Friday, July 11, 2008

Fannie and Freddie on the ropes

Fannie Mae and Freddie Mac may no longer be able to guarantee loans shortly.

Turns out that the housing bust has hit even "prime" mortgages. People are walking away from their homes, and Fannie/Freddie, as the owners of those loan, are taking the hit. They guaranteed a certain rate of return to the investors who bought the bundled mortgages from them, and aren't getting the cash flow in to pay that rate of return out. The doomsday scenario, shortly to arrive, is when they're no longer capable of paying the full amount to the investors who bought the "mortgage-backed securities". At that point they will be in default, and effectively bankrupt.

Now, the question is this: What do we do about it? There's a couple of scenarios. First, there's the Takeover scenario. In this case, the U.S. Treasury takes on the job of paying off the losses. Of course, the U.S. Treasury has no money -- the U.S. is trillions of dollars in debt already, and this would add another trillion dollars in debt -- but at least this prevents the sudden disappearance of a trillion dollars out of the economy, a staggering deflation that would create a deflationary spiral that would make 1929-1933 look like child's play. In this scenario the U.S. Treasury basically is printing the money that disappeared (i.e., issuing T-bills that are then "bought" by the Federal Reserve in exchange for freshly-printed cash), leading to no major net change in the money supply.

The next scenario: Let them collapse. This basically cuts off mortgage lending other than FHA loans. Housing prices slowly at first, then faster and faster, plummet to the amount of lending available (i.e., the FHA loan limits). People lose all the equity they had in their homes and can no longer use it as backing for loans or sell their homes to extract the equity, decreasing the effective money supply. Furthermore, the investors lose a trillion dollars of value for their mortgage-backed securities, getting back maybe 40c on the dollar. To counteract that much money evaporating out of the economy, the Federal Reserve would have to crank up the printing presses overtime, and there's just not much of a mechanism for getting that money into people's hands in this scenario to re-inflate the money supply.

The final scenario would be that rather than a bail-out, the U.S. Treasury take on the job of mortgage lending and send Fannie and Freddie to their graves. The job of securitizing mortgage loans then falls to Ginnie Mae through a takeover of the assets and liabilities of Freddie and Fannie and a vastly-expanded FHA loan program. The FHA loan program has traditionally been reserved for inexpensive "starter" homes. Loans are originated by banks or other approved brokers, and must follow a fairly stringent credentialling process to make sure that the home being purchased is in fact in livable shape and that the person borrowing for the home has the ability to repay the loan. FHA loans haven't done anything "imaginative" or "creative", they just keep plugging away and the default rate is fairly low on them compared to other forms of "sub-prime" loans aimed at first-time buyers of "starter" homes. Expanding this program would bring stability to the housing market and avoid staggering deflation, at the expense of making Fannie/Freddie stockholders VERY upset.

Personally, I think the Fannie/Freddie stockholders ought to just take their lumps anyhow, so I'm not personally interested in any solution that protects them. These stockholders were all too ready to allow Fannie/Freddie take on far too many questionable loans as long as they got their guaranteed dividend checks every quarter. These stockholders allowed the management of Fannie/Freddie to lead extravagant lifestyles and build extravagant offices and exercise lax lending oversight as long as the stockholders got their dividend checks every quarter. Fuck the stockholders, in other words. And frankly, I'm not so eager to protect the morons who bought those mortgage-backed securities either, they had to know that the housing bubble that backed those securities was going to get punctured sooner or later and with it would go the value of the mortgages underlying those securities. But unfortunately a bailout is the simplest way to avoid a 1929-1932 style deflationary spiral, so we have to bail out someone. Given that the stockholders have already lost all their value as Fannie/Freddie stocks have collapsed... (shrug). Let them eat cake? But we simply can't do that for the buyers of these mortgage-backed securities. A trillion dollars vaporizing out of the economy... (shudder). Talk about making the Great Depression look more like the Somewhat Large Depression, gah!

-- Badtux the Economy Penguin

7 comments:

  1. as long as they have enough money on hand to buy themselves the committee chairs and the leadership of both sides in congress there will be bailouts.

    letting investors tank is not part of the holy creed of the "ownership society."

    where's all the fucking privatization talk about social security now? huh? i'm listening you republican fucks. . .

