As I outlined in my previous post Deflation Avoided?, I highlighted the massive deflationary force sweeping through the land. If you click on the link to my market update, presented internally here at Catalyst the week before the demise of Bear Stearns, I highlight the ludicrously irresponsible leverage levels of not only the investment banks, but also the GSEs (also known as Fannie Mae and Freddie Mac). As I said at the time, I find it highly unlikely that the investment banks or the GSEs will survive in their current form.
Now the storm is circling around the GSEs and Lehman Brothers. There is no real reason for Lehman Brothers to exist as a standalone company and it likely won’t much longer. It only survives today because the list of potential buyers who are healthy enough is so short and the value of the target’s equity so uncertain that it is hard to envision a deal happening until it has to, with Lehman’s equity basically wiped out. Sorry to my friends at Lehman, but that’s the fate the company has earned, anyway.
Fannie Mae and Freddie Mac are another matter altogether. They have debt and guarantees outstanding roughly equivalent to that of the Treasury of the United States of America. That debt is held against collateral that is losing value, and the companies are basically as thinly capitalized as Bear Stearns was. They are so instrumental the functioning of the mortgage market that the government just increased their role in keeping the market afloat. If they were allowed to just collapse it would literally bring the apocalypse. I don’t mean a figurative apocalypse in the sense of another Great Depression…I mean like a chaos-would-reign-over-the-Earth type of apocalypse.
The good news is everyone knows this, so the government will ride to the rescue. The bad news is the government is funded by you, the taxpayer, and it will mean our national debt will double overnight. On the other hand, the good news to that is the bond market has always looked at agency debt as having a government guarantee. Another piece of good news is that the debt is collateralized by our houses (which are losing value but not all their value) and we already owed the money anyway, so its not like we just went out and borrowed $5 trillion and shot it out into space.
Hopefully we will learn a lesson from this. Any rational person who really thought about it knew this would happen someday. You had a for-profit company enjoying the benefit of an implicit government guarantee on its debt, so it could borrow unlimited quantities at rate below it actual level of risk. In pursuit of pure self-interest, you as the management team would naturally decide to issue yourself tons of stock options, leverage your company as much as possible to make as much money in as short a period of time as possible. When grumpy Republicans try to regulate your balance sheet because you’re taking on too much risk, lavish money on your Democratic friends to keep them at bay. Pay yourself $75MM to $100MM per year to congratulate yourself for the great public service you are doing.
Right there you have the last 15 years biography of former Fannie Mae CEO Franklin Raines and his cronies at the GSEs. Well done, Franklin, I hope you’re enjoying the beach. Back here in the real world we’ll just watch the value of our houses decline and bank lending seize up.