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End Of Illusions

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Fannie Mae and Freddie Mac | End of illusions | Economist.com

THERE is a story about a science professor giving a public lecture on the solar system. An elderly lady interrupts to claim that, contrary to his assertions about gravity, the world travels through the universe on the back of a giant turtle. “But what supports the turtle?” retorts the professor. “You can’t trick me,” says the woman. “It’s turtles all the way down.”

The American financial system has started to look as logical as “turtles all the way down” this week. Only six months ago, politicians were counting on Fannie Mae and Freddie Mac, the country’s mortgage giants, to bolster the housing market by buying more mortgages. Now the rescuers themselves have needed rescuing.

After a headlong plunge in the two firms’ share prices (see chart 1), Hank Paulson, the treasury secretary, felt obliged to make an emergency announcement on July 13th. He will seek Congress’s approval for extending the Treasury’s credit lines to the pair and even buying their shares if necessary. Separately, the Federal Reserve said Fannie and Freddie could get financing at its discount window, a privilege previously available only to banks.

The absurdity of this situation was highlighted by the way the discount window works. The Fed does not just accept any old assets as collateral; it wants assets that are “safe”. As well as Treasury bonds, it is willing to accept paper issued by “government-sponsored enterprises” (GSEs). But the two most prominent GSEs are Fannie Mae and Freddie Mac. In theory, therefore, the two companies could issue their own debt and exchange it for loans from the government—the equivalent of having access to the printing press.

Absurd or not, the rescue package notched up one immediate success. Freddie Mac was able to raise $3 billion in short-term finance on July 14th. But the deal did little to help the share price of either company or indeed of banks, where sentiment was dented by the collapse of IndyMac, a mortgage lender (see article). The next day Moody’s, a rating agency, downgraded both the financial strength and the preferred stock of Fannie and Freddie, making a capital-raising exercise look even more difficult. As a sign of its concern, the Securities and Exchange Commission, America’s leading financial regulator, weighed in with rules restricting the short-selling of shares in Fannie and Freddie.

The whole affair has raised questions about the giant twins. They were set up (see article) to provide liquidity for the housing market by buying mortgages from the banks. They repackaged these loans and used them as collateral for bonds called mortgage-backed securities; they guaranteed buyers of those securities against default.

This model was based on the ability of investors to see through one illusion and boosted by their willingness to believe in another. The illusion that investors saw through was the official line that debt issued by Fannie and Freddie was not backed by the government. No one believed this. Investors felt that the government would not let Fannie and Freddie fail; they have just been proved right.

The belief in the implicit government guarantee allowed the pair to borrow cheaply. This made their model work. They could earn more on the mortgages they bought than they paid to raise money in the markets. Had Fannie and Freddie been hedge funds, this strategy would have been known as a “carry trade”.

It also allowed Fannie and Freddie to operate with tiny amounts of capital. The two groups had core capital (as defined by their regulator) of $83.2 billion at the end of 2007 (see chart 2); this supported around $5.2 trillion of debt and guarantees, a gearing ratio of 65 to one. According to CreditSights, a research group, Fannie and Freddie were counterparties in $2.3 trillion-worth of derivative transactions, related to their hedging activities.

There is no way a private bank would be allowed to have such a highly geared balance sheet, nor would it qualify for the highest AAA credit rating. In a speech to Congress in 2004, Alan Greenspan, then the chairman of the Fed, said: “Without the expectation of government support in a crisis, such leverage would not be possible without a significantly higher cost of debt.” The likelihood of “extraordinary support” from the government is cited by Standard & Poor’s (S&P), a rating agency, in explaining its rating of the firms’ debt.

The illusion investors fell for was the idea that American house prices would not fall across the country. This bolstered the twins’ creditworthiness. Although the two organisations have suffered from regional busts in the past, house prices have not fallen nationally on an annual basis since Fannie was founded in 1938.

................

