A funny thing happened on the way to retirement:

• Fannie Mae           $59.42 10/26/2007          $0.87   10/21/2008
• Freddie Mac          $68.90 10/22/2006          $0.92   10/21/2008

If any of you had investments in Fannie or Freddie, (or Washington Mutual, IndyMax Bank, Lehman Brothers, AIG, Bear Sterns … you get the picture), my deepest sympathies.  A quick look at my 401k confirmed what the gnawing in the stomach foretold: I’m working for the foreseeable future!  After the nausea passed, the rage started to build!  Back in July, everything was rosy, wonderful, peachy-keen! 

Rep. Barney Frank on July 14, 2008 said in reference to Freddie and Fannie  ”They’re not the best investments these days from the long- term standpoint going back.  I think they are in good shape going forward. They’re in a housing market. I do think their prospects going forward are very solid. And in fact, we’re going to do some things that are going to improve them.”

So, how could a few TRILLION dollars go poof in 4 weeks?  The following is my assessment of “The Meltdown of ‘08″.

A Brief History

The events of 9/11 convulsed an already struggling American economy which was just recovering from the DotCom bubble collapse which began in March 2000.  To stimulate the economy, the Federal Reserve began a series of rate cuts which left the Federal Funds Rate (FFR) at just 1% by 2003.  As expected, the economy improved and began a period of steady expansion beginning in 2002.

Low interest rates beget sales. With the FFR at record lows, money was cheap and plentiful. Real estate began to look increasing attractive as an investment. Mortgages started to flow like beer at a frat party.  Usually, with funds tied up in mortgages, banks have a difficult time expanding their lending operations beyond the revenue stream generated by the mortgage payments.  Enter the Asset Back Security or ABS.  In principle, an ABS collects a number of individual assets (mortgages in this case) and lumps them together.  These combined assets should be of similar duration, interest rate, repayment risk etc. these ABSs are then sold on the market where investors obtain a return from the steady flow of payments coming from the underlying mortgages. Even better, these ABS instruments are collateralized by the homes upon which the mortgage were placed.  Add the imprimatur of a Rating agency like Moody’s or Standard and Poor’s and you have safe, solid, secure, guaranteed investments; a financial trifecta! 

• The investor gets a fixed and reliable revenue stream;
• the bank get a cash infusion by selling the bundled mortgages thereby obtaining capital with which to restart the cycle and
• the underwriters and rating agencies get a piece of the action for their part in the transaction.

Brilliant!

The forgoing assumes three things:

1. a valuable asset – the house
2. a qualified buyer able to repay the loan
3. an accurate rating to classify the ABS properly according to risk of non-repayment

At the same time, government policy was actively encouraging an increase in home ownership rates.  The pool of prospective home buyers could only be expanded by reducing the requirements to obtain a mortgage.  Simply put, the government decided home ownership was a good idea even for people with shaky financials. In 2003, Rep. Barney Frank explicitly stated that Fannie and Freddie’s government privileges were conditional on their willingness “to make housing more affordable.” The only way to achieve the low income loan targets while dramatically increasing lending was to erode underwriting standards. Fannie Mae aggressively bought Alt-A loans, where these loans may require little or no documentation of a borrower’s finances.

Sensing an opportunity to make money, banks began to create all sorts of exotic financial instruments: Adjustable Rate Mortgages (ARMs), balloon (or negative amortization) loans; loans with teaser rates and  just about any other idea you could think of; NO DOC loans for example.  These were the Alt-A loans Fannie and Freddie were buying up to provide affordable housing.

The combination of easy money chasing limited housing stocks caused a price runup typical of the classic bubble market.  As long as money flowed, the sky was the limit.  The seeds for disaster were already sown.

A funny thing happened on the way to “Who wants to be a Millionaire?”, not one, not two but all three assumptions holding up this house of cards turned out to be false.

Oversupply in the housing sector led to declining sales; the asset was no longer as valuable as the mortgage indicated (now called “being upside down”).  Adjustable mortgages began resetting and the mortgage holders found themselves unable to keep up with the payments.  Those AAA rated ABS started to drop in value as the revenue stream dried up. 

As sales tanked, home values dropped. Borrowers discovered they were trapped in their mortgages without ability to refinance as their homes were now worth less than their mortgages.  As the defaults began to mount, the value of ABS collapsed taking with them the aforementioned former Wall Street Titans.

