GSEs: Too many powers: Part 1, chasing the bus
[Commencing with last week’s How We Got Here post, I expect to put up one weekly installment (sometimes multi-part as circumstances warrant) about the GSEs, every Monday morning for the indefinite future. The GSEs’ situation is without precedent in American or global history, and warrants as much public scrutiny and evaluation as we can collectively bring to it. – Ed.]
Treasury Secretary Hank Paulson: what’s the encore?
After enactment of the landmark legislation that gave Treasury Secretary Hank Paulson the wheelbarrow full of powers he had requested:
Mr. Paulson started telling friends that after winning authority to intervene, he “felt like a dog who’d caught the bus and didn’t know what to do with it.”
Actually, as the New York Times chronology of the GSEs’ slide into conservatorship makes clear, enacting HERA gave Secretary Paulson too many powers – so many, in fact, that the potential for him to use any of them meant he had to use some of them, and much faster than he thought.
Powers and abilities far beyond those of mortal markets?
When HERA was enacted, I thought the capital markets would see it as underpinning the GSEs’ viability and hence allow a return to normality in the GSE securities markets. Although I got this completely wrong, I’m comforted by the fact that Secretary Paulson – an extremely smart man, with decades of experience in one of the world’s best cauldrons of risk-management (Goldman Sachs) – got it wrong too. Both of us were surprised by what transpired and how events forced him into placing the GSEs into conservatorship.
Examining in detail how the slope got so slippery so fast will help us see where we go from here, and what it means for (among others) beleaguered Lehman Brothers.
A Fannie/ Freddie timeline (from the New York Times)
The downfall of Fannie and Freddie stems from a series of miscalculations and deferred decisions, both by their executives and government officials, according to company insiders, regulators, auditors and outside analysts.
To begin with, the GSEs were (and still are) unique. What happened to Fannie/ Freddie could only have happened to these particular GSEs, with their awfully big advantages. Because they carried an implicit Federal guarantee without an explicit cap on their ability to use that guarantee in the marketplace, they were able not only to expand their market share without the normal risk-curve checks and balances imposed by market discipline, but also to turbocharge their balance sheets.
[1] The companies expanded rapidly in recent years, initially playing down the risks posed by a housing bubble.
Many people warned of this, from OFHEO (which blasted Fannie Mae in an unrebutted report) through former Fed chair Alan Greenspan and on down through humble bloggers, but the markets and elected officials were unresponsive.
It’s too much trouble to regulate them
Unresponsiveness was a consequence of smugness. The markets were booming, the companies were making money hand over fist, and the capital markets were chorusing optimism.
[2] Then, as the housing slump expanded nationwide, they resisted raising enough new capital that might have provided a financial cushion to weather the storm.
We will return to this; failure to strengthen cash in a time of credit tightening is a cardinal sin to be laid against the current management.
I believed in strengthening ze balance zheet
[3] Lawmakers, paralyzed by partisan infighting, delayed strengthening regulatory oversight of the politically powerful companies.
Indeed, as recently as late March, I was writing “so much for GSE reform” when the Administration declined to pursue tighter regulatory oversight even as it opened the spigots for greater GSE loan buying:
Roughly ten days ago, the Administration officially flew the white flag in attempting any further regulation of the GSEs.
Federal regulators, in an effort to contain financial turmoil, are handing government-sponsored companies an even bigger role in propping up the mortgage market.
Officials affirmed yesterday that government-sponsored mortgage investors Fannie Mae and Freddie Mac will enjoy loosened capital requirements, allowing them to pile more mortgage securities onto their balance sheets.
Two years ago in the ongoing Fannie Mae story, when the blistering OFHEO report came out, I posted at length about the multi-billion-dollar risks to taxpayers of GSEs turbocharging their balance sheets.
Fannie and Freddie could purchase an additional $200 billion of mortgage securities, equivalent to about 10% of expected
I believe, as do many others, that this was an explicit quid pro quo negotiated by Secretary Paulson, with the GSEs being given the latitude to make a lot more money by boosting their balance sheets, but at the price of raising more equity capital.
As the Times tells it:
On March 19, James B. Lockhart, their chief regulator, dismissed swirling rumors about their financial health. “The actions we’re taking today,” Mr. Lockhart declared, referring to a decision to ease restrictions on how much capital they were required to hold, “make the idea of a bailout nonsense in my mind. The companies are safe and sound, and they will continue to be safe and sound.”
