Be Careful What You Wish For (Schumer/Paulson Edition)

The inner and even not-so-inner workings of the Beltway frequently escape me. Nevertheless, a complaint made by Charles Schumer, chairman of the Joint Economic Committee, in an interview with the Financial Times, seems truly bizarre.

Schumer moans that Paulson isn’t doing enough to help with the subprime crisis because his hands have been tied by a White House ideologically opposed to intervention.

This comment is mystifying because it isn’t at all obvious what Paulson could do that would be useful even if he wanted to. The complaint seems to be focused on the so-far frustrated efforts to give Fannie Mae and Freddie Mac more latitude to throw money at the problem. We will also address the general case, of Paulson’s limited power, in due course.

First, from the Financial Times:

Hank Paulson, the US Treasury secretary, has been “handcuffed” by George W. Bush in his handling of the subprime mortgage crisis, according to a powerful Democratic senator.

Charles Schumer, chairman of the congressional joint economic committee, said the president was preventing Mr Paulson from taking stronger action to stem the crisis because of his ideological commitment to free markets and small government.

“Paulson is in ideological handcuffs,” said Mr Schumer in an interview with the Financial Times. “Everybody who studies this knows the government should be involved.”

Mr Schumer’s committee published a report on Thursday predicting that 2m homes would be subject to fore closure by the end of next year, destroying more than $100bn (€70bn, £49bn) in housing value. “This is serious and getting worse,” he said. “Until the market sees somebody is in charge and making sure this doesn’t get out of hand they are going to continue to get spooked.”

Congressional Democrats are pressing for Fannie Mae and Freddie Mac, the government-sponsored mortgage companies, to be given a bigger role in helping struggling borrowers refinance mortgages. However, the proposal is opposed by the administration, which advocates a more limited government response to the crisis.

This is more than a bit disingenuous. The problem, if you can call it that, is neither Paulson nor the administration, but one James Lockhart, the head of the Office of Housing Enterprise Oversight (OFHEO). Yes, OFHEO is part of the Treasury, but Lockhart is unusually resistant to the usual sorts of pressure. He was put in charge after the agencies were discovered to have serious accounting and management problems, and atypically, he takes his mandate seriously. As John Dizard of the Financial Times explained in “Fannie, Freddie to the rescue? Don’t bet on it“:

At a time when America, or at least Wall Street, needs a spineless hack as the head of a key agency, it is saddled with a credible man of principle: James Lockhart, OFHEO’s director. Yale graduate, Harvard MBA, lieutenant in the nuclear navy, risk management software entrepreneur, senior insurance executive, and former head of the Pension Benefit Guarantee Corporation. “A real hard-ass” in the words of a mortgage finance executive. It doesn’t seem as though he can be intimidated by the threat of being sent back to Plano, Texas, to work in his uncle’s car dealership.

Lockhart was appointed in the middle of last year to the directorship when there was no immediate, obvious cost to anyone of having a competent, effective regulator who actually knows what those buttons on his computer are connected to.

What is worse, his resistance to Fannie and Freddie ballooning their balance sheets and loosening their controls is reinforced by his experience in a previous job. The Pension Benefit Guarantee Corporation, a thinly capitalised government insurance operation, which charged inadequate premiums for covering beneficiaries of failed pension funds, was in turnround, as they say in Hollywood, during his tenure from 1989 to 1993. Lockhart had to clean up other peoples’ messes and one can guess he doesn’t want to do that again.

And so far, Lockhart has been acting true to form. From the Wall Street Journal, “Ofheo is Pressured Over Mortgages“:

Last month, Ofheo said it would give the companies slightly more flexibility to manage and boost their portfolios, but the regulator stopped short of the larger increase — 10% per company — for which many had argued.

Neither Fannie Mae nor Freddie Mac has filed timely, audited financial statements in several years, and Mr. Lockhart has said that the safety and soundness of both firms remains a concern.

