It’s clear now that Mr. Market has called Henry Paulson’s bluff. Fannie Mae (NYSE:FNM) fell 26% yesterday while cousin Freddie Mac (NYSE:FRE) was off 22%. The death/intervention watch for the GSEs is now round the clock. But what does it mean? And what happens next?
As the Barron’s story pointed out this weekend, both companies are effectively insolvent. But the charade continues. One reality check may come very soon. Fannie Mae has nearly US$120 billion in debt that matures by the end of September. Freddie Mac has US$103 billion in debt.
Can the GSEs roll it over? Who’s going to buy it? The Russians? Central banks? Private equity? Anyone. If they can’t fund their operations or roll over their debt, what point is there in having a government sponsored mortgage lender that cannot provide liquidity in the secondary mortgage market? (Shudder at what this means for the U.S. housing market…but the phrase ‘lower prices’ comes to mind.)
Do you get the impression that Hank Paulson doing his best Harry Callahan impersonation? Paulson must have hoped that by publicizing the fact that Treasury COULD buy equity in Fannie Mae & Freddie Mac and recapitalise them, it wouldn’t actually have to do it. That the words would have all the power of actions…without any action being taken.
But Harry Callahan had a .44 magnum, the most powerful handgun in the world. And the punk he was chasing down didn’t know if Dirty Harry had fired five shorts or six. It was a gamble the punk didn’t take because the magnitude of an imprecise calculation would result in a large hole in his head.
The difference here is the market knows that without direct nationalisation, the GSEs won’t last the month, and perhaps not the week. Common equity shareholders (those that are left) are headed for the gallows. This particular weapon-“Hey if we really need to we’ll buy $25 billion in preferred convertible”-ended up firing blanks.
But what really will they become if Treasury steps in now? We don’t know yet. We don’t know if it will restore any stability to the housing market. We’re pretty sure it won’t arrest the fall in U.S. home values. It may even precipitate a blow out in the spreads on GSE debt vs. Treasuries.
About the only thing you can be reasonably certain of is that the direct assumption of Government Sponsored Enterprise liabilities should be a negative for the U.S. dollar. Even if the Feds reorganise the company, liquidate the riskiest assets, and refloat it…there’s a lot of uncertainty. Markets don’t like that.
On the other hand, there is always the remote possibility that the appearance of a resolution to the decline and fall of the GSEs will give the stock market a shot in the arm. Irrational rallies are frequent when you have a sustained period of low-level crisis. But it all seems to be reaching a crescendo this week, doesn’t it?
In the bigger picture, that crescendo sounds like this: debt-financed consumption is not a long-term strategy for economic success. A minor, but building theme, might be this: buying common stock for less than underlying value (intrinsic value, net tangible value, or earnings power) is a sensible investment strategy.
Translation: keep your eyes on the resource prize. The stocks are in for some volatility as the financial markets wait to see which dominoes fall next. But the selling in equity markets simply makes some resource shares a lot more attractive (assuming, as we do, that the trends of urbanisation and industrialisation and rising per capita incomes in the emerging world are not derailed by the collapse of America’s Ponzi finance).
One interesting question now is if the Fed’s have a fast-enough reaction time to prevent deflation in financial assets from precipitating things like a bank run and a flight to cash. Paulson and Bernanke drew their weapons, hoping they wouldn’t have to fire. But now that they do, do they have any policy bullets left? Do they have the political will?
Our guess is that they do. The Fed is becoming a buyer AND a lender of last resort. It will manage the great collateral laundering in the financial markets, exchanging Treasuries for mortgage-backed and other dodgy debt (and expanding its balance sheet as much as it takes to accomplish this, something it has not yet begun to do… “I have not yet begun to defile myself,” as Doc Holliday says in Tombstone.)
Meanwhile, there’s no need to worry about “pushing on a string.” That refers to the inability of Fed policy makers to get money into the system by lowering rates. The futility suggested by that metaphor is based on the presumption that a middle-man, the bank, is necessary to get credit into the hands of people who will abuse it. If the banks won’t pass on the Fed’s easy credit on to consumers and corporations, then interest rates as a tool for deflating away debts aren’t effective.
But the stimulus package from last year showed the government is more than willing to bypass the banks and simply write checks to Americans. Drug dealers always give away free samples to get the user hooked. After that, it’s easy.
Mailing checks to Americans is a direct stimulus, although it’s hard to hide the nature of the system at that point. That means it can’t go on for long until people begin to lose confidence. But even then, public spending can be ramped up indirectly with an increase in the kind of massive public works that FDR pursued in the 1930s.
National rail system? Check! New Manhattan Project for oil shale? Check! A war to rebuild America’s infrastructure? Check! The checks are in the mail America!
Our point? The nationalisation of the GSEs may be a kind of starter’s pistol which causes the Fed and Treasury to roll out all their inflationary guns…and fire at will.
Markets and Money