Fannie Mae/Freddie Mac Meltdown?!?

Government-sponsored Fannie Mae (FNM) and Freddie Mac (FRE) own about 75% of the mortgages in the US, which amount to trillions of dollars. I've heard some wonderful Armageddon scenario from that crazy LaRouche camp, that there is a bubble in housing/mortgage prices that will pop and take down major banks and world economy.
http://www.larouchepub.com/other/2002/2924fannie_mae.html

I thought I'd try to see if this was plausible. It turns out they aren't the only ones out there being alarmist about this. Correct me if I make any mistakes but this is how it supposed to work:

1) You put your money in the bank.
2) They're allowed to reinvest a certain fraction of this money in the private sector (for FDIC).
3) They lend money in the form of a mortgage.
4) They sell this mortgage to a GSE (Fannie Mae or Freddie Mac).
5) They buy from the GSE bonds or Mortgage Backed Securities. These securities like government bonds don't count toward their fraction of assets they may invest in the private sector.
6) They loan more of your money out in a new mortgage (go back to 3).

I suppose they can do this until most of your money is invested in mortgages (fed reserve limit?). Whether GSE securities are backed by Uncle Sam is an open question. The market seems to think they are in pricing GSE securities. Right wingers like Cheney seem to want to say no, that the government should assume no responsibility.


Let's look back at what caused the great bank collapse that started the great depression? Banks hand no restrictions on how much money the could reinvest in the private sector.

1) You put $100 in the bank.
2) They loan it to Alice.
3) Alice pays Bob to do something.
4) Bob puts $100 in the bank (goto 1).

At some point in time You and the Bobs have the bank owing each of you $100, but there was only ever one $100. You run on the banks: the first one gets the money; the bank goes under; the rest get screwed!!!


Let's look at the GSEs and the major banks participating in this as a system S.

1) I put my money into the bank or fund. In other words I put money into S.
2) S loans much of it out as mortgages.
3) This money builds houses, pays workers, and goes into circulation.
4) It eventually goes into a bank or fund. (goto 1)

Now is this like the great bank collapse example? It's not quite as obvious, because S owns a ton of mortgages and those are backed by real property. However property values could fall, if they start foreclosing mortgages to pay off their debts. The money has to come from somewhere. If the economy starts failing and people can't pay their mortgages, and nobody wants to buy houses, it seems to me like S would fail.

I'm not 100% convinced of this analysis. It also seems to me like their complaints about the derivatives traded within S are red herring.


Here are some articles that point to this same phenomenon:
A Housing Collapse Could Wound the Banks
http://www.businessweek.com/magazine/content/01_36/b3747050.htm
Fannie Mae, Freddie Mac Say Collapse Unlikely
http://blogcritics.org/archives/2004/02/29/230718.php
Fannie Mae and Freddie Mac: Fear Not
http://www.businessweek.com/bw50/content/mar2002/a3776032.htm
A Microeconomic Analysis of Fannie Mae and Freddie Mac -- Cato doesn't think there's a danger
http://www.cato.org/pubs/regulation/regv23n2/vanorder.pdf
Freddie Mac and Fannie Mae: The time to panic is now
http://www.montanastandard.com/articles/2004/02/28/newsopinion/hjjfjhhcjjfgei.txt
Fannie Mae Distorts Markets
http://www.mises.org/fullstory.asp?control=986


Are housing prices inflated because of this?
Is there a serious risk of a big bubble popping here?
Does anyone else have a better understanding of thing?

Outlook: Housing bubble troubles markets' Dr Doom
Baltimore madness; Acambis lesson
By Jeremy Warner

14 April 2004

Tony Dye, Britain's perennially gloomy stock market pundit, has been at it again, only this time it's not a collapse in equities he's forecasting, but a housing market crash. Mr Dye, former head of Phillips & Drew Fund Management, was about four years too early in warning that the stock market was overheating, though he was proved right in the end. If the same holds true with his current prediction, we've a good few more years of booming house prices to look forward to yet before he's finally vindicated.

more...
http://news.independent.co.uk/business/comment/story.jsp?story=511227

...Remember also, that much of the mortgage market in the last three and a half years has been fueled by refinancing to take advantage of low interest rates. However, the effect of this has been to use more of the equity home owners have in their properties to pay off debts. So, now there are larger debts to pay than ever for many, especially the middle and working class who live paycheck to paycheck. Inflation (always follows a major war) is now on the rise, so interest rates will begin to racket upward, something Federal Reserve Chairman Greenspan has been stalling on for months. That will hit the housing market hard, so another recession is right around the corner and this recession could be worse than the one we have just emerged from. If there is a bubble, it will pop big time. But, that is only my opinion, for what it's worth.:shrug:

they became an independent corporation over 30 years ago. they have a unique corporate charter that exempts them from local washington d.c. taxes as long as they continue to pursue the mission of promoting home ownership for families below a certain income threshold. as such, there is still some governmental control, but it's limited to theoretically threatening to revoke the charter.

