Fannie Mae & Freddie Mac Fallout

With the Economies booming post 2007, Investors were not used to watch their financial stocks plummet more than 70 percent in close quarters.  American taxpayers were ignorant of left holding defaulted mortgages and abandoned homes while executives who presided over balance sheet implosions walked away with millions.  Taxpayers were also given the bill to bailout poorly managed Bear Sterns.

Over the course of this 18-month financial crisis, US lurched from financial land mine to land mine. The crisis from the fallout of Fannie Mae and Freddie Mac, the giant government-sponsored enterprises set up to provide affordable housing across the nation was a setback.  By issuing debt, these shareholder-owned companies guarantee or owned more than $5 trillion in home mortgages.  The majority of them were good, but because of the subprime mortgage mess, the percent that default increased over the past 18-months.

Investing in Fannie Mae and Freddie Mac seemed like conservative investments.  These were government established companies.  The implied guarantee is what drove Fannie and Freddie’s business models.  However, investors were foolish to think they were still government backed and therefore were guaranteed.

The reason why crisis hit these two companies was because they were not required to keep as much cash on their books as banks.  But with so many mortgages defaulting, there low cash supplies lead them in a dangerous state.  To raise the necessary capital to stay afloat, these companies called on the American taxpayers to bail them out.
Speculation that mounting losses at Fannie Mae and Freddie Mac would require billions of dollars in additional capital had fueled a firestorm, sending stock investors fleeing. Fear spread across financial markets after the government offered no hint that it would step in to help the companies.

The companies combined have about $1.6 trillion in debt outstanding, much of which was held by central banks around the world. They used the money to fund the portfolios and securities that lawmakers have increasingly relied on to support the ailing housing market.

So were government funded companies also not safe for investment, and did investment pundits learn anything from this fall out?

Source: Financial Times, Swapnil Pawar (CIO, Karvy Wealth)

Read more on demystifying facts of Global Economic Crisis by Swapnil Pawar, CIO, Karvy Wealth.

A real life case from Global Economic Crisis

Ripple Effect of the Subprime crisis

•   The effects of the US Subprime Mortgage crisis on the global market were huge. The crisis had ripple effect on the Asian, European as well as the Australian market.

•  The Asian market witnessed a massive sell off. It also has hit the stock markets of Australia, Germany and Thailand such that BNP Paribas had to hold all it withdrawals and IKB Deutsche had to seek a bailout of $11.1 billion.

•    Post the housing bubble burst in US the underlying mortgage defaults increased which affected adversely the global markets.

•    In the Great Britain, the stock market experts failed to realize the underlying faults and WestLB had to file bankruptcy.

•    One of the giant of Australian financial services Macquarie Bank, declared that the investors may lose 25% of their money.

•   The Nikkei stock average in Japan has decreased by more than 2%.

•   In Germany, France and Britain major indexes have fallen down, but by less than 2%.

•    Australia and Hong Kong's benchmark indexes have fallen down by above 3%.

•    South Korea's key index has dropped by 4%.

•   The First State Investment had withdrawn its entire share from the Asian financial market.

  

Source: Multiple

                               

                               

Chronology of Economic Crisis - The three phased crisis

There was a lot of confusion and divergence of opinion about when the crisis really began.The pursuits claim that it started with the Fed’s attempt to overcome the previous crisis (the dotcom bubble). We will concern ourselves first with the ‘what’ of it- in order to understand all that happened under the broad headings of credit crisis, financial crisis & global economic crisis.

The three phased crisis

There were three phases to the crisis of which is still prevalent in 2011.

The first phase

It was the uncovering of losses in the subprime mortgage market in US.  This was largely a wake up phase. It started in February 2007 & continued till early 2008. During this phase the reactions of most experts were mixed – some believed it to be the harbinger of a larger global crisis while others thought of it as nothing more than a serious setback in a specific sector of the American economy.  However, even for the lenders & investors the extent of the impact was limited to losses in subprime mortgages. This phase started in the US and the spread to the rest of the world through subprime mortgage investments.

