Financial Crisis

[pete]

BBC News

In a dramatic move, US Treasury Secretary Henry Paulson announced the rescue plan on Sunday, before markets opened.

Between them Freddie Mac and Fannie Mae finance or guarantee nearly half of the outstanding mortgages in the US, and have lost billions of dollars during the US housing crash.

The rescue could cost the Federal government $200bn (£100bn) as it invests fresh capital into the stricken mortgage giants to keep them solvent.

Together, Freddie Mac and Fannie Mae own or guarantee about $5.3 trillion (£3 trillion) of mortgages.

But they have made a combined loss of about $14bn in the past year and officials were worried that they would no longer be able to continue functioning if such losses continued.

Big decision & can't say I understand the US mortgage market too much. Seems they buy mortgages from the retail banks who sell them to homeowners.

Seems to be similar deal to Northern Rock but apparently 30 times in scale.

[jinxy lilywhite]

You hit the nail on the head there. Their main problem is, is that all their loans and collateral is tied in to long term mortgages 30 years. Their reserves or deposits aren't big enough to cover expenses and liabilities. What they would of done was get a bridging loan to tie them over and then when they got the cash immediately repay the loan. The same would happen the next month and earlier in the year this would of been fine. However now with banks pulling the plug on inter bank loans the like of these banks are suffering.
You can see it here with PTSB trying to get people to open savings accounts with them so they can get sufficient funds to cover their costs.

[dahamsta]

If the US government goes any more left wing in their actions - rather than words - they'll need to start looking at collectivisation.

Dachas for the boys!

adam

[cheifo]

Seems like a case of "We don't want any Goverment interference until we scew things up and need a dig out."

[pete]

Dodgy elections, massive budget deficits & nationalising banks is a slippery slope...

The firms lost more than $3bn alone between April and June, resulting in a sharp fall in their share values

Seems there was a real fear those companies would go bust.

A bizarre system to have 50% of the mortgages secured by just 2 companies. Weird system too as apparently these were state companies until they were "made" private.

The most recent figures show that about 9% of US mortgage holders were behind on their payments or faced repossession.

I don't know what the usual rate is but 9% seems extremely high.

[jebus]

I don't know what the usual rate is but 9% seems extremely high.

I don't have any figures but anytime I've read about the US housing crisis in the media they have been calling it an outright panic so 9% could be accurate

[Macy]

Weird system too as apparently these were state companies until they were "made" private.

Just another example of the folly of privatisation.

[Dodge]

A bizarre system to have 50% of the mortgages secured by just 2 companies. Weird system too as apparently these were state companies until they were "made" private.

Answered yourself there, the official term is "privately owned, government sponsored"

[Closed Account 2]

I think 9% is about right... it's waaaay over that in some of the big Mid-West cities.

http://news.bbc.co.uk/1/hi/business/7070935.stm

This piece was about Cleveland almost a year ago - clicking on the map you can see Deutsche Bank seems to own half the property in the inner city to to foreclosures (re-possesions due to non payments)... it's only going to have got worse in the 10 months since.

I see the housing market going down globally up to Christmas 2009 at least.

[pete]

http://news.bbc.co.uk/1/hi/business/7070935.stm

This piece was about Cleveland almost a year ago - clicking on the map you can see Deutsche Bank seems to own half the property in the inner city

I remember seeing that before. Amazing map when you see percentage of sub prime mortgages. I think could see people jailed for fraud on that yet...

I heard recently that in some ways the US manner of quick drop (aka crash) could be considered better in the long run as they hit the bottom quicker so can move on quicker.

The Fannie & Frannie companies still confuse me. They were public but now private (they have shareholders) but they are mandated by the state to guarantee mortgages. They also created a second one to give the original some competition. Weird quasi-private-duopoly

[Stuttgart88]

Pete,

I’ve long maintained that these GSEs (Government Sponsored Entities) were an extraordinary contradiction in that on one hand their presence facilitated an uber-capitalistic / free market approach to mortgage finance, yet at the same time their sheer scale as de facto state institutions were probably on a par with communist-era agencies in Russia. This fascinates me as the US holds itself up as a devotee of free markets yet in trade and the banking markets it’s ultimately shown up as being as interventionist as anyone.

What did Fannie & Freddie do?

They allowed mortgage lenders (think AIB, BOI, IL&P, IIB, EBS etc. in Ireland) to originate (i.e., source new loans) without ultimately holding these loans. However, taking Ireland as an example, a bank would typically source these mortgages through its branches, and continue to own them or pass them on to the debt markets by way of “securitisation” - however, the key difference is that an Irish bank would continue to collect payments and do all the administration of these loans – what’s called “servicing”. This servicing also includes the working out of problem loans, initiatin & executing foreclosure etc.

