Affordable Housing Institute : US

[For the introduction, see Part 1.]

[For previous installments, see Parts 2 and 3.]

 

[Quotes in green are from the OFHEO report (full document, .pdf), on which Fannie Mae declined to comment. Sentences are occasionally reformatted (bullets, boldface emphasis, inconsequential brief elisions) for clarity.]

 

Thus we have established OFHEO’s perspective that (1) under Mr. Raines, Fannie Mae management sought to maximize their bonuses, and (2) they did so via a single, unusual construct, core business Earnings Per Share. So far this might be of great interest to disgruntled Fannie Mae shareholders and their litigation attorneys, but what has it to do with us taxpayers?

 

I got my cap — have you received yours?

 

Because of their unique status and Congressional charters, GSEs Fannie Mae and Freddie Mac get to play not just with stockholders’ money, but also with ours:

Fannie Mae’s executive compensation program gave senior executives the message to focus on increasing earnings rather than controlling risk. Page 5.

 

This they did in part by turbocharging the balance sheet.

GSEs are not supposed to do this. As OFHEO put it, as long ago as 2000:

OFHEO has produced regulations, guidances and examination documents that provide Fannie Mae and Freddie Mac with information on the expectations of OFHEO with respect to safe and sound conduct and operating methods.

 

 

Contravention of the guidance establishes a red flag that the safety and soundness of an Enterprise may be at risk; OFHEO need merely evaluate the conduct and consider it in the context of any harm incurred or that is reasonably foreseeable. Page 22.

OFHEO then lists eight areas, including:

 

Eight risks a-voiding?

Balance Sheet Growth – Each Enterprise should manage its balance sheet so that balance sheet growth is prudent, and should consider changes in risk that may occur as a result of balance sheet growth, and appropriate policies and procedures needed to manage risk that may occur as a result of balance sheet growth. Page 23.

 

However, in OFHEO’s storytelling, the basic business line — buying pools of loans and immediately packaging them into mortgage-backed securities (MBSs) of equivalent duration and prepayment optionality, worked for a decade:

 

Fannie Mae began guaranteeing mortgage-backed securities (MBS) in 1981 and, after interest rates fell, became profitable again in 1986. In 1987 the Enterprise doubled its EPS, starting a 17-year pattern that continued through 2003. Through the early 1990s, Fannie Mae sustained rapid profit growth primarily by expanding the share of conventional single-family mortgage debt outstanding in the U.S. financed with its guaranteed MBS. Page 34.

Amid all the criticism, we must pause for applause.

 

And the members of Congress join with us too.

The growth of mortgage-backed securities (MBSs) and the nationalization of capital pools are great triumphs, in which the GSEs played an integral, catalytic, leadership role. This should not be belittled, begrudged, or minimized.

Starting in the late 1980’s, GSE securitization of mortgage loans created systemic liquidity never before seen in the world. It fueled an expansion of credit, and a compression of interest rate spreads, that coincided with a long-wave rise in national homeownership rates. Fannie Mae and Freddie Mac loudly trumpeted their success in bringing the American Dream to millions of American households — and rightly so. It was, and remains, a great achievement.

 

And should be suitably commemorated.

 

In fact, in one sense it was too successful — the entities ran out of worlds to conquer. Their market share was so large, they so dominated their main market, that Fannie Mae needed to do something else.

In fact, three something elses:

 

Fannie Mae management believed that, to double EPS by 2003, the Enterprise would have to achieve three business objectives. Page 45.

We need to go through these slowly, because each one is very important.

1. First, in the credit guarantee business Fannie Mae would have to securitize a greater share of the single-family mortgage market, in part by:

(a) penetrating the subprime market, and

(b) buying conventional loans that might otherwise be insured by the Federal Housing Administration. Page 45.

 

Subprime lending — that is, financing those who fall below conventional credit standards — is a hotly contentious area. Some see it as bringing needed capital to those redlined by prejudice. Others see it as exploiting the financially undereducated. It’s too big to address here.

The second move, moving into FHA’s space and out-competing them, is likewise debatable. Some would say, “if FHA isn’t giving its all, a good dose of competition will be healthy for them.” Others might answer, “of all the places to put Fannie Mae energy, why choose that one?” Again, too big to address here.

 

Too big to take a swing at right now

The next one’s easier:

2. Second, in the portfolio investment business, management would have to increase rapidly the size of Fannie Mae’s retained mortgage portfolio, while avoiding significant compression of the portfolio’s net interest margin — the spread between the average interest rate earned on assets and the average rate paid on liabilities. The portfolio investment business had generated the majority of the Enterprise’s net income in 1998 (and continued to do so in subsequent years), so that expanding business offered the best prospect for growing earnings. Page 45.

 

If I am interpreting correctly OFHEO’s statement, more than half of what the Fannie Mae made in this interval, they made by turbocharging the balance sheet, the thing that GSE should not do. That is extraordinary.

 

For Fannie Mae to grow rapidly without margin compression, the mortgage market would have to expand fast enough to accommodate increased demand from the Enterprise without the market prices of mortgages and MBSs being bid up (and their yields declining) significantly. Page 45.

The GSEs are given their awfully big advantages so they will use their powers for Good and increase affordability.

