Category / Federal Agency

Answering the call for private capital November 15, 2013 at 7:10 pm

Matt Levine, unexpectedly, is too generous. He suggests that the Fairholme Capital Management proposal to privatize Fannie Mae and Freddie Mac is pretty good. Not so much, Matt, unless you like the idea of the state handing billions of dollars to a bunch of hedge funds for no readily obvious reason. What Frannie needs is a whole bunch of new capital: not the $52B of Fairholme’s proposal, but hundreds of billions. This is because we simply cannot tolerate a repeat of 2008, so the new companies *must* be able to stand on their own feet, even in a severe downturn. My gut feel starting point is $200B of total capital for New Frannie as a whole, but I could be persuaded higher.

How can we get there? First, the pref holders should be converted into equity then massively diluted in stages – no single IPO could raise that much without a huge discount, so it makes sense to privatize New Frannie gradually. Perhaps one company per FED district would work: start with Kansas New Frannie, say, covering Colorado, Kansas, Nebraska, Oklahoma, Wyoming, and some corners of other states, capitalised at $12B, and work up to the bigger districts from there.

It is worth point out, BTW, that having the New Frannies be insurance companies represents a significant regulatory arbitrage, as Fairholme well know: the capital it would require for the same business if they were banks would be much higher. Indeed, whatever the status of the New Frannies, deeming them all systemic and imposing a supplemental leverage ratio would not be a bad plan.

Where should US mortgage risk be held? July 24, 2013 at 7:04 am

From the most recent 10-Qs:

  • Fannie Mae mortgages on B/S, $3T.
  • Freddie Mac ditto, $1.5T, plus $500B ‘mortgage related investments’.

So, very roughly, Freddie and Fannie have between them $5T of US mortgages: they also finance roughly 90% of new US resi mortgages.

Now what is very clear is that if you wanted to wind down the two agencies, you would need a home for a lot of mortgages. What percentage of the total mortgage stock outstanding? Roughly half it seems: a quick and dirty calculation from the flow of funds data suggests that there are $10T total US home loans. So where are trillions of dollars of loans going to go? Bank balance sheets are constrained, and we know what happened the last time the MBS market expanded dramatically (although of course this time it could be different).

It’s a dilemma. Fannie and Freddie are simply to big to wind down on less than a multi-decade basis, without a firm plan for what will replace them, how that thing(s) will be funded, and what consequences that will have for US housing market.

In this context, then, Freddie’s plan to issue agency MBS which pass on some of the default risk – structured agency credit risk securities – is interesting. Perhaps the answer to the Fannie/Freddie problem isn’t to wind down the agencies, but rather to reduce the amount of risk they have, by passing more of it on. Read in that context, there is a lot resting on STACR 2013-DN1.

What seems to be happening is that STACRs are Libor floater mezz tranches, with Freddie keeping the senior and equity tranches. Mezz tranches, of course, were an artificial market pre-crisis (in that they were seldom bought by real money purchasers: rather they went into CDOs of ABS) so it will be really interesting to see where the clearing price is on these risks*.

*If anyone knows what the spread was on these M1 and M2 STACRs, I’d appreciate a comment. I’m hearing roughly L+340 and L+715, which feels rich.

Securitization as a state sponsored enterprise September 10, 2012 at 2:40 pm

Amir Bhinde, writing in Bloomberg, has an interesting post which makes a few points. To begin, he makes the case that the growth of securitization was heavily influenced by state sponsorship:

The securitization revolution that really stifled traditional banking was led by Fannie Mae and Freddie Mac. The government-sponsored agencies paid banks a fee for originating mortgages that conformed to certain criteria, sparing banks the expense of in-depth analysis and losses from bad loans. Fannie and Freddie sold securitized bundles of the mortgages by suggesting they were as safe as Treasury bonds. Regulators then encouraged banks to buy the securities. Capital requirements for the residential mortgages that a bank kept on its books were more than twice those for mortgage-backed securities that had AA or AAA ratings.

