Sunday, September 13, 2009

Vested self interest and the future of Fannie Mae and Freddie Mac

Fannie Mae and Freddie Mac take credit risk and interest rate risk.

They take credit risk primarily by guaranteeing mortgages.

They take interest rate risk primarily by owning mortgages and financing them on their own balance sheet.  They also trade the interest rate risk of that book using derivatives.

The anti-GSE lobby always asserted (and I once erroneously believed) that Fannie and Freddie Mac would come to grief on their interest rate risk.  Taking interest rate risk is what the once-extensive anti-GSE lobby meant by charter creep.

Well the anti-GSE lobby were wrong.  So was I.  Fannie and Freddie did not blow up on interest rate risk – they blew up on credit risk.  Mainly they blew up on credit risk from non-charter mortgages but they still have had no noticeable interest rate problems during this cycle.

The Anti-GSE lobby always had an agenda

Wall Street always hated Fannie and Freddie taking interest rate risk – it encroached on the profitability of Wall Street trading desks.  Trading interest rate risk is the core business of Wall Street trading desks – and they hated having GSEs (with funding advantages) crowding them out of their own game.

But Wall Street loved Fannie and Freddie taking credit risk – that meant that Wall Street could splice and dice mortgages all they like – and know that eventually Uncle Sam will pick up any credit losses.

So they always pushed for limits on the interest rate risk that the GSEs could take.  I never heard FM-Watch or other anti-GSE lobbyists arguing for limits on GSE credit risk acceptance.

When the anti-GSE lobby now say “I told you so” they are lying.  They said the GSEs would blow up on interest rate risk and they were wrong – but they are falsely claiming intellectual credit anyway.  It helps their lobbying.

So how do the proposed reforms of Fannie and Freddie look?

All public proposals for GSE reform have the same feature.  They all allow Fannie and Freddie (or their replacement entities) to stay in the credit risk business by guaranteeing mortgages – but they insist that Fannie and Freddie shrink their balance sheet – and hence take less interest rate risk.

In other words they leave all the credit risk with the GSE – solving nothing from a taxpayer perspective and give all the interest rate carry (and most the revenue) to investment banks.  They do nothing to solve the problems that caused the GSEs to fail

That is also the structure of the conservatorship agreement by Hank Paulson forced the GSEs to sign – an agreement constructed by the staff of Morgan Stanley.  The agreement gave Wall Street precisely what it wanted – which is not surprising because it was drafted by Wall Street investment banks. 

The Mortgage Bankers’ Association proposal is even more egregious – but that is the subject for another post.  Even the Government Audit Office report leans heavily towards the wishes of investment bankers.  (You would think they would be better than that – but it seems they are only as good as the people lobbying them.) 

So here is a hope for the Obama administration.  Be very sceptical of the the vested self-interest behind anyone making GSE proposals.  [Whilst that includes me I am just shooting from the sidelines.  Investment bankers drew up the conservatorship agreement in the interest of investment bankers.  That sort of power should not go unchecked in America.]   


Wisely Managed said...

And that is why the best solution is to get the "GS" out of "GSE". Get the government out of this. As long as the government is supporting these entities, the form of that support will be politicized and determined by those who can obtain and wield the most influence on the government.

Of course, the same also holds true for everything else, including health care.

John Hempton said...

Of course we now know for sure that all the members of the anti-GSE lobby (knowm collectively as FM-Watch) were later bailed out or at least partially government guaranteed.

The main funder of Fannie Mae watch was - you guessed it - AIG


There is a purist solution of getting the governmnet out - but that is not on the table at all. The government is there for better or for worse in ALL big financial institutions.

If you are government guaranteed - even implicitly - you need to be regualted.

Half-pregnant is a bad idea.


Anonymous said...

I think the Wall Street lobby this time will fail. The main reason is that there are constitutional and legal issues with FnF that cannot be overlooked.

I argue FnF have been GSE's, and still are, and with this comes many good things, especially for the homeowners, lower mortgage rates, two huge organisaitons to be there in times of a meltdown, cost efficiency, reach, economies of scale, standardization of MBS, and many more thing that together have save US homeowners in my estimate 600-1.000 BUSD in current USD since first transformed to private shareholder enterprises 1968/1970.

Unfortunately for shareholders, but fortunately for homeowners and US citizens, the GSE's will take a huge responsibility in a meltdown market like this. It is inherent in their mission they should provide stability and liquidity. But it was never stated, or Chartered, that this mission should override FnF fight for survival.

If you look at FnF actions since the outset of this crises in 2007, they have more and more by the day, been part of the effort to stabalize this market.

It is clear most or their actions leading up to C-ship, made C-ship eventually a logical continuation of this series of actions. During the C-ship these policies and actions have NOT been reversed, but rather intensified.

