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TOPIC: The $5 trillion mess

The $5 trillion mess 9 years, 8 months ago #1410

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The $5 trillion mess, July 12, 2008

Fannie Mae and Freddie Mac were created by Congress to help more Americans buy homes. Now their shaky condition threatens the entire housing market.

NEW YORK (Fortune) -- They own or guarantee $5 trillion worth of mortgages­ - nearly half of all the country's outstanding home loan debt-and they're crashing. Big time.

Fannie Mae and Freddie Mac are struggling with an investor loss of confidence so great that, while they're unlikely to go under, they could conceivably see their ability to function impaired. That would wreak yet more havoc on an already wrecked housing market- making loans tougher to come by and possibly pushing hundreds of billions of dollars in cost onto U.S. taxpayers.

How could the companies end up in such awful straits? Given the way they were created and run, a better question might be: how could they not?

The two companies are so-called government-sponsored enterprises, created by Congress in 1938 (Fannie) and 1970 (Freddie) to help more Americans buy houses.

Their mandate is to maintain a market for mortgages - buying loans from banks, repackaging them as bonds, and selling those securities to investors with a guarantee that they will be paid. This makes lending more tempting for banks because Fannie and Freddie take on risks like missed payments, defaults and swings in interest rates.

But the companies are also publicly traded, with the usual mandate of trying to maximize profits for shareholders.

That effort, of course, involves risk, but as quasi-government programs, they've long carried an implicit guarantee that the feds wouldn't let them fail.

Their hybrid nature created both the opportunity and the temptation for the enterprises to take on more risk and to make themselves ever larger, more important and thus more profitable players in the mortgage market.
Very special treatment

The market and ratings agencies have treated Fannie and Freddie as bulletproof, even though the actual business of dealing with interest sensitive loans is very risky. This is in large part because of the very special perks granted to the mortgage giants, but to no one else.

Each may borrow up to $2.25 billion direct from the Treasury. They are exempt from state and local income taxes and from Securities and Exchange Commission registration requirements and fees. And they can use the Federal Reserve as their bank.

One result of all this special treatment was AAA credit ratings. That means Fannie and Freddie could borrow at super-low rates, a benefit they used to purchase - and hold -high-yielding mortgage loans. The spread between the two provided an irresistible earnings stream and the companies just kept getting bigger.

The mortgages they hold on their books alone total about $1.4 trillion, said Mike Stathis, managing Principal of Apex Venture Advisors, a research and advisory firm.

In the meantime, the companies were allowed to operate in this manner, piling on risk after risk, with virtually no capital cushion (Wall Street speak for the rainy-day piggybank financial companies keep should one of their investments blow up.) As the company's loan portfolio loses value and the mortgage market continues to crumble, it's easy to see why this was a fatal misstep.

Some saw the crisis coming before this week. For example, Alan Greenspan famously warned in 2004 that Fannie and Freddie's rapid growth needed to be curbed because their expansion threatened the financial markets.

Still, the cocktail of high credit ratings, domination of the mortgage securities market, and preferential government treatment led to the sort of shenanigans that go hand in hand with excessive privilege.

Fannie overstated its earnings by $10.6 billion from 1998 through 2004, and its chief executive Franklin Raines lost his job. Freddie Mac had understated its profit by nearly $5 billion from 2000 through 2002. Both companies missed earnings filings while their overhauled their books.

"If Fannie and Freddie had been created in the private sector, they wouldn't look like this," says Christopher Whalen, head of research firm Institutional Risk Analytics. "They have a public sector mission to expand housing and run what is essentially an insurance company. But they also have a conduit to securitize and sell loans, which is what broker-dealers like Lehman do; and they have an interest arbitrage piece (making money on the spread between interest rates) that looks like a hedge fund."

Robert Rodriguez, the founder of First Pacific Advisors, hasn't bought Fannie for Freddie bonds for over two years. "With the recent issuance of their financials, we were still uncomfortable with their leverage," Rodriguez says. "We believed there was considerable balance sheet risk in both of these companies.

