China Proactively Dumping Fannie/Freddie Debt in Favor of Treasuries

Posted on August 29th, 2008 in Daily Mortgage/Housing News - The Real Story, Mr Mortgage's Personal Opinions/Research

FT.com has reported that the Bank of China has sharply reduced its Fannie/Freddie securities holdings but sharply increased its holdings of US Treasuries. Is this a sign of things to come? Do they know something we don’t?

This is exactly the reason the Treasury should not give an open-ended, retroactive and explicit guaranty of the trillions in mortgage guarantees made on some of the worst loans to ever come out of the USA. While retroactively protecting a group by backing the debt, you throw those who own US Treasuries under the bus. That would be a real blow to investors and a much broader base of investors at that. I spoke in detail about this earlier this week in my piece ‘Fannie/Freddie – Who Gets Thrown Under the Bus?’

Remember, Fannie and Freddie have near $700 billion in subprime and Alt-A combined. Much of their Prime paper is many grades lower than originally rated due to their deeply flawed automated underwriting systems, DU and LP, during the bubble years, and now crashing house values. Much of the mortgage backed debt is owned by foreign Governments, banks, mutual funds, pension funds and rich investors such as Bill Gross and his clients. These investors knew full well this paper was not backed by the Government, but chose to invest anyway for yield over US Treasuries. They were taking a risk and were rewarded for years with higher yield.

If a retroactive, explicit and open-ended guaranty is given on debt that has never been guaranteed in the past, just as defaults and foreclosures are surging among all paper grades and with house prices continuing to crash, it could be disastrous for US Treasuries. We don’t know for sure the future default rate on loans the GSE’s made, but rest assured it will be much higher than everyone thinks. Without the guarantee, the trillions in mortgage backed debt may lose some value, but the damage is not as great as with Treasuries. The loss is manageable if “isolated” to the past GSE paper.

Bill Ackman actually spoke about a great plan to solve this problem and adequately back investors, which is important, and needless to say most important to the investors. Below are the links.

Threats are flying already. But what does “compensated adequately” mean? Perhaps ownership in the new Fannie/Freddie if indeed their GSE holdings lose value. This would pay big over the next 10-20 years but likely would involve a loss in value immediately. And, they are not considering what would happen to US Treasury values if Fannie/Freddie debt is becomes open-ended, retroactive and explicit guarantee.

“A failure of US mortgage finance companies Fannie Mae and Freddie Mac could be a catastrophe for the global financial system”, Yu Yongding, a former adviser to China’s central bank, says.

“If the US government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic,” Yu said in e-mailed answers to Bloomberg. “If it is not the end of the world, it is the end of the current international financial system.”

There should no problem with explicitly guaranteeing loans going forward after the firms are nationalized. As a matter of fact, the GSE’s are now making some of the best loans ever. With an explicit guarantee going forward, tighter lending guidelines and higher mortgage rates and spreads over Treasuries, investors should have no problem buying up the issues. They would be in such hot demand that it could conceivably make actual mortgage rates cheaper on the front end than they are today.

Without an explicit, retroactive and open-ended bailout that saddles the US tax payer with TRILLIONS in liability, people are worried that these players, especially foreigners, will quit buying Treasuries. Well, that’s the risk you take. But at this point in time that is just speculation.

As clearly reported in FT.com, many of these investors have already significantly lightened their Agency exposure. Strangely enough, even more so around the time the news began to break that the GSE’s were in trouble and there were questions surrounds their ‘implicit guaranty’. -Best, Mr Mortgage

Bank of China flees Fannie-Freddie
By Saskia Scholtes in New York and James Politi in,Washington. Published: August 29 2008 03:00 | Last updated: August 29 2008 03:00

Bank of China has cut its portfolio of securities issued or guaranteed by troubled US mortgage financiers Fannie Mae and Freddie Mac by a quarter since the end of June.

The sale by China’s fourth largest commercial bank, which reduced its holdings of so-called agency debt by $4.6bn, is a sign of nervousness among foreign buyers of Fannie and Freddie’s bonds and guaranteed securities.

Foreign investors have been a mainstay of the market for such debt, but uncertainty over the mortgage financiers’ capital positions and the timing and structure of a potential government rescue has made some investors reassess their exposures. Asian investors in particular have become net sellers of agency debt, said analysts.

Federal Reserve custody data shows that for the year to July, foreign official and private investors bought an average of $20bn of agency debt a month, including debt issued by other government agencies such as Ginnie Mae and the Federal Home Loan Banks. Purchases of US Treasuries averaged $9.25bn.

