Karl Denninger, "How To Make A Bad Idea Worse- FNM/FRE"

"How To Make A Bad Idea Worse- FNM/FRE"

Karl Denninger

"It has been reported that the administration is mulling over splitting Fannie and Freddie into a "good bank/bad bank" structure, or otherwise "taking" the bad part of their book onto the government directly (rather than implicitly): The bad debts the firms own would be placed in new government-backed financial institutions - so-called bad banks - that would take responsibility for collecting as much of the outstanding balance as possible. What would be left would be two healthy financial companies with a clean slate.

I cannot possibly over-emphasize how bad of an idea this is.

These two institutions currently hold some $6 trillion of mortgages - some 40% of the market. They have been riddled through with fraudulent accounting and outrageously-thin capitalization for years, and now, with defaults on so-called "prime" mortgages going parabolic, they threaten to exhaust even their "enhanced" $400 billion (combined) credit line through Treasury. Fannie and Freddie need a permanent resolution. Unfortunately the government seems to think that the most logical form of that resolution is to protect those who invested in the trash paper issued by these institutions when they were engaged in dubious (at best) lending and underwriting by transferring the risk (and realized losses) to the taxpayer.

This is dead wrong, and perhaps disastrously so.

The Government needs to approach this in the following way:
1. Cut the existing firms loose including their debt. That is, leave it to the market. These firms never had an explicit backstop or guarantee, and providing one now is to reward the outrageous behavior of the firms and those who purchased recklessly from them.
2. Restructure and make possible enhanced issue from Ginnie Mae, the only GSE with an explicit government guarantee.
3. Force all loans issued through Ginnie to be limited to no more than 80% LTV, 36% DTI (or "back end" ratio), fully-documented for income and assets.
4. If the private market wishes to support high-LTV and high-DTI loans, let it - without any government support or backstop.

Yes, I realize this will cause the housing market to immediately correct to a rational price point in every market area in America. It will also cause those who purchased Fannie and Freddie paper without doing their own due diligence on their underwriting practices to recognize losses - quite possibly (for those who bought recent issues) very large losses.

So what?

Capitalism requires that you lose when you do foolish or even criminal things; without the market punishing bad decisions we don't have capitalism, we have kleptocracy. Further, the CBO has already agitated to consolidate Fannie and Freddie onto the Federal Balance Sheet, so far without success. A formal program to take assets onto the Federal Government will trigger such a consolidation with certainty and will likely have a nasty impact on borrowing costs across the curve, and may even extend to a sovereign debt downgrade aimed at The United States.

IF the economy is truly improving then it is time for the market to recognize proper pricing for houses and mortgage money. Indeed, it is quickly becoming impossible for the outcome to be otherwise. Should government attempt to continue to play "stuff the bad debt under the rug" through some sort of hybrid bad/good bank scheme the outcome is likely to be a breakout north in the longer end of the Treasury Curve, which will instantly trash mortgage pricing, irrespective of attempts to do otherwise, and inexorably tighten credit across the spectrum, instead of containing the damage to the housing market.

Government's approach to housing so far has been "extend and pretend" in the hope that housing would bottom first in 2008 and now in 2009. This strategy is now known to have failed, and it is time for our government to accept that housing prices must correct to historical mean values in order for our economy to recover on a durable basis. We are quickly reaching the end of our rope as "bailout nation."

- Karl Denninger, http://market-ticker.denninger.net/

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