Gold News

Financial Doomsday

Might Fannie & Freddie implode? Watch the collapse in US Treasury bonds if Congress moves to prevent it...

"THE DOWNTURN in the housing market is beginning to bite corporate Australia," reports Ben Butler in today's Herald Sun, says Dan Denning for The Daily Reckoning.

   "Shares of big building supplies company CSR plunged almost 15% yesterday after it warned the housing market was taking a hit from high interest rates and declining confidence."

And so it begins. Or rather, it actually began years ago, back when people began to think that house prices always go up in double digits. But it will be interesting to see how things develop here in Australia. In the US and the UK, the mortgage lenders fell first, then the builders, then the banks, and finally the consumers.

The two big pillars of the US mortgage system – Fannie and Freddie – are surely doomed, too. First US Fed chairman Ben Bernanke told Congress both are well capitalized. Haven't we heard this one before?

Isn't this what Bear Stearns said before it collapsed? Didn't Citigroup say it was well capitalized, and then ask for more money? Why would anyone believe these investment bankers anymore when they tell the public they are well capitalized? It's almost like the moment a CEO of a company says it's "well capitalized" you should be prepared for a nasty shock.

We don't mean to alarmist about the government-sponsored US mortgage enterprises (GSEs). But as we explained to a colleague over the weekend, our job here at the Old Hat Factory is not to tell you what you may already know, or can read in the papers. Our job is to tell you about the low-probability but high magnitude investment events that could affect your money.

And just to be clear, the collapse of Bear Stearns and the whole credit crisis would look like mere child's play should a genuine crisis unfold in the quality of the debt owned and guaranteed by Fannie Mae and Freddie Mac.

It would be equivalent to that absurd scenario in that global warming movie a few years ago, where the Gulf Stream stops flowing and the entire Northern hemisphere enters a new ice a matter of days. The insolvency of the GSEs is as close as you're ever going to want to get to Financial Doomsday and live to tell about it.

Yet just this week former Fed governor William Poole told the world what many have been saying for awhile now: if you use conventional accounting methods, Fannie and Freddie are already technically insolvent.

Poole said, "Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer."

In simple terms, Poole points out that Freddie Mac owes $5.2 billion more than its assets are currently worth. Shareholders took note. Fannie shares fell 14% in New York trading while sister Freddie fell 22%.

What's really bad news for these companies is that two US Senators stood up to tell the world that these two companies are "too big to fail". Republican presidential nominee John McCain told reporters "They must not fail" and that they "are vital to Americans' ability to own their own homes."

Later, the distinguished windbag Senator from the state of New York, Charles Schumer, said that "markets should be assured that the federal government will stand by Fannie Mae and Freddie Mac." He said the firms are "are too important to go under," and Congress "will act quickly".

Who do these men think they are, Moses parting the Red Sea? We've never seen a public servant or elected politician perform a miracle. Acts of God that defy the laws of nature are generally reserved know...God. Saying something "must not fail" doesn't mean you can prevent it.

But it's Friday. So how about a hand for the unbridled idiocy of American policy makers! How about a standing ovation for the dizzying heights of audacity reached by people so far out of touch with reality that they believe they can defy the laws of economics? Hip hip! Hooray!

What exactly do you think the US Congress can do to save the GSEs? By our reckoning, it can provide the GSEs with cash to continue to meet operating expenses. There are only two other options. And let's be clear about this: if the US Government chooses either of the remaining options, it will be a virtual death blow for the US Dollar the rest of this year and pop the largest remaining sub-bubble in the credit market.

Nuclear Option 1). First, Congress can ask the Fed to extend its securities lending program to the GSEs. Fannie and Freddie would be able to exchange impaired mortgage-backed bonds for liquid US Treasuries.

   Granted, the Fed is running low on Treasuries already, having lent billions to its buddies on Wall Street. But that is a great thing about being a central bank with a monopoly on money. The Fed can simply print more money to buy more Treasuries, although the US Treasury Department would have to create new debt to sell to the Fed.

Nuclear Option 2).
The other option for US policy makers is to clearly state that Fannie and Freddie bonds are backed by the full faith and credit of the United States government. You can take that for what it's worth. We wonder how the bond market would take it.

   How much faith and credit does the world currently have in the financial position of the United States? Just take a look at the Gold Price in Dollars over the last three years to get a close approximation.

   Fannie and Freddie have guaranteed more than $5.2 trillion in mortgage-backed bonds and securitized mortgages. Who owns them? As we said the other day...everyone! Central banks, pension funds, insurance companies, you name it. The big and terrifying fact for the world's financial system is that GSE debt makes up some portion of the assets of many financial institutions and investment funds.

   The US government can move to stabilize that market by guaranteeing the debt. But we believe that if it does so, the move will lead directly to the popping of the other big remaining bubble in the credit markets: the US Treasury market of government bonds and notes.

   In the sixty-three years since the end of World War Two, there hasn't been a much safer investment on the planet than US Treasury bonds, at least according to conventional wisdom. But the credit rating agencies, for what they're worth, would have to take a serious look at downgrading the credit quality of sovereign American debt if the US government changed its implied backing of GSE debt to an explicit backing.

   The consequences of a (much deserved) lower credit rating for the US government are too long to go into here. Suffice it to say the bond market won't wait. The trouble is, what do you do with your money if government bonds aren't safe? Cash is one answer. Owning some form of your wealth in precious metals is another. Gold should regain ground against oil in the second half of 2008 if the GSE story continues to unfold in nightmare fashion.

Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

See our full archive of Dan Denning articles

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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