Tuesday, August 26, 2008

GSE Bailout: Alternative forms of persuasion

The other day I wrote about a possible form of a GSE bailout. In the spirit of stimulating creative ideas, here is another possibility. Bear in mind that its looking more and more like a bailout isn't imminent (meaning its a matter of weeks or months, not days). I expect an interim step, probably some kind of purchase of MBS, to come before any actual injection of cash.

Despite what all the talking heads are saying, no one really knows, maybe not even Henry Paulson, what a bailout will actually look like. But there are ways that a bailout could be structured to both protect senior bond holders and help prevent the need for another bailout in the future. Now is a good time for people with good ideas to come forward.

First we have to consider what the goal of a bailout should be. In this case, its very simple: ensure liquidity to the mortgage market. This protects banks which have committed to home loans assuming one of the GSEs would buy them. This also keeps mortgage borrowing rates stable.

Beyond that though, there needs to also be some long-term solution to the GSE situation. Fannie Mae and Freddie Mac cannot return to business as usual. Another structure needs to be devised that reduces the systemic risk surrounding the mortgage GSEs. On the other hand, a simple "demonstrable privatization" is not a near-term solution either. Currently Fannie Mae, Freddie Mac, and Ginnie Mae are the only thing standing between here and absolutely zero market for home loans.

Many solutions being bandied about presume the long-term model for mortgage securitization remains in tact. But why? A big part of the inherent problem in the GSEs' current business model is that it requires substantial leverage to generate a reasonable return on equity. Think about it. They collect a relatively small fee in exchange for guaranteeing MBS. The de facto leverage created is huge, evidenced by the fact that foreclosure rates in Fannie and Freddie's guarantee portfolio remain fairly low, and yet both GSEs are facing capital problems. There is just no way around the leverage issue if the current business model remains in tact.

Covered bonds have been advanced as a long-term solution for the mortgage market. But covered bonds, as currently conceived, would not be a good replacement for agency MBS. This is because covered bonds would not trade generically, meaning that a covered bond from smaller banks would trade as well as those from larger banks. We'd wind up with large banks dominating the mortgage market, which has its own systemic risk problems.

So what if in the future the GSEs provided some limited guarantee on covered bonds? Remember that a covered bond is backed both by the credit of the issuing bank as well as a pledged pool of mortgages. So in order for anyone to take a loss on a covered bond, the bank would have to be bankrupt and mortgages would have to be defaulting.

Let's say the newly recapitalized GSEs are restructured more like an insurance company, where the GSEs would guarantee to investors some percentage of par, say 95%. Banks would remain on the hook for losses within the pledged pool as long as the bank itself remained solvent. But in the event that the bank goes under, covered bond investors would have a known limit on their losses. The GSE would also have contained costs, since in most cases the pool of mortgages which had originally secured the covered bond would have some residual value.

This a plan combines the best parts of both the covered bond idea (alignment of incentives) and the original mission of the GSEs (lowering mortgage rates). It would also kick-start the emergence of a covered bond market, because it would give investors a known set of outcomes when buying the new bond sector.

That leaves what to do with the old GSE guarantee portfolio. Assuming the Treasury has infused Fannie Mae and Freddie Mac with new capital, those portfolios could simply be allowed to run off. Alternatively, the Treasury could require the new GSE to buy preferred shares of the old Fannie and Freddie, helping to offset tax payers costs. Eventually this new GSE could be "demonstrably privatized" as market confidence is regained.

28 comments:

ravinenator said...

I'm worried about the following analogy:

"GSEs as insurers" : covered bond market as
monolines : municipal bond market

Given that example, it isn't clear to me that the "GSEs as insurers" model will actually do any better at preventing systemic problems... What happens if people stop trusting "insurer GSE" insurance?

GS751 said...

"First we have to consider what the goal of a bailout should be. In this case, its very simple: ensure liquidity to the mortgage market. This protects banks which have committed to home loans assuming one of the GSEs would buy them. This also keeps mortgage borrowing rates stable."

