Fannie and Freddie: When the GSEs Go, So Goes the Dollar

The big news this week is the panic selling in the two GSEs (government sponsored enterprise): Fannie Mae (FNM) and Freddie Mac (FRE). The two companies together hold about $3.7 trillion of home mortgages. With increasing defaults on mortgages, sub-prime or prime, the total loss can easily exceed all of their capital reserve for the companies. According to a few GSE watchers, the net worth of FNM and FRE could eventually be negative (if it's not already).

 

Markets participants have always assumed that the U.S. government would bail out the GSEs. But since the mortgage portfolio at GSEs is on the same order of magnitude as the total debt owed by US government, such an action could easily double the level of current US debt. A big increase in the US debt, I believe, will translate into a lower $US. And a lower $US will kick the existing high inflation into the next gear. Gold, in that case, should soar.

Of course, this “efficient” but extremely short-sighted market has demonstrated through the subprime mortgage crisis that the market does NOT think ahead much. The initial process of price discovery is quite slow (until lately). Such “gradual” market reaction will mean that being multiple steps ahead of the market will not be immediately rewarded.

In fact, with the GSEs going down, and the markets going down, the US dollar has tended to rise initially. The US dollar has just bounced off the support, and may be heading higher in the short term. However, this gives plenty of time for people to heed the cautions and prepare for what may come to pass.

With more banks and investment firms trying to find the final last fool to take on their toxic mortgages, and while GSEs continue to happily loosen their underwriting standards with a low down payment (3% now in some cases), it may only be time that separates the GSEs from devastation.

There are many other reasons why the $US will head lower in the longer term. But whether the GSEs are bailed out by taxpayers or not, $US should go lower either due to the increase in the total debt, or through selling of GSE debts (in the case of no bailouts). In either case, the loss of confidence in US financial systems is becoming the reality.

Disclosure: Shorting markets through combinations of selling/buying calls/puts on IAI, SKF, QID, SDS.

Comments

[BS Detector]

I think you're missing a huge part of the story here, and overstating the effects on the dollar.

IF the government were to assume FNM and FRE assets and liabilities, it's not like the addition of debt we've incurred over the last eight years. There are substantial underlying assets. It's quite possible that an assumption of FNM and FRE, with some $3.5T in debt would actually REDUCE the leverage of the federal government in real terms.

Look at it this way; say FRE and FNM have between them $3.5T in debt, and the underlying assets have fallen to $3.3T in value. I haven't looked, but I'm pretty sure that $200B would more than make the companies insolvent.

So the federal government would take a $200B balance sheet hit by assuming FRE and FNM. So what? That's less than half of the current annual deficit, and less than 4% of the national debt.

And it's not like those underlying assets are going to continue to decline forever. No, eventually, the mortgages held by FNM, FRE, or whoever are going to regain and then exceed their original values. So whoever holds them at the end will see a potentially huge addition to the balance sheet.

Would be a very... interesting way to reduce the national debt.

[FrugalMillionaire]

Bonds lose their value when interest rates go up. What I expect things would unfold is that the rates for long or short term GSE/treasury bonds that have been fixed at a lower rate will continue to increase as they rollover. Anyone who buys up the bonds (by bailout) will continue to lose money whether you mark to the market, or thru an increase of financing the interest cost when rollover. That would be a "nice" way to add to US debts.

As far as the leverage of federal government is concerned, I kind of agree with you. The transaction is probably a "reduction" in leverage for federal government accounting-wise, when you don't add in all other assets that US has. But why don't you argue that USA can always sell off a couple of states and its land to repay debt. In that scenario, wouldn't the federal government have a massive asset base already, not needing to add more assets for leverage reduction?

[BS Detector]

Agreed, bonds fall in value as rates increase. But there are two points here.

First, I think the market for MBS has overreacted. If this assertion is correct (which BAC and MS certainly think), the mark-to-market requirement has led to more write-downs than necessary, which has forced lots of unnecessary de-leveraging. Those who are able to hold these under-valued assets for long enough will see them increase as the market's valuation comes back to reality. Eventually, if a bank like BAC is able to hold all of those CFC mortgages, the current write-downs and losses will be replaced by "write-ups" and profits. Of course, it's all paper - the assets haven't changed.

But the bonds are not the underlying security; the real property is. The value of the real property, which has fallen significantly and will fall some more or be stagnant, will eventually recover and increase. Always has, always will.

I was careful to use the word "possible" to describe a potential reduction in leverage. Certainly, the government has a hefty asset base; a quick search didn't find anybody trying to value it. However, I can say that most federal land is quite low in intrinsic value.

Finally, certainly the government doesn't need to add millions of mortgages to its balance sheet. My point is that if it did so, the impact would not be nearly as large as you suggest.

