In this issue:

Will Fannie and Freddie Sink the Financial System?

Fed Official Warns of Concentration of Derivatives Exposure

China Warns of 'Dark Clouds' Over U.S. Economy

Fannie Mae Understated Value of Mortgage Losses

Fed's Poole: No Inflation Round Here

Mortgage Rate Spike Threatens Housing Bubble

Blackout Report Ignores De-Reg as Number One Culprit


From Volume 3, Issue Number 15 of Electronic Intelligence Weekly, Published Apr. 13, 2004

U.S. Economic/Financial News

Will Fannie and Freddie Sink the Financial System?

Fannie Mae and Freddie Mac could sink the financial system, warned the London Economist April 8, in its online edition. In a special feature, headlined "Playing with Fire," the Economist comments on the failed efforts to re-regulate the mortgage finance giants. They note: "Of all the things that might upset America's financial system, top of most lists are Fannie Mae and Freddie Mac. The two companies stand behind $4 trillion worth of mortgages; when that much money is involved, even a minor glitch can send tremors through financial markets. Recently both have had more than their share of problems with their accounts. There are shortcomings in their regulation. If there were a disaster, no one could say that it had come without warning." Probably the biggest threat coming from Fannie and Freddie is their huge derivatives portfolio, the article mooted.

Fed Official Warns of Concentration of Derivatives Exposure

Some participants at the annual meeting of derivatives moguls in Chicago didn't swallow the line that derivatives were the new "built-in stabilizers," the Financial Times wrote April 4. Patrick Parkinson, Associate Director of the Federal Reserve Bank's research division, said that the broker-dealers were so exposed to Fannie Mae and Freddie Mac, that if one of them fell (a frequent subject of conjecture these days), it would bring down one of the major dealers as well.

Credit Suisse First Boston concurs, said the Financial Times. A report issued in March said that the huge interest-rate derivatives were concentrated in JP Morgan, Bank of America, and Citigroup. Despite their hedging, said the report, "If interest rates change significantly—up or down—a prime candidate for amplifying the move will be interest rate options, where the market has become huge and the risks concentrated."

China Warns of 'Dark Clouds' Over U.S. Economy

There are warnings of "dark clouds" for the U.S. economy, which is facing "many risks and uncertainties," especially the "colossal deficits," China's People's Daily newspaper wrote April 6, in a long commentary. Despite all the reported "sunshine" in the U.S. economy in 2003, the "excessive deficits" and "very low" domestic savings rate, its dependence upon foreign economies, and the weakness of the dollar, all add up to a situation, which, if it starts "running out of control, will possibly be a disaster to the U.S. economy and the world economy," the commentary states.

After going through all the "mainstream" analysis of the U.S. economy in 2003, the People's Daily commentary states that "globalization," especially the outsourcing of many jobs to developing countries, mainly China and India, is what has "greatly boosted profits for [U.S.] private departments and propelled the dramatic pickup of their investments." With all the attacks on outsourcing in the U.S., this is "precisely one of the main driving forces" in its economy. The other issue, allowing a growth of exports, was the weakening dollar.

But there are "dark clouds." For the U.S. to deal with its "colossal deficits" of current account and savings, it "has to 'borrow' money from foreigners. This requires that foreign countries have confidence in the U.S. economy and U.S. assets."

Were the U.S. to try to lower its current account deficit, it would have to devalue the dollar; this would mean that other nations' dollar assets would shrink, and they would "have to dump U.S. dollar assets if they want to preserve [the] value" of their holdings. Also, were the U.S. government to cut expenditures, and the population stop spending and start saving, another two stimulants for economic "growth" will go. If these situations were to get "out of control," this could spell "disaster to the U.S. economy and the world economy."

The commentary concludes by warning the U.S. against "trade protectionism"—i.e., one-sided exclusion of imports from poorer nations—and scapegoating other nations for its own problems.

Fannie Mae Understated Value of Mortgage Losses

The Office of Federal Housing Enterprise Oversight, the regulator of Fannie Mae, said that Fannie Mae may not have applied "the proper accounting guidance"—i.e., it understated its financial problem, the Washington Post reported April 6. A significant issue is the imputed value of mortgages Fannie holds on manufactured housing, including pre-fab and mobile homes.

