A Day Late and a Dollar Short

That's me, today. I meant to post this over the weekend, but I didn't get to it. So now you'll just have to take my word regarding my predictions. (My wife could vouch for me, but she's biased.) I'm also probably quite a few dollars short after this weekend, in part because I'm short the stock market.

And in part because I'm a taxpayer.

I predicted a couple of weeks ago that Paulson would bail out Fannie Mae and Freddie Mac by Labor Day. Missed it by a week.

Yesterday, when the bailout was announced, I read the details - and in this case, the devil is truly in there. I also predicted the Dow would rally 300 points today, then ultimately come to its senses.

See, the whole notion of a stock market rally on a deal that screws stockholders and taxpayers, let alone the idea of a rally on two quasi-government agencies failing, is pretty silly.

But this is the same market that rallied more than 200 points on August 28th because last quarter's GDP number was revised up. So much for the market being forward-looking. Never mind that the revision was built on trade, and the rapid slowing of the British, southern Eurozone, and some Asian economies is piddling that pillar of support away. Or that the original decent Q2 number was built on a one-time economic stimulus - which was largely spent on gasoline - and an unwanted bulge in inventories. Or that Q3 growth is almost undoubtedly in the crapper.

That's okay though. I'm on this train (wreck) for the long haul. My shorts will pay off. I've seen several articles this morning noting that the market has rallied on each government intervention since this debacle began, and that each rally has been shorter and weaker.

On to the Fannie/Freddie bailout. This is a bad idea, and it won't work. To some, it's the only thing to do, though. Here's why.

Fannie and Freddie guarantee about half of the $11 trillion US mortgage market. They buy primarily long-term, fixed-rate loans from banks and brokers who can't take the risk of holding them on their own books. Banks' primary source of funds - your deposit dollars (assuming you're an atypical American and actually have a savings account) - are short-term. You probably don't have many 30-year CDs. So when rates go up, you roll your short CDs and demand higher rates. But banks are still earning the earlier, lower rate on the mortgages they hold, if they hold them. So they'd prefer to sell them. If they can, they're willing to make more loans, and thus more people have access to housing credit, and therefore housing. (The mismatch between short funding and long-term fixed-rate assets spawned the S&L crisis, by the way.)

So if Fannie and Freddie are allowed to simply fail, they go away, and so does the conduit for about $5 trillion in home loans. The implications for housing are dire. Credit becomes uber-scarce. Homeownership plummets. Mortgage rates also go up, because banks will now have to hold the bulk of their loans on their books, and they're going to want to get paid for that. So there will be a higher risk premium, no matter what the underlying Treasury rates do (30-year mortgages are priced at a spread - reflecting the credit risk of the loan - above the ten-year Treasury yield).

And, as we've seen, as housing goes, so goes the economy. Fewer builders building, providing well-paying construction jobs. Fewer people buying houses, filling them up with "stuff," so the people that make and sell the "stuff" make less money - again fewer jobs of all kinds.

So, Hank Paulson - who's apparently forgotten everything he learned on Wall Street - believed the only thing to do was bail Fannie and Freddie out. He cited "three critical objectives":

1. "Providing stability to financial markets." No argument here. But I'd rather see short-term instability that leads to long-term stability, than vice versa, which is what Paulson's given us.

2. "Supporting the availability of mortgage finance." It was the too-easy availability of mortgage finance that got us into this predicament in the first place, Henry.

3. "Protecting taxpayers by both minimizing the near term costs to the taxpayer and by setting policymakers on a course to resolve the systemic risk created by the inherent conflict in the GSE structure" (GSE stands for government-sponsored enterprise, which is what Fannie and Freddie are - chartered by the government, back by its once-implicit, now explicit full faith and credit, but with private equity holders).

Okay, that last point begs four questions. Four absolutely, jaw-dropping-bug-eyed-incredulous questions.

First - Hank, is it wise to "minimize the near term costs to the taxpayer" with a plan that will maximize both the long-term costs and their duration?

Second - since when has unleashing policymakers on a problem protected the taxpayer? Holy smokes, Henry - do you not recall the S&L crisis?

Third - if you recognized the systemic risks inherent in the GSE structure when you landed this gig back in July 2006, why on earth didn't you start work on fixing it then, before it was too late?

And fourth - just who in hell are you trying to kid here, anyway?

Okay, so much for his rationale. Here's his plan:

1. Place Fannie and Freddie in conservatorship. Conservatorship is supposed to be a temporary parking spot for a company deemed insolvent until it can return to solvency. Instead, it is the purgatory to receivership's hell. I worked for an S&L that was placed in conservatorship. At the time the government took over, it had more than $300 million in capital. Three years later, it had gone the way of the dodo bird, and at a total loss to the stockholders (myself included) and a net cost to taxpayers (myself again included).