[islandcreek]

Although you have a stellar resume, frugal millionaire, you lack experience and perspective. It is not "different" this time, same as earlier in my career in 1980, and 1987, 1990, 1998, and 2000. Are there serious problems? Of course there are, same as in those previous years. But somehow, the country got through them and it will this time. Be careful not to get crushed, when the bubble in oil bursts, and I hope you can continue to make your mortgage payments long enough for your home to go back up in value.

[BS Detector]

Little corrections:

FNM and FRE don't hold $3.7T in mortgages, but they do guarantee them.

The mortgages won't exceed their original values, but the underlying real property will exceed the values of their mortgages.

[Richardinbellingham]

Trading in Freddie and Fannie today show they are toast; they are now history.

As the reality of insolvency sets in, and the bond market place sees Freddie Mac's, FRE, and Fannie Mae's, FNM, stock value going more towards zero; and as it senses that these two are going to be nationalized in some way, with real estate debt transferred over to the US taxpayer, then four things will happen:

First, the debt sectors will will sell off heavily in the stock market; these sectors will lead the stock market lower:
Mortgage REIT, REM
Investment Banking, KCE,
Banks, KBE,
Real Estate, IYR,
REITS, RWR,
Health Care REITS, HCN, and LTC

Second, there will be run on US Treaury bonds. The bond market place independent of Federal Reserve action will declare a defacto intreest rate hike on US government bonds. The interest rate on the 30 year US Treasury, $TYX, and the 10 year US Treasury, $TNX, will rise. The Treasuries will sell off as seen in the Treasury ETF, TLT, and the zero coupon mutual bond fund BTTRX, falling lower.

Third, There will be a run on the US Dollar, $USD: The dollar will quickly and awesomely loose value: it will rapidly fall through 72.

Fourth, the investment demand for gold, $GOLD, will increase.
Gold will continue its outbreak which was documented in the chart of gold by Alf Field in his article Elliott Wave Gold Update 20, where gold broke out on June 25, 2008 from $870.

The investment demand for gold will grow, and be seen in the ratio of gold relative to oil, GLD:USO, and gold relative to stock, GLD:VTI, increasing.

As I am posting these comments, I am watching the Kitco.com chart of gold zoom higher. Gold is rising from $930 to $940, which I believe is in response to four things: Poole's comments, the Dodd Frank bill working its way through Congress, a bearish stock market, and alarm over Bernanke statements that greater regulatory powers are needed to insulate the economy.

All I can say is: "Got Gold?"

[Think-About-It]

It is different this time. In fact the details & environment are different every time. I've always been a long-term bull on U.S. equities riding out recessions & bear markets with a buy & hold strategy, however, I believe it will take the U.S. stock market much much longer to recover from this set back (and it will fall another 10% - 15%, easy). The 2 primary reasons are 1) our financial system is strained and money is the grease to economic engins and 2) our federal government/politics has shifted left of center and 'socialist ideas/plans' are counter productive.

BTW, the author's main point was that the $US will fall if the Gov assumes FRE & FNM's debts (& assets) because it will further erode confidence in the U.S. If the net debt burdon is about $200B it is still a problem and extra debt that must be serviced. In absolute term, the annual interest expense on $1.5T will be more than the annual appreciation on the $1.3T real estate. That's my take anyway.

Disclosure: Short FRE

[Florin]

The FED could always decide to swap the entire mortgage portfolio of Fannie and Freddie.

What is more interesting is that the credit-default swaps are trading at levels implying a A2 rating, overlooking the government's implied guarantee of the debt. However, it could also be the case that traders rate the GSE debt at A2 to signal real US debt rating of A2!

[outtafavr]

To the author, I would just state that lower bond prices/higher interest rates will attract capital to the US, boosting the dollar. The credit crisis is about a shortage of capital in our markets at prevailing interest rates. Adjusted for risk, returns are negative, resulting in the flight of capital, a weaker dollar due to exchange imbalances. When rates rise to levels that adequately compensate for risk, capital will flow into this country once again, credit markets will be functional again, and the dollar will be strong again. The problem is that a substantial adjustment to our rates will be necessary, the sooner the better. The government's only strategy is to delay the inevitable.

BS Detector, you need to study pyramids, ponzies, and multilevel marketing schemes. The collateral you have so much faith in has an inflated value because of the $5 trillion FNM and FRE threw at it over decades past. That money is gone. The base of the pyramid just gets bigger and bigger. Another $10 trillion will be needed to keep the triangle intact. Where will that money come from? New issuance of agency/treasury(same thing?) debt? Please see my first paragraph above. Without dirt cheap interest, low/no down payment mortgage loans available from FNM/FRE/Uncle Sam, how much will all those precious US dwellings be worth?

islandcreek, so much for your experience and perspective. This time it is indeed very different. For your sake, I hope you are one of the very very few Americans with some money in the bank.

