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| Our Worst Nightmare….the Housing
Bubble |
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Another one of my long term subscribers wrote
me recently with his insights on how Fannie Mae and Freddie
Mac have transmogrified the offering of simple mortgages into
something one would expect to find at a Las Vegas casino.
Their financial innovations have facilitated the growth of
home ownership on one hand but have set up America for a financial
meltdown should the Fed increase interest rates beyond the
tipping point. All this begs the questions "Are we there
yet?" "How many more increases before the house
of cards come tumbling down?" With at least two more
increases expected in the first half of 2006 this could well
be the year. Below are my subscribers’ comments.
“Our Worst Nightmare - the Puncture
of the Current US Housing Bubble”
”The key to holding up the entire speculative
US financial system with its current excessive levels
of debt - federal (current account and trade), state, municipal,
corporate and household – is
maintaining the U.S. housing bubble. Anything less would result
in America’s worst nightmare
and, in short order, the entire world.
The housing market is dominated by Fannie Mae and Freddie
Mac who hold 75% of all outstanding home mortgages (and the
Federal Home Loan Bank Board to a much lesser extent). One
too many additional increases in the Fed rate may well turn
out to be the U.S. economy's Achilles' heel and lead to a
major crisis at these two institutions generating an out-of-control
systemic breakdown situation and disastrous financial implosion.
Here's why. Fannie’s and Freddie's (FF)
original functions were to provide liquidity to the housing
market. After a mortgage lending institution (MLI) originated
a mortgage – say, $100,000 - FF
would purchase that mortgage from the MLI for a fee and hold
the mortgage to maturity. The MLI
now had $100,000 to make yet another mortgage loan and earn
yet another fee. By the repeating of this process FF injected
liquidity into the housing market making it possible for MLIs
to increase the number of mortgage loans they could make each
year and earn considerably
more fees in the process.
Where did the money come from for FF to raise
money to purchase these mortgages from MLIs? It was easy.
FF simply issued bonds (which, as you know, are a form of
debt) at a somewhat higher interest rate which was their spread
or profit. The more mortgages they bought from the
MLIs covered by the issuance of their bonds the more money
they made. And it was all totally
secured by the assets of the houses themselves. A risk free
arrangement. Not bad. The MLIs
made money, FF made money and the consumers owned houses on
which they could afford to make their monthly mortgage payments.
Beginning in the 1980's FF got greedy! They
began to encourage the MLIs to sell mortgages to
purchasers who would have to spend more than the U.S. Department
of Housing’s recommended
28% of gross income to service the housing (mortgage payments,
home insurance payments and
home property tax due) costs involved. As FF expected the
demand for houses went up, the
price of houses went up, the number of mortgages went up,
the size of mortgages went up, the
profits of the MLIs went up and the profits of FF went up.
But the degree of financial risk for FF
increased dramatically. Many mortgagees had to pay out 50-60%
of their household income in
housing costs and were extremely vulnerable to any economic
setback they might encounter - loss of job; increased cost
of living; health problems; death, incarceration or illness
of breadwinner. As a result, the rate of delinquencies and
foreclosures went up. In many cases
the down payments made by these new mortgagees were so small
that the only way FF
could recoup its outstanding mortgages was if the resale prices
of the homes appreciated considerably from the date of the
initial purchase. The greater the appreciation of such homes
the less the risk to FF.
Next, in the unending search for increased profits,
FF undertook some financial innovation. They
began bundling groups of mortgages together as mortgage backed
securities (MBS) on which
they guaranteed, in case of default, to pay interest and principal
“fully and in a timely fashion”.
They sold these MBSs for a fee, to mutual and pension funds
and to insurance companies
around the world. This gave the funds a claim to the underlying
principal and interest stream of
the mortgage. In doing so the risks entailed in the owning
of mortgage debt were broadened
beyond FF. If FF were unable to fulfill their guarantee (and
the monies provided by the
government are totally inadequate) these funds, too, would
be adversely affected and depending
on the extend of the default, gravely so. FF's profits went
up but its reward/risk ratio dropped like a stone!
