July 16, 2003

Fannie Mae and Freddie Mac

The Economist cannot decide whether the concentration of so much of America's mortgage-backed securities (half?) in the hands of Fannie Mae and Freddie Mac is a good thing or not. I don't know enough to have an informed opinion:

Economist.com: ...Now fast-forward to the early part of 2003. Long- and short-term rates have been falling fast; investors are similarly hungry for duration because yields have been falling and the stockmarket looks unappetising. Then, in the middle of June, long-term yields rise sharply. You can see why nervous eyes might be cast at the mortgage market. For the moment, though, all is relatively calm: mortgage spreads have actually tightened. Perhaps this is because (worryingly) no one expects short-term rates or long-term yields to rise much. Or it may be because much of the mortgage market is now in the hands of Fannie and Freddie.

Is this concentration a good thing? The optimistic view is: of course it is. The 1994 debacle was not a one-off. The mortgage market suffers periodic blow-ups because it is inherently flawed. There are no natural buyers of the embedded options (the option to prepay) because they are so hard to price; though they are rewarded for buying mortgages in the form of extra yield, given the choice, institutions would prefer not to buy them. In the late 1980s, the saving-and-loans industry took the risk of the embedded options and paid the price in the early 1990s when large parts of it went bust. Then insurance companies and Japanese banks piled in. And then hedge funds.

Like Schliemannís Troy, one set of investors has constructed a new edifice on the ruins of the old. In the end, the government had to guarantee the buyers of mortgage-backed securities in one form or another because it wants Americans to own their own homes and it thinks that fixed-rate mortgages with no prepayment penalties are necessary to encourage this. Moreover, the government will never let Fannie and Freddie even look like they might get into trouble, because foreign central banks now hold about a third of their dollar reserves in bonds issued by the agencies; any doubts about their future, and the dollar's status as a reserve currency would take a fearful beating.

The other view is that Fannie and Freddie are like previous investors, only more so. Though they have the benefit of an implicit guarantee, they are owned by shareholders and must take risk to make money. They could almost completely immunise the risks of their mortgage portfolios by issuing debt with the same characteristics but do not because they would not make as much money. Perhaps they are better managed than past waves of investors, with more sophisticated models, but Freddie's recent sacking of its top three bosses suggests otherwise, and models tend to have a nasty habit of not working at precisely the moment they are most needed...

Posted by DeLong at July 16, 2003 10:39 AM | TrackBack

Comments

Well, given the crash in the bond market, I think we may all get to see the stuff that Fannie Mae and Freddie Mac (especially Fannie) are made of.

Posted by: Andrew Boucher on July 16, 2003 11:23 AM

Well, given the crash in the bond market, I think we may all get to see the stuff that Fannie Mae and Freddie Mac (especially Fannie) are made of.

Posted by: Andrew Boucher on July 16, 2003 11:28 AM

Did the bond market crash? When? The 10 year treasury rose from 3.11 to 3.98 from June 13 to July 15. This is hardly a crash and does much cut much from the gains since May 2000. Perhaps bonds will continue to sell off, but unless there are definite evidences of rapid GDP growth the sell-off should be moderate.

There have been bear markets in bonds before. Why worry just now in just this way? Worry first about whether GDP growth will soon be 4% and sustainable.

All we really need with Fannie and Freddie is more transparent accounting.

Posted by: anne on July 16, 2003 12:25 PM

In bond market terms, methinks that is a crash. (Or do you expect bond prices to go down 10% in a day, like an equity crash???)

"There have been bear markets in bonds before. Why worry just now in just this way?" I'm not worried at all, honest. Curious, yes, but not worried.

Posted by: Andrew Boucher on July 16, 2003 01:45 PM

"Moreover, the government will never let Fannie and Freddie even look like they might get into trouble, because foreign central banks now hold about a third of their dollar reserves in bonds issued by the agencies; any doubts about their future, and the dollar's status as a reserve currency would take a fearful beating. "


Well that's something I didn't know.

Posted by: Jim Glass on July 16, 2003 03:42 PM

The S&L crisis (1970-80s) developed because of liberal (sometimes fraudulent) "riskless"(FSLIC/FDIC insured) loans made by the mortgage holding banks. Recall Charles Keating's multimillion $ loans secured by worthless, undeveloped desert land? The S&Ls collapsed because of overvalued assets. Remember the thousands of repossesed houses in Houston and other large metros? The "Oil Crisis" recession?

