Question: Is it possible that political operatives are trying to damage the United States economy to benefit a particular party during the upcoming 2008 Presidential election?

Late Breaking Update (2) According to AFP ...

"Shares of US mortgage finance giants Fannie Mae and Freddie Mac were in a freefall Friday on heightened concerns the trillion-dollar firms may face insolvency or a government takeover. "

"Freddie Mac plunged 47 percent to 4.23 dollars at 1450 GMT following a 22 percent slide on Thursday and Fannie Mae lost 44 percent to 7.40 dollars after a 14 percent drop in the prior session. "

"The shares of the two firms have lost around 80 percent since the start of the year. "

"The latest action came amid a new report saying the government could put the finance giants in receivership, which would make their shares worthless. "

It appears that the situation is fast becoming a self-fulfilling prophecy as the sheeple rush for the exits and the major players continue to press the stock downward with short selling and hedge operations. If the slide continues, it is possible that trading will be halted until the situation is stablized.

Late Breaking Update (1)  According to Reuters  ...

"The U.S. government is considering taking over mortgage finance companies Fannie Mae and Freddie Mac if their funding problems worsen, in a plan that could leave shareholders nothing, the New York Times reported, citing people briefed on the matter."

Original blog entry ...

Fannie Mae is a creature of  a democrat Congress. Fannie Mae, having been chartered in 1938 by FDR’s New Deal legislation to promote liquidity in the mortgage markets. And in 1968 Fannie Mae was converted into a quasi-governmental corporation to help balance the federal budget by removing its mortgage liabilities from the government’s books. 

Freddie Mac was created in 1970 to expand the secondary mortgage marketplace as well as to provide some degree of competition to the much larger Fannie Mae.

Even today, the GSEs Fannie Mae and Freddie Mac serve as a unofficial congressional piggy bank to provide “off balance sheet funds” for politically sensitive “affordable” housing.

In some ways, this entire mortgage mess was enabled by Congress and the Bush Administration as they encouraged the modification of lending guidelines so that the poorest among us might be able to afford their first house and thus participate in the “American Dream of Home Ownership.” They failed to regulate lending guidelines, derivative creation, hedge funds, ratings agencies and allowed accounting rules which hid the rapidly accumulating liabilities and unacceptable risk off corporate balance sheets.

To be noted: both Fannie Mae and Freddie Mac do not act in a regulatory vacuum as do hedge funds. Congress provides the enabling actions for their operational limits and requirements while the Administration oversees their operations via OFHEO (Office of Federal Housing Enterprise Oversight).

Both institutions are highly political, have major political players in their leadership and maintain formal lobbyists to insure that they are well-taken care of, legislatively speaking.

Are Fannie Mae and Freddie Mac really insolvent?

Both financial firms have had an abysmal record with the failure of their respective politically-connected leadership to prevent false, misleading and fraudulent accounting that lead to massive multi-billion dollar losses. Both firms deal in complex derivatives that cannot be fairly priced without sophisticated computer models and  may become illiquid if willing buyers cannot be found. Both firms rely on sophisticated hedges and insurance schemes which depend on the financial strength of the hedge or insurer counterparty to manage their risk exposure. And both firms exhibit a relative lack of transparency that makes regulation by OFHEO (Office of Federal Housing Enterprise Oversight) extremely difficult, if not impossible. 

Understanding Insolvency …

Insolvent: the financial condition of a firm which is unable to pay their debts as they fall due and where their liquid assets are insufficient to cover the current liabilities or where the total liabilities exceed the total fair market value of the firm’s assets.

To prevent a financial firm from being declared insolvent by governmental regulatory agencies, they must maintain proportionate capital reserves that will allow them to continue their day-to-day business as well as respond to any somewhat unpredictable demand for funds in the foreseeable future.

Can Fannie or Freddie withstand an exceedingly rare “black swan” event where confluent circumstances witness a massive withdrawal of capital from their coffers? The simple answer is NO! And neither can any other financial institution. Hence, the Federal Reserve Board’s congressionally-chartered ability to supply additional funding to federally chartered institutions in cases of emergency.

Regulatory sufficiency …

In the recent past we found that the two GSEs (Government Sponsored Enterprises) had a combined core capital reserve of approximately $90 Billion dollars against outstanding debt obligations of approximately $5 Trillion dollars. There is no doubt that they are highly leveraged and that investments which exhibit this degree of leverage are more susceptible to extremely poor  financial performance in economic downturns than less leveraged enterprises.

But solvency as well as regulatory sufficiency are both artificial constructs that are defined and managed by the regulators and oversight agencies. No determination of solvency can be made without specific action by their politically-controlled oversight agency.

Perhaps a better question is: Will the government allow Fannie Mae and Freddie Mac to be declared insolvent?

And as per their regulator, OFHEO, both Fannie Mae and Freddie Mac meet their statutory capital requirements; even though congress has approved lowering the capital reserve requirements of the GSEs.

