Greenspan: GSE issues deserve more examination

Another Long Term Capital Management class timebomb. Except this time, all the real estate values in the US are riding on it. The politicians don't have the courage to tackle the issue. When the GSE's implode the real estate market will crumble, and then consumer spending, and then the fiat system.

Tick tick tick tick tick.

I just closed a 15 year fixed on my house. I'm not with the doomsayers, but I can't explain why high-end residential prices are still so high. Compare residential prices to commercial rents in Silicon Valley and it just don't make no sense.

Still, low to mid market rentals in low-crime small cities still seem like a good buy.

but I can't explain why high-end residential prices are still so high. Compare residential prices to commercial rents in Silicon Valley and it just don't make no sense.

Well, the commercial space isn't part of the GSE money pump. They don't receive money from Fannie Mae like the majority of residential mortgages.

If you can articulate why banks have multiplier restricitions on their loans, you should be able to articulate why Fannie's 40 to 1 debt to equity ratio distorts home prices.

But its worse than that, the more they distort home values, the more "collateral" they have to continue pumping up home values. Of course, your local government wants a cut as well. They do so with escalating property taxes on ficitious values further inflated by over-regulation of land use.

You know that awful screech a microphone makes when you get it too close to a speaker? Same thing. Positive feedback.

Except this PA system is going to take down the power grid.

The real questions for Fannie Mae and Freddie Mac is whether this ripple effect will trigger a higher rate of mortgage defaults (with a corresponding (and constricting) effect on mortgage finance markets).

Well let me ask you a simple question:

Do you trust a Socialist Frankenstein like Fannie to operate the one of the largest derivative's based hedge fund in human history?

The answer better be a resounding YES because our entire financial system is riding on it.

The multi-trillion dollar shock of a GSE implosion would simultaneously destabilize the bond, stock, and real estate markets.

I know. My house could supposedly be sold (and quick, too) for about 3X what I paid 12 years ago, netting me a cool half-mil. I could, just barely, afford to buy my house now, even though I make a lot more than I did when I bought it. I find it hard to believe people in my position are willing to shell out half their take-home pay on a mortgage AND risk such a large amount in a house that could be built for 15% (not counting land) of what they are paying to buy it. I'm lucky. I get to live the lifestyle without a huge nut. I could survive not working for a couple years. My newer neighbors must be big customers for Maalox.

Fannie Mae was created in order to establish a liquid secondary market for mortgages -- it is far from socialist.

Their existence is rationalized with socialist arguments. Since they can not be allowed to fail, they have the implicit backing of the state.

Fannie Mae packages conforming mortgage loans and sells them as mortgage backed securities in the opem market. The sale of the mortgages returns lendable capital to the selling banks which, in turn, makes more mortgage loans. banks do not run out of money to lend and, thus, more of us can get mortgages more easily

Which is the same thing as allowing a bank to loan money with no restrictions on its cash reserves. That would make it easy to buy a house as well. For a while.

Also, the Federal National Mortgage Asociation (FNMA) -- Fannie Mae -- does not run a derivative fund.

How do they secure their 40 to 1 debt to equity ratio, then ?

"You know that awful screech a microphone makes when you get it too close to a speaker? Same thing. Positive feedback.

Except this PA system is going to take down the power grid."

How do you think it is going to explode?

The money has already been loaned out. You've already gotten your home mortgage (probably indirectly via FNMA) and the person who built or sold you that house already has his/her money. FNMA could disappear tomorrow and the guy who sold you that house would still have the money that he recieved when you took out your mortgage.

Now, the owners (stockholders) of FNMA could be hurt if millions of people with home mortgages suddenly decided not to make their monthly payments, and that situation would impact how much cash/credit that FNMA had on hand to issue brand new loans, but that scenario would be more like a car slamming on its brakes (not traveling much farther forward, but you still have the car/asset) than like the car blowing up.

How do you think it is going to explode?

Home values no longer reflect merely the cost of construction,land,materials and competition. They have become instruments of speculation. At the heart of the speculation are the GSE's who are allowed to do what no sane bank ever would: loan out tremendous sums many times (40x) greater than their collateral.

There are a number of possible failure modes: Too many people defaulting on their mortgages, people pre-paying their mortgages, the transition from an inflationary environment to a deflationary one, an highly inflationary wartime environment popping the housing bubble, or just the fact that hot shot derivatives traders aren't as smart as they think they are. Pick one.

