RoR: Forum

A government bailout could cost taxpayers around $25 billion, according to the Congressional Budget Office.

Correction: The government loaning money to Fannie and Freddie whom will never repay _has_ cost USD holders around $25 billion (inflation). (If $25 billion is the correct figure of what they owe.) That's 1% of the $2,730 billion 2007 Fed budget according to Wikipedia.

Another source says that they are $1.6 trillion in debt! http://www.canada.com/theprovince/news/story.html?id=e7186134-bfb6-4abe-8c00-2d4cdc42e5f6&k=77856%3E%3Cspan%3EU.S.&p=2

That's an incredible more than 1/3 of the Federal budget! Does anyone know the sum of defaulted loans?

Its either inflation (USD holders pay) or taxpayers pay.
(Edited by Dean Michael Gores on 9/07, 9:22am)

Post 1

Monday, September 8, 2008 - 5:44am

Dean,
"Treasury Secretary Henry Paulson announced plans Sunday to take control of troubled mortgage giants Fannie Mae and Freddie Mac and replace the companies' chief executives. The Treasury will acquire $1 billion of preferred shares in each company without providing immediate cash, and has pledged to provide as much as $200 billion [my emphasis] to the companies as they cope with heavy losses on mortgage defaults." (source)

A brief historical perspective on the mortgage crisis.

Before the savings and loan crisis of the 1980s most mortgages were retained by the issuer of the mortgage (the S&L or bank). A big change began to occur. More and more mortgages were bundled by the primary mortgage lender and sold to Fannie Mae or Freddie Mac or other bundlers, who would then sell the bundles to investors (e.g., banks, pension funds, insurance companies). This gave the primary lenders cash to go out and make more mortgage loans. It's quicker to make money on loan origination fees and servicing mortgages than it is to patiently wait for mortgage payments, which are often strung out over 30 years. (Some do, of course, arrive early due to prepayment or the mortgagee moving or refinancing. Also, the primary lender gets a bit of the interest for servicing the mortgage.)

Because mortgage payments are strung out over so many years, they are not attractive to many investors. Here I refer mainly to the principal part of the mortgage payments. Many investors seek rather short-term, or medium term, or long-term principal payback. Enter the creative guys on Wall Street. Take these bundles of mortgages and divide them. For example, create one piece (often called "tranche", the French word for "slice") to receive the first 25% of principal payments, another tranche to receive the 2nd 25% of principal payments, and so on. Each tranche would receive (or accrue) interest based on the its share of outstanding principal. The resulting cash flows are akin to bonds -- some short-term, some medium-term, some long-term. Over time the tranching got more and more complex. These were usually called "collateralized mortgage obligations" (CMO's). Fannie and Freddie could rebundle mortgages, too.

In the 1990s the government acted to increase home ownership, which meant more mortgages for less credit-worthy borrowers. When the primary lenders can turn around and sell off the mortgages they originate, that allows more lax loan standards. If the borrower defaults years later, somebody else bears the burden.

Adjustable rate mortgages also entered the scene, with borrowers lured by the low "teaser rates." Fannie and Freddie had tight enough standards that they would not accept some mortgage bundles -- the ones held by less credit-worthy folks -- directly from the primary lenders. However, they could indirectly. If somebody else bundled the mortages and repackaged them into tranches, then Fannie and Freddie could buy CMOs, usually the apparently more secure ones. This also gave them "points" toward their obligations to lend to lower-income home buyers.

Both investment banks and ordinary commercial banks were investing in them too, quite heavily. When mortgage borrowers started defaulting this elaborately-created mortgage structure began to crumble. The market value of the less secure CMOs plunged. Many times borrowers defaulted because the adjustable rate rose substantially, a budget buster. Many times borrowers defaulted because the drop in the market value of their property made the outstanding loan larger than the market value of the property. Why keep paying on a $200,000 mortgage when the house is worth $170,000?

The following are some recent articles on the situation that go into more detail.
http://seekingalpha.com/article/85146-did-fannie-and-freddie-cause-the-mortgage-crisis
http://www.takimag.com/site/article/the_diversity_recession_or_how_affirmative_action_helped_cause_the_housing/

(Edited by Merlin Jetton on 9/08, 11:12am)

Post 2

Monday, September 8, 2008 - 9:05am

Is the Federal gov't TRYING to bankrupt the US????? And trust me, you won't be hearing Palin talking about how this bail-out is a very poor move by the US government. As a side note, if anyone is interested in reading about the Federal Reserve I highly recommend "The Creature From Jekyll Island: A Second Look at the Federal Reserve" by G. Edward Griffin.