From July 16 to August 20, foreign investors sold $14.7bn of agency debt, trimming their overall holdings to $972bn. They purchased $71.1bn of Treasuries in the same period. (STORY CONTINUED THROUGH LINK AT TOP OF STORY)

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Other Related Mr Mortgage Research

S&P Goes After Jumbo Prime With Heavy Downgrades

Prime and Alt-A Defaults Surge, Says S&P

Pay Option ARMs – Up to 48% Default Rate

Moody’s and Fitch Join S&P in Massive Jumbo Prime and Alt-A Downgrade Avalanche

25 Responses to “China Proactively Dumping Fannie/Freddie Debt in Favor of Treasuries”

  1. How are current holders of treasuries hurt by foreign CBs buying treasuries? It seems to me that prices will rise and current holders benefit.

  2. Its hard to put this into perspective, but it seems like the profit F&F need to make as private entities is at the expense of the mortgage market. Right now ANYTHING that gets taken away from mortgage formation increases the downward pressure on home prices which are already in stuck in a horrendous positive (down) feedback loop.
    This is an excellent reason to make F&F profitless immediately. If that can be done reliably in a receivership, fine. But if not, then we need to go the extra step and nationalize them.
    One of these two should be done right now.

    Unfortunately, the dialog always focuses on the word failure without spelling out exactly what that means. I don’t know what failure means in this case. If it means nobody gets anything, then we should avoid that (duh). But that scenario doesn’t seem to be on the table.

    In a receivership, all obligations and liabilities are negotiated downwards in a logical way. Everybody shares in the pain according to the risk they assumed in the beginning. This is a well worn path, although the size of these monsters makes it unusual.

    The various stakeholders in F&F would receive various amounts of return. Shareholders are probably wiped out. Corporate debt holders would take a pretty severe haircut, possibly zero coupons until the crisis is over. And the MBS’s would probably have to absorb the foreclosures in their respective mortgage portfolios, effectively reducing the coupons of each MBS. Finally, the CDOs and CDSs held by F&F could be negotiated very aggressively. It might take 5 years, but in the end the toxic debts would be purged and the GSE’s could come out of receivership.

    The problem with this scenario, is that all the available capital might be absorbed trying to fend off real failure. Their ability to acquire capital will be severely impaired. And F&F need to keep buying mortgages, which in this scenario might not happen.

    By nationalizing them, public funds could be injected as needed to keep the deleveraging process operating along side the mortgage purchasing activities. As you say the forward portfolio will be AAA for a long time to come.

    In other words, for F&F to deleverage like adults they have to recognize the true nature of their situation. Unfortunately, its so bad that they owuld be able to raise captial to keep going. However, if the government funded the mortgage purchasing part going forward, and the legacy was worked out within itself, that might work. The only questions are do Ben&Hank have the ‘stones’ for this difficult solution, and do we even have a choice?

  3. if the Chinese are dumping debt issued or guranteed by Fannie Mae/Freddie Mac, doesn’t this foreshadow higher mortgage rates, even in a down economy? if the foreigners aren’t willling to finance mortgage lending, doesn’t his reduce the pool of available funds?

  4. Money flowing out of the housing bubble was used to finance purchases and much flowed to China as their exports boomed. Now money is still needed but to finance depreciating home values. As China sees exports fall more and more they will be less and less likely to buy treasuries, bonds etc from the US as they will see less and less benefit from doing so. So the real credit crunch has not come yet. There is no doubt interest rates will be going up….way up. As an aside: GDP 3.3% in the second quarter…if you count the government rebate checks…FTF. How can you count the rebate checks in GDP? This mess is going to be getting much much worse. A Canadian view…and thank god we are a bunch of tight asses up here. I am however sure the wave will wash most of us away too. Love this blog! Thanks!

  5. I’m concerned with unintended consequences (looking beyond the obvious).

    As previous posts stated. Let’s say this event does bode well for the USD. How is that going to impact home loans and home sales? Up/Down? Is there going to be a trickle down to other areas (commodities/employment)that are going create a more negative economic reactions.

    Are there any safe investments left today, or is it just wait and see what the future brings?

  6. douglas tuttle — well said.

    I’m playing the world’s tiniest violin for Bill Gross right now.

  7. This entire situation is bullshit. Enough already!!!!

    Do anythingat this point and get it over with.

  8. This is all just part of the HYPERDEFLATION scenario.

    People are DUMPING GOLD. Inflation hedges are pathetic in a HYPERDEFLATIONARY environment.

    People are dumping real estate. Inflation hedges are pathetic in a HYPERDEFLATIONARY environment.

    People are dumping commodities. Inflation hedges are pathetic in a HYPERDEFLATIONARY environment.