2. Replace management. No more can I make jokes about how Fannie's CEO's name is actually Mudd. He's been replaced by a former Merrill Lynch vice-chairman.

Yes, Virginia, the same Merrill Lynch that has lost $51.8B over the course of the credit crisis. The same Merrill Lynch that ranks #2 on the loss leader board. The same Merrill Lynch whose stockholders have lost 70% of their investment over the last 15 months. The same Merrill Lynch that is vying with Lehman Brothers to be the next Bear Stearns.

Oh boy. I like this pick.

Freddie's boss will be replaced by the former CFO of US Bancorp, which has been relatively unscathed in this imbroglio. One out of two ain't bad, I guess.

Both of the new guys' "compensation will be significantly lower than the outgoing CEOs." Good thing, since an estimated two out of every three dollars of Fannie and Freddie's subsidies from the government went to its executives and stockholders, not to promoting homeownership.

3. The Treasury Department will become a senior preferred stockholder in Fannie and Freddie, in exchange for - get this - "ensur(ing) that each company maintains a positive net worth."

Wow. What's key in that phrase?

First, he didn't say Treasury would maintain adequate capital for Fannie and Freddie, just "positive net worth." They already had that, although not for long. But wasn't their issue capital adequacy? Paulson himself said yesterday, "Their statutory capital requirements are thin and poorly defined as compared to other institutions."

Well, thanks, Hank. They're certainly well-defined now: anything above zero. But that's still a tad thin, don'tcha think?

Second, Treasury will ensure - for as long as need be, up until its blank-check authority expires at the end of next year - that Fannie and Freddie have positive net worth. So, if the new guys continue to screw the pooch and the losses continue to mount and the net worth goes below zero, Treasury will keep flushing money down that toilet.

Our money.

Hank said, "It is more efficient than a one-time equity injection, because it will be used only as needed and on terms that Treasury has set."

I wish I'd seen his speech, because if he actually said that with a straight face, I have to believe that when he was an All-American O-lineman at Dartmouth, they didn't use helmets.

Are you flipping kidding me? "More efficient than a one-time equity injection?" Folks, what he's saying is, "We'll be paying on this ugly pig for most of your lifetimes."

4. Fannie and Freddie will have two "primary mission(s)":

a) "To proactively work to increase the availability of mortgage finance, including by examining the guaranty fee structure with an eye toward mortgage affordability."

Let me tranlsate. Fannie and Freddie charge a fee to guarantee the mortgages they buy and securitize. For years now, that fee has been too low to cover the true underlying risk of the mortgages, as credit standards have loosened and Alan "Mr. Bubble" Greenspan kept rates too low for too long. So recently - also too late and many dollars short - Fannie and Freddie have upped their fees, which has made mortgages more expensive than they were, but once again as expensive as they should be.

Sounds like Hank wants to lower those fees, back to sub-market risk levels. Not a wise move. Just when you thought it was safe to go back in the water ...

b) To "modestly increase their MBS portfolios through the end of 2009. Then to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10% per year ... eventually stabilizing at a lower, less risky size.

Let's read between the lines here. Hank acknowledges that increasing the size of their portfolios - even into 2010 - increases "systemic risk," and he also acknowledges that shrinking their portfolios to a "lower, less risky size" would reduce risk.

So he proposes increasing their portfolios in the short run. Great. More losses. More risk that the losses reach the taxpayer.

Also, the housing crisis isn't expected to be over until the end of 2009 anyway. So just when the party could be getting started, they're going to take away the punch bowl. That should bring a fresh wave of stagnation in the housing market.

To be fair, Hank admits that this step is designed to "promote liquidity in the secondary mortgage market and lower the cost of funding," which it should do. But it won't stimulate housing demand.

Let's put that last point in perspective. The Fed and the Treasury have been intervening in the credit markets since last summer - cutting interest rates, opening up the discount window to everybody but the payday loan shop junkies, and bailing out Bear Stearns and now the GSEs. Not to mention the brilliant and highly effective "Project Hope" and other such initiatives.

What has the effect on housing and mortgage affordability been?

Home prices have continued to fall, reaching fresh year-over-year records every month. Delinquencies and foreclosures have continued to rise, doing the same. And mortgage rates - which were about 6.50-6.60% for a Fannie- or Freddie-conforming, 30-year fixed-rate loan in June 2007, before the Bear Stearns hedge fund collapse that triggered the credit melt-down - were at 6.55% last week. Now, after the bailout, they're running around 6.20%.

Great news! Mortgage rates are down 35 basis points!

Time to sober up. They were as low as 5.50% in January. At the time, purchase mortgage application volume was down about 4% from where it was the previous summer, when rates were a full point higher (and those levels were already down 10% from the bubble's peak). Why? Falling home prices. Today, the 13-week moving average of the weekly volume index is at a six-year low.

