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Stock Market Trend Forecast March to September 2019

US Tax Payer Takeover of Fannie Mae and Freddie Mac, The Mother of All Bailouts

Companies / Nationalization Sep 07, 2008 - 02:41 PM GMT

By: Chris_Ciovacco

Companies

Best Financial Markets Analysis ArticleThe text below is taken directly from the government's announcement.

The Good News For Taxpayers:

"With this agreement, Treasury receives senior preferred equity shares and warrants that protect taxpayers. Additionally, under the terms of the agreement, common and preferred shareholders bear losses ahead of the new government senior preferred shares."


"While conservatorship does not eliminate the common stock, it does place common shareholders last in terms of claims on the assets of the enterprise."

"Similarly, conservatorship does not eliminate the outstanding preferred stock, but does place preferred shareholders second, after the common shareholders, in absorbing losses."

The Bad News For Taxpayers:

“To promote stability in the secondary mortgage market and lower the cost of funding, the GSEs will modestly increase their MBS portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off, eventually stabilizing at a lower, less risky size.”

  • [Ciovacco Capital Management (CCM) comment: This means taxpayers will take on more risk in the form of additional mortgage-backed securities above and beyond what Fannie and Freddie have now. No one else in the free market wants to take on this risk, so the taxpayers will do it.]

"Treasury will ensure that each company maintains a positive net worth."

  • [CCM comment: This should read “the taxpayers will ensure each company maintains a positive net worth.”]

“The second step Treasury is taking today is the establishment of a new secured lending credit facility which will be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.”

  • [CCM comment: The credit facility is ultimately backed by the taxpayers. No one else wants to lend Fannie and Freddie money, so the taxpayers will do it.]

“Finally, to further support the availability of mortgage financing for millions of Americans, Treasury is initiating a temporary program to purchase GSE MBS.”

  • [CCM comment: No one in the free market wants to buy these mortgage-backed securities (MBS) from Fannie and Freddie, so the taxpayers will do it.]

The Spin For The Public:

"Preferred stock investors should recognize that the GSEs are unlike any other financial institutions and consequently GSE preferred stocks are not a good proxy for financial institution preferred stock more broadly. By stabilizing the GSEs so they can better perform their mission, today's action should accelerate stabilization in the housing market, ultimately benefiting financial institutions. The broader market for preferred stock issuance should continue to remain available for well-capitalized institutions.”
  • [CCM comment: This means those of you who own preferred stock issued by banks and financial institutions should not be concerned if the value of Freddie and Fannie preferred and common shares plummet in the coming days and weeks. Everything is fine.]

“Nothing about our actions today in any way reflects a changed view of the housing correction or of the strength of other U.S. financial institutions.”

  • [CCM comment: Even though we told you Fannie and Freddie were fine five weeks ago and now we feel we must take them over, you should trust us when we say the housing market is going to be fine and the banks will be fine too. No need to panic and no need to sell your stocks.]

NOTE: The portion of the article below was written on Saturday before Sunday's detailed Fed announcement.

Welcome To The Mortgage Business

As a U.S. taxpayer and private citizen, I never intended to enter the mortgage business. According to reports published after the markets closed on Friday, all U.S. taxpayers will soon be active participants and financial stakeholders in the U.S. mortgage market. When a homeowner decides to “walk away” from their mortgage obligation or cannot make the payments for any reason, you and I, without our consent, will be obligated to help.

What Are We On The Hook For?

Fannie Mae and Freddie Mac buy mortgages from mortgage originators. They pool the mortgages and sell an interest in the mortgage pool in the form of bonds. The principal and interest payments from the homeowners pass-through to bondholders in the form of a payment. If some of the mortgage holders default or simply walk away, Fannie and Freddie guarantee principal and interest payments to the bondholders. In the very near future, you and I as taxpayers will guarantee the principal and interest payments to the bondholders. You and I will stand behind what the New York Times referred to as “huge potential liabilities” which could cost the taxpayers “tens of billions of dollars”. Welcome to the mortgage business.

Fannie & Freddie Part Of The Problem: Guarantees Encourage Lax Lending Standards

Mortgages carry risk. If you place a guarantee behind a mortgage-backed security, like Fannie and Freddie bonds, there really is no risk to the investors who keep supplying capital to the mortgage market. As investors supply more capital to the system, more questionable mortgages can be written and builders can keep building more houses. Why is anyone guaranteeing mortgages? Placing a guarantee behind a risk asset creates moral hazards. Why? Because the loan originators do not care if the mortgage holder keeps making their payments since they can sell the mortgage to Fannie and Freddie, who in turn will place a guarantee behind the mortgage.

