Wednesday, March 19, 2008

Fannie And Freddie Reduces Capital Reserve: Risk Of Taxpayer Bailout Just Increased

With the news out today that Fannie Mae (FNMA) and Freddie Mac (FRE) have been allowed to reduce their capital reserve by $3.2 billion and $2.6 billion, respectively, it is now abundantly clear that the Federal Government is willing to pick up the check, yet again, for the mess that the banks have made.

According to their joint press release, the Office of Federal Housing Enterprise Oversight (OFHEO), the regulatory body that monitors Fannie and Freddie (collectively, GES), the official reason for allowing Fannie and Freddie to reduce their capital reserve is “To support growth and further restore market liquidity.”

How This Action Will Not Support Growth
Firstly, there is no growth in real estate. According to the National Association of Realtor’s current forecast, existing home sales is projected to drop by 4.8% and new home sales is projected to drop by 23.7% in 2008.

Secondly, the Banks are still holding a vast amount of real estate loans that they were unable to offload as mortgage back securities (MBS) when the market collapsed in mid 2007. According to the FDIC, the real estate loan holdings by FDIC insured financial institutions more than doubled from 0.82% of total asset in December 2006 to 1.71% in December 2007. As of December 2007, this translates into $135.2 billion in real estate loans on the books, based on a total of $7.9 trillion in all loans.

Thirdly, it will not benefit the homeowners since they will have to go through a complete refinance procedure. For those with conventional adjustable rate mortgages with low loan-to-value (LTV) ratio, this is an option. However, for those homeowners who have taken out a ‘NINJA’ loan (No Income, No Job/Asset verification loan), the recent tightening up of mortgage approval process has closed the door on their ability to refinance since NINJA loans are not offered.

Fourthly, many homeowners with good credit and verifiable income are at high risk of defaulting on their mortgage since they had obtained 90% or more LTV, no-money down financing that included a ‘piggy-back’ second mortgage. While they desire to refinance out of ever increasing mortgage payment, they cannot since they do not have the money to pay off the difference between the refinanced amount (typically 80% LTV) and the current mortgage balance (still about the original loan amount).

Finally, for those that can afford to refinance, there is now a more stringent standard that they will have to meet, resulting in higher rate of rejection (see chart, courtesy of AM Best 2007 Special Report).

So Who Does This Fed Action Support?
In the press release, the answer becomes very clear [bold and italics added for emphasis]:

“OFHEO, Fannie Mae and Freddie Mac today announced a major initiative to increase liquidity in support of the U.S. mortgage market. The initiative is expected to provide up to $200 billion of immediate liquidity to the mortgage-backed securities market.

Once again this is not an attempt to help the homeowners but rather a way to get the banks out of trouble that they gotten themselves in the first place. Now, helping the banks to restart the economy is something I am all for. However, this latest ploy does not do anything to restart our economy.

Risk Of Federal Government Bailout Of The GSE
As capital reserves of Fannie and Freddie decline by a third from 30% to 20%, they are going to take on additional risk on their books by investing in MBS. This creates a thinner cushion against write-downs. New York Times report highlights the issue:

“At the end of 2007, Fannie Mae had $45 billion in capital and Freddie Mac had $37 billion, for a total of $82 billion between them. That cushion supports more than $1 trillion of combined debt.”

Now, with the Fed action, the total reserve between the GSE will be reduced by $5.8 billion while taking on an additional $200 billion in MBS. So, Fannie and Freddie will have $76.2 billion in reserve to cushion potential losses from $1.2 trillion in MBS, or a tier-1capital reserve ratio of 6.35%, which is lower than most banks, including Citigroup, which was above 8% in 4Q 2007. This scenario increases the potential of the taxpayer needing to bailout Fannie and Freddie. If expected default rate and loss given expected default, as detailed in my previous article “Risk of Irrational Fear”, are applied to the GSE, then expected losses will be:

$1.2 trillion x 4.2% junk bond default rate x 40 cent/$1 loss = $20.6 billion in losses, nearly 27% of the reserve capital, resulting in a capital reserve ratio of 4.6%.

Should losses in the 4% to 5% range occur, Fannie and Freddie will require immediate capital injection. Moreover, this would cause substantial losses in the market. After all, if Fannie and Freddie, the two truly “can’t fail” companies begin teetering, then the entire market will begin free falling.

The probability of this risk event unfolding is high given the continuing deterioration in the real estate market and with nearly $700 billion in ARM mortgage interest rate resets to occur in 2008. If the projected defaults increase substantially over the historic average, then the Federal Government will be forced to step in with tens of billions dollars in capitalization. And guess where that money is coming from.

May Your Trading Be Profitable

Ed Kim

Sphere: Related Content

No comments: