It is refreshing to see someone actually think and write about the repercussions of this massive bail-out rather than simply herald the positive but suspect headlines.

Regards - VHF

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Why The Fannie-Freddie Bailout Will Fail
by Martin D. Weiss, Ph.D.

09-08-08

With yesterday's announcement of the most massive federal bailout of all time, it's now official: Fannie Mae and Freddie Mac, the two largest mortgage lenders on Earth, are bankrupt.

Some Washington bigwigs and bureaucrats will inevitably try to spin it. They'll avoid the "b" word with vengeance. They'll push the "c" word (conservatorship) with passion. And in the newspeak of 21st century bailouts, they'll tell you "it all depends on what the definition of solvency is."

The truth: Without their accounting smoke and mirrors, Fannie and Freddie have no capital. The government is seizing control of their operations. Their chief executives are getting fired. Common shareholders will be virtually wiped out. Preferred shareholders will get pennies. If that's not wholesale bankruptcy, what is?

Some Wall Street pundits and pros will also try to twist the facts to their own liking. They'll treat the bailout like long-awaited manna from heaven. They'll declare that the "credit crisis is now behind us." They may even jump in to buy select financial stocks. And then they'll try to persuade you to do the same.

The reality: This was the same pitch we heard in August of last year when the world's central banks made a coordinated attempt to rescue credit markets with massive injections of fresh cash. It was also the same pitch we heard in March when the Fed bailed out Bear Stearns. But each time, the crisis got progressively worse. Each time, investors lost fortunes.

Together, both Washington and Wall Street are trying to persuade you that, "no matter what, the government will save us from financial disaster." But the real lessons already learned from these events are another matter entirely:

Lesson #1. Each successive round of the credit crisis is far deeper and broader than the previous.

• In 2007, the big news was big losses; in 2008, it's big bankruptcies.
  
  
• In March, the failure of Bear Stearns shattered $395 billion in assets. Now, just six months later, the failure of Fannie Mae and Freddie Mac is impacting $1.7 trillion in combined assets, or over four times more. And considering the $5.3 trillion in mortgages that Fannie-Freddie own or guarantee, the impact is actually thirteen times greater than the Bear Stearns failure.

Lesson #2. Despite unprecedented countermeasures, Washington has been unable to stem the tide.

Yes, the Fed can inject hundreds of billions into the banking system. But if banks don't lend, the money goes nowhere.

Sure, the Treasury can inject up to $200 billion of capital into Fannie and Freddie. But if their mortgage portfolio is full of holes, all that new capital goes down the drain.

And of course, the U.S. government has vast resources. But if the $49 trillion mountain of U.S. debts and the $180 trillion pile-up of U.S. derivatives are beginning to crumble, all those resources don't amount to more than a band-aid and a prayer.

Lesson #3. Shareholders are the first victims.

Bear Stearns shareholders got wiped out. Fannie and Freddie Mac shareholders are getting wiped out. Ditto for shareholders in any of Detroit's Big Three that go belly-up, any bank taken over by the FDIC or any insurer taken over by state insurance commissioners.

The Next Lesson:
The Primary Mission of the Fannie-Freddie
Bailout Will Ultimately End in Failure

Most people assume that when the government steps in, that's it. The story dies and investors shift their attention to other concerns. In smaller bailouts, perhaps. But not in this Mother of All Bailouts.

The taxpayer cost for just these two companies — up to $200 billion — is more than the total cost of bailing out thousands of S&Ls in the 1970s. But it's still just a fraction of the liability the government is now assuming.

Why?

First, because the number of home foreclosures and mortgage delinquencies has now surged to a shocking four million — and a substantial portion of the massive losses stemming from this calamity have yet to appear on Fannie's and Freddie's books.

Second, because the U.S. recession is still in an early stage, with surging unemployment just beginning to cause still another surge in foreclosures and mortgage delinquencies.

Third, even before Fannie and Freddie begin to feel the full brunt of the mortgage and recession calamity, their capital had already been grossly overstated.

Indeed, right at this moment, while Wall Street analysts are trying to evaluate the details of a bailout plan that's supposed to save them, regulators and their advisers are poring over the Freddie-Fannie accounting mess they're supposed to inherit. According to Gretchen Morgenson and Charles Duhigg's column in yesterday's New York Times, "Mortgage Giant Overstated the Size of Its Capital Base" ...

• Freddie Mac's portfolio contains many securities backed by subprime and Alt-A loans. But the company has not written down the value of many of those loans to reflect current market prices.
  
