Bush to blame for mortgage mess...NYT

White House Philosophy Stoked Mortgage Bonfire
By JO BECKER, SHERYL GAY STOLBERG and STEPHEN LABATON

“We can put light where there's darkness, and hope where there's despondency in this country. And part of it is working together as a nation to encourage folks to own their own home.” — President Bush, Oct. 15, 2002

WASHINGTON — The global financial system was teetering on the edge of collapse when President Bush and his economics team huddled in the Roosevelt Room of the White House for a briefing that, in the words of one participant, “scared the hell out of everybody.”

It was Sept. 18. Lehman Brothers had just gone belly-up, overwhelmed by toxic mortgages. Bank of America had swallowed Merrill Lynch in a hastily arranged sale. Two days earlier, Mr. Bush had agreed to pump $85 billion into the failing insurance giant American International Group.

The president listened as Ben S. Bernanke, chairman of the Federal Reserve, laid out the latest terrifying news: The credit markets, gripped by panic, had frozen overnight, and banks were refusing to lend money.

Then his Treasury secretary, Henry M. Paulson Jr., told him that to stave off disaster, he would have to sign off on the biggest government bailout in history.

Mr. Bush, according to several people in the room, paused for a single, stunned moment to take it all in.

“How,” he wondered aloud, “did we get here?”

Eight years after arriving in Washington vowing to spread the dream of homeownership, Mr. Bush is leaving office, as he himself said recently, “faced with the prospect of a global meltdown” with roots in the housing sector he so ardently championed.

There are plenty of culprits, like lenders who peddled easy credit, consumers who took on mortgages they could not afford and Wall Street chieftains who loaded up on mortgage-backed securities without regard to the risk.

But the story of how we got here is partly one of Mr. Bush's own making, according to a review of his tenure that included interviews with dozens of current and former administration officials.

From his earliest days in office, Mr. Bush paired his belief that Americans do best when they own their own home with his conviction that markets do best when let alone.

He pushed hard to expand homeownership, especially among minorities, an initiative that dovetailed with his ambition to expand the Republican tent — and with the business interests of some of his biggest donors. But his housing policies and hands-off approach to regulation encouraged lax lending standards.

Mr. Bush did foresee the danger posed by Fannie Mae and Freddie Mac, the government-sponsored mortgage finance giants. The president spent years pushing a recalcitrant Congress to toughen regulation of the companies, but was unwilling to compromise when his former Treasury secretary wanted to cut a deal. And the regulator Mr. Bush chose to oversee them — an old prep school buddy — pronounced the companies sound even as they headed toward insolvency.

As early as 2006, top advisers to Mr. Bush dismissed warnings from people inside and outside the White House that housing prices were inflated and that a foreclosure crisis was looming. And when the economy deteriorated, Mr. Bush and his team misdiagnosed the reasons and scope of the downturn; as recently as February, for example, Mr. Bush was still calling it a “rough patch.”

The result was a series of piecemeal policy prescriptions that lagged behind the escalating crisis.

“There is no question we did not recognize the severity of the problems,” said Al Hubbard, Mr. Bush's former chief economics adviser, who left the White House in December 2007. “Had we, we would have attacked them.”

Looking back, Keith B. Hennessey, Mr. Bush's current chief economics adviser, says he and his colleagues did the best they could “with the information we had at the time.” But Mr. Hennessey did say he regretted that the administration did not pay more heed to the dangers of easy lending practices. And both Mr. Paulson and his predecessor, John W. Snow, say the housing push went too far.

“The Bush administration took a lot of pride that homeownership had reached historic highs,” Mr. Snow said in an interview. “But what we forgot in the process was that it has to be done in the context of people being able to afford their house. We now realize there was a high cost.”

For much of the Bush presidency, the White House was preoccupied by terrorism and war; on the economic front, its pressing concerns were cutting taxes and privatizing Social Security. The housing market was a bright spot: ever-rising home values kept the economy humming, as owners drew down on their equity to buy consumer goods and pack their children off to college.

Lawrence B. Lindsay, Mr. Bush's first chief economics adviser, said there was little impetus to raise alarms about the proliferation of easy credit that was helping Mr. Bush meet housing goals.

“No one wanted to stop that bubble,” Mr. Lindsay said. “It would have conflicted with the president's own policies.”

Today, millions of Americans are facing foreclosure, homeownership rates are virtually no higher than when Mr. Bush took office, Fannie and Freddie are in a government conservatorship, and the bailout cost to taxpayers could run in the trillions.

As the economy has shed jobs — 533,000 last month alone — and his party has been punished by irate voters, the weakened president has granted his Treasury secretary extraordinary leeway in managing the crisis.

Never once, Mr. Paulson said in a recent interview, has Mr. Bush overruled him. “I've got a boss,” he explained, who “understands that when you're dealing with something as unprecedented and fast-moving as this we need to have a different operating style.”

Mr. Paulson and other senior advisers to Mr. Bush say the administration has responded well to the turmoil, demonstrating flexibility under difficult circumstances. “There is not any playbook,” Mr. Paulson said.

The president declined to be interviewed for this article. But in recent weeks Mr. Bush has shared his views of how the nation came to the brink of economic disaster. He cites corporate greed and market excesses fueled by a flood of foreign cash — “Wall Street got drunk,” he has said — and the policies of past administrations. He blames Congress for failing to reform Fannie and Freddie. Last week, Fox News asked Mr. Bush if he was worried about being the Herbert Hoover of the 21st century.

“No,” Mr. Bush replied. “I will be known as somebody who saw a problem and put the chips on the table to prevent the economy from collapsing.”

But in private moments, aides say, the president is looking inward. During a recent ride aboard Marine One, the presidential helicopter, Mr. Bush sounded a reflective note.

“We absolutely wanted to increase homeownership,” Tony Fratto, his deputy press secretary, recalled him saying. “But we never wanted lenders to make bad decisions.”

A Policy Gone Awry

Darrin West could not believe it. The president of the United States was standing in his living room.

It was June 17, 2002, a day Mr. West recalls as “the highlight of my life.” Mr. Bush, in Atlanta to unveil a plan to increase the number of minority homeowners by 5.5 million, was touring Park Place South, a development of starter homes in a neighborhood once marked by blight and crime.

Mr. West had patrolled there as a police officer, and now he was the proud owner of a $130,000 town house, bought with an adjustable-rate mortgage and a $20,000 government loan as his down payment — just the sort of creative public-private financing Mr. Bush was promoting.

“Part of economic security,” Mr. Bush declared that day, “is owning your own home.”

A lot has changed since then. Mr. West, beset by personal problems, left Atlanta. Unable to sell his home for what he owed, he said, he gave it back to the bank last year. Like other communities across America, Park Place South has been hit with a foreclosure crisis affecting at least 10 percent of its 232 homes, according to Masharn Wilson, a developer who led Mr. Bush's tour.

“I just don't think what he envisioned was actually carried out,” she said.

Park Place South is, in microcosm, the story of a well-intentioned policy gone awry. Advocating homeownership is hardly novel; the Clinton administration did it, too. For Mr. Bush, it was part of his vision of an “ownership society,” in which Americans would rely less on the government for health care, retirement and shelter. It was also good politics, a way to court black and Hispanic voters.

But for much of Mr. Bush's tenure, government statistics show, incomes for most families remained relatively stagnant while housing prices skyrocketed. That put homeownership increasingly out of reach for first-time buyers like Mr. West.

So Mr. Bush had to, in his words, “use the mighty muscle of the federal government” to meet his goal. He proposed affordable housing tax incentives. He insisted that Fannie Mae and Freddie Mac meet ambitious new goals for low-income lending.

Concerned that down payments were a barrier, Mr. Bush persuaded Congress to spend up to $200 million a year to help first-time buyers with down payments and closing costs.

And he pushed to allow first-time buyers to qualify for federally insured mortgages with no money down. Republican Congressional leaders and some housing advocates balked, arguing that homeowners with no stake in their investments would be more prone to walk away, as Mr. West did. Many economic experts, including some in the White House, now share that view.

The president also leaned on mortgage brokers and lenders to devise their own innovations. “Corporate America,” he said, “has a responsibility to work to make America a compassionate place.”

And corporate America, eyeing a lucrative market, delivered in ways Mr. Bush might not have expected, with a proliferation of too-good-to-be-true teaser rates and interest-only loans that were sold to investors in a loosely regulated environment.

