The Morning After

Having had a day to digest the Fannie/Freddie bailout, let's take a fresh look.

Apparently I'm not the only one with indigestion. A Credit Union Times article bore the headline, "Bush Administration Defends Fannie and Freddie Action."

If it was such a great idea, why does it need to be defended?

A taped interview with the President intended to do just that will bear this unbelievable gem:

"I wouldn't call it a bailout, I'd call it a stabilization."

Well, the stabilization has cause credit default swap spreads on US Treasury debt to widen to record highs. Those swaps are a market bet on the likelihood a debt issuer will default. The wider the spread, the greater the chance of default. And they've been an uncannily accurate predictor of corporate defaults, much better than credit ratings.

Of course, a blind truffle-sniffing pig could do a better job than the ratings agencies.

Now, the spreads aren't nearly wide enough - yet - to suggest the Treasury will default. But it could get the attention of the ratings agencies, resulted in a downgrade or negative watch. That would cause Treasury borrowing costs - and hence mortgage rates - to rise.

Even if the ratings agencies don't take any action, foreign investors watch the swap spreads, and will almost certainly start demanding higher yields - with the same impact on mortgage rates.

How's that for stabilization?

The administration will blame Congress' long resistance to action for the need to bail out Fannie and Freddie. While I still don't believe an outright bailout was the right thing to do, the administration is correct in its fault assessment.

A Wall Street Journal op-ed piece this morning quoted another of my favorite targets, Barney Frank, as suggesting that Paulson's plan to begin reducing the size of Fannie and Freddie's MBS portfolios beginning in 2010 - after they're increased through the end of next year - won't happen. "Good luck on that," he said.

Beginning in 1992, some legislators and regulators have recognized the flawed structure and inherent risks in Fannie and Freddie, and Frank has fought tooth and nail against a fix. In 2000, he said concerns were "overblown," and made the statement that there was "no federal liability there whatsoever," according to the Journal.

In 2002, he said, "I do not regard Fannie Mae and Freddie Mac as problems ... I regard them as great assets." A year later, he said "there is no federal guarantee" of their debt. Well, there is now. Shortly after that, Freddie's now-infamous accounting fraud was exposed, and Frank said, "I do not think we are facing any kind of a crisis," and that there was no "threat to the Treasury."

Fast-forward to last year, by which time Barney chaired the House Financial Services Committee. Now, he was claiming he'd always been a proponent of reforming the GSEs. He blamed the lack of action on conservatives that "don't think there should be a Fannie Mae or a Freddie Mac."

The WSJ article goes on: "In January of last year, Mr. Frank also noted one reason he liked Fannie and Freddie so much: They were subject to his political direction. Contrasting Fan and Fred with private-sector mortgage financers, he noted, 'I can ask Fannie Mae and Freddie Mac to show forbearance' in a housing crisis ... And this is exactly what Mr. Frank attempted to prove when the housing market started to go south. He encouraged the companies to guarantee more 'affordable' mortgages, thus abetting their disastrous plunge into subprime and Alt-A loans. He also pushed for, and got, an increase in the conforming-loan limits to allow Fan and Fred to securitize and guarantee larger mortgages. And he pressured regulators to ease up on their capital requirements -- which now means taxpayers will have to make up that capital shortfall."

So Barney, as much as Alan Greenspan, fathered the housing bubble. In his zeal for every American to be a homeowner - whether or not they could afford the mortgages - he used taxpayer money to fuel the bubble, fought protections that could have prevented this mess, and now says it's somebody else's fault. He's more culpable than Paulson.

So why does he oppose reducing the MBS portfolios in 2010? At first blush, one would assume that now that he's got the taxpayer on the hook, he has no problem with siphoning off our money to fund even more homeowners who can't otherwise afford a home.

But the Journal piece points to an even more sinister reason:

"The biggest payoff for Mr. Frank is the 'affordable housing' trust fund he managed to push through as one political price for the recent Fannie reform bill. This fund siphons off a portion of Fannie and Freddie profits -- as much as $500 million a year each -- to a fund that politicians can then disburse to their favorite special interests. This is also why Mr. Frank won't tolerate cutting the companies' MBS portfolios. He knows those portfolios (bought with debt borrowed at taxpayer-subsidized rates) were a main source of Fannie's profits before the housing crash, and he figures that once this crisis passes they can do it again. And this time, his fund will get part of the loot."

I swear, I need to find a nice ex-pat community someplace warm.

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Besides widening default swap spreads on Treasuries, the bailout also triggered the unwinding of credit default swaps on Fannie and Freddie debt. This will be ugly.

No one knows the exact amount of credit default swaps outstanding on the pair's debt, given the lack of transparency in that market. But it's a lot. Nobody knows how the unwinding will take place. But my guess is it could bring down another Wall Street firm.

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Want to know the real reason Hank bailed out Fannie and Freddie?

Foreign pressure.

Foreign central banks had increasingly leaned on Bungalow Bill, as I now like to call him, because institutions in their own countries had been heavy investors in Fannie and Freddie debt, and they were fearful of a global ripple effect if the two went under. At the time of the Bear bailout in March, foreign central banks themselves bought about as much agency debt as Treasury debt. Since then, there's been a massive flight to quality, as they were net sellers of agencies in July, switching their money into Treasuries.

But declining values of Fannie/Freddie debt made unloading the stuff costly. And the more they sold, the more they put further pressure on the prices. So, instead of incurring the losses that naturally come with taking risk in the markets, they leaned on Hank, who, with his pal Helicopter Ben, has proven all too willing to throw US taxpayer money at anybody who whines loud enough. So we're taking their losses for them.

I should at least get a free vacation each year in the country of my choice for my largesse.

This is a wealth transfer of unprecedented proportions. All the bitching and moaning about the US shipping jobs overseas is misplaced; that pales in comparison to this. My office is still on US soil, but a third of every paycheck now goes abroad.

I seriously, seriously need to find that ex-pat community.