Post 3

Monday, September 8, 2008 - 9:53am

Sen. Joe Biden was on Meet the Press yesterday.

MR. BROKAW: The country�s waking up this morning to the news that the federal government�s about to move in on Fannie Mae and Freddie Mac. Those are quasi government agencies holding $5.3 trillion in mortgage debt. They�re in serious trouble at the moment, but they�re in a free fall, in effect. The government reorganized them, it appears that they�re going to pump in some fresh capital on a quarterly basis, but shareholders will have their shares greatly diluted by this move. But the preferred shareholders�China and other governments that have invested in Fannie Mae and Freddie Mac will not suffer, because the government will prop them up. Is that fair?
SEN. BIDEN: Well, no, it�s not fair, but I don�t think that�s what�s going to happen. I talked to Secretary Paulson last night. I�m not at liberty to lay out what he told me, because he should announce it today. But there�s three principles that have to play here for this to work, in my view. One, you have to make sure that you help homeowners and stabilize, at the same time, financial institutions. Secondly, you got to make sure that you�re not bailing out shareholders vs. the taxpayers. And the third thing you got to do is make sure that they�re still in a position to be able to continue to lend, because there is a need for them to continue to have this elasticity of being able to deal with the market. Now, what I�ve heard the outline of, I am�I want to wait till I see all the detail, but if it meets those three principles, then I think it has a great chance of succeeding. And as I understand it, whatever proposal Secretary Paulson is going to make is a proposal to get us over this hump of instability and uncertainty. It�s not an official reorganization. It will be left to the next administration and the Congress to make those judgments.
MR. BROKAW: All investors suffer equally?
SEN. BIDEN: They should. They should. We�ll see what the plan is.

It's not a big deal, but there are a couple of words Biden misused that indicate his unpreparedness.
1. Fannie and Freddie aren't lenders, except in a trivial or roundabout way. They are buyers and borrowers. They mainly buy bundled mortgages from mortgage originators, not lend to them. They borrow by issuing FNMA or FHLMC debt backed by the mortgages. The trivial or roundabout ways are (a) when they invest in CMO's others have created and (b) their buying enables mortgage originators to do more lending.
2. The investors in Fannie and Freddie include common stockholders, preferred stockholders, and holders of FNMA or FHLMC debt. All investors won't suffer equally. Common stockholders will suffer the most. The holders of FNMA or FHLMC debt will suffer the least, if at all. Indeed, the market price of FNMA and FHLMC debt rose after the announcement, because that debt now has another backer, the federal government (or taxpayers). The fate of preferred stockholders is still open. However, preferred stockholders include many U.S. banks as well as China and other governments. That makes a dilemma.

Post 4

Monday, September 8, 2008 - 10:26am

Merlin, thanks for the article - that was an excellent summary of a scary event.

When Harry Browne's "Devaluation" book came out, about 1970, I read it in one night - a Friday night. I remember because it threw me into a panic and I wanted to get my money out of the bank and into gold coins and waiting till Monday felt like being dangled over the edge of a cliff (what can I say, I was younger then :-)

Harry Brownes' predictions on the price of gold and most things were accurate, but not the dreaded collapse. I've been made nervous once or twice since then by 'doom sayers' - whose economics were solid, but the timing and extent of predicted damage wasn't.

I'm getting real nervous now.

I don't ever remember a situation with debt so high, the dollar so weak, the government so irresponsible, the economy so burdened (taxes, food costs, cost of war, costs of fuel and extent of regulation), both housing, and credit markets in crisis, and the baby-boomers starting their financial avalanche of retirement. All this with a congress that must think there is no limit to what they can spend money on from prescription drugs, to bail-outs, to nation building, to hurricanes, to banks in trouble, to home owners that bought houses they shouldn't have, to Bear Sterns, to Fannie Mae and Freddie Mac, to.... Fear-based reactions. The politicians are scared - they know they've been fucking up and things are bad - they hope that throwing money at today's crisis will let them keep things afloat till tomorrow. And the consequences or cures? Blank-out.

Erik's comment of "Is the Federal gov't TRYING to bankrupt the US?????" seems dead-on since the line between government and private is becoming blurred such that all that is visible is that most profitable stuff stays private but regulated and taxed, while any large scale bankruptcies mean a bail-out or take over. The Detroit automakers just asked to have multi-billion dollar line of credit opened - with the government! (We laugh at the buffoon Chavez but at least he nationalizes the profitable enterprises.)

