We are told today that Freddie Mac has some $3.4 billions in derivatives called "inverse floaters" that profit if homeowners do not refinance out of high interest rate mortgages. At the same time that Freddie Mac was accumulating its holdings of inverse floaters, it was tightening requirements for refinancings, thus either wittingly or unwittingly increasing its chances of profiting from its inverse floaters.
The contradiction between Freddie's investment in inverse floaters and its mission of fostering affordable housing for Americans is obvious. Freddie's regulator, the Federal Housing Finance Agency, has been pushing Freddie and Fannie Mae to limit the extent to which they receive taxpayer subsidies. Seeking investment gains has been one way of pursuing that goal. That may be why Freddie took a flyer with the inverse floaters.
While details remain scarce, it appears from news reports that these inverse floaters are interest only strips--investments that paying the holder (Freddie, in this case) the interest payments from a large pool of mortgages. Refinancings of these mortgages mean that interest payments from the pooled mortgages would stop (while interest payments on the new, refinanced mortgages would go to whoever holds the right to those payments, not to the strip). So the more the old mortgages in the pool are refinanced, the greater the likelihood of Freddie losing money on the strip. Inverse floaters are likely to be volatile in value if interest rates change, and probably aren't very liquid because they're risky.
Refinancings increase as interest rates drop. By investing in the inverse floaters, Freddie was in effect speculating on the direction of interest rates. If rates dropped, the inverse floaters would lose money. If rates rose, the inverse floaters could rise in value (although higher mortgage rates would detract from the value of the stream of interest payments, which would be detrimental to the value of the inverse floaters). These inverse floaters may have been a bet on largely stable interest rates.
The silly thing about all this is that Freddie was speculating on the direction of interest rates in volatile investments that would be an embarrassment if the financial press found out about them. After being nationalized in 2008, Freddie should have become greatly sensitized to the need to look good while doing good. These inverse floaters could produce outsized losses if refinancings pick up. Taxpayers might then be called on to provide more subsidies to Freddie, not fewer. And not because Freddie took losses trying to make homes more affordable for America but because it was betting homes wouldn't become more affordable.
It's entirely possible that Freddie's traders have an explanation for the inverse portfolios that sounded pretty good when they talked among themselves. But from a public relations standpoint, the inverse floaters are silly, at best. The true problem is that Freddie and Fannie have too many conflicting goals, attempt to fulfill too many differing expectations, and are simply too big. There are some pretty good arguments that the biggest banks should be broken up into smaller, not too big to fail pieces. All of those arguments apply a fortiori to Freddie and Fannie.
Showing posts with label Freddie Mac. Show all posts
Showing posts with label Freddie Mac. Show all posts
Monday, January 30, 2012
Sunday, August 7, 2011
The Weird and Unknown From the U.S. Credit Rating Downgrade
We learned in a big way during the 2008 financial crisis that what we don't know can really hurt us. That would still be true today, after S&P lowered America's credit rating from AAA to AA+. We also know that weird stuff happens when the financial markets get a tummy ache. They seem likely to be queasy from the downgrade when the markets open tomorrow. The weird and unknown may surface soon.
Complex Trading. Major banks and hedge funds frequently trade esoteric investments in multi-investment positions involving U.S. Treasuries as hedges or otherwise. Quite often, these market players embrace leverage in playing this game, since it boosts potential profits. The downgrade shouldn't have come as a complete surprise, since the rating agencies have been loudly frowning at the U.S. debt situation for several months now. But the downgrade's timing was uncertain and its impact uncertain. Complex trading positions may become unhinged for unanticipated reasons. These large institutional traders may find their positions exposed, or may receive unexpected demands for collateral from brokers or counterparties, and then struggle to keep things on an even keel. If so, that could prove unsettling for the markets, especially if the exposures from such trading are directly or indirectly concentrated in one or two companies, a la AIG circa 2008. The reform of the derivatives market has proceeded slowly, if at all, and regulators likely have no idea if there exists the potential for another meltdown. So all we can do is wait and see what happens. If there is another AIG lurking out there, expect very bad consequences.
Housing Market Hassles. Fannie Mae and Freddie Mac provide almost all the financing in the residential real estate markets, primarily because their debts are effectively 100% guaranteed by the U.S. government. It's logical to expect that Fannie and Freddie will be downgraded, since their sugar daddy was just downgraded. This could make mortgage loans harder to get. Not necessarily because interest rates would rise, because the U.S. Treasury downgrade could trigger a flight to safety that ironically would increase demand for U.S. Treasuries (there being few alternatives). But a Fan/Fred downgrade would make it harder to find investors for the mortgage backed securities that Fan/Fred backed loans go into. Investors in those securities are the true source of liquidity for the mortgage market, and may demand higher quality borrowers than current already stringent credit standards require. The housing market could slip on yet another banana peel in its path.
Chinese Communists Strengthened. China's Communist government has been coming under increasing domestic political pressure, because of rising unemployment, poor protection of consumers, sporadic protection of the environment, corruption and co-optation by China's capitalist plutocracy. The S&P downgrade of U.S. Treasuries, however, highlights the fundamental strength of the Chinese economy and its levitating currency, the yuan. That makes the Communist government look good, at a time when it needed some positive spin. Of course, S&P wasn't trying to influence internal Chinese politics. But the law of unintended consequences is the supreme authority in the world of finance.
