The GSE End Game?

This week, shares of the two Government Sponsored Enterprises, or GSEs, imploded again: Fannie Mae lost 39% between last Friday and yesterday’s close. Freddie Mac tanked 46%. Freddie Mac fell to its lowest in almost 18 years … Fannie Mae to its lowest in more than 19.

It’s not just the common stock, either. Investors are dumping their preferred shares and they’re selling off Fannie and Freddie bonds. The message from the markets is coming through loud and clear: These companies are in big, big trouble.

So today, I want to focus on why this is happening, and what it means for your investments and your finances. But first, I need to provide some background on just who the heck Fannie and Freddie are …

A Primer on “Securitization” and the
“Secondary” Mortgage Market

Chances are, many of you hadn’t heard of Fannie Mae or Freddie Mac until recently. It’s not like these companies have bank branches after all. When you went to get your last mortgage, you probably got it from Bank of America, Citibank, Wachovia, or a local mortgage broker.

But behind the scenes, Fannie and Freddie play a crucial role in providing liquidity to the mortgage market. The two giants buy hundreds of billions of dollars worth of home mortgages from lenders for their own portfolios. That’s the “secondary” mortgage market at work (the “primary” market being where you and I get loans in the first place).

Failing giants Fannie Mae and Freddie Mac have hundreds of billions of dollars worth of home mortgages from lenders in their portfolios.

Fannie and Freddie also slap guarantees on bundles of home loans called mortgage-backed securities (MBS). Essentially, they promise to pay investors who buy MBS timely payments of principal and interest even if the underlying borrowers default on their loans. This is called the “securitization” process.

These processes grease the wheels of the mortgage market. Banks can make loans, turn around and unload them to Fannie and Freddie, then use the money they get back to make new loans.

During the housing bubble, vast quantities of home loans were also made and securitized by PRIVATE market participants, rather than Fannie and Freddie. This allowed the subprime and “Alt A” mortgage markets to explode.

Bottom line: As long as some investor further down the pipeline was willing to buy and invest in mortgages and mortgage bonds, front-end lenders and brokers were able to make more and more loans.

How Things Have Changed

But that was then. Beginning in 2007, the subprime market started imploding. Rising delinquencies on the underlying loans caused losses to mount on mortgage investments. Falling home prices only made a bad problem worse. Liquidity drained out the market as investors started dumping subprime mortgage bonds.

For a while, Wall Street and Washington tried to sell Main Street on this idea that it was a “subprime” problem only. They said it was “contained.” We told you the exact opposite — that the problems in the subprime market were only the start of a massive crisis that would work its way up the mortgage food chain.

Sure enough, we soon started hearing about emerging problems in Alt-A loans. Those are mortgages made to borrowers with higher credit scores, but other risk factors. For instance, a loan might be considered Alt-A if it requires interest-only payments, it’s made against an investment property, and the underwriter wasn’t required to verify the borrower’s reported income. One of the biggest Alt-A lenders during the bubble was none other than IndyMac, which, as we all know, just failed and was taken over by the FDIC.

Now, even “prime” quality borrowers are falling behind on payments at a record pace. The delinquency rate on prime mortgages hit 3.71% in the first quarter of this year, according to the Mortgage Bankers Association. That’s the highest since the MBA started splitting out subprime and prime borrowers back in 1998. The overall delinquency figures go much farther back — to 1979. They show the same thing: A record high delinquency rate of 6.35%.

Home prices are way down, but they show little signs of bottoming out just yet.

As for home prices, they show little sign of bottoming out. Figures from S&P/Case-Shiller show home prices down 15.8% in May from the same month a year earlier. That’s the largest drop on record. Prices fell in all 20 metropolitan areas the firm tracks. Las Vegas (-28.4%), Miami (-28.3%), Phoenix (-26.5%), and multiple markets in California (-24.6% in L.A., -23.2% in San Diego, and -22.9% in San Francisco) are leading the way.

Lenders are responding by tightening lending standards across the board. That’s preventing many troubled borrowers from refinancing into new loans.

The Fallout for Fannie and Freddie

The result? Losses are surging at Fannie Mae and Freddie Mac. Fannie Mae bled $2.3 billion, or $2.54 per share, in red ink during the second quarter. That was the fourth straight quarterly loss, and much worse than the 72-cent forecast that analysts were carrying. Freddie Mac lost $821 million, or $1.63 a share. That compared with a profit of $764 million, or $1.02 a share, in the year-earlier period.