I'm getting real, real nervous.

Post 5

Monday, September 8, 2008 - 11:05am

Excellent recommendation, Erik. Here is a video of it.
http://video.google.com/videoplay?docid=6507136891691870450

Oh, we just witnessed a merger or marriage -- poppa Fed (b. 1913), momma Fannie (b. 1938), and their son Freddie (b. 1970).

Post 6

Monday, September 8, 2008 - 11:25am

Steve,

(We laugh at the buffoon Chavez but at least he nationalizes the profitable enterprises.)

I don't know whether to laugh or cry about this!

:-)

Ed

Post 7

Monday, September 8, 2008 - 4:12pm

Merlin,

Very informative summary. Thanks.

jt

Post 8

Monday, September 8, 2008 - 5:21pm

Merlin Jetton,

In the end, after the those that lend to Freddie and Fannie, and those that lend to those, do we not get to the The Federal Reserve Discount Window, who lends at a ridiculously low 2.25% interest rate, handing out money simply by increasing electronic numbers?

Isn't the federal target interest rate kind of a sleazy tricky way to hide the discount window and the fact that the Fed is handing out money to its friends in an _inflationary_ manner?
(Edited by Dean Michael Gores on 9/08, 6:12pm)

Post 9

Monday, September 8, 2008 - 7:17pm

Dean Michael Gores wrote:

In the end, after the those that lend to Freddie and Fannie, and those that lend to those, do we not get to the The Federal Reserve Discount Window, who lends at a ridiculously low 2.25% interest rate, handing out money simply by increasing electronic numbers?

The Federal Reserve discount rate is for commercial banks. It and the more used Fed funds rate are explained here. As best I know Fannie and Freddie don't directly deal with the Federal Reserve. That may change after the government takeover.

Isn't the federal target interest rate kind of a sleazy tricky way to hide the discount window and the fact that the Fed is handing out money to its friends in an _inflationary_ manner?

I don't know what you mean by the "federal target interest rate." Do you mean the "federal funds rate target" (also described at the above link)?

The Fed doesn't hand out money per se. But banks can expand the money supply by making a loan if they have sufficient capital. Suppose a bank makes a loan to a customer and the loan amount is simply added to the the customer's checking account. The bank's assets and liabilities increase by the same amount. That's how banks create money.

Post 10

Tuesday, September 9, 2008 - 4:57am

Merlin Jetton,

You did not answer my question. Isn't the discount window at the end of the trail of loans?

Wouldn't it not make financial sense for a bank (like you are suggesting) to make a loan at current interest rates unless they could acquire a loan from another bank (such as... if you follow the loan trail far enough eventually the discount window) at 2.25%?

===================

A bank giving out a loan by increasing an account balance is not inflation because they are not simply giving money created from no where. When a bank gives out a loan, it then actually looses money. For example lets say a new bank has $100 of deposits (it owes its depositors $100) and actually has the $100 on hand. Lets say I loan $10 from it. The bank now has $100 of deposits (it owes $100), it actually has $90 on hand. So you see, the money does not come out of thin air, there is no inflation.

There is a difference between a bank giving out a loan (where it still owes the money) and the Fed giving out a loan (where it doesn't owe anyone). Well, except for when FDIC insurance which bails out (inflation) borrowers who default, but this again is the Fed inflating the money supply.

Post 11

Tuesday, September 9, 2008 - 5:36am

Dean Michael Gores wrote:

You did not answer my question. Isn't the discount window at the end of the trail of loans?

I'd say sometimes, yes. Most of the time it's Fed funds.

Wouldn't it not make financial sense for a bank (like you are suggesting) to make a loan at current interest rates unless they could acquire a loan from another bank (such as... if you follow the loan trail far enough eventually the discount window) at 2.25%?

I'm confused. If by "make a loan" you mean "lend" and "acquire a loan" means "borrow", then it seems you are comparing apples and oranges.

For example lets say a new bank has $100 of deposits (it owes its depositors $100) and actually has the $100 on hand. Lets say I loan $10 from it. The bank now has $100 of deposits (it owes $100), it actually has $90 on hand. So you see, the money does not come out of thin air, there is no inflation.

This misses a piece of the accounting. The bank's assets change from $100 cash to $90 cash plus a $10 loan (as lender). The total is the same. I agree there is no inflation in this transaction, but there was in the one I described. In this transaction, the amount of assets and liabilities remain the same. In the transaction I described, both increased.

There is a difference between a bank giving out a loan (where it still owes the money) and the Fed giving out a loan (where it doesn't owe anyone).