“This administration made decisions that allowed the free market to operate as a barroom brawl instead of a prize fight,” said L. William Seidman, who advised Republican presidents and led the savings and loan bailout in the 1990s. “To make the market work well, you have to have a lot of rules.”

But Mr. Bush populated the financial system's alphabet soup of oversight agencies with people who, like him, wanted fewer rules, not more.

Like Minds on Laissez-Faire

The president's first chairman of the Securities and Exchange Commission promised a “kinder, gentler” agency. The second was pushed out amid industry complaints that he was too aggressive. Under its current leader, the agency failed to police the catastrophic decisions that toppled the investment bank Bear Stearns and contributed to the current crisis, according to a recent inspector general's report.

As for Mr. Bush's banking regulators, they once brandished a chain saw over a 9,000-page pile of regulations as they promised to ease burdens on the industry. When states tried to use consumer protection laws to crack down on predatory lending, the comptroller of the currency blocked the effort, asserting that states had no authority over national banks.

The administration won that fight at the Supreme Court. But Roy Cooper, North Carolina's attorney general, said, “They took 50 sheriffs off the beat at a time when lending was becoming the Wild West.”

The president did push rules aimed at forcing lenders to more clearly explain loan terms. But the White House shelved them in 2004, after industry-friendly members of Congress threatened to block confirmation of his new housing secretary.

In the 2004 election cycle, mortgage bankers and brokers poured nearly $847,000 into Mr. Bush's re-election campaign, more than triple their contributions in 2000, according to the nonpartisan Center for Responsive Politics. The administration did not finalize the new rules until last month.

Among the Republican Party's top 10 donors in 2004 was Roland Arnall. He founded Ameriquest, then the nation's largest lender in the subprime market, which focuses on less creditworthy borrowers. In July 2005, the company agreed to set aside $325 million to settle allegations in 30 states that it had preyed on borrowers with hidden fees and ballooning payments. It was an early signal that deceptive lending practices, which would later set off a wave of foreclosures, were widespread.

Andrew H. Card Jr., Mr. Bush's former chief of staff, said White House aides discussed Ameriquest's troubles, though not what they might portend for the economy. Mr. Bush had just nominated Mr. Arnall as his ambassador to the Netherlands, and the White House was primarily concerned with making sure he would be confirmed.

“Maybe I was asleep at the switch,” Mr. Card said in an interview.

Brian Montgomery, the Federal Housing Administration commissioner, understood the significance. His agency insures home loans, traditionally for the same low-income minority borrowers Mr. Bush wanted to help. When he arrived in June 2005, he was shocked to find those customers had been lured away by the “fool's gold” of subprime loans. The Ameriquest settlement, he said, reinforced his concern that the industry was exploiting borrowers.

In December 2005, Mr. Montgomery drafted a memo and brought it to the White House. “I don't think this is what the president had in mind here,” he recalled telling Ryan Streeter, then the president's chief housing policy analyst.

It was an opportunity to address the risky subprime lending practices head on. But that was never seriously discussed. More senior aides, like Karl Rove, Mr. Bush's chief political strategist, were wary of overly regulating an industry that, Mr. Rove said in an interview, provided “a valuable service to people who could not otherwise get credit.” While he had some concerns about the industry's practices, he said, “it did provide an opportunity for people, a lot of whom are still in their houses today.”

The White House pursued a narrower plan offered by Mr. Montgomery that would have allowed the F.H.A. to loosen standards so it could lure back subprime borrowers by insuring similar, but safer, loans. It passed the House but died in the Senate, where Republican senators feared that the agency would merely be mimicking the private sector's risky practices — a view Mr. Rove said he shared.

Looking back at the episode, Mr. Montgomery broke down in tears. While he acknowledged that the bill did not get to the root of the problem, he said he would “go to my grave believing” that at least some homeowners might have been spared foreclosure.

Today, administration officials say it is fair to ask whether Mr. Bush's ownership push backfired. Mr. Paulson said the administration, like others before it, “over-incented housing.” Mr. Hennessey put it this way: “I would not say too much emphasis on expanding homeownership. I would say not enough early focus on easy lending practices.”

‘We Told You So'

Armando Falcon Jr. was preparing to take on a couple of giants.

A soft-spoken Texan, Mr. Falcon ran the Office of Federal Housing Enterprise Oversight, a tiny government agency that oversaw Fannie Mae and Freddie Mac, two pillars of the American housing industry. In February 2003, he was finishing a blockbuster report that warned the pillars could crumble.

Created by Congress, Fannie and Freddie — called G.S.E.'s, for government-sponsored entities — bought trillions of dollars' worth of mortgages to hold or sell to investors as guaranteed securities. The companies were also Washington powerhouses, stuffing lawmakers' campaign coffers and hiring bare-knuckled lobbyists.

Mr. Falcon's report outlined a worst-case situation in which Fannie and Freddie could default on debt, setting off “contagious illiquidity in the market” — in other words, a financial meltdown. He also raised red flags about the companies' soaring use of derivatives, the complex financial instruments that economic experts now blame for spreading the housing collapse.

Today, the White House cites that report — and its subsequent effort to better regulate Fannie and Freddie — as evidence that it foresaw the crisis and tried to avert it. Bush officials recently wrote up a talking points memo headlined “G.S.E.'s — We Told You So.”

But the back story is more complicated. To begin with, on the day Mr. Falcon issued his report, the White House tried to fire him.

At the time, Fannie and Freddie were allies in the president's quest to drive up homeownership rates; Franklin D. Raines, then Fannie's chief executive, has fond memories of visiting Mr. Bush in the Oval Office and flying aboard Air Force One to a housing event. “They loved us,” he said.

So when Mr. Falcon refused to deep-six his report, Mr. Raines took his complaints to top Treasury officials and the White House. “I'm going to do what I need to do to defend my company and my position,” Mr. Raines told Mr. Falcon.

Days later, as Mr. Falcon was in New York preparing to deliver a speech about his findings, his cellphone rang. It was the White House personnel office, he said, telling him he was about to be unemployed.

His warnings were buried in the next day's news coverage, trumped by the White House announcement that Mr. Bush would replace Mr. Falcon, a Democrat appointed by Bill Clinton, with Mark C. Brickell, a leader in the derivatives industry that Mr. Falcon's report had flagged.

It was not until 2003, when Freddie became embroiled in an accounting scandal, that the White House took on the companies in earnest. Mr. Bush decided to quit the long-standing practice of rewarding supporters with high-paying appointments to the companies' boards — “political plums,” in Mr. Rove's words. He also withdrew Mr. Brickell's nomination and threw his support behind Mr. Falcon, beginning an intense effort to give his little regulatory agency more power.

Mr. Falcon lacked explicit authority to limit the size of the companies' mammoth investment portfolios, or tell them how much capital they needed to guard against losses. White House officials wanted that to change. They also wanted the power to put the companies into receivership, hoping that would end what Mr. Card, the former chief of staff, called “the myth of government backing,” which gave the companies a competitive edge because investors assumed the government would not let them fail.

By the spring of 2005 a deal with Congress seemed within reach, Mr. Snow, the former Treasury secretary, said in an interview.

Michael G. Oxley, an Ohio Republican and then-chairman of the House Financial Services Committee, had produced what Mr. Snow viewed as “a pretty darned good bill,” a watered-down version of what the president sought. But at the urging of Mr. Card and the White House economics team, the president decided to hold out for a tougher bill in the Senate.

Mr. Card said he feared that Mr. Snow was “more interested in the deal than the result.” When the bill passed the House, the president issued a statement opposing it, effectively killing any chance of compromise. Mr. Oxley was furious.

“The problem with those guys at the White House, they had all the answers and they didn't think they had to listen to anyone, including the Treasury secretary,” Mr. Oxley said in a recent interview. “They were driving the ideological train. He was in the caboose, and they were in the engine room.”

Mr. Card and Mr. Hennessey said they had no regrets. They are convinced, Mr. Hennessey said, that the Oxley bill would have produced “the worst of all possible outcomes,” the illusion of reform without the substance.

Still, some former White House and Treasury officials continue to debate whether Mr. Bush's all-or-nothing approach scuttled a measure that, while imperfect, might have given an aggressive regulator enough power to keep the companies from failing.

Mr. Snow, for one, calls Mr. Oxley “a hero,” adding, “He saw the need to move. It didn't get done. And it's too bad, because I think if it had, I think we could well have avoided a big contributor to the current crisis.”

Unheeded Warnings

Jason Thomas had a nagging feeling.

