After two long posts focusing on outgoing Treasury Secretary Hank Paulson’s Remarks on the Role of GSEs in Supporting the Housing Recovery, we’ve seen that the Secretary:

1. Has concluded, with audible reluctance, that privately-run GSEs are likely essential.

2. Correctly restates the inescapable dynamic tension between social and economic goals.

Tell me something I don’t already know

He offers a menu of four possible futures:

The future’s up in the air

Depending on the degree of subsidy policymakers choose, there are a variety of options for structures to replace the GSEs, including:

(1) Expanded FHA/ Ginnie Mae. Some advocate that beyond the current credit crisis the U.S. government’s long-term policy should make the implicit, explicit. Explicitly guaranteeing Fannie and Freddie’s obligations would essentially nationalize this significant portion of the U.S. housing finance market.  Under this model, the GSEs could become a government entity, or their functions could be absorbed by FHA/Ginnie Mae.

Along with RHS, the oldest Federal housing agency, established 1934

FHA is an arm of the Federal government; Ginnie Mae is a private corporation wholly-owned by the Federal government.

Once upon a time, the peer of Fannie Mae

In either case, the GSEs would no longer have private shareholders. The size of the eligible population of homebuyers would determine how large a share of mortgage credit exposure the government would own.

I view the permanent nationalization of the GSEs, essentially expanding the role of FHA and Ginnie Mae, as a less-than optimal model.  

Me too.

The blogger agrees with me?

While it offers the perceived advantage of explicit government support, it eliminates the necessary private sector evaluations of credit risk and the private market stimulus to innovation.

That’s the big defect of a purely governmental model.  FHA’s last innovative product was over a decade ago, and its ability to grow its business is constantly at the whim of Congress, which doles out credit subsidy.  A banker shouldn’t be politically controlled, and a banker should have financial incentive to innovate.

Next victim!

(2) Partial Guarantee. A hybrid of this would be to create a Ginnie Mae-like entity for non-FHA mortgages, structured as a partial guarantee mechanism. The new entity could operate on a similar basis as Ginnie Mae, but provide only partial guarantees for MBS.  Investors would then have a floor under potential MBS losses, but would still evaluate the credit risk associated with individual issuers.

In effect, this model would make the GSEs into a last-loss insurer, taking risk greater than some negotiated levels.

That be us

The devil, of course, is in the details; if you’re taking some of the losses, then you have to negotiate how much loss you take in each issue or asset class.  Pre-conservatorship Fannie Mae solved this problem very effectively with its massively successful and clever Delegated Underwriting and Servicing (DUS, rhymes with ‘muss’) program – a program, we should note, whereby Fannie Mae acquired and resold huge volumes of loan pools, without experiencing the systemic risk or balance-sheet turbocharging that got the GSEs, Fannie in particular, in their current impasse.

While such a hybrid program would clearly define the extent of the government’s guarantee, developing risk sharing parameters compatible with profit incentives would be as problematic, and potentially as inefficient, as in the current GSE structure.

The Secretary’s arguing that if the GSEs are going to have to balance the tensions between risk/ profit and subsidy/ affordability, they might as well own all of it, not just some of it, and they might as well be in the program space themselves, rather than adding a layer of principal-agent risk in working with and through independent mortgage originators, who sometimes go bad and make bad loans.

I don’t care what a blogger says, I still don’t like it

(3) Privatization. A third alternative would be to remove all direct or indirect government support, completely privatizing these companies while breaking them up to minimize systemic risk.

What we might call the AEI solution, because solons like Alex Pollack have long advocated this, and claimed it can be done at the stroke of a pen.  It could, if we had an autocracy, but in a democracy, the government OODA loop of creating legislation is so slow the forces of incumbency would likely rally.

Curiously, with the conservatorship, we theoretically could completely privatize the GSEs – but we need the eggs:

As appealing as this alternative sounds, it is difficult to envision a sound, practical, private sector mortgage insurance business of any significant size that does not require large amounts of capital, and consequently generates only a modest return on capital.

“If it were privatized, it would need tons of capital that it hasn’t got.”

The recent problems encountered by monoline insurers, which ventured into guaranteeing mortgage product, as well as the experience of the GSEs, underscores this point.

Good point.

Moreover, a break up scenario does not look particularly promising, as reverse economies of scale would take hold.

Having built it, don’t unbuild it.

It is also worth noting that a regional mortgage insurer would lack diversity as a risk mitigant.

Right.  Capital is national if not global.

Perhaps a consortium of banks would find it advantageous to own a national mortgage insurer to wrap their product, or some other good private sector business model may emerge.

Perhaps they wouldn’t.

Anybody out there want to own a national mortgage insurer?  No?

But I am skeptical that the “break it up and privatize it” option will prove to be a robust or even viable model of any substantial scale, without some sort of government support or protection.

And I’m not the only skeptic

However, should policymakers choose to scale back public policy bias toward homeownership, we will eventually find out what business model the free market would support.

Elsewhere in this speech the Secretary makes a long philosophic discursion into the economically rational but politically incendiary territory of suggesting we should get rid of the mortgage interest deduction – but that third rail of politics is best left for another post or posts.

