Monday, January 24, 2011

What to do with Fannie and Freddie

There are a bunch of ideologues out there with solutions to the Fannie and Freddie situation.  They argue that government intervention has to end and then propose a system with a permanent role for government.  It is not just nonsensical - it is usually in the interest of some large financial institution.  All they want is Frannie out of their part of the business.  They like government subsidies in the rest of their business.

Anyway I have the free market solution to the Fannie and Freddie situation - and - I hate to say it - it is dead obvious.

Answer:  raise Frannie’s pricing.

At the moment there is nobody doing conforming mortgages except Fannie and Freddie.  Indeed there is almost nobody doing mortgages of any kind except Fannie and Freddie.  If the free market wants the business they can have it.  (They just don't want it at this sort of interest rate spread - and I don't blame them.)

All the government need to do is tell Frannie to raise their price a little each quarter.  Currently they charge 20-25bps for guaranteeing mortgages.  (The free market won’t take credit risk at that price.)  So it is entirely open to the FHFA (and hence the Treasury) to tell Fannie and Freddie to raise their prices by 5bps.  The government will get paid better for the risk they are taking (and what free market ideologue will disagree with that) and the private sector can compete if they want to.

I doubt the free market will.  But then in a quarter or two Frannie can raise their pricing by another 5 bps.  And a quarter or two later Frannie can raise by another 5bps.

At some stage you will get to a level where the private sector chooses to compete.  Frannie should not set its price competitively though.  In another quarter they should raise the price another 5bps.  And in another quarter they should raise again.

Over time Frannie will become non-competitive.  It will shrink simply because bankers and mortgage brokers do not bring it business.  And so Frannie is put into market chosen run-off and the business is effectively privatized.

You can do the same thing with Frannie's portfolio - you could ask them to raise their internal revenue exectations on any mortgage they buy by 5bps.  They might buy less - they may not.  Don’t limit the size of the portfolio: raise the profitability of the portfolio.  When another quarter elapses raise spreads by another 5bps.  Eventually of course the private sector won’t bring Frannie business - and so Frannie will shrink.

If you want the government to keep supporting the housing market (an object of policy it seems) then you just slow the rate of price increase down.  Do 5bps per half rather than 5bps per quarter - or even 8bps per year for a slow exit.

Over time the government will make a full exit from the mortgage business.  Along the way the taxpayers recover as much money from Frannie as possible.

If you look at my long series on Fannie and Freddie and compare my model predictions to current results you will notice that the credit losses are lower than my projections.  The revenue however is much lower than my projections.  The lower projected revenue has been a government choice: the Government has been forcing Frannie to charge lower spreads to support the housing market.

This is so obvious it is painful: if you want to remove the subsidy remove the subsidy.  If you want to do it slow do it slow.

So why can’t anyone see it?

Every proposal for the government to get out of Fannie and Freddie is in reality a proposal for the government to get out of only a bit of Fannie and Freddie.

For example: if you are a business that likes managing interest rate risk you want Fannie and Freddie out of the interest rate risk management business but you want them to stay in the credit risk management business.  You would prefer the government take the risks that you don’t want.  And moreover you would prefer they took it at the lowest possible price.

The worst proposal out there (much worse than doing nothing) comes from Phil Swagel and Don Marron.  They propose that the government exit the interest rate risk management business (the only business at Frannie that never lost money) and allow ten or so new competitive companies with government guarantees to compete with each other to sell government guarantee of credit risk.  That means that credit risk (the risk that blew up the system) will be priced as close as possible to zero with the government wearing the downside.  I can't see that Swagel and Marron learnt anything from the crisis.

But Swagel and Marron are an extreme variant of the typical proposal.  Everyone’s proposal involves getting Frannie out of their business whilst leaving subsidies (preferably increasing subsidies) in the parts of the value chain they don’t compete in.  Every proposal is thus about maximizing profits of some financial institution whilst sticking those risks that they don't want to the government.

Are you surprised?


Disclaimer:  Every proposal out there is conficted.  I am too.  I own defaulted preference shares in Frannie on my own behalf and on behalf of my clients.  A proposal that allows Frannie to maximize revenue on their way to oblivion is in my interests.  But then I only get paid if taxpayers get back 100c in the dollar plus penalty interest and fees.  And from the perspective of a US taxpayer it is hard to see what is wrong with that.  You exit Fannie and Freddie and it does not wind up costing anything.


Adam Levitin said...

