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Will Continued Stealth Bailout of Housing Produce Unwanted Side Effects?

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The Treasury Department, as reported by Bloomberg, and commented on by Rolfe Winkler and Huffington Post (among others) noted, considerably increased its Freddie and Fannie safety net, by removing all limits on the amounts on offer (an increase from a ceiling of $400 billion) and simultaneously allowing the two GSEs to increase their balance sheets near term. Previously, they had been required to shrink their portfolios by 10% per annum; now it is their ceiling which will be lowered by 10% a year, and that ceiling is much higher than their current exposures ($900 billion versus roughly $760 billion for Freddie and $770 billion for Fannie as of the end of November).

A stunner reported at the same time was that Treasury bought $220 billion of MBS last year, in addition to the massive Fed purchases.

The timing of the announcement (Christmas Eve) was designed for it to receive as little notice as possible, already a bad sign. Skeptical observers focused on two possible explanations: first, that losses at the GSEs will be high, troubling investors, and the offer of unlimited support will calm them. Freddie and Fannie debt is now de facto a full faith and credit obligation of Uncle Sam, as if there was any doubt of that once the conservatorship was announced. But the idea that nearly $300 billion of firepower (the agencies had used roughly $110 billion of an authorization of $400 billion) is troubling.

The relaxation of the requirement that the GSEs shrink their balance sheets is also not pretty. I’m sure the argument would go something like “after all this extraordinary support to the housing markets, we don’t want Fannie and Freddie reducing their commitments at the same time when the Fed is ending its support.” That could have been achieved merely by pushing out the shrinkage timetable a year, rather than allowing for Freddie and Fannie to conceivably increase their exposures by over $200 billion between them. So one has to conclude that the agencies might well (ahem, are likely to) throw their firepower behind the “prop up the mortgage market” program, particularly with Obama’s ratings plunging and mid-term elections coming this year.

But if this comes to pass, what might the collateral damage be? Well first, even if you are not of the Austrian (malinvestment) persuasion, subsidizing the housing market to this extent is simply not a good idea. Housing is not a productive investment, and some research suggests that high levels of consumer indebtedness are correlated with lower levels of GDP growth (business debt, by contrast, is positive provided it is funding useful projects, versus, say, land and stock market speculation, as was the case in bubble era Japan).

But second, having the GSEs increase their balance sheets (assuming that does occur) creates other complications. John Dizard explained this back in 2008:

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..

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 {Yves here, Dizard is being ironic]. 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 [Yves here, that also happened to be the position LTCM got itself into right before its meltdown...]. 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…
Yves here. Since everyone who counts is now backstopped, we of course have no reason to worry now. Back to Dizard:
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…

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.

Yves again. A lot of commentators have worried about credit risk at the GSEs, and that is a real concern. But they have missed the increased interest rate assumption taking place, and that is occurring independent of portfolio growth as more mortgages are refinanced from floaters to fixed. And that could conceivable be exacerbated if the GSEs expand their portfolios in 2010. But that very growth increases systemic risk. A lovely equation.

One has to wonder if this calculus contributed to the Treasury’s decision to give Freddie and Fannie open-ended support.

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32 comments

  1. RueTheDay

    My take is that there’s a clear reason why the GSE caps have been eliminated shortly before the Fed is to wind down its MBS purchases: the next step is for the Fed to start unloading its holdings on the GSEs. The GSEs are to become the “bad bank” that was much discussed in the early days of TARP.

    1. Yves Smith Post author

      RueTheDay,

      The problem here, and I did not say this clearly in the post, is Fannie and Freddie are not good vehicles for this role, except around the margin. Recall that they are 79.9% owned by the government. The powers that be kept the fiction of private ownership for the same reason the GSEs were spun out of the government in the first place: to avoid consolidating the debt.

      So Fannie and Freddie, unlike the Federal government, must report earnings and its balance sheet according to GAAP. This constrains how much it can use the GSEs as a dumping ground.

  2. AgencyBystander

    This is an interesting topic RE the GSE Portfolio Hedging. There were some great interest rate futures opportunities that developed due to GSE dynamic hedging in the past. Early Spring 2002 and Late Summer 2003 for example stand out in my memory. The GSEs were forced to chase a temporarily falling bond market and really drove out the Eurodollar Futures Curve as one consequence. It seems like other knowledgeable market participants get out of the way which exaggerates the move.

