Monday, July 14, 2008

The GSEs: Even Yoda cannot see their fate

This is a bond market blog. Fannie Mae and Freddie Mac are dominant players the bond market. Not only are they the biggest non-Treasury issuers of straight debt securities, mortgage-backed bonds guaranteed by the two mortgage giants represent over 30% of the total taxable bond market. Therefore the problems at the GSEs probably touches just about every investor directly in a way few other companies would.

While delinquencies on their guarantee portfolio remain relatively small (0.81% for Freddie Mac and 1.22% for Fannie Mae), the fact is that both companies employ tremendous leverage, and therefore losses even mildly above historic norms are likely to put huge pressure on the company's equity. In addition, Freddie Mac is yet to complete the $5.5 billion capital raise they promised in May, and given market conditions, this will be all but impossible without government intervention. So I'm not here to challenge the plunging share price of either Fannie Mae or Freddie Mac.

I also don't feel like commenting on the bailout plan, other than to say that its a sad day for free markets. I see the Treasury as between a rock and a Depression, and has selected the rock. I'd have done the same. I don't blame Treasury so much as I lament that its come to this. Exactly who to blame for this or what could have been done differently in the past is a discussion for another time.

There are two somewhat unrelated things I want to comment on. First is this stupidity about FAS 140. FAS 140 has nothing to do with anything. Or at least, it should have nothing to do with anything. An upcoming revision to FAS 140 will tighten the rules about off-balance sheet accounting. Based on how both GSEs currently operate, this would probably require both Fannie Mae and Freddie Mac to bring their guarantee portfolio on balance sheet. Under current statues, the GSEs minimum capital required is 0.45% of of their guarantee portfolio and 2.5% of their aggregate on-balance sheet assets. So taken literally, the GSEs capital requirements would increase dramatically if their entire $4.5 trillion guarantee portfolio were brought on balance sheet. The commonly reported number is $43 billion for Fannie Mae and $38 billion for Freddie Mac.

Of course, its ridiculous to think that regulators would allow an accounting rule change to dictate the GSEs minimum capital. Economically the GSEs are no more or less safe whether this stuff is on balance sheet or off. Its especially ridiculous given that a capital infusion of that level would be impossible to achieve in almost any market, much less now. And the GSEs alternative would be to sell massive amounts of MBS on their books, which would benefit exactly no one. Indeed OFHEO director James Lockhart has said point blank that FAS 140 should not apply to the GSEs and that accounting changes would not drive a capital change.

The second is where we should go from here with the GSEs. I will ignore what the Libertarian in me would like to see and thinking about what could happen. In other words, we should take it as a given that the base mission of the GSEs will remain as is. Congress wants to see some entity out there which can promote home ownership and help stabilize the mortgage market.

My idea would be to break up Fannie Mae and Freddie Mac into several, smaller entities. Say we make it 10 different companies, which I'll just call the "Macs." The $4.5 trillion guarantee portfolio would be divided equally among the Macs, not by geography, but more or less randomly, with some effort made to be sure the quality of each loan portfolio is roughly the same.

All of the Macs would be given a credit line with the Treasury equal to 10% of their guarantee portfolio. Any amounts drawn on the line would be at some small spread to LIBOR, say 3-month LIBOR + 20bps. This would in essense ensure liquidity at each of the Macs while at the same time giving them a strong incentive to use private funding, which would almost certainly be at a better rate than LIBOR +20. Note that historically, Fannie Mae and Freddie Mac debt has traded at LIBOR minus 20 or so.

The Macs capital adequacy could be managed more like a bank's. And there would be a stipulation that if the Macs capital fell to a certain level, the Treasury would take over operations, not unlike the FDIC taking over a failing bank. There could then be something similar to a bankruptcy procedure, but with the Treasury credit line ensuring that some mass contagion did not ensue.

What's the advantages here? First of all, no one Mac would be too big to fail. If one of the Macs f'ed up their hedging or some such, the government could liquidate shareholders relatively easily. Second, there would be a more known procedure for what happens in event of a Mac failure. Third, having several Macs would encourage competition among them, which would probably drive mortgage rates down. As it is, Freddie and Fannie are dictating terms of the mortgage lending business.

Now I know this isn't a complete plan, but I'm interested to hear comments on what we should do with the GSEs. I encourage everyone to remain within the realm of realism. There will be such a thing as a GSE in the future. So let's consider what they will look like.

16 comments:

Greenie said...

GSEs are to US government what SIVs were to Citibank and other big banks.

Only solution here is to bring GSEs on to the balance sheet of Federal government, so that people understand the true cost of subsidized housing. Anything else is going to perpetuate the concept of creating free money out of nowhere. Congress will continue to claim that their non-stop bailouts will not require much of taxpayer's money.

Zlatko said...

This is just treating the symptoms instead of the underlying cause. As long as government is expanding the money supply then we'll have crises of malinvestment regularly.

NorkaWest said...

"...having several Macs would encourage competition among them, which would probably drive mortgage rates down..."

It could also drive risk up as the managements of each Mac competed to maximize profits on their watch. If one Mac did something apparently profitable, financial analysts would beat up the managements of all the other Macs to copy and double-up. It would all be done in the name of "maximizing shareholder value."

