Affordable Housing Institute : US

 

[Continued from yesterday’s Part 1.]

Yesterday we saw that Federal Reserve Bank president Bill Poole of the St. Louis Federal Reserve analyzed changes in financing affordability as the GSEs were pounded from pillar to post by accounting shocks and regulatory edicts. He found that despite shocks from all directions, affordability never changed. But maybe that was because the shocks were minor. What happened to the companies’ stock prices?

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.

 

Stock price drops give me indigestion

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.

What did bad news do to mortgage affordability? Nothing.

 

What happened to the stock prices? They got pounded.

 

Take that, stock prices

Toward the beginning of my remarks, I noted that disclosure of the accounting irregularities did affect the stock prices of the two firms. Now we see that there was no effect on the mortgage market. The issue, clearly, is the profitability of the firms and not effects on the mortgage market.

 

Meanwhile, did the capital markets conclude that the GSEs were weaker, and needed to be propped up? Not that either:

Since the GSE accounting scandals emerged in mid-­2003, one thing has remained rock­-solid: The GSEs have continued to borrow at yields only slightly higher than those of the U.S. government and noticeably lower than those available to any other AAA-­rated private company or entity.

 

Thus, although (absent the Federal umbrella) the GSEs should not be able to access capital cheaper than an AAA security, they have continued to do so — meaning the market is paying for an implicit guarantee, and given that the GSE rates are closer to Treasuries than to AAA bonds, the markets evidently think it’s more likely than not that they would be bailed out.

 

People believe in it even though it doesn’t say “U. S. government” anywhere

In other words, despite the vast recent accumulation of knowledge about the significant risks run by the GSEs, as well as their inability (or unwillingness) to manage these risks, investors in GSE debt secu­rities appear unmoved. Upon reflection, the lack of market discipline evident during this crisis period is striking—like a dog that did not bark.

 

“I call your attention to the curious incident of GSE spreads during the turmoil.”

“The GSE spreads did nothing during the turmoil.”

“That was the curious incident,” remarked Sherlock Holmes.

 

The obvious answer to why the dog did not bark is that the so­-called “implicit guarantee”— that is, the belief by investors that the U.S. govern­ment would not allow the GSEs to default on their debt obligations—has not been removed.

In Mr. Poole’s view, when a market discovers risks bigger than it had thought they were, it should reprice the cost of its insurance. Hence the GSEs problems, and the revelations of significant risks not being managed as they had been advertised they were being, ought to have caused the insurer (Congress) to rein them in — as happened, for example, to hazard insurance policies in the aftermath of Hurricane Katrina.

 

This fact [Lack of market repricing — Ed.] indicates to me that there still is a signifi­cant problem with the GSEs that needs to be fixed.

Markets aren’t stupid. Either there has been no increase in risk, or someone else is absorbing it. Since the increase in risk is palpable and undeniable, concludes Mr. Poole, the market has reached only one conclusion, one he dislikes:

 

Indeed, the talk of increased GSE regulation and the failure of structural­ reform legislation to become law [Yet — Ed.] may actually have reinforced the belief of many that, overall, the government is perfectly happy with the situation as it is.

Translation: if you don’t rap their knuckles hard when they misbehave, your rights to rap them are drastically weakened.

 

“Rap their knuckles, fool!”

“Gosh, Dr. Jekyll, what would you prescribe?”

 

The blow … on the head!

Three essential reforms are needed to elimi­nate the GSEs’ threat to financial stability.

1. First is a limit on their portfolio growth

2. Second is an increase in their minimal required capital

3. Third is satisfactory bankruptcy legislation so that, should the worst happen, federal authorities can deal with the problem in an orderly way.

“Does anyone think the patient will accept the treatment?”

 

Freddie Mac apparently does not expect any significant increases in constraints on its opera­tions.

“How do you know?” “Because a regular company would need greater capital reserves, and would build them up.”

Funds that could have been used to build capital to better protect taxpayers have instead been used to increase common stock dividends. Freddie set a quarterly dividend of $0.22 in the fourth quarter of 2002 and has increased the divi­dend every year since. As of the fourth quarter of 2006, the dividend stands at $0.50 per quarter, more than twice its level four years earlier. Fannie Mae cut its dividend in half in early 2005 to build capital, but I’ll hazard a guess that once it starts issuing regular financial statements the company will increase its dividend rather than build capital further.

If you’re not saving for a rainy day, even after there’s just been a downpour, you must think somebody will lend you an umbrella.

“Hmph,” say Fannie Mae’s defenders, of whom there are many.

 

“I pity the fool who believes your reasoning”

The GSEs remain politically powerful, if less strident than they were a few years ago.

“That’s just one event,” the defenders persist. “Where’s the academic or statistical research to prove that this was anything but the one moment?” Mr. Poole has an answer for them too:

 

We now have some solid evi­dence on how the mortgage market would func­tion if the housing GSEs became fully private firms. A careful econometric investigation by three economists at the Board of Governors last year (Lehnert, Passmore, and Sherlund, 2006, abstract) reached this conclusion: “We find that GSE portfolio purchases have no significant effects on either primary or secondary mortgage rate spreads.”

 

We find that both portfolio purchases and MBS issuance have negligible effects on mortgage rate spreads and that purchases are not any more effective than securitization at reducing mortgage interest rate spreads. We also examine the 1998 liquidity crisis and find that GSE portfolio purchases did little to affect interest rates paid by borrowers. These results are robust to alternative assumptions about causality and to model specification.

 

“These results are robust” is academic-speak for “it’s really hard to find any other plausible explanation.”

The amount the GSEs buy or don’t buy, these researchers concluded, makes no difference in market pricing. The GSEs are part of the market, not a market maker or market leader.

 

Take us, we’ll make you feel better

Put another way, the 30­-year mort­gage rate fluctuates in tandem with the rate on 10-­year Treasury bonds and the spread over the Treasury rate is not affected by portfolio purchases by Fannie and Freddie.

Is that worth $6+ billion in annual taxpayer subsidy?

Even if we assume that the 2 basis point blip we observed above applies to every dollar of GSE debt outstanding, 2 bps x $4.4 trillion = $0.88 billion of annual savings, roughly a tenth of the $8 billion of annual subsidy the GSEs receive. To justify their existence, the GSEs need to demonstrate at least 25 basis points advantage across the whole portfolio, not the minuscule amounts derived in Mr. Poole’s analysis.

What can we take away from this evidence of absence?

 

Long, long ago, in a galaxy far, far away, there were no GSEs, no secondary market. Loans were made by local banks who used depositors’ money to fund them and who held the loans until maturity. Banking was local, friendly, cozy … and inefficient.

Then came the GSEs.

 

Riding to the rescue of homeowners everywhere

They revolutionized homeownership finance in the US, leading to substantial efficiency gains, and increases in the homeownership rate. A decade later, conduit lending and securitization were invented and spread like wildfire; the homeownership rate rose again. Most recently, securitization and the computerization of financial information fueled the emergence of specialist lenders, subprime or otherwise, and their arrival coincides with another boost in the homeownership rate — one that, at this writing, looks transitory and rickety, with financial consequences that are still playing out.

 

Buildings need scaffolding to arise. Pumps need priming to flow. Fires need matches to start them. All, once started, sustain themselves.

Have the markets outgrown the need for GSEs? Mr. Poole’s evidence of absence — the absence of cheaper debt when the GSE grew, the absence of more expensive debt when they shrank — suggests that they have.

 

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