- Fortune magazine
As U.S. mortgage lenders tumble further into a black abyss, there is one question to ask: Got gold?
Stock futures are rallying this morning on news of a government rescue. Fannie and Freddie shares (tickers FNM and FRE) are up, too, in European trading. It appears that the Treasury and the Fed are ready to step in once again... and investors are cheering the rescue.
But what does the news really mean?
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On Friday, the Fed seized the assets of IndyMac, an S&L mortgage lender whose failure counted as the second- or third-largest bank bust in U.S. history (depending on whom you ask).
Now the plan is to save Tweedle Dum and Tweedle Dee -- er, make that Fan and Fred -- by opening the Federal Reserve discount window to the two companies, and getting authority from Congress to buy "unlimited stakes" in both.
In other words, taxpayers are on the hook for a blank check once again. This is Bear Stearns on a bigger scale. "Too big to fail" is becoming an epidemic.
How Did We Get Here?
So how did we get into this mess? "Stupidity" is one word that immediately springs to mind. Others are greed, foolishness, myopia, idiocy, and so on. You get the picture. The sheer larceny of it all speaks volumes as to why you should own gold.
The thing to understand about Fannie and Freddie is that their special deal wound up being the worst of both worlds.
The gray area both resided in -- not exactly public institution, not exactly private enterprise -- has produced the ultimate in bad results for taxpayers (you and me), while lining the pockets of countless politicians and insiders on the road to fiscal ruin (the place we've just arrived).
To better understand, let's take a look at Fannie Mae, the Federal National Mortgage Association (as little brother Freddie basically followed in big sister's footsteps).
Here is the bottom line: As a "quasi-government entity," Fannie was always seen as "too big to fail." What's more, Fannie enjoyed implicit backing from the U.S. government the very strong hint, though, not the spelled-out promise, that its finances were guaranteed by Uncle Sam.
This quasi-public status and implied guarantee helped Fan sell massive amounts of debt at super low interest rates.
The thing is, Fannie was also a private company with stockholders, a share price and a profit-driven culture. This created an intense pressure to drive profits higher. Everyone from Fannie Mae execs to big shareholders wanted to see rising earnings, a rising stock price, and so on.
A Hedge Fund in Drag
In the mid-1980s, Fannie Mae almost went under thanks to horrible management of its loan book. Then a new (and much smarter) team stepped in and brainstormed on how to get profits up.
The new managers quickly realized what a huge asset they had in terms of the public/private straddle. This unique deal let Fannie borrow huge sums from investors at piddling interesting rates. The rock-bottom borrowing costs meant they only needed a few percentage points of return to make a lot of money.
Here's how it works: If you have a super-safe strategy that earns you, say, just 0.5% a year, you can still get very rich. All you have to do is borrow huge sums to magnify the return.
If you can borrow, say, 40 times your original capital and plow it all into your 0.5% strategy, then all of a sudden you're making 20% a year (0.5 at 40x leverage = 20% return).
This is pretty much what Fannie Mae figured out... that they could borrow insane amounts of money thanks to their public status, plow the borrowed funds back into mortgages for a slightly higher rate of return, and basically operate as a hedge fund in drag.
Cui Bono Redux
On Friday we introduced the term "cui bono?" which is Latin for "who benefits?" With the Fannie and Freddie story, cui bono applies in spades.
After Fannie figured out the public/private "hedge fund in drag" strategy -- and Freddie copycatted it -- the sky became the limit in terms of profits. Fannie's share price had risen many thousands of percent from its 1980s low, and that was just the start.
In fact, the only real limit on profits, it seemed, was a lack of mortgage loans to buy. Fannie was getting so big, there was a danger of buying up too much of the nation's mortgage pool. It might look bad in the eyes of the public for a quasi-public entity to start shoving its private competition aside.
So what did Fannie do?
They figured out how to make the mortgage pool bigger... much, much bigger... by chipping away at the "20% down" feature that traditionally kept riskier buyers out of the mortgage market.
Basically, Fannie started a series of political campaigns aimed at improving the plight of the poor would-be home owner who couldn't afford 20% down on a house.
Home ownership was as American as mom and apple pie, the campaign argued, and who are we to stand in the way of the American dream just because John and Jane Public can't scrounge up a hefty 20% down.
The strategy worked like gangbusters; down payments fell, and everyone was happy. Politicians loved it, because more of their voters could own homes. First-time home buyers loved it, because 5% down (or even 0% down) made it so much easier to buy the house of their dreams. Wall Street loved it, too, for obvious reasons.
But Fannie and Freddie execs loved it most of all, because the more the mortgage market expanded, the higher their profits soared into the stratosphere.
As the mortgage market grew by trillions, Fannie's and Freddie's mortgage books grew by the trillions, too. Their leverage strategy made Long-Term Capital Management look like pikers. Eventually their eyes got bigger than their stomachs, the market turned with a vengeance, and now here we are staring down the barrel of a housing crisis.
It was pure greed, plain and simple. And we all bought it...
No Free Lunch
There is no free lunch on Wall Street. (Some say that diversification counts as the one free lunch, but that's baloney, too. You can't get rich avoiding concentration.)
Now we are realizing, the hard way, that there is no free lunch when it comes to the American Dream, either. The dream of homeownership has become a nightmare for millions of Americans.
Just remember this: When politicians and executives and investment bankers get together to do something for the greater good, you can be sure that the first and last "good" that will be served is the good of their wallets.
And that's why you need to own gold... because this debacle is far from done. In fact, it's just getting started.
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With the Bear Stearns failure, the IndyMac Bank failure, and now the as-yet-to-be-determined Fannie and Freddie rescue, we are paying for the ill-gotten gains of many years prior.
The motto of the players might well have been, "Reap billions now; let others foot the bill later." Later being right now and the bill-footers being taxpayers... you and me.
If the cost is not paid via the IRS, then it will be paid via rampant inflation, as the printing press slowly turns the dollar into monopoly money.
Cool Hand Hank
As with Bear Stearns, Treasury Secretary Hank Paulson is working to make sure Fannie's and Freddie's current shareholders don't get any love in the rescue.
It was Paulson who originally insisted on a $2 share price for Bear, to send a stern message along with the bailout. (In defending the low price paid, JP Morgan's CEO later said, "There's a difference between buying a house and buying a house that's on fire.")
We'll probably see some similar harshness to the Fannie/Freddie rescue... but don't be fooled. Those who reaped true riches from Fannie and Freddie -- the bigwig execs and politicians -- have already ridden off into the sunset with anywhere from tens to hundreds of millions each. Those hurt by the recent share price collapse are mainly holders of poorly managed mutual funds.
Still, you have to admire Hank Paulson's game face. As the former head of Goldman Sachs, he's got a very good one. His stage reaction to the carnage thus far reminds me of the Road Captain in Cool Hand Luke:
What we've got here is... failure to communicate. Some [banks and hedge funds] you just can't reach. So you get what we had here last week, which is the way he wants it. Well, he gets it. I don't like it any more than you men.
Warm Regards,
JL
P.S. Wall Street keeps wishing and hoping with all its might that the credit crisis is over. With this latest Fannie/Freddie rescue plan, they are wishing and hoping some more. There'll be no such luck, though... Things are going to get worse before they get better, for the many reasons we've highlighted and cited.
I just sat down with Adam Lass of WaveStrength Options Weekly to discuss the depth and scope of the current crisis -- and also to find out what he's doing about it and how WOW readers are profiting from it.
The resulting "Emergency Telesummit" is packed with a lot of high-quality vital information -- and best of all, it's free. All you have to do is sign up and tune in later this week. See you there.
- Fortune magazine
