TCS Daily


Portfolio Poppycock

By Duane D. Freese - June 15, 2006 12:00 AM

Timing is everything. And the critics of Fannie Mae and Freddie Mac, the giant national mortgage market makers, think the political timing could hardly be better to enact strict limitations on their operations.

But the economic timing for the critics' favorite reform -- a draconian reduction in the mortgage portfolios held by the two government sponsored enterprises (GSEs) -- could hardly be worse. Just as you don't raise taxes in a recession, neither do you reduce mortgage market liquidity when housing prices are sliding.

A report on an investigation of Fannie's operations by the Office of Federal Housing Enterprise Oversight has given new traction to a push for capping the firms' mortgage portfolios -- used to back bonds issued to foreign lenders that in turn increases mortgage market liquidity -- at $200 billion, about a seventh of current levels.

The need for large restatements of earnings by the GSEs in recent years had given rise to the push for caps -- backed by big banks, the Federal Reserve and even some in the Bush administration. Cappers argued the GSEs' purchases of mortgages with debt they issued wasn't needed to perform its main task -- bundling together mortgages into securities for sale to investors. Further, they said the portfolios posed a systemic risk to the financial system if suddenly mortgagees began defaulting on their debts.

That argument, though, was slipping in the face of the facts. As Stephen Blumenthal, who was responsible for uncovering problems at Freddie, pointed out last fall when he was acting director of OFHEO, Freddie's and Fannie's earnings restatements resulted from accounting and management impropriety, not risk management. "Their credit risk management has been exceptional and their actual experience with interest rate risk should satisfy even the most critical," he told bankers at a meeting in Asia.

Even former Fed chief Alan Greenspan, one of the harshest critics of the GSEs, admitted in congressional testimony last year that the mortgage portfolios at current levels posed no systemic risk. And in a letter to Sen. Robert Bennett, Greenspan suggested the GSEs have the flexibility to increase their portfolios during periods of financial crisis.

Thus the move for caps stalled. Until the new OFHEO report. It has the GSEs' critics smelling blood. Sen. Richard Shelby, who has made portfolio reduction a major goal, held a hearing on the report this week.

There's no question that Fannie's problems aren't just with accounting but with some of its former executives' intentions. The OFHEO report cited Raines specifically for earning $52 million in bonuses over five years directly tied to the company hitting earnings targets.

"Fannie Mae has a special mandate and position of public trust," James B. Lockhart III, the current acting director of OFHEO told Congress this month. "The previous management team, led by chairman and chief executive officer Franklin Raines, violated that trust. ... By encouraging rapid growth, unconstrained by proper internal controls, risk management and other systems, they did serious harm to Fannie Mae while enriching themselves through earnings manipulation."

So reform is needed. But the funny thing about all the critics' activity is that it gets in the way of sensibly improving regulatory oversight. By focusing on capping portfolios as the only meaningful reform, GSE critics have prevented enactment of a House bill that would consolidate regulation of the GSEs under a single regulator. That regulator would have the authority to deal with portfolios not based on arbitrary levels -- never a sensible idea in economics -- but on principles of safety and soundness.

And that's important. While slashing the GSEs' portfolios may sound like a good way to cut risk to taxpayers from defaults, it could increase risk to the nation's financial system and do drastic harm to the housing market.

As University of Florida finance scholar Mark Flannery, co-author of Flannery & Flood's ProBanker financial game and editor of Money, Credit and Banking, told an American Enterprise Institute audience for a discussion of GSE issues, Fannie and Freddie and their portfolios provide a social good -- liquidity.

Mortgage market liquidity works in several ways to help the economy.

Immediately, it helps lower mortgage rates, as can be seen by the difference between conforming loans financed by the GSEs' securitization and portfolio purchases and Jumbo loans. While critics like to diminish the amount of savings, a Congressional Budget Office report in 2001 found the difference at 22.8 basis points from 1995-2000, no small deal to a homebuyer.

Secondly, the liquidity provided by the GSEs' activities spreads to the regular economy. By helping finance prepayable, fixed rate mortgages, something not often available in other countries, the GSEs give home owners the ability to refinance when rates are down, thus improving their own cash flow.

And when times are tough, they can use the equity in their home through home equity loans to see themselves through. A study completed last fall by none other than Greenspan and Fed economist James Kennedy, "Estimates of Home Mortgage Originatins, Repayments, and Debt on One-to-Four Family Residences," found that the net equity extracted by homebuyers from their homes has risen during George Bush's presidency from $400 billion to more than $600 billion.

This has no doubt helped the economy weather stock market uncertainty, rising oil prices and terror concerns. Americans not only feel wealthier because of rising home prices and increased homeownership, they can make use of that wealth, thanks to liquidity in the mortgage market.

Now, though, housing has hit a slump. According to the National Association of Realtors®. Pending Home Sales Index, contracts signed in April dropped sharply, the third consecutive monthly decline, making contracts 25.7% below the peak level in June 2005. Currently, existing home sales are projected to drop 6.8% to 6.6 million this year from the record 7.08 million in 2005, and new home sales are forecast to drop 13.4% from a record 1.28 million in 2005.