And finally, to squeeze out even more profits,
FF began taking 50% of their MBS holdings and
pooling them once again into derivative instruments called
Real Estate Mortgage Investment Conduits, i.e."restructured
MBS" or into what are called Collateralized Mortgage
Obligations for which they are paid a fee. These instruments
are highly specialized derivatives, i.e. bets on the direction
of future rates of interest. FF's profits went up even more
but the risks associated with these actions became excessive!!
Thus, what started out as a simple home mortgage,
has been transmogrified in to something
one would expect to find at a Las Vegas gambling casino. Yet
the housing bubble now depends
on precisely these instruments as sources of funds.
If too great a portion of FF mortgages were
to go into default and cease to pay interest or principal,
FF would not have sufficient cash to pay the holders of its
bonds. If the situation
were to become too great FF would default on its bonds. So,
whereas before one had one
economic catastrophe - the default of some mortgages –
because of the way the housing
market is structured, this produces a second catastrophe –
the default of FF’s bonds which
are at least 10 times greater than that of any corporation
in the U.S. Such a default would put
an end to the U.S. financial system, right then and there.
Yet a second obligation compounds the problem
- its guarantees on the MBS. In a crisis in the housing mortgage
market, FF would not be able to meet the terms of their guarantees
and would go bankrupt from this source, if it had not already
defaulted on their bonds. The pension and
mutual funds which had bought the MBS on it guarantees, would
suffer tens of billions of
dollars in losses.
Finally, FF's derivative obligations in hedges,
allegedly to protect it from risks, could themselves
go in to default against the banks and other counter parties.
The above mentioned obligations of FF total
over $5 trillion. Another $1 trillion in obligations
are held by the Federal Home Loan Bank Board and private issuers
of MBS. These $6 trillion
in risky obligations are distinct from, and in addition to,
the more than $6 trillion in mortgages
themselves. As such, a total in excess of $12 trillion is
laden on to the homes and attached to
to the incomes of America's homeowners. And then there is
credit card debt, car lease debt, cell phone contract debt,
bank loan debts, margin debt, etc!
Nothing, absolutely nothing, must stand in the way of consumers
fulfilling their financial obligations - and they absolutely
must not default on their mortgages. Cheap money must prevail.
Not dirt cheap like before but still very cheap by historical
standards. Cheap money is necessary to keep the real estate
bubble in force because consumer spending increases 0.62%
for every 10% gain in the housing market (more than twice
that of a 10% gain in the stock market).
Regretfully, though, this FF house of cards
is on the verge of collapse. Bond prices have fallen and interest
rates are approaching 5%. The ramifications are dire.
A wide variety of partners hold large chunks
of FF debt: commercial and investment banks, hedge funds,
mutual funds, pension funds, insurance companies, private
investors. They are all exposed to large losses were either
Fannie Mae or Freddie Mac to default on their debt. In the
U.S., for example, 60% of all banks (approx. 5000) own FF
debt in excess of 50% of their equity capital. As the Office
of Federal Housing Enterprise Oversight has said "such
an event as the default of FF debt could lead to contagious
illiquidity in the market for those debt securities which
would cause or worsen illiquidity problems at other financial
institutions .... potentially leading to a systemic event."
The Fed is between the proverbial 'rock and
a hard place'. They engineered low interest rates in the first
place, both to keep the financial markets going, and in large
measure to keep the housing bubble afloat. They are now in
the final stages of raising interest rates to prop up the
collapsing US dollar and to forestall rampant inflation. Were
they to initiate one quarter percent increase too many it
would destroy the interest rate environment that is essential
to keeping the housing bubble alive; to keeping consumers
spending at a high level thereby keeping the economy growing;
to keeping corporate sales and profits high thereby keeping
the stock market healthy. Have they gone too far already?