What about Moral Hazard?

~~~~~ Preftrader ~~~~~ said...

The Pref Dilution Continues

Bank of Nova Scotia today announced quarterly earnings just over $1 Billion.

An hour later, Bank of Nova Scotia announced yet another Preferred Share offering, this one for $200 million.

For all you analytical types that are ready to pounce . . .

(continued at preftrader.blogspot.com)

Accrued Interest said...

Avoiding moral hazard is a goal, but isn't *the* goal. I feel like the blogosphere is obsessed with moral hazard, allowing that issue to trump everything else.

See this:

http://tinyurl.com/6od3kc

Wisdom-Seeker said...

All in favor of stimulating new ideas, but we should be simplifying the system instead of layering on added complexity ( = hidden risks, unintended consequences...)

Grammar Nit: "in tact" -> intact

I take some exception to this:

"Currently Fannie Mae, Freddie Mac, and Ginnie Mae are the only thing standing between here and absolutely zero market for home loans."

No... the market would re-equilibrate at higher rates and favoring better credit risks. Securitization might be dead, but as long as there's money to be made in lending, there will be lenders. And even without lenders, if home prices fall far enough there will be those willing to buy the properties with cash and rent them out again. There will always be a housing market. Beyond that, we don't need a market for securitized home loans. The one we tried didn't work. Phase out this monstrosity that we've stuck ourselves with, and run the bad vintages off.

I suggest we go back to the desired end-state:

"Another structure needs to be devised that reduces the systemic risk surrounding the mortgage GSEs."

Why not simply eliminate the government "guarantees" altogether? We need to stop enabling risky behavior whose consequences are not borne by the risk-taker. Whenever someone claims that the government is "insuring" something, all they're really saying is that the "insured" (i.e. risk-enabled) gamblers will keep any gains, and the rest of us will be eating the socialized losses.

If we get the government out of the mortgage market (on the path of least pain) and implement straightforward regulations to prevent banks from over- and mis-lending again, we'll buy another 80 years before the next generational credit crisis, at the lowest possible price.

I see no sustainable forward path with government-subsidized lending. The risks have to be minimized (through careful underwriting) and the residual risk has to be paid for by someone. As we've all learned this year, risks are not minimized unless they're borne directly by the creditor handing out the cash. And the government can't be that creditor because the government isn't handing out its own money. It's our money as taxpayers that's at stake. Fannie and Freddie and the FHA and such are all piled high with dogcrap loans that we'll have to pay off via the national debt.

The most efficient mortgage market is likely to be the simplest one, where the creditor is best able to understand the borrower's risks. Everything else is just shell games with hidden risks and agency costs. If investors want to buy mortgage-based securities, they should buy bank-issued stocks and bonds, and leave the bank on the hook for the quality of the loans it makes, rather than going through a GSE and putting every U.S. taxpayer on the hook.

Daniel Newby said...

Moral hazard is the cause of the financial meltdown. The GSEs have high leverage because their executives are playing with other people's money with no consequences. The banks laundered their portfolios into GSEs specifically to make Joe Taxpayer cover their gambles. The sound banks are being kept from doing business by GSE risk mispricing specifically to keep an open market from starting to clear transactions.

And why all the angst about mortgage bond insurance? The down payment, collateral value, and inconvenience of eviction provide inherent insurance of extremely high quality. If those factors do not provide good insurance, then the mortgage writer is speculating, not investing, and insurance cannot help.

"... the original mission of the GSEs (lowering mortgage rates)."

How were the GSEs ever to accomplish this except by mispricing risk? I agree the that the GSEs may have served as a useful national clearinghouse back when software and networks were primitive, but these days anyone can package anything into an ETF and trade it to the four winds. All that we need are for the GSEs to stop skimming all the profit with their underpriced risk and time for rational underwriters to start dipping toes in the water.

Mark said...

I entirely agree that moral hazard is the main issue here. Look how well hedge funds have handled the financial crisis. Yes, there have been a few blow-ups but for the most part hedge funds have thrived.

How is it that these financial "newcomers" have succeeded where the banks & GSEs have failed? Simple, they have their own money at stake and highly value their reputations.

All the government regulation has created a system that allows for massive leverage, opaque disclosure, and asymmetric payoffs. That is a recipe for disaster.

Now is the time to create a system based on common sense. Yes, homeowners will lose more money. Then again, that is money they never should have "earned."

Cate Long said...

Wonderful ideas...

Accrued Interest said...

If all you care about is avoiding moral hazard, then you allow the GSEs to survive or not survive on their own.

Then you eliminate unemployment insurance, farm subsidies, government-backed student loans, etc.

