

An insider's explanation of the Fannie Mae Meltdown - bokonist
http://billburnham.blogs.com/burnhamsbeat/2008/07/fannie-maes-gol.html

======
ctkrohn
To the finance & trading nerds out there: here's why callable debt is such a
big deal. Like everything else in the mortgage bond world, it all comes down
to prepayments.

Borrowers have the option to prepay their mortgage by refinancing or simply by
paying more than the minimum requirement. Because of the prepayment option,
mortgages have a duration (defined as the average maturity of the cash flows,
weighted by the present value of the cash flows) much less than their 30-year
term. For example, the 10yr treasury note has a duration of just over 8 years,
but FNCL 5.5 TBA mortgage futures (the most liquid type of mortgage-backed
security) have a market-implied duration of around 5 years.

Duration also measures the sensitivity of a bond's price to interest rates:
for longer duration bonds, you are discounting the cash flows further back in
time, so the rate at which you value future cash will have a greater effect on
the present value. Think about it: if you are to receive $1000 in six months,
it won't much matter to you if interest rates are at 1% or 10%. If the
financial situation is relatively normal, $1000 in six months isn't worth much
less than $1000 now. But a 30-year bond yielding only 1% is almost worthless
(why would you lock up your money for 30 years at such a low rate), while one
yielding 10% is extremely valuable.

If prepayment speeds were static (i.e. if people always paid off their
mortgages at the same rate), Fannie Mae could issue debt with 5-year duration
(probably ~7yr maturity) at, say, 5%, and buy 30-year mortgages (also with
5-year duration) yielding 6%. They would thus make 1% per year, and on average
they would pay off their own debt right when the borrower pays off his
mortgage. Fannie and Freddie do issue debt in this form, referred to as
bullets.

The problem is that agency bullets have a very different convexity profile
than mortgages. (If duration is the sensitivity of prices to interest rates,
convexity is the sensitivity of duration to interest rates). Bullets have
_positive_ convexity: as interest rates go down, the bond has a _longer_
duration. With low interest rates, future money isn't worth much less than
money now. So when you are computing duration, the large cash flows towards
the end of the bullet's life are dominant. Mortgages are exactly the opposite:
they have _negative_ convexity. As interest rates go down, a mortgage's
duration gets _shorter_ because borrowers refinance out of their old mortgage
into a new one at a lower rate. If rates go up, the opposite happens.

So suppose rates go up. The debt that Fannie issued trades to a shorter
duration, but the mortgages they own trade longer. This means that on average,
Fannie would have to pay off its debt faster than the borrowers pay off their
mortgages. When Fannie's debt comes due before the mortgages, Fannie will have
to refinance. And since rates went up in this scenario, it will have to
refinance into more expensive debt than before.

Now imagine rates go down. Fannie Mae's debt trades longer, and mortgages
trade shorter. So Fannie Mae is still paying debt even after it received the
cash flows from the mortgages. Even worse, it's paying debt at above market
rates now that rates went down since issuance.

Callable agency debentures fix this problem by giving Fannie Mae the same
option that borrowers have. As borrowers call their mortgages in (i.e. as they
prepay them), Fannie can call its own debt by paying it off early. Fannie can
now make sure the duration of its liabilities (its debentures) is matched by
the duration of its assets (the mortgages it owns).

I'd be happy to explain any other aspect of the mortgage bond market, if
there's anyone out there who's interested.

~~~
axiom
Can you recommend a good introductory book on the subject?

~~~
ctkrohn
EDIT: This primer from Goldman is a couple years old but still a great guide:
[http://www.classiccmp.org/transputer/finengineer/%5BGoldman%...](http://www.classiccmp.org/transputer/finengineer/%5BGoldman%20Sachs%5D%20A%20Mortgage%20Product%20Primer.pdf)

As far as books go, there aren't any, unfortunately. I think it's because the
mortgage-backed securities market is largely confined to professional
investors and traders who learn everything on the job. Stocks are the
opposite: it's dead easy to open an ETrade account and buy some shares, so
there's a ton of information for individual investors.

