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Sunday, September 07, 2008

Fannie Freddie Takeover

There is excellent coverage over at Calculated Risk. Try here and here for starters. My comments are at the end of this post.

Treasury is taking them into "conservatorship". Greenspan, it would seem, is still casting a long shadow. The Treasury statement.

The main provisions:
First, Treasury and FHFA have established Preferred Stock Purchase Agreements, contractual agreements between the Treasury and the conserved entities. Under these agreements, Treasury will ensure that each company maintains a positive net worth. These agreements support market stability by providing additional security and clarity to GSE debt holders – senior and subordinated – and support mortgage availability by providing additional confidence to investors in GSE mortgage backed securities. This commitment will eliminate any mandatory triggering of receivership and will ensure that the conserved entities have the ability to fulfill their financial obligations. It is more efficient than a one-time equity injection, because it will be used only as needed and on terms that Treasury has set. With this agreement, Treasury receives senior preferred equity shares and warrants that protect taxpayers. Additionally, under the terms of the agreement, common and preferred shareholders bear losses ahead of the new government senior preferred shares.
So the current shareholders will lose most of their value, but the bondholders will be protected. The taxpayers will be anteing up as needed, but the taxpayers get a stake in any further profits, so over time they should make out well. The bottom line is that the GSEs are the only game in town for mortgages, so they have an effective monopoly. That BS over covered bonds was just a feeble attempt to pretend that this all wasn't happening.

The main problem is that this inflicts some major losses on smaller, previously well-capitalized banks, because they had the preferred shares in their capital base:
The agencies encourage depository institutions to contact their primary federal regulator if they believe that losses on their holdings of Fannie Mae or Freddie Mac common or preferred shares, whether realized or unrealized, are likely to reduce their regulatory capital below "well capitalized." The banking agencies are prepared to work with the affected institutions to develop capital restoration plans consistent with the capital regulations.
Treasury also establishes a credit line to the GSEs and FHLB:
The second step Treasury is taking today is the establishment of a new secured lending credit facility which will be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Given the combination of actions we are taking, including the Preferred Share Purchase Agreements, we expect the GSEs to be in a stronger position to fund their regular business activities in the capital markets. This facility is intended to serve as an ultimate liquidity backstop, in essence, implementing the temporary liquidity backstop authority granted by Congress in July, and will be available until those authorities expire in December 2009.
And Treasury is going to outright buy the bonds in order to support the market:
Finally, to further support the availability of mortgage financing for millions of Americans, Treasury is initiating a temporary program to purchase GSE MBS.
So institutions (and some are banks) stuck with the MBS should get a capital boost.

My Comments:
The interesting part of this decision is the move to stick it to the current preferred shareholders. There was never any question that the bondholders would be protected some way or another, because without that protection the GSEs were out of business and new money for mortgages would be hard to come by, producing a depression.

But there was another way to do this - Treasury could have backed the bonds, but not the GSEs. This would have left the shareholders at the mercy of management, forcing the GSEs to operate more conservatively. However, the GSEs were not going to go bust; they would have had to change their mortgages rates and terms, and they would have had to constrain lending without a capital infusion. So this move is really aimed at extending below market mortgages to borrowers with substandard capital, i.e., shoring up the bubble markets. That's why I say that Greenspan's shadow keeps getting longer. Indeed, the statement specifies exactly this motive:
As the GSEs have grappled with their difficulties, we've seen mortgage rate spreads to Treasuries widen, making mortgages less affordable for homebuyers. While the GSEs are expected to moderately increase the size of their portfolios over the next 15 months through prudent mortgage purchases, complementary government efforts can aid mortgage affordability. Treasury will begin this new program later this month, investing in new GSE MBS. Additional purchases will be made as deemed appropriate. Given that Treasury can hold these securities to maturity, the spreads between Treasury issuances and GSE MBS indicate that there is no reason to expect taxpayer losses from this program, and, in fact, it could produce gains.
Probably around another 200 banks have just been wiped out with the goal of making easy money mortgages available. One wonders about the wisdom of this.

I also wonder about feasibility. The losses coming are the losses - if easy mortgage lending is to be continued, more money will have to be pumped into the GSEs in one form or another. Essentially, Treasury is hoping to move the "liberated" capital of the shareholders into mortgages in a backhanded fashion.

