Fannie and Freddie play with a loaded deck
By
Bill Bonner Jul 18, 2008
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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.
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 FreedomWorks, owns $376bn worth of US agency bonds. Altogether, foreigners hold $1.3trn 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 1930s. But his programme 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, aka 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.
Fannie Mae gave local banks a way to finance mortgage lending. For the next 32 years, the firm resembled a nationwide savings and loan institution – borrowing from large institutions and lending to smaller ones, and 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 the Federal government’s books, privatising it as a ‘government sponsored agency’. For good measure, he created a competing organisation: the Federal Home Mortgage Association, aka Freddie Mac.
Many are the ham-fisted dictators and sticky-fingered kleptocrats who have nationalised industries. Even without a credit crunch for camouflage, Francois Mitterand nationalised 36 leading French banks in 1982. Robert Mugabe grabbed farmland in 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 privatised the profits while nationalising the losses.
This formula has been a honey pot for clever dirigistes ever since, providing countless opportunities for defeated politicians and hustling lobbyists – speaking fees, consulting contracts, board memberships, bonuses, stock options, 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 government 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 in the City. Fannie’s main man, Daniel Mudd, took home $13.4m in 2007, a year in which the firm lost $2.1bn. While the Freddie Krueger of mortgage finance, Dick Syron, pocketed $18.3m for helping Freddie Mac to a $3bn 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, US 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 loaded from the very beginning.
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