The Four Headed Monster

I'm sure you've read and heard countless stories over the past year regarding Fannie Mae and Freddie Mac. These are the two government created machines that purchased or guaranteed $5.4 trillion in residential mortgages through 2008. The were the buyer of first, second, and last resort for any mortgage that entered the market place.

Two names which you may not have heard are Ginnie Mae and FHA, or the Federal Housing Administration. However, last week Ginnie Mae announced that it had issued a monthly record of $43 billion in mortgage-backed securities in June. Their size is growing at an exponential pace and they have essentially taken the form of a new Fannie Mae.

Ginnie's main function is to be a partner with the FHA who guarantees a vast majority of new mortgages currently being issued. Ginnie will purchase these loans and do its best to sell them into the market.

What may strike some observers as troubling are the underwriting standards for FHA loans. Borrowers need only to put down 3.5% when making a purchase, and many of the borrowers have lower credit qualifications. Subprime borrowers.

After watching what has recently taken place in the mortgage market you would assume FHA is very well capitalized and is capable of withstanding massive losses should they occur. The reality is the exact opposite.

The FHA just recently reported that its reserve fund has now dwindled down to 3%. That means they are leveraged 33 to 1. If that sounds familiar it is the leverage Bear Stears was at before it self combusted. The FHA's default rate has just recently grown to 7%. They are on a collision course with disaster.

Get ready for something even more frightening:

FHA, Ginnie Mae, Fannie Mae and Freddie Mac now guarantee 9 out of every 10 new mortgages in America. They are now guaranteed by the tax payer.

9 out of 10.

Meanwhile, as these new loans are purchased and guaranteed by the government, the Federal Reserve is purchasing huge pools of these loans from the agencies. They announced today that they will continue their purchase of $1.25 trillion in mortgages through the rest of this year.

Here is a simple flow chart to see the process:

1. Homeowners purchase home with mortgage

2. That bank then sells that loan to Fannie, Freddie, Ginnie, or FHA (9 out of 10)

3. These agencies then sell the loans to the Federal Reserve

Where does the Fed get the money to purchase mortgages? It prints the money.

The same concept is currently happening with treasury debt. The following chart shows the new expenses taken on by government vs. the income that is coming in through taxes:

One is skyrocketing and the other crashing.

No worries however because the government can issue as much debt as it wants. Why? Because a large portion of the debt is being purchased by a new buyer: The Federal Reserve. They announced today they will continue with their treasury purchase program through October. After that? They will buy more of course.

Where does the Fed get money to buy Treasury bonds? It prints it. Here is the flow chart:

1. The government wants to spend money so it issues debt.

2. An auction is held to sell the debt to investors.

3. The Fed shows up to this auction and adds treasury debt to its balance sheet.

I'm am not exaggerating with any of this. As we speak, they are currently working on expanding a program to buy commercial mortgages. A program called TALF. This market is on the verge of collapse with over $500 billion in debt set to roll over this year. There is no money right now to refinance these buildings because they were all bought with short term financing at bubble prices.

Who will buy the debt? Yep. Where will they get the money? Yep, you've got it now.