Former regional Fed president William Poole argues forcefully in a New York Times op-ed today that Fannie Mae and Freddie Mac are not only unnecessary but also distort the financial markets and should be wound down. This program would also be consistent with a strategy of minimizing risk and cost to taxpayers.
Probably due to space limitations, Poole did not include some arguments against the GSE’s role. For instance, the US already has the most extensive subsidies to the housing industry of any advanced economy, the most important of which is the tax deductability of mortgage interest. Eliminating the GSEs is actually a step in the right direction of lessening subsidies to a sector that does not aid in American competitiveness.
In addition, the GSE’s size alone makes them perilous. As we have noted earlier, the hedging of their interest rate exposures is pro-cyclical. Back in 2002, Greenspan was concerned that Freddie and Fannie were creating systemic risk. The 2003 accounting scandals put a brake on their growth and took the hedging concern off the front burner. But now that many sectors of the credit markets are moribund and the GSEs are the far and away the biggest game in town as far as mortgage securitization is concerned, they again have the potential to be a destabilizing force in more ways than one.
The selection below skips over Poole’s criticism of Congress’s failure to rein in Fannie and Freddie (“Congressional inaction over the last 15 years contributed to the bailout”) and focuses on his recommendations. I’ve taken the liberty of highlighting the money quote.
From the New York Times:
Because the government cannot permit Fannie and Freddie to default, their obligations are part and parcel of the full-faith-and-credit obligations of the United States. Thus, the national debt, usually viewed as the $5 trillion held by the public, is really $10 trillion….
For now, the Congressional Budget Office has entered a “place holder” of $25 billion to cover the bailout costs over the next two years but recognizes that this is a guess. The important issue is not the 2009 outlay, but the total that will be required eventually….
Given this faith on the part of the marketplace, there will be no immediate catastrophe that would force the federal government to provide additional capital to Fannie and Freddie. The situation is similar to the one in the 1980s, when many savings and loans were technically insolvent yet had no difficulty attracting deposits, as they were covered by federal deposit insurance. So the federal government has the option of delaying any ultimate resolution of the Fannie-Freddie mess, as it did with the savings and loans 20 years ago, in hopes that the two giants can dig themselves out of the hole. Still, it seems more likely that — again, just as in the 1980s — the longer we delay, the higher the eventual taxpayer cost will be.
Freddie Mac, according to its own fair-value accounts for the end of March, is technically insolvent — the estimated market value of its liabilities is greater than the estimated market value of its assets. Fannie Mae has a small positive net worth. In coming quarters, these figures may deteriorate because of accounting adjustments (some of the assets are questionable) and continuing defaults on mortgages. The eventual losses could run to several hundred billion dollars.
Whatever the amount of the bailout, even if “only” $25 billion, the real question is not immediate survival of the loan giants but their long-term future. Instead of being regarded as too big to fail, we should look at them as too big to liquidate quickly.
Fannie Mae and Freddie Mac are not essential to the mortgage market; if they were put out of business in an orderly fashion over 5 to 10 years, the market would pick up the business they abandon. Fannie and Freddie exist to provide guarantees for mortgage-backed securities trading in the market. The business is simply insurance.
There are lots of insurance businesses around: property, auto, life and many others. These markets work fine without any government-sponsored enterprises. They are not highly concentrated into a small number of dominant players whose failure would threaten the entire economy; rather, lots of companies compete and spread the risk. Indeed, there are well-established firms in mortgage insurance, but their growth has been stunted by the special advantages Fannie and Freddie enjoy.
In fact, there has already been a test case for how the mortgage market would function without Fannie and Freddie. After an accounting scandal in 2005, regulators severely constrained their activities. The nation’s total residential mortgage debt outstanding rose by $1.176 trillion in that year, even though Fannie’s and Freddie’s stakes rose by only $169 billion, just 14.4 percent of the total. In essence, the market barely noticed that the two agencies’ private competitors were providing 85 percent of the increase in mortgage debt in 2005.
There are more general economic reasons for liquidating Fannie and Freddie, the biggest being that it is very dangerous to maintain such a large role in any market for only two operators. Markets work best when numerous firms compete against each other.
And then there is moral hazard. Knowing they had a federal backstop, Fannie and Freddie held too little capital and the market financed their activities at interest rates very close to those enjoyed by the government. Now we are living through the result. Does it make sense to reconstitute them so that they can engage in a repeat performance?
