U.S. Dollar Could Be Vulnerable to a Blow Up in Fannie Mae or Freddie Mac

Freddie Mac and Fannie Mae are not the solution but the main problem of the U.S. mortgage market since their sole existence gives incentives for investors to take more risks that they should. Indeed, excessive regulation in the U.S. credit markets continue to hold back the economy and the greenback could be vulnerable to a violent pullback in a wave of profit taking.

This week a report on the U.S. housing market showed that New Home Sales rose 2.4 percent in July after having drop 0.6 percent in June. However, one data point does not make a trend and these numbers reflect more short term measures introduced by the Bush administration than real strength in the housing market. Indeed, Henry Paulson, the U.S. Secretary of the Treasury, recently announced a plan to provide liquidity, stability and affordability to the U.S. residential mortgage market. Among those measures was one to increase lending to Freddie Mac and Fannie Mae since many investors argue that these two agencies are just too big to fail. Since then Freddie Mac and Fannie Mae have been in the market buying mortgages and issuing complex securities. Yet, their investment strategy is not that different from the one taken by some of Bear Stearns’ hedge funds just before the firm’s collapse.

Source: FHA and Fannie/Freddie Loan Limits Higher EDIT

Freddie Mac and Fannie Mae are not the solution. In fact, they are the biggest problem since their sole existence gives incentives for investors to take more risks that they should. Nothing, even the Federal Reserve is too big to fail, and we may need to see a big blowup before we can say that the housing market has hit the floor. Looking ahead, a significant U.S. dollar undervaluation is now likely to lead to a substantial improvement of the U.S. Balance of Payments through continued strong export performance and propel USD/JPY to 120 and EUR/USD to 1.40. However, tight conditions in the U.S. credit markets continue to hold back the world’s largest economy which could make the greenback vulnerable to a violent pullback in a wave of profit taking.

Historical Chart of USD/JPY and Fannie Mae Stock Price

Source: Bloomberg.

Written by Antonio Sousa, Chief Strategist
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