"Capitalism Isn’t Perfect" (Federal Support to Mortgage Lenders Edition)

This quote, from Countrywide’s CEO Angelo Mozilo, has the potential to be one of those career-death-wish utterances, in the same league as Citigroup ex-CEO Chuck Prince’s “We’re still dancing,” when asked in July if he saw any cause for pause in the recent wobbles in the credit markets.

The worst is that Mozilo’s proclamation isn’t what you expect it to be, a coded 21st century reaffirmation of Ivan Boesky’s “Greed is good,” which somehow summed up Eighties. For Mozilo to deem his well-honed ability to impoverish hapless borrowers for his corporate and personal benefit as a defect of capitalism, rather than a Darwinian virtue, would reveal a tiny glimmering of heretofore well hidden guilt.

No, instead, his “Capitalism isn’t perfect” is merely an unfinished thought. And the conclusion is, “and therefore we need government handouts.” This is the sort of behavior that Dean Baker decries as the corporate nanny state.

The Wall Street Journal story in which this remark appears, “Mortgage Crisis Extends Its Reach,” also isn’t perfect. It talks mainly about the way various federal housing related agencies, Fannie Mae, Freddie Mac, the FHA, and the Federal Home Loan Banks, are playing a bigger role than ever in the housing markets, and what the implications are (short answer: tougher standards).

But the story understates how much of a government lifeline has already been thrown to housing lenders. It gives reasonably good detail on Countrywide, but gives the impression that the Federal Home Loan Bank borrowings have gone entirely to fund more mortgage lending. Consider this (boldface ours):

To raise funds to lend in the first place, lenders are leaning more heavily on the 12 regional Federal Home Loan Banks, which are cooperatives chartered by Congress but owned by commercial banks and other financial institutions. The Home Loan Banks’ loans to financial institutions — which are known as “advances” and typically secured by mortgage loans — grew 29% in the first nine months of 2007, to $824 billion.

In addition, some mortgage lenders — among them the largest, Countrywide Financial Corp. — are growing more reliant on deposits insured by another government agency, the Federal Deposit Insurance Corp. “Capitalism isn’t perfect,” says CEO Angelo Mozilo of Countrywide, which had a $1.2 billion loss in the third quarter as investors suddenly grew allergic to mortgages they had eagerly bought before…..

Before this summer’s credit squeeze hit, Countrywide raised money to fund its lending through short-term borrowings such as selling commercial paper. With that spigot largely closed, Countrywide also is leaning on the federal Home Loan Bank system for credit. The company’s borrowings from the Atlanta home loan bank soared to $51 billion on Sept. 30 from $28 billion nine months earlier.

At the same time, Countrywide is relying more on the FDIC by heavily promoting certificates of deposits, with above-market rates, insured by that federal agency. The company recently said deposits were growing at a rate of $50 million a day at its savings bank unit. Those deposits are providing more of the funding for Countrywide’s home loans now.

Now the impression created above is that the FHLB lending is funding new loans. That all sounds kosher. But in fact, as an October Bloomberg story made clear, the banks were instead posting existing collateral with the FHLBs to secure credit. This wasn’t money for new loans. This was tantamount to going to the Fed’s discount window, except lower profile (no stigma attached) and instead of being at a penalty rate, as economists recommend. the banks got a better rate than they could get in the money markets. Indeed, given the cost savings, it is likely the banks went to the FHLBs sometimes out of convenience rather than necessity:

Countrywide Financial Corp., Washington Mutual Inc., Hudson City Bancorp Inc. and hundreds of other lenders borrowed a record $163 billion from the 12 Federal Home Loan Banks in August and September as interest rates on asset-backed commercial paper rose as high as 5.6 percent. The government-sponsored companies were able to make loans at about 4.9 percent, saving the private banks about $1 billion in annual interest.

To meet the sudden demand, the institutions sold $143 billion of short-term debt in August and September, according to the FHLBs’ Office of Finance. The sales pushed outstanding debt up 21 percent to a record $1.15 trillion, an amount that may become a burden to U.S. taxpayers because almost half comes due before 2009.

The government is “taking a lot of risks through the Federal Home Loan Banks that are unnecessary,” according to Peter Wallison, a fellow at the American Enterprise Institute, a Washington-based organization that analyzes public policy, and general counsel at the Treasury Department from 1981 until 1985.

The home loan banks, known as FHLBs, are increasing risks to taxpayers by assuming the role as a lender of last resort, said Wallison. That’s the job of the Federal Reserve, he said.

