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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Financial weapons of mass destruction

In the wake of the Fannie Mae and Freddie Mac fallout last week, I thought it appropriate to re-post an article that I wrote in April this year for the Everything Warren Buffett Blog on reactions to the sub prime fallout.

In less than 5 months things have gotten considerably worse.


Latest on global financial fallout - to July 17 2008

The Fannie-Freddie Dodge -Washington Post
Dollar Little Changed Before Housing, Manufacturing Reports - Bloomberg
Financial crisis and inflation fears plunge w markets - Merco Press
Dollar up, stocks dip on Fannie Freddie plan - Forbes
Economic pain: 'Payback' for debt-fueled growth? - USA Today
Of Course It's A Recession -Forbes
Britain Appears Recession-Bound - BusinessWeek
Economist Predicts Worst is Just Ahead - West Orlando News


The announcement on March 31 (US time) that secretary Paulson is going to regulate the United State's financial markets with changes to it not seen since the Great Depression leaves me with a thought that has been running rat wheels in my mind ever since the current "Credit Crunch" kicked off.

Midway through last year, the Fed began sticking its filthy little hands in dikes all across the financial backbone of the USA by propping up institutions who had lent too much money to those who now cannot pay and to keep the wheels of commerce greased by trying to increase liquidity in the credit market-so we can do business with each other.

Now I am skeptical at the best of times as to State involvement in anything, let alone interfering in capital markets and don't have the foggiest whether the announcement by Paulson is going to change anything in the future at all.


Global financial fallout - to April 31 2008

German watchdog eyes $600 bln global bank losses: report- Reuters
Overhaul of Wall Street regulation doesn't address current crisis- International Herald Tribune
International Financial Panel Urges Bank Disclosures on Risk Exposure- Wall Street Journal
G7 to press big banks to reveal extent of credit crunch losses -Times Online
US prepares to give Fed sweeping oversight powers -Taipei Times
Ghosts of the Great Depression -Business Spectator
US Fed to be grilled over massive support to financial system- MercoPress
World Bank cuts East Asia growth forecast- Channel News Asia
East Asia Economies Pressed by Inflation- The Associated Press

The 1933 changes didn't stop the bear market in the 1970s, it didn't stop the sharemarket crash of 1987 or the tech bubble bursting in 2000 or the current credit crisis because of dodgy lending and investment practices related to that lending.

The interventions by the Fed and its global equivalents, to shore up credit liquidity is the main rat on the wheel in my mind.

What have these interventions stopped?

One can only speculate but one can do that with a largish amount of surety.

During the Great Depression, when faith in financial markets at the time was at an all time low there simply wasn't any intervention by the State apparatus to ameliorate what happened on that infamous day in 1929 when Wall Street threw a woopsey and capitalism jumped out of tall buildings in the financial districts around New York and around the world.

Have interventions in financial markets by State backed funds globally stopped some sort of 2008 crash from happening?

Probably, but not to the extent of 1929, but it is clear that it would have been a crash of some serious nature had there not been intervention.

Another question I have running through my head is, how long will the squillions of taxpayer dollars pumped into the economy stave off the inevitability of a bigger blowout?

That is harder to answer. In order to know better one would have to know the losses involved in the Sub prime loans and associated sub prime bonds, and we are no closer to knowing that than knowing if Hillary Clinton is going to be the Democratic Party leader or if Barry Obama still loves his preacher.

The vexed question of the massive derivatives market also looms in the minds of investors:

Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by nondealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.

"Derivatives are financial weapons of mass destruction. The dangers are now latent--but they could be lethal".

[Warren Buffett 2003]


Warren Buffett aside, I don't think anyone fancies the Fed's chances of shoring up the derivatives market should the dominoes start to topple.


What is clear is this scenario has at least the rest of the year to fully play out and further State intervention should be carefully applied only if is really going to work and not because the Fed needs to be seen to be doing something.

Hold onto those gold bars and keep the cash under the mattress, you just might need it.

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Dont dare use the "D" word

The announcement on March 31 (US time) that secretary Paulson is going to regulate the United State's financial markets with changes to it not seen since the Great Depression leaves me with a thought that has been running rat wheels in my mind ever since the current "Credit Crunch" kicked off.

Midway through last year, the Fed began sticking its filthy little hands in dikes all across the financial backbone of the USA by propping up institutions who had lent too much money to those who now cannot pay and to keep the wheels of commerce greased by trying to increase liquidity in the credit market-so we can do business with each other.

Now I am skeptical at the best of times as to State involvement in anything, let alone interfering in capital markets and don't have the foggiest whether the announcement by Paulson is going to change anything in the future at all.



Latest on global financial fallout

German watchdog eyes $600 bln global bank losses: report Reuters
Overhaul of Wall Street regulation doesn't address current crisis Int' Herald Tribune
International Financial Panel Urges Bank Disclosures on Risk Exposure Wall Street Journal
G7 to press big banks to reveal extent of credit crunch losses Times Online
US prepares to give Fed sweeping oversight powers Taipei Times
Ghosts of the Great Depression Business Spectator
US Fed to be grilled over massive support to financial system MercoPress
World Bank cuts East Asia growth forecast Channel News Asia
East Asia Economies Pressed by Inflation The Associated Press

The 1933 changes didn't stop the bear market in the 1970s, it didn't stop the sharemarket crash of 1987 or the tech bubble bursting in 2000 or the current credit crisis because of dodgy lending and investment practices related to that lending.

The interventions by the Fed and its global equivalents, to shore up credit liquidity is the main rat on the wheel in my mind.

What have these interventions stopped?

One can only speculate but one can do that with a largish amount of surety.

During the Great Depression, when faith in financial markets at the time was at an all time low there simply wasn't any intervention by the State apparatus to ameliorate what happened on that infamous day in 1929 when Wall Street threw a woopsey and capitalism jumped out of tall buildings in the financial districts around New York and around the world.

Have interventions in financial markets by State backed funds globally stopped some sort of 2008 crash from happening?

Probably, but not to the extent of 1929, but it is clear that it would have been a crash of some serious nature had there not been intervention.

Another question I have running through my head is, how long will the squillions of taxpayer dollars pumped into the economy stave off the inevitability of a bigger blowout?

That is harder to answer. In order to know better one would have to know the losses involved in the Sub prime loans and associated sub prime bonds, and we are no closer to knowing that than knowing if Hillary Clinton is going to be the Democratic Party leader or if Barry Obama still loves his preacher.

The vexed question of the massive derivatives market also looms in the minds of investors:

Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by nondealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.

"Derivatives are financial weapons of mass destruction. The dangers are now latent--but they could be lethal".

[Warren Buffett 2003]


Warren Buffett aside, I don't think anyone fancies the Fed's chances of shoring up the derivatives market should the dominoes start to topple.



Warren Buffett has always
feared the massive derivatives
market.

What is clear is this scenario has at least the rest of the year to fully play out and further State intervention should be carefully applied only if is really going to work and not because the Fed needs to be seen to be doing something.

Hold onto those gold bars and keep the cash under the mattress, you just might need them.


Essential related reading from Share Investor

The Global Economy looks bad now? But wait there's more
Global credit squeeze: There is no free lunch
Current Credit crunch a blessing in disguise
Lenders must come clean over losses to restore faith in credit markets
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Global Market Meltdown: I can smell the fear from here
Warren Buffett's The Intelligent Investor
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Visit Everything Warren Buffett-for everything Warren Buffett

C Share Investor 2008