Sunday, July 13, 2008

Stock Market Week Recap: Fannie Mae and Freddie Mac

Contrary to my belief that GE's earnings would be some kind of bellwether for the overall market, Fannie Mae and Freddie Mac stole the show. GE had set expectations so low, when it beat its own lowered expectations, the market barely noticed.

Meanwhile, Fannie (FNM) and Freddie's (FRE) stock prices got cut in half after liquidity concerns arose. What are Fannie and Freddie, and why are they so important? I realized I didn't really know much about these institutions, which hold between five to six trillion dollars in debt.

According to its own website, FNM "operates in America's secondary mortgage market to ensure that mortgage bankers and other lenders have enough funds to lend to home buyers at low rates." FRE's business sounds similar:

We connect Main Street – the residential mortgage market – to Wall Street – dealers and investors – through our mortgage purchase, credit guarantee and portfolio investment activities.

Our customers are predominately lenders in the primary mortgage market. Our activity in the secondary mortgage market supports a continuous flow of funds to the primary market, which leads to consumer benefits in the form of a steady flow of low-cost mortgage funding.

What is a secondary mortgage market? It's when a bank gives you a mortgage and then wants to spread its risk around. If it holds onto your loan, and you don't pay, then it is the only entity on the hook. But if it sells the right to future interest payments and/or principal in your loan to someone else, it reduces its reliance on one source of profit. Another way to reduce risk is to have more people involved in a deal, so if one person pulls out, there are plenty left to handle the remaining issues. So most banks re-package their mortgage loans and put them into one big "debt pie" (my own term) and then instead of holding onto the pie, they sell slices to other entities. The bank cuts the "debt pie" into several pieces, some better than others, and sells off its loans at different prices to investors who want to receive the monthly mortgage payments and/or interest.

FRE and FNM get a fee for repackaging various banks' mortgage loans and shouldering the risk that the borrower might not repay the principal or the interest. By allowing banks to place everyone and their mortgages into a large pie, the banks spread their lending risks and possibly get some immediate cash back to make more loans.

The problem is that the pie slices kept getting sold off to more and more buyers through even more complex financial instruments. When the music stopped, everyone forgot that someone had to pay the original mortgages or the game couldn't continue. Ironically, by trying to reduce the risks of lending, banks and FNM/FRE actually increased overall risk, because no one had an interest in making sure the original borrower paid up. The geniuses on Wall Street created no incentive to make sure the guy at the bottom had the papers or the income or the willingness to pay his/her mortgage, because everyone assumed that the original bank checked out the papers and did the due diligence. As we know, loan agents didn't always require tight documentation before submitting loan applications, but the banks that received the applications didn't care, because they knew they could put the loan into a large pie and sell it off and get paid. In violation of the philosopher Kant's ethical guidelines, the banks treated people as a means to an end, rather than an end, knowing they could dump the loans on someone else because FNM and FRE would guarantee them.

The U.S. government has decided that in order to encourage people to buy homes, it needs to support companies (FNM and FRE are both publicly traded and owned by shareholders, not the government) willing to buy up the "debt pies." It supports them by offering loans from the Federal Reserve's discount window, currently at 2.25%. Without this kind of support, the government believes banks would be less willing to make mortgage loans, thereby causing housing prices to decrease. Because most Americans have most of their net worth in their homes, if housing prices decrease, it would make them feel more poor and less willing to spend, causing a recession. As a result, the government has lent an implicit promise to FNM and FRE that they can make loans and will receive liquidity from the government to support American home ownership. This "promise" isn't written down anywhere, but the amount of debt pies held by FNM and FRE are staggering--again, it's around half the entire mortgage loan market, or around 5 to 6 trillion dollars. They are "too big to fail," as some might say.

Recently, the Federal Reserve, which holds taxpayer money (read: our money) refused to loan more money to FNM or FRE, causing their stock prices to decrease by around 50% [This just in: the Fed Reserve Bank of New York will lend money to FNM and FRE]. [Still,] In a worst case scenario, FNM and FRE have been guaranteeing mortgage loans that can't be repaid, in which case they have to reduce their mortgage guarantees, diminishing further demand in the housing market.

At the same time, this might be a welcome development, because by reducing the availability of mortgages, housing prices might decrease enough to allow more first time buyers to buy homes. A friend of mine reminded me not everyone should buy a home--some people are better off in apartments. This reality caused some cognitive dissonance because I am a firm believer in the American Dream including a home, but he is correct. Not everyone can afford to buy a home--some people's incomes are not steady or high enough to guarantee their ability to pay property taxes and repairs, much less the monthly payments on a home. In addition, FNM and FRE's business models work best if you assume housing prices will always increase, allowing homeowners to refinance to pay their mortgages in lean times or during a layoff. But there is no guarantee that housing prices will keep increasing, nor should the government "guarantee" infinitely increasing property prices. The problem, of course, is it looks like the government has done just that.

It appears that when the Fed lowered interest rates post-9/11, basically making money free to the public, it gave everyone a green light to buy a home. In retrospect, Mr. Greenspan didn't really have a choice--he had to open the money spigot to bring back American confidence. But neither Mr. Greenspan nor anyone else thought an Iraq war would last several years, or that oil would increase to 160 dollars a barrel. Therefore, people who blame Greenspan might want to look in the mirror first--the Iraq war, which the Democratic Congress continues to finance, has contributed to taking trillions out of the United States' economy and into non-productive areas, destroying the value of the American dollar. In time, when Iraq's oil fields are producing oil at full capacity, the war might make more sense. But for now, Congress needs to commit to a balanced budget and restore the world's faith in the American dollar. Fannie and Freddie are just symptoms of an overall refusal by our government to restrict spending.

On a personal note, I can't figure out the difference in FRE and FNM, but apparently, Congress approved FRE to counteract FNM's monopoly. If someone can explain the difference between Fannie and Freddie, please add to the comments section. In addition, I can't figure out if FNM and FRE just get paid a fee for buying the loans from the bank and then dumping them on someone else, or if they hold onto some percentage of the mortgage loans.

Also, do FNM and FRE line up a buyer for the loans in advance of buying them from the banks? If not, then they could be stuck with trillions of loans on their own books. If they do have loans on their books they can't dump on someone else, and they go bankrupt, what happens if the government doesn't bail them out? I think the banks would get screwed, but not the homeowner, as long as s/he's paying his mortgage. That means we could have major banking collapses, but that's a shareholder matter, unless the FDIC gets involved. It is also probably cheaper to pay FDIC guarantees than FNM/FRE loans. Of course, if the government doesn't support FNM/FRE, and lets the banks shoulder the risk, the entire banking system collapses, because Americans would take their money out of banks, causing an IndyMac situation (i.e., if bank deposit holders think their bank is going under, they will remove the capital the bank is using to fund other loans, causing the bank to collapse). Sigh. It really doesn't look good, folks. Any comments are appreciated.

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