The money has already been loaned out. You've already gotten your home mortgage (probably indirectly via FNMA) and the person who built or sold you that house already has his/her money. FNMA could disappear tomorrow and the guy who sold you that house would still have the money that he recieved when you took out your mortgage.

Most people don't have the money, they have fictious equity in their homes.

Now, the owners (stockholders) of FNMA could be hurt if millions of people with home mortgages suddenly decided not to make their monthly payments, and that situation would impact how much cash/credit that FNMA had on hand to issue brand new loans, but that scenario would be more like a car slamming on its brakes (not traveling much farther forward, but you still have the car/asset) than like the car blowing up.

The stock value is distinct from the viability of business model. That said the stock is also insanely over-valued. Up 4000% from 1990.

"Home values no longer reflect merely the cost of construction,land,materials and competition. They have become instruments of speculation. At the heart of the speculation are the GSE's who are allowed to do what no sane bank ever would: loan out tremendous sums many times (40x) greater than their collateral."

First of all, most mortgage warehouse lenders restrict their mortgage broker clients to 20 to 1 leverage, not 40 to 1. I'd have to guess that if you've seen 40:1 leverage that what you saw was a mortgage broker who had access to a private investor(s).

With that said, the reason that mortgage brokers can have 20:1 leverage is because they only loan money in most cases for less than a month.

The mortgage broker gets her money from the mortgage warehouse lender, then loans it to you, the home-buyer. You immediately spend that money on the purchase price of the house and begin making payments on your loan. In the meantime, your mortgage broker has "packaged" your loan together with scores of other home loans, gotten a special brand of insurance above and beyond the insurance that you pay for (so that the entire package is protected from default), and sold off the package on the open market in New York, often (but not exclusively) to FNMA. With the money from the sale in NY now on-hand, your mortgage broker then repays the mortgage warehouse lender.

At this point, your mortgage broker is probably just acting as the agent who collects your monthly mortgage payment and forwards said payment on to the investor that purchased the "package" of loans in which your mortgage was included.

So everyone is paid off except the investor, and everyone is making money from this series of transactions except the buyer, you. But you got a house out of the deal, the only tangible asset in play.

Of course, you're probably going to be paying on the note for your house for 15 to 30 years, but this series of transactions only took 1 month. The mortgage broker only put up 5% of the money for your note (hence the 20:1 leverage), and has now been paid off by the investor. Since your broker is paid off, she repeats this action with that same money on a new loan for a new client, and continues this process ad infinitim.

Now at this point you might be thinking that the investor (which might even be FNMA) could get stiffed if you stopped making your mortgage payments, but that really wouldn't be accurate. Your mortgage broker forced you to purchase insurance for that very sort of situtation, and in the case of most defaults that insurance would pay off your note to the investor. Well, what if the insurance company didn't pay up or there were numerous defaults in that loan "package"? In those cases the Additional insurance from an entirely different class of insurers would kick in, once again paying off the investor in full.

The investor has yet ANOTHER trick up her sleeve, too. She can re-sell that loan package on the open market in precisely the same way and place that she bought it to begin with.

So quite a lot would have to go wrong with an enormous amount of home loans before even the first wave of insurance was broken, and even then there are still two more levels of protection that the investors for that paper have available to help protect them, and that doesn't even get to the point where the investor is repossessing your house for non-payment.

Is 20:1 leverage unreal in a business with that many levels of safeguards? Not at all.

Can a collapse happen rapidly in that business? Not in any realistic scenario.

"There are a number of possible failure modes: Too many people defaulting on their mortgages, people pre-paying their mortgages, the transition from an inflationary environment to a deflationary one, an highly inflationary wartime environment popping the housing bubble, or just the fact that hot shot derivatives traders aren't as smart as they think they are. Pick one."

No, only if large numbers of people default on their home loans and two levels of insurance fail do we even get close to a crisis in home loans.

That's VERY unlikely to happen so long as unemployment remains below 7% (I doubt that it even briefly pushes past 6.5% in the worst case) and interest rates remain low.

Right now people are refinancing to lower their monthly payments. That reduced-debt burden likewise reduces the overall odds of loan defaults.

First of all, most mortgage warehouse lenders restrict their mortgage broker clients to 20 to 1 leverage, not 40 to 1. I'd have to guess that if you've seen 40:1 leverage that what you saw was a mortgage broker who had access to a private investor(s).

