Fannie and Freddie Get Naked

I was going to use the title “Fannie and Freddie are Frakked (as they say on Battlestar Galactica)” but the one I’ve finally chosen summarises what I want to say even better. And is likely to get more hits! 😉

The essential underlying problem with the US mortgage market should be obvious to anyone who uses Yahoo!’s US Finance pages. I have to say Yahoo! provide an excellent service though it’s a shame that their UK site has so many broken share price graphs, and lacks some of the facilities available across the Pond. I often think Yahoo!’s offerings have a certain nostalgic 1990s clunkiness that would make their business a good fit with (say) Microsoft. 😉

Perhaps I jest overmuch. I must be punch-drunk. Back to the serious business.

If you scroll down a little on Yahoo!’s US Finance home page, you’ll see a table of average mortgage rates. The average price today for a “30 Year Fixed”, for example, is 6.14%, whereas for a “30 Year Fixed Jumbo” it is 7.16%. What’s the difference? You may well ask. The point is that in the US smaller mortgages are cheaper because they can be sold to Fannie Mae and Freddie Mac – they are effectively underwritten by these institutions.

Alarm bells ringing yet? The difference between the cost of different mortgages should (on average) reflect (mainly) the risk (and costs) of default. Now, it seems to me that the risk of default is not higher simply because a mortgage is larger. In fact the whole sub-prime disaster suggests that the risk of default in the US mortgage market is higher the lower the amount of the mortgage. I would have thought buyers of larger mortgages are also more likely not to be first-timers, so are not only likely to have successfully paid a previous mortgage, but may also be borrowing less than the full value of the house they are buying. I don’t know if the Yahoo! data takes these factors into account by correcting for the credit rating of the mortgagees and comparing like mortgages (e.g. 90%). Nevertheless, there’s no reason for larger mortgages to be riskier and therefore more expensive than smaller ones. It must also be cheaper to administer $1bn worth of large mortgages than $1bn worth of smaller ones.

Now, the approximately 1% difference between the pure market rate of Jumbo mortgages and the distorted rate of regular mortgages is a lot. That is, Fannie and Freddie are in effect subsidising regular mortgages by charging too little for the risk. Clearly they have not put enough aside for a rainy day. I daren’t even calculate the value of the subsidy (it’s not 1% of the $5 trillion plus of outstanding loans, which would be a mere $50 billion, since the monthly payments are not 1% lower than what they should be, they’re 6/7ths of what they should be, and that’s before subtracting F&F’s funding costs). Obviously it depends on how much of the risk F&F have been able to pass on. But as far as I understand it, the whole caboodle (less any remaining shareholder capital) is underwritten by Uncle Sam.

The Empress and Emperor, Fannie and Freddie, are wearing no clothes!

No wonder the markets are spooked. There’s a lot I admire about the US. But I do not include in that category the effectively nationalised mortgage market – rather incongruous in the land of free enterprise, don’t ya think? – and the lack of effective gun control laws. But I suppose when the Yanks head for the hills at least they’ll be able to shoot rabbits.

I mentioned the “shareholder capital” in F&F a couple of paragraphs ago. I should say at this point that I do not agree with my new best blogging buddy (thanks to his views on biofuels) Professor Willem Buiter of the FT, when he writes that:

“Outright nationalisation, with the existing shareholders getting nothing… would be [a] fair and efficient option.”

though it’s clear that:

“Fannie and Freddie… are not viable as private institutions without a government guarantee for their liabilities.”

IMHO, the shareholders have been mis-sold and should be compensated.

Buiter is quite correct when he argues that the liabilities represented by F&F belong to the US Government. But fudging is their only policy option. Because the next focus of the crisis may be the US fiscal deficit and hence the dollar (it’s surely hardly the time to be thinking about increasing the deficit). Which could simply push up the dollar price of oil (particularly as “black gold” is taking over some of the safe-haven role traditionally filled by the metal itself) increasing the pain for consumers and indirectly depressing house prices further…

Time to clean the shotgun?

There are a lot of positive feedbacks in the housing market, so clear thinking is called for. The critical consideration is who carries the risk. Effectively concentrating the risk and assuming the state can bear the burden seems to me to be one of the worst options. At least the UK is trying to run down its Northern Rock mortgage book, though it would have been far preferable to allow this risk to remain private, as I pointed out at the time.

I vaguely understand why Fannie was created in the first place. But, once they’d stabilised the mortgage market, why on Earth did they underwrite new loans (and create Freddie in 1968)? Surely the correct policy was to run down the mortgage book and try to prevent another Depression? Keeping the cost of mortgages artificially low just inflates house prices.

11 months ago I thought the credit crisis would be “over by Christmas”. Now I fear years of trench warfare. A bursting asset bubble (created by a failure to take the pain of the previous one, the dotcom bust) has collided with an inflationary shock. The incorrect policies (it’s not just me – Ricardo Caballero at the FT also “gets it”) to address the first problem have exacerbated the second.

As Alan Partidge might say, the markets wanted the “bread” of liquidity, but were fed the “cake” of lower interest rates. They couldn’t digest the cake, so it’s being eaten by the breeding rats we call inflation! (As I said, punch-drunk!).

The correct historical parallel is not the 1930s or the 1970s. Our present difficulties embody elements of both crises. Every sign is that we’re going into a tailspin and have failed to meet the challenge. Now it’s just a question of how bad it gets. Everything depends on when the oil price peaks. Talk about eggs and baskets.