Debate, Part I: Missed Opportunity

Reflecting on the 1st Presidential Debate of the fall season, there are certainly several positives to talk about in relation to Sen. McCain's performance. He once again delivered when it came to clear, decisive, leadership attributes; especially on the subjects of government spending, and our strategies in various foreign theaters. Based on the arc of the debate, to my viewpoint, he won the evening.

I don't feel satisfied this morning, though. I feel there was a major missed opportunity in last night's discussion, that quite honestly, neither candidate took a real swing at. The major news story of the past couple weeks - the US Treasury takeover of several financial firms, and the proposed 700 billion dollar bailout of even more financial institutions, wasn't competently discussed by either candidate. This was very disheartening.

The moderator, Jim Lehrer, tee'd the issue up for the candidates; a golden opportunity to grasp hold of an issue of major concern, and really set themselves apart from their rivals by discussing the heinous errors that got us here, and defining the principles we should be concentrating on going forward. Sen. Obama delivered his well-rehearsed four talking points regarding what he and his congressional allies expect to be in any bailout agreement, but failed to adequately explain how we got here (other than "George Bush's eight years of failed policies". yawn.), or give any reassurance about such a bailout's effectiveness, or how and what his administration would do to make sure it wouldn't happen again. His answer fell flat. 

Sen. McCain, with a clear opening to hammer congressional and regulatory oversight, Fannie & Freddie as deeply flawed and corrupt financial institutions doomed to failure, and the asserting of power by the US Treasury Secretary in the takeovers of failing Wall Street firms as constitutionally disturbing, failed to deliver. It was a wide open opportunity to reclaim the mantel of economic and fiscal responsibility, by clearly outlining conservative economic principles, and the risks that improper government interference in the marketplace pose to the stability of the economy. It was an opportunity to put some real distance between himself and the current administration on economic policy, by strongly criticizing the bailout plan, siding with Senators Shelby and DeMint, and reinforcing the conservative ideals of limited government. All we got was a brief mention of his sounding the alarm about Fannie & Freddie a couple years ago, and clarification of his call for the resignation of the SEC chair as a call for accountability. Not bad points, but not seizing the opening he was given. 

The entire arc of this campaign could change drastically, if one of these two candidates could get a firm grasp on the issues at stake, and take a clear and concise leadership position with regard to the current financial situation. The American people would be thrilled to see that someone really "gets it". Being a free-market, limited government conservative, John McCain should have a serious advantage over his rival in this arena. It's a clear opportunity for him to distance himself from the Bush administration, and their questionable bailout plan, especially while his rival and the Democrat Party, it seems at this point, are only too willing to align themselves with it. 

Yes, this debate might be recorded as a "win" in McCain's column, but a win in November is the real goal; and he can't afford to not seize on such glaring opportunities if he hopes to turn this race strongly in his favor, and tally the big win.

The Current Financial "Crisis" - In Layman's Terms: no bailout necessary

There are many out there trying to understand what's going on in the financial markets, and why the US Treasury Secretary and Federal Reserve Board Chairman are proposing a near trillion dollar bailout for investment bankers. 

To really go back to the beginning, please refer to my previous posting on the history of Fannie and Freddie, for reference.

Now, let's see if I can follow this. 

As politicians tend to do, back in the early nineties, it was decided that expanding homeownership to those who had previously been unqualified for mortgages would be a great way to pander to those Americans who had "slipped through the cracks", and thus legislation was enacted that forced lending institutions to do just that via a strategy of penalization and roadblocks for lenders who didn't comply. It is also my understanding that Fannie Mae lowered the standards of qualification for a mortgage around that time as well.

Following the burst of the tech bubble in the late nineties, the Federal Reserve set off on a series of record interest rate reductions in an attempt to stave off a recession, making the lending/borrowing of money very cheap. 

These actions created an environment in which investors started putting money into real estate, a historically stable market, but in new irresponsible ways.  Homebuilders saturated the market with homes often too expensive for the average buyer. Mortgage brokers in concert with bankers, came up with new and creative ways to extend mortgage privileges with "interest only" and "bubble mortgages". Many of our fellow citizens took on loans they hadn't fully considered the ramifications of, feeling that if creditors were offering it, it must be safe. With interest rates trending downward, adjustable rate mortgages, previously an investment taboo, also appeared attractive to the ignorant, and were being actively marketed by lenders as the smart way to go. As more expensive new homes were built, and new neighborhoods appeared, home values all over towns increased in response. Lenders were marketing "home equity" mortgages, into which huge credit card debts were being buried, all over the place. On the outside, the home market was looking great.

