Disaster Planning for Freddie and Fannie Intensifies

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The Wall Street Journal (hat tip Saboor) sends mixed signals in a page one story for tomorrow, “U.S. Mulls Future of Fannie, Freddie.” The Journal reports that contingency planning in case the two GSEs get into trouble has stepped up, yet go to some lengths to take a reassuring tone:

The Bush administration has held talks about what to do in the event mortgage giants Fannie Mae and Freddie Mac falter, according to three people familiar with the matter, as the stock prices of both companies continue to fall sharply.

These discussions have been going on for months and are part of normal contingency planning that the Treasury Department and other financial regulators regularly undertake. The talks have become more serious recently given the financial woes of the shareholder-owned, government-chartered companies, whose stability is vital to the functioning of the nation’s housing market, these people say.

The government doesn’t expect the entities to fail and no rescue plan is imminent, these people said. Government officials and market analysts expect both companies will be able to raise large amounts of capital relatively easily. Treasury officials are nonetheless talking about what the government could — or should — do if Fannie and Freddie become so pressed that they are unable to borrow money and continue operating.

Contrast the “Oh we’re planning for a disaster as a matter of prudence, there’s really nothing to worry about” message with the presentation by Jim Hamilton at the Fed’s Jackson Hole conference last August. Remember, that was during the first acute phase of the credit crunch, when the focus of concern was interbank liquidity and the implosion of the asset backed commercial paper market:

Since 1990, U.S. nominal GDP has increased about 80% (logarithmically). Outstanding mortgage debt grew 50% more than this, raising the debt/GDP ratio from about 0.5 to 0.8. Mortgage-backed securities guaranteed by Fannie and Freddie grew 75% faster than GDP, while mortgages held outright by the two GSEs increased 150% more than GDP. The share of all mortgages held outright by Fannie and Freddie grew from 4.7% in 1990 to 12.9% in 2006, which includes $170 billion in subprime AAA-rated private label securities. The fraction had been as high as 20.5% in 2002.3. It is hard to escape the inference that expansion of the role of the GSEs may have had something to do with the expansion of mortgage debt.

This acquisition of mortgages was enabled by issuance of debt by the GSEs which currently amounts to about $1.5 trillion. Investors were willing to lend this money to Fannie and Freddie at terms more favorable than are available to other private companies, despite the fact that the net equity of the enterprises– about $70 billion last year– represents only 5% of their debt and only 1.5% of their combined debt plus mortgage guarantees. If I knew why investors were so willing to lend to the GSEs at such favorable terms, I think we’d have at least part of the answer to the puzzle.

And I think the obvious answer is that investors were happy to lend to the GSEs because they thought that, despite the absence of explicit government guarantees, in practice the government would never allow them to default. And which part of the government is supposed to ensure this, exactly? The Federal Reserve comes to mind. I’m thinking that there exists a time path for short term interest rates that would guarantee a degree of real estate inflation such that the GSEs would not default. The creditors may have reasoned, “the Fed would never allow aggregate conditions to come to a point where Fannie or Freddie actually default.” And the Fed says, “oh yes we would.” And the market says, “oh no you wouldn’t.”

It’s a game of chicken. And one thing that’s very clear to me is that this is not a game that the Fed wants to play, because the risk-takers are holding the ace card, which is the fact that, truth be told, the Fed does not want to see the GSEs default. None of us do. That would be an event with significant macroeconomic externalities that the Fed is very much committed to avoid.

While I think that preserving the solvency of the GSEs is a legitimate goal for policy, it is equally clear to me that the correct instrument with which to achieve this goal is not the manipulation of short-term interest rates, but instead stronger regulatory supervision of the type sought by OFHEO Director James Lockhart, specifically, controlling the rate of growth of the GSEs’ assets and liabilities, and making sure the net equity is sufficient to ensure that it’s the owners, and not the rest of us, who are absorbing any risks. So here’s my key recommendation– any institution that is deemed to be “too big to fail” should be subject to capital controls that assure an adequate net equity cushion.

