Affordable Housing Institute : US

 

A few days back, I posted on the GSEs’ performance in improving housing affordability, drawing heavily from a January, 2007 speech, now published by St. Louis Federal Reserve, by Federal Reserve Bank president of St. Louis, William Poole. 

 

 

Mr. Poole’s speech is a gold mine of insight.  As I’ve previously posted, the GSEs’ fundamental policy value equation has three elements:

 

1. What we citizens get, as increased housing affordability.
2. What the GSE cost us, in direct and indirect subsidy.
3. What risks we run, both explicit and implicit, and their cost.

My previous post, in two parts, focused on his comments about affordability — which are the most cogent I’ve seen.  Elsewhere in the same talk he covered the systemic risks, with commentary that’s very worthwhile to review as Congress moves slowly toward enacting a GSE reform bill.

 

The stunning accounting irregularities at Freddie Mac and Fannie Mae served as wake­up calls both to the GSEs themselves and to the super­visory and legislative communities. Freddie Mac fired virtually all of its top-­level management immediately in June 2003 and then, a few months later, fired the new CEO it had hired to replace the original disgraced CEO.  Barely a year ­and­ a ­half later, Fannie Mae ejected its own top man­agers, who had repeatedly declared that, unlike Freddie’s, its own books were clean. The boards of both companies agreed to a series of governance reforms designed to bring the GSEs into line with other large financial firms.

 

Start with the basics: there are fourteen GSEs, of which two are really large and twelve are ’small’:

 

Two national GSEs and a nice dozen of the little ones

 

The bulk of all GSE assets are in the housing GSEs—Fannie Mae, Freddie Mac, and the 12 federal home loan banks (FHLBs).

 

The Federal Home Loan Banks are regionally distributed and chartered to lend for housing.

 

Twelve colors, twelve regions, twelve banks

 

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.

 

GSEs debt on the right, US debt on the left, taxpayer going before

 

GSEs like to grow because they can borrow more cheaply than any other mortgage companies, so they have a competitive advantage:

 

It is very profitable for a firm to be able to borrow at close to the Treasury rate, lend at the market rate, and hold little capital.

 

If borrowing cheap and lending expensive is so profitable, why doesn’t every bank simply grow at the same rate? 

 

Everyone understands that financial leverage, like physical leverage, increases volatility — big swings.  So, as a company becomes more highly levered, it becomes inherently more risky. 

 

Our capital’s thinly spread

 

Capital markets watch for this, and penalize it by demanding higher rates for new capital.  That’s why banks hate FIN 46 balance sheet consolidation — it increases their perceived leverage.  Why aren’t the GSEs so penalized? 

 

Because the capital markets believe that the GSEs’ charter means the government will bail them out:

 

Do you believe in my implicit guarantee?

 

I believe that many risk managers simply accept that GSEs are effectively backstopped by the Federal Reserve and the fed­eral government without ever thinking through how such implicit guarantees would actually work in a crisis. The view seems to be that some­one, somehow, would do what is necessary in a crisis.

 

If you know you will never be punished or harmed, you’re much more inclined to take risks.

 

Heads I win, tails you lose

 

Any firm with such a privileged position will want to extend its scope of operations. Over the past 15 years, Fannie Mae and Freddie Mac have grown much more rapidly than has the stock of mortgages outstanding.  Given the powerful incentive Fannie and Freddie have to grow, the systemic risk they pose to the economy will also grow.

 

If the capital markets were confident that the government would protect GSEs against risks, what would make them lose confidence in the stock price?  Not accounting irregularities so much as the threat of capping GSE portfolio growth.  In fact, that’s what happened:

 

That is why the promise of constraints on the portfolio growth at Fannie and Freddie had a significant effect on their stock prices.

 

In terms of market perception, this is a smoking gun.

 

What smoking gun?  I don’t see any smoking gun

 

It’s as if the equity markets, realizing the GSEs’ earnings engines had been turbocharged, were entirely content that they do so as long as taxpayers stood behind them. 

 

Ordinary companies using that much leverage, with such sophisticated and complex financial instruments, need very precise and reliable accounting, pricing, and re-pricing information technology:

 

Sound risk management practices require that GSE management base decisions on market values, or estimates as close to market values as financial theory and practice permit.  

 

The reason is simple: Fannie Mae and Freddie Mac pursue policies that inherently expose the firms to an extreme asset/ liability duration mismatch.

 

I’ve written previously about the GSEs’ propensity for Turbocharging the balance sheet:

 

They hold long-­term mortgages and MBS financed by short­-term liabilities.

 

Lending long and borrowing short puts you at great risk if the yield curve wobbles.

 

Given this strategy, they must engage in extensive operations in derivatives markets to create synthetically a duration match on the two sides of the balance sheet. These operations expose the firm to a huge amount of risk unless the positions are measured at market value.

 

Mr. Poole thus believes the only way to understand what’s going on with all those numbers (as David Stockman once asided) is to have precise, real-time re-pricing of assets and liabilities, so you can see all the fluctuations in value and equity.  A global bank whose accounting and financial controls were in disarray would be subjected to withering criticism from shareholders and analysts, so for a while, the GSEs smoothed their earnings with financial tricks.  When these were revealed, the GSEs’ fessed up:

 

Hundreds of millions of shareholder dollars were committed to rebuild­ing accounting and control systems at both firms.

