Fannie Mae and Freddie Mac Investors Have Already Lost 80% of Their Money

Back on the job...

USA Today was in a blue mood on Friday. The stock market fell more than 300 points the day before, after its reporter realized that falling commodity prices were not necessarily such good news.

"Investors fear that crashing oil, coal and platinum prices signal something far more sinister: a sharp business slowdown abroad that could crimp the economy here and hamper US corporate profits."

Retail sales are weak. On Friday, we reported that unemployment is at a five-year high...and foreclosures have hit a new record.

Of course, when you sell houses to people who can't afford to pay for them, you have to expect to get some returns. And you have to expect that the folks who financed the mortgages will regret it. In the case at hand, the investors who bought shares in the mortgage twins - Mac and Mae - have already lost 80% of their money.

And yesterday, the U.S. government seized control of the mortgage giants. The New York Times reports:

"Hurricane Hank swept through the nation's capital yesterday with gale-force regulatory winds and a tidal surge of federal cash, upending two of Washington's biggest enterprises and permanently changing the landscape of housing finance in America.

"In wresting control of Fannie Mae and Freddie Mac, and in authorizing the Treasury to begin purchases of mortgage-backed securities, Secretary Henry M. Paulson Jr. has taken responsibility for assuring that low-interest loans will continue to flow into the country's hard-hit housing markets. Not since the early days of the Roosevelt administration, at the depth of the Great Depression, has the government taken such a direct role in the workings of the financial system.

"Although the details of yesterday's takeover are complex, the rationale is quite simple: to restore some semblance of normalcy to the housing market. Paulson and other policymakers think that until that happens, neither financial markets nor the wider economy will be able to regain their footing.

"Fannie and Freddie did not go gently into conservatorship. Although their access to badly needed equity capital had dried up and their borrowing costs had increased, they had hoped that they could muddle through by raising fees and demanding higher interest rates from borrowers. But that plan was cut short when Paulson, backed by Fed Chairman Ben Bernanke and their newly empowered regulator, James Lockhart, concluded that Fannie and Freddie could no longer reconcile their sometimes-conflicting obligations to shareholders and homeowners without posing additional risks to an already shaken financial system.

"Under the deal they could not refuse, Fannie and Freddie directors and top executives will lose their jobs. Shareholders will lose their dividends, voting rights and most of their ownership stake, while agreeing to pay dearly for the government's money and backing. Left unharmed will be holders of trillions of dollars in Fannie and Freddie debt - or securities backed by mortgages that Fannie and Freddie have insured against default - who will get all their money back, with interest."

We pause for a moment to review. For a long while, we described the financial world as though it were a war - a battle between the natural forces of deflation (following a bubble)...and the unnatural forces of inflation (as the feds continue to pump up the supply of money and credit).

Early this spring, inflation had the upper hand in this war. Prices were soaring for oil, metals, food, fertilizer - and just about everything else. Commodities were going up because the go-go economies of Brazil, Russia, China and India were going so fast. And not only were their raw materials prices moving up fast, so were there internal labor costs. So, instead of exporting lower priced goods - as they had been for the last 15 years - they began to raise prices too.

Then, the gods of financial war went over to the other side. The emerging economies slowed down. Demand for commodities slumped. The price of oil dropped from a high of $147 down to $106 on Friday. Gold fell down below $800. Yesterday, it rose $2.80 - to end the day at $806. And bonds too are signaling a weaker economy. The 10-year T-Note has risen in price to yield only 3.66%.

What is behind this shift in the fortunes of war? Why are the feds losing this battle?

Well, it's not clear that they are really losing. So far, they are beating an orderly retreat. The economy is pulling back. But the feds believe they can still win. Curiously, all the shooting and casualties have encouraged investors to seek safety. They believe they've found it in the U.S. dollar. Investors expect lower inflation rates; that's why they're willing to buy U.S. bonds and notes at yields well below the current inflation rate. As long as the dollar holds, and inflation rates are under control, they figure they can continue pulling back in good order...until the U.S. consumers get back on their feet.

We don't know what will happen. But that doesn't prevent us from taking a guess - that it ain't gonna work that way - and hang on to our gold.

*** Former Federal Reserve Chairman Paul Volcker says the U.S. financial system is "broken."

At a banking conference in Calgary, he went on to predict that "Growth in the economy in this decade will be the slowest of any decade since the Great Depression, right in the middle of all this financial innovation.''

"It is the most complicated financial crisis I have ever experienced, and I have experienced a few," said Volcker. That's quite a statement from a man who, as Fed chief from 1979 to 1987, had the duty of battling down the runaway inflation of the 1970s.

At the end of last year, Short Fuse and Addison had the opportunity to sit down with Dr. Volcker in his office above Rockefeller Center in New York City for an interview for I.O.U.S.A. He told the movie crew that he felt that the United States was careening down a path it had traveled before, when inflation got the best of the country.

"With respect to the fiscal crisis looming out there in the future," he said, "We'll see whether a democracy can deal with an obvious problem that's going to be present in not too many years. The earlier we take action to deal with it the better."

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

P.S. to get The Daily Reckoning direct to your inbox sign up to our free e-mail newsletter or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.

Related Articles:

• Fannie and Freddie in a Free Market Economy
• What’s Going to Happen to the Mortgage Twins – Fannie and Freddie
• Fannie and Freddie Say Goodbye to Veto
• Fannie and Freddie are Finito
• The Disturbing Facts About Paulson, Fannie, Freddie and Friends