Posted on 07/06/2006 6:40:55 AM PDT by 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 its 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 thats 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:
(Article continues below)
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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 Todays 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."
Those "dire warnings" themselves were all this article had in the way of "substantive data".
The Brits are always ready to meet the demand for US disaster scenarios. That's a good business strategy for journalists, but a good business strategy for home finances is to ignore the British press. The reason being is that anyone who wants to worry that "US mortgage debt could cause a global financial crisis" will also have to worry about Martians invading.
US mortgage debt is about where it's been throughout the '90's --at about 40% of total value. IMHO it's not unreasonable to own a $100k house and with a $40k mortgage.
Besides, the role that home equity plays in the average American's total assets is still less than it was in the '90's when Saint Billy was in charge-- and even then it was only about a fourth of total wealth. Big deal.
bump
Id worry most about your brother's friend. His wife will be ok unless there's deflation.
Thanks for the ping, Cal.
Even though we rent, own our vehicles, and have no credit cards, I'm concerned. There is such a thing as the World Bank. Trade with other nations is one thing, entangling everyone's finances together is another thing entirely.
I will now read all the replies ridiculing this very good article.
Not quite as simple as I make it seem, but only in detail.
This will seem kind of strange, but money is the same thing as credit.
This will seem kind of strange, but money is the same thing as credit.
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This may seem kind of strange, but REAL money is not quite the same as credit. A paper dollar with nothing behind it is another matter.
When I read the article, I put off deciding whether it was good ('very' or otherwise) until I had a chance to first check the facts myself.
What I found was that "US mortgage debt" was no closer to presenting "a global financial crisis" than it's been for many decades. That's when I decided that the article was more of the same old America-bashing that UK press loves to indulge in. The idea is to check things out before passing judgement.
Question: how did you know the replies would be "ridiculing this very good article" before you read them?
How high is production? Are you worried that a gold standard would prove deflationary?
It is possible that gold production would further deflation. The reverse is also possible. The combination of consumer cost inflation, commodity inflation, and decreasing consumer real wealth is more due to other factors than gold mining, I think. The current systemic and deeply rooted inflation and decreasing "middle class prosperity" can adequately be explained by the Austrian economic model in my opinion.
Sounds prudent to me. I've taken steps to minimize time out of doors without my helmet, just for when it starts to fall. That, and bird droppings are two good reasons.
bttt
Just make certain to line it with tinfoil and you'll be fine. :-)
Right now the dollar IS backed by gold in practice. Anyone wishing to exchange a dollar as value for gold is free to do so.
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You might as well say the dollar is backed by the services of prostitutes (anyone wishing to exchange a dollar for said services is free to do so), or peanuts or speaking appearances by Bill Clinton or other forms of torture. In other words the dollar according to your words is backed by everything and therefore backed by nothing. It is fiat money any way you cut it and its only value is what people are willing to give it. I am not allowed to print my own money but the government can print any amount they wish even though therir money has no more actual value than what I might print. Whatever trials and tribulations might have resulted from using gold and silver as money pale in comparison to the results of issuing paper backed by nothing more than the hot air of political speech.
You misunderstand 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?
The current systemic and deeply rooted inflation and decreasing "middle class prosperity" can adequately be explained by the Austrian economic model in my opinion.
I'm almost afraid to ask, what "decreasing middle class prosperity"? And how can the Austrian economic model explain?
Really? Are you claiming that inflationary and deflationary swings have been more severe since we left the gold/silver standard?
What "trials and tribulations" are you talking about? Since leaving the gold standard, inflation peaks are half what they used to be, and deflation has virtually stopped altogether. We've not had a single depression.
I see an amazing career opportunities for them in areas such as sales, politics, law, and diplomacy.
"I hate, HATE these "mortgage vultures", that prey on the undisciplined."
Why is it "preying" on someone if they (the homeowner) want to do a cash out refinance on their home? Is the lender supposed to be a nanny and determine if the loan proceeds are going to a worthy end?
Are the above people extremeley stupid, yes.
Like our so-called government?
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