-
19 words and
the ballooning debt that shook yesterday's market,
-
Monday's
gains go plainly down the drain,
-
All the background you need on the Fan & Fred debacle and
more...
-------------------------
Joel Bowman, reporting
from Dubai in the Persian Gulf...
"You should not deal in
securities unless you understand their nature and the extent of your
exposure to risk." Disclaimer found on Fannie Mae's website,
September 10, 2008.
What stupidity giveth, reason
taketh away.
Markets around the world
rejoiced on Monday, celebrating the socialization of the world's two
largest mortgage finance companies, Fannie and Freddie. On Tuesday,
reason came home to roost and ordered Monday's revelers to clean up
their mess. All gains were promptly handed back.
In a matter of 29 hours, the
Dow Jones Industrial Average swung some 600 points. Now, back where
they started the week, traders and investors are scratching their
heads. They didn't have to scratch for long, however, as Peter Orszag,
director of the Congressional Budget Office soon made things a bit
clearer for them.
"It is the CBO view that
Fannie Mae and Freddie Mac should be directly incorporated into the
federal budget." With those 19 words, Orszag acknowledged what many
either feared or simply overlooked: The burden, dear taxpayer, now
rests on our collective shoulders.
The CBO then went on to raise
its estimate of the budget deficit to $407 billion this year and a
record $438 billion in '09.
Predictably, the cost of
insuring against a potential default on the nation's ballooning debt
soared. The price of 5-year credit default swaps, for instance, leapt
to a record 18 basis points. According to an article in this morning's
FT, the US is now considered more likely to renege on its obligations
than not just Japan, Germany and France, but also the Netherlands and
some Scandinavian countries.
A few hundred points hither, a
few hundred points thither and the whole situation is about as clear
as the view from a submarine under the Loch ness.
Perhaps the best way to find
an end to all this kafuffle is to start at the beginning. Yesterday we
brought you some thoughts on the matter from Eric Fry and Chris Mayer,
complete with a Fannie and Freddie R.I.P. graphic, just for fun.
As your junior editor read
through the notes of his slightly older, far wiser colleagues', we
noticed a link to another essay one of them had prepared on the topic.
Clicking through, we read the first line, "The mortgage markets of
America are on the verge of nationalization." This assertion would not
have seemed at all unusual...expect that the essay was penned back in
2002, when the mortgage giants were kings of the castle.
Chris Mayer's arguments were
so eerily prescient that we've decided to reproduce the entire column
for you today. It's a bit longer than usual, but with $5.3 trillion in
fresh liabilities dumped onto your government's balance sheet – and
with us taxpayers on the hook for the bill - we think a few extra
words are warranted.
We hope you enjoy this
background look at Fan and Fred, including the special privileges that
helped get them (and now us) into this whole mess in the first place.
Please send any comments to the address below.
[The following essay first
appeared on the indispensable Mises.org website.]
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Mortgage Market
Socialism
By Christopher Mayer
The mortgage markets of
America are on the verge of nationalization. Fannie Mae, Freddie Mac,
and the Federal Home Loan Bank System (all government-sponsored
enterprises, or GSEs) have become giants in the mortgage markets. The
Big Three have grown at such a rapid rate over recent years that at
the end of 2000, they collectively held $2.9 trillion of mortgage
debt, which was equivalent to nearly 56 percent of all US household
mortgage debt. Combined, they account for 90 percent of the total
federal agency debt, and federally sponsored agency debt outstanding
at the end of 2000. In 2001, the growth of GSEs did not abate.
The expansion of the GSEs—neither
wholly private nor wholly public institutions—has far outpaced the
growth of the mortgage market as a whole, which means that their share
of the mortgage pie is growing each year. This has led to predictions
that the GSEs will inevitably nationalize mortgage risk by acquiring
virtually all domestic mortgages. This thought leads not only to the
prospect that American taxpayers will be the ones to foot the enormous
bill of bailing out the GSEs if they should run into trouble, but also
has led to fears that the GSEs will then have to expand their charters
and enter more consumer markets in order to continue to grow.
