July 11, 2008

Freddie, Fannie in suicide pact

Let me just say, there comes a time where you'd like to stop the world. And get off it. This is one of those days.

On Bloomberg, they are currently interviewing two morons who, aside from today's manufactured crisis, would never be listened to. But today, because they think FNMA and FHLMC (the Agencies... those are the acronyms that represent Fannie and Freddie, respectively) are in trouble, they are the toast of financial television.

Here's the thing... it's all a bunch of bullshit. For one thing, the Agencies (or GSE's, if you prefer) are adequately capitalized according to their regulator, the Office of Federal Housing Enterprise Oversight. Their projected losses were already telescoped and people knew about it. Further, those losses would have to increase by ten fold for them to be insolvent per OFHEO.

The problem isn't that there ARE some non-performing assets. There have always been some non-performing assets because there will always be people who don't pay their mortgage. In point of fact, the OVERWHELMING majority of the credits (loans) that the Agencies have on their books are performing. However, that doesn't mean that they have value...and now we go down the rabbit hole of financial accounting.

There are a number of ways to value assets. The prevailing way is to 'mark to market' which means, for simplicity, that you take a security you hold and price it according to the bid for that asset in the market, for instance the secondary market for mortgages and related securities. Unfortunately, the market can be irrational at times and this is one of those times.

As I pointed out earlier, the PRICES paid for less than perfect credits were way too high. So the market corrected and stopped paying ANYTHING for them. Which meant, even though there securities were made up of paying loans, that according to accounting rules those securities are worthless. Those were the subprime and Alt A credits and now A credits, like the ones the Agencies have, are getting hit. The fear regarding the Agency's is that on a mark to market basis these companies are insolvent. It doesn't mean they have $5 trn in the hole, it means that they owe $5 trn but have assets worth less than $5 trn. Which means negative equity and insolvency.

However, using that metric that means that 10 out of 20 major investment banks are now insolvent. It also means that Citibank is insolvent. And what's really going on is that the market has swung from one direction to the other... from valuing all mortgages too highly to not valuing them at all. Do they still have value? Of course. However, according to accounting rules it's tight.

What's spooking the market today, in the equity of the two Agencies, is that shareholders may be diluted if the Agency's have to raise capital by issuing new equity. That devalues existing shareholders and so, you have a selloff of the stock. However, it doesn't mean the companies are going bankrupt.

There's also former FOMC member Bill Poole telling anyone who'll listen that the Agencies are insolvent. For a little background on Poole, you gotta know he's NEVER been a big fan of the Agencies. He thinks their government charter (which they DO have) gives them an unfair advantage over depository and investment banks. He's right. However, that 'advantage' has been passed on to MILLIONS of homeowners in the United States.

So, before you think this is all a huge bailout and taxpayers will be on the hook, keep in mind before mortgage securitization and the buildup of the Agencies, people had to put down 20% for a home. And pay a high interest rate.

Oh, but McBlogger... you've been bitching about lax underwriting guidelines and mortgages with nothing down. Wouldn't it be better to go back to the old days of 20% down?

Absolutely not. And my issue with lax underwriting and exotic, low down payment and low documentation mortgages is that the market never priced them adequately for the risk they represented, not to mention offering them to people who, frankly, didn't need them. I think it's ridiculous to price a no-doc loan made to a salaried borrower at a price comparable to the one you'd give a full income documentation loan. However, that doesn't mean the product itself was bad... the application and pricing of that product was bad. These loans were originally intended for borrowers with difficult to document income (usually self employed borrowers) and carried a high interest rate as well as 10% down payment in most cases. When these loans performed well, the market started to expand the eligible borrowers. And lessened the down payment requirements. And loosened the credit guidelines.

And then people stopped paying. And that made everyone question all mortgages. Which left only Fannie and Freddie, not to mention FHA, to keep the market somewhat stable.

THAT'S the problem no one is really pointing out right now... the private market that the supply-siders love so damn much froze up and stopped moving. The invisible hand just stopped all motion. It was the Agencies and FHA that have kept us afloat. And we need them to continue doing that.

If they don't, then the repercussions are serious. Well, they're serious if you think an economic depression is serious.

However, these companies will survive. So will the economy. And the smart money isn't sitting on the sidelines right now. It's quietly buying good assets at rock bottom prices.

Posted by mcblogger at July 11, 2008 02:54 PM

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OK, that makes a lot of sense. Thanks a bunch for the clarification. This morning, the talking heads were sounding like the sky was falling.

Posted by: WhosPlayin? [TypeKey Profile Page] at July 11, 2008 04:58 PM

That's what they do...

Posted by: mcblogger [TypeKey Profile Page] at July 11, 2008 11:24 PM

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