Now the dwindling pool of mortgages, higher foreclosure risk, and a shaky interest rate environment have the companies on the ropes; and investors are beginning to lose faith in Fannie and Freddie.

Both firms told Fortune that they have enough capital to weather the storm and continue to support the nation's housing market.

And yet, Fannie has fallen 32% this week and 65% since the beginning of the year. Freddie plunged 47% so far this week and is down 75% since January.

Investors have lost faith that the companies can operate in their current incarnation without running into major problems.

If investors abandon these companies, what do we learn from this odd Frankenstein of a business model?

"Nobody every believed that Fannie and Freddie were truly private and they never should have been," says Whalen. "Now we will all have to pay for a company that has gone astray."

Options expert calls Fannie, Freddie shares 'worthless'

Market analyst Jon Najarian at options research firm OptionMonster Inc. in a research note Friday morning said that, although he believes government-sponsored mortgage giants Fannie Mae will continue doing business, "their shares in my opinion are likely worthless." He said crude-oil prices hitting another record and tough talk from Treasury Secretary Paulson on banks had set the table for a "monster" day in the markets Friday. "There is no reading between the lines necessary here," Najarian wrote. "I think Freddie and Fannie equity may be toast, which means the government will simply take over both, as [it] can't let $5 trillion in mortgages vaporize."

Re:The $5 trillion mess 9 years, 8 months ago #1411

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US regulators close IndyMac Bancorp savings bank

Times Online, July 12, 2008

IndyMac Bancorp became the biggest retail bank to fall victim to the US mortgage crisis on Friday, as regulators shut down the Californian savings back after the markets closed because it was unable to raise the cash needed to make good the almost $900 million of losses it has suffered in the worst housing crisis since the Great Depression.

The Federal Deposit Insurance Corporation, which regulates the bank, said it would take over the running of the group from when it will be called IndyMac Federal Bank.

IndyMac specialises in so-called Alt-A mortgages, relatively high-risk homeloans which don't require borrowers to prove their incomes. It suffered badly as its home state of California ranked second among the US states in terms of foreclosures, which accounted for one in every 192 households in June, nearly three times the national average.

The group's shares peaked at $50.11 on May 8, 2006. They lost 87 per cent of their value in 2007 and a further 95 per cent this year. On Friday they declined by a further $0.03 to $0.28.

The collapse of IndyMac, which was America's second-biggest independent mortgage bank with $32 billion of assets, is the second biggest bank to go under, after Continental Illinois National Bank & Trust - with $40 billion of assets - in 1984. Indy Mac, which was America's ninth biggest mortgage lender, when the main financial services groups are included, is the fifth US bank to fail this year.

Re:The $5 trillion mess 9 years, 8 months ago #1412

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The disaster in the two private companies was obvious as far back as 2003 when grave accounting abuses in the two companies were made public.

With the US housing market bottom no where in sight there exists the potential for financial catastrophe on the collapse of Freddie and Fannie as the US would be forced to take on liabilities of more than $5 trillion therefore increasing the national debt by 54% from $9.4 trillion to 14.5 trillion which would result in severe consequences for the US dollar and the US bond market in terms of loss of confidence.

US faces global funding crisis

Daily Telegraph, 16/07/2008

The US Treasury is running out of time before foreign patience snaps.

Merrill Lynch has warned that the United States could face a foreign "financing crisis" within months as the full consequences of the Fannie Mae and Freddie Mac mortgage debacle spread through the world.

Dollar bills
Draining away: The US may struggle to plug its capital gap

The country depends on Asian, Russian and Middle Eastern investors to fund much of its $700bn (£350bn) current account deficit, leaving it far more vulnerable to a collapse of confidence than Japan in the early 1990s after the Nikkei bubble burst. Britain and other Anglo-Saxon deficit states could face a similar retreat by foreign investors.

"Japan was able to cut its interest rates to zero," said Alex Patelis, Merrill's head of international economics.