    A key question is whether the GSEs funding/hedging approach going forward will be the same as it was now that it is effectively in the end run by the Treasury Dept and maximizing ROE will not be the primary goal. For example if most/all funding were done with Callable Debt the dynamic hedging would be less or not even necessary. Not sure whether that is feasible. There are possibly/probably other funding approaches that would reduce the need for dynamic hedging. Would love to hear from Yves or anyone who knows what the Fannie/Freddie funding/hedging approach will be now compared to early 2000s.

  3. David

    Certainly, the high levels of household mortgage debt impede the recovery as well as simply the quality of life for many Americans. But allowing rates to go back up before this is passed through the system will tighten the screws further on those mortgage debtors, exacerbating the depressing effect on the economy.

    A decision has been made to take private debt onto the government’s books, and this is just another step on that path.

  4. anonymous

    But surely the vicious circle can be broken if the GSEs can simply ignore mark-to-market losses and therefore no longer need to carry out those procyclical hedging operations. This can be accomplished by nationalizing whatever small part of them isn’t already nationalized, or simply by fiat (after all, the “recovery” of financial stocks began in March soon after mark-to-market was weakened for those companies).

    1. Yves Smith Post author

      Per above, they are not going to be fully nationalized. The whole reason for the conservatorship was to avoid consolidating the debt as government debt. That is simply not happening, absent a very radical set of events that would make it advantageous.

  5. charcad

    Yves,

    subsidizing the housing market to this extent is simply not a good idea.

    Is this in fact what’s being subsidized? If so, then never in the course of human events has so much been spent to obtain so little (to paraphrase Churchill paraphrasing others). The results make military procurement practices look like a model of efficiency.

    “Meanwhile, individuals built nearly three million houses during the nineteen-thirties without government aid…”

    A.J.P. Taylor, English History; 1914-1945, The Oxford History of England.

    iow, during the Great Depression in the 1930s the UK built at a rate of 300,000 houses annually. In November 2009 the US new construction rate was about 355,000 per annum for a country with at least seven times the population of the 1930s United Kingdom. And this is after the temporary tax credit.

    Nothing in existing home prices would lead one to believe they’re being effectively subsidized, either.

    The other report we just had was Freddie Mac’s call for 6% 30 yr fixed mortgages in one year.

    http://www.washingtonpost.com/wp-dyn/content/article/2009/12/26/AR2009122600031.html

    If any part of this prediction comes true we’re clearly still a long way from any r.e. bottoms forming for prices or volume.

    Housing is not a productive investment

    I agree with this. However, where is a “productive investment” opportunity to be found in the USA at this point?

    1. ozajh

      There was massive pent-up housing demand in the UK at that time, and the Great Depression had strong regional aspects, especially after about 1932. In the South and around Birmingham, the recovery was much faster than further North, with conditions almost normal by about 1936.

      This was also the decade where private cars became somewhat affordable, the Underground (subway) network grew in London, and bus networks grew rapidly everywhere. In short, commuting became possible for a much larger percentage of the population.

    2. liberal

      Housing is not a productive investment…

      Ask anyone w/o a roof over their head whether housing is a productive investment.

      The point is that a house is a productive investment. “Housing,” however, is a house plus land. The house is a capital investment; the land isn’t. Unimproved land yields income which is pure economic rent. That’s indeed why “home” ownership is so attractive (whether or not it’s a good investment in the short run).

      If you don’t understand the division in classical economics between capital and land, then you’re not going to be able to understand the roots of the current crisis.

      1. charcad

        Ask anyone w/o a roof over their head whether housing is a productive investment. The point is that a house is a productive investment.

        By this standard clothes, sheets and blankets are also “productive” investments. So is a McDonald’s Big Mac since the homeless are often hungry, too.

        I otoh think of concrete block plants, textile mills and large bakery plants as being “productive” investments. Their “products” are consumer items.

  6. i on the ball patriot

    Christmas eve in scamerica and the wealthy ruling elite give themselves a nice little pain metering present that will be used to further incrementally eliminate the middle class as we head to that — now more obvious every day folks — two tier ruler and ruler world.

    Housing, a non productive investment you say? Hell no! Not if you are the tax man collecting those yo yo, perpetual conflict causing, property taxes – and that’s what this is all about. Wouldn’t want to bankrupt all of the states all at once, that might cause crowds and chaos in the ‘put your state deeper in mass debt’ borrowing lines. Think of this as a sort of a slush fund for control of the marks at the mass debt enslavement line.

