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Investors, mortgage holders and policymakers are gawking at the New York Stock Exchange these days like drivers passing a 100-car pileup, mesmerized by the crash of two more financial giants and hoping the debris won't damage their own vehicles.
Yet unless you have all your money under the mattress, fat chance of avoiding a direct hit now, as the same sort of misguided government policies that brought us $145-per-barrel oil and a five-year Iraq war have now clearly taken the American financial system to the brink of ruin.
The problem in focus today is the implosion of the two largest U.S. financial institutions focused solely on residential mortgages, Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs), and how the government hopes to rescue them.
These two quasi-governmental organizations charged with safeguarding the bedrock of American society, the home, were encouraged by policy to place bets on dangerous loans that would make a Las Vegas bookmaker blush with embarrassment. Now those loans are going bad in an unprecedented but not unpredictable way, at the expense of homeowners and American citizens.
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These issues have been simmering for more than a year but burst into investors' consciousnesses last week, sending the two government-sponsored enterprises' shares down by 45%.
Today Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke proposed new ways to shore up the two financial institutions' accounts by making them eligible for cheap loans and equity infusions of staggering size: $15 billion at minimum and probably much more. Yet investors in Europe, in Asia and even on Wall Street are much savvier now than they were last year at this time and called the bluff, pushing the stocks of Fannie Mae and Freddie Mac down again today.
Shares of the two companies have now plunged by nearly 90% in the past year, a situation that has impaired their ability to raise money cheaply through equity markets and forced them to shore up their balance sheets in the most expensive way possible: through the sale of new shares that are likely to require big dividend payments to mitigate their risk and will come with regulatory demands that will tie them in knots. This puts their ability to finance new home loans in jeopardy -- though it doesn't directly impact current mortgage holders.
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Through a variety of clever financing schemes, innovators at the organizations figured out how to spread the fear that middle-class Americans would default on their mortgages by spreading out the risk in the form of a new type of asset-backed bond. Rather than every little thrift and bank in the country owning risky mortgages directly, these new mortgage-backed bonds allowed investors from Berlin to Beijing to share them.
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A question of confidenceAnalysts were trying to gauge the scope of the government's rescue plan for mortgage giants Fannie Mae and Freddie Mac. But they agreed the companies were under no immediate pressure to raise capital.
Instead of leveraging their assets by lending at a rate of $10 in loans to $1 in assets, they were able to lend at up to 30-to-1. And this was made worse by an implicit guarantee that any asset-backed bonds created by the two organizations would be backed by the full faith and credit of the U.S. government.
Continued: Trillion-dollar holes
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