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Death of Fannie, Freddie Only the Beginning


The next devaluation will be a doozy.


As the world celebrates the US government's takeover of Fannie Mae (FNM) and Freddie Mac (FRE), a few thoughts from someone who told you 2 years ago that this would happen. For those few who dare to see past the market's immediate positive reactions, this is all a very long-term negative for the U.S. and the world in general.

The following 3 bullet points were written by Alex Barron of Agency Trading Group:

"1. From a philosophical economic standpoint, what the government has done is the biggest move yet in the direction of socialism, and has prevented the free market from working itself out.

What was needed was not a conservatorship, but a restructuring. This means allowing investors who took the risk of investing in Fannie and Freddie in exchange for a potential reward to absorb the losses - not the taxpayers.

This would basically consist of allowing the equity and preferred equity to get wiped out and convert every $1,000 of debt to some conservative combination of debt and equity such as $500 of debt and $500 of new equity. This would effectively allow Fannie and Freddie to become "well-capitalized," and would also allow the previous debt-holders to absorb future losses in their new equity.

2. From a financial standpoint, what was needed was to completely privatize the economic functions of Fannie and Freddie, not have the government stepping in to buy securities in the open market and helping the GSEs provide more un-economic mortgages.

In order to get out of a hole, you first need to stop digging. So, to get Fannie and Freddie out, the first thing they need to do is to stop buying more un-economic mortgages. As long as home prices are dropping -- and they will continue to drop as long as REO (bank -owned) inventories are growing -- the risk of losing money by lending to someone buying a home exists.

The only way to minimize that risk is by demanding a higher down payment, higher interest rates, and lending only to highly qualified borrowers. A private entity would eventually do this, or else it would go bust. A public mortgage lender will simply continue to lend money at low rates in order to provide "affordable housing" and "expand homeownership" - and have the taxpayer absorb the losses down the road.

3. From a moral hazard standpoint, this sends the strong signal that the government won't require anyone deemed "too big to fail" to pay the piper. Instead, the government will bail them out by simply printing money. This will cause a long line of people to "position themselves," as Pimco euphemistically put it this morning, for a handout. The amount of inflation that will follow shouldn't surprise anyone.

The first point I've touched on before. The Federal Reserve and any central bank is a socialist institution. It steps into markets when real capital decides not to lend because risk is too high, and then lends taxpayer money (you'll see that this is the case when the Federal Reserve asks Congress to print money to make up its losses).

I couldn't have said it better myself, so why try?

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No positions in stocks mentioned.
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