Tag Archives: financial stability

Fannie, Freddie and Trump

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FHFA Director Bill Pulte

Central Banking quoted me in Fannie, Freddie . . . and Donald. It reads, in part,

IIn a client note on May 13, investment management firm Pimco said any privatisation of Fannie and Freddie would be a solution in search of a problem.

“If the GSEs are released but the government remains accountable to come to their rescue, wouldn’t taxpayers ultimately be the biggest loser, once again, by seeing GSE gains privatised but losses socialised?” it said, adding: “Don’t fix what’s not broken.”

David Reiss, professor at Cornell Law School, says Pimco’s view reflects the fact that the mortgage market has been functioning “pretty smoothly” since Fannie and Freddie were nationalised. According to this viewpoint, there is “no need to release them from conservatorship”.

However, Reiss says he does not like to see so much power and influence concentrated in the GSEs, and he believes the private sector would do a better job of evaluating credit risk.

“Some people – mostly investors in Fannie and Freddie securities – think [privatisation] is the right thing to do because the conservatorships were supposed to be temporary and the companies should be returned to private control and investors should be able to get some kind of return on their investments,” he says.

Reiss adds that some members of the Trump administration think privatisation would generate hundreds of billions of dollars in revenue that could be used to help pay down the national debt, offset tax cuts and seed a sovereign wealth fund.

Joe Tracy, senior fellow with think-tank the American Enterprise Institute and a former official with the Federal Reserve banks of New York and Dallas, agrees with Reiss. “The problem is that they are in conservatorship limbo, so the government has effectively nationalised a large segment of mortgage finance,” he says. “This should be carried out by the private sector.”

    *     *     *

Lawrence White, professor at New York University and co-author of Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance, says the GSEs are unlikely to become boring unless they are broken down. He believes that if Fannie and Freddie are privatised in their current form, each enterprise will be likely to pose a systemic risk from a financial stability perspective.

“The implication is that their regulator, the Federal Housing Finance Agency [FHFAI, will need to have strong powers of examination and supervision and will need to impose substantial, risk-adjusted capital requirements,” he says.

“It is unclear whether there will be implications for the Fed as lender of last resort, since the Fed’s lending function is currently limited to banks.”

Reiss agrees that the two lenders are systemically important. If they “had to significantly scale back their lending, it would likely cause a crisis in the financial markets”, he says. “If that crisis were not quickly addressed it would cause a crisis in the real economy as well, freezing up credit for new construction and resales.”

Given that the two GSEs issue more than 70% of the outstanding $9 trillion of mortgage-backed securities in the US and, if privatised, would be two of the country’s largest publicly traded companies, the financial stability risks are clear, he says.

Reiss adds that if the privatisations were poorly planned, and if this were priced in by the markets, it would lead to “higher mortgage rates, with all of the knock-on effects that would have”. This, he says, would “increase the magnitude of a financial crisis if the two companies were to report poor financial results down the line”

Reiss’s interpretation of the Fed’s role is different to that of White, and he believes history may end up repeating itself. He says that although the FHFA is Fannie and Freddie’s primary regulator, the Housing and Economic Recovery Act of 2008 requires the Fed to be consulted about any federal government processes related to the companies.

“The Fed may also co-ordinate with other parts of the federal government in responding to a financial crisis, such as purchasing Fannie and Freddie securities, as they did during the financial crisis of 2007-08,” he says. “One could well imagine the Fed playing a similar role in future crises involving Fannie and Freddie.

De Facto Housing Finance Reform

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David Finkelstein, Andreas Strzodka and James Vickery of the NY Fed have posted Credit Risk Transfer and De Facto GSE Reform. It opens,

Nearly a decade into the conservatorships of Fannie Mae and Freddie Mac, no legislation has yet been passed to reform the housing finance system and resolve the long-term future of these two government-sponsored enterprises (GSEs). The GSEs have, however, implemented significant changes to their operations and practices over this period, even in the absence of legislation. The goal of this paper is to summarize and evaluate one of the most important of these initiatives – the use of credit risk transfer (CRT) instruments to shift mortgage credit risk from the GSEs to the private sector.

