Market Ticker (Karl Denninger): Fannie, Freddie, Banks and Government Debt

[Fergasun]

Good read right here on Fannie/Freddie...

So here we sit with two firms that are running with leverage ratios that make a Hedge Fund look like a convocation of the Girl Scouts. The Federal Government continues to claim that they are "well-capitalized." Uh huh. And I'm the Easter Bunny. Nobody running with a leverage ratio of 60:1 is "well-capitalized", say much less someone running with a leverage ratio of 200:1. How did this happen? Quite simple - our government allowed it and in fact prodded these firms into doing it.

Fannie and Freddie began as firms that existed to provide liquidity to the conforming marketplace for mortgages, defined as 80/20 full-doc 30 year and 15 year loans. That is, you put down 20% of the purchase price of the house in cash, limiting your leverage ratio to 5:1, and in addition the typical "back end ratio", or total debt to income, was limited to 36%. These loans are extremely safe because they have a fixed interest rate, your leverage is limited, and even in a severely-down housing market if you find yourself unable to pay the losses taken by the noteholder are limited or non-existent (you may be wiped out, but the note holder is likely to get most or all of their money back at foreclosure.)

As the 1990s and especially 2000 passed, however, Fannie and Freddie began to loosen standards. They put in place "automated approvals" that were, for the most part, essentially driven by FICO scores - that is, whether you pay your credit cards on time. In addition Congress prodded them to be the "standard bearer" for what was and is a horrible mis-allocation of capital - that is, to push the "American Dream" of homeownership to the maximum possible extent, and to glorify not owning a small bungalow in which you had enough room to sleep and raise a kid or two, but rather the "McMansion" philosophy of building on every square inch of farmland within 100 miles of a population center. This is a misallocation of capital for a simple reason - a house does not generate GDP. It has utility value as shelter but, unlike a machine, it generates no new GDP by being in existence. You cannot base an economy on housing for this reason.

...

Now we are faced with the reality - Fannie and Freddie, under fair value accounting rules, are insolvent (if you listen to Bill Poole.) What does that mean? It means that if Fannie and Freddie were to sell their assets and net it out today, you'd wind up with a negative number. That is, its assets are less than its liabilities. The question now comes down to "what do we do about this?"

On spot, but a long read. I've excerpted enough to hopefully leapfrog a discussion on his options. I was surprised we didn't have a thread on this in the tailgate... this is just about the ultimate housing market implosion and an immediate threat to our country, so I think people should be paying attention (although I admit to most people economic issues are hard to observe unless you've been really paying attention).

[DjTj]

I really like this quote.

This is a misallocation of capital for a simple reason - a house does not generate GDP. It has utility value as shelter but, unlike a machine, it generates no new GDP by being in existence. You cannot base an economy on housing for this reason.

Bush's fundamental economic policy has been based on the "ownership society" where everyone is supposed to get rich simply by owning things. We have pushed everyone to invest in the stock market and to buy up property to try to get rich through capital appreciation. Our government has subtly shifted to favor this kind of behavior by dramatically lowering capital gains taxes, making it far easier to obtain loans, and removing oversight from our capital markets.

This strategy is starting to fail in spectacular fashion, because "ownership" is not the engine that drives the American economy. You can't "own" your way to wealth; you have to work your way to wealth. We have been so obsessed with encouraging ownership, that we have forgotten to encourage hard work.

Perhaps this should be no surprise, since we have been led by a President who made all his money through simply owning things ... unfortunately, that's not how the vast majority of the Americans make their money. We have to work for it, and it's much more important to make sure that work pays instead of protecting wealth.

America was built on work, not wealth. It's time to drop the idea of the "ownership society" and get-rich-quick schemes, and start telling Americans that they have to roll up their sleeves.

E.J. Dionne actually had a great column yesterday about how laissez-faire Republican economics have failed spectacularly, and the pendulum has to swing back the other way: http://www.washingtonpost.com/wp-dyn/content/article/2008/07/10/AR2008071002264.html

[Fergasun]

DjTj,

That may be true, but we're all the suckers who believed and bought into the "ownership society". I didn't hear too many people challenge that assertion, or challenge the assertion that home-ownership was the way to get rich in this country. Looking back at it, the exuberance of it all and the massive failure (not even sure we're halfway through) is astounding. Props to anyone who sold a home in the past 5 years, but sucks if you bought a home in the past 5 years.

The machinations were put in place after 9/11 to use the housing industry to fuel the economic hit from 9/11. I'd really like to find the people who were screaming against the train for the past 7 years, because I don't seem to remember too many people saying that "housing prices are insane, I'd recommend you *not* buy a house"... at least not in main street.

[DjTj]

DjTj,

That may be true, but we're all the suckers who believed and bought into the "ownership society". I didn't hear too many people challenge that assertion, or challenge the assertion that home-ownership was the way to get rich in this country. Looking back at it, the exuberance of it all and the massive failure (not even sure we're halfway through) is astounding. Props to anyone who sold a home in the past 5 years, but sucks if you bought a home in the past 5 years.

Well, it's hard to challenge the exuberance when so many people were making so much money during the boom.

The machinations were put in place after 9/11 to use the housing industry to fuel the economic hit from 9/11. I'd really like to find the people who were screaming against the train for the past 7 years, because I don't seem to remember too many people saying that "housing prices are insane, I'd recommend you *not* buy a house"... at least not in main street.

Nobody questioned it on main street, and nobody questioned it on Wall Street either. The "professionals" are taking a huge beating from this collapse - it's much worse than the tech bubble because real estate was all so highly leveraged.

I guess I like to blame Bush, but the truth is that it doesn't really matter whose fault it is ... we all have to deal with the consequences, and we all have to learn from the mistakes that were made.

I'm not going to rely on my condo to get me rich, and I'm not going to expect astronomical gains from my 401(k). I'm going to work hard and try to save some money. If the rest of America does the same, we should be fine.

[luckydevil]

I really like this quote. Bush's fundamental economic policy has been based on the "ownership society" where everyone is supposed to get rich simply by owning things. We have pushed everyone to invest in the stock market and to buy up property to try to get rich through capital appreciation. Our government has subtly shifted to favor this kind of behavior by dramatically lowering capital gains taxes, making it far easier to obtain loans, and removing oversight from our capital markets.

This strategy is starting to fail in spectacular fashion, because "ownership" is not the engine that drives the American economy. You can't "own" your way to wealth; you have to work your way to wealth. We have been so obsessed with encouraging ownership, that we have forgotten to encourage hard work.

Perhaps this should be no surprise, since we have been led by a President who made all his money through simply owning things ... unfortunately, that's not how the vast majority of the Americans make their money. We have to work for it, and it's much more important to make sure that work pays instead of protecting wealth.

America was built on work, not wealth. It's time to drop the idea of the "ownership society" and get-rich-quick schemes, and start telling Americans that they have to roll up their sleeves.

E.J. Dionne actually had a great column yesterday about how laissez-faire Republican economics have failed spectacularly, and the pendulum has to swing back the other way: http://www.washingtonpost.com/wp-dyn/content/article/2008/07/10/AR2008071002264.html

I pretty much agreed with every point you made, but there is nothing laissez-faire about the republican economic agenda. This only confirms my belief that genuine supporters of the free market should never vote republican,because any republican administration or government will be portrayed as advocating and practicing laissez faire ( when in reality they are just corporatists).