The guarantee behind Freddie and Fannie bonds were and will continue to be a source of moral hazard. If you remove the guarantee and Fannie and Freddie from the entire system, banks and investors would treat mortgages as risk assets, which is what they are. Instead of propping up Fannie and Freddie with taxpayer funds and guarantees, both firms should be gradually removed from the system. The free market can supply mortgage capital to people who have the necessary debt-to-income ratios and credit history. Loans should be made to people who can pay them back. The current state of the mortgage and housing markets clearly illustrates the results of placing guarantees behind risk assets, which is what Fannie and Freddie do. Fannie and Freddie are part of the problem, not part of a solution. Selling a house to someone who cannot make the payments is not helping anyone and is not part of the American Dream.

Government Cannot Keep Spending Money It Does Not Have

If you are worried about the sustainability of Medicare and Social Security, this announcement will not help you sleep at night. Our government is rapidly moving down an unsustainable path. The longer we continue to plug holes with more taxpayer commitments, the harder the eventual and inevitable fall will be. We are moving closer and closer to the United States losing its AAA credit rating. The decisions being made today have serious long-term economic consequences. The most recent bailout is “good news” in the short-run and for the short-sighted, but bad news in the long-run for all Americans. This bailout significantly damages our country's long-term financial outlook.

"Treasury Secretary Hank Paulson swatted back reports of government nationalization of Fannie and Freddie, which would mean making explicit what, has long been an implicit taxpayer guarantee of their liabilities. This would instantly add $5 trillion in liabilities to the federal balance sheet, doubling the U.S. public debt burden and putting America's AAA credit rating at risk. This is a nightmare scenario for taxpayers." Wall Street Journal, Saturday, July 12, 2008

Changing the Rules In "Free" Markets Over The Weekend

As stocks for no apparent reason found some support late on Friday afternoon, I repeatedly searched Google News right up until the close on Friday. For those of you who do not use Google News, it enables you to search thousands of news outlets for stories on any topic. It is a great way to make sure you are not missing something which may affect asset prices. Before the markets closed on Friday, I searched for Fannie and Freddie, but found nothing, not even a rumor of any government intervention or possible capital injections. I chalked Friday's somewhat unusual strength in financial stocks up to the persistent rumors that Lehman Brothers (an investment bank/brokerage) was close to making an announcement to help stop the bleeding on their balance sheet.

After Hours and Weekend Bailouts Leave No Opportunity for Action

The first reports of the impending government bailout came around 4:40 pm ET on Friday; forty minutes after the markets had closed. The initial reaction to the news from the financial markets on Monday will no doubt be positive. Treasury Secretary Henry Paulson sold his plan for Fannie and Freddie to Congress saying he had no plans to use the authority. In recent weeks, Treasury spokespersons reiterated there was no plan to take any action. The law giving Paulson the authority to intervene was signed by President Bush only five weeks ago. The last public comments by Paulson were made on August 10th when he reiterated he had “no plans” to use his authority. As a taxpayer and investor, I question Mr. Paulson's credibility given the recent public statements and this weekend's news. What has changed so dramatically since August 10th to warrant a bailout over a weekend? It is nearly impossible to believe plans were not being made behind the scenes for what now appears to be a full bailout at the taxpayer's expense. Yet, we were told by our trusted public servants that no action was imminent. I thought transparency was part of a free market system.

Those of us close to the financial markets knew it was only a matter of time before this announcement would be made, which does not mean we agree with it. The announcement is not a surprise, it is the fact that Feds went from “no plans” for intervention to Congressman Barney Frank admitting this Saturday that intervention will take place. Based on recent government intervention (Bear Stearns and the Fannie/Freddie July announcement) , it appeared very likely the Feds would wait until Fannie and Freddie's stock came under extreme duress or until a new issue of Fannie or Freddie bonds received a very poor bid from the market. Once the situation turned bleak, a transitory statement from the Treasury stating ‘we are exploring all options' would have given participants in the free market some time to prepare. Instead, the Feds acted in the absence of an immediate crisis, no transitional statements from the Treasury, no warning…. just another weekend surprise. It is disturbing that we have now reached the stage where the government is intervening in the free markets before there is a crisis to provide cover for their actions. Policy makers must assume government participation in the free markets is now an accepted practice. They no longer try to pretend their intervention is warranted due to an immediate crisis which leaves them 'no choice' but to act.

The Markets May React Positively, But the News and Long-Term Outlook Is Not Good

The bailout is being announced now because the policy makers know a bottom in the housing market is not imminent. If there was even a remote possibility of an impending turn in housing, do you really think a Republican administration is going to announce the bailout of public companies two months before a Presidential election? This bailout sends a clear message that things are bad and they are likely to get worse before they get better.