For their part, the GSEs have
remained supremely confident of their future and have aggressively
fought any attempts to sever or disrupt their special relationship
with the US government. The December issue of Money wrote of Franklin
Raines, the CEO of Fannie Mae, that he "may be the most confident CEO
in America." When asked whether any realistic economic scenario scared
him, Raines replied, "No. . . . Our expectation is that in almost any
environment, we can produce earnings growth in the mid-teens."
Forgotten is the truism that
periods of prosperity necessarily precede periods of crisis. Thus,
caution becomes heresy and optimism becomes the new religion. For
Raines, the future can only look like the recently traversed past.
Perhaps Raines's view of
realistic economic scenarios is a narrow one, but his confidence is
not entirely without foundation. As Money reports, US home prices have
yet to fall (year after year) in twenty-six years since the federal
government has been tracking them. Moreover, Fannie Mae enjoys several
important advantages that its competitors cannot ever replicate.
While Fannie Mae's stock and
bond prospectuses carry the disclaimer that its obligations are not
backed by the US government, the market believes something else. GSE
obligations yield only slightly more than treasury securities, but
below that of America's top-rated corporate obligations. And the
rating agencies treat GSE obligations as if the US government backs
them.
As Bert Ely stated in an
American Enterprise Institute research briefing, "Anybody who has any
doubts about these institutions has to realize that they are not only
'too big to fail' institutions, just by their sheer size, but again,
if they got into trouble as the Farm Credit System did back in 1987,
they would get bailed out. . . . Long-Term Capital Management was
small potatoes in size compared to where Fannie and Freddie are today
and where they're going." More recently, if the government can't sit
by and watch the airlines perish or watch domestic steel producers
fail, then it can hardly be expected to let these much larger giants
fall.
The lower yields mean that the
GSEs have a significant funding advantage over their competition. The
GSEs also receive other benefits, as detailed in a research paper
written for the Mercatus Center titled "Neither Fish nor Fowl: An
Overview of the Big-Three Government-Sponsored Enterprises in the U.S.
Housing Finance Markets" by Mises Institute adjunct scholar John
Cochran and Catherine England. Among these benefits:
Lines of credit with the US
Treasury. Fannie and Freddie may borrow up to $2.25 billion each from
the US Treasury, and the FHLB system enjoys a $4.0 billion line of
credit. They have never used these lines, but have fought vigorously
to maintain them. The lines surely add to the belief that the US
government backs the GSEs.
SEC exemption. The debts
issued by the GSEs are exempt from SEC registration and disclosure
requirements, which saved them collectively an estimated $236 billion
in 2000.
Privileged treatment. While
banks face strict limits on the amount they can lend to any one
borrower, this regulatory requirement does not apply to GSE debt.
Therefore, banks can hold unlimited amounts of GSE debt, and this debt
is given favorable treatment in computing compliance with regulatory
capital requirements. In addition, the Federal Reserve acts as a
transfer agent for all of the GSE debt, just as it does for the US
Treasury and for government agencies. These privileges expand the
market for GSE debt beyond what it might otherwise be.
Tax exemption. GSEs are exempt
from state and local income taxes. Fannie and Freddie also don't pay
federal income taxes on their earnings, nor property taxes on any of
their offices. Cochran and England maintain that the GSEs saved $1.3
billion in tax exemptions in 2000.
There are other benefits more
technical in nature but every bit as real. For all practical purposes,
the GSEs are government agencies. In addition to the benefits the GSEs
receive, the GSEs have imposed a cost on the market as well. We do not
know how the mortgage market might have developed if the GSEs had
never been created, nor can we guess what alternative uses the capital
invested in the mortgage market might have found and what would have
been created instead.
The GSEs' preeminent position
in the mortgage markets is fortified by these advantages and has
undoubtedly contributed to their growth. And yet, while Raines boasts
of his company's impressive earnings track record, and as the GSEs
take credit for the fact that 70 percent of Americans own their own
homes, there are storm clouds gathering.
