The Fannie Mae and Freddie Mac reform proposal from Goldman Sachs

Donald Marron and Phil Swagel have written a paper which proposes a reform structure for Fannie Mae and Freddie Mac.  It should not be taken seriously – and indeed it should disqualify this pair from serious debate – a larger gift to Wall Street that does not solve the problems of the GSEs is hard to envisage.  But – as the Washington Post takes it seriously and this pair are not lightweights I thought I should have a go at explaining what is wrong with it.

Fannie and Freddie (collectively the GSEs) did a few things some of which wound up hurting them and some of which did not. 

a.  They guaranteed mortgages – taking credit risk.  Some of these mortgages were well secured first mortgages with significant downpayments.  Some were more funky including 95 percent loan to valuation mortgages with odd payment features but supplementary credit insurance.  They insured substantial portfolios of what is now widely known as Alt-A.

b.  They purchased mortgages for their own book – usually, but not exclusively, the mortgages that they insured anyway.

c.  They purchased securitization strips including the (originally rate AAA strips) of private label mortgage securitisations including some truly atrocious mortgages.

In doing this they took credit risk (the risk the mortgages would default), interest rate risk (the risk that interest rates would change sharply causing loss of value of the mortgages or loss of spread on funding mortgages) and refinance risk (being the risk one day they would find they could not borrow money even if they were solvent).

You can take credit risk by guaranteeing mortgages or owning them.  But it is only by owning mortgages that you take interest rate risk and refinance risk.  If all you have done is guarantee the mortgage you don’t have to finance it or refinance it – so there is no refinance risk.  And you don’t care what the coupon on the mortgage is because you are not collecting the coupon.

I should not need to say at this point that the problems of Fannie and Freddie were entirely credit related.  They lost money guaranteeing mortgages and owning AAA strips of securitizations but they did not lose money on interest rate risk.  Interest rates have not been sufficiently volatile to do them great harm.

Alas every solution around for the GSEs that is in the public domain – ranging from the original (Hank) Paulson GSE conservatorship agreement down, force the companies to reduce their interest rate risk (by shrinking their portfolios) and do nothing at all about the credit risk (by allowing them to grow their guarantee business). 

The Swagel/Marron proposal is this taken to its logical extreme – it wants to allow multiple private entities with an explicit government backstop to compete in issuing guarantees – presumably driving the market price of the guarantee down.  They do not state this – but this will allow Wall Street to lay credit risk off to the government at minimum cost to them.  These entities however will not be allowed to own or finance mortgages or take interest rate risk – in other words they will be prevented only from doing the thing that is (a) profitable and (b) did not actually hurt Fannie and Freddie.  The profitable business that did not hurt the GSEs will of course be taken up by the banks – especially the investment banks.

Swagel and Marron are not completely stupid – they want to restrict the type of mortgages the competitive entities can guarantee to limit the risk to the government – with maybe a more strict definition of “qualifying mortgages”.  However one lesson of the crisis is that private sector entities competing with thin capital are more-than-keen to sell the trashiest mortgages and pretend they are golden.  If private sector institutions can do that to other private sector institutions (proven by observation) then it is absolutely assured that competitive private sector GSEs will do that to their regulator. 

The Swagel/Marron proposal is all the credit risk (proven nasty) to the Government and all the rest (so far looking pretty benign) to Wall Street.  It is the proposal from Goldman Sachs and – I presume that Wall Street could not be happier.

Serious and non-serious contributions to the economic debate

I like to think you know people who are not serious when they always have the same solution – no matter what the problem.  For instance there is a faction in the Republican party who think that whatever the problem the solution is to cut taxes.  If you are running too big a surplus the solution is to cut taxes. If you are running a deficit the solution is to cut taxes.  If you are fighting a war the solution is to cut taxes.  If you face global warming the solution is to cut taxes.  These people can be effective political operators but are useless at furthering the intellectual debate.  There are similar groups who think the solution is always more government regulation.  Puerile arguments exist on all sides of politics.

If you go back to the anti-Fannie-Mae debate as it was about the year 2001 the argument was always that Fannie and Freddie were taking too much interest rate risk – and that the interest rate risk would eventually blow them up.  You can see that in Greenspan’s 2005 views on how to reform the GSEs.  Greenspan stated that the GSEs posed  a threat to the system.  However the risk he focuses on exclusively comes from the owned portfolio – from interest rate risk.  I believed Greenspan’s views when he stated them in 2005 – and I was short many stocks based on interest rate risk.  [I got that wrong as I have detailed before on this blog.]

Greenspan proposed solutions to the interest rate risk problems posed by the GSEs.  Incidentally they are the right solutions if you think interest rate risk is the problem – they are the wrong solutions if you think credit risk is the problem.  Greenspan (and other GSE critics) would have handed the whole financing issue – including interest rate risk management to the banks (including the investment banks).  I thought that was right because they could manage that better.  Sure it would have been good for Goldman Sachs but the standard analysis of the risks said you wanted to put that risk in Goldies hands anyway.  I would have supported the gift to Goldies because I thought it was the right thing to do.

The GSEs blew up – but they blew-up entirely on credit risk.  The risk Greenspan and all the bulk of anti-GSE thought (including me) identified was the dog-that-did-not-bark.  The GSE critics (including myself) got the analysis wrong.  The solution we proposed was not the right solution to the problem that actually occurred (but it remains the right solution if you are Goldman Sachs).  Moreover post crisis there is little evidence that the banks could handle the derivatives exposure embedded in hedging Fannies and Freddie’s book any better than the GSEs (the other pre-crisis assumption I made). 

Alas the bulk of the GSE critics want to enact the solution for the problem that did not occur.  Like Swagel and Marron they want the solution that maximises government exposure to credit risk and minimizes government exposure to (and revenue from) all the other risks in the mortgage business.  They want the solution from Goldman Sachs despite it being the solution to the wrong problem.

I was wrong on the facts.  I changed my mind.  Most of the other critics were wrong too.  They did not change their mind.  That might make them effective political operators but it makes them useless at furthering the public debate.

Marron and Swagel however are (usually) far better than that.  They are amongst the best that the Republican Party has to offer on economic policy – thoughtful and knowledgeable.  I ran my criticism of their proposal past them and they stated that they just assumed that the “American Public” wanted the government to absorb mortgage market credit risk.  That may be their view (and they should state it up front) – but for “American Public” here I think you should substitute “Goldman Sachs” and you will have a more accurate picture of the politics.

That said – I hope serious commentators less in love with Wall Street come up with some decent solutions – because if they don’t what we will get is the solution from Goldman Sachs because no other proposal is on the table.  Mike Konczal – I am laying out a challenge for you.