When markets are wrong -- Why the Fannie-Freddie bailout is a bad sign

The stock market is rallying at the open, which is noise, and news, but not insight.

For insight, read Paul Krugman's New York Times column on the Fannie and Freddie bailout, which argues the federal takeover is a bad sign.

Things are getting worse. The Bush administration -- hardly a bunch of eager interventionists -- had no choice; it couldn't save these companies with jawboning and bluster about a bazooka full of cash; it had to take them over. It had to put our money where its mouth had been (sounds kind of dirty, doesn't it?).  And it had to be even more aggressive (the government, surprisingly, will buy mortgage-backed securities) than the markets expected. This is pretty much a full federal takeover of the financing of mortgages. And the treasury secretary says he had "no choice." The scary thing is, he's probably right.

Krugman writes the takeover " ... was certainly the right thing to do — and it was done fairly well, too." You know there is a "but" coming:

But Sunday’s action needs to be seen in a larger context — that of the attempt by the Federal Reserve and the Treasury Department to contain the fallout from the ongoing financial crisis. And that’s a fight the feds seem to be losing....

... the effort to contain the financial crisis seems to be failing. Asset prices are still falling, losses are still mounting, and the unemployment rate has just hit a five-year high. With each passing month, America is looking more and more Japanese. So yes, the Fannie-Freddie rescue was a good thing. But it takes place in the context of a broader economic struggle — a struggle we seem to be losing.

-- Peter Viles

Your thoughts? Comments? E-mail story tips to Peter Viles.
Photo credit: Bloomberg News

Comments

[Buy Houses Now!]

The losses weren't destroyed, they were merely transferred from the Bill Grosses, China, foreign central banks, and other holders of GSE debt and MBS, to US taxpayers. Either through US government borrowing or ultimately higher taxes, those losses will eventually dampen the economy. The public interest rationale is that Bill Gross will fund Mom and Pop's next round of debt if they pay for his losses on the last round via taxation.

[Anonymous]

That excerpt takes the word "Japanese" out of context. He doesn't really mean "Japanese." He means "America is looking more and more like it will confront Japan's deflationary troubles of the last two decades."

[Michael Snyder]

Being a Musician, I'm always relieved when someone request a song I actually know. As the markets strike up the band this morning they're playing a well rehearsed tune indeed. I got a copy of the chart and it goes something like this:
Intro: Back room negotiations & consultation with Lobbyist.
Verse: Pay lotto sized severance to those who created the mess.
Verse: Secure the fortunes of foreign investors.
Verse: Inflate the value of preferred shares.
Verse: Wipe out the common shareholders.
Outro: Hold a press conference to proclaim your genius.

From www.bloomberg.com this morning; " Sept. 8 (Bloomberg) -- Investors may be forced to settle contracts protecting more than $1.4 trillion of Fannie Mae and Freddie Mac bonds against default after the U.S. seized control of the companies in a bid to bolster the housing market.

Thirteen ``major'' dealers of credit-default swaps agreed "unanimously'' that the rescue constitutes a credit event triggering payment or delivery of the companies' bonds, the International Swaps and Derivatives Association said in a memo obtained by Bloomberg News today. Market makers for the privately traded contracts will discuss how to settle them in a conference call at 11 a.m. in New York, the document said.
"This is a big deal,'' said Sarah Percy-Dove, head of credit research at Colonial First State Global Asset Management in Sydney. "The market is not experienced at settling a credit event for a name of this size, so it is a bit of an unknown.''

Writers Oliver Biggadike and Shannon D. Harrington continue; "Today's conference call will determine whether enough dealers agree the Treasury's action constitutes a credit event, Louise Marshall, spokeswoman for ISDA, said in a phone interview from New York today.
``We believe conservatorship is a credit event,'' Barclays Plc analysts Vince Breitenbach and Jeff Meli said in a note to clients yesterday. Barclays is a member of the ISDA.
U.S. default protection costs as measured by the Markit CDX North America Investment Grade Index will also decline, they said. A basis point, or 0.01 percentage point, is worth $1,000 on a swap that protects $10 million of debt. "

"We believe conservatorship is a credit event,'' Can I get a,"No Sh*t Sherlock"? To even make such a statement shows the disconnect between the "leadership" in the financial sector and the reality on the streets. Once again we get to see CEOs walking away with millions ( 17 & 24 respectively) while the common shareholders get wiped out. On the backside plans are already in place to assist the investors in the CDSs in avoiding their obligations. And just who are to be the recipients of the CDS payout? You can be sure it will neither be the common shareholders or the American taxpayers who are footing the bill.

