June 28, 2006

‘No Need To Endure’ The GSE ‘Test’

Some highlights from a recent speech by Emil W. Henry Jr., Assistant Secretary for Financial Institutions, U.S. Department of the Treasury. “Imagine for just a moment if some of our most prominent complex financial institutions announced major accounting improprieties, significant restatements and serial failings and shortcomings in risk management and internal controls, and then further announced the cessation of annual reports and other standard disclosure materials.”

“Does anyone doubt the ferocity of market discipline that would sweep down upon these institutions in the form of higher borrowing costs for market-based funding and heightened counterparty scrutiny? Simply put, traditional market discipline has not applied for the GSEs.”

“That lack of market discipline is reflected in preferential funding rates that result directly from the market’s long-standing false belief that the US government guarantees or stands behind GSE debt. Of course, it is this funding advantage which drove the expansion of the portfolios in the first place.”

“Systemic events can unfold by direct and/or indirect spillovers. How could such a systemic event begin? They are many possible sparks but an unexpected sharp or volatile..interest rate ’shock’ would certainly be a distinct possibility. If such an interest rate shock occurred in a way that was not captured by the models, the results could be without precedent.”

“The GSEs make use of a considerable amount of short-term funding. Short-term instruments account for more than 20 percent of all outstanding debt for both Fannie Mae and Freddie Mac. In a financial crisis, the GSEs might face difficulty in accessing debt markets. This difficultly might force the GSEs liquidate some MBS holdings, putting excessive downward pressure on prices in a market that the GSEs are supposed to be stabilizing.”

“There are virtually limitless scenarios. But you get the point. We already know the lessons here. There is no need to endure the test. I feel compelled to remind you that the federal government has taken steps to assist a troubled GSE in the past. Do we really want to be faced with unwarranted and irresponsible calls for bailing out another failed GSE?”

“What I hope you ask yourself after hearing this is ‘Why?’ and ‘What can we do about it?’ The answer to the first question is unsatisfying. Ignoring all the rhetoric and spin, the simple truth is that there is no need for our financial markets to be exposed to this risk. Passionate statements made by the GSEs to the contrary, the GSE investment portfolios are not necessary for them to stay true to their mission.”

“The answer to the second question is much more satisfying, we can address this risk rather easily. As long as the portfolios of the GSEs are reduced gradually and responsibly, the overall impact to the housing market should be trivial.”




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52 Comments »

Comment by Ben Jones
2006-06-28 12:17:00

For anyone interested in reform of the GSE’s, this speech is worth reading in total. For instance, look at how much GSE paper the banks hold:

‘Since 1990, the mortgage investment business of both of the housing GSEs has grown rapidly. From 1990 through 2003, Fannie Mae’s mortgage investments increased from $114 billion to $902 billion. Freddie Mac’s growth in mortgage investments was even more dramatic. From 1990 through 2003, Freddie Mac’s mortgage investments increased from $22 billion to $660 billion. Today’s combined GSEs’ mortgage investment portfolios still total almost $1.5 trillion. By any standard, these are huge investment portfolios.’

‘As of December 31, 2005, commercial banks held $264 billion in GSE debt obligations (while not specifically broken out on call reports, given the relative size of the GSEs, the bulk of these obligations are likely those of Fannie Mae, Freddie Mac, and the FHLBanks). In comparison to bank tier-1 capital, GSE debt obligations exceeded 50 percent of capital for 54 percent of these commercial banks, and GSE debt obligations exceeded 100 percent of capital for 34 percent of these commercial banks. ‘

Comment by Getstucco
2006-06-28 12:47:08

‘By any standard, these are huge investment portfolios.’

As other posters have pointed out here in the past, Fannie Mae is the world’s largest hedge fund.

 
Comment by oikonomikos
2006-06-28 12:53:39

With Mr Paulson being confirmed, I think, too, this one will just die until something blows up. Then, at least, Mr Henry will have his glory day with “I told you so”, but who will be listening?

Comment by Sunsetbeachguy
2006-06-28 13:23:23

No I bet Paulson will reign in GSE’s and help his buddies out at Goldman. Goldman would step into the gap.

 
 
 
Comment by Bryce Mason
2006-06-28 12:23:57

I’ve been thinking long puts in the lenders would be a good option for profiting from a collapse, but perhaps there is a more direct way? The speech made it seem like MBS are bought and sold–is there a fund that is made up of these? Wonder if I could directly put those? Thoughts?

