RateWatch #360 – What’s Up With FHLMC?
June 14, 2003 by Dick Lepre

What's Happening

At mid-week the 30-year Treasury future price has formed what is called a "high pole" formation. This is significant because this formation is regarded as the most accurate at forecasting market movement.

In short, this is calling for an 8 point upward movement in 30-year Treasury futures with a 128 price objective for the September future. This could translate into a 0.375% lower yield. (This is from this past Tuesday to the market top.)

What mortgages need in order to be able to respond to this is a quick resolution to the FHLMC issues so that Mortgage Backed Securities move in harmony.

It must also be noted that when this market turns, prices will be killed and yields affected adversely to the extreme.

Of further note is the fact that these technicals are forward looking and indicative of the fact that the recent run-up in equities flies totally against what the bond market is saying.

Something's happening here. What it is ain't exactly clear.

Good news/Bad news: Initial Jobless Claims were down last week but are still too high.  Core Retail Sales were +0.1%. I keep reading about a "housing bubble."  This week, columnists with nothing else to do are trying to establish a nexus between FHLMC's accounting problems and a
"bursting of the housing bubble."  Home prices may fall in some geographic areas as they are economically impacted but that is not what "bubbles" are all about. "Bubbles" are investments in things that owners suddenly decide to sell because it becomes clear that their value is no where near the market price. Examples are the tulip bulb thing from centuries ago, the South Sea Bubble
(read about those two on the Internet - very interesting stories), the Internet stock bubble and the Tokyo commercial real estate bubble. Unless people suddenly decide to start living in cardboard boxes rather than houses, there will be no bursting of a housing bubble.


Without getting into the details too deeply, it would serve well to look at what the problem is with FHLMC. Let's first back up. There are three GSE's (Government Sponsored Entities) that have been created to help the housing and mortgage markets:  GNMA, FLMMC (Freddie Mac) and FNMA (Fannie Mae). 

GNMA is designated to help low to moderate income folks. FHLMC and FNMA are, for lack of a better term, for the middle class.

FHLMC and FNMA are the providers of what we always refer to as "conforming" loans.  They do essentially the same thing. They buy conforming loans from mortgage originators, pool them into groups and sell these groups in pieces as MBS Mortgage Backed Securities or PCs
(Participation Certificates).  If you own a PC you own a piece of a certain set of loans. As the funds come in to the servicer each month, the servicer collects a small piece for the servicing and passes the rest of the money to FHLMC or FNMA. They then divvy the booty to the holders of the PCs or MBS. The loot consists of principal, interest and any partial payoffs.

Mortgage Backed Securities are, in essence, a derivative - an instrument intended to pass along rate risk.

This system has provided two excellent things:

1) lower rates on mortgage because the assumption is that these loans are of a less than average risk and
2) on the other side - an excellent investment opportunity offering a higher return than Treasuries with almost no perceived risk.

It is worthwhile here to note that GNMA debt is guaranteed by the Federal government whereas FHLMC and FNMA debt is not.

So what did FHMLC do wrong? At minimum, they fudged their accounting of certain income on derivatives to as to underreport income for some quarters with the presumed intention of bringing that income into future, less sanguine quarters and, in effect, smooth out their quarter-to-quarter

That may not be an "Enron-like" crime but is flat-out dishonest in as much as it deceives the investing community about quarter-to-quarter variance in income and eliminates a factor that an investor might otherwise use to determine the value of FHLMC stock.

But with the markets being what they are investors are, for the moment, fearing the worst. Maybe FHLMC did something 100 times worse than this and we are looking at the front-end of a gigantic problem.  There is no evidence that this is the case but investors erred on the side of caution this week as a 2 point gain in Treasuries failed to move MBS.

There are several other problems that FHLMC and FNMA have had over the past few years that have become "running arguments" between these GSEs and others in the government.

I think that the underlying issue is that these two entities dominate the mortgage business and those would-be competitors, for example, large banks have set out to undermine some of the favors that these GSEs get from the government with the sole intention of getting a bigger piece of the action.

There is an entire organization called FMWatch (see: http://www.fmwatch.org/) which exists for the sole purpose of dissing FHLMC and FNMA.

For me, the bottom line is that these two entities have done wonders for those of us in the mortgage business and for all homeowners.  FHLMC cleaned house very quickly in response to the recent revelations and needs to restate its income and get on with the business of securitizing
mortgages and not do any creative accounting in the future. Oh, and as a deja vu thing, FHLMC's former auditors were (drum roll please) - Arthur Andersen.

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