For one, Warren Buffett sold
his Fannie Mae stake last year, writing in his annual report that "the
risk profile had changed." Perhaps he was concerned about Fannie Mae's
increasing willingness to undertake riskier activities, such as its
entry into the sub-prime mortgage market. Fannie Mae, as well as the
other GSEs, are also holding more mortgages than before, thereby
taking on more interest rate risk. (A GSE has two options when it
acquires mortgages: it can package them together and offer them to
investors, guaranteeing the timely payment of principal and interest,
while allowing the investors to bear the interest rate risk; or it can
hold a mortgage itself, taking on the interest rate risk as well as
the credit risk.)
Perhaps Buffett realized the
increasing difficulty that Fannie is going to have in meeting its
target 15 percent annual earnings growth rate. By virtue of simple
mathematics, Fannie and its GSE cohorts will eventually control the
entire mortgage market and will then have to expand their charters to
go into other lines of business—all the while getting bigger and
taking on more risk.
It is interesting to note that
the GSEs are among the most leveraged of all US industries. Only
federally insured commercial banks and savings institutions exceed
their debt ratios. Moreover, as Cochran and England point out, if you
add back certain off-balance-sheet liabilities (like mortgage-backed
securities which the GSEs guarantee) there is approximately $80.55 of
debt for every one dollar of equity in Fannie Mae and $64.70 in debt
for every one dollar of equity in Freddie Mac.
The fact that the market
implies that GSE obligations are backed by the US government only adds
to their ability to further leverage their assets. Perversely, as
Cochran and England note, "the ambiguous nature of the GSEs'
relationship to the government may reverse customary market
incentives. In sharp contrast to the concerns that arise when a
private corporation increases its outstanding debt, investors in GSE
debt could expect that the more debt Fannie Mae has outstanding, the
less likely the government will be to allow it to default. Some
investors may thus interpret increased GSE debt as embodying less risk
rather than more."
The risk to the GSEs is that
an economic downturn results in falling home prices, increasing
delinquency rates and thus leading to loan losses. With the GSEs' high
leverage, it won't take much in the way of losses to cause some
significant damage to their financial health. As James Grant recently
observed, "Ignorance about tomorrow is a constant of human affairs.
Submission to this truth is what's variable. In finance, submission
entails a healthy fear of leverage." The GSEs are operating as if the
future is certain and prosperous.
An explosive concoction has
been created with the GSEs. The GSEs have increasingly dangerous
levels of debt, coupled with an implicit government guarantee that
seems to encourage even more debt. In the case of Fannie and Freddie,
they are publicly traded companies accountable to shareholders for
delivering earnings growth that is going to be increasingly difficult
to deliver as they grow to the limits of their market. Thus, they are
faced with the prospect of lower earnings growth or of finding a way
to expand into other (riskier) areas of consumer finance—and further
spreading the threat of nationalization beyond just the mortgage
market.
The only way to correct this
problem is the same way all socialistic practices are corrected—the
government's involvement must be severed completely. Just because the
GSEs have led a charmed life so far is no reason to infer that their
future will always be so bright. Socialism is not dead; it is alive in
institutions like the GSEs, which are for all practical purposes
government agencies.
It has often been said that
there are no free lunches. Surely, Americans cannot continue to
subsidize (indirectly) mortgage finance without cost. What most
Americans cannot see is that such subsidization of the mortgage
industry has led to the assumption of a great deal of risk on the part
of the taxpayer. The longer the GSEs are able to expand as they have,
the more certain it becomes that someday taxpayers will have to bear
the cost of such excess. Like Russian roulette, the longer you play,
the more certain it becomes that you will bear the risk for playing.
[Joel's Note:
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[Rude Endnote:
As a quick final word, I'd like to mention that Chris has the best
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With limited seats available,
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If you're still umming and aahhing, now's the time to act.
Read on Here
Until tomorrow...
Cheers,
