Systemic Risk From an Outsized Fannie and Freddie?

People never learn, as John Dizard reminds us via “Forget the past and you make the same mistakes again” in the Financial Times.

Quite a few policy makers have talked up plans to use Fannie Mae and Freddie Mac as central agents in salvaging the US housing market, typically by refinancing stressed borrowers. The markets reacted badly to that, driving up the GSEs’ spreads over Treasuries, but no one is getting the message, despite the fact that the Fed launched the Term Securities Lending Facility primarily to address the problem of gaping mortgage spreads.

Yet the Wall Street Journal tells us the powers that be want to push forward nevertheless:

The Bush administration, in an effort to stabilize the housing market, is preparing two new initiatives aimed at creating more funding for mortgages by relaxing constraints on Fannie Mae, Freddie Mac and the Federal Housing Administration.

Both efforts are in advanced planning stages, though neither has received final approval.

The Office of Federal Housing Enterprise Oversight, which regulates Fannie Mae and Freddie Mac, is close to reducing — but not eliminating — an excess-capital requirement for the government-sponsored entities, people familiar with the matter said. This would give the companies more flexibility to buy and securitize loans. That, in turn, would allow the companies to play a bigger role in helping the housing market regain its footing.

Fannie Mae and Freddie Mac would both be expected to raise more capital, providing more of a shock absorber against potential losses….

Separately, officials at the Department of Housing and Urban Development have talked recently with the White House’s Office of Management and Budget about a proposal to allow more people to qualify for mortgages insured by the FHA….

So far, HUD’s efforts to insure more mortgages have had a limited impact, mainly because it is hard for financially distressed homeowners to qualify

Lovely. The borrowers don’t qualify for FHA’s well tested standards. Note that FHA paper is insured by Ginnie Mae, which makes it a full faith and credit obligation of the government.

Dizard points out that there are other reasons to be leery of making Fannie and Freddie any bigger: their size alone led to market distortions before the accounting scandals curtailed their growth. Dizard anticipates new ways in which their massive financial operations are likely to cause big-time trouble, since in the past, their risk control process created systemic risk for the debt markets. Dizard explains why he thinks it will create an even bigger mess this time around

From the Financial Times:

The institutional memory of governments and the financial industry now has the lifespan of a fruit fly. In the past, the lessons of history have been forgotten because a generation of managers and policy people retired, taking with them their essential historical experience.

Thanks to modern management techniques and high technology, though, we can now achieve near- complete amnesia in a year or two.

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. This time, though, given the present run of bad luck and fast-forwarding of the markets, a GSE-driven crisis could come a lot faster.

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. 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. 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. Worse, from the point of view of the Fed, and Alan Greenspan in particular, the GSEs’ management had financial incentives to continue to expand their books of business. They had the political clout, since expanding the number of homeowners had strong support across party lines in Congress.

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. Hank Paulson, Treasury secretary, has strongly suggested they prepare for this by raising capital. Freddie Mac’s chief executive has already said he does not want to.

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.

I believe it more likely that before we get to that point again, the GSEs will be formally nationalised. The Bush administration is just kicking the can a little further down the road. These “public-private” mutants will simply become public agencies. There is no way to raise the equity capital for them to remain halfway in the private sector. In any event, the foreign central banks and related institutions have made clear to the US government that it will be held responsible for the GSEs’ debt.

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  1. a

    “The foreign central banks and related institutions have made clear to the US government that it will be held responsible for the GSEs’ debt.”

    They may have made it clear, but I hope the U.S. government told them to take a walk. The U.S. government has made it clear that the full faith and credit of the U.S. is not behind the Agencies. If foreign central banks have then bought the Agencies to get a few bips more in yield, that is their problem. They were greedy, they took the risk, and now they should pay.

  2. Anonymous

    Oh, the irony.

    On a thread about systemic risk, a disgusting spammer posts his contribution — a link to a website enabling liar loans.

    Yves, could you please forward his information to the SEC after you delete it? Thanks.

