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October 12, 2008

Evelyn Mulwray

In a climactic scene of 1974's noir classic "Chinatown,"  Jack Nicholson's character LA private eye Jake Gittes is confronting Faye Dunaway's character Evelyn Cross Mulwray.  Gittes demands that Mulwray explain the identity of the little girl she is trying to spirit out of town. 

"She's my daughter," Mulwray says.  Gittes slaps her hard.

She's my sister," Mulwray says, and Gittes slaps her again.

"She's my daughter."  Slap.  "She's my sister."  Slap.

And so on.  The horrible truth is that the girl is Mulwray's daughter and her sister through an incestuous relationship with her father.  It's the capstone image of the cesspool of corruption into which Gittes has fallen while investigating water deals in post-war Los Angeles.

My Sister

This is the image that's been running through my mind this week.   Fannie Mae's and Freddie Mac's new regulator announced that while both companies were adequately capitalized, they were not adequately capitalized and anyway, from now on FHFA won't worry about whether they're adequately capitalized or not.   According to the October 10, 2008 Washington Post,

"Fannie Mae and Freddie Mac had said at the end of June that they had billions of dollars more of a financial cushion than required by their regulator. The report by the Federal Housing Finance Agency yesterday reaffirmed that, saying Fannie Mae had $9.4 billion and Freddie Mac had $2.7 billion more capital than required.
"But, even though the companies were adequately capitalized, the regulator yesterday declared them undercapitalized.  How did it square that circle?
"The regulator, in essence, said capital wasn't a good enough barometer of the companies' financial footing. The law gives the regulator the authority to designate the companies undercapitalized even if they technically have enough capital. In its report, the FHFA said that the sharp downturn in the mortgage market over the summer ‘raised significant questions about the sufficiency of capital.'
"...Usually, being declared undercapitalized would subject the companies to modest penalties, but none will be exacted while they are under government control. The FHFA also has suspended the capital requirements, though the companies will continue to disclose capital figures in their quarterly reports. The government set up a program to lend money or inject capital if the companies falter. "

Note that although the conservatorship came with authority to inject up to $200 billion into the two companies to shore up their capital, to date not one dollar has been invested.  The companies continue to operate much as they did before the takeover, without any taxpayer money so far being spent.

That could change in a hurry, though, because FHFA also announced this week that it is wrenching them back into the portfolio lending business.  But this time, the regulator wants to make sure they buy junk.

My Daughter

Earlier this year FHFA Director James Lockhart said repeatedly that Fannie and Freddie's portfolios were not needed to help stabilize the markets or carry out their mission.  Both companies, he said, had ample opportunity to guarantee securities backed by mortgages and let other investors buy them.  GSE bashers from all sides opined that their portfolios were a prime source of the credit crisis, that they were unnecessary vestiges of a bygone era, and had permitted the two companies to borrow huge amounts at discounted rates to re-invest it to buy mortgage securities in a market that didn't need them.

Since then, Fannie and Freddie have been practically the only source of capital in the mortgage markets.  When Freddie announced it had shrunk its portfolio by more than $30 billion last month, shivers went through the markets because of the sudden prospect of even less liquidity for mortgage debt.

Secretary Hank Paulson said that they would increase their portfolios by a modest amount over the next 18 months when the US Treasury and FHFA forced the two companies into conservatorship in September.  After that, he expected them to be reduced over 10 years to around $250 billion each.  They are both presently at a about $760 billion.  At the time, I wrote that "The announced intention to force the companies' portfolios into an annual 10 percent reduction to $250B each begs the question of what sources will make up this difference, or why it is sensible, wise or necessary prior to determining the best future course for the system."

Now this week, Bloomberg's Dawn Kopecki reports that

"Federal regulators directed Fannie Mae and Freddie Mac to start purchasing $40 billion a month of underperforming mortgage bonds as the Bush administration expands its options to buy troubled financial assets and resuscitate the U.S. economy, according to three people briefed about the plan.
"Fannie and Freddie began notifying bond traders last week that each company needs to buy $20 billion a month in mostly subprime, Alt-A and non-performing prime mortgage securities, according to the people, who asked not to be identified because the plans are confidential. The purchases would be separate from the U.S. Treasury's $700 billion Troubled Asset Relief Program."

Now that the government owns them, it seems that their portfolios are not only useful tools in a credit-starved marketplace.  They are  handy tools to purchase junk. 

Some folks who ought to know tell me on Monday, October 13, 2008, that this report is unfounded.  I hope so.  But so far there has been no retraction on Bloomberg and no disclaimer from FHFA, Treasury or anywhere else that I could find.  If it's not true, someone please stand up and say so!

This news comes at the same time the Treasury is reported to be reconsidering the $700 Troubled Asset Recovery Program (TARP) it just got Congress to approve.  Treasury apparently won't be haggling with Wall Street banks and others holding this toxic crap to force a cramdown.  Instead, it seems that Treasury will buy shares in banks and Fannie and Freddie will lighten their debt load using their now-government guaranteed portfolios.

It's Chinatown, Jake

So, to recap: 

During most of 2007-08, Director Lockhart used his authority under settlement agreements with both companies to limit their portfolio growth through requiring both to hold penalty levels of capital.

When Congress pushed to allow their portfolios to expand, Lockhart and others responded that they could issue mortgage backed securities instead.

In September, Lockhart triggers new conservatorship powers asserting that they are in danger of being undercapitalized.

A month later Lockhart acknowledges that they actually both have sufficient capital according to the standards laid out in law and administered by Lockhart himself.  But he announces these measures are actually no good, so the companies had to be taken over anyway.  Lockhart questions whether certain assets claimed by the companies are really valid.  Although the companies are using the same generally acceptable accounting principles (GAAP) that everyone else does to value these assets, Lockhart decides these may not be good enough to rely on.  Footnote here:  can you remember what happened the last time someone suggested that GAAP accounting rules weren't being followed at the GSEs?  Can you say, "fired?"

In October, without having spent any of the funds set aside to shore up the two companies, Lockhart apparently has decided that both should dive back into the portfolio lending business big time, and start making a market for bad mortgage assets stuck on others' books. 

No wonder Fannie and Freddie must feel like poor Evelyn Mulwray.  Slapped this way, slapped that way.  What's a girl to do?

But as the man in the movie says, "forget it, Jake, it's Chinatown."


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