Affordable Housing Institute : US

“I would, but I need the loans”

 

Guy goes to a psychiatrist and says, “Doc, uh, my brother’s crazy; he thinks he’s a chicken.”

And the doctor says, “Well, why don’t you turn him in?”

“I would, but I need the eggs.”

Woody Allen, Annie Hall

 

That, in a nutshell, represents the views of outgoing Treasury Secretary Hank Paulson, as presented in an important testamentary bequest he has written, romantically entitled by Treasury, Paulson Remarks on the Role of GSEs in Supporting the Housing Recovery:

 

Who you calling ‘romantic’?

 

After a cogent recapitulation of how we got here, unnecessary for faithful readers of this blog, the Secretary dives into the GSE conundrum:

 

Today, Fannie Mae and Freddie Mac are in a temporary form that, while stable, cannot efficiently serve their Congressionally-chartered mission and protect the taxpayers’ investment over the long-term.  

 

About to become a butterfly or an alien?

 

The GSEs are critical to getting us through this current period, and this is our first priority. More may need to be done to clarify and simplify their structure and to increase their effectiveness in curbing further housing price correction. But we cannot look only at this short-term need; policymakers must resolve the question of long-term structure because the pre-conservatorship model has been disproven.

 

As we’ve previously explored, in their pre-conservatorship phase (what ordinary folk might call ‘life’), the GSEs were able to turbocharge their balance sheets, surf the risk curve, generate massive profits, and squelch criticism.

 

Over time, the GSEs’ advantages enabled them to grow at a phenomenal pace, so that today they have $5.4 trillion in obligations outstanding, held by investors in the U.S. and around the world.

 

Just for reference, that’s:

 

            $5,

     400,

                        000,

                               000,

                                     000.

 

Feed my balance sheet!  Feed me!

 

As a comparison, that is almost 40% the size of the entire $14 trillion U.S. economy. The systemic risk posed by such size was heightened by the fact that investors assumed that GSE securities were backed by the U.S. government and therefore virtually risk-free, despite repeated statements by consecutive U.S. administrations to the contrary. These debt-holders would be the largest, but not the only, conduits of systemic impact should either GSE fail.

 

Massive systemic impact?  Pig pile!

 

Derivative counterparties, for example, would also be overwhelmed by a default of either GSE.

 

As we’ve seen, the uncontrolled growth of unlicensed insurance – credit default swaps – posed a unique new systemic risk to the global financial system.

 

With that as background, you’d expect Secretary Paulson to use his conservatorship powers to shut down the GSEs. 

 

Why should I do what you expect?

 

As we progressed through the current housing market downturn, investors fled mortgages that carried any credit risk. But because the GSEs take the credit risk on the mortgages they guarantee and because investors believed there was implicit government backing, the conforming loan market continued to function relatively well.

 

But we needed the eggs …

 

As a result, the GSE share of new mortgage business rose from 46% in the second quarter of 2007 to 84% in the second quarter of 2008.

 

Within that innocent small statistic lies a powerful and perhaps painful admission for the Treasury Secretary to make:

 

“I’d have shut down the GSEs, but I needed the liquidity.”

 

In 2008, we desperately needed the GSEs. 

 

Without the GSEs to finance mortgages, it was very clear that mortgage finance would essentially dry up.

 

That is, the US housing finance system would have seized up, with incalculable consequences for the world economy.

 

This is what happens when your engine seizes up

 

So, in the manner of the Breaker Morant court martial, which let the Australians out of prison to help beat off a Boer attack, only to convict them later for having killed other Boers, Secretary Paulson green-lit a massive expansion in GSE lending even while wanting their balance sheets to shrink.

[After helping repel a Boer attack on the prison where he and Morant are being held]

Well, that broke the monotony.

 

Leaving the GSEs, who are now providing backstop liquidity on five out of every six new mortgages, each of them directly backed by Treasury, actively growing the marketplace even as their ultimate fate is unresolved.

 

Secretary Paulson thus tries, in the face of this contradictory behavior, to assert a consensus:

 

The public debate over the long-term structure of the GSEs is dramatically changed today – no one any longer doubts the systemic risk these entities posed.

 

That’s right, I think – but such consensus is rapidly forgotten in the hurly-burly of Washington politics and budget expediency.  Fortunately – or is it? – during the conservatorship the GSEs are statutorily prohibited from any form of lobbying.

 

It is clear to all conservatorship is a temporary form, and that returning the GSEs to their pre-conservatorship form is not an option.

 

All right, even accepting this, should the GSEs, now on trial for reckless financial endangerment, be hanged, sentenced, pardoned, or commended?

 

How can you condemn me, Your Honor, when I’m so winsome?

 

Lower mortgage rates enable more potential homebuyers to return to the market and help put a floor under home prices.

 

A reason to keep the GSEs.

 

Initially, following our September actions, mortgage rates did fall.

 

This was after the conservatorship, remember.  Meaning that the Treasury guarantee initially calmed the debt markets.

 

Market turmoil subsequently increased and mortgage rates rose, but not nearly as much as the cost of other forms of credit. Still, neither the taxpayers nor the economy were getting the full benefit of the agreements put in place to effectively guarantee GSE debt.

 

Translation: The markets were so spooked they couldn’t see the nose on their face.

 

Who has time to think?

 

We could have gone back to Congress to ask for authority to directly guarantee GSE debt, however this would have been difficult to achieve.

 

The Secretary declines to state the more likely reasons: (a) such a step would probably have been politically irreversible, in effect mooting the deliberations by granting financial amnesty, and (b) the Secretary already had too many powers, and the markets feared he would exercise them – which in turn made their exercise inevitable.

 

We immediately noted that, given the effective government guarantee and the spread between Treasury rates and those of the GSEs, the taxpayers would profit if the government simply issued Treasuries to buy GSE securities.

 

Those of us who saw this as it happened were – and are still – astonished. 

 

“The market can stay irrational longer than you can stay solvent.“

– John Maynard Keynes

 

Imagine you can buy either of two IOU’s.  One is signed by your friend’s father.  The other is signed by your friend, and co-signed by her father.

 

Whose IOU is better?

 

Your friend’s IOU pays 6.5% interest; her father’s pays 5.0%.  You have 150 basis points of favorable risk-curve spread for taking the same risk. 

 

You buy the 6.5%, don’t you?  The markets didn’t; in fact, there was an avalanche away from GSE securities to Treasuries.

 

This baffled me then.  It baffles me now.

 

Run away!  Run away!

 

On November 25, the Federal Reserve announced a new program to purchase up to $100 billion in GSE debt securities and $500 billion in GSE MBS. This Federal Reserve program had a significant impact. The 30-year fixed rate has fallen from an average of 6.04% the week before the policy was announced to a record low 5.10% last week –

 

Ah – rate relief

 

–  accomplishing a vitally important step in addressing this housing correction – lower mortgage rates that may bring additional credit-worthy buyers into the housing market.

 

And keep other people from defaulting:

 

[Continued tomorrow in Part 2.]

 

 

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