- Written by Dan Ferris
- Wednesday, 17 September 2008
"Screw the currency, screw the taxpayer, and keep the whole thing propped up."
If you're not fluent in Treasury-speak, you might not have picked this up from the documents detailing the Fannie Mae/Freddie Mac bailout. But after spending a lot of time studying the biggest financial disaster of our generation, I know that's what they say.
The bailout involves three primary agreements.
One of them is an agreement by the Treasury to acquire new senior preferred stock amounting to 79.9% of equity. The old shareholders now own just one-fifth of the equity, and the new preferred shares are senior to all the old preferred shares. In other words, the American taxpayers are Fannie and Freddie's new controlling shareholders.
Another agreement describes the Treasury program to buy Fannie and Freddie's mortgage-backed securities in the open market, $5 billion worth, initially. This is a government subsidy to homebuyers, keeping interest rates low and failing to discourage risky behavior on the part of borrowers and lenders.
A third agreement details a new Treasury credit facility that will make cheap 30-day loans to "government-sponsored enterprises" (GSEs): Fannie, Freddie, and the Federal Home Loan Banks. The GSEs will pay a paltry 50 basis points (0.5%) above LIBOR, which is what the most creditworthy institutions pay. These cheap loans represent another taxpayer subsidy to the financial system and more incentive to take on too much risk.
There's some very important language for investors in these agreements.
From the preferred stock purchase:
These agreements are the most effective means of averting systemic risk and contain terms and conditions to protect the taxpayer.
From the mortgage-backed security purchase:
Treasury is committed to protecting taxpayers and will ensure that measures are in place to reduce the potential for investment loss.
And then there is the much ballyhooed implied government guarantee of the GSEs, made explicit by the U.S. Treasury:
To address our responsibility to support GSE debt and mortgage backed securities holders, Treasury entered into a Senior Preferred Stock Purchase Agreement with each GSE which ensures that each enterprise maintains a positive net worth.
Allow me to translate the above passages...
Protecting the taxpayer against investment loss and ensuring the GSEs maintain a positive net worth means printing enough money to back nearly $6 trillion of mortgages and mortgage-backed securities owned and guaranteed by Fannie and Freddie. It means the Treasury doesn't care if it has to drop money out of helicopters to keep the charade going.
It boils down to what I said a moment ago, "Screw the currency, screw the taxpayer, and keep the whole thing propped up."
But the Treasury's new commitment totals just $200 billion, less than 4% of the GSEs' total held and guaranteed mortgages. That doesn't seem like it could possibly be enough to absorb the coming losses.
I said I expected at least $1 trillion of mortgage losses back in April. That figure may prove too low. Too many loans were made with substandard underwriting parameters like low FICO scores, inadequate income documentation, and little or no down payment.
I can imagine total losses of 10% (roughly $1.2 trillion or higher). If I'm right about this, both GSEs will require substantial new capital injections of many times the initial $200 billion commitment.
Where does all this backstop money come from? Taxes, but there aren't enough taxes to pay the government's budget now. So it just creates what it doesn't have by selling new debt. That's what our money is: monetized Treasury debt.
It's as if you decided you wanted another $1,000 in your checking account, merely added that amount to your balance, and started writing checks against it... checks the bank honored. Lately, the Federal Reserve, which is a private corporation granted extraordinary powers by law, has been adding lots of numbers to its checkbook.
Federal Reserve bank credit grew at an annualized rate of 9.5% the last three months, more than two and a half times the rate of the last 12 months (3.7%).
Foreign central banks create money and buy Treasuries, too. From August 2007 to August 2008, foreign central bank holdings of U.S. Treasuries surged 21%, from $1.98 trillion to $2.40 trillion. Foreign central bank holdings of Treasuries grew at an annualized rate of 23.6% the last three months, versus 19.6% over the last 12 months. There's plenty of new credit out there all of a sudden. New credit is new money. This is the definition of inflation.
That's why I said at the outset that the failure of Fannie and Freddie is only the beginning. Fannie Mae, Freddie Mac, the Federal Home Loan Banks, the FDIC, Social Security, and the Pension Benefit Guaranty Corporation all force the U.S. taxpayer to subsidize the government-led underpricing of risk.
Inadequate risk compensation and taxpayer guarantees, explicit or otherwise, attract the wrong managers. Those managers then push the system to its limits, taking on more underpriced risk... which requires more backstopping... all of it requiring new money.
That's why Fannie and Freddie failed. That's why those other government schemes will fail. And that's why the U.S. dollar is doomed. Don't mind the short-term rallies. The dollar is burnt toast.