Fannie and Freddie on the Brink

As shares in Freddie Mac (FRE) and Fannie Mae (FNM) rocket up and down faster than a whale on a bungee cord, US Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke have taken to Capitol Hill to testify about the government's rescue of these two out of control mortgage finance giants.

Former US Treasury Secretary John Snow got it right last week when he said that Fannie Mae and Freddie Mac have relied on leverage to fund their businesses in the same fashion as a hedge fund.

And now, after Fannie and Freddie have blown out their economic circuits, Americans get to own a piece of these shoddy businesses whether they wanted to or not, companies who provide Exhibit A of the worst form of government entrepreneurial senility, as one of my readers wrote me.

It's a strange and disturbing thing to behold the delightful bit of throat clearing from Congress finger-wagging Wall Street for not setting aside adequate capital against their exposures and for poor risk management (all true), despite the fact that elected officials let these two DC-based hot air balloons inflate the housing bubble even more and grow out of control right under their noses.

Given that teetering atop their painfully razor thin capital cushions is a book of business that is nearly half the size of the US gross domestic product. The wheels started coming off these two careening freight trains a long time ago.

What is going on should be as clear as a country creek to you. Elected officials still refuse to put the guard rails up around these two businesses in the form of statutory limits on their colossal $5.3 tn book of business.

Fear is now rampant that the US government must now swallow these two obesities, causing the US dollar to plunge in anticipation of the need to mint more dollars, creating more inflation. At minimum, some kind of taxpayer funding will be a backstop. Since when did you, the taxpayer, agree to this mess (not to mention the $99 tn in unfunded liabilities at Social Security and Medicare, according to Fed stats).

This mess should tell you that Congress has no regard whatsoever for taxpayers, and these developments are proof positive that Congress has no more sense than a flock of geese. Elected officials should be as tight as a miser's fist when it comes to spending your hard-earned tax dollars but they clearly do not care about such inconveniences when it comes to using your money to dole out pork to get re-elected. Instead of fixing the problems, Congress wastes time fingerpointing, as debate becomes target practice.

Because as losses mount at these two goliaths--$11 bn in the last three quarters and counting--the Treasury will simply mint more debt and use that resulting capital to inject more liquidity into them, despite their history of accounting misdeeds, losses and misstatements that prove that these two companies do not know what they are doing.

Fannie and Freddie buy mortgages, providing funds for banks to use to keep lending more loans. They also keep some mortgages on their books and repackage the majority into securities now sitting as potential landfill in central banks, pension funds and all sorts of investment portfolios around the world.

Those securities are backed by zombie loans given by banks such as Countrywide Financial (CFC), which pointed its conveyor belt of bad loans at Fannie, Freddie and Wall Street to repackage as securities.

Together, Fannie and Freddie own or back about $5.3 tn of U.S. home mortgages--nearly half of all mortgages outstanding. They now touch 80% of new loans (emphasis on new), and support about 80% of mortgage-backed securitizations, as Wall Street isn't doing much of these deals any more because its recycling machine for these cut and paste jobs has had sand thrown in its gears.

Which is why a downturn in shares in both Fannie and Freddie, down some 90% from a year ago, coupled with the plunging value of their mortgage debt sitting on their balance sheets, couldn't come at a worse time.

The government hopes to rely on them with its housing rescue plan to securitize even larger jumbo loans for the first time in the history of Fannie and Freddie to keep the US housing market above water.

And because banks here and around the world have invested in their securities, any plunge in the value of the debt from Fannie and Freddie could hurt their books as well, forcing them to raise even more capital. 

The problem is, Fannie and Freddie combined have a net worth of $54 bn, despite the $81 bn you see in core capital (a pro forma figure that doesn't include losses shoved into a line item called other comprehensive income).

Again, teetering atop that is their $5.3 tn book of business.

The two have a total of about $260 bn of subprime and Alt-A loan securitizations (the no-income, no-asset stuff somewhere between sub and prime loans). Another $3.3 tn in securitizations sit in off balance sheet vehicles, Lehman Bros says. Again those sums dwarf their capital positions.

Freddie has $156.8 bn in level three assets, those illiquid securities it can't sell because no one wants them. That's a fifth of its fair valued assets. Fannie has $56.1 bn in level three assets, or about a seventh of its fair valued assets. Again those sums dwarf their capital positions.

Fannie has $804 bn in total liabilities, Freddie has $786.8 bn in total liabilities. Their guaranteed liabilities were 29 times their net worth at the end of the first quarter.

JPMorgan Chase (JPM) or Bank of America (BAC), for example, have almost as much bank-level capital as these two "combined supporting one fifth of the commitments," says the research website The Institutional Risk Analyst, published by Lord, Whalen LLC.

