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John Hempton: What to do with Fannie and Freddie

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By John Hempton, a Sydney-based investor, recovering financial services analyst, and former Australian government official who writes at Bronte Capital

There are a bunch of ideologues out there with solutions to the Fannie and Freddie situation. They argue that government intervention has to end and then propose a system with a permanent role for government. It is not just nonsensical – it is usually in the interest of some large financial institution. All they want is Frannie out of their part of the business. They like government subsidies in the rest of their business.

Anyway I have the free market solution to the Fannie and Freddie situation – and – I hate to say it – it is dead obvious.

Answer: raise Frannie’s pricing.

At the moment there is nobody doing conforming mortgages except Fannie and Freddie. Indeed there is almost nobody doing mortgages of any kind except Fannie and Freddie. If the free market wants the business they can have it. (They just don’t want it at this sort of interest rate spread – and I don’t blame them.)

All the government need to do is tell Frannie to raise their price a little each quarter. Currently they charge 20-25bps for guaranteeing mortgages. (The free market won’t take credit risk at that price.) So it is entirely open to the FHFA (and hence the Treasury) to tell Fannie and Freddie to raise their prices by 5bps. The government will get paid better for the risk they are taking (and what free market ideologue will disagree with that) and the private sector can compete if they want to.

I doubt the free market will. But then in a quarter or two Frannie can raise their pricing by another 5 bps. And a quarter or two later Frannie can raise by another 5bps.

At some stage you will get to a level where the private sector chooses to compete. Frannie should not set its price competitively though. In another quarter they should raise the price another 5bps. And in another quarter they should raise again.

Over time Frannie will become non-competitive. It will shrink simply because bankers and mortgage brokers do not bring it business. And so Frannie is put into market chosen run-off and the business is effectively privatized.

You can do the same thing with Frannie’s portfolio – you could ask them to raise their internal revenue exectations on any mortgage they buy by 5bps. They might buy less – they may not. Don’t limit the size of the portfolio: raise the profitability of the portfolio. When another quarter elapses raise spreads by another 5bps. Eventually of course the private sector won’t bring Frannie business – and so Frannie will shrink.

If you want the government to keep supporting the housing market (an object of policy it seems) then you just slow the rate of price increase down. Do 5bps per half rather than 5bps per quarter – or even 8bps per year for a slow exit.

Over time the government will make a full exit from the mortgage business. Along the way the taxpayers recover as much money from Frannie as possible.

If you look at my long series on Fannie and Freddie and compare my model predictions to current results you will notice that the credit losses are lower than my projections. The revenue however is much lower than my projections. The lower projected revenue has been a government choice: the Government has been forcing Frannie to charge lower spreads to support the housing market.

This is so obvious it is painful: if you want to remove the subsidy remove the subsidy. If you want to do it slow do it slow.

So why can’t anyone see it?

Every proposal for the government to get out of Fannie and Freddie is in reality a proposal for the government to get out of only a bit of Fannie and Freddie.

For example: if you are a business that likes managing interest rate risk you want Fannie and Freddie out of the interest rate risk management business but you want them to stay in the credit risk management business. You would prefer the government take the risks that you don’t want. And moreover you would prefer they took it at the lowest possible price.

The worst proposal out there (much worse than doing nothing) comes from Phil Swagel and Don Marron. They propose that the government exit the interest rate risk management business (the only business at Frannie that never lost money) and allow ten or so new competitive companies with government guarantees to compete with each other to sell government guarantee of credit risk. That means that credit risk (the risk that blew up the system) will be priced as close as possible to zero with the government wearing the downside. I can’t see that Swagel and Marron learnt anything from the crisis.

But Swagel and Marron are an extreme variant of the typical proposal. Everyone’s proposal involves getting Frannie out of their business whilst leaving subsidies (preferably increasing subsidies) in the parts of the value chain they don’t compete in. Every proposal is thus about maximizing profits of some financial institution whilst sticking those risks that they don’t want to the government.

Are you surprised?

Disclaimer: Every proposal out there is conficted. I am too. I own defaulted preference shares in Frannie on my own behalf and on behalf of my clients. A proposal that allows Frannie to maximize revenue on their way to oblivion is in my interests. But then I only get paid if taxpayers get back 100c in the dollar plus penalty interest and fees. And from the perspective of a US taxpayer it is hard to see what is wrong with that. You exit Fannie and Freddie and it does not wind up costing anything.

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23 comments

  1. Cedric Regula

    Sold. I read every now and then that the GSEs lower interest rates by .75% due to the implicit gov guarantee. But if we need to get there slowly to avoid collapsing the housing market even more, I can be patient. In the mean time we need to keep from collapsing the entire USofA, so the improved profitability should be a step in the right direction. We’ve already seen that taxes are a no-no.

  2. PatR

    We don’t need govt credit supports for more than a small fraction of the housing market, let’s say 10% of all transactions. Do whatever you want with 10% of the market, but get govt guarantees out of the 90% of the market where they aren’t needed.