Some believe that tighter regulation is the answer. I am skeptical of that because I know the extent to which the regulatory system is tied up in Fannie’s and Freddie’s political activities. I find it deeply troubling that Fannie and Freddie, essentially in receivership to the secretary of the Treasury today, continue to employ lobbyists and hand out campaign contributions to influence the legislative debate over their own futures. Fannie and Freddie paid out more than $170 million to lobbyists over the last decade — more than General Electric spent. Government departments cannot hire lobbyists or give money to campaigns — why should Fannie and Freddie, now wards of the government, be permitted to do so?
The long-term health of the mortgage market is too important to be left to only two firms. If Fannie Mae and Freddie Mac can survive as vigorous competitors without the special government privileges they’ve long enjoyed, fine. But if they insist on coming back to life as public-private hybrids with all sorts of unfair federal advantages, we’ll only be setting ourselves up for more disasters. The wisest move, in the end, is to carefully let them wither away.
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This “too big to fail” is poor policy and I agree with Poole.
In the military, you don’t put all your missiles in one place as it is too easy for an enemy to target them and wipe them out with one big strike. Instead you spread them out widely.
It is clear that the same has to be done with these large financial institutions. No institution in the future should be allowed to grow so big that they become “too big to fail”. Such institutions as exist today should be frozen and dismantled into smaller parts over time.
As to the mortgage interest deduction, I’d love to see that go away as it would make the choice of buying a house vs. renting more equal. However, the hue and cry from those currently benefiting from this largesse would be incredible.
Congress has the opportunity now to act on these issues but will they? Do they have the balls to “take the bull by the tail and look the situation in the eye” and act accordingly? It’s doubtful that we will get anything other than superficial bandaid’s from Congress, many of whom are beholden to corporations and lobbyists and will do what they are told.
The implosion of F&F is going to be spectacular, the die is already cast. A mushroom cloud and the Argentina moment awaits.
I agree with Poole. He writes, “Fannie Mae and Freddie Mac are not essential to the mortgage market. … Some believe that tighter regulation is the answer. I am skeptical about that because I know the extent to which the regulatory system is tied up in Fannie’s and Freddie’s political activities”. I say kill these beasts as soon as possible. I am very skeptical of regulation, having seen its 31-year failure in the CPA industry and subscribing to the “regulatory capture” hypothesis of C. Walton Hamilton.
I disagree with author’s the proposal to “getting rid” Fannie and Freddie. I’m not an apologist for either of these. Clearly, they allowed certain amount of unethical behavior. The millions of dollars paid as part of the buyout package of former CEO Franklin Raines was obscene. Also, the lobbying activities of these two giants must be ended immediately.
My big problem with this NYT piece is that the author offers up no practical alternative. He states that new regulations are not the answer. I agree (other than new anti lobbying laws and regulations). He then hints at the idea of a new government sponsored insurance program as a possible solution. OK, so a tremendous amount of effort should be placed on creating a huge new government bureaucracy that increases the level direct government involvement in the real estate credit markets. My gut tells me this is a terrible idea. Remember the general rule- government works best when it assumes the role referee, a lesser degree when it plays the market protector, and rarely (if ever) as a direct market participant.
The author’s example of the market’s performance without the GSE’s is ludicrous.
“In fact, there has already been a test case for how the mortgage market would function without Fannie and Freddie. After an accounting scandal in 2005, regulators severely constrained their activities. The nation’s total residential mortgage debt outstanding rose by $1.176 trillion in that year, even though Fannie’s and Freddie’s stakes rose by only $169 billion, just 14.4 percent of the total. In essence, the market barely noticed that the two agencies’ private competitors were providing 85 percent of the increase in mortgage debt in 2005.”
Is he kidding??? When the market shifted away from Fannie and Freddie during the period 2004 through 2006 there was a degradation in mortgage underwriting standards that allowed(as we now know) a large number of truly unqualified borrowers to buy real estate. We don’t need an anvil to drop on our heads to remind us that this environment, along with the exponential growth of structured financial products that was enabled by the blatant misrepresentation of risk by the large financial services firms who peddled these toxic products to careless investors, that resulted in the financial doomsday scenario that we happen to be experiencing at this very moment. A much stronger case can be made that the shift away from the GSE’s to the private securitization markets led to the hyperinflation of real estate markets, the bursting of which was actually the major cause of the current GSE problems.
However, the author’s comment, in the second paragraph of the NYT article hits home- “Congress could and should have required Fannie and Freddie…to maintain more capital, but didn’t…”
The problem was not with structure or rules, but with enforcement (or lack thereof). The refs simply didn’t do their job. The real solution for the markets is to find a way, whereby the regulators in question, are free of any behind the scenes inappropriate political influence. This free them up to make the tough calls, and be able to stand behind them, penalize any negative patterns of conduct by market participants, before the evolve into a systemic crisis. No amount of new rules, laws or restructurings will make a difference, if the refs (individual agency leaders such as Chris Cox and Harvey Pitt) who are responsible for ensuring market participants behave properly, refuse to enforce the rules until it’s too late.