"It would be very difficult for the US to do this. Foreigners will not be willing to supply the capital. Nobody knows where the limit lies."

Brian Bethune, chief financial economist at Global Insight, said the US Treasury had two or three days to put real money behind its rescue plan for Fannie and Freddie or face a dangerous crisis that could spiral out of control.

"This is not the time for policy-makers to underestimate, once again, the systemic risks to the financial system and the huge damage this would impose on the economy. Bold, aggressive action is needed, and needed now," he said.

Mr Bethune said the Treasury would have to inject up $20bn in fresh capital. This in turn might draw in a further $20bn in private money. Funds on this scale would be enough to see the two agencies through any scenario short of a meltdown in the US prime property market.

He said concerns about "moral hazard" - stoked by hard-line free-marketeers at the White House and vocal parts of the US media - were holding up a solution. "We can't dither. The markets can be brutal. We have to break the chain of contagion before confidence is destroyed."

Fannie and Freddie - the world's two biggest financial institutions - make up almost half the $12 trillion US mortgage industry. But that understates their vital importance at this juncture. They are now serving as lender of last resort to the housing market, providing 80pc of all new home loans.

Roughly $1.5 trillion of Fannie and Freddie AAA-rated debt - as well as other US "government-sponsored enterprises" - is now in foreign hands. The great unknown is whether foreign patience will snap as losses mount and the dollar slides.

Hiroshi Watanabe, Japan's chief regulator, rattled the markets yesterday when he urged Japanese banks and life insurance companies to treat US agency debt with caution. The two sets of institutions hold an estimated $56bn of these bonds. Mitsubishi UFJ holds $3bn. Nippon Life has $2.5bn.

But the lion's share is held by the central banks of China, Russia and petro-powers. These countries could all too easily precipitate a run on the dollar in the current climate and bring the United States to its knees, should they decide that it is in their strategic interest to do so.

Mr Patelis said it was unlikely that any would want to trigger a fire-sale by dumping their holdings on the market. Instead, they will probably accumulate US and Anglo-Saxon debt at a slower rate. That alone will be enough to leave deficit countries struggling to plug the capital gap. "I don't see how the current situation can continue beyond six months," he said.

Merrill Lynch said foreign governments had added $241bn of US agency debt over the past year alone as their foreign reserves exploded, accounting for a third of total financing for the US current account deficit. (They now own $985bn in all.) By most estimates, China holds around $400bn, Russia $150bn and Saudi Arabia and other Gulf states at least $200bn.

Global inflation is now intruding with a vengeance as well. Much of Asia is having to raise rates aggressively, drawing capital away from North America. This may push up yields on US Treasuries and bonds, tightening the credit screw at a time when the US is already mired in slump.

Russia's deputy finance minister, Dmitry Pankin, said the collapse in the share prices of Fannie and Freddie over the past week was irrelevant because their debt has been effectively guaranteed by the US government under the rescue package.

"We don't see a reason to change anything because the rating of the debt of those agencies hasn't changed," he said.

Foreign policy experts doubt that the picture is so simple. Russia is likely to use its $530bn reserves as an implicit bargaining chip in high-stakes diplomacy, perhaps to discourage the US from extending Nato membership to the Ukraine and Georgia.

Vladimir Putin, now Russia's premier, has stated repeatedly that his country is engaged in a new Cold War with the United States. It is clear that Moscow would relish any chance to humiliate the United States, provided the costs of doing so were not too high for Russia itself.

China is regarded as a more reliable partner, with a greater desire for global stability. Treasury Secretary Hank Paulson has intimate relations with the Chinese elite, dating from his days at Goldman Sachs when he visited the country over 70 times.

Brad Setser, from the US Council on Foreign Relations, said the Chinese have a stake in upholding Fannie and Freddie, not least to ensure that their loans are "honoured on time and in full".

David Bloom, currency chief at HSBC, said fears that regional banks could start toppling after the Fed takeover of IndyMac last week were now the biggest threat to the dollar.