Fannie Mae and Freddie Mac have significant mortgage credit risk exposure, largely because they provide a credit guarantee to investors on the agency mortgage-backed securities (MBS) they issue. Since the CRT programs began in 2013, Fannie Mae and Freddie Mac have transferred to the private sector a portion of the credit risk on approximately $1.8 trillion in single-family mortgages (as of December 2017; source: Fannie Mae, 2017, Freddie Mac, 2017). The GSEs have experimented with a range of different risk transfer instruments, including reinsurance, senior-subordinate securitizations, and transactions involving explicit lender risk sharing. The bulk of CRT, however, has occurred via the issuance of structured debt securities whose principal payments are tied to the credit performance of a reference pool of securitized mortgages. A period of elevated mortgage defaults and losses will  trigger automatic principal write-downs on these CRT bonds, partially offsetting credit losses experienced by the GSEs.

Our thesis is that the CRT initiative has improved the stability of the  housing finance system and advanced a number of important objectives of GSE reform. In particular the CRT programs have meaningfully reduced the exposure of the Federal government to mortgage credit risk without disrupting the liquidity or stability of secondary mortgage markets. In the process, the CRT programs have created a new financial market for pricing and trading mortgage credit risk, which has grown in size and liquidity over time. Given diminished private-label securitization activity in recent years, these CRT securities are one of the primary ways for private-sector capital market investors to gain exposure to residential mortgage credit risk.

An important reason for this success is that the credit risk transfer programs do not disrupt the operation of the agency MBS market or affect the risks facing agency MBS investors. Because agency MBS carry a GSE credit guarantee, agency MBS investors assume that they are exposed to interest rate risk and prepayment risk, but not credit risk. This reduces the set of parameters on which pass-through MBS pools differ from one another, improving the standardization of the securities underlying the liquid to-be-announced (TBA) market where agency MBS mainly trade. Even though the GSEs now use CRT structures to transfer credit risk to a variety of private sector investors, these arrangements do not affect agency MBS investors, since the agency MBS credit guarantee is still being provided only by the GSE. In other words, the GSE stands in between the agency MBS investors and private-sector CRT investors, acting in a role akin to a central counterparty.

Ensuring that Fannie Mae and Freddie Mac’s credit risk sharing efforts occur independently of the agency MBS market is important for both market functioning and financial stability. The agency MBS market, which remains one of the most liquid fixed income markets in the world, proved to be quite resilient during the 2007-2009 financial crisis, helping to support the supply of mortgage credit during that period. The agency market financed $2.89 trillion of mortgage originations during 2008 and 2009, experiencing little drop in secondary market trading volume during that period. In contrast, the non-agency MBS market, where MBS investors are exposed directly to credit risk, proved to be much less stable; Issuance in this market essentially froze in the second half of 2007, and has remained at low levels since that time.4 (1-2, citations and footnotes omitted)

One open question, of course, is whether the risk transfer has been properly priced. We won’t be able to fully answer that question until the next crisis tests these CRT securities. But in the meantime, we can contemplate the authors’ conclusion:

the CRT program represents a valuable step forward towards GSE
reform, as well as a basis for future reform. Many proposals have been put forward for long-term reform of mortgage market since the GSE conservatorships began in 2008. Although the details of these proposals vary, they generally share in common the goals of

(1) ensuring that mortgage credit risk is borne by the private sector (probably with some form of government backstop and/or tail insurance to insure catastrophic risk and stabilize the market during periods of stress), while

(2) maintaining the current securitization infrastructure as well as the standardization and liquidity of agency MBS markets.

