Saturday, February 02, 2008

Fannie Mae, A Ticking Time Bomb

Congress created Fannie Mae in 1938 as a government sponsored entity (GSE) with private ownership. Their goal was to provide financing to make home ownership available for the common man. With the present housing collapse, this giant is facing a fiscal catastrophe. Meltdown is probably a better choice of words. This implies a Congressional bailout (the price of gas will go up another dollar).

The housing market swings like a pendulum, right now it's going the wrong way. The financial institutions are not set up for a swing of this magnitude. Fannie Mae can weather a 20 % drop in home values and break even. Most of their note packages are at 80% of actual value. The typical Fannie Mae loan has a 20% down payment or a 20% second mortgage held by a third party. In banking circles, a 20% drop in housing values is almost unheard of. Just about every house sold in the last ten years could come under the axe. That’s how far values have swung.

Fannie Mae has about 2.7 trillion dollars worth of loans guaranteed. They have 34 billion cash on hand. Just for the sake of simplicity, let’s figure the average guaranteed home loan at $340,000. Divide $340,000 into the 34 billion cash on hand and the result is 100,000. That figure is the actual number of houses Fanny Mae can redeem at any one point in time. So if the pundits are predicting 2 million foreclosures this year and Fanny Mae underwrites 40% of the market, that’s about 800,000 houses.

Figure a best case scenario. Calculate houses guaranteed at $170,000 apiece, half of the price above. That would give them room to cover 200,000 returned contracts. Also figure of the 2 million homes that only 20% of them are covered by Fannie Mae (another 50% reduction). The total houses would still be 400,000. Fannie Mae's goal is to convert each home to cash and apply the proceeds to the next problem loan. It could prove difficult.

There are side issues here that are not real apparent. Another 1.2 million houses are in the same foreclosure mill in competition with them. Is the house boarded up? Have the pipes frozen and broke? Has the house been stripped or trashed? Who pays the property taxes? Converting the asset to cash will take time.

What can be deduced from this experiment in unscientific speculation is that Fannie Mae will run out of operating capital (cash in the till) somewhere between 100,000 and 200,000 housing contracts. If the market drops 30%, they would have a guarantee commitment of 10% of the insured amount. This assumes the note was for 80% of the home's purchase price and they can sell the unit for 70% of the original purchase price. In the San Diego area the question comes up "Sell it to whom?"

There is the ongoing discussion; can the government let a GSE like Fanny Mae, go belly up? In theory they should be able to, but would it wise to do that? It could destroy faith in the system.

Time is the real killer here. It's kind of like waiting in line to use the rest room. The wait only makes it worse!

Copyright 2008 All rights reserved


Tyrone said...

Sobering thoughts and numbers, Jim.

My financial flight to safety continues!

Sackerson said...

And if you read Karl Denninger, his latest post interprets Fed statistics to mean that the banking system is running on ZERO reserves. If he's right, fractional reserve banking has finally hit the buffers. This is dreamlike.

Jim in San Marcos said...

Hi Sack

I think things are getting confused here. Our banking system runs on the fractional reserve system. A bank receives a deposit of $100. The Fed says that in order to make a loan, the bank must deposit 5% in its Federal reserve account. The bank deposits $5. and goes on its way. The Fed can move the reserve amount up or down to stimulate or limit lending by the bank.

Now if depositers start withdrawing more than is being deposited, the bank goes to the Fed for a bridge loan to cover the withdrawal. In the meantime they will write no new loans and sell to raise cash to pay back the Fed. I think that this is the money Karl is refering to. The banks are having trouble liquidating assets and need more time.

I've been refering to it as a run on the bank. The banks are solvent, but if everyone wants their money, it isn't there. It seems like a lot of people want to "stuff the matress."

Let's face it at 3% interest why not keep your money at home where you can keep an eye on it.

