With Fannie and Freddie common and preferred all down 80-90%, it might seem a little persnickety that I'm irritated that they have any value whatsoever. That the U.S. taxpayer can be on the hook for future losses yet shareholders not be completely wiped out is absurd and disgraceful.
A lot has been written on this bailout, so I'll just focus on a few areas. Let's start with who's to blame. If you listen to management or government officials, no one is really to blame as they attribute the downfall to the housing bust. Funny how that works. If house prices had only kept going up at an unprecedented rate, everything would have been fine. We'd all be millionaires sipping umbrella drinks and stroking our cockapoos in our newly installed home theaters with our mortgage brokers as we prepared to take another slug of cash out of our residential ATMs to fund the botox injections we'll need to stop all that smiling over our good fortune.
The truth is that there is plenty of blame to pass around. The very structure of the Fannie and Freddie has been flawed from the beginning, and we can thank Congress (and FDR) for that. Coupling profit-making with a government mandate to make home ownership more widespread was never very neat and tidy. This was made very clear recently when Congress pressured Fannie and Freddie to expand their activity to the less credit-worthy at a time when housing was weakening. That was exactly the wrong thing to do. It's like hitting the gas rather than braking when the car in front of you slows.
We can also place some blame at the feet of their regulator (OFHEO). Back in March, OFHEO lowered the amount of capital that Fannie and Freddie were required to hold. As I wrote in my very first post on this blog, "...lowering capital requirements during a time of distress seems quite the opposite of what common sense would dictate. Credit losses are rising and asset values are falling, so let's reduce our safety cushion! Sounds like dot-com math to me." The regulators should have required Fannie and Freddie to raise capital, curtail new lending, and increase prices.
Of course, management and the board are to blame as well. They had a front row seat to what was unfolding in the housing and mortgage market, and they should have known better than anyone that it was time to pull back, take less risk, and bolster capital. They also should have known better than anyone just how weak their capital position was. Perhaps the CEOs were too busy counting the millions they received in compensation to bother with such trivia.
So, let's not blame the housing bust. Busts follow bubbles, and isn't it the job of management and regulators to account for and adjust to the dislocations that occur at such times?
What does this bailout mean? First of all, U.S. taxpayers will now be stepping in and shouldering the risk of this housing collapse. This obligation could run north of $1 trillion. Although the U.S. taxpayer is now on the hook for future losses, foreign governments around the world have just been bailed out and will be made whole on the debt that they own. Perhaps this is why the dollar continues its rally on this news. We're telling our foreign benefactors that we're willing to sacrifice ourselves to make them whole. Good deal for them. Bad deal for us.
The implications of this bailout for correcting the scourge of moral hazard (the propensity to take increased risk when you believe the government will bail you out if you fail) are grim. The Treasury and Fed continue to pay lip service to moral hazard as they commit to serial bailouts. What a message it would have sent if Fannie and Freddie had been allowed to fail, and shareholders and debtholders had to go through Chapter 11! It would have been earth-shattering. It would have clearly sent the message that the government does not exist to bail out industry and that there is a cost to taking higher risks. Stop laughing. A guy can dream.
What does this mean for the market? Judging by the initial response, market participants seem to think that this is unquestionably positive. As is typical, I disagree. The market hates uncertainty, and the bailout definitely helps to resolve some uncertainty near term. Thus the rally. So far during this bear market, the bulls have tried to rally the market on every government intervention. I would be shocked if any form of government intervention actually marks the low of this bear.
Does this bailout change the overhang of housing inventory? No. Does it encourage banks to lend more? No. Will it prevent future foreclosures? No. Does it bolster the consumer's balance sheet? No. Does it address the commercial real estate imbalance? No. Does it create new jobs? No. Does it bolster the capital of other financials? No.
Importantly, this bailout does nothing to change the fundamentals impacting the country. The bulls can have their 300 point day, but eventually they'll have to face the fact that this wasn't done from a position of strength. Rather, it illustrates the weaknesses and challenges our economy faces. Until this is adequately reflected in valuation, it would be foolish to chase these knee-jerk rallies.
Disclosure: The Rubbernecker is short moral hazard and the socialization of losses.