The New Century Financial Corporation, a huge subprime lender whose mortgages were bundled into securities sold around the world, was headed for bankruptcy in March 2007. Mr. Thomas, an economic analyst for President Bush, was responsible for determining whether it was a hint of things to come.

At 29, Mr. Thomas had followed a fast-track career path that took him from a Buffalo meatpacking plant, where he worked as a statistician, to the White House. He was seen as a whiz kid, “a brilliant guy,” his former boss, Mr. Hubbard, says.

As Mr. Thomas began digging into New Century's failure that spring, he became fixated on a particular statistic, the rent-to-own ratio.

Typically, as home prices increase, rental costs rise proportionally. But Mr. Thomas sent charts to top White House and Treasury officials showing that the monthly cost of owning far outpaced the cost to rent. To Mr. Thomas, it was a sign that housing prices were wildly inflated and bound to plunge, a condition that could set off a foreclosure crisis as conventional and subprime borrowers with little equity found they owed more than their houses were worth.

It was not the Bush team's first warning. The previous year, Mr. Lindsay, the former chief economics adviser, returned to the White House to tell his old colleagues that housing prices were headed for a crash. But housing values are hard to evaluate, and Mr. Lindsay had a reputation as a market pessimist, said Mr. Hubbard, adding, “I thought, ‘He's always a bear.' ”

In retrospect, Mr. Hubbard said, Mr. Lindsay was “absolutely right,” and Mr. Thomas's charts “should have been a signal.”

Instead, the prevailing view at the White House was that the problems in the housing market were limited to subprime borrowers unable to make their payments as their adjustable mortgages reset to higher rates. That belief was shared by Mr. Bush's new Treasury secretary, Mr. Paulson.

Mr. Paulson, a former chairman of the Wall Street firm Goldman Sachs, had been given unusual power; he had accepted the job only after the president guaranteed him that Treasury, not the White House, would have the dominant role in shaping economic policy. That shift merely continued an imbalance of power that stifled robust policy debate, several former Bush aides say.

Throughout the spring of 2007, Mr. Paulson declared that “the housing market is at or near the bottom,” with the problem “largely contained.” That position underscored nearly every action the Bush administration took in the ensuing months as it offered one limited response after another.

By that August, the problems had spread beyond New Century. Credit was tightening, amid questions about how heavily banks were invested in securities linked to mortgages. Still, Mr. Bush predicted that the turmoil would resolve itself with a “soft landing.”

The plan Mr. Bush announced on Aug. 31 reflected that belief. Called “F.H.A. Secure,” it aimed to help about 80,000 homeowners refinance their loans. Mr. Montgomery, the housing commissioner, said that he knew the modest program was not enough — the White House later expanded the agency's rescue role — and that he would be “flying the plane and fixing it at the same time.”

That fall, Representative Rahm Emanuel, a leading Democrat, former investment banker and now the incoming chief of staff to President-elect Barack Obama, warned the White House it was not doing enough. He said he told Joshua B. Bolten, Mr. Bush's chief of staff, and Mr. Paulson in a series of phone calls that the credit crisis would get “deep and serious” and that the only answer was big, internationally coordinated government intervention.

“You got to strangle this thing and suffocate it,” he recalled saying.

Instead, Mr. Bush developed Hope Now, a voluntary public-private partnership to help struggling homeowners refinance loans. And he worked with Congress to pass a stimulus package that sent taxpayers $150 billion in tax rebates.

In a speech to the Economic Club of New York in March 2008, he cautioned against Washington's temptation “to say that anything short of a massive government intervention in the housing market amounts to inaction,” adding that government action could make it harder for the markets to recover.

Dominoes Start to Fall

Within days, Bear Sterns collapsed, prompting the Federal Reserve to engineer a hasty sale. Some economic experts, including Timothy F. Geithner, the president of the New York Federal Reserve Bank (and Mr. Obama's choice for Treasury secretary) feared that Fannie Mae and Freddie Mac could be the next to fall.

Mr. Bush was still leaning on Congress to revamp the tiny agency that oversaw the two companies, and had acceded to Mr. Paulson's request for the negotiating room that he had denied Mr. Snow. Still, there was no deal.

Over the previous two years, the White House had effectively set the agency adrift. Mr. Falcon left in 2005 and was replaced by a temporary director, who was in turn replaced by James B. Lockhart, a friend of Mr. Bush from their days at Andover, and a former deputy commissioner of the Social Security Administration who had once run a software company.

On Mr. Lockhart's watch, both Freddie and Fannie had plunged into the riskiest part of the market, gobbling up more than $400 billion in subprime and other alternative mortgages. With the companies on precarious footing, Mr. Geithner had been advocating that the administration seize them or take other steps to reassure the market that the government would back their debt, according to two people with direct knowledge of his views.

In an Oval Office meeting on March 17, however, Mr. Paulson barely mentioned the idea, according to several people present. He wanted to use the troubled companies to unlock the frozen credit market by allowing Fannie and Freddie to buy more mortgage-backed securities from overburdened banks. To that end, Mr. Lockhart's office planned to lift restraints on the companies' huge portfolios — a decision derided by former White House and Treasury officials who had worked so hard to limit them.

But Mr. Paulson told Mr. Bush the companies would shore themselves up later by raising more capital.

“Can they?” Mr. Bush asked.

“We're hoping so,” the Treasury secretary replied.

That turned out to be incorrect, and did not surprise Mr. Thomas, the Bush economic adviser. Throughout that spring and summer, he warned the White House and Treasury that, in the stark words of one e-mail message, “Freddie Mac is in trouble.” And Mr. Lockhart, he charged, was allowing the company to cover up its insolvency with dubious accounting maneuvers.

But Mr. Lockhart continued to offer reassurances. In a July appearance on CNBC, he declared that the companies were well managed and “worsts were not coming to worst.” An infuriated Mr. Thomas sent a fresh round of e-mail messages accusing Mr. Lockhart of “pimping for the stock prices of the undercapitalized firms he regulates.”

Mr. Lockhart defended himself, insisting in an interview that he was aware of the companies' vulnerabilities, but did not want to rattle markets.

“A regulator,” he said, “does not air dirty laundry in public.”

Soon afterward, the companies' stocks lost half their value in a single day, prompting Congress to quickly give Mr. Paulson the power to spend $200 billion to prop them up and to finally pass Mr. Bush's long-sought reform bill, but it was too late. In September, the government seized control of Freddie Mac and Fannie Mae.

In an interview, Mr. Paulson said the administration had no justification to take over the companies any sooner. But Mr. Falcon disagreed: “They absolutely could have if they had thought there was a real danger.”

By Sept. 18, when Mr. Bush and his team had their fateful meeting in the Roosevelt Room after the failure of Lehman Brothers and the emergency rescue of A.I.G., Mr. Paulson was warning of an economic calamity greater than the Great Depression. Suddenly, historic government intervention seemed the only option. When Mr. Paulson spelled out what would become a $700 billion plan to rescue the nation's banking system, the president did not hesitate.

“Is that enough?” Mr. Bush asked.

“It's a lot,” the Treasury secretary recalled replying. “It will make a difference.” And in any event, he told Mr. Bush, “I don't think we can get more.”

Fannie, Freddie to Buy $40 Billion a Month of Troubled Assets

By Dawn Kopecki

Oct. 11 (Bloomberg) -- Federal regulators directed Fannie Mae and Freddie Mac to start purchasing $40 billion a month of underperforming mortgage bonds as the Bush administration expands its options to buy troubled financial assets and resuscitate the U.S. economy, according to three people briefed about the plan.

Fannie and Freddie began notifying bond traders last week that each company needs to buy $20 billion a month in mostly subprime, Alt-A and non-performing prime mortgage securities, according to the people, who asked not to be identified because the plans are confidential. The purchases would be separate from the U.S. Treasury's $700 billion Troubled Asset Relief Program.

The Federal Housing Finance Agency, which placed the two companies in conservatorship on Sept. 7, directed them last month to start increasing their purchases of loans and mortgage-backed securities as the Treasury seeks to absorb underperforming and illiquid assets from financial companies.

''For now, they're under conservatorship and they have to be used to keep the flow of capital going to the housing market,'' former Treasury Secretary Lawrence Summers said in an interview on Bloomberg Television's ''Conversations with Judy Woodruff.'' ''They're important to maintaining the flow of government finance'' and need to be used actively, he said.

