Fannie and Freddie get burned

Floyd Norris at the International Herald Tribune is beginning to realise that the credit crisis is oh so much more than a sub-prime crisis among low-income borrowers. Welcome to the party, Floyd.

"It's not just subprime anymore," he writes. "Freddie Mac, the US government-sponsored mortgage lending enterprise, said this week that enough borrowers were defaulting on loans made this year or last that it needed to mark down the value of the loans by $US1.2 billion. How many of those loans were sub-prime? None. But that does not make the losses any less real."

Nope. The losses are mounting for banks and mortgage lenders from the East coast to the West, and everywhere in between. "The virtuous circle of 2005 clearly made the economy appear stronger. Easy credit helped raise home prices. Rising home prices made it appear that loans to risky borrowers were safe and encouraged people to take out new loans to finance consumption. That spending helped the economy grow and persuaded companies to hire."

A bubble makes everyone feel richer. And even if that feeling has no connection with reality, it's enough to keep the thing going until something changes. Something has changed, Norris says.

"Now we face the threat of the opposite, vicious, circle. Tight credit puts downward pressure on home prices. Lower home prices make it harder to refinance mortgages even for those with good credit, and discourage spending. That can cut corporate profits and lead to layoffs."

The latest trouble with Fannie Mae and Freddie Mac is especially troubling. Why? Those two firms exist as secondary mortgage lenders. That is, they buy mortgages from primary lenders to facilitate the orderly function of the US mortgage market, especially the provision of mortgage loans to people who couldn't otherwise get them. Banks and other primary lenders are comfortable originating loans as long as they know they can sell that loan (and pass the risk buck) to a Freddie or Fannie. All the profit, none of the risk! What a deal! What a country!

Now, needing to raise more capital and realise loan losses, Freddie and Fannie will be a lot less active in buying mortgage loans from primary lenders. Besides, Freddie and Fannie already face limits from the Congress on how much and what kind of loans they can buy. It is not pretty.

But anyone who was willing to look at it dispassionately could have seen it coming. The GSEs sell bonds to institutions in order to buy mortgages in the secondary market. With borrowing costs up, the GSEs will see further erosion in their profit margins. And none of this takes into consideration the quality of the subprime backed bonds the GSEs have on their own balance sheets. It used to be that only their accounting policies (or lack thereof) were doubted. Now, asset quality at the GSEs is a real issue too.

Ugh. There are a lot of moving parts to this credit crisis story. But at heart, it's simple. There's a bear market in credit. The leverage that allowed people to amass huge paper wealth when interest rates were low is costing them now. To unwind all those levered bets, assets will have to be sold and bad investments liquidated.

You might call that a bear market.

Dan Denning
The Daily Reckoning Australia