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Freddie Mac, Fannie Mae Deja Vu?

Posted by Larry Doyle on May 28, 2009 4:21 PM |

Can our economy absorb another financial hit of the magnitude of Freddie Mac and Fannie Mae?

In the process of digging for some data on Uncle Sam’s TARP commitments, I came across a compelling story at Subsidyscope, a Financial Primer (right sidebar) link here at Sense on Cents. The lead story at Subsidyscope, dated May 26, 2009: Concerns Grow Over Federal Home Loan Bank Investments. They write: 

The Federal Home Loan Banks, or FHLBs, may be the biggest financial players you’ve never heard of. Collectively, they hold $1.3 trillion in assets and are the largest U.S. borrower after the federal government.

For readers here at Sense on Cents, I have raised warnings about the FHLB system both on April 3rd (Putting Perfume on a Pig!!) and just this past Monday, May 25th (FHLBs: Red Sea, Dead Sea, or Both?). In my opinion, there is little doubt that the FHLB system was the greatest beneficiary of the FASB’s relaxation of the mark-to-market. Subsidyscope says as much:

A Subsidyscope review of the FHLBs’ financial statements has found that several of the banks are carrying substantial “unrealized losses” on their investments in mortgage-backed securities. Because the banks believe these losses are temporary, they don’t have to be recognized on the banks’ accounting statements.

What’s potentially worrisome is the sheer size of the losses. For the Federal Home Loan Bank of Seattle, they are substantially larger than the capital the bank holds to protect itself against such declines. If its mortgage-backed securities don’t regain their value, the bank will have to write them down, which could wipe out its capital buffer and raise risks for taxpayers. 

Remind you of Freddie Mac and Fannie Mae? I thought so. Let’s continue to dig even deeper. Subsidyscope asserts:

The troubles began when several FHLBs invested heavily in mortgage-backed securities created by Wall Street. As the housing crisis developed, these investments lost a good deal of their value. A Subsidyscope review of the banks’ annual reports found that in the first three months of 2009 alone, several FHLBs saw the ratings of a large portion of these securities decline from AAA to junk status, most notably the Boston, San Francisco and Seattle banks.

What were these securities? To a large extent they were Jumbo prime mortgage-backed securities (MBS), Alt-A (not full documented loans), pay-option ARMS, and sub-prime product. These securities trade everyday but at prices which would substantially, if not completely, wipe out the capital base of many of the FHLBs. Subsidyscope provides further riveting analysis:

Over the past week, new financial reports have come out that confirm trouble at the Federal Home Loan Banks — and the biggest news comes from the Seattle bank. In the wake of the downgrades to its securities, the Seattle FHLB reported nearly $1,374 million in unrealized losses. That’s almost one-and-a-half times the $960 million the bank held in capital on March 31. 

Bank officials maintain they have sufficient capital to withstand writedowns and defaults in the interim and that the securities will recover in value over the long haul. Does that remind you of the arguments put forth by many iterations of management at Freddie and Fannie? I thought so . . . me, too. 

When Freddie and Fannie went into Uncle Sam’s hands last September, the FHLB system was also showing signs of serious stress: 

Last fall, the FHLBs’ private mortgage-backed securities had already run into enough trouble to raise concerns about capital levels. In January, Moody’s reported that in the worst-case scenario, if their securities never regained their former value, eight of the 12 home loan banks would fail to meet capital requirements.  

While government officials want to keep this FHLB story “under the rug,” Wall Street is well aware of the issues amongst these 12 banks. In fact, as a measure of risk Wall Street is pricing the credit default swaps on FHLB debt at more than twice the level of CDS on Freddie Mac and Fannie Mae debt when those entities were taken over by Uncle Sam. 

Thank you Subsidyscope for shedding light on these developments within the FHLB system. I strongly recommend reading the Subsidyscope piece for those who care to understand this gaping canyon on our economic landscape.  


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