Another one of my long term subscribers wrote me recently with his insights on how Fannie Mae and Freddie Mac have transmogrified the offering of simple mortgages into something one would expect to find at a Las Vegas casino. Their financial innovations have facilitated the growth of home ownership on one hand but have set up America for a financial meltdown should the Fed increase interest rates beyond the tipping point. All this begs the questions "Are we there yet?" "How many more increases before the house of cards come tumbling down?" With at least two more increases expected in the first half of 2006 this could well be the year. Below are my subscribers' comments.

"Our Worst Nightmare - the Puncture of the Current US Housing Bubble"

"The key to holding up the entire speculative US financial system with its current excessive levels of debt - federal (current account and trade), state, municipal, corporate and household - is maintaining the U.S. housing bubble. Anything less would result in America's worst nightmare and, in short order, the entire world.

The housing market is dominated by Fannie Mae and Freddie Mac who hold 75% of all outstanding home mortgages (and the Federal Home Loan Bank Board to a much lesser extent). One too many additional increases in the Fed rate may well turn out to be the U.S. economy's Achilles' heel and lead to a major crisis at these two institutions generating an out-of-control systemic breakdown situation and disastrous financial implosion.

Here's why. Fannie's and Freddie's (FF) original functions were to provide liquidity to the housing market. After a mortgage lending institution (MLI) originated a mortgage - say, $100,000 - FF would purchase that mortgage from the MLI for a fee and hold the mortgage to maturity. The MLI now had $100,000 to make yet another mortgage loan and earn yet another fee. By the repeating of this process FF injected liquidity into the housing market making it possible for MLIs to increase the number of mortgage loans they could make each year and earn considerably more fees in the process.

Where did the money come from for FF to raise money to purchase these mortgages from MLIs? It was easy. FF simply issued bonds (which, as you know, are a form of debt) at a somewhat higher interest rate which was their spread or profit. The more mortgages they bought from the MLIs covered by the issuance of their bonds the more money they made. And it was all totally secured by the assets of the houses themselves. A risk free arrangement. Not bad. The MLIs made money, FF made money and the consumers owned houses on which they could afford to make their monthly mortgage payments.

Beginning in the 1980's FF got greedy! They began to encourage the MLIs to sell mortgages to purchasers who would have to spend more than the U.S. Department of Housing's recommended 28% of gross income to service the housing (mortgage payments, home insurance payments and home property tax due) costs involved. As FF expected the demand for houses went up, the price of houses went up, the number of mortgages went up, the size of mortgages went up, the profits of the MLIs went up and the profits of FF went up. But the degree of financial risk for FF increased dramatically. Many mortgagees had to pay out 50-60% of their household income in housing costs and were extremely vulnerable to any economic setback they might encounter - loss of job; increased cost of living; health problems; death, incarceration or illness of breadwinner. As a result, the rate of delinquencies and foreclosures went up. In many cases the down payments made by these new mortgagees were so small that the only way FF could recoup its outstanding mortgages was if the resale prices of the homes appreciated considerably from the date of the initial purchase. The greater the appreciation of such homes the less the risk to FF.

Next, in the unending search for increased profits, FF undertook some financial innovation. They began bundling groups of mortgages together as mortgage backed securities (MBS) on which they guaranteed, in case of default, to pay interest and principal "fully and in a timely fashion". They sold these MBSs for a fee, to mutual and pension funds and to insurance companies around the world. This gave the funds a claim to the underlying principal and interest stream of the mortgage. In doing so the risks entailed in the owning of mortgage debt were broadened beyond FF. If FF were unable to fulfill their guarantee (and the monies provided by the government are totally inadequate) these funds, too, would be adversely affected and depending on the extend of the default, gravely so. FF's profits went up but its reward/risk ratio dropped like a stone!

And finally, to squeeze out even more profits, FF began taking 50% of their MBS holdings and pooling them once again into derivative instruments called Real Estate Mortgage Investment Conduits, i.e."restructured MBS" or into what are called Collateralized Mortgage Obligations for which they are paid a fee. These instruments are highly specialized derivatives, i.e. bets on the direction of future rates of interest. FF's profits went up even more but the risks associated with these actions became excessive!!

Thus, what started out as a simple home mortgage, has been transmogrified in to something one would expect to find at a Las Vegas gambling casino. Yet the housing bubble now depends on precisely these instruments as sources of funds.

If too great a portion of FF mortgages were to go into default and cease to pay interest or principal, FF would not have sufficient cash to pay the holders of its bonds. If the situation were to become too great FF would default on its bonds. So, whereas before one had one economic catastrophe - the default of some mortgages - because of the way the housing market is structured, this produces a second catastrophe - the default of FF's bonds which are at least 10 times greater than that of any corporation in the U.S. Such a default would put an end to the U.S. financial system, right then and there.

Yet a second obligation compounds the problem - its guarantees on the MBS. In a crisis in the housing mortgage market, FF would not be able to meet the terms of their guarantees and would go bankrupt from this source, if it had not already defaulted on their bonds. The pension and mutual funds which had bought the MBS on it guarantees, would suffer tens of billions of dollars in losses.

Finally, FF's derivative obligations in hedges, allegedly to protect it from risks, could themselves go in to default against the banks and other counter parties.

