin in an article due to show up on newsstands on Monday (subscription required)
"It is growing increasingly likely that the Treasury will recapitalize Fannie and Freddie in the months ahead on the taxpayer's dime, availing itself of powers granted it under the new housing bill signed into law last month. Such a move almost certainly would wipe out existing holders of the agencies' common stock, with preferred shareholders and even holders of the two entities' $19 billion of subordinated debt also suffering losses. Barron's first raised the possibility of a government takeover of Fannie and Freddie in a March 10 cover story, "Is Fannie Mae Toast?""
Yep.
But before I put forward a prescription for how I believe the government should act (and act it will, in due course), I want to take a look at how this all happened up front.
Let's look at an article in the International Herald-Tribune entitled "How Banks Sold Home Equity Loans":
"Still, "Live Richly" won out. The advertising campaign, which cost about $1 billion from 2001 to 2006, urged Americans to lighten up about money, and helped persuade hundreds of thousands of Citi customers to take out home equity loans - that is, to borrow against their homes. As one of the ads proclaimed: "There's got to be at least $25,000 hidden in your house. We can help you find it.""
"Ads for banks and their home equity loans often portrayed borrowing against the roof over your head as an act of empowerment and entitlement."
"Bankers defend home equity loans by saying they merely give customers what they want: easy credit to buy things they otherwise might not be able to afford." (Ed: you mean "can't afford but we'll make you think you can, right?")
"Live Richly" eh?
Hmmmm.
But back to Freddie and Fannie.
A large part of the trouble they're in is due to the more than half-trillion dollars worth of "ALT-A" - or liar loans - that they bought or guaranteed in the last few years. The GSEs claim that their mission statement is to promote "affordable housing" targets and this is why they got in trouble.
What part of buying loans from people who lied to get them and were demonstrably unable to afford the payments at their full level is about "promoting affordable housing"?
None.
These loans were made to real estate speculators in Florida, Las Vegas and California, in the main, along with pseudo-wealthy "middle class" Americans trying to "Live Richly." There was exactly no connection of any kind to low-income borrowers in the cities, where this mandate does in fact exist.
Nor is there a hint of prudence in Freddie and Fannie's recent actions since the stress became declared in their public statements (never mind that Freddie's CEO disclosed recently that their risk manager warned of this very problem quite some time ago.)
In the last quarter Freddie Mac's growth of on-balance sheet exposure exploded higher by 11% - all out of proportion to the declared "risk" they claim they now see, and in addition, they have taken down hedging costs, which means they're now even more exposed to interest-rate changes than they were before.
What prompted that? Both Fannie and Freddie went to OFHEO and The Bush Administration early in the year and told them they'd raise more capital in exchange for loosening their "excess capital requirements" and removing portfolio size caps. Fannie did raise the capital, but then lost nearly all of the additional capital in just one quarter; Freddie welshed on the deal and still hasn't raised jack, citing "market conditions", but they still got their loosened capital requirements and used the expanded capacity to lever up even higher!
This amounts to walking into a Casino, betting (literally) half your house, losing, and then doubling down. You either are a zero or hero, and the odds favor the zero.
Why is such behavior tolerated?
Because management believes they can blackmail Congress and Paulson into bailing them out - in short, they believe they can take these sorts of risks on purpose, not for their chartered and proper reasons in helping Americans but to enrich their shareholders and management, and get away with it - "heads we win, tails you lose."
Then there's the issue of exactly how they're valuing things. I've written about this many times in the past, and now Barrons is blowing the whistle on it as well. Is there any reason to believe that their "marks" reflect trading reality? No.
I believe both firms are intentionally overstating the marks on their assets, thereby making them appear to be in much better health than they really are, not to mention counting "deferred tax assets" that can't be spent (they're only "assets" to the extent you have taxable income in the future!) As written about in The Ticker in the past, this isn't my opinion alone - many have opined that under any sort of real "Fair Value" assessment both of the GSEs are insolvent right here, right now.
In addition we now know from both firms filings that they are intentionally refusing to take repurchases of defaulted mortgages from securitizations they guaranteed, instead choosing to make the interest payments themselves on those bonds. This is simple chicanery in that these defaults will not cure themselves; the GSEs are doing nothing more than pushing forward the day of recognizing the impact of these losses, which have already in fact happened. This sort of artifice and accounting trickery is an outrage.
