Affordable Housing Institute : US

Tiptoeing toward the markup

As Congress moves slowly [They’d say deliberately! — Ed.] toward enacting a GSE reform bill, left unvoiced is the question, Are the GSEs worth the government help we give them? As I’ve previously posted, the GSEs’ fundamental policy value equation has three elements:

· What the GSE cost us, in direct and indirect subsidy.

· What risks we run, both explicit and implicit, and their cost.

· What we citizens get, as increased housing affordability.

 

We can quantify the first — it’s several billion annually — and we can observe the second, even if we can’t readily quantify it. Hint: it’s gargantuan:

 

Risks? What gargantuan risks?

Using information as of September 30, 2006—the latest available as of this writing—these 14 firms have total assets of $2.67 trillion; given their thin capi­tal positions, their total liabilities are only a little smaller. Just two firms—Fannie Mae and Freddie Mac—account for $1.65 trillion of the assets, or 62% of all housing GSE assets. Moreover, Fannie Mae and Freddie Mac have guaranteed mortgage­-backed securities outstanding of $2.82 trillion. Thus, the housing GSE liabilities on their balance sheets and guaranteed obligations off their balance sheets are about $4.47 trillion, which may be compared with U.S. government debt in the hands of the public of $4.83 trillion.

 

The third variable, increased housing affordability, is really hard to measure, for we have no control experiment. We don’t have a modern parallel-universe world without the GSEs — we can’t know what our world would look like if the GSEs vanished as if they had never been — leaving us only with proxies.

Or can we? Is there another way to quantify life without the chartered GSEs — after GSE privatization?

Federal Reserve Bank president Bill Poole, who’s been studying the GSEs intently for nearly a decade, thinks there is.

 

Poole’s been intent for a decade

In a January, 2007 speech, now published by St. Louis Federal Reserve, he presents some remarkably relevant evidence, based on the respective responses of Freddie’s and Fannie’s shareholders and bond buyers to the same events — the accounting scandals.

 

For Fannie Mae and Freddie Mac, the two stockholder-owned housing GSEs, history can be divided into two distinct eras—before June 2003 and after. June 9, 2003, was the day the board of directors of Freddie Mac announced discovery of significant accounting irregularities. The stock prices of both Freddie Mac and Fannie Mae plunged, as investors immediately realized that something might have gone terribly wrong with both GSEs.

First premise: markets react quickly. Accounting irregularities immediately translated into a drop in shareholder value.

 

Subsequent investigations by private experts and public authorities confirmed the fears of many investors and financial supervisors. These giant, fast ­growing firms had poor account­ing systems and financial controls.

 

A small second point: the scary initial headlines proved true.

Because it is important for my analysis later, keep in mind these facts: First, the effect of dis­closure of accounting irregularities at Freddie Mac on June 9, 2003, led to a decline of 16% in Freddie’s stock price and 5% in Fannie’s stock price that day.

Note the duopoly effect: even though the disclosures were only about Freddie Mac, investors also dumped Fannie Mae. As if they were joined at the hip.

 

His dropped 16%; contrariwise, mine dropped 5%.

However, as I’ll document later, the effect of these disclosures on the mort­gage market was negligible.

Stock prices dropped sharply; bond rates never wavered. Equity moved; debt didn’t.

 

Some of us are equity, some of us are debt!

Similarly, when Fannie’s accounting irregularities were disclosed on September 22, 2004, its stock fell by 6.5% that day and by a total of 13.5% over a three ­day period; the mortgage rate was again unaffected.

 

Again, bad news hits the market, equity prices tumble, mortgage prices don’t.

In 2004, we learned that Fannie Mae’s accounting was revealed to be faulty. In December 2006, Fannie restated its earnings for 2002, 2003, and the first half of 2004, revealing that it had overstated its earnings by a total of about $6 billion.

 

The same phenomenon occurred even when the two shocks went in opposite directions: Freddie Mac restated its earnings up, Fannie Mae restated its down. Despite opposite-vector stimuli, the responses were identical: equity markets down, mortgage markets flat.

 

Shareholders not idolizing the stock

It’s as if the equity markets, realizing the GSEs’ earnings engines had been turbocharged, penalized both GSEs retroactively for having given a flase impression by smoothing earnings. Nor were the impacts confined to just those two moments of surprise. The scandals led to enduring consequences, in the form of a GSE retreat from the market, and substantial reductions in their market share:

 

In 2006, their retained portfolios continued to decline and by the end of the third quarter their portfolios were below year­end 2005. Meanwhile, the total market continued to expand. The com­bined market share of Fannie and Freddie fell from 22% at the end of 2003 to 14% at the end of the third quarter of 2006.