No meaningful answers until the level of political corruption has been resolved. The banking and financial crisis has quickly landed on the gov’t doorstep and rightly so, but the political process is so corrupt that reasonable solutions become another excuse for Congress and the Exective Branch to create more power for friends and financial backers rather then new directions.
My guess is that the situation will at some point become clear even to the many Democrats and Republicans that vote for their parties choice like robot’s that its not working and needs a big fix.
As I look into this, Fannie is being engineered to use covered bonds as a structured financial derivative, which will also use QSPEs, i.e, entities to spin off debt, but IMHO, these derivatives are a new way to connect taxpayers to a debt that will be transfered to corrupt politicians and people supportive of these derivatives, like the members of SIFMA.
You will recall SEC Cox and recent discussions about QSPEs and Paulson pushing for covered bonds.
You will also recall that the recent bank failure is a transfer of assets from a failed bank to an insurance holding company, something very new in America.
You will also recall that the only two covered bonds in America are those that were spun out by WaMu and bank of America, two banks that are in great financial trouble.
IMHO, there is a great deal of nasty collusion afoot and people would be smart to iisten to Poole!!!!! Fannie needs to be destroyed, not re-fueled!
Been there said:
“Is he kidding??? When the market shifted away from Fannie and Freddie during the period 2004 through 2006 there was a degradation in mortgage underwriting standards that allowed(as we now know) a large number of truly unqualified borrowers to buy real estate”
Spot on-where can Poole demonstrate that the private financing of mortgages will work better? US Mortgage financing worked pretty good until Wallstreet got into the picture.
Paulson’s plan is to use taxpayers funds via the Homeowners Relief Act of 2008 to clean out the bad debt of Fan and Fred at which point it will be reconfigured and handed over to Wallstreet for profit. In the future look foward to only variable rate mortgages with home borrowers assuming all interest rate risks.
Our independent(?) central bank is now regulating our privately owned mortgage guarantors who may have an equity investment in them by our Treasury.
Bananas. I hope Willem Buiter and his ilk shred this one.
In the Times article Poole states:
“…Fannie and Freddie exist to provide guarantees for mortgage-backed securities trading in the market. The business is simply insurance.”
This is true. Rather than eliminating Fannie and Freddie and directly absorbing all of their assets and liabilities, having the government offer insurance may be a more effective response. Offer Fannie and Freddy debt holders the opportunity to purchase insurance to protect their investments. The price and amount of coverage could be determined later.
Getting the concept of limiting the government’s participation to one of providing insurance on the table is important. An insurance approach could minimize taxpayer exposure and at the same time provide a revenue stream(premiums) that could offset some of the GSE portfoloio losses. BTW, certain investors might be willing to filter themselves out of the taxpayer loss equation by choosing not to participate.
Congratulations to the commenters that pointed out the political nature of the prolem. Fannie and Freddie represent a politicians dream. Plenty of direct campaign cash plus lots of money directly from them to favored constituencies. Kind of like off balance sheet political donations.
IMHO, the new law just further entrenches them. It increases the scope of their lending by jacking up the loan limits. Once they have been cleaned up-either via direct federal assistance or rewriting the accounting rules-they are going to be incredible cash machines. And make no mistake, they know how to spread that cash around. No politician is going to be able to resist the favors they can provide.
Consider what has transpired over the last few years. They callously cook their books to boost executive compensation, take several years to unravel their accounting, come perilously close to insolvency, engage in self-dealing with their biggest customer, Countrywide, and require the explicit support of the federal government to ensure survival. In addition, blatant conflicts of interest on the part of their Congressional overseers are exposed. What happens to them? Nothing really, if you want to be honest about it.
Until you deal with the political realities of Fannie and Freddie, any thought of reforming or downsizing them is just a pipe dream. There is a great book here, but it is probably not going to be written until a few more crises occur. Nothing will happen until some real pain wakes up the electorate.
We aren’t there yet.
P.S. These were my thoughts yesterday. http://blog.metro-real-estate.com/?p=782
Follow on to 1:56:
Have the government set up a window of opportunity for buying the insurance and limit it to a specific time frame (e.g. next 18 months). The window closes after that date, limiting governement exposure.