[Florin]

Lower bond prices/higher interest rates will not attract capital to the US perse. Only when the rate of return is higher than the real inflation rate.

[sunrises]

Hello,

If anyone gets a chance to read this then...news:

Canadian forecast for the 8th largest economy added jobs for 6months. Canadian dollar reached highest this month before gov.t report tommorrow.

According to TD securities in Toronto, "Canadian dollar could strenghten."

CAD/YEN

Good luck.

[sunrises]

Correction:

"Canadian dollar could strenghten from here."

Thus, higher than $106.245 Cad/Yen

[BS Detector]

"In absolute term, the annual interest expense on $1.5T will be more than the annual appreciation on the $1.3T real estate. That's my take anyway."

(I think you meant $3.5T v. $3.3T) Sure. But you're forgetting that more than 95% of these mortgages are performing just fine, meaning that the holders are being paid interest regularly.

"The collateral you have so much faith in has an inflated value because of the $5 trillion FNM and FRE threw at it over decades past... Without dirt cheap interest, low/no down payment mortgage loans available from FNM/FRE/Uncle Sam, how much will all those precious US dwellings be worth?"

As interest rates rise, the underlying asset values fall, this much is true. But real estate a pyramid? Please. Suppose real estate loses 25% from the peak; sounds reasonable. Does that mean all of those mortgages default? Of course not. As long as people can make their payments, the losses won't touch the holders. And as well over 95% of mortgages are in NO stage of default, the impact isn't nearly what the chicken littles are saying.

But hey, why take my word over theirs? I'm just another voice in the crowd.

[Anil]

BS Detector,

Although your analysis is good, it may contain one small flawed assumption. "The housing value of the assets will return to previous values". While this may come true in next 10 years, the NPV of those gains vs. cost of carrying these resources may not be attractive.

I guess it depends on what side is the bias. If we think that housing prices will return to their peak in next 3 years or so then your argument may have merit.

What are your thoughts?

[BS Detector]

Anil -

There are a couple of factors at work here.

For those not in dire financial straits, the value of the underlying real estate is not material. The homeowners are the ones who suffer the (paper) losses; it's only if they can't pay the mortgage that the banks face losses. The house I bought in 1994 for $142K promptly lost some value - this had no impact on my ability to pay the mortgage, because that ability was not related to the value of the house, but rather to my having a job.

The vast majority of mortgage holders are not in danger of defaulting. I heard (not verified) that less than 2% of mortgages are currently in some sort of default, whether that's foreclosed, in the process, being sold short, or more than 60 days late. Without foolish government action, I expect this number to increase modestly into the middle of next year, after which almost all of the people who do not belong in the houses they bought will be flushed out. After that, all losses will have become real (instead of paper) and the remaining mortgages will eventually regain the (paper) value they have lost. The "eventually" is the key; how long will the market continue to undervalue mortgages that have very little chance of default?

Next, real estate values. Remember, the GSEs and banks don't carry the assets, but rather the mortgages. I believe the market is significantly undervaluing these mortgages. So the underlying value of the real estate is not at issue, except in those cases where people bought more house than they could afford, or were sold mortgages that screwed them. I expect 99% of those cases to pan out, one way or another, in the next 18 months.

The rest of the mortgages will continue to behave as expected. These assets will, once the dust clears, have regained their original value based on reasonable risk assessments. And just as their undervaluation in the market has contributed to the losses we're seeing now, so will their re-valuation contribute to large future profits.

But, to answer the question, I don't think it will take too long for real estate to regain the lost value. Since 1975, the median home price has increased about 6% per year (through 08Q1). Not a world-beating ROR, but based on that I expect it will take not longer than five years to regain the peak, assuming a further 10% drop from 08Q1.

But remember, most of that drop from the peak has already happened; the 08Q1 number is down 16.2% from the peak in 06Q2, and I think most of the remaining drop will be reflected in the Q2 and Q3 numbers.

[FrugalMillionaire]

I don't claim to know all, or know more for that matter. Everyone is entitled their own view.

I just want to retract my statement above on markets not being reacting fast enough. It looks like markets are getting much wiser this time around. Gold/silver went up, $US dropped, US treasury bonds dropped, and just about everything that you would expect is happening. Hold on tight.

By the way, in my previous post, I have stated that I believe real estate will not hit bottom until 2012/13. The results of what happen to these mortgages obviously depend heavily on what happens in the housing market.

