Sunday, September 07, 2008

The Mortgage Option

It's a case where market psychology became more important than the fundamentals, and that's why they had to act. There's no immediate crisis. It's not like they're going to run out of money tomorrow or Monday. It's a decision that the market is simply not going to accept the status quo. Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee.

Is it just me or do others notice how often unwanted changes in market prices (or, in this case, difficulties in clearing) are attributed to "psychology" or "speculation." The same chaps who cheered the rapid ascent of US equity prices during the 90s as a sign of US superiority (no psychology or speculation driving that!) now decry the rise in oil prices as speculatively driven and argue, as per the above, that with housing values falling and unemployment rising, international investor fears of GSE Mortgage Bonds defaulting is just psychological.

Evacuating a city before a hurricane hits is, under that head, psychological too. After all, my house isn't flooded or blown over....yet.

I suspect, now that Fannie and Freddie have been nationalized, (yes, I know the powers that be would prefer a different term, and they might benefit from a read of Shakespeare's views on the smell of rose by any other name) the good Senator is about to learn that the fundamentals of US housing finance are unsound.

After all, if the fundamentals were solid, surely at least a few SWFs who have been so eager to purchase equity stakes in major financial institutions (like Citi, UBS and ML, to name a few) would be willing to inject some capital into the GSEs.

OK, enough ranting. Let's take a look at the policy.

According to
RGE Monitor:

Key features of government intervention (final deal to be announced before Asian markets open):
1) Fannie and Freddie and their combined $1.6 trillion investment portfolio business financed through agency bond issuance will be taken under a government-run conservatorship for an orderly restructuring process--> new housing law says that under a conservatorship, the authorities would aim to preserve Fannie and Freddie assets, rather than dispose of them.
2) The value of the companies' common stock would be diluted but not wiped out, while the holdings of other securities, including company debt and preferred shares likely to be protected by the government. (Washington Post)
3) taxpayer backstop for combined $5.3 trillion F&F owned or guaranteed debt: taxpayer funds will be used to pay any cash-flow shortfalls (e.g. due to borrower defaults) on mortgages F&F own or guarantee;
4) capital infusions to F&F in conservatorship on a quarterly basis depending on reported results instead of large capital infusion upfront;
5) Fire CEOs and replace the board

Points 3 and 4 are the keys to assessing the impact of this policy on US public sector finance, and consequently, US Bonds and the US$, inter alia.

Unlike the last US mortgage industry bail-out, which was financed by a combination of direct Treasury appropriations ($55.9B) and RefCorp Bond sales ($30.1B), this bail-out will not require a large upfront capital infusion, perhaps because, as the
NYTimes avers, It is not possible to calculate the cost of any government bailout.

What makes calculation so difficult? The nature of a mortgage contract is a good place to start.

As Michael Lewis described so humorously in Liar's Poker, "no trader or investor wanted to poke around suburbs to find whether the homeowner to whom he had just lent money was creditworthy." Additionally, "[mortgage owners] couldn't be certain how long the loan lasted." If interest rates fell, people refinanced and that sweet 9% per annum investment turned back into cash, which could no longer be invested at 9%.

Default on one side and refinancing on the other makes analysis of mortgage cash flows more option like than bond like (admittedly, other bonds can default or be refinanced, but this is more the exception than the rule- to wit, there isn't a refinance index for corporate of government bonds, as there is in the mortgage industry).

Ever clever mortgage investors, however, found a way to hedge refinance induced discontinuities, they bought US bonds, with leverage. In that way, when interest rates declined and refinancing increased, mortgage investors had, in a sense, already invested the cash received at higher rates.

Alas, declining interest rate induced refinancing is not what ails the US mortgage market, rather it is defaults caused by rising rates (and inflation in general). The hedge which worked so well in the case of falling rates, came at the cost of increased risk under opposite conditions.

Who would'a thunk it?

It seems worth noting that one of the factors which kept US Gov't Bond rates so low while the mortgage machine was humming along was the leveraged hedge.

But, I digress. Let's try to get some sense of the risk of default, applied to the scale of the problem.

Unlike refinancing, which at least leaves investors with principal, in the form of cash, intact, default turns bond holders into real estate investors, in a falling market. I suspect neither China nor Japan is keen on owning large tracts of US suburbia, which may partially explain the attractiveness of the new policy.

As noted earlier, rising defaults seem to be a function of a combination of rising rates, particularly in the case of the ARMs promoted by Mr. Greenspan a few years ago, rising prices in general and stagnant wages. If we wanted to get technical a first stab might be f (i, cpi, w) = default rate where i = change in interest rate, cpi = actual inflation rate, and w = % change in wages for a certain term and type of mortgage.

So long as i and cpi were rising faster than w the default rate would, I assume, rise.

This, it seems to me, presents policy makers, having opted to guarantee some $5.3T of mortgages, with a very difficult scenario given the effect wage arbitrage has had on restraining US incomes. Keeping inflation down might require higher interest rates, which, assuming stagnant wages, might actually raise the default rate.

Rising defaults, by virtue of the need to guarantee, increases the fiscal deficit which will eventually push rates higher still, perhaps pushing more mortgages into default and the cycle begins again.

The key, it seems to me, is keeping inflation down. If oil prices continue their climb (despite the recent sharp decline oil prices are still up 35-40% y/y), and interest rate increases are needed, the cost of this bail-out could easily be in the 100s of billions with a trillion not out of the question.

An alternative method of keeping a lid of inflation is a strong US$, which, it seems to me, has been a focus of recent Central Bank activity.

If the powers that be can keep the US$ stable without igniting a more globalized inflation (which, I suspect, will prove quite difficult) the effects of this bail-out might not be catastrophic.

If, however, the US$ starts to fall and oil, and other prices begin to rise again...well let's just call that US$ doomsday.

On that note, have you read the news about Hurricane Ike?