by Scott Wright
May 20, 2005
In the wake of the Great Depression of the 1930s, the national housing market was experiencing quite a slump. The banks that survived the financial travail of the time were afraid to loan to consumers, and consumers were afraid to commit to any long-term financial obligations. America needed a boost, a hero to take the reins of the economy, a strong arm with a gentle hand that could take commanding charge while embracing and nurturing it back to health.
As part of Franklin Roosevelt's New Deal, the U.S. government was just that "hero" and took it upon itself to inject the free market with its self-perceived acumen and policy making skills in support of the national housing industry. In 1938 the Federal National Mortgage Association (Fannie Mae) was created with the purpose of supporting, stabilizing and decreasing risk for the banking industry in providing home mortgages to the public. In essence, a secondary mortgage market was created to inject liquidity into the economy.
Since federally controlled business units often have a difficult time functioning in a capitalistic society, and with the mortgage industry still waxing volatile in the late 1960s, the U.S. government decided to remove Fannie Mae from its primary budget and control. A legislative charter was enacted in 1968 to "fully" privatize Fannie Mae. As part of this charter, the Federal Home Loan Mortgage Corporation (Freddie Mac) was created in order to abate Fannie Mae's monopolization of the secondary mortgage market.
The Federal government fully knew the importance and potential danger the secondary mortgage market could have on the economy. With that in mind, it couldn't possibly let it out of its complete control, after all, the government had created it. Since their weaning, Fannie Mae and Freddie Mac have operated as government-sponsored enterprises (GSEs). They are still designated as private companies owned by their shareholders, but as a GSE the government provides them with various financial benefits and protections. Some of these include a conditional line of credit with the U.S. Treasury Department, exemption from paying state and local taxes as well as exemption from oversight of the Securities and Exchange Commission (SEC).
Even with these exemptions, Fannie and Freddie voluntarily registered their stock with the SEC and are now permanently required to disclose their financial statements. Despite this good-faith gesture, both Fannie Mae and Freddie Mac have come into the limelight of recent with serious accounting scandals. These scandals have forced them to restate earnings for previous years proving a negative effect in the billions of dollars and have seen several executives from each company get ousted as a result. Even though fraudulent accounting scandals have come out of the woodwork, the real issue that should concern every American that values his capital is the debt-laden time bomb that Fannie and Freddie are housing.
Similar to a salmon swimming upstream making itself available for an opportunistic grizzly bear, the Real Estate bubble is swimming upstream in a downstream economy and these GSEs are seizing the opportunity to fill their bellies with what seems like unlimited fish. The fish in question are the glut of mortgage debt that the GSEs are swallowing to fill the economy with bogus liquidity. Fannie and Freddie have their bibs fully suited and are piling up their trays at this all-you-can-eat buffet.
There are two core issues GSE activity is accountable for. First is the socioeconomic anomaly that has given consumers a false sense of wealth. We will cover this in more detail in the next section of this series. Second is the egregious exposure to risk in the financial markets that Fannie and Freddie have taken on in the midst of this Real Estate bubble and the impact it could have on the economy.
In order to truly understand the problems we may face with these GSEs, we need to understand the role they play in today's economy as well as the underlying catalysts that have led to this housing market circus we are witnessing today. The first notable observation is to recognize that we are in a Real Estate bubble, and probabilities are in favor of it deflating rapidly.
The rapid decline in interest rates is the fundamental force that started this game. A combination of these ultra-low rates, mixed with GSE exploitation of such, has led to today's speculative mania that has driven home values to bubble status. Common conjecture leads one to believe the Real Estate bubble was the catalyst that created the boom in the primary mortgage market, hence opening the floodgates for the secondary mortgage market. That is valid, logical and true, but a different twist may demand some attention. Perhaps the activity in the secondary mortgage market can be viewed as the catalyst for the Real Estate boom.
Enter the Federal Reserve, led by its fearless leader Alan Greenspan. In late 2000 the Fed was starting to notice that its hyper-inflationary policies and running of the presses were not working as planned. The tech bubble had burst and recessionary trends were imminent. In order to buoy the economy and further disrupt what's left of a free-market natural correction, it decided to try and head off this recession by creating a Real Estate bubble.
Holding hands with its precious GSEs, the Fed dropped rates to their lowest point in nearly 40 years, giving birth to today's housing boom turned bubble. This plan successfully and intentionally allowed the primary and secondary mortgage markets to come to life and relentlessly thrust massive amounts of capital into our increasingly fragile economy. These obscenely low mortgage rates, accompanied by venomous new lending vehicles, have seduced consumers into a refinancing and speculative frenzy. But similar I imagine to the fix a heroin addict gets when he pumps his veins full of a toxic substance, it is only a temporary high.
