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Fannie and Freddie: Why doubts persist

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Published Date: 10 September 2008
By Bill Jamieson
10 September, 2008
LET'S count our blessings. Two hours on from the great Large Hadron Collider (LHC) switch-on and we're all still here. But oh for an LHC switch-on to blast away the financial market blues.

Barely a day after US Treasury Secretary Hank "Bazooka" P
oulson pulled the trigger to rescue the country's two largest mortgage institutions Fannie Mae and Freddie Mac and early reaction as to the outcome is not too good. Doubts are already settling in.

Will this really fix America's housing and banking miseries? Or prove just another staging post in a deepening crisis?

Yesterday the Dow Jones Industrial Average dropped 280 points, undoing a Monday rally triggered by news of the emergency takeover. Anxiety with a capital 'A' is back in financial markets. Shares in investment bank Lehman Brothers plunged 35 per cent amid growing worries about the bank's ability to raise new capital. Confidence is shaky. The Financial Times reports today that the liabilities of Fannie and Freddie will have to sit on the US government's books and that the cost of insuring against a US default has started to rise. That's worrying.

The nightmare scenario for markets is a slump in confidence in the US dollar and a flight out of dollar assets - just when the US needs to draw money in.

US federal government debt has effectively doubled from $5 trillion to $10 trillion. As at end June Fannie and Freddie debt outstanding was $1.7 trillion combined, with over $220 billion coming due right now. This, says veteran Wall Street commentator Ed Yardeni, is one of the main reasons why Paulson had no choice but to nationalise Fan and Fred. Foreign investors, including commercial and central banks, were threatening a buyers' strike unless the Treasury explicitly guaranteed the GSEs' new issues.

The take-over has been widely reported as a "crisis of capitalism" with the US government having to step in and rescue private sector institutions from the mess they got themselves into. Really? The lesson, says Yardeni, is that the government shouldn't have meddled in the mortgage market in the first place by implicitly guaranteeing these mortgage institutions and allowing them to become behemoth monopolies.

The Treasury owns 80% of the GOEs now. This means that we will soon get to see just how much they previously underestimated their losses when they were "simply" Government Supported Enterprises. This is what the regulator found as at end July: Fannie Mae and Freddie Mac increased their Mortgage Backed Securities issuance by nearly one-third in 2007 as competition virtually ceased in the second half of the year.The share of single-family mortgages backing MBS issued by Fannie Mae and Freddie Mac with features that pose high credit risk was higher in 2007 than in the previous year.Adjustable-rate loans represented 11.4% of Fannie Mae's purchases, down from 17.7% in 2006. For Freddie Mac, ARMs represented 16.8% of single-family acquisitions, down from 22% the previous year.

The reality is that the government now is involved in every aspect of America's property and mortgage markets. One of the objectives of the take-over is that the yield spread between Government Owned Enterprises (GOEs) and Treasury yields will narrow to zero.Really? Much depends on the next President and Congress, who have yet to be elected, as to what further help will be forthcoming. That adds political calculus to any investment decision and the uncertainty could act as a brake on any rally in the value of the firms' long-term debt.

For the economy, the main issue now is whether mortgage rates will come down enough to revive housing activity, or at least enough to stabilise home prices. In "housing affordability" terms, a 100 basis points drop in the US mortgage rate is comparable to a 10 per cent drop in home prices. So we are back to watching events in the real economy and the housing market in particular.

My hunch? Both America and the UK will be cutting interest rates soon. Cauterising the fall in the housing markets will become the prime aim of policy now that the oil price and inflation fears have begun to recede.




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  • Last Updated: 10 September 2008 11:09 AM
  • Source: The Scotsman
  • Location: Edinburgh
  • Related Topics: Bill Jamieson
 
1

A Friend of Fernando Poo,

10/09/2008 12:46:24
"The lesson, says Yardeni, is that the government shouldn't have meddled in the mortgage market in the first place by implicitly guaranteeing these mortgage institutions and allowing them to become behemoth monopolies"

Exactly so. Many people tried over the last decade to warn that the GSEs were ticking time-bombs. However they donated to Republican and democrat campaigns and kept an army of lobbyists to prevent their detractors from getting any political traction.

Now Brown is itching to set up a similar system here to get the mortgage markets moving again. Of course that's how Fannie and Freddie got started in the first place.

When politicians are in trouble, there's no disaster they won't repeat if it will give them a temporary reprieve.
2

A Friend of Fernando Poo,

10/09/2008 13:05:33
Another aspect of the Fannie and Freddie crisis remains unremarked. It is true that they entered the subprime markets only late in the day and thus had limited eposure to this. Their motives appear to have been simply to avoid ceding that entire market to their competitors.

However, Fannie and Freddie are arguably responsible for the very existence of the subprime mortgage markets.

