Readers have hopefully had the opportunity to read “The Center for American Progress Objects to Our Critique of Its GSE Reform Plan”, which contained an e-mail by David Min of the Center for American Progress presenting its bones of contention.
While we appreciate that the CAP has gone to the trouble to communicate with us directly, we are not persuaded by its arguments.
We’ll recap the e-mail and then address the issues individually:
1. You need to have some form of government guarantee to have a mortgage product that is fair to middle class consumers (his writing is a bit confused, at one point he uses “no” when he means “yes”, but this is the drift of his gist).
2. We’ve mistated who would eat “catastrophic risk” under the CAP scheme, since the Catastrophic Risk Fund and the new mortgage insurer investors would take losses first
3. Not all “banks” are behind or support the CAP proposal
4. This plan is the best option for the public and less lucrative to the financial services industry than a “privatization” model
Let’s dispatch these arguments in order.
Without a government guarantee, mortgage products would be a bad deal for average consumers. This belief is contradicted by the fact that every advanced economy in the world has a long dated mortgage market, and virtually all also have a high level of middle class homeownership, some like Australia even higher than the US, with no Freddie/Fannie equivalent or other form of large scale government mortgage guarantee program.
The credit guarantee has allowed the US to have unusually consumer favorable features in its 30 year product, namely both fixed rates and no restrictions on prepayments. Analysts outside the US (including former government officials) consider the US product to be unattractive to investor because it makes them bear all the interest rate risk. Thus the government guarantee effectively subsidizes features which the experience of the rest of the developed world says are unnecessary to have a healthy mortgage market.
In addition, there is evidence in the US that the private market will provide attractive products without a guarantee. As we and Dean Baker have stressed, the jumbo mortgage market is only at a modest rate premium to the Freddie/Fannie market, normally 25 to 40 basis points, post crisis more like 75 basis points. The market has admittedly been thin post crisis, but that has much more to do with investors sitting on the sidelines due to the lack of securitization reform than antipathy to this type of borrower (if a investor were to go into a non-guaranteed deal pre-reform and then stronger reforms were implemented, they would be the new standard and would probably lead to his pre-reform purchase being repriced downward. No portfolio manager wants to look like an idiot and take losses by stepping in front of an obvious risk).
There are other long standing niches that disprove the Min thesis. Loans to co-ops (a New York City staple) have never been GSE eligible, and they include middle class housing, particularly in the outer boroughs. A fair portion of the condo market is also not GSE eligible.
Moreover, a thirty year fixed rate mortgage is not always the best product for borrowers. An adjustable rate mortgage, particularly one with floors and ceilings on interest rate movements (which was a staple of co-op loans in New York in the early 1980s)
In addition, a thirty year fixed rate mortgage is not always the best product for borrowers. An adjustable rate mortgage, particularly one with floors and ceilings on interest rate movements (which was a staple of co-op loans in New York in the early 1980s) would in many cases be better for borrowers.
The government guarantee product also comes with not-widely recognized systemic risk. As we discussed back in 2007 and intermittently since then, Freddie and Fannie engaged in hedging on a massive scale to manage the interest rate risk of their exposures. This hedging was “pro cyclical”, which meant it increased the amplitude of interest rate movements. In 2002 and 2003, Fannie and Freddie hedging had reached the scale where it was economically destabilizing. And as John Dizard described in the Financial Times in 2008, this interest rate risk was also a hazard to Fannie and Freddie themselves:
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.
To give a frame of reference, LTCM held 10% of the dollar interest rate swaps position at the time of its implosion. Roger Lowenstein’s When Genius Failed depicts this swaps position as the proximate cause of its demise.
Concern about the risks of the GSE’s hedging may have been one reason why that the Maestro pushed adjustable-rate mortgages, since an ARM product would not need to be hedged. So independent of other considerations, large scale GSE equivalents in the business of insuring the sort of product the CAP clearly prefers and the Treasury bizarrely treats as sacred in its report, the “pre- payable, 30-year fixed-rate mortgage,” will increase, not reduce, systemic risk
Taxpayers will not eat catastrophic risk. We need to back up and explain the CAP plan a bit (which happens to be close to a consensus plan; it’s virtually identical to ones presented by the Mortgage Bankers Association, the New York Fed and the Financial Services Roundtable; one later put forward by Mark Zandi differs only in cosmetic details).
