Why the US had to bail out Freddie and Fannie: Kohler

Exactly 10 years to the month after the fiasco of hedge fund Long-Term Capital Management, the moral hazard chickens are roosting. LTCM was too big to fail, and the lessons from its $US3.65 billion rescue went unlearnt. Now everyone is too big to fail – f

Exactly 10 years to the month after the fiasco of hedge fund Long-Term Capital Management, the moral hazard chickens are roosting.

LTCM was too big to fail, and the lessons from its $US3.65 billion rescue went unlearnt.

Now everyone is too big to fail – first Bear Stearns, and now Fannie Mae and Freddie Mac, which have blown up their equity by rapidly expanding assets in 2006 and 2007 through lower and lower quality mortgages.

That is, they used their implied government mandate to expand into riskier business than they should have.

How ironic that in the greatest capitalist nation on the planet the credit system has been supported by an implicit state guarantee, and that privately owned institutions use that “guarantee” to leverage tiny slivers of capital into vast risk-taking enterprises.

And now, inevitably, the implicit has become explicit. There was no way the US Government could walk away from these Government Sponsored Enterprises (GSEs), both because of the implications for foreign central banks, as described by my colleague Robert Gottliebsen, and more importantly because it would lead to a total collapse of the US banking system, and probably a new depression in the United States.

But note that Treasury Secretary Hank Paulson has stopped short of guaranteeing the GSE debt – he has only agreed to buy some of it, without saying how much, or at what price.

He has kicked out the management, cancelled all lobbying (amusingly) and cancelled stock dividends, both ordinary and preferred, but is only putting in $US1 billion of government money as new preferred equity – which, by the way, carries a coupon of 10%, if you don’t mind.

There is a new “secured lending credit facility” that has been made available as well – not just to Fannie and Freddie, but also to the 12 federal home loan banks, which is the first time these institutions have been mentioned as being in trouble.

Not that the Government is admitting that they’re in trouble. James Lockhart, head of the Federal Housing Finance Agency, which is taking over “conservatorship” of Fannie and Freddie, said last night that it was “very unlikely” that the FHLBs will need to use the liquidity program now being provided by the US Treasury, but we’ll see.

These 12 federal banks are the largest borrowers in the US after the Government, with $US1.25 trillion in debt and holding $US1.35 trillion in assets – loans to credit unions, thrifts and small banks to support their lending. That suggests their combined capital is $US10 billion, or 0.75% of assets.

But the FHLBs are tomorrow’s problem (perhaps). Today is all about Fannie and Freddie, and the US Government accepting, finally, that it stuffed up by allowing, as Paulson put it in his statement: “…ambiguities in the GSE congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS. Our nation has tolerated these ambiguities for too long…”

The world will now hold its breath and hope that Hank Paulson’s four steps will work.

First, conservatorship; second, a guarantee of positive net worth through new preferred stock; then the new lending facility for them; and fourth, buying mortgage backed securities.

Most of these things have not been spelled out in detail, so ambiguities and therefore uncertainties remain about the future operations of the GSEs themselves.

The other uncertainty is how the rest of the US banks will be affected by the unquantified loss of their investments in Fannie and Freddie and the disappearance of their dividends.

Paulson said the FHLA had studied which banks would be affected by this and is confident that “only a limited number of smaller institutions have holdings that are significant compared to their capital”. In any case, those who are in trouble because of the loss of their Fannie and Freddie stock are encouraged to ring their federal regulator and ask for help.

Overall, this plan relies on Fannie Mae and Freddie Mac continuing to operate viably under government control and to eventually be able to function without life-support. And to that end James Lockhart says he will ensure the GSEs loan books are reduced by 10% a year until they get down to $US250 billion.

Sounds like a plan, at least.

This article first appeared in Business Spectator.