Now instead of following Hamilion’s prescription, the GSEs are increasingly being made one of the preferred vehicles for shoring up the housing market. Freddie and Fannie’s share of US mortgage issuance is 80%, double the level the year prior.

And the Journal downplays signs of increased investor worries:

So far, the companies have been able to tap the credit markets at relatively low cost, despite jitters over their financial condition. On Wednesday, Fannie Mae issued $3 billion in two-year bonds that were priced to yield 3.272%. That was 0.74 percentage point more than yields on comparable Treasury bonds, more than double the gap between those two yields a year ago.

Contrast that paragraph with how Bloomberg described that financing in a story titled “Fannie Mae Pays Record Spreads on Two-Year Note Sale“:

Fannie Mae paid a record yield over benchmark rates on $3 billion of two-year notes amid concern that the U.S. mortgage-finance company doesn’t have enough capital to weather the biggest housing slump since the Great Depression.

The 3.25 percent benchmark notes priced to yield 3.27 percent, or 74 basis points more than comparable U.S. Treasuries, the Washington-based company said today in an e-mailed statement. That’s the biggest spread since Fannie Mae first sold two-year benchmark notes in 2000 and triple what it paid in June 2006.

Investors and traders are overlooking the government’s implied guarantee of Fannie Mae and Freddie Mac debt as credit losses grow. The companies have raised more than $20 billion since December as their combined losses grew to more than $11 billion. Credit-default swaps tied to their $1.45 trillion of AAA rated debt are trading at levels that imply the bonds should be rated A2 by Moody’s Investors Service, according to data compiled by the firm’s credit strategy group.

“There’s tremendous fears in these two,” said Andrew Brenner, co-head of structured products and emerging markets in New York at MF Global Inc. “Look how they’re trading in credit- default swap land.”

Note Bloomberg commented yesterday on the so-called downgrade of Fannie and Freddie in the credit default swaps market.

In fairness, the Journal piece strikes a more concerned tone later in the piece and gives readers the probable denouement:

To continue bolstering the mortgage market, the companies need constant access to the debt markets. If investors suddenly decide they don’t want to buy the companies’ debt, the companies might have to unload some of their holdings, including mortgage-backed securities. Investors have already lost confidence in mortgage-backed securities other than those guaranteed by Fannie, Freddie and the Federal Housing Administration. A dumping of mortgage-backed securities would raise interest rates for people seeking home loans.

The Treasury has been worrying about such a dire scenario for years. In a 2006 speech, Emil Henry, then a Treasury assistant secretary, likened a failure of one of the companies to a “single gunshot setting off an avalanche.”…

There is at least one precedent for the government making concrete a financial obligation that was previously only assumed. During the crisis caused by the failure of savings-and-loan institutions in the 1980s, Congress passed the Competitive Equality Banking Act of 1987, making the government legally liable for obligations of the Federal Deposit Insurance Corp. Congress had previously adopted a joint resolution that the government would support the deposit insurance fund if necessary, but the pledge wasn’t binding.

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  1. Samuel

    despite the absence of explicit government guarantees

    GSE debt doesn’t merely have the “absence of explicit government guarantees”, they contain an explicit disclaimer that they are not government guaranteed.

    There’s a big difference between being silent on guarantees and point-blank telling people that there is no guarantee.

  2. S

    Check out the Bank of America speech today by KL where by he says out of the goodness of the co heart they are letting people stay in foreclosed homes for a few months. Perhaps this has optical benefits for BAC too? Just asking…

    Also, reported today that BAC has set up a sub that will take on the CFC debt. When asked about it, KL could not comment due to the quiet period. $30 billion here, $60 billion here, few Trillion here, what’s next.

    By the way, there has been sufficient article son the soundbess of the CHicago FHLB and the news about CFC debt and the explosion of FHLB, surely make that sewage dump a great place to find overvaliued property shall we say. I don’t know what that paper trades at but surely if fnma is blowing out this stuff should be tanking. With the likes of LEH, CIT, CFC drawing on the regional banking hub, it shold tell you how the “clever” investment bankers and their enablers are “finding” capital.

