Systemic Risk From an Outsized Fannie and Freddie?

People never learn, as John Dizard reminds us via “Forget the past and you make the same mistakes again” in the Financial Times.

Quite a few policy makers have talked up plans to use Fannie Mae and Freddie Mac as central agents in salvaging the US housing market, typically by refinancing stressed borrowers. The markets reacted badly to that, driving up the GSEs’ spreads over Treasuries, but no one is getting the message, despite the fact that the Fed launched the Term Securities Lending Facility primarily to address the problem of gaping mortgage spreads.

Yet the Wall Street Journal tells us the powers that be want to push forward nevertheless:

The Bush administration, in an effort to stabilize the housing market, is preparing two new initiatives aimed at creating more funding for mortgages by relaxing constraints on Fannie Mae, Freddie Mac and the Federal Housing Administration.

Both efforts are in advanced planning stages, though neither has received final approval.

The Office of Federal Housing Enterprise Oversight, which regulates Fannie Mae and Freddie Mac, is close to reducing — but not eliminating — an excess-capital requirement for the government-sponsored entities, people familiar with the matter said. This would give the companies more flexibility to buy and securitize loans. That, in turn, would allow the companies to play a bigger role in helping the housing market regain its footing.

Fannie Mae and Freddie Mac would both be expected to raise more capital, providing more of a shock absorber against potential losses….

Separately, officials at the Department of Housing and Urban Development have talked recently with the White House’s Office of Management and Budget about a proposal to allow more people to qualify for mortgages insured by the FHA….

So far, HUD’s efforts to insure more mortgages have had a limited impact, mainly because it is hard for financially distressed homeowners to qualify

Lovely. The borrowers don’t qualify for FHA’s well tested standards. Note that FHA paper is insured by Ginnie Mae, which makes it a full faith and credit obligation of the government.

Dizard points out that there are other reasons to be leery of making Fannie and Freddie any bigger: their size alone led to market distortions before the accounting scandals curtailed their growth. Dizard anticipates new ways in which their massive financial operations are likely to cause big-time trouble, since in the past, their risk control process created systemic risk for the debt markets. Dizard explains why he thinks it will create an even bigger mess this time around

From the Financial Times:

The institutional memory of governments and the financial industry now has the lifespan of a fruit fly. In the past, the lessons of history have been forgotten because a generation of managers and policy people retired, taking with them their essential historical experience.

Thanks to modern management techniques and high technology, though, we can now achieve near- complete amnesia in a year or two.

In the case of the US government sponsored enterprises, the biggest of which are Fannie Mae and Freddie Mac, for example, we are now about to get into the same mess we only crawled out of about three years ago. This time, though, given the present run of bad luck and fast-forwarding of the markets, a GSE-driven crisis could come a lot faster.

At the beginning of this decade, derivative risk management geeks, interest rate swaps traders and central bank econometricians filled up entire server farms with what-ifs on the balance-sheet hedging activities of the GSEs. The essential problem was that the GSEs were balancing ever-larger portfolios of fixed-rate mortgages on tiny equity bases. Fortunately, as we all knew, the credit risks of those portfolios were limited because homeowners rarely default on their mortgages. But that still left very large interest rate risks.

The core problem for the housing GSEs is, and has been, the prepayment option embedded in US fixed-rate mortgages. That has meant that the term of the GSE assets extends or contracts depending on whether homeowners can refinance at an advantageous rate. However, most of the long-term debt on the liability side of the GSE balance sheets has a fixed term. So the GSEs must more or less continually offset this imbalance between the average maturity of their assets and liabilities through the derivatives market, specifically the interest rate swap market. Otherwise the mark-to-market losses would overwhelm their small equity bases.

This process of risk control on the part of the GSEs creates systemic risk for the fixed-income markets. GSE hedging tends to be pro-cyclical. As interest rates rise, the average term of the GSEs’ assets extends, since homeowners are not refinancing. As rates fall, the average term contracts, as homeowners prepay the mortgages on the GSE books. So the hedging activities tend to accentuate market moves. As rates rise and bond prices fall the GSEs are, in effect, selling fixed-income derivatives into a falling market. As long as the derivatives books are small relative to the size of the market, that is not a big problem. When the GSE derivatives books got big, that was a problem.

By 2001 Fannie and Freddie together had more than 10 per cent of the total market in dollar-based interest rate derivatives. That concentration of risk was worrisome for the central banks. As we wrote at the time, they were concerned that the banks and brokers who were the counterparties for the GSEs would need back-up for these commitments from the Federal Reserve Board. Worse, from the point of view of the Fed, and Alan Greenspan in particular, the GSEs’ management had financial incentives to continue to expand their books of business. They had the political clout, since expanding the number of homeowners had strong support across party lines in Congress.

Then Mr Greenspan, the GSE regulators and their geeky allies got lucky. A management compensation scandal broke at the GSEs that quickly turned into a more general accounting scandal. The reformers had the political wind at their back, and as the accountants and lawyers sifted through the books, the portfolio growth reversed. Even better from a systemic stability point of view, the GSEs’ share of the interest rate derivatives markets dropped by more than two-thirds by 2005. As homeowners took on more adjustable rate mortgages, they assumed some of the rate risk the GSEs shed.

Unfortunately, the squeezed balloon of mortgage credit just bulged out elsewhere. The GSEs, and the rest of the financial markets, assumed more credit risk, and they are now incurring those very real losses.

This recent history seems to have been forgotten by the government and the financial institutions. The caps on GSE portfolio growth have been lifted, and Congress and the markets are now asking them to take on the mortgage assets that everyone else wants to sell. Hank Paulson, Treasury secretary, has strongly suggested they prepare for this by raising capital. Freddie Mac’s chief executive has already said he does not want to.

If this balance sheet growth does happen, the GSEs will be back to assuming the same rate risks that were so alarming four or five years ago, only bigger. And they will be attempting to hedge their rate risks using counterparties that are far more capital constrained than before.

I believe it more likely that before we get to that point again, the GSEs will be formally nationalised. The Bush administration is just kicking the can a little further down the road. These “public-private” mutants will simply become public agencies. There is no way to raise the equity capital for them to remain halfway in the private sector. In any event, the foreign central banks and related institutions have made clear to the US government that it will be held responsible for the GSEs’ debt.