Wanna not get re-elected?  Touch the mortgage interest deduction

Finally, in the manner of good salesmen everywhere, the Secretary finishes with the option he favors:

(4) Housing Utility. Finally, given traditional U.S. public policy support for marshalling private capital to expand homeownership, establishing a public utility-like mortgage credit guarantor could be the best way to resolve the inherent conflict between public purpose and private gain.

Turning on and off the spigot of liquidity?

Under a utility model, Congress would replace Fannie Mae and Freddie Mac with one or two private sector entities. The entities would purchase and securitize mortgages with a credit guarantee backed by the federal government, and would not have investment portfolios.

These are the GSEs pre-Jim-Johnson era, with no balance-sheet turbocharging.  But the Secretary wants a further shackle:

Where did those pesky GSEs go?

These entities would be privately-owned, but governed by a rate setting commission that would establish a targeted rate of return, thereby addressing the inherent conflicts between private ownership and public purpose that are unresolved in the current GSE structure.

Alternatively, the ‘rate commission’ could instead set ongoing capital requirements, and periodically require capital to be redeployed into new products.  State HFA’s operate something along these lines.

This commission would also approve mortgage product and underwriting innovations to continually improve the availability of mortgage finance for a population to be defined by the Congress.

A noble ambition.  Much harder than it sounds.  If the rates of return are set, where’s the pressure to innovate?

In this model, continued safety and soundness regulation would be essential.

Actually, in any model they’re essential.

So Secretary Paulson plumps for a public-utility concept – which is by no means nonsensical – but just at the point the hard questions would need answering, he punts.

Next Administration!

Maybe that’s right – the decisions will belong to his successors – but it’s disappointing.

Not boldly going anywhere

In all the Secretary’s many words, there are some whose absence was deafening:

He didn’t say we needed two.

Didn’t I?

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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 Enterprise would have to achieve three business objectives. Page 45.

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.]

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 Enterprise’s net income in 1998 (and continued to do so in subsequent years), so that expanding business offered the best prospect for growing earnings. Page 45.

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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“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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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.

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

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While the main consequences of HR 3221, the great big deal known as the Housing and Economic Recovery Act (HERA) of 2008 (this Reuters summary is as good as any), are the financial and regulatory coup that completes a fundamental revolution within the financial system, changing both the GSEs specifically and the capital markets generally (into banking on value), there are even more consequences – important ones:

Serving up banking and GSE reform with all the trimmings!

9.         Technical corrections will abound

This legislation is massive. 

We landed it, but what have we landed?

It’s far-reaching.  It’s complex.  And it was put together under enormous pressure, by people who were working against clocks both economic and legislative.

“I’m just a legislative cook”

Guaranteed, there are going to be mistakes – technical flaws.

These will include:

Incorrect cross-references.  You’d be surprised at how often section references are just wrong – they point to nowhere, or to the wrong subsection.

It was here when we designed it

Very quickly – it’s called morning-after proofreading – everybody will realize the citation is wrong, but its fixing requires a legislative amendment. 

Dueling ‘notwithstanding anything to the contrary’ phrases.  At least in my experience, most legislation is written in an intellectual vacuum – the drafters know of some laws that bear on the subject they’re legislating, but other laws touch on the subject of which they are unaware.

“I know something about this legislation you don’t know!”

Loopholes.  Oversights that allow people to get away with things the legislation was trying to prohibit, or that enable people to combine provisions to achieve an unintended and grossly over-generous result.

Normally technical-corrections legislation gets passed within a few months of original enactment, and with little opposition.  But then, normal is not a state in Washington.

It’s on my Congressman’s desk – how about yours?

10.       LIHTC pricing will be better long-term … but in the short term, chaotic

On balance, this legislation is great for the Low Income Housing Tax Credit. 

I chaired two committees at once

Not only does the Credit retain primacy of place among Federal housing resources, it is streamlined, with the states granted ever more discretion in allocation and administration. 

Also, there will be more LIHTC around: the per-capita amounts are boosted for the next couple of years, and the states now have the flexibility to give any property a 30% basis boost previously reserved only for Difficult to Develop Areas (DDAs).  I expect that some states could decide that, for 2008 at any rate, their whole state is a DDA and all the properties get a 30% basis boost.

[Full disclosure: my for-profit consultancy Recap is an advisor to the Michigan LIHTC allocating authority; however the comments above are purely personal and have nothing to do with any position MSHDA might take. – Ed.]

This won’t increase the Federal tax expenditure – it’s still capped at the same amount – but will allow the states to concentrate their attention.

Just add basis boost and stir

All that is for the long term.  For the short term, there’ll be more LIHTC in a market that’s already got an excess of supply over demand.  As I wrote last March, in What price a LIHTC ticket?

Traveler: “How much does a ticket cost?”
Airline: “How badly do you want it?”

Any idea when the LIHTC will take off?

As of March, 2008, nobody knows what $1 of 2008 LIHTC will be worth, because by far the majority of investors who will eventually buy it are deferring their purchase decisions, and may do so for the next several months. Right now the effect on our industry is about the same as if the air-traveling public had elected to stay home for six months.

