The Federal Housing Finance Agency has released the results of its latest DFAST (Dodd-Frank Act Stress Tests) results and it might be worthwhile to look at one of the worst-case scenarios that the government uses to evaluate the large mortgage enterprises known as Fannie Mae and Freddie Mac.
Here is the worst-case scenario ...
"The 2017 DFAST Severely Adverse scenario is based upon a severe global recession which is accompanied by a period of elevated stress in corporate financial and commercial real estate markets. It includes large reductions in asset prices, significant widening of corporate bond spreads, and strained market liquidity conditions. The scenario is not a forecast, but instead is a hypothetical future economic environment designed to assess the strength of the Enterprises and other financial institutions and their resilience to unfavorable market conditions."
"The planning horizon for the implementation of the 2017 DFAST is over a nine quarter period from December 31, 2016 through March 31, 2019.
In the 2017 DFAST Severely Adverse scenario, U.S. real GDP begins to decline immediately and reaches a trough in the second quarter of 2018 after a decline of 6.50 percent from the pre-recession peak. The rate of unemployment increases from 4.7 percent at the beginning of the planning horizon to a peak of 10.0 percent in the third quarter of 2018. The annualized consumer price inflation rate initially declines to about 1.25 percent by the second quarter of 2017 and then rises to approximately 1.75 percent by the middle of 2018."
"As a result of the severe decline in real economic activity and muted inflation levels, short-term Treasury rates decline to near zero and remain there through the end of the planning horizon. In the scenario, the 10-year Treasury rate drops to about 0.75 percent in the first quarter of the planning horizon before gradually and consistently increasing to a level of about 1.50 percent in the first quarter of 2019."
"Due to these macroeconomic developments, asset prices decline sharply as corporate financial conditions are severely stressed, reflecting mounting credit losses. Spreads on domestic investment-grade corporate bonds versus long-term Treasury securities increase to 5.5 percent by the end of 2017."
"In addition, equity prices fall by approximately 50 percent from the start of the planning horizon through the end of 2017, and equity market volatility increases substantially, approaching levels last seen in 2008. Home prices decline by approximately 25 percent, and commercial real estate prices fall by 35 percent through the first quarter of 2019."
"The 2017 DFAST Severely Adverse scenario also includes a global market shock component that impacts the Enterprises’ retained portfolios. The global market shock involves large and immediate changes in asset prices, interest rates, and spreads caused by general market dislocation, uncertainty in the global economy, and significant market illiquidity. Option-adjusted spreads on mortgage-backed securities widen significantly in this scenario."
"The global market shock also includes a counterparty default component that assumes the failure of each Enterprise’s largest counterparty. The global market shock is treated as an instantaneous loss and reduction of capital in the first quarter of the planning horizon, and the scenario assumes no recovery of these losses by the Enterprises in future quarters. For those positions subject to the global market shock, FHFA directed the Enterprises to report the greater of the global market shock losses or the losses attributable to the macroeconomic scenario for the identical positions."
The Summary Report can be found here.
The scariest part of this scenario is contained within the phrase "counterparty default," a euphemistic term that implies that the highly-leveraged derivatives cannot be unwound and that the instability and disruption in the marketplace will be disproportionately larger than if an enterprise simply went bankrupt. The global spread of the mortgage meltdown contagion in 2008 was felt far beyond the United States and threatened to destroy the financial world.