The credit risk transfer program, now into its fifth year, represents an effective mechanism for achieving these twin goals. (21, footnote omitted)

The Money Problem

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Professor Ricks

I recently read The Money Problem: Rethinking Financial Regulation by Morgan Ricks (University of Chicago Press 2016).  While it is not a book for the financially faint of heart, it does provide a great introduction to what money is and what banks and other financial intermediaries do. The back matter reads,

Years have passed since the world experienced one of the worst financial crises in history, and while countless experts have analyzed it, many central questions remain unanswered. Should money creation be considered a ‘public’ or ‘private’ activity—or both? What do we mean by, and want from, financial stability? What role should regulation play? How would we design our monetary institutions if we could start from scratch?

In The Money Problem, Morgan Ricks addresses all of these questions and more, offering a practical yet elegant blueprint for a modernized system of money and banking—one that, crucially, can be accomplished through incremental changes to the United States’ current system. He brings a critical, missing dimension to the ongoing debates over financial stability policy, arguing that the issue is primarily one of monetary system design. The Money Problem offers a way to mitigate the risk of catastrophic panic in the future, and it will expand the financial reform conversation in the United States and abroad.

I particularly recommend Part I to those trying to get their hands around money (the concept, not hard currency itself) and how it is created. Ricks reviews the “standard textbook description” of bank money creation and others’ account of it before providing his own “modified story.” (58-59)

Parts II and III provides a far-reaching blueprint for reforming the monetary system.  This reform agenda is not without its critics, but I think Ricks gives a fair reading to competing views so you can make up your own mind as to who is right.

Dodd-Frank and Mortgage Reform at Five

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The Department of Treasury has issued a report, Dodd-Frank at Five Years: Reforming Wall Street and Protecting Main Street. The report is clearly a political document, trumpeting the achievements of the Obama Administration. It is interesting nonetheless. It opens,

When President Obama took office in January 2009, the U.S. economy was in crisis. The nation was shedding more than 750,000 jobs per month, and confidence in our financial system had been shaken to its core. The worst financial crisis since the Great Depression exposed a toxic mix of excessive risk-taking, shoddy lending practices, inadequate capital levels, unstable funding, and weaknesses in regulatory oversight. A collapsing financial system choked off credit to consumers seeking to purchase a car, a home, groceries, or to finance an education. Nearly 9 million Americans lost their jobs, and over 5 million lost their homes. Nearly $13 trillion of families’ wealth was destroyed, wiping out almost two decades of gains.

In response to the crisis, the Administration released a proposed set of reforms in June 2009. Congress held numerous hearings and crafted legislation based on the Administration’s proposal, incorporating ideas from both Republicans and Democrats throughout the process. On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law, a historic and comprehensive set of financial reforms, which put in place critical new protections for consumers, investors, and taxpayers. Five years later—as a result of Dodd-Frank and other Wall Street reforms—our financial system is stronger, safer, more resilient, and more supportive of sustainable economic growth. Regulators also have better tools to deal with financial shocks when they occur, to protect Main Street and taxpayers from Wall Street recklessness.

Critics of reform have claimed that Wall Street Reform would deter lending and choke off the recovery. But, today it is clear that the opposite is true. Reform has served as a building block for economic growth, providing Americans with safe places to invest their savings and enabling banks to lend to individuals, businesses, and communities. Only a financial system strong enough to withstand a major financial shock is capable of promoting sustainable economic growth. Five years after the President signed Wall Street Reform into law, nearly all of the major elements of financial reform are in place. Today, our financial system is safer and stronger as a result of these hard-won reforms, and our economy is in a far better position to continue growing and creating jobs. (1)

I was struck by the fact that the report does not address the biggest financial reform failure of the last five years, the lack of reform of the housing finance system.  Fannie and Freddie remain in conservatorship, putting the housing finance system at risk of another crisis.

I was also struck by the following passage:

In the run-up to the financial crisis, abusive lending practices and unclear underwriting standards resulted in risky mortgages which hurt consumers and ultimately threatened financial stability. Wall Street Reform bans many of the abusive practices in mortgage markets that helped cause the crisis, and requires lenders to determine that borrowers can repay their loans. (2)

My recollection from academic conferences over the course of the last six or seven years is that many leading academics denied the link between abusive lending practices and systemic risk. It seemed pretty clear to me, but I was in the minority on that one. I am glad to see that at least the Treasury agrees with me.

