You may have noticed that I am obsessed with banks and the current problems the entire banking industry is facing. I have been reading up on Federal Government Accounting and the assumption of the two GSEs.  I answered a question on another board about the fact that 9% of mortgages in the US are in arrears and the impact on the US debt rating caused by placing the two GSEs in conservatorship.  I want to post it here too.

Placing the two GSEs in conservatorship shouldn't have a major impact on the debt rating.  There are a couple of reasons why it could be an nonissue.  Right now, the entities aren't accounted for in government accounts.  They're regarded as two independent corporations.   It could be argued that since taxpayers appear to be the lender of last resort, the two entities should be rolled onto the federal accounts; however, federal accounting standards are pretty arcane and for now, at least, the Treasury seems content to regard them as independent corporations.  An argument between the Congressional Budget Office and the Administration is likely to begin soon.  Personally, I don't understand how the two entities could be considered off budget; however, I had meetings with some EY people on Friday and, when the topic came up, they gave a somewhat detailed explanation of why the items should be kept off budget.

On a more practical note, despite all the criticism and concerns of Freddie and Fannie, these two entities had a very strong portfolio of performing loans.  Only 1.7% of loans were in arrears, well behind the national average.  Over half of the loans were more than 50% paid.  The problem that the two entities faced was liquidity.  Each had capital requirements that fell well below the average for US banks.  S&P, in justifying the strong bond rating, claimed that they were content with this situation because, ultimately, the Federal Government was the lender of last resort.  In fact, the government had no legal obligation to rescue the two entities.  The challenge that each faced was the trend in delinquencies: not necessarily a bad thing, but in a market where raising new funds or rolling over bonds is challenging, the two giants faced problems.  With lower capital requirements, a small change can have a big impact.  The discount window was always available to them; however, to borrow from the Federal Reserve (for short term liquidity issues), an entity has to be a going concern.  It was getting clear that, with looming liquidity problems, neither Freddie nor Fannie was a going concern.  Their portfolios are still sound.  So even if the liabilities were added to the national debt, they are solid, performing assets to offset them.  The one thing that the Federal Government and Federal Reserve have to avoid is a scenario similar to what happened in Japan in the 1990s.  If real estate values nationwide fall by more than another 20 to 30%, then the US has just assumed an additional $2 to $3 trillion in debt.  If real estate languishes and recovers in a manner similar to what's happened in the past sixty or so years, then all is well.

Just one more thing--and I don't mean to be a prophet of doom and gloom--however, in the US at least when we're not hearing about belipsticked canines and ungulates and hurricanes in Texas, there are news reports about how foreclosures are way down!  Don't believe it.  Many of the states with the most severe real estate problems have enacted legislation which has temporarily stalled the ability of banks to foreclose on property.  I expect that in the fourth quarter, we'll see the rate of foreclosures surge again.  Also, quite a few loan rates reset next year, so there's more to come in 2009.