How US mortgage debt could cause a global financial crisis

Moneyweek.com ^ | 7-5-06 | Dan Denning

[Hydroshock]

In the US, Fannie Mae (FNMA) and Freddie Mac are Government Sponsored Enterprises (GSEs) which buy residential mortgages and repackage them to sell on as mortgage-backed bonds. Although these bonds are not backed by the US government, most believe the GSEs would never be allowed to fail. But Dan Denning reports below on how a US Treasury report has warned that this mistaken belief and the illiquid nature of property means that an ‘interest rate shock’ could topple the US mortgage market – making the Long Term Capital Management (LCTM) crisis look like a walk in the park...

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Best of the Day Article What's more likely - stagflation or depression? Are we about to see a return to the 1970s? The US is at war, oil prices are soaring, the Federal Reserve is hiking rates – it’s no surprise many analysts are experiencing déjà vu. But as Mike Shedlock... Every once in a while, a report comes out from a government agency that’s so unassumingly candid you're forced to admit a mistake has been made and that the document was mistakenly leaked, or that its author will soon be fired.

I couldn't help thinking something like that when I read the remarks of Emil W. Henry Jr., assistant secretary for financial institutions at the U.S. Department of the Treasury. You can find his entire speech here. But for the purposes of brevity, I've excerpted the key passages below.

And if you want the even briefer version, here it is: The large size of GSE mortgage portfolios (about US$1.5 trillion), coupled with the lack of market discipline at correctly pricing the risk of GSE debt, multiplied by the interconnectivity of the world's financial institutions has led to a possibility "without precedent." Henry adds that "Financial markets across the board would likely become very illiquid and volatile as firms with significant losses attempted to unwind their positions."

Notice he said “attempted.” Here are more excerpts. Emphasis added is mine, with some sideline commentary interspersed:

• “At the outset, let me be clear on the meaning of systemic risk: It is the potential for the financial distress of a particular firm or group of firms to trigger broad spillover effects in financial markets, further triggering wrenching dislocations that affect broad economic performance. Perhaps a useful analogy is to think about system risk as an illness that can become highly contagious...

• “The hard lessons from Long Term Capital Management (LTCM) include: i) the danger of investment decisions which rely upon the presumption of liquidity, ii) the importance of transparency and disclosure, iii) the extent of the interdependencies of our global markets, financial firms, investors, and businesses, iv) the fact that complexity is sometimes the enemy of stability, v) the danger of complacency and false confidence in hedging strategies which, by definition, can never hedge out all risk and which can produce the opposite of the desired effect in the absence of liquidity.”

Complexity is sometimes the enemy of stability, but not always. For example, an arrangement in which interest rate risk is not "aggregated" to the balance of the GSEs would be more "complex." But it would also be more stable because the stability of the financial markets and the guarantee of liquidity would not depend on the solvency of two poorly run companies that are engaged in the kind of risk management that's far too complex for one single firm.

In other words, a division of labour in interest-rate risk management, though more complex, would be more stable and more efficient. Centralization loses again. But just what kind of risk are we talking about here?:

“There are numerous levels of risk presented by the mortgage investment portfolios, but at a basic level, the risk is created as follows: GSE portfolios are comprised primarily of fixed-rate mortgages, either held as whole loans, mortgage-backed securities (MBS), or other mortgage-related assets. While mortgages in the U.S. typically allow borrowers the option to prepay at will, the aggregation of fixed-rate mortgages requires that the investor develop strategies to mitigate risks presented by these uncertain cash flows - both prepayments and extensions. Unless the portfolios are hedged properly, in a period of significant interest rate movement, there is the risk to the GSEs that their assets and liabilities will quickly become broadly mismatched, which can lead to insolvency - much like the dynamics of the S&L crisis.”

It's both refreshing and astonishing for a public official to state what has been plainly obvious for three years now: The GSEs could be come insolvent, and take a lot of people with them. It is not just the idle musings of congenital doom-mongering pessimists like myself. But how might it happen? Henry continues:

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“There are three primary ways that the GSEs uniquely impose systemic risk on our financial system. Taken individually, each reason might not be a cause for dramatic action. However, aggregating each of these attributes under a single entity that also carries with it the broad misperception of a government backstop or a guarantee creates a perfect storm scenario. The first element is the size of the GSEs’ investment portfolio… Today’s combined GSEs’ mortgage investment portfolios still total almost $1.5 trillion...

