Monday, September 08, 2008

What Will The Candidates Really Do?

The Treasury Secretary of the United States took over Fannie Mae and Freddie Mac over the weekend. Last week, Pimco, a huge bond dealer, refused to buy anymore of the short term paper of either agency. Privately, both the Russian and Chinese Government buyers had also called the Treasury. Secretary Paulson already had decided that both institutions were too big to fail, that these two institutions going under would do extensive damage to the capital markets here and throughout the world.

There are thousands of questions that remain, starting at Treasury itself. By taking over these two institutions, the implied government guarantee is now explicit. This means that you the American taxpayer, if you are an American taxpayer, are essentially guaranteeing the mortgage pools issued by these institutions, even those stinky subprime loans. Wayne Angel, a former Fed Governor, said that they would need deeper capital reserves in the future. One estimate is a minimum of $200 billion.

The capital markets rejoiced today. Credit speads narrowed (take the yield of the Freddie Mac 10 year bond and divide it by the Trasury 10 year yield. As the spread narrows, things are getting better; as it widens, things are getting worse). Bank stocks soared. Fannie and Freddie both dropped to $1 per share since their stockholders will lose everything.

The average person gets almost nothing from this. Mortgages will get cheaper, but the price of houses won't necessarily stop dropping. You need more qualified buyers, and the banks aren't going to make it easier to get a mortgage. The people who are underwater because the price of their house is now below their mortgage will still be underwater. The people who are being foreclosed will still be foreclosed.

Earlier today, Senator Jim Bunning, Republican of Kentucky called the Treasury's move Communism, the state takeover of the Housing Industry, in essence. I'd have thought it was Socialism, but I'm not a U.S. Senator.

To see how the individual makes out, you must take a long term view, and understand the original mission of both Freddie Mac and Fannie Mae and why they were created. I will try in very short order.

Originally, special banks called savings and loans paid higher savings rates to savers to get capital, and they made mortgages to people to buy houses. They held the mortgages until people paid them off. The average life of a mortgage was 6 years and 10 months. In that time, in a self-amortizing mortgage (you paid a little principal and mostly interest so after 30 years you actually paid off the mortgage) you paid mostly interest and then paid the bank back the principal. You might be refinancing to get some cash out, you might be moving, but you typically refinanced.

The bank had to maintain a reserve to service the depositors, who might want to make a withdrawal now and then. The reserve proves to be a limit on what a bank can lend. There is also a reserve for losses, assuming that some loans will go bad, the underlying real estate secured, and then sold to reacquire the capital. Works fne except when the value of the real estate drops.

Now, what if there wasn't enough money in the savings and loan system to finance the number of people who wanted houses? With the modern miracle of computers, you can create an underwriting matrix, or in plain English, a computer system that runs 80 tests or so on a mortgage application, including income ratios and expense ratios, if you have a telephone, etc. And then the computer can buy the mortgage from the savings and loan offering it.

The computer could buy tens of thousands of conforming loans, loans that conformed to the rules that the institution established that buy mortgages. The S&Ls wanted the deal, they get a 1% servicing fee for collecting the monthly payment on the mortgage, plus they got the discounted present value of the mortgage (dig that fancy finance lingo, it means what the mortgage is worth today).

The institution then forms a pool of mortgages that is geographically distributed, etc. The pool will yield an average reflecting mortgage risk in the country. Shares are sold on the pool to institutional investors. As long as there is a spread of 16 basis points (0.16%), the institution will make money. The process is called securitization, the institution could be either one of the companies, since putting more money into individuals hands to buy homes was the goal. Ultimately, it still is. It's just hard to see.


Mel said...

I don't mind telling you that I keep myself relatively oblivious to stuff like this.
Probably not wise....huh?

Sooner or later I have to cast a vote for someone who stands for something.


This is the most important election in my lifetime yaknow!

The CEO said...

Hi Mel, neither candidate could really have the depth of understanding for this problem, and that includes the current President of the United States. Gov. John Corzine of N.J. ran the fixed income section of Goldman Sachs, before running Goldman Sachs, then going to the Senate for N.J. Yesterday he said that the problems were so complicated that they were difficult to understand. I just tried to simplify the top of it for those who might be interested. What's really important are the people that get put into the Cabinet.

M@ said...

To call oligarchy socialism is a bit of a stretch. If they didn't have such a big market share, it wouldn't be a problem. Most analysts say it had to be done.

M@ said...

Perhaps next the government can bail me out for a little debt of my own. The capitol markets would love it!

Glamourpuss said...

Is it wrong of me to raise an eyebrow when the World's loudest advocate of a free market suddenly intervenes so spectacularly?


The CEO said...

Hi M@, I refuse to believe that W could lead an oligarchy, the oxymoron is so obvious, the stench so strong, not that I have an opinion, naturally.

As for debt relief, we can tryit toether. You can be Fannie, I'll be Freddie, OK.

Hi Puss, you have made my day. I was worried that I might not have written this post well enough for it make sense to non-financial people. You have made my day. Thank you.

PhoenixHearse said...

"The people who are underwater because the price of their house is now below their mortgage will still be underwater."

Yes, damnit. Life sucks.

The CEO said...

Hi Heather, the good thing is that your area will start recovering next year. If you can hang in there, there should be economic expansion and more job growth, and a need for housing where you are, and that means you should see some price improvement, hopefully. Good luck, really.

WanderingGirl said...

My brain hurts after reading that... but I hope to buy a house soon. Drop market! DROP!!!!!!!!!!!

The CEO said...

Hi Tiffany, Farmville (say it with me, Fahmvulle) should keep dropping at least through next year. You'll still need to go to Richmond for any sushi though. Feel better.

Open Grove Claudia said...

It's just odd. You know? Politics aside - this is such a huge thing that I cannot believe McCain is doing so well. I... I... have nothing to say about it.

The CEO said...

Hi Claudia, McCain and Palin are getting the 'bump' from their convention end. Palin is doing well appealing to the American public about energy independence, and bringing down the price of energy. There's a long way to the election. Be vocal about what you believe, and as long as you're honesy, you'll help a lot. Of course I am VERY BIASED and very influenced by you anyway. But this election I'll probably make my final decision in the booth, and Judy always ends up with the last shot at me. She could be WnG's older sister.

Echomouse said...

All I keep thinking is...thank GOD Canada has CMHC. For all the complaints about government interference (from people outside Canada) it really works for us. On the downside though, our banks, all banks worldwide, being connected means we are feeling the effects too. It's how I decide where to put my money - who made the worst loans and took the biggest hits in the market.

Thanks for this Monty. I wasn't following it enough to understand well. You've done a great job explaining things with this post.

Have a coffee on me!! :)

The CEO said...

Hi Carrie, I'm glad you liked it. I'm also glad you know how to invest. You're pretty smart!

Echomouse said...

Monty, you are my go to source on all this financial stuff.
Thanks again :)