Thursday, July 31, 2008

Robert Van Order on Fannie and Freddie

When I left Madison for Washington six years ago, it was to follow my wife, who was offered a terrific job practicing geriatric medicine for under-served communities at the Washington Hospital Center. I decided to go to Freddie Mac at the time, in large part because I admired many people there, including Ed Golding, who was in charge of financial research, and Bob Van Order, who was the chief economist for many years.

Bob wrote the following on the raison d'etre for Fannie and Freddie, and with his permission, I am passing it along:

By Robert Van Order
University of Aberdeen and University of Michigan
July 2008
Financial markets are different from other markets. They deal intensively in information and misinformation. Most of the time information is good enough and financial markets work fine, but when there are serious doubts about the quality of information entire blocks of investors, e.g., institutional investors who are not confident about information, exit and markets break down. In the case of lending markets borrowing rates go up abruptly and some borrowers have trouble getting loans at any price. Something like this has been happening in mortgage markets, especially subprime markets, and it seems to be spilling over into other markets.
Since the Great Depression when financial markets really went crazy we have developed institutions to try to control financial panic. A big part of this development has been deposit insurance, which provides bank depositors with assurance that they can get their money no matter what their bank does. Most of the time deposit insurance has served us very well. We don’t see bank runs to any great extent; in 1987 when the stock market crashed in a way that was not that different from 1929 we saw not a whiff of a bank panic. Of course the security has come at a cost. Banks can use deposit insurance as a basis for risk-taking and cause large costs to tax payers and distort resource allocation, as was the case with the Savings and Loans in the 1980s.
Fannie Mae and Freddie Mac (FF) are a part of this apparatus. They are usually referred to as Government Sponsored Enterprises or “GSEs.” That is, they are enterprises (they are privately owned), but they have special charters and benefits primarily in the form of implicit guarantees, for which they do not pay, and regulation (for instance, FF are limited to the mortgage markets and have regulations on their capital and on lending to targeted groups) which constrain their operation. They buy mortgages from lenders and they fund the purchases by issuing their own debt and (most often) mortgage backed securities (securities backed by particular pools of mortgages). They take credit risk because they are responsible for paying off investors in their securities in the event of default. They also take interest rate risk to the extent their debt funding is out of sync with their assets’ cash flows. Interest rate risk has not been the issue recently, but credit risk certainly has.
The GSEs have several purposes. Much of the recent focus has been on subsidizing homeownership, but the really important function has been to provide “liquidity” to the mortgage market, which basically means that they keep the market open even when times are tough, like now. Along with this they provide an element of standardization, which helps lenders and investors better understand what they are originating and buying. They can do this in part because their implicit guarantee allows them to raise money in bad times in the same way that deposit insurance allows banks to raise money even when they are in trouble.
Guarantees involve a subsidy, if they are not paid for. In FF’s case their debt has been rated AAA or AAA+ because of the government connection; whereas on its own it has been rated in the low AA range. The difference in borrowing rates between the two is around a quarter of a percent to .40%, which is a rough measure of their subsidy. Banks get a similar subsidy, which varies from bank to bank. The subsidy is probably larger now.
The analogy with deposit insurance is deliberate. Banks are de facto GSEs. Indeed, so are most major financial institutions around the world, which is in part why we have had relatively stable financial markets for decades. That does not mean that all GSEs are good things or that regulation can’t be improved on, but we’re not in uncharted water here. Nor are we looking at unprecedented support for mortgage markets. Since at least the 1950s almost all U.S. mortgages have benefited from guarantees: initially direct insurance like FHA and deposit insurance, especially via the Savings and Loans, and more recently via GSEs. The only part of the market without substantial government presence has been the subprime market.
What we have is a trade off. The GSEs provide stability. A measure of some of the current benefit from having FF in the market can be seen from a natural experiment that comes from the way the GSEs are regulated. There is a limit on the size of loan that FF can buy (It has been changed recently; at the beginning of this year it was $417,000. The limit is indexed to house prices over time). For years the loans above this cutoff (so called “jumbo” loans) paid rates about a quarter of a per cent higher than on loans below the limit (on 30 year fixed rate mortgages). The loans above the limit are not much different from those below; they are prime loans (the borrowers have good credit histories) with similar characteristics. However, at the end of last summer, as the subprime news hit the fan, the spread rose by over 1% and has stayed in that neighborhood. Again there is nothing in the data to suggest anything like that big a difference in credit risk on these loans. The difference is due to the existence of FF as liquidity providers in their part of the market. There is every reason to believe that without FF interest rates would have gone up in a comparable manner in most of the market.
