Fannie And Freddie Bailed Out - What Does It Mean?
09/07/2008
Excerpt: Like it or not, the interesting times have arrived. With this weekend’s nationalization of Fannie and Freddie, and other such bailouts of a financial industry beset with self-inflicted wounds (actions I predicted some 4 years ago), we have now crossed a line.
Like it or not, the "interesting times" have arrived. With this weekend’s nationalization of Fannie and Freddie, and other such bailouts of a financial industry beset with self-inflicted wounds (actions I predicted some 4 years ago), we have now crossed a line.
Given that our entire banking system is insolvent (case made below), there are no financial solutions to this crisis, only political ones. The question before us now is both simple and stark: “Who is going to be left holding the bag?” This weekend, we found out with the nationalization of Fannie (FNM) and Freddie (FRE) that there is strong political, bipartisan support for making current and future taxpayers the ultimate recipients of the bag.
At times like this, I feel the need to back way up and take in the big picture, because the details are too slippery and too numerous to grasp. For example, consider this proposal on how the government should structure the FNM/FRE bailout, by Pershing Square Capital Management:
The issuance of senior sub debt is permitted under the GSE legislation and under the existing terms of the outstanding debt and equity securities of the two entities (please see the attached memo for further details). As a condition of Treasury’s purchase of senior sub debt, the GSEs would defer the interest payments on the outstanding sub debt (which can be deferred for as much as five years), and the dividend payments on preferred and common stock. All of the Subordinate Securities would continue to remain outstanding according to their existing terms.
The new senior sub debt should have a market-based coupon and Treasury should receive low-strike price warrants (penny warrants) for a substantial portion, i.e., 49% of the two companies.
Say what? I cannot figure out what that means to me, individually, or to my country collectively. I just have no idea. Which means it is time to back up and take in a wider view.
The bailout of Fannie and Freddie was necessitated by the fact that they are insolvent. They have been claiming to be solvent right up to this weekend, but according to their former overseer, Armando Falcon of the OFHEO, a “more accurate accounting of their assets and liabilities…would show them to be insolvent.”
Worse, in a brilliant weekend article in the NYT, Gretchen Morgenson revealed that when Morgan Stanley auditors pored through the books of Fannie and Freddie, they found that both had systematically and willfully cooked their books to make themselves appear healthier than they really are.
[A]s the companies’ stocks continued to languish and their borrowing costs rose, some within the Treasury Department began urging Mr. Paulson to intervene quickly.
Then, last week, advisers from Morgan Stanley hired by the Treasury Department to scrutinize the companies came to a troubling conclusion: Freddie Mac’s capital position was worse than initially imagined, according to people briefed on those findings. The company had made decisions that, while not necessarily in violation of accounting rules, had the effect of overstating the companies’ capital resources and financial stability.
They are being very kind in the article by describing these actions as "not necessarily in violation of accounting rules." If you or I attempted these same actions in the conduct of our business, we'd be up on fraud charges in a skinny minute.
Let’s review what Fannie and Freddie do. They buy pools of mortgages from banks, and then sell those pools in the form of guaranteed bonds to “investors,” many of whom are foreign central banks. Banks write the mortgages, but then sell them to FNM/FRE for cash. FNM/FRE then resell the mortgages for cash. Lather, rinse, repeat. The great circle of money is complete.
In taking over FNM and FRE, what the government is doing is picking up the guarantee on the bonds sold to investors. Additionally, FNM and FRE retain some of the mortgages for themselves and hold them on their own books. Collectively, then, the US government is on the hook for whatever losses might arise in those mortgages and guaranteed bonds.
How will the government do this? Well, since the government is already estimated to be running a $500 billion deficit next year, the answer is to sell more Treasury bonds into the financial markets. At this point we have to ask, “To whom?" Banks are also struggling at this time, and many are desperately trying to raise cash for themselves. The second quarter FDIC review of banks was a disaster and should only be read by adults with strong hearts. We’re going to take a quick tour through some of the FDIC-supplied charts to make the case that banks themselves are in no position to buy up any of the flood of new Treasury bonds that will be required to fund the bailout of FNM/FRE.
Figure 1: Bank earnings decline 86%. This chart of earnings reveals a pretty nasty 86% drop in earning yr/yr for all banks (in aggregate). But even this hides the real truth. One item that hits banks' earnings is the charging off of bad loans and setting aside of reserves for non-performing loans to cover future expected losses. In this next chart, we see that the trend moves clearly towards higher amounts of both charge-offs and non-current loans, meaning those that are significantly behind in their repayment schedule.
Figure 2: Troubled loans rise. It is important to compare the potential losses implied by the non-current loans to the current earnings of banks. A $5 billion earnings cushion looks pretty weak, when compared to consistent quarterly increases in non-current loans that are five times as large. Non-current loans turn into charge-offs, and they do so at greater rates during times of economic hardship. To get a better sense of this trend, I created the chart below, showing bank delinquency rates over time. The data comes from the Federal Reserve.