Comment by DC_Too
2006-06-28 12:42:47

There is no more direct way than that. I think “Ginne Mae” bond funds are made up of “mortgage-backed securities.” You might find a way to short those.

The other option might be to go long companies that profit from cleaning up financial messes - loan servicers (deal with, but do not hold, problem mortgages) - that sort of thing.

Comment by mort_fin
2006-06-28 18:20:56

Ginnie’s are the one form of MBS that IS backed by the full faith and credit of the government. If you’re worried about credit risk why on earth would you short those?

 
 
Comment by Bryce Mason
2006-06-28 14:57:47

I found this in a paper that describes the MBS market:

Investors in MBSs do not want to hold credit risk on the underlying mortgages, so MBS issuers provide guarantees. When Fannie Mae and Freddie Mac issue MBSs, they charge a guarantee fee that is currently between 20-30 basis points. This is taken from the gross yield on the loan so it is netted to the investor. These corporations are able reduce their risk of mortgage default by diversifying their large portfolios across the nation. Investors in these MBS thus have not the individual borrower, but Fannie Mae and Freddie Mac as a counter party to their credit risk. Therefore the credit risk of mortgage-backed securities issued by Fannie Mae and Freddie Mac reflects the credit rating of those corporations.

Freddie and Fannie and all the other major banks that are issuing MBS are charging guarantee premiums that guarantee that if the underlying loans do not perform, they will pay the MBS investors. So if there is a big failure, we should look to the lenders to get their profits slashed as they have to pay up to the investors. Their premiums will rise to account for the poor risk assessment, and there will be less capital inflow to the mortgage lending business. This will in turn tighten lending and further depress the market. MBS is where it’s at folks. I’m putting in my long puts soon on these dog banks.

By the way, I called a few option arm lending institutions and just chatted it up with the loan officers today on my lunch. I asked who they sell their loans to, and I just kept following the money up the chain until it reached, invariably, a few fine upstanding banking institutions that package the MBS and sell them off to Wall St. I called their operators and asked to speak with someone in the MBS department and holy hell, they connected me. I asked about the guarantee premium being charged and confirmed they had to cover if the asset-owner defaulted, and then I heard a beeping sound on the phone every few seconds. My call was being recorded, and when I asked if this was the case, they guy hung up. Wow!

Comment by SD_suntaxed
2006-06-28 18:22:37

Very interesting stuff Bryce. I had been wondering about this question myself while trying to decide where I wouldn’t want to be banking when things really start to come apart. I’m still trying to decide. Ideas? How odd that the person you were talking with decided to panic about the call being recorded. Hm…

Comment by bluto
2006-06-29 08:23:51

Wall St firms have recorded everything since the stock bubble popped. He most likely hung up when you were surprised (as it meant that he wasn’t talking to someone who knew anything about his market).

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Comment by flatffplan
2006-06-28 12:28:55

BOG gov won’t let them fail
remember the hedge fund in 98
peanuts compared to this

2006-06-28 12:43:26

It’s a good thing we’ve been running a budget surplus all these years. I’m glad the fiscally conservative Republicans are in charge.

Comment by feepness
2006-06-28 12:59:28

Yawn.

Comment by santacruzsux
2006-06-28 13:19:05

Republican? Democrat? Elephant? Donkey? If the consequences weren’t so sad, the farce would be almost funny.

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Comment by Joe Momma
2006-06-28 13:29:27

No kidding. Fiscal conservative my ass.

 
 
Comment by fred hooper
2006-06-28 13:31:47

From the speech:

“Thus far, legislative reform efforts have not been successful. You might be asking yourself, what other shoe needs to drop? Throughout my career, I have relied on the markets to react accordingly to these types of facts. But, it seems clear that the markets do not treat these enterprises in the same way as other public companies. First, they continue to enjoy a significant funding advantage over similarly-situated non-GSE competitors. This continues to be the case despite the fact that the Treasury Department and other government officials have made it abundantly clear that the federal government does NOT guarantee the housing GSE debt. Indeed, the GSEs are required to place such disclosures on the securities that they issue. So it is somewhat difficult to understand fully why the market’s perception of some sort of federal backstop for the GSEs continues to persist and why these enterprises can tap the capital markets at preferential levels.”