All I'm saying is, let's not kid ourselves into thinking that tax payers aren't going to take on some risk/cost here. I agree with comments that moral hazard is a big part of this whole credit crisis. But I think a more accurate term is the "principal/agent problem." Where the person choosing the risks and the people bearing the risks are different entities.

I'll also say that other financial institutions are much more to blame for this problem than the GSEs. The GSEs fostered the growth of securitization to be sure. But the GSEs are looking at relatively small losses as a percentage of assets (made problematic only by the degree of leverage). Whereas other institutions were the ones providing seemingly unlimited cash for no-doc and/or speculative loans.

So I merely posit that while the GSEs are a disaster, their problems are more of a knock-on effect of weak lending standards. And while they had something to do with those weak standards, they are not the primary culprit.

Accrued Interest said...

Oh and on the muni insurance comparison... fair enough. But the muni insurers, if they had stuck to muni insurance, wouldn't be in this mess. And even as it is, the muni market is still functioning just fine, at a higher spreads to be sure, but still functioning.

If Fannie and Freddie went down, mortgage lending would drop 80% or more.

PNL4LYFE said...

If we choose to punish FRE/FNM now to prevent moral hazard, the victims will be all homeowners and all banks, not just the ones that behaved irresponsibly. Take away FNM/FRE and the mortgage market will either cease to operate or reprice to such high rates that no one can afford a mortgage even with house prices down so much. Prices will probably wind up down 60-80% from the peak nationwide.

Also, one thing that no one ever mentions is that homeowners and taxpayers are THE SAME PEOPLE! To save the taxpayer from the potential liability of guaranteeing the GSEs, you're going to haircut the value of his biggest asset by another 20-40%? That makes no sense to me. One thing that's certain is that the amount of wealth destroyed by allowing the collapse of the GSEs will be orders of magnitude larger than the cost of guaranteeing their obligations.

Lastly, the fall in house prices will disproportionately punish lower and middle income homeowners since their houses are a larger portion of their net worth. And since the wealthy pay a larger share of the tax burden, guaranteeing FNM/FRE debt will potentially punish them more. So if part of the moral hazard argument is that wall st. should not be bailed out at the expense of main st., why would anyone want to further damage the housing market?

Accrued Interest said...

Well put PNL.

Wriiight said...

Just to voice my opinion on a couple of things:

Someone said "Securitization is dead", which I don't believe for a second, though it certainly down for a 10-count at the moment.

When securitization returns, banks are healthy, and there is some regained confidence in lending standards, I think the world could live without the GSEs and only suffer from rates comparable to Jumbo.

One big exception: lending would get much more expensive for low income and low house price. I don't think people realize how much worse the performance of these loans are, and how much the GSEs have helped this sector by pooling the risk with the loans in the upper half of the conforming loan limit.

That being said, now is a TERRIBLE time to do away with the GSEs, because the other banks are in no position to take up the slack. Lets talk more drastic plans after the dust has settled. We can debate about how, when, or whether to rescue in the meantime. (I still vote this is mostly hysteria, but there are reasons I can be considered less than impartial)

Unsympathetic said...

PNL and AI, it's time to stop drinking the kool-aid.

1) " or reprice to such high rates "

Why exactly do you think the market would reprice to higher rates? Shocking how you suddenly don't trust the wisdom of the market when you can't skim free bips off the top and jawbone the rest of the world into believing your schlock.

The reason house price rates would adjust is that THEY NEED TO ADJUST. The current economic situation is the inevitable result of years of free money, which you can't fathom ever stopping.

Home loan rates NEED to adjust - because the current rate does not price in the cost of default.

2) " Prices will probably wind up down 60-80% from the peak "

The reason prices went up is wholly a realtor-driven gratuitous ponzi scheme. Prices are not a reflection of any underlying "reality" other than the job market for a particular neighborhood.. 3x income must be the price ceiling, NO MORE.

Every time prices go higher than 3x median income, that's the definition of a bubble and economic fallout is inevitable.

House prices are not a microcosm of the economy, house prices ARE the economy.

PNL4LYFE said...

Unsympathetic: I don't disagree with anything you said; I only disagree with the timing. I think a drastic fall in nominal prices will be an unnecessary disaster for homeowners (i.e. consumers), banks, and the rest of the real economy. I think a best case workout would result in nominal prices falling perhaps 15% further from here and then stagnating for as long as it takes for price/income metrics to come back to historical levels. When this happens, nominal prices will begin to rise again and the rate subsidy can be removed in such a way that it won't cause waves of defaults. Ideally, the mortgage interest deduction would go too, but I'm not holding my breath..

Daniel Newby said...

pnl4lyfe: "Also, one thing that no one ever mentions is that homeowners and taxpayers are THE SAME PEOPLE!"

No. It is the minority of "homeowners" who "need" mortgage handouts. The vast majority of taxpayers either own a home free and clear, bought well within their means, or are renting. We don't want to pay higher taxes in order to artificially drive up housing prices.