Other details weren’t pretty. Freddie Mac’s credit loss provision surged to $2.63 billion from $469 million a year earlier. The company also revealed that it had roughly 22,000 foreclosed homes on its books. That was the most in the almost four decades it has been operating.

Fannie Mae’s credit losses jumped 66% to $5.3 billion. The company said it will cease buying Alt-A loans and slashed its dividend by 86% to preserve capital.

Investors are responding by running for the hills. Not only are they dumping many of their existing stock and bond positions, but they’re also demanding that Fannie and Freddie pay up to borrow NEW money. One example: Freddie Mac had to fork over 1.13 percentage points in excess yield (over Treasuries with a similar maturity) in a five-year note sale earlier this week. That was up from 69 basis points in May and the highest in at least a decade, according to Bloomberg.

If you recall, Treasury Secretary Henry Paulson tried to assuage these kinds of fears a few weeks ago by obtaining the authority to buy an unspecified amount of equity in the GSEs. He also was granted the right to provide the GSEs with an unlimited credit line from the government.

Paulson suggested at the time that the mere existence of this authority would obviate the need to actually use it. This allowed the administration to suggest that the cost to taxpayers would be limited or even nonexistent.

But the market just isn’t buying it anymore. Investors are voting with their pocketbooks. They’re rendering a simple verdict — namely, that the GSEs probably don’t have enough capital to weather the mortgage crisis and cover all the losses they’re facing. So they’re going to need government support.

What is the ultimate outcome here? That depends on the credit markets. If Fannie and Freddie can keep raising money, even at more expensive levels, then they can drag this thing out for a while. But if debt and stock buyers completely step away, forget it. Who’s going to give Fannie and Freddie money to keep operating in that event? The government — or more accurately, taxpayers like you and I!

Frankly, several indicators I monitor are signaling that something is rotten in the state of Denmark. I already mentioned that spreads on Fannie and Freddie debt over Treasuries are widening out. I could also point out that financial stocks are rolling over again … that a measure of market risk called swap spreads is flashing “red” … or that Treasury prices are rising sharply again. These all suggest bond market players are piling into “safe haven” assets and fleeing risk.

What This Means for You and Me

For the housing market and the economy as a whole, this GSE crisis is yet another hot poker in the eye. Fannie and Freddie (along with the FHA) have become essentially the only game in town when it comes to the mortgage market.

Private market players on Wall Street have all but stopped buying and packaging subprime or Alt-A mortgages into bonds, and there’s little demand from end investors for that paper anyway. Meanwhile, the major banks have neither the appetite nor the capital on hand to lard their balance sheets up with conventional mortgages.

If Fannie and Freddie have to slash their mortgage guarantee operations, or shrink the size of their loan portfolios, to preserve capital, what’s going to happen? The cost of home mortgages on Main Street U.S.A. will go up.

Despite clear signals that the Fed has no intention of raising rates, mortgage rates remain stubbornly high.

Heck, it already is. Despite the lousy economy and clear signals from the Federal Reserve that it has no intention whatsoever of raising the rates it controls directly, mortgage rates remain stubbornly high. A 30-year fixed rate loan goes for just under 6.5% right now. That’s not far from the multi-year high of 6.86% in mid-2006.

Bottom line: Mortgage credit will likely get pricier for some borrowers, and be cut off completely for others.

When that dynamic starts to change, I’ll do my best to let you know. But until then, I’m going to reiterate what I’ve been saying for a long time now … and throw something else into the mix:

Drown out Wall Street’s siren song. Lash yourself to the mast if you need to. Do whatever it takes to avoid sinking your money into the financial sector.
Play it safe when it comes to your own fixed-income investments — in other words, stick with short-term Treasuries rather than mortgage bonds, junk bonds, and the like.
Don’t fall for the trite argument I’m starting to hear. It posits that the reason the financial stocks are falling is because of some vast conspiracy among short sellers to drive these companies out of business.

What a load of B.S. Short sellers didn’t make banks and brokers originate, buy, bundle, trade, and invest in all these crappy mortgages and mortgage securities. Short sellers didn’t force lenders to make stupid leveraged buyout loans or reckless commercial real estate mortgages.

And short-sellers most certainly did NOT go out in front of the public and repeatedly — REPEATEDLY — say they were done taking losses and didn’t need more capital … only to announce more losses and raise more capital a few months later.

The mess the financial industry is in is entirely one of its OWN making. This effort by some in Congress and the regulatory community to redirect the focus onto some nameless, faceless cabal of meanie hedge fund managers is patently ridiculous.

And by all means, keep your eye on Fannie and Freddie. They could really hold the key to the next big move in the markets.

Until next time,

Mike

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