The GSE's are under heavy influence by the government and regulators, and this is inherent in their structure. Paulson was right on one thing, it was their "hybrid" status as GSE's that made them fail, but not because they engaged in irresponsible lending, as he implicitly claim, but beacues they could not act as all other private lenders to defend themselves when the market crashed.

This was never an option for them.

I want someone to please, explain to me, why otherwise FnF expanded guarantees with 30% during tha latest 2 years?, Why they kept on lending in CA.FL and other meltdown markets? Why they did not raise guarantee fees to reflect the increase risk in the market? Etc.

They acted in TOTAL contradiction to ALL other mortgage lenders.

They have been used BEFORE C-ship, and even more so AFTER C-ship, to help out banks, homeowners, taxpayers, in this crises. Without FnF filling the vacuum, this mortgage market would have been a black hole.

I think it is sorry to hear and read people think they should be winded down, but first we should make use of them. it is like saying you don't need the Air-Bag, never more, just because it just saved you your life.

I can write 200 pages more on this, but stop now, for your sake.


Kyle F said...

Doesn't a shrinking of the B/S necessarily imply less mortgages bought/held and less overall credit risk as well?

John Hempton said...

In answer to KFNUCK1 - no you can have a very small balance sheet and massive credit risk...

Ambac and MBIA (and for that matter AIG FP) were GUARANTORS.

AIG in particular guaranteed 550 billion in the most unimaginable trash - and had NONE of those assets on the balance sheet. Ambac and MBIA balance sheet never exceeded 15 billion but they had half a trillion between them in credit risk.

You can get credit risk entirely without owning any assets.

Shrinking the balance sheet whilst allowing the guarantee book to grow unchecked does not reduce credit risk.


Kyle F said...

This is true, those are excellent examples.

But What do I Know? said...

Thanks for this in-depth look at Frannie; your candor is greatly appreciated. I myself couldn't understand why Paulson drew the line to exclude Frannie preferreds last year--they could have easily guaranteed them as well as the bonds. It makes sense if Wall Street was trying to get them out of the interest-rate risk business as you say.

As long as the elites cooperate they are essentially invulnerable; it is only when they seek advantage among themselves that they can fall.

Anonymous said...

"Wall Street always hated Fannie and Freddie taking interest rate risk"

Perhaps, but I would guess Wall St loved Fannie and Freddie hedging their convexity risk - option market making is a good business, if you do it right.

Anonymous said...

Yes credit risk was the principal driver of the GSE blowup, but they had massive problems on the interest rate side as well. When you are running a massive carry trade and duration gap to the tune of 5+ years, then you are banking on carry and the ability to keep funding the assets short. As I recall, in the end pre-conservatorship Fannie and Freddie could NOT issue and discos yields spiked to 100s over short-end Treasuries. We might say that inability to issue was a necessary but not sufficient cause of the blowup, similar to Bear and Lehman not being able to tap repos or counterparties for funding. Thus, credit risk was the underlying driver but inability to fund huge carry was the precipitant cause.

Also, the push to independent regulation of the GSE's by Bush White House, Mankiw, Greenspan was driven both by the concern of the duration gap (the carry trade they) and the increase in the size of the balance sheet (the credit trade) via guarantee business and purchases of securities. Their warnings and efforts to reform seem pretty prescient in light of what has transpired, which is more than I can say for Barney "Roll the Dice" Frank or Barack "Acorn" Obama (who happened to be the 2nd largest recipient of GSE lobby money in his relatively short tenure)

And I'm not sure Wall Street rates trading desks want to divorce GSE interest rate business from mortgage/credit risk. The GSE's deal massive size and not only to dealers earn the bid-offer but they also trade in the direction the GSE's trade since negative convexity often snowballs hedging flows from GSE's and servicers. I think the problem Wall Street always had with Fannie and Freddie was the implicit (now explicit) backing of US taxpayer competing with underpriced yet much higher risk premiums on the securities dealers and investment banks.

Anonymous said...

Dear John,

The most important part have you not written about, and that is that FnF have been tools, and gradually increasingly so since 2007. The C-ship is just a natural consequence of FnF not acting primarily to save themselves, that is, shrink the balance sheet, raise fees and margins, foreclose aggressively and stop lending in meltdown areas.

Well Fargo recently reported they earn 3% on assets, that is 1% point more than the average bank that earns 2%. FnF earned a meager 0.3% on average during 2000 to 2007.

If you volume adjust PBT FnF earnings have not increased at all to make them absorb losses and to save themselves.

They have been tools to save the US economy and the mortgage market.

Your very persuasive and elegant financial analysis, needs to be supported also by a legal analysis.

In my view, it is no doubt, FnF could not be wiped out, when have been used to such large extent. It would not be legal or according to the US constitution.

Obviously, it is not illegal to wind down their business if someone would think that is a good idea. But I doubt it. FnF is of so much benefit to the US homeowners, it is politically very difficult, to give the savings to banks or foreign investors, instead of passing that through lower mortgages rates for homeowners.


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