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Audit Freddie and Fannie

Posted by Larry Doyle on December 30, 2009 12:16 PM |

Who will reveal the truth and consequences embedded in the operations of Washington’s newly designed slush funds housed within Freddie Mac and Fannie Mae? The Washington Way all too often pays off those who promote the administration’s interests (both Republican and Democrat alike) while sticking future generations with an ever larger bill.

Is slush fund too harsh a characterization for a Washington-issued blank check? In my opinion, a blank check in Washington has never been anything other than that.

Ron Paul (R-TX) has created quite a stir in 2009 given his continual calls to audit the Fed. Who in Congress will call for the same treatment for Freddie and Fannie?

Let the record show that on December 30th, Sense on Cents is issuing what will be the first of many calls to audit Freddie Mac and Fannie Mae. Why am I calling for an audit of these entities?

Freddie and Fannie are de facto wards of the state, but their operations are housed off Uncle Sam’s balance sheet. As such, who will keep them accountable? Who will properly monitor their operations? Who will question their business practices?

I have no doubt that the blank check provided to Freddie and Fannie on Christmas Eve is nothing short of the continuation of Uncle Sam’s quantitative easing program currently managed by the Federal Reserve. Recall that the Fed’s quantitative easing program to purchase mortgage-backed securities is scheduled to end on March 31, 2010. At that point, if not prior, I fully expect the internal investment portfolios housed within Freddie and Fannie to reenter the marketplace and become the biggest buyer of mortgages.

Readers may wonder why I am so concerned about this activity. Look for economists, market analysts, and political pundits to promote this activity as both necessary and beneficial for the American housing market. This misinformed crowd believes Freddie and Fannie can issue debt at favorable rates, use the proceeds to purchase mortgages at prevailing rates, and make big, fat, juicy returns. Look for this overly simplistic analysis to be fed to the American public a lot over the next quarter and throughout 2010.

If it were that easy, and that is the Freddie/Fannie business model, why and how did these entities lose so much money? Don’t listen to those who would say it is sub-prime or Alt-a exposures that brought these companies to their knees. The fact is, Freddie and Fannie have not only mispriced risk across their core mortgage operations for a long time but continue to do so. The blank check is a clear indication to me that the mispricing of this risk is about to be increased dramatically.¬†In my opinion, this activity is extremely unhealthy for American housing over the long haul. Why? Let’s navigate.

Freddie and Fannie are now clearly in the too big to fail camp. The beneficial financing rates Freddie and Fannie can access in the capital markets provide a cheap source of funds to run their operations. Those funds are used to run the day-to-day operations. For a long time, a major component of the operations was the purchase of mortgages. The risks in purchasing mortgages are threefold:

1. Simple interest rate risk of rising interest rates and thus falling values on the mortgage-backed securities.

2. A greater risk is the prepayment risk embedded in each mortgage. Any homeowner in our country can choose to refinance his mortgage, or not, whenever he so chooses. That risk makes it challenging for an investor to determine and manage the effective duration of his portfolio. Fannie Mae was exceptionally horrendous at managing its effective duration risk.

3. The greatest risk is the credit risk of the underlying mortgages. This risk of default is guaranteed by Freddie and Fannie.

All of these risks are exacerbated by the blank check provided to Freddie and Fannie. That check will keep mortgage rates artificially low. What is wrong with that? It promotes borrowing from those who truly can not afford a mortgage. It promotes the purchasing of homes otherwise outside a borrower’s price range. It detracts from appropriately risk-based and risk-priced private pools of capital entering the market. It forces losses onto the taxpayer which would and should otherwise be borne private entities.

Ultimately, the transferral of risk to the American taxpayer is nothing more than a massive redistribution program.

If Washington truly wanted to support the economy, how about they issue a blank check in the form of small business loans to companies that create real jobs? Issue a blank check in the form of funds to entities which will provide credit cards at a mere 10% rate instead of the usury charged by our large Wall Street banks.

This blank check for Freddie and Fannie must be tracked.

America deserves an independent audit of Freddie and Fannie now and on a going forward basis.

I’d love to hear from those who disagree with my assessment. Please regale us with why Freddie and Fannie should not be subject to an aggressive and independent audit.

LD






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