"We have a pure dollar sell-off," he said. "It's a hating competition: at the moment the markets hate the dollar more than they hate the euro, even though German's ZEW confidence indicator was absolutely atrocious."

Re:The $5 trillion mess 9 years, 8 months ago #1413

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Fannie, Freddie spent $200M to buy influence

Yahoo News, Wed Jul 16.

If you want to know how Fannie Mae and Freddie Mac have survived scandal and crisis, consider this: Over the past decade, they have spent nearly $200 million on lobbying and campaign contributions.

If you want to know how Fannie Mae and Freddie Mac have survived scandal and crisis, consider this: Over the past decade, they have spent nearly $200 million on lobbying and campaign contributions.

But the political tentacles of the mortgage giants extend far beyond their checkbooks.

The two government-chartered companies run a highly sophisticated lobbying operation, with deep-pocketed lobbyists in Washington and scores of local Fannie- and Freddie-sponsored homeowner groups ready to pressure lawmakers back home.

They’ve stacked their payrolls with top Washington power brokers of all political stripes, including Republican John McCain’s presidential campaign manager, Rick Davis; Democrat Barack Obama’s original vice presidential vetter, Jim Johnson; and scores of others now working for the two rivals for the White House.

Fannie and Freddie’s aggressive political maneuvering has helped stave off increased regulation and preserve special benefits such as exemption from state and local income taxes and the ability to borrow at low rates.

When their stock prices took a dive last week, their government allies extended another helping hand with a plan for the Treasury Department, the Federal Reserve and, possibly, Congress to shore up the companies.

The housing crisis is sure to linger into the next administration, when the mortgage companies will inevitably be well-represented — no matter who’s in the White House.

Fannie and Freddie’s political contacts exist deep in the two presidential campaigns.

At least 20 McCain fundraisers have lobbied on behalf of Fannie Mae and Freddie Mac, netting at least $12.3 million in fees over the past nine years.

Political insiders Arthur B. Culvahouse Jr., picked by McCain to vet his vice presidential nominees, and Jim Johnson, picked by Obama to perform the same function, once worked for the mortgage giants.

And for years, Rick Davis served as president of an advocacy group led by Fannie Mae and Freddie Mac that defended the two companies against increased regulation.

So far this election cycle, Freddie Mac’s political action committee and employees have contributed $555,567 to Senate and House candidates, and Fannie Mae’s PAC and employees have given more than $1.1 million, according to the Center for Responsive Politics.

In total, the two companies have spent $170 million on lobbying over the past decade, according to the Center, although they have scaled back in recent years. Last year, they paid $14.1 million in lobbying fees, a significant decrease from a high of more than $26 million in 2004. The connections of both campaigns to the well-entrenched mortgage companies highlight the difficulties the candidates face in selling voters on an outsider message.

McCain’s campaign denied that its political connections have affected his view on the issue.

“I have written every word that has to do with Fannie and Freddie in this campaign, and I don’t know who the people are that are linked to the companies,” said McCain’s economic adviser, Douglas Holtz-Eakin.

“Sen. McCain has favored GSE reform in the past and continues to favor GSE reform,” Holtz-Eakin said. “That’s unchanged.”

McCain has called the government’s weekend intervention in the struggling companies “correct,” saying he hoped that the action would “preserve the ability of Americans to obtain loans in order to buy a home and be able to afford mortgage payments they’re having to make.”

A spokesman for the Obama campaign declined to comment, noting only that former Fannie Mae CEO Jim Johnson stepped down from his campaign post in June. His resignation came in the wake of charges that he collected more then $7 million in home loans at special, below-average rates.

On Sunday, Obama shied away from commenting on the specific proposals, but cautioned regulators to give top priority to the interests of homeowners.

“That should be our No. 1 priority, not just shareholders, investors or CEOs of companies,” he said.

