Fannie and Freddie’s “House of Cards”
Richard Benson, SFGroup
August 15, 2003
We are all in favor of the positive public policy attributes of encouraging home ownership. Nothing is more American than “Motherhood, Apple Pie, and Owning Your own Home”. Indeed, people who own their homes are more likely to take better care of the housing stock, and act in a more conservative manner with their money. Home ownership and virtue go hand in hand. Being good Americans, we own our home, but unlike most Americans, we paid cash for it.
To even begin to understand what is happening in the economy and the Capital Markets, one has to understand housing finance. There are well over $6 Trillion of home mortgages, and, of that amount, over $3.3 Trillion are backed or owned by Fannie Mae and Freddie Mac. This is an extraordinary amount of debt and spending, and the number has been growing at the rate of $800 billion a year. Very few mortgages are owned by long- term investors such as insurance companies and pension funds, which recycle savings. Most mortgages are the credit created and financed by the creation of new money, which finances mortgages in the money market.
For those readers old enough to remember the prime rate and Treasury Note yields in the high teens, and Savings and Loans dropping like flies, the inherent problems of funding long-term mortgages with short-term money need not be explained. However, even for these savvy old-timers, the modern version of the problem is of a totally different order of magnitude. In the old mortgage market before almost all mortgages were turned into liquid tradable securities, rising interest rates would slowly drain a thrift. The effect was a bit like being slowly drained of blood by a swarm of mosquitoes. Now that most mortgages are in mortgage securities and financed in the “carry trade”, the effect of rising interest rates is a bit more like being stripped of all flesh by hungry Piranhas in a matter of minutes.
There should be about $4 Trillion of mortgages in the “carry trade” including Fannie and Freddie’s balance sheet. The way the carry trade works is that mortgage securities can be financed (carried) by borrowing in the money market with Fed Funds, LIBOR or REPO money. Wall Street, being the generous souls that they are, will allow leverage of about 20 to 1 for these GSE securities. For 5% down, these carry trade players can run massive positions on very small equity. They get to earn the difference between short-term money at 1%, and the mortgage coupon of about 5% to 6%. If a carry trade player can make a 4% interest margin, and 20 times leverage, they can make a lot of money. However, they can only make a lot of money as long as interest rates are falling, or guaranteed to never go up.
A few months ago when the Fed was talking about deflation and buying Treasury Notes and Bonds to “peg interest rates”, interest rates kept falling and all the carry trade players thought they could sleep soundly and safely at night. When the Fed cut interest rates by only ¼% and began to talk about a strong economy and said there would be no need to peg interest rates, disaster struck. Just about every major Wall Street firm, bank, and hedge fund that has been active in the carry trade, went to hedge at the same time. It’s not possible to hedge several Trillion of market value overnight. The 10-year Treasury Note lost 11%, and the average mortgage security lost 8%. If the carry trade can be run on 5% equity, and bonds lost 8% - 11%, there are probably some big players that are gone; we just haven’t missed them yet.
The real problem for the capital markets is that now almost all mortgages are in liquid securities and financed short-term. As interest rates rise, the shock of falling bond prices will regularly be heard around the world. There are over $160 Trillion of OTC derivatives – a huge share of these derivatives are in interest rate swaps, caps, and other hedges built around the mortgage carry trade. Clearly, we are in a position that when it comes to hedging and high leverage, he who sells first, wins! Selling begets selling, and market players can be wiped out overnight! Collateral damage will kill many innocent investors who suddenly discover they were nothing more than unwitting speculators.
Fannie Mae and Freddie Mac not only guarantee mortgage securities that other leveraged players use in the carry trade, but they themselves are the largest hedge fund carry trade players in the world. More interestingly, they can run their balance sheet positions not with 5% equity and 20 times leverage, but 2% equity and 50 times leverage. Both entities can try heroic efforts to “hedge their interest rate risk” but mortgage prepayment rates that drive mortgage convexity, swap spreads, and mortgage spreads over Treasuries that are all used to hedge, are not stable when the market suddenly has several Trillion of the same securities going “bid wanted”. On interest rate risk alone, Fan and Fred are simply “too big not to fail.” Their level of leverage can not be hedged, and they will end up making Long-Term Capital look like a conservatively run firm.
Fannie and Freddie have gotten into moral hazard lending in a big way. Their willingness to believe all mortgage appraisals and to bend over backwards to help that disadvantaged single mother buy a house with virtually no money down is just what you might expect of the Federal Government. Moreover, in a world where housing prices only seem to jump higher, who could fault them for protecting housing prices by helping those who have lost jobs by not foreclosing - instead, they rewrite the mortgage for a larger principal balance. As long as housing prices rise, Fan and Fred can play a “rolling loan gathers no loss”.
The mortgage and housing market, as we know it, however, is coming to an end. We just discovered that mortgage interest rates don’t always go down for homeowners. Indeed, if mortgage rates can suddenly rise, housing prices can suddenly fall. Falling interest rates, not personal income, has been behind the house price bubble. As interest rates rise, the same monthly payment buys much less house.