Pull up Fannie's profile on Yahoo. Its 40 to 1. The Wall Street Journal reported it as 60 to 1 last year.

I understand how the mortgage system works. I understand it would take quite a spectacular failure to break through the many layers of insurance. But once you break through its like a small hole in the bottom of a dam.

Here's the WSJ article, FYI

Fannie Mae Enron?

Risky investments, fishy accounting, big campaign contributions: Sound familiar?

Tuesday, March 19, 2002 12:01 a.m. EST

(Editor's note: This editorial originally appeared in The Wall Street Journal, Feb. 20.)

We were reading President Bush's budget the other day (we know, get a life), when we came across an unusual mention of our all-time favorite companies--Fannie Mae and Freddie Mac. What we found is a tale we think taxpayers and investors should want to hear.

It seems that Fan and Fred, two "government-sponsored enterprises" that hold the majority of all home mortgages in the U.S., have been growing their debt at an annual rate of 25%. They now have about $2.6 trillion in debt outstanding, a big number in any case, but really big considering that taxpayers are on the hook for it. The budgeteers also expressed some anxiety about Fan and Fred's increasing dependence on derivatives.

Hmmm. Where have we heard this before? The more we've since looked at Fan and Fred the more they look like poorly run hedge funds: lots of leverage and snarkily hedged risk. The word Enron ring any bells?

Last year, Fan's debt/equity ratio was about 60 to 1, more than five times the average for commercial banks. Moreover, as mortgage lenders, Fannie's equity can hardly be said to be well-diversified. Risk thus becomes a critical question. Fan and Fred face two kinds of risk: credit risk from the possibility that mortgage holders will default, and interest-rate risk from the possibility that mortgage holders will prepay, leaving Fan and Fred on the wrong side of the spread, that is, lending at low rates and borrowing at high rates. Of course, giant risk won't lead to giant problems if it's properly hedged.

But Fan and Fred's risk management looks to be rather frisky. Take insurance. Some credit risk can be reduced by buying insurance against default. But lately the siblings have been cutting back on insurance, leaving them with greater exposure to default. Self-insurance may not be a dumb strategy in good economic times, but in a sharp downturn it can look pretty stupid.

As for interest-rate risk, Fan and Fred hedge with a giant and complex program using all manner of derivatives. At the end of 2000, their combined derivative position was valued at $780 billion. Even scarier, these hedges are only as good as the counterparties' ability to pay up. But Fan and Fred don't disclose the identity of their parties, so investors have no idea how much risk comes from possible counterparty failure. (By the way, last year Fan's derivative strategy went, um, somewhat amiss and she had to write down shareholder equity by $7.4 billion.)

Fan and Fred also pool mortgages and then sell those securities--that is, they retain the credit risk since they guarantee the soundness of the mortgages and buyers assume the interest-rate risk. But Fan and Fred have recently been buying back their own securities; each now holds 30% of all mortgage-backed securities outstanding. Simply put, they are reassuming interest-rate risk. Not necessarily a terminal practice when interest rates are stable, but dangerous if rates turn volatile.

Shaking in your boots yet? Well, there are even more parallels with Enron. Fan and Fred's financial disclosure is terrible. They are not required to file financial statements with the SEC. The New York Stock Exchange requires that they report to shareholders, but they keep disclosure and clarity to a minimum. Their financial statements are audited, for whatever that's worth. Last year Fan paid KPMG $2 million in audit fees and $6.6 million in consulting fees. Fred's auditor is Arthur Andersen; last year, Fred paid $1.1 million for auditing and more than $8 million for consulting.

Fan and Fred do have a federal regulator. It's the Office of Federal Housing Enterprise Oversight, and in 1992 it was required by Congress to produce a risk-based capital rule for Fan and Fred. Essentially OFHEO had to figure out how much capital they needed to survive a period of financial stress. Nine years later, last September, OFHEO finally published a rule that took some 600 pages to explain and that everybody found opaque. Informed suspicion is that the proposed standard is below that of other financial institutions and less than the capital that Fan and Fred currently maintain.

Then there's the matter of political influence. During the 1999-2000 election cycle, Fan spread around $1.6 million and Fred $2.4 million, giving to both parties about equally. The total of $4 million is almost double what Enron spent. And finally, there's Wall Street. Just as stock analysts sold the stuffing out of Enron's stock without having a clue about the true condition of the company, they are madly selling Fan and Fred despite the fact they can't possibly know what's what.