If the secondary mortgage market either did not exist or perhaps was not as careless with its government-sponsored economic liquidity injections, would banks have the bandwidth to loan at such rampant rates, to create such maniacal loan packages or have the knack to approve loans so quickly and effortlessly? The answer is absolutely not!
There would be more accountability on the issuing front and financial institutions would think twice about what they had in their books. If this were the case, home loans would have been harder to come by and housing prices may not have risen so hastily perhaps preventing this dangerous Real Estate bubble. In my opinion, today's Real Estate bubble could not have spawned to life without the help of the GSEs and their synthetic injection of liquidity into the housing market and the economy as a whole.
Today's Real Estate bubble has propelled Fannie Mae and Freddie Mac to become two of the largest financial institutions in the world. Their presence in today's financial markets is dominating as they play a monstrous role in the debt and derivatives markets. Today's housing and refinancing boom along with the GSEs' aggressive push to grow their portfolios has created a monster of epic proportions. To show you how this monster is being fed, we need to understand how funds flow in this market.
If anyone has obtained a new mortgage loan or refinanced an existing loan in recent years, which according to statistics most everyone has, you have likely seen your loan change hands multiple times amongst various financial institutions. Before the existence of the secondary mortgage market, when a financial institution issued a home loan, that loan was on its books as risk and liability and limited the availability it had to issue additional loans based on a ratio of its net financial assets to current liabilities.
Today, this primary issuer is able to sell this loan to the secondary mortgage market and relinquish its liability from its books. There are other minor players in the secondary mortgage market, but the major market makers, Fannie Mae and Freddie Mac, are the Oz's behind the curtain of most mortgage loan purchases from originating financial institutions.
As the GSEs purchase these mortgages from the primary market lenders it allows these primary lenders to continue to originate and pump out additional loans to the public. With record low interest rates among many factors spurring demand for mortgage origination and refinancing, the primary mortgage market has been able to feed this monster gargantuan portions.
Among Fannie Mae's Fed-driven corporate initiatives is to "...improve the liquidity of the mortgage market for consumers and investors." Mission accomplished! With the government's help, the GSEs have indeed increased the flow of funds in the economy by creating liquidity in order to enhance consumer spending temporarily heading off a recession, but at what cost?
Fannie and Freddie are able to fund the purchases of these primary market mortgages by issuing debt to the public via the bond markets. One of the extra-special benefits of being a GSE is they can borrow, with virtually no limits or volume restrictions, at cheaper rates compared to other top debt-rated companies. They have this capability because investors tag these bonds nearly as safe, if not as safe, as Treasury debt. With the spread between their ultra-low borrowing rate and the interest rates on the loans they house, they have a continual cash flow that provides them with further expansion opportunity for their portfolios. What a fantastically easy way to make money! Almost like growing it on a tree.
The investment vehicles Fannie and Freddie use to flood the bond markets are called Mortgage Backed Securities (MBS). An MBS is comprised of a pool of mortgages that serve as the underlying asset providing principal and interest payments passed through to investors. The GSEs sell claims to the principal and interest payments generated from this pool of mortgages in the open bond market, while fully guaranteeing the funds to the investor.
Currently, Fannie and Freddie are liable for over $3 trillion dollars of outstanding debt securities to the markets. Folks, our national debt is at $8 trillion. How is it possible that Fannie and Freddie can accumulate debt of their own that is nearly 40% of our nation's debt? Keep in mind an MBS carries a guarantee from the issuer to the investor on its payment, regardless of the cash flow generated from the underlying assets. $3 trillion dollars is a lot of money to have at risk with the assumption the underlying cash flow will always be there!
You may ask yourself how they can possibly issue so much debt and where the demand comes from. Many mutual funds, commercial banks, pension funds, local governments, foreign Central Banks, etc provide ample demand for GSE debt. In most cases these institutional investors use it in their fixed-income portfolios as a replacement for U.S. Treasury debt because they get a little higher yield and deem it just as safe.
It's the misconstrued implication that this debt has 100% U.S. government backing that makes it so easy for a GSE to issue to the public. This is a big problem, because even though the GSEs have a conditional and limited credit line with the U.S. Treasury, the debt they issue is private debt and is not fully backed by the U.S. government. Fannie, Freddie and the U.S. government tout this disclaimer, but it seems to be pushed too lightly onto near-deaf ears.