This process should also have the effect of drawing an implicit line in the sand that clearly communicates to future investors of GSE paper- This investment does not automatically include government backing (no more winking and nodding otherwise). Consequently, newly issued GSE paper will probably carry higher rates that reflect actual market risk. Mortgage rates will be slightly higher as a result. Mortgage rates have probably also been artificially restrained in the past by this government protection facade.
This won’t stop the crisis at the banks. The option arm tsunami is just hitting, a disproportionate amount of which are non-conforming.
The banks are still up against it. The FDIC fund will have to be replenished after WaMu and Wachovia bow out. Inflation will continue to explode. It will push back on the FCB purchase of Treasuries. I don’t know the exact tipping point, but the pressure is still increasing…
Of course it’s a political problem. With a 30-second spot going for US$ 600K on American Idol, able to reach 30M Americans, what politician would think 2x about pandering to Fan/Fred.
Want to resolve problems like Fan/Fred? Then you’ve got to support the strict regulation of “speech” on radio and TV (both cable and broadcast) so that money doesn’t play a role. Also, you’ve got to ensure that RightWing firebrands like O’Reilly and Limbaugh aren’t allowed to overtly campaign for a specific party.
Obviously, in present-day America, this will not happen. That’s why over US$ 2B will be spent this campaign cycle, over 70% on TV.
Given our system of government, periodic implosions like Fred/Fan are inevitable.
Tom,
I’ve written before to encourage Yves to act. Your use of comments for self promotion offends me. Your comments are mundane, your tone is self-important, and you regularly and blatantly try to steer traffic to your blog.
I read a fair number of blogs, and no one pulls your “Here are my thoughts” with a link trick. Far more successful bloggers than you leave comments here and at other places. It shows you to be a clumsy amateur.
It would be no loss if Yves blocked your IP address.
Retread,
Let me offer my sincere apologies. I have been blogging only since March so I truly am an amateur. I obviously do not understand the rules and etiquette of the blogosphere. My mistake was in assuming that it was supposed to be an open, uncensored forum for the free exchange of ideas and opinions.
In the future, I assure you that I will try harder to conform. Thank you for your constructive criticism of my writing and please put in a good word for me with Yves so that I may occassionally leave a comment here.
“Eliminating the GSEs is actually a step in the right direction of lessening subsidies to a sector that does not aid in American competitiveness.”
I’m of two minds about Poole. On the one hand, stripping away the palliatives that have buffered the middle class and exposing them directly to the incredibly predatory policies favored by the minions of the plutocrats like Poole might be galvanizing, in a Leninist way. It would entail an uprising against Reaganism that would definitely consign it to history. And, of course, far from “not aiding” American competitiveness, it would cause a freefall in which the last shred of American economic power would be dissipated. In some distant way, some good might come of that.
But the non-Leninist in me recognizes that this is one of the stupidest suggestions to find its way to the NYT Op Ed page since – well, since last week’s Bennie Morris piece. In fact, housing is a pretty large and functional part of the mixed economy America has created to sustain its prosperity. Economics should always serve the culture – not some abstract thing like “competitiveness”, the benefits of which seem, by some wondrous magic, to accrue solely to the top one percent. – Except insofar as consumers can get tres rich buying cheaper toys from Mattel.
In the next decade, the housing market is going to have to be a significant part of any energy policy the U.S. comes up with. More than likely, that means more State interference “disturbing” the god given market to shift the homebuying market to more concentrated clusters, less sprawl, more energy efficient houses. It is true that the GSEs have supported sprawl and done their best to make sure that, instead of living in hovels and saving their pennies so that someday, some great grandchild of can go to school for… I don’t know, butlering, to serve on one of the great hedgefunders estates (oh, the joy of a society in which the successful, the truly successful don’t have to deal with peons), the GSEs have wastefully and with criminal intent helped people take on long term loans for houses. The horror! And they’ve only been around in the shape they have since 1968 – and you can tell, looking about, that since that time the economy has been reduced to rubble. They are state parasites encouraging rentseeking, unlike such sterling private enterprises like Citibank, which would never, ever allow rentseeking by, say, allowing its CEO to amass beaucoup cash selling it a ringer, and in which the management compensation structure reflects their moral mission of optimizing profit. Yes indeed, and there are plenty of other fairy tales like that which can be purchased at your local libertarian bookstore.
One of the funny things about conservative economics is that its sense of the economy is much like the old fashioned bloodletter – let the fever go! harm the body! those business cycles are good for ya! Because counter-cyclic policies introduce “disturbances” into God’s own market. Next thing you know, they’ll be inventing medicines for the weak and harming the health of the race. Poole is mounting the same tired arguments that will be mounted against any government program that “entitles” the middle class – why this is supposed to be bad is beyond me – and those arguments are political non-starters for good reason: the only people they will help are in the country clubs in which they originate.
