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Fannie Mae (FNM) stock was trading around $51-52; I had covered some of my short, planning on trading around a core short position, but I fully had the opinion that the stock would drift significantly lower. I thought Congress was finally on the right path of shrinking this dangerous institution, slowly ridding the system of a source of monstrous leverage. With less revenue (for never did I think the company actually made profits) the bulls would finally have to capitulate.

But the stock began to trade differently. It began to drift up as the buying began outweighing the selling under heavy volume. Because of the long gamma nature of my option position, I covered some more short deltas by just not selling more as the stock rose. Around $54 Scott talked me into being more aggressive in covering my short and although I didn't get long deltas; I adjusted the position to remain neutral. I couldn't figure out why the stock would drift higher on heavy volume knowing that the company was properly being neutered, but the stock action was clearly telling us something.

I should have known better. New reports out of regulators and Congress are showing (at least at this point) that our government does not have the political will to do the right, but painful thing. Rather, it seems the opposite for the right thing would be to diffuse this bomb sooner rather than later.

Despite the claim that the GSEs make it easier for low income families to obtain a mortgage (a claim motivated more by politics than economics), what they more importantly do is facilitate speculation, risk taking, in the real estate market. The expansion of the real estate market is the driving force behind growth in the economy and without the GSEs, growth would soon slow. The Federal Reserve can make liquidity available, but they cannot force that liquidity into the system. In other words, they can increase the supply of money, but not its velocity. The GSEs are in a unique position to do what the Fed cannot do: expand the "velocity" of money. Here is how.

Banks (and other lending institutions) have a certain capital base and will make loans only up to a certain amount based on that capital base. As the Fed Funds rate drops, the banks' source of liquidity becomes less expensive and if capital is available to support more loan activity, they will make more loans because they are more profitable. As banks make more loans, the original liquidity injected into the system by the Fed through lower interest rates (or a higher money supply) is multiplied through the system. But the bank will stop making loans if they reach their limit of loans to capital (increased profits grow capital so this is a moving target) or if they cannot find credit worthy customers to loan to (the more loans they make, the more difficult it is to find them). As banks slow loan growth, the velocity of money slows. The Fed cannot "make" banks lend out the money they "create".

Enter FNM. The GSEs buy the loans from the banks at prices that are attractive to them because FNM can borrow at even lower rates from bond investors, who "think" the GSEs are basically risk-less via an implied guarantee from the government. FNM has alone bought around $3 trillion in mortgage loans from banks and other companies. As FNM buys these loans from banks, the banks are then "freed-up" to make new loans. And the banks will go further down the credit worthiness path knowing the FNM will buy those too. The banks essentially become brokers to FNM. By eliminating banks concern for risk, the GSEs increase the velocity of money.

All of this has a profound two-fold effect: the GSEs perfect the Federal Reserve's inflationist policies and, perhaps worse over time, socialize risk. In the end, it is the taxpayer that will own the risk.

This is what has some "thoughtful" people concerned about the activities of the GSEs. $3 trillion is a very large number and if something went wrong in the GSEs' "managing" of such a large number it could/would pose extreme difficulties (to say the least) for the entire financial system.

So the GSEs are essentially dumpsters for loans (they re-package some of these loans and re-sell them to other investors through the CDO market, but this is only possible because FNM continues to guarantee these investments). They are the mechanism by which liquidity injected into the system is expanded by the multiplier effect, something the Fed needs to complete their control over the system.

In my opinion the GSEs cannot properly "manage" the risk of such a large portfolio of debt. They try using all sorts of derivatives, but the problem is they are just too big: large losses would ripple through the system if there is a large change in interest rates. This all comes at a time when foreigners have become the largest holders of U.S. government debt. Some argue that those foreigners would never "sell" that debt because it would hurt them just as much as it would the U.S. This is silliness. The fact is that we have given foreigners control of our debt and that there are situations in which they would sell it, push come to shove.

Sure enough as the stock began to trade up, we got an announcement out of the regulators that "FNM now has adequate capital". This may be true based on certain assumptions, but perhaps adequate for only the barest of uncertainties. And now we hear that Congress is actually talking about increasing the size of the GSE portfolios. How did this happen?

Maybe Congress never intended to "neuter" FNM in the first place. Or perhaps when they delved into the web of accounting spun at the company they found that it could not be "un-spun" without significant costs. In order to reduce the company's portfolio, they would have to sell off more loans to the private sector than it could bear at the price they were marked at.

For if they did neuter the company now, although they may avert a catastrophe in the future, they would risk derailing the economy for the velocity of money would slow.

So they lengthen the fuse, but do not de-fuse the bomb. As foreclosure rates rise, the bomb will tick ever louder. So I have re-adjusted my option position by buying a little more gamma, as options have gotten cheaper in this rally, and re-shorted some deltas, thinking the good news is in the stock and that the White House may force Congress to be a little more rational.

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