GSEs: Greenspan’s last testament
Throughout his tenure Alan Greenspan was both opaque and transparent. When he wanted to conceal, as in playing his Fed rate move cards close to his chest, he was a paradigm of opacity.
“How many basis points have you got?”
But, when he wanted to be transparent, he was a paradigm of precision … but the tightly compacted precise economic terminology he used had the effect, for many readers, of encrypting it as securely as Pretty Good Privacy.
[By the way, I believe Mr. Greenspan’s decision rule for opacity-versus-clarity was simply this: If it was a decision he controlled, then he would be opaque, but if he needed to influence, then he must needs be clear.]
Earlier this month, Mr. Greenspan stepped down, but before he left, he responded to Senator John Sununu regarding the GSEs (link in .pdf). So crystalline is its lucidity that, as a public service, we hereby translate Mr. Greenspan, in full, into blog:
“If I wanted to be imprecise, I would have written a longer letter.”
The Honorable John E. Sununu
United State Senate
Dear Senator:
Thank you for inquiring about my views concerning supervision and regulation of government-sponsored enterprises (GSEs) and about how best to focus the GSEs on their public mission without destabilizing the economy. I also appreciate your kind words about my public service on the Federal Reserve Board.
“Now that we have the compliments out of the way …”
Fannie Mae (Fannie) and Freddie Mac (Freddie) essentially run two lines of business:
1. Securitization of mortgage credit,
2. Holding of mortgage and other assets for investment purposes.
Securitization means that an entity (the “issuer”) does two things simultaneously:
- It buys a bundle of existing loans (the “loan pool”) from lenders who originated them.
- It simultaneously issues a new bond instrument on its own credit, whose additional security is an assignment of the loan pool. (The new securities, being collateralized by mortgages, are often called collateralized mortgage-backed securities, or CMBS.)
By doing so, the issuer provides liquidity back to originators, since they receive cash. And the system can efficiently cycle again, increasing volume.
This was Fannie and Freddie’s original purpose, because it’s essential for a healthy housing finance ecosystem:
The first line of business provides substantial benefits for affordable housing through the process of using credit guarantees to turn mortgages into marketable securities that trade in public debt markets. This process creates a wide variety of liquidity benefits, some of which flow to homeowners and mortgage originators.
“To paraphrase our president, a rising tide makes the pie higher.”
Making loans more liquid frees up originators to go back to work, and the competition also lowers the rate spread (between safe rate and what the borrower pays), so customers get cheaper money. (”When lenders compete, you win.”)
Moreover, creating securities from the mortgages extended to nontraditional homeowners is an important step to making mortgage credit more widely available.
Newly liberated originators go find new borrowers, and move gradually down the bankability pyramid. That’s good for everybody:
Focusing Fannie and Freddie on this type of securitization activity can promote affordable housing without creating significant risks to the [nation’s] financial system [and by extension, the taxpayers].
The financial system is not at risk because the securities are issued only when the loan pools are sold, so there is a perfect match in asset maturity (when the loans come due, so do the bonds). Private parties are taking the risk, not the Federal government.
Why, you ask, is the government involved? Because of the implicit credit enhancement extended by the government to Fannie Mae securities, an awfully big advantage worth $5-7 billion a year to the GSEs.
So this first function, Mr. Greenspan is saying, is worth something in affordability. But the GSEs are in a second business:
In contrast, once a mortgage has been securitized and sold into the public markets, Fannie’s and Freddie’s purchases of their own (or each other’s) mortgage-backed securities (MBS) for their investment portfolios creates substantial systemic risk while yielding negligible additional benefit for homeowners, renters, or mortgage originators.¹
¹ For further details, please see my April 2005 testimony before the Senate Committee on Banking, Housing and Urban Affairs, my May 2005 speech under the auspices of the Federal Reserve Bank of
“How many times must I explain these simple precepts?”
This second concept’s a bit more complicated. If the GSEs buy long-term loans and hold them without securitizing, how do they raise the capital to do this? They could use equity, but their assets are many multiples of their aggregate net worth, so they borrow. And they borrow short-term. That’s great when the yield curve is positive, because the short-term interest rates they pay (on the money they borrow) are less than the long-term rates they receive (on the loans they bought), so they have favorable spread. But if the yield curve inverts — which it some does, and quickly! — the GSEs are exposed … and hence, so are taxpayers.
Under normal circumstances, GSEs are able to easily maintain and grow their large portfolios of mortgage and non-mortgage assets without the significant market checks or balances faced by other publicly traded financial institutions.
“Alan, didn’t you learn to never split an infinitive?”
A private company trying this trick would be tested for its ability to cover an adverse swing. Since the GSEs are perceived to be protected by Congress, this doesn’t happen, so the market doesn’t charge the GSEs a premium, and hence the market doesn’t check their balance sheet growth.
These large portfolios, while enriching GSE shareholders, do not meaningfully benefit homeowners and do not facilitate secondary market liquidity.
The rate spread compression (cheaper loans) occurs at origination and initial securitization. Buying and selling existing portfolios doesn’t help the consumer. It does make Fannie Mae a ton of money, and it puts taxpayers at risk:
They do add systemic risk to our financial system, which normal market forces are unable to resolve.
“And risk is bad.”
But, Mr. Greenspan thinks you may say, the GSEs are very clever. Can’t they watch the markets and react the instant there’s a flicker of a problem?
Well no, he answers, because they’re too big:
In the current system of mortgage financing, the prepayment and interest rate risks associated with mortgages …
Prepayment risk is that the holder of a high-rate loan may pay it off even as the securitizer can’t prepay its matching instrument. If so, all that favorable spread vanishes in an instant.