Cross my heart and hope to die/
I think they’re sound and you should buy
I’ve met Mr. Lockhart a few times; as OFHEO head, for several years he’s been the lonely and politically unsupported (either by the Administration or by Congress) voice of tighter GSE regulation. I don’t blame him his March judgment; I thought the same thing.
Increased GSE regulation is now politically dead.
Regulatory legislation is dead, and the GSEs are grateful
“It is a complete defeat for the anti-GSE ideologues” in the Bush administration, said Kenneth Posner, an analyst at Morgan Stanley, using an acronym for government-sponsored enterprises.
Accounting scandals that erupted in 2003 and 2004 put Freddie and Fannie on the defensive.
Nobody who gives away $200 billion of new borrowing authority in a political heartbeat without getting pending legislation enacted has any credibility about trying to push it later.
[Snip]
The GSEs are enormous, and have an enormous impact on the American housing market, and the American political market. As I posted long ago:
$2.1 trillion is the Gross Domestic Product of France. As I discussed in my extended series on Fannie Mae, that much leverage has enormous volatility and systemic risk for taxpayers, the more so when Fannie Mae’s accounting and financial control (previously used to give the illusion of smoothness) remain unproven, leaving taxpayers at grave risk.
That opportunity [for bipartisan reform legislation in 2006] is now gone for good.
Investors welcomed the shrinking gap and news of a greater role for Fannie and Freddie. Fannie’s shares rose 8.8% yesterday to $30.71, while Freddie shares were up nearly 15% to $29.90.
Will that do the trick?
It’s understandable that the GSEs, having now been freed from their capital incarceration, are incapable of stifling their triumphalism:
“Do a little examination and ask yourself, ‘What do you think the housing market in the
And their lust to expand:
However, the companies also see an opportunity for profit, should the crisis pass and the securities now trading at distressed prices rise in value. “It’s kind of a shopper’s paradise right now,” said Daniel Mudd, Fannie’s chief executive officer.
Their potential regulators are glumly pragmatic:
While Treasury Secretary Henry Paulson supported yesterday’s move, he said he remains frustrated that lawmakers haven’t bolstered oversight of Fannie and Freddie.
“We almost had ‘em, but then they got away.”
In March, things looked good for the GSEs, except for one fly in the ointment. You see the sentence in blue boldface above? The GSEs promised to raise capital. Fannie Mae fulfilled its promise. Freddie Mac did not.
I know I promised to raise money, but I didn’t
But within about a month, Mr. Paulson was becoming concerned about the companies. In April, he met with their chief executives and top members of the Senate Banking Committee in a closed-door session.
I deduce that Secretary Paulson had stumbled upon the rhinoceros in the GSEs’ room: their purchases of riskier assets to sustain their earnings.
Over the previous years, as the housing bubble inflated, Fannie and Freddie stepped up their purchases of the risky but profitable subprime and alt-A loans that were at the root of the mortgage crisis.
This move is the second action by Fannie/ Freddie’s new management that many will question. As readers know, this worried AHI.
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.
Evidently what Secretary Paulson found, upon examining the GSEs’ books, worried him.
Though Congress had just pushed Freddie and Fannie to accelerate purchases of loans to give the housing market a boost, Mr. Paulson was now urging lawmakers to establish stronger oversight and push the companies to raise more capital.
The actions one might take if one feared future writedowns.
I fear writedowns behind the door
In the months after, Fannie Mae managed to raise $7 billion in new capital to offset losses, fulfilling a promise made to regulators. Freddie Mac, however, failed to make good on its pledge to raise $5.5 billion. Still, though the companies’ stock prices continued drifting downward, they continued to borrow money without problem, which is crucial to their ability to buy mortgages.
“Rule Number 1: break your promises”
Most observers have long regarded Freddie Mac as Fannie Mae’s little brother – it’s smaller in balance sheet and market share terms.
One of us is the big brother here
When Freddie failed to close its capital offering, I assumed (probably wrongly, as it turned out) that (x) the company had concluded the cost was too high, and (y) Treasury/ Fed had acquiesced, based on a review of Freddie’s balance sheet.
What made you think that?
Mr. Paulson did not fully recognize the extent of Fannie’s and Freddie’s financial problems until recent months. In July, seeking to avoid a government takeover, he asked Congress for the power to bail out Fannie and Freddie — hoping that gaining such authority would calm markets and make a rescue unnecessary.
But he quickly learned that getting those powers made their execution inevitable.
“I want you to pump in – one hundred billion trillion dollars!“
[Continued tomorrow in Part 2.]