GSE conservatorship: what it means, and how we got here

September 8, 2008 | Capital markets, Ecosystem, Global news, GSEs, HERA, Subprime, US News

Hindsight always makes things clear.



Why didn’t I see that before?


With the GSEs having been placed in conservatorship – a state akin to a bank seizure to protect the depositors – a few things are clear:



Given that Treasury decided it had to do this, it’s almost certainly the right thing for the broader housing economy – Fannie/ Freddie must remain liquid, and their paper must circulate freely and with capital-markets confidence.



Once confidence drains away, something has to be done to get it back


[I’ll have more on the GSEs once I’ve figured out what I think – which could be awhile!]


Instructive too is how we got here:


August 8, 2008: GSEs report higher-than-expected writedowns, calling their capital base into question



Not happy with the second quarter: Dan Mudd, now ex-CEO of Fannie Mae


Gaping losses at Fannie Mae and Freddie Mac are causing the two mortgage giants to slow their purchases of home loans at a time when the government is counting on them to help prop up the housing market.


The reductions and associated measures that the companies are taking are likely to drive up home mortgage rates, which are near their highest levels in a year.


Concern over the companies’ financial health was heightened on Friday when Fannie Mae reported a second-quarter loss of $2.3 billion. The deficit was three times what analysts had forecast and was the company’s fourth consecutive quarter in the red.


This week, Freddie Mac reported a $821 million loss for the quarter. Although Fannie Mae’s revenue was up slightly — to $4 billion, an increase of $200 million from the previous quarter — its expenses related to foreclosures and other credit losses soared to $5.3 billion, up from $3.2 billion in the previous three months.



July 28: Congress gives Treasury broad powers to recapitalize GSEs


From the blog:


In the four years I’ve been posting about the GSEs, the story reached its climax on Saturday.  Catastrophe being a precondition of fundamental financial reform, for nearly two decades, the Federal commitment to the Government Sponsored Enterprises (GSEs) was like the love children of Charles II – everywhere visible and never politically acknowledged. 



What Federal guarantee?


The Federal government got away with this doublethink because for most of that era, the GSEs’ financial strength seemed impregnable; their smoothly-managed earnings rose from strength to strength, so whether and how Uncle Sugar would bail them out could remain a mystery.


Two weeks ago, the stock market wolf pack took a run at the GSEs, driving their share prices down to absurd levels.  Perhaps they were motivated by two AHI blog posts that seem, in the words of Mickey Kaus, eerily prescient:


Huh? Does Krugman not know that Fannie Mae was a huge buyer of subprime mortgages, including mortgages from Angelo Mozilo’s Countrywide? David Smith’s eerily prescient AHI blog noted that Fannie Mae and Freddie Mac reportedly bought $35 billion in subprimes in the first quarter of 2007 alone.


The GSEs’ financial position became a crisis in July or the reason I highlighted in this June post, Capital, almost as good as money:


Time will tell what this costs the taxpayers:


There is a better-than-even chance that the emergency measures will not be needed, meaning there will be no cost to taxpayers. If the lifeline is required, the Congressional Budget Office said, there is a 5 percent chance that the companies may need $100 billion but more likely would need $25 billion.


July 21: Sovereign debt buyers (governments) express worries about GSE paper.


From the New York Times:


“No less than the international perception of the credit quality of the U.S. government is at stake,” said Richard Hofmann, an analyst with CreditSights, an independent research house with offices in London and New York.


Also at stake is Americans’ future ability to gain access to credit. If foreign companies and governments abandon United States investments, home, auto and credit card loans will be much more difficult to come by.


That helps explain why Treasury Secretary Henry M. Paulson Jr. is pressing American lawmakers for the authority to inject unspecified billions in cash into either company or both. The “blank check” nature of his request has raised concerns on Capitol Hill, but Mr. Paulson is betting that Congress is even more fearful of the consequences of doing nothing to rescue Fannie and Freddie.



What is to be done?


Most likely because they were worried about the character of the GSEs’ capital.  As I wrote in June:


For financial institutions, capital is just as good as money, even if it’s not cash – and this matters enormously, because banks are judged sound based on their capital, whereas (like Bear Stearns) they can suddenly go bust when they run out of cash.  Since we care about cash, we need to be alert for capital that isn’t cash, as revealed by a Wall Street Journal article – that, while repeatedly crossing from reporting into editorializing, performs a service with a healthily skeptical focus on the government-sponsored enterprises, Fannie Mae and Freddie Mac:


Fannie Mae and Freddie Mac may soon come under the thumb of a new, beefed-up regulator following a compromise reached last week between the White House and Congress on new housing legislation. Like any new sheriff, this one will want to clean up the town.



