So I haven’t posted for a few days, and unfortunately it’s not because I’ve been on vacation. Analyzing AIG for Motley Fool got me thinking more and more about the financial crisis, and I decided to dig deeper into a recent article I read that Bill Ackman was buying shares of Fannie Mae and Freddie Mac. The result of my digging will (hopefully) be two published articles here on Trading Common Sense and on Motley Fool sometime in the next few days.
Since this site, my book, and my general approach to trading revolve around common sense, and the involvement of Fannie Mae and Freddie Mac in the collapse of the housing bubble was far from common sense, I decided my post today will be Housing Bubble 101.
During most of the financial crisis, I knew next to nothing about the secondary mortgage market, including how it worked and what purpose it served. Even though I was hearing about Fannie Mae, Freddie Mac, AIG, and Countrywide Financial on TV on a daily basis, I didn’t understand the role each of these entities played in the whole mess until the dust started to settle. Let’s take a quick overview of the way the mortgage business works:
1. A mortgage originator creates a new mortgage. These mortgage originators are typically banks such as Wells Fargo or JP Morgan Chase, but can also be thrift banks or other mortgage specialists.
2. A mortgage aggregator, such as Fannie Mae or Freddie Mac, buys the mortgage from the originator, bundles it in a pool of other mortgages, and creates from those bundles the infamous mortgage-backed security (MBS).
3. Investors buy the MBS from from the aggregator and receive payments (plus interest) on the MBS over time.
In theory this system works, and everyone profits along the way. Wells Fargo and other originators charge an origination fee on the mortgage then sell it to aggregators such as Fannie and Freddie. This sale provides cash the originators can use to make more mortgage loans. Fannie and Freddie then create MBSs, sell them to investors, and charge the investors a guarantee fee (g-fee), which guarantees the investors will receive the payments they are due. Finally, investors profit from owning a security that pays an interest-like yield and is theoretically guaranteed by the aggregator. Since Fannie and Freddie are Government Sponsored Enterprises (GSE) they have the implicit backing of the U.S. government, which gives investors confidence in the guarantees.
The tailspins in Fannie Mae and Freddie Mac started during the housing bubble when mortgage originators, names such as Countrywide, Ameriquest Mortgage, and New Century Financial, started approving mortgages for anything that moved. These mortgages to borrowers with bad credit were referred to as sub-prime mortgages. The idea seemed to be that by bundling a bunch of terrible sub-prime mortgages into a mortgage-backed security (MBS), you end up with a security that is not nearly as risky as each of the underlying mortgages itself was. As it turns out, a bundle of crappy mortgages produces a crappy MBS. Who would have guessed? The problem was that the investors that were buying these crappy MBSs had no idea how bad they were because many of them were still AAA-rated by credit agencies, the highest rating possible for a security. Unbelievably, many the MBSs that were unable to obtain a credit rating high enough to sell to investors were pooled and re-pooled to create collateralized debt obligations (CDOs), and many of the CDOs were then somehow assigned AAA ratings from ratings agencies such as Moodys, Standard and Poors, and Fitch. People who had the foresight to see the risk involved in these sub-prime mortage-backed securities bought insurance (credit default swaps) against them from AIG and other entities.
When the sub-prime mortgage borrowers inevitably defaulted on their payments, it set into motion a catastrophic chain of events. Fannie and Freddie stopped receiving mortgage payments and did not have enough capital to continue paying the guarantees they owed to MBS investors. That meant that MBS holders were not getting paid, and the market value of MBSs started to tank. Unfortunately, Fannie and Freddie combined had over $1.5 trillion of these mortgage-related assets on their own balance sheets, so the massive losses from these assets were piled on top of the massive losses they sustained from their guarantee business.
Losses were so overwhelming that Fannie and Freddie required a $187 billion government bailout and were placed under conservatorship by the Federal Housing Finance Agency (FHFA) in 2008. Any company that had MBSs on their balance sheet was also suddenly screwed. And lets not forget our friend AIG, who provided insurance for these sub-prime MBSs. Turns our AIG had to pay up on all those policies, and they didn’t have the capital on hand to do it.
So there you have it in the smallest of nutshells. What a mess… If you add to that story the fact that hardly anybody knew what the hell was happening at the time, you can see how panic quickly set in. The massive size of all these entities involved in the uncertainty triggered unprecedented selling in the stock market, and the financial crisis resulted.
Stay tuned for my article(s) about what happened to Fannie Mae and Freddie Mac in the years since the crisis and why Bill Ackman thinks the $4 shares of both companies could be as high as $47 per share in the future.
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