It’s amazing how a problem isn’t a problem until it’s presented as one on television or a respected print outlet. Never mind the fact that the cognoscenti have been worried about the possibility that the two big mortgage guarantors, Fannie Mae and Freddie Mac, were too thinly capitalized relative to their massive balance sheets. Never mind that well respected economists have told the Fed it should be worried to its face, as James Hamilton did at the Jackson Hole conference last August. Never mind that Fannie and Freddie spreads rose sharply at the end of January, the market’s protest against Congressional plans to make the two government sponsored enterprises the rescuer of stressed homeowners, and led to creative footwork by the Fed to combat the caution toward Fannie and Freddie’s offerings (namely, the TSLF).
On the one hand, it’s high time that the great unwashed public is finally being told that the GSEs might be a wee bit precarious, and expanding their balance sheets too far could set in motion a very nasty chain reaction.
But on the other, there is still a failure to grasp certain not so pretty realities. The first is that there are certain things that America cannot have, that are simply beyond our reach. We cannot prop up a $20 trillion housing market. It’s simply too big. No one seems willing to fess up to that, and (even if you accept that a salvage operation is desirable) that choices will have to be made among who is spared and who isn’t. A lot of the proposals implicitly engage in triage, or at least set priorities, but the PR (for the most part) is that these measures can and will save homeowners on a mass basis. That just isn’t happening.
A second problem is that this “save the homeowner” talk runs the risk of digging us into a deeper hole. The US already has one of the most, if not the most, heavily subsidized housing markets in the world. Now the midst of a crisis is probably not exactly the best time to rein in the support programs. However, the public is being done a great disservice in not being told how our policies have led so much of US investment to go into housing, a sector that does not help US competitiveness. Even if it is unrealistic to remove the props anytime soon, how much we are subsidizing housing and whether it produces social benefits that it is alleged to ought to be discussed rather than assumed. (Oh, but wait, I’ve just recommended a full employment act for lobbyists and PR agencies representing homebuilders, banks, and brokers. Ain’t democracy in America grand?)
Today in the New York Times is a good piece, “Doubts Raised on Big Backers of Mortgages,” which put the finances of Fannie and Freddie in the spotlight.
It’s when I read statements like this from otherwise intelligent people (and yes, Barney Frank is intelligent) that I get worried:
“I want these companies to help with affordable housing, to help low-income families get loans and to help clean up this subprime mess,” said Representative Barney Frank, a Massachusetts Democrat and the chairman of the House Financial Services Committee. “Otherwise, why should they exist?”
Um, my understanding is that the FHA, and not Fannie and Freddie, was designed to help low income families secure housing. Indeed, the reason we got in this mess was that the private sector decided to improve on FHA loans by making them more user friendly, ie, by dispensing with nuisance items like making the borrower he was good for the payments. And it isn’t obvious to me why Freddie and Fannie should be made to take on risky mortgages to save bail out hapless investors and foolhardy creditors.
If you must go the intervention route, I’d first prefer figuring out how to get/induce/force servicers to do more mods (see next post for more discussion), second the Dean Baker’s “own to rent” proposal, or lastly, using a new entity (Alan Blinder proposed a revival of the 1930s Home Owners Loan Corporation) to avoid tainting Fannie’s and Freddie’s paper and make the cost and scale of the operation explicit.
Other key bits from the New York Time article:
And as Wall Street all but abandons the mortgage business, Fannie Mae and Freddie Mac now overwhelmingly dominate it, handling more than 80 percent of all mortgages bought by investors in the first quarter of this year. That is more than double their market share in 2006.
But some financial experts worry that the companies are dangerously close to the edge, especially if home prices go through another steep decline. Their combined cushion of $83 billion — the capital that their regulator requires them to hold — underpins a colossal $5 trillion in debt and other financial commitments….
The companies are sitting on as much as $19 billion in additional losses that they have not yet fully acknowledged, analysts say. If either company stumbled, the mortgage business could lose its only lubricant, potentially causing the housing market to plummet and the credit markets to freeze up completely.
And if Fannie or Freddie fail, taxpayers would probably have to bail them out at a staggering cost….
Bush administration officials, the Federal Reserve and lawmakers all believe that the companies’ financial safety cushion is far too thin and have pleaded with them to raise more capital from investors.
Freddie and Fannie, which are enjoying new growth and profits, have largely resisted those pleas, people briefed on the talks say, because selling new shares could dilute the holdings of existing shareholders and drive down their stock prices. Though executives have promised to raise money this year, they refuse to specify how much and when.
Let me interject. That ugly little problem, of management refusing to issue more stock and rushing out eagerly to book new business, is pouring gas on a fire. It’s also clear evidence that this quasi-public structure is untenable. The GSEs are clearly to big to fail, and need to be nationalized ASAP.
However, the article notes that the only plan to forestall the likely socialization of risk is to criticize Fannie and Freddie. No joke. Indeed, this very article may be part of that plan.
Back to the Times:
….Though the companies’ main regulator, James B. Lockhart III, director of the Office of Federal Housing Enterprise Oversight, has voiced strong confidence in the companies, a high-ranking member of his staff said some officials had begun considering the worst.
“It’s not irrational to be thinking about a bailout,” said that person, who requested anonymity, fearing dismissal….
