This is very long but interesting read about Fannie Mae and Freddie Mac by Martin D. Weiss, Ph.D. Editor, Safe Money Report Chairman, Weiss Ratings, Inc. martinonmonday@weissinc.com

It will be worth your time to read it. It is scary in light of the fact that the current investigation being conducted may lead to criminal actions.

It's just one big balloon waiting to be pricked--and U.S. Representative Richard Baker has the needle....

It's time to change those variable interest loans to fixed!

During the Depression, Franklin Delano Roosevelt had a dream -- to create a government agency that would help buy homes for American families that could otherwise not afford one.

And in 1938, the dream came true: Congress gave birth to the Federal National Home Mortgage Association, later nicknamed Fannie Mae. Still later, Congress transformed it into a stock company with special government privileges.

Today, however, that dream is turning into a nightmare:

-- The company has grown into a government-subsidized monster that so thoroughly dominates the mortgage market, its contraction or failure could cause a collapse of the entire housing industry ...

-- Its executives have just been caught with their hands deep in the cookie jar -- an accounting scandal that's potentially so serious, it could make the Enron and WorldCom scandals look like a game of marbles ...

-- Its shares have just taken a big beating, wiping out more than $11 billion of shareholder value last week alone, and ...

-- Its balance sheet is so shaky, any change in the marketplace, or even any sudden legislative or regulatory moves to fix its problems, could precipitate serious financial difficulties.

This is not new. I warned about it over thirty years ago when I published my first book, The Money Panic.

I warned about it again in the 1980s and the 1990s in my Safe Money Report. And on September 18, 2000, I warned my readers still another time, when I wrote: "Fannie Mae is already drowning in a sea of debt. It has $34 of debt for every $1 of shareholder equity. That's big leverage and of the wrong kind. Plus, the company has only one one-hundredths of a penny in cash on hand for every $1 of current bills."

"How could a company get so laden down with debt and operate with such scant cash reserves? Because of Fannie Mae's unusually close relationship with Uncle Sam ...

"Think Fannie Mae can't go under? Think again. [Someday] Fannie Mae ... could lose one of its most important assets of all: The implicit backing by the U.S. government.

"Indeed, Representative Richard Baker is leading the charge in Congress to repeal the line of credit from the Treasury Department that Fannie Mae receives. That means Fannie Mae's bonds would no longer have government funds to back them up.

"Fed Chairman Alan Greenspan himself has raised a related issue. He's apparently unhappy that government-sponsored enterprises like Fannie Mae are being subsidized by the government, in the form reduced borrowing rates from the Fed."

That warning was published exactly four years and nine days ago. But since that day, even while this situation has continued to deteriorate, there have been few voices of protest ... and even fewer concrete steps taken to avert the disaster we face today.

Reason: Fannie Mae's executives, while allegedly enriching themselves at the expense of investors and taxpayers, mobilized one of the most powerful -- and most fearless -- lobbies on Capitol Hill. Congress, the SEC and the Justice Department were pushed back.

Even Baker and Greenspan were repeatedly forced into reluctant retreat.

And throughout it all, the company just kept growing in size and power, virtually nonstop, emerging as the greatest single monopoly on the face of the earth.

So this morning, I wondered ...

IF FDR WERE HERE TODAY, WHAT WOULD I TELL HIM AND WHAT WOULD HE SAY?

I imagined how I'd present the facts to Franklin Delano Roosevelt, and what his response would be ...

"Mr. President, I have some surprising news for you.

A lot has changed since the 1930s. Now, the agency you originally created, Fannie Mae, plus and a smaller, younger cousin, Freddie Mac, control 90% of the home mortgage market in America."

The former president is shocked. "What?! 90%?! Fannie Mae was supposed to be like a national savings and loan. It was supposed to supplement and support home mortgages -- not take them over. How in the hell did this happen?"

"Initially, it worked according to your plan. Fannie Mae bought some mortgages from banks, bundled them up and sold them to a few investors. This way, they helped pump some extra pump money into the housing market. But no one else besides Fannie Mae could do this. So the government agency had a virtual monopoly on this business, and the business grew like wildfire. A whole new market was created in America -- the secondary market for mortgages."

"Was that a problem?" asks FDR.

