July 11, 2008
Will Fannie and Freddie fail?
The so-called Government Sponsored Enterprises, Fannie Mae and Freddie Mac, together with the Federal Home Loan Bank, have played a central role in shoring up the housing-finance market since the sub-prime meltdown began. It is not much of an exaggeration to say that they have become the entire market. But the more money they have pumped into housing, the faster their own financial condition has deteriorated. Now investors are ditching Fannie and Freddie stocks; on Thursday shares in Freddie fell nearly 20 per cent, to their lowest since 1991. Anxiety had been building for a while, then worsened suddenly when Bill Poole, a former head of the St Louis Fed, said that Freddie was technically insolvent in the first quarter under mark-to-market accounting (that is, the value of its assets was less than the value of its liabilities).
It is inconceivable that the government would stand aside and let these institutions go down: to say that they are too big to fail hardly does the case justice. Their liabilities are now larger than those of the entire federal government. If regulatory forbearance–the traditional approach to the GSEs–should fail, and the choice comes to standing by or outright nationalisation, it would be the latter in a heartbeat. The question is not whether there would be a bail-out, but how hard the terms would be on creditors and shareholders. (Bear Stearns was not allowed to fail–but its shareholders were crucified.) We may very well discover the value of that fabled “implicit guarantee”. Owners and lenders alike are having second thoughts about it: shareholders are running for the door and lenders have raised their spreads sharply.
Will a recovering housing market come to the GSEs’ rescue? Not for some while yet. Consider what Janet Yellen, boss of the San Francisco Fed, told the UCSD Economics Roundtable this week (via Econbrowser):
Unfortunately, it appears to me that there are at least three reasons for thinking that housing prices have further to fall. First, the ratio of house prices to rents—a kind of price-dividend ratio for housing—still remains quite high by historical standards, despite having fallen from its historical peak reached in early 2006. That suggests that further price declines may be needed to bring housing markets into balance. Second, inventories of unsold homes remain at elevated levels. This “excess supply” of available homes will put downward pressure on housing prices. Indeed, these inventories are likely to directly depress construction activity, since there is little point in building new homes when there is already a large backlog of unsold homes. Third, the futures market for house prices predicts further declines in a number of metropolitan areas this year. In particular, the Case-Shiller composite index for home prices shows a 15 to 20 percent year-over-year decline in the second half of this year. The bottom line is that construction spending and house prices seem likely to continue to fall well into 2009.
In short, the GSEs’ financial condition is going to get worse before it gets better. If it happens, a rescue of Fannie and Freddie would dwarf not only anything seen up to now, but anything even contemplated. This crisis isn’t over.
Recently Fannie and Freddie have been writing 80% of all USA home mortgages— Up from 40%. 95% sure F & F will fail with the worst USA housing crisis/drop since the Great Depression.
Posted by: Lammie | July 11th, 2008 at 11:23 am | Report this commentThe title of this post should be “What if Fannie and Freddie fail?” Most everyone agrees a bailout would be in order, but the more pertinent question is if we’ll actually get to that point. Though Paulson, Bernanke, and F&F exaggerate how well capitalized they are, most of the mortgages they hold are of the pre-2006 variety–that is, when lending standards were much better.
A lot has to still play out, but it’s not yet doomsday
Posted by: Andrew | July 11th, 2008 at 2:57 pm | Report this commentThe Fed wil print dollars to save F&F. The dollar will thus continue to fall. This is a good reason to bet on further collapse of the dollar.
Posted by: joe | July 11th, 2008 at 3:26 pm | Report this commentSo now the Chinese Communist Party runs the most successful capitalist venture, and the US Republican Party nationalises the financial institutions ?
Posted by: ian | July 11th, 2008 at 6:13 pm | Report this commentThey always get it wrong.
It is hard to fathom how F&F guaranteed 81% of mortgage securities in US in 1Q08, an increase of almost 100% compared to that of a year earlier when the subprime liqidity/credit crunch started. Did they acquired these toxic RMBS from investment banks and hedge funds that were deleveraging? If so, at what prices?
Posted by: Michael Khor | July 11th, 2008 at 7:07 pm | Report this commentI shall be listening carefully to conservative talk show hosts to see if they advocate a smaller government which allows the market to operate freely without intervention in the cases of Freddy Mac and Fannie May.
Posted by: James Hannah | July 12th, 2008 at 12:14 am | Report this commentfor the record
just 3 days ago fed head jeffrey lacker said that he had seen considerable improvement in the
financial crisis.
can we believe anything these guys say anymore
Posted by: terry bonds | July 12th, 2008 at 12:27 am | Report this comment[…] from Clive Cook’s Blog July 11, 2008 […]
Posted by: politicalOBSERVER » Blog Archive » Will Fannie and Freddie fail? | July 12th, 2008 at 1:45 am | Report this commentThis financial system is absolutely rotten to the core and one crisis follows another. What bankers call “innovation” is nothing but subterfuge and smoke and mirrors that gives the appearance of being respectable hard earned profits. Isn’t it oxymoronic that this so called market mechanism which should eventually correct itself is always propped up by the unwitting taxpayer. Capitalism for the gains and socialism for the losses. When and if this current crisis comes to an end the cracks will be papered over, the black boxes will be back and worthless bits of paper with grand titles will be stuffing the pockets of the Big Boyz. Onward to the next disaster!!!!
