Vinny’s Blog

What is debt ? You can find lot of definitions in books but my definition in simple words, it’s money borrowed which sometime in future must be paid back. Interestingly if it need not be paid back then, it becomes a gift or a donation.

Anyway, we are sticking to debt, what is rolling over of debt ? when debt cannot be paid back in full it’s rolled over. When you don’t pay your credit card bill what happens ? Credit card company will ROLLOVER your balance to next month’s statement with applicable finance charges + interest on it.

In my example..it sure means not being able to pay full amount and also means that next month one would pay little more than balance (balance + interest).

What is the worst case scenario with debt ?

1. Bad case is “ that one can make only minimum or slightly more than minimum payments due each month and hope sometime in future debt will be paid off completely.
2. Worst case is “No payment at all and then bankruptcy is the only option left.

Now that we understand few aspects of it, why can’t we make business out of it and make some money ? won’t that be fun ?……..so let us beginthis is how I plan to make money.

I want to open a furniture shop. For that I want to borrow 500$ from a bank. As soon as I borrowed I have a debt to the bank in the amount of 500$ + Interest each month. Until I paid back in full. If the loan from bank is for 5 years then bank will determine my monthly payment amount (principal + interest) such that all of it is paid back in 5 years.
With that bank loan of 500$, I imported furniture from China to America in my shop. And started selling furniture on conditions that people can pay for furniture in installments over 5 years but payments are due each month because I have to pay the bank each month.

I price installments in such a way that every month I will receive enough money from my customer to pay the bank their installment (principal + interest ) and I still have some money left to take care of my family, rent of the shop, salary of my employees etc. etc.

Anyway, you might have guessed it..thatthis model will continue to work as long as my customers keep on making payments when due otherwise I have a problem. If they don’t pay me, I can’t pay the bank, can’t pay shop rent, salaries of my employees. If I can’t pay the bank then, bank in turn cannot pay it’s office rent, salaries of it’s employees and interest to it’s depositors. How do you think bank got 500$ ? it gets is because people, you and me deposited our money with the bank. That is the money (yours and mine) that banks lend to others for business.

If you are wondering why I was trying to explain all this..wonder no more because right about now all of it will start making sense

Now imagine , I am Fannie Mae

Instead of borrowing 500$ I borrowed 5 Trillion dollars.

Since the amount borrowed is so huge (5 Trillion dollars) no one bank wanted to give all that money so Fannie had to go to various banks and it landed up borrowing from Central and Reserve banks of China/Japan/Russia/India/Brazil, almost every country ( it’s 5 Trillion dollars.)

Furniture I sold is actually housing. That almost every American has bought on installments ( in other words home loan).

The problem I am having is they are not paying me the installments, money I am getting is not even enough for me to make the minimum payment to these central banks.what can I do now ? Fannie has same problem today.

I only have few options left, I (Fannie Mae) can borrow more from yet another bank to make my minimum payment. But truth is looking at debt situation ( 5 Trillion) no one wants to lend me any more money they think I have borrowed too much already and it’s too risky to lend anymore money to me.

If at all anyone does want to lend me (Fannie Mae) money (thank god for that) , they want to charge huge premium for it, 1% above the market rate. ( 1% of 100$ is only 1$ but 1% of a billion $ is 1 million $). Since I have to borrow big amounts this is not a good option.

Actually this option is bad in the long run “ If I borrow at higher interest rate, then all that furniture (homes) I am (Fannie Mae is ) going to sell will have higher monthly payments. When my customers ( Americans ) cannot handle lower monthly payments NOW, how can they handle HIGHER MONTHLY PAYMENTs later ? this (Fannie, borrowing at higher cost ) is sure to cause more damage in long run.

OK don’t panic “ Remember I have 2 other options

a. File for Bankruptcy and
b. Don’t make the payments skip a few what can banks (China/Japan etc) do ?

Well, These are really not options. If I (Fannie) don’t pay back these banks will sell all the US treasury bonds they have invested in and that will bring down the value of USD which will cause inflation, prices of everything will go up, then central bank of US will have to raise interest rate ( Just like Reserve bank of India did to combat inflation) and we are back in the same situation “ higher interest rate. . higher interest rates means higher monthly payment..When Americans cannot handle lower monthly payments NOW, how can they handle HIGHER MONTHLY PAYMENTs later ?

If I am thinking right there is only, truly one option left. Someone just need to gift or donate me (Fannie Mae ) truck load of money.

Wow ! Bingo ! US Treasury..they have all the tax money from Americans I (Fannie) sure can use a lot of it.