What's even worse is that banks are and have been offloading paper to the GSEs as fast as they can, and the GSEs are still more interested in flooding their balance sheet than scrutinizing what comes in the door for sustainability and payment capacity. Anyone care to take a guess at what sort of real credit quality is behind that recently-acquired paper?
It is clear that both of the GSEs will and must fail.
I believe their failure from a market perspective is unavoidable as a consequence of their conduct and the resulting "quality" of their book.
I also believe they must be allowed to fail to set an example for all the banks, brokerages and others who have engaged in similar conduct - to point out that such sort of willful abuse of the taxpayer will not be permitted.
Here is what must happen now:
- The government must force full, public, outside audits. The recently-announced Treasury action in this regard is a nice start, but not having access to the GSE's internal books is an outrage. Give us a full, public accounting.
- All marks must be documented and defended. This, I believe, will force both firms into immediate receivership (bankruptcy.)
- To the extent that management is implicated in intentionally falsifying reporting (if any), they need to be indicted, tried, and if convicted locked up.
- The Government should then step in and forcibly purchase a large (~$10 billion each) interest in super-senior preferred stock, granting them the right to:
- Replace the board of directors and management
- Supersede all other classes of stock, suspending dividends across the board.
- Support the super-senior and senior coupon to the extent possible, until that capital is depleted.
- The government then places both firms in rundown, fires management, and brings in outside parties to operate this process. All acquisition and forward funding ceases. The debt in the non-originated portfolio is sold off for whatever it brings and each class of debtholder is retired as the portfolio runs off, category-by-category. End of GSEs.
- To take over the GSE's former function, Ginnie is authorized to guarantee the issue of mortgages to the general public (not just VA and FHA), but under strict, 20% down, 36% DTI, 30 and 15 year fixed term underwriting criteria. These notes are issued with the Ginnie explicit government guarantee. Note that Ginnie has never engaged in the sort of "hedge fund" nonsense that got the other two GSE's in trouble. This provides the mortgage liquidity function that Paulson and others believe is "critical." It puts the desired "floor" under housing, but at an actual sustainable price, which is, incidentally, quite a ways down from where we are now.
Most bondholders under this action would take no or very little loss.
Those who bought bonds from the far-riskier hedge-fund like activities, or the open-market purchases of ALT-A "assets" that are in fact worth far less than they're being carried at would be partially exposed, but this was a choice - if you look at what sorts of debt Fannie and Freddie have issued, it is not just single-family residential mortgage-backed debt, it is many different classes of bond linked to many different sorts of retained, purchased and guaranteed assets. You choose what you want to buy, and each has a very nice prospectus detailing what's in there.
If you bought bonds backing ALT-A liar loans to speculators in Nevada, then expecting the taxpayer to back up your bad purchase is beyond ridiculous and into the realm of theft and, if you threaten someone (like Paulson) over it, blackmail.
The preferred stockholders in this scenario would be in serious trouble while common equity holders would be just plain wiped out. Preferred holders might be able to (depending on how the quality of that retained portfolio actually works out over time) to recover some of their investment, but almost certainly not all.
The important point here is that the longer the government waits to do this the worse the losses will get for everyone, as housing prices remain in decline and they will continue to do so until they reach 3x incomes, on average, in each market area.
It is now CLEAR to anyone who has even a double-digit IQ that Bernanke and Paulson's ideas from last year of allowing financial institutions to lie, cheat, and try to borrow their way around telling the truth and selling off this debt to deleverage has only led to more losses as the value of the collateral has continued to decline.
As I said originally last summer the right move was (and still is) to force these people to sell off the debt NOW for whatever it will bring, because its value today is higher than it will be tomorrow.
We must force resolution of this problem now as we are headed straight for the result that Japan got by allowing their institutions to lie and fail to report their losses honestly, declaring their "marks" by fantasty, wish and dream instead of the market.
Today, more than ten years on, the Nikkei stock market has still not recovered from the loss of 2/3rds of its value, and the Japanese economy still has failed to bottom and recover.
Goodbye Fannie and Freddie, it was nice knowing 'ya.
Oh, and for my fellow Americans?
Exactly what will it take before you will get off your butts and start demanding that The Government stop allowing people to lie to you about matters financial?
Go back and read this whole thing. This mess did not happen in a day and you have consistently sat on your tush and bought your plasma TVs and iPODs, without regard to whether you could afford them.
You listened to those who intentionally deceived you for their profit and your loss, and you still are.
Do you hear the alarm clock in your head yet?
If not, how much more of your standard of living do you have to lose before you do?
Economics
