Fannie and Freddie: Playing with a Stacked Deck
Much of what goes on in public finance is fraudulent. The rest is nonsense. The hardest part of our métier is just figuring out which is which. Bill Bonner explores…
As recently as February of this year, Russian officials cleared the way for two of its sovereign wealth funds, the Reserve Fund and National Wellbeing Fund, to invest in various foreign bonds, including those issued by the twin towers of American residential finance, Fannie and Freddie.
"The prospect for every GSE bond clearly states that it is not backed by the United States government," says Matt Kibbe, president of FreedomWorks. "That’s why investors holding agency bonds already receive a significant risk premium over Treasuries."
The Russians ignored the warnings and grabbed the risk premium. Today, fully 21% of Russia’s monetary reserves are invested in the obligations of Fannie, Freddie and the Home Loan Banks. And the largest holder of Fannie and Freddie debt is another friendly foreigner, China. The middle kingdom, according to the FreedomWorks organization, owns $376 billion worth of U.S. agency bonds. Altogether, foreigners hold $1.3 trillion of them.
Maybe the foreigners didn’t understand what they were getting into. Or maybe they did.
Franklin Delano Roosevelt, whose family had made a fortune in the opium trade, promised the nation a "New Deal" during the Great Depression of the ’30s. But what he gave it was more like the old false shuffle. The president pulled cards from the bottom of the deck, pretending that government bureaucrats could do a better job of allocating capital than private investors. In 1938, he set up the Federal National Mortgage Association, b.k.a. Fannie Mae. Then, as now, the national housing market was in crisis. House prices had been declining for almost a decade. Who wanted to lend money against falling collateral values? Only a fool…or a government.
For the next 32 years, the firm resembled a nationwide savings and loan institution — borrowing from large institutions and lending to smaller ones, keeping a piece of the spread for its trouble. But Fannie Mae was an imposter from the get-go. Lenders knew that it had something no free market business ever had – the full faith and credit of the US government behind it. Fannie was able to borrow at below-market rates; lenders knew they had no risk of losing their money in a default or bankruptcy. Fannie, with the aces dealt her by the Roosevelt administration, dominated the business for the next 30 years.
Then, another crisis came along, followed by another bamboozle, this one perpetrated by Lyndon Johnson. Specifically, the feds were spending too much on wars – the War on Poverty at home…and one against the Viet Cong across the ocean. Victory eluded Lyndon Johnson on both fronts, but his handling of Fannie Mae should have brought him at least a bronze star. Attempting to balance the government’s ledgers (this was in the days when Americans still believed in balanced budgets), he moved the mortgage business off of the Federal government’s books, privatizing it as a ‘government sponsored agency.’ For good measure, he created a competing organization – the Federal Home Mortgage Association, b.k.a. Freddie Mac.
Many are the ham-fisted dictators and sticky-fingered kleptocrats who have nationalized industries. Even without a credit crunch for camouflage, Francois Mitterand nationalized 36 leading French banks in 1982. Robert Mugabe grabbed farmland in the Zimbabwe. Evo Morales took the gas industry. And Hugo Chavez seized the Orinoco oil fields in 2007. But Lyndon Johnson rarely gets credit for his great advance in the history of public larceny: he privatized the profits while nationalizing the losses. This formula has been a honey pot for clever dirigistes ever since, providing countless opportunities for defeated politicians, hacks and hustlers – speaking fees, consulting contracts, board memberships, bonuses, stock options (notably, the $170 million spent on lobbyists over the past 10 years…mentioned above) – things that wouldn’t be possible for a "public" company. In effect, Fannie Mae could pick the taxpayer’s pocket twice – once by sticking him with a mortgage he couldn’t really afford and a second time by raiding the taxpayers’ vault for a bailout.
In the case at hand, by the year 2007, the CEOs of Fannie and Freddie were earning salaries that would have been respectable, even on Wall Street. Fannie’s main man, Daniel Mudd took home $13.4 million in 2007, a year in which the firm lost $2.1 billion. While the Freddie Kruger of mortgage finance, Dick Syron, pocketed $18.3 for helping Freddie Mac to a $3 billion loss and a 33% trim for the shareholders.
As recently as May of this year, Mr. Mudd told the New York Times that he was "seeing the best opportunities since I’ve been in this business." Two months later, both Fannie and Freddie are "insolvent," says former Fed governor William Poole.
In a better world, Mudd and Syron would be hanged…and the bondholders would be wiped out along with the shareholders. But last Sunday, U.S. Treasury Secretary Henry Paulson announced a bailout. And on Monday, an auction of Freddie Mac debt was oversubscribed. The Russians were right; the deck was stacked from the very beginning.
Enjoy your weekend,
The Daily Reckoning
July 18, 2008 — Paris, France
Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of the national best sellers Financial Reckoning Day: Surviving the Soft Depression of the 21st Century and Empire of Debt: The Rise of an Epic Financial Crisis.
