As
we all know, the US Treasury Department introduced a plan to nationalize Government
Sponsored Entities (GSE) Fannie Mae and Freddie Mac. After months of rumors and the back and forth
of the costs and the effect of a bailout on the system, the Treasury announced
its plan to bailout the companies using up to $200 billion in taxpayer money ($100
billion for each GSE). In its current
form, the bailout is already the largest in the history of the world. In mid-August, the New York Times printed a
story about Nouriel Roubini, aka “Dr. Doom”.
In the article, the New York University Professor explains why he has
been so pessimistic about the US economy over the past few years in the face of
many of his peers, how he predicted the housing bust and current recession, and
why he is still negative about the short and medium term outlook for the
economy. The article closes with Mr.
Roubini saying that the US “will likely muddle through the crisis but will
emerge from it a different nation, with a different place in the world. ‘Once
you run current-account deficits, you depend on the kindness of strangers,’ he
said, pausing to let out a resigned sigh. ‘This might be the beginning of the
end of the American empire.’” Unfortunately, with the events of the past
weekend, and the inability and unwillingness of our nation’s leaders to
confront a problem before it arises, it is very difficult to disagree with Mr.
Roubini’s predictions.
What
started out as a “subprime problem” has turned into a credit crisis that has
wiped out trillions of dollars in home equity and threatens to plunge the
global economy into a recession or possibly worse. The decision that the government had to make
was not an easy one. On the one hand,
they could have let the market decide what would happen to the companies, which
would most likely have been bankruptcy and a default of the Fannie Mae and
Freddie Mac implicitly guaranteed debt, which is mostly owned by large
institutions and foreigners. The
ramifications of this could have been disastrous in the sense that if foreign
governments started to question the United States’ ability to repay its debts,
there would be a massive sell off in US treasuries and the dollar. According to
the New York Times article, “Roubini argues that the Fed’s actions averted
catastrophe, though he says he believes that future bailouts should focus on
mortgage owners, not investors”. Contrary
to Roubini’s view, the government decided to use taxpayer money, to inject
capital into organizations that are effectively bankrupt because of years of
poor management and risk controls. In
effect, 300 million Americans are being asked to pay for the financial risks
that were taken on by reckless borrowers, lenders and Fannie and Freddie bond
investors.
Many
view this unprecedented move as another example of the Federal Reserve and US
Treasury coming to the aid of Wall Street and the well connected, while Main
Street struggles to pay its bills. Where
we go from here is anyone’s guess. The
government is hoping that the added liquidity will spur lending and prop up the
housing market. If nothing else, the
plan does give the government more control over mortgage interest rates which
have been decoupled from Treasury Bond Rates for a few years now. However, the idea that the bailout will spur
demand for homes and stabilize the housing market is an entirely different
story. Going back to the New York Times
article, Roubini explains, “…we have problems with credit-card debt,
student-loan debt, auto loans, commercial real estate loans, home-equity loans,
corporate debt and loans that financed leveraged buyouts.” All of these forms
of debt, he argues, suffer from some or all of the same traits that first
surfaced in the housing market: shoddy underwriting, securitization, negligence
on the part of the credit-rating agencies and lax government oversight. “We
have a subprime financial system,” he said, “not a subprime mortgage market.” Add a rising unemployment rate, and rising
costs pretty much everywhere else, on top of all of that debt, we believe that
US consumers are most likely going to take a good hard look before they decide
on a new mortgage.
After
the bailout of Bear Stearns in the March of this year, it became evident that
the US government and the Federal Reserve were not going to allow certain banks
to go bankrupt because of fears of “disruptions to the system”. Another excuse for a bail out that Henry
Paulson actually used over the weekend is that the companies “are just too big
too fail”. It is difficult to argue with
the Treasury and the Federal Reserve’s views about the ramifications of banks
of the size of Fannie Mae and Freddie Mac failing, but there is a fundamental
and moral hazard when you subscribe to this line of thinking. Exactly what size constitutes a bank that is
“Too Big To Fail”? Perhaps this is a
good idea for a new fund category at Goldman Sachs? You have your Small Cap Funds, Mid Cap Funds,
and now the Too Big To Fail Fund. Which
would you want to invest in?
On
Tuesday, Lehman Brothers stock fell over 40%, the biggest one day drop in the
history of the company after talks about a capital infusion from Korea
Development Bank ended. It is becoming
more difficult for the banks to raise new capital now because the
counterparties are watching seemingly conservative and knowledgeable investors
lose a lot of money quickly. The New
Jersey Government Pension Trust Fund, for example, on June 11, 2008 made a $180
million investment in Lehman Brothers while the stock was trading at $28 per
share (yesterday’s closing price was $7.25, and today it’s trading as low as
$4.00). The news out of the company
yesterday wasn’t any better with an earnings report that included a $7 billion
write down, and no real plan for the future, it will be interesting to see
whether or not the company fits into the “Too Big Too Fail” category. And if you are a Lehman Brothers employee, you
are thinking why not at this point. What is so different from Lehman Brothers
than Bear Stearns? The irony of it all
is that Alan Greenspan, Ben Bernanke, and Henry Paulson all come from a free
market, Laissez Faire school of economics that preaches entirely against
government intervention because it is known to be very unlikely to work. Ben Bernanke in particular is an expert on
the Great Depression and Japan in the 1990’s.
He has written articles and books that highlight the dangers of what can
result when the government and central banks become too cozy with the financial
sector during a financial crisis. Now
that he is at the helm of the Federal Reserve, it seems that making the correct
policy decisions is taking a back seat to bureaucracy and politics.
Moreover,
the size of the combined Fannie Mae and Freddie Mac portfolios merit a much
bigger bailout than the one put together by the Treasury. On paper, Fannie Mae and Freddie Mac have
obligations estimated in the $5.5 to $6 trillion range. A $200 billion injection is only
going to keep them afloat for a limited time.
The government is betting that a) the economy will strengthen from here
on out, and b) that the consumer will be willing to borrow again. With August unemployment figures coming in at
a whopping 6.1% , and an increase from the previous month that hasn’t been seen
in years, the Treasury’s odds for winning this bet seem slim. In addition, there are still billions, if not
trillions of dollars in Adjustable Rate Mortgages that are due to reset
beginning later this year. Lastly, the
plan over the next year or so is to wind down or reduce the size of the
portfolios of Fannie and Freddie which is going to make it harder for new
homebuyers to get a loan, the exact opposite of what the bailout was supposed
to do. Luckily for Mr. Paulson, he has
already stated that he will not be coming back to serve at the Treasury no
matter who wins in the Presidency.
We
agree fully with Mr. Roubini’s views, and LRG Capital Group’s various portfolio
managers have been in agreement with him for years now. We can’t keep borrowing from abroad and hope
for the best. The bailout will help to
stabilize the economy for now, but it is no cure. The tradeoff was either to take the pain
right away, or have it drag on over a long period of time. The government chose the latter. It will cost more and will take longer to
resolve. The last country to go through
a similar situation of credit unwinding was Japan in the 1990’s. The Japanese now infamously call this period “The
Lost Decade”. We are just now seeing the
result of years of financial illiteracy and recklessness. Anyone who believes this crisis is nearing an
end has their head in the sand. It’s
time to finally listen to Professor Roubini.
www.larrygoldfarb.com or www.lawrencegoldfarb.com