It breaks my heart to see out country becoming all of the things we and our parents fought against. Our electoral process has been completely corrupted and the legislators and judiciary designed to keep wanna be Czars in check have completely bought into the "plan". And the worst thing is they get away with it because we let them.

[Roger Moore]

Of course asset prices are falling. Housing was just one area where there was a bubble; other assets suffered from it, too. This just goes to show why Greenspan was wrong about the advisability of pricking asset bubbles while they're still inflating.

[Nick]

We're losing the struggle to fix the economy precisely because of the context in which the government has defined the struggle; it's evident in the statement above. Controlling asset prices and limiting corporate losses? That's the mandate of government market manipulation, not a free market economy. Without corporate losses our system cannot function, and that's the problem the government is creating.

If the government wanted to start succeeding and prevent a depression, it should immediately modify what constitutes acceptable outcomes. Specifically, asset prices should be allowed to correct to whatever value the market assigns, corporations should absorb all losses, idiotic socialist pseudo-corporations (the GSE's, for example) should be gutted so they serve a minimal purpose, the FHA should be scaled back so as not to unduly influence the market, and Congress should take the opportunity to ensure the laws streamline the correction process and limit the fraud on the way down.

Unfortunately, our government is hell-bent on creating another great depression, doing in most cases the exact opposite of what they should be doing. The people want it, and they shall have it.

[LA-renter]

Maybe an understatement, but there's something wrong...

Paulson and crew continue to misidentify REAL winners and losers with little questioning from media.

The purported goal is to keep an unknown FUTURE mortgage market flowing. As logical as this may sound, it's still just a hypothetical fear.

The reality of the US treasury's action: Paulson has left no doubt that mortgage investors will be spared any losses.

Truly unbelievable.

Why should the US treasury pay a dime? Any loss should be passed onto mortgage investors as the risk that was taken with this investment.

If Paulson real just wanted to keep the mortgage market liquid, why not create a new temporary government-controlled "raft" company to handle mortgages while Fannie and Freddie sink like the Titanic?

[Giacomo]

A good summary, Peter.

This is emergency-room stuff, trying to control blood loss-- it's a little premature to announce the patient is on the road to recovery.

As the more realistic in the media are saying, this doesn't re-create the bubble, it only saves some in the margins from foreclosure, at least in the short term. Home prices will continue to fall simply because 1) there are no more crazy loan products to entice foolish buyers and 2) affordability is still poor -- prices still too high for incomes, and it's still much cheaper to rent.

[KenDoMore]

Paul Krugman's comment is unfortunately just an opinion. An opinion based on one-sided sentiment isn't worth anything. He doesn't offer any idea how the Fed or the government could do better. He also doesn't have much data to support his assessment on his prognosis that the rescue plans are failing.

[Millionaire says greed is good]

The stockmarket will only start to recover when the the market in CDOs etc unfreeze and the credit crisis abates. Unless investors start to freely buy mortgage backed securities again, home loan rates will remain high and keep home sales low. Will this bailout unfreeze the credit market as a whole? Only partly. The question is - to what extent? The answer will determine whether the stockmarket will continue to go down or turn around.

[Tony]

The Chinese govt. holds over 1 trillion dollars in Fannie Mae and Freddie Mac bonds and treasuries. If we were to let those institutions go bust, the people financing our war over in Iraq might not be very pleased. Better to stick it to the American taxpayer who is more concerned about flag pins, guns, and abortion, and has no idea that they are being robbed. Much easier, too.

[Rainman]

The sad thing is that a failure to adequately regulate banking or home mortgages when it mattered has forced the government to bail out these two mammoth institutions. It's just like the S&L crisis, when regulatory failures combined with fraud and a go-go atmosphere led to poor choices and too much risk.

