Nouriel Roubini's Global EconoMonitor

FannieMae & FreddieMac Seized: Bail-Out of the Mortgage Industry

On Sunday, September 7, 2008, the U.S. Treasury finally recognized the inevitable – that Fannie & Freddie (GSEs) are insolvent. Secretary Paulson’s adopted action plan entails 4 dimensions: 1) Expand the GSEs combined investment portfolio from currently $1.55trillion to a max of $1.7trillion by 2009 and then start shrinking it by 10% per year; 2) the Preferred Stock Purchase Agreement includes an immediate $1bn stake in each company, with option to expand the preferred equity stake to max $100bn in each company. The Treasury’s new preferred equity is senior to existing preferred and common stockholders but junior to existing senior and subordinate debt holders. The creditors’ interest and principal payments are guaranteed by 3) a new secured lending facility for GSEs,including the Federal Home Loan Banks, intended to serve as an ultimate liquidity backstop. 4) Treasury is also initiating a temporary program to purchase a yet unspecified amount of GSE MBS starting later this month.

Secretary Paulson underlines the temporary nature of this 4 point program that expires December 2009. Until then, Congress is advised to engineer a long-term solution for the GSEs that removes the current ambiguity resulting from private ownership with public financial backing. See: “Overview of Long-Term Solutions for Government-Sponsored Enterprises (GSEs)”.

Did Secretary Paulson live up to his role as prudent steward of the public purse and secure the best deal for taxpayers while containing the systemic risk emanating from the GSEs? Pundits’ reactions are mixed but the markets distinguished quickly between the real winners and losers. Predictably, agency debt holders experience large capital gains as spreads recede towards the long-term 100bp average – by itself a yearly subsidy to the tune of $50bn courtesy of the U.S. taxpayer). But the biggest winners turn out to be subordinated debt holders – once again in virtue of large numbers CDS contracts outstanding that are now being unwound at near par. Existing preferred and common shareholders take a beating and won’t receive any dividends but they are not wiped out as would be expected in insolvency. Still, a few regional banks are likely to suffer from large GSE preferred stock holdings.

Judging from the record spike in the price to protect U.S. public debt against insolvency, taxpayers are likely to feel the pinch down the line, even in the absence of large upfront outlays. Given the largely prime quality of assets and assuming an ultimate loss rate of 5% on the GSEs total debt of $5.3trillion that is either owned ($1.6trillion) or guaranteed ($3.5trillion), Nouriel Roubini quantified the expected losses from a bail-out to amount to $250bn – $300bn back in June – as a reminder, the total taxpayer bill for S&L was $140bn then and $300bn in today’s dollars. Importantly, GSEs hold $320bn of private-label securities on their balance sheets, or 20% of their combined assets. Of these, approximately $217bn are backed by subprime and Alt-A mortgages. It is a legitimate question to ask whether Treasury could end up holding this ‘toxic waste’ in its efforts to put the GSEs on a sound footing by 2010?

How will the seizure of the GSEs affect the housing and wider credit markets going forward? Some analysts are confident that whatever alleviates the stress in the housing market at the heart of the current turmoil, will by consequence have a positive impact on the wider credit markets. Other observers are less sanguine – after all, the GSEs have nothing to do with banks’ large amounts of off-balance sheet assets that continue to drive write-downs and interbank spreads. Neither can the GSEs prevent U.S. home prices from falling further upon a large and growing oversupply in the wake of record foreclosures and further employment disruptions to come down the line. See: “Can the GSE Rescue Solve the Interbank Liquidity Hoarding at the Core of the Credit Crisis?

The GSE bailout stoked risk appetite initially but, like past attempts to solve the credit and housing crisis, the confidence boost faded on the recognition that the bailout was no magic bullet to a weak U.S. and global economy. U.S. stock indices rallied more than 2%, led by Financials, on Monday but turned back down on Tuesday after commodity prices fell and Lehman failed to woo its Korean suitors. Treasury yields rose on the reversal to the flight-to-safety bid but long-dated Treasuries retraced their losses by the end of Monday on mortgage convexity hedging, which continued into Tuesday. The U.S. dollar appreciated to a 2008 high of $1.41 per euro on equities buying then turned around Tuesday as Lehman’s precipitous share drop re-ignited concerns about the U.S. financial sector.

The medium-term outlook for equities is still bleak. According to some analysts, the GSE bailout may have shortened the time it would take for the U.S. housing market to stabilize but it remains on the scale of years. The fall in mortgage rates should contribute to an improvement on the demand side, although the impact of falling mortgage rates is usually affects home sales with a lag of about a quarter. Stocks with foreign exposure may weaken as the rest of the world slows down. U.S. consumers and firms will still have to grapple with tighter credit and asset deflation. Barring further upsets related to the economy, financial sector or housing market, the GSE bailout is a positive for equities. Optimistic analysts believe the recession’s end is as near as year-end and so is the stock market bottom that usually precedes the end of recessions. In more pessimistic scenarios, stocks will continue to languish with a stagnant U.S. and global economy in 2009. The crumbling ‘safe haven’ in commodities may dim the energy and materials sectors, pulling out the last leg from the U.S. equity market. See “U.S. Stocks: Bear Market to Bottom When Recession Is Recognized?