“Secondly, the GSEs are not subject to the same degree of market discipline as other large mortgage investors. That lack of market discipline is reflected in preferential funding rates that result directly from the market's long-standing false belief that the U.S. government guarantees or stands behind GSE debt…

“The third element is the level of interconnectivity between the GSEs’ mortgage investment activities and the other key players in our nation's financial system… In comparison to bank tier-1 capital, GSE debt obligations exceeded 50% of capital for 54% of these commercial banks, and GSE debt obligations exceeded 100% of capital for 34% of these commercial banks. In addition, the GSEs’ interest rate positions are highly concentrated and pose significant risks to a number of large financial institutions.”

Three risks, then. Large size, lack of market discipline, and "high degree of connections throughout our financial system." What could it lead to?:

“Systemic events can unfold by direct and/or indirect spillovers. Direct spillovers arise when the failure of a particular firm creates substantial losses for those who carry direct exposure with such firm, such as its creditors. Indirect spillovers typically develop, not from direct exposures to the firm at the epicenter of the crisis, but when this firm causes a lack of confidence leading to a sense of panic and turbulence that results in action that generates substantial losses for firms that were not directly related to impaired firm. Such spillovers -- not the initial event -- typically take the greatest toll on economic activity, and in the case of the GSEs, the potential for both direct and indirect spillover effects is nothing short of breathtaking.”

Interest rate shocks DO happen. Henry points out that:

“If such an interest rate shock occurred in a way that was not captured by the models [currently in use by market forecasters], the results could be without precedent. The immediate implication would be actual and mark-to-market losses.”

What is without precedent is the magnitude of the losses should such an interest rate shock hit the GSEs today. It's not like this hasn't happened before:

“Has it been so long that we have forgotten Fannie Mae's significant financial troubles in the late 1970s and early 1980s? During this time period, Fannie Mae's balance sheet looked a lot like a savings and loan. As interest rates rose, Fannie Mae's cost of funds rose above the interest rate it was earning on its long-term, fixed-rate mortgages. Like many S&Ls, Fannie Mae became insolvent on a mark-to-market basis. It lost hundreds of millions of dollars.”

If the same thing happens today, you can replace "hundreds of millions" with "trillions."

[Darnright]

>Are the above people extremeley stupid, yes.<

Therein lies the rub. Usury has been illegal, not to mention vilified throughout the ages, just for this reason.

[Toddsterpatriot]

I see an amazing career opportunities for them in areas such as sales, politics, law, and diplomacy.

I saw a recent article about car dealerships needing workers, salesmen included. Maybe someone has a career change in their future?

[RipSawyer]

Well, you're certainly right about one thing, deflation has not been a problem. Of course one now needs an annual income roughly equal to my father's entire lifetime earnings and three gallons of gasoline cost what we used to spend for a week's groceries for a family but I suppose you are going to tell me that we are better off by having no backing for our money. Save it for somebody else, I ain't buying.

[Iris7]

Again, money is credit.

Later in my post I tried to deal with your objections. The problem is that the modern system of money began because it allows manipulation of money supply growth. The 19th Century U.S. gold standard came under intolerable political pressure and was scrapped for the Federal Reserve central bank system. Recollect William Jennings Bryan "Cross of Gold" speech. The modern "liberals" arose in that era and forced the abandonment of cold base money. They then found the joys of "dirigisme" irresistible.

The English began the modern world by basing money on government credit with the Bank of England. Probably the biggest reason the Stuart Monarchy was deposed and the Battenburgs begun is to be found in the Whig Magnate class' need for less expensive bank loans. Less expensive borrowing costs made industrialization possible.

The situation is unfortunate as a catastrophic chaotic collapse of dollar based credit is eventually certain. In the mean time various arbitrage plays are possible. Devil take the hindmost. Sigh.