Obama-Boehner in 2012? Increased factionalism in both political parties is stretching current party delineations close to the breaking point. The Republican Party is held hostage by a limited number of Tea Party ideologues. Respected mainstream conservative voices have labeled Tea Partiers "hobbits, " which, albeit an affront to hobbits, captures the fantastical quality of the thinking on the far right. At the same time, the fissure between President Obama and liberal Democrats has been outed. Emotions are red hot. Ralph Nader publicly, and likely others nonpublicly, predict a primaries challenge to President Obama next year. No one is naming names yet. The most obvious challenger, Secretary of State Hillary Clinton, has publicly said she isn't running for elective office again. Neither a liberal left agenda, nor a Tea Party-style conservative platform, will win the White House in 2012. Both Obama and Boehner know that. Their problems with their parties will increase, because the debt ceiling deal creates a bipartisan committee to squabble more about deficit reduction, giving all factions many opportunities for further raucousness. With so many shouting past each other instead of having a dialogue, the conditions for a realignment of parties are ripening. It's impossible that Obama and Boehner would actually team up to run in 2012. But the pressures for a functioning U.S. government come from powerful forces in the financial markets and the economy. We're no longer debating political philosophy or ideology over beer and pretzels or coffee and Danish. Lots of jobs, careers, wealth, and retirements are on the line. The will of the people is for a functioning government, and ambitious politicians will find a way to give them one. Current party alignments may be endangered.
Complex Trading. Major banks and hedge funds frequently trade esoteric investments in multi-investment positions involving U.S. Treasuries as hedges or otherwise. Quite often, these market players embrace leverage in playing this game, since it boosts potential profits. The downgrade shouldn't have come as a complete surprise, since the rating agencies have been loudly frowning at the U.S. debt situation for several months now. But the downgrade's timing was uncertain and its impact uncertain. Complex trading positions may become unhinged for unanticipated reasons. These large institutional traders may find their positions exposed, or may receive unexpected demands for collateral from brokers or counterparties, and then struggle to keep things on an even keel. If so, that could prove unsettling for the markets, especially if the exposures from such trading are directly or indirectly concentrated in one or two companies, a la AIG circa 2008. The reform of the derivatives market has proceeded slowly, if at all, and regulators likely have no idea if there exists the potential for another meltdown. So all we can do is wait and see what happens. If there is another AIG lurking out there, expect very bad consequences.
Housing Market Hassles. Fannie Mae and Freddie Mac provide almost all the financing in the residential real estate markets, primarily because their debts are effectively 100% guaranteed by the U.S. government. It's logical to expect that Fannie and Freddie will be downgraded, since their sugar daddy was just downgraded. This could make mortgage loans harder to get. Not necessarily because interest rates would rise, because the U.S. Treasury downgrade could trigger a flight to safety that ironically would increase demand for U.S. Treasuries (there being few alternatives). But a Fan/Fred downgrade would make it harder to find investors for the mortgage backed securities that Fan/Fred backed loans go into. Investors in those securities are the true source of liquidity for the mortgage market, and may demand higher quality borrowers than current already stringent credit standards require. The housing market could slip on yet another banana peel in its path.
Chinese Communists Strengthened. China's Communist government has been coming under increasing domestic political pressure, because of rising unemployment, poor protection of consumers, sporadic protection of the environment, corruption and co-optation by China's capitalist plutocracy. The S&P downgrade of U.S. Treasuries, however, highlights the fundamental strength of the Chinese economy and its levitating currency, the yuan. That makes the Communist government look good, at a time when it needed some positive spin. Of course, S&P wasn't trying to influence internal Chinese politics. But the law of unintended consequences is the supreme authority in the world of finance.
Obama-Boehner in 2012? Increased factionalism in both political parties is stretching current party delineations close to the breaking point. The Republican Party is held hostage by a limited number of Tea Party ideologues. Respected mainstream conservative voices have labeled Tea Partiers "hobbits, " which, albeit an affront to hobbits, captures the fantastical quality of the thinking on the far right. At the same time, the fissure between President Obama and liberal Democrats has been outed. Emotions are red hot. Ralph Nader publicly, and likely others nonpublicly, predict a primaries challenge to President Obama next year. No one is naming names yet. The most obvious challenger, Secretary of State Hillary Clinton, has publicly said she isn't running for elective office again. Neither a liberal left agenda, nor a Tea Party-style conservative platform, will win the White House in 2012. Both Obama and Boehner know that. Their problems with their parties will increase, because the debt ceiling deal creates a bipartisan committee to squabble more about deficit reduction, giving all factions many opportunities for further raucousness. With so many shouting past each other instead of having a dialogue, the conditions for a realignment of parties are ripening. It's impossible that Obama and Boehner would actually team up to run in 2012. But the pressures for a functioning U.S. government come from powerful forces in the financial markets and the economy. We're no longer debating political philosophy or ideology over beer and pretzels or coffee and Danish. Lots of jobs, careers, wealth, and retirements are on the line. The will of the people is for a functioning government, and ambitious politicians will find a way to give them one. Current party alignments may be endangered.
Tuesday, August 17, 2010
Back Door Deficit Spending
The best kind of deficit spending, if you're the spender, is the kind other people (like taxpayers) don't see. Even though deficit reduction is now the political flavor of the month, acolytes of John Maynard Keynes still work their agendas quietly.
With mortgage rates now running 4.5% and even lower, courtesy of the Fed's 24/7 money printing presses, proposals are being floated to consciously spur mortgage refinancings--not to increase homeownership levels, but to put more cash in the hands of existing homeowners to spend. This would add who knows how many billions of consumption to the economy. Of course, it would entail a relaxation of lending standards. One proposal is to allow homeowners with mortgages guaranteed by Fannie Mae or Freddie Mac who are current on their payments reduce their rates to 4% and borrow up to the appraised value of their homes, regardless of the value of their homes or their current financial circumstances. (Presumably, only those who aren't underwater could increase the principal amount of their loans, but those that are underwater but current could get a lower rate.) There is a name for this loan: the no doc loan. We had problems with it during the financial crisis, and some of those problems still burden us today.