This is moral hazard written on a huge scale. The mortgage industry got the upside during the bubble, but everyone gets the losses. I don't see a way around it (because the alternative is a panic), but I don't have to like it.
What I don't get is why they should insure and/or buy the existing bonds. Those were explicitly *not* guaranteed. Let everybody who bought that shit eat it and just insure the new bonds going forward - after putting in place the tightest underwriting standards anybody ever heard of.

(Better yet, just abolish these abominations. Let the IBs and CBs die too, if that's what happens without intervention. It's time for some economic Darwinism.)

The housing market may crash - if it does, that's because it needs to. Crashing is what happens to a market at levels that are utterly unsupported by fundamentals - once everybody realizes that's the case.

Nothing good can come from the housing sector until the 'typical' person can buy the 'typical' house with real financing. The sooner we get to that price the better.
Bob - it's not the domestic implications, it's the international implications.

A lot of foreign buyers are holding this debt, and if we don't back it, we're sunk. We can't default on our debt - it would have the same implications as defaulting on T-Bills.

John - well, no one LIKES this. But we have to face it. What worries me is that I don't see the exit strategy here. The Treasury can do this in the short term without a problem; it is borrowing short and lending long with a nice spread. But if the GSEs are actually managed henceforth to provide easy credit on housing in bubble areas, the future costs will mount significantly. The valuations in bubble markets are just off still, especially on jumbos, and they will not come back over the next 5-10 years.
This is a short term fix that moves the problem past 1/20/09.I would like to see some informed comments on the antitrust implications,F&F are the mortgage market and merging them without an exemption might be a tad awkward.
Bob - it's not the domestic implications, it's the international implications.

A lot of foreign buyers are holding this debt, and if we don't back it, we're sunk. We can't default on our debt - it would have the same implications as defaulting on T-Bills.

We are so completely and totally screwed.
What is going to happen to the houses that back the troublesome securities? Few people can realistically afford them at the levels implied by the paper they back. So they still need to be devalued somehow or they will sit there and rot waiting for a buyer. Now that the tax payer is making up the difference I propose all the excess property that will be laying around the country just be burned. It will speed up the loss of the physical asset that is bound to happen and partially protect those sensible people that bought a house they could actually afford to pay for by reducing the supply of available homes. Its win-win! YT for president!
Tom - we don't know enough about how these places will be run to know the implications. They are going to be run as separate units, because two new heads have been chosen, one for each.

Norris in the NY Times wrote a pretty good article on the situation and the inherent contradictions in the stated goals. I see this as a plan to destroy Fannie & Freddie, thus wiping out the previous shareholders. Essentially, putting them in run-off.

However, Fannie and Freddie were needed parts of the mortgage market long before the repeal of Glass-Steagall in the late 1990s, and I think they still will be needed.

Smaller, regionalized mortgage pools don't have the same characteristics and are inherently less stable, thus forcing higher rates. We've seen how well wholesale brokerages worked in mortgages recently, haven't we?

I see no way the banks can take over this business - they've proved they can't handle it. Fannie and Freddie are suffering now because of their own lax underwriting (they don't have enough bad loans of their own). They lost much market share in the mortgage mania, and their liabilities are concentrated on the guarantee side of the business and the devaluations produced by lax appraisal oversight and underwriting standards BY THE PRIVATE ENTITIES.

I think Paulson is talking a line of bullshit.
YT - those vacant houses have value, just not the value that lenders depended on.

And the truth is that razing all the vacant houses wouldn't boost values that much. It would help developers, but not the lenders. The problem is that too much lending was done without considering any realistic ability to repay. Instead lenders were relying on valuations that were created by lending to people who couldn't repay the loan, and would have to sell the house to do so. The lenders just figured that they'd get paid back from the sale of the house.

Well, there is no way out of that unwinding once new lenders aren't willing to lend to people who do not seem able to repay the loan without selling the house - not unless incomes rise significantly.

So before you get my write-in vote for president, tell me how your policies are going to jack median household incomes up 15%?

I am waiting with bated breath, but the answer had better not be Congress passing economic stimulus bills to pay people's mortgages for them!

I realize the homes have *SOME* value. But since the treasury is now buying the paper they back at face value the tax payer is takin' a loss regardless. Now, the question becomes: can these homes actually be sold before they rot? From what I've seen looking at foreclosed property banks have a hard time managing them before this mess occured (and the rate of foreclosures is still accelerating right?). Now we'll have a glut of them on the market AND no incentive to take care of them since the treasury can just buy the mortgage. So I beleive the distressed properties will remain empty and unkept.

