The GSEs’ future: Part 2, you might as well live
[Continued from yesterday's Part 1.]
Yesterday we saw from outgoing Treasury Secretary Hank Paulson’s Remarks on the Role of GSEs in Supporting the Housing Recovery, that no matter how much he worries about their existence, he has (correctly, I think) concluded the GSEs play an essential role in creating omnipresent secondary-market liquidity, and in allowing targeted rate cuts to particular asset holders – namely, owners of homes.
Policymakers must decide if the GSE subsidy is a public policy priority.
Although the Secretary is properly cautious, it’s clear, I think, that he grudgingly accepts their value.
“We need the eggs”
If the GSEs are to play a role, then, the debate is clearly framed:
Which side do you come down on?
Government support needs to be either explicit or non-existent –
Yes. We’ve learned, to our sorrow, that the peekaboo Federal guarantee – now you see it, now you don’t – combined the worst of both worlds: massive agency risk (management could just pump up the volume of balance sheet) with minimal Federal supervision.
– and structured to resolve the conflict between public and private purposes.
Any middle ground is a recipe for another crisis.
Please, lord, not another crisis
Although there are strong differences of opinion over the government’s role in supporting housing, under any course policymakers choose, there are structures and choices that can resolve the long-term conflict of purposes issues.
Sounds like a man reconciled to the GSEs’ continued existence in some form:
And it is clear that to protect against systemic risk in the future, the GSEs should be constituted with a portfolio no larger than what is minimally necessary for warehousing purposes.
Here is Secretary Paulson’s core, critical message – leash them lest they overrun you.
This won’t hurt a bit
Why? As I wrote back in June, 2006 when the OFHEO report came out:
Starting in the late 1980’s, GSE securitization of mortgage loans created systemic liquidity never before seen in the world. It fueled an expansion of credit, and a compression of interest rate spreads, that coincided with a long-wave rise in national homeownership rates.
[Snip]
In fact, in one sense it was too successful — the entities ran out of worlds to conquer. Their market share was so large, they so dominated their main market, that Fannie Mae needed to do something else.
In fact, three something elses:
Fannie Mae management believed that, to double EPS by 2003, the
We need to go through these slowly, because each one is very important.
1. First, in the credit guarantee business Fannie Mae would have to securitize a greater share of the single-family mortgage market, in part by (a) penetrating the subprime market …
Subprime lending — that is, financing those who fall below conventional credit standards — is a hotly contentious area. Some see it as bringing needed capital to those redlined by prejudice. Others see it as exploiting the financially undereducated. It’s too big to address here. [June, 2006 – Ed.]
Addressing the subprime fallout was too big to swing at then
The next one’s easier:
2. Second, in the portfolio investment business, management would have to increase rapidly the size of Fannie Mae’s retained mortgage portfolio, while avoiding significant compression of the portfolio’s net interest margin — the spread between the average interest rate earned on assets and the average rate paid on liabilities. The portfolio investment business had generated the majority of the
If I am interpreting correctly OFHEO’s statement [and we now know they did – Ed.], more than half of what the Fannie Mae made in this interval, they made by turbocharging the balance sheet, the thing that GSEs should not do. That is extraordinary.
3. Third, senior management believed that it would have to achieve steady, rather than irregular, EPS growth.
Now we know those smooth earnings were a manufactured illusion.
Everything was on the up and up at headquarters
Secretary Paulson is in no doubt that even a tightly constricted GSE would serve its essential function:
Without portfolios of significant size, the enterprises’ management of interest rate risk would remain a vital function for the safety and soundness of the enterprises, but would no longer present the same potential systemic risk.
This is essentially the same point made by Fed Chairman Alan Greenspan (that is, before conventional wisdom decided this whole mess was his fault):
That was Fannie and Freddie’s original purpose, because it’s essential for a healthy housing finance ecosystem:
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.
“A rising tide makes the pie higher.”
