Housing Bubble, Mortg*ge R*tes, and Spam

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The re-fi
mania was a very rational decision for those who locked in long-term
rates, but a far riskier decision for those who signed up for
Adjustable R*te Mortg*ges (ARMs).

If you did
not refinance your home at a three-year fixed rate, you missed
a golden opportunity to skin the victims of Greenspan’s policy
of lowering short-term rates, i.e., the lenders. But don’t despair.
There will be another opportunity. All it will take is the destruction
of the dollar.

When the
Fed’s monetary inflation pushes up price inflation, as it will,
and price inflation then produces inflation premiums for long-term
loans ("Don’t pay me off with those depreciating dollars!"),
both Fannie Mae and Freddie Mac will face bankruptcy on a scale
larger than anything seen in Western economic history. There are
trillions of dollars at risk between them. They hold the paper
for half of America’s home mortg*ges. At that point, Greenspan
& Co., sensing the threat of “cascading
cross defaults
," will start buying T-bonds again, forcing
down all long-term rates, including mortg*ge r*tes. The Japanese
central bank has done this for 10 years. Why not the Fed?

But if the
Fed does this in the face of a true sell-off of bonds, it will
take an enormous increase in monetary inflation. This will put
more upward pressure on mortg*ge r*tes.

I will get
to this shortly, and what it means for home values. But first.
. . .


Why do I
keep writing "mortg*ge r*tes"? Because of spam-blocking
software that many, many Internet service providers have installed.
This software blocks phrases that spammers commonly use. This
includes you-know-what. The refinancing mania filled our Internet
service provider (ISP) mailboxes with offers for lower mortg*ge
r*tes. These offers began to annoy some ISP clients. So, they
complained. The rest of us — the vast majority — grinned
and bore it. So, to get the complainers off their backs, ISP managers
direct their programmers to Do Something. Installing spam-blocking
software is what they do.

The average
ISP client doesn’t know that his mail is being blocked. So, he
doesn’t complain to the ISP. The anti-spammers are vocal. They
do complain. The squeaky wheels get greased.

The rest
of us now enjoy an advantage: less spam.

This comes
at a price: reduced liberty of communication.

There is
one very large ISP company that blocks 70% of the subscribers
to my email newsletter. I must not upset anyone in senior management
of the firm, or else they may start blocking the other 30%. So,
let me describe this firm.

  1. It used to send out free CD-ROM’s with their program, offering
    80 hours (then 120, then 500 then 1,000) of free Internet time.

  2. Its clients, once signed up, cannot easily locate the address
    for "I’m canceling," so letting their credit cards
    lapse is the only known escape.

  3. The company, by merging with Ted Turner’s company, reduced Mr.
    Turner’s wealth by about 80% by forcing down its newly merged
    stock price (as I publicly predicted it would in February of
    2000), thereby forcing Mr. Turner to renege on his promise to
    donate a billion dollars to the United Nations, which is why
    I — no longer a client, having let my credit card lapse
    — applaud this company.

It is my
hope that this company will go bankrupt, thereby wiping out the
rest of Mr. Turner’s fortune, now that "Gods
and Generals
" lost so much money that Mr. Turner will
not finance the third movie in the series.


I live in
the sticks. So, I’m tied to a modem. If I lived in the city limits,
I would get broadband: cable modem, DSL, or something. Everything
online works faster with broadband.

It costs
more, but the value of my time, and any businessman’s time, is
far higher than the extra monthly fee for broadband.

There are
also ever-cheaper ISP services. Poetworld costs $8/month for 200
hours. The problem is, they are cheap because their customer service
is lousy. I have called. No such service. I have e-mailed. No
reply. I have been a customer for a week, and already I am not
happy. But my wife uses the service, and it works well. My son-in-law
taught her how to set it up.

This means
that this service is for experienced users. Newbies must go to
higher-priced local services or else the previously mentioned
company that blocks my letters.

I use two
ISPs. I need a backup. That’s because my business is tied to the
Web. I have to have access. If one ISP goes down, I need a backup.
That’s why I signed up with Poetworld. It replaces That Other

As experienced
users move to broadband, as they have been doing by the tens of
millions, local services will get squeezed. Inexperienced users
will demand free support, while experienced users will move to
DSL or cable modem. To compete, local ISP’s will have to offer
cheap broadband service. They will find themselves competing against
well-financed national companies.