The trade off is that the GSE structure, particularly the implicit guarantee, invites risk-taking in the same way that deposit insurance invites it. This distorts resource allocation (in this case diverting resources toward housing and homeownership). Perhaps more important, politically, it risks bail-outs (like with the S and Ls in the 1980s). Both the benefits and costs of GSEs are real and need to be balanced.
Right now the two GSEs are in trouble, and it is important to understand why. We can think of their business as having two parts: the “core” business of buying and funding prime mortgages, mostly 30 year fixed rate mortgages, and a portfolio of other “non Agency” mortgage-backed securities, which are not backed by prime loans, but rather by riskier loans like subprime and “Alt-A” mortgages. FF bought pieces of subprime and Alt-A deals that had insurance and subordination (meaning there were other investors in the loan pool that took risks first (e.g., the first 15% of the pool losses), which were supposed to protect them, so their parts of the deal (tranches) were rated AAA. These have performed worse than AAA and have fallen sharply in value. The non Agency portfolio is less than 10% of the combined $5 trillion in mortgage related assets held by the two, but it has been most of the recent controversy.
The core business of FF has been experiencing large defaults, almost certainly larger than either has ever experienced. This does not appear to have been due to changes in risk-taking or growth in the companies: the prime mortgages they bought have not changed much over time, and their performance has actually been better (lower delinquency rates) that those for prime mortgages in general. Nor was excessive growth a problem; the FF market share and level of purchases dropped sharply after 2003, as the subprime share rose. As far as one can tell so far the answer to “why?” is mostly that house prices have declined faster than at any time since these two have been around (It may have been worse in the 1930s). Both companies have taken write downs from this and more is likely to come. However, while this will certainly cut sharply into profits for several years it is likely that the two will weather the storm.
How do we know this? Well, we don’t know for sure, but we can get some ideas from history. Comparable declines in prices in some recent bad regional declines suggest that there is room for quite high default rates without collapse. An underappreciated tool that the FF regulator uses to assess FF capital is a series of “stress tests, which simulate the companies’ performance under stressful (in this case large credit loss situations). While the tests are a bit complicated the principle is simple: take the worst regional experience in recent history (for which we have data; this is the “oil patch” states in the 1980s) and project it nationwide and ask if the institution has enough capital reserve to survive ten years (leaving positive capital behind). The tool has not gotten much publicity because the institutions have generally (this includes the first quarter this year) had no trouble passing . It is important in part because the stress test appears to be actually happening. It looks like the two still pass (they had considerable excess in the first quarter of this year) but not without considerable pain. They will need added capital cushions both to make sure they get through the stress and so that they can grow. This part of their problem is a little controversial, but not a lot.
It is the non agency portfolios that are the big issue. A problem in assessing the non Agency portfolio, and the economic position of the two GSEs in general, is that the two standard measures of their position—two measures of their net worth- are both wrong. Standard accounting measures are almost always wrong because they are (generally) too slow to adapt to changing economic conditions. Hence, while accounting net worth of the two has worsened as they have set aside reserves for future losses, accounting rules do not do this fast enough to anticipate the full extent of future losses, so accounting (GAAP) net worth is probably too big.
The other measure, “mark to market” net worth, which estimates the market value of assets and liabilities of the two and takes the difference as their net worth, errs in the other direction. Right now mark to market net worth is around zero or negative for the two companies, primarily because the mark to market value of the non Agency securities has fallen sharply. This has been the genesis of much of the recent news about the two. It is certainly the case that if FF had to liquidate their portfolios they would be in trouble. However, they don’t have to; they are in a position of being able to hold them and fund their assets. Normally the mark to market value would also reflect the value of holding the assets as well as the value if sold; that is how competition in the market among buyers of securities works. But that only works if the market is working.
