FHA Issues CDS
Research for Online Investors

by John Dalt

11/16/09

American International Group (AIG) received $70 billion dollars in TARP funds to cover the Credit Default Swaps (CDS) they issued to banks.  These CDS were sold as ‘insurance’ that the loans the banks held would not default.  Since the CDS were not technically ‘insurance’ AIG did not put aside reserves in case the covered assets turned sour.

We have just come through the credit crisis and real estate implosion, brought on by easy credit and questionable loan procedures.  A buying frenzy in real estate, fueled by ever increasing home prices and cheap easy money created a bubble that was sure to pop, to those observers experienced enough to see it.

When any bubble pops, buyers are slow to come back to buy the assets that have seen the greatest fall in value.  These are the times of ‘maximum pessimism’.  The normal cycle takes time to complete as the asset builds a base, and buyers re-enter the market as they see an opportunity to profit.  This creates a problem, as politicians don’t like falling home prices and slow economic growth.

The difference between our personal problems and the economy is the tweaking that occurs with the economy.  We know that we personally cannot effect tomorrow, it will be what it will be.  Government, in great collective wisdom, believes they can put their hand on the scale and make it change to a more likeable outcome.

How does our government ‘fix’ the problem?  Pump air in the bubble!  This is the ‘typical’ government response.  If a government program does not work, it must need more money.  So after a couple of trillion in stimulus and TARP funds, we are rushing down the road to another bailout at the Federal Housing Administration (FHA).

The FHA has become the dominant lender in the last year, insuring 49% of the mortgages originated under the $8,000 refundable tax credit.  Since the FHA only requires 3.5% down, the refundable tax credit can put a ‘buyer’ in a home with a purchase price of $228,500 with no out of pocket expense except closing costs.  Isn’t that how we got here in the first place?

The FHA is a government institution started in 1934 as a last resort lender for citizens with less than perfect credit.  The FHA guaranteed less than 3% of new mortgages in 2006, this year they account for one-third of all new mortgages and 20% of all re-finances.  The FHA does not directly loan money, they cover any losses on loans they approve.  Doesn’t this sound like Credit Default Swaps (CDS)?  If you said yes, you win the prize.  The FHA is issuing CDS on over 30% of every new mortgage in the U.S., with the government checkbook.

The FHA has $3.6 billion in reserves against guarantees on $686 billion in loans, about 0.5%. That ought to work out well. Except 20% of their loans from 2006 and 2007 are expected to default. As of June 30, 2009, 17% of all loans were behind in payments and 8% were seriously delinquent or in foreclosure.  Back of envelope accounting looks like the FHA needs $55 billion to cover the foreclosures and $30 billion for the loans that are delinquent if half of them end in foreclosure.  That makes the coming bailout of FHA bigger than AIG.  Of course, some dollars may be recovered when they sell the homes they foreclose on, if they can keep them from being stripped and pillaged, or taken over by squatters.  It is good to know that our government, unlike AIG, has put money in reserve to cover these CDS.  How many people at FHA will be fired?  Will they be shut down, like AIG?  Don't hold your breath.

Time magazine online has the story, “FHA: Housing Safety Net Begins to Fray.”

When it rains, it pours.  The market is punching through to new highs this morning.  Our Long-Term Portfolio is doing well with a couple of laggards that may need to be culled on a bounce.  Buy, Sell, Hold is performing at expectations, and the Swing Trader is having the best month since September.  Our subscribers closed a trade this morning for a quick 11.5% profit.  So why am I talking about rain?

Our second daughter is having a few challenges at college.  She lost an election last week and was disappointed.  Like many of us, pressure from class projects weakened her immune system allowing some health issues to surface.  Someone slipped a drug into her drink at Saturday’s football tailgate party, which caused to be violently ill thru Sunday.  Last night, she went to visit her older sister for some sympathy and warm chicken noodle soup.  This morning she wrecked her car on an icy bridge.  When it rains, it pours!

All of us have problems seeing all the good around us when bad things happen.  It is hard to enjoy a great day in the market, when other problems command our attention.  I am reminded of the old song from the musical ‘Annie’, “The Sun Will Come Out Tomorrow.”

Some  learn early, others wait till they pay taxes.
Did you take you kids Trick-or-Treating?

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions.  It may contain errors and you should not make investment decisions based solely on what you believe you have read here.  Do your own research, it is your money.  If you lose it, it is your responsibility, not ours or your grandmothers!  The editor may or may not have a position in any securities discussed.  The editor may have held a position in a security earlier, or in the future.

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