This is broadly accurate; the GSEs were the parents of securitization, and (for reasons not wholly unconnected with the Pfandbrief market), RMBS are cheap for regulatory capital purposes.

The Bloomberg article then criticizes securitization for its reliance on ‘a few abstract variables’, and certainly we have seen that there is more to mortgage risk than stated income, LTV, FICO, and DTI. That said, if honestly sourced, these variables often do quite a good job at predicting the risk of a securitization. Often, though, is perhaps not good enough.

Amir’s next suggestions are more controversial:

To fundamentally reform the financial system, we need to end state sponsorship of securitization.

First, the federal government must stop guaranteeing mortgage securities. If lawmakers feel impelled to divert credit to homebuyers, the Small Business Administration’s approach of offering partial guarantees for housing loans would do less harm. Let the private sector securitize the loans if it can.

Second, banks should be required to evaluate the creditworthiness of every individual or business they directly or indirectly lend to, rather than outsourcing credit analysis to ratings companies or relying on reductionist statistical models. Allowing banks to buy securitized assets with only superficial knowledge of the ultimate borrowers is folly.

There are two issues here.

A correctly functioning government guaranteed (or for that matter covered) bond market provides a useful source of safe assets. That safety is worth more to investors than the cost to the state. What you do with the lower tranches – and who pays for them – is a different story*, but at least for the top tranches, securitization is performing a useful service for investors as well as borrowers.

The second problem is how credit is extended. Like it or not, the large banks have more or less killed off the loan officer in favour of statistical models for most retail and SME credit extension, not just for the securitized piece of it. If you want to go back to the prelapsarian world of local credit for local people, then banking is going to get a whole lot more expensive.

*Whether the state should subsidize home ownership or not, and by how much, is essentially a political rather than a financial question.

What is Fannie good for? January 24, 2012 at 7:19 am

Papagianis and Swagel writing on Bloomberg view about Fannie Mae and Freddie Mac argue that the US government should

recognize budgetary reality and put the firms’ liabilities on the government balance sheet and include their spending in the federal budget.

They are probably right. I certainly think that if an entity enjoys a government guarantee on its debt, then it should be on the government’s balance sheet. Indeed, you could make an argument that Fannie and Freddie’s problems were at least partly due to having private shareholders (which in turn was a 1954 trick to keep them off balance sheet).

Anyway, let’s ignore whether Fannie and Freddie should exist, and assume that they do. What function can they perform?

You could argue as follows.

  1. A credit spread contains (at least) a liquidity premium, compensation for default, and a return on the equity needed to support unexpected risk.
  2. Non mark to market holders are only exposed to default risk, assuming they are well enough funded and capitalized to hold to term.
  3. Therefore, a non-mark-to-market government guaranteed player in the mortgage market does not need to make as a high a return as private capital and thus can charge less for mortgages.
  4. If you believe that home ownership is a societal good (something I do not intend to get in to here), then having such an entity would by extension be good too.
  5. But, seen in this light, it is really clear that government has the risk that the aggregate credit spread paid on mortgages is not sufficient to support experienced credit losses, and the profit if indeed the credit spread charged is more than sufficient. It is in the position of an equity investor as well as a debt guarantor (and so should consolidate).

What these entities do then – indeed what any mortgage insurer does – is attempt to monetize the difference between the spread you can charge on the mortgage and the compensation needed for default risk. This only works, of course, given that they do not need to mark their portfolios to market…

It wasn’t just Fannie January 20, 2012 at 7:49 am

Jonathan Weil, as so often, has a good article on Bloomberg. He trashes the ‘Fannie and Freddie were the cause of the crisis’ thesis, pointing out that

there was no single cause. What we can say is this: But for the actions of a vast number of actors, including Fannie and Freddie, the crisis wouldn’t have happened the way that it did.

