How US mortgage debt could cause a global financial crisis

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:

“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.”

“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."

You are so predictable as to be patently ridiculous!

I know you are, but what am I?

You cherry pick one short period which fits your theory and ignore the rest.

How about something a little more recent?

Under a gold standard, we'd have had severe deflation (over 30%) from January until mid-May and severe inflation (over 20%) from mid-May until mid-June. Yeah, that sounds more stable than an unbacked dollar. LOL!

You show me a chart with the price of gold up one hundred dollars an ounce over a few months and you use that to indict gold for instability? You are becoming very tiresome, go and play with the other children.

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.

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I can't imagine any way that you could be wrong on this but you could have mentioned that along with negative real interest rates that loan requirements have been dropped drastically, I see posts to the effect that the norm is to buy a house costing five years gross income, this would have been considered insanity forty years ago. Also there is no way that housing prices can continue indefinitely to rise faster than incomes.

I like him but you might also want to try Dave Ramsey.

BUMP for Dave Ramsey. His baby steps helped me see the light and get out of all debt except the house (working on that step but it'll take a while).

You show me a chart with the price of gold up one hundred dollars an ounce over a few months and you use that to indict gold for instability?

Actually, that was a rise of over $200 an ounce in 6 months and a drop of $140 in a month. I guess in your world a 50% jump in 6 months and a 20% drop in 1 month is a sign of gold's stability? LOL! Maybe you can show me a time where our fiat money showed such giant swings in value?

You are becoming very tiresome, go and play with the other children.

Only if you promise to go play with the rest of the senile goldbugs.

Senile goldbugs at least have better sense than to judge the value of gold by the fluctuations of a paper dollar. Gold is fluctuating in terms of the dollar because it is once again returning to its true value which it has not been allowed to do because of international manipulations. The gold bubble in 82 came about precisely because the dollar was no longer backed by gold and the right to own gold had been restored to the people after a long period in which they were forbidden to own gold bullion. You are reversing cause and effect to justify your position. Somehow I think you are aware of this but don't want to admit it. I suspect that if you had to choose between holding an ounce of gold for forty years with no interest earned or holding the equivalent in paper dollars for the same time with no interest earned you would have sense enough to choose the gold. Don't bother replying with some non-sequitor such as that you wouldn't hold a dollar without earning something on it. If you bother to reply at all deal with what I said and not what you wish to make of it.

Senile goldbugs at least have better sense than to judge the value of gold by the fluctuations of a paper dollar.

Right, because gold doesn't fluctuate!

Gold is fluctuating in terms of the dollar because it is once again returning to its true value which it has not been allowed to do because of international manipulations.

Wow, international manipulations. How can it be manipulated if it is stable?

I suspect that if you had to choose between holding an ounce of gold for forty years with no interest earned or holding the equivalent in paper dollars for the same time with no interest earned you would have sense enough to choose the gold.

Holding paper dollars for 40 years with no interest is just as stupid as claiming that gold is the only real store of value.

Holding paper dollars for 40 years with no interest is just as stupid as claiming that gold is the only real store of value.
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I knew you wouldn't deal directly with what I said, you couldn't possibly be stupid enough to hold the paper dollars, hell even if I grant you the prospect of drawing interest and you pay taxes on the interest you would still come out in the hole and you know it.

I knew you wouldn't deal directly with what I said

You said gold was more stable than the dollar. I showed you a gold chart from this year that shows you were wrong. No luck finding a time frame where the US dollar fluctuated as much as gold? I didn't think so.

I knew you wouldn't deal directly with what I said
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And you still haven't, or are you just incapable of understanding what I said?

And you still haven't, or are you just incapable of understanding what I said?

I don't understand what your point is. Yes, in 1966 one ounce of gold was a better purchase (oh, right, you couldn't) than holding $35 with no interest until now.

In 1980, one ounce of gold was a worse purchase than holding $800 with no interest until now.

Buying the S&P 500 index would have beat gold and cash over both those time frames. So, what was your stupid point again? That gold is more stable? I'm still laughing at that one.

OK, I misjudged you, you obviously ARE in fact incapable of understanding me.

I understand you perfectly. You believe gold would somehow cure all our problems. You don't understand economics and are allergic to facts.

Goodby.

Run away. You wouldn't want to learn anything. The shock of it could kill you.

Okay, one last attempt, please see if you can wrap your little brain around this and not wander off into something else.

IF I were to offer you the choice of;
1. A free ounce of gold with the understanding that the only thing you could do with it is keep it locked in your safe for forty years at which time you could take it out and do as you pleased or it would go to your descendants if you were deceased or,

2. The equivalent of one ounce of gold in paper dollars at today's gold price with the same stipulation as I made on the ounce of gold above.

If either one were available to you today as a gift which would you take? Forget past history and all that, which would you take? Anyone of normal intelligence should be able to understand the question and give a straight answer, if you insist on clouding the issue I will know that you are simply an evader.

If either one were available to you today as a gift which would you take?

Chances are, inflation would make the gold more valuable than the paper dollars. I would have said the same thing in 1980 and I'd have been wrong. So what is your point? Is there inflation? Yes there is. Is gold a hedge against inflation? Sometimes.

Now, how about answering my question? Are you claiming that inflationary and deflationary swings have been more severe since we left the gold/silver standard?

Now, how about answering my question? Are you claiming that inflationary and deflationary swings have been more severe since we left the gold/silver standard?

Inflationary, yes, I haven't seen a deflation problem yet.
So after all you have said you still admit that you would consider the gold a better bet over a forty year period, interesting but not surprising.

Inflationary, yes, I haven't seen a deflation problem yet.

Interesting. Despite all the evils of fiat money, even you admit deflation is no longer an issue. Do you admit that while we were on the gold standard, deflation was a major problem in the US?

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.

We all know that you are buying, and you're just not being honest about it.

You know full well that when you get your check in US dollars that you'll be able to use it to pay your food bill. Just like we all know that the problem with that idiot gold standard was that it never supported an economy where people could eat as well as you can now.

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