And in the face of this slump, some in the Bush administration and in Congress would sop up liquidity by having Freddie and Fannie engage in a sell off of their portfolios rather than raise money for new mortgages.

The effect would reverberate throughout the economy. "You reduce the profitability of these companies (as reducing their portfolios would do) and you've just caused a massive sell-off of the equity in these companies" affecting pension and mutual funds as well as homeowners, Blumenthal noted last fall.

In short, you could create the very financial panic and problem you hope to avoid. And who knows what next? Perhaps, in the ensuing recession, you'll have these same Republicans calling for tax increases. It would make just as much sense.

Duane Freese is TCS Daily Deputy Editor.

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4 Comments

Liquidity = Inflation
"the net equity extracted by homebuyers from their homes has risen during George Bush's presidency from $400 billion to more than $600 billion."

The above is not good. All it is is borrowing that will require continued inflation into the future in order to repay and to maintain the market price of the underlying collateral.

It's a good thing that Fannie and Freddie are being capped. They helped fuel the inflationary housing boom. With luck, it will cause a housing price crash. That way, those of us who like to save can buy a home at a reasonable price, rather than see the dream slip further away, unless one loads up on debt.

Rewrite this piece...
... and say the exact opposite of everything you just stated.

Saying that we shouldn't phase out the portfolios because bad things might happen is like saying you shouldn't stop a drinking binge because a really bad hangover will happen. The damage has already been done, the only question is how bad the effects are going to be. The longer this goes on, the worse the eventual hangover will be.

All that equity extraction was taken from the wealth "effect", not actual wealth. The bubble is hollow; if a reasonable amount of people decided they would like to convert the house wealth into any other kind of wealth, prices would drop, and it would quickly become evident that it was a shame all along. But the thing that is real, is the debt taken on by so many households. They're buying things like Kawaski jet skis, plasma screen TV's and other imported gadgets and gegaws. Or my other favorite, yet more real estate. I call it "doubling down". The GSEs played a key part of the credit expansion that lead to this largest ever asset bubble and record personal debt.

The issue isn't whether or not the GSE's are good at managing risk or not, its WHO is taking the on the risk. In the case of the GSEs, its you and I, the taxpayer. In the case of private companies, like it should be, frankly I don't care how well they manage risk, unless I happen to be a voluntary shareholder.

The GSE's are in their simplist form private profit at the expense of public risk.

Its funny that proponants of goverment meadling in the mortgage markets (ALA the GSEs) say that it helps making house affordable. But in the next sentance, say that if you get rid of the GSE's portfolios, housing prices would go down and hence become more affordable. Anyone who has thought about this a little bit realizes that the cheaper money is to borrow, the higher the prices go since everybody has equal access to this extra credit. They just bid up prices to the new amount they can qualify for. The thing that stays about the same is the monthly payment. The real beneficiaries are the housing building, lending, and selling industries. This malinvestment of resources causes harm to the entire economy. Instead of ivesting in means of production, we're building ever larger consumer items.

As the money gets really cheap to borrow, many markets become speculative, regular people become "real estate investors" and flippers. You get wild movements first up, then down.

In the later stages of the up cycle people resort to ever riskier types of borrowing- interest only, payment option, negative am, ... These aren't modern lending intruments at all. You know the last time people used them like they are now? It was called Americas Great Depression. That was the last time we had a negative savings rate like we do now.

The reason the house bill is BS is because its doesn't mandate the portfolio reduction, it mearly give authority. And past history has shown the Fannie and Freddie are so big, corrupt and rich that they've been able to buy-off any meanful attempts at reform as they would to this regulator.

Any by the way, the recession is coming, the groundwork has already been layed. The only thing we can do is brace for it, and remember the people, policies and agencies that got us into this mess in the first place so we can punish those responsible and do better next time.

Those Responsible and What to Do
"Any by the way, the recession is coming, the groundwork has already been layed. The only thing we can do is brace for it, and remember the people, policies and agencies that got us into this mess in the first place so we can punish those responsible"

The responsible parties are several decades of Congressmen and the Presidents. The current Congress should do the following for the benefit of future generations:
1) Privatize the GSE's...gradually if necessary.
2) Redo the charter of the Federal Reserve. The Fed's monopoly control over interest rates (through their subservient banks) amounts to excessive and unwarranted economic power under control of unelected/unaccountable government employees. Interest rates should be set by markets, not committee’s.

Second that
I'd second that. We rely on markets to set prices for most other things, why do we attempt central planning for such an important factor in our economy? And while they aren't elected directly by the people, they are pointed and serve at the pleasure of the president, a person whose public perception their actions dramatically effect. Many argue Greenspan's easy money policy after the tech bust got Bush re-elected and as a secondary result caused the asset bubble in residential real-estate.

Before the Fed we had recessions sure, but they were never as bad as they were after the Fed came into being. The fed was created supposedly to save us from recession.

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