Comment 56. Tracing the Liquidity Squeeze (7): Fannie Mae and Freddie Mac, another financial storm in the making. (July 14, 2008)

Stock markets are accelerating their decline recently. Many are probably wondering why such a sudden swoon. Economic data are not rosy, but the data shows that the US economy is in a slow growth mode for quite a while now and there is no sign to indicate that it is caving in suddenly. The crude oil price is high and rising, but it has been high and rising for many months. Why should stock markets suddenly care about the crude oil price so much now. Actually the recent malaise of the markets come from the fear that two mortgage giants, Fannie Mae and Freddie Mac, are running into financial trouble due to the burst of the housing bubble and the steadily advancing liquidity squeeze. As has been pointed out in Comment 46 and discussed in more detail in article 10, the formation and the demise of the housing bubble is due to the expansion and the stagnation of US trade deficits. The fall of Dollar under the weight of the runaway US trade deficit has finally curtailed the expansion of the trade deficit. The liquidity squeeze is the result of the stalled trade deficit, and the liquidity squeeze deflates the debt bubble to which the housing bubble is a major component. Since the start of the liquidity squeeze in 2006, there had been three notable financial fire storms. Though all those three fire storms have been touched upon at various places of this series of discussions titled “Tracing the Liquidity Squeeze”, it is instructive to summarize them here before we plunge into the analysis of the coming fourth financial fire storm of Fannie Mae and Freddie Mac. For that purpose the short-term interest rate graph introduced in Comment 49 is expanded to cover the data up to early July of 2008, and is posted below.

The first financial fire storm hit in the middle of August of 2007 as the spike in the red curve attests. The red curve is the interest rate difference between one month CD (the blue curve) and one month T. Bill. During the spike of the red curve in August of 2007 there was no corresponding spike in the blue curve, that is, the rate of one month CD. This means that the spike of the red curve is caused by the sharp drop of the interest rate of one month T. Bill as liquid money in the market panicked and rushed into the safe haven of short-term US treasury instruments. The financial fire storm of August of 2007 was triggered by the panic among the buyers of commercial papers issued by heavily leveraged entities called SIV's. SIV's were created for the purpose of purchasing large amounts of securities backed by subprime mortgages, using borrowed money raised by issuing commercial papers. When the buyers of those commercial papers belatedly realized the woes of subprime mortgages one day in August of 2007, they boycotted those commercial papers by refusing to roll them over when they mature. Eventually under the urge of FED (The Federal Reserve Board) and the US Treasury Department not to let those SIV's fail and dump those troubled securities related to subprime mortgages on the already unsettled markets, financial institutions that had sponsored those SIV's are forced to take those SIV's back into their own balance sheets. Thus the woes of subprime mortgages have become the burden of banks and Wall Street firms. Financial media had reported originally that the commercial paper buyeres triggered the first financial fire storm by their boycott were money market mutual funds. However, a detailed analysis of the z1-report of FED in Comment 54 has revealed that the buyers of commercial papers of our concern is actually a sub group of a mysterious entity called “funding corporations”. This subgroup of funding corporations provided $250 billion to support the market of securities backed by subprime mortgages through their purchase of related commercial papers before the fire storm, but had withdrawn all those $250 billion during the fourth quarter of 2007 after triggering the financial fire storm of August of 2007. In the z1-report “funding corporations” are simply described as the non-bank financial subsidiaries. Who are the parents of those funding corporations played such a big role in the subprime mortgage market? Are they foreign trusts of super riches and hedge funds? Are they banks and Wall Street firms that underwrites and initiates those subprime mortgages? We do not know the answer. It will be the role of later academicians to uncover the true identities of the parents of this subgroup of funding corporations in the course of studying the details of this subprime mortgage fiasco.