In fact, I live in an area where housing costs are either flat or even up a little from 2007. Because there was no bubble and little suicide lending. Anyone who proposes to raise our taxes so hairdressers can live in handout mansions in pleasant coastal cities had better be bulletproof.

"To save the taxpayer from the potential liability of guaranteeing the GSEs, you're going to haircut the value of his biggest asset by another 20-40%?"

This is wrong on so many levels. Firstly, the value is unchanged. It is the market price that changes, and that is the expected outcome of trying to run a get rich quick scheme. Gaining $300k requires years of hard work, not "appreciating" a house. Secondly, a house is not a monetary asset, it is an illiquid consumption good. E.g., selling one house and buying a replacement typically blows 10-20% of sales price on overhead and expenses. It's a place to live. You can do carpentry without the landlord blowing a fuse. It is not a Vanguard fund.

AI: "Then you eliminate unemployment insurance, ..."

Indeed. It's not insurance if you can be permanently banned from receiving payouts yet be forced to pony up premiums.

Unsympathetic said...

pnl:

1) "a best case workout would result in nominal prices falling perhaps 15% further from here and then stagnating for as long as it takes for price/income metrics to come back "

This is ENTIRELY wrong.

Nominal prices will AND SHOULD fall all the way down until price/income metrics come back.. back to 3x the income of each homedebtor in the area. 36% back-end DTI - no games.

Wages won't inflate in the US, despite what the Fed morons state. Krugman just showed today that wages have stagnated on his NYT blog. The EU will experience wage/price inflation due to their unions.. the US will not.

2) "a drastic fall in nominal prices will be an unnecessary disaster for homeowners"

Wrong. This is pure pablum.
a) Fixing prices has never and will never work, because nobody will buy at the gratuitously high price.. a la Japan. The people who lose their house due to leverage -- should not have been homeowners in the first place because they couldn't afford the loan without price appreciation.

b) In fact, we call those people "Homedebtors." Homeowners.. own their house, and are not affected aside from having their tax burden lowered. Homedebtors who didn't get a 20% down, 36% back-end loan.. lost their risky bet.

Instead of fixing house prices, we should clawback all Wall Street securitization profits from 2004-2007 to cover the losses as the Ponzi scheme deflates.

PNL4LYFE said...

Daniel:

When I referred to homeowners and taxpayers, I wasn't referring specifically to people who overborrowed. Every person who owns a house will be hurt by falling prices. In fact, people who own their home outright will be hurt WORSE by further declines from here. The reckless borrowers have already lost everything they invested (if anything) and can't be hurt by further price declines. Only responsible people like yourself will be hurt.

"Firstly, the value is unchanged. It is the market price that changes.": Wow!! This is the best news I've heard in months! I suppose this means that banks should write all their CDOs back to par because the fact that they're trading at 20c is only a market price and not their 'value'. /sarcasm off

Seriously though, this argument only holds any water if you assume that you will live in your house (or another house that you own) until the day you die. If you have to move for job-related reasons or because of a change in life circumstances, the market value of your house is very important. The fact that transaction costs are high and that housing is not productive does not mean that it is not a monetary asset.


Unsympathetic:

1) "Nominal prices will AND SHOULD fall all the way down until price/income metrics come back.. back to 3x the income of each homedebtor in the area. 36% back-end DTI - no games.

Wages won't inflate in the US, despite what the Fed morons state. Krugman just showed today that wages have stagnated on his NYT blog. The EU will experience wage/price inflation due to their unions.. the US will not."

As I said before, I agree that prices/wages must eventually come back to a sustainable ratio. My argument was that to do so in an orderly manner over a period of time will prevent a lot of economic disruption. For bank solvency, nominal prices are what matter. If the price correction happens all at once, then we will have to bailout the FDIC instead of the agencies; pick your poison.

I have not read the Krugman post you are referring to, but I assume he was referring to real wages. Even if real wages are stagnant, they will eventually catch up to nominal house prices.

2) "Fixing prices has never and will never work, because nobody will buy at the gratuitously high price.. a la Japan. The people who lose their house due to leverage -- should not have been homeowners in the first place because they couldn't afford the loan without price appreciation."

Continuing the long-existing policy of artificially low mortgage rates is NOT the same as a price control; it changes the price at which people should be indifferent between buying and renting. There are countless tax and subsidy policies that influence the market price of various commodities. Why make the change when the housing market is already under unprecedented pressure?

Disclaimer: Just so that no one thinks I'm 'talking my book', I have thought housing (particularly CA) was doomed since 2003 and convinced several friends to sell in 2005. But I am still a citizen and would rather not see the entire economy damaged to punish the reckless people who have already lost whatever they invested.