Therefore, while one can continue to worry about a black swan event – the regulators and oversight agencies seem satisfied. If anything, they are urging both GSEs to increase their investment capital and core capital reserves. And certain members of Congress continue to advocate for a stronger regulatory framework – one that includes the possibility of receivership, much like the RTC (Resolution Trust Corporation) which was chartered to pick up the pieces of the savings and loan debacle.

According to the head of OFHEO, James Lockhart … 

“OFHEO has been monitoring and continues to monitor closely Fannie Mae, Freddie Mac and the mortgage and financial markets.  As one would expect, we are carefully watching the Enterprises’ credit and capital positions.”

“As I have said before, they are adequately capitalized, holding capital well in excess of the OFHEO-directed requirement, which exceeds the statutory minimums.  They have large liquidity portfolios, access to the debt market and over $1.5 trillion in unpledged assets.”

“At the time of our March 2008 capital agreement with the Enterprises I said: `OFHEO will remain vigilant in supervising the safe and sound operations of these companies, and will act quickly to address any deficiencies that may arise.  Furthermore, we recognize the need to ensure that their capital levels are strong, protecting them from unforeseen risks as the market recovers.’”

“Including the $7.4 billion Fannie Mae raised in May in accordance with our March agreement, the Enterprises have raised over $20 billion in capital.  They are using it to continue to grow and to play a critical role in the mortgage markets, which we expect them to continue to do. To support their mission, Freddie Mac is committed to raising an additional $5.5 billion, which they will do given appropriate market conditions.  At a very difficult time in the market, the Enterprises have the flexibility and sound operations needed to support their mission.”  (issued by OFHEO for immediate release on 7/10/2008)

So what’s up with Poole? 

According to Reuters …

“Mortgage lenders Fannie Mae and Freddie Mac are ‘insolvent’ and may need a U.S. government bailout, former St. Louis Federal Reserve President William Poole was quoted as saying in an interview with Bloomberg.”

"' ‘Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer,’ Poole was quoted as saying in an interview held on Wednesday.”

“Chances are increasing that the government may need to bail out the two mortgage companies, Poole was quoted as saying.”

Other than sparking some degree of both public and institutional panic, similar to that sparked by Chuck Schumer when he publicly questioned the finances of IndyMac, one wonders about the motivations of William Poole. Certainly he is not acting as an ordinary citizen commenting on an esoteric financial subject.

Is he suggesting the the GSEs raise their core capital requirement? Is he suggesting that Congress review the Congressional charter of Fannie Mae and Freddie Mac with an eye to oft-discussed privatization? Is he suggesting that the Federal Reserve take some type of regulatory action? Or is Poole just commenting on the high degree of leverage and the inability to price derivatives? Nobody knows. Poole remained unavailable for comment according to Reuters.

However, the investing public did react. Driving down Fannie Mae’s stock price to $15.31 (down 13.1%) and Freddie Mac’s stock price to $10.26 (down 23.8%) according to Reuters.

Is the trouble temporary?

There is no doubt that both Fannie Mae and Freddie Mac have serious issues with leadership, accounting, financial operations involving derivatives and regulatory oversight. However, auditing these financial behemoths is an almost impossible task as ever-shifting “mark-to-market” securities valuations and the continuing turbulence in the underlying real estate and mortgage markets makes their financial valuations a moving target.

The answer …

In the case of both Fannie Mae and Freddie Mac, insolvency is something that can be determined only by their regulators in conjunction with the Treasury Department and Federal Reserve. In essence, they are too large to fail in the conventional sense and the turbulence in their market valuations is time-dependent. If the majority of their obligations are well-secured by real estate rather than speculative hedges and insurance gimmicks – they should be just fine. A little poorer as time goes on, but not, at least according to the financial pundits, bankrupt. 

There is no doubt that Fannie Mae and Freddie Mac need to be downsized to reduce systemic risk. There is no doubt that access to federal funds which guarantees profitable transactions should be curtailed. And there is no doubt, at least in my mind, that Fannie and Freddie cannot be continually raped by Congress to provide “affordable housing funds” to meet political necessity involving wealth redistribution based on social engineering.

What can YOU do?

Unless you have a direct investment Fannie or Freddie, there is little you or anyone else can do to ameliorate the current problems with Fannie or Freddie.

Of course, you could sell your stock to protect against further declines, buy some stock at a potentially advantageous price or play with various combinations of puts and calls. But, in the final analysis, only time and governmental action can resolve issues affecting Fannie Mae and Freddie Mac and the broader economy.

You can always reduce your personal run rate (expenditures) and look for the opportunities which seem to be present in every downturn.

And have hope – or as my best friend Al always says – this too shall pass!

-- steve

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Reference Links:

Fannie, Freddie insolvent, Poole tells Bloomberg | Reuters

"The Bush administration had also considered calling for legislation that would give an explicit government guarantee on the $5 trillion of debt owned or guaranteed by the companies, the paper said. That was seen as a less attractive option because it would effectively double the size of the national debt."

Origininal Post ...