Economic Outlook: Fannie Mae and Freddie Mac

This week's highlights

Focus is squarely on the two American operators in the mortgage credit market, Fannie Mae and Freddie Mac. They are neither banks nor ordinary mortgage credit institutions, but basically have two functions.

The first and original function is to act as an intermediary between mortgage lenders and banks on the one side and investors on the other, and that role ensures ample liquidity for the mortgage credit market. The two enterprises buy mortgage loans from mortgage credit institutions and banks. They then package the loans into 'mortgage-backed securities' (MBSs) and sell these to investors. The market is worth USD 3,700bn. Investors receive instalments and interest from the home owners, and Fannie Mae and Freddie Mac claim a small insurance premium (about 20 bp) annually. The insurance premium acts as payment of a guarantee: if the home owner defaults, Fannie Mae and Freddie Mac will make payment instead.

The second and newer function is that of ordinary investors who buy up mortgage bonds, funding the purchase by borrowed sums. This market amounts to USD 1,600bn. They obtain funding at a lower rate than do similar enterprises, because the market participants take it that Fannie Mae and Freddie Mac enjoy an implicit state guarantee. However, the guarantee is not evidenced in writing, and Fannie and Freddie deny its existence. Still, there can be little doubt that the government will step in if bankruptcy threatens. This is because bankruptcy would render it more expensive to buy a house and ever more difficult to obtain a mortgage loan, and such a development is not exactly what the US housing market needs at present.

Together, the two enterprises are financial giants. Between them they own or guarantee almost half the US mortgage debt.

They are facing problems on several fronts: the falling house prices and the rising number of defaults among home owners may cause the two enterprises losses on their guarantees. But please note that they only buy up mortgage loans up to 80% of the value of real estate. And they do not buy up sub-prime mortgage loans or loans for houses costing more than USD 417,000. Of course, they have a buffer because they buy the least risky loans.

The second problem is the fact that Fannie Mae and Freddie Mac have geared their investments heavily. Their aggregate equity amounts to about USD 81bn; their debt to USD 5,300m. Mr Poole, a former Fed member, has described the two institutions as technically insolvent. Moreover, they may run into liquidity problems because some of their funding is relatively short-term.

The Fed and the government are doing their best to dampen market anxiety. The Fed has announced that it will make loan facilities available to the two institutions. The government is endeavouring to have a bill passed which will increase their access to borrowing at the Treasury Department and allow the government to buy shares in the two institutions.

This week's other highlights

• The US: Beige Book, existing home sales
• The euro zone: PMIs
• Japan: Consumer prices
• Germany: IFO
• The UK: minutes of the BoE meeting held on 10 July, retail sales

Tuesday

The US: OFHEO house prices - May

There are various measurements of home prices in the US. This week will see the release of OFHEO prices, which are particularly interesting in the light of recent weeks' crisis at Fannie Mae and Freddie Mac. OFHEO only measures the price development of houses financed through the two mortgage credit institutions Fannie Mae and Freddie Mac. Usually Fannie Mae and Freddie Mac will only lend up to 80% of the value of real estate. Fannie Mae and Freddie Mac therefore have a certain buffer to offset the fall in house prices.

So far, house prices measured by OFHEO have fallen by 'only' 4.6% y/y. This leaves a fair buffer, but it is of course important that house prices do not fall too sharply. As mentioned below, there has been a tendency to stabilisation in home sales, but there are still a lot of homes for sale, and that will increase the downward pressure on house prices. Prospects are, therefore, that house prices have further to fall.

Wednesday

The US: Beige Book

The Beige Book is one of three reports that are produced up to the Fed meeting on 5 August, but it is the only one of them to be published. It is an extract of comments from businesses across the US. The comments describe the development in the various sectors of the economy such as the manufacturing industry, retail sales, the housing market, the financial sector, etc. Moreover, there are comments across the sectors about employment, wages and prices. The report is thus a relatively up-to-date description of the US economy, but it should be mentioned that the Fed is the author and that the report thus reflects the views of the Fed.
It also reflects the Fed's numerous contacts in the US corporate sector, and it is one of the instances where the Fed is better informed than the rest of the market.

The UK: Minutes of the BoE meeting held on 10 July

The BoE decided to hold interest rates at 5% at the meeting earlier this month. This was not surprising, given the BoE's dilemma over sharply rising inflation and economic slowdown. A more detailed explanation for the interest-rate decision will be provided in the minutes.
In its explanatory letter to the Chancellor of mid-June, the BoE stated that the inflation rate would exceed 4% this year, whereas in the Bank's May inflation report it was estimated at only 3.5%. The BoE is of the opinion that the rise - mainly due to food and energy prices - is temporary and there are no signs of generally rising prices and wages. The rising inflation rate means that, despite the sombre growth prospects, the coming months will see no interest rate cuts, since the BoE finds a certain slowdown in growth to be necessary in order to take the inflation rate down to the target for the medium term. On the other hand, it is not on the cards for the BoE to raise interest rates to curb inflation. We expect that the minutes will send the same message.

The most interesting point of the minutes will be how the members of the monetary policy committee voted. We expect there was relatively broad agreement behind leaving interest rates unchanged. It is possible that a few members voted in favour of a hike, which was discussed as an alternative at the June meeting, although there were no votes in favour of a hike. It is very likely that Mr Blanchflower voted in favour of a cut as he did in October last year.

Thursday

The US: existing home sales - June

Existing home sales have fallen by 33% since the autumn of 2005, but over the past seven months there has been some stabilisation in home sales, and the major question is of course whether this trend continues.