When demand falls, prices also fall until there emerges a new body of consumers who support a new lower price. Where will they come from, and at what level will prices stabilize? While prices are falling, what does that mean for current participants, especially lenders and investors?

Normally, when prices are falling, you don’t add to supply.  Yet that’s what Congress has done, for what may well be very good reasons.  Even as prices are falling, the boost in total credit amount, coupled with the waiver of recapture bonds decreasing the barriers to sale, probably means that LIHTC equity prices will weaken even further.  Yields will rise.

AHI blogs: where the future begins tomorrow!

11.       House prices will firm

Moving to provide liquidity and loan-paying support to a broad range of home owners, major assistance is provided across the spectrum, from current owners to new buyers.

Pots of gold under many homes’ rainbows

A homeownership tax credit (really, an interest-free loan run through the tax code).  Middle-income households (anyone below $150,000 married filing joint) can tap a one-time tax credit of up to $7,500 for the purchase of a first home.  Homeownership tax credits work (as we’ve seen in Washington DC), and although this one amounts to a 15-year interest-free loan rather than a direct transfer, for our purposes it’s functionally equivalent to a $7,500-per-home injection of hard equity, with five beneficial consequences, as I posted three years ago:

1. Provides accessible capital.

2. Places the owner in first-loss position.

3. Shows the borrower has some financial wherewithal.  (A credit works better for this than a grant, since the borrower has to bring the cash to the closing table, and gets the credit only when he or she files a tax return.)

4. Gets the borrower’s undivided attention.

5. Demonstrates that the borrower has an investment mindset.

States secure $4 billion of foreclosure-repositioning grant money.  As we’ve seen, abandonment and blight are value destroyers even more than foreclosure is. 

The kind of thing that signals, nobody’s home

What’s needed are solid citizens occupied solid homes, and when a property is abandoned, it has to be secured, renovated, and then re-sold:

Local communities that are burdened with maintenance of abandoned properties would have access to nearly $4 billion in federal grants to buy and repair those homes.

That’ll go a long way to upholding prices and re-establishing liquidity in neighborhoods threatened with blight.  So will this:

One-time boost in tax-exempt bond authority.  Bonds that are tax-exempt sell for a lower interest rate, which state housing finance agency lenders can, should, and usually do pass through to home buyers.  Now they have much more to work with:

Local governments would have authority to issue an additional $11 billion of tax-exempt bonds to refinance shaky loans

If today’s thirty-year taxable fixed is 6.40% [Visited 27 Jul 08 – Ed.], and the corporate tax rate is basically 34%,  the equivalent tax-exempt rate is 4.2% [Calculated as 6.4% x (100% - 34%) – Ed.], and the difference in debt service is 22% (7.51% constant taxable, 5.89% tax-exempt) assuming the same thirty-year term. 

A 22% drop in occupancy costs could be equivalent to a 27% boost in sustainable home price [100% / (100% - 22%) – Ed.], which is a big underpinning.

Holding up home prices until the financial ground restabilizes

Counseling and helping borrowers.  When people get into financial trouble, especially with a large purchase like an owned home, they need assistance.  Now there’s significant money available to homeownership counseling:

$200 million would be offered to foreclosure-prevention programs

It helps to have somebody to talk through the math

12.       HUD’s demise into irrelevancy is now inevitable

When Hurricane Katrina hit, causing the biggest localized housing crisis in America’s last decade, HUD was nowhere; FEMA took the lead, and when New Orleans needed to be rebuilt, we observed the Case of the Vanishing HUD.  

When the GSE scandals broke, to its eternal credit, HUD’s Office of Federal Housing Enterprise Oversight (OFHEO) did the digging and made the case in the early days (complete early-AHI archive here), eventually issuing the report that blasted Fannie Mae, so thoroughly the company never rebutted a single charge. 

OFHEO set you up, now I administer the coup de grace

As its reward for this exemplary service, HERA abolishes OFHEO, transferring all of OFHEO’s powers to the newly created Federal Housing Finance Agency, and granting FHFA many more powers as well:

That ’s FHFA, Seppi, not FIFA

Meanwhile:

FHA’s loan limits are now aligned with the GSEs, rendering FHA more likely a backstop than an alternative.

Fannie Mae, Freddie Mac and FHA would be permitted to purchase loans as large as $625,500 in high-cost areas — a big increase from the $417,000 cap typically in place.

The new rescue money (in the affordable housing trust fund) flows through HUD’s hands and is decided by the states.

OFHEO is abolished (as we saw above), with a pat on the back for a job well done.

Great job … not hit the showers

At this point, what is there for HUD to do?  All of its functions have been wholesaled, most of them to the states, except for EEOC (which could easily go to the Justice Department) – and the legacy public housing inventory, which needs a bold Gordian-knot-cutting solution and turn into the essential housing authority, one that is no longer micromanaged by HUD.

“Everything not mandatory is forbidden.”

So here’s a final prediction:

By 2012, HUD will be gone as a Cabinet branch.

Whether this is good for the country’s affordable housing is something I can take up in future posts; for now, we can already hear a future Congress having the last word.

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