In the aftermath of the first financial fire storm, FED lowered the target rate of federal funds by 0.5%, and relaxed drastically the conditions for commercial banks to borrow through its discount window. FED hopes that the banks will bring in hard to sell securities of their clients as the collateral to borrow from the discount window, and thus save their clients from bankruptcy. Even though banks and Wall Street firms were pulled deeper into the mortgage and other leveraged loan mess, FED's action misled many investors to think that the worst is over. Those investors bid stock prices to new highs by early October of 2007, and the red curve dipped below 1% line as money parked in the safe haven of short-term US treasuries left the haven. However, financial institutions had become more and more paranoia from the suspicion which parties are exposed to those poisonous structured securities. As the end of year 2007 approached, and the season of active liquidity trading arrived, many institutions with extra liquidities refused to lend those spare liquidities to other parties no matter at what interest rates, apparently from the fear that borrowers may be exposed heavily to those poisoned securities and may suddenly go under. The banks short of liquidities were forced to turn to the depositors by offering higher yields on CD to obtain the required funding. That effect shows up in the spike of the blue curve near the end of 2007. As the events unfold complacent investors woke up from their rosy dream and panicked. They ran away from stock markets and parked their liquidity in the safe havens of short-term US treasuries again, creating a broad top in December of 2007 for both the red and the green curves respectively. In order to contain the second financial fire storm, FED established special auction facilities to allow Wall Street firms along side with the commercial banks to use hard to market securities as collateral and borrow from the special facilities. With the dawn of the new year of 2008 the seasonal liquidity pressure had eased somewhat, and the popularity of FED's new special auction facility eased the liquidity strain further. The interest rate of one month CD (the blue curve) fell sharply, bringing down the red and the green curves with it. However, stock markets were not fooled by that superficial calm of the money market and kept sliding downward. The voice from the Wall Street and their representatives on major financial media asking FED to lower interest rates became a chorus. Those pundits soon got from FED more than what they wished for. From the late January of 2008 FED staged a series of interest rate easing moves to bring down the federal funds rate from 4.25% to 3.0% in less than three weeks. The aggressive easing by FED, of course, was not aimed to save stock markets and it indeed did not, but was based on FED's panicky realization of the steadily creeping in “Japan Syndrome”. Japan Syndrome is a phenomena that even liquidity rich institutions refuse to lend to others from the fear of credit risks. The syndrome was what Japan encountered since the middle of 1995 when it lowered the interest rate to near zero (please see article 1 for the details about how the syndrome evolved in Japan). In the case of the US financial market the syndrome is based on the fear about the exposure of other parties to the poisonous structured securities backed by subprime mortgages and other dangerous loans. On the other hand holders of those poisonous securities probably received secret encouragement from FED and the US Treasury Department not to disclose the depth of their exposure from the fear that such disclosure will cause further turmoil in the financial market to the degree of bringing down the whole financial system, in spite of their pretended public stance of urging more transparency. We refer readers interested in the issue of who are exposed to those poisonous securities by how much to an estimate made in Comment 54.

The overzealous secrecy about the exposure to the poisonous structured securities has fanned more anxiety in the market that has induced more secrecy in turn. This vicious cycle of secrecy and anxiety finally resulted in the run of a Wall Street investment bank, Bear Stearns in March of 2008. The red and the green curves spiked anew as the liquidity in the market ran for the safe haven of short-term US treasuries third time just within nine months. FED has taken $29 billion of Bear Stearn's difficult to sale poisonous securities directly into its own book, an unprecedented event in the whole history of FED, and has arranged Bear Stearns to be taken over by J. P. Morgan and Chase, a giant bank with strong balance sheet. At the same time FED opened its discount window wide to Wall Street investment banks even without the detailed information about the balance sheets of those investment banks, another unprecedented move in the history of FED. If Bear Stearns had been allowed to fail, it would probably have brought down the house of cards of $75 trillion inter wound derivative market and induced the collapse of the global financial market. Some say casually that the giant unregulated derivative market needs to unwind to a substantial degree so that large institutions can be allowed to fail without the fear of bringing down the whole financial system. Those people do not realize that the size of the derivative market is in proportion to the size of the amount of debts outstanding. Currently the amount of debts outstanding is still growing but at a slower pace than at the peak of the debt bubble. If the size of the derivative market shrinks by a meaningful degree, the amount of debts outstanding needs literally to shrink, bringing down many financial institutions and induce a deep global recession. The situation that the failure of a big player will bring down the whole financial system will last as far as our eyes can see. After FED has opened its discount window to Wall Street investment banks, quite a few Wall Streeters and their representatives on major financial media spread the view that the worst of the liquidity squeeze was over and thus bid stock prices higher until well into the latter part of May of 2008. However, their hope was dashed again as the weight of the looming havoc of Fannie Mae and Freddie Mac has sunk in, and stock prices has started to slide deeper into the negative territory. Currently stock markets are in a deeply oversold condition. Any good news about Fannie Mae and Freddie Mac, like FED opens the discount window to them, may trigger a counter rally. However, such action is a temporary aid only and will not solve the basic problems of Fannie Mae and Freddie Mac as we will discuss in the remaining part of this comment.