The GSEs’ market share dropped by a full third. A full-scale retreat.

 

Damn those accounting irregularities

What happened to the mortgage spread when the GSEs stopped accumulating ever­ larger port­folios?

Nothing.

 

Highlighting the impact on mortgage spreads

 

Nothing? If the GSEs are providing affordability benefits in the form of lower interest rates being passed through to consumers, taking them out of the market — in fact, turning them from net buyers into net sellers — ought to have raised the price of residential mortgage debt. That didn’t happen? Where’s your evidence?

Because fixed­-rate mortgages are subject to prepayment risk, whereas the 10­-year Treasury bond is not, there is a degree of variability of the mortgage spread.

‘Prepayment risk’ means that a lender cannot be sure how long the loan will be outstanding, because the borrower can prepay at any time.

 

 

You get one of these with every residential mortgage

‘Mortgage spread,’ in the capital-markets lexicon, means the amount (in basis points) by which home mortgage interest rates are higher than corresponding safe rates. Mr. Poole uses the ten-year Treasury because the average mortgage loan is held a little less than ten years.

 

“Oh, I’m so blue mah rates are higher …”

 

So he’s saying, quite correctly, that if we want to measure the capital markets’ contribution to homeownership affordability, we should look at how much home buyers have to pay above a purely safe rate. The lower that premium — that mortgage spread — the cheaper their housing, and the better for homeownership.

But if the ces­sation of the GSEs’ portfolio growth had made a difference, it surely would have shown up in the data. The annual average of the spread in 2003, before the OFHEO orders that restricted Fannie and Freddie’s portfolio growth, was 180 basis points; the spread was 157 basis points in both 2004 and 2005.

When the GSEs were growing unfettered by regulatory angst, when their market-share skies were entirely blue, consumers paid T + 180. After their travails, while the GSEs were retreating, consumers paid T + 157. Home mortgages were 23 basis points cheaper with the GSEs in remission than when they were in full flower.

 

This didn’t prove what I thought it would

That’s good evidence for the intermediate term — the period of months and years after the cataclysm. But a longer-term perspective could mask major short-term disruption.

 

Maybe the capital markets panicked, then settled back down. What about the shorter term? Did rates shoot up on fear that the GSEs wouldn’t be buying?

Nor did we observe any sort of shock to the market when the accounting irregularities at Freddie were disclosed in June 2003. The spread was 196 basis points in May 2003, 198 basis points in June, and 196 basis points in July.

 

Homeowners paid T + 196 before the shock, then T + 198, then T + 196. A two-basis-point blip. Insignificant.

 

No, really, that’s a huge element

The GSEs make much of their lower capital requirements; normal banks have to leave twice as much of their money idle as the GSEs do.

 

Gotta put your money to work

Maybe that’s the reason? What happened to mortgage spreads when OFHEO made the GSEs beef up their cash?

Consider also January 2004, when OFHEO imposed a capital surcharge on Freddie. That month, the mortgage spread was 159 basis points. The month before, the spread was 161 basis points; the month after, 156 basis points.

T + 159 became T + 161, then T + 156. A two-basis-point blip, followed by a net three-beep drop.

All right, maybe the markets were smart enough not to penalize Freddie Mac for an earnings restatement boost; surely they’d hit Fannie Mae for a massive earnings restatement drop?

 

No, they didn’t, and don’t call me Shirley

The OFHEO order applying to Fannie came in September 2004. That month the spread was 163 basis points; the month before, 159; the month after, 162.

OFHEO’s order, it should be noted, preceded the earnings drop, but still … T + 159 became T + 163, then T + 162. A four or three-point blip.

Recognizing that the blips we are measuring are tiny relative to the interest rates themselves (roughly 1/200th), it’s looking as if a few basis points month to month is simply normal variation. If so, the larger housing markets were completely indifferent to the GSEs’ troubles, as if their contribution to housing affordability is close to zero.

 

We defend housing affordability to the last

Absence of evidence, one learns in law school, is not by itself evidence of absence. But Mr. Poole cites numerous bits of evidence of absence:

Mortgage spreads — the most direct measure of GSE affordability benefit — remained utterly unaffected:

· When Freddie Mac admitted major accounting mistakes causing earnings to go up.

· When Fannie Mae admitted major accounting mistakes causing earnings to go down.

· When OFHEO announced hard caps on the GSEs’ ability to grow their portfolios.

· When the GSEs’ share of the mortgage market dropped by a full third, from 22% to 14%.

During those years the GSEs were hit with exogenous shocks up, down, and sideways. What did those whacks do to stock prices?

 

“Is something wrong with your stock price, sir?”

[Concluded tomorrow in Part 2.]

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