    ReplyDelete
  2. Unfortunately, even without the massive bribes, replacing a *trillion* dollars of disappearing money is mind-boggling enough without having to figure out a way of handing it out *other* than assuming Fannie's liabilities (i.e. bailing them out). A bailout simply is the only way to do it in a short-term manner without having to ramp up new mechanisms that just don't exist at the moment. So I expect it to happen -- bribe or no bribe. Say hello to stagflation as the U.S. Treasury prints money (by selling Treasuries to the Federal Reserve) to pay for it. But the alternative... [shudder]. Given that the alternative is 1929-style spiralling deflation and national bankruptcy (as vs. merely a debased dollar), I'm not sure the alternative is something we really want to seriously consider at this point.

    - Badtux the Practical Penguin

    ReplyDelete
  3. Sophisticated economic analysis there, Tux. I am impressed at your pengintelligence.

    You've probably contemplated how Fannie and Freddie and Ginny, and countless similar efforts, allowed the U.S. economy to inflate. Bank lends $100,000 for a mortgage, bank sells that $100,000 mortgage as part of a bond, bank gets to loan that same $100,000 again. And again. And again. The magic of leverage, creating money from nothing, gold from straw! And bankmaggots get to live large as long as everyone has a job and the interest payments keep rolling in. When the gravy train gets laid off, though, the system hits the wall. As it has now. You can see why Islam has a horror of lending money at interest.

    It's going to be some interesting times ahead, mate. I'm glad I have some gold coins that I can lay my hands on, and a lot more in a vault under Paradeplatz in Zurich.

    I hope you've got some metal aside from the kind that rides on two wheels. If not, keep Don's Village Coins on Ocean Avenue near the Stonestown Mall in mind. He's a crusty, survivalist type geezer who does honest business and seems like the type who wouldn't keep records that the government might examine in case of another FDR-style confiscation. I had Mrs. Bukko stop in to top up our stash when she was in S.F. last month.

    ReplyDelete
  4. Another interesting wrinkle as to who would benefit most if Fannie and Freddy's bagholders were bailed out. Lends credence to your attitude of "Sprog 'em." But maybe you knew who's holding those cards already.

    ReplyDelete
  5. Gold coins. Err, Bukko, I hope you realize that gold is not edible? Okay, so I have gold coins. The U.S. dollar deflates horrendously. My gold coins that I bought for $500, how much are they worth -- a) $500, b) $5, or c) $50,000?

    The answer is b) $5, because deflation reduces the price of *everything*, including gold coins. I would have been better off stashing the $500 under my mattress, because then I'd still have my $500, but it would be worth $50,000 now (in "old" pre-deflation dollars).

    Okay, so let's say that instead we get galloping inflation. I'm a bit better off then, because my gold coins are now worth $50,000 rather than $500 now. Fine and dandy, so I sell one of my gold coins and buy some food. That's nice. But there's other inflation hedges that historically have had better returns than gold coins. I'd be better off investing in other commodities if I want to hedge against inflation.

    And if things go to hell in a handbasket and the U.S. dollar becomes totally worthless, then the gold coins become worthless too. Let's say I have ten gold coins and the farmer next door has ten ears of corn for sale. How many ears of corn will my ten gold coins get me? a) zero, b) ten, c) something inbetween? Answer: Zero. The farmer can't eat gold either. What he needs is fertilizer and fuel, and maybe some meat to eat with his corn. So if I go grab my hunting rifle and take down a nice juicy wild boar from the nearby state park and drag it to the farmer's place and we slaughter it and make sausages and shit out of it, the farmer will trade me corn and veggies for sausages, but he won't trade me corn and veggies for gold. Because he can eat sausages. But he can't eat gold.

    Note that I am not speaking hypothetically here. This was my grandparents during the 1930's. They survived the Great Depression via hunting, subsistence farming, and whatever else they could barter. The town had no cash so paid the teachers in eggs and room and board. There was a small cash economy based around selling cotton in exchange for the few things the community could not grow for itself, such as cloth (from that cotton) and tools, but mostly it was barter.

    In short, if I wanted to cope with the complete collapse of the dollar as a currency, I'd be better off stocking up on bullets, not gold coins.

    Note: I've talked about this extensively in the past:

    The Gold Standard
    What is money?
    Bear Stearns, fiat money, and regulation

    Probably more, but those are a few that typing 'gold' into that search box up there turned up near the top of the list, heh!