In the meantime, Fannie and Freddie were taking on a tremendous number of these new high-risk mortgages, and cooking the books to make it appear as if they were going to reap tremendous profits, ignoring the tremendous risk they were assuming. Democrat political hacks, like Franklin Raines, Jamie Garelick, and Jim Johnson, as a reward for their loyalty, were being appointed to executive positions yielding huge bonuses nearing 100 million each, based on this chicanery.

Everything was looking great, ...until the foreclosures started rolling in. Folks who should not have been given loans in the first place - surprise - couldn't meet the terms of payment, and unable to sell their homes immediately due to a saturated market, went into foreclosure. This meant banks had properties on their hands that in the past, when it was rare, they would sell at a loss to recoup at least the majority of their money. However, if there is a concentration of foreclosure sales in an area, the property values of all homes in that area are depreciated, setting up a vicious circle. Depreciation means the value of your home might be less than what you owe, meaning you can't sell it at a profit, or even break even. In fact, you wouldn't be able to sell it all unless you have cash on hand to make up the difference, which most people don't, and even if they did, probably wouldn't part with it. This set up a situation wherein even folks who had put down a significant downpayment were now living in properties that were worth less than their current mortgage balance.

(In the Midwest, which I recently left, it was not unusual to have several abandoned homes in a brand new neighborhoods (less than 10 years old), and see several more homes up for sale or rent.) 

As the burden of debt increased for lenders, cash flow was becoming scarce, as the interest rates their creditors extended to them increased because of that debt, the value of their stocks decreased, and their cash was being tied up in assets that were decreasing in value. Fannie and Freddie, who had assumed the bulk of these subprime loans, were on the ropes. If the other banks couldn't unload their bad loans to Freddie and Fannie, their financial viability was at risk. Since Fannie and Freddie were backed up by the US Treasury (see the previous blog entry) these other investment firms saw them as the clearinghouse for bad debt. 

Eventually the markets were saturated with as much bad debt as could be handled, but more was on the way. So these investment bankers, trying to recoup some cash and maintain some liquidity, came up with some creative securities to sell, with these bad mortgages buried in them in such a complex way, that the true value of the security was near impossible to ascertain by the buyer.  Sales of these complex securities exponentially exacerbated the problem.

The collapse of Fannie and Freddie set off a firestorm. With nowhere for the private sector investment bankers to dump off their bad debts to anymore, they realized they were in really big trouble. With their cash tied up in complex bad securities, of unknown negative value, they had to assume the worst, and started looking for a bailout, or a buyout, selling off their remaining assets for pennies on the dollar. 

It is I believe, these complex securities,  into which bad debt was buried, that are the source of the 700 billion dollar figure being bandied about as the necessary amount for a bailout of the financial system. Because the real amount of financial risk is almost too complex to uncover at this point, financiers are vastly overestimating the amount of money needed from the Treasury in order to make sure they can cover their losses, and still have enough cash on hand to rebound into profitability again. The panic over available credit and capital is not helping the situation.

I personally believe there are plenty of financial institutions out there that will be more than happy to pick up assets with real value for pennies on the dollar from these firms that were engaged in risky financial behavior, and that a bailout is not only not necessary, but could serve to lengthen the financial downturn significantly.

In straight economic terms, what we had is a short term of overinflated demand continue long enough for supply to rise to meet it. When the bubble of demand collapsed, as was inevitable, the value of the assets supplied became devalued relative to the size of that collapse. In order to sell off those assets with any margin of profit relative to the new market value established by the corrected demand, those assets would have to be sold at a price not only below market value, but significantly lower than their original sale price at the peak of the demand bubble. 

It is important to note that no money is really "lost", except on paper valuation, until those assets actually change hands. However, because of the foreclosure rates, financiers were having too much of their cash tied up in depreciated assets, which put them in a real cash crunch. They couldn't afford to sit on those assets until their value increased again. Selling off those depreciated assets had their losses piling up. Without influx of cash to lend and invest, after all, they cannot make money.

To stave off collapse, it seems they tried to generate cash by fooling each other into buying each other's bad debts, by burying them in complex securities. This was just a shell game however, and eventually the inevitable collapse came.

All that capital is not lost for good however, as some on the left, who have no undestanding of economics, would have you believe. There are still plenty of companies out there with plenty of capital on hand who see a perfect buying opportunity in front of them. They will have the golden opportunity to snap up a tremendous amount of undervalued assets with intrinsic, "real" value for below market price. They will then be able to turn around and sell those assets that they bought for a steal, at market value, make a nice profit on them, and be overflowing with even more capital that they can reinvest, to make even more money. In other words, the free market will correct itself. People still need homes after all; and last I checked, populations are still growing.

