Comment 51: Tracing the liquidity squeeze (4): More about the super-SIV, the volatilities of stock markets and the ramifications of the US Government bailout of mortgage markets
It has been reported on Nov. 11, 2007 that the super-SIV as discussed in Comment 50 is taking shape. The super-SIV will buy from SIVs their collateralized debt obligations (abbreviated as CDO) that are mainly consisted of mortgage backed securities. The purpose of such purchases is to prevent the fire-sale of those CDO by SIVs, since the fire-sales will establish market prices for CDO involved; other financial institutions will be forced to write down similar CDO in their possession to the market prices and force them to realize hefty losses. The super-SIV will not buy securities backed by subprime mortgages in order to prevent the super-SIV be regarded as just another giant SIV and be shunt from the commercial paper markets as well. However, this tactic will leave the risky parts of CDO in the hands of SIVs. We should expect that those risky CDO will eventually become almost worthless. This will drive many SIVs eventually into bankruptcy, causing wide spread losses to investors holding commercial papers issued by those SIVs; many such endangered investors are money market funds. The fear of financial institutions to see the establishment of market prices of troubled CDO is vividly displayed in this series of complicated maneuvers involving the super-SIV. It is also not surprising that the stock markets have turned sour suddenly when the news of the liquidation of a small SIV spreads, since such a liquidation will establish market prices for CDO possessed by that small SIV.
As the gloom in financial markets grows, there also grows the expectation that FED will be forced to lower interest rate again. The expectation of lower interest rate in the US is causing the yen-dollar exchange rate to plummet. Recently the yen-dollar exchange rate has dipped momentarily below the crucial line of 110 yen/dollar, and as expected Japanese Government has started the usual verbal intervention to push the exchange rate up above the 110 yen/dollar line. For a while the skirmish around this 110 yen/dollar line will continue, but eventually this line of support will be broken, and then Japanese Government must decide either to intervene physically by buying a large sum of dollars again or let the yen-dollar exchange rate to fall freely into an unforeseen consequence. The drop of the yen-dollar exchange rate has induced some unwinding of yen carry trades that in turn has caused the yen-dollar exchange rate to fall further. The unwinding of a special kind of yen carry trades based on the purchasing of stocks with borrowed yens has caused the global stock markets to experience a sudden down draft. On the other hand the bounce of the yen-dollar exchange rate following Japanese Government's verbal intervention has ignited a strong stock market rally. In recent times the yen-dollar exchange rate and the euro-dollar exchange rate often go on opposite directions; when yen strengthens vs. dollar, euro usually falls vs. dollar, and when euro strengthens, yen either stagnates or weakens vs. dollar. As mentioned in Comment 50, euro moves in synchronization with the price of crude oil due to the oil dollars converted into euro, whereas the move of yen is dominated by US interest rate expectations and the currency market interventions by Japanese Government. When yen strengthens and triggers the unwinding of yen carry trades, the trades based on the buying of oil with borrowed yen also unwind and as the consequence both the prices of oil and euro will come down as well. The general trend of the yen-dollar exchange rate is to move lower toward stronger yen, so the unwind of yen carry trades will overwhelm the new installations of such trades. However, a lot of cash in the hands of hedge funds is parked in US Treasuries from the fear of financial market turmoil. Such idled money of hedge funds are more likely to be thrown into the stock markets chasing speculative gains; hedge funds are known to move quickly, and such money will be withdrawn from stocks rapidly at any sign of negative news like the unwinding of yen carry trades and will turn a plummeting market into a rout. Those two broad trends, the yen carry trades and the hedge fund's money, are colliding and are creating wide gyrations in the stock markets. We expect that such violent gyrations to continue until a firm trend of economic development is established.