Fannie and Freddie own or guarantee almost half of the country’s $12 trillion in mortgage debt. Over the past few months, their shares of the housing market have grown as private companies curtailed their mortgage lending in the wake of massive subprime-related losses.

Critics have long argued that both Fannie and Freddie operated with too small a capital cushion to adequately offset financial risk. But the mortgage giants have consistently beaten back congressional efforts to increase oversight, even after a major accounting scandal in 2003 resulted in a $400 million fine for Fannie.

Fannie’s government relations operations dramatically expanded in the mid-1990s, when then-CEO Johnson recruited Washington A-listers Robert Zoellick, who served in the Reagan and Bush administrations; Lawrence M. Small, former secretary of the Smithsonian Institution; and William M. Daley, commerce secretary in the Clinton administration.

Johnson spearheaded an aggressive campaign to create a local grass-roots network of company advocates. Under his leadership, Fannie opened more than 50 partnership offices in cities and rural communities. At the same time, the Fannie Mae Foundation, a private nonprofit financed by the mortgage giant, contributed generously to local charities, arts institutions and housing organizations, giving Fannie influence in lawmakers’ home districts.

Both Fannie and Freddie made large and visible commitments to low and moderate-income housing, quieting criticism from advocacy groups. With the companies in trouble, their political ties are under new scrutiny.

Johnson headed Fannie Mae from 1991 to 1998, leaving with a $21 million payout. Even after he left, Fannie continued to pay him an annual fee of at least $300,000 a year for consulting services and a $71,000 monthly pension, according to filings with the Securities and Exchange Commission.

From 2001 to 2005, Fannie also paid for Johnson’s support staff, communications services and provided him a car and driver.

McCain tapped Culvahouse, the former Reagan administration official, to head his search for a running mate.

Currently a partner at O’Melveny & Myers, Culvahouse lobbied on behalf of Fannie Mae in 1999, 2003 and 2004, according to Senate records.

The campaign connections to the two mortgage companies go far beyond vice presidential vetters.

McCain campaign manager Davis headed the Homeownership Alliance, a lobbying association that included Fannie, Freddie, nonprofit groups, real estate agents, homebuilders and consumer advocates. The group’s stated goal was to increase affordable housing. But it also worked to oppose congressional efforts to tighten controls on Fannie and Freddie.

In July 2003, Davis wrote to the American Banker, taking issue with an opinion piece by Leslie Paige of Citizens Against Government Waste, arguing that Fannie and Freddie should operate with greater transparency.

“Several of Ms. Paige’s assertions bear correction,” Davis wrote, defending Fannie and Freddie on behalf of the group. “The GSEs are subject to an innovative and stringent risk-based capital stress test — the toughest in the financial services industry.”

Other McCain aides with ties to the two companies include economic adviser Aquiles Suarez, who worked as Fannie’s director of government and industry relations; congressional liaison John Green, who lobbied for Fannie from 2004 to 2007; and finance co-chairman Frederic V. Malek, a former Freddie board member.

Jamie S. Gorelick, deputy attorney general in the Clinton administration and a chief policy adviser to Hillary Rodham Clinton, is rumored to be a possible attorney general in an Obama administration. She was vice chairman of Fannie Mae and sat on its board of directors.

Re:The $5 trillion mess 9 years, 8 months ago #1414

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Fannie Mae and Freddie Mac - End of illusions

Economist, Jul 17th 2008

THERE is a story about a science professor giving a public lecture on the solar system. An elderly lady interrupts to claim that, contrary to his assertions about gravity, the world travels through the universe on the back of a giant turtle. “But what supports the turtle?” retorts the professor. “You can’t trick me,” says the woman. “It’s turtles all the way down.”

The American financial system has started to look as logical as “turtles all the way down” this week. Only six months ago, politicians were counting on Fannie Mae and Freddie Mac, the country’s mortgage giants, to bolster the housing market by buying more mortgages. Now the rescuers themselves have needed rescuing.

