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Replacing Housing Risk With Dollar Risk, Updated

Understanding the Dimensions of the Fannie Mae/Freddie Mac Problem

As of Sunday night, the US government, speaking through Treasury Secretary Henry Paulson, has committed to guarantee the value of securities issued by the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac.

That means that you, dear Taxpayer, are about to get into the housing business in a way you’ve probably never imagined and certainly didn’t choose.

So it’s worth asking a few questions about the business we’re all about to get into.

What does it mean to say that Freddie Mac is insolvent on a mark-to-market valuation basis? Exactly how much risk are the taxpayers going to be exposed to? Who owns the securities (or “agency debt”) issued by Fannie and Freddie, and how do they benefit from the bailout?

And most of all, what does it mean for people who want to buy houses in the future?

This update of a story that was originally written three days ago includes sections on market and Congressional reactions to the GSE bailout plan.

Keep reading…

Preventing Revolutions

Fannie and Freddie (the GSEs) are chartered by Congress to borrow money from the public, and then lend it to homebuyers in the form of mortgages, at a higher rate of interest. They’re supposed to make a nice profit from the interest-rate spread.

But Congress long ago gave the GSEs a line of credit from the Treasury (currently $2.25 billion, although Paulson just proposed to raise it). So there has always been a tacit assumption that agency liabilities would be guaranteed by the US government.

This makes for a very interesting business model. Because of the implicit Federal guarantee, agency debt is perceived as nearly free of credit risk. This makes it exceptionally attractive to investors, and interest rates on the paper are correspondingly low.

So the agencies have an artificially low cost of capital, compared to other lending institutions. Fannie and Freddie don’t make money because they’re particularly good at what they do. They make money only because people believe that the government has assumed the credit risk on their liabilities.

This significantly reduces the interest rates that people have to pay on their mortgages, which without the agencies would be quite a bit higher than they are today.

And that’s why Congress chartered these entities in the first place. Politicians have long understood that asset ownership keeps people from demanding radical social change. People who own houses and make mortgage payments tend not to participate in revolutions.

On Balance Sheet And Off

In addition to the direct mortgage lending that they engage in, Fannie Mae and Freddie Mac also guarantee the payments on a much larger amount of mortgage debt. What kind of numbers are we talking about here?

There are maybe $12 trillion worth of home mortgages in force in the US today. Fannie and Freddie together own about $1.6 trillion of those mortgages, either directly or in the form or mortgage-backed securities.

To support those assets, they’ve issued liabilities in the form of coupon bonds and other debt sold directly to investors. And underneath those liabilities, the agencies have shareholder equity amounting to maybe $70 billion in all.

The agencies have also been major issuers of mortgage-backed securities, which are not carried on their balance sheets. These securities amount to a total of nearly $4 trillion. They’re based on mortgages that were underwritten by Fannie and Freddie, and conform to their strict standards. So the agencies guarantee the payments made by these securities, even if the underlying mortgages default, and they earn a fee for making the guarantee.

So all in, you’re looking at about $5 trillion in mortgages that are owned or guaranteed by Fannie and Freddie: nearly half of all US mortgages.

Ok, now let’s get out the back of an envelope and do some arithmetic.

Potential Losses

What if the sky falls and 10% of the agency-guaranteed mortgages go into foreclosure? (Remember, we’re talking about conforming, prime mortgages: the good stuff, not the subprime toxic waste.) Figure the recovered value from a foreclosure averages half the value of the original loan. That adds up to a potential loss of half of 10% of $5 trillion. Maybe $250 billion.

Does that number sound familiar? It should, because the contemplated maximum size of the mortgage bailout bill now working its way through Congress is $300 billion. So at least we’re all working off the back of the same envelope.

But Fannie and Freddie only have about $70 billion in equity capital between them. When mortgages default and they lose money, the first losses are taken by the equity. When the equity is wiped out, the agencies’ debt takes the hit. So if you want to not worry about them defaulting on their liabilities, you have to make up the gap between $70 billion and whatever you think their loan losses will be.

And that’s why Hank Paulson is talking about buying equity in Fannie and Freddie. It would be a matter of desperation for them to sell additional common stock in the open market now, with their stock prices at smelling distance from zero.

But who’s being protected by all this? Well, who owns the debt that’s been issued or guaranteed by the agencies to fund your mortgage?

The International Dimension

To a perhaps surprising extent, part of the answer is the central banks of China, Russia and Japan. “Official” holdings of US agency debt are said to total just under $1 trillion, but they are likely somewhat higher.

What the heck happened here?

What happened is that investors, including central banks, chose to treat the cash flows generated by American homeowners as reserve assets, a role typically played by securities issued directly by governments (that is, US Treasury debt).

