Should Fannie and Freddie hold lots of mortgages? David Wessel says no:
Posted by DeLong at October 8, 2004 09:18 AM | TrackBackWSJ.com - Capital: Over the past decade, Fannie and Freddie have gone a step further and held on to more mortgages instead of selling them. As of the end of August, the two held a total of $1.56 trillion in mortgages. This is a lucrative business because the companies borrow so inexpensively, thanks to widespread market perceptions that the U.S. government will bail them out if they get in trouble. That supposition gives the Treasury and Federal Reserve agita. After all, Fannie alone has borrowed more than $940 billion, nearly triple the debt of General Electric Co.
Holding mortgages, particularly 30-year fixed-rate mortgages, in a world in which interest rates gyrate is a volatile business. To damp that, Fannie and Freddie hedge in financial markets. The proper accounting for such hedges is now at issue at Fannie. Cutting through the rhetoric and accounting duels, Fannie and Freddie's newly energetic regulator, the Bush administration, the Federal Reserve -- and the companies' competitors -- want to make it hard for Fannie and Freddie to keep expanding their holdings of mortgages....
What if Fannie and Freddie are forced to hold more capital or pay more to borrow or restrain the growth -- or even shrink -- their mortgage holdings? Their profits would suffer. The cost of any future taxpayer bailout would shrink. But what about mortgage rates?... Federal Reserve Chairman Alan Greenspan, citing Fed economist Wayne Passmore's calculations, says the companies save homeowners less than 0.16 of a percentage point and probably about 0.07 of a point, or $4.87 a month, on a $100,000 mortgage. Former Fed Vice Chairman Alan Blinder, a Princeton University economist hired by Fannie to rebut Mr. Passmore, says that's too low. He says Fannie and Freddie's mortgage-holding activities save homeowners as much as 0.29 percentage point, or $20.80 a month on a $100,000 mortgage. Over millions of mortgages, that's a lot of money....
Fannie and Freddie are part of a broader U.S. policy of encouraging Americans to buy homes. Their most important function is greasing mortgage markets by making it possible for banks and others to make mortgages and then sell them. The companies' eagerness to own mortgages does shave rates a little, and probably helps sustain the popular 30-year, fixed-rate mortgage. If the government restrains their mortgage-owning appetite, Americans will be making a trade: as taxpayers, they'll face less risk of a costly bailout someday; as homeowners, they'll pay more, but not much more, for mortgages.
Does anyone care to comment on whether the OFHEO charges have merit?
There are two main components:
1) "Cookie jar" accounting (carrying forward gains or losses to be used to smooth future earnings statements) applied to the value of their mortgage portfolio. Since the value depends on certain parameters (interest rate forecast, prepayment rates which depend on future economic conditions), there is a degree of subjectivity that can be used for manipulation. In 1998 OFHEO charges there was a $200M deferral (of an expense) that allowed them to hit an EPS threshold for management bonuses.
2) Hedge accounting for derivatives. Fannie hedges the interest rate risk of its retained mortgage portfolio, but OFHEO claims that their derivatives holdings don't qualify for hedge accounting because the behavior of the holdings doesn't sufficiently match the behavior of the mortgage portfolio. If this were the case they would have to mark the derivatives to market every quarter and their earnings would fluctuate even more than they do.
I watched several hours of House subcommittee testimony by OFHEO as well as Raines and Howard (Fannie CEO and CFO). The latter are incredibly polished and confident (but so was Andy Fastow of Enron), esp. compared to the OFHEO people like Falcon.
From CSPAN it is pretty clear that the Democrats on the committee are lining up to protect Raines (frmr Clinton OMB guy and influential demo. figure) while the Republicans have really pushed OFHEO to go after Fannie. (BTW, almost none of the congressmen seem to understand anything about finance, which is very scary, although the Republicans seemed to have a better grasp.)
The final determination on accounting legality is up to the SEC, but as a by-product of the investigation the huge bonuses awarded to Raines and co. through a stock option program have been revealed.
Posted by: steve at October 8, 2004 09:51 AMDoes anyone care to comment on whether the OFHEO charges have merit?