Despite repeated denials by the Federal Reserve, the Treasury Department, the President's economic advisers, and other notable officials, scholars and experts, there still isn't such a thing as a free lunch. If mortgage refi standards are relaxed to spur consumption, investors currently holding the mortgages that would be refinanced would be losers. Early prepayments would cost them money because the refinanced mortgages available to investors would pay a lower rate. Overall interest rates have been falling as well, so investors wouldn't have attractive alternatives. They'd simply end up with less yield. Refinanced homeowners would have more to spend, but mortgage investors would have less to spend.
Other losers would be--guess, and you have only one chance, but you'll get it right because there's no possible answer other than--taxpayers. That would be you and me. We're already on the hook (line and sinker) for Fannie and Freddie because they've been nationalized. Nationalizing them has already cost us over $300 billion. That's more than the economies of most countries. Relaxing underwriting standards means a higher risk of loss--a lesson from the 2008 financial crisis that some seem to have forgotten. Early onset Alzheimer's must be prevalent in economic policy circles. Throw a lot of cheap refi money at people who aren't demonstrably able to repay it, and guess what? Some of it won't be repaid.
Because Fannie and Freddie remain "private" corporations in a technical sense (you can still trade their stock if you're in a mood to speculate), their balance sheets are not incorporated into the federal government's financial statements. Indeed, Fannie was privatized back in the 1960s because Lyndon Johnson wanted to indulge in massive (for the times) deficit spending in order to advance his Great Society program while fighting a major war in Southeast Asia. Keeping Fan on the federal balance sheet would have been a political roadside bomb. So Johnson did the expedient thing (imagine that, an expedient politician) and turned Fannie over to private investors. Everyone pretended not to notice the market assumption that the government implicitly backed Fannie, and we were launched on the trajectory that led to the 2007 mortgage and credit crisis.
So using Fan and Fred as refi vehicles to stimulate consumption is likely to add to their liabilities, and in turn to the federal government's liabilities. Not all deficit spending is necessarily bad, even now. But it should be done out in the open, where all can see it and discuss its advantages and disadvantages. As long as Fan and Fred's liabilities aren't incorporated into the federal balance sheet, it's hard to notice a refi giveaway driven increase in deficit spending. For those of the Keynesian persuasion, it's an elegant solution (as academics would put it). Look for mortgage bankers, who have the most to gain from this proposal, to quietly lobby for it. And keep your hand on your wallet. There's always somebody ready to take your money and those somebodies are on the prowl.
With mortgage rates now running 4.5% and even lower, courtesy of the Fed's 24/7 money printing presses, proposals are being floated to consciously spur mortgage refinancings--not to increase homeownership levels, but to put more cash in the hands of existing homeowners to spend. This would add who knows how many billions of consumption to the economy. Of course, it would entail a relaxation of lending standards. One proposal is to allow homeowners with mortgages guaranteed by Fannie Mae or Freddie Mac who are current on their payments reduce their rates to 4% and borrow up to the appraised value of their homes, regardless of the value of their homes or their current financial circumstances. (Presumably, only those who aren't underwater could increase the principal amount of their loans, but those that are underwater but current could get a lower rate.) There is a name for this loan: the no doc loan. We had problems with it during the financial crisis, and some of those problems still burden us today.
Despite repeated denials by the Federal Reserve, the Treasury Department, the President's economic advisers, and other notable officials, scholars and experts, there still isn't such a thing as a free lunch. If mortgage refi standards are relaxed to spur consumption, investors currently holding the mortgages that would be refinanced would be losers. Early prepayments would cost them money because the refinanced mortgages available to investors would pay a lower rate. Overall interest rates have been falling as well, so investors wouldn't have attractive alternatives. They'd simply end up with less yield. Refinanced homeowners would have more to spend, but mortgage investors would have less to spend.
Other losers would be--guess, and you have only one chance, but you'll get it right because there's no possible answer other than--taxpayers. That would be you and me. We're already on the hook (line and sinker) for Fannie and Freddie because they've been nationalized. Nationalizing them has already cost us over $300 billion. That's more than the economies of most countries. Relaxing underwriting standards means a higher risk of loss--a lesson from the 2008 financial crisis that some seem to have forgotten. Early onset Alzheimer's must be prevalent in economic policy circles. Throw a lot of cheap refi money at people who aren't demonstrably able to repay it, and guess what? Some of it won't be repaid.
Because Fannie and Freddie remain "private" corporations in a technical sense (you can still trade their stock if you're in a mood to speculate), their balance sheets are not incorporated into the federal government's financial statements. Indeed, Fannie was privatized back in the 1960s because Lyndon Johnson wanted to indulge in massive (for the times) deficit spending in order to advance his Great Society program while fighting a major war in Southeast Asia. Keeping Fan on the federal balance sheet would have been a political roadside bomb. So Johnson did the expedient thing (imagine that, an expedient politician) and turned Fannie over to private investors. Everyone pretended not to notice the market assumption that the government implicitly backed Fannie, and we were launched on the trajectory that led to the 2007 mortgage and credit crisis.
So using Fan and Fred as refi vehicles to stimulate consumption is likely to add to their liabilities, and in turn to the federal government's liabilities. Not all deficit spending is necessarily bad, even now. But it should be done out in the open, where all can see it and discuss its advantages and disadvantages. As long as Fan and Fred's liabilities aren't incorporated into the federal balance sheet, it's hard to notice a refi giveaway driven increase in deficit spending. For those of the Keynesian persuasion, it's an elegant solution (as academics would put it). Look for mortgage bankers, who have the most to gain from this proposal, to quietly lobby for it. And keep your hand on your wallet. There's always somebody ready to take your money and those somebodies are on the prowl.