Due to the implict threat or promise of a government rescue, prevalent long before the current crisis, the GSEs could undercut any competitor in the mortgage markets. They manage to gain 90% of the US market in securitisation of prime mortgages.

Anyone wanting to compete, and many did following the Savings and Loans mess and the deregulation it entailed, had to look for markets that Fannie and Freddie hadn't already locked in.

That led to subprime mortgages which were outside the GSE requirements for credit rating or amount of deposit. Then the markets for "jumbo" mortgages (higher than the GSE loan limits) and the more exotic Alt-A (no income verification) ARM (low-start adjustable rate "teaser" mortgages with a time-bomb interest rise built-in) and Neg-Am (you don't even pay all the interest, never mind any capital - until your payment automatically quadruples) were initiated and grew.

These of course all blew up in everyone's faces. Their existence was down to Fannie and Freddie using a government guarantee to keep these players out of prime mortgage markets. Governments mess with these markets at great peril to national economies.

Also little-noticed in the hullaballoo over their nationalisation was that the most threatening rise in mortgage defaults for Fannie and Freddie was not amongst the subprime mortgage-backs they'd foolishly guaranteed, but amongst prime mortgages that have always been their core business.

If their nationalisation marks the end of Phase One of the credit bust and the subprime risis, it's becoming clear that Phase Two will involve a simila
3

A Friend of Fernando Poo,

10/09/2008 13:05:59
[...]

If their nationalisation marks the end of Phase One of the credit bust and the subprime risis, it's becoming clear that Phase Two will involve a similar problem in quite ordinary prime mortgages, of which there are a far greater number.
4

JRA,

10/09/2008 13:53:08
So, do you think your final phase will see the US becoming 'bankrupt' - unable to meet its debt obligations?

I don't.
5

JRA,

10/09/2008 14:50:40
#3

One of the problems I have with your arguments generally is your frequent reference to the Japanese asset bubble and subsequent recession.

As far as I can see, most commentators agree that it was a lack of action by government in the initial stages of the crisis combined with the wrong action when it finally came, that exacerbated Japanese decline.

Even in the Great US Depression of the 1930's, the hands off lack of a Fannie type solution by the US government was - in the opinion of Ben Bernanke - one of the main factors deepening and even increasing the scale of the crash. Clearly as a student of the Great Dep. he is attempting to make sure the same mistake is not made twice.

But back to Japan. At Market peak, many properties in Tokyo were valued at $1.5m per square m. The crash may be evident now. But if you look at Tokyo real estate for sale now - even in fairly humble parts of the city - you are talking £500k for a 1 bed Leith style new build.

The peaks seen in Japanese value far outweigh enything we have seen in the western world, No?.

In Japan, there are other factors there that contributed to the decline in Real Estate. Earthquakes, lack of insurance and a complete aversion to old properties for a start.
6

JRA,

10/09/2008 16:02:25
#4 2nd last paragraph I meant 'anything'

What about the US election. GDP normally surges at this time. How will that affect matters ?
7

A Friend of Fernando Poo,

11/09/2008 14:17:21
#4: No. I don't see sovereign bankruptcies in the West.

On the Japanese reaction near the top of their credit bubble in 1989. I think the politics of the situation conditions the response more than the economics of it. The politicians will do what they think the electorate will let them get away with. I don't see that it's any different here or in the US.

The theory runs that the Japanese raised interest rates to halt the credit bubble, which is fine, but that they didn't drop them fast enough, which allegedly causes the deflation.

Firstly: I believe that the deflation is caused by the excesses of the credit bubble, and consequent malinvestment, not by whatever twiddling of the knobs is carried out just as the bubble peaks.

Secondly: we ought to hope I'm right on that, because in the UK and EU at least, we're not dropping the interest rate due to a perceived threat of inflation. I watched the Japanese bubble avidly (and predicted it in advance too, right down to the 80% drops in stocks and house prices) and the politics that had them hold rates in 1989 and 1990 looked very similar to ours.

I agree that because his expertise lies there, Bernanke is trying to avoid a repeat of the 1930's Depression. Indeed I believe that the bubble was exacerbated by precisely his ideas on this causing Greenspan to drop rates too far for too long since 1003. Essentially we should have had a deflationary recession to follow the tech bubble bursting in 2000. By goosing the bubble once again, we now face a worse situation while we've built up far more debt. There's great danger in a general fighting the last war.

Finally: yes, in terms of property in Tokyo, extremes were present in 1989 that we haven't reached.

On the other hand, japan's experience does bear out the "larger they are, harder they fall" hypothesis of bubbles. That's really not good news for those places where property has risen the most since 1982.

US election: There will likely be some attempts to
8

A Friend of Fernando Poo,

11/09/2008 14:17:58
[...] goose the US economy in February/March as the new guy takes over. By then though, their goose will be cooked.

 

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