    And the only reason to go slowly with pulling back on govt guarantees is to bail out more people who already made big bets on the housing market bubble. Why should everyone else pay for that kind of betting? Asking for a “go slow” approach is just more self-serving lobbying.

  3. jimmy jones

    Sounds like a good idea, Hempton, but doesn’t this eventually result in no more 30-year mortgages being written? Or do we keep the other government mortgage programs (FHA, etc.)?

    1. skippy

      Smack down of the hole GFC, *its stupid* what NOT to do!

      Yet no counter argument save Jane you ignorant Slut, even Dan expanded after that statement.

      Skippy…what would one expect from a commenter using “a” as a handle.

      1. Paul Tioxon

        It is ipso facto stupid and further more, it is simply a priori knowledge that Jane is a stupid slut. However, it is clear that taking a system that was built from inception by a GSE and then trying systems integration by giving it to the free market will result in precisely what consequences? All of them, and not only the obvious “it will now be under market forces and out of the hands of government”. These are ambiguous platitudes at best because there are no market forces. The concept of a market is simply coupled with the word forces, but there are no observable social force or forces that have been identified by science. There are a great many essays which give insight, but I would not write an algorithm using a social force, it would result in nonsense.

  4. attempter

    As Hempton implies, the real question should be government support for “the housing market” (i.e. for the FIRE sector and big builders, not to mention neoliberalism in general via the “American dream” propaganda). This has been proven to be a destructive policy in every way. The best thing to do is get rid of the Fannie and Freddie completely.

    But if you still support this policy, then the first part of this is a good idea in an ivory tower sense. But like all other reformism, it assumes a special case government which doesn’t exist, namely a government which seeks policy beneficial to the country, or which is at least rational.

    The second part is far more realistic given the government we do have, which is an illegitimate kleptocracy dedicated to nothing but corporatist looting. The Swagel/Marron proposed crime is typical of policies we do have. Indeed, that’s exactly the kind of corporatism which sets especially Obama’s heart aflutter. Better not show him this. (But Republicans would support this as well. Both parties are criminal enterprises.)

    1. skippy

      Mate…some times we have to climb down out of our ideological tree[s. Sure I would like a lot of things to change but social evolution unfortunately is a slow process (Stalin and Lenin generational shift thingy), the path has many steps and it takes more to get back, on it if lost.

      John offers a back azimuth to a better place, one we can work from, better than machetes and pitchforks at dawn…methinks.

      Skippy…how much death have you seen, its their tool, lets not make our selves that which we decry.

      1. attempter

        What ideology? I’m deducing from empirical observation (along with some analogy from history) – this government is a terminal kleptocracy and simply won’t ever do anything like that.

        Are there even debates anymore in government and the MSM about the basic crimes? No. Nor does even strenuous conventional protest do anything to cause any neoliberal to be willing to compromise at all, as we’ve seen in France, Greece, Spain, and elsewhere. No matter how clear the people’s voice is, the criminal elites just say: “Absolutely not. We’re going to push through our entire agenda and that’s that. Fuck the people.”

        No, the only policy debate is the tempo of the liquidation. But there’s absolutely no debate engaged in and no negotiation allowed on the basic, manifest goal – total liquidation toward a restored serfdom.

        So the only thing which can forestall that is for the people to withdraw support from the government and the finance system and do all we can to rebuild our own communities and economies, enduring the assaults from above until the horrid structure collapses.

        None of that has anything to do with ideology. It’s all inferred from observation.

      2. attempter

        What ideology? I’m deducing from empirical observation (along with some analogy from history) – this government is a terminal kleptocracy and simply won’t ever do anything like that.

        Are there even debates anymore in government and the MSM about the basic crimes? No. Nor does even strenuous conventional protest do anything to cause any neoliberal to be willing to compromise at all, as we’ve seen in France, Greece, Spain, and elsewhere. No matter how clear the people’s voice is, the criminal elites just say: “Absolutely not. We’re going to push through our entire agenda and that’s that. Death to the people.”

        No, the only policy debate is the tempo of the liquidation. But there’s absolutely no debate engaged in and no negotiation allowed on the basic, manifest goal – total liquidation toward a restored serfdom.

        So the only thing which can forestall that is for the people to withdraw support from the government and the finance system and do all we can to rebuild our own communities and economies, enduring the assaults from above until the horrid structure collapses.

        None of that has anything to do with ideology. It’s all inferred from observation.

  5. Brick

    On paper it looks like a recipe for success, but comparing the US mortgage market to other mortgage markets shows there might be some more wide ranging consequences. Having quickly looked at the balance sheet of one of the GSE’s in the past I was surprised by what was on the balance sheet which at first glance appeared to have little to do with housing, and here I am not talking about treasuries which you would expect. It looked like the GSE in attempt to maximise profit had dabbled in a number of areas and I am not sure how shrinking the GSE’s would affect those other markets.
    Looking at markets outside the US then you tend to notice that other markets have shorter duration mortgages and go about convexity hedging through a wider range of mechanisms. It occurs to me that the purpose of the GSE’s apart from shifting money from the relatively poor renter to the house owner, is to prevent volatility in the bond markets. The reality looking at foreign mortgage markets might be that the GSE’s don’t lower mortgage interest rates by 0.75% but by at least double that. Any exit strategy would then delay the housing recovery and potentially employment recovery for a long enough time that the fiscal deficit becomes a problem. Spending money wins US politicians votes, not doing the right thing, in any case if John is right in his views about the long term viability of the GSE’s then I think politicians are unlikely to tip the boat. I think we just have to wait for the next GSE accounting scandal before this will even be considered.