Raising the g-fee might have been good advice in 2005-2006. Doing it now would help recapitalize the GSEs, but recapitalization of the GSEs isn't the primary policy concern for the administration in the housing market. As I see it, there are (at least) three problems with this proposed solution:

(1) raising the guarantee fee increases the cost of mortgages, which runs contrary to the government's myriad policies aimed at restarting the housing market (e.g., first time homebuyer tax credit).

(2) the GSE's have already raised their prices. You won't see this in the basic g-fee. Instead, there is a .25 point (not basis point) charge on all mortgages and a "loan level pricing adjustment" of up to 3 points (not basis points) depending on the risk profile of the loan (this includes refis). Most borrowers don't have the cash to pay up to 3.25 points up front, so these points are getting rolled into the interest rate, which has greatly increased the cost of mortgages. That's why there's now a huge spread between the federal funds rate and the mortgage rate.

(3) antitrust issues.

John Hempton said...

Antitrust: Non issue. The whole point of this is to raise prices to the point where the GSEs can't compete. There is no anti-trust between the private sector companies.

Raising the price of mortgages: Key issue. The subsidy keeps mortgages cheap. That is why getting out of the GSEs is difficult. Solution - do it slowly. Moreover the policy is reversible - if the housing market cracks you can explicitly put 5bps back in.

Sure the GSE fee has been raised a little - but not to the point where there is no subsidy. If 3 points keeps the GSEs in place do 6pts etc.

And it is not just about the G-Fee. You could also increase the expected spread at which mortgaes will be purchased. The GSEs have a model which says "buy mortgages when spread hits X". So use their internal model - but make it X plus 5bps. Then X plus 10bps.

The initial reaction of the market will be that market spreads go up. Eventually though it becomes profitable for private sector participants. They fill the void and Fannie and Freddie shrink.


babar ganesh said...

i was under the impression -- from your previous series and subsequent posts -- that the revenue line depended mostly on the interest rate spread as applied to the held portfolio and that the guarantee fee is only a small percentage of their revenues at this point; because of that i thought that the revenue line would have collapsed just because the interest rate spread flattened for a while.

Anonymous said...

I like the idea, but the fantasy about "competition" arising is the most graphic allusion ever.

John Hempton said...

What if "competition arising" is a fantasy - and the government can raise spreads by 50bps without substantial private sector compensation.

Then you would need to make an argument that the mortgage market deserved or warranted that 50bps of subsidy. 50bps on 6 trillion dollars is 30 billion per annum. More than enough to bail out the GSEs.

But if it is 50bps then you need to ask why should taxpayers be subsidizing that amount. And if competition does arise - oh well - mortgages wind up 30-40bps more expensive without the GSEs.

You have to do this on both the guarantee book AND the owned portfolio.


Anonymous said...

One major issue which wasn't brought to light much was mortgages to minorities, and in the US, the word 'racism' was thrown around so much in 2000-2007 in regards to mortgage denials.

I'd say it's a fine thing to get rid of Fannie/Freddie, but it wouldn't main reason being this alleged 'racism'.

Matt Hill said...

I just can't imagine that Wall Street Banks and the certain Republicans that are bankrolled by them still think they can get away with grifting the taxpayers yet again. So they took us all for morons with the toxic mortgage crap several years ago. How do they have the gull to propose that they should be given all the reins to the US mortgage industry on the cheap? Are you kidding me? Is it really possible they can pull all this off and make the general public believe they are doing them a favor? This is the part in the low grade movie where everyone calls BS and says this type of thing is not realistic and could not happen in the real world. Is there a cigar room somewhere, where all the people orchestrating this grift job hang out and laugh about getting over on the financially ignorant American public? Can we all be duped as a Nation again by the Wall Street end around?

Please Washington, do the right thing and at least get our money back for us before handing the business off to Wall Street. Enough time has gone by. The story is soon to be made official that Frannie weren't the main culprit in the crisis. Do the right thing for us and you got my vote in 2012.

I'm just your average college educated IT guy, coaching my kids soccer team. If I can understand the real story behind all of this, please have faith that the rest of America can do so as well.

Jacob said...

to add some colour: in the Netherlands a similar entity (NHG/ 'the Dutch Mortgage Guarantee') charges 55 bp. and no competition in sight. of course, rules may differ here and there, but in essence it is the same construction.

there are voices saying 55bp might not be enough (and if my memory serves me well it was 80bp some years ago) to fund the coming correction.

so F&F charge just half???

Tim Coldwell said...

