Signup for our free newsletter:

The Mother of All Bailouts: FRE and FNM

Written By Brian Hicks

Posted June 17, 2010

As every magician who has ever lived knows, illusions create our world.

Even David Copperfield himself is willing to admit that “real” magical powers are the stuff in the best-selling Harry Potter novels.

Copperfield explains that what he does is nothing more than a masterfully performed mirage which, when done properly, can make you believe that the Statue of Liberty has suddenly disappeared.

It works because the magician is a master manipulator.

He only lets you see what he wants you to see. By keeping other things hidden out of sight, the magician blurs the reality of an audience that deep down inside wants to believe in the possibilities.

The ruse complete, the audience leaves dumbfounded by the elaborate illusion. Reality has been transformed — at least temporarily.

It’s only later that we find out that the statue hasn’t moved an inch; that the lovely assistant hasn’t really been sliced in half.

In short, it’s a scam writ large. And the bigger the lie, the bigger the box office.

Buy hey, at least it’s entertaining — if only for a few moments.

Freddie and Fannie: The mother of all bailouts

Unfortunately, the same thing can’t be said for Uncle Sam’s act involving Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE).

Instead of making this problem disappear, there is real bloodshed taking place behind the velvet curtain as the ultimate illusion of them all — the housing bubble— continues to blow up in everyone’s faces.

More trick than treat, it’s the gift that never stops giving.

And while the federal government will do anything to keep you from peeking, the truth behind this curtain cannot be hidden forever. Before this show ends, the housing bailout will the biggest of them all — dwarfing AIG, General Motors, and Citigroup combined.

“It is the mother of all bailouts,” Edward Pinto, told Bloomberg on Monday. And he should know…

After all, Pinto is a former chief credit officer at Fannie Mae, which makes him privy to what’s actually going on among the smoke and the mirrors.

In fact according to the story in Bloomberg, the bailout of Freddie and Fannie could grow as high as $1 trillion if the housing market hits absolute rock bottom.

That’s $1 trillion with a t. This situation has the potential to become the greatest disappearing act in history as the money pours down the rat hole.

And even if the housing market does manage to avoid the worst-case scenario, the reality is that the cost could be as high as $500 billion if home prices fall another 20% and default rates triple, according to a report by Barclays Capital.

That’s over three times the government’s best estimate of $160 billion in costs, should the economy actually strengthen. Already the bailout has cost taxpayers $145 billion.

But even then, that’s only part of the story. Since Freddie and Fannie “only” own or guarantee 53% of the nation’s $10.7 trillion in residential mortgages, there are more mortgages underneath the magician’s top hat…

The other 44% can be found in the FHA and VA pools, along with the $1.4 trillion in loans already dumped on the Federal Reserve — all of which are also backed up by U.S. taxpayers.

That’s you and me.

And here’s a little secret for you: Despite all of the pain they have caused, subprime loans are alive and well.

In fact, your Uncle Sam has been using FHA loans to fund non-prime borrowers for some time nowall the way up to $729,750 in some cases, with just a 3.5% down payment.

That’s how desperate we’ve become to prop up home prices. (The old limit was $417K.) The funny thing is that we are expecting different results this time; by definition, this is insane.

However, the cold, hard reality is that the FHA now expects defaults on 25% of all the loans they insured in 2007, and 20% of those backed in 2008.

Those, by the way, were the same default rates that imploded the entire subprime industry. According to Pinto, FHA “appears destined for a taxpayer bailout in the next 16 to 28 months.”

Keep in mind, that’s on top of what it’s going to cost to bail out Freddie and Fannie, both of which were delisted yesterday from the New York Stock Exchange…

The elusive housing bottom

There were 2.1 million loans in the foreclosure process in the first quarter — almost quadruple the number from three years ago.

What’s more, borrowers were late making payments on $338.4 billion-worth of Fannie and Freddie loans — up from $206.1 billion a year earlier, according to the companies’ first-quarter filings.

That leaves income and job growth as the two key factors in determining whether or not the U.S. real estate market can remain afloat, especially after the end of the federal homebuyer tax credits.

A magic trick of its own, the credit resulted in 1 million additional home sales since it began, according to Lawrence Yun, chief economist of the National Association of Realtors (NAR).

But the truth is that all the program accomplished was to pull sales forward from the future and drives us deeper in debt. And in short, that has left the housing market in an economy where unemployment will be around 9.6% and interest rates have nowhere to go but up.

Those headwinds, in the end, may prove to be too tough even for Uncle Sam to hide.

Until then, it’s all nothing more than an illusion. And unfortunately, it’s not the only one.

Your bargain-hunting analyst,

steve sig 

Steve Christ
Editor, Wealth Daily

P.S. Not everybody loses when a home goes into foreclosure… In fact, the companies that process them are going gangbusters right now earning savvy investors big profits. To learn more about these companies, click here.