Adding underperforming assets to Fannie and Freddie's combined $1.52 trillion mortgage portfolios would come at a time when the two mortgage-finance companies already hold as much as $210 billion of bad debt that may be eligible itself for the Treasury's relief program, their regulator said Oct. 5.

A spokesman for Washington-based Fannie, Brian Faith, and Doug Duvall at McLean, Virginia-based Freddie wouldn't comment.

Overall Goal

Neither Fannie nor Freddie has turned a profit in the past year, accumulating $14.9 billion in combined quarterly losses, largely related to bad subprime and Alt-A mortgage assets.

FHFA spokeswoman Stefanie Mullin declined to comment on the details of the program. Treasury spokeswoman Jennifer Zuccarelli wasn't immediately available to comment.

''The overall goal of the program will be to contribute greater stability and liquidity in the mortgage market, which should enhance consumers' access to mortgage financing and ultimately result in reduced mortgage interest rates,'' FHFA Director James Lockhart said in a Sept. 19 statement.

Subprime loans were given to borrowers with poor or limited credit records or high debt burdens. Alt-A loans were made to borrowers who wanted atypical terms such as proof-of-income waivers, without sufficient compensating attributes. About 35 percent of subprime loans in non-agency mortgage securities are at least 60 days late, while 15 percent of Alt-A loans are, according to a Sept. 9 report by FTN Financial Capital Markets.

Growth

Non-agency, or private-label, bonds are issued by banks and don't carry guarantees by Fannie, Freddie or government-agency Ginnie Mae. Freddie held about $207 billion in non-agency debt in its $760.9 billion portfolio as of August, according to its latest monthly volume summary. Fannie had about $104 billion of such securities in its $759.9 billion portfolio in August.

Regulators initially restricted Fannie and Freddie's growth when they seized control of the government-sponsored enterprises Sept. 7. To ''promote stability'' and lower mortgage costs to borrowers, Treasury Secretary Henry Paulson said the two would be allowed to ''modestly increase'' their mortgage portfolios to as much as $1.7 trillion through the end of next year and said they would no longer be run ''to maximize shareholder returns.''

Less than two weeks later, Fannie and Freddie were told to ramp up their mortgage bond purchases as the financial crisis deepened and credit activity came to near standstill.

Fannie and Freddie which own or guarantee almost half of the $12 trillion U.S. home loan market, were given access to $200 billion in emergency Treasury financing as part of their rescue package. The companies may also be able to sell their bad debt to the Treasury through its $700 billion financial-rescue program signed into law Oct. 3.

FHFA has said the companies plan to release third-quarter results next month as scheduled. Analysts surveyed by Bloomberg project losses for both Fannie and Freddie at least through 2009.


RE: Who says PB posters are stupid? sss355 NEW 10/11/2008 4:48:23 AM
At least, half a dozen PruBear postere suggested that FNM/FRE were accquired by Paulson so that the taxpayers can be forced to absorb toxic waste from the investment banks.

Fannie & Freddie - Holding Back The Tide!

* by Satyajit Das
* September 15, 2008

The US Treasury's "rescue" package for the Federal National Mortgage Association ("FNMA" or Fannie Mae) and the Federal Home Loan Mortgage Corporation ("FHLMC" or Freddie Mac") (collectively the "Agencies" or Government Sponsored Enterprises ("GSEs")) elicited a spectacular reaction from financial markets. In a triumph of hope over experience, markets betrayed their essential "romanticism". As John Maynard Keynes observed: "It is necessarily part of the business of a banker to profess a conventional respectability which is more than human. Life-long practices of this kind make them the most romantic and the least realistic of men."

The Fannie and Freddie show had all the staged, stylised and utterly predictable drama of Japanese Kabuki theatre. Confusion over objectives, aggressive expansion, increased risk taking, inadequate capital, (sometimes) controversial accounting and frequent political interference led to entirely predictable financial problems and ultimately the inevitable government "bailout". In July 2008, one US newspaper accurately predicted the denouement in a prophetic headline: "Fannie et Freddie est fini!"

Established by the US government and then subsequently privatised (Fannie Mae was sold into private ownership by the Johnson administration to help finance the Vietnam War), successive administrations have used the GSEs to create liquidity and support the financial system in times of stress. In 1994, the GSEs expanded their balance sheets (chiefly holdings of mortgages and mortgage backed securities ("MBS")) by US$150 billion (double the previous year's expansion) to reduce the effect of the bond market collapse. GSE balance sheets expanded in the period 1998 to 2001 in response to the Asian monetary crisis, Russian default, LTCM collapse and end of the Internet and Telecom boom: US $305 billion (1998); $317 billion (1999), US$ 238 billion (2000) and US $344 billion (2001). Since 2007, the US government has used Fannie and Freddie to increase mortgage lending to help ameliorate the effects of the sub-prime mortgage crisis.

Under the bailout proposal, the government will commit to purchase (up to) US$ 100 billion in 10% coupon preferred stocks in the company consisting of an initial commitment of US$1 billion and warrants for 79.9% of common stock. The aim is to maintain positive net worth of the entities. The government will also provide funding to Fannie and Freddie secured against MBS issued by the GSEs and the Federal Home Loan Banks ("FHLB"). The structure of the support package avoids "ambiguities in the GSE Congressional charters" and benefiting shareholders.

The plan falls short of a full faith unconditional U.S. government guarantee of GSE obligations. There are advantages tactical advantages in this arrangement. Continuation of Freddie and Fannie as "implicitly" but not "explicitly" guaranteed entities creates a cover of "plausible deniability" for the US to pay higher costs on its borrowings without increasing the cost of Treasury bonds.

The government actions benefitted Fannie and Freddie senior debt holders as credit spreads on the bonds tightened due the US Treasury support. Credit spreads on Fannie and Freddie decreased to 38 basis points (0.38% pa) on 5 September 2008 from around 80 basis points (0.80% pa) in July 2008. PIMCO, the asset manager, reputedly recorded a gain of US$ 1.7 billion. Bill Gross, co-founder of PIMCO, has been one of principal advocates of a government rescue of the troubled GSEs.

Subordinated debt holders also receive a "get out of jail" card as the proposals cover these obligations. Fannie subordinated debt credit spreads fell to 233 basis points (2.33 % pa) on 5 September 2008 from 364 basis points (3.64% pa) on 20 August 20008. Subordinated debt is normally treated as equity or near equity and would not normally have benefited.

Common and preferred stock holders suffer through dilution and the suspension of dividends. Under the conservatorship, the GSEs are to be managed to meet their obligations rather maximise shareholder returns. The common and preferred stock rank effectively last in terms of claims on the assets. It is difficult to see a significant recovery in the value of these securities in the near term.

The government actions address the supply of housing finance. As the US mortgage crisis developed, private label mortgage securitisation fell sharply. As at end August 2008, asset-sacked securities ("ABS") issuance year-to-date in the US was down 73% on 2007. CDO issuance was down 90% and home equity ABS issuance was insignificant. The grand mal seizure in securitisation means that the availability of non-GSE mortgage finance has become extremely restricted. The U.S. Administration loosened capital controls, promoted additional lending and encouraged GSE purchases of MBS in order to support the mortgage market. A failure of Fannie and Freddie would have exacerbated the deep seated problems in the housing market.

The US also needs to maintain financial credibility with investors, especially international investors. Foreign demand for GSE bonds and (to a lesser extent) US Treasury bonds has weakened in recent times. Low nominal (negative real) interest rates and dollar weakness are key factors.

Foreign investors are also beginning to question the credibility of the Federal Reserve and US Treasury. Foreign investors, including more than 60 global central banks, hold over $1,400 billion in securities of US agencies including Fannie Mae and Freddie Mac. Chinese investors alone own around US$500 billion of GSE debt.

On 23 July 2008, the Financial Times, reported that the US embassy called the Kuwait Investment Authority ("KIA"), the world's sixth-biggest sovereign wealth fund, to reassure them about the "soundness" of bonds issued by Fannie Mae and Freddie Mac after Kuwait's minister of finance announced that the KIA was not planning to invest in their debt in future. Yu Yongding, an influential Chinese economist and former advisor to China's central bank, recently warned that: "If the US government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic. If it's not the end of the world, it is the end of the current international financial system." Pressure from key foreign investors forced the US government to act order to ensure essential access to international capital.

Markets and some commentators interpreted the government actions as a major step in the resolution of the current financial crisis. There are reasons for caution.