 

Are you using your powers to increase affordability?

Here OFHEO is suggesting that when Fannie Mae moved into the market, it sought to keep rates unchanged, rather than lowering them as a pure-affordability mandate would dictate.

3. Third, senior management believed that it would have to achieve steady, rather than irregular, EPS growth. CFO Timothy Howard presented the following argument for that objective to the Board of Directors. The Enterprise’s special relationship to the government gives it unparalleled liquidity and low funding costs. To capitalize on those benefits and maximize shareholder value, Fannie Mae “must be, and be perceived to be, a low-risk company.” Page 45.

 

Give Mr. Howard his due for insisting that Fannie Mae must be a low-risk company. As suggested in Part 2, and as will be further discussed in Part 5, perception overtook reality.

The argument ignored the fact that Fannie Mae’s strategy for managing the retained mortgage portfolio involved taking a significant amount of interest rate risk, as members of the Board should have been aware. Page 46.

 

Time out for two definitions:

 

Interest rate risk

The risk that a change in interest rate will whipsaw one’s financial position. Arises for a borrower whose income is fixed and who takes out a variable-rate loan. Arises for a lender who lends long and borrows short.

 

Optionality

Someone’s ability to make a choice based on changing circumstances. If I have the right to buy your house at a fixed price, but you lack the ability to compel me to do so, then I have the optionality and you do not.

Now back to OFHEO:

 

During the period covered by this report, Fannie Mae’s strategy was to match between 50 and 60 percent of the optionality of its mortgage assets with comparable options on the liability side. Page 46.

 

This is absolutely critical. Imagine the following scenario:

· 100 home buyers take out fixed-rate loans with thirty-year terms and the right to prepay after five years.

· We sell 100 bonds of the same amount, with half of them thirty-year bonds, callable after five years, and the other half (say) short-term bonds of one year’s duration.

In this example, we have matched the optionality 50% because we will call our bonds if our borrowers prepay, but the bonds we can call are only half of the total. The other half are short-term bonds. So what happens if interest rates rise? None of our borrowers prepay — they like their now-cheap loans — but all of our short-term bonds have to be refinanced at high rates.

 

No risk here at all.

We’ve turbocharged the balance sheet, to the substantial benefit of Fannie Mae, but at great risk.

Actually, this had happened before:

 

From Fannie Mae’s conversion into a government-sponsored enterprise in 1968 through the 1970s, the Enterprise financed fixed-rate mortgages with short-term debt. Beginning in October 1979, large increases in interest rates raised Fannie Mae’s interest expense, and the Enterprise lost money in four of the six years between 1980 and 1985. Page 34.

 

Who’s at risk beyond Fannie Mae’s stockholders? Taxpayers. As Federal Reserve Chairman Greenspan has repeatedly warned, the market expects the federal government to bail out a failing GSE, and the GSEs are so large their abrupt failure could easily destabilize national and global markets. (Fannie Mae is the world’s second largest borrower behind the U S Treasury.)

 

Because we taxpayers are in effect the catastrophic loss reinsurer, GSEs are supposed to avoid such risks:

Market Risks – Each Enterprise should protect itself from various risks (e.g., changes in interest rates) by developing plans for responding to each contingency. Page 23.

 

Fannie Mae benefits, while we take the risk.

 

What’s the warning sign of this optionality mismatch? Earnings volatility.

 

At least some members of the Board should have been aware of the degree of options mismatching practiced by Fannie Mae, and that the associated interest rate risk is a source of earnings volatility that, if reflected properly in the financial reports, would make it difficult for the Enterprise to maintain very stable EPS growth. Page 46.

 

Got it now? You double your earnings by turbocharging the balance sheet. Ordinarily the resulting mismatched optionality would make the earnings engine rattle and shake, which would worry the board.

 

Indeed, the earnings volatility would arise even if you didn’t sell the loans, because those FAS rules — FAS 133, FAS 115, and FAS 91 — are all about pricing and repricing inventory based on expected but not realized gains and losses. The vibration would show up in earnings if not in cash.) You couldn’t hide it.

 

We’re managing our earnings — you’re not!

Silly me. Fannie Mae had elected to ignore FAS 133, 115, and 91.

The wobbles should also show up in cash, and in frantic financial patching — and it did:

The interest rate risk to which Fannie Mae was exposed during the period covered by this report is illustrated by the Enterprise’s experience when interest rates declined dramatically in 2002 and 2003. Fannie Mae was not well prepared for the resulting surge in refinancings of fixed-rate mortgages. Page 47.

 

This is the flip side of the early 1980s period: when rates drop, everybody refinances.

 

The Enterprise had matched only a portion of the prepayment options held by borrowers whose mortgages it held in portfolio (either as whole loans or MBS) with options in its liability portfolio of debt and derivatives. When rates declined, Fannie Mae engaged in rebalancing actions in order to keep its duration gap, and its interest rate risk exposure, from increasing. Those rebalancing actions took the form of paying substantial sums to cancel pay-fixed swaps that had imbedded losses. Page 47.

So the earnings engine was rattling and shaking, and it should have been making financial noise.

 

But Fannie Mae put in place a great muffler.

[Continued tomorrow in Part 5.]

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