There are two main components:
1) "Cookie jar" accounting (carrying forward gains or losses to be used to smooth future earnings statements) applied to the value of their mortgage portfolio. Since the value depends on certain parameters (interest rate forecast, prepayment rates which depend on future economic conditions), there is a degree of subjectivity that can be used for manipulation. In 1998 OFHEO charges there was a $200M deferral (of an expense) that allowed them to hit an EPS threshold for management bonuses.
2) Hedge accounting for derivatives. Fannie hedges the interest rate risk of its retained mortgage portfolio, but OFHEO claims that their derivatives holdings don't qualify for hedge accounting because the behavior of the holdings doesn't sufficiently match the behavior of the mortgage portfolio. If this were the case they would have to mark the derivatives to market every quarter and their earnings would fluctuate even more than they do.
I watched several hours of House subcommittee testimony by OFHEO as well as Raines and Howard (Fannie CEO and CFO). The latter are incredibly polished and confident (but so was Andy Fastow of Enron), esp. compared to the OFHEO people like Falcon.
From CSPAN it is pretty clear that the Democrats on the committee are lining up to protect Raines (frmr Clinton OMB guy and influential demo. figure) while the Republicans have really pushed OFHEO to go after Fannie. (BTW, almost none of the congressmen seem to understand anything about finance, which is very scary, although the Republicans seemed to have a better grasp.)
The final determination on accounting legality is up to the SEC, but as a by-product of the investigation the huge bonuses awarded to Raines and co. through a stock option program have been revealed.
Posted by: steve at October 8, 2004 09:53 AMNow, with rates so low, is a much better time to ease out of the implicit taxpayer bail out risk.
Posted by: Tom Grey - Liberty Dad at October 8, 2004 10:29 AMI also would love to hear someone comment on the merits of the Fannie Mae charges. Thanks, Steve.
Posted by: Tedb at October 8, 2004 12:01 PMForgive this old derivatives trader for thinking that 29 basis points is rather more significant than represented; the 30-year savings of 16 to 29 bp is between $30,600 and $57,000 at a mortgage rate around 7.5% (high right now, but middling on a relative basis).
Comparative: Monthly social security benefit for retiring at 62 (max): $1,436/month (current dollars)
So that mortgage savings is equivalent to =at least= 21 months worth of Social Security payments.
Key pull quote: "The companies' eagerness to own mortgages...probably helps sustain the popular 30-year, fixed-rate mortgage."
Gedankenexperiment: calculate the effect on housing prices (nationwide average) assuming the maximum mortgage goes from 30 to 15 or 20 years.
If I were "bettng the house"--or the accrued equity, which is theoretically convertible at retirement to living expense money--I'd speculate that it would cost the economy =as a whole= MUCH more if the 30-year mortgage disappeared (or was "redefined" without Fannie and Freddie) than even Mr. Blinder's estimate.
Mr. Wessel's attempt to construe the issue as "big bailout v. small payment increase" to make it seem otherwise is disingenuous at best.
Posted by: Ken Houghton at October 8, 2004 12:12 PMTed,
Without commenting directly on the charges:
If the standard to which Fannie is being held for "Hedge Accounting" were applied strictly to all financial institutions (even excluding Hedge Funds), the Current Account and Budget wouldn't be the only major things "in deficit" in the U.S.
Posted by: Ken Houghton at October 8, 2004 12:17 PMIs there a detailed description of the US mortgage market somewhere?
Some of this is confusing to me, living in Denmark. Here mortgage loans are directly linked to the bonds used to finance them, so the mortgage institutions (who issue the bonds) don't carry any term risk. So when a home is financed with a 30-year loan, the homeowner makes payments equivalent to I gather this isn't the case in the US?
Posted by: Guan Yang at October 8, 2004 01:16 PMGuan Yang,
Same situation here. Buyers putting down less than 20% of the price of the house (note I do not say "value") also may be required to pay Mortgage Insurance.
Whether the assets are securitized, though, is both a matter of management and where they are in the proceedings (committed, drawn down, offered, pooled, securitized, etc.).
Posted by: Ken Houghton at October 8, 2004 01:49 PMI would only add to Ken Houghton's excellent comments, that anyone who thinks that transferring the USA's mortgage industry from Fannie Mae and Freddie Mac to Citigroup and Bank of America "gets rid of" the risk of a taxpayer-funded bailout, is kidding themself.
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