by Gary North
In my previous article, I presented evidence that the recent upturn in long-term interest rates threatens the liquidity of the market for homes. I reprinted three detailed articles from Establishment newspapers that point to the enormous problem that Fannie Mae and Freddie Mac have imposed on the U.S. bond market. They hedge their positions. When long-term rates rise, they sell T-bonds short, which causes rates to rise even more.
But there is good news: the two organizations have so little cash in reserve that their ability to sell T-bonds short is limited. This means, of course, that their ability to protect the equity of their portfolios is exceedingly limited. Those investors who have put their money in these mortgage-generating Government Sponsored Enterprises are about to have a moment of truth that could last for years, namely that the enterprise the government sponsors isn't profitable without additional government support.
The mortgage market has been dramatically affected recently by investors' expectations regarding the inflationary price effects of additional monetary inflation by the Fed. This is so obvious that it ought to be the number-one explanation offered by anyone trying to explain the threat to the bond market and the mortgage market. It isn't.
It was widely believed until late June that the Fed was buying long-term U.S. Treasury debt to force down long-term rates, something it had not done in the past. Then, without warning, long-term rates went up sharply. The bond market fell just as sharply. Had Fed policy changed? The suspicion of a change in Fed policy seemed to be verified by Greenspan's testimony to the Committee on Financial Services of the House of Representatives (July 15). He announced:
The Federal Reserve has been studying how to provide policy stimulus should our primary tool of adjusting the target federal funds rate no longer be available. Indeed, the FOMC [the Fed committee that decides to create or destroy money by either purchasing or selling debt] devoted considerable attention to this subject at its June meeting, examining potentially feasible policy alternatives. However, given the now highly stimulative stance of monetary and fiscal policy and well-anchored inflation expectations, the Committee concluded that economic fundamentals are such that situations requiring special policy actions are most unlikely to arise.
The key phrase was "special policy actions." This may mean — with Greenspan, meaning is rarely clear — the Fed's prior purchases of long-term debt instruments, which have now ended. Down went the bond market. Down also went the portfolio value of both Fannie Mae and Freddie Mac. Down went their stock prices.
Because of the threat to the American bond market that mortgage lending institutions pose, I don't expect the Fed to allow long-term rates to rise to double-digit levels. But, before the Fed panics and starts buying T-bonds to force down long rates, I do expect mortgage rates to rise at least back to the 7% to 8% range. This will have negative consequences for the following:
The supply of people who can qualify for loans;
The retail prices of homes that prospective buyers can finance with their existing incomes;
The home equity that existing buyers now possess;
The liquidity of the housing market;
The monthly disposable income of people who bought homes using Adjustable Rate Mortgages.
In short, pop goes the bubble.
Trillions of dollars of holdings of mortgages by Fannie Mae and Freddie Mac are now exposed to the devastating prospect of rising long-term interest rates (the Fed's inflation premium) and the Fed's decision, for the moment, not to force down long rates by buying long-term Treasury debt with recently created money. Rising long-term rates will force down the market price of all existing mortgages. The process has already begun.
Ms. Morgenson and the other Establishment analysts I cited in the previous article were trying to explain how risky the mortgage markets have become. These markets now reveal the characteristic features of asset bubbles. The Fed's expansion of money has created a series of these bubbles, and the mortgage market and the bond market are the latest. Both have started down.
The Federal government has created a pair of mortgage lending institutions that have attracted the wealth of millions of investors, who have given these money managers their money to lend to real estate buyers of ever-less solvency as rates have been pushed down by the Fed. These investors have assumed that GSEs are somehow lower-risk entities, i.e., government-protected entities, and therefore superior to free market rivals. These investors are now facing the prospect of capital losses when the Fed-created bubble in housing pops: (1) higher risk of default; (2) lower liquidity for housing; (3) falling market value of mortgages because of rising rates, as these GSEs offset their risk by selling T-bonds short.
THE CARRY TRADE AND THE LEMMING EFFECT
Because the Fed has pushed down short-term rates by increasing the supply of credit money, and because of falling demand for loans by businessmen, investors in the carry trade can borrow short (1%) and lend long (5%). It looks like easy money. Warning: easy come, easy go.
This process has been going on in Japan for over a decade. It has been going on around the world. People borrow yen at well under 1% per annum, convert these yen into other currencies (mainly the dollar), and buy interest-bearing assets. It's all hunky-dory unless the yen moves up, for the borrowers must repay in yen. They must then go into the market and buy the yen they sold earlier. This drives up the price of yen even more. You get the idea. The debtors are trapped. The assets they own (dollars) are falling in value against the assets they owe (yen). The mad scramble begins. Then the bankruptcies begin.