The sad thing for Fannie Mae and Freddie Mac is that they have been a big part of the Fed’s policy of getting cash into the hands of households to spend. Lending standards have been incredibly lax. Most appraisals are biased upwards, and there is a far higher level of out and out fraud, which is likely to be on a scale exceeding the worst of what we have already seen from corporate America.
There are hundreds of billions of mortgages, where a charity made the down payment, and the charity got the money from a developer. We regularly hear of friends in housing developments conspiring to buy each other’s identical house, and then pocketing big sums of money. Indeed, people buying each other’s houses and “trading up” is primarily a bad joke played on the mortgage lenders, while the real estate agent, home seller, appraiser, title company, and mortgage broker laugh all the way to the bank. Moreover, cash out REFI’s may make the Fed Chairman happy, but a cash out REFI does not make a better loan.
While the mortgage game has allowed bigger mortgages and higher appraisals, homeowners are shocked by skyrocketing insurance costs and property taxes. Indeed, as housing prices rise, property taxes are beginning to approach the same drain on cash flow as interest payments incur. Fannie and Freddie have no doubt not even considered a world where their customers will be facing higher heating prices, insurance, property taxes, interest rates, and virtually no home equity to start, along with a home bought at the top of the real estate bubble.
Our honest opinion is that Fannie Mae and Freddie Mac are running massive Hedge Fund balance sheets. The equity base is 2%, leverage is over 50 times. The GSE’s derivative positions are in the Trillions of dollars, and their accounting is totally opaque, and impossible to figure out. Mortgage holdings of this size are impossible to hedge without blowing through the GSE’s eggshell thin equity layer. Moreover, there are serious concerns for credit quality, moral hazard, and simply being on the wrong side of the “housing bubble”. We cannot imagine why an investor would own any GSE agency securities, debt, or stock unless and until the US Treasury makes their soft implicit guarantee an actual “full faith” and credit guarantee for the full $3.3 Trillion guaranteed by the GSE’s.
We do remember “moral obligation bonds” that were sold in the municipal market a few decades ago. Agencies can default, and the type of inflation the Fed needs to get going to make all housing credit good, will certainly bring back an inverted yield curve, causing the prices of mortgage securities to plunge. The story for Fannie Mae and Freddie Mac will be a fascinating “House of Cards”; we plan to watch it from the short side.
Richard Benson, SFGroup
August 15, 2003
We are all in favor of the positive public policy attributes of encouraging home ownership. Nothing is more American than “Motherhood, Apple Pie, and Owning Your own Home”. Indeed, people who own their homes are more likely to take better care of the housing stock, and act in a more conservative manner with their money. Home ownership and virtue go hand in hand. Being good Americans, we own our home, but unlike most Americans, we paid cash for it.
To even begin to understand what is happening in the economy and the Capital Markets, one has to understand housing finance. There are well over $6 Trillion of home mortgages, and, of that amount, over $3.3 Trillion are backed or owned by Fannie Mae and Freddie Mac. This is an extraordinary amount of debt and spending, and the number has been growing at the rate of $800 billion a year. Very few mortgages are owned by long- term investors such as insurance companies and pension funds, which recycle savings. Most mortgages are the credit created and financed by the creation of new money, which finances mortgages in the money market.
For those readers old enough to remember the prime rate and Treasury Note yields in the high teens, and Savings and Loans dropping like flies, the inherent problems of funding long-term mortgages with short-term money need not be explained. However, even for these savvy old-timers, the modern version of the problem is of a totally different order of magnitude. In the old mortgage market before almost all mortgages were turned into liquid tradable securities, rising interest rates would slowly drain a thrift. The effect was a bit like being slowly drained of blood by a swarm of mosquitoes. Now that most mortgages are in mortgage securities and financed in the “carry trade”, the effect of rising interest rates is a bit more like being stripped of all flesh by hungry Piranhas in a matter of minutes.
There should be about $4 Trillion of mortgages in the “carry trade” including Fannie and Freddie’s balance sheet. The way the carry trade works is that mortgage securities can be financed (carried) by borrowing in the money market with Fed Funds, LIBOR or REPO money. Wall Street, being the generous souls that they are, will allow leverage of about 20 to 1 for these GSE securities. For 5% down, these carry trade players can run massive positions on very small equity. They get to earn the difference between short-term money at 1%, and the mortgage coupon of about 5% to 6%. If a carry trade player can make a 4% interest margin, and 20 times leverage, they can make a lot of money. However, they can only make a lot of money as long as interest rates are falling, or guaranteed to never go up.