TJ said...

Fannie and Freddie are failing due to risks that are systemic to their business. I don't see how breaking them up into 10 mini-Macs would change this systemic risk into idiosyncratic risk. Instead of two failing companies, you would have 10, and the 10 of them collectively would still be too big to fail.

Accrued Interest said...

Yes, all 10 would be too big to fail, but with a large credit line with the Treasury, every one would assume they wouldn't fail. So it would never come to this.

Feanen said...

I think the government should lend them money, but put restrictions in place while they are lending money. Things like a cap on how much any execs can be paid in cash in any year (stock grants could remain unlimited) and no dividends paid or stock buybacks until the government loan is paid off. Any cash not being used to pay off regular debt should be paying off the government loan. The government loans should be set up as senior to everything else the GSEs have issued. They should also be set at a rate relative to US treasuries, because that locks in a profit for the government (which will have to issue treasuries to fund the loans).

Refusing dividends and forcing the senior execs to be paid in stock will give them a very strong incentive to fix the mess quickly. It will also mean that only someone who thinks they can fix things quickly will be willing to take the job.

These companies will be profitable in the long run. No matter how large the losses are, they will eventually be made up for with future profits. This should not cost taxpayers anything, even if the government loans money to the GSEs. The loan terms could specify that the margin to treasuries is based on the size of the loan, so that it could more than cover the extra interest the government will have to pay on all of its regular debt.

DogFace said...

"Not only are they the biggest non-Treasury issuers of straight debt securities..."

Actually, the Home Loan Banks have them beat. Last year the FHLBs, which issue on a combined basis, sold more bonds (straight debt securities) than Fannie and Freddie together (http://www.sifma.org/research/pdf/RRVol3-2.pdf, page 5). The next shoe to drop?

basispoint said...

The recent GSE issues are symptoms of the problem. Forget FAS 140, forget the liquidity problem (in reality a solvency problem), forget the stock price. The mortgage model is badly flawed and until the investor, including the GSE's, realizes the optionality that has been given to the borrower the problem will repeat itself. There isn't a solution to the current problem; at this point there is merely the assignment of loss.

Bill said...

Feanen,

Don't mean to rain on your parade, but didn't the black box accounting of Fannie Ma'enron and Freddie MacWorldcom in order to boost their stock price and trigger executive bonuses lead to several hundred million dollars in fines and their inability to produce reliable financial statements? In hindsight, better they were de-listed (as any other company in their position would have been) as that would have minimized the crisis caused by watching their share price pancake. Yet another example of unintended consequences caused by Gov’t interference.

Wriiight said...

Their debt is still cheap for them to issue, their defaults aren't crazy yet, their reserves have not fallen below the 20% cap that OFHEO added to their regular requirements. I can see how their promised capital raising is now totally f'ed, but collapse? Bailout? The Fed is just doing the same confidence building type measures that they did for the banks during the start of the crisis, and in this panic it just isn't helping at all. My (not wholly impartial) view? The stock prices need rescuing, but the GSEs are fine.

Wriiight said...
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Molten_Tofu said...

Have to say I'm with tj on this - I'm not sure how 10 mini-macs would accomplish anything except, like you say but put differently: it would more socially acceptable for 10 mini-macs to fail then one big mac (mmm McDonalds...).

If it's a whiny CEO/America thing (a la what The Big Picture is all worked up about) 10 mini macs is a step in the right direction.

If it's a fundamentals thing, the portfolio hasn't changed, and neither has the risk. The only chance we have of this plan helping is some kind of agent-based-modeling emergent phenomenon type situation.

And I don't really believe in emergent phenomena any more...

Accrued Interest said...

I think the basic fundamentals of the GSEs isn't going to change anyway. What I'd like to see is two things.

1) In a systemic situation (like now) there would be a known backstop for the GSEs. Now we are sweating Congressional approval for a GSE bailout.

2) In a non-systemic sitation (e.g., one of them makes a bad hedge or they hire Nick Leeson), they can be liquidated. Right now anything idiosyncratic at one of the GSEs immediately becomes systemic.

cap vandal said...

Splitting them into small chunks would increase competition which is not what they need.

Right now the public/private dual nature is causing Paulson to be fundamentally wrong. That is, they need support for the equity so they can raise more. In addition, it is thought to be in the public interest for them to expand to provide adequate liquidity for the mortgages. However, if they start acting more like a private entity, they would be shrinking their balance sheet.

Actually, I think will contract in a manner that makes things worse. If they are making money today with today's fees and today's quality of business, then they should earn their way out of as much of this as possible.

The new pressure from the short side may drive the equity down further. If you go back to 1938, the basic idea was to provide counter cyclical liquidity and support for mortgage/homeownership. If they can't do this, then they really serve no purpose.

Shervyn said...

I honestly would like to see the two institutions completely dismantled and turned into private companies and in place of them for banks to be able to issue covered bonds (similar to German Pfandbriefe) in its stead. So all financial insitutions would be able to tap into the same debt markets that Fannie and Freddie currently dominate.

Accrued Interest said...

I really like the covered bond idea as a long-term solution to bank capital.