The actions, at best, stabilise the supply of mortgage credit in the US. Future activity of the GSEs will be restricted limiting supply of mortgage finance. Government support may help reduce the stubbornly high cost of mortgage finance despite cuts totaling 3.25% in the Federal Funds rate.

The proposals are not permanent. Withdrawal of support by future administrations and Congress although unlikely cannot be completely discounted.

The US$ 100 billion commitment equates to less than 2 % of the US$5.4 trillion GSE portfolio of mortgages and guarantees. If existing capital (around US$80 billion) is taken into account this improves to around 3%. Given rising default rates and the poor outlook of the housing market, the capital injection may not be sufficient to ensure solvency.

The GSE MBS investment portfolio (around US$1.4 trillion which will modestly increase through to the end of 2009) will be gradually reduced after 2010 at the rate of 10 % per year to $250 billion each, or $500 billion total. The US Treasury assumes that the reduction in GSE portfolio size will be through natural run off.

The Federal Reserve also holds MBS securities (over US$ 400 billion) as collateral for loans to financial institutions under various liquidity support arrangements. The overhang of these securities may affect MBS prices and activity. If credit conditions do not improve over the next 18 months, then the divestment of this portfolio may cause market dislocation, as the GSEs become users rather than suppliers of liquidity to the mortgage market.

Banks and insurers own a significant amount of the US$36 billion in outstanding preferred stock in Fannie and Freddie. JP Morgan has warned of a possible US$600 million loss on its US$ 1.2 billion investment. Federal banking agencies believe that only a limited number of smaller institutions have holdings that are significant compared to their capital. Given the fragile capital positions of many institutions, the losses create additional pressure to raise additional equity or reduce the size of balance sheets compounding the contraction of credit.

The problems and bailout of Fannie and Freddie indicate the severity of the problems facing the US and global financial system.

The problems at the GSEs indicate that the mortgage market generally, especially higher credit quality (prime and Alt A) mortgages, has deteriorated as the US economy slows, unemployment rises, availability of credit/ refinancing reduces and houses prices decline. The GSE rescue may presage further bank write-offs.

The banking system requires new capital to cover losses and involuntary asset growth (returning "off balance sheet" assets previously held in the "shadow banking system" (Collateralised Debt Obligations ("CDOs"), ABS, Structured Investment Vehicles ("SIV") and hedge funds)). The government bailout comes after the failure of the search for a buyer or major equity investor to recapitalise the GSEs. The reluctance of the usual suspects - sovereign wealth funds and Chinese Banks - to act as the "sugar daddy" does not augur well for future capital raising by financial institutions.

Credit default swaps ("CDS") on Freddie and Fannie (a form of credit insurance) have been triggered as a result of the conservatorship necessitating settlement of around US$500 billion to US$1,000 billion in contracts. Expected losses are unknown. Initial expectations were that they will not be significant as Fannie and Freddie debt would now trade around face value or 100%. However, even at a trading level of 95%, the losses would total US$25 billion onUS$500 billion in contracts.

Settlement of the CDS contracts may limit any decline in credit spreads on GSE debt. Government support for GSE subordinated debt appears to be designed to avoid the possibility of triggering large losses on CDS contracts. At a minimum, settlement of the CDS contract will impede progress on restructuring Fannie and Freddie. It also poses questions on the effectiveness of CDS contracts in transferring risk of default generally.

The GSE saga exposes systemic problems for the United State. The size of bailout and the ultimate cost to the US taxpayer is difficult to quantify. Henry Paulson did not mince words on CNBC on the cost of the rescue: "We didn't sit there and figure this out with a calculator."

The commitment of the US treasury is US$100 billion. This compares to the US$ 250 billion cost (in current dollars) of the Savings and Loan industry in the 1980s.

This does not include funding under the secured credit facility. The amount is unspecified but may be up to the US$1.4 trillion MBS portfolio held by the GSE that can be pledged as collateral. When added to US$400 of funding provided by the Federal Reserve to the financial system, the sums involved are not trivial.

The US authorities argue that the risk of loss is low because the loans are secured against high quality ABS securities. Based on the price of similar securities in actual transactions (e.g. Merrill Lynch's sale of a portfolio to Lone Star), current market values may be below levels assumed by the central bankers. The authorities may have to hold the securities to maturity and allow the underlying cash flows to repay their loans. The risk of actual losses cannot be entirely discounted.

There may also be other claims on the government. The Federal Home Loan Banks have expanded their lending and may need more capital. FDIC funding of around US$ 45 billion may be inadequate to meet demands from bank failures requiring additional government funding.

Non-financial parts of the economy, the car makers and the perennially troubled airline industry, may also require government support.

The US government's financial flexibility in meeting increased demands for funding is restricted as the budget deficit is already high and likely to worsen with falling tax revenues. After the GSE bailout, US Treasury bonds fell in price as interest rates rose anticipating the need for the US Treasury to increase issuance to finance its requirements.

The GSE debt problem has been transformed into a US national debt problem. The US has total private debt of US$4.7 trillion of which US$2.4 trillion (51%) is held by foreign investors. The GSE takeover adds around US$5.4 trillion in debt and guarantees, of which around US$1.4 trillion is owned by foreigners.

The increase may ultimately affect the ability of the US to finance its budget deficit and trade deficit. It may also affect the USA's AAA credit rating although the rating agencies have indicated that a re-rating is not eminent. A reassessment would threaten the status of the US dollar as the pre-eminent world major reserve currency.

A complete meltdown has been avoided temporarily. Equity markets and the US dollar rose sharply in response to the plan. The recovery in equity markets has not been sustained consistent with the reaction of the markets to previous government interventions over the last 18 months. As John Kenneth Galbraith noted: "In economics, hope and faith coexist with great scientific pretension".

Some stability has returned to the market for GSE debt. On 9 September 2008, Fannie Mae sold US$ 7 billion of two year bonds at a spread of 70 basis points (0.70% pa) over comparable Treasuries. The cost was lower relative to similar bond sales the previous month. Orders totaled more than US$9 billion and after the sale the spread tightened to 66bp (0.66% pa). Domestic investors bought most of the new notes. Foreign buyers purchase 37 % of the sale, below their typical participation rate of 50%. Asian investors purchased 12 % of the notes below the 39 % of Fannie's last sale of two-year notes in July.

Treasury Secretary Henry Paulson told Congess in July: "If you've got a bazooka, and people know you've got it, you may not have to take it out." Implicit authority and threat of action is much more powerful than the actual exercise of authority that only exposes the limits of power. The fact that Paulson had take out the bazooka but also fire it highlights the depth of the problems and how compromised US power has become.

The problems at the two GSEs, the need for recapitalisation and the reduction in leverage are symptomatic of the significant de-leveraging that is under way in the financial system. Adjustment in the level of debt and asset prices is part of process of "creative destruction" through which the global financial system re-establishes itself.

Governments and central banks can smooth the transition but they cannot prevent the necessary adjustments taking place. Like King Canute, central bankers and ministers cannot hold back the tide.



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Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

Extraordinary Measures Today, a Financial Funeral Tomorrow

by Kurt Kasun


I wish I was referring to Fannie and Freddie in the title of this piece, but because those institutions are being resurrected, the funeral I am waiting for is the one for our entire fiat-based system. We are now on the brink of a collapse in confidence that brings the whole world financial system to its knees. Each market intervening action is becoming more extraordinary. The rallies which pull the suckers in following the intervening actions are becoming briefer and less powerful. I expect this one to be no different. This sequence has now become a broken record. Markets threaten to take out technical support levels and the government comes to the rescue. Armageddon is avoided until another day and a relief rally ensues on the belief that the government has fixed the problem a new bull market can begin. After all, this is how investors have been conditioned over the last three decades.

The problem is that the government has made the problem worse. This first began with the surprise unprecedented 75-basis point cut in August 07, and followed with other extraordinary actions taken in January, March, July, and September of this year. I can't wait to see what they have up their sleeves for the next debacle. Ed Sullivan would say "we are in for a really big show." They better think up something fast because they are up against a multi-decade extended market that is now headed down after just having reached a major double top:


Courtesy: TheChartStore.com

Look out below. You could make the case that the S&P 500 will decline all the way back to 500 before being rescued by technical support.

After the moves to restructure Fannie/Freddie, it should be clear to all, that there are no limits to which the government officials will go to prevent a collapse (and for politicians to keep their jobs). The only reasonable conclusion is that we will one day arrive at a point where government action is not enough, and when it does, the magnitude of the collapse will be far worse than what it would have been if we allowed it to occur earlier. We need to let this beast die as I wrote in "It's Always Darkest Before the Dawn...of a Depression."