Fannie Mae (the nickname of Federal National Mortgage Association) was created in 1938 as a US Government agency in order to draw in more funds for home mortgages from the financial market. In 1968 for the purpose of balancing the budget of the federal government the major part of Fannie Mae has been turned into a private, publicly traded for-profit company under the charter granted by the US Congress. This private commercial company still carries the name of Fannie Mae. Freddie Mac (the nickname of Federal Home Loan and Mortgage Corporation) has been created in 1970 under the charter of the US Congress. It is also a private, publicly traded for-profit company just like Fannie Mae. The US Congress has created Freddie Mac for the purpose of giving Fannie Mae a competition. Fannie Mae and Freddie Mac mainly pursue two business lines. The first is to buy single family home mortgages (not subprime mortages nor alternative-A mortgages that are roiling the markets) from mortgage initiators, package them into mortgage backed securities, attach guarantees against mortgage defaults and sell those securities to various investors. Fannie Mae and Freddie Mac have substantial advantages over their pure commercial competitors in this line of business. Since they are set up by the US Government under the charter granted by the US Congress, market participants always assume that the US Government will come to their aid at the time of need in spite of repeated warnings from FED and from the US Treasury Department to the contrary. Their guarantees against mortgage defaults behind the mortgage backed securities sold by those two companies are assumed to be almost equivalent to the guarantees made by the US Government itself. From this kind of implicit, or “mental” guarantees of the US government, buyers are willing to accept lower yields, equivalent to willing to pay higher prices for the mortgage backed securities sold by those two companies compared to similar securities guaranteed by their commercial competitors. From the fees they charge for their guarantees and from their ability to sell their securities at a higher prices than their commercial competitors Fannie Mae and Freddie Mac profit handsomely from this first line of business. During the period that the housing market is bubbling up, more mortgages they buy and sell, more profits those two companies will make, higher their stock prices will rise, and more bonuses their managers will collect. Thus there are strong incentives for Fannie Mae and Freddie Mac to expand their first line of business as fast as possible. When the housing bubble bursts, more delinquency arises withing the mortgages they bought and packaged as mortgage backed securities so Fannie Mae and Freddie Mac are forced to pay out substantially more as guarantees to the buyers of their securities than in the bubbling years. The larger the scale of their first line of business becomes, more payout they must make, and thus this increased payouts to buyers become one of the major causes of their heavy losses in recent quarters.

The second line of business of Fannie Mae and Freddie Mac is again to buy single-family home mortgages from mortgage initiators. But this time they keep the mortgages in their own books as investments instead of selling them to other parties. They finance their mortgage investment portfolios by issuing short term and long term corporate notes and bonds to borrow from the financial market. Again thanks to the “mental” backing of the US Government Fannie May and Freddie Mac can borrow from the open financial market at the interest rate substantially lower than their commercial peers. They profit from the difference between the mortgage interest payment made to them from their investment portfolios and the low rate interest they pay to the buyers of their notes and bonds. During the bubbling years they have every incentive to expand their borrowing and their investment portfolios as quickly as they can to leap maximum amount of profits, and they did expand their liability enormously. As the bubble bursts, the delinquency rate in their mortgage investment portfolio increases. This not only reduces their income from the mortgage interest payments but suppresses the prices of the mortgages in their portfolios, forcing them to take huge losses when they mark the value of their portfolios to the market. The huge losses generated from both of their business lines are pushing Fannie Mae and Freddie Mac steadily closer to bankruptcy with no sign of turn around in sight, though non of the mortgages Fannie May and Freddie Mac bought are troubling subprime mortgages nor alternate-A mortgages.

