GSEs: the earnings engine
I’ve been carefully reading OFHEO’s excoriating report on the Fannie Mae scandal, and will be posting on it shortly — but before doing so, I need to set the intellectual and financial stage.
All the market’s a stage, the buyers and sellers on it merely players.
Because the OFHEO report was written for an audience knowledgeable about sophisticated multifamily finance, it takes for granted that the reader understands a GSE’s fundamental economic imperatives:
- The GSE’s earning engine.
- The potential for balance-sheet turbocharging.
The GSEs’ earnings engine has lots of horsepower even before turbocharging
(For background on primary and secondary mortgage market players, see yesterday’s entry.)
Today I’ll give you the basic GSE earning engine — tomorrow we’ll show you how balance-sheet expansion can turbocharge it.
1. The GSE earnings engine
All of the GSEs — Fannie Mae, Freddie Mac, the Federal Home Loan Banks — are secondary mortgage market makers. Rather than originate anything themselves, they:
- Buy loans from their correspondents (Fannie Mae’s Delegated Underwriting and Servicing, DUS, is global best-in-class at establishing effective correspondence relationships). These loans have an aggregate interest rate Collected.
- Issue (and sell) securities (Fannie Mae or Freddie Mac Mortgage-Backed Securities, MBS’s) that have an aggregate interest rate Paid.
With one hand buy, with the other sell.
The GSEs’ spread — the primary source of their organizational income — derives from the difference between interest Collected and Paid. Their earnings are spread times volume, leading to this simple equation:
The GSE earnings engine
Earnings = Volume x (Collected – Paid)
Volume = Total loans/ securities outstanding
Collected = Average interest rate collected from home loan borrowers
Paid = Average interest rate paid on Fannie Mae securities
‘Spread’ = the gap between Collected and Paid on any loan or portfolio
Just blow capital through it and watch the economics take off!
For visual clarity, I’ll put GSE receipts and assets in green, expenses and liabilities in red.
Beyond the core engine, GSEs can make money in other ways, among them ancillary financial products, buying and selling existing pools of instruments, CFO-type actions (e.g. LIHTC equity investment, sale/ leaseback or hedging transactions), and consulting or educational services, but all of these are small fractions of the main earnings engine.
2. The GSEs’ unique advantages
The earnings equation is entirely unremarkable — every secondary market maker thinks in the same terms — but the GSEs have awfully big advantages, one of which is both insubstantial and worth billions:
The story of Fanny, Freddie, and Sally?
When GSEs issue debt, the capital markets perceive their securities to have the implicit (but unacknowledged) backing of the US Treasury. As a result, GSE securities sell at lower yield (higher prices) than any other
- Any income stream is worth more if securitized by the GSEs than by any other issuer possible.
- The GSEs can make spread on securitizations where no one else can.
Make sure you have enough color toner cartridges for the money you’re going to be printing!
Congress chartered the GSEs, and then allowed them to become privately owned companies, in the expectation the GSEs would use these proprietary advantages not just to make money but also to expand affordability.
3. The three (plus one!) levers of earnings
The public-policy tension surrounding GSEs relates to where they strike a balance between serving shareholders and taxpayers.
How much profit, how much affordability?
As a thought experiment, let’s presume for the moment that evil Lex Luthor become the next Fannie Mae CEO.
Luthor would extract maximum value for minimal cost by turning each knob to its maximum setting:
Interest Paid. Luthor would seek to sell his securities at the absolute lowest yield possible in the marketplace. Not even Clark Kent’s X-ray vision could find anything wrong with this by itself; we all benefit if the GSEs can issue their capital at low cost.
OFHEO’s out of control!!
It would be a different story if that low cost were at the expense of innovating affordability (see below), or if the lower cost were achieved by turbocharging balance sheet to expose the Federal government to inordinate risk.
“I’d never put anyone in genuine peril … would I?”
Interest Collected. Luthor would set his lending interest rates with the tiniest advantage possible relative to the competition; five or ten basis points maximum. Clark Kent would try to see through his charade and demand that Luthor lower his rates, and shifty Lex would undoubtedly mount every sort of defense imaginable to show that in fact not only were his rates lower than the competition’s, his mere presence in the marketplace forced every other competitor to offer cheaper financing — in other words, Luthor’s GSE added value for taxpayers even if it was only meeting the market, because it was making the market and forcing other lenders to come down to Luthor rather than Luthor coming up.
Volume. The charter’s beauty is that it is infinitely renewing, a cornucopia always financially nourishing, so our economically insatiable Lex Luthor would want all the volume he could secure, by means fair, foul, or scurrilous:
- Maximum market share. Luthor would seek to dominate any market segment and wipe out any competitor gaining meaningful market share. (He might make tacit deals with his fellow villain, Mr. Mxyzptlk, to collaborate on eliminating third-party competition and reinforcing their duopoly.
- Breaking the charter’s bonds. Realizing that the charter circumscribed his areas of activity, Luthor would be constantly pressing to loosen them. Under the heading of pilots, demonstration programs, under-served markets, expanding homeownership, or increasing affordability, he would seek to bring in new products that would usurp markets now being effectively handled by the private marketplace. “People need cars to drive to and from their houses,” Luthor would observe, “therefore I should be able to provide car loans. And for every permanent loan, there must have been a construction loan, why not streamline the value chain and let us provide financing there as well?”
“We should be freely able to compete in every market.”
Affordability. Luthor would give this lip service but do as little as possible, for the more affordable a loan is, the riskier, and that erodes the Collection-Paid spread that he so covets. He would prove he is doing as much as anyone human could, and he would always be ready to pledge more if forced to do so, but having pledged, he would have no compunction about merely creating the illusion of performance, perhaps by hypnotizing honest citizens of Smallville or Metropolis into repeating that yes, they have been wonderfully served by Luthor’s loans.
“Both my child and my dog have been wonderfully served.”
This above all – Luthor would protect the charter at all costs. Anything and everything would be justifiable to assure the proprietary advantage. He would bribe every member of Congress, every senior Administration official, every opinion-maker, every journalist, even every humble blogger. “What’s good for Lex Luthor is good for the country,” he and his followers would repeat at every possible moment and in every possible context.
If, as Verbal Kint suggested, “The greatest trick the Devil ever pulled ever pulled was convincing the world he didn’t exist,” then Luthor’s greatest political triumph would be to make himself (and Mr. Mxyzptlk) invisible, so beloved and apolitically altruistic that his continued existence would be taken for granted — and then he would return to running the earning engine as fast and as hard as ever he could.
“And like that” — poof! — “he’s gone.”
