The markets seem to think so…..From Doug Noland at Prudent Bear:
Now Fannie is in theory a good credit, but its implicit Federal guarantee has never been tested. Market observers may be worried that many of the “rescue the homeowner” proposals, starting with what Tanta calls “Loans Formerly Known as Jumbos” now eligible for the GSE, rely on the government backing mortgage debt that formerly was left to its own devices, generally for good reasons.
This isn’t a free lunch, even though a lot of observers seem to think it is. Recall these comments from Jim Hamilton at the Fed’s Jackson Hole conference:
Since 1990, U.S. nominal GDP has increased about 80% (logarithmically). 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 insitution that is deemed to be “too big to fail” should be subject to capital controls that assure an adequate net equity cushion.
Not only is Hamilton’s recommendation being ignored, it’s being turned on its head.
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James Lockhart seems to have a clue, but it also seems like The Paulson’s of The World don’t care about The Lockhart’s.
Yves, I think its Doug not Donald Noland.
“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.”
…
“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.”
…
“So here’s my key recommendation– any insitution that is deemed to be “too big to fail” should be subject to capital controls that assure an adequate net equity cushion.”
I confess my innocence: In what, or where, would this “adequate net equity cushion” be placed – the Fed? (And I did link back to the original post and found no answer there.)
Hi,
While your topic is interesting, the analysis you present is incorrect from the very beginning. Investors in MBS also consider the liklihood that the loans underlying the loans will prepay. MBS are essentially callable by these customers whereas treasurys are not. Therefore comparing nominal spreads makes no sense because as interest rates falls, nominal spreads on MBS need to rise as investors require protection from the free put that the borrowers have. This is called negative convexity. Two much better measures of the GSE’s credit are their credit default swap spreads (CDS) or their debt spreads which more directly correlate to the markets’ view of their credit worthiness.
Let’s look at your final conclusion – that the Bush flunkee apointee Lockhart should be able to control the growth of the GSE’s portfolio and the amount of capital they are required to hold. Guess what – he’s already doing that!!! Both GSE’s have portfolio limits in place as suggested by Lockhart and they are both being required to hold extra capital due to Lockhart’s suggests.
In sum, your analysis and article don’t seem to illustrate that you understand or know what is actually happening in the marketplace or between the GSE’s and OFHEO.
Anon of 6:49 AM,
I suggest you learn how to read and be certain of your facts before making criticisms. The analysis cited above, as clearly stated in the post, is from Jim Hamilton in a paper presented at the Fed’s Jackson Hole conference. So this isn’t “your analysis” as you incorrectly state.
I am aware of Lockhart’s and OFHEO’s existence and role and have mentioned them in previous posts; I have no doubt Hamilton is as well if you bothered checking his blog or papers. Lockhart has held the line on GSE growth in the face of enormous pressure to increase their balance sheets. Note further that Hamilton’s comments clearly imply that GSE balance sheets need to shrink. As desirable as that is, it is a non-starter. The only time I can think of a government official doing something that would be similarly unpopular was Volcker raising rates in the early 1980s. Then, inflation had gotten bad enough that there was a lot of agreement that something had to be done, even though there were a lot of people screaming to reverse course as the program proved to be painful.
If you read the X axis of the chart, the spike up in the Fannie Mae spread over Treasuries conforms very closely with the passage of the stimulus package, which includes a provision to increase the celling on conforming loans from $417,000 to a maximum of $729,750.
Pray, tell me how could negative convexity explain a 30 basis point increase in spreads in a mere week?
As for Lockhart being “Bush’s flunky appointee”, you seem to be alone in that view. Lockhart has fought ongong pressure to raise the GSE’s limits, as John Dizard reported in the Financial Times:
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.
So it will only be after many more problems surface and under strict conditionality that F&F will pump a bunch of new money into the housing finance pipelines.
Similarly, per Tanta at Calculated Risk:
The bill does not require the GSEs to purchase the new higher-balance loans at the same terms currently in place for $417,000 loans. If they did offer the same loan parameters, that would mean–in theory at least–that the new LFKAJ could be made as high as 95% LTV/CLTV. However, a 95% LTV loan would require mortgage insurance. As a general rule, the MIs mostly limit purchase loans over $650,000** to 90% LTV. So unless the MIs relax their rules–which would surprise me–there wouldn’t be a lot of point in the GSEs setting a maximum LTV that cannot qualify for the required MI. Realistically, the GSEs will have a lot of work to do hashing out what the allowable guidelines are for these loans, which will involve a lot of discussions with the MIs. As OFHEO Director Lockhart has been signalling nothing but disapproval of the whole thing since the idea was first floated, it is surely certain that any proposal the GSEs come up with will involve review and possibly negotiation with OFHEO. Plus, the GSEs have to update their AUS (automated underwriting), their pricing and delivery systems, and their selling and servicing guides to accommodate the new rules. You can confidently expect this to take a while.
Lockhart’s no Armando Falcon. he was put in Falcon’s spot to toe the party line and raise token objection to keep the bleeding hearts happy.
He has hardly “raised token objections”; he has refused repeated requests over the last year to increase Freddie and Fannie’s balance sheets. That’s not “token objection.” And Tanta’s comments suggest he may be able to throw some sand in the gears as regards the Congressionally-passed increase in GSE conforming loan limits.
so much for “sand in the gears”
http://online.wsj.com/article/SB123249600058500249.html
http://tinyurl.com/9et2q8
“The overall [home-loan bank] system is strong,” James Lockhart, director of the Federal Housing Finance Agency, which regulates the banks, said in an interview.
another Lockhart masterpiece… again, he’s no Falcon.