Figure 3: Bank delinquency rates. It is interesting to observe that, even as banks have reported no growth in the non-current loans over the past three quarters (see Figure 2, prior), the delinquency rates have been climbing rather handily over that same period of time. Either the delinquency rates are in error, or the non-current loans are in error.
The banks covered in this delinquency report have about $6 trillion on the line: $5 trillion in mortgages ("real estate" on the chart above) and another $1 trillion of consumer loans. Over the past three quarters, the reported delinquency rate for real estate has risen from 2.38% to 4.21%, for a difference of 1.83%. While this may not sound like much, when we multiply $5 trillion by 1.83% we find that more than $90 billion in loans have slipped into delinquency over those quarters.
But I remain concerned that there is a serious and severe underreporting of both the rate of delinquency and of loans that should be charged off. Consider this recent data from the Mortgage Bankers Association:
WASHINGTON — An industry group says a record 9.2% of American homeowners with a mortgage were either behind on their payments or in foreclosure at the end of June, as damage from the housing crisis continued to mount.
The latest quarterly snapshot by the Mortgage Bankers Association on Friday broke records for late payments, homes entering the foreclosure process and for the inventory of loans in foreclosure.
The percentage of loans at least 30 days past due or in foreclosure was up from 8.8% in the January-March quarter, and up from 6.5% a year earlier.
This is a serious difference from the 4.21% in real estate delinquencies reported at the end of the second quarter of 2008. Assuming the 9.2% figure is real, this translates into $460 billion of non-performing loans for the banking industry for real estate alone. When we compare this to total bank capital of roughly $1.1 trillion, we can see that there’s trouble brewing here. I’m sure there are some differences between what is considered a non-performing loan vs. a ‘late’ loan, but I am sure that the truth lies somewhere north of 4.21%.
So, how will banks cope with these massive losses? Either they will become insolvent, or they will have to earn their way out of this mess. Bank earnings are a function of deposits, which are then pyramided into loans, which the banks refer to as assets.
In a very unusual situation, bank deposits recently declined by some $40 billion, choking off an important source of funds.
Figure 4: Bank deposits decline. Part of the explanation for this decline in bank deposits is that funds were withdrawn from US banks and deposited outside of US borders. While I don’t have more information on this at this time, I am speculating that this represents a capital flight, presumably by wealthier and/or well connected individuals who have read the writing on the wall. An insolvent US banking system is no place to keep your funds, especially if you can bring that money home to a safer system.
But while deposits allow banks to make loans, it is their asset base (i.e. their loan portfolio) that earns them their money.
Figure 5: Banks assets shrink. This decline in bank assets has certainly sent a shock wave through the Fed and Treasury departments. How are banks supposed to earn their way out this mess, if their assets are both shrinking and going sour (at increasing rates) at the same time?
Bottom line: Banks are experiencing declining deposits and shrinking loans, concurrent with spiking loan stress, at the exact same time that they need their earnings to grow in order to survive. It is for this reason that I remain utterly unconvinced that bailing out Fannie and Freddie is going to solve much in the long term.
The primary issue is, has been, and will continue to be that trillions of dollars in losses resulting from the housing bubble will have to be written off. For now, the Treasury is trying to buy time by nationalizing FNM and FRE, hoping (beyond hope) that the financial industry can somehow earn its way out of this mess in the meantime.
Left unspoken is the inconvenient fact that, unless personal incomes suddenly double, house prices will have to decrease by half. I see nothing in any of the government rescue plans that will do anything but help mitigate the paper losses of large institutions and the well-connected. In other words, symptoms are being treated while the disease runs rampant.
So here’s the conundrum for you to ponder, as the airwaves are filled with analysis and opinions about how this bold Treasury plan to nationalize FNE and FRE will play out: How is it possible for the federal government to borrow money from an insolvent financial system in order to bail out an insolvent financial institution?
In my mind there is only one answer: It’s not.
This is the earliest stage of direct monetization of our financial woes, in a desperate attempt to sustain the unsustainable. Success here has such a razor-thin probability that I pretty much discount it to zero. On one side lies deflation and the destruction of our entire financial system, and on the other side lays monetary printing and an attendant loss of faith in the (fiat) dollar, leading to hyperinflation. The deflation side is a historically weak bet, as inflation has nearly always been the preferred route.
No doubt this rescue plan will be greeted with massive cheering on Wall Street and a tidy stock market rally. That’s just the way the system currently works. Then the dust will settle, and people will begin to ask themselves the harder questions that have been asked above.
If you are holding stocks that you are in a position to sell, I would use the bounce to lighten up. I remain steadfast in my belief that holding all your wealth in US dollars is imprudent and risky, and I continue to advise that non-dollar assets, such as gold and silver, should be a part of any long-term portfolio as a hedge against the possibility of hyperinflation.
We truly live in interesting times.
Your faithful information scout,
Chris Martenson |