After a headlong plunge in the two firms’ share prices (see chart 1), Hank Paulson, the treasury secretary, felt obliged to make an emergency announcement on July 13th. He will seek Congress’s approval for extending the Treasury’s credit lines to the pair and even buying their shares if necessary. Separately, the Federal Reserve said Fannie and Freddie could get financing at its discount window, a privilege previously available only to banks.

The absurdity of this situation was highlighted by the way the discount window works. The Fed does not just accept any old assets as collateral; it wants assets that are “safe”. As well as Treasury bonds, it is willing to accept paper issued by “government-sponsored enterprises” (GSEs). But the two most prominent GSEs are Fannie Mae and Freddie Mac. In theory, therefore, the two companies could issue their own debt and exchange it for loans from the government—the equivalent of having access to the printing press.

Absurd or not, the rescue package notched up one immediate success. Freddie Mac was able to raise $3 billion in short-term finance on July 14th. But the deal did little to help the share price of either company or indeed of banks, where sentiment was dented by the collapse of IndyMac, a mortgage lender (see article). The next day Moody’s, a rating agency, downgraded both the financial strength and the preferred stock of Fannie and Freddie, making a capital-raising exercise look even more difficult. As a sign of its concern, the Securities and Exchange Commission, America’s leading financial regulator, weighed in with rules restricting the short-selling of shares in Fannie and Freddie.

The whole affair has raised questions about the giant twins. They were set up (see article) to provide liquidity for the housing market by buying mortgages from the banks. They repackaged these loans and used them as collateral for bonds called mortgage-backed securities; they guaranteed buyers of those securities against default.

This model was based on the ability of investors to see through one illusion and boosted by their willingness to believe in another. The illusion that investors saw through was the official line that debt issued by Fannie and Freddie was not backed by the government. No one believed this. Investors felt that the government would not let Fannie and Freddie fail; they have just been proved right.

The belief in the implicit government guarantee allowed the pair to borrow cheaply. This made their model work. They could earn more on the mortgages they bought than they paid to raise money in the markets. Had Fannie and Freddie been hedge funds, this strategy would have been known as a “carry trade”.

It also allowed Fannie and Freddie to operate with tiny amounts of capital. The two groups had core capital (as defined by their regulator) of $83.2 billion at the end of 2007 (see chart 2); this supported around $5.2 trillion of debt and guarantees, a gearing ratio of 65 to one. According to CreditSights, a research group, Fannie and Freddie were counterparties in $2.3 trillion-worth of derivative transactions, related to their hedging activities.

There is no way a private bank would be allowed to have such a highly geared balance sheet, nor would it qualify for the highest AAA credit rating. In a speech to Congress in 2004, Alan Greenspan, then the chairman of the Fed, said: “Without the expectation of government support in a crisis, such leverage would not be possible without a significantly higher cost of debt.” The likelihood of “extraordinary support” from the government is cited by Standard & Poor’s (S&P), a rating agency, in explaining its rating of the firms’ debt.

The illusion investors fell for was the idea that American house prices would not fall across the country. This bolstered the twins’ creditworthiness. Although the two organisations have suffered from regional busts in the past, house prices have not fallen nationally on an annual basis since Fannie was founded in 1938.

Investors have got quite a bit of protection against a housing bust because of the type of deals that Fannie and Freddie guaranteed. The duo focused on mortgages to borrowers with good credit scores and the wherewithal to put down a deposit. This was not subprime lending. Howard Shapiro, an analyst at Fox-Pitt, an investment bank, says the pair’s average loan-to-value ratio at the end of 2007 was 68%; in other words, they could survive a 30% fall in house prices. So far, declared losses on their core portfolios have indeed been small by the standards of many others; in 2008, they are likely to be between 0.1% and 0.2% of assets, according to S&P.

Of course, this strategy only raises another question. Why does America need government-sponsored bodies to back the type of mortgages that were most likely to be repaid? It looks as if their core business is a solution to a non-existent problem.

