An insider's explanation of the Fannie Mae Meltdown
billburnham.blogs.com
billburnham.blogs.com
This is just a total guess, but to me it seems like it gets this bad partly because of a feedback cycle between inefficiencies of real-world markets and government meddling. The players in the real world markets don't have perfect information and instantaneous communication, so they end up not balancing their potential payoffs against the risks. The government (or central bank, whatever) steps in to rescue the system when the situation gets bad by propping up failing banks. Sounds good so far, but the problem is that this effectively functions like a zero-cost insurance policy and insulates the banks from some of the true risk of their investments. This encourages the banks to take riskier investments, since they get part of the risk paid for for free. Now you've got a positive feedback loop: banks take riskier investments due to gov't guarantee, gov't steps in when the investment goes bad, banks gain confidence in gov't bailout and make more even worse investments, rinse & repeat.
It also seems like the governmental "insurance policy" encourages the kind of interdependency where one bank's failure can bring down other banks. It's more likely that the banks can collect on the insurance policy if many of them go down at once, but if only one bank is in trouble it's more likely that the government will just allow that one bank to fail. (I'm not proposing a conspiracy theory; I'm just saying that this "insurance" shifts the banks' costs/benefits towards mutual dependence and reduces the attractiveness of pursuing diverse/unconventional strategies.)
OK, that's my half baked hypothesis -- what's the real explanation?
In my country there is no real equivalent of Fanie Mae/Fredie Mac, so in order to get a mortgage you must have proven income, stable job, and at least %30 down payment.
It makes it harder to buy a house, but deliquinces are low, and prices are not heated up.
If banks had to bear the risk of issuing the mortgages, you would see lending standards tightenning up overnight, and most of the risky borrowrers wont be able to get any mortgages, which actually is a good thing.
In the article it says how Fanie Mae started this huge campain so the congress would loosen up the credit requirement in the name of "house affordability" for the poor etc... when it was actually self-centered policy, by the top executives so Fanie Mae could keep its profits rising, and their bonuses flowing. Of course, this would backfire at some point, but who cares, they made their money in the bank, who cares on what happens 10 years down the road, the goverment will bail them out, right...?
I really hope the goverment doesn't, and just let them go down. It would be fun. Actually houses will end up being affordable for those people that live honestly within their means, have good credit, stable jobs, and a good amount of savings, while the irresponsible wont be able to even get a mortagage anymore, (or one with reasonable rates).
Prices rose quote a bit in Italy and especially Spain, despite having similar conditions to those you describe.
A comparable house in Ronda, Spain to those in my native Kansas is roughly twice as expensive, but to a Londoner accustomed to things costing four times that (eight times Kansas prices), Spanish houses look like a great deal.
Evidence seems to suggest the market does not work this way. Sometimes, it appears not to work at all.
Imagine that you open a flood insurance office right next to a levee in New Orleans. You could price things rationally, but if there's a flood you're dead anyway, so why not price your insurance low and live it up in the meantime?
Then, the costs get socialized. The Fed guarantees Bear Stearns for some fucked-up reason, making all taxpayers liable for the gambler's losses. With the Fannie Mae, this happened in reverse; first the gambler was isolated from getting a bullet in her brain, then the gambler proceeded to play Russian roulette.
*However, this game is not zero sum when it comes to markets. First, houses are rather illiquid, and second, meltdowns create unemployment and other inefficiencies. There's a reason nobody really plays Russian roulette in real life.
It could be that all the top dogs on Wall Street and at the Fed are buddy-buddy, and don't want anything terrible to happen to each other, so they watch each other's backs. (Similar to how foreign rulers sometimes allow their deposed enemies to go into "exile", to hopefully win some good karma should they themselves ever become deposed).
It's probably not either of these. I don't know. I don't think anybody does.
We're reducing the small bank losses in search for "stabilities" that group up all the losses in on fell swoop.
Everything fails over time. Eliminating the small failures by making things too big to fail only creates the chance for things to fail in a biggest possible way.