The problem is that there has been a liquidity crunch in the “non Agency” markets for mortgage-backed securities that is worse than the one we know about and can measure in the “Jumbo” market. The market for buying these has more or less evaporated, so it is hard to get the kind of clear read on the value of the securities that we would get in a market like the one for Treasury bonds. This is what is most controversial: the argument is that the senior, would-be AAA, subprime pieces are being priced at discounts that are way above any reasonable estimate of default loss. If that is the case, then holding the securities and using the proceeds to pay off the debt that funded them has a good chance of working—certainly it is better than selling the securities into a very thin market and trying to use the proceeds to pay off the debt.
Should we worry about this? Of course, but we should not overdo. Stress test tests run by FF and by outside analysts suggest that these securities are certainly not AAA, but they are not junk bonds either, and losses will be manageable. This is probably why the Congressional Budget Office opined recently that there probably will be no cost to the recently passed “bailout” bill.
But the “probably” part matters. Things could turn south, and that could be costly. Indeed, a problem right now is that FF would get most of the upside if things improve, but Treasury (taxpayers) would be stuck with a large part of the downside. This is the balance part. Guarantees, both for GSEs and banks, give financial institutions incentives to take risks because they get the upside benefits, but not all of the downside costs, and the market does not make them pay for it. On the other hand, the situation we are facing now, a possible financial meltdown, happens infrequently, but when it does it can cause a great deal of damage, a small glimpse of which we are seeing in the Jumbo market.
The short run response, in the recent Housing Bill, to this has been to shore up the perception of a guarantee, so that it is more or less certain that FF can continue to raise money. That is what the so-called line of credit is about (Ditto for opening the Fed discount window). It gives Treasury authority to extend its ability to make secured loans to FF (at Treasury’s discretion, not FF’s). Right now it is not necessary; FF are liquid and raising money easily, but knowing that the line is there probably makes it less likely that it will be used (for the same reason that the existence of deposit insurance mitigates bank runs). A separate part of the Bill allows Treasury to buy FF stock. This makes less sense. From a public policy perspective the issue is keeping the market open, and the line of credit can do this without helping shareholders. If FF fail, the line of credit will be the main vehicle for paying off the implicit guarantee.
Longer term, the balance will most likely come from limits on risk-taking and on capital reserves. The risk-taking of FF has not been a major issue, but the capital reserve has. Reforms going forward will probably raise the minimum levels of capital. The stress tests have not been mentioned much. That is unfortunate for two reasons: One is that as house prices fall and losses get paid out the ability to withstand the stress test going forward will diminish and there will be built in need to raise capital. Second the stress tests can be revised. The 1992 law that set up FF regulation required taking the stress test from the worst regional downturn in the data. We shall surely have a region (the southwest? Florida?) from the current period that will best the oil patch states. As a result simply updating the stress test will increase required capital, and it will do it the right way—related to the risk the institutions take.
If you want to get an idea of how the two are doing, forget the accounting net worth and the mark to market net worth and look at what is happening with stress tests.
A dimension of the problem that has not been seriously addressed is that FF, like banks, do not pay for the insurance they get. A way of solving this is via user fees. Charging fees would really solidify the guarantee and take it out of the conjecture box. To some extent this is a question of the extent to which taxpayers want to subsidize mortgage rates. It is not likely to be as good a way of controlling risk as are capital requirements and stress tests.
More broadly: there are four likely ways that housing finance will get done in the U.S:
1. GSEs.
2. Non Agency (“private label”) securitization.
3. Banks (and S and Ls)
4. Government owned institutions like FHA and Ginnie Mae
These all have benefits and costs. The second is the only 100% private (without guarantee) model. It runs the risk of fragility—probably not as bad, going forward, as the subprime debacle, but at least like the current Jumbo market. The third has many similarities to the GSEs. In principle the GSEs and banks are hard to separate; in practice the GSEs have won the market, but innovations like “covered bonds” can allow banks to do almost the same thing as securitization. Both have incentives for risk-taking and risk of bail out. The fourth presents the problems of government management and inflexibility (For instance, pricing by both FHA and Ginnie Mae are fixed by statute), and it is not clear that there is less risk.
Going forward, there is no doubt that there are risks, but not the sorts of catastrophes that have been floating around the press, blogs and newsrooms. The current zero or negative mark to market net worth is more a figment of a broken market than a judgment about future prospects. In any event the last thing we should want to do now is take away the liquidity role of FF. Around 90% of all adults are homeowners at some time in their life and almost all homeowners take out a mortgage at some time. The mortgage market is important, and keeping it open is important. Sometimes you need someone to bring the punch bowl back to the party when the guests are threatening to leave.