For those
who require hands-on technical support, the local ISP is best.
For those who desire high-speed downloads, cable modem or local
DSL is best. For those who are too timid to pay extra for the
power and convenience of a high-speed connection, or go to the
trouble to learn Netscape Navigator, Opera, or Microsoft Internet
Explorer, That Other Company is best, with its daily mailbox full
of spam, despite its spam-blocking software that keeps people
from receiving my newsletter.

I suggest
that you make a switch.


The Federal
National Mortgage Association (Fannie Mae) and the Federal Home
Loan Mortgage Association (Freddie Mac) are private investment
organizations that enjoy the reputation of being backed by Congress
in some way. Freddie Mac really does call itself Freddie Mac.
I dare you to discover its real name on its
Web site

This reputation
of being backed by Congress has led to their ability to attract
investors to the tune of trillions of dollars. The fact that these
are GSE’s — government-sponsored enterprises — does
not mean legally that Congress must bail them out if they go under.
It’s a political question. It’s also economic. How could Congress
bail them out when the government is already running a deficit
of $450 billion a year?

These GSE
investments have gone into mortgages. Like bonds, these paper
investments fall in value whenever long-term interest rates rise.
Also, they get repaid early through re-financing at lower rates
whenever interest rates fall. They are, in short, terrible investments.
They are asymmetric, with both sides of the transaction favoring
the debtors against the creditors.

One of the
services I perform is to keep you informed of what is being written
in the financial press. When I find someone who says something
better than I do, I cite him or her and provide a Web link, if

The New
York Times (Aug. 8) ran an
article on Fannie Mae by Alex Berenson
. Its language was subdued.
Its message was "Red Alert! Red Alert!"

Mae, the giant mortgage finance company, faces much bigger losses
from interest rate swings than it has publicly disclosed, according
to computer models used by the company to estimate the value
of its assets and debts.

At the
end of last year, the models showed that Fannie Mae’s portfolio
would have lost $7.5 billion in value if interest rates rose
immediately by 1.5 percentage points, internal company documents
provided to The New York Times indicated. At that time, the
market value of all the assets on Fannie Mae’s books, minus
all the company’s debts, was about $15 billion. So it would
have lost roughly half its market value from such a sharp increase
in interest rates, according to the models.

With $923
billion in assets, Fannie Mae is the second-largest financial
company in the United States, trailing only Citigroup. Fannie
Mae, which is sponsored by the Federal government, helps keep
mortg*ge r*tes down by buying mortgages from banks and selling
them or its own bonds to investors around the world. But some
investors and outside experts say the company has become dangerously
large and highly leveraged, with too much debt and not enough

The models
were provided to The Times by a former Fannie Mae employee,
in return for assurance that he not be identified.

The company’s
chairman, Franklin D. Raines, responding to a question at a
news conference last week, said Fannie Mae did not depend on
the market value of its portfolio to judge the success of its
business. Asked whether Fannie Mae constructed such estimates
weekly, he did not reply.

In interviews
yesterday, executives at Fannie Mae acknowledged that the company
estimates the value of its portfolio weekly, though it discloses
such information to investors only once a year. The models provided
to The Times are several months old, the executives said, and
present an incomplete and misleading view of Fannie Mae’s finances.
They added that Fannie Mae hedges its risks properly and discloses
them fully to investors.

is no reason for anybody to be worried about the company,"
said Peter Niculescu, Fannie Mae’s executive vice president
for the mortgage portfolio. "We are very happy, comfortable,
and proud of our performance this year in what has turned out
to be a very volatile interest rate environment."

Mr. Niculescu
declined to say whether Fannie Mae’s portfolio had gained or
lost value this year.

The former
employee, who now works for a company that does not directly
compete with Fannie Mae, said he had decided to publicize the
documents because he was worried that Fannie Mae was becoming
a risk to taxpayers and the financial system.

it is so large, and because many investors think that the Federal
government will repay its bonds if the company cannot, the government
could become engaged in a very expensive bailout of Fannie Mae
if it mismanaged its risk, the company’s critics warn. And if
investors balked at buying Fannie Mae’s bonds because they were
concerned about the company’s financial strength, mortg*ge r*tes
could rise rapidly.

