Investors shouldn't underestimate the significance of the U.S. Treasury takeover of Fannie and Freddie. Now that the U.S. taxpayer has been forced to accept repayment obligations for the two mortgage giants, U.S. government debt has exploded (as if it hadn't already). Nevertheless, U.S. government debt is expanding at an even faster rate. As a result, interest rates have risen and U.S. government debt has sold off. Oddly enough, it is causing interest rates for mortgages to rise, too!
Are you skeptical of the impact? Just look at the daily chart for the 10-year note (above). That last red candle is just the impact on overnight trading!
Since the takeover has effectively equalized U.S. treasury debt and Fannie/Freddie debt, instead of interest rates on Fannie/Freddie debt going down, U.S. treasury debt interest rates have moved higher. There is an increase in perceived risk, and investors are demanding higher interest rates for that risk. This increased risk is real. Fannie and Freddie have derivatives instrument with leverage of about 50 to one (50:1). Even most hedge funds, which are now dropping like flies, only had leverage of about 20 to one (20:1). Now that the taxpayers have been forced to accept that kind of debt obligation, the surging debt of the U.S. government causes increased risk of default for investors. Thus, interest rates must rise.
This increases exponentially the counter-party risk that the U.S. taxpayers incur on all of these derivatives instruments. If, as was announced last Friday, mortgage foreclosure rates continue to rise, the cost of that risk rises exponentially, not incrementally. For more on this subject, read the links to John Mauldin's newsletters that I posted over the weekend. Mauldin's warnings were well-timed!
Also as an odd twist: the increased interest rates that the world requires will force the U.S. government to pay out higher rates, and thus increase the deficit even more!
Since the takeover has effectively equalized U.S. treasury debt and Fannie/Freddie debt, instead of interest rates on Fannie/Freddie debt going down, U.S. treasury debt interest rates have moved higher. There is an increase in perceived risk, and investors are demanding higher interest rates for that risk. This increased risk is real. Fannie and Freddie have derivatives instrument with leverage of about 50 to one (50:1). Even most hedge funds, which are now dropping like flies, only had leverage of about 20 to one (20:1). Now that the taxpayers have been forced to accept that kind of debt obligation, the surging debt of the U.S. government causes increased risk of default for investors. Thus, interest rates must rise.
This increases exponentially the counter-party risk that the U.S. taxpayers incur on all of these derivatives instruments. If, as was announced last Friday, mortgage foreclosure rates continue to rise, the cost of that risk rises exponentially, not incrementally. For more on this subject, read the links to John Mauldin's newsletters that I posted over the weekend. Mauldin's warnings were well-timed!
Also as an odd twist: the increased interest rates that the world requires will force the U.S. government to pay out higher rates, and thus increase the deficit even more!