Lots of people use Fabozzi ([http://www.amazon.com/Handbook-Mortgage-Backed-
Securities-Fr...](http://www.amazon.com/Handbook-Mortgage-Backed-Securities-
Frank-
Fabozzi/dp/0071460748/ref=pd_bbs_sr_1?ie=UTF8&s=books&qid=1215915490&sr=8-1))
as a reference, but I'm not a fan... it's disorganized, not particularly well
written, and doesn't provide much information on how the market works on a day
to day basis. The Salomon book ([http://www.amazon.com/Salomon-Barney-
Mortgage-Backed-Asset-B...](http://www.amazon.com/Salomon-Barney-Mortgage-
Backed-Asset-Backed-
Securities/dp/0471385875/ref=sr_1_1?ie=UTF8&s=books&qid=1215915811&sr=1-1)) is
popular too, but I've never read it.

------
jey
I don't understand the whole "too big to fail" idea. They say that the
collapse of a large institution would have a domino effect through the rest of
the banking world, but how does it ever get that bad to begin with? If a
particular institution is getting too big, shouldn't the other players want to
hedge against its failure to protect themselves against the low-probability
but high-cost situation in which a really big bank fails? Is this a situation
where the market would behave like that in the ideal case (with perfect
information, instantaneous communication, unbounded computation, etc) but we
end up with "too big to fail" banks due to some sort of inefficiencies that
occur in practice? Or is this situation due to government meddling (bailouts,
guarantees, etc)? Or are these swings just due to humans acting
emotionally/irrationally (e.g. in response to scare mongering news stories)?

This is just a total guess, but to me it seems like it gets this bad partly
because of a feedback cycle between inefficiencies of real-world markets and
government meddling. The players in the real world markets don't have perfect
information and instantaneous communication, so they end up not balancing
their potential payoffs against the risks. The government (or central bank,
whatever) steps in to rescue the system when the situation gets bad by
propping up failing banks. Sounds good so far, but the problem is that this
effectively functions like a zero-cost insurance policy and insulates the
banks from some of the true risk of their investments. This encourages the
banks to take riskier investments, since they get part of the risk paid for
for free. Now you've got a positive feedback loop: banks take riskier
investments due to gov't guarantee, gov't steps in when the investment goes
bad, banks gain confidence in gov't bailout and make more even worse
investments, rinse & repeat.

It also seems like the governmental "insurance policy" encourages the kind of
interdependency where one bank's failure can bring down other banks. It's more
likely that the banks can collect on the insurance policy if many of them go
down at once, but if only one bank is in trouble it's more likely that the
government will just allow that one bank to fail. (I'm not proposing a
conspiracy theory; I'm just saying that this "insurance" shifts the banks'
costs/benefits towards mutual dependence and reduces the attractiveness of
pursuing diverse/unconventional strategies.)

OK, that's my half baked hypothesis -- what's the real explanation?

~~~
curiousgeorge
>> If a particular institution is getting too big, shouldn't the other >>
players want to hedge against its failure to protect themselves >> against the
low-probability but high-cost situation in which a >> really big bank fails?

Evidence seems to suggest the market does not work this way. Sometimes, it
appears not to work at all.

~~~
pmorici
In this case as the author explains the reason they were able to grow so big
is because of government involvement which through implicit and explicit
measures made the risk appear artificially low.

------
technolah
This was predicted by Nicholas Nassim Taleb in the Black Swan.

We're reducing the small bank losses in search for "stabilities" that group up
all the losses in on fell swoop.

Everything fails over time. Eliminating the small failures by making things
too big to fail only creates the chance for things to fail in a biggest
possible way.

