US owns Fannie Mae and Freddie Mac: Inflationary or not?
A quick re-cap of why this matters.
The mortgage industry today is structured very differently today. Mortgages are bought and sold to government entities, pension funds and other investment groups that want a steady cash flow. The banks processing the individual loans rely on a clearinghouse to aggregate the loans and sell them on. This role has been played by Fannie Mae.
Fannie Mae's role is more than just an expediter. It provides a certain amount of liquidity and risk management, both of which keep mortgage prices low. Without a Fannie Mae, mortgage rates would soar. FNM's business model is simple - they make money on the difference between the rates on the money they borrow and the rates on the loans they buy. That might only be 1/4%, but it's across trillions of dollars.
Lately FNM/FRE have faced a serious problem. Entities don't want to buy their debt because they rightly doubt the companies' longterm viability. Inability to borrow cash is a double hit: FNM/FRE can't buy mortgage loans and FNM/FRE capitalization (aka solvency) is a problem.
To calm the markets, some tricks have been rolled out. last month they sold $2B in new debt. http://news.moneycentral.msn.com/ticker/article.aspx?Feed=OBR&Date=20080825&ID=9058077&Symbol=FNM
In reality, they just rolled over new debt for old debt. Buyers of new debt were guaranteed that FNM/FRE would use the cash to buy back the same amount of old debt. In other words, buyers did not want to increase exposure to FNM/FRE but they were willing to go along with the game to bolster FNM/FRE shows of strength. Not only that, but FNM/FRE capitalization didn't change. Why the charade? To prevent a massive dumping of FNM/FRE debt. That would make their capitalization that much worse and make the value much less for the bond holders.
China had $340B in FNM/FRE debt, and they are selling it and not buying any more.
The implications of a FNM/FRE failure go beyond the US housing market and hit directly at the entire US economic model. We depend on low-cost debt. The term "too big to fail" is bandied around a lot, but the reality is, if we don't keep FNM/FRE in business, then global investors will lose faith in our system. If we had to compete for money in the global marketplace, we would have to raise interest rates a lot higher.
Even saving FNM/FRE opens the door to inflation. A lot of money has to get printed to cover the debt. The US Government just added $5T in debt.
Now, not all of that debt is bad. But would you, as an investor, feel comfortable trusting anyone to tell you which is which? Especially given the current climate of accelerating foreclosures and falling prices.
In fact, price stability is critical. Can it be delivered? It will be very hard in a recessionary climate with unemployment rising. Incredibly, making housing out of reach for the majority of Americans is th eonly way to keep the US economy afloat.
It's hard to know how the markets will react. They will favor the 'business as usual' approach that will maintain the current system of writing mortgages and selling them on.
ETFC and other investment companies should look good because they can now unload their FNM/FRE debt onto taxpayers.
The dollar could even rise as US economic stability is delivered, regardless of the cost. After all, wth global recession on the way and inflation largely tamed, other countries have scope to drop interest rates. By default, that makes the dollar stronger. That would mean a further drop in commodity prices. Oil at $80???
Or will the markets realize that this can not be funded without printing more dollars, undermining its value? It's a fight between reality (the dollar is more worthless) and systemic collusion (governments fighting to keep the dollar strong)