I think that Freddie and Fannie could be in a similar "underwater" asset crisis if home values regress. These GSE's (Government Sponsored Enterprises) have a promise of a Billion dollars of unsecured credit available from the Treasury to smooth over a localized bursting of a housing price bubble. Is a mere Billion enough? The repayment risk due to growing unemployment or deflating incomes.

The Fed must keep interest rates low because of the threat to housing market stability -- allowing some time before growing inflation to help pay for this Country's debts with cheaper dollars; or somehow causing the revaluation of Chinese, Indian, etc. currencies to allow a "payback" for their holding such large dollar claims. Sometimes much is unsaid by the Fed Chairman.

The Sinical Brane

Posted by: Don Majors on July 16, 2003 05:21 PM

The S&L crisis (1970-80s) developed because of liberal (sometimes fraudulent) "riskless"(FSLIC/FDIC insured) loans made by the mortgage holding banks. Recall Charles Keating's multimillion $ loans secured by worthless, undeveloped desert land? The S&Ls collapsed because of overvalued assets. Remember the thousands of repossesed houses in Houston and other large metros? The "Oil Crisis" recession?

I think that Freddie and Fannie could be in a similar "underwater" asset crisis if home values regress. These GSE's (Government Sponsored Enterprises) have a promise of a Billion dollars of unsecured credit available from the Treasury to smooth over a localized bursting of a housing price bubble. Is a mere Billion enough? The repayment risk due to growing unemployment or deflating incomes.

The Fed must keep interest rates low because of the threat to housing market stability -- allowing some time before growing inflation to help pay for this Country's debts with cheaper dollars; or somehow causing the revaluation of Chinese, Indian, etc. currencies to allow a "payback" for their holding such large dollar claims. Sometimes much is unsaid by the Fed Chairman.

The Sinical Brane

Posted by: Don Majors on July 16, 2003 05:22 PM

Andrew

This is the 4th such move in bonds in the last 2 years. Could it be serious? Yes. This could begin a bear market in bonds. So far? Not yet serious.

Anne

Posted by: anne on July 17, 2003 08:42 AM

Brad,

This is off topic, but I'm curious if you are collecting data on how many comments you get per topic. Mention National Review or Paul Krugman, and you get multiples of ten. Mention the Lombards or Fannie Mae, and you can't get up to ten. In a way that's to be expected, but I wonder if there are any surprises.

Posted by: maciej on July 17, 2003 09:01 AM

"The other view is that Fannie and Freddie are like previous investors, only more so. Though they have the benefit of an implicit guarantee, they are owned by shareholders and must take risk to make money. Perhaps they are better managed than past waves of investors, with more sophisticated models, but Freddie's recent sacking of its top three bosses suggests otherwise, and models tend to have a nasty habit of not working at precisely the moment they are most needed... "

I worked at Freddie for a few years, and before that was a mortgage derivatives trader at Kidder (and Granite was a big customer) -- and have some information to offer an opinion.

And it is this -- at some point, Fred & Fan are going to take the poor American taxpayer for a huge, huge bath.

In other words, I agree with the second view, and think that they actually underestimate the risk. Both Fannie & Freddie have taken on humongous market and interest-rate risks and only the collective suspension of thinking by investors (especially regional banks and central banks, who Wall Street-ers refer to as the "dumb investors") has kept these two institutions afloat.

Also, in terms of management -- the human capital at Freddie & Fannie is mediocre compared to Wall Street or the buy-side. You could have set up an Excel macro to replicate the hedge-fund activities of Fannie & Freddie, which is where over 70% of their income comes from.

After a decade of experience, I am an even more ardent believer in the teachings of my beloved finance professors (Schwartz and Brennan) ie, that the financial markets are fairly efficient. As a natural corollary, if a financial institution makes pots of money over a long period of time, esp via trading or investment, while no one else can (eg, Enron) something is wrong, somewhere.

Posted by: Prashant P Kothari on July 17, 2003 09:25 AM

Prashant: very interesting. Can you be specific about what kind of interest-rate shifts would imperil Freddie/Fannie's solvency? I assume a large bet in one direction on interest rates followed by a contrary move in the markets but more information would be welcome.

Posted by: JT on July 17, 2003 10:12 AM

"I don't know enough to have an informed opinion"

Good grief! If people waited until their opinions were informed before expressing them, the blogosphere (and many other spheres in life) would be much less lively. The signal to noise ratio would be higher, but the amplitude would be too small to attract attention. Thank God most of us never let our ignorance debar us from posting.

Posted by: derrida derider on July 18, 2003 05:32 AM
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