Instead of having the GSEs, which were in a weird indeterminate state between public and private until the box was opened and they were revealed to be public (shame they handed out all that executive comp before they figured that one out), the CAP proposal claims to have a better version: the new GSE analogues will be private!
Peel the onion further and you see how questionable that is. The GSEs 2.0 are an even worse combination of public backstopping of private sector risk. We should know by now this movie ends badly and should be undertaken only when an entity is regulated like a utility (and that includes utility-company pay to the top employees).
CAP would replace the GSEs with Chartered Mortgage Institutions. They would get a BETTER guarantee than the GSEs ever had, an explicit guarantee of the CMI’s obligations, (note the detail later in the document carves out the CMIs’ own bond issues, but the government stood behind not only the Frannie bonds, but those of every major bank save WaMu. We can hardly be certain the resolve to let bond investors take their lumps will hold in a future crisis).
These CMIs would be required to hold more capital than the old GSEs and would pay premiums into a fund called the “Catastrophic Risk Insurance Fund”. Now because it is called a “Catastrophic Risk Insurance Fund” we are therefore supposed to think it covers catastrophic risk. If you believe that, I have some AAA rated CDOs I’d love to sell you.
The fund is modeled on FDIC insurance. That alone should be a tipoff. FDIC insurance has never been fully priced to cover banking system risk. FSLIC premiums were inadequate to clean up the savings & loan crisis (the process of getting budget approvals for the cleanup was hugely contentious) and FDIC reserves fell even more obviously short in the crisis just past (witness the TARP, the alphabet soup of Fed facilities, the Fed’s not-so-hidden subsidy of super-low interest rates).
Having been at McKinsey when the firm was pushing securitization (the message to clients was “you are on this bus or you are under this bus”), the analysis was very clear. The economics of securitization worked thanks to regulatory arbitrage. The cost advantage, which was compelling, was due to saving the cost of bank equity and FDIC insurance. Basically, if you price the guarantee high enough to cover the true tail risks (which both risk models and human nature underestimate), which is what “catastrophic risk” amounts to, the true cost of the insurance is certain to be higher than what the premiums will cover.
Consider what is likely to happen: a credible “catastrophic risk” fund must accumulate huge reserves in a seemingly safe environment. This invites CMIs to lobby regulators for lower rates, since they are sitting on a huge fund and experience has shown that there is no apparent risk.
Put it another way: a full faith and credit obligation of the US is a full faith and credit obligation, meaning ultimately borne by the taxpayer. Yes, the CAP plan puts in first and second loss buffers (the “Catastrophic” Risk Insurance Fund and hopefully the equity and bondholders of the CMIs themselves) but the taxpayer shoulders any additional losses. Pretending otherwise is a major misrepresentation. Min sort of concedes the point, but argues all the protections will work:
Along with resolution authority, and the ability to issue “ex post facto” assessments if the Fund is running low, we strongly believe (although clearly one can never predict anything with 100% accuracy) that the taxpayer is fully protected.
I must note:
The GSE were fully domestic firms, and there were no legal impediments to resolving them (unlike the major dealer banks, which had globe-straddling operations). So “resolution authority” existed (Paulson’s conservatorship is a variant use of the same power), yet we didn’t go that route with the GSEs. Why? As the US’s top bankruptcy lawyer Harvey Miller said when he was stunned to be told to file for the Lehman bankruptcy, the resolution of even a mid-sized broker-dealer is highly disruptive to markets (and broker-dealers are very well regulated; to my knowledge, none of meaningful size has every failed to pay out to all its creditors in bankruptcy).
And the other issue all these schemes miss is that having more CMIs is unlikely to reduce the risk. Recall the scenes from Andrew Ross Sorkin’s Too Big Too Fail. Paulson told the Fannie Mae chief Daniel Mudd that he was going to put the company into conservatorship. He was stunned and argued his firm was sound (and it was in much better shape than Freddie). This wasn’t simply his view; the dean of US bank regulatory lawyers, the normally cool and collected Rodgin Cohen, exploded at his Treasury contact when he got word. Paulson said it didn’t matter, the markets would not believe him. And Paulson had already lobbied Fannie’s Congressional backers.