Let's paint a picture of what the Real Estate bubble has done to the bond markets and the presence Fannie and Freddie have in it. Total estimated bond market debt today, both public and private, amounts to $25 trillion. That includes Municipal, U.S. Treasury, Corporate, Fed Agencies, Money Market, Asset-Backed and of course Mortgage-Related bonds. Mortgage-related debt includes common MBS vehicles such as Pass-Throughs and CMOs (Collateralized Mortgage Obligations) as well as others. Out of these seven or so major bond market categories, mortgage-related debt is the largest by far accounting for over 20% of all bond market debt, and towering over corporate debt by 15% and U.S. Treasury debt by 30%. Fannie Mae and Freddie Mac house nearly 60% of this mortgage-related debt!
The Real Estate bubble has drastically changed the dynamics of the bond market. Up until 1999, only six short years ago, Treasury debt actually exceeded mortgage-related debt with several other categories nearly at par. Today, mortgage-related bonds have left them all in the dust. To take it even further, in 1990 mortgage-related bonds totaled only half as much as U.S. Treasury bonds. This bond market data in fact reveals that the Real Estate bubble is not a myth and has changed the dynamics of the world financial markets.
It's simply amazing that the GSEs have the ability to balloon their mortgage portfolios on false pretenses. Don't get me wrong, I'm all about capitalism and free markets, but foolish investors are led to believe that this debt monster is fully backed by the federal government, which it is not. Investors in these debt instruments just don't realize that the underlying mortgage loans filling this securitized debt tank have come about from a speculative mania that has spawned mythical home valuations.
Even though Fannie and Freddie have GSE status, you will find they have extremely ineffective regulation with virtually no size limits for their mortgage portfolios. You would figure with this GSE tag, having such large exposure to the financial markets and such incredible economic influence, there would be strict federal monitoring and regulation. It's not like some entrepreneur started the secondary mortgage market out of his garage and grew it to what it is today. The Federal government created the secondary mortgage market as we know it today and has allowed Fannie and Freddie to exist and prosper.
Lo and behold, there are indeed Federal government regulators for these GSEs. The U.S. Department of Housing and Urban Development (HUD) has the primary task at hand. HUD acts as the high-level watchdog of Fannie and Freddie, but in 1992 it was deemed necessary to more closely monitor the capital adequacy and financial safety of the two GSEs.
Therefore, the Office of Federal Housing Enterprise Oversight (OFHEO) was established within HUD to serve such a purpose. In light of the recent accounting scandals and increasing public concern with the size of GSE portfolios, it is becoming apparent that the federal watchdogs of these GSEs may not be sufficient in keeping this monster in line.
On April 6, 2005, Alan Greenspan himself lobbied Congress to place more controls and limits on the portfolio size of the GSEs. He stated, "World class regulation, by itself, may not be sufficient." Mr. Greenspan's interest rate policies have allowed the GSEs to get to this point, yet might he now see the folly of his ways? Though I have avowedly loathsome distaste for Greenspan's economic policy, in the core of his being there is a smart economist. If Greenspan is starting to see the writing on the wall, and publicly drawing attention to the power and danger of the GSEs, could it be worse than we realize?
In response to increasing amounts of public concern and criticism, Congress has championed some probing on this issue. Shortly after Greenspan took stage to voice his concern, Freddie Mac CEO Richard Syron testified before the Senate Banking, Housing and Urban Affairs Committee. As you would expect, Syron lobbied against restrictions that would limit the size of the retained mortgage portfolios that Freddie can have.
Mr. Syron in person and representation is bullish on the Real Estate market and, as one would imagine, would give no acknowledgment to the possibility of a Real Estate bubble and Freddie's exposure to financial crisis. Fannie and Freddie feel as though it is their duty to liquefy the housing market. Mr. Syron sat in front of Congress and insinuated that placing caps on Freddie's portfolio size would prevent it from fulfilling its mission to the housing market. I suppose you can't blame him for believing that, as the GSEs project that in the next 5 years the nation's homebuyers will need an additional $6 trillion to help finance their homes. Bah!
Fannie and Freddie have the obvious stance that there is no Real Estate bubble, that housing prices are sustainable and according to their projections above, will continue to rise. They see no imminent risk in their portfolios. That type of attitude puts them at the throne of the speculative bubble we discussed in our previous section. Even so, they claim to be protected from adverse economic events by throwing money into the derivatives markets.
In order to hedge against market risk, most notably interest rate risk, Fannie Mae and Freddie Mac have notional balances in their derivatives portfolios summing in the trillions of dollars. Mainstream media giants like The Wall Street Journal have gone so far as to publicly criticize and compare Fannie and Freddie's derivatives schemes to those of Enron. That is quite a bold accusation.
