"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
(IF) original functions were to provide liquidity to the housing
market. After a mortgage lending institution (MALI) originated
a mortgage - say, $100,000 - IF would purchase that mortgage
from the MALI for a fee and hold the mortgage to maturity. The
MALI now had $100,000 to make yet another mortgage loan and earn
yet another fee. By the repeating of this process IF 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 IF 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!"