That is in fact what the US Treasury Secretary is counting on. He is looking at this as an opportunity for the US government to fatten it's coffers in just that way. That is why he is promoting this "bailout" as such a positive for the taxpayer. 

What we as Americans have to ask ourselves is whether we want all that capital tied up in the US government to be mismanaged and squandered, or do we want it to be in the private sector, where it can create jobs and wealth not just for political hacks, but for those who work hard enough and smart enough to merit it's rewards?

The free market can never collapse. There can only be a shift of capital from one institution to another, profit from one entity to another. Let's not mire ourselves for years in more New Deal socialist folly, doomed for another collapse, but protect our free market economy. Call your Congressman and oppose any government "bailout".

Fannie & Freddie in the rearview mirror

In keeping with the theme of this blog, I've posted an article from HNN posted back in December of 2003. While it would have been nice to have an understanding of these institutions before they failed - to therefore avert that failure, it is now too late. Please read it to gain an understanding of how we got to here.

12-08-03

What Are the Origins of Freddie Mac and Fannie Mae?

By Rob Alford

Mr. Alford is a student at the University of Washington and an HNN intern.

In recent months, the nation's two largest mortgage finance lenders have come under increasing scrutiny at the hands of Congress, the Justice Department and the Securities and Exchange Commission (SEC). The Federal National Mortgage Association, nicknamed Fannie Mae, and the Federal Home Mortgage Corporation, nicknamed Freddie Mac, have operated since 1968 as government sponsored enterprises (GSEs). This means that, although the two companies are privately owned and operated by shareholders, they are protected financially by the support of the Federal Government. These government protections include access to a line of credit through the U.S. Treasury, exemption from state and local income taxes and exemption from SEC oversight. A recent accounting scandal at Freddie Mac that resulted in the replacement of three of the company's top executives has led to mounting concerns over the privileged status these GSEs enjoy in the marketplace.

Fannie Mae was created in 1938 as part of Franklin Delano Roosevelt's New Deal. The collapse of the national housing market in the wake of the Great Depression discouraged private lenders from investing in home loans. Fannie Mae was established in order to provide local banks with federal money to finance home mortgages in an attempt to raise levels of home ownership and the availability of affordable housing.

Initially, Fannie Mae operated like a national savings and loan, allowing local banks to charge low interest rates on mortgages for the benefit of the home buyer. This lead to the development of what is now known as the secondary mortgage market. Within the secondary mortgage market, companies such as Fannie Mae are able to borrow money from foreign investors at low interest rates because of the financial support that they receive from the U.S. Government. It is this ability to borrow at low rates that allows Fannie Mae to provide fixed interest rate mortgages with low down payments to home buyers. Fannie Mae makes a profit from the difference between the interest rates homeowners pay and foreign lenders charge.

For the first thirty years following its inception, Fannie Mae held a veritable monopoly over the secondary mortgage market. In 1968, due to fiscal pressures created by the Vietnam War, Lyndon B. Johnson privatized Fannie Mae in order to remove it from the national budget. At this point, Fannie Mae began operating as a GSE, generating profits for stock holders while enjoying the benefits of exemption from taxation and oversight as well as implied government backing. In order to prevent any further monopolization of the market, a second GSE known as Freddie Mac was created in 1970. Currently, Fannie Mae and Freddie Mac control about 90 percent of the nation's secondary mortgage market.

GSEs such as Fannie Mae and Freddie Mae, with their combination of private enterprise and public backing have experienced a period of unprecedented financial growth over the past few decades. The current assets of these two companies combine for a total that is 45 percent greater than that of the nation's largest bank.

 

On the other hand, their combined debt is equal to 46 percent of the current national debt. It is this combination of rapid growth and over leveraging that has lead to the current concerns of Congress, the Justice Department and the SEC with regards to the financial practices of these GSEs.

Fannie Mae and Freddie Mac are the only two Fortune 500 companies that are not required to inform the public about any financial difficulties that they may be having. In the event that there was some sort of financial collapse within either of these companies, U.S. taxpayers could be held responsible for hundreds of billions of dollars in outstanding debts. A recent investigation by the Justice Department and the SEC into the accounting practices at Freddie Mac revealed accounting errors in the amount of 4.5 to 4.7 billion dollars and resulted in the termination of three of the company's top executives. Ongoing investigations by Congress, particular the House Finance Services subcommittee that oversees the activity of GSEs, will determine the future role of Fannie Mae and Freddie Mac and the secondary mortgage market that they dominate.