"Not immediately. But it kept ballooning in size. Then, in 1968, the U.S. was in a war in Southeast Asia and ran into budgetary problems. So the president at the time, Lyndon Johnson, along with Congress, transformed Fannie Mae into a semi-private company and moved its finances off the books of the federal budget."

"Why did they do that?"

"Most people in government knew it was mostly a gimmick to make the federal deficit appear smaller. But they went ahead and did it anyhow."

GSEs

FDR is perplexed. "If Fannie Mae is no longer a government agency, what the heck is it then?"

"They have a new name for it. They call it a 'government sponsored enterprise' or a 'GSE.' It's essentially a private company with special subsidies and privileges."

"What subsidies and privileges?"

"They have a line of credit to the Treasury. They're exempt from some SEC insider trading rules. They're exempt from local taxes. They don't have to meet the same disclosure requirements as ordinary private companies."

"How much are these subsidies worth?"

"According to the Federal Reserve, somewhere between $119 and $164 billion."

FDR seems surprised. "That's a lot of money. How much of that money are the shareholders and executives getting?"

"About $50 billion to $97 billion, according to the Fed. So a big chunk of the taxpayer subsidy underwrites executive salaries and stockholder profits and is NOT passed on to borrowers in form of lower mortgage costs."

FDR shakes his head in disapproval. "In other words, instead of pursuing the original mission we established in 1938 -- to help homeowners -- they're mostly helping themselves?"

"Probably some combination of both."

"DIDN'T ANYONE DO ANYTHING TO STOP THIS MADNESS?"

The former president shakes his head again. "So what we did was to take a giant, formerly government- controlled monopoly ... let it fall into private hands under private-sector management ... and then let them play it up to the hilt without proper checks and balances? That's crazy. Didn't anyone in Congress or the administration do anything to stop this madness?"

"Not right away. But some people in Congress eventually got around to saying: 'Hey! It's far too dangerous to have so much economic power in the hands of just one company. It's way too risky for the entire mortgage market -- and for millions of homeowners.' "

"So what did they do?"

"In 1970, they created another entity just like Fannie Mae, with essentially the same mission and a similar business model -- Freddie Mac. So now they had two of these semi-private mortgage giants instead of one."

"Did that break up the monopoly?"

"Of course not. We have over 10,000 commercial and savings banks in this country ... more than 7,000 life/health and property/casualty insurance companies ... and over a thousand security brokerage firms. That's free market competition."

"Yes, it is. But what about the GSEs?"

"We still have only TWO companies dominating virtually the entire market for secondary mortgages!

That's anything BUT free market competition. Besides, Freddie Mac, although a giant compared to most companies, is still a midget in comparison to Fannie Mae. Bottom line: Fannie Mae is still a monopoly, the largest monopoly in the world."

INCEST

FDR smirks, but then asks: "Can you give me a better idea of the full dimensions of this monopoly?"

"Sure. But take a deep breath. The facts are so shocking they could knock the wind out of almost anyone."

The former president sits silently while I rattle off the facts one by one ..

"Fact number one. As I said earlier, Fannie Mae and Freddie Mac control 90% of the secondary market for home mortgages.

"Fact number two. Their combined debt is almost half as large as the current national debt of the entire U.S. government.

"Fact number three. Among all private financial sectors of the U.S. economy, they have emerged as the single biggest borrowers of credit in the financial markets. They owe over two and a half times more credit market debt than all the commercial banks, bank holding companies and savings institutions put together. They owe nearly 44 times more credit market debt than all the nation's brokerage firms and THREE HUNDRED times more than all the insurance companies."

"That's quite unbelievable," says FDR after a few moments of deep thought. "Even in the pre-Depression era, we had nothing even remotely similar to the situation you describe. Are you sure about your numbers?"

"Absolutely. The proof is in the Federal Reserve's Flow of Funds for the second quarter of 2004, in the section covering the LEVELS of debt, under their table L.3, 'Credit Market Debt Owed by Financial Sectors.' And it's available in an easily accessible public forum known as the 'Internet.' Almost anyone can view this data instantly ...

http://www.federalreserve.gov/releases/Z1/current/Z1r-4.pdf (ADOBE ACROBAT READER REQUIRED)

"Fact number four. These government-sponsored enterprises themselves actually hold more of their own securities than any other sector in the world."

"What do you mean?"