For years,
critics of Fannie Mae have warned that it does not give them
enough information to judge its risks. "I have no clue"
about the company’s sensitivity to interest rate moves, said
Stan Jonas, managing director at Fimat USA, a bond and derivatives
broker. "But no one else does either."

Mae has never publicly disclosed how much money it could lose
if interest rates rose 1.5 percentage points in a very short
period of time. The company said in its most recent annual report
that if rates rose 1 percent on Dec. 31, it would actually have
made $600 million. But that figure included gains that were
not directly related to the value of its mortgages. In fact,
the model predicted that Fannie Mae’s portfolio would have lost
$2.6 billion if rates rose 1 percent. From June 13 through July
29, the yield on the 10-year Treasury note, the benchmark of
long-term interest rates, rose 1.33 percentage points, from
3.11 percent to 4.44 percent. The yield has since fallen slightly
but remains more than 1.2 percentage points above its June low.

Mr. Niculescu
said Fannie Mae had moved in the last few months to protect
itself more aggressively from interest rate changes. Compared
with other financial institutions, he said, it is well hedged
and has plenty of capital.

Mae has not disclosed how much the recent rise in rates affected
the market value of its holdings, and analysts have wildly varying
estimates. Kenneth Posner, a stock analyst at Morgan Stanley
who is bullish on Fannie Mae, said it did not disclose enough
information for outside analysts to determine monthly changes
in the portfolio’s value.

This could
create havoc for the U.S. Treasury bond market, as Gretchen Morgenson
wrote in the New York Times (Aug. 17). Note: this is not
some oddball newsletter. This is the sedate New York Times.
Get ready to sweat.

many investors think that the Treasury market sets mortg*ge
r*tes, mortgage-backed traders are the ones who hold sway. Their
hegemony is a function of two things: the runaway growth in
the mortgage market and the way mortgage portfolio managers
must respond when rates rise or fall.

Until 2000,
the United States Treasury market was the world’s largest and
most liquid. Now the government bond market is overshadowed
by the mortgage-backed securities market. Treasuries and corporate
bonds each account for about 22 percent of the Lehman Brothers
United States Aggregate Index, a measure of the whole fixed-income
market; mortgage-backed securities make up almost 35 percent.

This would
not be a problem if mortgage traders and managers of big loan
portfolios, like Fannie Mae, did not typically hedge their holdings
with Treasuries. Holders of mortgages hedge by selling short
Treasury securities with maturities roughly equal to the average
life of the mortgages in their portfolio.

Now, the
hedgers’ needs can swamp the market they tap. This exacerbates
moves in interest rates, producing a snowball effect that can
push rates far lower or higher, and faster, than in previous

securities respond violently to moves in interest rates. When
rates fall and homeowners refinance, some of the mortgages in
large portfolios held by banks, hedge funds and mortgage originators
are cashed in. That requires the managers of these portfolios
to rebalance their hedges by buying Treasuries. Such buying
helped push interest rates down to ridiculous levels earlier
this year.

When rates
rise, refinancings drop, and the average life of a mortgage
grows. That forces traders to rebalance portfolios by selling
Treasuries. Selling begets selling; interest rates spike.

Last week,
the Federal Reserve rattled the bond market by promising to
keep rates low for as long as possible. Traders feared that
the accommodative stance could be inflationary. They sold Treasuries,
and rates rose.

James A.
Bianco of Bianco Research in Chicago pointed out that the last
time interest rates moved up — in the mid-1990’s —
the mortgage-backed securities market was much smaller and more
manageable. "Back in 1996, the mortgage market was roughly
half the size of the Treasury market," he said. "Now
it is 125 percent of the Treasury market."

Mr. Bianco
fears that the size of the market and the fact that so many
players are heavily leveraged make a disaster almost inevitable.
"If you look at the last 15 years of bond market derivative
debacles, a lot of them involved mortgages," he said. "These
things have killed more people than any other trade."

The people
running big mortgage portfolios would tell you that hedging
allows them to manage away their risks.