~~~~~ Preftrader ~~~~~ said...

Canadian Banks remain unstoppable -- but prefs are still junk

It's unbelievable actually; with all the big 5 third quarter numbers on the street, and National in as well, the numbers defy reality. Scotia, Royal, and TD all reported a net profit in the vicinity of $1 billion. BMO and CIBC came in with a half billion and about $80 million respectfully, showing the only ABC exposure that amounts to much in Canada. National reported a record profit of $286 million.

Accordingly, all the common stock of these 6 which has been rising steadily all week, is on fire today. All in all, we have gains of approaching 10% in this sector over the past week or so.

What does it all mean? Well, for one, it means that regardless of financial calamity anywhere else, Canadian banks . . .

continued at preftrader.blogspot com

Accrued Interest said...

Pref: Calm down with the blog pumping.

Others: It sounds like there is a liquidationist streak in some of what Unsymp and others are saying. To me that's exactly what got the Great Depression going. You cannot assume that a market gripped by fear will ever reach equilibrium.

I'm going to write another post on the subject of fear/illiquidity causing markets to simply not function. I know there is a strong contingent who doesn't believe that illiquidity is ever a problem. But I'm telling you that it is. I'm also telling you that every one at the Fed and the ECB and the BOJ and the BOE thinks that it is.

Accrued Interest said...

Great conversation by the way. Even those I disagree with here are well reasoned. See and some people thought that eliminating anon posts ruined the blog!

Covenant said...

There is no immediate need to bail out Fannie/Freddie ("F&F"): First, both F&F are adequately capitalized according to their regulator, the FHFA. Second, the regulator/congress could remove the excess capital restrictions which were put in place back in 2004 following the accounting irregularities investigation. That would free up Fannie's capital by 15% and Freddie's by 20%. Third, F&F can borrow from the Treasury if they ran into trouble rolling maturities or if it got too expensive. Fourth, if F&F were to become severely undercapitalized and the government decided it was time to step in, while I agree that common shareholders would likely be wiped out, Treasury would not want to wipe out existing the pref holders, and could purchase Prefs parri passu to exiisting. That would also have the effect of lowering the pref yields and their borrowing costs.
I'm sorry but I don't agree with breaking up F&F I think it would be counterproductive, if anything Treasury should look ahead to merging them and then providing a full federal guarantee.

Unsympathetic said...

pnl:

Wages will, indeed, get to the 04 bubble prices - IN 40 YEARS.

covenant:

" excess capital restrictions which were put in place back in 2004 "

If they had excess capital restrictions, there wouldn't be a problem with drops in the value of the underlying. Rather, their capital restrictions are TOO LOOSE.

