The carefully designed disaster at Fannie and Freddie

The situation at the mortgage giants of Fannie Mae and Freddie Mac continue to get worse. The news yesterday is that Fannie Mae lost another $25.2 Billion last quarter and has requested another $15.2 Billion bailout just to stay afloat.

“We expect the market conditions that contributed to our net loss for each quarter of 2008 to continue and possibly worsen in 2009, which is likely to cause further reductions in our net worth,” Fannie Mae said in a statement.

The other player here, Freddie Mac, is watching defaults on its mortgage debts accelerate to record highs. Freddie will need another bailout as well.

This all sounds very tragic, not to mention costly for the taxpayer, but would it surprise you to learn that this was no accident? It was designed by the Bush Administration.

Unwinding the East Asian Currency Crisis

The major stock market indexes hit their lowest levels since 1997 on Friday. What has that got to do with Fannie and Freddie?
Nothing directly. However, indirectly the two are connected. You see 1997 was the start of the East Asian Currency Crisis.

The Asian countries collectively decided to never allow themselves to be vulnerable to foreign lenders and the IMF ever again. To do this they began a process of "self-insurance".
What this involved was using their large trade surpluses with America to accumulate oversized foreign currency reserves. For the nations of Indonesia, South Korea, Thailand, Taiwan, and Malaysia, that means holding around $500 Billion of dollar-assets in their central banks. Far more than they would need outside of a new currency crisis. China and Japan each hold around $1 Trillion in foreign currency reserves.

To do this those East Asian nations bought massive amounts of American bonds, mostly treasuries, but also Agency bonds such as Fannie Mae and Freddie Mac. By the end of 2006, Asian investors owned 32% of all U.S. Treasuries and 13% of all U.S. Agency bonds.
What this has done is allowed America to rely on the world's savings, rather than its own. It's artificially held down interest rates in America, which has encouraged borrowing (as opposed to saving) which led directly to the Real Estate Bubble. In fact, the mortgage titles of tens of thousands of Americans are currently being held somewhere on the other side of the Pacific.

This brings up another news article from last week of direct relevance.

Feb. 20 (Bloomberg) -- Asian investors won’t buy debt and mortgage-backed securities from Fannie Mae and Freddie Mac until they carry explicit U.S. guarantees, similar to those given on bonds issued by Bank of America Corp. or Citigroup Inc.

Quite an amazing turnaround, doncha' think?

So how did we get from point A, where foreigners couldn't buy our Agency bonds fast enough, to point B, where foreigners won't buy those bonds without the direct backing of the American taxpayer? And how did Fannie and Freddie get in a situation that they had to be nationalized to keep from going under?
To answer that question we need to go all the way back to 2001, shortly after Bush took over the White House.

Lies, Cover Ups, and the Making of a Disaster

When the Federal Reserve panicked in 2001 and cut interest rates down to 1%, Wall Street was flooded with cheap money. So what do you think happens when you mix cheap money with Wall Street bankers?

for years, observers have wondered how Fannie could manage its inherently risky portfolio without a whiff of volatility. Now, thanks to Fannie's regulator, we know the answer. The company was cooking the books. Big time.

Lay and Skilling at Enron were amateurs compared to the boyz at Fannie Mae and Freddie Mac.

As part of a scandal that's been running nearly two years, Fannie Mae has "misstated earnings" to the tune of $10.8 billion. That's some tune.

Freddie Mac had their own $5 Billion scandal. The accounting scandal was so large that even Fannie and Freddie didn't know what was in their portfolio. They failed to register with the SEC for at least eight quarters.

Considering the massive size of this scandal, how did Fannie and Freddie manage to avoid being heavily regulated or even nationalized? They spent $170 million lobbying Congress and another $19.3 million in direct campaign contributions. In other words, they legally bribed the people who were supposed to be regulating them.

Now let's fast forward to March 2008.
The housing bubble had burst. The economy was melting down. Real leadership was needed, so the Bush Administration swung into action.