This bailout tells us that more foreclosures are coming, which means more problems lie ahead for banks and brokerage firms. This announcement will help moderately improve the availability of mortgage credit, but it does not directly address the core economic issue of supply and demand in the housing market. Short of the government bulldozing homes, it is going to take more time to work off the inflated inventory of homes. At this point, I'm sure the government would be happy to state it has “no plans” to bulldoze homes. As long as the supply of homes remains high, prices will continue to fall. Based on history, we can expect some hope when the inventory of unsold homes falls to a 6 to 7 month supply. We currently have a 10 to 11 month supply of unsold homes. It does not take a Harvard MBA to figure out prices have further to fall in most markets around the country.

Even if sales increase, sales at lower prices mean continued deterioration of the value of assets held on bank balance sheets. As a result, banks will continue to be in need of capital injections. More write-offs are coming. Banks will remain reluctant to extend credit. Tight lending standards are not good for an economy which is highly dependent on credit. Tight lending standards mean fewer buyers for all goods and services. Fewer buyers lead to a weaker economy. A weaker economy leads to more job losses. Job losses lead to more mortgage defaults….and around and around we go until the supply of homes is reduced to a reasonable level.

The government's bailout of Fannie and Freddie does not make things much better, but it does prevent them from getting worse in terms of further constraints on Fannie's and Freddie's ability to support the mortgage market. My guess is Wall Street will once again declare this signals the end of the financial crisis, just as they did after the Bear Sterns bailout and the first Fannie and Freddie announcements in July. While this is truly distressing news for taxpayers and the long-term outlook for the dollar, it is good news for the financial markets in the short-run since it will remove one layer of uncertainty. However, it is a stretch to believe this most recent unprecedented move by our government will mark an end to the credit crisis. A good way to sum up this situation is that this announcement is good news for traders and bad news for longer-term investors and taxpayers. While we can expect Wall Street's positive spin on the big picture next week, the real big picture is housing prices have further to fall, banks still face serious problems, and the financial stability of the U.S. government continues to deteriorate.

The Markets Are Running Out Of Things To Look Forward To Down The Road

Financial markets are always looking forward, albeit only about three weeks in the current trading-oriented markets. The markets have looked forward to Fed rate cuts and government bailouts since the credit crisis began. Now that the Fannie and Freddie news is out, I'm not sure what the markets have to look forward to.

How Does This Affect Our Current Investments?

This article was written on Saturday before the formal details of the Feds plans were announced. Therefore, it is difficult to speculate on the market's reaction. This news could spark a rally in stocks which lasts several weeks. In the short run, defensive positions will most likely come under pressure and more speculative positions will benefit. In the long run, I'm not sure too much has changed. We'll continue to closely monitor the situation over the next few days.

By Chris Ciovacco Ciovacco Capital Management

    Copyright (C) 2008 Ciovacco Capital Management, LLC All Rights Reserved.

    Chris Ciovacco is the Chief Investment Officer for Ciovacco Capital Management, LLC. More on the web at www.ciovaccocapital.com

    Ciovacco Capital Management, LLC is an independent money management firm based in Atlanta, Georgia. As a registered investment advisor, CCM helps individual investors, large & small; achieve improved investment results via independent research and globally diversified investment portfolios. Since we are a fee-based firm, our only objective is to help you protect and grow your assets. Our long-term, theme-oriented, buy-and-hold approach allows for portfolio rebalancing from time to time to adjust to new opportunities or changing market conditions. When looking at money managers in Atlanta, take a hard look at CCM.

    All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors and tax advisors before making any investment decisions. Opinions expressed in these reports may change without prior notice. This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. The investments discussed or recommended in this report may be unsuitable for investors depending on their specific investment objectives and financial position. Past performance is not necessarily a guide to future performance. The price or value of the investments to which this report relates, either directly or indirectly, may fall or rise against the interest of investors. All prices and yields contained in this report are subject to change without notice. This information is based on hypothetical assumptions and is intended for illustrative purposes only. THERE ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO ACCURACY, COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION CONTAINED IN THIS ARTICLE. PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.

Chris Ciovacco Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Comments

ejhickey
08 Sep 08, 02:56
Fannie and Freddie Mortgages

Good article. I hadn't realized that I am now in the mortgage business. One thing troubles me. If a current homeowner whose mortgage is now owned by Federal Government decides he is no longer going to pay his mortgage but is going to continue to live in the house, what will the Federal Government do? Start foreclosing on its own citizens? It is one thing for a private bank to foreclose on a homeowner. But when it is a government foreclosing its citizens (i.e. voters) things might get a bit sticky.


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