I agree. The Fed mainly inflates by issuing Treasury bills, notes, or bonds. Banks can't do that. As I described, banks inflate in a different way.
(Edited by Merlin Jetton on 9/09, 5:59am)

Post 12

Tuesday, September 9, 2008 - 2:08pm

Greenspan's interview on CNBC with Maria Bartiromo

A self-described libertarian Republican, Greenspan has a reputation for being wary of giving the government extra powers.
However, in crisis situations, there needs to be a clear process for handling bailouts, rather than depending on the Fed to do so, he reckons. A high-level panel of financial officials should be given broad authority to quickly determine whether a failing company poses a sufficient threat to the entire U.S. economy, he recommends. If so, the company would be shut down.

He expects that inflation won't really heat up until the subprime crisis hits bottom, perhaps in a year or so and then we will have inflation "such as we have not seen for some time." When asked if he would serve on such a panel he explained that, no, it should be composed of professionals who could act at a moment's notice with, presumably, authority to act on behalf of the government.

Here we have a man so embroiled in his own profession and enamored of his ability to deal with the most complicated issues that can be conceived who has repudiated his libertarian and Objectivist convictions and believes that more government is the answer.

Sad.

Sam

Post 13

Wednesday, September 10, 2008 - 6:27am

What are your thoughts on how the price of gold and boost of the dollar has been manipulated?

I am not sure it can be sustained this time. I am no longer of the opinion that they know what they are doing (I think for a time, when Greenspan was running it and was younger and perhaps cared more, they did). I think we may be headed for just that - a pretty bad bout of it too.

Post 14

Wednesday, September 10, 2008 - 6:45am

Will Wilkinson of the Cato Institute gave a commentary on NPR's Marketplace this morning. Here's the link. It's a brief but interesting note on the Fannie Mae and Freddie Mac bailout.

For those who don't know him, Will is an erstwhile objectivist who, when he was a graduate student, attended and spoke at the Atlas Society Summer Seminars. He lost his way, but he's not totally in the dark.

Thanks,
Glenn

Post 15

Wednesday, September 10, 2008 - 8:04am

Glenn, thanks for posting the link.

Fannie Mae and Freddie Mac mortgage-backed securities contain with them guarantees that the investors will receive all interest and principal promised. In other words, they are insulated from default risk of the mortgagees. The timing of when they will receive them differs a little.

I have little doubt about one thing. The designers and supporters of these guarantees anticipated a few "snowflakes" spread out over time, i.e. a few individual mortgagees defaulting. They didn't anticipate an avalanche.

These government-created insurers (Fannie and Freddie) are akin to an insurance company (more exactly a reinsurer) that writes catastophic coverage (like for hurricanes). The insurer collects a small premium because a claim is a low probability event. The insurer can collect the small premiums for years and do well because there are no or few claims. Then boom! There is a catastrophe and the insurer is overwhelmed.

A similar thing happened to MBIA and Ambac, except they did it writing credit default swaps. Have a look at their price charts covering the past 12 months.

(Edited by Merlin Jetton on 9/10, 10:44am)

Post 16

Wednesday, September 10, 2008 - 11:17am

The government hasn�t just manipulated the housing market with below market mortgage rates but home owners have had special deductions that make it almost insane not to eventually buy a home. Here�s one fellow who�s not only protesting the bail-out but the injustice of the tax system stacked against those who don�t own a home. He's got a good point.

Post 17

Wednesday, September 10, 2008 - 1:07pm

I was saddened by the comments to the article by Wilkerson - they show how little the public understands of economics or ethics.
There were some intelligent comments, but look at these awful comments (my summaries):
- Bailouts are ok as long as the participants (CEOs) pay a price and it doesn't happen again????
- We need to level the playing field so foreign competition doesn't make us have bailouts?????
- The big three automakers should not get a bailout because they haven't been ardent enough in following governments calls for more fuel efficiency and lower emissions????
- the lesson should be that government regulations aimed toward the good of the public *must* be enforced. (then we wouldn't need a mortgage bailout)????
--------------

I agreed with the Justice for Renters article and thought it well done, but for one point. Zoning should be dumped all together - not just modified. It should be replaced with covenants which are free market.

Post 18

Wednesday, September 10, 2008 - 2:23pm

I can sympathize with the author of the Justice for Renters article. However, politicians and the IRS will probably not be favorable to it. The property owner gets a deduction for any mortgage interest on the property, so giving one to the renter also would make a double deduction.

Post 19

Wednesday, September 10, 2008 - 3:18pm