Thursday, July 8, 2010
Now for the Biggest Financial Regulatory Reform: Residential Mortgages
If we likened the efforts to prevent another financial crisis to the government's program to combat the flu, here's what it would look like. The financial reform legislation now working its way through Congress changes structure and process. Regulators will operate in a new structure, with an overarching systemic risk council and a new consumer protection bureau. Processes for trading in derivatives would change, as would proprietary trading by banks. Heightened capital requirements would be imposed on banks, and troubled financial institutions would be subject to seizure and wind down by the government. Comparable changes in government programs to combat the flu might consist of structural change at the CDC and FDA, together with heightened reporting requirements for hospitals and medical professionals concerning all actual or potential cases of the flu.
But what about the vaccine? The government's primary weapon against the flu isn't structure or process. It's fostering the manufacture of vaccine. Vaccines do the most to prevent illness. New flu vaccines are produced every year. Where's the vaccine for the financial crisis?
The biggest single reason for the financial crisis of 2007-08 was the way residential real estate transactions are financed. The large majority of purchases were (and still are) made with long term mortgages--those that contemplate a 30-year or comparably long repayment period. Although many of those mortgages had adjustable rates, the amortization schedules for those mortgages (i.e., the anticipated repayment of the principal of the loan) involved only gradual reductions of principal or none whatsoever (in the case of interest only loans). Whether or not the loans had fixed or adjustable rates, they were all structured with long repayment periods and very gradual amortization of principal, in order to make home purchases more affordable.
Long term obligations are subject to a high degree of interest rate risk. Stated otherwise, when interest rates change, the obligation imposes large burdens on one party or another. If the debt has a fixed rate, the creditor takes the loss. If the debt has an adjustable rate, the borrower takes the loss. It the loss has been transferred by means of a derivatives contract, the counterparty bears the loss. The important thing to understand is that losses are sustained and someone must bear those losses. The losses cannot be made to go away. This is a crucial reason why long term mortgages are so risky.
The long repayment schedules of these mortgages were meant to serve a governmental purpose: making it easier to buy a home. The private mortgage market didn't develop a 30-year mortgage on its own. Government policy, beginning in the 1930s and 1940s, created it. To accommodate financial institutions that didn't want to hold these puppies (and there were many), the government created first Fannie Mae, and then Freddie Mac. Fan and Fred bought the hot tamales, in effect passing the long term risks onto taxpayers. However, the federal government's numerous subsidies for housing and the nation's recovery from the Depression caused home prices to rise steadily on a national level. The risk to taxpayers seemed theoretical. So more and more 30-year mortgages were written, prices rose more, and demand for housing grew apace. The secondary market for mortgage-backed securities blossomed, supported by a seemingly golden asset that never fell in value. Institutional investors far and wide piled into the mortgage markets, believing they'd found the pot of gold at the end of the rainbow. But as the mortgage markets ballooned, so did the systemic risks presented by the ever increasing number of outstanding mortgage loans. The sheer quantity of loans (encouraged by the government to increase home ownership) puffed prices up into a bubble, and that meant systemic risk was skyrocketing.
Certainly, bad lending practices made things worse. The plethora of subprime, Alt A, no money down, no doc, no verified income, more stupid than stupid loans that came into fashion added a shipload of credit risk to the the interest rate risk inherent in long term obligations. But much of the reason these loans were so toxic is they too were structured along the same lines as the traditional 30-year mortgage: a long repayment period, with amortization of principal almost imperceptible in the early years of the loan. They presented the same risks as traditional 30-year fixed rate loans, along with a big helping of credit risk. And all this was possible because of the government policy of sponsoring and subsidizing long term real estate lending.
Once the real estate bubble burst, prices fell and numerous homeowners went underwater on their loans. Many defaulted due to unemployment. Increasing numbers are defaulting for strategic reasons. The real estate market remains in the septic tank for now. When it will recover is anyone's guess, because the sheer quantity of defaulting mortgages from the 2000s weigh heavily on the financial system and the economy.
It is unrealistic to believe that changing the structure of financial regulation and the processes of the financial system are sufficient to prevent another crisis. We need to reduce the levels of systemic risk. The 30-year mortgage and its first, second and other cousins create systemic risk of the first order. Because this risk was the biggest factor leading up to the credit crisis, federal regulators should treat it as their highest priority. Structure and process won't suffice. No package of new rules, more thorough examinations, heightened capital requirements and other measures can shield the financial system from the uncontrolled growth of risk from mortgage markets gone wild. The creation of risk must be moderated, and that means limiting access to long term mortgage finance.
Credit standards are already tightening. But perhaps not enough. There is still no meaningful secondary market for home mortgages without a federal guarantee, which means that the private market adjudges them to be overpriced compared to the risks they present. When long term mortgages can be sold to private investors without a federal guarantee, then we can be comfortable that their downpayment requirements, interest rates and other terms are reasonably priced in relation to the risks they present. That they cannot now be sold signals that taxpayers are still subsidizing real estate purchases to a significant degree.
There is little indication that the mortgage markets will be privatized. Talk now is of nationalizing Fannie Mae and Freddie Mac, which would formalize the federalization of housing finance. And why not? They're functionally nationalized already, and any privately owned-publicly backed hybrid would only perpetuate the outrage of the 2000s: private profit at public risk. But nationalizing them could contribute to the problem--the opacity of governmental accounting (which would apply to the nationalized Fannie and Freddie) would make the extent of taxpayer subsidies, already in the hundreds of billions, even less clear and therefore subject to abuse. As it is, Americans suffer grievously from taxpayer abuse syndrome in subsidizing residential real estate. One can only rationally assume the abuse would continue unabated and rarely seen if Fannie and Freddie are nationalized.