 
 
Comment by garcap
2006-06-28 12:34:57

“As long as the portfolios of the GSEs are reduced gradually and responsibly, the overall impact to the housing market should be trivial.”

But who is the buyer?

Comment by P'cola Popper
2006-06-28 13:04:27

“As long as defaults are gradual and spread over a suitable time period, the overall impact…”

 
Comment by HARM
2006-06-28 13:38:23

Let’s put her through the ole’ BS filter:

“As long as the toxic waste of the GSEs is offloaded to pensioneers & foreign bag-holders faster than pot at a Grateful Dead concert, the overall impact to the government should be trivial.”

Comment by Mort
2006-06-28 13:54:03

You translate well grasshopper.

 
 
 
Comment by Thomas
2006-06-28 12:36:36

The troubles with the GSE remind me of the Japanese Banking of the late 80’s-early ’90’s. Afterwards RE went into a multi-decade slump.

 
Comment by seattle price drop
2006-06-28 12:41:56

Amazing. Thankyou for the update Ben.

 
Comment by Getstucco
2006-06-28 12:42:58

“That lack of market discipline is reflected in preferential funding rates that result directly from the market’s long-standing false belief that the US government guarantees or stands behind GSE debt. Of course, it is this funding advantage which drove the expansion of the portfolios in the first place.”

So I guess that settles the matter — there is no guarantee (implicit or otherwise) of GSE debt in the event of widespread portfolio defaults. Which begs the questions, why is Fannie Mae’s stock price so resilient on days when other housing-sector stocks are tanking? And why is the spread between risk-free Treasury bond yields and risky GSE bonds so persistently narrow?

Comment by P'cola Popper
2006-06-28 13:19:42

I was also under the impression that the federal government guarantees the debt issued by GSEs and that was why they got such preferential rates on their debt. Is this not the case?

I found a brief abstract from the Journal of Real Estate Finance and Economics that may be helpful to some readers of the blog below:

http://www.jrefe.org/ab05-2a5.html

Comment by oikonomikos
2006-06-28 18:05:28

to me, this is an attempt by a government official to skirt the “implicit” obligation. whether there is one i guess it’s for the courts to decide, after hearing a lot of expert testimony

 
 
Comment by HARM
2006-06-28 13:52:13

So I guess that settles the matter — there is no guarantee (implicit or otherwise) of GSE debt in the event of widespread portfolio defaults. Which begs the questions, why is Fannie Mae’s stock price so resilient on days when other housing-sector stocks are tanking? And why is the spread between risk-free Treasury bond yields and risky GSE bonds so persistently narrow?

Because GSE-issued MBS buyers assume that there IS an implicit guarantee. And the history of federal GSE (and other) bailouts actually lends credence to this belief.

GSE debt-buyers assume:
1. The GSEs are politically “too big to fail” (arguably true)
2. The “G” in GSE stands for “Government” (it does)

For large instutional investors, you can add:
3. There are more stupid f@cks who believe GSE debt is federally backed than there are smart investors who know better, and that politicians care more about pleasing the idiot majority than the intelligent minority (probably true as well)

 
Comment by Bryce Mason
2006-06-28 14:09:41

One reason why FNM and FED are so stolid is that they have like 95%+ institutional ownership. People don’t daytrade this shit.

 
Comment by oikonomikos
2006-06-28 17:55:12

this risk-free mantra is some kind of finance religion…is Swiss government obligation more or less risk free than US paper?

Comment by NH_renter
2006-06-29 07:29:53

I’ve read a little bit of quantitative finance. One of the cornerstone assumptions is that “risk free” rates of return do exist, and that T-bonds provide this. Returns on investments are compared to what you would get “risk free” from the US gov’t. So a lot of financial instruments are designed with this “risk free” comparison in mind.

Comment by bluto
2006-06-29 08:34:14

US T Bills (short term treasuries) are the definition of the risk free rate, by identity. All other potential investments are judged based on their comparison to Treasuries. Swiss bonds are riskier due to their trading in a less liquid market (if for example a large bank wants to buy $10 billion in treasuries they can probably do it in a few minutes). That’s not true about Swiss governement obligations.

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Comment by Getstucco
2006-06-28 12:45:37

“I feel compelled to remind you that the federal government has taken steps to assist a troubled GSE in the past.”

Can anyone who knows please explain this reference?

