AUGUST 5, 2008
AUGUST 2008 COMMENTS - REBATES AND REALTY, WHICH PREVAILS
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Recently the government tax stimulus plan has wound its way through the economy. Recession fears eased for the time being as the stimulus package increased spending somewhat. Still, a closer look at the numbers reveals some chinks in the armor. Disposable income in May was up a whopping 5.7% only to fall 1.9% in June. Tax rebates were largely responsible for the surge in May. More importantly, real personal income, excluding government transfers as calculated by NBER, was a negative 0.5% in June and has fallen four months in a row. While we muddle through this economic period, one has to wonder if the economy is heading for a quarter or two of negative growth.
- The culprit behind economic weakness is continued liquidity constraints caused by the sloppy lending standards of the past several years. The Wall Street Journal reported recently that banks have thus far written off $480 billion in this cycle and have had to raise capital to replace capital lost. Behind the write-offs are rising delinquency rates on loans. While subprime delinquencies seem to be finally peaking, both Alt-A mortgages, (loans that differ from conforming government sponsored entity (GSE) loans and are inherently riskier) and prime mortgage delinquency rates are moving sharply higher, (12% and 2.7% of total, respectively in April 2008). Clearly as these delinquencies fall into default or even foreclosure, banks' loans on non-performing status will escalate, increasing the pressure to raise more capital. Does all of this sound familiar? Recall the experience of the late 80's and early 90's when the terms "Southwest Plan" and "Resolution Trust" were widely used. In that period, greater than 500 banks failed and we experienced a recession in the early 90's. While this was only a young 18 years ago, we are now experiencing a similar situation to that era if not more widespread.
- We expect the economy to remain weak for many of the reasons above. The persistent downward trajectory in the underlying assets of many of these mortgages, mainly housing, will continue to dominate trends in economic activity into 2009. Some relief is being felt via the sharp drop in commodity prices and second quarter earning reports that have held up. Equity prices have adjusted significantly to reflect the expected economic weakness. The forward-looking nature of the stock market should begin to anticipate an economic turn well in advance of the actual turn.
- Background
The Federal National Mortgage Association (FNMA, or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac) are "Government Sponsored Enterprises (GSEs)" chartered by Congress that were formed in 1938 and 1970, respectively. The purpose of both of these entities, now publicly held, is, in general, to facilitate the functioning of the mortgage market.
Fannie and Freddie are huge. As Moody's pointed out on July 24, 2008, "The on-balance-sheet liabilities of the two mortgage finance companies total about $800 billion each, while their guarantee portfolios together total $3.9 trillion, bringing total liabilities and guarantees to $5.5 trillion. This is slightly larger than the existing federal government debt held by the public, which is $5.3 trillion [emphasis added]."
Both Fannie and Freddie had long been viewed by market participants as having an implicit guarantee of the U.S. Government, but this belief, until recently, was always discouraged by those in Washington . (In fact, among actively traded securities, only U.S. Treasuries enjoy the explicit "full faith and credit" guarantee of the U.S. Government.)
here has always been a 3-way conflict in the operation of FNMA and FHLMC-pressure by the Congress for "affordable housing" (with more credit risk), pressure from the regulators for appropriate capital and underwriting standards (less "affordable housing"), and pressure from other mortgage market participants-i.e. commercial banks--jealous about the preferred status of FNMA and FHLMC (lower borrowing costs, state tax exemption, etc.). Some suggest one of the principal causes of the current problem was a government decision in the early 1990s to raise the home ownership rate that was then about 64%, but rose to a peak of 69.2% in June, 2004.
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Current Situation
The combination of earlier governance and financial reporting issues at Fannie and Freddie, the weak housing and mortgage markets, a slowing over-all economy, and the "credit crunch" combined to cause market participants to question the financial soundness of the two mortgage giants. (The common stock of each entity is down in the area of 70% on a YTD basis.)
- The Government Solution
Shortly after 7AM on July 30 th , President Bush signed into law legislation that, among other things, is designed to restore confidence in Fannie and Freddie by tightening regulations and authorizing the Treasury Secretary to lend money or buy stock in the companies through 12/31/09 [emphasis added]. Thus, the government moved its former implicit guarantee closer to an explicit guarantee . This new authority is "open-ended" in terms of size (reportedly to prevent the market from "gaming" a fixed size), but specific in terms of duration.
Needless to say, short-term, this government action has calmed the markets. Going forward, there is still much to "play out"-will the economy and housing prices slowly stabilize and then recover, or will the U.S. Treasury actually need to spend money to support publicly owned Fannie and Freddie? The Congressional debate on the possible extension of this legislation in the Fall of 2009 should be a performance not to be missed.
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