What now for Fannie & Freddie?

With Fannie Mae and Freddie Mac now firmly under federal control, what might the future look hold for the mortgage giants? Barron's has an idea (hat tip: Brian McDonald):

FANNIE MAE AND FREDDIE MAC , THOSE two wild and crazy kids who partied on Uncle Sam's dime, finally have been sent to the "time out" corner. In the near term, the federal bailout of the heretofore quasi-governmental mortgage giants, which occurred last week amid doubts about their continued solvency, will improve conditions in the secondary mortgage market, and already has begun to lower mortgage rates.

Longer-term, some in government and the financial markets think Fan and Fred should remain under federal control, while others favor privatization or the outright elimination of the agencies -- an outcome that, by some estimates, could boost mortgage rates to as high as 9%-10%. Whatever Congress decides, the seizure of Fannie (ticker: FNM) and Freddie (FRE) closes an especially ugly chapter in U.S. financial history, when greed trashed fear, and opens the door to a rethinking of mortgage finance generally, perhaps along the European model that more responsibly ties lenders to credit risk...

In the government takeover, engineered by Treasury Secretary Henry Paulson, the top managers and directors of both Fannie and Freddie have been shown the door. The Treasury has agreed to invest up to $100 billion in each of the agencies to ensure that they maintain a positive net worth on a GAAP basis...

By placing Fan and Fred in "conservatorship," not receivership, the government has created what Paulson calls a time out to recapitalize and rehabilitate the companies, not liquidate them. Both now will be under the thumb of their new regulator, the Federal Housing Finance Agency, with Treasury looking over the FHFA's shoulder...

Some proponents of continued government control argue not only that the size of their balance-sheet investment portfolios, or the mortgages on their books, should be reduced, but that the two should lose their privileged debt status, thus evening the playing field with their private competitors in the Wall Street securitization business and the mortgage-insurance game.

As for Fannie's and Freddie's shared social mission of providing cheap mortgages and extending home ownership to the less affluent, that might best be assumed by other government-owned and financed agencies, such as the Federal Housing Administration, or FHA...

Many observers, no matter their political stripe, have high hopes the U.S. will copy Europe in using "covered bonds" to finance most home mortgages. In this case, banks and other lenders retain the credit risk on home mortgages they have made, but sell bonds backed by those mortgages to outside investors, thus off-loading interest-rate risk. Such a system is cheaper and more efficient than the multi-level government-sponsored-enterprise financing system that has flourished in the U.S. for years...

THE BIGGEST POSITIVE to emerge from the Fran and Fred bailout to date is the increased amount of money that will flow into the secondary mortgage market, and at lower interest rates, to make up for the agencies' recent neglect of their mission. Under the rescue plan, the Treasury Department will create a new, unlimited borrowing line for both companies, permitting them to borrow directly from the government, using existing mortgage paper the U.S. owns to collateralize the loans.

Signs of a housing rebound?

The cover story for the 7/14/08 edition of Barron's magazine has controversial in that it's calling for a bottom in the housing market. How can that be? Read on:

Home prices are down nearly 18% from the market's peak, according to Case-Shiller, and inventories of unsold homes are at near-record levels. Foreclosures are mushrooming on "subprime" properties, or homes whose purchase was financed with subprime debt. Blowback from the crisis has left mortgage-finance giants Fannie Mae (ticker: FNM) and Freddie Mac

(FRE) financially strapped, while many other lenders lack the stomach -- or money -- to offer new mortgages. Noted market experts such as Pimco bond-fund manager Bill Gross and economist Mark Zandi of Moody's Economy.com predict the meltdown in housing will continue for many months, with home prices declining by 10% or more from today's depressed levels.

Yet, such pessimism appears overdone, based on much recent data. Sales of existing homes are showing tentative signs of increasing, while the plunge in prices likely is nearing an end. Total inventories fell in May to 4.49 million existing homes for sale, or a 10.8-month supply at the current sales pace, down from an 11.2-month supply in April, according to the National Association of Realtors, in just one statistic emblematic of the nascent trend.