  6. Neil D

    It sure would be nice to get the government out of the mortgage business, but we’re so far down this path, I have a hard time believing any of these ideas will do the trick. The fact remains that Americans are addicted to cheap home mortgages as a way to provide housing.

  7. RichFam

    Just privatize them. This way – force all future debt from the agencies to be issued without Treasury backing – both debentures and pass-thru’s. Make the market determine the price of borrowing rather than the government. Make investors determine the value of the mortgages behind those pass thru’s.

  8. Great Goober

    Imprison management at Fannie, the goons helped design MERS. They helped create a low cost foreclosure machine – I could search for the names of the Fannie executives and note where they live so we can begin the legal “mock-evictions” as a form of protest – just have to consult with counsel before any public dissent, to find what lines can’t be crossed and so forth, when protesting deeply entrenched criminal organizations.

  9. ella

    No more guarantees period. These guys want it all… guarantee their profits by guarantying their debt. If they want taxpayer guarantees, then they can share their gross revenues. Socialism for the rich. Sick of it.

  10. ron

    That funny sound in the background is the American credit system cracking as the foundation for that system real estate both commercial and residential slides back to long term growth trends or put another way its underwater like many homeowners. While Hempton’s idea is straight forward it will not save the RE market from its continued slide in value, and without a constant flow of new credit consumer consumption levels decline putting the whole system at risk of collapse.
    American household income levels will not support large levels of debt for auto/housing so however the government and private investors want to rig the playing field the rewards will continue to be slim and focused on smaller numbers of winners.

  11. Moopheus

    “This is so obvious it is painful: if you want to remove the subsidy remove the subsidy. If you want to do it slow do it slow. So why can’t anyone see it?”

    Very likely they can see it. I remember when I was 12 years old, during the Ford administration. Do you remember Ford’s “Stop Inflation Now” campaign? No, I don’t either. I remember hearing somewhere that the problem of inflation was too much money. So I wanted to write a letter to president Ford, saying, if there’s too much money, the government should stop printing money. My dad told me not to send it.

    Sure, we can agree that it would be better if the housing market didn’t depend on F&F, and we need a way to get them under control. So what’s the cost? When Volcker finally tackled inflation, the cost was a recession, high unemployment. No big change like this comes for free, even if in the long run it’s the right thing to do.

    1. Paul Tioxon

      WIN buttons were distributed at the PR events for “Whip Inflation Now!”. It was not sin, but win.

      1. craazyman

        that’s right. I do remember that too — the Whip Inflation Now buttons.

        I also remember the 55 mph limit on highways. My dad would stick to the limit like it was a Biblical Law, driving the station wagon in the right hand lane while I sat in the back and watched the guard rails flash by. And I would think, “WTF is wrong with this guy? Why can’t he just go 60 like everyone else?” It seemed excessively deferential to me. Deferential to some disembodied authority that existed only in his mind and not anywhere in reality. Some people.

        Can you imagine this nation — now — collectively coming together obediently and civically for anything. I can’t.

        I’m not sure if that’s good or bad, to be honest. But I think one reason Roosevelt’s administration nailed the banksters while we — hah! “we” how quaint! — can not, is a profound change in the culture on a number of levels that would require some degree of elucidation.

        There is no “we”. The only question is what it will take to reform a “we”. Usually these things are rough slides.

    2. ron

      What’s the Cost?

      A typical house forsale in Northern Calif outside the inner bay area is 339K built in 1971. here is the listing:http://www.redfin.com/CA/Petaluma/Undisclosed-address-94954/home/2159082

      In 1971 this house was selling for something less then 20K but I will be generous and use 20K. Now the inflation adjusted price today is close to 104K.

      How about a typical house in the inner bay area.
      http://www.zillow.com/homedetails/2504-Johnson-Pl-Santa-Clara-CA-95050/19599467_zpid/

      Recently sold for 550K and at best went for 30K back in 57 so its inflation adjusted value is:226K

      What these numbers say is that the cost to get back to trend at least in Calif is lots of deflation in home values in the coming years and in reality its says that the inventory of Fannie and Freddie homes is a fraction of their current book value. This is more then a book keeping cost adjustment!

  12. Doc Holiday

    Come on, wake up here, Fannie & Fweddie and Sallie and the whole squid-backed family of GSE’s are goingto be packaged in Covered Bonds … all these entities will be rolled into financial assets that will be traded by Goldman, BAC, Citi, Lehman, WaMu and Friends of Dodd … wake up, this is already in the works and Moody’s, Fitch and S&P will bless these pools of assets even if they are totallly backed by nothing less than 100% dog shit.

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