Nature of the Fannie Mae Bailout

I strongly believe that GSEs are part of the problem and no part of the solution. Government has no business promoting housing over renting and I would abolish HUD, the FHA, and end government sponsorship of the GSEs as quickly as practical. Ron Paul has advocated the same.

Has anyone even bothered to look up the Mission Statement of Fannie Mae?

We are a shareholder-owned company with a public mission. We exist to expand affordable housing and bring global capital to local communities in order to serve the U.S. housing market.

Fannie Mae exists to expand affordable housing. Clearly Fannie Mae has failed its core mission. All government sponsored corporations fail their mission. The very nature of promoting housing makes prices go up, until the final blowoff top which we are now on the backside of, having reached Peak Credit.

In a surprising statement Treasury Secretary Paulson said Financial Institutions Must Be Allowed To Fail. My Translation is "This mess has finally gotten too big for the Fed to bail".

That leaves taxpayers on the hook as Fannie and Freddie Waterfalls Are Too Big For Fed to Bail.

I posted the most likely form of a bailout would come in the nature of nationalization. Inquiring minds will want to read We're All Homeowners Now, Nationalization of Fannie, Freddie Unavoidable.

The Covered Bond Proposal

Minyan peter, former treasurer for a major US bank discusses a Continental Illinois style bailout and a conservatorship situation in conjunction with covered bonds. Let's pick up the discussion in Fannie, Freddie Expecting Bailout.

With the rumors swirling on both Fannie (FNM) and Freddie (FRE), I would offer the following thoughts:

The US Government will not explicitly guarantee the debt of Fannie and Freddie, but rather will either inject capital (super senior preferred stock subordinated debt a la a Continental Illinois style bailout) or provide a “make-whole” guaranty on the assets of both companies (a la an FDIC/RTC style failing bank resolution). The choice of the former suggests a “going concern” for the GSEs, while the latter suggests an orderly wind-down.

In either case there's considerable historical precedence. And either choice implies that the common stock of both companies is worthless and the preferred stock value is at best uncertain.

If Freddie and Fannie are placed into conservatorship and are wound down (the second choice), I expect that the US mortgage market will move quickly to the covered bond format that is common to the Europe mortgage market.

I believe that Hank Paulson began laying the public groundwork for this on Tuesday when he stated at the FDIC conference that “…as Treasury seeks to encourage new sources of mortgage funding in the United States, improve underwriting standards and strengthen financial institutions' balance sheets, covered bonds have the potential to serve these purposes and reduce the costs for first-time home buyers, and for existing homeowners to refinance.”

PIMCO offers a discussion on Bond Basics: Covered Bonds, for those who want to get up to speed.

Mother of all Bailouts

Noriel Roubini is discussing How to Avoid the "Mother of All Bailouts".

The issue now is: what happens next to Fannie and Freddie given that they are effectively insolvent?

The conventional answer is that their shareholders get fully wiped out but that their creditors (those holding the $5 trillion of these agencies' debt and their other liabilities) are made whole as the U.S. government cannot afford reneging on the implicit guarantee of the liabilities of Fannie and Freddie and it cannot risk a collapse of the mortgage and housing market that defaulting on part of the liabilities of Fannie and Freddie would imply. Unfortunately, the conventional wisdom may turn out to be right; but it could also turn out to be wrong.

The hawkish rhetoric about the “moral hazard” the from implicit guarantees that Greenspan, Bernanke, Paulson, Bush and the administration peddled for eight years was thrown out of the window the moment the housing and mortgage bust started. Instead, for the last few months the GSEs – that were already bleeding and becoming insolvent on their own portfolio – have been used by the government to back stop the mortgage markets: their portfolio limits were raised, their regulatory capital was reduced and the limits to what conforming mortgages (that the GSE can repackage/insure) are were raised from $420k to over $720k. So much for barking in public about “moral hazard” and then going ahead and using already distressed GSEs to bail out the mortgage market and make them even more insolvent. Now this “the emperor has no clothes” farce has been revealed to be what it always was: a high-flatulin “moral hazard” farcical rhetoric with zero substance and credibility.

To minimize the financial cost of this farce the administration should stop pretending that these are private institutions and go ahead and take them over and nationalize them since they are going to bail them out anyhow.

Socialism For The Rich

In a long as well as interesting read, Roubini goes on to explain his position:

The creditors/bondholders of Fannie and Freddie should not be made whole, i.e. bailed out, once the insolvency hole of these institutions emerges .... Will this optimal policy solution - an haircut for bondholders - be undertaken? Most likely not as the political economy of housing, mortgages and of “privatizing profits and socializing” losses may dominate the policy outcome.

...

Financial institutions love a system where they gamble recklessly, pocket the profits in good times and let the fisc (taxpayer) pay the bill when their reckless behavior triggers a financial crisis; this is socialism for the rich. That is why you already hear the whole Wall Street Greek chorus moaning for a bailout of the GSEs. But the financial costs of this financial crisis – the worst since the Great Depression – are mounting so fast that any bailout will become fiscally extremely expensive.

Roubini Conclusion

If we fiscalize all of these losses the U.S. may fast lose its AAA sovereign debt rating and eventually end up like an insolvent banana republic. It is thus time to put a stop to the coming “mother of all bailouts” starting with a firm stop to the fiscal rescue of Fannie and Freddie, institutions that have behaved for the last few years like the “mother of all leveraged hedge funds” with their reckless leverage and reckless financial activities."

Repeating my opening gambit, a position I have stated many times over the years: "GSEs are part of the problem and no part of the solution."

It is doubtful that Congress will see it that way. After all, Fannie Mae is one of the biggest campaign contributors around, stuffing the pockets of Congressmen everywhere.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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