If it can't raise more capital-- one move being considered is to cut shareholder dividends by 50 percent-- then Freddie executives say they may have to limit growth or reduce the size of the company's retained loan portfolio and slow down the pace at which it guarantees loans.
After a homeowner has borrowed money to buy a home the original lender likely resold that loan to Fannie or Freddie. The GSE in turn collected some of those mortgages in a pool which was sold in the form of mortgage-backed securities (MBS) to private investors for which the GSEs collect a fee in exchange for guaranteeing payment on the MBS. Other mortgages purchased by the GSE are held directly by the GSE for its own investment portfolio. The GSEs obtained the funds for these investments primarily with money borrowed directly from private investors which instruments are referred to as "agency debt". The total volume of mortgages either held outright by the GSEs or packaged and resold by them as mortgage-backed securities has tripled over the last decade currently standing at around $4.7 trillion. That's about the size of the total publicly-held debt of the U. S. Treasury.
And how big a loss might the GSEs expect to take on these various assets and liabilities? Since the subprime MBS aren't traded directly we don't have a direct observation on their worth. But we can get an indirect idea from the ABX index reported by. This is an index based on the prices of credit-default swaps on about twenty different AAA-rated tranches of privately-issued subprime MBS. These credit-default swaps are essentially an insurance policy a holder of an MBS can take out against the possibility of capital loss is leery of relying on the ABX index on grounds that there may be a hedge component in these prices and that the reference securities will likely do worse than a "typical" AAA subprime MBS. Notwithstanding this seems like a decent way to come up with a quick ballpark figure. With the 2007-01 AAA-ABX at 72 we might guess that a holder of $170 billion in AAA subprime MBS has an expected loss in the neighborhood of $50 billion. It's not clear to me to what extent the GSEs may themselves have already purchased such credit default swaps to hedge this risk the extent of counterparty risk in any such hedge or how much of that $50 billion loss may have already been entered on the GSEs official accounts.
because OFHEO is being strict with Freddie it's being forced to sell tens of billions of dollars' worth of mortgages. Freddie should be part of the solution to this mortgage-bond crisis; instead it's contributing significantly to the magnitude of the problem. Freddie should be a source of liquidity in the market not a forced seller.
This is all wrong. The reason why capital-adequacy rules exist is to make sure that there's a cushion in times of crisis. Well guess what-- this is a time of crisis. The capital-adequacy rules should be loosened but instead OFHEO is sticking to its decision to impose significantly tighter requirements on Freddie.
This is no time to be punishing Freddie for past accounting irregularities-- or even present accounting irregularities for that matter if such things existed. Let's keep our eyes on the prize people. Fannie and Freddie can and should be using their deep pockets and their mortgage expertise to buy up undervalued and fundamentally-curable distressed mortgages both above and below $417,000 at less than the mortgages are worth but more than the market is asking.
Whether you share Felix's view has to depend in part on how you view the magnitude of the underlying problem. If you thought that the market was overreacting to the default risk then the key goal of policy would be to reassure markets and provide a buyer for the currently unwanted assets perhaps in the form of a or further balance-sheet expansion of the GSEs such as Felix recommends. On the other hand if you believe that big losses are ahead for all holders of mortgage debt no matter what then maintaining solvency of the GSEs may be job 1. From either perspective though. I think you would regard cutting (or eliminating) the GSE dividends as an unambiguously healthy and favorable development under the circumstances.
Of course there's lots of middle ground in between. Perhaps you think we'll probably muddle through OK unless the sale of Freddie's assets would so depress the market as to hinder extensions of new loans to creditworthy borrowers thereby reducing home sales further thereby depressing house prices further thereby inducing more borrowers to default so that we go from the good equilibrium to the bad equilibrium. But figuring out exactly where we stand currently on that slippery slope between A and B is not an easy matter.
Suppose the gov't decides to view the GSE's as GSE's to maintain liquidity. The idea of increasing the mortgage amount to cover overpriced housing is really just creating an opportunity to pass the expected loss to someone else. The corruption in the appraisal process needs to be cleaned up first along with the Enron style of accounting. Should we provide the GSE's with tax payer capital in support of fallacious appraisals ?
IMO investors expect losses because the price of the underlying collateral is overpriced and is adjusting down. People will not buy MBS because they are over-priced. Until the certainty of housing prices and the price of the securities adjust to reflect the repayment risk the market will be in turmoil.
The GSE's the regulators the lenders the rating agencies the borrowers (have I left anyone out) have all been lying not mistaken. And they continue to lie. Would you recommend that your pension fund buy CDO's ? Why did the GSE's.
I think you have the dynamic of what's going on but I think until the lying cheating and stealing stops and the true price of the underlying is evident the crash will continue. If as you suggest the MBS securities are currently under-priced relative to the potential losses then efficient price discovery and re-pricing is the best solution.
How do they arrive at 100:1? Simple: it is the output of econometric models of losses. These econometric models doubtlessly employ the past fifteen years as a data set perhaps more but with fewer variables (FICO use for mortgage underwriting dates back only to the early nineties).
Now professor what faith do you have in these econometric models right now? Could it be that geographic correlations are understated? Could it be that the relationship of HPA to defaults is understated? Could it be that the three or six sigma range for severities is understated? HGow about the relationship between uneployment and default levels and severities?
you'll find enough data to choke a hippo what the data suggests is that Freddie's suffering the ills of a harsh dichotomy -- the majority of its book of biz is sound - 86% fixed rate. 91% owner-occupied and overall the garbage ratio is relatively small: 8% Alt-A. 9% IO and 1% option arm note: due to the overlap of categories percentages are not additive). The problem FRE has is that the 38% of its book concentrated in '06 and '07 vintages has very different characteristics from the overall book: 39% Alt-A. 44% IO and 14% option arm. (WHAT were they thinking these past 21 months enquiring minds want to know?)