To clarify, I give FDR the following stats:

-- All banks, including thousands of commercial banks, bank holding companies and foreign banks are currently holding $1.1 trillion in agency - and GSE-backed securities;

-- Thousands of insurance companies are holding $733 billion of those securities; and meanwhile

-- Just these two GSEs -- Fannie Mae and Freddie Mac hold over $2.6 trillion! That's two and a half times more than amount held by all banks and over three and half times the amount held by all insurers.

(The source of this data is also the Fed's Flow of Funds, table L.210, 'Agency- and GSE-backed Securities.' ") Take a look ... http://www.federalreserve.gov/releases/Z1/current/Z1r-4.pdf(ADOBE ACROBAT READER REQUIRED)

A MEAN VICIOUS CYCLE

Roosevelt is shocked. "Just TWO companies holding more of their own stuff than thousands of banks and insurance companies put together? What happens if these two companies fall on hard times?"

"It could create a mean vicious cycle. The more their balance sheets deteriorate, the less the $2.6 trillion they hold in their own securities will be worth; and the less those securities are worth, the more their balance sheets will deteriorate. They have a name for this in the financial world."

"What's that?"

"Incest. It's supposed to be taboo. But it isn't."

DERIVATIVES

FDR's next question is right on point: "From what you're saying, it sounds like they're exposed to huge risks for themselves, for investors, for taxpayers, for homeowners, for everyone. My question to you is:

Don't they know this? Aren't they aware?"

"To some degree, yes, they are. That's why they engage in huge special transactions in instruments called 'derivatives.' That's their attempt to somehow offset some of the risk. But these instruments are very complex and potentially risky themselves. Just last year, Freddie Mac booked shocking losses in these derivates."

"What does the current Federal Reserve Chairman have to say about this?"

"His name is Alan Greenspan, and he recently opined on this very subject. He said 'the current system depends upon the risk managers at Fannie and Freddie do everything just right.' He says 'our financial system would be more robust if we relied on the market-based system that spreads risks, rather than the current system, which concentrates such risk with the GSEs.' "

TOO BIG TO FAIL? OR TOO BIG TO SAVE?

FDR raises his hand signaling he wants to interrupt.

"Let me go back to what you said earlier. You said Fannie Mae and Freddie Mac own the biggest chunk of their own notes and bonds. That's the incest. But they can't be the only ones. Who else owns them?"

"Banks. More than 3,000 banks have all their reserve capital requirements met by investing in these government-sponsored entities. Plus 74 central banks around the world invest in them. So as you can see, the Fannie Mae and Freddie Mac bonds are more common in financial institution portfolios than almost any other securities, perhaps even more than Treasury securities."

"Banks?! Foreign central banks?! How in the heck did THEY wind up with so many Fannie Mae bonds?"

"Remember: Fannie Mae bonds used to be like government securities. So nearly everyone in the market thinks they're still safe, that they still have the tacit backing of the U.S. government."

"Do they really have that backing?"

"Good question. Fannie Mae and Freddie Mac securities carry explicit disclaimers stating that they're NOT insured by the U.S. Treasury Department. And our current Treasury Secretary, John Snow, recently warned investors not to count on a federal bail-out.

He said he doesn't believe in the 'too big to fail' doctrine. In other words, no matter how big they are, they can still go under."

FDR nods and then asks: "So are investors getting the message?"

"Stockholders? Yes, they're starting to get the message. That's one of the reasons they started dumping Fannie Mae shares last week. But bondholders like banks and insurers? No, not yet. They still don't get it. They still think the government and millions of American taxpayers will bail out Fannie Mae."

"That's strange," says FDR with a smile. "From what I remember in the 1930s, bond investors were a pretty smart bunch. Why are they still believers in Fannie Mae?"

THE ROLE OF RATING AGENCIES

"The rating agencies share a large part of the blame," I respond. "They're rating Fannie Mae and Freddie Mac notes and bonds as if they still had some government guarantee. But that's going to change soon."

"When?"

"Don't know. But on Thursday of last week, Standard & Poor's said it may downgrade some of Fannie Mae's debt, noting that the company may be riskier than once thought. S&P said it may cut Fannie Mae's 'AA-minus' subordinated debt and 'risk-to-government' ratings. The latter represents Fannie Mae's credit quality exclusive of the implicit government support."

"Then what?"

