Chapter 84 5. Fannie Mae and Freddie Mac: Second Federal Reserve

Many financial institutions do not seem to understand the risky nature of these (short-term GSE-issued) bonds.Investors mistakenly believe that their investments can completely avoid (GSE) credit risk. The reason is that when the crisis occurs, they think that there is enough warning time to wait for these short-term bonds to mature in a few months.The problem is that when a financial crisis hits, short-term GSE bonds become completely illiquid in a matter of hours or days at most.Although any investor can choose to exit, when all investors flee at the same time, no one can escape.As in the case of a bank run, the rush to sell GSE bonds will not succeed as a whole because the real estate assets underlying these short-dated bonds cannot be liquidated quickly.Federal Reserve Bank of St. Louis President William.Pohl, 2005

The government chartered agencies here refer to Fannie Mae and Freddie Mac, the two largest real estate loan companies chartered by the US government.The two companies are responsible for building the secondary market for U.S. real estate loans, and they have issued bonds with real estate as collateral totaling as much as $4 trillion.In fact, most of the seven trillion dollars in real estate loans issued by the US banking system are resold to these two companies.They bundle these long-term real estate mortgages into MBS bonds, and then sell them on Wall Street to financial institutions in the United States and central banks in Asia.There is a spread between the MBS bonds they issue and the real estate mortgages they buy from banks, which constitutes the source of profits for the two companies.According to statistics, 60% of banks in the United States hold more than 50% of the bank's capital in the bonds of these two companies.

As public companies, both Fannie Mae and Freddie Mac are profit-oriented, and it is more profitable for them to directly hold real estate mortgage loans. In this case, interest rate fluctuations, mortgage prepayments and credit risk will be borne by themselves.When the Federal Reserve began the long process of raising interest rates in 2002, Fannie Mae and Freddie Mac began to buy and directly hold real estate mortgage loans in large quantities.Five trillion dollars. As a financial institution with such a huge debt, it should be careful to avoid risks. The most important strategy is to match the maturity of assets and debts, otherwise the risk of interest rate fluctuations will be difficult to control.Second, short-term financing to support long-term debt should be avoided.The traditional conservative method is to issue long-term recoverable bonds, so that the time limit of assets and debts can be synchronized, and the interest rate difference can be locked at the same time, so that the two major risks of interest rate fluctuations and mortgage prepayment can be completely avoided.However, in fact, these two companies mainly use long-term fixed bonds and short-term bonds for financing. The scale of their short-term financing is as high as 30 billion U.S. dollars in short-term bonds every week, thus exposing themselves to a high degree of risk.

In order to avoid the risk of interest rate fluctuations, they must adopt complex hedging strategies, such as using debt and interest rate swaps to generate a combination of short-term debt + future fixed-interest cash flows to simulate the effect of long-term bonds.Use swap options to hedge your mortgage prepayment risk.In addition, they also use incomplete dynamic hedging strategies to focus on defending against possible sharp fluctuations in short-term interest rates, but are negligent in defending against unlikely long-term interest rate fluctuations.With these measures, everything looks solid, and the cost is quite low, which seems to be the perfect way.

Under the strong desire to pursue profits, Fannie Mae and Freddie Mac also bought a lot of MBS bonds issued by themselves in their investment portfolios.It may sound counterintuitive at first, how can there be any reason to issue short-term bonds to buy long-term bonds? Strange things have their own reasons for strange things.Fannie Mae and Freddie Mac are monopoly operators in the secondary market of real estate loans authorized by the US government, and the US government provides indirect guarantees to these two companies.The so-called indirect means that the U.S. government provides a certain amount of credit lines to these two companies, which can be used in emergencies.In addition, the Federal Reserve can discount the bonds of Fannie Mae and Freddie Mac, which means that the central bank can directly monetize their bonds. In the past half a century, except for US treasury bonds, no corporate bonds have had this award.When the market learned that the bonds issued by Fannie Mae and Freddie Mac were almost equal to dollar cash, their creditworthiness was second only to US Treasury bonds.Therefore, the interest rate of the short-term bonds they issue is only slightly higher than that of government bonds. Since there are such cheap sources of financing, there is still room for arbitrage in buying their own long-term bonds.

It is not an exaggeration to say that the bonds of these two companies play the role of the bonds of the U.S. Treasury to a certain extent. They have actually become the second Federal Reserve, providing a large amount of liquidity for the U.S. banking system, especially when the government is inconvenient. when.This is why after the Federal Reserve has raised interest rates seventeen times in a row, the financial market is still flooded with liquidity, and the liquidity originally sucked back by the Federal Reserve flows back into the financial market through the GSE's large-scale purchase of bank real estate loans.This situation is similar to that in the movie "Tunnel Warfare" in which the devils continuously pumped water from the well and poured it into the tunnel in the village. The clever guerrillas sent the water poured into the tunnel back to the well through the secret passage, which made the devils wonder, don't know How deep is the tunnel.