Posted by: Deano UK | July 12th, 2008 at 12:31 pm | Report this commentTerry Bonds: I’ve a great idea for another commodity. Bullsh!t. These financial guys are full of it and its traded on a massive daily basis. Bull Runs could mean an entirely different thing in this market.
Posted by: Deano UK | July 12th, 2008 at 12:37 pm | Report this commentare we going back to central planning.. It seems to be John Maynard Keynes might have actually been PARTIALLY correct about behaviors affecting market and ultimately markets failing.
If Keynes theory brought us out of great depression, it might be needed again. Only problem this time is it would leave the US govt insolvent. Taking on 5 trillion in debt from F & F and with almost an equivalent debt already on the books, that would leave the next generation paying for the sins of their parents and grand parents.
What a scenario..
Posted by: austin | July 12th, 2008 at 4:34 pm | Report this commentUS is following Uk for the mortgage bail out, this has been created by algorithmic trading and a group of people wants the mortgage insurance market to be nationalized and Mortgage brokers to be nationally registered. This will revolutionize the Real estate Market, and realtors will be irrelevant. With this token, paying a spread for realtors or Mortgage brokers would be diminished. There would be companies that would be building or supporting sustainable ecological and environmentally friendly houses. The Real Estate values will not go down but the way in which building maerials and the way of building would be reduced human factor.
Posted by: Mathew Turk | July 13th, 2008 at 2:53 am | Report this commentIt’s amazing what a fall of a few percent in real estate prices can do to banks.
Posted by: Tom | July 13th, 2008 at 3:37 am | Report this commentBush’ big deficit economic policies are what caused this, in part. If USA had been running budget surpluses most of his years, then Fed. Govt. would have the money to help shore up Fannie Mae and Freddie Mac.
Also, rather than having given Tax Rebates to consumers to send more money to Oil-Arab/Iranian Economies, and more money to Chinese and Japanese mercantilist exporter economies,… Bush should have spent money helping US citizens and US banks in the mortgage crises… that is deal with area of economy having problems: Housing.
Posted by: Drew | July 13th, 2008 at 5:21 am | Report this commentAs I understand it, Fannie May and Freddie Mac have been functioning as banks, but with high concentration risk as pretty much all their assets are of one type - mortgages. Despite being owned in the private sector, they have benefited from a hazy implied government guarantee which has enabled them to operate with much less capital than a proper bank. This bubble has now burst.
I have read that their capital is only about 1.5 percent of assets. A normal bank is required to have capital of at least 8 percent or so of assets. If their combined assets are USD 5 trillion, this implies a capital shortfall of more than 300 billion.
By normal measures, the troubled state of their chosen sector implies that capital levels should be higher than 8 percent of assets. Against this, they may get by with less for now if the market believes that the US government will help out if needed. However, this cannot be certain, it seems that even the US Treasury would have difficulty writing as cheque for the full shortfall. The size of the apparent capital shortfall does strongly suggest that the mooted government injection of some USD 15 bn would be too little to make a real difference. Indeed, a subsidy at this level might just make matters worse by highlighting the US government’s inability to supply enough cash to solve the whole problem.
Posted by: zero charles | July 13th, 2008 at 6:24 am | Report this comment“Their liabilities are now larger than those of the entire federal government.”
CC
Excellent article. Excellent comments.
To fill in a few numbers:
According to the data [page 4] submitted by Peter R. Orszag, the Director of the Congressional Budget Office, in his January report to congress, the 2008 US budget deficit was estimated to be $219 billion. The estimated national debt held by the public was $5,232 trillion!
“If their combined assets are USD 5 trillion, this implies a capital shortfall of more than 300 billion.”
Comment by zero charles
These are frightening numbers.
Fannie and Fred hold mortgages amounting to almost the size of the entire national debt accumulated since the founding of the country.
To make up the Fannie and Freddie shortfall would seem to take more than 135% of this year’s total deficit anticipated for the whole federal government, including two ongoing wars.
There is no way that tax revenues can make up the difference and the scale of the problem is such that the creation of funds to fill the gap will have a serious impact on inflation and the value of the dollar.
Posted by: J Llewellyn | July 13th, 2008 at 2:56 pm | Report this commentAgree… major fall in dollar tomorrow… and inflation is coming in a big way…
It seems that we are close to chaos… most companies with any value will be bought by the Europeans and Chinese…
Posted by: Geo | July 14th, 2008 at 3:52 am | Report this comment“If Keynes theory brought us out of great depression, it might be needed again. Only problem this time is it would leave the US govt insolvent. Taking on 5 trillion in debt from F & F and with almost an equivalent debt already on the books, that would leave the next generation paying for the sins of their parents and grand parents.”
Yes, Keynes advocated that we save our governent save our surplus during the good years and spend during the lousy ones, this will help smooth out the cycle… of course the US gov has been spending spending spending no matter what the economy is doing. At what point does the government become insolvent? Treasuries INCREASE in price the worse things get. The more debt the government takes on in bailouts and stimulus packages and wars and of course skyrocketing pensions and health care cost, a shrinking tax base, one has to wonder WHEN will investors and central banks star demanding higher yeilds for US treasuries? Is it possible that a country that no longer has any exportable resources, declining manufacturing, negative savings, and a third rate infrastructure has any claim as a safe haven?
Posted by: Kurt Ellis | July 14th, 2008 at 4:43 am | Report this comment