The companies have also been unwilling to accept the pain of market prices in acknowledging delinquent loans. When borrowers fail to keep up payments on mortgages in the pool that supports asset-backed loans, Fannie and Freddie must buy back the loan. But that requires an immediate write-off at a time when the market prices of asset-backed loans are depressed. Instead, the twins sometimes pay the interest into the pool to keep the loans afloat. In Mr Rosner’s view, this merely pushes the losses into the future.

Adding to the complexity is the need for both Fannie and Freddie to insure their portfolios against interest-rate risk—in particular, the danger that borrowers may pay back their loans early, if interest rates fall, leaving the companies with money to reinvest at a lower rate. This risk caused the duo to take huge positions in the derivatives market, and was at the centre of an accounting scandal earlier this decade.

.................

With the credit crunch, Fannie and Freddie have become more important than ever, financing some 80% of mortgages in January. So they will need to keep lending. Nor is there scope to offload their portfolios of mortgage-backed securities, given that there are scarcely any buyers of such debt. And if the Fed has to worry about safeguarding Fannie and Freddie, can it afford to raise interest rates to combat inflation? American monetary policy may be constrained.

The GSEs are not the only liability for the government. IndyMac’s recent collapse is the latest call on the Federal Deposit Insurance Corporation (FDIC). The FDIC has some $53 billion of assets, so it is better funded than most deposit-insurance schemes. But if enough banks got into trouble, the government would be on the hook for any shortfall. The same is true of the Pension Benefit Guaranty Corporation, which insures private sector benefits, but is already $14 billion in deficit.

In the end, the turtle at the bottom of the pile is the American taxpayer. But that suggests that, if Americans are losing money on their houses, pensions or bank accounts, the right answer is to tax them to pay for it. Perhaps it is no surprise that traders in the credit-default swaps market have recently made bets on the unthinkable: that America may default on its debt.

What a system!!!!

So will America default on it's debt, is that really likely. The most indebted nation on the planet defaulting on it's debt.

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Fannie Mae and Freddie Mac | End of illusions | Economist.com

What a system!!!!

So will America default on it's debt, is that really likely. The most indebted nation on the planet defaulting on it's debt.

Yeah and after it got so indignant about venusula or mexico or wherever it was defaulting on theirs

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So will America default on it's debt, is that really likely. The most indebted nation on the planet defaulting on it's debt.

I think it'll go down the inflation route myself - print the money to pay the interest and put up with a few years of 10-20% inflation.

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Gentalmen we are now facing the prospects of a full blown meltdowm lead by the $USD !

Smell it, feel it, embrace it and then go out and stack up on food.

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Fannie Mae and Freddie Mac | End of illusions | Economist.com

What a system!!!!

So will America default on it's debt, is that really likely. The most indebted nation on the planet defaulting on it's debt.

while America may have some of the highest nominal debt, per capita, Britain isn't doing to well lately.

have you checked out the external debt recently?

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It won't need to...it's been outsourced.

Also from the economist...

"Separately, the Federal Reserve said Fannie and Freddie could get

financing at its discount window, a privilege previously available only to

banks. The absurdity of this situation was highlighted by the way the

discount window works. The Fed does not just accept any old assets as

collateral; it wants assets that are “safe”. As well as Treasury bonds, it is

willing to accept paper issued by “government-sponsored enterprises” (GSEs). In theory, therefore, the two companies could issue their own debt and exchange it for loans from the government—the equivalent of having access to the printing press."

I think your avatar sums it up nicely.

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It won't need to...it's been outsourced.

Also from the economist...

"Separately, the Federal Reserve said Fannie and Freddie could get

financing at its discount window, a privilege previously available only to

banks. The absurdity of this situation was highlighted by the way the

discount window works. The Fed does not just accept any old assets as

collateral; it wants assets that are “safe”. As well as Treasury bonds, it is

willing to accept paper issued by “government-sponsored enterprises” (GSEs). In theory, therefore, the two companies could issue their own debt and exchange it for loans from the government—the equivalent of having access to the printing press."

