Strategy

A blank cheque for America's mortgage giants

Critics say extra bailout dollars bring mortgage giants closer to nationalization.

Tim Geithner is on a roll. Indeed, despite his critics, the U.S. Treasury secretary was lauded late last year as one of the key architects of the global financial sector’s apparent recovery.

At the time, the former investment banker was making noise about taking the world’s largest economy off life support, which helped market bulls roar into the new year. Since then, he has extended the US$700-billion Troubled Asset Relief Program to, among other things, address housing market weakness and revive small-business lending. And that was nothing compared to the time bomb he tried to drop quietly before the holidays, on Dec. 24, when Fannie Mae and Freddie Mac, America’s beleaguered mortgage giants, were granted access to unlimited bailout dollars.

Late in the day on Christmas Eve, Treasury officials issued a press release. It was billed as a simple update on housing-market support programs. But buried deep inside was the unexpected announcement that Washington was removing its US$400-billion cap on aid to Fannie and Freddie, which jointly own or insure about US$5 trillion of mortgage-backed securities.

Lawmakers from both political parties were outraged by the move, which has the potential to put America’s triple-A credit rating in jeopardy. Republicans have called on the House Financial Services Committee to hold a hearing, while Democratic Congressman Dennis Kucinich, chairman of the domestic policy subcommittee of House Oversight Committee, is planning his own probe.

“This relationship between Treasury and Fannie and Fredie bears inspection,” Kucinich announced in late December, “particularly in the wake of reports that the mortgage giants’ chief executives will now receive US$900,000 each in annual compensation, bonuses of up to US$6 million each.”

Treasury officials insist the news – issued one week before the expiration of White House authority to extend more aid to the firms without congressional approval – should not be taken as a sign that the two so-called government-sponsored enterprises (GSEs) need an unlimited credit card to survive.

Some market watchers buy that line, noting the two firms have used only about a quarter of the US$400 billion put at their disposal after Washington seized them in September 2008 due to losses from rising home foreclosures and falling home values. But David Kotok, head of New Jersey — based Cumberland Advisors, almost choked on his eggnog when he heard the news. He then voiced disgust in a special market commentary entitled “Government by Stealth,” which was issued on Christmas.

“We didn’t plan on writing today,” the high-profile money manger noted, “but are doing so to be sure our clients and readers and especially the 300 worldwide journalists on our [distribution] list see the action just taken by the Treasury Department under Secretary Geithner.”

According to Kotok, the timing of the announcement was clearly designed to minimize press coverage of worsening conditions at Fannie and Freddie, while paving the way “for the recognition of losses in the hundreds of billions.” America,he added, is now one step closer to the full nationalization of the troubled mortgage giants, which would place their liabilities on the government’s balance sheet.

Peter Demirali, a portfolio manager who works with Kotok, says letting Fannie and Freddie crash would be worse. He thinks everyone should remember it was a failed attempt to shore up the GSE balance sheets that started the financial crisis in 2008. “We know the result,” he says. “Lehman Bros. failed. AIG was taken over. And every asset class save Treasuries got pummelled.”

Cumberland argues it is time to officially accept U.S. taxpayers are on the hook for the multi-trillion-dollar liabilities associated with Freddie and Fannie. Nevertheless, Demirali says, doing that will “blow a hole” through Uncle Sam’s budget and move rating agencies to downgrade American debt.

Daryl Jones, an analyst with Research Edge, based in New Haven, Conn., agrees U.S. liabilities are going to get a lot worse in the years ahead. In a recent commentary, he notes U.S. debt as a percentage of GDP has already seen exponential growth in the past two years, after climbing steadily since 2000. The current ratio of 83.5% is a level not seen since the 1950s. And if you include the obligations of Fannie and Freddie, the ratio jumps above 120% – the highest point ever, or at least since they first recorded these statistics in 1792.

To help people understand the problem, Jones points out America’s balance sheet woes have placed it fifth among countries with the highest level of indebtedness, just above Singapore and just below Jamaica. The only other countries more indebted are the economicstalwarts of Zimbabwe, Japan and Lebanon. “Keep your eyes on U.S. government debt,” he warns. “This Queen Mary is not turning any time soon and will hold investment implications related to many asset classes for years to come.”

Strangely, some investors managed to see the new support for Freddie and Fannie as a reason to bid up company shares. That made no sense to Bose George, an analyst with investment bank Keefe, Bruyette & Woods. As he pointed out, unlike TARP recipients, neither mortgage firm is being forced to follow guidelines that supposedly align executive compensation and shareholder interests. In other words, Freddie and Fannie are run by executives who don’t want to be paid with stock or options. And that, George says, “reinforces our view that the common shares will eventually trade to zero.”

So if Treasury officials really want to restore faith in Freddie and Fannie, then maybe Geithner should be paid in GSE stock. That may sound silly, but it would be better than trying to dump a load of coal on the market on Christmas Eve.