GSE’s arbitrage behavior of purchasing long-term MBS bonds with short-term bonds, coupled with international bankers financing from the yen market at very low cost, and then buying options for U.S. treasury bonds with high leverage, artificially caused the U.S. long-term bond (Treasury bonds and 30-year MBS bonds) The boom in unusually high demand, which drove down long-term bond yields, made market fears of long-term inflation look unfounded.Therefore, after a while of hesitation, foreign investors will return to the U.S. long-term bond market, so the savings of other countries can continue to fund the U.S. economic perpetual motion machine experiment, so people continue to revel in the feast of desire.

It's just that the best illusion is an illusion after all.When GSEs continue to supply alcohol for the carnival, their own capital has dropped to an extremely dangerous three.at the five percent level.Under the heavy debt of trillions of dollars, in the violently turbulent international interest rate market, its capital is so low that it is enough to make Greenspan lose sleep.Recalling that the long-term capital management fund had the most complete and complex risk hedging model under the guidance of the world's most economical master, a Russian debt crisis wiped out this perfect hedge fund admired by the world in an instant.Can the GSE hedging strategy that relies heavily on financial derivatives withstand unexpected emergencies?

The weakness of GSE lies in its serious flaws in preventing sudden changes in short-term interest rates.Federal Reserve Bank of St. Louis President William.Pohl was worried about the GSE's ability to resist interest rate shocks. After analyzing the daily interest rate fluctuations of U.S. Treasury bonds over the past 25 years, he concluded that: Among the price fluctuations of more than 1% of national debt, about three-quarters of the cases have an absolute value of more than three.Five standard deviations, which is sixteen times higher than estimated by the usual normal distribution pattern.Assuming that there are 250 trading days in a year, the probability of interest rate fluctuations of this intensity is twice a year, not once in eight years as people estimate.The normal distribution model completely misjudged the risk of wild swings in interest rates.More than four.The super-intensity volatility of five or more standard deviations, not seven parts per million as one would expect, but eleven out of 6,573 trading days, would be sufficient Shock a company that relies heavily on financial leverage.Another point is that violent fluctuations tend to burst out in a concentrated way.This feature is important because it means that a company can be shaken violently several times in a short period of time.Incomplete hedging will lead to the complete failure of this company in the case of wild fluctuations in interest rates.

If financial hackers suddenly attack the U.S. dollar, terrorists carry out nuclear or biochemical attacks on the U.S., and the price of gold continues to soar, the U.S. treasury bond market will be shaken violently. Liquidity was lost within a few hours, and the Federal Reserve did not even have time to rescue it, and even the Federal Reserve could only rescue it intentionally but unable to rescue such a large-scale collapse.In the end, 60% of American banks may be dragged down, the highly vulnerable 370 trillion financial derivatives market will experience an avalanche, and the world's financial markets will experience a frenzied escape.

The huge risks in the financial derivatives market reflected by the GSE are only the tip of the iceberg. Kiyosaki, the author of "Rich Dad Poor Dad", described the prosperity of the debt economy in today's world in the article "The Lust of Debt": The problem, as I see it, is that these (sky-high) acquired companies were not bought with money and capital, they were bought with debt.My common sense tells me that someone will have to pay these debts in the future.The ultimate collapse of the Spanish Empire was due to an excessive greed for war and conquest, and I fear that the world today will eventually repeat the same mistakes due to its expensive lust for debt.So what is my suggestion?For now, revel in the party (of lust) but don’t drink too much and stand near the exit. In a huge casino full of colorful lights, people are concentrating on betting the dollar, which Kiyosaki called a funny currency. At this time, those who are not yet drunk can already see smoke from the corner of the casino. , they quietly walked towards the narrow exit of the casino as calmly as possible at this time.At this time, the flames were already faintly visible, and people still didn't realize it, but more people smelled the smoke, they looked around, and some people began to whisper.The casino owner was afraid that everyone would discover the flames that had appeared, so he yelled loudly and set up a more thrilling game, and most people were attracted to the gaming table again.The flames finally gradually turned into flames, and more people started to commotion, some started to run, and most people were at a loss.The casino owners started to say that some flames and smoke are normal and stimulate the casino business, and that the flames (inflation) are completely under control, as they have been since 1971.Propaganda played a role in stabilizing people's hearts, so people continued to gamble.It's just that more and more people are crowding towards the exit.The scariest thing right now is a scream When disaster strikes, everyone looks for their own exit.For Kiyosaki, the casino's exports are gold and silver.In his article "Betting on Gold, Not Funny Money" he states: I think gold is cheap and it goes up when the price of oil goes up and when Russia, Venezuela, Arab countries and Africa become less and less accepting of our dollars.For now, we can still pay for products and services in other countries with our ridiculous currency, but the world is getting tired of dollars.My strategy for many years has been: Invest in real money, which is gold and silver.I also continue to lend out funny money to buy real estate.Whenever the price of gold and silver fell sharply, I bought more of the real thing.What smart investor wouldn't want to borrow funny money to buy cheap real money?