Alvin Soong’s Blog

One of the reader requested on the impact on investments in Asia market esp. Singapore based Investments after the Indy -Mac incident. Incidentally, Straits Times has a report on this and I placed this up to answer on his question.

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In the worst-case scenario, US government support is still affordable. The Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac) and the 12 regional Home Loan Banks are what are known as government-sponsored enterprises (GSEs).

The current attention is focused on Fannie and Freddie, which between them own or guarantee about half of all US mortgages, worth about US$5.2 trillion (S$7 trillion). Some mortgages they keep on their balance sheet, others they buy as a pool from lenders and then create mortgage-backed securities, with their guarantee, to be sold in the capital markets. To fund the on-balance sheet mortgages, they issue debt paper at various maturities, but they do not take deposits.

Freddie and Fannie are listed companies in the United States and are not owned by the US government. Nor is their debt formally guaranteed by the government. Technically, this is still not guaranteed, but the latest announcement by US Treasury Secretary Hank Paulson that the government would support Fannie and Freddie with additional temporary lending facilities and capital injections, if necessary, gives added weight to what was always thought to be an implicit government guarantee.

The Federal Reserve also announced that it would extend its liquidity facilities to the GSEs.
The GSEs do not provide housing loans themselves but buy these loans from banks and, in the past, they were able to borrow at relatively low spreads over interest rates paid to US government bonds.

This is partly because home mortgages are normally fairly safe assets and partly because the markets and ratings agencies always believed that the government would have to stand behind them if it ever became necessary.

The implicit guarantee, together with a special regulatory regime allowing them to operate with much lower capital ratios than commercial banks, enabled them to provide mortgages at relatively low interest rates while still making money for their shareholders.

Unfortunately, the plunge in the US housing market has called into question their ability to stay afloat. With combined mortgage assets of US$5.2 trillion and existing capital of only US$81 billion, Fannie and Freddie are operating on a capital ratio of only around 1.6 per cent (US$81 billion divided by US$5.2 trillion), much less than banks. An eventual loss of just 1 per cent on this portfolio, even taking into account the interest margins they earn, would erode their capital beyond sustainable levels. The stock market realised this, and their stock prices are off 80 per cent or more since last September. On July 11, their stocks closed with a combined market capitalisation of just US$15 billion.

They have since recovered.

Nonetheless, the vast bulk of the mortgages they have bought are relatively safe middle-market mortgages. And while they did buy some sub-prime mortgages and Alt-A mortgages, it seems that they generally are fairly selective, buying or guaranteeing those that are insured - somewhat. Most of the mortgages with the GSEs are outside the worst-hit segments of the housing market. And we can see this from the OFHEO house price index compiled by the Office of Federal Housing Enterprise Oversight, Freddie and Fannie’s regulator. This index rose less than the widely followed housing index, the S&P Case-Shiller Index, during the 2002-2006 housing boom. Crucially, it has fallen by only 4 per cent, much less than the 17 per cent drop in the Case-Shiller Index, which covers almost all houses, in the last year or so.

In short, the GSEs have a relatively good portfolio. Having said that, house prices are still falling fast and both indices are certain to fall far more. The housing downturn has yet to bottom out.

So far, Fannie and Freddie have reported only modest losses, but as house prices fall further, the losses will accumulate. While we are unable to provide a realistic evaluation of the likely eventual losses at this point, it is worthwhile to try to imagine an extreme worst-case scenario and explore the implications. To do this, we assume that the Case-Shiller Index falls an eventual 45 per cent and the OFHEO index falls 30 per cent. This is at the outside range of our expectations.

We further assume that 50 per cent of mortgage holders end up with homes worth less than their loans, that is, they are in negative equity. The next step is to hypothesise that 20 per cent of the total end up with their house values worth less than 80 per cent of their mortgage values, the point at which Fannie and Freddie have insurance. If all 20 per cent default and the agencies collect only 50 per cent on the mortgage, then the losses amount to 10 per cent of their portfolio, or US$500 billion. These losses would emerge over several years and some would be covered by the ongoing interest rate spread but, ultimately, the government might face a loss approaching US$500 billion.

This looks like, and is, a huge number, but to put things in perspective, it is less than 4 per cent of the gross domestic product of the US and less than the cost of the Iraq war.

Moreover, the assumptions made are based on the worst-case scenario, so the likely actual outcome, even if house prices do fall this much, should be substantially less.

The US government had no choice but to explicitly support Freddie and Fannie. The conclusion is, therefore, that even in the very worst scenario, government support for the GSEs is affordable and the alternative is, in any case, unthinkable. If it had failed to do so, the availability and cost of home mortgages would have tightened sharply, exacerbating the house price collapse, while investors holding Fannie and Freddie debt paper, which include most banks, would have potentially faced new write-downs.

In our view, the ongoing collapse of the housing market will require the government to put in capital at some point. The eventual cost to taxpayers could be substantial, but is affordable and there is no need for worry over the US government’s credit rating.

Bond markets are correct to interpret these moves as adding to inflation risks, but we think the US economy will stay weak and inflation will fall back next year. However, there will be political strains to accommodate these losses in a budget which will almost certainly be under stress from a weak economy and low tax revenues over the next few years. We could see some eye-watering US budget deficits for a few years and a rise in government debt.

There is also some danger that this situation may lead to expansionary fiscal and monetary policy which eventually accommodates higher inflation. However, if the economy is weak, there will also be very strong disinflationary forces and we expect them to prevail.

Importantly, almost lost in the turmoil over Freddie and Fannie, a large Californian savings bank called IndyMac was taken over by the Federal Deposit Insurance Corporation (FDIC) after a run on deposits. Its balance sheet of US$32 billion makes this the largest US bank failure since the failure of Continental Illinois in 1984, although IndyMac is substantially smaller than Northern Rock in the United Kingdom.

In comparison to IndyMac, the failure of Freddie and Fannie would be immense, with the repercussions likely to reverberate throughout the financial world, plunging the markets into a deeper crisis.

The problems at Freddie and Fannie should have little direct impact on Singapore because the local banks have minimal exposure. But if the crisis at Freddie Mac and Fannie Mae deepens, it will have implications for Singapore.

A deepening crisis at these GSEs would necessarily mean a worsening housing crisis in US and further unwinding of the credit turmoil inflicting the global financial markets. And the credit and housing crisis, should it deteriorate further, could lead the US into a much sharper slowdown than what we are currently anticipating.

Already, Singapore exports are showing signs of strain with the second quarter’s non-oil domestic exports contracting 5.5 per cent on weaker demand from key export markets, including the US, the European Union and Japan. Tighter global credit conditions could also lead to more cautious lending practices domestically and slow investments.

While the US housing tumble is unlikely to have a contagious effect on the domestic property market, the dent in consumer confidence and investor sentiment would, in turn, impact negatively on property market activity, as we have seen in recent months.

Surely, while the fortunes of Singapore are not directly tied to that of Freddie and Fannie, the GSEs’ fate in the next few months could point to where the Singapore economy - as well as the global economy - could be heading.

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Impact on Singapore

The problems at Freddie and Fannie should have little direct impact on Singapore because the local banks have minimal exposure. But if the crisis at Freddie Mac and Fannie Mae deepens, it will have implications for Singapore.

20th July Straits Times 2008

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