Freddie & Fannie bought mortgage loans and bundled them up into larger pools and sold them to US pension plans, insurance companies and other long term bond investors. In recent years more and more of these bonds were sold to China & Asian central banks who had massive dollar reserves because of their exchange rate policy and trade surpluses with the US.

These agencies therefore allowed for the mortgage market to disaggregate all the component parts of a mortgage loan during its life cycle. A cohort of originators would source the loans, special companies were set up to service these loans and the agencies ultimately financed these loans over their life.

I think I heard that 50% of all US mortgage loans were financed by Fannie & Freddie.

One other key difference between the US mortgage market and those in Europe is that borrowers take out fixed rate mortgages as the norm, but can prepay these mortgages without penalty. This is because there is a huge market in the US for trading US interest rate risk and Fannie & Freddie were an integral part of facilitating this. Because their debt was considered free of credit risk (!) the risks in owning their bonds - and hence what determined how their value changes - was that they paid a fixed rate but when you were actually repaid depended on how quickly or slowly all the underlying mortgages were repaid.

In Europe there are also sophisticated markets for trading interest rate risk but buyers of fixed rate bonds in Europe are far less keen on assuming this type of risk. For this reason, most (but not all) of the mortgage securitisation products in Europe are based on floating rate mortgages and are* financed by debt investors by way of floating rate bonds. Therefore, the speed of repayment of the underlying mortgage loans was less of an issue in the european capital markets.

*I should probably say “were financed” as the natural buyers of European mortgage bonds were banks (which have funding & capital issues) and “the shadow banking system” – an opaque series of bank-like special purpose asset management vehicles that were set up to be on the brink of accounting & capital rules but which blew up spectacularly in 2007 & 2008. In the US the natural buyers of mortgage bonds were longer term buyers like insurers or pension plans that bought long term assets to match long term liabilities. In Europe, this type of buyer was far less keen on buying structured credit assets, typically preferring government bonds & corporate bonds for their bond portfolios.

Now it's all kicking off this morning: Lehman files for bankruptcy, Merrill Lynch bought by Bank of America (a commercial bank), AIG the world's largest insurer on the ropes and Washington Mutual, a large retail and mortgage bank on its knees. Other household names are subject to rummours too. Scary stuff...

[pete]

Pete,
What did Fannie & Freddie do?

Good post, think some of that makes sense.

I knew already that US mortgages were fix rate for the term. I think this is why it is more difficult to move lender.

Whatever part of the political spectrum you come from it is not good to have 50% of all mortgages secured by two companies. I wonder is there any chance the US will in time when things more stable sell off the Frannie/Freddie debt & let the market look after...?

Now it's all kicking off this morning: Lehman files for bankruptcy, Merrill Lynch bought by Bank of America (a commercial bank), AIG the world's largest insurer on the ropes and Washington Mutual, a large retail and mortgage bank on its knees. Other household names are subject to rummours too. Scary stuff...

Lehman Brothers file for bankruptcy

AIG apparently has a "bridging loan".

When was the last time such a collapse has been seen?

Pension statement will be "interesting" next year.

[Stuttgart88]

When was the last time such a collapse has been seen?

ICI?

In due course I expect Fannie & Freddie will be run down, old assets falling off their books will not be replaced. They'll shrink naturally and will ultimately be replaced by one state sponsored entity fulfilling a social mandate to make sure there's a functional mortgage market for less well off families (like Lehman employees .

[OneRedArmy]

Unlike say Bear Stearns or Northern Rock, there was always an implied guarantee of Freddie and Fannie by the US Government so they really had no choice but to honour this.

The core problem is the NINJA and other similar loans that really should never have been approved. This was caused as a result of remunerating mortgage brokers and investment bankers (who re-structured and sold on the products) on short-term sales goals, rather than quality or performance goals.

If you take it up a stage further, you would have to question the Anglo-Saxon mentality that home ownership is a right rather than a privilege. Fannie and Freddie were set up to further this objective but somewhere along the way absurdity took over and nobody questioned the Emperor's (played by the NINJAs) nudity. It shouldn't take a rocket scientist to point out that people without an income probably aren't a good bet to make a payment every month for 35 years!

I'm surprised that its taken so long for the unravelling down the chain to reach this point, obviously markets weren't as efficient as we thought!

Though it is good to see the US finally realise that they haven't re-written the economics textbook and that constant interest rate reductions aren't the panacea for all ills. I can't see Alan Greenspan being deified as much as he has in the past.