The dollar has benefited from flight-to-safety by domestic investors and by a reassessment of the global outlook. The GSE bailout might have whittled away further impetus for the Fed to cut rates, providing support for the dollar. The now explicit backing of agency debt could also restore foreign demand for agencies that has been anemic in the last few months with foreign investors trimming their overall holdings. See “USD Rally: Is the Dollar a Safe Haven from Global Slowdown?” and “Foreign Governments Shying Away from U.S. Agency Debt?

However, the increase in government debt resulting from the bailout could mar the U.S.’s credit rating. The expected rise in the Treasury supply could depress bond prices should demand fail to rise along with supply. As a result, the GSE bailout would have a lifting effect on Treasury yields but mortgage-related buying and safe haven flows co
uld offset the effect. Reduced expectations for the Fed to cut and the deflationary impact of falling commodity prices could tip the balance towards lower yields. Initially the GSE bailout-related issuance will affect T-bills and intermediates more than longer maturities. At this point, it is unclear how much longer-dated supply will increase. See “Will GSE Bailout Push U.S. 10-Year Treasury Yields Above 4%?” and “U.S. Sovereign Rating: Downgrade Approaching?

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10 Responses to “FannieMae & FreddieMac Seized: Bail-Out of the Mortgage Industry”

ptmSeptember 11th, 2008 at 8:52 am

Have you been suspicious of recent poll results?Well it turns out your suspicions are justified. The basis for any statistical sample is that it must be randomly drawn from the population of interest. So, if you want to see who America is voting for, then randomly sample 1,000 Americans. But Gallup, SurveyUSA, and others have changed their sampling! They now say in effect: We sample 1000 people of which 500 are Republicans and 500 are Democrats, that’s the way it is!The problem is that there 42 million registered Democrats and 31 million Republicans in the country, so the new method is oversampling Republicans. My, my, I’m shocked, dumbfounded, and awed that a private corporation would deliberately bias it’s results to favor the status quo!The good news is that voter registration is up by over 400,000 in Florida, Michigan, and North Carolina, and up by over 100,000 in 10 other key states and most of the people being registered are under 35, thereby nullifying Carl Rove’s voter caging methodology.

GuestSeptember 11th, 2008 at 9:05 am

You should be glad that there is voting anywhere.(If you call votings with manipulatable machines as this).Manipulated States of America.

Little SaverSeptember 11th, 2008 at 9:10 am

We sample 1000 people of which 500 are Republicans and 500 are Democrats, that’s the way it is!Funny and fraudy.

bythewaySeptember 11th, 2008 at 9:21 am

Question from an european:I can not understand why the US is limited at 2 parties.Democracy is not defined as a 2 party system.While there is obvious no or little difference between this two parties there will never be a change.Its only changing the label.So why is there nobody launching a new party?Obviously has Ron Paul for Example a lot of contributors but no support in his party.He, or others, should launch a new one.

AnonymousSeptember 11th, 2008 at 11:59 pm

Excellent discussion of the Fannie and Freddie bust. The question is now how many other institutions will the Fed and Treasury rescue. Will Lehman be treated like Bear Stearns if it collapses? How will the systemic effect of a collapse of Lehman be managed?

