Gary North

Reality Check (September 9, 2008)

Henry Paulson, the Secretary of the Treasury, blew through Washington, DC over the weekend like a category-three hurricane. While the world worried about Hurricane Ike, Hurricane Hank blew away the joint legacy of Franklin Roosevelt's New Deal and Richard Nixon's attempt to prove that he had become a Keynesian.

He announced the end of an experiment that began in 1938 (Fannie Mae) and was extended in 1970 (Freddie Mac). He announced, loud and clear, that the private mortgage markets in the United States had become dependent on two government-sponsored enterprises (GSE's), and that these two agencies had been weighed in the balance and found wanting.

It was as if Paulson had walked into the Bedford Falls Building and Loan and announced that the Federal government was taking over the whole operation. He would have had good reason, too. The entire accounting operation had been run by Uncle Billy.

In my previous report, "The Worst Economic Downturn in 60 Years," I mentioned the inevitability of the bankruptcy of Fannie Mae and Freddie Mac. I said that as the housing crisis continues to deteriorate, the Federal government would intervene in a massive bailout of these two officially nongovernmental agencies. Before the end of the day, the announcement came out of Washington that Paulson would have an announcement sometime on Sunday afternoon regarding the demise of these two outfits.

Sure enough, on Sunday afternoon, he announced that the Federal government was placing Fannie Mae and Freddie Mac under something called a conservatorship. That sounded comforting. Everybody likes to conserve assets. The trouble is, both of these organizations were in the process of going bankrupt. So, in order to conserve assets, Paulson concluded that they had to be swallowed up by the Federal bureaucracy.

It is still not clear exactly how this is going to work. It is not clear that Congress is going to approve it as promoted. Finally, it is not clear that the court system is going to approve it. It is quite possible that class-action lawsuits against the Federal government will be brought by shareholders. The government has intervened in two organizations that officially were not funded by the government.

Certainly, when you have a pair of organizations that are privately funded, and the heads of these organizations have taken out millions of dollars a year in salaries and bonuses, you have to say that maybe this is not normal for a Federal government agency. As a matter of fact, it is not normal for many kinds of agency. Yet this has been going on for years. Everybody in government knew what was going on. Congress did not intervene to stop it.

The two outfits were leveraged in the range of 50 to one. For comparison, the Carlyle Capital Corp., which went bankrupt earlier this year in just two weeks, was leveraged at 32 to one. So, if the government was not really legally obligated to defend these two organizations, then on what basis is the Federal government nationalizing them? I think the answer is clear. Politics: international and domestic.

International: Central Banks. In my previous article, I pointed out the real reason why there would be nationalization. The Central Bank of China and other central banks have purchased hundreds of billions of dollars in the bonds of these gigantic, over-leveraged turkeys. They purchased these bonds on the basis that the United States Government was standing behind them. Yet both agencies officially asserted openly that there was no such guarantee.

This did not matter for Chinese central bankers, who had lots of money to create and wanted to buy American bonds, so that they could keep the Chinese yuan from appreciating against the dollar. They wanted a higher interest rate than they could get by investing in Treasury bills and Treasury bonds. So, using newly created fiat money, they bought IOUs of GSE's. These enterprises have some minimal government guarantees of two or three billion dollars associated with them, but nothing in the range of the $5 trillion in mortgages that these two agencies have either purchased or guaranteed.

Domestic: Mortgage Market. These two agencies in 2008 were responsible for the packaging of at least 75% of all new mortgages written in the United States. That is to say, these two agencies constituted most of the American housing market.

Politically speaking, the United States Treasury justified its intervention in order to save the American housing market. But Congress had known since 2003 that the accounting procedures of both organizations were in complete chaos. The details appear in a September 7 story in the "New York Times."

There was no way for these organizations to exist if they had not been protected by the Federal Government from the Securities and Exchange Commission, an agency of the Federal Government. The protecting agency was the toothless Office of Federal Housing Enterprise Oversight. This was about as close as government has ever gotten to obeying a command of Jesus, who warned His disciples that the right hand should not know what the left hand is doing (Matthew 6:3). Jesus was speaking about voluntary charity. That was not the context of the Federal government's regulation of Fannie Mae and Freddie Mac.

Five years after the scandal of the lousy accounting reached Congress, the OFHEO was still trying to get a straight answer from each of them about their financial status. No one knew. Nevertheless, the companies assured investors and everything was going to work out. Congress, while admitting that there might be some problems, also did nothing to intervene.