Making loans more liquid frees up originators to go back to work, and the competition also lowers the rate spread (between safe rate and what the borrower pays), so customers get cheaper money. (”When lenders compete, you win.”)
Moreover, creating securities from the mortgages extended to nontraditional homeowners is an important step to making mortgage credit more widely available.
Newly liberated originators go find new borrowers, and move gradually down the bankability pyramid. That’s good for everybody:
Focusing Fannie and Freddie on this type of securitization activity can promote affordable housing without creating significant risks to the [nation’s] financial system [and by extension, the taxpayers].
The financial system is not at risk because the securities are issued only when the loan pools are sold, so there is a perfect match in asset maturity (when the loans come due, so do the bonds). Private parties are taking the risk, not the Federal government.
Thus the GSEs, even in the minds of libertarian-oriented marketers like Greenspan and Paulson, serve the essential role of providing continuous permanently-available secondary-market liquidity. We need the eggs …
Two elderly women are at a Catskill mountain resort, and one of ‘em says, “Boy, the food at this place is really terrible.”
The other one says, “Yeah, I know; and such small portions.”
Even as we need the GSEs, the Secretary would really like to create alternatives to them:
If we are to maintain a private-sector secondary mortgage market – which I believe serves the taxpayer and the homebuyer equally well – then we must enhance the ability of depository institutions to fund mortgages, either as competitors to a newly-established government structure or as a substitute for government funding.
As I previously posted in the Adventure of the Money Store, deposit-taking is for a bank the lowest-cost source of capital yet it exposes banks to maturity-risk mismatches. Depositors can pull their money out at any time – such as panic – in which case the bank would have a liquidity crisis. The deposit-taking system thus relies on the Federal deposit insurance, making the government the liquidity source of last resort (as with big banks under TARP). The Secretary doesn’t like having to make the Hobson’s choice between the TARP risk or deposit-insurance risk, so he’s wishing for powers to push deposit-taking institutions more into the capital markets. Yet still, in part because of what I’ve labeled Jefferson’s Curse (to match John Steele Gordon’s Hamilton’s Blessing), we in the United States have over 10,000 banks, a commendable locality in banking service that nevertheless has a very large cost: inefficient anti-scaling in complex capital finance.
Securitization was supposed to solve that.
Didn’t work so well
Every new technology experiences a honeymoon interval where it is seen a panacea – creating new benefits with no risks. The longer it takes for the risks to appear, the worse they seem to be when they show up, perhaps because they encouraged such risky behavior. Securitization will return, probably with boring old high-hard-equity requirements.
One way to do this is for the government to receive some compensation for its guarantee. The current GSE Preferred Stock Purchase Agreements take a small step in this direction, in that as of 2010 the GSEs must pay the government a fee for the taxpayer backstop on their guarantees.
This is promising, but there’s an inherent tension:
Of course, if this rate perfectly reflected the risk versus the cost of the guarantee, there would be no subsidy to mortgage availability.
I perfectly balance the dynamic tension
As I posted over four years ago, in Fannie Mae’s awfully big advantages, the GSEs’ existence is predicated on the expectation that they are a more efficient deliverer of government advantages, and hence more efficiently convert government resources into ongoing affordability. This is challenging:
I don’t
It is obviously inherently difficult to reach an exactly correct price, yet a long-term fee-like structure in exchange for explicit government backing would help to reduce advantages over private institutions.
Once that decision is made, the GSEs should be restructured to meet that public policy choice and satisfy three objectives:
How many objectives?
[1] There must be no ambiguity as to government backing. It must be explicit or non-existent.
“Guarantee or guarantee not. There is no try.”
[2] There must be a clear means of managing the conflict between public support and private profit.
Conflict means tension. Sometimes it can be balanced.
But sometimes it can’t …
[3] There must be strong regulatory oversight of the resulting institutions.
Those are entirely sound precepts.
Ah, but how to do it?
Sorry, out of time today, answer tomorrow.
[Continued tomorrow in Part 3.]
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