Nationalizing Fannie and Freddie may, in the end, be how the government controls the systemic risk presented by the gargantuan hordes of long term mortgages rampaging around the financial system. That would be a poor outcome, since it would continue costly policies of taxpayer subsidies, with most of the benefit probably going to the higher income brackets. And if the housing market makes another gigantic u-turn, as it did in recent years, the risks of taxpayer support of the real estate market would be realized. While most likely the federal government would simply increase the federal deficit to finance these costs in the near term, they remain real costs that eventually would be visited on taxpayers.
It's important to have a way to measure these potential costs. One way would be for federal authorities to require Fannie and Freddie to offer mortgages for sale in the private market without a federal guarantee, simply to see what price they would command. The discounts that private investors would demand could be used as a proxy to calculate the extent of taxpayer exposure. The numbers would probably be Brobdingnagian. But ignorance won't be bliss. Such a calculation would be a useful way to measure how much systemic risk is quietly building up in housing finance. Large figures would trigger alarms--and that's the idea.
But what about the vaccine? The government's primary weapon against the flu isn't structure or process. It's fostering the manufacture of vaccine. Vaccines do the most to prevent illness. New flu vaccines are produced every year. Where's the vaccine for the financial crisis?
The biggest single reason for the financial crisis of 2007-08 was the way residential real estate transactions are financed. The large majority of purchases were (and still are) made with long term mortgages--those that contemplate a 30-year or comparably long repayment period. Although many of those mortgages had adjustable rates, the amortization schedules for those mortgages (i.e., the anticipated repayment of the principal of the loan) involved only gradual reductions of principal or none whatsoever (in the case of interest only loans). Whether or not the loans had fixed or adjustable rates, they were all structured with long repayment periods and very gradual amortization of principal, in order to make home purchases more affordable.
Long term obligations are subject to a high degree of interest rate risk. Stated otherwise, when interest rates change, the obligation imposes large burdens on one party or another. If the debt has a fixed rate, the creditor takes the loss. If the debt has an adjustable rate, the borrower takes the loss. It the loss has been transferred by means of a derivatives contract, the counterparty bears the loss. The important thing to understand is that losses are sustained and someone must bear those losses. The losses cannot be made to go away. This is a crucial reason why long term mortgages are so risky.
The long repayment schedules of these mortgages were meant to serve a governmental purpose: making it easier to buy a home. The private mortgage market didn't develop a 30-year mortgage on its own. Government policy, beginning in the 1930s and 1940s, created it. To accommodate financial institutions that didn't want to hold these puppies (and there were many), the government created first Fannie Mae, and then Freddie Mac. Fan and Fred bought the hot tamales, in effect passing the long term risks onto taxpayers. However, the federal government's numerous subsidies for housing and the nation's recovery from the Depression caused home prices to rise steadily on a national level. The risk to taxpayers seemed theoretical. So more and more 30-year mortgages were written, prices rose more, and demand for housing grew apace. The secondary market for mortgage-backed securities blossomed, supported by a seemingly golden asset that never fell in value. Institutional investors far and wide piled into the mortgage markets, believing they'd found the pot of gold at the end of the rainbow. But as the mortgage markets ballooned, so did the systemic risks presented by the ever increasing number of outstanding mortgage loans. The sheer quantity of loans (encouraged by the government to increase home ownership) puffed prices up into a bubble, and that meant systemic risk was skyrocketing.
Certainly, bad lending practices made things worse. The plethora of subprime, Alt A, no money down, no doc, no verified income, more stupid than stupid loans that came into fashion added a shipload of credit risk to the the interest rate risk inherent in long term obligations. But much of the reason these loans were so toxic is they too were structured along the same lines as the traditional 30-year mortgage: a long repayment period, with amortization of principal almost imperceptible in the early years of the loan. They presented the same risks as traditional 30-year fixed rate loans, along with a big helping of credit risk. And all this was possible because of the government policy of sponsoring and subsidizing long term real estate lending.
Once the real estate bubble burst, prices fell and numerous homeowners went underwater on their loans. Many defaulted due to unemployment. Increasing numbers are defaulting for strategic reasons. The real estate market remains in the septic tank for now. When it will recover is anyone's guess, because the sheer quantity of defaulting mortgages from the 2000s weigh heavily on the financial system and the economy.
It is unrealistic to believe that changing the structure of financial regulation and the processes of the financial system are sufficient to prevent another crisis. We need to reduce the levels of systemic risk. The 30-year mortgage and its first, second and other cousins create systemic risk of the first order. Because this risk was the biggest factor leading up to the credit crisis, federal regulators should treat it as their highest priority. Structure and process won't suffice. No package of new rules, more thorough examinations, heightened capital requirements and other measures can shield the financial system from the uncontrolled growth of risk from mortgage markets gone wild. The creation of risk must be moderated, and that means limiting access to long term mortgage finance.
Credit standards are already tightening. But perhaps not enough. There is still no meaningful secondary market for home mortgages without a federal guarantee, which means that the private market adjudges them to be overpriced compared to the risks they present. When long term mortgages can be sold to private investors without a federal guarantee, then we can be comfortable that their downpayment requirements, interest rates and other terms are reasonably priced in relation to the risks they present. That they cannot now be sold signals that taxpayers are still subsidizing real estate purchases to a significant degree.
There is little indication that the mortgage markets will be privatized. Talk now is of nationalizing Fannie Mae and Freddie Mac, which would formalize the federalization of housing finance. And why not? They're functionally nationalized already, and any privately owned-publicly backed hybrid would only perpetuate the outrage of the 2000s: private profit at public risk. But nationalizing them could contribute to the problem--the opacity of governmental accounting (which would apply to the nationalized Fannie and Freddie) would make the extent of taxpayer subsidies, already in the hundreds of billions, even less clear and therefore subject to abuse. As it is, Americans suffer grievously from taxpayer abuse syndrome in subsidizing residential real estate. One can only rationally assume the abuse would continue unabated and rarely seen if Fannie and Freddie are nationalized.