    People are dumping stocks. Inflation hedges are pathetic in a HYPERDEFLATIONARY environment.

    People are dumping corporate bonds.

    THE ONLY investment in a HYPERDEFLATIONARY environment is the HIGHEST quality bonds.

    The markets (in this case China) are simply saying that the GSE debt is LESS LIKELY likely to be safe in a hyperdeflationary.

    There is a BULL MARKET in the SAFEST bonds you can find.

    Right now the market says those are Treasuries.

    All this is consistent with the complete, total and absolute liquidation of the world’s entire financial system. Get ready for the falling pianos.

    Tony Buzan

  9. I am surprised swiss government bonds aren’t more popular.

    The bigger issue to me is deleveraging. The entire system was leveraged by alan, george, ben, hank
    and as people shed leverage, they take their cash into treasuries.

    if things are really deflating buying puts and futures is a good play too

  10. Tony. I fear when the “pianos fall” Treasuries won’t even be safe. I guess they will be as safe as any storage value and that is where I have been for awhile. Sounds like “cash is king”.

    To everyone thanks for the comments.

  11. Funny bit of synchronicity that the cover of this week’s Barron’s has a picture of a falling piano!!

    Either you believe in the markets or you don’t. Right now the markets are saying that gold will not be safe, real estate will not be safe, commodities will not be safe, stocks will not be safe, corporate bonds will not be safe, GSE bonds are less likely to be safe and Treasuries will definitely be safe.

    That’s simply what the markets are saying at this point in time. Either you believe in markets or you don’t and Treasuries easily trade 800 BILLION EVERY DAY, it’s the most transparent market in the world with the tightest bid/ask spreads in the world.

    Either you believe in the markets or you don’t.

    That’s my opinion.

    Tony Buzan

  12. For all the doom and gloomers out there, it is interesting to note that the “horrible” books of the GSEs only have a delinquency rate of about 1%. Not all of these loans will default. After the loan defaults, there is some recovery when the REO is sold. So think about what the ultimate value of all those MBS after you run through the math. Seems like the downside on an MBS which would take place if the GSEs fail and the US government also lets them go is something over 99 cents on the dollar.

  13. Hold on with the stats. Fannie of quickly approaching 1.5% from .75% last year. That’s a 100% increase in less than a year. With values continuing to plummet and going out of the summer selling season defaults will pick up just like we are seeing across all paper grades.

    And, they only report AFTER the NOD phase meaning we never see the 30-90-day delinquency rate. In the past 6 months the cure rate from NOD to foreclosure and even from 30-day late to NOD has plummetted.

    The GSE’s back some $700 billion in Alt-A and subprime but their Alt-A and Subprime were not structured like the Wall St bank product. Due to the longer fixed periods before the first adjustment and much of it being 30-year fixed, other factors than payment resets will force default. But that is exactly what we are seeing due to the negative equity effect. Like Jumbo-Prime and Alt-A, the GSE’s time has not come yet for massive loan defaults but it will. You have to be ahead of the market and the ratings agencies to be able to accurately predict where this market is going. I don’t care what the defaults have done in the past – it is of little consequence and does in no way portray the future.

    Remember, the GSE’s back almost half the loans in the US. They have so many loans on their books a 1.5% default rate is massive.

    A more interesting stat is how many of the loans originated from 2003-2007 are delinquent. Very few track this. I have heard estimates from a couple sources with a particular GSE that within later vintage loans the default rate is over 5% and growing quickly as values fall.

    Lastly, remember that in addition to the $700 billion in Alt-A and Subprime, they guaranty about $1 trillion of ‘prime’ loans that in all probability will act much closer to Alt-A and Subprime due to their broken underwriting systems, DU and LP, during the bubble years.

    That makes for about $1.7 trillion of ‘at-risk’ loans that could very well experience a double-digit default rate over the next year.

    Oh and recovery through foreclosure is very low. In CA, the average loss from original loan amount is 50% and from original value is over 60%.

    Quit looking in the rear view mirror or you will not see that diesel truck bearing down on you.

  14. Apparently credit card debt is exploding as people try to maintain their standard of living. The calculation may be that since one’s credit is going to be ruined anyway, it doesn’t matter how much other bad debt you take with you when you default on your mortgage.

  15. Response to Tony Buzan.
    I think it’s pretty obvious that the US and global economies, if left to themselves, will deflate like crazy. This is already full swing with the deflation in housing that is spreading around the world.
    HOWEVER, the central banks aren’t about the leave these economies to themselves. The best guess is that they consider deflation worse than inflation, and will FLOOD the system with money to stop deflation at all costs. Who knows, they may be right.