YES, THE SUPPLY OVERHANG still is humongous, but at least the numbers are moving in the right direction, as even Treasury Secretary Henry Paulson noted last week. Speaking at a Federal Deposit Insurance Corp. conference, Paulson declared that "we are well into the adjustment process." Inventories of new single-family homes are down 21% from a 2006 peak, he observed, while "existing-home sales appear to have flattened over the past several months, indicating that demand may be stabilizing."

Still other numbers suggest prices are close to bottoming. The S&P/Case-Shiller Index for April, released just last month, showed the biggest year-over-year price decline yet, of 15.3%. Buried in the numbers, however, and widely ignored in the media, was the news that home prices actually rose, albeit slightly, between March and April, in eight of the 20 markets covered by the index (Boston, Charlotte, Chicago, Cleveland, Dallas, Denver, Portland, Ore., and Seattle). This was in sharp contrast to the readings for March, which showed prices falling in 18 of the 20 surveyed markets. Also, the pace of monthly price declines is starting to slow in most of the markets with negative readings...

In general, transaction-based home-price indexes, including S&P/Case-Shiller, may be painting a bleaker picture of price trends than warranted. That's because subprime housing, though less than 10% of the total U.S. housing stock, accounts for a far larger share of current sales volume, owing to spiraling defaults and distress sales. In the San Francisco area, expensive homes ($721,548 and up) have suffered a peak-to-trough drop in price of only 10.7%, compared with low-priced homes ($473,711 and under), down 40.9%, and mid-range homes, down 28.3%, according to the latest Case-Shiller numbers. The surge in low- and mid-range sales has been sufficient to push average peak-to-trough prices down by 24.6%, despite the index's valuation-weighting.

Help for the housing market also may be on the way in the form of proposed congressional legislation that would allow the recasting of some $300 billion in troubled subprime mortgages through the Federal Housing Administration. The bill, which some have derided as a bailout, would demand sacrifices by both lenders and borrowers, and could help to ease conditions in the subprime market.

Of greater importance, a government takeover of loss-ridden Fannie and Freddie -- the subject of widespread speculation late last week -- would ease concerns about the continued availability of credit in the housing market. Fannie and Freddie, which buy mortgages from banks and repackage them into mortgage-backed securities, are the biggest source of financing for the U.S. mortgage market...

SURPRISINGLY, CHIP CASE, whose knowledge of the housing market goes back decades and is based on the voluminous collection of data, is among those who think home prices may be nearing a bottom. Case notes, among other things, that new housing starts fell to 975,000 in April from a peak rate of 2.27 million in January 2006, and that three declines of similar magnitude -- from more than two million to less than one million -- have occurred in the past 35 years. "Every time this has happened before, housing-market activity has rebounded within a quarter and caught experts by surprise," he says. "In many areas, particularly outside the overbuilt markets of Arizona, Florida and Nevada and the huge bubble market of California, home prices may well stabilize" and begin to recover before the end of this year.

Case acknowledges history might not repeat, as the U.S. could be on the cusp of a painful recession. Unlike the three prior dips of a million-plus starts -- in the first quarter of 1975, the second quarter of 1982 and first quarter of 1991 -- the latest slide was triggered by insensate speculation and suicidal lending practices rather than the traditional factors of rising unemployment and interest rates and slowing economic growth. Thus, he says, a protracted dip in the economy would temper his optimism, though the official measures of economic growth don't indicate a recession yet.

Jim Paulsen, chief investment strategist of Wells Fargo's primary investment unit, expects home prices to steady by year end, with the pace of foreclosures slackening shortly. Most of the subprime debt at the center of the current crisis already has been written down by financial institutions, he notes, while many subprime borrowers who lost their homes are returning to rental units. "Folks who compare this home-price cycle to the one that occurred in the early '80s obviously have short memories," Paulsen says. "In the 1980s the economy was in a deep recession, mortgage rates were at 17% or more, and unemployment [was] hitting a post-Great Depression high of nearly 12%."...