Mr. Bianco
argues that the extreme volatility in the market suggests that
the players have not properly managed their risks. "We
wouldn’t see these wild undulations in interest rates if they
had already been hedged," he said.

It is unfortunate
that the problems of mortgage traders can create such havoc.
But these traders drove down rates, benefiting consumers, companies
and bondholders. Now, it is higher borrowing costs — and
their grimmer implications — for which everyone must prepare.

Not worried
yet? Well, then, take a look at Philip
Coggan’s article in the staid, stiff-upper-lip London Financial
Times. This ran on Aug. 11.

The speed
of the retreat seems to have been driven by the peculiar structure
of the US mortgage market. Most US homeowners borrow at a fixed
rate, but unlike their British counterparts, they have a virtually
free option to refinance their mortgage as rates fall.

Many of
those mortgages are acquired by Fannie Mae and Freddie Mac,
two giant US agencies. They either hold on to those mortgages
or package them and pass them on to outside investors in the
form of mortgage-backed securities.

holds the mortgages faces a risk. As long-term yields fall,
homeowners will be tempted to refinance their debts. So instead
of holding long-dated debt, the investor (or the agency) will
suddenly be holding cash.

This can
have dramatic effects on the duration (a function of a bond’s
yield and term to maturity) of the mortgage-backed bonds, and
of the agency’s portfolios. As yields fall, the duration dramatically
shortens; as yields rise, it lengthens just as quickly.

In the
jargon of the markets, such bonds have high convexity.

the investors try to hedge this risk. When yields are falling
and duration is shortening, they hedge by buying longer-dated
securities such as Treasury bonds. This has the effect of driving
down yields even further, creating a virtuous circle.

When yields
start to rise, however, the circle turns vicious. Repayments
dwindle, tending to lengthen the maturity of investors’ portfolios.
This causes investors to sell longer-dated Treasury bonds, pushing
yields up even further.

This vicious
circle has kicked in over the past few weeks. As the duration
of the mortgage-backed securities has lengthened, there has
been heavy selling in the 5—10 year portion of the Treasury
bond market. The same hedge can be achieved in the swaps market,
where investors have been eager to borrow at a fixed rate (the
equivalent position to shorting a Treasury bond); swap spreads
have widened sharply.

The disruption
to the market has been so great because these agencies are huge.
They have traditionally been regarded as quasi-governmental
organizations, allowing them to borrow cheaply. And they have
taken on a vast amount of leverage.

They also
have fairly rigid hedging policies. According to Mr. Wozniak,
the agencies have stated that they will not tolerate a duration
mismatch of more than six months. Recently, they have been at
the limits of this mismatch, so they have been forced sellers,
rather as insurance companies were forced sellers of equities
around the end of last year.

How bad
could it get? There are some who believe that Freddie Mac and
Fannie Mae are the potential Achilles heels of the US financial
system. Indeed there have been reports that the European Central
Bank has advised other government banks in Europe to reduce
their exposure to their debt.

A further
rise in Treasury bond yields could release an immense amount
of selling in the market. Tim Bond, of Barclays Capital, estimates
that another 25 basis points rise in yields could prompt $180bn
of sales in the 10-year swap market. In the past, such rapid
market movement has caused distress in the bond market. One
has the feeling that someone, somewhere has just lost his shirt.


If any of
this happens — and eventually, it will happen — anyone
with an ARM will be forced to sell his home, as his monthly payments
rise. I call this "an ARM and a leg." This will flood
the market with unsaleable homes. As rates climb, the number of
would-be buyers who qualify for loans falls. Also, the monthly
payment rises, so people cannot afford to buy homes that they
could have purchased when rates were low.

This is the
bubble effect. It balloons when rates are falling. It pops when
rates rise and are expected to rise even more.

To stop the
rise in mortg*ge r*tes, one of two things must take place: (1)
a depression, where all interest rates fall; (2) mass inflation,
where the Fed buys long-term Treasury bonds. But the second policy
is temporary. Eventually, no one will loan money because it will
be re-paid in depreciated money. At that point, the Fed will be
the lender of last resort in the housing market.

I think the
latter is more likely.

20, 2003

North is the author of Mises
on Money
. Visit http://www.freebooks.com.
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