Then, without warning, the Secretary of the Treasury announced unilaterally that the Treasury of the United States now stands ready to inject $100 billion of taxpayers' money into each of these collapsed boondoggles. What was the response of the world's stock markets of the world on Monday? They went up. The Dow Jones Industrial Average rose by 290 points. Investors loved to hear the news that taxpayers would bail out these two gigantic organizations in what is widely accepted as the largest bailout in American financial history. Everyone said that the free market had failed. Everyone lined up to praise the Secretary of the Treasury. "It had to be done."

One intervention leads to another. At each stage, the latest intervention is justified by free enterprise advocates because "it has to be done." At each stage, the errors accumulate, and so does waste. Then comes a new crisis and another intervention.

Mortgage rates went down in one day by about 3/10 of a percentage point. Yet it was all based on perceived meaning. The perception was that the Treasury's plan will apply to all of the existing packages of mortgages that Fannie Mae and Freddie Mac are on the hook for: old and new. But Congress has not voted on such a measure yet.

How much money are we talking about? The two agencies have guaranteed or have purchased $5 trillion in mortgages. If 10% of these mortgages go bad over the next three years, adding to the existing mortgages that have gone bad over the past two years, taxpayers could be on the hook for $500 billion.

Until a few days ago, the official estimate made by the Congressional Budget Office was that the United States Treasury would be on the hook for $25 billion. If anybody believed that figure, he is in need of professional counseling. Paulson speaks of a total of $200 billion of new capital being infused into these two organizations. This means almost immediately. If they had not been on the brink of bankruptcy, then it would not be necessary to pony up this much money. The housing market would have slowly recovered. The foreclosures would have slowly declined. There would be no problem in terms of liquidity in the mortgage market. But, obviously, we had a weekend intervention precisely because the liquidity of the entire mortgage market was at risk.

Paulson intervened specifically because the most recent evidence of the financial status of the two organizations indicated looming bankruptcy. That would mean the bankruptcy of the entire mortgage market United States. At the margin, these two organizations were making 75% to 80% of all the mortgages in the country. What matters is what happens at the margin. The private markets had dried up for new mortgages by the early part of 2008. If you think we have had a tight mortgage market, with 1.2 million homes now in foreclosure, imagine what would have happened if 75% of the mortgages that have been made this year had declined by 50%. What do you think would have happened to housing prices, housing liquidity, and public opinion regarding the future of the most important investment that the average American makes?

WEEKEND CRISES

The Federal government intervenes on a weekend only when it is facing a major crisis. That is why it intervenes on Friday evening. It does not want the world's stock markets to make a rapid assessment of the crisis which the government is facing. It does not want the free market to evaluate what the Federal government is doing.

Government officials want a time of calming over the weekend. Politicians understand that investors are innately optimistic. Investors want to believe that whatever the government does is going to save their investments. They want to believe that the market will recover, and do so rather rapidly. Politicians rely on this innate optimism to let investors calm down over the weekend. They are fearful of investors at any other time.

What we find is that the good news pushes up the stock market rapidly, and then loses its momentum by the next day. Whatever benefit is going to come from the announcement is going to come on the Monday following Friday's announcement of Sunday's emergency bailout. The fact that the stock market rose by almost 300 points, fell back by about 150 points, and rose late in the afternoon back by just under 300 points indicates just how skittish the market is. The good news does not maintain itself for very long.

Let us assume that Congress will pass whatever enabling legislation is necessary to guarantee the packages of mortgages created by Freddie Mac and Fannie Mae, past, present, and future. Let us also assume that class-action suits brought by angry shareholders will not be upheld by the courts. Let us assume, in short, that the U.S. Treasury gets what it wants. The mortgage market will be saved for the time being. What will this do for the 1.2 million families whose homes are in foreclosure? Furthermore, what will it do for at least another million families whose homes will be in foreclosure a year from now? Extend this foreclosure process out for another three or four years, which is indicated by the looming re-sets of the pay option ARM mortgages, which had been estimated at $500 billion. When these families receive notification that their monthly mortgage payments have doubled, will they be able to continue to make these payments? At least half of these people so far have not been able to do so. Yet the re-sets for the pay option ARMs only really began to accelerate in August 2008. They will continue to escalate until August 2011, and then taper off over the next year.