Well, kind of, it's a bit more complex than that. The Fed can only lend out treasuries it possesses - half a trillion or so last time I heard - so, if it runs out, then it has to get the federal government to issue some more so the government can, in theory, say no. Either way, it's not looking good!

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Why is the world looking more and more like a monty python sketch? Financial 'reality' is like winnie the pooh's missing honey- the more you look inside, the more it isn't there.

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while America may have some of the highest nominal debt, per capita, Britain isn't doing to well lately.

have you checked out the external debt recently?

Britain going bust is not going to destroy the world economy.

A US sovereign debt default would be in a league entirely of its own.

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Even in the debt states we are insignificant.

that's a load off, then it seems I don't have to be concerned about worrisome numbers like

these?

Edited by Mr Nice

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that's a load off, then it seems I don't have to be concerned about worrisome numbers like

these?

Great.

When we go bankrupt we take everyone else down with us.

At least we will be able to do it in style.

On edit - Looking at the Office Of National Statistics links attached to the wiki page it seems that a lot of this UK debt consists of short term currency deposits held by UK banks so the debt figures are not quite as dire as they might seem

http://www.statistics.gov.uk/downloads/the...ExtQ1_Q4_07.xls

Edited by up2nogood

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That is mental - did anyone else notice Ireland's external debt per capita figure?

The tax take in Ireland now has dropped so much, they are talking about bringing in a "property tax". I assume this would be something like the Council Tax here. At the moment, there is no such thing there. That should prove popular!

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only a few trillion, which still leaves about 8 trillion in overhang.

I really wonder why it's so much higher for the UK per capita, than any other western country.

Edited by Mr Nice

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That is mental - did anyone else notice Ireland's external debt per capita figure?

Well spotted, although I suspect it's the total debt that matters more.

The per capita figures actually make the USA look healthy when we know that it is facing problems in financing its external debt.

Ireland does not have the same problem, I suspect, because of the small size of the debt (population 4 million?) and because its currency is the Euro. :unsure:

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Well spotted, although I suspect it's the total debt that matters more.

The per capita figures actually make the USA look healthy when we know that it is facing problems in financing its external debt.

Ireland does not have the same problem, I suspect, because of the small size of the debt (population 4 million?) and because its currency is the Euro. :unsure:

while the US has a lot of debt, and is racking up more, there is also a massive economy behind it (near 5 times the GDP of the UK).

so a trillion owed in America has much less effect than a trillion owed in the UK.

I'd really like to see what the current numbers for everyone are for debt in general.

after all of the bailouts and central bank infusions there has to have been a bit of a shake-up over the last year or two.

Edited by Mr Nice

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Exactly.

I think you cannot possibly draw any conclusions about the state of countries' finances by looking at a gross external debt figure.

It may partly reflect the international nature of London as a financial centre. It may partly reflect non doms. It may also reflect how 'international' and interdependent a country is with other countries.

The Benelux countries used to crow about the fact they exported more per capita than Japan. Well that is partly a reflection of the fact that it is smaller and therefore more trade is international.

I would be interested in looking at a net debt number. (It would probably still look awful).

This is a good post by "hotairmail" as a conclusion cannot be made on the external debt figure until we see the other side of the balance sheet. London's position as a world financial centre must also complicate matters !

What would be interesting would be in circumstances where the British economy "went belly up" what would be the net position as regards amounts that would require to be paid in hard foreign currency. For example, I presume Government bonds are always in sterling, all be it often held by overseas investors. A debt that you have to repay in a foreign currency is another matter altogether and would be a much more serious cause of concern. This is one of the main reasons joining the Euro would be such a risk but that is for another day.

I suspect that analysis of the net position may paint a somewhat better picture.

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  • 401 Brexit, House prices and Summer 2020

    1. 1. Including the effects Brexit, where do you think average UK house prices will be relative to now in June 2020?


      • down 5% +
      • down 2.5%
      • Even
      • up 2.5%
      • up 5%



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