Thursday, July 17, 2008

Not so sweet Fanny Mae

The Fannie Mae and Freddie Mac saga is big by world standards.

Trillions of dollars of mortgages are involved, in fact the firms between them own or guarantee about half of the $12 trillion in U.S. mortgages.

I asked a question about 6 years ago, what would happen if these two institutions tipped over? This was in the light of many US companies involved in "accounting irregularities" at the time and that Fannie and Freddie was a possible inclusion.

The immediate cause of the problems that became public at Freddie Mac in 2002 appeared to be accounting properly for the use of derivatives, what Warren Buffett has called "financial weapons of mass destruction". Under the previous accounting procedures, income for the years 2000, 2001 and 2002 was understated, with income for the future overstated. Freddie and Fannie management decided that this method would be used to “smooth out” earnings, providing reassurance to financial markets and leading ultimately to lower interest rate costs.

The President of Freddie Mac was sacked for his part in the company's "accounting problems".

While assets of the 2 big macs went up in value, via customers house prices, there wasn't a problem, but as the sub prime saga unfolded property prices were hit and Fanny and Freddie now have a big cash flow problem. They are essentially insolvent.

I now know the answer to my question and it ain't a pleasant one to stomach, especially given the problem was painfully evident years ago.

These entities will probably go under without US taxpayer funds being pumped into them and the current credit crises that the business and financial world is experiencing will get considerably worse and there would probably be a contagion effect with other banks going under. The derivatives market upon which most of Fannie and Freddie's business is backed, would unwind and explode upon other financial institutions holding theses derivatives as assets, some of them the ones we have already seen in the news and some we haven't heard from yet.

As the planet is facing tough economic times at present, for Fannie May and Freddie Mac to go under would no doubt cause a massive recession the likes of we haven't seen in generations so one could understand why Henry Paulson and the Fed are looking at bailing these turkeys out.

But, and its a big giant butt, why should the US taxpayer have to bail out even more financial institutions, this time possibly to the whopping tune of US$1 trillion?

The answer is that they will take the rest of us down with them if nothing is done. Hard to stomach, given those that didn't binge on cheap debt and over spend, were not the ones who took the risks in the first place but will suffer anyway.

In New Zealand our mainstream lenders haven't been as reckless, however, the present Labour government wants to start our own sub prime lending, so it could be a problem for us in the future.

Kiwis would be affected indirectly though by a collapse of the two macs, so it is an important story for New Zealand and every other country because a collapse would affect our fragile economy and faith in markets, lending and business even more than it already has.

The bizarre thing is though, while we have been flooded with Tony Veitch and Winston Peter's stories, coverage by our local media over Freddie Mac and Fannie Mae has been largely relegated to small pieces in the businesses pages and biz segments on TV news, not in the mainstream news, where it clearly deserves to be.

Confidence in the economy is much needed right now, Fannie and Freddie have knocked it about again. What Henry Paulson does in the next few days is going to be the difference between a complete meltdown and the status quo.

Unfortunately, I fear there are more Freddies and Fannies to come.

That just ain't sweet.

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Related Amazon Reading

The Two Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash
The Two Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash by Charles R. Morris
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c Share Investor 2008