Who Determines Interest Rates?
Research for Online Investors

by John Dalt

12/30/09

Subscriber T.M. sent in a response last night to our MarketToday letter yesterday. She saw an angle to the unlimited backstop to Fannie Mae (FNM) and Freddie Mac (FRE) I had not thought of. A little back ground first.

The U.S. Treasury announced on Christmas Eve, while everyone was sipping eggnog that the backstop limits on Fannie Mae and Freddie Mac (twins) debt would be lifted for three years. As part of last year’s rescue of the ‘twins’, they were limited to $200 billion each and supposed to reduce their balance sheets by 10% every year. That requirement was modified by treasury, allowing them to increase their loan portfolio by an average of 7% in 2009 then start reducing by 10% in the following years.

According to the Associated Press, the the 'twins' already account for 75% of all new mortgages written in the U.S.  The Treasury (administration) was able to sidestep congress by issuing this change before the end of 2009.

The Fed has been buying mortgage-backed securities (MBS) in order to keep interest rates lower. This coupled with the direct buying of Treasury bonds was under their term of “quantitative easing.” A fancy way of saying they were “printing $1.25 trillion.”

The Fed announced they would end the purchase of Treasuries in the fourth quarter of 2009 and stop purchasing MBS in spring of 2010  This means that market forces would start to work again, which cannot be good news for world improvers.

I wrote on Nov. 17, “Cryin’ In Their Beer” that the Chinese “will never let it (Yuan) float, with the value determined by traders.  Free markets are not predictable enough for the Chinese.”  They (communists) want to control the exchange rates to maintain a competitive advantage in world trade.

Is our Treasury Department doing the same thing in bonds?  Duh.  T.M wrote, “One thought I had…The Fed's buying of mortgage securities is scheduled to end March 31, 2009.  So, if the fed isn't buying this…garbage who else is going to? Why of course, Freddie and Fannie!  Now it doesn't matter how much they lose as long as they keep loading their balance sheet!” Touché T.M. you may have hit the nail on the head.

The ‘twins’ can buy MBS to force the market down, relieving the Fed of intervening.  Even more nefarious they can sell their bonds for less than face value and book a loss to the taxpayer.  They can also write down mortgages for troubled homeowners, and send the bill to the Treasury.

This allows the Fed to act as if they are withdrawing from supporting the markets. Just like Three Shell Monty, when you watch one shell there is mischief occurring with the other shells. Classic.

When you force the yields on MBS down the effect is also felt in the treasury auctions.  The added political benefit is that the losses on the ‘twins’ debt will not show up for a few years.  The Fed has a mess on their hands.  All the treasuries and MBS they have bought sport low interest rates.  They will be marked down as interest rates rise.  The ‘twins’ can pump some air back in the real estate market, and leave the ensuing bubble under a new administration.

Another unintended (intended?) consequence is the Wall Street banks will not be able to compete with the ‘twins’ and their unlimited backing by the U.S. Government.

Thanks to T.M. for boring down and seeing the game, as I had not.

Reuter’s article “Government ties trump U.S. agency debt supply rise in 2010” and Associated Press "Fannie, Freddie Proving to Big to Shrink" were used for reference in today’s article.

Conclusion: Treasury will use the ‘twins’ to hold interest rates down, loading their balance sheets with low interest loans. The ‘twins’ will be used to write down existing troubled loans for political points.  The result will be more losses to taxpayers, a shrinking pool.

I have never written that the current executive branch occupants are dumb, far from it.  They are deceitful, and power hungry.  Willing to do whatever it takes to further their goals.  Witness the past eleven months.  Where they are inept; national security and fiscal responsibility, it is because they have no interest or experience in such mundane tasks.

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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