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The Red Sea

Posted by Larry Doyle on April 24, 2009 11:26 AM |

While there is tremendous focus on the Bank Stress Tests, there remains limited focus overall on the centerpieces of our domestic housing finance industry. I am talking about Freddie Mac, Fannie Mae, and the Federal Home Loan Banks. Some have categorized these institutions as “black holes.” I believe a more appropriate designation would be The Red Sea as these institutions are awash in losses and continue to bleed money.

We may never know the circumstances surrounding the death of acting Freddie Mac CFO, David Kellerman, but there is a lot of focus by government officials on these institutions. There has been much less focus by private analysts. To that end, I am most grateful to Bloomberg’s David Reilly for reporting on Fannie Mae Creates Housing Mirage With Bum Loans.

Effectively, Fannie Mae is giving funds away to very high credit risk individuals who would have otherwise most likely already defaulted on their mortgages. As Reilly reports:

Give money away. That was a solution to the housing crisis mortgage giant Fannie Mae hit on last year.

Faced with growing numbers of homeowners unable to make mortgage payments, Fannie decided to fund loans to borrowers that were instant losers.

The point was to buy time. Even though those loans resulted in a $453 million loss, they helped keep troubled homeowners from defaulting. That meant Fannie for now didn’t have to make good on loan guarantees that may have cost it as much as $2.4 billion.

Make no mistake, this Fannie Mae program was also being utilized by Freddie Mac. Reports have come out that Freddie Mac’s Kellerman was pressured by Freddie’s accountants to improperly report their financials. In a similar vein, Fannie is playing another version of the “shell game” in order to buy time and forestall losses.

The relaxation of the mark-to-market accounting rule along with the government programs (TALF, TARP, PPIP) are also versions of the “shell game.”

This scenario is ultimately one enormous gamble that consumers and investors will both be in better financial position down the road than they are currently. From a different perspective, the government is borrowing future earnings to pay current debts.

Where was that last tried? In Japan in the 1990s, these stall tactics created more stagnation than anything else. Reilly highlights how this may play out here:

Markets may not rebound as quickly as some investors expect, meaning time might not heal the wounds of borrowers who can’t meet payments today. That would leave them in even worse shape in the future. And by failing to deal with problems now, financial institutions may cause them to grow even bigger.

That’s sure to lead to nasty surprises down the road at individual banks. It also promises to lengthen the economic slump by preventing markets from finding natural bottoms that allow excess inventory to be sold.

Fannie’s program shows how potentially big losses are still festering within the system, unbeknownst to investors.

As you read this, perhaps you are thinking that I am looking at the glass as half empty. Well, what more can we glean from Fannie’s report to further clarify the credit quality of these borrowers and their underlying loans? Thank you, Mr. Reilly:

Fannie funded $462 million in such loans during 2008. The company tells investors in notes to its financial statements, though, what it thinks the loans are actually worth.

Based on market prices, Fannie said the loans had a value of just $8 million. That’s right, the loans, which are in many cases just months old, were worth 1.7 cents on the dollar.

If you are scratching your head right now, let me explain. Fannie Mae literally gave away $462 million dollars so it would not write off $2.4 billion dollars on a large number of second liens.

Quite a way to run a business. Although, I guess one would not call Freddie Mac and Fannie Mae a business right now. Businesses have a profit motive. These agencies are now nothing more than extensions of government welfare programs with lots of red tape in the midst of The Red Sea.


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