This isn't going to stop anytime soon.

~~~
davidw
> This was predicted by Nicholas Nassim Taleb in the Black Swan.

I got the impression that he firmly asserted that he was _not_ in the
predictions business.

------
noonespecial
Lets use the laymens sniff test to figure out the level of WTF present in our
system, using IndyMAC as an example.

 _You_ have all your money in an IndyMac account. _They_ hold your mortage.
IndyMAC collapses prompting the FDIC to take them over and bail them out. What
happens:

 _You_ lose at least half (probably more) of all the money you have in the
bank over $100k. _They_ get a fat bailout, so long and thanks for all the
cash. _You_ are still expected to repay your mortgage in full.

I know there's probably some logical explanation in financialese showing that
this is the right outcome... But, come on, they lose your money and still
demand to be repaid... WTF?!

------
tokipin
damn. for a moment i thought it was Sallie Mae melting down and i wouldn't
have to pay my college debt any more T_T

------
ajkirwin
Am I the only person who wishes they WOULD fail? It seems like it's the only
thing that would scare these massive companies into taking less risks.

~~~
Zev
Think about the impact it would have on everyone else though. These companies
aren't small companies. They're huge conglomerates that play major parts in
peoples financial situation.

Sometimes taking risks is the best way to profit. And they're not called risks
for no reason. And I doubt the company wanted to lose money intentionally..

~~~
tortilla
The problem is these companies, with the implicit backing of the federal
government take unnecessary and huge risks knowing they will be bailed out if
they fail.

It's not "risk" if they only profit from the upside and don't take their
medicine on the downside. Heads they win, tails you lose. :)

~~~
timr
It isn't fair to paint Fannie/Freddie with the same brush that you'd use for
(say) Bear Stearns.

These guys have been serving as the de-facto buyer of last resort for all of
the bad debt that _other_ banks have accumulated. They're acting as the US
mortgage-banking safety net, and as such, have knowingly taken on a huge
amount of bad debt that other commercial banks wouldn't touch. If it weren't
for Fannie/Freddie, the mortgage crisis would be _much_ worse than it is.

(That said...if they had the good sense to raise their lending standards back
in 2003, we probably wouldn't be in this mess.)

~~~
tortilla
Actually if it weren't for the actions of Fannie/Freddie, the mortgage crisis
would have needed to be dealt with sooner. By F/F taking on all the toxic
loans that the mortgage banks wanted to dump, they allowed the problems to
increase in size and scope thus prolonging the bubble much longer. All this
quasi-government intervention does is to distort the true market. I want
transparency in government and I want it in business. When you allow these
mortgage banks to fail on their own (no safety nets), you clear the system of
inefficient players and allow the market to adjust.

I'm all for free enterprise. You take risks, you make some smart moves, and
you profit. You take another risk, you make some mistakes, you lose, and you
can start over (and learn). You don't keep doing it like these banks did (I
don't even know if you can call them mistakes, more like reckless disregard).
Like degenerate gamblers who got their line-of-credit extended, they double-
downed and lost.

Think about it, the average US citizen's safety net is quite small. Get sick,
get dropped by insurance, lose your job and you're basically on your own.
We're told to buck up, stop whining, take responsibility, and work harder.
Fine, but don't tell me these companies need our sympathy and help. They
profited handsomely during the run-up by making risky loans and lobbying for
tougher bankruptcy laws.

There's no easy answer. Bail them out, the dollar plummets and the economy
goes to shit. No bailout, the financial market freezes up and the economy goes
to shit. I'm leaning towards no more bailouts. At least then we might be able
to address the root cause, which I think was reckless risk taking and
financial engineering, with the perpetuated belief that the US government (tax
payers) would be the ultimate safety net.

Here's a good link regarding what the mortgage market might look like in the
near future: [http://www.bubbleinfo.com/journal/2008/7/12/mortgage-
credit-...](http://www.bubbleinfo.com/journal/2008/7/12/mortgage-credit-
crunch.html)