Some of you are aware of the carry trade in the gold bullion market. Large institutional borrowers borrow gold from central banks at under 1% per annum, sell the gold, and buy interest-bearing securities that pay far more than 1%. It's all hunky-dory for the borrowers until the price of gold starts rising. Then they must pay off their debts, which are denominated in gold. They must re-purchase the gold at a higher price. At some point, they won't be able to afford to pay off their debts. That's when the fun will begin.
The carry trade looks incredibly profitable until it looks incredibly risky. It starts looking risky after the lemmings have gotten into a "no-lose" deal. It all looked so easy!
Here is the problem for the carry trade in the bond and mortgage markets. What if long-term rates continue to rise? This will continue to reduce the present market value of the bonds and mortgages that the carry traders have purchased. They owe money short term (90 days or less), but their offsetting assets won't be paid off for 10 or 30 years. This "borrowed short, lent long" position is what brought down the savings & loan industry in the mid-1980s. If they sell bonds to repay their short-term loans, this selling pressure will lower the market value of the bonds, which is another way of saying that it will push long rates up. A vicious circle appears. This is the classic description of a bursting bubble market.
This is what used to be called disintermediation. It means the inability of the debtor to re-pay the loan because he cannot get his hands on the money, which has been loaned out long-term. He has to borrow more money by rolling over the loan, presumably at a higher rate.
RICHARD BENSON'S WARNING
On Aug. 14 Richard Benson published an analysis of a looming problem for the mortgage lending agencies. You now have the background to understand it. Not many Americans do. Benson comments on this threat to the credit markets.
To even begin to understand what is happening in the economy and the Capital Markets, one has to understand housing finance. There are well over $6 trillion of home mortgages, and, of that amount, over $3.3 trillion are backed or owned by Fannie Mae and Freddie Mac. This is an extraordinary amount of debt and spending, and the number has been growing at the rate of $800 billion a year. Very few mortgages are owned by long-term investors such as insurance companies and pension funds, which recycle savings. Most mortgages are credit created and financed by the creation of new money, which finances mortgages in the money market.
For those readers old enough to remember the prime rate and Treasury Note yields in the high teens, and Savings and Loans dropping like flies, the inherent problems of funding long-term mortgages with short-term money need not be explained. However, even for these savvy old-timers, the modern version of the problem is of a totally different order of magnitude. In the old mortgage market before almost all mortgages were turned into liquid tradable securities, rising interest rates would slowly drain a thrift. The effect was a bit like being slowly drained of blood by a swarm of mosquitoes. Now that most mortgages are in mortgage securities and financed in the "carry trade," the effect of rising interest rates is a bit more like being stripped of all flesh by hungry Piranhas in a matter of minutes.
Benson next presents an analysis based on the existence of markets for short-term credit. Speculators enter the scene by writing contracts (long and short) on these GSE securities. The existence of these speculators affects the rate of interest by affecting the bids offered for them.
There should be about $4 Trillion of mortgages in the "carry trade" including Fannie and Freddie's balance sheet. The way the carry trade works is that mortgage securities can be financed (carried) by borrowing in the money market with Fed Funds, LIBOR or REPO money. Wall Street, being the generous souls that they are, will allow leverage of about 20 to 1 for these GSE securities. For 5% down, these carry trade players can run massive positions on very small equity. They get to earn the difference between short-term money at 1%, and the mortgage coupon of about 5% to 6%. If a carry trade player can make a 4% interest margin, and 20 times leverage, they can make a lot of money. However, they can only make a lot of money as long as interest rates are falling, or guaranteed to never go up.
He uses the figure of $3.3 trillion. In 2002, it was $3.1 trillion. In 1996, it was $1.4 trillion. (Source: Office of Federal Housing Enterprise Oversight. Its very name sends chills down my spine, and it's August.)
The big question today is this: Will the various lending agencies, with the Fed behind them, continue to loan to the carry traders? Will they roll over the loans even though the capitalized assets — mortgages — are falling in value because long-term interest rates are rising? I think the lenders will do this because the Fed dares not pull the plug. It dares not stop the flow of new money into the capital markets. But the Fed may allow mortgage rates go to 7% or 8% before it intervenes to bring long rates down by buying T-bonds in order to keep the housing bubble from bursting. It may hesitate too long, just as it did for the stock market in 2000 and 2001.