… are concentrated in Fannie’s and Freddie’s large portfolios rather than being more widely dispersed across a broad range or market participants, including the overwhelming number of financial institutions that are significantly less leveraged than the GSEs (such as commercial banks and insurance companies).
Unlike the typical financial institution, which is as a fish in the sea, each GSE is like a whale in a swimming pool. It’s so big that it soaks up disproportionate space, and any move, any tremor, any twitch, sends shock waves throughout the pool, scattering the fish.
As Fannie and Freddie increase in size relative to the counterparties [The other half of any transaction. — Ed.] for their hedging transactions, their ability to quickly respond to changing market conditions and correct the inevitable misjudgments inherent in their complex hedging strategies becomes more difficult,
“You can’t hedge something this big.”
Whales move more slowly than fish (they have a much slower OODA loop). The GSEs are so big they cannot be financially nimble.
especially when vast reversal transactions backed by their thin capital holdings are required to rebalance portfolio risks. ²
² For mortgage portfolios in particular, misjudgments are inevitable mainly because of the inherent difficulties in forecasting households’ prepayment behavior.
It would be one thing, Mr. Greenspan is correctly observing, if the GSEs kept so much capital on hand they could absorb this themselves. But they’re highly levered now, so they have to match a market countermove … and they’re too slow to execute it without causing substantial disruption.
Put an elephant on one end of a seesaw, and then put a hundred small children on the other. If the elephant gets off, the kids go flying.
“Now, Fannie, you’re Congress’s friend, right?”
Furthermore, the success of interest-rate-risk management, especially the exceptionally rapid timing necessitated by dynamic risk adjustments [There’s that OODA-loop problem again. — Ed.], requires that the ultimate counterparties to the GSEs’ transactions provide sufficient liquidity to finance an interest-rate-risk transfer that counters the risk.
If the GSEs don’t keep cash on hand to settle these transactions, others must — and Mr. Greenspan plainly doubts that they do or will.
“All accounts must be settled at the end of the day, Mr. Duke.”
So the system has no shock absorbers and the train has no brakes.
Otherwise, large and rapid destabilizing adjustments will result in sharp changes in the interest rates required to rebalance and hedge the GSEs mortgage portfolio.
The natural reaction to a GSE desperate for cash would be (supply and demand, kiddies!) to jack up the price of that capital — raise interest rates. When that happens, the GSE spread compresses (profit shrinks) or vanishes entirely (GSEs lose money).
And who pays when the GSEs lose money?
“Show me the money!”
You do. We do. The taxpayers do … because the government does.
Heedless of your potential shock and depression, Mr. Greenspan continues implacably onward:
Also, as I have testified earlier, the GSEs and their government regulator need specific and unambiguous Congressional guidance about the intended purpose and functions of Fannie’s and Freddie’s investment portfolios.
“You’ve got this problem already,
Often, this proposal is referred to as “portfolio limits” The purpose of this guidance, however, is not just to limit the GSEs’ portfolios, but to firmly anchor the GSEs’ investment portfolios to their public purpose.
“We’ve got them firmly tethered.”
Strong portfolio guidance by Congress is needed because GSEs are an unusual government intervention in private markets; such institutions lack the typical financial market discipline that is commonplace for other publicly traded firms.
“I said this above,
The bill approved by the Senate Banking Committee in July 2005 (S. 190) provides this much-needed anchor and would refocus Fannie and Freddie on their important public policy mission. In addition, S. 190 appropriately strengthens the capital authority of the regulator and establishes a clear and credible receivership process for handling a failed or failing GSE.
“Focused, get it?”
The bonds of S. 190 are strong ones.
In contrast, as I observed during my July 2005 appearances before Congress on monetary policy, the bill that passed the House of Representatives in October, 2005 neither takes the steps needed to create an effective GSE regulator nor addresses the systemic risks posed by Fannie’s and Freddie’s investment portfolios.
The House’s behavioral constraints are flimsy and easily stretched or broken.
In the first instance, the House bill fails to sufficiently strengthen the capital authority of the regulator and does not establish a clear and credible receivership process for handling a failed or failing GSE. But, more importantly, the House bill fails to comprehensively address the problem of systemic risks presented by the GSEs’ investment portfolios. Improved regulation by itself may be insufficient and could exacerbate the potential systemic problems associated with the GSEs large portfolios if financial markets infer from such regulation that the government is more strongly backing GSE debt.
“Just holding up your hand saying ‘stop’ isn’t enough.”
“While a big GSE moves slowly compared to the financial markets, it is as lightning compared with the crack bureaucracy you put in place to stop them — any crack bureaucracy.”
Moreover, the Federal Reserve Board believes that any legislative approach that relies mainly on the future regulator to oversee the GSEs investment portfolios without providing that regulator with specific and unambiguous Congressional guidance is unlikely to succeed in directing these portfolios toward their important public purposes.
“You have more faith in bureaucrats than I do, gentlemen.”
Because the players have much bigger contracts than the referees, the players will always bully the refs.
Faced with trillions of dollars of assets and the large profits and capital gains created by the perception of government backing, the current GSE regulator needs a precise and clear statement from the Congress about the purpose of the GSEs’ portfolios in order to assure these portfolios achieve their public mission in a manner that does not run the risk of destabilizing the housing finance markets or the financial system more generally.
“Good night and good luck, Ben Bernanke.”
[signed] Alan Greenspan
“My work here is done.”