Monday, September 8, 2008

Exposing Fannie Mae and Freddie Mac - Subprime Crisis

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our video for this posting can be found at:

By August 2007, it became clear that the U.S. housing market was in trouble. Banks and brokers were starting to face massive write downs for all the irresponsible home loans they had been granting for the previous several years and this was causing available mortgage money to dry up. Federal government officials, including President Bush, the Treasury Secretary Henry Paulson, the Fed chair Ben Bernanke, the head of the Senate Finance committee Chris Dodd and his counterpart in the House Barney Frank, unanimously supported using government backed Fannie Mae and Freddie Mac to help prop up the faltering mortgage market. While this was done purportedly to help struggling home buyers, it was in reality an attempt to help the U.S. banking system. The likelihood that the U.S. taxpayer would be stuck with one huge bill because of these actions didn't seem to have been considered - and if it was, no federal official or representative seems to have been bothered by it.

Fannie and Freddie were encouraged to buy dicier loans, particularly Alt-A. Even some subprime loans started showing up on their books. Together these loans accounted for as much as 20% of the total debt they backed by the first half of 2008. A similar percentage of loans on their books were for over 80% of the original home price and since housing prices were falling, this percentage for actual home value was not only much higher, but growing rapidly. Caps on the size of a mortgage that Fannie could handle were raised substantially at that time to over $700,000. These actions along with the diminished role of banks in mortgage lending wound up creating a de facto nationalization (the de jure nationalization would come later) of the American mortgage market. In the last half of 2007, Fannie and Freddie backed 90% of mortgages in the United States and 81% in first half of 2008.

As a consequence of government policies, the condition of these already financially weakened and corruption plagued companies deteriorated even further. The leverage, calculated as liabilities divided by shareholder equity, that Fannie Mae was utilizing rose to an eye popping 78 to 1, more than double the 33 to 1 leverage that caused Bear Stearns to implode overnight. This huge leverage was made possible with the complicity of Fannie and Freddie's regulator (OFHEO) who kept lowering the capital surplus requirements the companies needed to maintain, first from 30% to 20% and then to 15%. This allowed Fannie and Freddie to continually state to the press that they had much more capital on hand than the minimum amount set by their regulator and thereby imply that they were in a sound financial state, even though they were not.

In fact, by the first quarter of 2008, Freddie's liabilities exceeded it assets by $5.2 billion. Based on the basic principles of accounting, it was an insolvent company. While this information was public, other than the New York Investing meetup, few seemed to notice this obvious fact. Only when a former Fed official made a public statement pointing out that the emperor had no clothes in July 2008, did the problems with Fannie Mae and Freddie Mac suddenly receive major press and government attention.

NEXT: Exposing Fannie Mae and Freddie Mac - The Bailout

Daryl Montgomery
Organizer, New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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