Another minor reason to jack the rates:

Since the government took over Fannie Mae and Freddie Mac, taxpayers have spent more than $160 million defending the mortgage finance companies and their former top executives in civil lawsuits accusing them of fraud. The cost was a closely guarded secret until last week, when the companies and their regulator produced an accounting at the request of Congress.

gdr said...

Aussie New Mortgage Share of Gross Household Median Income ::

Sydney :57 %
Melbourne : 50 %
Adelaide : 47 %
Brisbane : 43 %
Perth : 43 %

Anonymous said...

From your keyboard to God's ears:

Seems to me though that the mission of Freddie and Fannie (and FHA too) - subdize mortgage rates and lend to borrowers who might not qualify in a purely private environment - is exactly what this country needs right now. Maybe in ten years we can have the policy debate of whether the government should encourage homeownership, but the last thing we need to do is chase potential buyers out of the market.

Tom Lindmark said...

What are your thoughts on the AEI proposal? It doesn't seem that far away from your proposal.

But What do I Know? said...

An elegant, fair, and simple proposal? No way that will be adopted. . .

Seriously, though, I'm glad you brought this up--at least the idea is out there in the blogosphere, and from what I gather the Treasury is reading. . .

Adrian Meli said...

Good post, but the key as some of the comments point out is that our policy makers don't want to do anything that leads to further weakening home prices and that is what this would do. The Fed has pursued QE2 to specifically keep long rates low and that is the only thing keeping housing from totally mean reverting at this point. So, although the idea is good to fix the GSEs, it would further weaken the housing market, cause further write downs at banks, more capital raises, etc etc. I am not saying that it is not the right thing to do but it is clear policy makers would not want this outcome. - Adrian Meli

Anonymous said...

John, an update on your freddie models would be greatly appreciated. Some of us are eager to see an update if you could take the time. Do you believe Freddie is over reserved?

Anonymous said...

John Gapper, op-ed staffer in the Financial Times 27 Jan 2011, calls for 'getting out' of Fannie and Freddie on the basis that mortgage guarantees are unjustified. This, he says, is because the percentage of owner/occupiers in housing in a European state without guarantees is much the same as in the USA.
Apparently to the Financial Times the difference in inequality, and the difference between the conventional mortgage terms in the USA and elsewhere, don't rate a mention.

Wayne Olson said...

I wrote a paper a few months ago called Like Public Utilities Regulating Fannie and Freddie. You can google the title and ask for a copy. Anyway, there are some ways to implement your proposal that would pass muster from a public policy perspective. The details would matter. I may have some additional comments later.

A. Rosenberg said...

Thanks for another insightful report. I'd like to get your thoughts on several issues (I'll share mine too, but I'm not as well informed on this as you are).

First, there were several reports today (Friday, Feb 4) indicating that Treasury plans to propose raising fees and reducing guarantee amounts on government mortgage insurance. It's not completely clear how this would break down between the GSEs and FHA. This sounds a lot like your plan.

The Washington Post article discussed closing the GSEs as one option, but the CNBC report this afternoon did not.

I suspect that Treasury leaked this to guage market reactions. Moreover, whatever their plan, Republicans in Congress are either aligned with or scared by the Tea Party, so I see very little chance of any meaningful reform that keeps the GSEs alive passing until 2013.

Do you have any thoughts on the rumors (I'm particularly interested the effect of the preferreds), and also the likelihood of any proposal getting through the House?

Second, the price of the GSE preferreds has risen dramatically recently. I loved them at 2 to 3 cents on the dollar, and I'm still in them now, but I wonder whether this is just a temporary bump. I don't know of any reason for the preferreds to have done so well other than anticipation of proposals, and I suspect that the enthusiasm will wear off as people realize that any proposal is dead in the water in the House. What do you think about the runup in the preferreds?

Third, if I'm right that nothing the Obama administration would support can pass the house, how would that play out? As I understand it, the GSE's unlimited call on the Treasury ends at the end of 2012. Perhaps the housing market will be much better by then enough to save the GSEs, but, if not, do you think Treasury would move on its own to recapitalize the GSEs through a common for preferred swap? That seems to me our best hope for the preferred paying out, so I was encouraged (on this issue, at least) by the Republican gains in the House and Senate--I think gridlock improves the chance that Treasury will act alone.

Anonymous said...

Hi John. It has been a while since you posted on the Frannie preferreds aand I was wondering if you had any updated thoughts you wouldn't mind sharing.

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