That was just a lousy $1.9 trillion (admittedly at one institution). But $62 trillion? Where is it? Who owns it? Who thinks they are covered and may not be, but their balance sheet reflects a fully valued bond because “I have insurance?” How long will it take to find out where the real problems lurk?

So, let’s add up the damage. $50 billion for loan losses in a market where home values will be down 20% at the least - but let’s be optimistic here. Add in another $36 billion for the preferred shares, because if we let the banks go down, we just have to pay it through the FDIC. And add in another $19 billion for the subordinated debt, because the risk of setting off a firestorm in the CDS market may just be too great. That adds up to $105 billion.

Maybe those sharp guys at Morgan Stanley can figure out a way to get around these problems. The regulators recently forced buyers of Ambac CDS to take anywhere from $.13 to $.60 on the dollar. Maybe they can make everybody play nice in the sandbox, but this is a very big sandbox, far larger than Ambac.

And why? Critics have said that Fannie and Freddie were nothing but hedge funds with an implicit government guarantee. This is an insult to hedge funds. Hedge funds don’t pay hundreds of millions in campaign contributions so that they can risk taxpayer dollars, prop up their profits, and pay huge bonuses to executives. They risk their own capital with no safety net.

Fannie and Freddie are banks that are levered between 40 and 50 times. I can think of two hedge funds, Carlyle Capital and Long Term Capital Management, that had leverage at those levels. They both went bankrupt, as will any such levered business.

As long as the prices of homes kept rising, Fannie and Freddie had no problems. That extra leverage allowed them to post record profits every quarter, boosting stock prices and keeping those bonuses and options for executives rising. And Congress let them do it. In fairness, there was a significant minority who wanted tougher regulations, including the Bush administration. But a bipartisan majority decided to take the campaign contributions and listen to the fabrications about how much Fannie and Freddie did for the country and how there was no risk.

And so now we are at a point where we are going to be forced to pick up the very expensive pieces. The alternative is to let the world as we know it go up in smoke. The mortgage market is dysfunctional now without Freddie and Fannie. The housing crisis would be far worse if you let them die. And once you determine to pick up the costs, you have gone down a very slippery slope. Yet if we don’t do it, the systemic crisis will be far worse than the problems resulting from Bear, and those would have been horrific.

This is the Savings and Loan Crisis, Part 2. Maybe they can figure a way to lessen the cost. And the hope is that at some point the companies once again regain their value and the costs will be somewhat mitigated.

But if we don’t get credit derivatives on an exchange, we are going to have to continue to do this. It is all so maddening. The only bright side to bailing out Freddie and Fannie is that it will make Bill Bonner wrong in his prediction of a soft depression.

Baltimore, La Jolla, South Africa, and LondonOn a personal note, things are going well. My arm is much better. The doctor said I tore a pronator muscle which broke a vein and resulted in some serious pain for about a week and a very ugly bruise along my whole arm. Who knew golf was such a rough sport?

My oldest son Henry just graduated from the University of Texas at Arlington with a degree in history, after going part-time for eight years. He has worked at UPS all that time, but kept at his school work. I am proud of him. He turned 27 yesterday. Tiffani is back from her honeymoon with Ryan. She says she will have pictures up in a week or two, and I will post a link.

Business is good. I am amazed at the opportunities out there. I will be in Baltimore next weekend for Bill Bonner’s birthday. Then on to La Jolla to meet with my partners at Altegris (and drinks with Richard and Faye Russell). The next weekend I host Chuck Butler of Everbank and his compadres from the Sovereign Wealth Society at a Friday night Rangers game, and then take off the next morning for South Africa for a speech, then back to London for a day to meet with the team (and my partners) at Absolute Return Partners.

Life is busy but good. And this weekend I am going to take it easy and fire up the grill for some steaks and barbecue at Tiffani’s new home. It will be a great weekend. And I hope your Labor Day will be as enjoyable. (There will be no Outside the Box on Monday.)

Your happy I don’t have to figure out the Freddie and Fannie mess analyst,

John Mauldin

Source: Who Holds the Old Maid?

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