[Iris7]

Since I wrote #108 will respond. The current "housing" market deflation is feared, a deflation caused by interest rate increases. Interest rate increases are used to decrease the money supply. The Fed has been increasing fed funds cost steadily on the Bernanke watch.

Bernanke is quite correct to fear inflation. There are huge inflation pressures at this time. The dikes, the levies, are holding but the crews are stacking sand bags at full speed.

Furthermore the petroleum producing states are demanding, and getting, oil prices indexed for inflation (to our dismay). If the dollar drops in value versus other countries the oil prices in dollars will get higher proportionately. To keep the price of dollars reasonably stable will require raising interest rates.

The booming housing markets that we have just seen were and are products of past negative real interest rates. Interest rates are rising and for very good reasons. Rising real interest rates increase the cost of buying a house. The resulting price changes in housing must therefore be, in aggregate, down.

[Iris7]

What "trials and tribulations" are you talking about?

I said "Whatever trials and tribulations might have resulted from using gold and silver..." By this I mean financial panics, deflation, fluctuation in commodity prices, and probably a return to the old banking rule never to loan money with real estate collateral.

The current world wide monetary system cannot continue indefinitely. Money creation would have to "go to infinity" or a serious depression created.

The M3 money supply series has, curiously, been discontinued. Nonetheless what is available is interesting.



The M2 money supply, likewise,

[Iris7]

I will do my best to explain important concepts of a non-PC sort. Please bear with my weaknesses. The "decreasing middle class prosperity" statement rests on what is meant by "middle class".

Perhaps we can agree that the "middle class" are those persons not of "lower class", i.e. those who have as productive assets their own intellectual or manual labor, nor those persons of the "upper class" whose assets are largely various income producing properties?

"Middle Class" then can not include those (whatever their income) without income producing property since they then must be "lower class". In the Seventeenth, Eighteenth, and Nineteenth Centuries this was well understood. The middle class individual owned a business, whether a farm or a shoe repair shop, a productive mine, a cloth making business, or other some such. They were independent from dependence on wages and "the boss".

This group is smaller every day.

The Austrian School is a complete economic theoretical system in the same sense as is Adam Smith's. Smith's "Theory of Moral Sentiments" and "Wealth of Nations" is an economic theory, as is Marx's "Das Capital".

An important Austrian concept is that manipulation of interest rates causes misallocation of labor and resources and so decreases real wealth creation. Money and effort are invested in relatively low performing wealth producing investments during periods of managed low interest rates and produce rising commodity prices since these projects consume real resources at a greater rate than than the actual non-financial economy can support. Interest rates held artificially high cause many potential wealth producing investments to be foregone. Wealth creation therefore operates in a less than optimum manner.

One remembers Econ 101 where "Savings=Investment" is seen as a tautology, and the marginal propensity to save equals the marginal propensity to invest. This results in a market price for capital. Artificially reduced cost of capital, that is, interest rates held lower than market cost, makes investors see opportunities where value only appears to exist because of these lower than market interest rates. Mis-investment ensues.

Same thing happens with government spending, transfer payments, and such like because the money when used can only distort market prices. Market prices are necessary to set savings, investment, and consumption at the maximum wealth creation rate.

[Toddsterpatriot]

The "decreasing middle class prosperity" statement rests on what is meant by "middle class".

Yes, usually defined as an income range.

Perhaps we can agree that the "middle class" are those persons not of "lower class",

And not of "upper class".

"Middle Class" then can not include those (whatever their income) without income producing property since they then must be "lower class".

So your theory means a shoe repair shop owner who earns $25,000 a year is middle class while a wage earner who makes $1,000,000 a year is not middle class or upper class?

That's one way to show the middle class is shrinking. Change the definition to the point of uselessness. Why not use a silly, much easier definition, like range of income?

You never did answer my question...If we returned to a gold backed dollar, do you think we could find enough new gold each year to expand the money supply enough to prevent deflation?

[palmer]

If we returned to a gold backed dollar, do you think we could find enough new gold each year to expand the money supply enough to prevent deflation?