Comment by bacon
2006-06-28 13:22:33

“The first GSE rescue occurred in ’87, w/ congressional enactment of a $4 billion line of credit for the FCS, which had been crippled by the collapse of farmland values in the early and mid-80s, following FCS inflation of a farmland bubble in the 1970s. (on page 3)

The second GSE rescue occurred nine years later when Congress broadened the assessment base for deposit insurance premiums levied to pay $800 million annually of interest on bonds issued by the Financing Corp, or FICO. (pages 3-4)”

source: http://www.senate.gov/~govt-aff/072103ely.pdf

Comment by mort_fin
2006-06-28 18:18:23

the FICO bailout was a bailout of S&Ls, and some banks, not generally considered GSEs (although for all practical purposes maybe they should be). In the mid 1980’s Fannie was insolvent but HUD, their regulator (this was before OFHEO) excercised forebearance and won the gamble. Not exactly a bailout, but close.

 
 
 
Comment by pt_barnum_bank
2006-06-28 12:49:12

When and if the GSE’s go insolvent.. no big deal.. Just means no more new loans from them. Then have joe taxpayer provide liquidity as needed to pay their obligations. These are loans remember? I would guess the vast majority would still pay their debts. Foreclosures would pay back hopefully 70 cents on the dollar. Again, joe taxpayer picks up the tab. Oh, and also, loan standards go way up as do interest rates.

Comment by climber
2006-06-28 13:51:41

The rot is bigger than that. Someone found a house that had 4 GSE backed mortgages on it. Which one will they foreclose on? 70% for that one, and 0% for the other three. There were a bunch of other things like forged signatures on applications and appraisals and such.

 
 
Comment by Bigdaddy63
2006-06-28 12:55:28

Wow, talk about sawing the limb out behind you. This guy pulls not punches in calling the GSE’s a bunch of crooks.

I nominate him for President.

Comment by oikonomikos
2006-06-28 13:13:51

The new Secretary will take care of the scaremongers. All the politicians were able to challenge him on was if he would get back to them when asked. I don’t think so.

 
 
Comment by P'cola Popper
2006-06-28 14:13:42

“If such an interest rate shock occurred in a way that was not captured by the models, the results could be without precedent. The immediate implication would be actual and mark-to-market losses.”

I have to reason that one of the factors that makes MBS so popular is low default risk relative to other debt securities that are available on the market. The low default risk premium is a product of a historically conservative lending environment. We all know that the lending environment has changed dramatically with both the quality of the borrower and the coverage afforded by the collateral declining substantially.

I would propose that the current risk premium reflects the historical high quality borrowers with adequate “real” collateral values and not the recent “lower” quality borrowers with less than adequate collateral value. Eventually through higher default rates and loss of collateral value due to the RE bubble popping the market will revalue the risk premium associated with MBS which will produce the “interest rate shock” alluded to in the speech. That’s when all hell breaks out.

Comment by bacon
2006-06-28 16:46:37

how does that jibe w/ F&F’s “dynamic hedge” practice? seriously, i’m clueless and trying to learn this sh*t.

 
Comment by Bryce Mason
2006-06-28 17:25:16

I think I came up with the same conclusion independently today. I am reposting a portion of a post above:

Freddie and Fannie and all the other major banks that are issuing MBS are charging guarantee premiums that guarantee that if the underlying loans do not perform, they will pay the MBS investors as if the defaulters had made their payments on time. So if there is a big failure, we should look to the lenders to get their profits slashed as they have to pay up to the investors. Their premiums will rise to account for the poor risk assessment, and there will be less capital inflow to the mortgage lending business. This will in turn tighten lending and further depress the market. MBS is where it’s at folks. I’m putting in my long puts soon on these dog banks / MBS issuers. Some are worse than others.

 
 
Comment by Mort
2006-06-28 14:19:26

Fannie Mae shouldn’t even be publicly traded. If it weren’t for all the bribe money they paid to the most corrupt congress in the history of the US they wouldn’t be. Every one of them bastiges should be in prison. This is going to end so badly. What we are looking at is the end of the capitalist system of economics due to graft, corruption, and stupidity. Funny, all the corruption is finally going to bite them all in the buttocks.

Comment by Thomas
2006-06-28 14:51:12

Oh for heaven’s sake. Graft, corruption and stupidity have never kept capitalism from flourishing. The Gilded Age set the gold standard for corruption — but economic growth went ballistic (although with nasty panics every couple of decades), and average living standards increased consistently.