These investors eagerly chose to invest in securities that paid a relatively high yield, because it was understood that the US government would assume their credit risk.

Turn this over in your mind a few more times. It’s quite remarkable.

Fannie and Freddie have been giving investors a free ride for years now. Investors benefit from the high yields paid by mortgages, without being exposed to the risk of default. You’d take this deal too, if you could.

This totally explains the rapid growth of Fannie and Freddie, who especially in the Nineties, went out and actively marketed themselves as a substitute for US Treasuries, which were in short supply because of the Federal budget surpluses.

And now these investors are demanding that the US make good on its implicit guarantee. In effect, they want to exit from their exposure to the US housing market, and replace it with exposure to the US dollar. They want their agency paper to behave like Treasury paper.

Does that sound like a windfall profit for the governments of China and Russia? Yes, it most certainly is. Their agency securities will now appreciate sharply in value until they nearly converge with the value of US Treasuries.

But they will still face the problem of holding securities that are denominated in dollars. They’ve replaced housing risk with dollar risk. And the dollar risk is real, because the taxpayer-funded bailout of any losses on agency-guaranteed mortgages will take the form of inflation.

Foreign central banks, particularly China, will prove entirely willing to take this risk. The Chinese appear to have recently decided to slow down this year’s sharp appreciation of renminbi, partly to slow down a flood of hot-money inflows. So they’ll continue to pile up dollar reserves as fast as ever. They’ll need a place to put those dollars.

And in addition, the fact that there is so much official ownership of agency debt makes it a matter of international diplomacy to propose anything which might impair their value. (For example, the otherwise perfectly reasonable idea of asking agency debtholders to take up to a 5% “haircut,” or reduction in principal value, to reflect roughly that much damage in the housing market.)

I suspect that this reality is part of why Secretary Paulson insists that the pain be borne exclusively by shareholders, not bondholders.

Congressional and Market Reactions

Financial markets originally had a positive reaction to the Paulson announcements, but they turned sour almost immediately. The interest-rate spread between agency and Treasury debt, which had tightened sharply on Friday with the rumors of a GSE bailout, started widening again on Monday and subsequent days this week.

Secretary Paulson himself came in for a tongue-lashing in Senate Finance Committee testimony on Tuesday. Fed Chairman Bernanke’s testimony was received with more politeness. But I can’t have been the only one who was struck by a sense that Bernanke is acting like a man with limited options.

Bernanke is walking on a knife edge. He’s trying to mitigate an ongoing credit crisis, with tools that are better suited for dealing with macroeconomic problems. He can’t cut interest rates any further because inflation is already roaring now. (Although this is more complicated than it looks, as the Fed has actually kept total money-supply growth muted through sterilization operations.) And he dares not raise rates because that would slam the brakes on the financial sector (which is in dire distress) and the economy as a whole.

Freddie Mac successfully executed a discount-bill raise on Monday and has another one scheduled for Friday. This wasn’t surprising. Fannie and Freddie are not in immediate danger. A rather remarkable steepening of the Treasury yield curve this week, however, suggests that people are starting to realize that high inflation is here to stay. We’ve also seen fresh signs this week that foreign central banks and sovereign investors are accelerating their diversification away from dollar assets.

Where do we go from here?

The net effect of Congress’ 40-year experiment in fostering home ownership has been a significant misallocation of economic resources. Think about it: whenever you make something (like mortgage risk) cheaper than it should be, people will buy more of it than they should.

And that crowds out investments that make more economic sense. I have a hunch that some smart economists will figure out that this is exactly why the US economy has been growing more slowly than it could have for so many years.

So what happens to homeownership now? We’ve been subsidizing it with an implicit government guarantee. Should we continue to do so, but with an explicit taxpayer-funded guarantee?

Or should we let the free market figure out the true value of US housing? (Undoubtedly a lot lower than it is now.) And should we end the deductibility of home mortgage interest?

Free-market orthodoxy suggests that we should, because otherwise we’ll continue to overallocate resources to housing, even now that events have proven this to be a bad idea. Efficient resource allocation is what free markets do best. But it’s also what scares politicians the most, because they can’t predict (or control) what free markets will do.

The mantra of many successive Administrations has been that America needs high rates of home ownership. For better or worse, we’re already hearing a very different point of view, expressed not only by Barack Obama but by some Republicans as well.

Obama says that “we need to put more money in people’s pockets, and ensure that housing is affordable and available.”

That’s actually very different from saying that “home ownership is the American Dream.”

The former implies a continued reliance on distorted incentives created by government. The latter activates the idea that if people work hard and smart, the economy will create affordable houses for them to buy.

We will all need to decide together which one of these competing visions is the way forward.

-Francis Cianfrocca

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