So who’s to blame?

As Chairman of the House Banking Committee, Mr. Frank, this happened on your watch.  Starting in 1992, numerous attempts were made to corral the out-of-control lending at Fannie and Freddie but you, Sir, blocked every attempt.  You then had the temerity to claim you were only a committee member and had no way to influence legislation.  

In cultures with a more highly developed sense of personal honor, you sir, would have resigned long ago.

On Nov 4, the Citizens of Massachusetts have an opportunity to do for Mr. Frank what he will not do for himself; vacate his office.

The Good

Sorry, there is no good in this headlong rush to socialism.

The Bad

Yesterday, the Senate stuffed the “Emergency Economic Stabilization Act of 2008″ H.R. 1424 with enough pork to open a Sonny’s Bar B-Q.  Larding on another $100 Billion or so in earmarks, our illustrious senators punted this pig without lipstick to the House for “consideration” and passage.

A funny thing happened on the way to socialism. A few high minded Congressmen decided the taxpayers deserve more than the scant consideration this bill received in the Senate.  A critical bloc of more than a dozen lawmakers who voted against the bailout measure Monday were prepared to support the new bill if a few key provisions were added including:

• the initial pay-out under the plan be sharply limited
• last-minute pork projects added by the Senate be stripped from the bill.

“We have a critical mass,” said Rep. Steven C. LaTourette who voted against the bill Monday. He had talked to 14 other members willing to support the new version of the bill if the amendment he authored was accepted.  “Our core group is sufficient to take care of the margin to pass this bill, if our amendment is ruled in order and passed,”  Rep. LaTourette declined to identify the other lawmakers he said were prepared to switch.

Mr. LaTourette’s amendment limits initial Treasury Department spending to $250 billion and requires congressional approval if more funds are needed.  In addition, it strips spending items included in the Senate bill, including special provisions benefiting rum producers and the NASCAR stock-racing circuit.

The Ugly

The core of the Wall Street rescue package proposed by Mr. Paulson remains intact. Packaged within a 450 page “novel length” bill, this work of financial fiction would allow the Treasury Department to buy up to $700 billion of now-worthless mortgages and mortgage-related securities. This is the toxic debt clogging the books of the nation’s banks and financial firms.  A fundamental, untested and hotly debated assumption by Mr. Paulson assumes banks will not lend and therefore consumers and businesses will be unable to borrow until this debt is removed from their books.

Mr. Paulson contends the resulting aftershocks would be felt in retirement pensions, savings plans, paychecks and payrolls across the country.

Lawmakers say they have improved the original three-page Paulson blueprint, adding several layers of oversight; some relief for homeowners struggling to meet mortgage payments; strict limits on executive pay for those who participate in the plan; and an ownership stake for the federal government in the companies being helped. If and when the U.S. housing market recovers and the mortgages gain in value, the government stands to recoup at least some of the money spent.

The Really Ugly

The “new and improved” plan still has the taxpayer holding the bag.  The wizards of Wall Street, the geniuses in the mortgage brokerages and the best and brightest in the bond rating agencies get off with no downside risk to their retirement plans, stock options, compensation plans.  Mr. Paulson’s concern that the resulting aftershocks will be felt in retirement pensions, savings plans, paychecks and payrolls across the country is right on the mark.  Only problem, those most affected are those least culpable.

So we are back to square one. Privatized profit; socialized risk.

Nice try but no thanks. 

Don’t you dare dump $700,000,000,000.00 in unsecured debt on my kids and grand kids just because you folks in the Senate and House want to adjourn and begin your re-election campaigns.  It’s time to stick around and cleanup after yourselves.  Create a real bill; with real enforcement provisions;  needed changes to accounting rules; restrictions on “exotic” financing arrangements; in short the type of oversight we taxpayers expect from our hired help!

With any luck at all,  Congress and the Senate will stay in session another week or two and craft a real bill. (which takes time.  Who reads 450 pages of dry, financial policy in 24 hours?)  They can then return home and face the wrath of the voters who I can only pray will retire the lot of them.

God knows just about ANYBODY could do better than the current crop of “legislators”.

Contact your Senators and Representatives and tell them to stay in town until they get this right.