Quite right. As I suggested in my account of the Crisis, there is no single cause, nor a single bad guy who we can blame. The Crisis was caused by a complex interaction between the design of various element of the financial system and the incentives of various parties within it. Blaming Fannie for the crisis is like Woodrow Wilson for the second world war. Sure, he might have had something to do with it, but other things were happening too…

What do you do if people don’t want the risk? January 17, 2011 at 6:06 pm

Laurence Kotlikoff writing for Bloomberg has a suggestion for reform of the US mortgage market:

Step 1: Set up a new government agency — the Federal Financial Authority. The FFA would hire companies to verify, rate, appraise and disclose mortgage applications. These contractors would work exclusively for the FFA, eliminating any conflict of interest. Liar loans and no-doc loans would be history.

Mutual Funds’ Role

The government would neither endorse nor accept responsibility for appraisals and ratings, and would let borrowers add privately purchased appraisals and ratings to disclosures.

Step 2: Limit buyers of home loans to doing so only through closed-end mortgage mutual funds. If a fund manager chooses poor mortgages, the value of his fund’s shares will fall, but the fund itself won’t go broke. Mortgage defaults will never again lead to financial-sector collapse.

The mutual funds would sell shares up to a closing date, use the proceeds to buy mortgages of the type in which they are specializing, and pay out the cash flow to stockholders. The funds would terminate when the loans mature.

Step 3: Establish an electronic mortgage auction and require mutual funds to purchase loans at this market so borrowers receive the best price (lowest interest rate).

Now, this would probably achieve the public policy objective of dramatically reducing the probability that the mortgage market would have a huge claim on the public purse. Unfortunately it would also likely dramatically increase the cost of some mortgages and reduce the availability of many.

There are two reasons for this. The first is that there is a limited amount of private money seeking to invest in RMBS (or anything like it) and a bit of transparency, while useful, is not likely to change that. This means that there will be many fewer mortgages made under this system. (There is a huge demand for safe paper, which is why people bought Fannie/Freddie – the [as it turned out correct] perception was that there is a government backstop.) So the policy questions are: do we think that the supply of home loans is sufficiently important that the government is willing to backstop them in order to faciliate enough mortgages? And, if so, what should the regulatory framework be around this activity? My guess is that most US policiticans would answer yes to the first question and then would have various answers (including doc standards, LTV limits and so on) to the second.

The other reason that the Kotlikoff proposal would make mortgages more expensive even assuming that sufficient funding were available is that mortgage portfolios have tail risk. In particular US mortgages have lots of tail risk thanks to the non recourse nature of mortgages in many states. Private mortgage investors need to be compensated for this risk, and that makes mortgages much more expensive. Historically the government (meaning the tax payer) have backstopped this, and there is an argument that this risk should sit with the government firstly because they have some control over it (via the effect of monetary policy on house prices) and secondly because it is a social good for mortgages to be affordable. Of course there is significant dissent on this position not least because the liability has become actual rather than theoretical, but some still argue this line.

My view is that governments have a duty to address what they see as social needs. One of those needs, at least for many politicians, is the cost and availability of mortgage finance; another is the supply of safe assets for investment. Both can be met at once if you can eliminate (or at least dramatically) reduce the risk of mortgage portfolios. One way to do that is prescriptive, defining a class of ‘low risk’ mortgages which can be used to back ‘good’ assets; another is legal, for instance by increasing recourse and changing the mechanics of foreclosure. The public policy issue here is balancing the rights of mortgage holders with that of the mortgage owners: it isn’t easy. But both groups deserve some consideration.

Fannie and Freddie losses? 10% to you sir January 17, 2010 at 6:39 am

From Laurie Goodman at Amherst Securities via the Big Picture:

Freddie will likely lose around $178 billion of its $1.86 trillion credit guarantee book, and Fannie will likely lose $270 billion of its $2.81 trillion book. Combine the credit guarantee books of the two firms, and you reach a $4.67 trillion book, with estimated losses at just under 10%, or $448 billion.

My, that is a big number. And of course it suggests that the right capital haircut for residential mortgages is not 4% as per Basel, but rather 8-10%.

Freddie now has negative net worth March 12, 2009 at 7:14 am

The big Mac is now not only little, but actually less than nothing. Bloomberg explains.