    For individuals like us, trying to save our butts, the questions are:
    1. can they actually print and deploy that much money?
    2. or will deflationary pressures just win out?
    3. can they really control such a blunt instrument, or will they print too much and create hyper-inflation?
    4. will the whole global economy follow?
    4. what happens after this scenario plays out?

    Personally, I think the US still drives the world economy and the Fed will successfully create more than enough inflation for the whole world. The dollar is still the reserve currency, which means deals all over the world still have to clear in dollars.
    The depression was a deflationary cycle that wasn’t properly dealt with.
    Ben&Hank will err on the other side by over doing it, which is more like the 70’s where too much money got printed before Paul Volker’s very high interest rates were used to rebalance the economy. This time it’s worse, though.
    If they print like crazy, all world currencies will inflate, including treasuries, making commodities like gold the safer refuge. Gold is the only currency that can’t be created (printed) or destroyed (inflated out of existence).
    At the end, there will simply be too much money around to have much value. Is it the end of the world? Of course not. But a whole lot of people will have a whole lot less money, and I’d prefer not to be one of them.

    Fiat currencies have devolved into tiny magnetic impressions on disk drives that are worth even less than ink on paper. At least you can burn paper money to stay warm. For that matter you can’t eat gold, either. But historically, paper currencies come and go, where gold has always retained value. Only real commodities can retain value in a hyper-inflationary envrionment.

    This is a kind of war between deflation and inflation. I’m not sure which will win, but I will be hedging my bets.

  16. To admin –

    Your understanding of how the GSEs report their delinquency figures is incorrect.

    Your total amount of loans originated that are guaranteed by the GSEs that you assume will go bad is wrong.

    Your thoughts about the total amount of prime loans the GSEs have insured that will go bad is lunacy. These loans have already gone through a very severe stress period and are still performing.

    You are stetching your figures to reach your 100 percent increase claim.

    Even if all your thoughts were facts, it still does not change the assertion of the original post which is that the real downside risk to default of MBS is extremely low and these cash flows help service agency debt.

  17. MA – many have heard the exact same arguments before beginning with subprime securities, then CDO, then Pay Option, Alt-A now Jumbo Prime.

    I am not saying any ‘total’ will go bad.

    I maintain that all GSE securities have such low levels of credit support due to the false assumptions about credit quality and collateral valuation that all loss assumptions are incorrect.

    I am not saying 100% of the securities will go bad by any means but I absolutely could see 33-50% of all their Alt-A and Subprime individual loans go bad over time. I maintain that those labaled ‘Alt-A’ are more likely subprime quality especially after values have fallen so far so fast.

    Due to their faulty underwriting systems, DU and LP, I think another $1tt to $1.25tt of ‘Prime’ loans are actually anything but that and will perform much closer to Alt-A or Subprime over time.

    If I am correct, then it could conceivably wipe out many securities now thought to be safe.

    One more thing, if you are correct then why is there any question whatsoever over th US Gov’t backing these securities. If they all are going to be fine why are threats rolling in from their owners about the ‘implicit’ becoming ‘explicit’.

    If you are right, there should be no ‘explicit’ guaranty and these securities should trade on their own accord, with respect to both price and cash flows.

  18. GSE MBS are not senior sub securities like other securities you reference and will not get wiped out like non-agency subprime or CDO securities.
    The severity figures you quote are accurate for non-agency subprime loans but not GSE severities.
    The 2006 non-agency subprime delinquency is about 40% of current balance. The GSE prime loans you claim that will eventually perform like subprime loans have current delinquency rates of less than 1%. When do you predict these 30 year, fixed rate loans are going to start going bad? 5 years after they were originated? If they are going to perform like subprime loans, they better hurry up and start defaulting because their current performance is a long, long distance from subprime loans.
    There is a current panic because many financial players are under stress. All spread product has widened and trade based upon liquidity, cash flows and fear and greed. Just like always.
    I do not understand your comments about threats rolling in from the GSEs owners. The management of Fannie and Freddie are not requesting an explicit guarantee.

  19. I believe that in the future, defaults across GSE loans will sky rocket as we saw with private label. I spend the better part of 20-year originating, packaging and selling billions of this stuff.

    This is where Wall St analysts fall flat on their face. They have no clue what was really done during the past 5 years and base everything off the ratings. I, on the other hand, have consistently been 6 months a year ahead of the raters. I am just telling you things that WILL happen based upon my intimate knowledge of what really happened.

    I saw 580 credit score borrowers fresh out of a foreclosure, get a ‘Prime’ loan with the best rates Fannie had available if you lied on the input and said he had 50% of the mortgage amount in liquid assets which includes ready cash and retirement at 70%.