NAR economist Lawrence Yun is optimistic home prices will stabilize in the next five months and begin to recover next year, despite today's gloom and overly stringent lending standards. NAR officials typically are cheerleaders, but Yun advances some reasonable arguments to buttress his view. Home sales, he notes, currently are running at a pace of about five million a year, around the same level as a decade ago. Yet, the population has grown by 25 million in the past 10 years, and the U.S. has created 10 million new jobs. Though the rate of new-household formation requires the net addition of 1.6 million housing units a year, housing starts likely will remain below one million into next year, creating pent-up demand in the years ahead...

Delinquencies, defaults and foreclosures hit the housing market with a rapidity and virulence unmatched in previous cycles, pushing total loans past-due and foreclosure rates to unprecedented highs. As a consequence, the current residential real-estate cycle has been front-end-loaded relative to past bear markets, which suggests the pain, though excruciating for many, may be shorter-lived than in the past. Early mortgage defaults have blunted the negative impact of subprime-mortgage-rate resets, which peaked in the spring, and are likely to curb the effect of interest-rate resets on option ARMs and other affordability products, expected to peak between 2009 and 2011. Many of these mortgages already are in the foreclosure pipeline, which will lessen the overhang of foreclosed properties in the future...

An ebbing tide of new delinquencies strongly hints that the worst may soon be over for the housing market, at least in terms of burdensome supply. The pig, in other words, is well along the python's alimentary canal.

In hindsight, the housing bust hasn't been nearly as calamitous as depicted in the media, or as Wall Street's woes might suggest. Yes, people have lost their homes, but more than a few were mendacious mortgage applicants and mere speculators, who eagerly sought out 100% margin loans, only to fold just as quickly when prices turned against them.

It is important to remember, as well, that even after a steep drop in the S&P/Case-Shiller Indices, long-term buyers in the top 20 U.S. metro markets have seen their properties appreciate by 70% since 2000. Home prices often take five to 10 years to recover fully from severe declines such as this. But at least the available data suggest the scary dive in home prices soon will be over.

On the other hand, TheStreet.com's Marek Fuchs insists that 'they' just don't get housing in this video:

The "Humpty Dumpty" Economy

Writing in Barron's, economic bear Alan Abelson has coined an interesting term: The Humpty Dumpty Economy. What that means is that although the economy will certainly manage to piece itself together again, it's going to take some time to fix what ails us and the end result may look different from what it did before. It's a changing world, and Humpty is going to have to change with it:

The trouble with striving to look on the bright side of things is that it's pretty darn hard these days, to tell the truth, to find the bright side of anything. For what we're all being forced to bear witness to is an extraordinary and extraordinarily blood-curdling sight: the enormously endearing and widely presumed eternal Goldilocks economy is, right before our startled eyes, metamorphosing into the Humpty Dumpty economy.

Just to lift your spirits a bit, we hasten to reassure you that even though like its prototype in the old ditty, the Humpty Dumpty economy is due to suffer a great fall, the pieces most definitely can be put together again. It's just that it may take quite a few years, or maybe more than quite a few years. And, we should admit, too, that the end result will look more like Humpty Dumpty stuck together with Band-Aids than Goldilocks....

The wrenching changes being wrought by a falling Humpty Dumpty economy, largely created by credit, and a swooning stock market, kited by leverage, are everywhere evident. Housing foreclosures swirled up to an all-time high of 0.83% of all mortgages nationwide. Over 5.8% of homeowners were behind in their mortgage payments, the largest number in upwards of two decades. House prices lost a staggering 8.9% in 2007 as a whole (and they're still tumbling).

Yet, despite the ubiquitous plunge in prices, the supply of unsold houses rose to four million, or to over 10 months' worth. Homeowners' equity fell below 50% for the first time since 1945, hitting a new low of 47.9%. As Barry Ritholtz nicely put it, never before have banks and the other various and sundry lenders owned more of the average American's house than he or she does.

Speaking of lenders, thrifts and savings outfits lost a cool $5.24 billion in the final quarter of '07, as they diligently wrote down tons of goodwill (perhaps it should more properly be called ill will).

In January, to continue this lugubrious litany of the damage done in the Humpty Dumpty economy and the ravages wrought by the bear market, the equity portfolios of the largest U.S pension plans, according to the calculations of Mercer, which keeps tabs on such things, shrunk by $110 billion. Not exactly chump change, even when it's other peoples' money.