  3. crmorris

    BNP Paribas from the Fed Flow of Funds data: In Q3 07, combined GSE and FHLB new borrowings annualized were 14% of GDP; only slightly smaller in Q4. Mortgage market already nationalized. Suggests the black hole that this market is turning into. Bernanke’s pittances will be swallowed up in a trice.

  4. Anonymous

    Would it be too tacky to point out that if the banks had adhered to the required standards of fiduciary care that none of this would have happened?

    Or would it be wrong of me to note that this is yet another “unintended” consequence of revising the bankruptcy law so that the borrower can’t dump the unsecured loan, but can dump the secured loan?

    How tasteless is it really to note that Bernanke’s definition of inflation was only wage inflation and that asset inflation was A-OK with him? But now that wages haven’t kept up with asset inflation, most people (not just poor people (and really, why don’t those poor people just crawl off and die quietly after serving The Company for thirty years?)) are pinched and pinched hard.

    Just a passing thought. Or two.

  5. Anonymous

    As a global recession looms, is there any way to halt the slide? pages…in_page_id=1770

    The bearded Bernanke, who took over the Fed from the legendary Alan Greenspan last summer, has spent most of his adult life as an academic at the Massachusetts Institute of Technology studying the circumstances which led to the Great Depression of the 1930s.

    He is acutely aware of the risks of contagion, when the problems of one financial institution spread to another and you face a systemic crisis across the whole business landscape.

    He also knows that the great mistake made by central banks in the 1930s – and more recently, in the Japanese financial crisis of the 1990s – was to sit on their hands and hope it will pass.

    Bernanke knows that when you are in the eye of a financial storm, only dramatic and urgent action can help stave off a full-blown crisis.

    That explains why, a week ago, Bernanke promised ailing banks that the Fed was willing to make available up to £100billion of cash in exchange for almost any security they would care to offer, including sub-prime mortgage loans.

    The fact that greedy and incompetent banks would be saved, thus overturning the principle of moral hazard, doesn’t matter.

    As Alan Greenspan told this paper last September, in a banking crisis such as that caused by the collapse of sub-prime mortgages, the central bank has to act, even if it means rewarding the “greedy and egregious”.

    It is up to the law authorities to deal with those responsible afterwards.

    ritain, so closely connected to the U.S. through the role of the City in global finance has, with the best will in the world, been painfully slow in recognising the threat.

    Indeed, the complacency of last week’s maiden budget by Alistair Darling was, in retrospect, shocking.

    Unless the Government wakes up to the scale of the crisis we are facing, then this may yet be seen as the point of no return for New Labour as it seeks to hang on to power.

  6. Dave Raithel

    Mr. Volcker spoke at length last evening on Charlie Rose’s show. He is all in favor of Freddie Mac and Fannie Mae getting back to, in his words, “their original purpose” to manage mortgages in crises. He also made interesting observations re the Fed and Bear Stearns; in sum, that SOMEBODY needs to do what the Fed is doing, but that it should not be the Fed – meaning more direct government intervention (and future regulation of all those inventions that have brought us to here.) I don’t claim to be a Volcker fan as much as I notice some others here are, as I recall life in the early 80’s when inflation was wrung from the working class; but it was refreshing to hear yet another experienced voice, from the generation that precedes mine, acknowledging that this is no time for dogma…

  7. Yves Smith


    I didn’t see the Volcker interview (I pretty much don’t watch TV) but put a link to some quotes in the Links for 3/19.

    Re Volcker: he did something politically unpopular and badly needed at considerable personal cost (his wife was very ill then, so it was not a good time to be on a Fed chairman’s salary. A lot of people on the Street were worried he’d quit).

    The immediate pain did fall on workers due to a rise in unemployment. But the recession, although nasty, wasn’t overly long. And had inflation stayed at its stagflationary levels, businesses would have continued underinvesting and you would have seen steady erosion in employment as the workforce kept growing but jobs didn’t (or contracted gradually), but over a longer period.

    Sadly, the working man always takes it on the chin when capitalists screw up.

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