“My brother who has studied this more, said if 3% of Fannie Mae’s loans become insolvent, they become insolvent too and it would set off a derivatives and banking crisis.”
Fannie Mae is levered about 33 to 1, such that if 3% of its loans are “charged off” then its equity will evaporate (and it will be insolvent). Hopefully that’s what your brother meant. Mortgages don’t become insolvent; they become “delinquent” and eventually go into “foreclosure.” Insolvency relates to businesses and individuals, not mortgages.
Now, the only way Fannie Mae’s equity disappears is if 10% or more of its loans move into foreclosure AND a third of the foreclosure balances get charged off. Highly unlikely even considering today’s craziness. (But we could still see a derivatives crisis related to Fannie even if it remains solvent.)
Now, dont’ get me wrong, I’m very bearish on Fannie Mae’s equity and long-term debt. But there’s no way that the government or investors will let Fannie Mae disappear – it will survive via new equity and debt if it runs into serious trouble, which brings us to Fannie’s short-term debt, which is held by lots of money market funds…
If you look at Fannie’s balance sheet, you’ll see over $900 billion of long-term debt (plus its equity) that lies below the short-term debt in terms of liquidation preference. Consequently, you can be very bearish on Fannie’s equity and long-term debt and still be bullish on its short-term debt. Bottom line: I wouldn’t worry about money market funds with Fannie’s short-term paper… but I’d be very worried about owning its equity.