This isn't going to stop anytime soon.
I got the impression that he firmly asserted that he was not in the predictions business.
Borrowers have the option to prepay their mortgage by refinancing or simply by paying more than the minimum requirement. Because of the prepayment option, mortgages have a duration (defined as the average maturity of the cash flows, weighted by the present value of the cash flows) much less than their 30-year term. For example, the 10yr treasury note has a duration of just over 8 years, but FNCL 5.5 TBA mortgage futures (the most liquid type of mortgage-backed security) have a market-implied duration of around 5 years.
Duration also measures the sensitivity of a bond's price to interest rates: for longer duration bonds, you are discounting the cash flows further back in time, so the rate at which you value future cash will have a greater effect on the present value. Think about it: if you are to receive $1000 in six months, it won't much matter to you if interest rates are at 1% or 10%. If the financial situation is relatively normal, $1000 in six months isn't worth much less than $1000 now. But a 30-year bond yielding only 1% is almost worthless (why would you lock up your money for 30 years at such a low rate), while one yielding 10% is extremely valuable.
If prepayment speeds were static (i.e. if people always paid off their mortgages at the same rate), Fannie Mae could issue debt with 5-year duration (probably ~7yr maturity) at, say, 5%, and buy 30-year mortgages (also with 5-year duration) yielding 6%. They would thus make 1% per year, and on average they would pay off their own debt right when the borrower pays off his mortgage. Fannie and Freddie do issue debt in this form, referred to as bullets.
The problem is that agency bullets have a very different convexity profile than mortgages. (If duration is the sensitivity of prices to interest rates, convexity is the sensitivity of duration to interest rates). Bullets have positive convexity: as interest rates go down, the bond has a longer duration. With low interest rates, future money isn't worth much less than money now. So when you are computing duration, the large cash flows towards the end of the bullet's life are dominant. Mortgages are exactly the opposite: they have negative convexity. As interest rates go down, a mortgage's duration gets shorter because borrowers refinance out of their old mortgage into a new one at a lower rate. If rates go up, the opposite happens.
So suppose rates go up. The debt that Fannie issued trades to a shorter duration, but the mortgages they own trade longer. This means that on average, Fannie would have to pay off its debt faster than the borrowers pay off their mortgages. When Fannie's debt comes due before the mortgages, Fannie will have to refinance. And since rates went up in this scenario, it will have to refinance into more expensive debt than before.
Now imagine rates go down. Fannie Mae's debt trades longer, and mortgages trade shorter. So Fannie Mae is still paying debt even after it received the cash flows from the mortgages. Even worse, it's paying debt at above market rates now that rates went down since issuance.
Callable agency debentures fix this problem by giving Fannie Mae the same option that borrowers have. As borrowers call their mortgages in (i.e. as they prepay them), Fannie can call its own debt by paying it off early. Fannie can now make sure the duration of its liabilities (its debentures) is matched by the duration of its assets (the mortgages it owns).
I'd be happy to explain any other aspect of the mortgage bond market, if there's anyone out there who's interested.
As far as books go, there aren't any, unfortunately. I think it's because the mortgage-backed securities market is largely confined to professional investors and traders who learn everything on the job. Stocks are the opposite: it's dead easy to open an ETrade account and buy some shares, so there's a ton of information for individual investors.
Lots of people use Fabozzi (http://www.amazon.com/Handbook-Mortgage-Backed-Securities-Fr...) as a reference, but I'm not a fan... it's disorganized, not particularly well written, and doesn't provide much information on how the market works on a day to day basis. The Salomon book (http://www.amazon.com/Salomon-Barney-Mortgage-Backed-Asset-B...) is popular too, but I've never read it.
You have all your money in an IndyMac account. They hold your mortage. IndyMAC collapses prompting the FDIC to take them over and bail them out. What happens:
You lose at least half (probably more) of all the money you have in the bank over $100k. They get a fat bailout, so long and thanks for all the cash. You are still expected to repay your mortgage in full.