We have strayed too far off course and there will be no avoidance of catastrophe at this point. We are just too far extended now. The decision to save Freddie and Fannie was totally expected. The third and final leg on our path to collapse (first initiated by the creation of the Federal Reserve in 1913) was set in motion by our total abandonment of the gold standard in 1971 and is now only months, if not weeks away. Nixon gets the blame, but he was merely reflecting the collective will (or "non-will") of the American people to exercise a little sacrifice and discipline and pay our national and international debts. See my piece titled, http://www.greenfaucet.com/the-market/debt-demographics-debasement-are-destiny. The price we will pay the piper will be catastrophic as a result. We became the most gluttonous nation in the history of the world. The image of that fat guy who ate so much that he exploded in that Monty Python movie comes to mind when I look for an analogy.

Many have written that our children will be paying for the extravagance of the baby-boomers for the rest of their lives. I disagree. I now think that we are close to a reckoning event that will impose austerity, economic pain and suffering on the vast majority of Americans. This will be difficult to endure and could last a while. The US Government and consumers will be forced to make major adjustments. Lifestyle changes will be revolutionary. But on the positive side, it could restore some of the bedrock principles this country was founded, built, and thrived upon (thrift over profligacy, savings over consumption, and discipline over excess). This will hopefully place us back onto the path of responsibility and sustained growth. We should be able to refresh anew after the cleansing process which expunges the huge multi-year debt overhang. This will be painful and most government officials will fight it tooth and nail, pandering to the masses to prop up the current system, now clearly doomed to failure.

This backdrop will prove to be treacherous for investors. I think we are now embarking in a period that will see financial convulsions between inflation and deflation. Battling between the two and trying to position for the correct scenario will rip most portfolios apart. If you are positioned for one while the other occurs, it destroys your capital base, leaving an investor with less to try to take advantage of the next swing. Since last August (2007), the correct bet was on the inflation trade. That trade changed on dime on July 15. Many incorrectly interpreted the dollar strengthening and rebound in deeply oversold sectors as a return a bull market for US equities. Wrong! This was a reversal of a very crowded trade as the winds of deflation began to displace inflationary forces. The reversal of the long commodities/short the dollar (and equities which benefit) was swift and brutal and continues today.

Because the jig is up and the end game / reckoning has now begun, the only question that remains is will in end in fire (inflation/hyper-inflation) or ice (deflation). I like the recent quotes from the prescient old-timer Harry Schultz (from Peter Brimelow at CBS Marketwatch) to explain: "Fed maneuver room approximately gone. Any $US injection big enough to avert a depression triggers runaway inflation. If not big enough: depression. US on knife-edge. Gold helps you either way. If Bush bails them [financial institutions] all out, the die would be cast for inflation unseen in the West since 1923 Germany. If no bail: Hello, 1929." In order to determine which scenario to position your portfolio for, I like to turn to the US Dollar for clues. The "80-level", a multi-decade support level violated a year ago, should now offer firm resistance for any further dollar strengthening as it rises to 80 once again. Look at the chart below:


Courtesy: TheChartStore.com

As the dollar rose from under 71 (the end of March) to over 79 (now) over the summer we saw an across-the-board selloff in commodities and emerging market equities and a mini-counter-trend rally in the stinky US sectors (tech, financials, consumer discretionary) where investors had previously been losing their shirts. Government bonds also rallied indicating that this was a period in which you should have been invested for deflation. We are now approaching an important test for the US dollar is it approaches 80 again. The dollar has rallied up to 80 over the last couple of weeks (not quite shown on the chart above).

If the dollar does in fact rally above 80, then I think that the deflation trade will accelerate further and takedown US equities this time in a major whiff of asset deflation which takes down almost all asset classes except US treasuries. If it continues unabated it will result in a major deflationary depression. Gold will eventually rise in value amidst the chaos and removal of the paper currencies, but not after first declining significantly.

If, on the other hand, the US dollar begins to decline back below the 74-73-level, I think that investors will need to consider repositioning for the inflation trade. While the dollar stays in the 75-80 range we can expect big gyrations, but little real movement or investment direction. In the inflationary environment, your best investment choices are energy and precious metals. If the dollar does move above 80, I view it highly likely that at some point before a deflationary depression occurs, governments and politicians around the world will massively debase their currencies and enact ultra-expansionary fiscal and monetary policies in order to fight it. Therefore, anyone with a one-way bet on deflation could be wiped out if we experience one or two highly-inflationary periods along the way.

Planning for the unavoidable collapse of this beast of a fiat financial system we must now confront (the "Financial Funeral") is thus fraught with danger as you try to navigate between seemingly wild and capricious swings between inflation and deflation. The only bet sure to fail is that the government actions will succeed in preventing the Financial Funeral from ever occurring.

The Mortgage Option

It's a case where market psychology became more important than the fundamentals, and that's why they had to act. There's no immediate crisis. It's not like they're going to run out of money tomorrow or Monday. It's a decision that the market is simply not going to accept the status quo. Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee.

Is it just me or do others notice how often unwanted changes in market prices (or, in this case, difficulties in clearing) are attributed to "psychology" or "speculation." The same chaps who cheered the rapid ascent of US equity prices during the 90s as a sign of US superiority (no psychology or speculation driving that!) now decry the rise in oil prices as speculatively driven and argue, as per the above, that with housing values falling and unemployment rising, international investor fears of GSE Mortgage Bonds defaulting is just psychological.

Evacuating a city before a hurricane hits is, under that head, psychological too. After all, my house isn't flooded or blown over....yet.

I suspect, now that Fannie and Freddie have been nationalized, (yes, I know the powers that be would prefer a different term, and they might benefit from a read of Shakespeare's views on the smell of rose by any other name) the good Senator is about to learn that the fundamentals of US housing finance are unsound.

After all, if the fundamentals were solid, surely at least a few SWFs who have been so eager to purchase equity stakes in major financial institutions (like Citi, UBS and ML, to name a few) would be willing to inject some capital into the GSEs.

OK, enough ranting. Let's take a look at the policy.

According to RGE Monitor:

Key features of government intervention (final deal to be announced before Asian markets open):
1) Fannie and Freddie and their combined $1.6 trillion investment portfolio business financed through agency bond issuance will be taken under a government-run conservatorship for an orderly restructuring process--> new housing law says that under a conservatorship, the authorities would aim to preserve Fannie and Freddie assets, rather than dispose of them.
2) The value of the companies' common stock would be diluted but not wiped out, while the holdings of other securities, including company debt and preferred shares likely to be protected by the government. (Washington Post)
3) taxpayer backstop for combined $5.3 trillion F&F owned or guaranteed debt: taxpayer funds will be used to pay any cash-flow shortfalls (e.g. due to borrower defaults) on mortgages F&F own or guarantee;
4) capital infusions to F&F in conservatorship on a quarterly basis depending on reported results instead of large capital infusion upfront;
5) Fire CEOs and replace the board

Points 3 and 4 are the keys to assessing the impact of this policy on US public sector finance, and consequently, US Bonds and the US$, inter alia.

Unlike the last US mortgage industry bail-out, which was financed by a combination of direct Treasury appropriations ($55.9B) and RefCorp Bond sales ($30.1B), this bail-out will not require a large upfront capital infusion, perhaps because, as the NYTimes avers, It is not possible to calculate the cost of any government bailout.

What makes calculation so difficult? The nature of a mortgage contract is a good place to start.

As Michael Lewis described so humorously in Liar's Poker, "no trader or investor wanted to poke around suburbs to find whether the homeowner to whom he had just lent money was creditworthy." Additionally, "[mortgage owners] couldn't be certain how long the loan lasted." If interest rates fell, people refinanced and that sweet 9% per annum investment turned back into cash, which could no longer be invested at 9%.

Default on one side and refinancing on the other makes analysis of mortgage cash flows more option like than bond like (admittedly, other bonds can default or be refinanced, but this is more the exception than the rule- to wit, there isn't a refinance index for corporate of government bonds, as there is in the mortgage industry).

Ever clever mortgage investors, however, found a way to hedge refinance induced discontinuities, they bought US bonds, with leverage. In that way, when interest rates declined and refinancing increased, mortgage investors had, in a sense, already invested the cash received at higher rates.

Alas, declining interest rate induced refinancing is not what ails the US mortgage market, rather it is defaults caused by rising rates (and inflation in general). The hedge which worked so well in the case of falling rates, came at the cost of increased risk under opposite conditions.