Nationalizing Fannie and Freddie may, in the end, be how the government controls the systemic risk presented by the gargantuan hordes of long term mortgages rampaging around the financial system. That would be a poor outcome, since it would continue costly policies of taxpayer subsidies, with most of the benefit probably going to the higher income brackets. And if the housing market makes another gigantic u-turn, as it did in recent years, the risks of taxpayer support of the real estate market would be realized. While most likely the federal government would simply increase the federal deficit to finance these costs in the near term, they remain real costs that eventually would be visited on taxpayers.
It's important to have a way to measure these potential costs. One way would be for federal authorities to require Fannie and Freddie to offer mortgages for sale in the private market without a federal guarantee, simply to see what price they would command. The discounts that private investors would demand could be used as a proxy to calculate the extent of taxpayer exposure. The numbers would probably be Brobdingnagian. But ignorance won't be bliss. Such a calculation would be a useful way to measure how much systemic risk is quietly building up in housing finance. Large figures would trigger alarms--and that's the idea.
Tuesday, December 29, 2009
The Revival of the Bank of the United States
The U.S. government is, for all practical purposes, becoming the most important bank in America. Two recent measures demonstrate the point. First, the Treasury Department announced yesterday that it was lifting the $200 billion limit it had previously placed on the funding it would provide to each of Fannie Mae and Freddie Mac. It will now back those two firms without limit. Admittedly, $200 billion is pocket change these days, with our multi-trillion dollar federal debt and all that. But the absence of any limit now means that for all practical purposes, the federal government, through its cheery sales staff (Fannie, Freddie, Ginnie Mae and the FHA) is responsible for virtually all the mortgage loans in America. Okay, the government is technically guaranteeing the loans, not funding them. But without the government (and taxpayers) being on the hook for defaults, there would be hardly any mortgages. The government makes today's real estate market (however weak it may be) possible.
Second, the Federal Reserve announced yesterday a new measure to "withdraw" some of the accommodative flood of liquidity it spewed into the financial system over the past year. It will offer interest bearing term deposits (equivalent to certificates of deposit) to member banks. These deposits will take cash out of the financial system for the length of the term, so there is a temporary reduction of liquidity. But what happens when the term ends? The deposit goes back to the member bank, where as part of the money supply it could have inflationary impact.
Why doesn't the Fed simply take back some of the cash it printed and sent out into the financial system? It hasn't said. Remember that much of that money was used to buy asset-backed securities and U.S. Treasury securities. One suspects that the reason is that it can't find buyers for those assets, not without pushing interest rates higher than it wants them to go. Thus, the Fed won't reduce its balance sheet (just as it wouldn't with its previously announced reverse repo idea; see http://blogger.uncleleosden.com/2009/12/will-feds-reverse-repos-reverse.html). The Fed will continue as a major financier of asset-backed securities and U.S. Treasury securities (the latter being really weird because it means the government is printing the money it "borrows" and spends; that would be a pure money print in any place except a rabbit hole).
One also suspects that another reason for the member bank term deposit idea is that these accounts would be treated as part of the bank's capital for regulatory purposes. The banks all know that higher capital requirements are in the picture. If they had to buy, say, U.S. Treasury securities in the bond markets to meet those requirements, they might push interest rates up. By offering special CDs to member banks only, the Fed allows them to meet capital requirements without having to roil the Treasury securities markets. In other words, the federal government would appear to be providing special funding to capitalize banks while keeping interest rates lower.
We've already proposed that Fannie and Freddie be reconstituted as nonprofit organizations whose public purpose would not be entwined with private, profit-seeking shareholder interests that distort incentives. See http://blogger.uncleleosden.com/2009/12/fannie-and-freddie-dont-privatize-them.html. Yesterday's announcement by the Treasury Department that it was lifting its ceiling on federal assistance boosted Fannie's and Freddie's stock prices by about 20% over the last two days. This was a nice belated Christmas present to the speculators who probably comprise most of Fannie's and Freddie's shareholders. But what about the taxpayers, who so generously now guarantee assistance without limit to Fannie and Freddie? They get lumps of coal, as far as we can tell.
There are good reasons for government intervention in times of crisis and panic. But growing mission creep is turning the government into another Bank of the United States. There were two Banks of the United States in the late 18th and early 19th centuries. The federal government twice created a national bank in order to provide financial services on a larger scale than it thought private banks of the day could handle. But the charter of the Second Bank of the United States was allowed to expire by President Andrew Jackson, out of concern that the Bank favored commercial interests of the East Coast, to the detriment of rural interests and the Western states (those now called the Midwest). This may ring bells in light of present day concerns that the federal government is too attentive to Wall Street while ignoring Main Street.
When the government supersedes private industry, market principles become diluted by politics. This isn't wrong by itself. Taxes, police and fire protection, national defense, social safety nets like unemployment compensation, workers compensation, Social Security, Medicare, Medicaid and so on all represent political solutions to problems that market principles were thought to handle poorly. But if the federal government is going to become the most important bank in the country, then we should have a serious, explicit discussion about how it will allocate credit--instead of today's quiet, step-by-step mission creep--and why so much federal support should be given to humongous private banks that compensate their executives munificently but lend so little the government needs to step in and lend in their place at the expense of the soon-to-be-more-heavily-taxed citizenry.
Second, the Federal Reserve announced yesterday a new measure to "withdraw" some of the accommodative flood of liquidity it spewed into the financial system over the past year. It will offer interest bearing term deposits (equivalent to certificates of deposit) to member banks. These deposits will take cash out of the financial system for the length of the term, so there is a temporary reduction of liquidity. But what happens when the term ends? The deposit goes back to the member bank, where as part of the money supply it could have inflationary impact.
