GSEs: Greenspan frowns … clearly
Given his predilection for technical obscurity, Federal Reserve chairman Alan Greenspan could hardly have been clearer in his GSE testimony yesterday:
Without restrictions on the size of GSE balance sheets, we put at risk our ability to preserve safe and sound financial markets in the United States, a key ingredient of support for homeownership.
In his verbal remarks, Mr. Greenspan was even more forthright:
Greenspan called on Congress to sharply reduce the two companies’ massive mortgage portfolios “while we can.”
Nevertheless, as a public service, we here translate Greenspan into blog: anything in italics is ours. Let’s see how the long trail of Fannie Mae’s problems leads him to reach this emphatic conclusion.
He starts by saying something nice:
Fannie and Freddie played a critical role in promoting mortgage securitization–the key to the success of secondary mortgage markets in the
Mortgage securitization: what is it?
Under securitization, mortgages are bundled into pools and then turned into securities that can be easily bought and sold along side other debt securities. Mortgage securitization continues to perform this important function, and such securitization techniques now have been applied extensively by the private sector to many other types of financial instruments.
Translation: notice how I carefully spoke in the past tense, Senators.
What about now, Mr. Chairman?
Although prospectuses for GSE debt are required by law to say that such instruments are not backed by the full faith and credit of the U.S. government, investors have concluded that the government will not allow GSEs to default, and as a consequence offer to purchase GSE debt at substantially lower interest rates than required of comparably situated financial institutions without such direct ties to government.
The GSEs receive a Federal subsidy, the amount of which is uncapped except by GSE policies:
Private investors have granted them a market subsidy in the form of lower borrowing rates. Unlike subsidies explicitly mandated by the Congress, the implicit subsidies to the GSEs are incurred wholly at the discretion of the GSEs.
Translation: the more mortgage securities they sell, the greater the implicit subsidy. And the greater the profits the GSEs can make, and the bonuses they can pay executives.
The above sample yield curve can be found here.
Match-funding versus playing the yield curve: S&L redux
Lending is renting money for a fixed period of time. A financial institution makes money on the spread between:
+ The yield it receives on money it lends out
– The cost it pays on money it raises from its capital sources
= Financial institution ’spread’
When an institution lends money at a fixed rate — as the GSEs and many banks do — it is taking a risk that interest rise will rise in the meantime. If they do, the institution’s spread can vanish — or even go negative (that is, lose money) as the cost rises on the money it is renting from capital sources.
Institutions can reduce (’hedge’) this risk by match-funding — that is, if you lend money out for (say) 10 years at Y% rate, then you borrow money in for the same 10 years, at Z% rate. You ‘lock in’ a spread (Y% — Z%) but you eliminate the interest rate fluctuation risk.
Or you can borrow short – that is, rent money from your capital sources for (say) 1 year at a time. Because the yield curve is normally positive — that is, short-term money is cheaper than long-term — this increases spread in the short run. But it means that the financial institution is taking the interest rate risk should rates rise during the long interval when debt is outstanding.
In the 1970’s and 1980’s, the savings and loan institutions lent long (fixed-rate home mortgages) while borrowing short (taking deposits). They too absorbed the interest rate risk — and they too had a Federal guarantee (this time, an explicit one, in the form of FSLIC deposit insurance. And they too could increase that subsidy (Federal guarantee) without limit.
And we all know how well that worked …
Until the mid-1990’s, GSE subsidy stayed within bounds:
The management of Fannie and Freddie, however, chose to abstain from making profit-centers out of their portfolios in earlier years, and only during the mid-1990s did they begin rapidly enlarging their portfolios.
Translation: until the mid-1990’s, the GSEs match-funded, they did not play the yield curve. (A very snazzy dynamic yield curve over the last eight or so years can be found here.)
Translation: Ask me who became CEO then.
Over the last 13 years, the GSEs have grown fourfold relative to the economy:
The ability of the GSEs to borrow essentially without limit has been exploited only in recent years. At the end of 1990, for example, Fannie’s and Freddie’s combined portfolios amounted to $132 billion, or 5.6 percent of the single-family home-mortgage market. By 2003, the GSEs’ portfolios had grown tenfold, to $1.38 trillion or 23 percent of the home-mortgage market.
Translation: GSE growth has been fueled by The GSEs rode this new strategy.
However, market discipline with respect to the GSEs has been weak to nonexistent. Because the many counterparties in GSE transactions assess risk based almost wholly on the GSE’s perceived special relationship to the government rather than on the underlying soundness of the institutions, regulators cannot rely on market discipline to contain systemic risk.
Translation: When investors think the Federal government will bail something out (can you spell S&L), they don’t look closely at the deals or the issuer’s balance sheet. So this growth in risk has gone unchecked. (Recall that Bill Poole of the St. Louis Fed observed that he can find no private company able to do the same thing, from which he infers that they cannot because market discipline holds them back.)
Beyond strengthening GSE regulation, the Congress will need to clarify the circumstances under which a GSE can become insolvent and, in particular, the resultant position — both during and after insolvency — of the investors that hold GSE debt, as well as other creditors and shareholders. This process must be unambiguous before it is needed.
Translation: It’s not clear that GSEs can become insolvent today, which means the market is still betting heavily on an inferred government bailout.
Current law, which contemplates conservatorship and not receivership for a troubled GSE, requires the federal government to maintain GSEs as ongoing enterprises, but other than the symbolic line of credit at the U.S. Treasury, provides no means of financing to do so. Left unresolved, such uncertainties could threaten the stability of financial markets.
No translation needed.
We have been unable to find any purpose for the huge balance sheets of the GSEs, other than profit creation through the exploitation of the market-granted subsidy.
Translation: The massive growth in GSE balance sheet does not have any public purpose, only a private one.
Some maintain that these large portfolios create a buffer against crises in the mortgage market. But that notion suggests that the spreads of home-mortgage interest rates against U.S. Treasuries, a measure of risk, would narrow as GSE portfolios increased. Despite the huge increase in the GSE portfolios, however, mortgage spreads have actually doubled since 1997.
A recent study by Federal Reserve Board staff found no link between the size of the GSE portfolios and mortgages rates.
Translation: It hasn’t lowered the borrowers’ (homeowners’) cost of capital.
The strong belief of investors in the implicit government backing of the GSEs does not by itself create safety and soundness problems for the GSEs, but it does create systemic risks for the
Translation: Regulation alone is not enough.
“Regulate me, regulate me!”
So what can we do, Mr. Greenspan?
Limiting the systemic risks associated with GSEs would require that their portfolio holdings be significantly smaller.
Won’t this hurt home buyers?
At the same time, reducing portfolios would have only a modest effect on financial markets.
Wouldn’t that be a sudden shock?
Limitations on portfolio holdings could be imposed gradually over several years and then adjusted upward or downward depending on the growth of the single-family mortgage market.
Wouldn’t that erode the GSEs’ ability to serve affordable homebuyers?
[E]ven with such portfolio limits, Fannie and Freddie would likely remain among the most formidable of financial institutions in our country.
Is it really necessary to rein in the GSEs in this way? Wouldn’t some form of regulation do the trick?
If legislation takes only these actions and does not limit GSE portfolios, we run the risk of solidifying investors’ perceptions that the GSEs are instruments of the government and that their debt is equivalent to government debt. The GSEs will have increased facility to continue to grow faster than the overall home-mortgage market; indeed since their portfolios are not constrained, by law, to exclusively home mortgages, GSEs can grow virtually without limit. Without restrictions on the size of GSE balance sheets, we put at risk our ability to preserve safe and sound financial markets in the United States, a key ingredient of support for homeownership.
