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."
>I was spending $80 a month on haircuts for my boys. NOT.<
Try that on a GIRL. Thank goodness my little princess has very, very long hair (LOL).
I did, however, purchase a set of clippers for the Cocker Spaniel. No expensive trips to the groomer in our house!
(of course, the dog has a crew cut, but she doesn't mind a bit)
So how can a rise in interest rates affect fixed rate loans? You might suffer an opportunity cost if you have invested in long-term fixed rate loans and could get a higher rate elsewhere or suffer a real loss if inflation jumps to much higher levels, but that's it.
For me, it would take almost as much courage to clip the dog as to cut a daughter's hair! Fortunately, our pooch doesn't need clipping, but I'd definitely learn. We used to have an adorable poodle mix (may she R.I.P. the little darlin') and it was truly a pain, not to mention expensive, trying to keep up with her grooming.
I hate, HATE these "mortgage vultures", that prey on the undisciplined.
They serve a purpose.
Credit is for big boys and girls. If you don't take it seriously, you'll learn a hard lesson. Maybe those around you will learn something, too.
It may be that their sole purpose in life is to serve as a warning to others.
All you are buying is a piece of paper entitling you to pay the government 3 or 4 thousand dollars a year. Unless someone else offers to pay more.
Viva La Kelo
Buy a few acres. Zone 1/3 acre for residential. Build a house. The rest is personal open space, no?
Unfunded Social Security liabilities are $71 trillion over the next 50 years.
What's another trillion and a half?
Don't get me started.
No. In many places Zoning changes do not happen unless you know somebody or have really expensive lawyers. Getting permission to build a house even on property zoned for such is about as likely as the zoning change. Travel around the country and see how bad it is in some places.
Debt derivatives: the only 500-year floodplain that floods every five years.
Why would traveling enlighten one to zoning issues? I've lived up and down the East Coast. That doesn't mean local zoning ordinances are learned.
If property drops to a few hundred an acre, I'm sure zoning will become more workable. Everyone needs to make money. Property and building will be an incentive.
True. Property value drops will spark a lot of reform.
I hope you are right. I'm getting excited thinking about it :)
LOL!
I've been going to Google news every three days or so and searching "foreclosures".
It is interesting.
You remind me of those stupid jerks that were telling everyone the market was not looking very stable back in September of '29.
Go peddle your Bush hating economic pessimism somewhere else
/sarcasm
>>Everyone in professional investment management believes that the government will end up backing all mortgage-backed securities, regardless of the financial condition of the issuing GSE's. They are considered the equivalent of AAA-rated Treasury instruments. So this article is bit of a red herring - if the government ever refused to shore up the MBS market in a crisis, it would be equivalent to touching off another Great Depression. They wouldn't dare not to do it.<,
Wonder if that would impact taxes?
He asked for fact you insult him?
I'm debt free to the point that I don't even own my home any more. I rent. And my rent is $1600. To buy the house three doors down (same quality and reverse floor plan), my monthly payment would be approximately $3,700, including taxes.
Something is fishy in the Seattle suburbs market when you compare those two dollar amounts.
This time is unique. here are some things that were not there during other cycles:
1. A flippers mentality (housing as an investment)
2. Creative loans
3. Fifty year mortgages
4. >50% of your monthly income allowed for a mortgage payment - even on a "teaser" rate.
5. New bankruptcy laws
6. Massive refinancing for "non-home-related" items.
It is going to be interesting to watch the loans reset in the next 18 months. We are seeing some of it now, but so far we are like the guy during the tsunami that walked out into the newly exposed ocean bed and said, "Hey look. It looks like the water's starting to come back".
Interesting times are ahead.
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