The Takeover Necessary?

Roger Schlesinger
Posted: Sep 10, 2008 9:55 PM
The Takeover Necessary?

You have to be in the industry to realize what was going on, or you have to accept what many experts and I are saying. Actually you don’t have to do either but looking from the outside in, things aren’t as clear as you might think. First off, Fannie and Freddie didn’t make bad loans; they bought derivatives secured by bad loans from the peddlers on Wall Street. Why? Your guess is as good as mine. It just might be the “grass is greener” theory that has ruled and ruined many a successful plan. It could be that bonuses to the executives depended on earnings and they felt this would be an easier way to improve earnings and help themselves to a bigger piece of the pie. If you saw how much this executive group was making, then “obscene” might be the thought that runs through your mind. Whatever it took to motivate these fellows (generic and not referring just to men), it proved to be their downfall, and hopefully not ours. Time will tell.

What made it necessary to take over these two giant mortgage companies? Primarily two occurrences: the inability for Freddie Mac to raise sufficient capital and the general unrest of China, Japan and Russia. Freddie Mac’s executives apparently told Treasury Secretary Paulson that they would quickly raise $5 billion from investors and simply failed to do so. Growing very nervous about whether the United States Government would back the two Government Sponsored Enterprises (Fannie and Freddie), China as holder over $375 billion of Fannie and Freddie securities intimated they may have started selling the bonds. It was reported that Secretary Paulson stepped in to avoid a double disaster: losing Fannie and Freddie’s ability to conduct business in the mortgage arena, and having a flood of their securities hit the credit market. He had already received permission to take drastic measures with Fannie and Freddie through the bailout bill that was passed and signed into law in July of this year.

Losing Fannie and Freddie most likely would have triggered a depression as basically no loans would be made in the United States mortgage market. The majority of loans made today are conforming (conforming to the rules of Fannie and Freddie) and with the GSEs in bankruptcy, the fear was the banks wouldn’t lend because they couldn’t sell the loans to Fannie or Freddie. Lack of liquidity is a worst-case financial scenario for any individual, business or industry. Try spending your real estate equity, antique collection, rare paintings or anything else you might have that isn’t readily turned into cash. Not likely to happen, and if it does it will be for less than the assets are worth and will take twice as long to accomplish as you thought. I do not want to think what would have happened to our economy, nor do I want to explain it to those who don’t know. Just think “unbelievable” and you will be pretty close.

The real owners of Fannie and Freddie, the stockholders, are basically wiped out. The preferred stockholders, primarily banks, also were left to spin in the wind. The Treasury received new preferred stock and the Chinese, Japan, Russia and the Cayman Islands were given U.S. Treasuries to replace their current holdings. Current tally: Stockholders, 0; U.S. Treasury, 1; China, et al, 1. Before you insist that we simply have to deal with the cold, hard reality of the situation, just know that the Cayman Islands bothers me because that is where all the “strange” money goes for shelter. Just an aside!

I believe that once Fannie and Freddie started feeling the heat, they made one basic business error: raising prices in hope to raise profits. Not exactly a Phi Beta Kappa move. With the mortgage market in a slowdown for lack of jumbo product and still adjusting to the loss of sub-prime, stated loans, and highly leveraged loans, a raise in prices for all loans that amortized over 30 years wasn’t exactly what borrowers were looking for. Executives with better business acumen might actually have lowered prices to increase volume and try to bring back the mortgage market. But without a trial balloon, Fannie and Freddie initiated FICO/LTV hits and increase the fees on cash-out, non-owner occupied and two- to four- unit properties. I believe the takeover validates the foolishness of this business plan (if you don’t believe me, see how the desperate airlines are looking even worse thanks to their baggage fees).

The immediate result of the takeover was the narrowing of the spread between mortgage backed securities (now being backed by the U.S. Government) and the U.S. Treasury bills, notes and bonds. Rates dropped the first day of the new arrangement by up to 3/4%, with the average drop about 3/8 to 1/2%. Mortgage volume jumped, but did it help real estate? It should have, but psychology dictates that if an action is taken to relieve a problem, people tend to believe the problem is even worse than it is and will freeze in response. This generally happens in the short run but corrects itself in time and eventually will provide the impetus to get real estate moving. Having real estate turn the corner is so important. Most of the Wall Street firms, banks and lenders who have written off huge amounts of money haven’t realized the losses as yet but simply marked their portfolios to current prices. This caused the large writedowns. If real estate comes back, the losses disappear and writedowns become gains, not losses.

So have we reached the end of the problems? As my late mother would say, “If you are alive, there will always be problems to solve, which keeps all of us alive.” The banks that held preferred stock and lost will have to probably raise more capital and some of them won’t make it. While I don’t believe this is the end of the problems in the credit, mortgage and real estate industries, I can only hope this is the beginning of the end.