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| Economic question
Posted: 9/15/2008 9:15:01 PM | http://network.nationalpost.com/np/blogs/fullcomment/archive/2008/07/11/david-frum-on-the-demise-of-fannie-mae-and-freddie-mac.aspx
David Frum on the demise of Fannie Mae and Freddie Mac
Posted: July 11, 2008, 4:00 PM by Marni Soupcoff
David Frum
The shapers of the American mortgage finance system hoped to achieve the security of government ownership, the integrity of local banking and the ingenuity of Wall Street. Instead they got the ingenuity of government, the security of local banking and the integrity of Wall Street.
Yesterday, shares of the two U.S. mortgage companies Fannie Mae and Freddie Mac collapsed. Freddie’s shares have lost 70% of their value in a week; Fannie’s 55% over the same period.
Fannie and Freddie are technically known as government-sponsored enterprises. What that means in practice is that everybody assumes they carry a government guarantee even though in reality they do not.
This assumed guarantee has allowed them to engage in decades of dubious market activity, which has now come to a disastrous head.
For its first 30 years of life, Fannie Mae actually was owned by the government. In those quiet early years, Fannie (formally known as the Federal National Mortgage Association) borrowed at very low rates, typically an eighth of a point above the U.S. Treasury itself, then loaned the money to banks for middle-class mortgages.
In 1968, the Johnson administration decided to privatize Fannie — not for any free-market reason, but because the federal government’s debt was rising fast, and the administration realized it could make the government’s accounts look better by moving Fannie Mae’s obligations off the books.
The administration then created a second company to provide competition to Fannie. Thus was born Freddie Mac, the Federal Home Loan and Mortgage Loan Corporation. (It owes its nickname to its ticker initials FRE.)
Today the two companies together are responsible for some US$5-trillion of mortgage debt. To put that in perspective, that’s more than half the entire U.S. federal debt.
Fannie’s and Freddie’s ability to pay their debts depends in turn on their ability to collect from retail mortgage lenders. And with those lenders dropping dead like roses in a heat wave, collection suddenly looks very much in doubt.
The two institutions have long been run not by bankers but by retired political figures, predominantly Democrats. From 1991 to 1998, Fannie Mae was headed by James Johnson, a longtime aide to former Democratic vice president Walter Mondale. Johnson’s successor, Franklin Raines, had served as budget director to Bill Clinton. Jamie Gorelick, vice chair of Fannie Mae from 1998 to 2003, served as deputy attorney general in the Clinton administration.
These figures have paid themselves impressive private-sector salaries. Johnson earned US$21-million in just his last year at Fannie Mae. Raines earned US$90-million for five years’ work at Fannie Mae. Gorelick got US$26-million.
Yet the companies never had to meet the discipline of the private marketplace. They paid no taxes, and they had access to a line of credit at the Treasury department. More ominously for today’s crisis: They were not required to provide anything like the level of information about their internal operations expected of a privately owned company.
This non-transparency allowed Fannie Mae to engage in serious accounting fraud, overstating its earnings by more than US$6-billion over the Raines years — overstatements that incidentally justified the company’s lavish compensation packages. (Both Johnson and Raines incidentally also received below-market mortgages from the large mortgage company — and major Fannie Mae beneficiary — Countrywide Mortgage.)
The loss of confidence that struck the markets this week has been gathering for years. It is the natural byproduct of the bad practice of merging private business with government power.
As so often happens with large scandals, the cost will fall on everyone except the responsible parties. In 2006, federal regulators sued Franklin Raines and two other Fannie Mae executives to recover US$115-million of compensation. The case was settled for US$3-million, plus the surrender of some (now probably valueless) stock options and other contingent benefits. The US$3-million was paid from Fannie Mae’s
own insurance.
And at the polls this November, the voters will likely exact a political price for the debacle from John McCain and the Republicans — even though the party most tainted by the failure ought to have been the Democrats. Indeed, James Johnson until recently chaired Barack Obama’s vice presidential selection committee.