We aren't trying to scare readers here, and perhaps all of these concerns will come to nothing. So far during this recession, the housing market has held up well, knock on wood. Then again, unlike Enron, where only shareholders got taken to the cleaners, in the case of Fannie and Freddie taxpayers will take any bath. Maybe this time Congress should hold hearings before things go wrong.

"Pull up Fannie's profile on Yahoo. Its 40 to 1. The Wall Street Journal reported it as 60 to 1 last year."

You're confusing a stock's P/E ratio with a lender's leverage/reserve requirements, those are two very different things...

FANNIE MAE (NYSE:FNM) - Trade: Choose Brokerage
Last Trade 4:01pm · 72.63	Change -0.10 (-0.14%)		Prev Cls 72.73	Open 72.60	Volume 6,534,200	Small: 1d 5d 1y none Big: 1d 5d 3m 6m 1y 2y 5y max
Day's Range 72.11 - 73.99	Bid N/A	Ask N/A	P/E 13.99	Mkt Cap 72.339B	Avg Vol 3,501,545
52-wk Range 68.80 - 87.10	Bid Size N/A	Ask Size N/A	P/S 1.41	Div/Shr 1.32	Div Date May 25
1y Target Est 99.18	EPS (ttm) 5.20	EPS Est 6.15	PEG 0.82	Yield 1.81	Ex-Div Apr 26

"Last year, Fan's debt/equity ratio was about 60 to 1, more than five times the average for commercial banks."

Hmmm... That figure needs some explaining from the WSJ.

You're confusing a stock's P/E ratio with a lender's leverage/reserve requirements, those are two very different things...

The hell I am. Fannie's earnings (ttm) are 5.72 per share, the shares are $72. P/E is 12.5.

That said, what the hell does P/E have to do with debt to equity?

Push the max timescale button on the graph and post the plot FNM vs. the NASDAQ on freerepublic, please.

Then push the profile button and check out the debt to equity.

Fannie Mae was created in order to establish a liquid secondary market for mortgages -- it is far from socialist.

You can try to spin the facts, but you can't get away from the fact that Fannie Mae and Freddie Mac are Government-backed entities. Whenever the government interferes in the free market to bring about some social goal (e.g. home ownership), that is socialism.

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FANNIE MAE (NYSE:FNM)

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FNM vs. S&P Nasdaq Dow

Splits: 17-Oct-89 [3:1] 16-Jan-96 [4:1]

Last Trade
4:01pm · 72.63

Change
-0.10 (-0.14%)

Prev Cls
72.73

Open
72.60

Volume
6,534,200

Day's Range
72.30 - 73.99

Bid
N/A

Ask
N/A

P/E
13.99

Mkt Cap
72.339B

Avg Vol
3,501,545

52-wk Range
68.80 - 87.10

Bid Size
N/A

Ask Size
N/A

P/S
1.41

Div/Shr
1.32

Div Date
May 25

1y Target Est
99.18

EPS (ttm)
5.20

EPS Est
6.15

PEG
0.82

Yield
1.81

Ex-Div
Apr 26

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Tue	7:15pm	FNM	[external] Treasury backs full disclosure by U.S.-backed firms - at CBS MarketWatch
Tue	5:48pm	FNM	U.S.--all GSEs should follow financial disclosure - Reuters Company News
Tue	5:43pm	FNM	Rep. Baker To Continue Push For New Fannie, Freddie Laws - Dow Jones Business News
Tue	4:22pm	FNM	US agency spreads weaken as Greenspan eyes recovery - Reuters Company News
Tue	2:48pm	FNM	WaMu unit sells $800 mln home equity asset-backeds - Reuters Company News
Tue	1:54pm	FNM	Fannie Mae $1 Billion 2-Yr Yields 3.00%; Priced At Par - Dow Jones Business News
Tue	1:44pm	FNM	US Tsy Calls On All GSE To Comply With SEC Requirements - Dow Jones Business News
Tue	1:42pm	FNM	Fannie Mae sells $1 bln two-year global notes - Reuters Company News
Tue	1:37pm	FNM	Fannie Mae Announces Common and Preferred Stock Dividends - Business Wire
Tue	12:14pm	FNM	Greenspan: GSE issues deserve more examination - Reuters Market News

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