[Brad]

One of the implied benefits of the bailout is the expected drop in mortgage rates by as much as a point and its potential to revive the R.E. markets. Like rates aren't still at generational lows? A 5.5% rate may be easier to swallow than a 6.5%, sure, but that makes little difference if you're about to lose -- or already have lost -- your job. Or have a weak FICO (perhaps due to a recent forclosure). And of course housing prices continue to plummet in many areas. Why buy today even at a lower rate when it will most assuredly cost less in another year or two? Rates may go up but you can always refinance. You only buy once.

Fannie and Freddie are now assured to still be around as Krugman states, and this is one piece of the stability puzzle. But the other fundamentals just aren't there yet and won't be any time soon. This is no magic bullet.

[Drew]

"Rates may go up but you can always refinance."

Isn't that mindset one of the primary reasons we are in the trouble we are currently in? It would seem that most of the people losing their houses today were unable to refinance.

[JenniferK]

To add to a host of troubles, when the new management of FNMA digs into the details of its REO portfolio, they will find that the houses may be 20% or more overvalued. As home prices have fallen, FNMA has been sitting on more and more REO inventory, because it did not want to recognize more losses. Smart lenders foreclose and sell fast. Lenders playing games with their accounting records foreclose and sell at their leisure.

FNMA and FHLMC have gotten favored treatment from their regulators in Washington. Perhaps as part of the takeover, some brave soul will carefully look at the well paid FNMA executives who have been artificially propping up the value of FNMA's assets.

[Brad]

"Rates may go up but you can always refinance."

Isn't that mindset one of the primary reasons we are in the trouble we are currently in? It would seem that most of the people losing their houses today were unable to refinance.
-----------------------------------------------

Agreed, though the reason the upside-downers can't refi is because the value of the property has dropped. Interest rates for sane (read: fully amortizing, no pre-pay penatiles or exploding adjustments) have been unnaturally low for most of the decade. Lowering them again may trigger a small wave of refi's for those that aren't upside down but it won't revive the market nor cause prices to slow their decent.

C.R says the same thing, though much more eloquently than I could ever hope to:

http://calculatedrisk.blogspot.com/2008/09/fannie-freddie-thoughts.html

[Winfield J. Abbe]

Isn't local government becoming superfluous? The Federals dictate everything from education to fire response times, they lose all wars from the war on cancer to the war on drugs, they imitate Robin Hood by stealing from the rich to give to the poor but even shaft the rich by using worthless printed money. Both political parties are bought and paid for by selfish interests. "Higher education" is bailed out, stock market speculators are bailed out, but gambling is illegal for lowly citizens although they must pay tax on the winnings. Capital gains mostly from inflation is taxed the same as short term gains. As one of the posters said above, we have become a country our ancestors fought so hard to rid the world of. The best both political parties could do after a violent revolution and the Boston Tea Party over unfair taxation was to imitate Karl Marx and his Communist philosophy: "From each according to his ability, to each according to his need." It seems like the more "higher education" Americans get, the dumber they become.

[watuzi]

"One of the implied benefits of the bailout is the expected drop in mortgage rates....why buy today even at a lower rate when it will most assuredly cost less in another year or two?"

Because the other 48 states have RE markets that are in much better shape than CA or FL, with much lower median home prices. Any drop in mortgage rates will further decrease the cost of purchasing a home, and increase the pool of buyers.

[sheila]

i just read that our foreign debt has literally DOUBLED in the past 8 years, largely because we haven't paid a dime of the disastrous war that will "pay for itself," but also because we import so many cheap goods and kill all the American businesses and the planet in the process.

yes, as other posters have noted, communist china holds more than 376 billion of our debt, but countries like Japan, the Cayman's, Belgium and Luxembourg hold nearly another trillion between them. apparently, they have each had a word with Paulson, basically making it clear that either the taxpayers bail them out or they will stop bailing the Bush admin out with its reckless deficit War Machine.

well, we all know that the War (or whatever this mess is) Must Go On, so now we will pay for it at least three times. firstly, with the quadrupled gas prices, secondly, with this bailout, then thirdly, when we have to actually PAY THE BILL, which is estimated at over $30,000 per family of 4.

we are being bled dry, and the fun has just begun...

