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 – 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."
--and in just 6 billion years the sun will explode and destroy all life on the earth. Nothing lasts forever.
Just like usefulness of the m3. The m3 stopped growing for a while in the '90's and inflation stayed as it was. It soared in the late '90s and inflation stayed where it was some more.
Maybe you want your tax dollars to be spent tracking the M3 but let me keep mine for something useful, like tracking soaring private wealth.
ROFLMAO!
Do you admit that while we were on the gold standard, deflation was a major problem in the US?
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I admit that deflation can be a problem, just the reverse of inflation, some people seem to have no objection when inflation drives up the dollar price of assets and destroys the value of savings but they think the reverse is a major catastrophe. Of course deflation is more likely than inflation under a gold standard but either one is possible. If you are referring to the great depression which my parents lived through I don't think you can make the case that that was caused by gold.
Actually, I don't see that a general deflation would really be harmful to anyone who is not in debt since the price of everything would go down together meaning that if you sold your stock for less the money you received would still buy the same amount of other goods and services. For those who have large mortgages or own stocks on margin it could be a disaster just as inflation has been a disaster for people holding large amounts of cash. Inflation shifts wealth from cash holders to asset holders and deflation shifts wealth from asset holders to cash holders.
Your post indicates an incredible depth of misunderstanding. I don't have time to point out all your errors.
Yes, of the two bad choices you gave me, holding the gold may be the least bad choice. Buying a diversified portfolio of dividend paying stocks beats gold or cash over the long term.
This seems to be the blind spot of the gold bug and the economically ignorant, but then I repeat myself.
So let me see if I have this straight, deflation which would drive down the dollar price of assets is no big deal?
Actually, I don't see that a general deflation would really be harmful to anyone who is not in debt since the price of everything would go down together meaning that if you sold your stock for less the money you received would still buy the same amount of other goods and services.
Deflation wouldn't hurt businesses? Wouldn't hurt the economy?
For those who have large mortgages or own stocks on margin it could be a disaster just as inflation has been a disaster for people holding large amounts of cash.
Just when I think you're a total idiot, you make sense. And you made fun of me for saying holding cash for 40 years would be stupid.
Inflation shifts wealth from cash holders to asset holders and deflation shifts wealth from asset holders to cash holders.
But that's no big deal? Because we should all aspire to hold as much cash as possible? You're funny!
"Breast enhancement surgery can easily be moved from the debt to the asset column, if properly promoted."
You sound like a bean counter. Just turn those liabilities into assets. Hah!
I don't dispute the facts. The reality of the situation is that the post dot-com & 9/11 crash was ameliorated through really low interest rates which inflated the real estate markets. Combine this with a new generation of mortgage instruments (ARMs and interest only loans) that expose borrowers to signifcant amounts of risk and the stage is set.
Not that I agree with your conclusions or the way you chose facts to support them. What I'm saying is that you're making me think and my thinking feeds my family. Please let me share the other facts I'm seeing that point away from your impending disaster scenario to my continuing success scenario.
My take is that Bernanke fears inflation like we fear high voltage electricity. We respect it, control it, and it makes life better. OK, the idiot press will twist his words to make it look like Ben is sweating bullets about "huge inflation pressures" and "stacking sand bags at full speed", but he doesn't talk that way. If you chuck the idiot America-bashing news sources and go directly to the Fed's press releases, you find that Bernanke calmly says things (here) like "The outlook for inflation is reasonably favorable but carries some risks."
He's not doom and gloom. He does not show "dismay" when he talks about oil. He says "Increases in energy prices have pushed up overall consumer price inflation over the past year or so. However, inflation in core price indexes, which in the past has been a better indicator of longer-term inflation trends, has remained roughly stable over the past year." Translation: "calm down and stop crying about oil prices".
That lets us get back to housing; once again by only looking at what the the idiot America-bashing press gives us we get scared. By looking at all of reality we can get back to work and feed our families. OK, the scary part is that interest rates are going up. We control our emotional fears with sanity by remembering that rates are still very low and they're supposed to go up. See for yourself; both mortgage rates and the prime rate are still at historic lows, construction spending is still climbing, and homes are still affordable.
It may be a lot of work to have to set a side a scary, dramatic, belief system that the TV and all your freinds back you up on, and trade it in one that's well, boring. It's worth it. The two big reasons are that the boring truth can feed your family, and the other is that the boring truth is not a lie.
JMO, but I think that recent history effectively counters your belief that there is a correlation between interest rates and property prices. The last great property market was from 1976-1979. From January 1976 to January 1980, the fed funds rate rose from 4.87 to 13.82 percent. During that time real estate values skyrocketed. In his 1981 book Wealth and Poverty, George Guilder notes that by 1979, the value of individually owned dwellings had reached $1.3 trillion dollars, twice the worth of individually owned corporate stock. He also noted that half of the newly minted multimillionaires in 1978 achieved their fortunes in real estate.