[BS Detector]

Real estate won't bottom until 2012-2013? Why? There wasn't a spike in new housing that corresponded to the bubble; in fact, the current decline in housing starts PRECEDED the June '06 market top by a couple of months.

According to the latest Case-Shiller report, we're 20% off the market top already, two years into the decline. I expect prices to decline another 5-10% and start to recover at some point next year.

[VegasBob]

Unemployment is increasing. Therefore real estate won't bottom until 2010-2013 because people without jobs can't buy houses. There are no more NINJA loans.

A potential Fannie/Freddie insolvency simply demonstrates what many foreign creditors are beginning to realize. The US is a profligate deadbeat that has no intention of paying anything back to anybody. The only action the US ever takes is to borrow more money. We are currently writing about $1 trillion of hot checks every year to pay for the US trade deficit and federal budget deficit.

This non-stop borrowing will never make the dollar stronger - only progressively weaker, until our foreign creditors have had enough and cut off our credit.

[BS Detector]

"Unemployment is increasing. Therefore real estate won't bottom until 2010-2013 because people without jobs can't buy houses."

First off, I questioned his 2012-13 timeframe; 2010-2013 as a target for the bottom is so broad as to be meaningless. I'm going to pick the World Series winner; it will be a team that plays on natural grass.

What makes you think employment will be lower in two years than it is now? Since 1960, there have been only five years when employment declined, and only twice has there been less employment than there was two years earlier (1992, 0.25% less than 1990; 2002, 0.3% less than 2000). Even the 1981-2 recession, which was far worse than either 1992 or 2002, saw employment rise in any relevant two-year timeframe.

Also, the correlation is weak. During the 1990-1992 period, housing prices declined 4.9% (by far the largest drop since 1987); however, during the 2000-2002 period, they increased 24%.

[FrugalMillionaire]

I just realized that SeekingAlpha doesn't have my post on housing bottom. Here is the link:
www.1stmillionat33.com.../

I won't be checking comments here going forward. Frankly, I've got so many things to do, that I don't have any time to pick a fight with anyone. I'm always telling my own opinion. You can take it, object to it, or whatever you want to do with it. My only hope is that you may benefit from my thinking (even if you like to take it contrarianly).

Regards,

Frugal

[hypratt]

Here is an idea, an across the board lowering of interest rates on all existing mortgages instead of attempting to help only those cash strapped borrowers and bailing out the banks who tried to take advantage of those with poor or no credit. That would be the very ones that all contributed to the massive problem that exists. The rates do not encourage any savings. While we are at it let's reduce the exhorbenent rates that are charged by the credit card companies to say a maximum of 10%. Both of these reductions would certainly leave more available cash to fund our consumer driven society. It is always about profit, profit, profit. Just what do all of these companies need with hoardes of cash but to buy other companies anyway.

[iThinkBig]

Interesting, both BS Detector and Frugal both mentioned the US jobs market as critical to providing the ability to continue servicing a mortgage.

Both agree that real estate values will continue to drop for the foreseeable future, Frugal calling bottom 2012 soonest, BS 18 months or mid 2010. Splitting hairs over a year is indeed interesting.

However, what may be the more salient point or function would be to calculate the current debt load including mortgages of Americans in the bottom 90% income bracket by month, and then calculate this same groups total monthly earning power. What is the debt to income ratio? Then parse our mortgages individually to income. That chart would be most useful to at least understanding the scope of this problem. The top 10% will be fine unless the dollar outright collapses and those civil police others mentioned are necessary. A black swan event is now a very real possibility if not probability (any major geopolitical misfortune fpr the US could cause this now) but yet some would probably not recognize or understand the reality of the statement itself. It's happened in other countries it can happen here. And it will. But in some ways, this is better in the long-term. Our nation is no longer a free Republic as was founded in 1780. The good news is we have a hell of a lot of infrastructure, bright minds, hard workers, a phenominal military with scientific advantages, and plenty of food and good communications. We'll recover fast. The US govt is indeed just staving off the inevitable. I suppose elections and passing the baton to the next guy is more important then real leadership these days. Sad.

We all seem to rightly assume jobs is important but job losses are accelerating. It's a different world. Any job of a cubicle work or desk-jockey for that matter can be offshored to other nations. This has happened and I assume will happen as long as government continues policies that do not help America be competitive. And what does the US offer the globe that it needs? Agriculture, metals and some medical. The US could accelerate jobs and exports through energy independence of all options, including drilling. But what do we see by the liberal dominated government as options? Windfall profit taxes, suing OPEC. Bailing out iBanks whom gambled and lost. Rewards for irresponsible managers at the top (chronie capatalism) supported by the corrupt on the Hill. No, the $US is not going to have a comfy landing. I guess we can all 'hope for change' yeah that will fix it all.