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 pay cash for everything except my mortgage, which I am paying down 2x and will be done in 5 years.
We keep a small account that we put $$ into so when we want to buy something or go somewhere we have it already accumulated. But we don't use it much -- we are OK with a 5-yo TV and a 8-yo DVD player/sound system.
We keep our cars in excellent shape -- at the current rate they will last about 20 years.
I don't how debt-ridden people sleep.
heh, heh. I drive a 2001 LeBaron convertible. I'm doing the same.
OOPS. 2001=1991
I was going to say, my car is a 2000, so what's the big deal? :)
yeah, been there. There is also foreclosurS.com.
did you try the free trial? is it legit?
Naw. I just want news stories. The only money I have ever spent on the internet is guitars from Rondomusic and a garage door opener remote from Ebay.
I don't even do free trials.
It is getting scary.
Yeah, I keep getting their junk mailings.
Amazing how much weight you can get into a standard postage-paid envelope when you put your mind to it.
People in this country have become so pacified by the relative piece and calm of the last 60 years. Sometimes people need to look at films of the depression and even people escaping the Blitz in Poland and realize that those things ARE possible.
Every generation must be diligent on many fronts. We have not been. We have been fortunate and are an accident just waiting to happen. A quite bad one, I fear - and to say we are "soft" would be a severe understatement.
"We are cutting spending, increasing savings, and paying down debts."
Good Idea, the FedGov needs to get the extra cash from somewhere, glad it will be YOU...
First, he didn't ask me for any facts. Second, every article he posts here is doom and gloom. I do tease him about it. Third, here is the end of our conversation:
Hydroshock: "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."
L98Fiero: I would say that is good policy. We are doing the same.
Now, mind your own business.
Lead.
You're right, of course, but I would put it more strongly.
They are considered the equivalent of AAA-rated Treasury instruments. So this article is a gigantic 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.
and you must have missed the part where he said dispute facts and you said he wanted our economy to collapse..
Your post just goes to show, pimpdaddies never change!
Various snippings from the garage help. Really, if they're going to insult my intelligence with the suggestion that I'd seriously consider exchanging my 5.75% fixed mortgage for one of their dubious offerings, what other response should they expect?
At least some of it was put to good use.
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