Time for some new capital requirements


That means putting Fannie and Freddie on firmer financial footing so they can be strong enough to act when the housing market needs them. The current regulator, James Lockhart, says they are far from that now. In a recent speech, he said that Fannie and Freddie “have continued to be a point of vulnerability for the financial system because they are so highly leveraged relative to their risks.”


Right now, with the huge increases in volume they are experiencing, Fannie Mae and Freddie Mac are almost certainly generating much larger profits from their origination activities.  These may well generate a substantial cushion, but as we’ve seen before, they could be facing large writedowns on the existing book of business, especially the 2007 vintage.


Just like banks, Fannie and Freddie are judged by their regulatory capital. But regulatory capital at Fannie and Freddie is a mirage thanks in part to the inclusion of deferred tax assets.  These are essentially losses that can one day be used to offset future tax bills.


To be precise, if a company has tax losses, it doesn’t get a rebate from the Treasury (unless it ‘carries them back by amending the tax return from a previous year), so they can be carried forward and used against future taxable income.  The deferred tax asset represents the estimated savings (losses times projected effective rate, plus unused credits like LIHTCs) – and they go on the balance sheet as a capital, implicitly ‘just as good as cash.’


These assets won’t be much use if Fannie and Freddie need to come up with quick cash.


Some (like LIHTCs) could be sold, although right now the LIHTC market is in a ground-hold.



Not many new syndicates taking off


Banks, for example, only get to count a portion of these assets toward their regulatory capital.


Just another one of the GSEs’ Federally chartered awfully big advantages.



January, 2008: GSEs portfolios come under scrutiny


In Who’s next, I asked:


We’ve barely had two weeks so far in 2008, and already we’ve had mega-writedowns from big Wall Street banks (Citi, Merrill, and Bank of America), a monoline insurer (AMBAC) lose its prized AAA rating, raise new capital and implicitly announce that it was on a voluntary glide path to orderly dissolution.  I thus find myself thinking of Tom Lehrer’s 1964 ditty, Who’s Next?



First we got the bomb and that was good

‘Cause we love peace and — motherhood

Then Russia got the bomb, but that’s okay

‘Cause the balance of power’s maintained that way


Who’s next?


Who, in fact, is next?


Last summer, Inside Mortgage Finance, a relatively obscure publication, read only by the cognoscenti —



“The study of affordable housing finance is infinite, Watson.”


– published a little story entitled, Inside the GSE’s


Inside the GSEs                               

June 20, 2007


GSE Nonprime MBS Up Among Top Issuers


Does this say that, during the summer of 2007 — a period, we now know, when some of the worst new issues were going on the street — the GSEs were busily buying?


In the wake of the much-publicized pledges by Fannie Mae and Freddie Mac to help out subprime borrowers, a review of the latest data provides a somewhat conflicted story. 


The two GSEs have increased their purchases of subprime and Alt A mortgage-backed securities from the top 20 issuers by 13.4% during the first quarter, while purchases from all issuers dropped 3.4%.


Does this say that the GSEs were buying heavily in the first quarter of 2007?


Compared to the first quarter of 2006, GSE purchases from the top 20 issuers are off 10.5% and off 19.2% from all issuers.


Does this say that the issues were already being marked down in summer, 2007, seven months ago?


Alt A and subprime MBS issuance among the top 20 issuers for the first quarter of 2007 came to roughly $137.86 billion, according to the latest data from the Inside Mortgage Finance MBS Database, down 5.1% from the fourth quarter of 2006. Of that total, the GSE portion came to $34.95 billion, or 25.3%.


This fairly clearly says that the GSE’s bought $35 billion of new subprime MBS issues in the first quarter of 2007.


Back last spring, lots of people — myself among them — though that what we had was a gradual re-pricing, nor the severe credit crunch we’re now facing.  Chances are these purchases are ones Fannie and Freddie now wish they could unwind.


Then Indonesia claimed that they

Were gonna get one any day.

Who’s next?