House Financial Services Committee Chairman Barney Frank (D., Mass.) and Sen. Schumer are working on a legislative plan that would allow the companies to boost their portfolios by 10% for six months to help subprime borrowers refinance. Mr. Lockhart, Ofheo’s director, has said he opposes such a plan.

Now before you decide this is all DC gamesmanship, concerns about Fannie and Freddie are valid. Professor James Hamilton in a presentation at the Fed’s Jackson Hole conference in August said a run on Freddie and Fannie was possible, and the best way to forestall it was to restrict growth of their balance sheets:

Outstanding mortgage debt grew 50% more than this, raising the debt/GDP ratio from about 0.5 to 0.8. Mortgage-backed securities guaranteed by Fannie and Freddie grew 75% faster than GDP, while mortgages held outright by the two GSEs increased 150% more than GDP. The share of all mortgages held outright by Fannie and Freddie grew from 4.7% in 1990 to 12.9% in 2006, which includes $170 billion in subprime AAA-rated private label securities. The fraction had been as high as 20.5% in 2002.3. It is hard to escape the inference that expansion of the role of the GSEs may have had something to do with the expansion of mortgage debt.

This acquisition of mortgages was enabled by issuance of debt by the GSEs which currently amounts to about $1.5 trillion. Investors were willing to lend this money to Fannie and Freddie at terms more favorable than are available to other private companies, despite the fact that the net equity of the enterprises– about $70 billion last year– represents only 5% of their debt and only 1.5% of their combined debt plus mortgage guarantees. If I knew why investors were so willing to lend to the GSEs at such favorable terms, I think we’d have at least part of the answer to the puzzle.

And I think the obvious answer is that investors were happy to lend to the GSEs because they thought that, despite the absence of explicit government guarantees, in practice the government would never allow them to default. And which part of the government is supposed to ensure this, exactly? The Federal Reserve comes to mind. I’m thinking that there exists a time path for short term interest rates that would guarantee a degree of real estate inflation such that the GSEs would not default. The creditors may have reasoned, “the Fed would never allow aggregate conditions to come to a point where Fannie or Freddie actually default.” And the Fed says, “oh yes we would.” And the market says, “oh no you wouldn’t.”

It’s a game of chicken. And one thing that’s very clear to me is that this is not a game that the Fed wants to play, because the risk-takers are holding the ace card, which is the fact that, truth be told, the Fed does not want to see the GSEs default. None of us do. That would be an event with significant macroeconomic externalities that the Fed is very much committed to avoid.

While I think that preserving the solvency of the GSEs is a legitimate goal for policy, it is equally clear to me that the correct instrument with which to achieve this goal is not the manipulation of short-term interest rates, but instead stronger regulatory supervision of the type sought by OFHEO Director James Lockhart, specifically, controlling the rate of growth of the GSEs’ assets and liabilities, and making sure the net equity is sufficient to ensure that it’s the owners, and not the rest of us, who are absorbing any risks. So here’s my key recommendation– any institution that is deemed to be “too big to fail” should be subject to capital controls that assure an adequate net equity cushion.

So let’s return to the general complaint that Schumer made, that Paulson ought to be doing more. I am at a loss to understand what that could be. We have discussed repeatedly in this blog that the best, in fact, only viable solution is good old fashioned workouts, which have to be evaluated, structured, and negotiated case by case with borrowers. Fiat solutions of the sort suggested by Shiela Bair of the FDIC are not only impossible to implement from a legal standpoint, but also wildly impractical. They will have the effect of keeping too many otherwise dead borrowers on life support for too long, and by ripping apart the terms of tons of mortgage securitizations, would destroy the willingness of investors to buy that sort of paper for at least a generation.

The Treasury has very limited powers, far fewer than the Fed, and its main role in this mess is via its agencies OFHEO and the Office of the Comptroller of the Currency. By all account, the OCC did a better job than the Fed at keeping an eye on subprime issuance by regulated banks and watching out for predatory lending.

The most useful role Paulson could play is by giving his input and support to regulation to prevent future subprime-type disasters. But my impression is that Paulson, like his masters, is opposed to greater borrower protection and tougher rules for securitizations.