Thursday, March 06, 2008

Mortgage Market Meltdown

The credit crisis got serious today. The mortgage market has been a big part of the credit problem all along but in the last few days the problems have become more acute. When the sub prime market first started unraveling last summer, it was just sub prime that was a problem. It became obvious that so called Alt A mortgages would have similar problems and the implosion of Thornburg this week confirms that.

But what happened over the last two days is the most worrying. Now mortgages backed by Fannie Mae and Freddie Mac are falling. A London hedge fund, Peloton, had its portfolio seized by creditors last week. And this was a fund that made a killing last year shorting sub prime. This week Carlyle Capital failed to meet margin calls on a portfolio of Fannie and Freddie paper. These guys were leveraged 32 to 1 so it doesn't take much price movement to trigger a margin call, but that portfolio will now be coming on the market so the supply will just increase and prices will probably keep falling.

Even worse is that Fannie Mae and Freddie Mac themselves own vast amounts of these mortgages. And they are highly leveraged. If you look at the official debt/equity ratios, they are leveraged about 25 times. That actually seems low but even if it's right it's still a lot of leverage. It would not take much of a fall in the value of their mortgage portfolios to completely wipe out the equity.

This situation is more serious than anything the market has faced since this started last summer. The market believes there is an implicit US government guarantee on Fannie and Freddie debt. We may find out soon whether implicit can become explicit.

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