"If the rating agencies are serious about the downgrades, they'll drop the ratings several notches further, one notch at a time. Then, Fannie Mae and Freddie Mac notes and bonds will get dumped in bigger and bigger amounts. Their prices will plunge, and you'll see gaping holes appearing in the portfolios of everyone who's loaded with these notes and bonds. That includes the banks, the central banks and, of course, Fannie Mae and Freddie Mac themselves."

FDR is again pensive. "If I were still president," he says in a near whisper, "I wouldn't let them fail. But what about today's president?"

"We don't even know who the president will be. But there's one thing we do know: The federal budget deficit is already huge. Some independent economists estimate that, unless Medicare, Medicaid and Social Security are cut, we could have a total, accumulated deficit of up to $9 trillion over the next few years. So, sure, there may be some GSE bail-outs by the government. But it's going to be partial, not total.

It's going to be messy and complicated -- not a clean take-over."

BAD BEHAVIOR

"What about right now?"

"Right now, no lobbyist in the world is going to be able to restore Fannie Mae's credibility to its former level. Fannie Mae is going to get smacked so hard for their bad behavior that their business will never be the same again."

"What exactly are these people at Fannie Mae accused of doing?"

"The authorities have been investigating them for eight months and just issued their report last week.

They say that Fannie Mae's management deliberately developed and adopted inappropriate accounting policies. They say that management supported widespread violations of generally accepted accounting principles. They say management tolerated lax internal controls. And they accuse management of postponing $200 million in expenses so executives could get bigger bonuses. This looks like it's far worse than a similar accounting scam that came out in June of last year at Fannie Mae's smaller competitor, Freddie Mac. Freddie Mac manipulated profits to the tune of about $4.5 or $5 billion. But the Fannie Mae scandal may be both bigger and more egregious."

"So what's going to happen next?"

"Now, suddenly, the regulators are plowing in. Fannie Mae is going to come under more intense scrutiny by Congress to take away its taxpayer subsidies ... by the Justice Department to take away its monopoly ... and by the Securities and Exchange Commission to take away its insider trading and privacy privileges."

"When is this starting?"

"Almost right away. U.S. Representative Richard Baker, the same one who's been leading the charge against the GSEs for many years, has called for an October 6 hearing to unearth the extent to which Fannie Mae manipulated its financial statements."

"Can he really have an impact?

"Yes. Baker is pretty powerful now. He's chairman of the Capital Markets Subcommittee under the House Committee on Banking. In Fannie Mae's case, Baker says executives apparently manipulated the numbers not only to smooth earnings but to enrich themselves -- which, if proven, is criminal."

"What's your point?"

"My point is that, after this damning report that just came out, Baker may finally get enough political support to prevail and pass a law that could kill the golden goose of the GSEs. Fannie Mae is going to get dragged through the mud -- in Congress and in the press. And worst of all, its stocks and bonds are going to get punished by investors. Sure, their lobbyists will fight back. But this time, I think the GSEs will lose the political battle."

THE VICTIMS

Hurricane Jeanne is gone, and windless sunshine is flowing, everyone here is safe, and at the office, all our back-up systems are working -- so I can get this issue of "Martin on Monday" to you on schedule.

Unfortunately, however, the storm coming in the mortgage market in America will not be over so quickly.

The first victims will be stock investors. You saw that start already last week.

The next victims will be bond investors, especially when the next rating downgrades are announced.

Even before Congress passes tougher legislation, less money will be flowing into Fannie Mae and Freddie Mac. And these two companies, in turn, will have less money to pump into the home mortgage market. The housing industry, already a house of cards, could suffer a serious blow.

Mortgages will be scarcer -- and more expensive. Result: Homeowners, especially those with adjustable- rate mortgages (ARMs), will be victims as well. My advice: If you own Fannie Mae or Freddie Max stocks or bonds, get out now. If you have an ARM, convert to a fixed-rate mortgage ASAP. Or better yet, if you have the cash flow, pay down your mortgage more quickly than scheduled.

Good luck!

Martin

Martin D. Weiss, Ph.D. Editor, Safe Money Report Chairman, Weiss Ratings, Inc. mailto:martinonmonday@weissinc.com

P.S. If you're interested in concrete proposals for change at the GSEs, visit the website of the Citizens Against Government Waste and see their most recent release ...