Corruption is part of human nature. To the extent there may be more of it now, it’s largely because markets have gotten so complex that it’s easy to hide shenanigans in the impenetrable thickets. The idea that capitalism breeds corruption which in turn destroys capitalism is part of the Marxist myth of “internal contradictions” of capitalism, which I would have thought would have landed on the ash heap of history when actual Marxist regimes (1) proved far more corrupt than anything capitalism could produce and (2) collapsed.

No, even though we’re in for a doozy of a recession due to all the colossally stupid malinvestment in nonproductive real estate, capitalism will bounce back as long as government doesn’t do something even more colossally stupid to prevent it from doing so in the (impossible) pursuit of stamping out corruption.

Comment by Mort
2006-06-28 15:02:48

I stand by the first part of my statement. Perhaps I shouldn’t have extended my remarks to capitalism as a whole since it flourishes in so many parts of the world and has for centuries. How about this: The US ponzi scheme known as fiat currency and towering debt is on the verge of a meltdown.

Comment by Bubble Butt
2006-06-28 20:48:10

Perfect.

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Comment by santacruzsux
2006-06-28 15:04:43

Rothbard, Hayek, and Mises are terrorist names to modern day economists. In this world there is no such thing as malinvestment, only poorly executed business plans and not enough regulation. ;)

 
2006-06-28 16:08:03

I agree with Thomas, but what do GSEs have to do with Capitalism? They socialistic/utopian fantasies that exist to manipulate markets, not participate in them.

Comment by Mort
2006-06-28 17:12:20

I would respond to that statement if only I could figure out what was meant by it.

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Comment by Mort
2006-06-28 17:24:23

The capitalist lends money with the hope that he will be paid back with interest. The modern day lenders do not care if they get paid back or not, It is not their money anyway, they only want the fees that are paid up front. More and more loans, more and more fees. When the band quits playing and the people quit dancing and it is time to pay the tab we will find out that there never was that much money to be loaned out and that money will never be repaid with interest because there isn’t that much money in the world. It was a hopeless ponzi scheme that could only exist as long as the players were all stoned on OPM and parlaying their holdings with greater and greater levels of leverage created out of thin air. Well, it is going to be one hell of a hangover with the end result being that no one will trust the US ponzi system and thus the confidence game is over. Capitalism will survive, I have already said this, it was my bad for bringing it up. If anyone thinks that the US guvmint will just print their way out of this one I must tell you I have my doubts.

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Comment by sigalarm
2006-06-28 18:36:33

Fannie Mae is there to make a market. If you look over its history it has had a huge positive impact on the US economy.

Fannie is very well hedged, I worked with it first hand about a decade ago, and at that point I could not believe several aspects of the way it worked. At that point I came to the conclusion that Fannie could stop writing loans today and still make money hand over fist. The money they make they pour back into the Portfolio.

That being said, something happened in the late 90s, and the execs started going crooked (my opinion). The concept behind Fannie Mae is still solid, and can work as intended. For example, they are (and Freddie) are no longer the sole market makers. A lot of other guys have started doing MBS, and thats a good thing (current anomoly aside).

Fannie is not going anywhere. Some of the execs may go to jail, but the institution will get gutted, re-wired and be back better.

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Comment by Mozo Maz
2006-06-28 15:05:21

Prime lending started softening a few weeks ago — double digit percentage declines. This will be hidden in 2Q, since prime lenders had pretty good April/March application numbers. 3Q and 4Q will be tough to spin, if things don’t turn around.

Take my word on it. I’m not a broker– but, I know this stuff. The slowdown is not a subprime problem anymore…

 
Comment by bookishbetty
2006-06-28 17:23:04

I figured SB was due for a big-time fall . . . the sentiment here has really changed. Anecdotal stuff: everywhere I go, people tell each other, “we’re going to sell our house and move to (fill in the blank). . . we just looked at each other and said, ‘why are we paying all of this money every month to live here? we could pay cash for a house in (fill in the blank) and retire on the extra money.” People are starting to get that they’ve been hoodwinked.

 
Comment by jim A
2006-06-29 04:36:32

Sounds like somebody’s been talking to Armondo Falcon, and we know what happened to him. Anybody want to start a pool on how long before Emil W. Henry “resigns”?

 
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