Debt Free

Reports are surfacing this morning that officials in the Bush Administration are meeting to determine the ultimate fate of the mortgage lending giants Fannie Mae and Freddie Mac. This is on the heels of reports from the financial press such as Bloomberg and the Wall Street Journal that the two federally backed corporations are, if not in trouble, at least feeling a bit queasy.

Much of the furor has been caused by statements by former (retired in March) Federal Reserve Bank President William Poole in an with Bloomberg yesterday, and an interview with Reuters at the end of June. In his Bloomberg interview, Poole indicated that Fannie Mae is upside down, owing more than their asset total. The fair value of FNMA's assets fell some 66%, as real estate deflation takes hold in many markets.

William Poole has a long history of criticizing the federally backed mortgage lending corporations, and as recently as last year called for revocation of their federal charters.

He is also of the opinion that continuing to cut interest rates, as the Fed has done for a while now, is not going to help the economy, but rather cause an inflation problem. Here are some quotes from the interviews:

"I think policy has been too accommodative and there is a substantial risk we'll see inflationary pressures more generally unless the Fed reverses."

"The longer they delay, the greater the risk it will get into inflation expectations and wages,"

"I would look for opportunities to raise interest rates sooner rather than later."

"If we pump up demand in these circumstances with expansionary monetary policy ... we'll end up with inflation rather than higher demand resulting in more output,"

"It is adequate at this time to say, 'We'll undo the emergency rate cuts, and define the magnitude (of that easing), and once we get there, we'll reassess the (situation)."

“Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer,''

``We know in a crisis the Federal Reserve tap would be open,''

According to past statements, Poole is of the opinion the the Federal Government will probably have to take over the two mortgage giants as the mortgage foreclosure situation worsens.

What does this mean for us little people? Well, current Fed Chairman Ben Bernanke feels that the two corporations should be used exclusively to back affordable housing loans. Could they be retooled to serve such a function? Possibly, then the majority of the taxpaying public could see more of their money used for subsidizing low income housing. Currently FNMA repackages about 23% of all U.S. mortgages as mortgage backed securities to be sold in the world's financial markets. One doubts that 23% of all U.S. housing could fall into the affordable housing category, so their allocation would be changing.

How much would it cost the American taxpayer and the economy as a whole if the two were to fail or require a massive government bailout to avoid failure? Currently they are much the same position as many banks. The security they're using is based upon a depreciating asset, in this case U.S. residential real estate. They posted a Q1 loss of over $2.1 BILLION against assets of $42 billion and an outstanding loan portfolio of about $2.7 TRILLION. If only 2% of their loans were to become uncollectable, that would consume all their capital.

As a reference, the current default rate for 8 quarter old loans originated in 2006 is about 6/10 of 1%. Nothing to be afraid of, right? Guess again. Looking at the 8 quarter old point for loans originated in 2000 – 2003 reveals that when those loans were 8 quarters old, their default rate was about .1 - .15%. Moreover, those loans have gone on to default rates of an average of 1%, trending upward. That would mean the newer mortgages are on pace to experience a 5% - 6% default rate, far beyond the point where Fannie Mae's resources would be exhausted. Guess who'll pick up the tab then? Where will all that money come from, anyway?