So the fear is that, as mortgages belly flop right and left and an increasing number of homes go into foreclosure, the two are insolvent. Former Fed official William Poole has said as much of Freddie Mac, and the government would at worst have to take onto its balance sheet their $5.3 tn, blowing out the US books. Or again backstop it with some kind of taxpayer funding.

The government's plan is to now let these two giants borrow much more out of their credit pipelines into the US Treasury, now at $2.25 bn each. So far the two have not accessed these pipelines. They also now have access to the Fed's discount window at a cheap 2.25% rate to get untold sums of liquidity injections. But the question is whether they can potentially use as collateral for those loans securities they can mint themselves backed by mortgages taken out by, we can only hope and pray, upstanding borrowers.

Because as losses mount at these two goliaths--$11 bn in the last three quarters and counting-the US Treasury will simply mint more debt and use that capital raise to inject more liquidity into them.

The markets are behaving quite rationally in response to the government's weekend rescue plan by bidding down the shares of Fannie and Freddie and by sending up the prices of their debt, the idea being that equity shareholders may get zeroed out here while the bonds are protected.

Fannie Mae was born in 1938 as part of FDR's New Deal to get the country out of the Great Depression and provide home ownership. Back then millions of Americans were struggling to buy homes, and also faced foreclosures, as banks weren't lending and mortgage money had dried up.  

For years Fannie sat on the government's books, helping to expand the real estate industry. In 1968, the LBJ administration said, get this thing off of the government books, so Fannie Mae became a publicly traded company.

When the savings-and-loan industry wanted its own mortgage financing creature to play with beginning in 1968, Congress obliged and in 1970 Freddie Mac was born. 

So up cropped two quasi-socialist mortgage finance giants.

But Congress failed in a really dramatic way to rein them in through the decades.

It used to be that when mortgages were sold to these two mortgage giants, the same lender who did the selling to Fannie and Freddie would hold some of the risk of these loans repackaged as securities on their balance sheet.

But banks figured out a way to offload that risk via derivatives and shot these risky loans into the ether from here to the Arctic circle. That broke the bond between the overseer, meaning the lender, and the borrower. Why care about monitoring a borrower who has no skin in the game with a zero down mortgage when you've entirely offloaded that loan as a security?

Through the decades, Congress did little to dissuade taxpayers and investors from the notion that Fannie and Freddie were backed by the full faith and credit of the U.S. government, when they are not. Again, they both have credit pipelines into the US Treasury of $2.25 bn each, and that's where the backing was supposed to end.  

For years now the government knew these two posed a problem. A 2001 study by the Government Accountability Office said that these two might warrant only an "A" rating as private stand alone entities, but likely near junk status, based on their leverage, says the research firm The Institutional Risk Analyst is published by Lord, Whalen.

The research firm also notes a prescient dialogue between former Fed chairman Alan Greenspan and then-Senate Banking Committee Chairman Richard Shelby (R-AL).

Greenspan, who had been warning about these two for years, said the two mortgage finance giants "could not be supervised using the safety and soundness rules employed by regulators with banks," due to "woefully inadequate capital compared to commercial banks."

And yet, Fannie and Freddie lumbered along, becoming to the US economy what off-balance sheet entities were to companies "like Enron, Parmalat and Citigroup (C)," says The Institutional Risk Analyst. "Bloated far beyond their historical role of merely acting as conduits for securitization of residential mortgages, Freddie and Fannie [are] at much higher leverage ratios than any bank or hedge fund," it adds.

The research outfit says it sees a federal takeover of the two "as not only inevitable, but as an avenue to rationalize and shrink these institutions, and thereby remove a costly distraction from the Washington political scene."  

Finally, listen to what Sen. Jim Bunning (R-KY) had to say at the hearing today--though his words were hot enough to melt silver, and the thing is, many market watchers say he's right--and right to be angry. Since when did you the taxpayer agree to this mess that was created?:

"Now the Fed wants to be the systemic risk regulator. But the Fed is the systemic risk. Giving the Fed more power is like giving the neighborhood kid who broke your window playing baseball in the street a bigger bat and thinking that will fix the problem."

"When I picked up my newspaper yesterday, I thought I woke up in France. But no, it turns out socialism is alive and well in America. The Treasury Secretary is asking for a blank check to buy as much Fannie and Freddie debt or equity as he wants. The Fed's purchase of Bear Stearns' assets was amateur socialism compared to this." (see blogs, "New Details from Fed Minutes on Bear Stearns Rescue," "The Bear Trap," and "The Brinkmanship at Bear Stearns").

"And for this unprecedented intervention in the markets what assurances do we get that it will not happen again? None. We are in the process of passing a stronger regulator for the G.S.E.s [government-sponsored enterprises], and that is important, but it allows them to continue in the current form."

"If they really do fail, should we let them go back to what they were doing before?"