An Armageddon Aptly Avoided (Volumes 1 – 4)

To properly start this newsletter, allow me to quote myself from my last newsletter:

“Everyone is all up in arms about Fannie Mae and Freddie Mac.  The big concern on Wall Street is that these two mortgage giants are going to collapse under the weight of all these bad loans that they have been accumulating over the course of the past five years.  If they did happen to close their doors, it would cause a catastrophic chain reaction across the mortgage, finance and real estate markets that would wreak havoc the likes of which our country hasn’t seen in some time.  And the sky would fall on our heads.”

Well, our worst-case scenario has come upon us, and has promptly been answered by the government.

As you’ll recall, Hank Paulson got a bill approved granting him all sorts of authority and money to bail out these two institutions should they fail.  To use Hank’s own words, “When you have a bazooka in your pocket and everybody knows it, you probably won’t have to use that bazooka.”  The assumption was that investors would see the back-stop as a safety net and start investing more in the compa­nies…making them have no ultimate need for a safety net at all.

The plan, it appears, was better in theory than in practice.

So, when foreign investors didn’t immediately come flocking back to the American mortgage-backed securities market, the proverbial bazooka needed to be used.  This Sunday, the government officially took over Fannie Mae and Freddie Mac.  Though they were adequately capitalized by regulatory stan­dards, their cash on hand was described as “thin”.  So, Big Brother sent his men in black suits to seize the whole operation.

You have no idea how long I could talk about this.  In my industry, this is mega-huge.

But one thing I have learned through my blogging is that you, my faithful readers, have short attention spans.

So, I’m gonna break this event down into bite-sized pieces over the course of this week.  Keep your eyes open for daily updates on how this decision will rock financial markets both locally and globally.

Never a dull moment for us mortgage people.  Talk to you tomorrow!

For Volume 2…

So Greg, why did the U.S. government take over Fannie Mae and Freddie Mac and what changes are being made?

Well Greg, that’s an excellent couple of questions.  The Fannie and Freddie takeover was not brought to fruition because of their capital reserves falling below some sort of magical threshold.  The trigger was pulled because there was an “increasing danger of systemic risk.”

You see, foreign investment in mortgage-backed securities is a central element in keeping the entire home finance industry going.  Recently, and for the 1st time in over a decade, the Chinese and Japa­nese (usually huge fans of our mortgage debt) became net sellers of these securities.

Basically, the audience we were performing for was walking out the side doors and we wanted to keep the party going.  We needed to do something big to reclaim the lost enthusiasm for this investment product.  And we did, by placing the full faith and credit of the U.S. government behind both compa­nies.

So, the implicit, unspoken and otherwise assumed guarantee that the government would financially prop up these companies in the event of extreme circumstance has finally manifested.  That means that Uncle Sam now has the authorized ability to purchase as many mortgage-backed securities as he likes and can extend a dang-near infinite credit line to Fannie and Freddie to make sure they have all the money they need to function properly.

So far, it’s resulted in a renewed hunger for mortgage-backed securities across the entire investment community, which has caused mortgage interest rates to come plummeting downward for the past two days.  While the squeaky clean borrowers have a very good reason to rejoice, it is this author’s estima­tion that an already tight lending environment is going to get even tighter for marginal borrowers.

The last thing that Fannie and Freddie’s new owners want to do is purchase more bad loans.  So, in an effort to “play it safe”, they will doubtlessly adjust qualifying guidelines to allow only the most credit-worthy of clients to borrow any funds.  This will force lenders to scrutinize potential mortgage clients even more than present standards to stay within compliance.  So, this is as good an excuse as any to get to work on cleaning up that credit report.

So how is everyone reacting?  That, my friends, we shall save for tomorrow’s newsletter.

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Volume: 3

By this point in the newsletter tirade, you may ask yourself how much you really care about Fannie Mae and Freddie Mac.  I mean, when’s the last time you even heard a question about them on Jeop­ardy?  Or even had some random guy standing next to you in line at Subway say “How’s about that Fannie Mae, huh?  Real doozy.”  So what is up with Greg’s infatuation with these companies’ futures?

It’s the ripple effect that this historic governmental takeover has on financial markets.  These are the market fluctuations that directly impact your own taxes, borrowing rates and investment yields.  And I’d venture to guess that you care at least a teensy bit about your personal financial situation.

So, what significant has happened since the big announcement?

The dollar’s value has steadily increased.  This implies, amongst other things, a renewed confidence that any sort of worst-case American housing market collapse scenario has been effectively avoided.

Mortgage-backed securities have enjoyed a strong boost in demand from local and international inves­tors.  This means mortgage rates have been dropping like a rock.  In fact, FHA 30 year fixed mortgage rates hit 5.75 today (5.918 APR).  Yes, I actually quoted a rate in my newsletter.  You know this is a big deal when I quote rates.

All 30 stocks that comprise the Dow Jones Industrial Average were up within the 1st hour of the trad­ing day on Monday.  Now, plenty of other factors have since caused a bunch of changes in those stocks, but the knee-jerk reactions to the news of the weekend takeover was overwhelmingly positive.

Paul MacCulley, the managing director of Pimco, a leading global investment management firm and bond giant, stated on CNBC that mortgage availability is at the epicenter of America’s economic slow­down.  He endorsed the bold move by the U.S. government and expects it to increase the supply of mortgage money on the market.

Barack Obama and John McCain <gasp> basically agree with and support the takeover.  While they do differ on how they think the plan should be maintained long-term, I’m just going to enjoy the fleeting sense of unity this issue has brought to our presidential campaigns.

Tomorrow we’ll discuss who will be picking up the bill for this bailout.  Spoiler alert -  there is a very good chance that it’s going to be you and me!  Super fun!

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Volume 4

So, Uncle Sam swoops in and financially back-stops Fannie and Freddie.  And it takes a whole lot of money to do so.  And Uncle Sam is financed by somebody……

Oh right.  Us.  The taxpaying, hard-working citizens of the United States.

So who IS paying for this massive takeover and the bad assets that come along with it?  And how much is the whole ordeal going to cost?  Well, nobody really knows.  There is no price ceiling that has yet been attached to the whole project.

This situation could play out in one of two ways:

Best case scenario: confidence is renewed in the American real estate finance industry.  Local and in­ternational investment in mortgage-backed securities continues to flourish, driving up the value of the assets that Fannie and Freddie owned.  And, since Uncle Sam now owns those assets by proxy, the whole thing pays for itself and allows legislature an ample sum of time to determine the best long-term strategy for these two mortgage giants to continue doing business and not repeat the fiascos of the past.

Worst case scenario: confidence is not renewed in the American real estate finance industry.  The as­sets on Fannie Mae’s and Freddie Mac’s balance sheets continue to deteriorate, financed solely by upwards of 200 billion in taxpayer dollars.  We the people get slammed upside our heads with a huge tax bill as penance for our loose borrowing habits and even looser repayment habits in years prior.

And, of course, neither of these scenarios takes into account the potential for moral hazard.  By that, I mean that other big and failing companies (like General Motors or Lehman Brothers) would expect handouts when they experience trouble, further burdening our fine country’s balance sheet.

The truth is, reality will fall somewhere in between these scenarios.  Sadly, they are both better options than allowing the government to stand by and let the support pillars of our home finance industry crumble.  Regardless, we can effectively eliminate a complete housing collapse from the pool of op­tions, and that alone should have everyone breathing a sigh of relief.

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