The Biggest Bailout of All Time

By: Doug Casey | Wed, Sep 10, 2008
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The failure and subsequent government bailout of Fannie Mae and Freddie Mac has been no surprise to the Casey Research team. But where do we go from here - will the bold action of the federal government save the housing market and revive the economy? The editors of The Casey Report weigh in with their thoughts...

A Casey Research Prediction Come True

On Sunday, September 7, Treasury Secretary Hank Paulson, flanked by James Lockhart, the new conservator from the Federal Housing Finance Agency, announced a plan to take over the operation of Fannie Mae and Freddie Mac and to guarantee their debt. They cited what we all knew, that they did not have enough capital to continue operating. Their business is to borrow to lend for housing mortgages, and to guarantee half the country's housing mortgages, about $5.4 trillion. The equity and preferred is all but wiped out as all dividends are suspended and management and the board are fired.

This is the biggest bailout ever. If 10% of the $5 trillion of guarantees must be made good by the government, the payments would be $500 billion. That is the size of the annual U.S. defense budget. The outstanding debt of the U.S. held by the public is the size of the guaranteed mortgages. It is huge.

We from Casey Research have seen this coming for more than a year:

"For one thing, at the point that falling prices leave homeowners with mortgages exceeding the value of their homes, default rates will soar. This, in turn, will put lenders that hold large amounts of mortgage debt at risk, and possibly jeopardize the solvency of Fannie Mae and Freddie Mac, since they guarantee much of this debt. If these mortgage giants faced collapse - and they are already in well-documented trouble - a government bailout involving hundreds of billions of dollars would be a likely next step.

"...The impending calamity - mass housing foreclosures, failing banks, Fannie Mae and Freddie Mac in ashes, millions of personal bankruptcies - is so dire... most people can't even conceive of it. And indeed it may not hit us this year, or next, but the market always corrects itself, and this time will be no exception, sooner or later.

"We have said before, and we repeat again: Rig for stormy weather."

[International Speculator (the predecessor of The Casey Report), March 2007]

Unusual Aspects

The Treasury will add funding to Fannie and Freddie when their assets are less than their liabilities. The Treasury gets warrants to own 79.9% of the equity. Fannie and Freddie are allowed to expand mortgage lending through the end of 2009 but are required to wind down their $850 billion of debt at 10% per year until they are essentially out of business at only $250 billion debt.

The effect on the Credit Default Swap (CDS) market could be big: there are about $1.47 trillion of CDS on Fannie/Freddie-backed mortgages. The creation of the conservatorship is probably a credit event, triggering the payment of the insurance on the debt. But as we know, the insurers are already weak, and forcing them to pay could eliminate them as ongoing business, thus creating a cascading loss of the value of insurance on other debt they guarantee.

The "New Secure Loan Agreement" that is designed to bail out the debtors of Fannie and Freddie will also be used to bail out the Federal Home Loan Banks. $274 billion additional housing market funding was passed through the FHLB last year, and it is safe to assume there are problems there too.

Who Will Rescue the Taxpayers from Fannie and Freddie?

The U.S. Government has decided to spend an enormous amount of money to prevent the two mortgage giants from defaulting. What will be the real effects?

The rescue won't resuscitate the housing market. As much as prices have declined, they still haven't come down enough to make houses affordable. (They only seemed affordable for a while because of the artificially low interest rates the Federal Reserve engineered during the housing boom through its inflationary policies.) Don't expect the rescued Fannie and Freddie to revive the housing market; the government's rescue package requires them to shrink their operations.

The rescue won't end the credit crisis that is pulling the economy into recession. Fannie and Freddie are perhaps the biggest, but certainly not the only, institutions that overcommitted to risky mortgages. Banks, insurance companies, and pension funds are holding billions in the same kind of dangerous stuff. And they still must get through another two years of interest "resets" on subprime mortgages created during the housing boom. As those resets occur, there will be more defaults on mortgages that borrowers can no longer afford - or no longer want because the loan balance exceeds the value of the house.

The rescue helps keep bad decision makers in place. Managers of banks and other financial institutions that invested heavily in Fannie and Freddie paper get let off the hook. They get another chance to make more bad decisions about how to deploy trillions of dollars of capital. And the politicians who passed the laws that encouraged Fannie Mae and Freddie Mac to take all those wild risks? They're up for reelection.

Implications for the Future

The complete collapse of what was 80% of the funding of new mortgages this spring is now here. The whole structure of creating mortgage-backed securities and passing them on is gone. There will be no creating new phony tranches of sliced and diced SIV debt, and no CDO and no CDS and no AAA-rated toxic waste. We don't know what happens to $62 trillion of notional CDS derivatives, but somebody is holding a disaster. This financial crisis is far from over.

By itself, the government might be able to manage some of these problems, but the problems are not isolated: the Federal Deposit Insurance Corporation (FDIC) guarantees deposits at banks of $4.3 trillion but has only a $50 billion reserve to handle bank failures.

Interest rates are close to 50-year lows, from the Fed cutting the short-term rate, and from flight to Treasuries, which are safer than other debt. But the longer-term implication of the bailout is that more deficits will weaken the dollar and therefore higher interest rates will be required in the long term, especially for non-government-guaranteed debt, to cover inflation and increased risk.

There will be many more financial institutions in trouble: perhaps 150 banks will fail, including probably one or two big banks, like Lehman, Citi, or Merrill. FDIC is next, in our opinion, once a big commercial bank goes under.

The dollar is up in the short term on what we expect is a short covering rally, but that is not consistent with long-term implications, so we don't expect it to stay up.

Homeowners gain, as Fannie and Freddie are allowed to continue to expand in 2009. But after that, they will be looking for a newly reconstituted system beyond what is in the conservatorships that are being asked to unwind. The long term is unclear.

The U.S. Treasury is now in the mortgage business. The financial future of the world is crumbling, and this is the biggest step in that change.

The Casey Report is the latest monthly newsletter from Casey Research. With its focus on big market trends and outstanding investment opportunities, it shows subscribers how to keep their money -- and multiply it - in times of economic crisis. Try The Casey Report risk-free, with a 3-month money-back guarantee... click here.

 


 

Doug Casey

Author: Doug Casey

Doug Casey
Chairman
Casey Research, LLC.

Doug Casey

Doug Casey is a highly respected author, publisher and professional investor who graduated from Georgetown University in 1968.

Doug literally wrote the book on profiting from periods of economic turmoil: his book Crisis Investing spent multiple weeks as #1 on the New York Times bestseller list and became the best-selling financial book of 1980 with 438,640 copies sold; surpassing big-caliber names, like Free to Choose by Milton Friedman, The Real War by Richard Nixon, and Cosmos by Carl Sagan.

Then Doug broke the record with his next book, Strategic Investing, by receiving the largest advance ever paid for a financial book at the time. Interestingly enough, Doug's book The International Man was the most sold book in the history of Rhodesia.

He has been a featured guest on hundreds of radio and TV shows, including David Letterman, Merv Griffin, Charlie Rose, Phil Donahue, Regis Philbin, Maury Povich, NBC News and CNN; and has been the topic of numerous features in periodicals such as Time, Forbes, People, and the Washington Post.

Doug, who divides his time between homes in Aspen, Colorado; Auckland, New Zealand; and Salta, Argentina, has written newsletters and alert services for sophisticated investors for over 28 years. Doug has lived in 10 countries and visited over 175.

In addition to having served as a trustee on the Board of Governors of Washington College and Northwoods University, Doug has been a director and advisor to nine different financial corporations.

Doug is widely respected as one of the preeminent authorities on "rational speculation," especially in the high-potential natural resource sector.

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