Bill’s latest book, Mobs, Messiahs and Markets: Surviving the Public Spectacle in Finance and Politics, written with co-author Lila Rajiva, is available now.
Today’s news brings little comfort to investors…and no joy to economists’ hearts either – if they had hearts.
The Dow rose another 207 points yesterday. But the bond market finally bothered to look ahead…and it didn’t like what it saw.
"Inflation fears hit long bond," says the Wall Street Journal.
The yield on the 10 yr. Treasury note rose back over 4%…and the yield on the long bond – the 30-year Treasury – rose to 4.63%.
"Inflation at painful highs in Europe and the United States," says the International Herald Tribune. Despite the European Central Bank’s hard line against inflation – the ECB’s key rate is nearly twice that of the Fed – inflation in Europe is running at about the same level as it is in America.
In the United States, the consumer price index shot up 1.1% in June, led by the cost of energy, which rose 53% over the previous 12 months.
Meanwhile, the price of oil slipped another $4 yesterday – to $129. And the price of gold rose $8. If both were reacting merely to economic forces – they would both be going down. If both were reacting merely to monetary forces – they would both be going up.
But that’s the problem for both investors and economists; we’re all caught between two opposing forces…between the unstoppable force of inflation on the one side, and the immoveable object of deflation on the other. Mr. Market doesn’t know quite what to make of it; he doesn’t know whether to back up or go forward. Gold goes up because inflation threatens the value of paper money. Oil goes down because deflation threatens to reduce demand for energy. Stocks go up because inflation spurs consumers to get rid of their money. And then stocks go down because investors fear a tighter inflation-fighting Fed. Then they go up again, when they think the Fed has turned to fight deflation instead.
But all of this back and forth is a distraction. What is really happening is that the party is over…and the mess has to be cleaned up. There are empty bottles all over the place. Cigarette burns on the carpet. And over on the couch is a banker who drank so much he couldn’t drive home.
Every day’s headlines bring more details:
Subprime losses, Bear Stearns, Fannie, Freddie, Northern Rock, Case-Shiller Housing Index, foreclosures…the scene in the living room has become so familiar that the papers barely bother with it any more.
Now, we’ve moved on to the kitchen and the study…and soon we’ll be finding drunks in the broom closets…
"Too many malls, too few tenants…" reports the Wall Street Journal. Yes, dear reader, we saw it coming. Problems in the housing sector are becoming problems in the commercial sector. Consumers have too little money. They spend less…and the retailers suffer.
"More Americans dip into retirement funds," continues the WSJ. Same logic. People have less money to spend; they look under the cushions…use more credit cards…and break into their own retirement piggybanks.
"Home auctions up 47% since 2003," adds USA Today. Here again, the underlying story is the same. People are just putting things back in order. They spent too much during the party years. Many bought houses they couldn’t really afford. Now, they have to cut back on spending and get rid of oversized houses and oversized expenses. But when so many people are in the same situation, the market for oversized houses gets crowded. Buyers find a lot more choice than they had a couple of years ago. And with prices falling, what’s the hurry? But many sellers need to unload their houses – even at a loss. They may be getting divorced…or moving to a different area of the country…or may simply be unable to keep up with the payments. What can they do? They put the place up for auction and hope for the best.
And below…we see there was a little hanky panky going on in the guest bedroom, too.
*** "Fannie and Freddie spent $170 million on lobbyists," is the report from AP.
What did you expect? They were no angels. They knew it didn’t hurt to have friends in high places – not when you were in such a compromising relationship. Friends in Washington come at a price…but the two mortgage companies had the deepest pockets in town – generously paying fees and expenses for a long list of former members of Congress and Capitol Hill hacks. The $170 million paid to lobbyists was just the beginning. Executives of the firms were also among the biggest contributors to political campaigns and to politicians’ pet programs and vanity charities.
What a glorious scam! The two pretended to be important parts of private enterprise…partaking in the grand scheme of risk/reward along with all other capitalist businesses…but they had the world’s biggest government standing behind them all the time; it was all reward and no risk, right from the beginning. Fannie and Freddie could funnel millions in profits from homeowners to politicians…and then, when they got into trouble, lay the losses onto shareholders and taxpayers. (More below…)
*** Who’s dumber: the public voter or the public shareholder? We don’t know, but both are fun to watch – especially when they are new to the game. The neophytes take these things seriously. In Pakistan, for example, investors rioted yesterday – breaking out the windows of the Karachi stock exchange and stoning officials.
What set off this popular uprising was the 15th day of declining prices – bringing the total loss for Pakistani investors to 35%. That doesn’t seem like much of a loss to us. Major market declines can take 80% or 90% off investors’ stock market holdings. But the Pakistanis are fairly new to the city and to the ways of modern markets. They don’t seem to realize that prices go up and down. Nor, do they seem to understand that markets are supposed to be beyond the reach of public officials.
