Tuesday, July 15, 2008

Goodbye Fannie and Freddie, we hardly knew ye

The meltdown started late last spring with the implosion of a few lesser-known financial firms such as New Century Financial. Then in March of this year, once-venerable investment bank Bear Stearns basically evaporated overnight after 85 years of business and having weathered the Great Depression. The company was bought for $2/share by JP Morgan (w/Fed backing), after falling from $150/share in less than 9 months.

Moving on up, we are just now witnessing the nationalization of Fannie Mae (FNM) and Freddie Mac (FRE), the two companies chartered to provide liquidity to the U.S. mortgage market. Just this past Friday, the Federal Government stepped in and indicated they will "make good" on the implicit Government guarantee to backstop these companies financially.

I have no doubt that the Government will do whatever it takes to keep these companies from failing outright, because these companies now underwrite roughly half of the $12 trillion U.S. mortgage market. But to be sure, equity (stock) holders will be wiped out in the process and the cost to taxpayers could run north of a trillion dollars [unofficial guess]. Further to the point, in reaction to the news, U.S. Government bonds sold off sharply, based on genuine fear that through this action the U.S. Government may be at risk of losing it's AAA bond rating as a Sovereign borrower. As indicated here, major rating agencies were quick to clarify that a downgrade of the U.S. government, is not an immediate concern; however, the mere fact that a Sovereign downgrade is even on the table is beyond disturbing, and portends badly for the future. These bond rating agencies (Moody's/S&P) have been so incompetently behind the curve on their ratings relative to the market reality, that their reassurances basically have no value at this point.

That these two companies have lost 90% of their equity value and now are on the verge of massive failure, can come as no surprise. One would be hard pressed to find two companies more leveraged to the Global Ponzi scheme than these two. Both companies were chartered to bring liquidity to the mortgage market by buying up mortgages from local banks, thus providing local banks with fresh cash to originate still more loans. The FNM/FRE portfolios were typically leveraged 30:1 (you read that right), meaning for every dollar of equity, these companies held $30 of debt. What this means is that only a 3% decrease in value in the portfolio wiped out all of the equity. In other words, these companies had become massive call options on the U.S. economy, that worked great when the economy and housing market were growing, but have now since "expired" - and "out of the money", I might add.

Lastly, and almost forgotten in the excitement over FNM/FRE, IndyMac went bankrupt last week and was taken over by the FDIC. This was the third largest bank failure in U.S. history - so far...