In spite of brave talks flooding financial media, economic and monetary policy makers are apparently less sanguine about the situation of the financial markets. As the result the talk of a government bail out of the troubled mortgage markets persists. In Comment 50 we have already discussed the vague reports about Treasury Secretary Paulson's effort to persuade the White House to come into bailing out troubled subprime mortgages. In the hearing of the Joint Economic Committee of the US Congress on Nov. 8, 2007, FED Chairman Bernanke has floated a plan of using Fannie Mae and Freddie Mac to bail out the jumbo mortgage market that is also shunned by the commercial paper markets; key members of the US Congress have immediately expressed strong interest in this plan. We need to study the implications of a comprehensive bail out of mortgage markets by the US Government, and the analysis of Bernanke's plan is a good place to start.
Fannie Mae (the popular name for Federal National Mortgage Association) and Freddie Mac (the popular name for Federal Home Loan Mortgage Corporation) are established by the US Government in order to draw in more funds into the mortgage markets to increase the home ownership among lower income groups. Those two entities are not funded nor backed by the US Government, and the debt instruments issued by them are not guaranteed by the US Treasury. Fannie Mae and Freddie Mac raise capital by selling stocks in the open markets and operate like ordinary private financial institutions. Those two entities buy mortgages from mortgage initiators, like commercial banks and mortgage banks, and package those purchased mortgages into securities to be sold to investors; such practice is apparently the forerunners of CDO that is at the center of the current financial crisis. Fannie Mae and Freddie Mac guarantee against the risks of default by mortgage borrowers when they sell the mortgage backed securities to investors, and charge fees for such guarantees. This fee become the major income of those two entities, but they also keep a portion of mortgage backed securities issued in their own portfolio as investments. Investors always think that the US Government will never abandon their own creation at the time of needs and demand a lower interest return from the debt instruments issued by Fannie Mae and Freddie Mac than from the similar instruments issued by their truly private rivals, in spite of repeated reminders from the US Government that the securities issued by those two entities are not backed by the US Treasury. This kind of investor psychology allows Fannie Mae and Freddie Mac to sell securities issued by them at a lower interest rate easily, and they in turn use the sale-proceeds to buy more mortgages. There is also a strong incentive for Fannie Mae and Freddie Mac to buy more and more mortgages and issue more and more mortgage backed securities to collect more and more fees; more fees means higher income, higher stock prices and larger bonuses for the managers of those two entities. Through this magical setup, a large amount of money has been funneled into the mortgage market and has boosted both the home ownership and the housing price in the US. The maximum size of mortgages that Fannie Mae and Freddie Mac are allowed to buy is set by the US Government, and the limit is currently at $417,000. The mortgages with the size above this limit are called “jumbo” mortgages. Securities backed by jumbo mortgages can only be issued and guaranteed by purely private entities, and as the result investors demand a higher return from such jumbo mortgage backed securities to hedge against the higher perceived risk of default compared to the securities issued by Fannie Mae and Freddie Mac. The demand of higher return then translates into higher interest rates for jumbo mortgages than the mortgages that Fannie Mae and Freddie Mac are allowed to buy. In the current financial crisis, securities backed by jumbo mortgages are also avoided by many investors, the initiators of jumbo mortgages are shunt from the commercial paper markets, and the funding for jumbo mortgages is drying up as well, though the default rate of jumbo mortgages supposedly has not risen noticeably.
As Fannie Mae and Freddie Mac issue mortgage backed securities with guarantees, they must apply their own capitals to cover the risk of default by the mortgage borrowers. In the time when financial derivatives have proliferated, Fannie Mae and Freddie Mac have also started to use derivatives to hedge against the risks of default by mortgage borrowers. With the presumed risks of default reduced in theory by manipulation of derivatives, Fannie Mae and Freddie Mac have been able to issue much more mortgage backed securities than the case of a straightforward application of their own capitals to cover risks without the risk management involving derivatives. Currently Fannie Mae and Freddie Mac have a combined capital of about 70 billion dollars on the books, and the total amount of mortgage backed securities issued by them is near 1.5 trillion dollars. We must say that Fannie Mae and Freddie Mac have contributed substantially to the inflation of the mortgage and the housing bubble that is now deflating painfully. Probably irritated by the role of Fannie Mae and Freddie Mac in the inflation of the mortgage bubble and from the suspicion about the adequacy of managing the default risks through derivatives, FED and the US Congress have been trying to restrain the activities of Fannie Mae and Freddie Mac. After the accounting scandles, currently total amount of mortgage backed securities that Fannie Mae and Freddie Mac are allowed to hold in their own portfolios is capped at 1.5 trillion dollars. In 2003 the total amount of outstanding mortgage backed securities issued by Fannie Mae and Freddie Mac was about 2.1 trillion dollars, 27% of all the outstanding home motgages in the US. By the second quarter of 2007, the total amount of outstanding securities issued by those two entities have balooned to 4.5 trillion dollars, representing about 45% of the total outstanding home mortgages in the US. This picture shows how those two entities have contributed to the mortgage bubble.