Currently Fannie Mae and Freddie Mac combined have $1.6 trillion liability used to finance their failing mortgage investment portfolios. There are $3.6 trillion worth of mortgage backed securities outstanding that carry their guarantees. The two companies in aggregate have lost $11 billion in the past three quarters. The ratio of mortgages the payments of which are overdue for 90 days or longer is currently 1.22% for all the mortgages that Fannie Mae has bought, a sharp rise from 0.62% one year ago. The delinquency ratio for all the mortgages that Freddie Mac has bought is currently 0.81%, also a sharp rise from the ratio of 0.49% one year ago. It is said that the two companies combined need $50 billion new capital infusion to stay solvent, in spite of large amount of capital raised in recent months. It is doubtful that there are so many private deep pockets willing to throw away their own money just to prolonged the life of those two struggling giants. The solution for this havoc must eventually come down to what FED and the rest of the US Government will do.

How about let Fannie Mae and Freddie Mac fail as the market dictates? In that case $1.6 trillion direct debts issued by those two companies will default immediately, and the mortgage portfolios backing those debts need to be dumped on the already troubling secondary mortgage market, causing existing mortgage backed securities to go down sharply further. On top of that, $3.6 trillion worth of mortgage backed securities sold by those two companies will lose guarantees, and their prices will sink sharply, too. The holders of $5.2 trillion mortgage backed securities and debts related to the mortgage portfolios will suffer heavy losses, many of them will fail along side with Fannie Mae and Freddie Mac, the global financial market will be in turmoil, and a severe global recession will be induced.

At the other extreme how about an outright takeover of Fannie Mae and Freddie Mac by the US Government? The US Government apparently will not be able to sell the ill fated investment portfolios of those two companies otherwise will cause the collapse of the secondary mortgage market to the dire consequences as discussed in the previous paragraph. Thus the US Government will immediately increase its own liabilities by $1.6 trillion as it shoulders the burden of the liabilities of Fannie Mae and Freddie Mac. Then the US Government must assume the guarantee made by those two companies on $3.6 trillion mortgage backed securities. Let us assume that the US Government increases it liabilities by $1 trillion by shouldering the guarantees made by Fannie Mae and Freddie Mac. Currently the US Government has a liability of about $5 trillion. What does the sudden increase of the liability of the US government by 50% mean? Is the credit rating of the US Government going to suffer? Is US Dollar going to collapse? Will the global financial market in turmoil due to the collapsing Dollar and the falling house of cards of derivatives? Will the global economy plunges into a recession as the consequence? Those are all open questions under this scenario.

The least painful option is probably as follows: FED opens its discount window borrowing to Fannie Mae and Freddie Mac just as for Wall Street investment banks. This will eliminate the fear of the imminent collapse of Fannie Mae and Freddie Mac due to the liquidity squeeze. The US Government injects $50 billion new capital into those two companies but without guaranteeing $1.6 trillion direct debts nor $3.6 trillion mortgage backed securities sold by those two companies. As the losses of Fannie Mae and Freddie Mac continue and the newly injected capital exhausted, the US Government can repeat the capital injection again and again. The hope is after injecting a few hundred billion dollars in the time span like 3 to 5 years, the housing market will eventually bottom out and Fannie Mae and Freddie Mac will regain their financial health. This solution apparently is safer than to increase the liabilities of the US Government by a few trillion dollars in one stroke. Can Fannie Mae and Freddie Mac still increase their investment portfolios, say by $1 trillion to help the sinking housing market as some politicians want them to do? It all depends on whether the financial market is willing to dance along the tune of the politicians and throw a large sum of good money after the bad ones. The irony is larger the investment portfolios of Fannie Mae and Freddie Mac become, heavier their losses will be in a downward housing market. Even if the financial market is foolish enough to lend them this amount of sum as politicians wish, there is no guarantee that the falling housing market will be saved. In that event, politicians will be widening the hole into an abyss for Fannie Mae and Freddie Mac.

Former FED Chairman Alan Greenspan has warned about the danger of Fannie Mae and Freddie Mac quite a few years ago. There are also other discussions about the worrisome situation of those two mortgage giants. For example, interested readers can find an inspiring discussion about the issue in an economics blog conducted more than one year ago.

P.S.After finishing writing this comment, on the evening of July 13, 2008, FED and the US Treasury Department has announced a rescue plan for Fannie Mae and Freddie Mac roughly along the line of the least painful option as outlined above. Whether this rescue action will inspire a strong bear market rally of stocks in an otherwise deeply oversold market is an interesting thing to watch.