That’s not close enough to justice, not even close enough for government work.
That is right, the people(Congressional Democrats) who are destroying our financial systems are now controlling more of it? Instead they should be going to jail. Obama in just 3 years has collected $126,000 from fannie and freddie. For what?????????? | |
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| Economic question
Posted: 9/15/2008 10:10:06 PM | ^^^ Golly, look who got bashed first! And incoherently to boot! ^^^
I don't want to dwell, let alone start a fight, but, much as I admire the expertise displayed in this thread, a crucial element of the current crisis is strangely nowhere mentioned. I take it for granted that our experts are mum on the point because it casts doubt on their rote opposition to banking regulations.
The fact is, some of the regulations crafted in Roosevelt's New Deal have been dismantled in a long process that began in the Reagan administration. President Clinton also contributed to deregulation in some of his compromises with the Republican Congress. And, in the Cheney administration, the last regulations were undone that had prohibited banks from issuing securities. That is, under those regulations, banks could not convert their business into tradeable paper for the open market. Banks had to make their money from mortgages off of the mortgages themselves, which was powerful motivation to qualify their borrowers and make prudent loans.
With deregulation, banks could bundle mortgages as securities on the open market. Any financial institution, in or out of the mortgage business, could "invest" in mortgages just as they could invest in stocks and other securities. These bundled mortgages were traded just like stocks and other securities, and were considered and graded as conservative, reliable investments, in large part because of standard banking practices in qualifying borrowers and pricing property.
A funny thing happened, however. Because banks now saw the real money in the repackaging of mortgages, they began to cut the very corners that gave those securities value. Thousands of cases are emerging of banks who falsified borrowers' income and debts or encouraged borrowers to lie about them. Some banks also encouraged borrowers, qualified or not, to take bigger loans than they needed or could comfortably afford. Other banks encouraged inflation of purchase prices to further increas the amount of mortgages. All of this was done to make more paper for conversion into securities.
The argument that debt-crazy Americans, irresponsible individual borrowers, are to blame for the global collapse of this market betrays a charming innocence about the numbers. A few defaults - or even a lot of defaults - could not have crashed and burned Freddie, Fannie, Bear Stearns, and the L Brothers. That required the active complicity of the financial institutions themselves, who, it is clear, took advantage of thousands of mortgage clients whose interests they were bound to serve.
The only reason it is happening now is that the regulations forbidding the practice are gone. Once greed was disencumbered, it did the damage it is wont to do.
Here. Don't take my word for it.
www.baltimoresun.com/topic/la-oe-meyerhoff14jan14,0,3926437.story
www.nytimes.com/2007/12/18/business/18subprime.html
blogs.wsj.com/law/2008/06/06/mukasey-sums-up-mortgage-crisis-enron-or-no-enron/
www.salon.com/opinion/conason/2008/05/30/mccain_gramm/
R.I.F!
Vulf 
Bonus reading, just published!
www.mcclatchydc.com/227/story/52559.html | |
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| Economic question
Posted: 9/15/2008 11:20:35 PM | Good question sim. Good answers str8. Thanks! You and your prof deserve a beer on us.
The only point I'd slightly clarify is the price determined by the offering company. True, but the offering company sets that price based upon what they believe people will pay for them. So a sensible company sets the price to reflects the market valuation of the company - with appropriate hype to maximize that valuation. Price isn't wholly determined by the true value of the company.
It seems many people don't understand that when you buy shares, you are truly buying a 'share' of the company. Stocks are the same thing, simply referring to a generic collection of shares whereas shares generally refer to a specific company. The price you pay per share is the perceived market value of the company divided by the number of shares issued.