The Rescue of Fannie and Freddie

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Federal Reserve researchers, W. Scott Frame, Andreas Fuster, Joseph Tracy and James Vickery, have posted a staff report, The Rescue of Fannie Mae and Freddie Mac. The abstract reads,

We describe and evaluate the measures taken by the U.S. government to rescue Fannie Mae and Freddie Mac in September 2008. We begin by outlining the business model of these two firms and their role in the U.S. housing finance system. Our focus then turns to the sources of financial distress that the firms experienced and the events that ultimately led the government to take action in an effort to stabilize housing and financial markets. We describe the various resolution options available to policymakers at the time and evaluate the success of the choice of conservatorship, and other actions taken, in terms of five objectives that we argue an optimal intervention would have fulfilled. We conclude that the decision to take the firms into conservatorship and invest public funds achieved its short-run goals of stabilizing mortgage markets and promoting financial stability during a period of extreme stress. However, conservatorship led to tensions between maximizing the firms’ value and achieving broader macroeconomic objectives, and, most importantly, it has so far failed to produce reform of the U.S. housing finance system.

 This staff report provides a nice overview of the two companies since the financial crisis. I was particularly interested by a couple of sections. First, I found the discussion of receivership versus conservatorship helpful. Second, I liked how it outlined the five objectives for an optimal intervention:

(i) Fannie Mae and Freddie Mac would be enabled to continue their core securitization and guarantee functions as going concerns, thereby maintaining conforming mortgage credit supply.

(ii) The two firms would continue to honor their agency debt and mortgage-backed securities obligations, given the amount and widely held nature of these securities, especially in leveraged financial institutions, and the potential for financial instability in case of default on these obligations.

(iii) The value of the common and preferred equity in the two firms would be extinguished, reflecting their insolvent financial position.

(iv) The two firms would be managed in a way that would provide flexibility to take into account macroeconomic objectives, rather than just maximizing the private value of their assets.

(v) The structure of the rescue would prompt long-term reform and set in motion the transition to a better system within a reasonable period of time. (14-15)

You’ll have to read the paper to see how they evaluate the five objectives in greater detail.

A Framework For Housing Finance

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The Government Accountability Office has released Housing Finance System: A Framework for Assessing Potential Changes. The GAO writes,

To help policymakers assess various proposals for changing the single-family housing finance system and consider ways in which the system could be made more effective and efficient, we prepared this report under the authority of the Comptroller General. Specifically, this report (1) describes market developments since 2000 that have led to changes in the federal government’s role in single-family housing finance; (2) analyzes whether and how these market developments have challenged the housing finance system; and (3) presents an evaluation framework for assessing potential changes to the housing finance system. (2)
It is useful to have a framework to figure out what kind of housing finance system we want for the 21st century. The GAO’s has 9 elements:
  1. Clearly defined and prioritized housing finance system goals
  2. Policies and mechanisms that are aligned with goals and other economic policies
  3. Adherence to an appropriate financial regulatory framework
  4. Government entities that have capacity to manage risks
  5. Mortgage borrowers are protected and barriers to mortgage market access are addressed
  6. Protection for mortgage securities investors
  7. Consideration of cyclical nature of housing finance and impact of housing finance on financial stability
  8. Recognition and control of fiscal exposure and mitigation of moral hazard
  9. Emphasis on implications of the transition (54-55)
This all sounds very Yoda-like, but the report itself goes into great detail as to what each of these 9 elements means. Given that Congress has left the housing finance system to its own devices, it is helpful that other branches of government like the GAO, Treasury and the FHFA are trying to move us beyond our current state of limbo. We need a housing finance system that is designed to last longer than the Band Aids and duct tape that were applied to it during the financial crisis.