The bubble seems to be loosing air slowly at this point but
what will the impact be of the next increase? The impact of
one too many rate increases on such a chronically debt-ridden
and maladjusted economy must not be over estimated.
It is just a matter of time before further increases
in mortgage rates will result in increases in monthly mortgage
payments than some borrowers can not handle. This will be
particularly so for borrowers of sub-prime loans who were
able to purchase their first homes with almost nothing in
the way of a down payment and who, even now, have a delinquency
rate at near record levels. In addition, as mortgage rates
rise further, fewer first-time buyers will be able to afford
to buy a home which will, in turn, slow down the sale of new
and resale homes.
With further increases in mortgage rates there
will be dramatically reduced refinancing of mortgages which
have gone a long way to financing the retail boom in retail
sales over the past few years. Indeed, more than $500 billion
in equity has been withdrawn annually in the US and $29 billion
annually in Canada for that purpose.
But rest assured the Fed will do absolutely
everything in its power to prevent the puncturing of the housing
bubble!
FF assets have expanded so rapidly over the
past few years due to the number of mortgages,
the escalating value of mortgages (as a result of escalating
real estate prices) and the
refinancing of mortgages and they have so much debt in the
form of mortgages, bonds, MBS’s and derivatives that
should they encounter any problems servicing the debt it most
likely will have a destabilizing effect on the US economy.
Indeed, the Fed are so concerned about this
happening they are flooding the economy with almost limitless
liquidity. There must be a crisis of historic proportions
coming, and the Federal Reserve Bank of the United States
is making sure that there is enough liquidity in place to
protect our nation's fragile financial system. The amazing
thing is that the Fed's actions mean they know what is about
to happen.
What could it be?" Perhaps the Fed finally
recognizes that the housing bubble has experienced a leak
that could well escalate into major proportions soon. Perhaps
the Fed has learned that one (or more) of the 3 American banks
holding 95% of U.S. derivatives are experiencing some difficulties
managing their risks. Perhaps the FF are encountering major
derivative losses once again. Perhaps the Fed are concerned
that the rising budget deficit and/or the ever increasing
and already record-high current account (trade) deficits are
very near the tipping point. Perhaps it is their fear that
the recent and continuing interest rate hikes are going to
have a very negative impact on the already overly indebted
U.S. consumers (rising mortgage, lease and credit card rates),
the stock market (lower corporate profits) and the bond market
and lead to a recession. Perhaps the Fed sees their greatest
fear of all - deflation - just around the corner.
So where should we be investing our money? Certainly
not in real estate. Definitely not in bonds. Absolutely not
in the general stock market. What’s left? Well, there
is cash (at least you won't lose your shirt if you hold it
in something other than U.S. currency); gold bullion which
performs well in such a chaotic environment (and by extension
mining company shares and/or their warrants) and also energy
stocks because of the political climate being the way it is
in the Middle East. Pay off your debts, build up your savings
and invest accordingly and you will be protecting yourself
from what could well become our country's (and the world's)
worst nightmare and enjoying sweet financial dreams for years
to come. Good night and God bless!”
While these are not my words, many of us share
these views.
Please note: the CEO of Freddie Mac disagrees
with the assertions made above. See his comments at http://news.yahoo.com/s/nm/20060125/bs_nm/financial_freddie_dc_1
“Freddie Mac poses no special systemic
risk: CEO - Yahoo! News.”
You be the judge as to the merits of both.
January 31, 2006
Dudley Baker
Email: info@preciousmetalswarrants.com
Website: PreciousMetalsWarrants
*****
PreciousMetalsWarrants.com is not an investment advisor and
any reference to specific securities does not constitute a
recommendation thereof. The opinions expressed herein are
the express personal opinions of Dudley Baker. Neither the
information, nor the opinions expressed should be construed
as a solicitation to buy any securities mentioned in this
Service. Examples given are only intended to make investors
aware of the potential rewards of investing in Warrants. Investors
are recommended to obtain the advice of a qualified investment
advisor before entering into any transactions involving stocks
or Warrants.
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