Who would'a thunk it?

It seems worth noting that one of the factors which kept US Gov't Bond rates so low while the mortgage machine was humming along was the leveraged hedge.

But, I digress. Let's try to get some sense of the risk of default, applied to the scale of the problem.

Unlike refinancing, which at least leaves investors with principal, in the form of cash, intact, default turns bond holders into real estate investors, in a falling market. I suspect neither China nor Japan is keen on owning large tracts of US suburbia, which may partially explain the attractiveness of the new policy.

As noted earlier, rising defaults seem to be a function of a combination of rising rates, particularly in the case of the ARMs promoted by Mr. Greenspan a few years ago, rising prices in general and stagnant wages. If we wanted to get technical a first stab might be f (i, cpi, w) = default rate where i = change in interest rate, cpi = actual inflation rate, and w = % change in wages for a certain term and type of mortgage.

So long as i and cpi were rising faster than w the default rate would, I assume, rise.

This, it seems to me, presents policy makers, having opted to guarantee some $5.3T of mortgages, with a very difficult scenario given the effect wage arbitrage has had on restraining US incomes. Keeping inflation down might require higher interest rates, which, assuming stagnant wages, might actually raise the default rate.

Rising defaults, by virtue of the need to guarantee, increases the fiscal deficit which will eventually push rates higher still, perhaps pushing more mortgages into default and the cycle begins again.

The key, it seems to me, is keeping inflation down. If oil prices continue their climb (despite the recent sharp decline oil prices are still up 35-40% y/y), and interest rate increases are needed, the cost of this bail-out could easily be in the 100s of billions with a trillion not out of the question.

An alternative method of keeping a lid of inflation is a strong US$, which, it seems to me, has been a focus of recent Central Bank activity.

If the powers that be can keep the US$ stable without igniting a more globalized inflation (which, I suspect, will prove quite difficult) the effects of this bail-out might not be catastrophic.

If, however, the US$ starts to fall and oil, and other prices begin to rise again...well let's just call that US$ doomsday.

On that note, have you read the news about Hurricane Ike?

Mortgage Giant Overstated the Size of Its Capital Base

By GRETCHEN MORGENSON and CHARLES DUHIGG

The government’s planned takeover of Fannie Mae and Freddie Mac, expected to be announced on Sunday, came together after advisers poring over the companies’ books for the Treasury Department concluded that Freddie’s accounting methods had overstated its capital cushion, according to regulatory officials briefed on the matter.

The proposal to place both companies, which own or back $5.3 trillion in mortgages, into a government-run conservatorship also grew out of deep concern among foreign investors that the companies’ debt might not be repaid. Falling home prices, which are expected to lead to more defaults among the mortgages held or guaranteed by Fannie and Freddie, contributed to the urgency, regulators said.

Investors who own the companies’ common and preferred stock will suffer. Holders of debt, including many foreign central banks, are expected to receive government backing. Top executives of both companies will be pushed out, according to those briefed on the plan.

The cost of the government’s intervention could rise into tens of billions of dollars and will probably be among the most expensive rescues ever financed by taxpayers.

Both presidential nominees expressed support for the government’s plans. Senator Barack Obama, Democrat of Illinois, said as he campaigned in Indiana that not acting could place the housing market in further distress.

Senator John McCain’s running mate, Gov. Sarah Palin, said at a rally in Colorado Springs that Fannie Mae and Freddie Mac have become too big and too expensive .

The takeover comes on the heels of a rescue of the investment bank Bear Stearns, which was sold to JPMorgan Chase in a deal backed by taxpayers. Already, the housing crisis has cost investors and consumers hundreds of billions of dollars.

The big question now is whether the federal government’s move to take over Fannie and Freddie will restore investor confidence in the nation’s credit markets, help stabilize the stock market and keep loans flowing to creditworthy borrowers.

Fannie and Freddie, by buying mortgages, provide banks and other financial institutions with fresh money to make new loans, a vital lubricant for the housing and credit markets.

Under the plan, the Treasury Department itself will begin buying mortgage securities, providing crucial market support.

As a result of the government’s intervention, the cost of borrowing for Fannie Mae and Freddie Mac should decline, because the government will be insuring their debts. Equally important, because the government is backing the companies, they will continue to buy and sell home loans.

But the plan will probably do little to stop home prices from falling further. And foreclosures are almost certain to rise.

Just a week ago, Treasury officials were still considering a wide variety of options for Fannie Mae and Freddie Mac, ranging from doing nothing to taking over the companies completely, according to people with knowledge of those discussions.

The Treasury secretary, Henry M. Paulson Jr., who won authority from Congress last month to use taxpayer money to bolster the companies, always maintained that he hoped never to use that power. But, as the companies’ stocks continued to languish and their borrowing costs rose, some within the Treasury Department began urging Mr. Paulson to intervene quickly.

Then, last week, advisers from Morgan Stanley hired by the Treasury Department to scrutinize the companies came to a troubling conclusion: Freddie Mac’s capital position was worse than initially imagined, according to people briefed on those findings. The company had made decisions that, while not necessarily in violation of accounting rules, had the effect of overstating the companies’ capital resources and financial stability.

Indeed, one person briefed on the company’s finances said Freddie Mac had made accounting decisions that pushed losses into the future and postponed a capital shortfall until the fourth quarter of this year, which would not need to be disclosed until early 2009. Fannie Mae has used similar methods, but to a lesser degree, according to other people who have been briefed.

Representatives of both companies did not return calls or declined to comment. But officials who have been briefed on the plans said late Saturday that the companies had agreed to the takeover.

On Friday, executives from Fannie Mae and Freddie Mac were ordered to appear in the offices of their regulator, James B. Lockhart, in separate meetings. They were told that regulators were exercising their authority to place Fannie Mae and Freddie Mac in conservatorship, which would allow for uninterrupted operation of the companies but would put them under the control of Mr. Lockhart.

The details of those plans continued to be worked out on Saturday, when the Federal Reserve chairman, Ben S. Bernanke, met with Mr. Paulson, Mr. Lockhart and key company executives in Washington.

While Freddie Mac’s accounting woes make it easier for regulators to force the company into conservatorship, there was more resistance from Fannie Mae, according to people familiar with the discussions. Once the government took action against Freddie Mac, however, confidence in Fannie Mae would certainly waver. Given Fannie Mae’s declining financial condition, the company has few options but to concede to the government’s demands.

Accusations of questionable accounting are not new for either company. Earlier this decade, both companies paid large fines and ousted their top executives after accounting scandals.

Freddie Mac’s current chief executive and chairman, Richard F. Syron, joined the company in 2003 after the former managers revealed that they had manipulated earnings by almost $5 billion. The next year, Fannie Mae’s chief executive, Daniel H. Mudd, was promoted to the top spot after that company was accused of accounting errors totaling $6.3 billion.

The accounting issues that brought so much urgency to the bailout appear to center on Freddie Mac’s capital cushion, the assets that regulators require them to keep on hand to cover losses.

The methods used to bolster that cushion have caused serious concerns among the companies’ regulator, outside auditors and some investors. For example, while Freddie Mac’s portfolio contains many securities backed by subprime loans, made to the riskiest borrowers, and alt-A loans, one step up on the risk ladder, the company has not written down the value of many of those loans to reflect current market prices.

Executives have said that they intend to hold the loans to maturity, meaning they will be worth more, and they need not write down their value. But other financial institutions have written down similar securities, to comply with “mark-to-market” accounting rules. Freddie Mac holds roughly twice as many of those securities as Fannie Mae.

Freddie Mac and Fannie Mae have also inflated their financial positions by relying on deferred-tax assets — credits accumulated over the years that can be used to offset future profits. Fannie maintains that its worth is increased by $36 billion through such credits, and Freddie argues that it has a $28 billion benefit.

But such credits have no value unless the companies generate profits. They have failed to do so over the last four quarters and seem increasingly unlikely to the next year. Moreover, even when the companies had soaring profits, such credits often could not be used. That is because the companies were already able to offset taxes with other credits for affordable housing.

Most financial institutions are not allowed to count such credits as assets. The credits cannot be sold and would disappear in a receivership. Removing those credits from assets would probably push both companies’ capital below the regulatory requirements.

Regulators are also said to be scrutinizing whether the companies were trying to manage earnings by waiting to add to their reserves. Both companies have gradually increased their reserves for loan losses — Fannie’s reserves today stand at $8.9 billion, and Freddie’s at $5.8 billion.