June, 2006: Fannie Mae: the implied story


Two years ago, OFHEO issues a blistering report, to which I devoted seven long posts:


Part 1 Summary and introduction

Part 2 Maximizing executive bonuses

Part 3 Gaming the bonus formula

Part 4 Turbocharging the balance sheet

Part 5 Smoothing earnings with financial tricks

Part 6 Suppressing criticism

Part 7 What now?  Why should taxpayers care?


Here’s the introduction:


There are five main themes, all of which link together.



Five points in a pentagram too …


1. Maximizing executive bonuses. Fannie Mae’s senior management sought to maximize their personal bonuses through a deliberate strategy that permeated all aspects of the company’s operations.


This chapter reviews the emergence of Fannie Mae’s corporate culture, improper earnings management under Franklin Raines, the business strategy senior management developed to meet earnings targets, how senior executives defended Fannie Mae’s image, and the inappropriate “tone at the top” set by the Board of Directors and the highest level of senior management. Page 34.


2. Gaming the bonus formula. Management selected a bonus metric, Earnings Per Share, that could be gamed (manipulated for favorable effect) and was gamed.


Under the Fannie Mae executive compensation program, senior management reaped financial rewards when the Enterprise met earnings per share (EPS) growth targets established, measured, and set by senior management itself. Page 55.


While companies typically link the compensation of their executives to firm performance, relying heavily on one accounting-based measure such as earnings per share is problematic. Academic literature and practical experience suggests that when such a linkage exists executives can and do act aggressively to maximize their compensation by making accounting adjustments. Page 5.



Just a little tinkering with the formula, nothing to worry about.


3. Turbocharging the balance sheet. Earnings were boosted by a strategy of expanding the balance sheet through three means: (a) penetrating business areas already being well served for affordable housing, (b) trimming affordability benefits (subsidy passthrough) to customers, and (c) turbocharging the balance sheet by lending long and borrowing short, taking advantage of a favorable yield curve.


[Actually, OFHEO’s report deals mainly with the balance sheet turbocharging; movement into already-served markets and erosion of affordability benefits are possibilities outside OFHEO’s scope but consistently leveled by other Fannie Mae critics. Nevertheless, while those claims are not the focus of these posts, to overlook them entirely would be an oversight.]


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

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.



See, the needle’s not moving. No danger here of running it into the red!


4. Buffing the image by smoothing earnings in covert ways. To downplay balance sheet turbocharging, management smoothed out earnings using a variety of winkles, gimmicks, and tricks, all with the goal of giving the image of a flawlessly performing engine comfortably under control.


Fannie senior managemt


5. Squelching criticism. Management maintained a multiple-front campaign to conceal, cow, coerce, contain, or undercut analysts, critics, and regulators that might otherwise spotlight the earnings smoothing and balance sheet turbocharging.


The illusory nature of Fannie Mae’s public image and senior management’s efforts at concealment were the two essential features of the Enterprise’s corporate culture. Those features, which were both supported by repeated improper manipulation of earnings, are a major theme of this report. Page 34. 


September 8, 2008: GSEs placed in conservatorship


All of which explains this morning’s headline:


Two major Chinese banks that own US$8 billion in Fannie Mae and Freddie Mac securities welcomed Washington‘s bailout of the troubled mortgage lenders but declined to say Monday whether they expect to lose money.


“We think it is a good thing for the two companies,” said Wang Zhaowen, a spokesman for Bank of China Ltd. A spokesman for Industrial & Commercial Bank of China Ltd., Xie Taifeng, said, “It showed the positive attitude of the U.S. government. We welcome it.”


Chinese banks have largely avoided the impact of the credit crisis that has hammered U.S. and European lenders. They have set aside reserves for possible losses on subprime mortgage debt, but even the biggest owner, Bank of China, says such securities make up just 1.5 percent of its total holdings.


Bank of China, the country’s No. 3 commercial lender by assets, said in late August it owned US$7.5 billion in Fannie and Freddie bonds after cutting its holdings by about 25 percent. The bank also held US$5.2 billion in mortgage-backed securities guaranteed by the two agencies. Wang declined to give more recent figures.


The U.S. government took control Sunday of Fannie and Freddie, which own or guarantee about half of American mortgage debt.


“We think this is good for Fannie and Freddie because the U.S. government used to be invisibly guaranteeing them but now it is taking explicit action to positively guarantee them,” Wang said. He said Bank of China would decide what steps to take next based on what happens in the market.



In a global world, we need Mao’s images to keep Ben’s images smiling