Anyone can buy and sell shares in a company. The company has no interest in the sale, other than the sale price determines the current valuation of the company. That value changes every time a new trade is made at a different share price - often several times per day. The contract price is agreed between buyer and seller, nothing to do with the company. Individuals are just trading their shares of a company. Just like any other commodity, people make money when they buy low and sell high. The company gains or loses nothing as a direct consequence of the sale, although the sale values the company. Because you actually have a 'share' of the company, you also get to 'share' in the profits the company makes. The investor share of profits is called dividends. Companies which make profits pay dividends. Companies which don't make profits don't pay dividends. Thankfully, the ordinary shareholders of a company don't have to pay up when a company makes a loss. So, dividends figure into the share value because they are extra income and the potential for income is worth something. A company losing money becomes less attractive because there are no dividends and the share value therefore drops. If the company becomes insolvent or bankrupt, the shareholders own shares of a worthless company and the shares become worthless because no-one wants to buy them. Nobody owes the shareholders anything. They just bought a 'share' of a bad company and suffered the consequences.
High share prices generally reflect a company respected by the financial community and therefore likely to pay debts.Hence loans (capital) are easier to get. In addition, companies can trade in their own shares, buying them to increase the value of everyone's share in the company (and also earn the dividends), or selling them to raise more capital. Obviously high share prices allow them to raise more capital by selling company-owned shares. | |
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| Economic question
Posted: 9/16/2008 12:08:01 AM | The bit I'm not clear about here is the second part... about investors being a source of capital for the company.
I had been under the impression that, except for the initial stock offering, all the trading of stocks that goes on is not really generating money for the issuing company.
I will try to explain this as best as I can. There are three things you need to know about how banks operate.
Like all corporations, banks need to adhere to the accounting equation. This is simply that all Assets in a company are equal to all the companies Labilities plus its Equity (or book value of the stocks). Or A = L + E.
There are two ways to calculate the value of stocks. Fair Market and Book Value. Fair market is fairly simple, it is the the price you see in the papers, it is what the stock is selling for in the open market. Book value is calculated using the equation above. You begin with taking assets and subtracting liabilities, what you are left with is the equity in the company. You then take the equity subtract the face value of all outstanding prefered stocks. You are now left with the equity that is assigned to the common stocks, this number is divided by the total number of outstanding common stocks. Prefered stcks always have a book value equal to face value. Book value will effect fair market value, but fair market value will never directly effect book value. For this question we only need to look at book value.
The last thing, and this is the tricky part. Banks use a system called fractional lending. This is a system that allows banks to loan out the same money several times. What happens is they can take a deposit and use it for colateral to borrow from the Federal Reserve many multiples more of what the deposit was worth. Simply stated if I went into a bank and gave them a $100 deposit, they could then run to the Federal Reserve borrow $1000 using my $100 as colateral. Now here's the part that makes it awesome for the banks, they take the $1000 and loan it out to other people for a profit. On paper the bank has gained equal assets to liabilities. But once they earn profits equity and assets go up equally. The banks are also allowed to use their equity as a measure for their colateral at the fed. All transactions between the banks and the fed are done electronically. This might seem like a crazy way to allow banks to operate, but it is a great tool for growth. I am not sure what the mulitplier is right now, but it is very important for the Federal Reserve to keep it at an appropriate level to encourage growth, but not allow too much risk of liabilities.
So what is happening right now is that many banks are seeing loans defulted on. This is causing the banks to take on more liabilities while their assets are shrienking. Equity is now being shrunk by both the loss of assets and the gain in liabilities. When the banks equity is reduced, they lose much of their ability to loan out money. And since banks make their profits on loans and investments, a drop in the book price is a loss in profits.
What you are seeing is not the price people are willing to pay for the stocks affecting the banks ability of earning profits. The banks are losing their ability to raise profits, and that is affecting the fair market value of the stock. | |
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| Economic question
Posted: 9/16/2008 1:19:14 AM | In a way I'm having trouble seeing this as true 'investment'... I think I'd have to own a lot of stock before I'd feel like I was part owner in a business... even then I'm not sure I'd feel I'd 'invested' so much as 'gambled'... betting money on a horse I think has a good chance to win.
