Wednesday, May 23, 2007

Fannie and Freddie get a little House cooking

The House passed legislation creating a new regulator for Fannie Mae and Freddie Mac yesterday. The new regulator would have the power to set reserve requirements, will determine whether either GSE can enter new business lines, and will handle assets in the event of bankruptcy. It doesn't allow for a forced reduction in assets should it be believed that either GSE poses a risk to the financial system generally, which is a provision the Bush administration is insisting upon.

The cynic (or Democrat) might wonder if the administration's apparent desire to weaken Fannie and Freddie isn't in part an attempt to support friends in the private banking industry. Banks have long complained that Fannie Mae and Freddie Mac's cheap funding capability (which is a direct result of implied governmental support) is an unfair competitive advantage.

Regardless of where you come out on that, I'm not a big believer in the contagion theory of GSE regulation. Fannie Mae and Freddie Mac are in essence highly levered prime residential mortgage portfolios. In order for either to really face bankruptcy, I believe one of two things has to happen.

1) Massive defaults on the part of prime mortgage holders, simultaneous with a weak market for repossessed homes.
2) Massive fraud by someone at the GSE. Something like Barrings Bank.

If we have #1, then neither Fannie Mae or Freddie Mac caused the contagion, they were a victim of it. Would the bankruptcy extend an already bad problem? Well, remember that is Fannie Mae were liquidated, they wouldn't be selling homes, they'd be selling mortgages. So the market for mortgage loans would suffer. Bear in mind that we're already describing a Great Depression like scenario anyway, so what the marginal impact of weakness in the mortgage loan market would be in such a situation is hard to say. I'd wager its relatively small.

A fraud scenario is a little different. There we could have a pretty good housing market then all of a sudden, one of the GSE's has to liquidate their portfolio. That would cause sudden weakness in the mortgage market, thereby making mortgage loans more expensive for a period of time. If getting a mortgage is more expensive, that puts pressure on the housing market. Of course, it would be relatively easy for the Fed to handle this, just cut rates a little. But forget about that for a minute. How bad would this be? Would it cause mortgage rates to rise 200bps? 300bps? We've never seen a isolated move in mortgage rates (i.e., mortgage rates rising much faster than other rates) of that severity. But given that the economy has handled generalized moves in Fed Funds and the like of that severity, it would seem able to an isolated rise in mortgage rates. Maybe there would be a recession, but where is the risk/reward here? If we agree that we want the GSE's to exist to increase liquidity in the mortgage market, does it make sense to reduce their size? In other words, why would we create regulation which will certainly have a small deleterious effect to protect against the very small probability that there will someday be a small deleterious effect on the economy?

In thinking about contagion, I always point to all the events of the recent past which the economy has either taken in stride, or turned out have only small long-term impact. Long-Term Capital's collapse, S&L crisis, 9/11, Enron's collapse, Refco's collapse, Barrings Bank, etc. Some of these things were pretty bad at the time (S&L particularly) but none of these events had a material impact on the economy's long-term trend.

So this becomes a little like asking how much insurance should you buy? How much should we hamper the economy to protect against disasters that aren't so disastrous anyway?

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