Fannie Mae last year wrote down the value of such securities by only $155 million, not a big cut into the agency's reported profit of $7.9 billion. There are about 22 million Americans living in manufactured housing. Since mortgages on such properties are not traded on any securities market, there is no standard price being set for them. So Fannie Mae might have presumed to get away with under-reporting serious losses from defaults or other deterioration in these holdings.

John Barnett, an analyst with the private Center for Financial Research and Analysis, said, "I'm fairly confident that the number they [Fannie Mae] have [written off] is too low." His company issued a report last week saying Fannie Mae's assets' reported value "may be overstated due to the Company not using market prices to value its manufactured housing securities."

Fed's Poole: No Inflation 'Round Here

William Poole, president of the St. Louis Federal Reserve Bank, who has a reputation as an anti-inflationary "hawk," was asked by USA Today April 6, "What do you say to critics who argue the Fed is creating a bubble in the housing market by leaving rates so low for so long?" He blustered, "I don't think that the behavior of house prices is off the charts. Secondly, by the nature of this market, you can't get a crash in the prices in the space of a few days or a few weeks as you can in securities markets. A bubble means something entirely different in the housing market than it does in the stock market."

But while the Fed itself is driving hyperinflation, Poole pointed to falling prices for "computers, desktops, servers and laptops" as evidence "that the consensus forecast of low inflation is sound."

Mortgage Rate Spike Threatens Housing Bubble

On April 2, the Labor Department's March jobs report appeared to be "good news," but hit the housing market "like a ton of bricks," noted Business Week April 7, as spiking mortgage rates caused housing stocks to fall. "The risk of a serious downturn" in the real-estate market, the magazine warns, "is clearly increasing"—with "major economic ramifications" for homeowners and banks.

Business Week focussed on the risk of homeowners with adjustable-rate mortgages (ARMs) being unable to afford their home, as interest rates rise substantially. Some homeowners will be unable to make their payments on these mortgage loans—and could lose their homes. If mortgage rates rise by just two percentage points, the monthly payment on an ARM could double. Worse, homeowners with interest-only loans, or those who made very low down-payments could be stuck with houses worth less than what they owe on the buildings, were prices to stop rising or fall. An analyst at a New York investment-research firm warned: "At some point, rates will go higher, and when they do, we face serious risks of people losing their homes and banks taking losses."

Yet, many lenders have increased their holdings of mortgage paper. In the last 12 months, the amount of mortgages and mortgage-backed securities held by large banks rose 10%, to a whopping $998 billion, according to Bear Stearns.

Blackout Report Ignores De-Reg as Number One Culprit

The U.S.-Canadian Task Force investigating the blackout on Aug. 14, 2003, which left 50 million people in North America in the dark, released its final report on April 5, detailing the chronology of the grid failure, but not the policies that created it. Much of the blame was placed on Akron, Ohio-based FirstEnergy Corp., which failed to adequately trim trees, setting off a chain of events that cascaded through much of the Midwest, eastern Canada, and New York. Tree trimming is one of the maintenance activities that has been curtailed nationally, thanks to cost-cutting deregulation. It is still not entirely clear why the problem spread.

That single-point transmission failure could have been isolated, were it not for the chaos that deregulation has introduced into the system as a whole. The Task Force found, for example, that the generating companies in the region do not produce enough reactive power to keep the grid stable. This is not power that is sold, but is needed to maintain the voltage and stability of the transmission system. But in today's world of competition, why should a company want to dedicate generating capacity to produce power they don't get paid for? While the report did state that the burden of long-distance power transmission, known as "economy transfers" did contribute to the lack of reactive power, they recommended nothing to deal with this problem. The transmission system was never intended for such transfers sent over the transmission lines so a company can buy cheaper power, even thousands of miles away, to make a profit.

In its defense, FirstEnergy said that power being shipped long-distance from southern Ohio through its wires to Ontario, Canada was one cause of the company's problems the day of the blackout, and that this was being glossed over. In response to the suggestion that if FirstEnergy had blacked out Cleveland to prevent the problem from spreading, the company's senior vice president responded that that may or may not have prevented the event, and "We take exception to the idea that you should interrupt local customers in favor of long-distance transactions," apparently regardless of the consequences.

The remedy proposed by the Department of Energy and the Task Force is mandatory reliability standards, with government power to levy fines to punish violators. There is no way, however, to force companies to comply with standards—many would find it cheaper to pay the fines than follow the rules. Only reversing deregulation, so the organizing principle of the industry is the mandate to provide affordable, reliable electric power, rather than profit and greed, will change the deteriorating grid situation.

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