What a wonderful day to bury bad news February 10, 2009 at 4:08 pm

Lockhart is an amateur though: he should have waited until Geithner was speaking to announce that Fannie and Freddie may need another $200B. There were some temporary imbalances that made their numbers pretty dramatic he said. Yeah, right.

The conforming limit January 2, 2009 at 4:48 pm

With rather little fanfare the exceptional high limit for conforming mortgages of $729,750 expired yesterday. The limit is now $625,500 in high cost areas: it remains $417,000 elsewhere. The details are here.

I am surprised this was allowed to happen: I thought that the exception would be extended indefinitely given the state of the US housing market. This cannot be good for California, for instance.

Fannie and Freddie get real November 17, 2008 at 7:29 am

The highlights of the current new realism:

  • Freddie Mac has asked the US government for $13.8B;
  • It suffered a record $25.3B quarterly loss and said that shareholders’ equity was a negative $13.7B. So after being bailed out, it will be worth $100M, presumably.
  • A significant part of Freddie’s writedowns was $14.3B of deferred tax assets.
  • Fannie reported a $29B quarterly loss last week of which $21.4B were deferred tax assets.
  • Fannie said it might need more than the $100bn earmarked for each of the two companies in order to stay in business.
  • But it does at least claim to have a positive net worth.

Can I say neue sachlichkeit now?

F&F: It is a Credit Event September 8, 2008 at 1:10 pm

From Bloomberg:

Thirteen “major” dealers of credit-default swaps agreed “unanimously” that the rescue constitutes a credit event triggering payment or delivery of the companies’ bonds, the International Swaps and Derivatives Association said in a memo obtained by Bloomberg News today.

So the CDS are triggered. What I urgently want to know is is this a termination event on the enormous portfolio of IRD that Fannie and Freddie have as hedges against prepayment risk. Remember these two are amongst the largest players in the interest rate derivatives market, mostly as buyers of convexity. I can’t believe many people want an unwind so the situation should be manageable.

Update. Just in case you are not a regular reader of the components of the major credit indices, it is worth point out that Fannie and Freddie are both in the CDX.

The Holders of F&F Prefs at 10:58 am

The part of the Fannie and Freddie bailout that worries me is the prefs. From the FDIC:

The federal banking agencies have been assessing the exposures of banks and thrifts to Fannie Mae and Freddie Mac. The agencies believe that, while many institutions hold common or preferred shares of these two government-sponsored enterprises, a limited number of smaller institutions have holdings that are significant compared to their capital.

The Federal Reserve Board, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision are prepared to work with these institutions to develop capital-restoration plans pursuant to the capital regulations and the prompt corrective action provisions of the Federal Deposit Insurance Corporation Improvement Act.

All institutions are reminded that investments in preferred stock and common stock with readily determinable fair value should be reported as available-for-sale equity security holdings, and that any net unrealized losses on these securities are deducted from regulatory capital.

You’ve got a few hours before the US market opens. Can you figure out who has those holdings that are `significant compared to their capital’ in time for the open?

Update The WSJ says F&F have $36B of prefs outstanding. That’s a chunky loss for the financial system if they really do turn out to be worth basically nothing.

Colouring Hank August 31, 2008 at 8:09 pm

There’s nothing really new in the WSJ’s The Fannie & Freddie Question but it is a nice read and it gives some interesting colour on Paulson. I bet he really really wishes it was November.

Freddie with FED leverage August 27, 2008 at 1:44 pm

Dealbreaker points out a nice trade:

A bank that bought the six month notes from Freddie this morning could also bid to borrow from the Fed’s Term Facility, which held an $75 billion auction today. As collateral for the borrowing, the bank could offer the newly purchased Freddie notes, for which the Fed would give them credit for 97% of their market value. Recently, the TAF pricing topped out at 2.35 percent for 28-day borrowing. So a bank buying $100 million of Freddie paper yielding 2.858% could flip it to the Fed, borrowing $97 million at around 2.4% (assuming the pricing will be slightly higher this time around).

At the end of the day, a credit desk could buy $100 million of Freddie debt for just $3 million down. On that $3 million, the desk would receive a 17.7% annualized return, or 8.8% over six months.

