By Shah Gilani

It’s the end of the “American Dream.” It’s the story of how the inevitable bailout of insolvent housing giants Fannie Mae (FNM) and Freddie Mac (FRE) – with the Federal Housing Administration soon to follow – will ultimately lead to such sorrowful sequels as “TheDeath of the Dollar,” “The Downgrading of U.S. Government Debt” and, yes, “The Depression.”

Let’s be very clear on one point, however: There’s no question about it – Freddie and Fannie have to be supported. If the doctrine of “too big to fail” didn’t already exist, it would have to be invented – immediately. Although many are arguing against a “bailout,” those “experts” never seem to address the fallout that would emanate from such a strategy. Nor do they ever discuss the sad series of events that brought us to this financial brink. On that latter point, the truth is so ugly and the failure of governance and its resulting greed so disgusting that to not understand it will guarantee the loss of the American Dream for generations.

Fannie Mae and Freddie Mac: From Dream to Drama

Because it was designed to foster capital creation – and directly promote the American Dream of home ownership, as well as a vibrant economy – the creation of Fannie Mae and Freddie Mac involved some of the best and brightest legislation ever enacted.

That brings us to the most obvious question of all: What went wrong?

First and foremost, both Fannie and Freddie should long ago have been phased out as “government sponsored enterprises,” or GSEs. The implicit (now explicit) guarantee of U.S. government backing allowed the firms to borrow cheaply in the capital markets. If fixed-income (debt) investors – and equity investors as well, for that matter – believe their investments are guaranteed, they will likely invest more and with greater comfort.

The result: These enterprises are able to borrow more cheaply than their rivals – namely banks, investment banks, mortgage companies and other non-bank lenders.

Since Fannie and Freddie were able to borrow more for less, they were also able to post fatter profit margins and dwarfed all potential competitors. The federal government should have gradually unshackled itself from this implicit backing by simply declaring a timetable over which future debt issuance would be explicitly exempt from any government guarantees. This graduated phaseout would have resulted in existing debt being guaranteed up to its maturity, while any new debt would have to be raised competitively, and not at preferential rates. This would have fostered competition, reduced the swelling balance sheets of both enterprises, and kept U.S taxpayers from having to be on the hook for both institutions.

How simple that would have been.

Secondly, and manifestly because of their ability to cheaply fund their balance sheets, both enterprises diverged from their mandates and began to buy and hold the securities they were supposed to create and sell to investors. They bought their own products. The more they created, the more they bought. Ultimately, both enterprises were making more on an operating basis – by fattening their own balance sheets with trillions of dollars of their own securities – than they were making in fees from originating, guaranteeing and selling mortgage debt.

Both enterprises began to borrow aggressively and fund their purchases by borrowing shorter. Their “protected” status enabled them to tap the market whenever they wished.

After recognizing they were creating the classic dilemma of borrowing short and lending long, Fannie and Freddie decided to mitigate their interest rate exposure by hedging with swaps and derivatives. They also bought insurance from the monoline insurers, expecting that their investments would be further protected by these insurers whose own capital was so inadequate that they could never pay 1/100th of their contingent liability exposure.
So, just how big did the balance sheets of Fannie Mae and Freddie Mac actually get? Together, the two housing giants currently guarantee or hold approximately $6 trillion of mortgage-related securities.

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Those Missed Opportunities

The capital base underlying their bloated balance sheets was never adequate.

Never.

But again – because of their importance in the grand scheme of capital formation and the implicit government guarantee – investors didn’t focus on their equity or capital base. Just like what happened with technology stocks in the late 1990s, housing prices just kept moving higher.

Both companies saw their share prices escalate as the investments they held made money. Everyone’s eyes were diverted. People were getting rich – debt and equity investors, and especially management.

All hell should have broken loose when, in 2003 and 2004, Fannie Mae suffered from massive accounting scandals. Its top three executives pocketed over $115 million. They were cooking the books. After billions of dollars of the company’s money was spent to “fix” the accounting problems and $400 million of fines were paid by the company, no one went to jail.

Yes, you heard that correctly.

Where were the regulators? Where was the congressional outrage? Where were the analysts and ratings agencies?

There are myriad technical aspects to the workings and investments of both Fannie and Freddie. And there are many questions as to how they were allowed to grow and expose taxpayers to their massive liabilities, and how they are able to manipulate and coddle regulators when it comes to their accounting and specifically their capital adequacy.The day of reckoning has finally arrived. The Painful Payoff of the Fannie/Freddie Debacle Because of the precipitous drop in both companies’ share prices, the resulting erasure of their capital, and the fact that Freddie Mac was yesterday (Monday) scheduled to auction off $3 billion worth of 3-month and 6-month notes (they reportedly sold), the rescue was inevitable. In a classic attempt to calm the markets Sunday, U.S. Treasury Secretary Henry Paulson said the Treasury Department and the Federal Reserve will provide a “liquidity backstop” by offering a line of credit that is “to be determined.” Furthermore, “if needed,” it will supply “temporary authority to purchase equity” in the enterprises. [For a more-detailed story on Treasury Secretary Paulson’s bailout plan - including some harsh criticism’s from investing guru Jim Rogers, check out our news story on the Fannie Mae/Freddie Mac bailout plan also published in today’s edition of Money Morning.]

The Treasury Department and the Fed also will strengthen regulatory measures.
Now, I’m relieved!

The bailout has begun. The $6 trillion burden will be shouldered by U.S. taxpayers. U.S. debt will double to the equivalent of our gross domestic product (GDP). Borrowing costs will rise for homebuyers, further depressing the housing market and leading to hundreds of billions of additional bank write-offs, hedge-fund losses and failures of financial institutions and enterprises ranging from banks to hedge funds.

The Fed has no concern about inflation relative to the demise of the economy, and will have to keep interest rates low for critical liquidity demands and to stave off a deep recession. The building inflationary pressures in the face of the Fed’s efforts to provide liquidity and keep interest rates low will crush the dollar.

We are facing the prospect of a depression and the end of the American Dream. What can be done? Will the housing legislation on the table be the rescue plan we desperately need?

Absolutely not.

This crisis can’t wait. I’ll address the legislation, why it will fail and what should be done later this week.

Don’t be fooled by any bounce in the markets. Every bounce is an opportunity to sell and add to shorts. This is no time to be picking bottoms. The trend is your friend – and that trend is clearly down.

[Editor’s Note: Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In his new column, "Inside Wall Street," Gilani vows to take readers on a journey through the "shadowy back alleys" of the U.S. capital markets - and to conduct us past the "velvet rope" that guards Wall Street’s most-valuable secrets - in an ongoing search for the investment ideas with the biggest profit potential.]

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