    The only way this chess match ends as the endzone keeps moving is when as MInyanville has so often said, funding simply goes away. So far they have used every lever, ut time is running out and so are the credit lines, including the Fed.

  3. Doc Holiday

    Re: “market analysts expect both companies will be able to raise large amounts of capital relatively easily”

    >> Talk like that was pretty cheap last year (and the last 6 months) for rating agencies, bond insurers, mortgage companies, SIFMA, The Fed, Treasury and the multi-Trillion of easy Tsunami cash that was lost — no problem, Fannie and Freddie can go out and easily raise another trillion…


  4. Michael McKinlay

    S ~

    BOFA is letting people stay in the houses for at least 6 reasons …

    1. They don’t trash the house ..

    2. Someone else doesn’t trash the house …

    3. Insurance – most policies are dead if a principle residence is unoccupied for more than 3 months.

    4. To keep out drug activity and vagrants …

    5. Upkeep – Cities are now fining mortgage companies for unkempt properties.

    6. So that they do not have to sell all their inventory in one area all at once , driving down prices.

  5. Anonymous

    Prof Hamilton got really called out at economistsview some time ago.

    I quote the original comment

    That is the same guy, who pooh-poohed Roubini, Calculated Risk etc and ridiculed them, citing a study that claims to show even the Tulip Bubble did not exist. (see MT’s comment here (economistsview.typepad.com/economistsview/2008/03/easing-financia.html#c107158878)

    JDH’s delusional view of things…

    March 23, 2007
    Bubble, bubble, toil, and trouble

    It didn’t look to me like a bubble on the way up, and it doesn’t look to me like a bubble on the way down. ….. Second is the question of what we can or should do about it. If prices can go to any arbitrary values for any arbitrary reason, then I am not sure what to propose in the way of policy recommendations. But if the price run-up was the result of a specific market failure, then correcting that market failure seems like something that should be getting everybody’s attention.

    Bubbles? Bubbles? I see none. Toil and troubles? Could be plenty.

    October 26, 2006
    More evidence that housing may be stabilizing

    Data on new home sales and inventories released today from the Census Bureau continue to support the view that the market downturn may have reached its bottom.

    June 18, 2005
    Babble about a housing bubble

    There’s been much discussion recently of whether the U.S. is experiencing a speculative bubble in house prices. Like previous historical bubble sightings, this one only seems to pop up in situations where the fundamentals on their own might justify significant price increases.

    And right now housing bubbles seem to be popping up all over the place. Calculated Risk, writing at Angry Bear, finds one in Miami. Tyler Cowen thinks he maybe sees one in D.C. David Altig expects to hear about one whenever Robert Shiller is on the radio. And Brad Setser is now upping the ante, looking for bubbles in France and all around the globe….
    … that if a community experiences a change in its growth rate, property values can increase a great deal over a short time. For the above example, going from 2% to 3% growth would cause the property values to double overnight..the three states with the highest population growth rates as reported by the Census Bureau– Nevada, Arizona, and Florida– have also been among the locations that saw the biggest increase in home prices. .Forces such as these, rather than a random distribution of irrational exuberance, seem a more natural explanation for why some communities got bubbled and others didn’t.

    June 23, 2005
    What is a bubble and is this one now?

    …Now, even if you readily believe that large numbers of home buyers are fully capable of just such miscalculation, there’s another issue you’d have to come to grips with before concluding that the current situation represents a bubble rather than a response to market fundamentals. And that is the question, why are banks making loans to people who aren’t going to be able to pay them back? Maybe your neighbor doesn’t have the good sense not to burn his own money, but is the same also true of his bank?……… …..economic fundamentals look to me like the more obvious place to start in trying to understand exactly what’s happened to U.S. house prices over the last 5 years.

    [There is more in his blog and comments. His record on housing is one vast series of mistakes, equivocation and reluctance to accept reality.]