Bernanke's plan is to allow Fannie Mae and Freddie Mac to buy jumbo mortgages with a cap of 1 million dollars for each mortgage, and package them into securities to be sold to investors, but this time the US Government itself will guarantee against the defaults by the mortgage borrowers instead of the guarantees by Fannie Mae and Freddie Mac. Apparently Bernanke thinks that the guarantees by Fannie Mae and Freddie Mac will not be enough to entice investors to buy such jumbo mortgage backed securities in the current environment; also under this plan Fannie Mae and Freddie Mac are only acting as conduits. This plan, if enacted, will have profound and prolonged impacts not only on the mortgage market, but on the whole financial system. We better analyze its ramifications thoroughly and carefully.
Let us start from the minor ramifications of Bernanke's plan first. Securities backed by jumbo mortgages and guaranteed by the US government will have a credit rating equivalent to US Treasuries, though they still retain the unique characters of mortgage backed securities of varying durations depending on the refinancing activities of the mortgage borrowers. The yield of such US Government guaranteed securities backed by 30 year fixed rate mortgages should be almost equal to that of 10 year US Treasury Notes, currently about 4.3%. The US Government will charge a fee for issuing the guarantees. This fee that reflects the default risks, and the handling fees of intermediaries like Fannie Mae, Freddie Mac and mortgage initiators should add up to contribute 1% to the final interest rate, that is, 5.3% that a jumbo mortgage borrower will pay. This 5.3% rate is much lower than the rates current borrowers of jumbo mortgages are paying, and thus a wave of refinancing will occur as existing mortgage borrowers rush to lock in the windfall. On the other hand the existing holders of the securities backed by the existing jumbo mortgages will suffer substantial losses as the maturities of such securities are cut short suddenly by this wave of refinancing. Some may argue that the US Government can set the fee it charges artificially high to discourage such an unintended side effect. However, the fee should only reflect the default risks and nothing else, since once deviate from this principle the fee will be manipulated by many political forces for various reasons and the credibility of the whole system will be undermined.
The more serious impact of this plan is the distortion of the mortgage market. Just imagine what is going to happen to the securities backed by the mortgages with the size under $417,000 and are not backed by the US Government. Investors simply will shy away from such securities totally, causing the mortgage market for inexpensive homes to vanish. This will drive down the prices of inexpensive homes further and intensify the mortgage woes substantially. If Benanke's plan is enacted, it will surely cover all the mortgages below 1 million dollar in size. Thus the refinancing boom will extend to lower income groups and the problem of escalating foreclosures will be put to rest. However, the holders of securities backed by those mortgages will also be forced to realize whatever losses immediately just as their friends holding securities backed by jumbo mortgages.
For the US Government to guarantee all mortgages with size below one million dollars is in essence equivalent to the nationalization of the mortgage market. The US Government will be deciding the size of the mortgage market and thus the prices of houses by regulating how much mortgage backed securities it wants to issue. The political pressure will be on toward the direction to issue more and more of such government guaranteed securities backed by mortgages so that everyone's house will appreciate rapidly. Such a desire of the general public will push up the long term interest rates and crowd out other business financings. If FED monetize US Government's runaway mortgage issuance to save the hard pressed other businesses not related to housing, the hyper inflation era will then be ushered in. We think the plan of Bernanke is not the magic bullet to cure the ills of the financial market, but is like opening a Pandra's box. Apparently the plan is an important issue that financial media should be looking into, but unfortunately not yet at this moment.