RateWatch #396 – Mr. G Speaks About FHLMC & FNMA

February 28, 2004 by Dick Lepre

What's Happening

Preliminary GDP for 4th Q was +4.1%. This is slightly above expectation and slightly better than the previous quarter.  It seems to be benefiting equity and Treasury markets which may have feared the unexpected. The Chain Deflator (a weighted measure of inflation) was +1.2% - slightly higher than expectation but well within tolerance.

Mr. G Speaks

In case you have not been paying attention, Fed Chairman Greenspan this week laid out what is
probably a broader agenda than either political party will come up with this summer.

Greenspan suggested:

1) the tax cuts (of last year) should be made permanent
2) the real problem is us baby-boomers who are going to suck social security dry
3) people who's jobs are offshored should stop complaining and get on with their lives
4) GSE's (FHLMC & FNMA) represent a threat to the economy akin to al Qaeda

Fortunately, he expressed no opinions about gay marriage.

Tax cuts and social security are significant issues. Let's talk about the FHLMC/FNMA thing here.

Since no one can concoct sentences quite like Greenspan I am going to boost some of his material.

"... there are many ways to enhance the attractiveness of homeownership at significantly less potential cost to taxpayers than through the opaque and circuitous GSE paradigm currently in place."

I particularly love the last sentence.  If Bush could stand up and utter a sentence like that the Democrats would probably call off their convention.  Just kidding.

The proposition is that homeownership is good.  It leads to social stability.

"During the 1980s and early 1990s, Fannie Mae and Freddie Mac (hereafter Fannie and Freddie) contributed importantly to the development of the secondary mortgage markets for home loans and to the diversification of funding sources for depository institutions and other mortgage originators. Although the risk that a home mortgage borrower may default is small for any individual mortgage, risks can be substantial for a financial institution holding a large volume of mortgages for homes concentrated in one area or a few areas of the country. The possible consequences of such concentration of risk were vividly illustrated by the events of the 1980s, when oil prices fell and the subsequent economic distress led to numerous mortgage defaults in Texas and surrounding states. The secondary markets pioneered by Fannie and Freddie permit mortgage lenders to diversify these risks geographically and thus to extend more safely a greater amount of residential mortgage credit than might otherwise be prudent."

The primary beneficial function of Fannie and Freddie, thus, is mortgage securitization. Beyond the conforming mortgage market other debt markets have mimicked the models of Freddie and Fannie.  These include:  auto loans, credit cards, nonconforming mortgages and commercial
mortgages.  This debt securitization has created a stable credit supply because it has tapped into
an enormous pool of assets.  I may get a mortgage and be using the money of banks, S&L's, insurance companies, pension funds, Harvard University's endowments, Alex Rodriguez's CD's or Bill Gates' lunch money.

"Given their history of innovation in mortgage-backed securities, why do Fannie and Freddie now generate such substantial concern? The unease relates mainly to the scale and growth of the mortgage-related asset portfolios held on their balance sheets. That growth has been facilitated, as least in part, by a perceived special advantage of these institutions that keeps normal market
restraints from being fully effective. The GSEs' special advantage arises because, despite the explicit statement on the prospectus to GSE debentures that they are not backed by the full faith and credit of the U.S. government, most investors have apparently concluded that during a crisis the federal government will prevent the GSEs from defaulting on their debt. An implicit guarantee is thus created not by the Congress but by the willingness of investors to accept a lower rate of interest on GSE debt than they would otherwise require in the absence of federal sponsorship."

Greenspan is BS'ing here.  If Freddie or Fannie tanks the Fed will stand behind their debt even though Mr. Greenspan may say otherwise. The guarantee is not explicit but it is certainly implicit.

Freddie and Fannie are successful, in part, because they can hedge their positions on the assets that they are taking the rate-risk on.  If their model fails, they may suffer significant losses.  That
is Greenspan's concern.

Greenspan is suggesting that their be new oversight of the GSE's and that oversight be under the Treasury Department.  He is also suggesting that GSE's may need some regulation relating to
reserve requirement such as are imposed on banks and S&L's.

Freddie and Fannie has been under attack by commercial banks because these GSE's have
devoured a large part of the market share and potential profits from the mortgage business.
The flap last year about FHLMC's understated earnings in an attempt to smooth those
earnings into other quarters and paint a picture of a corporation with smooth, solid
earnings, has served to create skepticism.

Where this will lead is hard to tell. We folks in the mortgage business have gotten used to thinking
of Freddie and Fannie as "good guys" who keep rates low.  In fact they have laid a large part of the groundwork for mortgage securitization and, perhaps, a broader selection of mortgage securitizers may actually better serve the home buying public.

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