But wait a minute..if Fannie uses all that tax money won’t that affect people after all tax money is the money that gets spent on constructing and maintaining roads/bridges/tunnels/parks/schools/ water reserves/cleaning operations/ military /air port security/ space programs/ war on terror..etcetc.

Yaaaaaaa so what ! May be people are either not smart enough to figure that out.or they are dumb enough not to realize it. So, no problem !.yoo hoo..better still I don’t want to use tax money, I ( Fannie Mae) just want treasury guys to say it. This way all those who are worried about their loans to me will calm downthey will worry less..once they know Fannie has access to a lot of money they will relax and may be they will lend me some more.

Now let us look at Fannie and Freddie.and remember the business model story I used in the example.that will make it easy for you to understand and relate to the situation.

Fannie, based in Washington, has about $120 billion of debt maturing through Sept. 30, while McLean, Virginia-based Freddie has $103 billion, according to figures provided by the government-chartered companies and data compiled by Bloomberg.

So $223 billion payment is due by Sept 30^th. Like payment due on loan in the example.payment due is not end of loan but loan rolls over to next month until the next payment is due

Rolling over the debt “is the single most important factor to their ability to remain liquid,” said Moshe Orenbuch, an analyst at Credit Suisse in New York. “So far, they’ve been able to do that.”

So making payment this time and rollover the debt is very important. They have done it before but that is history question is can they make next payment due in September ?

First of all it’s a huge amount $223 billion if they can’t pay it ..thenthat gift money from Tax Payer’s account could be used also known as federal bailout.

In market trading, investors this week demanded an extra 104 basis points in yield to own Freddie’s five-year debt rather than Treasuries of similar maturity, the most since reaching a 10-year high of 114 basis points in March.

-This may sound slightly cryptic but in simple terms problem with borrowing too much money is - at some point lenders think there is too much risk and they either don’t want to lend you anymore or want premium (higher interest rate) to lend you in other words they want to discourage you to borrow more.

“ If one had to borrow at higher interest rate then one has to sell or charge higher rate.and poses same old problem - when customers cannot make payments at low interest rate how can they make payment at higher interest rate ? Odds are not in favor here.

“The 22 percent of Asian participation is worrying,” said Ajay Rajadhyaksha, the head of fixed-income strategy for Barclays Capital in New York.

JPMorgan Asset Management Japan is reducing its holdings of Fannie and Freddie debt, according to Shinji Kunibe, a senior money manager at the firm in Tokyo. And Yuuki Sakurai, the general manager of financial and investment planning in Tokyo at Fukoku Mutual Life Insurance Co., said his firm is also “a little bit worried about the fate of” Fannie and Freddie.

“The conditions don’t seem to be turning into a good environment,” Sakurai said.

Because the debt is too high and too risky, banks and financial institutes are turning away from lending more.

After receiving authority last month to inject unlimited capital into Fannie and Freddie, a Treasury spokeswoman this week said Paulson had no plans to use his new power.

Read this carefully this is the Tax Payer’s money that was announced to be given (gift or donation) but the plan WAS never to use it. Idea was to simply suggest that companies could get unlimited cash when they need it. Then, expect that this bluff is enough to boost confidence in the company.

Initial optimism that Paulson’s proposal would bolster confidence in the companies has vanished on concern that the deteriorating housing market may force a bailout, a move that would likely wipe out common shareholders and potentially some preferred stockholders, Miller said.

- Looks like people realized it was a bluff. That gift money was never actually given and there was no plan to donate it either. Now that people realized it they are concerned. Even more concerned about these companies.read ahead.

“It hasn’t restored any faith, it just highlighted their problems,” Miller said. “The market has come to accept the fact that the government has got to do something.”

As a matter of fact because government said they will step in and fund the company has highlighted their problem even more. That statement made clear to public that there INDEED is a problem and of such nature that government needs to step in.why a government needs to step in if
a company is stable ?

Investors in Asia, the biggest foreign owner of Fannie’s $3 trillion of bonds, are reducing their share of purchases, potentially increasing the need for Paulson to make good on his pledge to backstop the companies.

This is the biggest problem investors, creditors, central and reserve banks from Asia want their money backand they are moving away from lending new money to these companies. Not only that they are now selling bonds etc issued by these companies to reduce their exposure. This is only going to force US government to fill in the gapstatements that were used as bluff by government might actually be forced towards execution..

As always here is link to article.

Fannie, Freddie Bailouts May Hinge on Debt Rollover (Update4)

http://www.bloomberg.com/apps/news?pid=20601087&sid=aXEm3IuiZ3r4&refer=home

I am going to make this post a bit longer but I want to make sure you understand why this is a problem and why this is a very BIG problem and why finding a solution this problem is so difficult.