I know there's probably some logical explanation in financialese showing that this is the right outcome... But, come on, they lose your money and still demand to be repaid... WTF?!
Sometimes taking risks is the best way to profit. And they're not called risks for no reason. And I doubt the company wanted to lose money intentionally..
Taxes. Someone has to pay for the government bailing them out. And because it is essentially a blank check with no oversight, they'll make the mistakes again. And again. And again.
There's a reason it's called "risk". Because you have a chance of FUCKING IT UP!
It's not "risk" if they only profit from the upside and don't take their medicine on the downside. Heads they win, tails you lose. :)
These guys have been serving as the de-facto buyer of last resort for all of the bad debt that other banks have accumulated. They're acting as the US mortgage-banking safety net, and as such, have knowingly taken on a huge amount of bad debt that other commercial banks wouldn't touch. If it weren't for Fannie/Freddie, the mortgage crisis would be much worse than it is.
(That said...if they had the good sense to raise their lending standards back in 2003, we probably wouldn't be in this mess.)
I'm all for free enterprise. You take risks, you make some smart moves, and you profit. You take another risk, you make some mistakes, you lose, and you can start over (and learn). You don't keep doing it like these banks did (I don't even know if you can call them mistakes, more like reckless disregard). Like degenerate gamblers who got their line-of-credit extended, they double-downed and lost.
Think about it, the average US citizen's safety net is quite small. Get sick, get dropped by insurance, lose your job and you're basically on your own. We're told to buck up, stop whining, take responsibility, and work harder. Fine, but don't tell me these companies need our sympathy and help. They profited handsomely during the run-up by making risky loans and lobbying for tougher bankruptcy laws.
There's no easy answer. Bail them out, the dollar plummets and the economy goes to shit. No bailout, the financial market freezes up and the economy goes to shit. I'm leaning towards no more bailouts. At least then we might be able to address the root cause, which I think was reckless risk taking and financial engineering, with the perpetuated belief that the US government (tax payers) would be the ultimate safety net.
Here's a good link regarding what the mortgage market might look like in the near future: http://www.bubbleinfo.com/journal/2008/7/12/mortgage-credit-...
Good lord, whatever will happen. Poor, POOR traders. Frankly, I could give less than two shakes on whether you depend on it for your livelihood. It's besides the point.
Their primary business is to help people get homes. Or at least, it should be. Not to make money for traders.
Fannie Mae, Freddie Mac, and to a lesser extent Ginnie Mae play an important role in the mortgage market, and it's worth thinking twice before saying they should be allowed to go under. The market in their mortgage-backed securities (MBS) has led to substantially lower mortgage rates, to easily refinanceable mortgages, to a wide variety of types of mortgages: fixed year mortgages of all time periods, ARMs, balloons, etc. And while things were certainly taken too far, the government mortgage agencies allowed many deserving homeowners to take out mortgages that individual banks wouldn't have been willing to give. I don't think it's in the best interest of the country to go back to the old model of mortgage origination.
That being said, I do think that Fannie and Freddie should really change the way they do business. Right now they perform two roles: that of a monoline (i.e. an insurance company), and that of a REIT. The monoline is what's important: by buying mortgages, taking a cut of the monthly payments as an insurance premium, and then packaging the mortgages in easily tradeable securities, they promote a smoothly functioning mortgage market. The REIT part is where they borrow money at extremely advantageous rates and invest it in their own MBS, like the original article talked about. The idea behind letting them operate as a REIT is that by buying large amounts of MBS, they would support their price, promote lower primary mortgage interest rates, and make housing cheaper for the nation as a whole. That's fine as far as it goes, but there should be stricter requirements on the size and riskiness of its portfolio. Earlier this year when private mortgage funds like Carlyle and others were blowing up, Fannie and Freddie should have been required to raise more capital and reduce purchases of new mortgages. But they weren't, and now we're in the mess we see now.