The above mentioned obligations of FF total over $5 trillion. Another $1 trillion in obligations are held by the Federal Home Loan Bank Board and private issuers of MBS. These $6 trillion in risky obligations are distinct from, and in addition to, the more than $6 trillion in mortgages themselves. As such, a total in excess of $12 trillion is laden on to the homes and attached to to the incomes of America's homeowners. And then there is credit card debt, car lease debt, cell phone contract debt, bank loan debts, margin debt, etc!

Nothing, absolutely nothing, must stand in the way of consumers fulfilling their financial obligations - and they absolutely must not default on their mortgages. Cheap money must prevail. Not dirt cheap like before but still very cheap by historical standards. Cheap money is necessary to keep the real estate bubble in force because consumer spending increases 0.62% for every 10% gain in the housing market (more than twice that of a 10% gain in the stock market).

Regretfully, though, this FF house of cards is on the verge of collapse. Bond prices have fallen and interest rates are approaching 5%. The ramifications are dire.

A wide variety of partners hold large chunks of FF debt: commercial and investment banks, hedge funds, mutual funds, pension funds, insurance companies, private investors. They are all exposed to large losses were either Fannie Mae or Freddie Mac to default on their debt. In the U.S., for example, 60% of all banks (approx. 5000) own FF debt in excess of 50% of their equity capital. As the Office of Federal Housing Enterprise Oversight has said "such an event as the default of FF debt could lead to contagious illiquidity in the market for those debt securities which would cause or worsen illiquidity problems at other financial institutions .... potentially leading to a systemic event."

The Fed is between the proverbial 'rock and a hard place'. They engineered low interest rates in the first place, both to keep the financial markets going, and in large measure to keep the housing bubble afloat. They are now in the final stages of raising interest rates to prop up the collapsing US dollar and to forestall rampant inflation. Were they to initiate one quarter percent increase too many it would destroy the interest rate environment that is essential to keeping the housing bubble alive; to keeping consumers spending at a high level thereby keeping the economy growing; to keeping corporate sales and profits high thereby keeping the stock market healthy. Have they gone too far already? The bubble seems to be loosing air slowly at this point but what will the impact be of the next increase? The impact of one too many rate increases on such a chronically debt-ridden and maladjusted economy must not be over estimated.

It is just a matter of time before further increases in mortgage rates will result in increases in monthly mortgage payments than some borrowers can not handle. This will be particularly so for borrowers of sub-prime loans who were able to purchase their first homes with almost nothing in the way of a down payment and who, even now, have a delinquency rate at near record levels. In addition, as mortgage rates rise further, fewer first-time buyers will be able to afford to buy a home which will, in turn, slow down the sale of new and resale homes.

With further increases in mortgage rates there will be dramatically reduced refinancing of mortgages which have gone a long way to financing the retail boom in retail sales over the past few years. Indeed, more than $500 billion in equity has been withdrawn annually in the US and $29 billion annually in Canada for that purpose.

But rest assured the Fed will do absolutely everything in its power to prevent the puncturing of the housing bubble!

FF assets have expanded so rapidly over the past few years due to the number of mortgages, the escalating value of mortgages (as a result of escalating real estate prices) and the refinancing of mortgages and they have so much debt in the form of mortgages, bonds, MBS's and derivatives that should they encounter any problems servicing the debt it most likely will have a destabilizing effect on the US economy.

Indeed, the Fed are so concerned about this happening they are flooding the economy with almost limitless liquidity. There must be a crisis of historic proportions coming, and the Federal Reserve Bank of the United States is making sure that there is enough liquidity in place to protect our nation's fragile financial system. The amazing thing is that the Fed's actions mean they know what is about to happen.

What could it be?" Perhaps the Fed finally recognizes that the housing bubble has experienced a leak that could well escalate into major proportions soon. Perhaps the Fed has learned that one (or more) of the 3 American banks holding 95% of U.S. derivatives are experiencing some difficulties managing their risks. Perhaps the FF are encountering major derivative losses once again. Perhaps the Fed are concerned that the rising budget deficit and/or the ever increasing and already record-high current account (trade) deficits are very near the tipping point. Perhaps it is their fear that the recent and continuing interest rate hikes are going to have a very negative impact on the already overly indebted U.S. consumers (rising mortgage, lease and credit card rates), the stock market (lower corporate profits) and the bond market and lead to a recession. Perhaps the Fed sees their greatest fear of all - deflation - just around the corner.

So where should we be investing our money? Certainly not in real estate. Definitely not in bonds. Absolutely not in the general stock market. What's left? Well, there is cash (at least you won't lose your shirt if you hold it in something other than U.S. currency); gold bullion which performs well in such a chaotic environment (and by extension mining company shares and/or their warrants) and also energy stocks because of the political climate being the way it is in the Middle East. Pay off your debts, build up your savings and invest accordingly and you will be protecting yourself from what could well become our country's (and the world's) worst nightmare and enjoying sweet financial dreams for years to come. Good night and God bless!"

While these are not my words, many of us share these views.

Please note: the CEO of Freddie Mac disagrees with the assertions made above. See his comments at "Freddie Mac poses no special systemic risk: CEO - Yahoo! News." You be the judge as to the merits of both.