 

Yet three years later, the books are still not up to snuff:

 

Both firms agreed to restate earnings for the past few years; so massive was this undertaking that neither firm is current on its financial reporting. Freddie did release its annual report for 2005 but, according to its press release of January 5, 2007, may revise its results materially for the first nine months and the third quarter of 2006. 

 

Nor is Fannie filing current reports. In December 2006, Fannie filed its Form 10­K for 2004 with the Securities and Exchange Commission (SEC).

 

The cat ate our financial statements

 

Hey, information two years out of date is good enough, isn’t it?

 

Currently, investors in common stock or debt obligations issued by both companies rely on partial and incomplete information subject to material revision.

 

I have all the financial information I need … don’t I?

 

Lest anyone think that it’s only the big boys who stub their toes, the little guys have been experiencing similar problems:

 

Meanwhile, the FHLBs—the “other housing GSEs”—were enduring accounting and control crises of their own.

 

At some point this ceases to be an isolated virus and instead looks like an epidemic:

 

Two of the twelve FHLBs signed written regulatory agreements in 2004 with their supervisor, the Federal Housing Finance Board (FHFB), to rectify portfolio risk­ management deficiencies. Then, in 2005, 10 of the 12 FHLBs failed to meet their agreed deadline to register their stock with the SEC.  Like Fannie Mae and Freddie Mac, all of the FHLBs restated their earn­ings for recent years; all have now returned to timely filing of accounting statements.

 

If you’re scoring at home, that’s fourteen GSEs, and fourteen accounting irregularities or material restatements.

 

 

Understandably, the companies are embarrassed, and behaving contritely:

 

The GSEs have grown much more slowly, and they have been more reticent in public in recent quarters than they had been during the pre­2003 decade. It appears that they want to pursue a low­-key strategy while memories of their accounting and control failures gradually fade. Their aim, apparently, is to return to the environment before heightened scrutiny arose in 2003.

 

Mr. Poole is in no doubt about the GSEs’ next move after the coast is clear:

 

Once their current accounting problems are fully resolved, Fannie and Freddie will want to resume their growth.  It is simply very profitable to be able to borrow at close to the Treasury rate and invest in mortgages while holding minimal capital. Banks maintain capital ratios double or more the ratios that Fannie and Freddie maintain.

 

Fannie and Freddie get by with half the safety margin of their competitors; that’s a big advantage for them, a big risk for taxpayers.

 

What risk?  We’re sailing in calm seas!

 

Banks pay deposit insurance premiums to the Federal Deposit Insurance Corporation, whereas Fannie and Freddie pay no insurance premiums. Assuming that the implied guarantee would, in a crisis, lead to a federal bailout, US taxpayers bear the risk while the shareholders and managers of Fannie and Freddie enjoy the profits.

 

We have FDIC insurance to assure that depositors won’t lose their money.  Banks are required to have it, and to pay for it.  Mr. Poole suggests that since the capital markets are convinced they have deposit insurance akin to FDIC, the companies gain the benefit — which they do, in the form of lower costs of capital — without paying anything for it. 

 

This situ­ation encourages these firms to grow vigorously.

 

These two firms, however, cannot meet their growth targets in the long run if they confine their operations to conforming home mortgages.

 

Get me out of these conforming mortgages!

 

The plant pot of conforming home mortgages — what the GSEs were established to buy — is becoming too small for their ambitions. 

 

Their interest in increasing the conforming mortgage limit is clear. Moreover, in my opinion, it is inevitable that they will look for ways to extend their operations into new areas. They have that clear incentive because of the implicit federal guarantee they enjoy.

 

What’s wrong with that?  Why would it be a bad thing if the GSEs entered markets already being served by established players?  Isn’t that just Competition 101?

 

For them to extend their operations into market segments already well served by existing private firms will not enhance the efficiency of mortgage markets or reduce costs to mortgage borrowers.

 

Expanded GSE activity does nothing for affordability, Mr. Poole thinks, — for his evidence, see my previous two-part post – yet increases systemic risk.  Can the risk be capped?

 

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

 

1.       A limit on their portfolio growth

2.       An increase in their minimal required capital

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

 

The first two of these are straightforward — accomplishing them takes nothing more than political commitment.  The third is a challenge at whose difficulties Mr. Pool darkly hints:

 

Good risk management requires that the “someone” be identified and the “somehow” be specified. I have emphasized before that if you are thinking about the Federal Reserve as the “someone,” you should understand that the Fed can provide liquidity support but not capital. 

 

Translation: we lend money, we don’t grant it.

 

As for the “somehow,” I urge you to be sure you understand the extent of the president’s powers to provide emergency aid, the likely speed of congressional action, and the possibility that political disputes would slow resolution of the situation.

 

The president by himself cannot provide aid, and by the time Congress could do anything, Mr. Poole is implying, it would be too late to be effective.

 

Here’s our urgent relief legislation

 

Given all this, what does Mr. Poole recommend Congress do?

 

I continue to believe that the nation would be well-­served by turning the GSEs into genuinely private firms, without government backing, implied or explicit.

 

If they bolster their capital, they can function perfectly well as purely private firms.

 

“If you bolster your capital, sweetheart, maybe you can make it private, like I did.”

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