Fannie, Freddie, and Housing Finance: What s It All About?

Transcription

1 Fannie, Freddie, and Housing Finance: What s It All About? Lawrence J. White Stern School of Business New York University Lwhite@stern.nyu.edu Presentation to the Central Banking Seminar, Federal Reserve Bank of New York, October 21, 2008

2 The shapers of the American mortgage finance system hoped to achieve the security of government ownership, the integrity of local banking and the ingenuity of Wall Street. Instead they got the ingenuity of government, the security of local banking and the integrity of Wall Street. David Frum, National Post, July 11, 2008

3 ..the GSEs play an extraordinarily successful double game [telling] Congress and the news media, Don t worry, the government is not on the hook and then turn around and tell Wall Street, Don t worry, the government really is on the hook. Richard Carnell, Senate testimony, February 10, 2004

4 Overview Housing policy and home ownership The basics of mortgage finance The basics of capital The basics of Fannie & Freddie What is to be done? Short run Long run Conclusion

5 Housing Policy and Home Ownership

6 Housing policy Widespread subsidy of housing consumption Income tax deductions and exemptions Tax breaks and subsidies for rental GSEs (Fannie Mae, Freddie Mac, FHLBs) FHA, VA, Ginnie Mae Direct provision ( public housing ) Too much is never enough!

7 Home ownership Encouraging home ownership is a major goal of housing policy There are genuine positive social benefits (positive externalities) from home ownership Solid theory Growing empirical evidence But home ownership is not for everyone Rental subsidies do not encourage home ownership

8 Housing policy consequences Much of the subsidy encourages larger, better appointed homes on larger lots, second homes, etc. The U.S. invests too much in housing and not enough in other productive assets The tax advantages mostly benefit higher income households Housing policy is not especially well focused on encouraging greater home ownership

9 The Basics of Mortgage Finance

10 The components of mortgage finance Originate mortgages Service mortgages Collect the savings for funding the mortgages Issue deposits or liabilities to funders Guarantee deposits or liabilities

11 Traditional portfolio lender vs. securitization: summary Traditional portfolio lender Vertically integrated (bundled) components, by banks & thrifts Securitization Vertically dis-integrated (unbundled) components, by a wider variety of specialized parties

12 Traditional portfolio lender vs. securitization (1) Originate mortgages Trad: Thrifts & banks Sec: Thrifts & banks & mortgage banks Service mortgages Trad: Thrifts & banks Sec: Thrifts & banks & mortgage banks

13 Traditional portfolio lender vs. securitization (2) Collect savings for funding mortgages Trad: Thrifts & banks Sec: Thrifts & banks & insurance cos. & pension funds & mutual funds & hedge funds Issue deposits or liabilities to funders Trad: Thrifts & banks Sec: Thrifts & banks & Fannie Mae & Freddie Mac & Ginnie Mae & private label issuers

14 Traditional portfolio lender vs. securitization (3) Guarantee deposits or liabilities Trad: FDIC (FSLIC) Sec: Ginnie Mae &???

15 An evaluation The advantages of securitization Allows greater specialization Widens access to new sources of funding Allows risks to be better allocated The disadvantages of securitization Diffusion of responsibility, which encourages moral hazard behavior Difficulties of renegotiating mortgages

16 The Basics of Capital

17 Capital for a financial institution What capital isn t Cash Money Capital should not be confused with liquidity What capital is (approximately) Net worth Owners equity The arithmetic difference between the value of assets and the value of fixed liabilities

18 The importance of capital Adequate capital is crucial in a legal system of limited liability for corporate owners Capital is the cushion or buffer that protects fixed liability holders against losses in the value of assets Capital is a deterrent to risk-taking; the owners have more to lose

19 Leverage Leverage is the ratio of assets to capital Leverage is the inverse of the capital/assets ratio High leverage means that a small % increase in the value of assets yields a large % increase in the owners equity High leverage means that a small % decrease in the value of assets yields a large % decrease (or elimination of) the owners equity

20 Healthy, solvent bank Assets Liabilities 100 (loans) 92 (deposits) 8 (net worth; owners equity; capital

21 Fannie or Freddie Assets Liabilities 100 (loans) 96 (bonds) 4 (net worth; owners equity; capital

22 Insolvent financial institution Assets Liabilities

23 Limitations on GAAP accounting Generally accepted accounting principles (GAAP) has an historical orientation rather than a current value ( fair value ) orientation To the extent that book value overstates the current value of assets, capital is overstated To the extent that book value understates the current value of assets, capital is understated Markets care about current value and the future (and so should regulators)

24 Consequences of insolvency Assets are inadequate to cover liabilities Owners equity is negative Owners aren t liable for the shortfall Limited liability for corporate owners Fixed liability holders must absorb the shortfall in some fashion, unless those liabilities have been guaranteed E.g., deposit insurance E.g., government backing of Fannie & Freddie debt

25 Government receiverships The financial institution is insolvent The government honors the guarantees to the fixed liability holders Depositors Fannie & Freddie debt holders The (former) owners are wiped out The former senior managers usually are no longer employed Who is being bailed out?

