The Full Story of Fannie and Freddie

By Daniel | August 22, 2008

Before you can collect income on a loan, you have to first give the borrower the money.
When a loan defaults, you have lost not only the income but the loaned capital. Please understand, banks were not dependent on the income stream from their existing loans to grant new loans. That style of operating went out years ago.

What banks were doing was recycling their capital by issuing new mortgages until their capital was fully loaned, then bundling the mortgages into pools that were sold to commercial warehouse banks.
The bank gets all its loan capital back from the commercial bank, and starts issuing new mortgages again–rinse and repeat.

The warehouse bank bundled the mortgage pool into a bond called a mortgage-backed security, or MBS, and sold it to investors such as pension funds, university endowments, municipalities, insurance cos., hedge funds, etc.
This whole process is called the debt-securitization market, and it has ground to a halt. As investors came to realize what was in asset-backed paper, the market for securitized debt dried up and prices collapsed.

This is why FNM and FRE need at least $50 billion each right now. They claim to have reserves of billions of dollars, but most of that is what they call tax-deferred assets, which is nothing more than tax losses that can be carried forward against future profits. The likelihood of future profits is nil, so the value of those TDA’s should be written down to zero.
Then, in a matter of weeks, the GSE’s will have to redeem more than $200 billion in agency bonds. Where is that money coming from?

There is a widespread misconception that Fannie and Freddie deal in mortgages and are free from derivative risk. Nothing could be further from the truth. They hold considerable risk in CDOs, CDSs and other structured credit risks. None of that has been dealt with.

Also, be aware that “writing down” an asset’s value is not the same as taking a loss. It is a way of delaying the loss. The capital loss is not realized until the asset is sold. In the meantime, an entity can take a 30% writedown on an MBS that actually is bid at 22 cents on the dollar, and move a limited amount of capital to the LLR category. If they sold the MBS, they would have to book a 78% loss immediately.

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