Another thing I have noticed, people think that banks are raising their standards. If you are a bank, would you tell a perspective borrower that you are out of money?? Nah, you tell the potential borrower that their credit report wasn't up to your standards.

In essence, the Fed is advancing cash on assets the bank is selling. And as Denninger mentioned, the loans are exceeding the sequestered reserves. The Fed seems to be buying time by increasing the loans and length of time the bank has to pay them back.

I agree with Karl it can't go on much longer. This Fed infusion of cash is just Smoke and Mirrors.

Sackerson said...

Jim, thanks for the clarification. Like your point about standards - bit like the teacher's "deliberate mistake" ploy.

Anonymous said...

seems like we would be better of as a society without the GSEs, and that they are largely responsible for the run up in home prices.

With all the debt securitization, and gov't support of it, housing prices climb until the payment reachs all that people can afford, and then some.

My parents payed about 5k for their house in the 50's (a little less then 2x annual income) even adjusted for inflation, with an average income around here (LA) of about 50k, houses should cost no more then about 100k.

If loans are harder to get, economics says that prices should fall (lower demand). the easier loans are to get, the higher prices will climb (higher demand).

Jim in San Marcos said...

Hi Anon 10:32

Government steps in to help and creates an effect opposite of the desired one.

It's kind of like government rent control. One person observed that the a faster approach to the final result would be nuclear bombing the area. The results are the same.

Thanks for your post.

Anonymous said...

Vote for Hillary and get it over with. What we need right now is a good old fashioned Depression to get things moving again. Hillary will take care of everyone through government programs. The unemployed will get everything given to them for free, the workers will sign their checks over to Hillary & company and will get everything from a new government program as well. I'm moving to the midwest where I can grow vegtables and kill wild animals for dinner.

Anonymous said...

The government isn't all bad. Note that 70 years of a regulated electric industry brought reliable power capacity to all Americans at reasonable rates (this broke down 10 years ago with the start of de-regulation). Also, I've never known the fear of losing my money in a bank failure thanks to FDIC insurance.

Regardless of how laissez faire or libertarian you are, the opposite of regulation is still corruption, especially on the scale of utilities and banking.

Jim in San Marcos said...

Hi Anon 9:44

If you have ever grown vegetables, you will know that it is very hard work. As for killing wild animals, you need to have a hunting license and that usually cost more than the intended meal by $30. Plus your kids will hate you for killing Mr Rabbit. I love the rabbit barbecued, and it always cracks me up when someone says "how did you get a chicken with 4 legs?

As for Hillary and Obama, I can't quite figure it out. I thought the Democrats were a sure shot for election until those two popped up.

Whether people want to admit it or not, a lot of the new deal stuff of FDR got us to where we are today, deep in quagmire.

Either way, enjoy yourself in the move to the Midwest, I'm sure you will like it.

Anonymous said...

Jim, "hog cycle" is the informal definition economists use for the cyclic nature of markets like real estate. Not sure why we don't hear it used more often, but reflects this isn't a recent phenomenon or unique to homes.

Mike S.

Jim in San Marcos said...

Hi Anon 9:23

I agree FDIC insurance is great. The only trouble I see with the financial side of things is that most of everyone's money is in 401k's and IRA's. These are not insured. Could be some difficult times ahead.

Jim in San Marcos said...

Hi Mike

I remember the "Hog Cycle" from Economics 101.

There is a more interesting cycle I wrote about Kondratieff Wave You might want to read it. It was my second post as a blogger, back in May 2006

Talking "Hogs" in todays market, you gotta mean Harley; a good ride and great gas mileage.

Thanks for your comments

Anonymous said...

