Wishful Thinking

Author: Bob Eisenbeis, Post Date: September 10, 2008

Markets breathed a sigh of relief on Monday following the government bailout of the debt holders of Freddie Mac and Fannie Mae. But one wonders if that sigh is like that of the murderer who received life in prison rather than the death penalty. Once the immediate threat was removed then the reality of the long run set in, and it isn’t pretty.

We have a nasty mess our hands, and it isn’t helped by the fact that few of the parties to the problem have faced up to what the true causes were. For example, consider the observations of Senator Shelby quoted in a Bloomberg article on Tuesday, September 9.

“Once they got someone looking closely at Fannie and Freddie’s books, they realized there just wasn’t adequate capital there,” US Senator Richard Shelby of Alabama, the ranking Republican on the Senate Banking Committee, said after a briefing by Treasury officials. “They found out they had a house of cards.”

Coming from someone who was in Congress during the accounting scandals of the Frank Raines era and the failure of Freddie and Fannie to produce audited financial statements for many years, such a statement is incredible. The regulators and accountants have been in those two institutions for several years, trying to unravel the creative regulatory capital accounting they employed. It is hard to believe that the whiz-kids from Morgan Stanley were able to divine in less than a couple of weeks accounting problems that outside accountants and regulators couldn’t discern in years.

The fact is that problems weren’t found because no one wanted to find them. And if they were found, the fallout from Congress, as the Wall Street Journal’s Tuesday editorial correctly points out, would likely have been to protect the institutions from regulatory sanctions.

The bailout of debt holders doesn’t solve either the problem of Fannie and Freddie nor the problems in the housing market. Until housing prices find their new equilibrium, the demand for new mortgages will be slow and delinquencies will run their course. The drop in mortgage rates from this new temporary subsidy program will only have a marginal effect, if any, and the current problems make any attempt on the part of the Federal Reserve to begin fighting inflation by raising rates a non-starter in the near term.

All the intervention and government support also now creates expectations that will constitute moral hazard of the worst kind, because it extends far beyond just financial institutions and their incentives to take excessive risk. The bailout also rewards the “lobbying” efforts by foreign central banks and governments, which was widely reported in Tuesday’s press, and will only encourage them to keep at it when the risk in their dollar-denominated investments threatens to be realized. Actions to protect borrowers will encourage others to take on debt and engage in the same excessive leverage activities that home buyers did. The end result will only be more leverage and risk taking.

Speaking of leverage, it is remarkable that so little attention has been given to what turns out to be the common denominator affecting borrowers, lenders, and financial markets and that was the root catalyst of the current turmoil. Homeowners were highly leveraged, with little or no equity down payments. Lending institutions were encouraged by low regulatory capital charges on mortgages to take on leverage. Derivative securities vehicles relied upon highly leveraged structures to make them profitable. None of this was even considered by Chairman Bernanke when he reviewed the problems in his Jackson Hole remarks.

Finally, there is the issue of the need for an exit strategy to get the government out of the housing finance business. It is not likely to happen any time soon. Treasury now has a huge mortgage portfolio, due to its acquisition of Freddie and Fannie, and that portfolio will grow because of the new lending and liquidity facilities that Secretary Paulson has created. These programs will have to be managed, and he has already indicated that it will be done by an outside asset manager. Would you care to guess where the asset managers are likely to come from? To think that the government can run a mortgage lending and finance business better than the private sector or that the new management can change the flawed business model of Freddie and Fannie is wishful thinking. These institutions will borrow in the market at subsidized rates and distort the pricing decisions that the market might otherwise make.

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