[Todd in WeHo]

Thanks to the Bush administration, in one fell swoop I've gone from being a responsible tenant of a rent controlled apartment to a homeowner swimming in debt. Thanks, George W., but "I'm from the government and I'm here to help" just doesn't fly with me.

[Reno Dino]

Funny how they decided not to wipe out the shareholders so they could say to their right-wing God, Mr. Market, "See we
didn't nationalize it."

[E]

Tony at 11:54 seems to have nailed it IMO.

If we don't bail out the Chinese (which is pretty much what we are doing), it would be construed as extreme economic warfare.

How badly do you want to piss of China?

I sure don't.

[BottomFisher]

Fast food en quick fixes....now thats my kinda government...and I can discount store shop till I drop...I'm as happy as a clam.....problemo is though...I just got laid off.

[Maggie Knowles]

Very interesting interview of Michael Hudson in Counterpunch, here's an excerpt, I recommend reading the entire article:
http://tinyurl.com/572946
~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
The Road to Debt Peonage
In an earlier interview you said: “The economy has reached its debt limit and is entering its insolvency phase. We are not in a cycle but the end of an era. The old world of debt pyramiding to a fraudulent degree cannot be restored.” Would you expand on this in view of today’s developments?

Hudson: How long more and more money can be pumped into the real estate market, while disposable personal income is not growing by enough to pay these debts? How can people pay mortgages in excess of the rental value of their property? Where is the “market demand” to come from? Speculators already withdrew from the real estate market by late 2006 – and in that year they represented about a sixth of all purchases.

The best that this weekend’s bailout can do is to postpone the losses on bad mortgage debts. But this is a far cry from actually restoring the ability of debtors to pay. Mr. Paulson talks about more lending to support real estate prices. But this will prevent housing from falling to levels that people can afford without running deeper and deeper into mortgage debt. Housing prices are still way, way above the traditional definition of equilibrium – prices whose carrying charges are just about equal to what it would cost to rent over time.

The Treasury’s aim is to revive Fannie and Freddie as lenders – and hence as vehicles for the U.S. economy to borrow from the foreign central banks and large institutional investors that I mentioned above. More lending is supposed to support real estate prices from falling quite so far as they otherwise would – and in fact, the aim is to keep the debt pyramid growing. The only way to do this is to lend mortgage debtors enough to pay the interest and amortization charges on the existing volume of debt they have been loaded down with. And since most people aren’t really earning any more – and in fact are finding their budgets squeezed – the only basis for borrowing more is to inflate the price of real estate that is being pledged as collateral for mortgage refinancing.

It is pure hypocrisy for Wall Street’s Hank Paulson to claim that all this is being done to “help home owners.” They are vehicles off whom to make money, not the beneficiaries. They are at the bottom of an increasingly carnivorous and extractive financial food chain.

Nearly all real estate experts are in agreement that for the next year or two, many of today’s homeowners will find themselves locked into where they are now living. Their situation is much like medieval serfs were tied to their land. They can’t sell, because the market price won’t cover the mortgage they owe, and they don’t have the savings to pay the difference.

Matters are aggravated by the fact that interest rates are scheduled to reset at higher non-teaser rates for the rest of this next year and 2010, increasing the financial burden. You may remember that Alan Greenspan recommended that homebuyers take out adjustable-rate mortgages (ARMs) because the average American moves every three years. By the time the mortgage interest rate jumped, he explained, they could sell to a new buyer in this game of musical chairs – presumably with more and more chairs being added all the times, and plusher ones to boot.

But homeowners can’t move today, so they find themselves stuck with rising interest charges on top of their rising fuel and heating and electricity charges, transportation charges, food costs, health insurance and even property taxes as these begin to catch up with the rise in Bubble Prices.

The government has carefully avoided nationalizing the companies and thereby taking them onto its own balance sheet. It has created a “conservatorship” (a word that my spellchecker does not recognize). So the bailout of Fannie and Freddie looks like the Republicans are trying to play the financial just-pretend game simply until they leave office in February, after which time they can blame the failure of the “miracle of compound debt interest” on the incoming Democratic Congress.

So it’s politics as usual: play for the short run. In the long run – even next year – the real estate market will continue to drift down."