Other companies, like private mortgage insurers, have been quicker to identify large losses and have set aside much greater amounts. Fannie and Freddie have dribbled out bad news with each quarterly announcement, suggesting they may be trying to manage this process.

Finally, regulators are concerned that the companies may have mischaracterized their financial health by relaxing their accounting policies on losses, according to people familiar with the review. For years, both companies have effectively recognized losses whenever payments on a loan are 90 days past due. But, in recent months, the companies said they would wait until payments were two years late. As a result, tens of thousands of loans have not been marked down in value.

The companies have injected their own capital into pools of securities containing these loans, arguing that their new policies are helping more borrowers.

Under conservative accounting methods, changing these policies would not have any impact on the companies’ books. However, people briefed on the accounting inquiry said that Freddie Mac may have delayed losses with the change.

“We have just had to nationalize the two largest financial institutions in the world because of policy makers’ inaction,” said Josh Rosner, an analyst at Graham Fisher, an independent research firm in New York, and a longtime critic of the government-sponsored enterprises. “Since 2003, when these companies’ accounting came under question, policy makers have done nothing.”

Reporting was contributed by Stephen Labaton and Edmund L. Andrews in Washington; Jeff Zeleny from Terre Haute, Ind.; and Elisabeth Bumiller from Colorado Springs.

U.S. Plans to Seize Fannie and Freddie

By STEPHEN LABATON and ANDREW ROSS SORKIN
WASHINGTON — Senior officials from the Bush administration and the Federal Reserve on Friday informed top executives of Fannie Mae and Freddie Mac, the mortgage-finance giants, that the government is preparing a plan to seize the two companies and place them in a conservatorship, officials and company executives briefed on the discussions said.

The plan, effectively a government bailout, was outlined in separate meetings that the chief executives were summoned to attend on Friday at the office of the companies' new regulator. The executives were told that under the plan, they and their boards would be replaced, and their shareholders virtually wiped out, but that the companies would be able to continue functioning with the government generally standing behind their debt, people briefed on the discussions said.

It is not possible to calculate the cost of any government bailout, but the huge potential liabilities of the companies could cost taxpayers tens of billions of dollars and make any rescue among the largest in United States history.

The drastic effort follows the bailout earlier this year of Bear Stearns, the investment bank, as government officials continue to grapple with how to stem the credit crisis and housing crisis that have hobbled the economy. With Bear Stearns, the government provided guarantees and the bulk of its assets were transferred to J.P. Morgan Chase, leaving shareholders with a nominal amount.

Under a conservatorship, most if not all of the remaining value of the common and preferred shares of Fannie and Freddie would be worth little or nothing, and any losses on mortgages they own or guarantee could be paid by taxpayers. A conservatorship would operate much like a pre-packaged bankruptcy, similar to what smaller companies use to clean up their books and then emerge with stronger balance sheets.

The officials said that the executives were told that the government had been planning to announce the decision as early as Sunday, before the Asian markets reopen.

For months, administration officials have grappled with the steady erosion of the books of the two mortgage finance giants. A fierce behind the scenes debate among policymakers has considered whether to seize the companies or let them work out their problems.

But the declining housing and financial markets have apparently now forced the administration's hand. With foreign governments growing increasingly skittish about holding billions of dollars in securities issued by the companies, no sign that their losses will abate any time soon, and the inability of the companies to raise new capital, the administration apparently decided it would be better to act now rather than closer to the presidential election in two months.

Just five weeks ago, President Bush signed a law to give the administration the authority to inject billions of dollars into the companies through investments or loans. In proposing the new legislation, Treasury Secretary Henry M. Paulson Jr. said that he had no plan to provide loans or investments, and that merely giving the government the authority to backstop the companies would provide a strong shot of confidence to the markets. But the thin capital reserves that have kept the two companies afloat have continued to erode as the housing market has steadily declined and the number of foreclosures has soared.

As their problems have deepened—and the marketplace has come to expect some sort of government rescue — both companies have found it difficult to raise new capital to absorb future losses. In recent weeks, Mr. Paulson has been reaching out to foreign governments that hold billions of dollars of Fannie and Freddie securities to reassure them that the United States stands behind the companies.

In issuing their quarterly financial statements last month, the two companies reported huge losses and predicted that home prices would fall more than previously projected.

The debt securities the companies issue to finance their operations are widely owned by foreign governments, pension funds, mutual funds and big companies.

Officials said the participants at the meetings included Mr. Paulson, Ben S. Bernanke, the chairman of the Federal Reserve, and James Lockhart, the head of both the old and new agency that regulates the companies. The companies were represented by Daniel H. Mudd, the chief executive of Fannie Mae, and Richard F. Syron, chief executive of Freddie Mac. Also participating was H. Rodgin Cohen, the chairman of the law firm Sullivan & Cromwell, who was representing Freddie.

Officials and executives briefed on the meetings said that Mr. Mudd and Mr. Syron were told that they would have to leave the companies.

Representatives of the two companies did not return telephone calls seeking comment.

The meetings reflected the reality that senior administration officials did not believe they had the luxury of waiting for some kind of financial tipping point, as happened with Bear Stearns, which was saved from insolvency last March by government intervention after its stock plummeted and lenders withheld their capital.

Instead, Mr. Paulson has struggled to navigate through three potentially conflicting goals—stabilizing the financial markets, making mortgages more widely available in a tightening credit environment, and protecting taxpayers from possibly enormous losses.

Publicly, administration officials have tried to bolster the companies because the nation's mortgage system relies on their continued ability to purchase mortgages from commercial lenders and pull the housing markets out of their slump.

But privately, senior officials have been critical of top executives at the companies, particularly Freddie Mac. They have raised concerns about major risks to taxpayers of a bailout of companies whose executives have received huge compensation packages. Mr. Syron, for instance, collected more than $38 million in compensation since he joined the company in 2003.

Although Mr. Syron promised regulators earlier this year that he would raise $5.5 billion from investors, he has repeatedly failed to make good on that promise — even as Fannie Mae raised more than $7 billion. Mr. Syron was slated to step down from the chief executive position last year, but that was delayed when his appointed successor, Eugene McQuade, chose to leave the company.

Freddie Mac has approached numerous people about the chief executive position, including Kenneth I. Chenault of American Express and Laurence D. Fink of BlackRock, both of whom said they did not want to be considered for the position.

Another contender has been David Vitale, a former banking executive, a former chief executive of the Chicago Board of Trade, and adviser to the Chicago public school superintendent. Mr. Vitale declined to comment on whether he had been offered or accepted a position at Freddie Mac.

With the possible removal of the top management and the board, it is no longer clear who would appoint the new management.

Mr. Paulson had hoped that merely having the authority to bail out the two companies, which Congress provided in its recent housing bill, would be enough to calm the markets, but if anything anxiety has been increasing. The clearest measure of that anxiety has been the gradually widening spread between interest rates on Fannie- or Freddie-backed mortgage securities and rates for Treasury securities, making home mortgages more expensive. The stock price of the companies has also plunged over the last year.

After stock markets closed on Friday, the shares of Fannie and Freddie plummeted. Fannie was trading around $5.50, down from $70 a year ago. Freddie was trading at about $4, down from about $65 a year ago.

With Fannie and Freddie guaranteeing about $5 trillion in mortgage-backed securities, and a big share of those securities held by central banks and investors around the world, Mr. Paulson appears to have decided that the stakes are too high to take any chances.

One challenge for Mr. Paulson is that the Treasury Department is required by the new law to obtain agreement from the boards of Fannie and Freddie on any kind of capital infusion, which means Mr. Paulson has to negotiate to some degree with the two mortgage companies.

The exception to that requirement is if the companies' regulator, Mr. Lockhart, determines that the companies are insolvent or deeply undercapitalized. In that event, the government would have the authority to change the companies' managements and go so far as to take the companies over.

Experts said that the longer the administration waited, the greater the potential risks and costs.

Charles Calomiris, a professor of economics at Columbia University's School of Business, said delaying a government rescue would only increase the risks and costs.

“The last thing you want to do is give a distressed borrower more time, because when people are in distress they tend to take a lot of risks,” Mr. Calomiris said. “You don't want zombie institutions floating around with time on their hands.”

Stephen Labaton reported from Washington and Andrew Ross Sorkin from New York. Edmund L. Andrews contributed reporting from Washington, and Eric Dash and Charles Duhigg from New York.