Add to this scenario the looming recession with the likelihood of unemployment moving above 7%. It is already at 6.1%. Add to this the fact that housing prices are falling worldwide. We are into the first international decline of the price of housing since the Great Depression. Central banks all over the world have purchased Fannie Mae and Freddie Mac bonds. The entire leveraged bond market is being held together by bailing wire and Scotch tape. The Federal government had to intervene over a weekend due to its belated discovery that the accounting scandal that became public knowledge in 2003 was worse than the government had supposed. These people are slow learners. But they are fast actors. The act over the weekend. Whenever they act over a weekend, the public can be sure that the crisis could no longer be deferred. The government finally had to stop kicking the can down the road. Yet the reaction of investors, every time, is for the stock market to go up on the Monday following the weekend surprise. This gives you some indication of the degree of optimism that undergirds the American stock market.

There was a lot of optimism regarding Friday Mae and Fannie Mae a year ago. Between August 2007 and August 2008, both organizations lost 75% of their stocks' value. Then, over one weekend, shareholders lost all the rest of it, or close to it.

Secretary Paulson announced there will be no more dividend payments to shareholders. The bailout was for owners of preferred stock, which guarantee a fixed rate of return. The other beneficiaries are the holders of the bonds. But owners of common stock shares got the shaft. Yet, a year ago, four years after the accounting scandals had arisen, three years into the continued payment of millions of dollars a year in salaries and bonuses to the senior officers of these private organizations, shareholders still thought that everything was just fine. In short, the shareholders were blithering idiots. They did not understand what the American housing market was going through, in mid-2007, despite the fact that the market had been in decline since the beginning of 2006. These people were slow learners. But, unlike Treasury Secretaries, who were equally slow learners, they cannot tap into the United States Treasury, unilaterally, on their own authority, to announce to the world a bailout is coming. They do not have the authority Secretary of the Treasury has, along with the chairman of the Federal Reserve System, to get Congress to validate what the weekend bailout had proposed.

Voters still think it is a great idea to have the Federal government intervene to the tune of $200 billion to bail out Uncle Billy. This gives you some indication of the slowness of the learning process among American voters. They are even slower than investors in Fannie Mae and Freddie Mac common shares. That is to say, they are very slow learners indeed.

WHAT NOW?

The American housing market will continue to deteriorate for the next two years, and probably over the next four years. It will be a buyer's market. There will be other weekend announcements. There will be other presentations by senior bureaucrats, aimed at Congress, telling Congress that it has to fork over more money to preserve the ideal of American home ownership. There are a lot of voters out there who will force Congress to do whatever is announced by the Secretary of the Treasury over a weekend.

Here is a man who is in the last four or five months of his tenure as Secretary of the Treasury, who makes a weekend announcement on the assumption that Congress is going to validate everything he says. He expects United States Congress to open the taxpayers' checkbook and write all the checks he says these two agencies need until he leaves office next January, plus all the checks his successor will need, to keep these two bankrupt boondoggles alive. And you know what? Congress will do it.

Any resemblance between the American housing market and the free enterprise system is purely coincidental. It is a fantasy market that has been created by monetary inflation by central banks all over the world. The central banks have used GSE bonds as legal collateral for the expansion of their money supplies -- bonds of overleveraged, nongovernment organizations that were presumed by the buyers as being backed by the Federal government.

As it turns out, this assumption has been correct. The mortgage market is too big to fail, yet it came very close to failing. Congress is locked in, now and forever more, to bailing out the mortgage market.

As with everything else Congress does, it will eventually impose new rules and regulations governing who gets how much money, on what terms, and what guarantees. The mortgage market had become a plaything of senior managers who milked the two agencies for tens of millions of dollars in salaries and bonuses, with the acceptance of this by the shareholders, only for the taxpayers to be told by Congress, at the command of the Secretary of the Treasury, to get out its checkbook and be ready to write the checks.

CONCLUSION

Does this mean monetary inflation ahead? Yes, it does. Does this mean them recovery of the housing market? Yes, it does. But both processes are going to take years. When a bubble pops, it takes years for that bubble to recover, even when Federal money is being poured into it. The public thinks there is going to be a return to the good old days. It still thinks the Federal government can put together the remnants left by Uncle Billy. It turns out the James Stewart was not running the system. It was being run by clones of Mr. Potter. The system had all the efficiency of Uncle Billy, all the ethics of Mr. Potter, and all of the financial reserves of George Bailey.

It was a wonderful unofficially subsidized life.

It is now an officially subsidized life.

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