Conversely, each of the three property bear markets during the last 30 years or so (1974-75, 1980-82, 1990-92) occurred while rates were falling. Real estate is the most frothy when the dollar is weak. To state that housing prices must go down because interest rates are rising ignores recent history.
If you ever learn to respond to what I ACTUALLY SAID rather than what you wish to pretend I said then I might waste some more time responding to you, until then, GOODDAY.
Educate me in the wisdom of your goldbuggery.
then I might waste some more time responding to you, until then, GOODDAY.
Or run away again like a little girl. LOL!
Hey guys, check out some true gold bug ignorance about deflation. RipSawyer proves that gold bugs just don't get it.
I've seen folks on FR regularly post the charts on M2 and M3 like in #126 as if they're supposed to be self-evident proof that the government is printing money with reckless abandon and inflation is out of control.
I've never understood this because if what I read is true, The Fed has not used money supply but rather interest rates to spearhead monetary policy for the past 20 years. The fact that M2 and M3 have increased so dramatically with modest inflation clearly shows this disconnect.
If M3 is relevant to inflation, wouldn't there be some correlation between M3 and the CPI? I've looked at the history of M's, as well as the CPI less energy, and I can't find much of a relationship between M3 and the CPI.
The annual increase in currency is often the main component of the increase in monetary measures. If this is so, where is all this currency? Isn't a great deal of it being held overseas and is not in our economy and, therefore, is not in play? The Commerce Department publishes data on the amount of US dollars circulating in foreign countries and, if I could find it, I'd bet a chart of these flows looks very much like the M2 and M3 charts in post #126.
These flows probably don't include money spent by tourists and the incredible amount of personal remittances sent overseas (think Mexico). Drug dealing also causes a great deal of our currency to flow out of the country. Why should this be counted as part of the domestic money supply?
The massive underground economies of the world operate based on US dollars. Dollars are much easier to get and store than gold so I'd also bet that the dollar is used by underground economies as a safe haven. There is a serious lack of a relationship between macroeconomic fundamentals and monetary aggregates because of the unaccounted foreign holdings of US dollars. For these reasons, I have to think the charts showing the rapid growth of M2 and M3 are pretty worthless for predicting or indicating inflation.
Jumbo Shrimp?
Microsoft Works?
Healthy Tan?
Pretty Ugly?
Silent Scream?
A New Classic?
Brave Sir Robin?
I still don't understand why anyone would put gold or dollars in their safe for 40 years. The again, I'm not a gold bug.
I tried to tell him that. He accused me of not responding to his point (whatever the hell that was). But gold is more stable than the dollar. LOL!!
I wonder if he learned math from Havoc?
Maybe there is a connection and the effect is the other way around; namely that increasing real estate values drive up interest rates.
The reason I'm suggesting this is the fact that if you squint real hard at the long term trends you can almost see interest rate surges happening right after big increases in real estate values.
Just the same, I try to take this stuff with a grain of salt because one problem is that the human brain has a bad habit of seeing patterns even when there are none, and another problem is that even if there were a connection it's definitely not strong enough be able to predict anything.
It does look like something though...
I still don't understand why anyone would put gold or dollars in their safe for 40 years. The again, I'm not a gold bug.
I didn't recommend either one, it is known as a HYPOTHETICAL question. The point is that the man who claims that the paper dollar is more stable admits that if forced to choose he would hold the gold. If you don't get the point of that then there is no point in going any further. Clodster simply refuses to deal with what I have actually said, he puts words in the mouth of others and then responds to what he pretends was said. At this point I honestly don't know whether he is playing a game or simply lacks comprehension, how about you?
This is the core of the disagreement. With the gold standard, you can put your dollars in a vault and 100 years later your dollars don't lose as much value as they would with Fed management. (OK, we're not talking about what 100-year old mint-condition bills could fetch from a coin collector.)
Our point is that with Fed management there's a much better chance of being alive to open the safe, because the economy will have been so much more prosperous..
This is the core of the disagreement. With the gold standard, you can put your dollars in a vault and 100 years later your dollars don't lose as much value as they would with Fed management. (OK, we're not talking about what 100-year old mint-condition bills could fetch from a coin collector.)
Our point is that with Fed management there's a much better chance of being alive to open the safe, because the economy will have been so much more prosperous..
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Thanks, I am glad someone understands and can respond in an intelligent manner. As for the last part of your post I don't see how that can be proved or disproved, it seems to be purely a matter of conjecture to me. There is a broad range of opinion on the effectiveness of Fed management.
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