naked capitalism

I must admit to being hopelessly naive. The Fed opens its discount window to Freddie and Fannie, which is an admission that there is a problem but not much of a solution, since the GSEs are certain not to use it (accessing the discount window is a kiss of death, seen an admission that a firm is desperate).

Treasury Secretary Paulson makes a statement which presents in the vaguest possible terms a plan which falls far short of a remedy for the GSEs. These measures merely serve to stabilize the patient; there is no, zip, nada acknowledgment that major surgery is needed (Felix Salmon has an amusing but pointed parsing of Paulson’s remarks).

Oh, minor detail, the plan still has to be approved by Congress, which will hopefully roll over. But what if it doesn’t? Anyone with an operating brain cell knows that these moves put the US on the path to having taxpayers assume Fannie and Freddie liabilities. That in the end is probably unavoidable.

But the largely positive reaction in the press is simply mind-boggling and the Asian market response, particularly a rise in the dollar against most currencies, says that investors approve (update: gains early in the day reversed, largely on oil worries). Um, having to admit you are moving down the path of the lesser of two evils is far from good, at least in my book. particularly when six months ago most people had no knowledge that this course of action was even remotely a possibility.

Clive Crook in the Financial Times is far more clear-eyed about the matter:

US taxpayers are about to find out what their long-standing and (strictly speaking) non-existent guarantee of Fannie Mae and Freddie Mac will cost them. One way to think of it is this: take the US national debt of roughly $9,000bn and add $5,000bn. Not bad for an obligation still officially denied.

In the end, that astounding prospect might be the outcome. Partial or outright nationalisation of the housing lenders – colossal pseudo-private entities that own and underwrite US housing loans – would add some or all of their $5,000bn (€3,144bn, £2,513bn) in liabilities to the government’s balance sheet. While it is true that the agencies (unlike the government) own housing-related assets that roughly match those liabilities, the still-collapsing housing market makes this a lot less reassuring than one could wish.

Covering the agencies’ losses on their loans and guarantees is going to require an actual outlay, which will fall on taxpayers. You could plausibly call the rest – namely, bringing these “government-sponsored enterprises” explicitly inside the public sector – just a bookkeeping entry. But what an entry! It would surely shake financial markets, raise the government’s cost of funding and put heavy downward pressure on the dollar.

By contrast, Paul Krugman, Princeton colleague of Bernanke, joins the side of the boosters.

Christopher Wood, in a pre-Paulson edition of his Greed & Fear report, correctly anticipated that the Administration would attempt an optical rather than a real solution, but doubts that that will succeed:

The problem right now is that the Bush administration remains, understandably, reluctant to saddle US taxpayers with the US$5tn liability represented by Fannie and Freddie. Yet continuing to pretend that there is not a fundamental problem of solvency is serving only to damage further the fast diminishing credibility of Federal Reserve governor Ben Bernanke and US Treasury Secretary Hank Paulson. This is clear from the renewed weakness in the dollar and the renewed surge in the price of oil. The latter market action is further evidence, if it is needed, that oil is trading as a non-dollar proxy.

It is clearly possible that the administration may be able to come up with some fudge which allows Fannie and Freddie to continue to function in their present anomalous status for another few months until the November presidential election. But GREED & fear would not bet on it. The housing market is deteriorating too fast as is clear from Fannie and Freddie’s rising delinquencies…… Fannie and Freddie’s financial credibility cannot withstand any form of semi-detailed scrutiny. Fannie and Freddie have a combined “regulatory capital” of US$86bn, while the two own or guarantee US$5tn worth of US mortgages between them.

The result of the above is that the Washington establishment is now paying the price of having allowed the dangerous anomaly represented by the half public sector and half private sector Fannie and Freddie to function for so long and to become such a vast part of the US financial system. Indeed Fannie and Freddie, by their aggressive accounting practises and by their willingness to buy dubious “private label” mortgage–backed securities, were in no small part responsible for the excesses of the housing boom.

Note that Wood is not alone in the view that the GSEs contributed to the housing bubble. Jim Hamilton has said the same thing, repeatedly. The latest instance:

The GSEs’ book of business represented 25% of outstanding residential mortgage debt in 1990 but comes to 41.4% today. It is hard to avoid the conclusion that these moral hazard distortions were one factor that contributed to the rapid expansion of mortgage debt over the last decade and attendant excessive price appreciation and risk taking. Granted, the real excesses, such as the subprime loans that everybody was initially discussing, came from MBS created by private institutions rather than the GSEs. But the stock market seems to be declaring pretty loud and clear this week that risks associated with enterprise assets are significant.

But some seem to have trouble with that notion.

However, the investors that really count have not yet weighed in. We along with others had thought that a successful sale of $3 billion of short-term debt by Freddie today would be an important sign of confidence, particularly since it was a doubling of spreads over Treasuries of agency two-year notes that was the latest warning signal that all was far from well in GSE-land.

However, we have also said that the powers that be would lean on anyone whose arm they could twist to show support for Fannie and Freddie and try to change psychology.

But one robin does not make a spring. John Jansen at Across the Curve (hat tip Mark Thoma) regards the results of Monday’s sale as irrelevant. The real test is whether repo traders are persuaded (note he wrote this before the Fed and Treasury statements were made):

One of the items mentioned in most of the stories is a previously scheduled Freddie Mac sale of $3billion of securities. Bloomberg suggests that the notes are short term and a quick check of the Freddie Mac home page informs the reader that the agency is issuing $2billion 3month bills and $1billion 6 month bills.

The various articles suggest that there is some concern or angst regarding investor support for that sale. The reports suggest that these sales will be an important test of investor sentiment regarding the GSEs. I think that the success of this sale will demonstrate very little. That amount of issuance is paltry and could be funded by Secretary Paulson himself and a dozen of his former colleagues at Goldman Sachs.

In my opinion, the canary in the coal mine for the agencies is the repo market. If large institutional suppliers of funds (money funds and sec lenders) shun agency debt as collateral for their lending, that will mark the beginning of a far more serious phase of the problem and would signal hard times ahead. So I will busy myself in the early trading tomorrow observing the movements in the rate at which agency collateral trades relative to government collateral.

Stay tuned.