Why doesn't the Fed simply take back some of the cash it printed and sent out into the financial system? It hasn't said. Remember that much of that money was used to buy asset-backed securities and U.S. Treasury securities. One suspects that the reason is that it can't find buyers for those assets, not without pushing interest rates higher than it wants them to go. Thus, the Fed won't reduce its balance sheet (just as it wouldn't with its previously announced reverse repo idea; see http://blogger.uncleleosden.com/2009/12/will-feds-reverse-repos-reverse.html). The Fed will continue as a major financier of asset-backed securities and U.S. Treasury securities (the latter being really weird because it means the government is printing the money it "borrows" and spends; that would be a pure money print in any place except a rabbit hole).
One also suspects that another reason for the member bank term deposit idea is that these accounts would be treated as part of the bank's capital for regulatory purposes. The banks all know that higher capital requirements are in the picture. If they had to buy, say, U.S. Treasury securities in the bond markets to meet those requirements, they might push interest rates up. By offering special CDs to member banks only, the Fed allows them to meet capital requirements without having to roil the Treasury securities markets. In other words, the federal government would appear to be providing special funding to capitalize banks while keeping interest rates lower.
We've already proposed that Fannie and Freddie be reconstituted as nonprofit organizations whose public purpose would not be entwined with private, profit-seeking shareholder interests that distort incentives. See http://blogger.uncleleosden.com/2009/12/fannie-and-freddie-dont-privatize-them.html. Yesterday's announcement by the Treasury Department that it was lifting its ceiling on federal assistance boosted Fannie's and Freddie's stock prices by about 20% over the last two days. This was a nice belated Christmas present to the speculators who probably comprise most of Fannie's and Freddie's shareholders. But what about the taxpayers, who so generously now guarantee assistance without limit to Fannie and Freddie? They get lumps of coal, as far as we can tell.
There are good reasons for government intervention in times of crisis and panic. But growing mission creep is turning the government into another Bank of the United States. There were two Banks of the United States in the late 18th and early 19th centuries. The federal government twice created a national bank in order to provide financial services on a larger scale than it thought private banks of the day could handle. But the charter of the Second Bank of the United States was allowed to expire by President Andrew Jackson, out of concern that the Bank favored commercial interests of the East Coast, to the detriment of rural interests and the Western states (those now called the Midwest). This may ring bells in light of present day concerns that the federal government is too attentive to Wall Street while ignoring Main Street.
When the government supersedes private industry, market principles become diluted by politics. This isn't wrong by itself. Taxes, police and fire protection, national defense, social safety nets like unemployment compensation, workers compensation, Social Security, Medicare, Medicaid and so on all represent political solutions to problems that market principles were thought to handle poorly. But if the federal government is going to become the most important bank in the country, then we should have a serious, explicit discussion about how it will allocate credit--instead of today's quiet, step-by-step mission creep--and why so much federal support should be given to humongous private banks that compensate their executives munificently but lend so little the government needs to step in and lend in their place at the expense of the soon-to-be-more-heavily-taxed citizenry.
Wednesday, December 16, 2009
Fannie and Freddie: Don't Privatize Them Again
For all practical purposes, Fannie Mae and Freddie Mac now belong to the federal government. They were taken over by the government in the late summer of 2008 and remain under federal control. There has been discussion of re-creating them as private entities with some federal participation (in the form of guarantees of mortgage-backed securities they issue) and a lot of regulation, including profit limitations.
This is weird. The problems at Fannie and Freddie stem to a large degree from their mixed private-public nature. They ostensibly were privatized, but investors assumed that they were implicitly backed by the government. Fannie and Freddie took undue advantage of that assumption and seized a very large part of the mortgage market. They had a competitive advantage from their presumed implicit government protection, and could outcompete truly private mortgage lenders. They used some of their copious profits to hire the biggest lobbying guns in Washington to stave off meaningful regulation and effective private sector competition. By becoming so large with the benefit of a presumed government safety net, they made it unavoidable that the government provide them with a safety net. Yet the profits from their salad days went to their private shareholders and high level executives. Taxpayers only got to hold a bag with some really stinky stuff in it, while their homes sank in value.
Since the 1930s, promotion of home ownership has been a federal policy. Fannie Mae was created in 1938 as a federal mortgage financier, and was publicly owned for 30 years. In 1968, Fannie Mae was privatized, to remove it from the federal balance sheet (and thereby lower the apparent amount of debt carried by the federal government). In 1970, Freddie Mac was created as a private entity whose mission was essentially the same as Fannie Mae's, in order to compete against Fannie Mae. (This was an early sub silentio admission that private mortgage lenders couldn't effectively compete against Fannie.) While these two behemoths were not explicitly included in the federal government's balance sheet, it had to continue backing them up, if only because the market believed it would. Thus, Fannie and Freddie always existed to serve governmental policies and have always been liabilities of the government, regardless of what did or did not appear on the federal balance sheet. The 2008 bailouts and takeovers of Fannie and Freddie only reinforce this reality.
We can't take the federal out of Fannie and Freddie. So we should take the private for profit interests out of them. Doing so would rationalize the way they operate. They'd no longer have the incentive to dominate the mortgage markets in order to pump up their revenues and balance sheets to satisfy the demands of shareholders for ever increasing share prices. Their executives would no longer obtain pecuniary benefits from using aggressive accounting to boost bonuses and stock prices, as was the case in the late 1990s and early 2000s. Nor would they hire droves of expensive and influential lobbyists to protect their franchises from both private sector competition and prudent federal regulation. Shareholders would not profit while taxpayers bore losses.
Fannie and Freddie should be reorganized as nonprofit entities, similar to the Federal Reserve Banks. Mortgage lenders that want to do business with Fannie and Freddie would become members and would capitalize them, like the member banks of the Federal Reserve system. Their boards should have a majority of public members. Current shareholders should be bought out at prices reflecting the ocean of losses the Fannie and Freddie have inflicted on taxpayers.