  
• For years, both Freddie and Fannie have effectively recognized losses whenever payments on a loan are 90 days past due. But in recent months, the companies saidthey would wait until payments were TWO YEARS late. As a result, tens of thousands of other loans have also not been marked down in value.
  
  
• Both companies have grossly inflated their capital by relying on accumulated tax credits that can supposedly be used to offset future profits. Fannie says it gets a $36 billion capital boost from tax credits, while Freddie claims a $28 billion benefit. But unless these companies can generate profits, which now seems highly unlikely, all of the tax credits are useless. Not one penny of these so-called "assets" could ever be sold. And every single penny will now vanish as the company goes into receivership.

In short, the federal government is buying a pig in a poke — a bottomless pit that will suck up many times more capital than they're revealing. My forecast:

Just to keep Fannie and Freddie solvent will take so much capital, there will be no funds available to pursue the primary mission of this bailout — to pump money into the mortgage market and save it from collapse. That mission will ultimately end in failure.

The Most Important Lesson of All:
As the U.S. Treasury Assumes
Responsibility for $5.3 Trillion in Mortgages,
It Places Its Own Borrowing Ability at Risk

The immediate reason the government decided not to wait any longer to bail out Freddie and Fannie was very simple: All over the world, investors were beginning to reject their bonds, refusing to lend them any more money. So the price of Fannie and Freddie bonds plunged, and the yields on those bonds went through the roof.

As a result, to borrow money, Fannie-Freddie had to pay higher and higher interest rates, far above the rates paid by the U.S. Treasury Department. And they had to pass those higher rates on to any homeowner taking out a new home loan, driving 30-year fixed-rate mortgages sharply higher as well.

Now, with the U.S. Treasury itself stepping in to directly guarantee Fannie-Freddie debts, Washington and Wall Street are hoping this rapidly deteriorating scenario will be reversed.

They hope investors will flock back to Fannie and Freddie bonds.

They hope investors will resume lending them money at a rate that's much closer to the Treasury rates.

And they hope Fannie and Freddie will again be able to feed that low-cost money into the mortgage market just like they used to.

In other words, they hope the U.S. Treasury will lift up the credit of Fannie and Freddie.

There's just one not-so-small hitch in this rosy scenario: Fannie's and Freddie's mortgage obligations are just as big as the total amount of Treasury debt outstanding.So rather than the Treasury lifting up Fannie and Freddie, what about a scenario in which Fannie and Freddie drag down the U.S. Treasury?

To understand the magnitude of this dilemma, just look at the numbers ...

• Mortgages owned or guaranteed by Fannie and Freddie: $5.3 trillion.
  
  
• Treasury securities outstanding as of March 31, according to the Fed's Flow of Funds (report page 87, pdf page 95): Also $5.3 trillion.

If Fannie's and Freddie's obligations were equivalent to 10% or even 20% of the U.S. Treasury debts, the idea that they could fit under the Treasury's "full faith and credit" umbrella might make sense. But that's not the situation we have here — Fannie's and Freddie's obligations are the equivalent of 100% of the Treasury's debts.

And it's actually worse than that:

• Foreign investors, the most likely to dump their holdings if they lose confidence in the United States, hold an estimated 20% of the Fannie- and Freddie-backed mortgages outstanding. But ...
  
  
• Foreign investors own 52.7% of the Treasury securities outstanding (excluding those held by the Fed).

So based on the above stats, Treasury securities are actually more vulnerable to foreign selling than Fannie and Freddie bonds.

What happens if the international mistrust and fear afflicting Fannie and Freddie bonds infects U.S. Treasury bonds? Foreign investors would start dumping Treasury securities en masse. They'd drive Treasury rates sharply higher. And they'd wind up forcing Fannie and Freddie to pay much higher rates for their borrowings after all.

How will you know? Just watch the all-critical spread (difference) between the yield on Fannie-Freddie bonds, considered lower quality, and the yield on equivalent government bonds, considered high quality. Then consider these two possibilities:

• If that spread narrows mostly because Fannie and Freddie interest rates are coming down toward the level of the Treasury rates, fine. That means the immediate goal of the bailout is being achieved. BUT ...
  
  
• If the spread narrows mostly because Treasury rates are going up toward the level of Fannie's and Freddie's rates, that's not so fine. It not only means a failure to achieve the immediate goals, but it will also imply that the entire Fannie-Freddie bailout is backfiring on the Treasury.