Monday, July 14, 2008

Fed’s Failures To Stabilize The Market Continues

With the Sunday announcement that the Federal Government will honor the implied guaranty of Fannie (FNMA) and Freddie (FHLMC), it would appear that many MBS bond investors may feel a bit more positive in an otherwise a negative market. So, does this mean that the MBS bonds backed by Fannie (FNMA) and Freddie (FHLMC) mortgages will stabilize?

I think not. The smart investors will be trying to unload as much MBS bonds as possible while the good news is still creating a tiny bit of uptick. This is because they know that the euphoria will be short lived. Very soon, the investment community will come to realize that the Federal Government of making Fannie and Freddie “too big to fail” will hurt the U.S. economy and the financial market.

Firstly, both Fannie and Freddie are public stock companies, not a part of the Federal Government. By explicitly posturing that the U.S. Government will support and even bail out these two firms, the government is adding more uncertainty into the market.

Uncertainty such as:

  • How will the U.S. Government ensure that Fannie and Freddie do not fail?

  • To what extent is the U.S. Government willing to support these companies that, in the recent past, have clearly demonstrated illegal accounting activities (also here)?

  • How much will it cost the taxpayers to support Fannie and Freddie?

  • What will do to our money supply and interest rate?

  • How will the U.S. Government react if China, Japan, or other large holders of the Fannie and Freddie MBS bonds decide to sell?

  • What will happen to the U.S. economy if China, Japan, or other large holders of the Fannie and Freddie MBS bonds decide to sell?

  • How will the U.S. Government convince investors to continue buying Fannie and Freddie MBS bonds when Fannie and Freddie won approval recently to raise the conforming loan limits to 125% of area’s median home prices in select areas, not to exceed $729,750? This especially, in a market that is expected to lose 10% to 20% or more in value?

  • With foreclosure rates up over 73% from April to May 2008, what how much of the MBS b-pieces and subornation be wiped out?

  • With so much financial institutions – Lehman, Citigroup, Merrill, to name a few – holding on to so much b-pieces and unsold subornated MBS paper, how much more can they lose?
With so much uncertainty, the risks are very high. Traders would think: “higher the risk, higher the reward.” However, in this case, the rewards are not sufficiently high enough to justify the risks, especially when the Federal Government is manipulating them.

I see more trouble ahead for the financial institutions well into 2009 because Fannie and Freddie MUST continue to lend to marginal borrowers (also, here) even as the market tanks. It is in their mandate, which was modified with the Financial Institutions Reform, Recovery, and Enforcement Act of 1989. So, as the housing market continues to sour, Fannie and Freddie must continue to lend and churn out MBS bonds. This is a recipe of a major disaster.

I wonder how the federal government will play this one out. Stay tuned.

Ed Kim
Practical Risk Manager

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