Such a structure would not impede the flow of capital into the housing markets. Indeed, by making federal backing for Fannie/Freddie underwritten mortgage-backed securities all the more clear, capital would flow more readily. For a point of comparison, look how easily capital flows into U.S. Treasury securities, notwithstanding their very low interest rates.
By removing private profit-seeking interests from Fannie and Freddie, we restore to public control entities that exist primarily to serve public interests. The 30-year mortgage is a creature of government policy--before Fannie, mortgages tended to be in the range of five years, with a 50% downpayment. Fannie was created specifically to make the 30-year mortgage available, and the arguments for continuing federal participation in Fannie and Freddie revolve around the need to ensure the availability of inexpensive 30-year mortgages. While public ownership and control aren't panaceas--it's easy to think of public programs that have been screwed up--the opportunities for private profit made the problems at Fannie and Freddie much larger than they would have otherwise been.
The federal government, through Fannie and Freddie, the FHA, Ginnie Mae, tax deductions and credits, Federal Reserve purchases of mortgage-backed securities, and other measures, has staged a enormous, gigantic, gargantuan intervention in the housing markets. America's capital has been steered toward housing and away from other investments. This intervention won't end; indeed, with the current housing slump, it's becoming even more extreme as buyer tax credits extend and expand. The wisdom of public subsidies for housing can and will be debated until the end of the republic, because that's how long they'll exist. But we can at least eliminate the potential for private profit at taxpayer risk--and the increased distortion of the mortgage markets it can create--and restore what has always been a public policy to public status.
This is weird. The problems at Fannie and Freddie stem to a large degree from their mixed private-public nature. They ostensibly were privatized, but investors assumed that they were implicitly backed by the government. Fannie and Freddie took undue advantage of that assumption and seized a very large part of the mortgage market. They had a competitive advantage from their presumed implicit government protection, and could outcompete truly private mortgage lenders. They used some of their copious profits to hire the biggest lobbying guns in Washington to stave off meaningful regulation and effective private sector competition. By becoming so large with the benefit of a presumed government safety net, they made it unavoidable that the government provide them with a safety net. Yet the profits from their salad days went to their private shareholders and high level executives. Taxpayers only got to hold a bag with some really stinky stuff in it, while their homes sank in value.
Since the 1930s, promotion of home ownership has been a federal policy. Fannie Mae was created in 1938 as a federal mortgage financier, and was publicly owned for 30 years. In 1968, Fannie Mae was privatized, to remove it from the federal balance sheet (and thereby lower the apparent amount of debt carried by the federal government). In 1970, Freddie Mac was created as a private entity whose mission was essentially the same as Fannie Mae's, in order to compete against Fannie Mae. (This was an early sub silentio admission that private mortgage lenders couldn't effectively compete against Fannie.) While these two behemoths were not explicitly included in the federal government's balance sheet, it had to continue backing them up, if only because the market believed it would. Thus, Fannie and Freddie always existed to serve governmental policies and have always been liabilities of the government, regardless of what did or did not appear on the federal balance sheet. The 2008 bailouts and takeovers of Fannie and Freddie only reinforce this reality.
We can't take the federal out of Fannie and Freddie. So we should take the private for profit interests out of them. Doing so would rationalize the way they operate. They'd no longer have the incentive to dominate the mortgage markets in order to pump up their revenues and balance sheets to satisfy the demands of shareholders for ever increasing share prices. Their executives would no longer obtain pecuniary benefits from using aggressive accounting to boost bonuses and stock prices, as was the case in the late 1990s and early 2000s. Nor would they hire droves of expensive and influential lobbyists to protect their franchises from both private sector competition and prudent federal regulation. Shareholders would not profit while taxpayers bore losses.
Fannie and Freddie should be reorganized as nonprofit entities, similar to the Federal Reserve Banks. Mortgage lenders that want to do business with Fannie and Freddie would become members and would capitalize them, like the member banks of the Federal Reserve system. Their boards should have a majority of public members. Current shareholders should be bought out at prices reflecting the ocean of losses the Fannie and Freddie have inflicted on taxpayers.
Such a structure would not impede the flow of capital into the housing markets. Indeed, by making federal backing for Fannie/Freddie underwritten mortgage-backed securities all the more clear, capital would flow more readily. For a point of comparison, look how easily capital flows into U.S. Treasury securities, notwithstanding their very low interest rates.
By removing private profit-seeking interests from Fannie and Freddie, we restore to public control entities that exist primarily to serve public interests. The 30-year mortgage is a creature of government policy--before Fannie, mortgages tended to be in the range of five years, with a 50% downpayment. Fannie was created specifically to make the 30-year mortgage available, and the arguments for continuing federal participation in Fannie and Freddie revolve around the need to ensure the availability of inexpensive 30-year mortgages. While public ownership and control aren't panaceas--it's easy to think of public programs that have been screwed up--the opportunities for private profit made the problems at Fannie and Freddie much larger than they would have otherwise been.
The federal government, through Fannie and Freddie, the FHA, Ginnie Mae, tax deductions and credits, Federal Reserve purchases of mortgage-backed securities, and other measures, has staged a enormous, gigantic, gargantuan intervention in the housing markets. America's capital has been steered toward housing and away from other investments. This intervention won't end; indeed, with the current housing slump, it's becoming even more extreme as buyer tax credits extend and expand. The wisdom of public subsidies for housing can and will be debated until the end of the republic, because that's how long they'll exist. But we can at least eliminate the potential for private profit at taxpayer risk--and the increased distortion of the mortgage markets it can create--and restore what has always been a public policy to public status.
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