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:
(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… 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."
That is how we live. I drive 2001 jeep. I will drive it until the tires fall off.
"I hope it won't but fear it will. That is why I am perparing my families finances. We are cutting spending, increasing savings, and paying down debts."
I would say that is good policy. We are doing the same.
ping
I think the breast enlargement was money well spent. I would have held off on the furniture and the trip, however.
I am hoping for the best and preppoign for the worst. I do hope that realestate a teh skyrocketing debt has a soft landing bu the more I read on it the more I think it will be brutal in many markets and could damage theis countries economy severly.
>A friend of my brothers takes the cake. He and his wife cashed out all the available equity in their house last winter and along with new furniture and a trip, she got a breast enlargement.<
How old is this guy?
I hate, HATE these "mortgage vultures", that prey on the undisciplined.
"And what do you think of usury?"
"What do you think of murder?"
-- Cato
>>>and spiraling property taxes are creating a situation where property values may collapse suddenly, and to no more than a few hundred dollars an acre.
Oh THAT would be nice!
In their thirties. They are both college educated professionals. I met them once, I think at a party at my brothers.
I'm a Jerry Doyle fan and I'm debt free. Hooahh
I like him but you might also want to try Dave Ramsey.
Oh my
> They are both college educated professionals.<
They sure must have both slept right through Economics 101!
Sheesh.
Got my fav hosts mixed up - meant Dave Ramsey - LOL
She could use that breast enlargement to make money.
Wait a few months. People may begin to wake up around here by then. But naysayers will throw out taunts to the bitter end. They have no other way to view the world except through rose colored lenses. But a few astute people are aware of how miserable things are under the surface. Seems that the conservative New York Post is getting pretty disgusted with people playing games with employment statistics. They were castigating Bernanke for his HIGH RISK mistakes. [Learn More?].. Hopefully, people will continue misread the economic news until after the elections in November.
Then all hell may break loose. Does the term "stagflation" ring a bell?
Thanks for your insight.
Yes, it's possible to live quite "affluently" on even modest salaries if one spends wisely.
For example, I have plenty of money to buy a $29 t-shirt at Nordstrom's, but why should I when I can get the functional equivalent at Wal-Mart for $4.99?
I was spending $80 a month on haircuts for my boys. NOT. Another mom told me she cut her boys' hair (they mostly want military-style high-n-tights, especially during the summer) and that it was pretty easy to please them. A $29.00 clipper (from Wally World) later and we were in business. And the boys (and Mom) like the convenience of not having to make the trip to the barber shop, wait in line etc. This way it's zip and go. And parents save $80 bucks a month.
It all adds up --- to, say, our four vacations in Hawaii!
Word!
And I hate those plastic milk jugs!
There's a thought.
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