A few months ago when the Fed was talking about deflation and buying Treasury Notes and Bonds to “peg interest rates”, interest rates kept falling and all the carry trade players thought they could sleep soundly and safely at night. When the Fed cut interest rates by only ¼% and began to talk about a strong economy and said there would be no need to peg interest rates, disaster struck. Just about every major Wall Street firm, bank, and hedge fund that has been active in the carry trade, went to hedge at the same time. It’s not possible to hedge several Trillion of market value overnight. The 10-year Treasury Note lost 11%, and the average mortgage security lost 8%. If the carry trade can be run on 5% equity, and bonds lost 8% - 11%, there are probably some big players that are gone; we just haven’t missed them yet.
The real problem for the capital markets is that now almost all mortgages are in liquid securities and financed short-term. As interest rates rise, the shock of falling bond prices will regularly be heard around the world. There are over $160 Trillion of OTC derivatives – a huge share of these derivatives are in interest rate swaps, caps, and other hedges built around the mortgage carry trade. Clearly, we are in a position that when it comes to hedging and high leverage, he who sells first, wins! Selling begets selling, and market players can be wiped out overnight! Collateral damage will kill many innocent investors who suddenly discover they were nothing more than unwitting speculators.
Fannie Mae and Freddie Mac not only guarantee mortgage securities that other leveraged players use in the carry trade, but they themselves are the largest hedge fund carry trade players in the world. More interestingly, they can run their balance sheet positions not with 5% equity and 20 times leverage, but 2% equity and 50 times leverage. Both entities can try heroic efforts to “hedge their interest rate risk” but mortgage prepayment rates that drive mortgage convexity, swap spreads, and mortgage spreads over Treasuries that are all used to hedge, are not stable when the market suddenly has several Trillion of the same securities going “bid wanted”. On interest rate risk alone, Fan and Fred are simply “too big not to fail.” Their level of leverage can not be hedged, and they will end up making Long-Term Capital look like a conservatively run firm.
Fannie and Freddie have gotten into moral hazard lending in a big way. Their willingness to believe all mortgage appraisals and to bend over backwards to help that disadvantaged single mother buy a house with virtually no money down is just what you might expect of the Federal Government. Moreover, in a world where housing prices only seem to jump higher, who could fault them for protecting housing prices by helping those who have lost jobs by not foreclosing - instead, they rewrite the mortgage for a larger principal balance. As long as housing prices rise, Fan and Fred can play a “rolling loan gathers no loss”.
The mortgage and housing market, as we know it, however, is coming to an end. We just discovered that mortgage interest rates don’t always go down for homeowners. Indeed, if mortgage rates can suddenly rise, housing prices can suddenly fall. Falling interest rates, not personal income, has been behind the house price bubble. As interest rates rise, the same monthly payment buys much less house.
The sad thing for Fannie Mae and Freddie Mac is that they have been a big part of the Fed’s policy of getting cash into the hands of households to spend. Lending standards have been incredibly lax. Most appraisals are biased upwards, and there is a far higher level of out and out fraud, which is likely to be on a scale exceeding the worst of what we have already seen from corporate America.
There are hundreds of billions of mortgages, where a charity made the down payment, and the charity got the money from a developer. We regularly hear of friends in housing developments conspiring to buy each other’s identical house, and then pocketing big sums of money. Indeed, people buying each other’s houses and “trading up” is primarily a bad joke played on the mortgage lenders, while the real estate agent, home seller, appraiser, title company, and mortgage broker laugh all the way to the bank. Moreover, cash out REFI’s may make the Fed Chairman happy, but a cash out REFI does not make a better loan.
While the mortgage game has allowed bigger mortgages and higher appraisals, homeowners are shocked by skyrocketing insurance costs and property taxes. Indeed, as housing prices rise, property taxes are beginning to approach the same drain on cash flow as interest payments incur. Fannie and Freddie have no doubt not even considered a world where their customers will be facing higher heating prices, insurance, property taxes, interest rates, and virtually no home equity to start, along with a home bought at the top of the real estate bubble.
Our honest opinion is that Fannie Mae and Freddie Mac are running massive Hedge Fund balance sheets. The equity base is 2%, leverage is over 50 times. The GSE’s derivative positions are in the Trillions of dollars, and their accounting is totally opaque, and impossible to figure out. Mortgage holdings of this size are impossible to hedge without blowing through the GSE’s eggshell thin equity layer. Moreover, there are serious concerns for credit quality, moral hazard, and simply being on the wrong side of the “housing bubble”. We cannot imagine why an investor would own any GSE agency securities, debt, or stock unless and until the US Treasury makes their soft implicit guarantee an actual “full faith” and credit guarantee for the full $3.3 Trillion guaranteed by the GSE’s.
We do remember “moral obligation bonds” that were sold in the municipal market a few decades ago. Agencies can default, and the type of inflation the Fed needs to get going to make all housing credit good, will certainly bring back an inverted yield curve, causing the prices of mortgage securities to plunge. The story for Fannie Mae and Freddie Mac will be a fascinating “House of Cards”; we plan to watch it from the short side.