But Paulson’s view may have been well founded, and even if not, it reveals how regulators are certain to react the next time a big financial firm founders. When investors lose faith in a leveraged business, the spreads blow out and financing costs spike. A company that is in the markets often for funding will find it hard to roll its debt on affordable terms. If one CMI were to go under, a run on the others would be likely, particularly because the balance sheets of firms like this are opaque (financial firm balance sheets, and even more so those of insurers, include many line entries that are estimates based on multiple assumptions).
So official confirmation that one was in real trouble one could lead to a run on the rest. Putting one into resolution would be seen as confirmation that the solvency risk was real, and hence is unlikely ever to occur.
Not all “banks” are behind or support the CAP proposal
This is fairly easy to dispatch. This is more than a bit of a straw man, since we never said “all banks”, we used terms like “banking industry”. Min argues investment banks would not support the proposal. There are only two that hew to that model, Goldman and Morgan Stanley, out of 19 TARP banks. So per Min’s own argument, the overwhelming majority of the biggest banks would be backers of the plan. And there is not particular reason to think Goldman and Morgan Stanley would be opposed so much as indifferent, since they would still distribute and trade these guaranteed bonds. The other firms he mentions, hedge funds and REITS, are not banks.
Moreover, Lehman, which along with Bear Stearns, was particularly active in the private label mortgage business before the crisis, also lobbied in favor of Freddie and Fannie. The GSE allied themselves with private mortgage issuers to increase their political clout; what reason do we have to believe this won’t happen again? From “Too Big to Bail: The “Paulson Put,” Presidential Politics, and the Global Financial Meltdown,” by Tom Ferguson and Rob Johnson from the International Journal of Political Economy:
Fannie Mae and Freddie Mac never truly recovered from the scandals. Conscious of their political weakness, they deliberately allied themselves with Countrywide, IndyMac, Washington Mutual, Lehman Brothers, and other private firms that would find expanded GSE lending and guarantees useful.
This plan is the best option for the public and less lucrative to the financial services industry than a “privatization” model
First, any plan which gives an explicit full faith and credit guarantee is a subsidy to the mortgage industrial complex. A true privatization plan would not involve a subsidy. So it is hard to see on its face how this argument makes any sense.
Second, Min is effectively arguing it would be bad to go back to private securitization based on the experience right before the crisis. That’s true, but that’s also a straw man. The problem, as we have said over and over was that lax regulations, lack of enforcement, astonishingly short sighted behavior by major participants (what were they thinking when the quit adhering to the terms of their PSAs?), which was compounded by clever actors recognizing and worsening this dynamics through subprime short strategies that undermined price signals that would have encouraged investors to get out of the pool.
He and many others forget that we had a decade and a half of operation of the private label business with no major mishaps. So the business can work properly, and the FDIC has put forward a very sound pro investor proposal. So why is the CAP pursuing subsidies rather than supporting the FDIC plan, particularly when even advocates of the CMI scheme still anticipate that there will be some form of non-guaranteed mortgage market?
If the argument is really that a private market will result in mortgages that are too costly (that is, the subsidies are necessary for housing to be affordable), the evidence does not support it. Dean Baker did an analysis based on the assumptions of the Mark Zandi plan (which is pretty much the CAP plan) in which the GSE 2.0 scheme is called the “hybrid” plan. He finds, all in, that monthly payments by homeowners would actually be HIGHER using Zandi’s own assumptions (which are meant to favor the “hybrid” variant). Baker notes:
So, what have we learned about the relative merits of the private system and the hybrid model? Well the hybrid model will mean slightly lower monthly mortgage payments, but this benefit is likely to be offset by higher property taxes. The higher house prices in the hybrid model will mean that it will be more difficult for first-time buyers to come up with a downpayment. And, the wealth effect associated with the higher house prices in the hybrid model will mean lower savings and less growth.
So why is everyone lining up behind the GSE 2.0 plan? Because, as the Zandi analysis shows, they all believe (or think it necessary to convince third parties) that it will lead to higher house prices. This is ALL about propping up the housing market and the TBTF banks while appeasing calls to Do
Something about the GSEs But as John Hempton showed, that’s not necessary. He set forth a very simple path to getting the GSEs’ role reduced, and it can be done very gradually if the authorities are concerned about spooking the housing market.
It is depressing, but I suppose should be no surprise, to see how many people like Min who deem themselves to be independent have chosen to blind themselves to the banking industry’s continued efforts to get its nose deeper into the taxpayer trough.