The collapse of Bear Sterns and the precarious stability of the investment banks, hedge funds and all the other shadow financial institutions (which are NOT regulated by the Federal government as are regular banks but which now have more importance in financial markets than regular banks) is scaring the bejesus out of those who understand what is going on. The turmoil is being caused by all these toxic mortgage securities they hold in their portfolios which is causing their lenders to panic and call on them for either more money upfront or more collateral – and they don’t have either and can’t get it by selling their assets because so much of them are the toxic mortgages.

You may want to listen to the interview with Paul Volker (retired Chrmn of the Fed Res and well-respected unlike Greenspan.) Charile ROse did a long interview with him on Tuesday – and Volker is very very very worried about a collapse of the financial system. http://www.charlierose.com/home

THANKS! Great explanation. Much appreciated.

What OFHEO did is lower the amount of capital that Fannie/Freddie have to be carrying in their reserve accounts. (Think of it as how many dollars in the bank they have in case they have to cover a mortgage gone bad. Old conservative rule for decades was that $1 in the vault created $10 to lend. Then it went $1 yields $20 in credit etc.) Liek all lenders, Fannie/Freddie are leveraged in the market – they borrow money which they turn around and lend. They pay off their loans with the money received from their borrowers. Now if Fannie/Freddie’s borowers (mortgage debtors) don’t pay the mortgage, Fannie/Freddie still have to pay the ones who lent them the money to make the loan. That comes out of capital reserves. If thousands upon thousands of Fannie/Freddie loans go bust, first the money comes out of capital to cover those loans and pay off Fannie/Freddie’s lenders. If they run out of capital reserves and still owe money to their lenders,that is where the taxpayers could be on the hook to make up the difference. right now Freddie and Fannie between them have $82 billion in reserves and owe $1 trillion to their lenders. (Leveraged a little over 1::12 – very conservative.)
OFHEO has lowered the capital resrve requirement because of the crisis in the banking system (Keep in mind that OFHEO had raised the capital requirement in 2004 because of accounting problems at Freddie & Fannie) OFHEO has reduced the capital reserve requirement back to pretty much where it was before 2004.
How will this affect the sinking-fast-investment banks and others holding all these motgage securities? What those financial insititutions in trouble need to do is clear some ‘assets’ such as mortgages off their books by selling them so they can increase their capital reserve. Problem is that none of the other private financial institutions want to buy them – the market is completely frozn wih respect to mortgage securities. Now the fastest way for those financial institutions to raise moeny is sell the mortgages. The ones they will get the best price for will be the strongest mortgages on their books – simply a fact of life in the marketplace that the better the quality, the higher the price. Freeing up money from the capital reserves of Fannie/Freddie allows them to buy up mortgages (and still only mortgages that meet the Fannie/Freddie lending standards as that hasn’t changed). That lets the banks, investment banks and other holders of these mortgages (call them Bank A) increase their capital reserves so they can pay the other banks (Bank B) who lent them money which Bank A in turn had lent out. By being able to sell off their higher priced assets (good mortgages) to Fannie/Freddie, it lets Bank A be able to cover the losses on the toxic mortgages in its portfolio and pay Bank B who lent it money which Bank A had lent on those mortgages.
Still no need to get all in a fluster about Fannie/Freddie buying up some 2/28 ARM with 0 down and No Doc where the buyer has an income of $50,000 and the loan is for $500,000.
Fannie/Freddie are STILL NOT doing ‘no doc’ 0 down loans. It isn’t happening and I still don’t see it happening (I stand by what I said) if for no other reason than the political fallout of bankrupting Fannie/Freddie and running up a trillion or two on the national debt would be horrendous. Fannie/Freddie could become the ‘nodoc’ lender of last resort but for that ever to happen the entire shadow financial market (investment banks, SIVs, hedge funs) would have had to completely collapse – and at that point it will make 1929 look like walk in the park.
Want to worry about something? Worry about the Fed Res accepting any mortgage securities as collateral (unprecedented) for loans to investments (unprecedented as they have NEVER been permitted to borrow from the Fed.) The Fed has commited close to have its reserves to lending to investments banks through the discount window and the special auction – and has accepted as collateral any and all mortage securities – toxic included – as collateral.
Volker is horrified and said that while there was no choice, regulation on investment banks is needed now and the Fed needs to be out of the middle of it.