A loss of confidence in the companies could prompt investors to dump FHLB debt, potentially causing the collapse of one or more banks, according to Wallison and lawmakers including Representative Richard Baker of Louisiana. If others were unable to meet the liabilities, taxpayers would be on the hook, they said….

They borrow in the bond market and lend the money to their members. Federal Home Loan Bank obligations, when combined with the $1.5 trillion debt and $4.7 trillion in bond guarantees of Washington-based Fannie Mae and Freddie Mac in McLean, Virginia, are 46 percent more than the $5.04 trillion of Treasury debt held by the public.

Lenders turned to the FHLB as two main sources of funding, short-term IOUs backed by mortgages and mortgage-bond sales, began to dry up in August….

In July, lenders could raise funds by issuing one-month asset-backed commercial paper that yielded 1.8 basis points less on average than the one-month London interbank offered rate. A basis point is 0.01 percentage point.

In September, the asset-backed commercial paper, when it was available, cost as much as 51 basis points more than Libor. At the same time, the Federal Home Loan Bank of New York offered one-month funds at an average of 48 basis points below Libor, making their loans more attractive….

FHLB loans probably will continue to grow in the next few months, though at a slower rate than during August and September, said Margaret Kerins, an agency debt strategist at RBS Greenwich Capital in Greenwich, Connecticut….

The home loan banks can lend at below-market rates because their government charter enables them to borrow more cheaply than other financial institutions. The ties to the government suggest the U.S. will bail them out in times of trouble…

Five of the banks, including the Atlanta and Pittsburgh branches, restated earnings from 2001 through 2004, while the Chicago and Topeka branches corrected mistakes from 2001 through 2003. All of them fixed accounting errors for financial contracts used to protect against swings in interest rates.

The mistakes at the home loan banks, as well as those at Fannie Mae and Freddie Mac, prompted Republican lawmakers to spend the past four years pushing for legislation to create a tougher regulator for the government-chartered enterprises. While the House passed legislation in May, the Senate Banking Committee has yet to do so.

The failure to create new laws “is predicting disaster,” Baker, a Republican on the financial services panel, said in an interview. The FHLBs “have the potential for adverse economic impact if not properly administered,” he said.

The banks require borrowers to put up mortgages, mortgage bonds and other assets as collateral. None has experienced “a credit loss on an advance to a member, ever,” Ronald Rosenfeld, chairman of the Federal Housing Finance Board, the Washington- based regulator of the FHLBs, said in an e-mail.

The New York bank looks at detailed data on each asset when deciding how much to extend against it and doesn’t accept delinquent loans or non-AAA rated bonds as collateral, Paul Heroux, its head of member services said in an interview.

“The home loan banks are extremely low-risk institutions,” Allan Mendelowitz, one of five directors of the Federal Housing Finance Board, said in an interview. “There is probably no contingent risk to the taxpayer.”

Investors said the same about mortgage securities, which had home loans as collateral and were given top AAA ratings by S&P and Moody’s. Then defaults soared for loans to people with poor credit and some securities fell as much as 80 cents on the dollar.

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  1. a

    Truly scandalous. The taxpayer will be on the hook for tens of billions. Using “AAA” ratings as the test for collateral is a set-up for disaster, since you can go from “AAA” to junk in a blink of an eye.

    But what does “the ties to the government suggest the U.S. will bail them out…” mean? Is this like the Fannies, where the market believes in the too-big-to-fail model, but where the government has been reasonably clear it does not intend to bail them out?

  2. Anonymous

    Thank you for highlighting the uder-the-radar FHLB issue, Yves.

    I saw the Bloomberg article recently, courtesy of someone at CalculatedRisk, I think, and it prompted me to find a paper on FHLBs in the Atlanta Fed Review, here.
    Pretty good paper overall. I wish it talked more about the implications of the structure of membership at each bank, with a dominant clique of national/big regionals doing much of the borrowing. But they did highlight such recent trends as the extension of member banks into FHLBs outside their home regions, by way of national mergers. With the predictably weak central supervision of the Federal Housing Finance Board, it becomes possible for individual banks to get quite out of hand before anyone notices.

    It really gives one a bad feeling …

  3. dearieme

    I suppose that a new President will be able to say that she much regrets that people had persuaded themselves of Fed back-up, but that responsibility for that misunderstanding must lie with the previous administration.

  4. Anonymous

    What would the Real Estate market be without the GSE’s buying conforming loans? It appears that in real time there is no market for mortgage debt beyond the walls of gov’t.

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