The credit crunch, as has been deservedly publicized, has begun to punch a few holes in the great private-equity bubble and a scattering (so far) of hedge funds have been badly wounded, several fatally.

It's almost as if all its tributaries flooded the river Styx, causing its fetid and noxious waters to spill far and wide over its banks. And what it all spells in bold-face letters, of course, is recession.

But as Jay and David Levy, father and son proprietors of the famed Jerome Levy Forecasting Center, contend in their latest commentary, this is a much different animal than the tame and docile recessions we've grown accustomed to.

Never, they point out, "have such broad and severe credit-quality problems preceded a recession. Recessions cause burgeoning financial problems to intensify, not recede. Credit problems lag the business cycle, not the other way around."

Not surprisingly, then, they mock as "bizarre" the popular notion that the economy will rebound smartly after only six months of negative growth. Instead, they warn, "The financial damage accompanying the recession will be unprecedented in modern history and the economic consequence will be dire."...

"NEVER ASK THE BARBER IF YOU NEED A HAIRCUT. Never ask the Realtor if the house you are considering buying is a bargain at the price offered. And never ask the government to calculate the rate of inflation when it can save millions of dollars in cost-of-living adjustments."

Those tidbits of wisdom come from Ray DeVoe, who authors the eponymous DeVoe Report. We've known Ray for a bunch of years and read with pleasure his weekly observations on the market, the economy and life in general. A shrewd and, even rarer, sane investment type, he does his business under the Jesup & Lamont flag.

What makes the quote above especially pertinent, obviously, is that even while recession's clammy hand makes itself felt, inflationary fires are starting to flare in earnest, stirring unfond memories of the 1970s and early 1980s, when the cost of virtually everything from diamonds to doughnuts vaulted into the wild blue yonder. Ray takes due note of the double whammy of recession and inflation back then and points out that the measures of both used at the time were a heap more accurate than those Uncle Sam relies on today. Especially notable, we think, was the calculation he cites of January's 4.3% rise in the consumer-price index (vs. January 2006) by John Williams of Shadow Government Statistics.

Using the degimmicked yardstick that was in use prior to 1980, Williams comes up with a reading of 11.8%, which, to these tired eyes, seems a quantum leap up from the official 4.3%. And, more to the point, it squares a lot more closely with $106-a-barrel crude, not to mention upward leaps just this year of commodities of every kind from 30% or more in aluminum, oats and silver and double-digit gains in coffee, corn, wheat and zinc, among others.

Before 1980 and before fiddling with the CPI became the fashion at the Bureau of Labor Statistics, the reckoning was, as Ray points out, based on "a market basket of goods and services bought and used by the average American family." A measure, in other words, of the cost of living and evidently a good deal closer to the truth than the finagled numbers now in favor...

In contrast to the consensus expectations of 25,000 additional jobs, payrolls shrunk by a tidy 63,000 and that doesn't quite tell the whole dreary story. The private sector lost 101,000 jobs. So only by grace of hiring by the federal and local governments was the loss shaved.

What's more, our old bugaboo, the birth/death concoction, supposedly chipped in 135,000 jobs. We'll be generous and assume that half of those 135,000 mythical additions were real; anything more than that, though, isn't being generous; it's being downright silly.

Manufacturing took it on the chin, shedding 52,000 jobs. Construction was down 39,000. Those old reliables restaurants and health care tacked on 19,000 and 37,000 new slots, respectively. As Philippa Dunne and Doug Henwood of the Liscio Report note, something like 75% of the employment gains over the past year have been in health care and restaurants. Neither category typically abounds with exceptionally high pay and, we have a hunch, the eateries particularly are going to be painfully pinched by rising costs and declining patronage.

The unemployment rate ticked down, but that, alas, was due to a sharp contraction of the labor force. While Philippa and Doug make a reasonable argument that this may not wholly reflect would-be workers opting out because they can't find a job, we're not so sure. In those circumstances, psyches are tough to plumb.

An easier call is that Friday's dismal job report cinches it: We're in a recession.