"We demand that all stock prices be frozen at current levels," said a representative of the Small Investors Association, perhaps speaking for small investors all over the world. He was not, of course, speaking for short investors – who couldn’t be happier. All over the planet, stocks have lost ground. The least of the losers, so far, is the United States…where the S&P is only off about 15% from its high. In Europe, losses are in the 20-25% range. And in China and Vietnam, investors have lost about half their money.
"You will start hearing of suicides…" continued the spokesman for the little guys, and still not quite getting the point…and then, the scales seem to fall from his eyes:
"Regulators always favor big brokers and investors."
Of course they do. What did they think? How many small investors take the regulators to lunch? How many diminutive capitalists offer them jobs…and slip them envelopes? How many of the little guys hire lobbyists and big law firms to hobnob, pander and prevaricate?
C’mon, get with the program.
*** Meanwhile, in the U.S.A., the little voters still hope to get something for nothing too. From a speech given by the head of the Dallas Federal Reserve Bank, Richard Fisher, to the Commonwealth Club of California:
"…tonight I speak for neither the committee, nor the chairman, nor any of the other good people that serve the Federal Reserve System. I speak solely in my own capacity. I want to speak to you tonight about an economic problem that we must soon confront or else risk losing our primacy as the world’s most powerful and dynamic economy.
"…If you wanted to cover the unfunded liability of all three [Medicaid] programs today, you would be stuck with an $85.6 trillion bill. That is more than six times as large as the bill for Social Security. It is more than six times the annual output of the entire U.S. economy.
"Add together the unfunded liabilities from Medicare and Social Security, and it comes to $99.2 trillion over the infinite horizon. Traditional Medicare composes about 69 percent, the new drug benefit roughly 17 percent and Social Security the remaining 14 percent.
"I want to remind you that I am only talking about the unfunded portions of Social Security and Medicare. It is what the current payment scheme of Social Security payroll taxes, Medicare payroll taxes, membership fees for Medicare B, copays, deductibles and all other revenue currently channeled to our entitlement system will not cover under current rules.
"Let’s say you and I and Bruce Ericson and every U.S. citizen who is alive today decided to fully address this unfunded liability through lump-sum payments from our own pocketbooks, so that all of us and all future generations could be secure in the knowledge that we and they would receive promised benefits in perpetuity. How much would we have to pay if we split the tab? Again, the math is painful. With a total population of 304 million, from infants to the elderly, the per-person payment to the federal treasury would come to $330,000. This comes to $1.3 million per family of four-over 25 times the average household’s income."
"No combination of tax hikes and spending cuts, though, will change the total burden borne by current and future generations. For the existing unfunded liabilities to be covered in the end, someone must pay $99.2 trillion more or receive $99.2 trillion less than they have been currently promised. This is a cold, hard fact. The decision we must make is whether to shoulder a substantial portion of that burden today or compel future generations to bear its full weight.
"…Throughout history, many nations, when confronted by sizable debts they were unable or unwilling to repay, have seized upon an apparently painless solution to this dilemma: monetization. Just have the monetary authority run cash off the printing presses until the debt is repaid, the story goes, then promise to be responsible from that point on and hope your sins will be forgiven by God and Milton Friedman and everyone else.
"We know from centuries of evidence in countless economies, from ancient Rome to today’s Zimbabwe, that running the printing press to pay off today’s bills leads to much worse problems later on. The inflation that results from the flood of money into the economy turns out to be far worse than the fiscal pain those countries hoped to avoid.
"Earlier I mentioned the Fed’s dual mandate to manage growth and inflation. In the long run, growth cannot be sustained if markets are undermined by inflation. Stable prices go hand in hand with achieving sustainable economic growth. I have said many, many times that inflation is a sinister beast that, if uncaged, devours savings, erodes consumers’ purchasing power, decimates returns on capital, undermines the reliability of financial accounting, distracts the attention of corporate management, undercuts employment growth and real wages, and debases the currency.
"Purging rampant inflation and a debased currency requires administering a harsh medicine. We have been there, and we know the cure that was wrought by the FOMC under Paul Volcker. Even the perception that the Fed is pursuing a cheap-money strategy to accommodate fiscal burdens, should it take root, is a paramount risk to the long-term welfare of the U.S. economy. The Federal Reserve will never let this happen. It is not an option. Ever. Period."
*** Mr. Fisher means well. He goes on to tell his audience that they, as voters, must deal with this situation. Since the obligations cannot be met, they must be reduced. Fair enough. But what candidate is going to tell the voters that they must give up their free healthcare? And what voter is going to vote for such a thing?
Mr. Fisher is right about the problem; he is wrong about the solution. The problem will not be fixed by the feds…nor by the voters. Popular democracy – ridden with its lobbyists, insiders and hustlers – will not allow it. Instead, the government will go broke.