The Fannie/Freddie Bailout: The End of the Beginning of the End
By Michael E. Lewitt
Equity markets are rallying around the world this morning in the aftermath of the U.S. government's seizure of Fannie Mae and Freddie Mac. The rationale for this rally is that the government's open-ended commitment to support these two entities eliminates a huge cloud of uncertainty that was hanging over the markets. Naturally, HCM completely disagrees and believes this bailout is a sign of severe distress in the U.S. and global financial sector. While it provides short-term stability for the mortgage market, the bailout plan requires Freddie and Fannie to severely reduce their mortgage holdings in the future, removing two of the main liquidity engines from the housing market. Markets detest uncertainty, but this bailout leaves huge unanswered questions about how American home ownership will be supported in the future.
HCM still expects the Dow Jones Industrial Average to drop below 10,000 and potentially hit 9,000 before the full impact of this credit crisis is felt (i.e. most likely before mid- 2009). The Freddie/Fannie bailout is no reason to become a buyer of stocks except on a very short-term trading basis. This rally will be short-lived. Investors should use it to reduce exposure to financial stocks. Financial institutions' balance sheets are still significantly impaired. A significant part of today's buying will be related to short-covering by hedge funds that have been continually wrong-footed by the direction of the markets this year.
The seizure of Freddie and Fannie is another step on the way to unwinding the biggest credit bubble in history. The liquidation of the Mount Everest of mortgage debt, leveraged loans and other asset-backed securities that are weighing down the balance sheet of paralyzed financial institutions around the world has barely begun. While many of these institutions have reported some of their losses, that is a very different matter than selling these securities.
The markets have yet to see the rubber meet the road, so to speak, in terms of buyers and sellers agreeing on clearing prices for these hundreds of billions/trillions of dollars of securities. That is the next step that has to begin to happen for this crisis to begin to work itself out. The American model of debt-engorged free market capitalism is coming full circle and straining under its own weight. Fannie Mae and Freddie Mac were the epitome of the capitalism for-the-poor, socialism-for-the-rich policies that have been pursued by financial authorities in this country. Developed as a public-private partnership, these beasts were neither fish nor fowl.
While their equity was left in private hands and their stock-option incented management teams engaged in accounting fraud, they were able to fund themselves at below-market rates based on an implicit government guarantee of their debt. The U.S. government, particularly Congress, was fully complicit in permitting these companies and their managements to enrich themselves while abusing their unique charters. Apparently the final straw that led to the current conservatorship (translation: nationalization) was the "discovery" by the Treasury's financial advisor, Morgan Stanley, that both agencies were not marking their books properly.
The government was shocked, simply shocked to learn that these institutions were gaming the system by overstating the value of their mortgage holdings and delaying the recognition of losses and were in reality insolvent. As Christopher Wood wrote this morning, one of "the long-term consequences of the US Treasury's forced action is to lead to further decline in the moral authority of the US to lecture others on economic matters." The United States has become one big glass house, and it can no longer cast stones at others.
And indeed that is the point that HCM has been making over the past several months. The credit collapse can be laid directly at Wall Street's door. We do not say this because we like sounding churlish, but because what has occurred has real, negative long-term economic and political consequences. The cost of our unwise and corrupt policies has already been very high and it will continue to rise unless we act now to do better. Confidence in the American model of capitalism has been shaken with good reason.
Despite the rally of the dollar (mostly against the Euro, another compromised currency), the U.S. currency has been battered largely due to a loss of confidence in American economic policies and leadership. We continue to shift hundreds of billions of dollars out of our own coffers into those of countries that do not share our beliefs because we have moved too slowly to develop sound energy policies. In large part this is because our politicians remain indebted to an automobile industry that is on the verge of insolvency and to an energy industry that places its own interests ahead of the country's and the world's.
We have allowed our derivative markets - specifically those related to credit (i.e. credit default swaps) - to grow in a completely unregulated manner to the point where everybody is basically holding their breath and praying that a financial accident won't occur. This has occurred largely because it has been in Wall Street's interest to limit regulation of derivatives. But the time has come to stop allowing the fox to patrol the chicken coop. Just as it was completely foreseeable that Freddie and Fannie would fail, it is a certainty that we will face future crises if we continue to avoid difficult and unpopular choices or refuse to speak truth to power. How many wake-up calls do we need?
John F. Mauldin
johnmauldin@investorsinsight