i have never heard that holding government securities doesn't increase reserve requirements, but that certainly would make no sense for fnma.

also, fnma/gnma don't "own" 75% of the mortages. the majority of what they issue is securitized and sold to the private sector. much of the rest is merely guaranteed by fnma/gnma. they have to have some form of reinsurance and/or risk management portfolio to balance these risks. furthermore, if people start defaulting in droves, they would investigate, find certain lenders didn't adhere to the lending requirements 100%, and refuse to pay on the guarantees.

this is not to say that an fnma/gnma collapse is impossible if they're mismanaged. one hopes that they are being properly and thoroughly audited....

Yes they act as private corporations.

have never heard that holding government securities doesn't increase reserve requirements, but that certainly would make no sense for fnma.
I believe the issue is that banks are normally required to keep a proportion of risk free capital proportional to their total risk-weighted assets.
http://wfhummel.cnchost.com/capitalrequirements.html

So if a bank loans out some money in the form of a mortgage, normally they'd have to keep some cash equivalents or government bonds around too. They can't put all their money into mortgages.

The complaint/problem as I understand it is that the bank can effectively get around this by selling the mortgage to Fannie Mae and then buying back mortgage backed securities from them which are counted like government bonds as far as "total risk-weighted assets" is concerned.

Also, fnma/gnma don't "own" 75% of the mortgages. the majority of what they issue is securitized and sold to the private sector.
For a mortgage backed security, they own the mortgage until they (FNMA) defaults or the thing. They borrow money from the private sector to buy up mortgages. They do this by issuing securities on which they pay interest. They can't say "oh the mortgages backing these bonds we sold you went bad, so we will to default." Not unless they're going bankrupt.

This is not to say that an fnma/gnma collapse is impossible if they're mismanaged.
Well I think there have to be guidelines. Maybe these mortgage backed securities should count like corporate bonds as far as the banks are concerned.

One nice guideline I read somewhere is that the mortgages they're allowed to do this with can only be for 60% of the property value. So housing prices would have to drop 40% or more before the mortgages would be upside down.

my (perhaps technical) point about fnma is that, unlike gnma or fhlmc, fnma is a private corporation. the others merely act like private corporations.

my point about the ownership is that once sold in the form of a mbs or cmo, the underlying mortgages are off fnma's books. however, you are correct in that they usually remain as a guarantor in the event of default. so they've sold off interest rate risk, prepayment risk, and so on, but retain default risk.

their compensation for keeping the default risk is built into the price at which they are able to sell the mbs/cmos. in effect, they are paid a premium for taking risk, just as an insurance company is.

which, at the end of the day, is really what these companies/agencies are. they take mortgage default risk and sit on huge sums of cash and/or reinsure and/or take other positions to mitigate that risk.

Ok but these FDIC refers to FNMA as a GSE:
http://www.fdic.gov/bank/analytical/fyi/2004/030104fyi.html

So they've sold off interest rate risk, prepayment risk, and so on, but retain default risk. .... their compensation for keeping the default risk is built into the price at which they are able to sell the mbs/cmos. in effect, they are paid a premium for taking risk, just as an insurance company is.

That is kind of an interesting way of looking at it. So the price of MBSs should insure that FNMA can't get money for more mortgages unless it gives investors evidence that the mortgages it sits on are ok, and that it's got enough capital and is properly hedged?

So as an bank/investor buying MBS instead of setting up a mortgage, I'm swapping the risk of a single guy defaulting to FNMA defaulting. There is one problem with this. It looks like investors are banking on a government bailout in the event FNMA goes under. Uncle Sam takes some of the risk for free.

The problems as I see it are:
* Banks are allowed to buy more MBS/CMO then normal corporate bonds
* It's not clear if US will bail the system out.
* FNMA buys derivatives from banks, which I'm not to clear on.

Is this to hedge against interest rate hikes which could effect the housing market and therefore the value of the mortgages if they default? So FNMA has obligations to the bank; the bank has obligations to FNMA; someone has an obligation to pay his mortgage, but if that fails will anyone have my money I put in the bank?

This is why I tried to just look at the banks and FNMA/FHLM as one system S. Is that system being give a chance to loan more money then it ought to like the banks of the 20s?