26 The Basics of Fannie & Freddie

27 Fannie Mae s and Freddie Mac s businesses They have two primary businesses Issue mortgage-backed securities, with their guarantees as to credit risk (for which they charge fees) Invest in portfolios of residential mortgages (funded [96-97%] by debt)

28 Fannie & Freddie are special They are publicly traded companies; but They have congressionally legislated charters The President formerly could appoint 5 of their 18 board members Now just 13 board members, no Presidential appointees They pay no state or local income taxes They each had a potential line of credit with the Treasury of up to $2.25B Expanded by recent legislation

29 Specialness (continued) Their securities are government securities under the Securities Exchange Act of 1934 They are not required to register their securities with the SEC; exempt from fees Their securities can be purchased in unlimited quantities by banks and thrifts

30 Specialness (continued) Their securities can be purchased by the Federal Reserve for open-market operations They can use the Fed as their fiscal agent Insolvency had to be resolved by Congress Now can be resolved by their new regulator (Federal Housing Finance Authority)

31 Specialness (concluded) They were government sponsored enterprises (GSEs)

32 Some limitations They are allowed only to do residential mortgage finance They cannot originate mortgages They are subject to a maximum mortgage amount (the conforming loan limit) 2007: $417, : $417,000 - $729,750 (2009: $625K) They have been subject to mission regulation by HUD (now by FHFA) They have been subject to safety-andsoundness regulation by OFHEO (FHFA)

33 The consequences The securities markets treated their obligations as special agency debt They could borrow at about 40 bps (2/5%) less than their financial position would otherwise justify (in normal times) Differential varied over time, with financial conditions, and with nature of debt instrument

34 Further consequences Conforming mortgages were about 25bps (1/4%) lower than they would otherwise be (normally) But is this really a good thing when housing is already heavily subsidized? Are they well focused on the true positive externalities from home ownership? A $417,000 mortgage (at 80% LTV) allows the purchase of a $520,000 house! Are they efficient? Is their expansion efficient? Financial markets believed that their securities had an implicit federal guarantee The guarantee is now more explicit Taxpayers are at risk

35 Mortgage consequences (1)

36 Mortgage consequences (2)

37 Mortgage consequences (3)

38 Geographic consequences (1)

39 Geographic consequences (2)

40 Geographic consequences (3)

41 F&F s recent growth Residential Mortgages and MBS ($B): Fannie Freddie Tot Mkt Year Mtgs MBS Mtgs MBS 1980 $56B $0 $5 $17 $1, $114 $288 $22 $316 $2, $608 $707 $385 $576 $5, $821 $1,040 $590 $729 $6, $920 $1,301 $661 $752 $7, $925 $1,408 $664 $852 $8, $737 $1,599 $710 $974 $10, $726 $1,778 $700 $1,123 $11, $724 $2,119 $710 $1,382 $11,996

42 Reasons for growth Efficiencies of the MBS process Differential capital requirements Banks and thrifts need 4% capital to hold a mortgage, but only 1.6% capital to hold MBS Aggressive portfolio growth by Fannie and Freddie from 1990 to 2003/4 Advantageous funding costs Freddie went fully public in 1989 Differential capital requirements: Fannie & Freddie need 2.5% capital to hold a mortgage; specialist thrifts are constrained by the 5% leverage requirement

43 What Is to Be Done? - Short term

44 The financial dangers F&F were adequately capitalized on a GAAP basis; but The trends were bad; both ran losses in 2007 and 2008-Q1 & Q2 On a current value basis, Freddie had net assets of -$5.6B on June 30, 2008 (down from +$12B on Dec 31, 2007); Fannie had net assets of +$12.5B (down from +$36B) Markets care about current value and the future (and so should regulators) GAAP is mostly backward looking

45 The financial dangers (credit risk) F&F had high underwriting standards; but Even prime mortgages (20% down payment) may experience significant losses Mortgage insurers may not be able to cover losses on mortgages that had 5% down payments F&F may take losses on high rated pieces of mortgage related securities that they bought to support low and moderate income housing

46 The financial dangers (interest rate risk) F&F s large investment portfolios of mortgages may be subject to interest rate risk How well were their portfolios hedged?

47 New legislation The Housing and Economic Recovery Act of 2008 (signed July 2008) is primarily aimed at the sub-prime mortgage debacle Provisions that affect F&F New, stronger regulator (FHFA) Can set capital requirements Has receivership powers Also regulates the Federal Home Loan Banks Conforming loan limit: as high as $625,000 (2009) Authorizes the Treasury to invest unlimited funds directly in F&F

48 Government conservatorship Why a conservatorship? Loan losses likely to continue Some further accounting irregularities (?) Receivership might create further problems The U.S. Government will (must) honor the debt obligations The owners (shareholders) will be wiped out or severely diluted Otherwise we have privatized the gains and socialized the losses The creditors will be bailed out, not the owners or senior management

49 What Is to Be Done? - Long term

50 Housing policy To what extent should home ownership be subsidized? What are the best ways of subsidizing home ownership? Beyond encouraging homeownership, should housing consumption itself be subsidized? Is too much is never enough a sensible policy standard?

51 Housing finance (1) With mortgage securitization now a welldeveloped technology and with mortgage finance now a national market, is there still a need for the (former) special status of Fannie & Freddie? Are they the source of strength that was expected at times of crisis? Is there a need for the special status of the Federal Home Loan Bank system?

52 Housing finance (2) Are the large portfolios of Fannie & Freddie an extra systemic problem? How necessary are these large portfolios to their efficient operation? Is the 30-year fixed rate mortgage a necessary fixture in American mortgage markets? Does all of the prepayment risk have to be borne by lenders (i.e., no prepayment fees)?

53 Housing finance (3) Is the GSE model a good one for housing and housing finance? Risk to tax payers? Mission creep? What are the real benefits? What are the real costs? Are the benefits worth the costs? Maybe it s time truly to privatize them

54 Housing finance (4) The two companies should be truly privatized Social functions should be absorbed by the federal Housing Administration (FHA) All ties with the federal government should be severed Their borrowing would be more costly They would need more capital They would be smaller Grass would not grow in the streets of America But grass would continue to grow in the backyards of America Amtrak + Conrail as a model?

55 Conclusion Housing policy, housing finance, and GSE issues are important They are likely to be with us for a long time