Um. most countries have perfectly functional housing markets without having an analogue to Fannie/Freddie.
1. CMSA Applauds Bachus Letter on Rushed Securitization Accounting Reform
http://www.foxbusiness.com/story…unting-reforms/
The Commercial Mortgage Securities Association (CMSA) today praised House Financial Services Committee Ranking Member Spencer Bachus (R-AL) for announcing his opposition to a year-end timeframe for changes to FASB Statement 140 and Interpretation FIN 46(R: 64.12, +0.12, +0.18%). In a letter to Christopher Cox, Chairman of the SEC, and Robert Herz, Chairman of the Financial Accounting Standards Board (FASB), Ranking Member Bachus voiced his strong opposition to making rushed and sweeping changes to these accounting rules. The Congressman recommended an extension of the deadline until January 1, 2010 to “permit all stakeholders to have a full and fair opportunity to debate all policy alternatives and their consequences.”
2. http://www.fdic.gov/news/news/pr…8/ pr08060a.html
Currently, there are no statutory or regulatory prohibitions on the issuance of covered bonds by U.S. banks. Therefore, to reduce market uncertainty and clarify the application of the FDIC’s statutory authorities for U.S. covered bond transactions, the FDIC issued an Interim Policy Statement to provide guidance on the availability of expedited access to collateral pledged for certain covered bonds by IDIs in a conservatorship or a receivership.
Covered bonds are general, non-deposit obligation bonds of the issuing bank secured by a pledge of loans that remain on the bank’s balance sheet. Covered bonds originated in Europe, where they are subject to extensive statutory and supervisory regulation designed to protect the interests of covered bond investors from the risks of insolvency of the issuing bank. By contrast, covered bonds are a relatively new innovation in the U.S. with only two issuers to date: Bank of America, N.A. and Washington Mutual. These initial U.S. covered bonds were issued in September 2006.
We previously had a decrentralized home finance system in the U.S., it was the S&L industry until the mid 1980s. That did not work and turned into the RTC and cost $150 billion in the 1980s.
Private securitization relies upon rating agencies, S&P, Fitch, and Moodys. Look at how well they did rating SubPrime MBS in 2006 and 2007! And these are the entitites Poole thinks can control mortgage underwriting standards?
The fact is the housing crisis was not created by Fannie and Freddie, but they have gotten sucked into it. They failed to properly manage their hedging portfolios, which is where most of their losses come from, not from loans secured by single family houses.
The fact is that the market is set by the dumbest lender. Fannie and Freddie have never been the dumbest lender. Maybe the dumbest risk managers, pushed by greed to get larger bonuses, but not dumb SFD lenders.
Bottom line, the housing market is simply characterized by long term assets funded by short term liabilities. When credit becomes dear, the market locks up and fails to function until confidence in the players returns. The market will always behave in ways we cannot predict and hence, regulation cannot protect market participants over the long run without periods of correction.
These are the opinions of Robert Sheridan, CEO of Sheridan & Partners, a Chicago-area real estate & development company. Their site is http://www.sheridanpartners.com/market.php.
Not All Financial Woes Are Created Equal
The failure of Indymac Bank – according to The New York Times the largest lender to fail in more than two decades – can be laid squarely at the feet of the lax (or nearly non-existent) underwriting that is part of (a big part of) the sub-prime mess. The chickens simply came home to roost.
The troubles of Fannie Mae and Freddie Mac are quite different. Freddie and Fannie underwrote loans carefully; their difficulties are a result of the unprecedented decline of home values.
In 2006, going against the conventional wisdom that single-family home prices never decline (they might stop rising for awhile, but they never decline), we predicted that single-family prices could decrease 10 to 20 percent. Painfully, that forecast turned out to be very correct – but also optimistic. We’re in a cycle now in which housing declines already are greater than at any time since the Great Depression of the 30s. And we’re not at the bottom yet.
If you don’t want to be disappointed by housing performance in the near term, disregard forecasts that the bottom is just around the corner – unless that corner is in Timbuktu. The bottom is NOT coming soon. And when it does arrive, it will not be obvious, like the bottom in the chart of the DJIA. The housing “bottom” will become apparent only in the rear-view mirror, when you realize that prices have stopped falling. Don’t expect a sharp rebound.
We will stay at the bottom for quite a while. How long that lasts will vary, as always, market-by-market.
Phil Collins