    Hamilton defended his definition of the use of the term “bubble”. The problem is that according to that definition, even NASDAQ in 2000 was not a bubble.

    I don’t consider him credible.

  6. Anonymous

    You know what is next, of course; FNM and FRE will be given access to the Fed’s discount window.

    But after this, how long will it be until GM comes knocking at the glass too?

  7. Tom Lindmark

    Thought the WSj article was better than you gave it credit for. They also pointed out the premium that Fannie is paying which is probably the most telling point.

    But to your point that the GSE’s are being the preferred vehicle for shoring up the disaster. What choice is there save to shut down mortgage finance in the country? There is no private secondary market for mortgages.

    While it might not sound like it I actually liked this article a lot. There is going to be much more discussion on this topic and you deserve some credit for getting it out there. Don’t let it get buried in all of the other news.

    Note to Yves: I don’t want to go on you site and promote my own but this is what I wrote earlier this evening. http://blog.metro-real-estate.com/?p=690. Thanks for providing the forum.

  8. Yves Smith

    Anon of 12:57 AM,

    I see. Hamilton was wrong about the housing bubble. Ergo, he is wrong about Freddie and Fannie. I’m so relieved to learn that.

    From what I can tell, the discussion at the Jackson Hole conference revolved almost entirely around what interest rate policy the Fed should take. Hamilton was perhaps the only one to say that the real need was for regulatory reform.

    “Bubble” is not a concept that Serious Economists are allowed to consider. You will note that Hamilton was invited to the Jackson Hole conference to speak and Roubini wasn’t. The price for seeing trouble, especially on the early side, is being an outsider.

    To give you an illustration: I got in an argument with Brad DeLong (who I suspect no longer reads me) where he took issue with the idea that there were such things as asset bubbles! No joke, go read the post.

    Similarly, note how academic economists (and economically respectable journalists like Martin Wolf) categorically reject the notion that speculation can have anything to do with the runup in oil prices. They see that view as being akin to believing in alien abductions.

    These guys need to spend a month in a dealing room and learn otherwise. I’ve seen enough first hand to know it happens.

  9. Yves Smith


    What bothered me about the piece was its attempts at balance left it giving an impression I think was a bit too rosy. Yes, the WSJ may have felt compelled not to alarm the public. But per what I have read on Bloomberg, the pros, and those are the guys who guy agency paper, are rattled. So who is left for the WSJ to worry? Most retail readers are not going to pull out bond fund prospectuses or call their fund manager to ascertain how much agency paper is in their bond funds and switch to ones with lower agency exposure.

    I am bothered by the WSJ downplaying a doubling in spreads, particularly for two year paper. The difference in tone between Bloomberg and the WSj is noteworthy.

    And the Journal also relegated most of the bad news to the end of the article, which in the print edition will be after the jump and may not be read.

  10. Tom Lindmark

    I worded my comment badly. I said that “while it might not sound like it, I liked this article a lot” and was referring to your post not the WSJ article. Just wanted to clarify that point. YOUR article was well done.

  11. Anonymous

    The problem with Hamilton is his bland nerdy facade conceals a raging party-line ideologue. Then it was ‘stop bad-mouthing the miracle of homeownership’ with lots of academic valuation nonsense that assumed perpetual upward momentum. Now it’s ‘kill the the bolshy socialistic GSEs.’ Both are GOP dogma. At least the latter point has merit.

  12. ssternlight

    The WSJ is now a Murdoch(Fox) owned enterprise. Why would anyone be surprised at the “blandness” of an article that goes against their zeitgeist?

  13. Scott Finch

    Could someone more familiar with Prof. Hamilton’s work provide a link containing a description of an asset bubble or alternatively why the term asset bubble is misleading?

    It seems to me that any type of market will necessarily experience a range of money flow characteristics over time.

  14. Anonymous

    The problem with Hamilton is his bland nerdy facade conceals a raging party-line ideologue.

    Exactly. If you ever suggest he has a bias, you will be banned from his site.

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