Easy money will never be a solution to the problems caused from easy money.

Unsympathetic said...

" on the subject of fear/illiquidity causing markets to simply not function "

It's not a great secret that the governmental organization finally set up to runoff the Great Depression assets (HLC) ended up being a net positive for the taxpayers.

However, my point (and the point of the so-called "liquidationist" group that you saddled me with) is that eventually liquidity is simply pouring money into a singularity - because consumers have hit the wall.

OK, you're adding liquidity as a central bank. So? Who actually gets the money? The BANKS, who use it as tier 1 capital to backstop their own losses from the stupid loans they've already got on their books. THEY DO NOT LOAN MORE.

What happens when loan losses don't need to be taken? Prices don't need to be marked down. So we sit in a comical standoff.. no price discovery, yet we've added liquidity as a central bank and are shocked - SHOCKED! - that loan activity (and consumer shopping activity) isn't magically occurring. But the models say it should work!

"Liquidation mentality" didn't cause the depression. Rather, the inane credit expansion of the 1920's made it an inevitability. And we've gone right back there because "it's different this time." Sorry, but no.

P.G. said...

I wonder if 5% is enough. You have to leave enough of the loan with the bank for them to have their nuts in a wringer if they go bad. They are made whole after a year or so in interest payments if they can sell 95% of the loan, and after that it's all gain. The SBA program that seems to be working well in striking default fear in the hearts of bankers requires that the bank hold 15 to 25% of the loan and the SBA guarantees the rest of the loan even when the guaranteed portion is sold into the secondary market. Then again, If banks had to hold onto 25% of their mortgage loans, I don't think it would provide enough liquidity for the mortgage market to function.

Accrued Interest said...

My theory would be that the bank would be 100% on the hook for all the mortgages as long as they remained solvent. If the bank itself were insolvent, then the government backs 95% of the principal, or something similar.

Accrued Interest said...

Unsymp:

We'll have to agree to disagree that lack of liquidity caused the Depression. But I will point out that Ben Bernanke believes in the liquidity theory. So I'd argue that liquidity is what we're going to get.

anon said...

"If all you care about is avoiding moral hazard, then you allow the GSEs to survive or not survive on their own.

Then you eliminate unemployment insurance, farm subsidies, government-backed student loans, etc."

You know what? Much of this *should* be eliminated. It should largely be replaced with *direct cash transfers*, rather than loans.

Educating people is a public good: instead of student loans, we should have a massive expansion of student *grants*.

Instead of unemployment insurance, we should have a *guaranteed minimum income* paid to people whether employed or not (also called "negative income tax bracket").

Farm subsidies should be replaced with a government 'food security' program where the governement owns and guarantees the operation of a particular collection of farms designed to keep a secure minimum food supply (vaguely parallel to the Strategic Oil Reserve). (Farm subsidies also serve some environmental functions, which internalize externalities and need to continue in some form; the Soil Conservation Program is essentially sound, for instance.

We decide that people having housing is a public good? Then -- if the negative income tax isn't enough -- we provide government-owned and government-subsidized housing. Oh wait, we do, it's called HUD.

We decide that people *owning* housing is a public good (which I'm not sure about)? Homestead Acts: the government buys up masses of housing, and lets people get *title* to if they live in it and treat it well for X years. (Imagine HUD clients getting control of their apartments after X years -- they might treat them better, right?) Side benefit: the government can encourage housing in places and designs which are better for long-term planning, rather than the endless sprawling tract houses.

Structuring the government subsidies as "loans" has caused nothing but trouble. It amounts to phony accounting: since the government is not going to act like a hard-nosed lender, it shouldn't pretend to.

Where to get the cash for all these direct-payment programs without the government borrowing it? Well, that's what the progressive income tax is for.... the one which has become continuously less progressive in the last 50 years. The progressive income tax also acts as a major economic stimulus by transferring cash from the rich (who save it, generally) to the poor (who spend it, generally).

The big exception, the one form of government "insurance" which should be kept as "insurance", is deposit insurance, because it's designed specifically to prevent bank runs. However, it goes hand in hand with massive, massive, very restrictive, government regulation of banks: that's the only way to mitigate the moral hazard.

Sigh....