If the Fed does not cease inflating the currency, the rise in long-term interest rates is inevitable. The rate of money expansion will have to increase in order to maintain the stimulative effects for the economy. But if the Fed does cease inflating, then there will be a huge problem for the carry trade. Short-term rates will rise. This will cut off the carry trade's ability to borrow short and lend long. That will in turn reduce the supply of funds flowing into the mortgage market. This will tend to raise long rates. At that point, there could be a countervailing force: the imminence of recession, followed by a break in the housing market.
The Fed is trapped between the rock of rising long-term interest rates, which are bad for housing, and the hard place of a second recession, which is usually bad for housing. If it inflates, mortgage rates will rise. If it stops inflating, mortgage rates could fall, but only because housing prices are also falling.
Because the Fed will do whatever it can to overcome price deflation, I do not expect the second scenario. I expect, instead, the continued expansion of money, which will keep raising long-term rates until the Fed panics and starts buying long-term Treasury bonds as a way to force long-term rates back down.
WHEN MARKETS TURN DOWN
Benson says that in the last few weeks, the bond markets have turned down with such ferocity that the equity of the carry traders has all but disappeared.
The problem is, he says, is that these debts are themselves leveraged. The mortgage markets are part of a large derivatives market, where "longs" and "shorts" have made promises to pay off each other if the market goes against them. But what if the losers can't pay off? Then we get Greenspan's cascading cross default syndrome.
A few months ago when the Fed was talking about deflation and buying Treasury Notes and Bonds to "peg interest rates," interest rates kept falling and all the carry trade players thought they could sleep soundly and safely at night. When the Fed cut interest rates by only 1/% [I think he meant 0.25 percentage points] and began to talk about a strong economy and said there would be no need to peg interest rates, disaster struck. Just about every major Wall Street firm, bank, and hedge fund that has been active in the carry trade, went to hedge at the same time. It's not possible to hedge several Trillion of market value overnight. The 10-year Treasury Note lost 11%, and the average mortgage security lost 8%. If the carry trade can be run on 5% equity, and bonds lost 8%—11%, there are probably some big players that are gone; we just haven't missed them yet.
The real problem for the capital markets is that now almost all mortgages are in liquid securities and financed short-term. As interest rates rise, the shock of falling bond prices will regularly be heard around the world. There are over $160 Trillion of OTC [over the counter] derivatives — a huge share of these derivatives are in interest rate swaps, caps, and other hedges built around the mortgage carry trade. Clearly, we are in a position that when it comes to hedging and high leverage, he who sells first, wins! Selling begets selling, and market players can be wiped out overnight! Collateral damage will kill many innocent investors who suddenly discover they were nothing more than unwitting speculators.
TOO BIG NOT TO FAIL
We used to hear that a company was too big to fail. The government or the Fed would have to intervene and save it, what Greenspan calls a moral hazard — a forced loan. What if the entity is too big to bail out? The size of the American mortgage markets is huge. It is larger than Congress imagines.
Fannie Mae and Freddie Mac not only guarantee mortgage securities that other leveraged players use in the carry trade, but they themselves are the largest hedge fund carry trade players in the world. More interestingly, they can run their balance sheet positions not with 5% equity and 20 times leverage, but 2% equity and 50 times leverage. Both entities can try heroic efforts to "hedge their interest rate risk" but mortgage prepayment rates that drive mortgage convexity, swap spreads, and mortgage spreads over Treasuries that are all used to hedge, are not stable when the market suddenly has several Trillion of the same securities going "bid wanted." On interest rate risk alone, Fan and Fred are simply "too big not to fail." Their level of leverage can not be hedged, and they will end up making Long-Term Capital look like a conservatively run firm.
Fannie and Freddie have gotten into moral hazard lending in a big way. Their willingness to believe all mortgage appraisals and to bend over backwards to help that disadvantaged single mother buy a house with virtually no money down is just what you might expect of the Federal Government. Moreover, in a world where housing prices only seem to jump higher, who could fault them for protecting housing prices by helping those who have lost jobs by not foreclosing — instead, they rewrite the mortgage for a larger principal balance. As long as housing prices rise, Fan and Fred can play a "rolling loan gathers no loss."
