Who’s next? Part 2, the GSEs’ buying strategy shift

January 23, 2008 | Capital forms, GSEs, Markets, Subprime, US News

[Continued from yesterday’s Part 1 .]


Yesterday, wondering who might be next in the writedown game, I hauled out a June, 2007 story from Inside Mortgage Finance that reads much more scarily now than it did back when it was first published.



Back when the only thing we had to worry about was The Bomb


Who’s next?


Yesterday we saw that the GSEs were active buyers of subprime and Alt-A mortgages in 2007.  Why were they doing this?


Certainly, the two GSEs continue a delicate balancing act between their housing mission and the need for shareholder return. At the same time, they have to respond to the changes in the marketplace while still having to contend with temporary portfolio caps from their regulator, the Office of Federal Housing Enterprise Oversight.


“While they are interested in growing their portfolios, OFHEO is not interested in letting them grow,” said Eileen Fahey, a managing director in Fitch’s financial institutions group.  “Given the market over the past two years, they are interested in changing their portfolios and assuming new risks. They’ve moved away from the management of interest rate risk as their primary method of earning money and are shifting more toward credit risk.”


Read with the benefit of hindsight, that sentence is especially frightening.



Is that who you’ve been lending to?


Back two years ago, as I posted at great length, Fannie and Freddie took advantage of the yield curve to turbocharge their balance sheets and make a ton of money on the spread between long-term rates and short-term rates.


Now that we have a basic framework for assessing secondary mortgage market players, how might a GSE turbocharge its earnings?   



Alien not included. 


By exploiting the combination of (a) Federal implicit guarantee and ‘moral hazard’ — the managers’ ability to maximize use of the GSEs’ implicit Federal guarantee, and (b) Yield curve.  That short-term rates are usually lower than long-term fixed rates.




As I posted in my translation (emphasis added) of former Federal Reserve Chairman Alan Greenspan:  


Fannie Mae (Fannie) and Freddie Mac (Freddie) essentially run two lines of business:


1.       Securitization of mortgage credit,

2.       Holding of mortgage and other assets for investment purposes.


[They can only do the second by borrowing on their own credit. — Ed.] 


The first line of business provides substantial benefits for affordable housing through the process of using credit guarantees to turn mortgages into marketable securities that trade in public debt markets.  This process creates a wide variety of liquidity benefits, some of which flow to homeowners and mortgage originators. 


By matching maturities (colloquially called match-funding), an issuer like Fannie Mae can keep itself out of prepayment risk, and the securities issue can be free-standing, with no open-ended risks to the issuer; such an issue is spoken of as ‘off balance sheet.’   Naturally, securities buyers who know they could have their securities called any time interest rates drop will want a higher premium. 



More, gimme more yield


When the yield curve is positive (as it normally is), lending long and borrowing short manufactures spread.  It also mismatches maturities.  In the conventional environment, where the bond buyers are looking at the issuer’s creditworthiness, mismatching of maturities are penalized in rate; in effect, those who lend short cast a cynical eye over the borrower’s balance sheet, leverage, exposure, and management practices.  

A conventional borrower’s turbocharger has an automatic brake, but the GSEs, with their awfully big advantages including the implicit Federal guarantee, have no brakes at all, as Mr. Greenspan put it succinctly (full text in .pdf):  


Under normal circumstances, GSEs are able to easily maintain and grow their large portfolios of mortgage and non-mortgage assets without the significant market checks or balances faced by other publicly traded financial institutions. 



Some entities need to be scrutinized


A private company trying this trick would be tested for its ability to cover an adverse swing.  Since the GSEs are perceived to be protected by Congress, this doesn’t happen, so the market doesn’t charge the GSEs a premium, and hence the market doesn’t check their balance sheet growth.


These large portfolios, while enriching GSE shareholders, do not meaningfully benefit homeowners and do not facilitate secondary market liquidity. 


The rate spread compression (cheaper loans) occurs at origination and initial securitization.  Buying and selling existing portfolios doesn’t help the consumer.  It does make Fannie Mae a ton of money, and it puts taxpayers at risk:


They do add systemic risk to our financial system, which normal market forces are unable to resolve.



“And risk is bad.”


In 2005 and 2006, Congress realized how risky the GSEs’ balance-sheet turbocharging had been, and how lucky we had been with the systemic risk Mr. Greenspan referenced.  OFHEO put severe balance sheet clamps on the GSEs, and thus took them out of the turbocharging business.  That meant the GSEs had to replace their turbocharged earnings with something else.  Now let’s hear the June, 2007 sentence again:


“They’ve moved away from the management of interest rate risk as their primary method of earning money and are shifting more toward credit risk.”


Credit risk, for those of you unfamiliar with the jargon, is the risk that borrowers will default. 



And that the collateral’s no good


Translation: To replace the yield spread they were making on mismatched maturities, the GSEs have bought higher-yielding loans from less creditworthy borrowers.


Oh, great — just the thing we want them to be doing in the first quarter of 2007!



That’s just great, really great

“But what they can buy in terms of volume is restricted, so they are doing a balancing act of buying and selling.”

Translation: They sold lower-yielding higher-credit stuff and bought higher-yielding lower-credit stuff.

Double great.

Insanely great, in fact

Will the GSEs look more toward AA-rated securities going forward, in a bid to boost profitability?

“In Freddie’s case, in their year-end 2006 financials, they disclosed that 96% of their private label securities were AAA-rated, so they obviously bought some that are not AAA-rated, 4%, and that’s double from a year ago,” said Moody’s Harris.

Ordinarily, restricting an investor from buying other than AAA would mean you were safe.  

For Fannie, it’s a different story. In the annual report that OFHEO submitted to Congress in March, the GSE’s regulator said it was restricting Fannie’s ability to get involved in private label securities to anything other than AAA until certain controls have been put in place, and no timetable was mentioned.

That was when an AAA rating meant something. 

Luxembourg is next to go
And, who knows, maybe Monaco.
Who’s next, who’s next, who’s next?

Now we discover that the rating agencies, whose fee structure put them in a symbiotic relationship with issuers, were giving AAA ratings to lots of synthetic and structured securities, and has downgraded them in huge steps, in vast swathes.  How much of what the GSEs bought with an AAA label is now something else? 

As things age, they can get Rotten 

Officials at both GSEs declined to comment on their portfolio buying strategies.

Meanwhile, Wall Street analysts and investors hope the progress both Fannie and Freddie are making towards a return to timely financial reporting puts them closer to the day OFHEO removes its 30% capital surplus requirement.

But some analysts believe that is likely to happen sooner for Freddie than Fannie, since OFHEO seems to be more concerned about Fannie’s internal controls than Freddie’s. 

As I wrote only two months ago, managed earnings were much more fun: 

Back in the good old days,

“All you gotta do is — act naturally!

Fannie Mae and Freddie Mac aggressively managed their earnings, keeping unrealized gains and losses in reserve so they could turbocharge the balance sheet and deliver earnings that matched estimates with heartwarming accuracy, and maximizing their seven- and eight-figure executive bonuses.

We must be good if we hit it every time

Those days are over.  Between new reporting rules, accounting scandals, and pending strengthened oversight legislation, the two GSEs now have to report fluctuations in their earnings not just from realized gains and losses (that is, mortgages sold or foreclosed), but also unrealized (changes in inherent value resulting from market factors, chiefly payment performance), and the results are not pretty.  As reported last week by CNNMoney.com:

Freddie Mac scrambles for cash

As of January 21, the GSEs haven’t reported their fourth-quarter earnings yet.  

All the world sees in tune on a spring afternoon
When we’re poisoning pigeons in the park!

Who’s next?