Thursday, June 10, 2010

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.


Tom Lindmark said...

I have to digest all of your thoughts but as one who liked the Marron proposal let me offer a couple of knee jerk comments.

First, that the GSEs did not suffer interest rate losses might be as much a function of rates moving in their direction as it is their expertise in managing that risk. We will probably never know the answer to that question but given their ineptitude at running the other parts of their business, it's not necessarily a given that it is in our best interest to double down on their ability to hedge interest rate risk.

Second, if you view the Marron proposal in a larger context, specifically reducing the sway of the GSEs and therefore the Barney Franks of the world then it has its attractions. Simplifying and perhaps more aptly neutering the two has a great deal of merit.

Third, the Progressives are already developing the meme that Fannie and Freddie were not part of the problem. If you have not read this, I recomment it.

Finally, it's going to be a great battle over the fate of these two as well as the considerable political power that goes with their control.

Potato said...

Could not status quo ante be a proposal? Let the GSEs do their thing buying up conventional mortgages (and some limited amount of Alt-A), and just keep them clear of the private-label MBS and sub-prime stuff?

I'd have to go back and double-check, but I think you said back in your earlier modelling posts that their traditional guarantee business wasn't the big problem in driving them into the arms of the government...

Anonymous said...

This is a totally selfish request, but will you post a followup on what has happened with the GSEs in the last few months with regard to the probability of recoveries on the preferred stock?

It's been a few quarters since you had talked about them, and a lot has happened. So I would love to know your thoughts. Has the thesis become stronger or weakened?

Anonymous said...


Any thoughts on the basis capital case?
Did you know the people at basis?

John Hempton said...

On Basis Capital

Know people - yes
Have thoughts - yes

For blog - no. But there are no heroes here - nobody at Basis or Goldman stands up to much scrutiny.


Nick Abe said...

What's the Canadian model? It seems to work pretty well, the CMHC charges 3.5% on 95% LTV mortgages plus additional monthly premiums. I believe the CMHC also ends up "long" the house in the event that they payoff the insurance.

I think the simple thing is no one can bear that credit risk. If the whole system goes down, then only the government can bail it out... so they may as well be the ones profiting when it is working as intended.

doctorpat said...

To be strictly fair: it is possible for the same policy to be correct over several decades in a variety of different circumstances.

Going out of my way to choose an example which hopefully nobody will have issues with: Let us say there is a country which yearly takes 10% of the farm production, and burns it.
The stop-the-burning party says "we should stop the burning, it keeps us poor"
Then war breaks out. The STBP says "we should stop the burning, it damages our war effort"
The war finished, they struggle to rebuild their economy. The STBP says "we should stop the burning, it makes it harder to rebuild"
A nasty plague hits. The STBP says "we should stop the burning, it makes it harder to care for the sick"
Plague over, the country starts to build a tower up to heaven. The STBP says "we should stop the burning, it makes it more difficult to built the tower"

Should we ignore the STBP just because they have the same solution to every problem?

hs2230 said...

First I want to second the thoughts of Mr. Lindmark. Just because this past time they didn't blow up due to interest rate risk, doesn't mean they know how to manage it. Their interest rate exposure has never adequately been tested during a constantly rising rate environment like we had in the 70's.

Whether it is credit or interest rate risk, if given enough rope, these people will hang themselves. That to me seems to be the key here. The reason the traditional guaranty business worked so well was because it was originally designed in the depression era, when thinking was pessimistic and it had a public goal, not a private one.

As is typical with these things, the reason they were able to keep increasing their risk profile over the many decades since was because the original business was designed so well. Even that original design, however, may not have survived this housing bubble and people should not forget this.

Finally, one of the reasons the GSE's had to look for other ways to make money (though this started long before the bubble), was because during the bubble their market share was disappearing at an alarming rate. Most institutions when faced with a disappearing business will act in ways that postmortem will look ridiculous (ask Kodak). Self-preservation is a powerful instinct. One positive thing about government institutions is that they have a hard time changing their charter to do stupid things.

I offer no solutions just some thoughts.

Anonymous said...

Hi John,

I don't understand the following. Over the years, how did FNM and FRE successfully managed their interest rate risk?

I am very puzzled by this. After all FNM and FRE have been around for a long time and over widely differing interest rate and inflation environments. What is the key insight those who worried by FNM and FRE's interest rate risk missed?

If you've already written about this, please point me to it.


Anonymous said...

Hi John:
Since we are on the topic of GSEs, I'd be interested to know your current thoughts on their preferred shares, a topic you wrote a series of detailed blog posts about last year. It would be great to see a followup posting.

Pete DZ said...

I agree with your thoughts but I am going to go further as there is one comment in the proposal that really jumped out at me as signifying the worrying success of groupthink.

"It appears inevitable that the government will play some role in backstopping mortgage finance."

No. No. No no no. Why is it inevitable? Because there isn't enough credit in the world? Listen, bankers take credit risk, that's what they do. Governments shouldn't take it. If there isn't enough credit in the world to support higher house prices then GUESS WHAT HOUSE PRICES ARE TOO HIGH AND SHOULD BE ALLOWED TO FALL!!

Let's speak the words that apparently may not be uttered. No government subsidy of mortgage markets. No tax subsidy of property derived profits. No tax relief on mortgage interest. And no to the fallacy that rising property markets are a "good thing".

walt said...

I am puzzled by your reply to Anonymous. Looking back at your '08 thesis it appears your silence indicates politics prevailed and the preferred is dead with de-listing the first step. Your comment please.
Thank you. Best Regards, Walter

michael said...

Yea, I missed this piece when it first came out, and decided to look in after the delisting news. Why now? They could have done this a year ago. FRE was this close to going to the Russell index when the rug gets pulled, and there's been so much talk about July.

Thanks for your thoughts on this.

Unknown said...


A couple of things here. e21 has posted a more recent article that seems to be more friendly to the plight of our defaulted preferred shares. In addtion, Swagel has jumped onto the Millstein proposal to recapitalize the GSE's. With all of these developments, I had a few questions.

1. It looks like Millstein's plan will be positive for preferred shareholders. Do you agree and support his plan?
2. Is Swagel's plan more appropriate now that there is pretty much no hope left for FnF to keep large portfolios in the future?
3. If Millstein and Swagel can be counted on to push to recapitalize FnF, should preferred shareholders start backing them?
4. A lot of preferred shareholders I know believe the Millstein/Swagel plan is our best shot and are thinking of voting Republican to support this plan. As opposed to the indefinite nationalization the Democrats seem to want. I'm not sold either way actually. What's your viewpoint on this?

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The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.