Got it. Increased credit risk for banks (I don't think GSEs buy ARMs) is also a problem that might result from a GSE collapse (via the effect on house prices and a generally depressed economy). [edit: I think the thread is more geared to the question of mortgagee bankruptcy due to interest rate risk on retained portfolios, not credit risk. Generally, people agree that the GSEs do not have significant credit risk - knock on wood, though] Re the owner, though, you do not have to declare bankruptcy to walk away from your mortgage (in exchange for the house). Of course, it might make sense to excercise your put option when it's DITM. We had an inconclusive discussion about recourse on some other thread, though, so I might be wrong.
Hey an interesting aspect to this is that whenever you hedge, it hurts your profits. The net result is that loans will get more expensive in the form of higher rates above and beyond market forces. If I said I was predicting this, I know ya'll will call me a liar, so I won't. SM
Those are market forces, right? GSEs claim to hedge well, but don't use static hedges (though FRE is moving that way, I believe) precisely because of what you say. Then again, why should they as long as there's no regulatory pressure? They're acting like economically rational firms in the face of what the market thinks the feds will do.
From your comments I'm sure you know all this, but the problem is we basically have to take their word for it. Now we've learned that they were lying so they could make the benchmarks for options to cash in. The risk to the GSE's and others holding mortgages is not credit risk. Homeowners are not suddenly going to stop paying their mortgages, at least not in sufficient numbers to create havoc. The risk is that rising rates generate losses on their portfolios sufficient to wipe out their capital, rendering them insolvent. The pressure for a bailout would be irresistible. Supposedly, they are hedged against this, but the very size of their portfolios makes hedging problematic. Like the portfolio insurance debacle of 1987, their hedging has the effect of running the market even further against them. Unless the hedges were in place ahead of time in adequate size, which is questionable considering the quality of managment they had, the more they hedge, the deeper hole they dig.
Agreed... credit risk is less of a problem in a systemic way (though, who knows) than prepayment and interest rate risk. The problem with the latter is that they synthetically lengthen the duration of their debt and in a crisis the question is whether they'll find enough counterparties. Why not match the duration directly? (perhaps some sort of swap-curve arbitrage? not enough appetite for long er agency debt?) Re the former, the way around it would be to issue more callable debt. Rates drop, assets prepay, just call the debt instead of messing with this swaption stuff to recreate the original asset synthetically... or cap the portfolios. Don't get me wrong, I think these guys do a good job hedging, problem is just that when the stuff hits the fan, all neat little models go out the window. I also don't begrudge them excess profits. They're acting exactly the way they're supposed to. Up to the spine of the taxpayer, if they want things done differently (problem is it's not the renters and homeless that are voting, and since when do the beneficiaries of pork vote to get rid of it). On the whole, the US mortgage market is a lot better than many out there.... and the government really has a thing for the social benefits of homeownership.
How are rising rates going to cause losses? The cash flow from fixed rate mortgages will continue regardless of current market rates. The ARM loans, of course, will generate greater revenues due to a rise in interest rates.
MV of assets drops, cost of debt not as much - they're typically short-funded, but try to keep the duration gap at 6 months or less. D/V is about 2.5%. Problem is probably not a bunch of small, slow increases (can dynamically hedge) but the big jumps since they're short convexity. Static hedges would solve problem but reduce profitability.
If rates rise, only those fixed rate mortgages are going to experience a reduction in MV. The value of the ARMs are going to ride the interest rate tide. Besides, a reduction in MV of assets does not create a "loss". It would create a reduction in net worth, but not a loss.
If FNM holds your mortgage and goes bankrupt, the mortgage will be sold to another MBS investor. This will not affect you unless you refinance. The fear is that when FNM goes bankrupt, it will affect the whole finance system.
If FNM holds your mortgage and goes bankrupt, the mortgage will be sold to another MBS investor. This will not affect you unless you refinance. The fear is that when FNM goes bankrupt, it will affect the whole finance system.