Of course Fannie and Freddie take exception to that and insist that risk in their derivatives books is low and does not amount to the notional principal amounts people toss about. I can compose a completely separate essay on Fannie and Freddie derivatives, but to keep with the theme, all we need to know is if they were to default on their derivatives obligations it would cause quite a stir.
So we've made a big stink about the Real Estate bubble and Fannie and Freddie being over exposed in the debt and derivatives markets, but so what? If mortgagors continue to make their payments it shouldn't be a problem right? Ahh, but the only things certain in life are death and taxes, not mortgage payments. That is a big "if" we are clinging to, and only a fool will take that to the bank. Bubbles don't float around in the air forever, eventually they pop. Let's not forget about the economics that go into a recession and the forces behind them.
The burst of the tech bubble in 2000 started a recession that never was permitted to run its course. The Real Estate bubble only delayed it and the resumption will be much worse because of it. Interest rates are already starting to rise, but what will happen if they become dangerously volatile? What will happen if housing prices endure a momentous slide? What will happen if unemployment rises? These are just a few external factors that can cause delinquencies and defaults on mortgage payments that we will explain in more depth in the next section. Truth is, if we are really in the bubble we've been hinting at, all these scenarios and more are inevitable. Everything that goes into the recipe of a bubble ultimately spills out with relentless adverse effects.
Let's hear what the OFHEO has to say about GSE economic risk. In 2002 the OFHEO published its strategic plan for the next five years. In this document it stated, "The pace of the economy, the stock market and housing market activity will continue to influence the health of the housing finance system. While housing buoyed the economy through the recent recession, a recession accompanied by higher interest rates would test the Enterprises' abilities to manage the interest rate risk associated with their large retained mortgage portfolios."
The OFHEO, Alan Greenspan, as well as students of the markets are able to recognize the risk and danger these GSEs pose to the financial markets. Not only does the OFHEO's statement give credit to the housing bubble for keeping our economy afloat, but it also recognizes the risk and exposure Fannie and Freddie may pose to the future health of the economy.
When the mortgagors of the underlying assets that the GSEs guarantee start to default on their loans, watch out! It won't take a large percentage of defaults to trigger a catastrophic situation. When defaults and forced prepayments become rampant, Fannie and Freddie and any other institution that guarantees mortgage-backed securitized debt will be scrambling. The derivative instruments they rely on will only protect them so much.
Steady cash flows from these underlying mortgage pools are essential for business, and if they become compromised the health of these securities will be in danger. The culmination of such would really hurt the financial markets if Fannie and Freddie started to default on their debt obligations. It would turn into an ugly domino effect the likes of which we have never seen before.
If Fannie and Freddie do default on their debt, it's not just going to be Jan and George who lose a few thousand dollars similar to when their tech stocks fell. We're talking large market institutional investors that will bleed from this, affecting Jan and George in a different way. Mutual Funds, Pension Funds and the likes will have to take massive write offs because their so-called safe investments turned sour on them.
Imagine the panic that would ensue if peoples' pension funds, annuities, 401(k)s and personal mutual funds posted huge losses or even worse went insolvent because their so-called stable assets went belly-up. If the long-term investments of Jan and George or perhaps even foreign central banks which aggressively invest in these bonds start taking major hits, a selloff could ensue that would be disastrous not only for our domestic financial markets, but global financial markets.
The magnitude of financial crisis of this sort would be felt globally. We're not talking millions, or even billions of dollars here either, we're talking trillions, a number that is virtually impossible to comprehend. Government bailout would not suffice either. The conditional line of credit the GSEs have with the Treasury caps at $2.25 billion which, when you're talking trillions, won't go very far. The U.S. government does not have the resources to pull off a bailout of this magnitude. The Long-Term Capital Management (LTCM) crisis and bailout in 1998 will look like a ripple in a fish pond compared to the tsunami-type waves a storm like this could bring.
Congressman Richard Barker, who is part of the House Capital Markets Subcommittee, so eloquently states, "The gorilla has outgrown the cage, and we don't know what to do with him."
Bottom line is this Fed-generated Real Estate boom has allowed Fannie and Freddie to accumulate portfolios that are exceedingly dangerous for the U.S. financial markets. A tightening economy will test the ability of the GSEs to guarantee all their debt. If this teetering risk is not handled appropriately, it could unleash a massive global financial crisis.
The Fed/GSE marriage has produced consumer spending in recent years that has artificially buoyed this economy. We believe probabilities are in favor of major economic instability resulting from this. Aside from the financial market risk this creates, we will likely find the near-term socioeconomic repercussions of this to be devastating. Join us next week as we jump into the details of such and attempt to discover how this Real Estate bubble has truly affected today's economy.
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