The stabilisation of home sales comes after an improvement of the fundamental factors for home purchases. This is a combination of falling interest rates, cheaper homes and rising household income.
But the disposable income of households has improved less lately. Mortgage yields have increased and given the renewed financial crisis whose epicentre is the two giants in the mortgage lending market, Fannie Mae and Freddie Mac, there are no signs of a turn in the housing market.

The signals about home sales in June were mixed. Pending home sales have stabilised to a certain extent, indicating that home sales are stable. Builders are still very pessimistic about the current and expected sale, and mortgage applications are still on the decline.

Therefore we expect a minor fall in home sales in June.
Also, there is focus on the number of homes for sale. The stock of homes for sale is one the rise after a fall in late 2007. It rose sharply over the past two months. The time it takes to sell a house has risen to 10.8 months which is the second highest since the mid-1980s.

The euro zone: PMI - July

PMIs for both the manufacturing industry and service have over the past months confirmed our expectation of a weaker growth in the euro zone in the second and third quarters. The more forward-looking indices in PMI also point to weaker indices in July than in June, which will also be the first indication that growth in the third quarter will not be flamboyant either.

Germany: IFO - July

IFO has for a long period been very strong, which was also confirmed in the real-economic indicators. It did therefore not pass unnoticed that IFO has fallen from the sky-high levels twelve months ago and IFO is now signalling somewhat weaker growth in the coming quarters. It is not unlikely that IFO will show a minor rise in July after the steep fall in June. But we clearly see that the trend is on the decline in the coming months.

The UK: retail sales - June

Despite slower growth, falling house prices and tighter credit standards, retail sales have proven to be surprisingly strong and the very steep rise in May brought the annual rate of increase to 8.1% from 4.2%. However, this rise should not be over-interpreted since retail sales are very volatile on a monthly basis.

It is also a bit odd that surveys of retail sales indicate falling growth. The British Retail Consortium reported a fall in June after a fair rise in May while the CBI index of retail sales rose slightly in both May and June, but the index stays at a low level and indicates a continued fall in retail sales.
We therefore do not expect the trend of rising retail sales to continue and assess that retail sales will see a very sharp correction in June.

Japan: consumer prices - June

Headline inflation is now at the highest it has been since 1998 driven by global rises in food and energy prices. Since energy prices continued to skyrocket in June, we expect inflation to rise further this month. Consumer prices are not expected to fall again until late in the year.

In spite of the significant increase in consumer prices, by Japanese standards, there are not yet any indications that inflation is generally on the increase. Core inflation (exclusive of food and energy) is negative, wage growth is again close to zero after having been positive for a little while and economic growth is slowing. We expect core inflation to turn positive again but only through a marginal rise as was also the case for the Tokyo consumer prices for June. Generally, we do not expect that inflation will begin to show a convincingly positive development in the near future.

Friday

The US: durable goods orders - June

Durable goods orders are an indicator of the demand for industrial products, and the indicator is thus important as to the assessment of the future industrial production. However, new orders fluctuate heavily thanks to orders for transportation equipment, including private aircraft (from Boeing).
Generally, we assess that the weakening of the economy will also hit new orders, but so far this has not been the case. Durable goods orders have till now only fallen moderately and much less than during the latest recession in 2001. However, we expect that durable goods orders will begin to fall somewhat more.

ISM's order index has been below 50 for the past two months, which indicates a small fall in orders. Boeing reports that orders have been more or less stable. Car sales, on the other hand, have fallen sharply, which will dampen orders from this sector.

One of the sub-components is investment orders exclusive of defence and aircraft, and thus an indicator of corporate investment. These investments are interesting because they almost always fall during a recession. The surprising thing is that new orders for investment goods have increased in the past six months. We expect investment goods orders to begin to fall in coming months.

The US: new home sales - June

New home sales are important, since traditionally they bottom out 2-4 months before the end of a recession. Moreover, new home sales are important because builders have plenty of new homes for sale, which dampens the building of new homes and hence construction investment. Construction investment has pulled down GDP growth by almost 1 percentage point over the past eight quarters.

New home sales have already fallen by 62% since the peak in the autumn of 2005. This is the largest fall recorded in the period with data available (back to 1963). Over the past three months, new home sales have in fact shown a stabilisation and again it will be interesting to see whether this trend continues.

• Home buyers may be held back by rising mortgage yields, and banks are very reluctant to grant loans to home purchases
• Mortgage applications have fallen slightly
• Builders are still very pessimistic about current sales
• The disposable income index has fallen after a period with rises

There is good news:

• Pending home sales have shown some stabilisation over the past six months
• Builders lower prices for new homes On the whole, we expect a minor fall in new home sales.

The UK: GDP - Q2

GDP growth fell in the first quarter to 0.4% q/q and 2.5% y/y, and we expect growth to fall further in the second quarter to around 0.1-0.3% q/q. The tightening of credit standards hits both companies and households, and the latter is under further pressure due to lower real wage growth and falling house prices. But consumer spending remained robust in the first quarter, and retail sales for April and May were strong, but we expect the development to turn in June. The global slowdown indicates lower export growth but the weak currency has the opposite effect.

The first reading of GDP for the second quarter will only show the general picture of production - divided into the manufacturing industry and service. The sentiment indicators PMI Manufacturing and PMI Service have fallen further in the second quarter and indicate a setback in both sectors. The division of the GDP data into demand components will not be released until late August.

Jyske Markets - FX Research
http://www.jyskebank.dk/finansnyt
The analysis is based on information which Jyske Bank finds reliable, but Jyske Bank does not assume any responsibility for the correctness of the material nor for transactions made on the basis of the information or the estimates of the analysis. The estimates and recommendation of the analysis may be changed without notice.