    I saw up to 50% of all the rate and term refis to 80% loan to value and even up to 100% cltv get appraisal waivers for $150 fee to Fannie.

    I saw underwriters re-run the loan through the DU or LP system over and over and over again changing the numbers around slightly each time until the finding gave an ‘approved/eligible’ and it was classified Prime. Then the underwriter would write up an approval based upon the borrower or broker getting conditions that matched was needed for this specific approval even though by this time it was night and day different from the original loan application.

    I saw every appraiser from 2002-2007 not provide the ‘best’ comparables rather the most expensive comparables.

    When it comes down to it, subprime is subprime is suprime. The GSE’s have already categorized $700 billion and Alt-A and Subprime. I believe that up to 50% of these will default. There are also $1 to $1.25tt in loans currently rated Prime that are missing very important documentation and will perform as much lower grade paper, primarily due to borrower quality, negative equity and interest rate adjustments on the ARM product.

    The securities will fall apart. Nobody is expecting what I know will happen. They never expected Jumbo Prime to begin to default and the raters assulting this segment either. I was screaming about Jumbo Prime mid 2007. Just give it time.

  20. Personnally I don’t see any other avenue than monetization of the debt. The Chineese shouldn’t even be buying US treasuries. These foreign investors are the nicest people in the world. You are lucky. I wouldn’t want this paper, not even US treasuries. They will come to regret it. You lucky Americans. Always saved by Asia and Saudi Arabia, a second, a third, a fouth etc… chance.

  21. Mr. Mortgage — Great thread, especially your last comment. A couple questions if you are still following:

    1. I’m not surprised by most of your “I saw xxx” comments, I’ve seen or heard about a lot of that stuff going on, especially appraisers consistently using the most expensive comparables. But your comment about “appraisal waivers for $150 fee” is new to me, what exactly does that mean? Did the underwriter, or Fannie, waive the need for a real appraisal under certain circumstances?

    2. My impression has been that Fannie/Freddie underwriting was actually pretty decent, if not stellar, up until 2007 when private lending dried up, and then their standards really fell off a cliff and they started taking on all the toxic Alt-A stuff that used to go to the private paper market. Is that an accurate assessment?

  22. I believe the Russians started the dump in the January / February time frame. What I don’t quite clearly understand is what happened so fast and furious that in just roughly 120 days Freddie has lost nearly 90% of it’s value and Fannie has lost nearly 80%. We are talking a total collapse here!! This is unprecedented in time frame and the amount of money as a result I would guess…

    So where to now? Well the answer is obvious to me. We take it over and Common and Preferred share holders lose 100% period. No discussion here looking at the numbers. Period. end of story for them and then move to subordinated holders depending what is left after Seniors get their money. My bet is not too much is left. In fact nothing may be left to be quite realistic when you really look at the numbers here. Then destroy these agencies once and for all!

    The consequences for our countries actions will be felt for a long, long time and many, many people will suffer as a result of our decisions, but we now have a chance to break free of this foolish set up of GSE’s that never should have gotten as big as it has and as powerful in terms of dollars. This was totally wreckless in my opinion to our countries financial stability!!!

    Hey if it comes to the US jepordizing treasuries and / or tax payers footing the bill in America in order to save our fellow Asian countries I have news for you. It ain’t happening! Unless this country wants 100 million people to take up arms in the street it will never happen that we suffer at the hands of any other country. We have freedom of speech and the biggest armed army in the world bar none… The American Tax Payer!!! They will not go there. They can’t go there to be quite honest…

  23. Admin –

    It sounds like you are admitting on a public blog that you personally committed fraud. Is that correct?

  24. MA – well if you consider ‘I saw’ meaning I personally committed fraud then yes I personally committed fraud. I saw a dog get hit by a car last week too. Just so happens, the car that hit it was in the other lane going the opposite direction. WTF are you taking about.

  25. Interesting report out today on the agencies ability to find funding on the debt that must be rolled over soon… Hmmm I think the end may be near for these two agencies. Well at least as we know them to exist today. Mind you this is a good thing, but it will wreek havoc for home buyers and sellers at a time when they can least afford to handle it.

    I was thinking as well that if these two agencies account for 75% of the mortgages and they themselves default, then what will housing look like near term? Will inventory explode to 15-20 months literally what will seem like overnight? Will long term interest rates explode to near double digits? What will the default landscape look like? Will foreclosures spike by 200% or more? This could be a potential disaster in the making and the bad part is it has to happen, it will happen, heck in some ways it is already happening isn’t it?

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