The mortgage and housing market, as we know it, however, is coming to an end. We just discovered that mortgage interest rates don't always go down for homeowners. Indeed, if mortgage rates can suddenly rise, housing prices can suddenly fall. Falling interest rates, not personal income, has been behind the house price bubble. As interest rates rise, the same monthly payment buys much less house.
"MUCH LESS HOUSE"
This phrase summarizes the threat to homeowners who are not in the midst of a boom generated by in-migration, such as in Northwest Arkansas. When housing has been rising because lower rates enabled buyers to take on more mortgage debt, then rising rates threaten the bubble-generated housing market.
The sad thing for Fannie Mae and Freddie Mac is that they have been a big part of the Fed's policy of getting cash into the hands of households to spend. Lending standards have been incredibly lax. Most appraisals are biased upwards, and there is a far higher level of out and out fraud, which is likely to be on a scale exceeding the worst of what we have already seen from corporate America.
There are hundreds of billions of mortgages, where a charity made the down payment, and the charity got the money from a developer. We regularly hear of friends in housing developments conspiring to buy each other's identical house, and then pocketing big sums of money. Indeed, people buying each other's houses and "trading up" is primarily a bad joke played on the mortgage lenders, while the real estate agent, home seller, appraiser, title company, and mortgage broker laugh all the way to the bank. Moreover, cash out REFI's may make the Fed Chairman happy, but a cash out REFI does not make a better loan.
THE TAX MAN COMETH
Rising property values raise the taxable property value of the property. The squeeze is on.
While the mortgage game has allowed bigger mortgages and higher appraisals, homeowners are shocked by skyrocketing insurance costs and property taxes. Indeed, as housing prices rise, property taxes are beginning to approach the same drain on cash flow as interest payments incur. Fannie and Freddie have no doubt not even considered a world where their customers will be facing higher heating prices, insurance, property taxes, interest rates, and virtually no home equity to start, along with a home bought at the top of the real estate bubble.
Our honest opinion is that Fannie Mae and Freddie Mac are running massive Hedge Fund balance sheets. The equity base is 2%, leverage is over 50 times. The GSE's derivative positions are in the Trillions of dollars, and their accounting is totally opaque, and impossible to figure out. Mortgage holdings of this size are impossible to hedge without blowing through the GSE's eggshell thin equity layer. Moreover, there are serious concerns for credit quality, moral hazard, and simply being on the wrong side of the "housing bubble." We cannot imagine why an investor would own any GSE agency securities, debt, or stock unless and until the U.S. Treasury makes their soft implicit guarantee an actual "full faith" and credit guarantee for the full $3.3 trillion guaranteed by the GSEs.
We do remember "moral obligation bonds" that were sold in the municipal market a few decades ago. Agencies can default, and the type of inflation the Fed needs to get going to make all housing credit good, will certainly bring back an inverted yield curve, causing the prices of mortgage securities to plunge. The story for Fannie Mae and Freddie Mac will be a fascinating "House of Cards"; we plan to watch it from the short side.
I am not in a position to know if he is correct when he writes that "Fannie Mae and Freddie Mac are running massive Hedge Fund balance sheets." But there is no doubt that the accounting is confusing, which is why there were resignations of senior people at Freddie Mac a few weeks ago for accounting irregularities. Of this, I also have no doubt: "Mortgage holdings of this size are impossible to hedge without blowing through the GSE's eggshell thin equity layer." To short the bond market, you must have cash to put down as a minimum payment, called margin. It's basically earnest money. To hedge these two portfolios will take a great deal of cash. Shorting the bond market enough to cover a $3.3 trillion portfolio will push up long rates, further undermining their portfolio value.
When it comes to market bubbles, especially in markets as illiquid as real estate, the old rule holds true: "Things are easier to get into than out of."
There are going to be some real bargains available in housing over the next few years. Desperate sellers without any equity remaining and without enough disposable income to meet their monthly payments will walk away from their homes. Fannie and Freddie will have to auction off these abandoned, repossessed houses. This will put downward pressure on the market value of homes.
When people lose their home equity and are forced to move, where will they move to? Rented housing. They will strive not to move more than one rung down.
The 1,700 square foot, three bedroom, two bath home is the minimal home that a middle-class American wants to live in. When this kind of home comes onto the market as a foreclosure, it's time to start negotiating.
As for homebuilders, they are the classic victims of optimism during the boom phase. When they can't move their inventory, they have to sell. They have few reserves, and interest costs eat them up. If you want to buy a new home, bide your time. There will be plenty of them available at fire sale prices in a year.
August 23, 2003
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