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Tuesday, September 9, 2008

FRE and FNM Bailout Details

I was looking for details of the FRE and FNM bailout. The actual details were very confusing.

The total balance sheet of FRE and FNM is approximatly $5 trillion. Viewed that way, this bailout essentially doubles the national debt. All FRE and FNM debt is backed by the Federal government.

There was a direct cash infusion of approximately $100B. With over 300M Americans, that's a direct payment of $300 per American to finance the bailout. The Federal government is not putting up the money all at once, so the exact amount of money spent is unclear. If you use $5T as the price tag of the bailout, then the cost is over $15000 per American. The money is not paid all at once; it's paid over time via taxes and inflation.

The Federal Government received options to buy approximately 80% of FRE and FNM. This severely diluted the current shareholders, resulting in the 80% drop on Monday. Anybody who knew about this provision in advance could have profited immensely.

It's ridiculous to say "The terms of the bailout mean that taxpayers won't lose money." That is complete nonsense. The average American will pay for the bailout via inflation, or via direct payments.

The CEO and Board of Directors of FRE and FNM were completely replaced. One group of politically connected insiders will be replaced with another group of politically connected insiders. The management of FRE and FNM have no obligation to repay the huge salaries and bonuses they received over the past few years.

FRE and FNM have two businesses.

  1. They purchase mortgages and resell them as mortgage bonds.
  2. They borrow from the Federal Reserve and buy back their own bonds.
These two businesses place FRE and FNM in a conflict of interest position.

FRE and FNM have their debt backed by the Federal Government. This means they can borrow at the Fed Funds Rate or Treasury Rate, plus a negligible premium. This makes it very lucrative for FRE and FNM to buy back their own bonds. The Fed Funds Rate is currently 2% and mortgages yield approximately 6%. This means that FRE and FNM can make 4% times their leverage ratio. A few years ago, FRE and FNM successfully lobbied for permission to use more aggressive ratios.

When the housing market crashed due to the Compound Interest Paradox, this whole leverage scheme blew up.

If the FRE and FNM problem were seriously resolved, they would be completely eliminated. The Federal government should assume responsibility for the loan portfolio and hold the mortgage bonds to maturity. Bondholders would be paid off; their debt was already backed by the Federal government. If money were leftover, it would be paid to preferred stockholders and then common shareholders. Most likely, preferred and common stockholders would get nothing.

The "buy mortgages and repackage them as bonds" business would be left to the other large banks. FRE and FNM are completely unnecessary.

The insiders who control the State will not dissolve FRE and FNM. They are excellent vehicles for funneling wealth to politically connected insiders. The current shareholders may be SOL, but FRE and FNM will continue to exist.

Allowing FRE and FNM and other large banks to borrow at the Fed Funds Rate and speculate on bonds allows them to earn profits without doing any real work. Negative real interest rates feed financial industry profits. The current role of the financial industry is purely parasitic.

It's pointless to argue the parasitism of FRE and FNM relative to the financial industry as a whole. The entire monetary system and economic system is defective and should be replaced.

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