The second phase

The second phase was the wider credit crisis across the US and Europe brought about by the impact of the first phase, as well as other factors at work. This phase started in early 2008 with the collapse of Bear Stearns and continued till September 2008. This phase covered a larger section of the financial services industry. As mentioned in the first phase quite a few of American subprime lenders failed & many large American investment banks lost heavily on their investments in the subprime mortgages. If the problem was subprime credit alone, the crisis would have been contained at this stage. The second phase would have never come about.

The third phase

The third phase was the global economic crisis. The substitution of ‘economic’ for’ financial’ in the descriptor, has significant & dark connotations, It was in the phase that the crisis engulfed the wide economy began affecting the lives of people outside the financial services industry. This phase started in October 2008 – after series of big tickets bank failures on wall street & continued through 2009 & 200. In the first two phases, much of the brunt of the crisis was borne by the financial services industry in US & Europe. Banks and financial institutions lost close to $1500bn during the time according to IMF. However, the rest of the global economy was still chugging along. There were predictions of a slowdown no doubt; however, the real impact was not felt till September 2008.

It is important to understand however that these three phases unfolded not as an unhappy accident of the first leading to the second and that in turn leading to the third. It was not a disease that began in a section of the economy & then spread to the other sections.

So was there more to it? What were the main driving forces that lead to the global economic crisis?

Source : Anatomy of Froth by Swapnil Pawar

Lehman Brothers & The Great Wall Street Fall

September 15, 2008 was recorded as a Black Day in history of American Economy, as world’s 4th largest Investment Banking firm “Lehman Brothers” filed for bankruptcy leaving 25000 employees worldwide in absolute dismay.
With $639 billion in assets and $619 billion in debts making it the largest victim of the “Subprime crisis”. Lehman's collapse was a seminal event that greatly intensified the 2008 crisis and contributed to the erosion of close to $10 trillion in market capitalization from global equity markets in October 2008, the biggest monthly decline on record at the time.


The Prime Culprit
In 2003 and 2004, with the U.S. housing boom well under way, Lehman acquired five mortgage lenders, including subprime lender BNC Mortgage and Aurora Loan Services, which specialized in Alt-A loans (made to borrowers without full documentation). Lehman's acquisitions at first seemed prescient; record revenues from Lehman's real estate businesses enabled revenues in the capital markets unit to surge 56% from 2004 to 2006, a faster rate of growth than other businesses in investment banking or asset management. The firm securitized $146 billion of mortgages in 2006, a 10% increase from 2005. Lehman reported record profits every year from 2005 to 2007. In 2007, the firm reported net income of a record $4.2 billion on revenue of $19.3 billion.


Lehman's Colossal Miscalculation
In February 2007, the stock reached a record $86.18, giving Lehman a market capitalization of close to $60 billion. However, by the first quarter of 2007, cracks in the U.S. housing market were already becoming apparent as defaults on subprime mortgages rose to a seven-year high. On March 14, 2007, a day after the stock had its biggest one-day drop in five years on concerns that rising defaults would affect Lehman's profitability; the firm reported record revenues and profit for its fiscal first quarter.


The Beginning of the End
As the credit crisis erupted in August 2007 with the failure of two Bear Stearns hedge funds, Lehman's stock fell sharply. During that month, the company eliminated 2,500 mortgage-related jobs and shut down its BNC unit. In addition, it also closed offices of Alt-A lender Aurora in three states. Even as the correction in the U.S. housing market gained momentum, Lehman continued to be a major player in the mortgage market. In 2007, Lehman underwrote more mortgage backed securities than any other firm, accumulating an $85-billion portfolio, or four times its shareholders' equity. In the fourth quarter of 2007, Lehman's stock rebounded, as global equity markets reached new highs and prices for fixed-income assets staged a temporary rebound. However, the firm did not take the opportunity to trim its massive mortgage portfolio, which in retrospect, would turn out to be its last chance.
Lehman's collapse roiled global financial markets for weeks, given the size of the company and its status as a major player in the U.S. and internationally. Many questioned the U.S. government's decision to let Lehman fail, as compared to its tacit support for Bear Stearns (which was acquired by JPMorgan Chase) in March 2008. Lehman's bankruptcy led to more than $46 billion of its market value being wiped out...So was only Subprime Mortgage responsible for this colossal loss or there was more to it?


Source: Economist, Investopedia and Anatomy of Froth (Swapnil Pawar)