Financial Cryptography: When risks go south: FM&FM to be nationalized

September 06, 2008

When risks go south: FM&FM to be nationalized

Not just another two scalps being counted: Fannie Mae and Freddie Mac, the huge USA mortgage lenders, are to be nationalised:

The government’s planned takeover of Fannie Mae and Freddie Mac, expected to be announced as early as this weekend, came together hurriedly after advisers poring over the companies’ books for the Treasury Department concluded that Freddie’s accounting methods had overstated its capital cushion, according to regulatory officials briefed on the matter.

Well, what else can they do? Think about how huge this is: the two of them hold or back debts of around $5.3 trillion dollars . Failure is almost certain systemic collapse: first the US housing market, then the rest.

The theory of central banking has it that the CB is the lender of last resort. And after that last resort, it owns the bank. So the Fed now will own these mortgage lenders, as a consequence of its role. No change here.

But, the theory also has it that any lending brings on the most severe punishments. Collapse and rescue by the CB then means: all shareholders are set to zero. All directors are sacked. It is then welcome to see that, in contrast to earlier wimpy efforts by Bernanke's Fed, this:

The details of the deal have not fully emerged, but it appears that investors who own the companies’ common stock will be virtually wiped out; preferred shareholders, who have priority over other shareholders, may also wind up with little. Holders of debt, including many foreign central banks, are expected to receive government backing. Top executives of both companies will be pushed out, according to those briefed on the plan.

will be pushed out? Pah! In Switzerland, it is apparently a crime to be an officer of a failed bank. Think hard here.... Who are their auditors? Who were the ratings agencies? Who were the regulators?

While others ponder the detail of rounding up the guilty, there is the wider question of how to act, systemically, and properly, if one were a CB. What caused this to happen?

Clearly, we don't know the full detailed story. We do know the US economy has been out of balance for the last many years, you pick the number. We do know that pay-up time is now. Further, it has been obvious for a long time that FM & FM have been structured on continually rising housing prices. How dumb is that?

Still, assuming a free-market, the government is wise not to tell bad investors (or companies) how to act properly. Even if it "knows" what is "right", the theory of free markets is that it knows much less than it would like to, and certainly less than how to run a business. (Otherwise it would be doing it, right?)

The mistake then is in allowing the mortgage backers to become too big to fail. That is, assuming a free-market, we must also respect the right to collapse. When there is no right to collapse, there is no free market. All else is subsidies, and the various other isms are just around the corner. Communism, nationalism, socialism, playing-fieldism:

Fannie Mae executives are likely to have resisted the proposed takeover because the company's financial condition isn't as dire as its sibling company, said Bert Ely, an Alexandria, Va.-based banking industry consultant.
But the government would still have to take over both companies, he said, to allow them to borrow money at the same rates. "In order to level the playing field between the two companies, you've got to take over both of them," said Ely, a longtime critic of the two companies.

The backing by the USG for the mortgage lenders' debt is the tactical error. Having got the systemic details off our chest, let's move to the witchhunt. Who started these monstrosities then? How did the shared guarantee from the US taxpayer come into being? Who fell for that old trick? The US taxpayer deserves to know who's stupidity she's paying for this time, no?

Fannie Mae was created by the government in 1938, and was turned into a shareholder-owned company 30 years later. Freddie Mac was established in 1970 to provide competition for Fannie.

Oops!

Posted by iang at September 6, 2008 07:29 PM | TrackBack

Comments

"The financial sector, everyone whose business is essentially lending money, is now a ward of the state. They could lend to each other, but they don't trust each other. They can't raise money in the equity market. There is nowhere else to turn." - Howard Simons, research analyst at Blanco Research.

"That is precisely the point. There is now "nowhere else to turn" for the financial system but the supposedly unlimited credit issuing power of the government. It is true that a government can issue any amount of debt paper they choose to. It is NOT true that this debt paper will find a buyer, no matter what. Nor is it true that interest rates will remain unaffected forever. Nor is it true that the currency which all this paper supposedly "backs" is immune from its "value" being savaged.

It is said that there are no strings attached to "manna from heaven". That cannot be said down here on earth." - Bill Buckler, The Privateer

Series: BORROW, Total Borrowings of Depository Institutions from the Federal Reserve
http://research.stlouisfed.org/fred2/series/BORROW

Series: NFORBRES, Net Free or Borrowed Reserves of Depository Institutions
http://research.stlouisfed.org/fred2/series/NFORBRES?rid=19&soid=1

I have a chart on my hard drive by ECDeGroot, source: NBER, federalreserve.gov.
"Free Reserves As A % of Total Reserves Held at Federal Reserve Banks"
It starts a little bit before 1929.
1929: a little bit below -40%
1932: about -40%
1933: 0%
1937: about 50%
1943: about 50% (after a dip to about 10%)
Then the ratio goes down to about 0% around 1950 very roughly staying there till recently where it takes a direct plunge to almost -80%

So, if I make it through the coming new Dark Ages in the Anglo Saxon world, there is always the Singularity to look forward to. Or, maybe I don't have to wait that long. A tidbit from Jim Willie's latest at:
http://www.gold-eagle.com/editorials_08/willie090508.html
"...
In any newly established vacuum could quickly come new gold-backed currencies. Two are already planned, whose launch date is uncertain but clearly tied to the upcoming plan.
..."

Backed by gold is one thing. Whether they are redeemable in gold remains to be seen.

Posted by: bob at September 7, 2008 06:28 AM

recent reference to GSE documents obtained by washington post touting brilliant strategy buying toxic CDOs
http://www.garlic.com/~lynn/subtopic.html#12 Fraud due to stupid failure to test for negative

recent reference to having GSE bought $5bil in toxic CDOs with $80 mil of capital (i.e. heavily leveraged ... not quite 100 times)
http://www.garlic.com/~lynn/2008m.html#15 Fraud due to stupid failure to test for negative

and eference to Buffet getting out of GSE because of their use of accounting methods
http://www.garlic.com/~lynn/2008m.html#17 Fraud due to stupid failure to test for negative

from today:

Fannie, Freddie Capital Concerns Prompt Paulson Plan
http://www.bloomberg.com/apps/news?pid=20601087&sid=at2rZoL11_sw&refer=home

from above:

Treasury Secretary Henry Paulson decided to take control of Fannie Mae and Freddie Mac after a review found the beleaguered mortgage-finance companies used accounting methods that inflated their capital, according to people with knowledge of the decision.

... snip ...