By reducing the extra cushion of capital the two companies have been required to hold since 2004, the regulator, the Office of Federal Housing Enterprise Oversight, is enabling the companies to invest $200 billion more in home loans. In essence, the companies are being allowed to take billions of dollars that had been used as a reserve against possible further losses and invest that money now in the housing market.
But critics said that if the housing market continued to decline, the move could put the two companies on a less sure footing and ultimately require a huge taxpayer bailout.
“I think it’s very dangerous and it’s a sign that people are very frightened,” said Thomas H. Stanton, an expert on the two companies who teaches a course on credit risk at Johns Hopkins University. “At a time in which finance companies are holding questionable assets and facing losses, regulators typically require more capital, not less.”

"“Additional capital will enable the companies to help more homeowners and will strengthen the underlying fundamentals of the mortgage market.”
- Treasury Secretary Paulson

The Bush Administration had Fannie and Freddie cut their capital reserves to buy assets which were collapsing in price, even while the GSE's were entering a period where they were going to take massive losses.

Freddie Mac and its fellow GSE Fannie Mae are now financing more than 80 percent of all mortgages in the U.S., up from 40 percent a year ago.
"We are nearly the only game in town, and we think we are going to be able to enjoy that position for a number of years," Piszel said.

On top of that, the size of the mortgages that Fannie and Freddie were allowed to buy was increased.

As part of the bill, Congress is set to rush through an increase in the mortgage loan limits for Fannie Mae and Freddie Mac (and Federal Housing Administration insurance, too) - from $417,000 to $729,750 - the first step toward a massive financial disaster in which taxpayers will end up paying through the nose.

Homes worth nearly 3/4 of a million dollars are not part of the original reasons why Fannie Mae and Freddie Mac were created, nor should they be. People that can afford homes of that price do not need public subsidies, nor should they get it.

Now, thanks to Congress, junk bond investors will be able to pawn off their bad debt to Fannie and Freddie, instead of suing the big investment houses for ripping them off. This shift will certainly doom Fannie Mae and Freddie Mac, so don't be surprised if we, the taxpayers, have to bail out poor Fannie and Freddie - to the tune of more than $1 trillion.

It was a risky gamble, and it failed. Spectacularly.

That's not to say that Fannie and Freddie went down without a fight. They fought back with their best weapons - accounting trickery.

Freddie said Wednesday its first-quarter earnings beat Wall Street expectations, but it also reported that the "fair value" of its net assets fell to negative $5.2 billion at the end of March from 12.6 billion dollars at the end of December. That reflected a drop of nearly 32 billion dollars in value for its mortgage assets and credit guarantees that did not affect the company's net income.

With their portfolios in free fall, Fannie and Freddie hemorrhaged money all through the first half of 2008. The Bush Administration stuck to their guns and as late as July 11 assured everyone that there would be no bailout of Fannie and Freddie.
Less than a week later Treasury Secretary Paulson was pushing through a bailout of Fannie and Freddie.

"The game is over. [Fannie and Freddie] don't have any net worth."
- billionaire investor Warren Buffett"

It seems that the thin layer of cash reserves left over after the Bush Administration cut it 6 months earlier, wasn't enough to cover their massive losses. Yet the financial media failed to note that the Bush Administration was partly responsible for this enormous calamity.

But the Bush Administration was going to make it right now. They were going to backstop Fannie and Freddie and calm least that was the plan.

"If you have a bazooka in your pocket and people know it, you probably won't have to use it."
- Secretary Paulson displaying his ignorance of how the markets work

The powers Paulson won from Congress last month enabling a government rescue of Freddie Mac and Fannie Mae -- authority he likened to a weapon whose mere existence made it unlikely it would have to be fired -- may end up making a bailout more likely, say analysts and investors.

They say the threat of government action is creating uncertainty that is raising the companies' borrowing costs and increasing the odds Fannie and Freddie will need taxpayer funding.

