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Thursday, July 10, 2008

Will the Real GSE Please Stand Up...

Fannie / Freddie are insolvent per Fed President Richard Poole, but the government won't step up unless there are $77b in losses. So... Fannie will get bailed out if they ARE to fail (with equity holders getting nothing), but Lehman is currently not allowed to fail and ARE currently being bailed out (in the form of access to liquidity from the Fed). Thus, the question, which entity is the Government Sponsored Enterprise?
Lets rewind and start with Fannie and Freddie (the actual GSE's) to see if any of this makes sense...

Since 1990, U.S. nominal GDP has increased about 80% (logarithmically). Outstanding mortgage debt grew 50% more than this, raising the debt/GDP ratio from about 0.5 to 0.8. Mortgage-backed securities guaranteed by Fannie and Freddie grew 75% faster than GDP, while mortgages held outright by the two GSEs increased 150% more than GDP.

The share of all mortgages held outright by Fannie and Freddie grew from 4.7% in 1990 to 12.9% in 2006, which includes $170 billion in subprime AAA-rated private label securities. The fraction had been as high as 20.5% in 2002.3. It is hard to escape the inference that expansion of the role of the GSEs may have had something to do with the expansion of mortgage debt.
Sounds like a lot of leverage to me, but Possibly (with a big P) for the "public good"...

Now to Lehman (from the Washington Post):

Lehman's high-risk, high-reward strategy produced cash gushers during the good days -- the firm reported almost $16 billion of profits from 2003 through 2007 -- but those days are gone. Lehman recently reported a $2.8 billion second-quarter loss, which probably won't be its last unprofitable quarter.
The arms race -- and the associated risk for Lehman -- has grown exponentially more intense since 2004, when the world began to find itself awash in cheap short-term money, and globalization and dealmaking increased the call on Lehman's capital for such things as leveraged buyouts.
Where's the public good in that? Besides incentive for the employees and shareholders (over 30% of shareholders are in fact employees), I don't see much.

Taking a look at a chart of Lehman's Stock price vs. Fannie's (through yesterday - so drop them each another ~20%), one can clearly see where Lehman took off. While Fannie's stock rocketed in the early 1990's through early 2000 (a period in which their market share tripled) Lehman's stock kept up and blew it away starting in mid-2003, right when Lehman moved towards the more high-risk strategy.

While I am sure that employees with stock in Lehman are currently at a loss for words, there was EXTREME moral hazard at work when the risk-taker (employee) has an unlimited reward for doing so, yet with limited downside.