However, Fannie and Freddie did not stick to their knitting. In the late 1990s they moved heavily into another area: buying mortgage-backed securities issued by others (see chart 3). Again, this was a version of the carry trade: they used their cheap financing to buy higher-yielding assets. In 1998 Freddie owned $25 billion of other securities, according to a report by its regulator, the Office of Federal Housing Enterprise Oversight (OFHEO); by the end of 2007 it had $267 billion. Fannie’s outside portfolio grew from $18.5 billion in 1997 to $127.8 billion at the end of 2007. Although they tended to buy AAA-rated paper, that designation is not as reliable as it used to be, as the credit crunch has shown.

Sometimes the mortgage companies were buying each other’s debt: turtles propping each other up. Although this boosted short-term profits, it did not seem to be part of the duo’s original mission. As Mr Greenspan remarked, these purchases “do not appear needed to supply mortgage market liquidity or to enhance capital markets in the United States”.

Joshua Rosner, an analyst at Graham Fisher, a research firm, who was one of the first to identify the problems in the mortgage market in early 2007, reckons Fannie and Freddie were buying 50% of all “private-label” mortgage-backed securities in some years—that is, those issued by conventional mortgage lenders. This left them exposed to the very subprime assets they were meant to avoid. Although that exposure was small compared with their portfolios, it could have a big impact because they have so little equity as a cushion.

Both companies make a distinction between losses on trading assets (which they take as a hit against profits) and on “available-for-sale” securities which they hold for the longer term and disregard, if they think the losses are temporary. At the end of 2007, according to OFHEO, Fannie had pre-tax losses of this type of $4.8 billion; Freddie’s amounted to $15 billion.

The companies have also been unwilling to accept the pain of market prices in acknowledging delinquent loans. When borrowers fail to keep up payments on mortgages in the pool that supports asset-backed loans, Fannie and Freddie must buy back the loan. But that requires an immediate write-off at a time when the market prices of asset-backed loans are depressed. Instead, the twins sometimes pay the interest into the pool to keep the loans afloat. In Mr Rosner’s view, this merely pushes the losses into the future.

Adding to the complexity is the need for both Fannie and Freddie to insure their portfolios against interest-rate risk—in particular, the danger that borrowers may pay back their loans early, if interest rates fall, leaving the companies with money to reinvest at a lower rate. This risk caused the duo to take huge positions in the derivatives market, and was at the centre of an accounting scandal earlier this decade.

In addition, Fannie and Freddie have bought insurance against borrower defaults when the homebuyer lacks a 20% deposit. But the finances of the mortgage insurers do not look that healthy, which may mean the risk ends up back with the siblings. Just as the rescuers need rescuing, so the insurers may need insuring.

None of these practices seemed to dent the confidence of OFHEO in its charges. The regulator said as recently as July 10th that both Fannie and Freddie had enough capital. Indeed, their capital-adequacy requirement was reduced earlier this year so that they could make more of an effort to bolster the housing market.
Capital offence

By its own measure, OFHEO was right. At the end of the first quarter, the two companies exceeded their minimum capital requirements by $11 billion apiece, according to CreditSights. To fall to the “critical level”, which would require OFHEO to take the agencies into “conservatorship” (a fancy word for nationalisation), CreditSights says Fannie would have to lose $16 billion of capital and Freddie $14 billion. And because neither Fannie nor Freddie has depositors, there is no danger of their suffering a run, as Northern Rock, a British bank, did last year.

So why the crisis? Given the gearing in the businesses, things only need to go slightly wrong for there to be a big problem. Freddie lost $3.5 billion in 2007; Fannie reported a $2.2 billion loss in the first quarter, having lost $2.05 billion last year. Each had credit-related write-downs of between $5 billion and $6 billion last year. On a fair-value basis, which assumes that all assets and liabilities are realised immediately, Freddie had negative net worth of $5.2 billion at the end of the first quarter.
Illustration by Bob Venables

Clearly, if the pair continue to lose money for much longer, their capital base will be eroded. And, of course, Congress wanted their businesses to expand—meaning that more, not less, capital would be needed. That would require shareholders to stump up more money. But investors tend to anticipate a big equity-raising by selling the shares, and a falling share price makes an equity issue less likely. The fall was sufficiently speedy in mid-July to prompt Mr Paulson to step in. The stockmarket had called the government’s bluff.