I'm pulling my money out of my IRA and paying the taxes. I'm pulling my money out of a property and breaking the 1031 exchange chain... and paying those deferred taxes too. I'm also pulling my cash out of the now 4% yield money market. Why? Because I'm going to "become the bank" I'm going to use all of my cash and make small private loans (secured by real estate with a minimum of 40% equity). I'll charge 12% interest. I'll be in 100% control of my money and my returns will be the inflation index. If the government and the power elite of destroying savers and devaluing the dollar, the only thing one can do is become more proactive and look for better solutions. Lenders are holding back, lending requirements have stiffened, it's taking 2-3 months of red tape to get a loan funded, thus... I'll have something to offer: almost immediate funding and no red tape. This is the perfect time to be the bank. Assets are deflating along with the dollar. The only thing to do is liquidate your assets and create or buy businesses that are recession/depression proof. That isthe only way to survive. Whether it is a long recession or even goes further into a depression (deflationary depression would be murder) everyone better prepare by having businesses that offer services or products that people will need. The USA is on the way down and can not hold off much longer.

Jim in San Marcos said...

Hi Concerned.

I don't give investment advice, but I think you need to get some. If you have money in an IRA, you could transfer it to a Bank FDIC insured account by paying a surrender fee to your present plan. My transfer cost on 17k in my plan is $700. So I moved my holdings to very low risk investments rather than pay the $700 Just cashing out could cost you 25 percent in penalties.

As for property, never sell it if you got it at a good price. A rental unit is a great hedge against inflation just as good as gold.

My dad use to sell people houses that he owned on a land contract. Miss two payments and he got the house back. He sold one house several times. Some people have a lot of hard luck.

My only tip would be to diversify and get some financial advice from a banker. There are just too many different options that you need to seriously consider.

At present we don't really know whether it will be inflation or deflation. If gas goes to $100 a gallon your house could be worth a two million. Your life savings in cash might buy a two week cruise if that's the case.

I wish you luck, you're going to need it. Take Care.

Anonymous said...

Appreciate your concern Jim. For more clarity... my IRA is a stretch/inheritance IRA... no 10% penalty fee. My property is a TIC interest at 6.5% (I sold 3 sfr rentals and 1031'd into it as a temporary parking place). I don't see anything wrong with having notes, businesses and real estate comprising the core of one's portfolio. I can receive 80k per annum by converting the equity and cash from my existing investments into notes. The money I will lose in taxes will be repaid by the note income in a matter of 3-4 months (now I'm even and in full control of my cash). The income from the businesses can be used to buy real estate at the fire sale prices that will be available over the next many years (not to mention REOs and foreclosures). I believe this is a sound strategy. Stocks and bonds have been ruined by the power elite, only manipulators know which way things will go. Call me unconventional or contrarian, I don't know. "Rich Dad's Prophecy" by Kiyosaki is closer than we think... cash, businesses and real estate is a pretty good tripod to me. The best of luck to all of us.

Jim in San Marcos said...

Hi Alfred

Sounds like you'll do OK. The biggest problem people will have from here is planning tomorrow using today as a guide. It probably won't work. Investment vehicles are in a state of flux. There is nothing really certain.

We've seen what has happen to investing in real estate. I could get burned if the government outlawed private gold ownership. Diversity is the real key.

I too have been waiting for real estate to come down to where buying rentals could be a money making proposition.

Don't get greedy with future opportunities, that's where people get into trouble. Money is only a tool, and with a little care, you can build a comfortable life.

Let's have a round of luck for everyone. Thanks for your comments

Anonymous said...

Your analysis fails to recognize the GSE's now have 80% market share in selling guarantees on Mortgage Backed Securities, and they have the ability to raise the price of those guarantees (moving foward) in order to compensate them for their losses on old MBS's.

The GSEs are much more like an insurance company than a hedge fund, a near duopoly with friends on Wall Street, Pennsylvania Avenue, and on both sides of the aisle in Congress.

The GSEs only fail if a "crisis of confidence" prevents them from raising the additional capital necessary to cover their short term losses.

Keep in mind they still measure their default rates in basis points. And they are raising increasing the price of their guarantees moving forward.

With a Federal backstop, Freddie and Fannie only have to worry about massive fluctations in interest rates over short periods of time.