Five Things You Need to Know: Contrary to Popular Belief, Math Is Not a Rumor
For the GSE's, it is not about simply being able to borrow money. It's about being able to borrow very cheap money and then leveraging up that borrowing ability to make a profit for shareholders.
Kevin Depew's Five Things You Need to Know to stay ahead of the pack on Wall Street:
1. Flashback: March 4, 2008:
Let's step back for a moment and revisit something we discussed in detail in early March:
"Bernanke's Speech Lays Groundwork for Nationalization of Fannie Mae, Freddie Mac"
"Federal Reserve Chairman Ben Bernanke, in a speech this morning in Orlando, FL on "Reducing Preventable Mortgage Foreclosures," reportedly urged lenders to forgive portions of mortgages held by homeowners at risk of defaulting, according to mainstream media reports. That's one way to look at it, but it actually misses the entire point of his speech.
In the speech Bernanke outlines the grim path ahead for individuals besieged by declining home values and rising mortgage payment resets. This year about 1.5 million loans, representing more than 40 percent of the outstanding stock of subprime Adjustable Rate Mortgages, are scheduled to reset. According to the Federal Reserve, the estimated payment adjustments upon reset will result in an average monthly payment of $1,500, a 10% increase. The fear, a very real fear, is a cascade of defaults that puts additional downward pressure on home prices and forces continued risk aversion on the part of mortgage lenders.
"This situation calls for a vigorous response," Bernanke said. "With low or negative equity, as I have mentioned, a stressed borrower has less ability (because there is no home equity to tap) and less financial incentive to try to remain in the home."
Consequently, according to Bernanke, principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure. In other words, adjust the mortgage principal downward to reflect the declining home value.
Wait a minute, wouldn't that put yet more pressure on home prices in areas where a significant number of homeowners seek and receive principal writedowns? It sure would. Moreover, as Bernanke notes, "Lenders tell us that they are reluctant to write down principal. They say that if they were to write down the principal and house prices were to fall further, they could feel pressured to write down principal again." And of course, on the off chance home prices rise the lender would not share in the gains.
So what is this speech about? Is it really about urging principal writedowns that even Bernanke himself admits probably won't work, or is something else going on? We're going to go out on a limb and say, "something else." The real conclusion is reached at the very end of Bernanke's speech:
"The government-sponsored enterprises (GSEs), Fannie Mae (FNM) and Freddie Mac (FRE), likewise could do a great deal to address the current problems in housing and the mortgage market," Bernanke said. "New capital-raising by the GSEs, together with congressional action to strengthen the supervision of these companies, would allow Fannie and Freddie to expand significantly the number of new mortgages that they securitize."
That almost sounds like it would be a good thing. In at least one sense, it would be a good thing, but only by default. Bernanke concludes; "With few alternative mortgage channels available today, such action would be highly beneficial to the economy." That's certainly true, but only in a grimly ironic sense. It's government-enabled expansion of Fannie Mae and Freddie Mac that led to a situation where there are "few alternative mortgage channels available today" in the first place.
So Bernanke's ultimate conclusion is this: "I urge the Congress and the GSEs to take the steps necessary to allow more potential homebuyers access to mortgage credit at reasonable terms. " It takes either a massive degree of denial or a broad imagination to accept that sentence at face value. What Bernanke is really urging is the full-scale nationalization of the GSE's.
We can continue to pretend that these companies are going to be just fine, but the reality is it is impossible to fit together the pieces - raising massive amounts of new capital in the face of a yet-to-peak-wave of mortgage resets and housing price declines while simultaneously expanding their mortgage securitizations - without taking what Bernanke calls "congressional action to strengthen the supervision of these companies" to mean,essentially, nationalization of the housing market.
Fannie and Freddie stocks are down about 6% so far today. Perhaps the reality is now setting in that nationalization doesn't benefit shareholders."
2. What, Exactly, Is Fannie Mae?
Meanwhile, the day after suggesting in Five Things that we are seeing the groundwork laid before our very eyes for the nationalization of Fannie Mae and Freddie Mac, the mail came rolling in saying we were obviously wearing tinfoil hats. But let's step back for a moment and consider just what Fannie Mae really is, and how it came to be in the first place.
Fannie Mae was actually created as a government institution. It was de-nationalized (privatized) in 1968 in order to balance the budget, which if we really think about it is hilariously ironic. Fannie Mae was basically one of the first government "off balance sheet" vehicles.
As we wrote in March:
"Now, after 40 years of enriching private shareholders via the company's government sponsored and enabled business model, the reality, given the debt crisis and the magnitude of the collapse of the real estate market, is that Fannie Mae will almost certainly necessitate being re-privatized and returned to its original owner.