From wikipedia, there's 155,000 tonnes mined ever and 2500 tonnes mined per year. But a more meaningful comparison might be the 8133 tonnes in official U.S. holdings and 252 tonnes mined in the U.S. each year which is 3% growth.

[Caipirabob]

3. There may have been some speculation in homes by "flippers" but I don't see that as being anything much. Most people bought their homes to live in them and the RE market hasn't come close to crashing. The slow down is in certain markets that were on fire to begin with.Real estate prices go up and down but on average they have risen about 6-8% annually. I see nothing that will stop this. I know it's been said before but it is true that the reason RE is a good investment is they aren't making any more of it.

Two areas here impating South Florida. Those who invested in SFH and those who invested in condos. The SFH investors are generally going to be in much better shape that those who invested in Condos. Too many variables coming into play that impact that market, including overconstruction and availability of SFH's along with rental apartments turned condo during the boom.

Generally those who are flipping condos are feeling the pain somewhat dearly. Those who invested in SFH's at the height of the boom and overextended will be in for some tears as well. Verdict: Normal market cycle. Those who are into the condos are in for a far worse ride, I'd imagine, but in areas with consistently high demand, the turndown will inevitably turn around for the better, even if it takes 4-5 years.

We actually had an increase in SFH sales in June and construction continues unabated except by environmentalist lawsuits. Even those lawsuits may contribute towards a rebound in prices by way of limiting availability of said commodity.

Given historical interests rates and even less than "consistent" demand, my forecast would be for "Sunny skies with occasional showers" for the Florida market. : )

[RipSawyer]

Again, money is credit.
>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>

At any rate when the price of gold was pegged at $32.00 per ounce then 100 ounces of gold would buy a new car, the same 100 ounces of gold would buy an even better new car today. The 3200 dollars would buy a ten year old clunker today.

[Toddsterpatriot]

At any rate when the price of gold was pegged at $32.00 per ounce then 100 ounces of gold would buy a new car, the same 100 ounces of gold would buy an even better new car today.

100 ounces of gold in 1980 would buy an $80,000 car. 100 ounces of gold in 1982 would buy a $30,000 car. SO what was your point?

[Toddsterpatriot]

But a more meaningful comparison might be the 8133 tonnes in official U.S. holdings

If those are metric tonnes, that'd be about 286,883,116.7 ounces. At Friday's close of around $626, that's about $179,588,831,054. Do you think that'd be enough money supply for our economy?

[DennisR]

Or, as my instructor's husband told her, "You have given me so many things to read warning me about smoking, I am going to give up reading."

[Tax Government]

As boomers retire, we/they will sell housing rather than take out equity. That could lead to a decline in valuation.

[palmer]

No. There would have to be a huge increase in the gold price and a corresponding price deflation, making it very impractical to changeover.

[RipSawyer]

100 ounces of gold in 1980 would buy an $80,000 car. 100 ounces of gold in 1982 would buy a $30,000 car. SO what was your point?

>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>

The point is that the value of gold is more constant than the value of paper dollars, your illustration notwithstanding. Apparently you choose to believe that when the price of gold in dollars fluctuates wildly that the problem is with gold. I don't see it that way, I see the problem as being with the unbacked dollar.

[Toddsterpatriot]

The point is that the value of gold is more constant than the value of paper dollars

I'd have to disagree. Your precious gold lost over 60% of its value from 1980 to 1982. Doesn't sound very constant.

Apparently you choose to believe that when the price of gold in dollars fluctuates wildly that the problem is with gold.

No. I just think it shows the ridiculousness of your premise.

I see the problem as being with the unbacked dollar.

The unbacked dollar that buys more gold in 2006 than it did in 1980? That's funny!

[RipSawyer]

The unbacked dollar that buys more gold in 2006 than it did in 1980? That's funny!
>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>

You are so predictable as to be patently ridiculous! You cherry pick one short period which fits your theory and ignore the rest. How about comparing 2006 to 1983? I see your game but I cannot understand your motivation. You are not fooling too many by the way.

[Toddsterpatriot]

There would have to be a huge increase in the gold price and a corresponding price deflation, making it very impractical to changeover.

If only the goldbugs could understand that. Then I could stop poking them with a stick.