Also, it's hard to get excited about mortgage rates finally coming down 35 basis points when the Fed funds target has been cut by almost ten times that amount. Mortgages are priced off the ten-year Treasury yield, which is only down about a percentage point - or a third of the Fed's rate-cutting - since September. And it won't come down much further, with inflation expectations still high. So the bailout-induced reduction in mortgage rates is a function of perceptions of future liquidity. That may play out, and it may not.

The last linchpin in Paulson's scheme is that Treasury will start buying mortgage-backed securities from Fannie and Freddie - a rather incestuous support system - which is also designed to boost liquidity and increase mortgage finance availability.

The downside is that if losses in the MBS market continue, Treasury will take a hit.

Who is "Treasury?"

You, me and China. And China can stop funding anytime it wants. Not so, you and me.

So, what will the actual effects of Paulson's plan be?

1. Fannie and Freddie's stockholders will get nada. That's as it should be. When you buy stocks, you risk losing all your money. Oh, they'll ask for a bailout. If they get it, I'll defect.
2. Mortgage rates will not go down meaningfully enough to stimulate housing demand. The weakness in demand is a function of still-bulging inventories of housing stock, producing still-falling prices. And no one wants to jump on a sinking ship. Until prices bottom out, we won't see recovery in housing.
3. Furthermore, this will not meaningfully increase mortgage credit issuance. Lending standards have tightened - a most appropriate and long-overdue response to rampant speculation. So even if rates cheapen up enough to make a house affordable, and even if would-be buyers are willing to take the plunge - literally - in a falling-price market, many of them will not qualify. Or be able to come up with the reasonable 20% down payments that are now once again, and reasonably, being required.
4. The taxpayer is screwed. This year's budget deficit is already at $370 billion, and it's expected to grow by $105 billion with this week's report for August. The all-time record is $411 billion in 2004. This bailout will cost an estimated $300 billion to the taxpayer.

Let's put that in perspective. The S&L bailout ultimately cost the taxpayer about $125 billion. According to Wikipedia, it "contributed to the large budget deficits of the early 1990s" (which ran around half to two-thirds this year's projected shortfall) and "ended up being even larger than it would have been because moral hazard and adverse selection incentives compounded the system's losses."

If you think there's no moral hazard or adverse selection incentive in this bailout, here's a useful website for you: www.dictionary.com.

There may be another cost. When Paulson was first proposing asking for this blank-check authority to bail out Fannie and Freddie - all the while lying through his teeth, saying he didn't expect to actually have to use it - S&P came out and said that if Treasury bailed out the mortgage giants, the ratings on US Treasury debt might have to be reviewed.

I was stunned. Never in my 20+ years of following this stuff have I ever heard the sanctity of US sovereign debt's rating threatened.

The implications are huge. Higher borrowing costs, leading to higher mortgage rates anyway. And even if the debt weren't downgraded, that will happen: how do you think China and Japan feel about buying US Treasuries now - once they realize how much we've jacked up the national debt? They'll demand higher yields, and get them. And up go mortgage rates.

I have to give Hank credit for having the cojones to actually admit that this is a stop-gap measure and that it'll be up to the next administration and Congress to determine the ultimate resolution of Fannie Mae and Freddie Mac.

To which I'm sure Barack Obama and John McCain say a hearty thank-you.

What Hank is essentially saying is this: "We're going to put an incredibly expensive band-aid on a huge, life-threatening wound, and then let the next doctor on call figure out how to cure the patient."

Unbelievable.

But the best quote comes from New York Senator Chuck Schumer, who said that "avoiding a decision on the issue enhances the likelihood of congressional backing" for the plan.

Even more unbelievable. I thought we elected officials to make decisions, not avoid them. Maybe Chuck's constituents should take the same approach regarding their decision to re-elect the schmuck (the same schmuck who triggered the IndyMac failure, I might add).

Everyone from Alan Greenspan to Obama and McCain to Warren Buffett is saying that this just had to be done - Hank had no choice.

Wrong. There was a better solution: let them fail.

Pony up enough money to protect the bondholders, because the credit markets would truly collapse if the bonds defaulted. But let the stockholders lose their money (which will happen anyway).

And as for the availability and cost of mortgage credit - let the market determine that, as it should. Let private insurers step up to the plate and insure mortgages, based on their inherent risk. So what if homeownership winds up only being affordable for those who demonstrate financial responsibility by saving up a reasonable down payment and paying their bills on time, and can actually repay the mortgages?

Every time I look at Hank's stoic, Anglican face and his polished pate, I think of the old Beatles tune, "The Continuing Story of Bungalow Bill." It describes Bill as "the all-American bullet-headed Saxon mother's son." And the chorus asks, "Hey, Bungalow Bill - what did you kill?"

Oh, not much - just Fannie and Freddie's investors and the US taxpayer. Not bad for a day's hunting.