Why Ben Bernanke’s Incomplete ‘Exit Strategy’ Could Lead to a Decade-Long Downturn

You all know I don't know much about all this stuff but hasn't your gut instinct kind of told you we haven't really felt as much pain as we should have for all the debt and fiscal irresponsibility of the last decade or so? Haven't you wondered if some how the gov't. numbers guys were hiding something? I guess I can understand, because after-all they are politicians, they don't want the public to be aware of how bad it is but on the other hand, wouldn't it be nice to have some real change in Washington where our leaders really give us the straight scoop and respect we're intelligent enough to grasp this, conceptually anyway, and get behind them? - MBC

http://www.moneymorning.com/2009/07/30/bernankes-exit-strategy-2/

"...At its most basic level, the U.S. Federal Reserve’s so-called “exit strategy” is designed to let government bailout and liquidity programs unwind on their own, as markets return to a state of “normalcy.”

But what investors don’t realize is that without an exit strategy that includes plans for unwinding insolvent mortgage giants Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) - now more accurately defined as government-sponsored hedge funds - recent market gains will be limited and will likely reverse. If those setbacks cause the nascent U.S. housing market rebound to stall, it could even lead to a decade-long downturn.

And Fed Chairman Ben Bernanke’s exit strategy ignores Fannie and Freddie.

When the U.S. government - succumbing partly to pressure from foreign bondholders - last September forced Fannie and Freddie into government conservatorship, it essentially nationalized what amounted to the world’s two largest hedge funds.

Essentially, in the government-brokered deal, taxpayers bought senior preferred stock (with a 10% annual dividend yield) from Fannie and Freddie, which each received $1 billion in capital. Both firms were also granted a backstop guarantee worth $200 billion. In March, amid escalating fears that these arrangements wouldn’t provide enough support, an additional $200 billion of taxpayer muscle was added to the support pyramid.

Both firms use their special status as “government-sponsored enterprises” (GSEs) to borrow trillions of dollars in the public markets - at spreads just a couple of basis points above U.S. Treasury debt.

The September 2008 Congressional Research Service (CRS) Report for Congress - titled “Fannie Mae and Freddie Mac in Conservatorship” - plainly states that “the U.S. Treasury has put in place a set of financing agreements to insure that GSEs continue to meet their obligation to holders of bonds that they have issued or guaranteed. This means that the U.S. taxpayer now stands behind about $5 trillion of GSE debt.”

In last week’s “Semiannual Monetary Policy Report to the Congress“ and in his July 21 Wall Street Journal Op-Ed piece, Bernanke, the U.S. central bank chairman, laid out plans to wind down government credit extension programs and combat any potential inflationary pressures. What was not addressed was how - or even if - the two government-owned and operated de-facto hedge funds, with combined assets of more than $6 trillion, would be unwound, or whether they would remain in place as they are in order to be used as back-door fiscal and monetary policy tools.

In what amounts to more than just a bailout on an unprecedented and under-reported scale, the takeover of both Fannie and Freddie provides the Fed and the U.S. Treasury Department a super sponge to both guarantee new mortgages and absorb all the unwanted mortgage-backed securities that banks and non-bank originators package and need to offload.

Because they lack sufficient capital - or lack the appetite to hold any new mortgage paper on their balance sheets - banks need this government-sponsored outlet for the mortgages they want to unload. The Fed and the Treasury Department are using their taxpayer-supported hedge funds to grease the rusted wheels of the mortgage money machine to gain traction where there is none.

In an uncertain real-estate environment Fannie’s and Freddie’s wholesale purchasing of new mortgage pools is the only hope the U.S. government has of stimulating and accelerating the velocity of mortgage money. These hedge funds are now indispensable fiscal and monetary policy levers.

Propping up teetering banks may serve to shore up near-term public confidence in the financial system. But it also destroys the same system by dislocating any meaningful capital-allocation strategy by extending the life of sick institutions that suck up scarce resources. What’s happening at Fannie and Freddie is no different - except that it’s happening on an exponentially more debilitating scale.

Taxpayers are being duped into believing that the mortgage market is recovering and that money will be flowing when they decide it is time to buy homes again.

But there’s a big problem here: At some economic “inflection point” - a point that will come together very quickly if interest rates unexpectedly spike - losses at the “twin terrors” of Fannie and Freddie could spike into the stratosphere, as well, meaning the financial reality that we’re detailing here will necessitate another bailout, but on a scale we’ve yet to envision.

In the first quarter alone, Fannie lost $23.2 billion - its seventh-consecutive quarterly loss - and it drew another $19 billion from its government piggybank. The firm has a negative-net-worth of $18.9 billion.

Fannie Mae isn’t just insolvent, it’s dead - though its functions are being maintained by a federal-government life-support system.

Freddie Mac had a $9.9 billion loss for the quarter and drew $6.1 billion from the U.S. Treasury. Freddie’s 10% dividend to the government on the $51.7 billion it has drawn to date is costing it $5.2 billion a year - an amount that exceeds what it earned in nine of the last 10 years.

Unlike the unworkable plan that Bernanke outlined last week, there is an “exit strategy:” that will work. Government leaders need to understand that bigger is not always better, especially in light of the concentration of risk and taxpayer exposure that’s been created by these government-sponsored hedge funds. This exit strategy consists of two key initiatives:

• Get Competitive Again: Break up all the big banks and create a greater number of highly localized, community-centric banks. Let community and regional bankers securitize pools of mortgages using transparent “conforming” disciplines, and force originators and lenders to keep skin in the game. Create national ratings standards and let originators pool strictly defined, varying-quality loans into properly labeled packages, and let investors determine their risk tolerances without being blindsided. Large loans can easily be syndicated across multiple banking institutions and large risk-taking, non-deposit-taking institutions - such as real hedge funds and private-equity companies that will constitute the new “equity merchant banks” - can do a better job of high-stakes lending.

• Bring Down the Curtain on Fannie and Freddie: It’s time to break up Fannie Mae and Freddie Mac. The government has proposed reducing their portfolios by about 10% per year, but that’s not happening. In an end-around maneuver, while Fannie and Freddie are being propped up and still growing, the government is buying mortgages through the Federal Reserve. Either way, taxpayers end up holding massive pools of mortgages that no one else wants. Doing away with the socialization of homeownership financing will put the market back in control of appropriating risk.

The bottom line is this: The only “exit strategy” we really need is to position ourselves to diversify risk and promote stable rewards by taking apart what history has proven to be too-big-to-control.

Shutting down sick banks and unwinding government schemes to mask illiquidity will be painful and would certainly stress the financial markets again. But those are short-term pains that will lead to meaningful long-term change. On our current path, we may be keeping things copasetic in the near-term - but in the long run we remain on a potential collision course with some painful periods that will be deep and drawn out.

• The old adage tells us that “those who forget the past are doomed to repeat it.” After the tragic financial travails of the past year or so, the last thing the U.S. economy needs is to spring a bear trap that results in a 10-year financial malaise. Let’s learn from the mistakes of the most-recent past and make the changes needed to avoid this pending dour outcome.