Simlasa,
U.S. stock markets have collectively been described as the largest legalized gamblng casino in the world.
Another question though : So, if those stocks eventually become worthless, what does the company in question have to pay out ? Anything at all ? Does it go belly up liquidating assets to pay somebody for those stocks (which are now worthless) ? Or is it just the shareholders themselves who bear the burden here ? If it's them, how exactly does the company lose ? I mean, in a way, assuming that the company doesn't have to reimburse the shareholders much because the stock is now worthless, there's really no risk to it. Of course, I'm playing naive here because while I don't know the consequences would be for the company other than from the consumer end of thing, it seems to me that the company can't just go creating shares that can become worthless without having to assume a certain amount of responsibility or risk. Well, I would think anyway.
You've pretty much just described the dollar bill.
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| Economic question
Posted: 9/16/2008 1:50:17 AM | My understanding is that those sales, that trading... even if the value doubles from the initial sale price... generates no further income for the issuing company. They can only sell one share one time.
(they could release some more stock or split shares or something... but that's a different matter).
But you said
your stockholders become disillusioned, turn in their stock certificates and take their money out of the company.
That sounds like you are saying that the stockholders can show up and ask for the value of the stock from the company somehow...
They COULD show up - if they hold actual certificates. In very old days, they did just that. I was being figurative here - sorry. They'd just call their broker and issue a sell order to unload on someone else.
As for shareholders affecting company capital - as has been discussed, it can be by any number of ways - both up and down. A smart company might want to hang onto a good number of shares - selling them when prices go up, buying them if prices dip downward - so again there's capital based on actions of others.
"The shareholder" is actually normally a large number of people who may or may not react to the news of the day and how it affects the company. If they are satisfied (as has been discussed) the value of the stock remains good and the company can take advantage of this "good will" (for lack of a more appropriate term) in many ways, including its very existence.
If the news is derogatory - think Bear Stearns - the shareholder actions of dumping the stock as quickly as possible in vast numbers can have a fatal effect on company capital and even existence. Bear went from over $30 a share on a Friday, to - in Morgan Stanley's opinion which was based purely upon greed - a mere $2.50 a share on Sunday. The threat of this government funded buyout stood to wipe out smaller mom and pop shareholders and destroy retirement savings for many.
Only media exposure of Morgan's greed caused it to revise the offer to $10 a share, salvaging some of the value so others could walk away with some cash instead of nothing at all. As it is, Morgan got it for a song, as Bear's office building alone was worth $1.1 billion. Morgan paid about $250 million for the whole company including paper assets and saw a minimum 400% profit on the buyout immediately. They had been looking at over 1,500% immediate profit - greedy **stards.
Morgan has a long history of using its position on the Federal Reserve to leverage assets out of other companies, to privately profit using taxpayer money. Yes, we the taxpayers funded this profitable venture. Nice scam if you're in the position to pull - and they are.
But it was the media and the shareholders' continuing run on Bear that brought it from around $80 a share a few months earlier, to $30 a share the Friday before Morgan bought them out. They were effectively insolvent by Sunday, due to extensive media focus and brow-beating by the Fed and Morgan Stanley. No one was willing to lend them any further operating capital. It was take the deal or file for bankruptcy.
So shareholder action definitely has an effect upon the capital of a company. Positive as well as negative. | |
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| Economic question
Posted: 9/16/2008 8:37:52 AM | Great point Ryan. I missed that one but recognized it immediately. - thanks.
And probably most relevant to the current banking crisis. | |
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| Economic question
Posted: 9/16/2008 7:14:26 PM |
in Morgan Stanley's opinion which was based purely upon greed - a mere $2.50 a share on Sunday...They were effectively insolvent by Sunday, due to extensive media focus and brow-beating by the Fed and Morgan Stanley
My apologies and a correction.
The above should read "J.P. Morgan & Co", not Morgan Stanley, which was a spin-off started by J.P. Morgan's grandson. | |
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