    -- Badtux the Economics Penguin

    ReplyDelete
  6. I agree with you up to a point, Tux. I'm not a hard-core gold bug, and I do not advocate a return to a gold standard, like a lot of people on that Mish's blog. I know enough history to understand the background of William Jennings Bryan's speech about how "you shall not crucify us upon a cross of gold."

    While it's true that you cannot eat gold, it's also true that mankind will always need a medium of liquid exchange. That example you mentioned about the farmer and the ears of corn? Those ears (and more) would be yours for one gold coin, because the farmer is going to need something he can put in his pocket to pay for a new harness to attach to his wife so she can pull the sod-buster plow through the dirt of the back 40. And the harness-maker wants to get paid for his leather goods with something easy to carry to the bar when he gets drunk and flashes 'em to impress the barmaid who he'd like to get into some of his under-the-counter leather...

    I don't think it's going to get to the point of spending gold coins for real goods. (Although I think of each Maple Leaf as the equivalent to one cow.) If it reaches that point, organised fiat currency civilisation has collapsed, and all bets are off because one cannot rationally plan for something of that magnitude.

    I also acknowledge that gold makes for a shitty investment. The first time I ever bought gold coins was during the early 1980s when I was worried that Reagan would get us into a nuclear war. I literally buried 50 Maple Leafs (no Krugerrands then for me -- politically incorrect!) in my yard. But I was living on the shore of Lake Superior in the Upper Peninsula of Michigan then. The winters were already hellacious there, and when the theory of Nuclear Winter came out, I realised that there was no sense in trying to survivalist it out. I kept the gold for another decade, finally selling it to pay my way through nursing school when I was sacked from my previous career. In all that time, it had hardly changed in value. I would have done better in a bank savings account that paid 4%.

    Me and the Mrs. are not looking to get rich from gold speculation. At this point, we're more focused on capital preservation. We have gold (and silver, but that takes up a lot of space) as a small, but growing, percentage of our investment mix. Even Matt Gonzales, late of the S.F. supes and challenging Gavin for the mayoralty, current of Nader's V.P. slot as you know, recommended having 3% of your portfolio in metals when I heard him speak about investments at a seminar in 2003. I listen to the Greens.

    I didn't know your grands got through the Depression. I had pictured you like one of those super-smart immigrant-family Vietnamese computer guys Mrs. Bukko used to work with at the University of California. Mrs. Bukko says I must have starved to death in the Depression in a past life because I'm so inherently determined to eat every last scrap of deteriorating food in the fridge. A part of me is always thinking "What's the worst thing that could happen, and how can I be ready to deal with it?"

    That's why I like to have a few heavy gold coins where I can touch them. At night, in a room where the blinds are drawn, with a flashlight in my hand so I can see them sparkle. With my back up against the only door into the room, so they'll have to come THROUGH me to grab it!

    Anyway, I'm glad you disagree with me on something. I hate commenting on blogs where it's a self-reinforcing echo chamber. I shall gladly suffer your foolishness with a rueful smile...

    ReplyDelete
  7. i agree with both of you.

    gold will hold its value, although the value will not be in "dollars" or even euros. gold's value will remain, as it always has, in that it is a portable expression of wealth. there will always be a farmer, who, having enough seed and fertilizer (one of the beauties of plowing behind oxen or mules is that they fertilize as they go) want to have an "expression" of the accumulated wealth.

    most business though, will be done in barter. you can't simply print up counterfit gold when you want to fight a mechanized war half a world away.

    a lot of the barter that i do is around the "added value" thing. my neighbors know that if they give me a few bushels of peaches, i get busy canning and get back to them. citrus are turned into curds and marmalades, figs are dried, jammed, and otherwise processed, milk from goats and cows is turned into yoghurt. . .you see how it goes.

    imagine the look on a farmer's face when i tell him

    something i have learned in the woods is that an elk or a deer is born with exactly enough brains to tan their hide. i doubt that cows are much different.

    ReplyDelete

Ground rules: Comments that consist solely of insults, fact-free talking points, are off-topic, or simply spam the same argument over and over will be deleted. The penguin is the only one allowed to be an ass here. All viewpoints, however, are welcomed, even if I disagree vehemently with you.

WARNING: You are entitled to create your own arguments, but you are NOT entitled to create your own facts. If you spew scientific denialism, or insist that the sky is purple, or otherwise insist that your made-up universe of pink unicorns and cotton candy trees is "real", well -- expect the banhammer.

Note: Only a member of this blog may post a comment.