Also good that they are letting Lehmans fail. Otherwise we'd be straight into a Japan in the 90's situation which is the economic equivalent of putting your fingers in your ears and humming..

Short-term pain (and we are only feeling the start of it) is the only way to realise long-term gain.

[Reality Bites]

A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.
Mark Twain

[OneRedArmy]

A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.

Mark Twain

Fairly accurate!

Its because banks have never really been able to assess the risk of their assets over anything other than a very short-term. Not an excuse, but it is somewhat of a Holy Grail in banking as pro-cyclicality ("over"-lending in the good times, "under"-lending in the bads times) is clearly sub-optimal from a performance perspective as it produces very cyclical profits, when the markets much prefer steady earning.

Basel II was supposed to help reduce pro-cyclicality but whatever about achieving its other aims of capital transparency and adequacy, it hasn't achieved this one.

For those in the risk modelling world, the events of the last 18 months are great as they provide lots of data to refine the models that err, didn't work as well as they might have!

[Stuttgart88]

Are you in risk management?

Last week’s Economist ran an interesting piece on bank capital regulations, citing recent academic research presented to central bankers at Jackson’s Hole. Taking a contrarian view on bank capital, the authors suggest that less capital is better for banks. The scarcer it is the more respect they treat it with, the more they have the more likely they are to waste it.

(In fact, when people ask me for a short description of what caused all this mess I say it’s the same: money became too cheap & too plentiful, so people both lent it and borrowed it without proper care.)

Nominally most of the banking system is still well capitalised but banks are hoarding capital in fear of being punished by the investor market for publishing weak ratios.

Pro-cyclicality is a tough one.

Whatever about the top of the financial tree (regulation, disclosure, capital requirements, quality of management etc.) I’m firmly of the view that if there was tighter regulation at the bottom of the tree – by this I mean overseeing the scurrilous & fraudulent mortgage lending that occurred on the ground – a lot of the contaminated collateral would never have entered the wholesale system. If it wasn’t mortgages it’d have been something else though I’m sure.

[OneRedArmy]

Are you in risk management?.

Yes, mostly on the quanty credit risk side now but previously in op and market on the consultancy side.

Last week’s Economist ran an interesting piece on bank capital regulations, citing recent academic research presented to central bankers at Jackson’s Hole. Taking a contrarian view on bank capital, the authors suggest that less capital is better for banks. The scarcer it is the more respect they treat it with, the more they have the more likely they are to waste it.

(In fact, when people ask me for a short description of what caused all this mess I say it’s the same: money became too cheap & too plentiful, so people both lent it and borrowed it without proper care.)

Even very bright people have a habit of forgetting history very quickly. They assumed spreads of 10-20bps were "normal" and would continue indefinitely. Look at ISTC, Northern Rock and everyone else that relied on market funding, these were businesses whose whole business model was squarely built on ready access to limitless amounts of capital at a very low risk premia. Yet historically, none of the above conditions has ever persisted for any sustained period.

Whatever about the top of the financial tree (regulation, disclosure, capital requirements, quality of management etc.) I’m firmly of the view that if there was tighter regulation at the bottom of the tree – by this I mean overseeing the scurrilous & fraudulent mortgage lending that occurred on the ground – a lot of the contaminated collateral would never have entered the wholesale system. If it wasn’t mortgages it’d have been something else though I’m sure.

Absolutely agree. There is huge moral hazard when you disintermediate the origination and ongoing management of the loans. The broker is incentivised purely on quantity, therefore seeks to pile 'em high, don't worry about the quality..... We have lots of previous examples of misselling other products, endowments, private pensions in the UK etc because of the sales commission-based remuneration structure.

Taking it further the originating bank has an incentive to get it off the balance sheet quickly to be able to lend more and the investment banker has an incentive to slice it and dice it into CDOs etc. and make sure as many tranches get as good a rating as possible from the ratings agencies. So thus far nobody is being remunerating on quality of loans! That notwithstanding, this is all fine and well if the owner of the risk can
1) value the risk
2) bear the risk and crucially
3) there is transparency as to what each counterparty is holding.

We now know the risks were not valued correctly by either banks own models or the ratings agencies, but even worse, nobody knew who had the parcel when the music stopped. The lack of transparency drove the fear mentality and arguably it was this fear that killed Bear Stearns (although they died of shock its possible the burns, ie the losses, would've killed them anyway later on, but thats a moot point at this stage).

[Newryrep]

As has been stated before

If you owe the bank 200,000 its your problem

If you owe the bank 200 million its their problem

[Reality Bites]

As has been stated before

If you owe the bank 200,000 its your problem

If you owe the bank 200 million its their problem

Sean Dunne