The problem with the bailout plan is that Paulson is the implied threat of a de facto nationalization of the two mortgage giants. This would leave existing shareholders with pennies on the dollar.

Thus the bailout plan that Bush and Paulson assured us that they would never have to do, caused stock prices of Fannie and Freddie to crater. This reduced their capital reserves even further, increasing the chances of a taxpayer bailout.
To make matters worse, the taxpayer bailout was to cause collateral damage.

"The common shareholders will probably be completely wiped out," Paul Miller, an analyst at FBR Capital Markets, said in a Bloomberg Television interview. "Preferred will also see a lot of pain. But that is up in the air because a lot of banks own the preferred. You put a lot of banks in trouble if you just wipe out the preferred also."

And so, once again, the Bush Administration has lurched from one disaster to another, making each one worse with their every action.

But was it just a case of incompetence by the Bush Administration? Could it have been something much more sinister? Notice this WSJ article from July of 2008.

The Bush administration has held talks about what to do in the event mortgage giants Fannie Mae and Freddie Mac falter, according to three people familiar with the matter, as the stock prices of both companies continue to fall sharply. These discussions have been going on for months and are part of normal contingency planning that the Treasury Department and other financial regulators regularly undertake.

For months, huh? Several months before July takes us back to the infamous March deal. How in the world does a company like Fannie Mae, with $900 Billion in mortgages on its books, and only $44 Billion in capital, suddenly come up with hundreds of billions of dollar to add to its balance sheet?

I'll tell you what this looks like - a backroom deal.
The nationalization of Fannie and Freddie was agreed upon back in March of 2008 in the hopes that it would keep the financial system alive until after the November election. It failed, and in doing so, it added hundreds of billions of dollars in losses that will have to be paid by the taxpayer.

Meet the New Boss

After inheriting this disastrous legacy from the Bush Administration, you could only assume that the Obama Administration would do things drastically different, right?

Fannie Mae will drop some credit-score requirements, reduce income-documentation standards and waive the need for appraisals in some cases, according to a notice yesterday to lenders posted on the Washington-based company’s Web site. The changes apply to loans that the company owns or guarantees.

Let me translate for you. "Drop credit-score requirements" = subprime. "Reduce income-documentation standards" = Liar Loans.

And it just keeps getting better. The Obama Administration plans to subsidize at-risk borrowers. Has anyone bothered to ask "How long"? Meanwhile the Fed is buying up all those subprime, liar-loans that Fannie and Freddie are pumping out.

This week a new part of Obama's plan came out. You're going to love this.

The loan-to-value (LTV) limit on mortgages Fannie Mae and Freddie Mac will be able to refinance as part of Obama’s Homeowner Affordability and Stability Plan may go higher than the original 105 percent, according to National Mortgage News.

Bush's disastrous legacy was to at first ignore the bubble, then to try to keep it inflated until he was out of office by using Fannie and Freddie.
Obama's plan is to use taxpayer money to subsidize subprime, liar-loans at more than 105% of the home's value with Fannie and Freddie as a conduit. Thus attempting to recreate all the properties of the bubble that got us into trouble in the first place.

Seriously. Is this the best that Washington can do? Is our leadership really this bankrupt of ideas?



special interests

I hate to imply that maybe the radical right has a point....but on the "affordability" and "liar loans" I think there are certain "special interest groups" (cough,cough La Raza, Acorn, etc.) that aren't helping...

but who is precisely trying to keep the bubble afloat, I have no idea who/what are they thunin!

This is a magnificent post midtowng, seriously and I don't think I even saw anything about Freddie/Fannie as I scanned all of today's reports.

Nice piece!

I had almost forgot the Fannie graphic

Just added it to the diary.
And while we are talking about Fannie and Freddie and graphics...

Uh, I got a problem with this line ;o)

Real leadership was needed, so the Bush Administration swung into action.

It has always been about class warfare.

G, this is one of your best

A small quibble, I can't tell where the quotes about actions taken by Bushco in 2008 came from, even after searching the links.

But the analysis is great. And scary.