The Huge and Hidden Risk in Housing Loans

Hans Parisis
Thursday, April 17, 2008

Could the U.S. lose its triple-A rating?
You bet it could.

Ratings agency Moody's warned in January this year that the U.S. might lose its triple-A rating within the next 10 years.

On April 14, Standard & Poor's released a report that describes a specific scenario wherein they demonstrate, at least "analytically," that if the U.S. would slide into a deep recession, the government could be forced to bail out Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan and Mortgage Corporation).

This would happen because the two government-sponsored enterprises, which between them own $5 trillion in guaranteed mortgage-backed securities outstanding and mortgage investments, would be simply "too big to fail."

That is, they would be rescued because the impact of their collapse would be too painful for the U.S. economy.

In case this scenario should occur, a very serious material fiscal burden of an estimated $1.4 trillion would arise for the U.S. government, a debt that consequently would lead to downward pressure on its sterling risk ratings.

Of course, Standard & Poor's does not predict a deep recession nor that such a scenario will occur.

However, investors should keep in mind that such a scenario is not impossible in a near future. Let's say as early as 2009 or 2010.

According to the government, Fannie and Freddie's $5 trillion in mortgage guarantees and mortgage-backed securities is unparalleled in U.S. history in terms of the size and order of magnitude.

Unless a miracle happens in the U.S. real estate market before the middle of 2009, credit losses will continue to accelerate. Last week, analysts at Goldman Sachs reiterated their sell recommendation of Fannie Mae (1-year return: negative 50.17 percent) and Freddie Mac (1-year return: negative 57.72 percent).

The recently released annual report to Congress from the Office of Federal Housing Enterprise Oversight shows that Fannie and Freddie's combined fourth quarter losses of $6 billion have resulted in annual losses of $5.1 billion.

Meanwhile, the fair value of their net assets (equity) have declined by $7.9 billion at Fannie Mae and by $19.2 billion at Freddie Mac.

The fair value of net assets (equity) attributable to common stockholders at Fannie Mae and Freddie Mac also declined by $14.2 billion and $25.7 billion, respectively, when you exclude their latest $15 billion preferred stock issuance.

Nobody knows what the future holds, but all this doesn't bode well for most investors.

Still, a lot of people have great difficulty accepting that something extremely serious is developing, a potential mess that could cause severe purchasing-power losses.

I've always tried to be as realistic as possible. Therefore, I still believe that "real and always liquid tangibles" like energy, food, precious metals will be my best asset protection vehicles going forward.

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