If you believe in the Treasury guarantee of the GSEs, and I think I do, that’s not a bad return.

The other guy’s GSEs August 19, 2008 at 7:24 am

Fannie and Freddie fell twenty something percent yesterday as the market digested a report by Barron’s on the state of the Agencies. In practical terms the Barron’s report seems to be pretty much correct: the Agencies will require recapitalisation, and it is unlikely this will be achieved without substantial help from the Treasury. However I do wonder about the timing. As the WSJ pointed out, it all depends on how big Paulson’s balls are:

He can either continue to muddle along and inject a few billion dollars of preferred equity into Fannie and Freddie on an “as needed” basis until the end of the Bush administration in January.

Or he can go full steam ahead with a pre-emptive government takeover of Fannie and Freddie. Ironically, this radical step would make Fannie and Freddie an election issue. And perhaps only that would create momentum for true GSE reform.

The unfortunate reality is that politicians won’t embark voluntarily on a GSE overhaul a few months before an election. It isn’t a vote-winning issue. They would rather throw money at Fannie and Freddie and pray for a housing rebound.

The implication is that we will get piecemeal solutions to keep Fannie and Freddie afloat, just, until after the election rather than full scale reform. I think that’s right. The agencies are going to be the next guy’s problem.

There’s nothing like leverage August 12, 2008 at 8:28 am

From a recent Hussman Funds post, Nervous Bunny:

if we include the fair value of preferred equity, we find that on a fair value basis, Fannie Mae is operating at a gross leverage multiple of 72.7 (total assets comprised primarily of mortgage loans, divided by shareholder equity). In other words, a slight 1.4% deterioration in the value of Fannie’s book of assets will wipe out all of the remaining shareholder equity. This makes Long Term Capital Management look like a conservative strategy.

Obviously if we don’t include the prefs, it’s harder to compute the leverage as Fannie has negative equity on a fair value basis. So while Hank might have no plans to put more cash into Fannie and Freddie, it will only take a small fall in their assets before he has to.

Five into ten does not go July 20, 2008 at 6:15 am

Bloomberg points out:

The [U.S.] debt limit is $9.815 trillion and the current outstanding public debt subject to that limit is about $9.4 trillion, according to the Treasury.

In other words, actual US borrowing is within $415B of the maximum permitted by Congress. Now while more or less everything I know about the US budget process comes from an episode of the West Wing, it does seem clear that this $400B ceiling limits Hank’s ability to do much meaningful for Freddie and Fannie. And comparing $9.4T with $5T makes the impact of bringing the agencies’ $5T of mortgages onto the government balance sheet clear. Hank must be hoping the markets bought his `we’ll fix it’ speech because if he actually has to do something, is room for manoeuvre is limited.

Papering over the window July 18, 2008 at 6:52 am

The Economist points out something really cute about the GSE’s having access to the FED window:

The Fed does not just accept any old assets as collateral; it wants assets that are “safe”. As well as Treasury bonds, it is willing to accept paper issued by “government-sponsored enterprises” (GSEs). But the two most prominent GSEs are Fannie Mae and Freddie Mac. In theory, therefore, the two companies could issue their own debt and exchange it for loans from the government—the equivalent of having access to the printing press.

I just love the way unintended consequences sometimes result from attempts to make things better, don’t you? But fortunately no one could think that Fannie or Freddie would abuse their access to the window, so the Economist is just engaging in idle speculation, isn’t it?

Fantasy capital July 16, 2008 at 6:56 am

A post on Accrued Interest concerning Fannie and Freddie caught my eye. Two quotes. First:

delinquencies on their guarantee portfolio remain relatively small (0.81% for Freddie Mac and 1.22% for Fannie Mae)…

And second

Under current statues, the GSEs minimum capital required is 0.45% of of their guarantee portfolio

So their current level of losses is roughly twice the capital requirement – a level of capital which was presumably intended to cover unexpected losses at a high degree of confidence. If a more craven example of the supine nature of the US regulatory environment were needed, I don’t know where to find it.