    And this will create other financial complications you say? Ha! Scamerica loves financial complications — it adds to the complexity. And complexity is the engine that drives all of the sell out voodoo science economists into creating stark raving mad, mouth frothing speculations that legitimize and mask the real deceptions quite nicely.

    Ho! Ho! Ho! Merry Xmas!

    Deception is the strongest political force on the planet.

    1. liberal

      Not if you are the tax man collecting those yo yo, perpetual conflict causing, property taxes – and that’s what this is all about.

      Higher property taxes (well, land taxes) are a good thing. Would you rather pay land taxes that support schools, roads, etc? Or would you rather pay more for the land when you buy it?

      Capitalized land rent is there whether you like it or not. Either it goes to the tax man, or it goes to the person you’re buying the land from.

      I’d much rather pay the tax man and have lower income and sales taxes.

  7. ab initio

    With the pressure on the Fed with audit noises from the House and the possible requirement to monetize large volumes of Treasury issuances why not get back to how the GSEs were used before to reflate post the dotcom bust before private label MBS took over.

    GSEs will be the vehicle to reflate the housing market. I would not be surprised to hear that Obama wants all the TBTFs to sell all their crap loans, MBS, CDOs, etc to the GSEs. Maybe even to takeover all underwater mortgages. The more outlandish the more possible.

    Expect the most egregious action from the worse than banana republic corruption in DC!

  8. Sam in NY

    Is there an easy way for a mortgage payer to find out if their mortgage is still with the originator, who owns it now, whether it’s been sliced & diced, etc.?

    It could affect the trajectory for future mortgage payments.

  9. Hugh

    My take on this was a little different. The GSEs are the current housing market. The increase in the GSEs’ book is an admission that without the Fed and Treasury buying programs there really aren’t sufficient investors to keep the housing market going. The unsurprising other side of this is that foreclosures are expected to increase and the GSEs will have heavy exposures related to these. Hence the removal of the debt limits.

    As I have said before, the Obama Administration is going to use the tools it has, like the TARP-based $200 billion jobs program and this, to keep the economy pumped up, or at least not collapsing, through the 2010 elections. After that, all bets are off.

    1. MarcoPolo

      I was about to erige something vert similar. The Fed is the mortgage market. Fed is buying agency debt from the Chinese & mbs from the banks. Think sub-prime $. Then BB tells TG, “no really, March and that’s it”. So TG expects not to be able to sell mbs. No problem, keep them on the books – extend & pretend. Hold to maturity. And there is no reason to worry about hedging the rates either.

      Am I missing something?

  10. fresno dan

    “($900 billion versus roughly $760 billion for Freddie and $770 billion for Fannie as of the end of November).”

    “$300 billion of firepower (the agencies had used roughly $110 billion of an authorization of $400 billion) is troubling.”

    Chump change!!! Wake me when we talk serious money – some number followed by 20 zeros…which I expect some time next year!

    I know the Fed thinks my crap shack is worth 300K – I just wish instead of all this rigmarole Ben would just come out here and buy it directly.

  11. rjs

    “A stunner reported at the same time was that Treasury bought $220 billion of MBS last year, in addition to the massive Fed purchases.”

    chalk it up to my cynicism, but im drawing a connection between this and Geithners inability to sell his Westchester home…

  12. But What do I Know?

    I’m sure many people thought of this already, but isn’t the need for the Fed/Treasury to buy up MBS to keep mortgage rates low derived from the expectations that rates will rise in the future? Because of the prepayment option, MBS are terrible things to own in low rate environments–if rates rise you will be stuck with a low rate bond that will extend its maturity, and if rates fall you will have your bond called at a time when you do not want to reinvest the principal. It is no wonder that no institutional investor wants to own these things right now, so the Treasury/Fed are going to have to buy all of them (which essentially means that the government is going to own all of the mortgages being issued at this (5%) rate). So the federal government is currently subsidizing a 5% mortgage rate for qualified buyers in the middle class–but, like Atlas, they are never going to be able to put that burden down (without a sudden and potentially catastrophic economic dislocation.)

    On the other hand, they could make the rate 4, or 3, or 0% if they wanted to. . .

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