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Federal Reserve Issues Statement of Reassurance on Freddie Mac—Which Portends Trouble; Federal Prosecutors Open Criminal Investigation

June 11, 2003 (EIRNS)—In addition to the investigation launched June 7 by the Office of Federal Housing Enterprise Oversight, and the potential of an investigation by the Securities and Exchange Commission, today, the U.S. government opened a criminal investigation of Freddie Mac. "The U.S. Attorney's office in the Eastern District of Virginia has initiated an investigation involving Freddie Mac," said U.S. Attorney Paul McNulty.

Further, the Federal Reserve Board issued a statement today on the worsening crisis. "The housing market is still very strong," said Federal Reserve Board Governor Susan Bies. "And banks as a whole are very liquid right now, they have plenty of room to extend credit. So I haven't seen any signs that there will be a short-run impact [triggered by Freddie Mac]."

Whenever the Federal Reserve Board has to go to the lengths to issue a public statement, in its own name, that banks are strong, and they have plenty of room to extend credit, that normally indicates two things: 1) there are some serious problems that could get worse; and 2) that the Fed is already frantically engaged in behind the scenes measures to try to stop the Freddie Mac crisis from ripping apart the financial system.

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An Emerging Danger: Mortgage-Backed Securities Market Could Repeat Its Blowout of 1994, But on a Much Larger Scale

June 11, 2003 (EIRNS)—Freddie Mac and Fannie Mae have, along with Fed chairman Alan Greenspan, built up a huge housing bubble. They can carry out this operation by issuing three types of highly risky obligations: 1) corporate bonds that Freddie and Fannie issue; 2) Mortgage Backed Securities (MBS), in which Freddie and Fannie pool a group of mortgages together, put a guaranty on it (for which they earn a fee), and then they package these MBS to insurance companies, pension funds, and international investors; and 3) derivatives, which Fannie and Freddie have.

It should be recalled that in the 1990s, Kidder Peabody investment firm had built up, and took a controlling share in the market for instruments which were the precursors to MBS, called collateralized mortgage obligations (CMO); they worked on similar principles as MBS. Kidder Peabody dominated the CMO market, controlling approximately 25% of it. Kidder Peabody had five smaller firms, that functioned as "satellite firms" to Kidder Peabody, buying CMOs from and selling them to Kidder Peabody, and thus making the market in CMOs. The most important of these "satellite firms" were three hedge funds owned by Askin Capital Management, run by David Askin. Askin Capital Management often bought the most risky of the CMO instruments, which were known as "toxic waste," and packaged them and disposed of them to other firms.

During the first quarter of 1994, the interest rate on new 30-year mortgages had averaged 6.93%; Kidder and its satellites made a financial killing in the CMO market. But then during the second quarter of 1994, the interest rate on new 30-year mortgages jumped to an average of 7.45%, an increase in interest rates from the first to second quarter of half a percentage point. The CMO market, which was heavily leveraged, did not adjust well to the sharp increase in interest rates, even at only half a percent. At the end of March of that year, the three hedge funds controlled by Askin Capital Management were liquidated; but the Askin firms had $2.5 billion in CMOs, much of it on borrowed money. This set off a shock wave, which collapsed the more than 100-year-old Kidder Peabody, and bankrupted the CMO market. The Fed had to intervene to stem the crisis. In 1994, the size of the total CMO market was approximately $150 billion.