Congress To The Rescue

Oh great, we're all waiting for Congress to "save us" from ourselves in terms of a Bailout Package to deal with bad mortgage paper.

The history of where we are is long and undistinguished. It all started with Jimmy Carter's signing into law the Community Reinvestment Act of 1977, expanding the charter of Fannie Mae and Freddie Mac to increase home ownership. Bill Clinton also got into the act in 1995 and 1998, pushing for further home ownership, as well as the beginnings of the "sub-prime" segment of the market. George W. Bush called for further home ownership for lower income people in 2005. Along the way, efforts to put a lid on Fannie Mae and Freddie Mac were thwarted-- bills to address the oncoming threat posed to the system failed in Congress in 2003 and 2005.

With all of this, we now see the disastrous effects of relaxing the loan underwriting process, including "no doc" loans to people who were under-qualified to make a home purchase. Then we saw the rise of the "zero down payment interest only Adjustable Rate Mortgage", followed by the "negative amortization ARM". These work fine as long as home values are rising, and as long as interest rates do not rise; unfortunately the exact opposite occurred.

The United States is a country built upon credit, and periodically we undergo a financial crisis, a credit bubble, irrational exuberance or whatever other term we want to use. But the reality is that it is *not* irrational to borrow heavily when interest rates are so low; the Fed was basically begging people to borrow. In fact, on a 6% fixed rate mortgage, once you subtract the tax savings on the mortgage, and then subtract the inflation rate, the government is practically paying us to own a home. When home values go up, local tax revenues go up too; when people quit their jobs to flip houses, Federal tax receipts go up. Our long history of pushing the "dream" of home ownership has finally caught up with us, and the message is: there's no free lunch.

And as much as I am opposed to a bailout or rescue package, the alternatives look pretty grim. If the Paulson plan were implemented, Congress would basically take hold of $700 Billion of bad mortgage paper, create a market for it, buy credit-starved institutions some time and liquidity, and eventually (probably) sell the mortgage paper at a later date for a profit. The estimate is that the $700 Billion would buy about $2 Trillion in bad paper (i.e. 30 cents on the dollar). To a market guy like me, this looks like the "trade" of a lifetime, and one that could not only work, but put a huge positive number back into the Treasury at a later date. However, it has to work politically, with checks and balances (not a bad thing). But we're 34 days away from a Presidential election, and therein lies the rub.

Fannie and Freddie In Conservatorship. More Moral Hazard Ahead?

Since July 2007, the financial system has been an absolute mess. This of course has led to liquidity concerns among certain banks, and most recently to the virtual collapse of Fannie Mae and Freddie Mac. This is truly unprecedented. We now have two publicly traded companies (Fannie and Freddie) that were both "implicitly" backed by the U.S. Government, and due to the latest round of liquidity concerns and bad loans, the U.S. Government has made it an "explicitly" backed relationship.

While I decry bailouts and moral hazard, I honestly do not see any other options with this. And the lawyers actually made a smart move too, putting Fannie and Freddie into Conservatorship, rather than Receivership. Why is this important? Well, the distinction is that in receivership, a company continues operations until it completely winds down its commitments (i.e. this would have led to a run on the banks, institutions that trade mortgage backed products would have been destroyed, or in other words, the entire system would have frozen up). By putting these entities into Conservatorship, they continue operations with U.S. Government oversight, the Government backs the paper, liquidity continues, and the market for mortgage backed products continues, though sluggishly.

Famed investor Jim Rogers noted that "the U.S. has become more Communist than China". What he means is that we have virtually created a system where Risk has been Socialized for the benefit of wealthy people, and Rewards are still benefiting wealthy people. I absolutely agree with this assessment, and the risk premium is a big factor in investing. If investors and Wall Street types continue to have their risks socialized via de facto government bailouts, what's to stop them from taking even more undue risks in the future? This is just a reward for moral hazard in the system.