Even though '07 and '06 are only 38% of the Freddie's book these two unseasoned fresh vintage years account for 23% of the serious delinquencies which suggests that the ultimate default experience will be so bad that 67% of the $2.558 billion adjusted reserve was directed towards just these two cohorts of loans.
Or look at it another way -- FRE has only $36 bil of core capital and FNM another $42 bil of core capital -- the "in the neighborhood of $50 bil." loss on just the $170 bil of subprime MBS would wipe out about 2/3 of the total $78 billion in GSE core capital. THAT's not where we are or where we're going to be let us all hope.
Anyway should both FRE and FNM COMPLETELY eliminate their dividends? Of course. Should they be allowed to expand above-and-beyond the OFHEO-directed limit? In a potentially long-lived crisis when we're probably no further along than the 2nd inning of a 9 inning game. I think the answer has to be. NO. Survival should happen but needs to be assured.
My understanding is that to get the AAA rating subprime tranches started out with about 12% subordination. The insurers thought they were being safe in their underwriting if they figured a 50% recovery rate in default on the subordinated tranches. So to get a 28% loss rate on the AAA level with a 50% recovery you would have 12+28*2=68% default rate. Alternatively you could have a 40% default rate at 100% loss on defaults - take your pick. I find those kind of numbers hard to believe. The rating agencies pooh pooh them as well but an independent outfit called Egan-Jones made headlines a few weeks ago by claiming basically that they are good rules of thumb and therefore that the financial guarantors like MBIA and Ambac would wind up in default. If subprime in toto was really that bad the loss on '06-'07 Alt-A and prime is probably much larger than people expect as well and the survival of many financial institutions will be in danger. The difficulty in coming up with solid estimates is a huge problem in and of itself and shows up in vigorous debates about which institutions took the correct amount of write downs.
With the ongoing concerns about the subprime mortgage market both Fannie Mae and Freddie Mac have announced commitments to purchase tens of billions of dollars of subprime mortgages over the next several years. The portfolio cap flexibility plus their ongoing ability to securitize mortgages sell assets and replace maturing assets will enhance each Enterprise?s ability to purchase or securitize over the next six months up to $20 billion or more of subprime mortgages refinanced mortgages for borrowers with lower credit scores and affordable multi-family housing mortgages. These efforts should assist lenders in helping some subprime borrowers avoid foreclosure.
As you can read on Calculated Risk. Freddie said in February 2007 that it wasn't going to do any more Nina (No income no assets) loans but only beginning in Sept 2007. Their reason for such a long delay: they didn't want to disrupt the market. So they got stuffed with the worst mortgages all year when others were turning them away. Should Freddie and Fannie be forced to respect their capital requirements? Of course. Any economist who would say otherwise probably would also say that in a recession you run a deficit because when the times are good you can - yeah run a deficit.
One speculation I wonder about but haven't seen much commentary on is a possible connection between the subprime crisis and illegal immigration. Consider that subprime loans often involve applicants with low income; the greatest default rates occurred with applicants that had poor or no documentation of their income; we recently saw a lot of stepped up enforcement against employment of illegal immigrants; away from Ohio and Michigan the other sharp increases in subprime default were concentrated in California. Florida. Arizona and Nevada - states that have large populations of illegal immigrants; all of the risk models are confused by rising defaults in the face of apparently good employment statistics (which presumably largely exclude employment rates for illegal immigrants). Is all of the above coincidence?
Freddie and Fannie were in political difficulty and tried to gain some cover by raising the amount of support given to lower income borrowers. The largest-volume method they seem to have used was by buying billions of dollars of non-prime MBS (note this option doesn't appear in the flowsheet above).
FRE and FNM have certainly gotten mixed signals from Congress and the regulators - on the one hand. OFHEO was beating on them to hold down the growth of their portfolios (especially their retained mortgage portfolios) to lower their risk profile while on the other hand Congress was questioning their very existence since FRE and FNM provided so little support to less-creditworthy borrowers. Kind of like pulling back on the reins of a horse to slow him down while whipping the back end to make him go faster.
Jeff most people point to the reversal in home prices as a primary factor in explaining the large number of mortgage delinquencies and foreclosures that caught so many qualitative and quantitative analysts in the lending industry by surprise. It's hard to dispute that as a very important cause but it's also intriguing to wonder why models going back several decades which predicted that foreclosures would be low when unemployment rates were low turned out to be so wrong. When we look around the country we see some areas where unemployment and foreclosures were high - like Michigan and Ohio - an other areas where foreclosures were high while unemployment remained low like California. Florida and Arizona. Against that background it's an interesting question whether home price declines by themselves were severe enough to invalidate the models or whether something else is going on. Above I through out a speculation (labeled as such) about what else might be going on - i e the unemployment statistics could be misleading if they failed to measure employment of undocumented workers and. I should have added employment in mostly cash industries like some types of residential contracting.
You make a good point that Texas probably has a high level of illegal immigrants and hasn't had a big real estate boom crash or super high foreclosures. But perhaps the fact that real estate remained particularly affordable in Texas was a key mitigating factor? c f http://originatortimes com/content/templates/standard aspx?articleid=2202&zoneid=5You shouldn't read my speculation as an attempt to *blame* illegal immigration for an economic problem in a perjorative policy-related sense. It could just as easily have been read as blaming the employment crackdown policy but that wasn't my intent either.
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Related article:
http://www.econbrowser.com/archives/2007/11/freddie_mac_and.html
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