First of all let me give you some prospective on $223 billon dollars. How big an amount is it ?

So far all banks, all over the world, does not matter which bank, UBS, Citi, Chase, Bank of Americaany bankanywhere in the worldtheir total losses declared so far (till April-08) are only worth $500 billion USD.

Banks’ Subprime Losses Top $500 Billion on Writedowns (Update1)
http://www.bloomberg.com/apps/news?pid=20601087&sid=aSKLfqh2qd9o&refer=worldwide

These 2 companies alone have to make half of that money in payment due and that too only to rollover the debt.are you getting the picture ? This is a HUGE amount, once paid next installment is due again

OK..so these companies are worth Trillions of dollars how come they don’t have this money ? well, that exactly is the problem, if they EVER had money TAX money GIFT question will not arise. Would it ?

Why don’t these companies go ahead and raise (borrow) some more money ? after all they borrowed 5 Trillion so far. Well, that is right they borrowed and central banks and other financial institutes lent them so far but now everyone is nervous because this company is having trouble making payments on the bonds that are due in SEP-08.

Now if you’re wondering how did they make payments before where did the money come from ? I don’t know exactly how they made payments earlier but from my limited knowledge looks like every time there was payment due they just borrowed more. It’s like you borrow money from one credit card to pay for the one coming due. This will continue as long as offers are available for new credit cards. Looks like new offers just stopped cominghence the problem. I made a post earlier on these companies and this is extract from that post I said..

Now this reminds me of a drug addict guy. Recall in your memory what happens to a drug addict when he does not get his fix at the right time. Well, looks like situation here is no different than that..and Funny thing is I got this from Fannie’s website directly.

As Fannie Mae’s funding needs are so significant and constant, it is important for the corporation to consistently deliver value to its investors by creating securities that meet investors’ needs and adapting its funding approaches to meet the evolving demands of the marketplace.

http://www.fanniemae.com/markets/debt/understanding_fm_debt/understanding_debt.jhtml?p=Debt+Securities&s=Understanding+Fannie+Mae+Debt&t=Introduction+to+Fannie+Mae+Debt+Securities

Funding needs are so constant and important like drug for the addict that it must continuously delivery junk to it’s investor no matter what. Here is link to that post http://www.diwakars.com/wordpress/2008/07/fannie-mae-ii/

And here is evidence that New credit cards offers stopped coming in..

US faces global funding crisis, warns Merrill Lynch “ (Published July 18^th)

The US Treasury is running out of time before foreign patience snaps, writes Ambrose Evans-Pritchard
Merrill Lynch has warned that the United States could face a foreign “financing crisis” within months as the full consequences of the Fannie Mae and Freddie Mac mortgage debacle spread through the world.
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/07/16/ccusdebt116.xml&CMP=ILC-mostviewedbox
and this article was published on July 18^th. Here we are a month later.not only no one wants to buy more debt from these 2 companiesbut they are actually reducing their older debt

Investors in Asia, the biggest foreign owner of Fannie’s $3 trillion of bonds, are reducing their share of purchases, potentially increasing the need for Paulson to make good on his pledge to backstop the companies.

Now let us say some how these 2 companies do manage to get out of this $223 billion dollar payment obligationwhat next.remember debt rollover..that is it..next payment is due..but there is bigger problem waiting to happen before the next payment..more and more customers will not be able to pay their dues..

Housing Lenders Fear Bigger Wave of Loan Defaults
By VIKAS BAJAJ
Published: August 4, 2008
http://www.nytimes.com/2008/08/04/business/04lend.html?_r=1&ref=realestate&oref=slogin

So may be now you understand, $233 billion payment is due in another 45 days. There is money shortage, no one wants to lend any more. Those who do want to lend want higher interest rate (not good). And on top of that older debt is being sold causing more pain.to make matter worst.more people are likely to default on their housing payment that will further reduce how much money Fannie and Freddie will receive.

These amounts due now and later are very big, these companies are very big ( 5 Trillion $ worth). If they fail the impact will be huge everyone in US and ELSE WHERE INCLUDING ASIA will be impacted someway or the other.no one wants to be impacted adverselybut intelligence is in - to prepare yourself for a possible problem rather than ignoring and thinking that it might not happen.

[once again views and opinions expressed here are mine and you need not agree with them, you should not make any financial or other type of decisions based upon material and views you read here, for that you must contact a financial expert or expert in the area of your requirement.]