Manny HlouverakisSeptember 13th, 2008 at 11:00 am

When a disaster strikes, for example, The department of the Treasury taking under conservatorship the two largest Institutional Investors in our country, it is an inherent response on our behalf to assign blame and fault… Where do we begin? Please don’t get me wrong… I love pointing fingers as much as the next guy… But there should be a certain degree of prudence prior to us proceeding to “Hang’em High…”So who did this???Opinion abound offers explanations of: “Lack of regulations,” “lack of oversight,”, “Fraud, Greed, glutony….” The list goes on with the who is who of FNMA’s inferno…I guess there was no greed in 1936 when HUD was established…. I guess Fraud, and malicious intent to defraud are brand new concepts and were not around prior to the creation of Sub-Prime, or Alt-A, or Prime loans for that matter.The disaster is so extensive that we want to imagine that someone woke up one morning and said that today we are going to create a financial crisis in the United States and consequently the “decoupled” world…. No…. I am here to personally attest that some one woke up one day and said:”Things are chaotic, this is a mess… What can I do to streamline the process of managing risk? How can I make this process more efficient, more uniformed, hence more productive?”It was good and noble intent that brought us face to face with the abyss of owning 5 trilion dollars worth of mortgages collateralized by Real Estate that no one knows how much it is worth.Who Am I ???I am an Underwriter… I am a Mgr of risk, and Manager of many underwriters, and I have worked for the past 27 years for every single one of the lending institutions that are being euphemised in every financial TV network on a daily basis… I am part of the problem that we are facing… When I saw what was happening in 1994 and in 1996 I said nothing…. I said… “Wow that’s cool…”What happened in 94…?I think the more important question is what happened prior to that year…Here is my version….The Federal National Mortgage Association and the Federal Home Loan Mortgage Corporations issue an idiosyncratic publication that is called the Seller/Servicer Guide to originating, processing, underwriting, closing, selling, and consequently servicing the mortgage loan.. If you ever have the misfortune to read these ring bound tomes you will find the GSE’s forms, policies, and guidelines on “how” to do a mortgage… These things have been around since the 60’s… A lot of thought goes into them and they constitute a process that has worked well over the decades…. Very well. Every so often letters of revision are added, incorporated, substitued, and or deleted, in order for risk to be managed in accordance to the current Economic Environments…And then the Savings & Loan debacle, the creation of the Resolution Trust Corporation sends out scores of due diligence underwriters to determine the size of the “pig in a poke” that the government and the taxpayer is about to swallow.FNMA and FHLMC see and experience this… They come to the conclusion that what led to the debacle was lax, twisted, and gross mis-interpretation of underwriting guidelines already in place… Humans, taking guidelines and stretching them and twisting them in order for the square Borrower to fit into a round hole of a mortgage backed security..Henceforth, in Mclean, and in Vienna, in dark places where no one likes to talk about, Risk analysts with secret handshakes came to the realisation, or the profound epiphany that the underwriting process of mortgage loans must be removed from the hands of underwriters and placed in the capable hands of unbiased Computers…That’s right… It is easier to take and put everything on computer instead of taking the time to educate and train ignorant, egotistical underwriters who ultimately managed the financial wealth of the United States… Through a High School Education at best… It is so much easier to trust artificial inteligence than it is look at the ambiguity of of how the guidelines are presented, and that every time they start a sentence with the words; Traditionally or normally… These words beget ambiguity and are open to interpretation not to mention scrutiny, pressure, and the procurement of mal-feasance from the sales side.But how do you take thousands and thousands of guidelines and put then into a computer and letting the computer analyze the risk and manage it for you??How do you expect a computer to make a decision based on the following sentence: “NORMALLY we will not purchase a mortgage loan that is secured by Real Estate that is larger than 10 acres…” OR “NORMALLY we will not purchase a mortgage loan that the debt to income ratio exceeds 36%….”It is simple…. YOU CANNOT DO IT… The CPU is not capable of taking so much information and make an idiosyncratic decision for millions of different Borrowers and thousands of guidelines… So what do you do??? What can the computer understand??? Numbers…. That’s right numbers… A range of probability between 350 and 850… That’s right the introduction of credit scores…. It took them 3 years to assign a number to every single person with a social security number… In 1996 FNMA offered Desk Top Underwriter… FHLMC offered Loan Prospector… Mr. Muzilo gave us CLUES, and RFC told us they were Asset Wise…All these elaborate slot machines could be tweaked to manage the ever rising servicing portfolio and turn the risk analysis mentality of whether we have a credit worthy Borrower to how much can we sell this loan in the Secondary Market, also known as the coffers of Bear & Sterns and or Lehman Brothers..I tried to join them… I tried to learn how to operate a computer… Well to be honest… I flunked at the endeavor… I just could not get it.. But I did manage to walk away with a valuable attage… Garbage in Garbage out… Another words if you enter wishful Borrower information into an Automated Underwriting System you get dreamy results…The AUS systems rely heavily on the Borrower’s credit score which supposedly represent the Borrower’s willingness and ability to repay the debt. You see willingness and ability represent the two main criteria of managing risk… The third being the valuation of the collateral (Appraisal)….Willingness and ability have a problem… They are strictly ephemeral and strictly contingent upon the Good Lord’s sense of humor…The only thing that is worth anything is the asset, the colateral… And what did the GSE’s do…. They gave us a blurb in the AUS findings about getting an appraisal… Which progressed to drive by exterior and interior, if the pension funds were lucky…The result…. Simple… A new generation of ignorance, egoism, lack of education, warm body mentality of Underwriting managers, choked to fill positions, in the middle of a pressure spiel, and threatening tirades by an overpaid Account Executive.. You want an example??? I will give you one… A twenty two year old underwriter (oxymoron) in Newport Beach CA is reviewing an appraisal on a property outside of Des Moines IA… They notice that the values of the comparables and the subject have increased in the past 12 months by 4.2% They immediately dismiss such appreciation as normal since their own house in Newport Beach appreciated by 17% in the past 6 months… So 4.2% is definetely within FNMA/FHLMC guidelines… Too busy to check with reports that show appreciation in that city should nor exceed 3.6% per year… Based on this real life example one can begin to understand how easily we can slip into a bubble… The pressure exerted by that Realtor to that Appraiser to come up with that excessive price should have been caught by the Underwriter…. Yes there was fraud there… But the measure to stave the fraud was in place… The lack of education, the lack of experience, and the lack of the manager’s attention was, is and will be the reason that two fine institutions are no more…
I am in the process of putting a few thousand pages together as to what really happened, from an insider’s perspective… If you think that I should, send me a comment.. If not and you think that i should go back to digging ditches please let me know…