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Monday, July 21, 2008


the worst possible news for housing

as the troubles at fannie mae and freddie mac picked up steam in recent weeks, i sometimes felt queasy as i pondered my long-held belief that the GSEs would not be allowed to go quietly into liquidation. it was evident early in the crisis that there were deep problems. as things worsened and politicos started pushing the GSEs into the role of housing savior, deeply knowledgeable analysts like jonathan rosner made plain that FNM/FRE were going to struggle to save themselves.

slowly it has dawned on markets that great depression housing comparisons are legitimate, and that this spells damnation for any housing finance entity geared up to a 65x leverage ratio. particularly those which, as articulated very well by the economist this week,

did not stick to their knitting. In the late 1990s they moved heavily into another area: buying mortgage-backed securities issued by others. Again, this was a version of the carry trade: they used their cheap financing to buy higher-yielding assets. In 1998 Freddie owned $25 billion of other securities, according to a report by its regulator, the Office of Federal Housing Enterprise Oversight (OFHEO); by the end of 2007 it had $267 billion. Fannie’s outside portfolio grew from $18.5 billion in 1997 to $127.8 billion at the end of 2007. Although they tended to buy AAA-rated paper, that designation is not as reliable as it used to be, as the credit crunch has shown.

... Joshua Rosner, an analyst at Graham Fisher, a research firm, who was one of the first to identify the problems in the mortgage market in early 2007, reckons Fannie and Freddie were buying 50% of all “private-label” mortgage-backed securities in some years — that is, those issued by conventional mortgage lenders. This left them exposed to the very subprime assets they were meant to avoid. Although that exposure was small compared with their portfolios, it could have a big impact because they have so little equity as a cushion.

the result was a run on the stock of the GSEs in what amounted to a test of the implicit government guarantee that stands behind agency debt instruments. the government predictably and halfheartedly rose to the occasion, failing to nationalize the stricken companies outright -- probably in fear of fomenting a spike in treasury rates, even a possible run on both treasuries and the dollar -- but offering planned liquidity assistance through the treasury (with congressional approval) and the fed (as soon as needed).

but overlooked in the panic and subsequent relief is the fact that FNM/FRE remain in very deep trouble and will likely have to reduce the scale of their operations. confirmation of that appears to be coming today, as bloomberg reports (via calculated risk) that freddie mac will be cutting its purchases of mortages. one can be sure that fannie mae is not far behind.

and this is the worst possible news for the housing market, barring an actual GSE failure. for fannie and freddie now account for in excess of 80% of all home lending in the united states as private banking has utterly fled mortgagemaking, being already far more exposed to the sector than it would ever care to be again. as they are compelled to withdraw from loan purchases, there is no alternative but for fewer loans to be made -- and those that will be made will carry significantly higher interest rates to reflect risk premium. this will force housing demand down, housing inventory higher, housing prices lower, and foreclosures higher. further, in a continuation of the awful spiral we have been privy to all year, this will accelerate losses at the banks and GSEs alike, forcing further withdrawal from credit offering, in turn forcing housing demand down further still.

where is the bottom of this spiral? an eventual equilibrium of positive carry, i suspect, with possible detours including either an explicit nationalization or a recapitalization/breakup/sale of the GSEs, quite probably with an undershooting of valuation metrics to trough levels as mortgage finance transitions to a new model.

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