The rescue package may have reassured the creditors but it did not stop the share price of either Fannie or Freddie from falling. After all, the government is likely to extract a heavy penalty from shareholders in return for its support (creditors are another matter, especially as a lot of GSE paper is held by foreign central banks).

Nevertheless the hope is that, if confidence can be restored, Fannie and Freddie can survive without raising capital until market conditions improve. In the short term, as the success of the debt issue on July 14th showed, they should be able to go about their business.

The authorities are keen to avoid nationalisation, which would bring the whole of Fannie’s and Freddie’s debt onto the federal government’s balance sheet. In terms of book-keeping this would almost double the public debt, but that is rather misleading. It would hardly be like issuing $5.2 trillion of new Treasury bonds, because Fannie’s and Freddie’s debt is backed by real assets. Nevertheless, the fear that the taxpayer may have to absorb the GSEs’ debt pushed Treasury bond yields higher. That suggests yet another irony; the debt of the GSEs has been trading as if it were guaranteed by the American government, but the debt of the government was not trading as if Uncle Sam had guaranteed that of the GSEs.

If Congress approves this package, the Fed will have more authority over the agencies. But that will give the central bank another headache. If an institution is struggling, the normal answer is to shrink its activities and wind it down slowly. But that is the last thing that the housing market needs right now.

With the credit crunch, Fannie and Freddie have become more important than ever, financing some 80% of mortgages in January. So they will need to keep lending. Nor is there scope to offload their portfolios of mortgage-backed securities, given that there are scarcely any buyers of such debt. And if the Fed has to worry about safeguarding Fannie and Freddie, can it afford to raise interest rates to combat inflation? American monetary policy may be constrained.

The GSEs are not the only liability for the government. IndyMac’s recent collapse is the latest call on the Federal Deposit Insurance Corporation (FDIC). The FDIC has some $53 billion of assets, so it is better funded than most deposit-insurance schemes. But if enough banks got into trouble, the government would be on the hook for any shortfall. The same is true of the Pension Benefit Guaranty Corporation, which insures private sector benefits, but is already $14 billion in deficit.

In the end, the turtle at the bottom of the pile is the American taxpayer. But that suggests that, if Americans are losing money on their houses, pensions or bank accounts, the right answer is to tax them to pay for it.

Perhaps it is no surprise that traders in the credit-default swaps market have recently made bets on the unthinkable: that America may default on its debt.

Re:The $5 trillion mess 9 years, 8 months ago #1416

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Freddie Mac 2Q loss Worse Than Expected

Wednesday August 6

Freddie Mac swings to $1.05 billion loss in 2nd-quarter, falls below estimates

NEW YORK (AP) -- Freddie Mac said Wednesday it swung to a second-quarter loss that was more than three-times larger than Wall Street expected as more homeowners fell behind on their mortgage loans.

Including preferred dividends, the company said it lost $821 million, or $1.63 a share, for the quarter that ended June 30, compared with a profit of $729 million, or 96 cents a share, in the year-ago period.

Otherwise, the quarterly loss for common-stock shareholders was $1.05 billion, down from a $632 million profit last year.

Revenue fell to $1.69 billion from $2.34 billion.

Stock analysts surveyed by Thomson Financial expected a loss of 53 cents a share on $2.18 billion in revenue.

During the quarter, the company set aside $2.5 billion for credit losses as delinquency rate and foreclosures increased -- more than double what it had reserved in the first quarter.

Freddie's cash cushion against losses also shrunk, falling to $37.1 billion, or $2.7 billion more than the 20 percent surplus required by its federal regulator.
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