Doubts emerge about whether Freddie and Fannie rescue will actually work: Kohler

The inevitable disappointment when it becomes clear that the bail-out of Fannie Mae and Freddie Mac doesn’t do the trick after all, or simply proves too much for the US Government, is likely to be a crushing event for the markets

We must all hope it does do the trick, but there is a long way to go before that can be confidently concluded.

And the first hurdle is $US1.4 trillion in Fannie and Freddie credit default swaps (CDSs) that seem to have been triggered by the bail-out.

According to Bloomberg this morning, 13 major dealers of CDSs agreed unanimously that the Paulson rescue of the two government sponsored enterprises (GSEs) constitutes a credit event triggering payment or delivery of the companies’ bonds.

There has never been a credit event of this size, so the consequences are unknown. It’s likely, however, that because the Government’s announcement said it would guarantee a positive net worth for the two GSEs, there could be little or no actual pay-out because the bonds will trade at close to par.

So beating hearts, having quickened, were stilled again.

The second hurdle is more fundamental. Who owns Fannie and Freddie’s defaults? The Government has put in $US1 billion of new capital and says it might put in up to $US200 billion more (while confidently asserting that it won’t have to).

But this is a $US5.4 trillion residential mortgage portfolio; $US200 billion covers losses of 3.7%. Remember that NAB wrote down its portfolio of AAA super senior residential debt by 90%.

So the Paulson bail-out is a band-aid that requires the wound to heal itself. Let’s hope it does.

The reaction to it among the financial commentariat in the US has been a mixture of scepticism and hope, but very few believe it will be that easy.

Floyd Norris in the New York Times points out that the Bush administration is trying to have it both ways.

Having allowed Fannie Mae and Freddie Mac to totally dominate the mortgage market, it is now putting them into conservatorship, with the aim of more conservative management, while at the same time making sure they “proactively work to increase the availability of mortgage finance” – that is, continue to grow as before.

In other words they are supposed to grow until 2010 and then start shrinking.

Mohamed El-Erian of Pimco, writing in the Financial Times, also sounds a cautious note, likening what’s happening to a “deleveraging hurricane”. He adds: “Unlike New Orleans, a significant part of the global economy still lies in the path of this hurricane.”

El-Erian says the success of this bail-out depends on two things; first whether it “crowds in” capital from both domestic and foreign sources, because the Government’s balance sheet is necessary but not sufficient, and second whether it is part of “a broader policy response that has both a domestic and international dimension”.

John Hussman of Hussman Funds is a bit more worried about it. “I’ll tell you one thing – unless Congress mandates that mortgage originators will be partially on the hook in the event that future mortgages purchased by the Government go into foreclosure, we’re going to have a ‘moral hazard’ problem of epic proportions. Without that provision, mortgage originators will be able to write bad mortgages and put US taxpayers on the hook.

“In any event, you can be certain that this bail-out will cost dramatically more than the ‘tens of billions’ that press reports suggest.”

Daniel Gross, writing in Slate.com, agrees with our own Robert Gottliebsen that the bail-out is really about saving the Peoples’ Bank of China: “The bail-out of Fannie Mae and Freddie Mac will be sold and marketed as an effort to shore up the US housing market. Maybe so. But it is mostly meant to shore up our damaged international financial standing, preserving leadership and making sure the US Treasury Secretary doesn’t get tarred and feathered at the next G-8 meeting.”

In the Washington Post, Steven Pearlstein says the crisis reminds us that, when left on its own, the private sector will over-invest when the housing market is hot and then abandon the market when the boom turns to bust. “That’s why Fannie and Freddie were invented, and why keeping them afloat now is crucial.”

He concludes it will now take several years for Fannie and Freddie to dig themselves out of their respective holes, even with the infusion of taxpayers’ money.

David Rosenberg, North American economist for Merrill Lynch, wonders whether the rally from this intervention is going to have much staying power at all. “We find it difficult to see how it is bullish that the heavy hand of government is needed to such an extent. In our view, the takeover of Fannie and Freddie is actually a testament to how broken the financial system is at this time, as Paul Volcker alluded to on Friday (‘This bright new system, this practice in the United States, this practice in the United Kingdom and elsewhere, has broken down. Growth in the economy in this decade will be the slowest of any decade since the Great Depression, right in the middle of all this financial innovation’).”

Rosenberg believes the problem of the GSEs is really just symptomatic of a much larger problem – excessive leverage. Correcting it is not over yet, even if it’s hard to estimate what innings we’re in – “but we believe it sure isn’t the seventh innings stretch”.

The Institutional Risk Analyst says Hank Paulson’s actions are a good half step in the right direction, but maintaining the fiction of private ownership of Fannie Mae and Freddie Mac only draws “greater and greater attention to the contradictions and strains” within each of them.

Goldman Sachs’ research team believes the measures are a net positive for the US dollar and a short term positive for the equity market.

Jeffrey Saut of Wall Street firm Raymond James says that while brokers will see it as another “Bear Stearns moment” and rally the troops with chants that the worst is over, it’s not that simple. “Regrettably, it is difficult for us to envision a discernable trend for the equity markets until the credit markets straighten themselves out; and that is just not happening as credit spreads above US Treasuries have not narrowed in months.”

But perhaps the most interesting analysis is by Michael Mandel, writing in Business Week. He likens the situation to the fate of Schrodinger’s cat.

Erwin Schrodinger was an Austrian physicist who developed a thought experiment in the 1930s to illustrate quantum mechanics. You imagine a cat in a sealed box with a flask of poison. You can’t see whether the cat has drunk the poison or not. Is it alive or dead?

Schrodinger argued that as long as the box is sealed, the two states – “cat alive” and “cat dead” – exist at the same time.

“What does this have to do with Fannie and Freddie?” asks Mandel. “For many years, Fannie and Freddie have occupied two states simultaneously. On the one hand, they have been operating as private profit-making enterprises, just like any other company. On the other hand, they have been operating with the implicit full faith and backing of the Federal Government, allowing them to raise money at a lower price than anyone else.”

This worked as long as no one looked inside the box. Fannie and Freddie could make lots of money, investors would feel safe, and the Government didn’t have to do anything.

“But guess what? The box has been opened, and it turns out that Fannie and Freddie really have been government agencies all the time (you can decide for yourself whether this means the cat is alive or dead). What’s more, once we know they are government agencies, there is no putting them back into the box and pretending that we don’t know. In fact, no matter what Paulson and his friends do, Fannie and Freddie are now permanently wards of the state.”

Mandel argues that, over time, Fannie and Freddie will become genuine government mortgage agencies, not making profits and not paying dividends – simply insuring mortgages as the Federal Deposit Insurance Agency (FDIA) insures deposits.

Perhaps if that happens quickly, the weekend bail-out will become a permanent solution and the post-bail-out bounce won’t turn into a rout.

But the essential problem is this; who is responsible for their bad lending decisions up to now – shareholders and bondholders, or taxpayers?

Fannie and Freddie have been buying and insuring sub-prime and Alt-A mortgages for a few years and now have a toxic portfolio of defaulting loans.

Who now gets the “bad bank”? If Schrodinger’s cat really is out of the box and can’t be put back, can US taxpayers actually afford to take on the Fannie and Freddie bad bank?

Then again, can the US Government afford not to, since its political allies, like China, are the shareholders and bondholders?

This article first appeared on Business Spectator