As this happens there will still be downward pressure on home values since there will be so much extra supply, unless lending standards get as loose as they were (or incomes rise but thats not happening- not 15% before these houses fall apart from neglect).

So, I think we agree that this whole thing needs to unwind and the bad investments written off before life can return to normal. I'm advocating we just get it over with since houses are a perishable asset unless lived-in and taken care of. The pyro-plan has a side benefit of keeping the prices of occupied homes safe from the supply glut that will be caused before all the abandoned homes rot.

I hope that makes sense.

Did I mention that my running mate is an african-american woman and my opponents are poopy-heads?
YT since the treasury is now buying the paper they back at face value the tax payer is takin' a loss regardless.

Nope. The GSEs pay the investor regardless. If the loans default, the investor gets paid interest and principal (Fannie buys back the loan). So Treasury is going to get paid as long as the underlying entities can keep paying them. That's why GSE paper is considered so safe - the issuers guarantee payment. These bonds depreciate based on interest rate movements and the risk that the issuer won't be able to meet its contractual obligations.

See Tanta's GSE Pass-Through Primer

So I am still not convinced on the pyro-policy, although I like the name and I feel that this has a certain errant charm likely to appeal to a disaffected electorate. Also, I agree that your opponents are poopy-heads.

Perhaps you could fine-tune this plan by allowing taxpayers to torch the houses themselves? I feel that the prospect would galvanise a certain segment of the population who do not like their neighbors.
I'll be the first to admit I don't know much about investments or economics. That is why daddy sent me to Harvard: to meet and befriend people that DO and then take pictures of them in embarrasing positions after they passed-out drunk. My favorite way of learning about investments was to feed the finance interns ever-clear and grape coolaid then draw swastikas on their foreheads and erect penises on their cheeks after they fell asleep in their own vomit(but before I took a picture, obviously). Now they are my team of advisers.

My friends, this means that when it comes to economics I can't be wrong.

When the Fannie and Freddies' servicers can't collect on the loans they won't be able to sell the foreclosed property and the tax payer is holding the bag. My friends, under my pyro-plan the tax payer will be holding the bag anyway but at least hard-working and responsible homeowners won't be living in a sensibly-mortgaged houses surrounded by rotting homes occupied by not caring families but by drug dealers and animals. The pyro-plan protects those americans from years of declining home values. Fannie and Freddie (aka the government) will still need to buy off the burned homes butthey will have to do that regardless. This is america, we don't take our lumps in a long-drawn out fashion when we can have one hell of a weenie roast do we? Do I have to remind you that those with No Income Job or Assets - NINJAs if you will - wear uniforms the same color as one of my opponents?

My advisers also advised me that if we start as soon as I'm sworn in, the pyro-plan will keep the homeless squating in the empty houses warm this winter in the face of rising energy prices due to our dependence on foreign oil.
Your poll numbers are rising rapidly....

Keep saying "Harvard" a few times in each speech. This should pick up the disaffected I'm-Ivy_League_But_The_World_Refuses_To Recognize_My_Brilliance group. It is not large, but it IS loyal.
I suppose it could be worse. The policy makers could be listening to the Cato Institute. In Monday's Cato Institute podcast, Arnold Kling, the author of the paper at the link above, endorsed an immediate freeze on any further loans by Freddie and Fannie. To make new loans, he suggests cutting the capital reserve requirements for banks making 20% down, 30 year mortgages. That may be sensible after the crisis is past, but right now, the banks are undercapitalized as it is! I wonder where he dreams the money is going to come from?

His long-term goal (moving back to a 20% down, 30 year mortgage as the standard) is good, but the appalling disregard of the short run price of his policies boggles the mind. Can we say, "accelerate the housing collapse drastically?" I knew we could! It strikes me as a very bad idea precisely because we are trying to avoid a rapid resolution, also known as a financial panic. We need to unwind things slowly. Fast would be really bad!!
John - that's part of my concern over the "experts". It seems as if the "experts" have become the idiots.

I think you can write mortgages for large-market homes less than 20% down effectively, providing you verify significant reserves and require a 5% dp or housing cost PITI less than rent over two years, and a solid rental/credit history.

What's killing this market are the wild DTIs, crappy appraisals, and abandoning all the other risk mitigations. Or lunacy - because the underwriting turned lunatic in 2005, and has not returned to solidity even yet.
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