But now that the government depends on Fannie and Freddie to keep markets humming, the companies are making demands of their own — namely, repealing some of the limits created after the scandals and even some established by law.
Last year, in return for buying billions of dollars of subprime mortgages to help stabilize the market, executives won the right to expand their investment portfolios. In March, the companies agreed to raise more capital within the year. In exchange, they received an additional $200 billion in purchasing power.
Last month, the companies promised to pump money into the more expensive reaches of the housing market. In return, Congress temporarily raised the cap on the size of the mortgages they can buy to almost $730,000 from $417,000…
Each time Congress or regulators have given the companies new room for growth, their stock prices have risen. But so far the companies have balked at raising more capital….
As worrisome as the need for new capital, some analysts say, are the companies’ books.
A report released earlier this month by Mr. Lockhart, the regulator, noted that although Freddie and Fannie had a combined $19.9 billion of “unrealized losses” on mortgage-related investments, neither company had reduced its earnings to reflect those declines. That is because they judged the losses to be temporary — in essence wagering that the mortgage market would recover before those assets were sold. Such a wager is permitted by the rules but difficult for outsiders to analyze.
If the monolines can take that position, why not the GSEs? And of course, banks and securities firms have their Level 3 assets. Back to the Times:
….Both companies have also recently changed their policies on delinquent loans, which they previously recorded as impaired when borrowers were 120 days late. Now, some overdue loans can go two years before the companies record a loss.
Fannie Mae declined to discuss the accounting of impaired loans. A representative of Freddie Mac said marking loans as permanently impaired at 120 days does not reflect that many of them avoid foreclosure. But the biggest risk, analysts say, is that both companies are betting that the housing market will rebound by 2010. If the housing malaise lasts longer, unexpected losses could overwhelm their reserves, starting a chain of events that could result in a federal bailout.
A version of those events began in November, when Freddie Mac’s capital fell below congressionally mandated levels. The company stemmed the decline by selling $6 billion in preferred stock. But it might not manage that again if there is another unexpected loss, analysts say.
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William Poole of the St Louis Fed was worried about this early on:
http://www.stlouisfed.org/news/speeches/2003/3_10_03.html
Any economic historians out there that might enlight us poor readers about how the GSEs came to this weird public/private schizophrenic chimera-like structure? What exactly was the driving force or supposed advantages of such a model vs. an outright government or outright private entity?
Obviously a different standard of ‘intelligence’ must be in play for idiot politicians like Barney Frank. Anytime I see or hear the word “families” in a discussion about deadbeat mortgage co-conspirators/debtors, I immediately tune out.
If you want to encourage mortgage servicers to do mods, I’d guess you just have to allow bankruptcy judges to modify mortgage debt on primary residences in chapter 13 bankruptcy, and repeal the 2005 modifications to the bankruptcy code making chapter 13 more accessible to consumders. If the investors/servicers are afraid of what a judge will do to their mortgage debt in bankruptcy, that will encourage them to do workouts.
Everyone seems to assume that the US Govt will bail these monsters out. That is not so obvious to me. To me it appears that a purpose of airing the unwillingness of the GSEs to recapitalize by selling stock now that their stock prices are higher and they are have a golden opportunity to recapitalize by selling stock is to establish a moral basis for not bailing them out.
Well, in the worst case the government will almost certainly bail out Fannie and Freddie bondholders, but would haircut or wipe out the stockholders.
And of course the housing market is too big for the government to support. We’ve heard all the criteria for triage in terms of who was an honest borrower, who was miseld by lenders, who might be able to afford a loan if the principal were reduced to some reasonable sum. I offer one more for discussion: How about at least exploring the possibility of preferring to save homeowners who are located closer to urban cores and transport hubs, in order to encourage energy efficiency? We can no longer afford to subsidize suburban sprawl or exurban development with oil over $120. It’s high time we started looking at the energy and envirnomental impact of our economic policies in a more systematic fashion.
Foreign institutions own so much fannie and freddie paper that it is conceivable the federal government would not indemnify the security holders for losses.
Lune,
Here’s the short version. In Depression Fannie was created as a government agency to borrow on financial markets and then buy government insured mortgages. Liquidity in mortgage market (which private sector was not providing) increased availability of mortgages to public.
60s, expensive borrowing, meant that Fannie was losing money for government. Then privatized. Freddie created as competition. However, GSE status means that agency debt is acceptable as backing for Federal Reserve notes. Therefore even in the old days agency debt could be held on the Fed’s balance sheet, though in practice not much was held.
70’s Fannie/Freddie start buying mortgages without government guarantee, create mortgage securitization business.
In short what was a government business of borrowing short to lend ultra long (which in the 30s wasn’t a business even banks would get into) became a privatized business of doing same — with implicit government support because the Fed accepts agency paper as collateral for open market repos.
As we all know, however, the Fed’s balance sheet now includes a lot of things that could lose it money.
“Both companies have also recently changed their policies on delinquent loans, which they previously recorded as impaired when borrowers were 120 days late. Now, some overdue loans can go two years before the companies record a loss.”
Is that some kind of sick joke?
The US is turning into a banana republic.
How can this be legally permitted under the accounting rules?