Put another way, the government will be forced to take this off balance sheet vehicle back onto its balance sheet just like banks are being forced to do with a wide variety of their own off balance sheet vehicles."
That no one cares about this, or is upset by it, and that most consider anyone who suggests there is anything wrong with this picture is "wearing a tinfoil hat," speaks to the depth of denial in the marketplace.
We really have no problem with private citizens profiting from their investments in Fannie Mae, as has been the case for most of the past 40 years; we just have a problem with the company's debt and future obligations being forced onto the backs of taxpayers now that the ability for private citizens to profit from the company's business model has run its course.
Like it or not, that is what is happening with Fannie Mae and Freddie Mac. And that's why we should all be outraged over it.
3. What It Means
Let's clear up exactly what this means going forward. First, this action by the Federal Government is not unprecedented, as we shall see in just a moment. Second, this is a long-term process that will have the following very real ramifications going forward:
1) It will slow the eventual recovery as we enter a Japan-style deflationary credit contraction with the government committed to propping up various non-productive financial entities rather than allowing liquidation.
2) It will result in the eventual downgrade and reduced confidence in U.S. debt.
3) On the other side of the deflationary credit unwind, several years from now, that lower rating and lower confidence will result in sharply higher interest rates and a further stagnation of the economy... very likely right as it looks as if the economy is recovering.
We have been here before.
See if this sounds familiar:
"If the federal Reserve had an inflationist attitude during the boom, it was just as ready to try to cure the depression by inflating further. It stepped in immediately to expand credit and bolster shaky financial positions. In an act unprecedented in its history, the Federal Reserve moved in during the week of the crash - the final week of October - and in that brief period added almost $300 million to the reserves of the nation's banks. During that week the Federal Reserve doubled its holdings of government securities, adding over $150 million to reserves, and it discounted about $200 million more for member banks. Instead of going through a healthy and rapid liquidation of unsound positions, the economy was fated to be continually bolstered by governmental measures that could only prolong its diseased state."
- America's Great Depression, by Murray N. Rothbard
This is a long-term process. In our sound bite world it is all too easy to fall into the trap of thinking that a deflationary credit unwind is something that will have just happened one Monday when we walk in the office. I always come back to a statement made by someone who lived through the Great Depression: "Just when we thought it was over, it was really only beginning."
4. Real People; Real Lives
Writing about Fannie Mae and Freddie Mac, criticizing the companies and their operations, it is important to remember that, together, Fannie and Freddie employee more than 10,000 people. A Washington Post story this morning takes a closer look at how recent events are affecting employees of the GSE's:
"For the long-termers, this is just horrible," said Thomas Lawler, Fannie Mae's former senior vice president for portfolio management, who retired in 2006. "This is something people are just . . . their mouths are just agape. As an existing shareholder, you're sad, depressed and possibly even [ticked] off."
"This is my family's financial future," said Lorrie Rudin, former director of executive compensation for Fannie Mae, who retired last year. "I worked there for 20 years, and I'm just absolutely devastated and terrified."
But then there is this quote from the piece:
""[Employees] feel that no matter what they do at this point, the situation may get out of control, and something needs to be done to clamp down" on unfounded rumors, one Fannie employee said."
5. Contrary to Popular Belief, Math Is Not a Rumor
Let's clear something up about the growing mythology of the GSE's having been "taken down by unfounded rumors." This is not about rumors. This is about very simple math.
The ongoing decline in housing prices and the ongoing increase in foreclosures is having (and has already had) a very serious impact on the business models of Fannie Mae and Freddie Mac.
There are two misleading statements that appear in virtually every mainstream media article on the two companies:
1) Fannie Mae and Freddie Mac are still able to borrow money, so fears of their collapse are based on rumors and innuendo.
This is a very misleading statement. It is not about simply being able to borrow money. It's about being able to borrow very cheap money and then leveraging up that borrowing ability to make a profit for shareholders. That is the core problem at the GSE's. Their business models are no longer working due to the reality of the housing bubble unwind.
2) Fannie Mae and Freddie Mac are adequately capitalized.
This is another misleading statement. Technically, based on the Office of Federal Housing Enterprise Oversight (OFHEO) requirements, both companies have adequate capital cushions. But that's like jumping out of an airplane without a parachute and arguing on the way down over whether your shoes have the right government mandated soles. Yes, according to OFHEO guidelines, Fannie and Freddie have the right soles. But put in context, those shoes aren't going to be of much use when their feet hit the ground without a parachute.
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