Let's put Freddie and Fannie aside for a second and talk about the state of our banking and credit markets.
Up to now worldwide the financial institutions have written off $514 billion, and they have raised an additional $364 in new capital. Conservative estimates now show that these institutions will have total writeoffs in the neighborhood of $2,000,000,000. That's $2 Trillion. This means we are about one fourth of the way through the credit crisis in terms of losses.
Along with these writedowns, the financial institutions have been swapping hundreds of billions of dollars worth of toxic mortgages with the Fed in order to stay solvent. The Fed up to this point has said this is a short term loan and the banks will have to take this debt back on their balance sheet when the smoke clears. The big banks have also done some Enron style financial trickery, extending their loan loss grace period from 120 days to 180 days on home equity lines, thus pushing those losses to future quarters.
In addition to all this the banks have another enormous financial storm cloud looming in the not so distant future. In order to stay solvent the banks have taken on short term debt obligations in order to borrow at a lower cost. There is currently $900 Billion in debt coming due by the end of this year.
Let me use a simple example to help explain this. Imagine that you decided to buy a house in November, 2007 and you used an interest only mortgage at 4% that adjusts after the first year to whatever the market interest rate is going for. (This loan exists in real life, it is called an adjustable rate mortgage.) You gladly take the loan at 4% because it is the only way you can afford the expensive home that you really want. Then in November of 2007, you merrily walk into the bank to find out what happens next now that your loan will adjust the following month. Your loan officer let's you know that mortgage debt is currently trading at a 40% yield in the open market and your loan starting in December will now be 40% instead of 4%.
You then have three options.
You can refinance and try to find an interest rate a little lower. You then find out the best you can do is 36%, meaning your loan payment will now be $35,100 per month, instead of the $3,500 that you have been paying. You will be bankrupt after the first month with that scenario since you have no savings and only credit card debt.
The second option is to pay the loan off in full to avoid the higher payment. It will be difficult to quickly come up with $800,000 since you have no savings and massive credit card debt.
The third option is to call Benjamin Bernanke at the Federal Reserve and ask him if he will swap your debt for treasuries which are currently running at 2%. Unfortunately, he only takes calls from the major banks.
Does this seem like a silly scenario? Let's take a look at that $900 Billion adjusting by the end of the year for the big banks, instead of the $800,000 for your home. The current yield in the open market right now for Washington Mutual debt is 40%. Does that sound familiar? When they go to roll the debt over this fall they will have to pay the going rate, or they will have to come up with the cash to cover what they borrowed. Since all the banks are currently insolvent and on life support, it's going to be tough to do this.
We are on the precipice of a financial storm unlike anything we've seen since the great depression. The credit crisis will probably be at the heart of it's destruction during the 3rd quarter of 2009, just as the country is realizing that the oil "bubble" is actually a very serious supply problem that we have no answer for.
