Christmas Presents for Bankers

On Christmas night in 1776, George Washington led a surprise attack on a group of Hessian mercenaries employed by the British to suppress the American revolution. This was one of the biggest military victories of the Revolutionary War.

In the same spirit of surprise, the Obama administration announced on Christmas eve that it was removing the $400bn cap on Fannie Mae and Freddie Mac's access to the US Treasury. The new draw is limitless. It also announced that the chief executives of the two government-controlled mortgage giants would be getting compensation packages worth $6m a year. This was another big blow for the financial sector in its effort to sap every last cent from the productive economy.

After throwing the economy into the worst downturn since the Great Depression and bringing the whole sector to the edge of collapse, the financial industry has used its political power to succor itself back to life. It is now stronger than ever.

In the last quarter, the financial sector accounted for 34% of all corporate profits, dwarfing the share reached in the mad days at the peak of the housing bubble. The economy might look bleak on Main Street, with double-digit unemployment rates and nearly 200,000 foreclosures a month, but they were dividing up $13bn in bonuses at Goldman Sachs this Christmas.

Most people already knows the various public pots that Goldman and the rest tapped to make themselves healthy and rich again. There was the $700bn troubled asset relief programme (Tarp) loan fund, the hundreds of billions of dollars worth of guarantees that the FDIC provided to cover their borrowing at the peak of the crisis, and the trillions of dollars lent out by the Fed. However, the bottomless line of credit for Fannie and Freddie could prove to be the biggest pot of gold of all.

Fannie and Freddie both collapsed in September of 2008 when the bad mortgage debt they purchased at the peak of the bubble overwhelmed their reserves. The Treasury Department put them into conservatorship and gave each of the mortgage giants a $100bn line of credit to cover future losses. This level was raised to $200bn each earlier this year as losses ran higher than expected.

However, this increase was supposed to be just a safeguard. We were assured that actual losses would never approach these levels. That seems reasonable since the bulk of Fannie and Freddie's loans were prime, meaning that they came with either a 20% down payment or mortgage insurance. Even with a collapsing housing bubble it is difficult to lose too much on prime mortgages.

If 10% of Fannie and Freddie's mortgages (held or insured) defaulted, this would amount to $550bn in bad mortgages. If they lost an average of 25% on these mortgages, this still only leads to losses of $163 billion, less than half of their $400 billion line of credit. And, this is before taking into account their prior reserves and profits on ongoing operations. As it stands, Fannie and Freddie had drawn just over $100bn of their line of credit, so it is difficult to understand the need for raising their borrowing limit from an amount almost four times this level.

There is one possible reason that Fannie and Freddie could see much higher losses. Suppose that they deliberately buy up mortgages from banks at inflated prices. This was the initial purpose of the Tarp, but it quickly got sidetracked into lending capital to banks. This was the better policy, but it still left the banks with huge amounts of bad loans.

Perhaps Fannie and Freddie are now acting as a "backdoor Tarp". This could easily lead to losses in excess of $400bn. It also is the type of policy that you might want to announce on Christmas eve when no one is paying much attention.

This goes along with the $6m pay package for the people who now run these government controlled entities. Is this really what we have to pay for good help? The Treasury secretary gets paid $191,300 a year. Should we infer, based on this fact, that he must be incompetent?

The folks running Fannie and Freddie prior to their collapse pocketed tens of millions of dollars in compensation. The Treasury now tells us that their incompetence could end up costing taxpayers more than $400bn.

If nothing else, the great recession should teach us that paying executives lots of money obviously does not ensure that we will get competent people in charge. But, this is not a story about doing what is best for the economy and the country. This is a story about doing what's best for the financial industry. That was the name of game in Washington DC before the collapse and that is still the name of the game - until people get pissed off enough to do something about it.