Tuesday, July 29, 2008

A web site for bridge geeks who grew up near the Mississippi River

John Weeks provides a treasure trove of pictures and stories about bridges that cross the Mississippi River.

He dedicates one page each to the two highway bridges at La Crosse. He notes quite correctly that the Dresbach Bridge is remarkably pedestrian given its spectacular location (it is just south of the widest spot for the upper-Mississippi). The dual bridges five miles further south are far more interesting.

I think all government capital projects should be subject to cost-benefit analysis. But there is something to be said for spending something to make such permanent fixtures as bridges beautiful.

Monday, July 28, 2008

Cities as Museums

When I was a kid, my father told me that the way to get to know cities was to walk and take the bus. I have followed his advice ever since, which I think explains why I like thinking about cities, and about why some are more successful than others.

In any case, I had an afternoon to kill in San Francisco the other day, and managed to take in a wide variety of sites and people by simply taking the N car to the beach, walking on the beach, walking from the beach along Lincoln Way to 19th Street, taking the 71 bus through the Haight, getting off at Larkin and Market, walking north up Larking to Clay, and then east to near the top of Nob Hill, and then down through North Beach and back to the financial district where I was staying.

The whole thing took around 3-4 hours, and yet enabled me to observe and enjoy the many different and idiosyncratic aspects of San Francisco.

New to the top of the reading list

I need to go get Rick Perlstein's Nixonland. It is not just that Brad Delong recommends it (and I think the most valuable service Brad Delong provides is reading recommendations--if only I could read as voluminously as he). I have long had something of a Nixon obsession. According to my parents, when I was one, during the Kennedy-Nixon debates, Nixon's presence on TV would make me cry. And then he went and died on my birthday in the city where I was born.

I have read a lot of Nixon books--I think Wills' Nixon Agonistes is my favorite to this point. But I need to read Perlstein.

Sunday, July 27, 2008

Is William Poole kidding?

He gets some things right in his op-ed piece in today's New York Times. Fannie and Freddie should have higher capital requirements and they should stop lobbying. Beyond this, I think something should be done about executive compensation for senior management at both institutions. But when Poole says:

In fact, there has already been a test case for how the mortgage market would function without Fannie and Freddie. After an accounting scandal in 2005, regulators severely constrained their activities. The nation’s total residential mortgage debt outstanding rose by $1.176 trillion in that year, even though Fannie’s and Freddie’s stakes rose by only $169 billion, just 14.4 percent of the total. In essence, the market barely noticed that the two agencies’ private competitors were providing 85 percent of the increase in mortgage debt in 2005.

The market barely noticed???? I think we have been noticing quite a lot about mortgages generated in the "pure" private market over the past 18 months or so. And of course, the non-conforming (i.e., private) market for 30-year fixed rate mortgages is, shall we say, problematic at the moment.

Saturday, July 26, 2008

Mark Thoma thinks housing supply elasticities may be assymetric

The basic point is that in markets with lots of land, housing may be supplied elastically during booms, but takes a long-time to adjust during price declines. I have reason to think Mark is right.

My 2005 paper with Mayo and Malpezzi found evidence of this; cities that appeared inelastic included Pittsburgh, Toledo, Albany, Buffalo and Providence. None of these cities had upward pressure on housing production; rather, they were losing population and the housing stock took a long time to adjust to the loss.

Thursday, July 24, 2008

Never mind

From the National Association of Realtors today:

Total housing inventory at the end of June rose 0.2 percent to 4.49 million existing homes available for sale, which represents an 11.1.-month supply2 at the current sales pace, up from a 10.8-month supply in May.

Wednesday, July 23, 2008

What is normalcy?

gaius marius writes:

fwiw -- and i realize this is but anecdotal, but it is illustrative of the general condition -- i live in suburban chicago, renting a house. i pay $2000/mo, property taxes are $550/mo. my rental payment then would support (ignoring upkeep/insurance/etc) a $1450/mo today's 30-year fixed rate (~6.5%), that would support a $230,000 loan. with 20% down, call the purchase price $290,000 -- and generously, as we are excluding all expenses but taxes.this house sold in 2005 for $460,000. houses in the neighborhood still list for $410,000.

Actually, this suggests to me that houses in your area are priced at something like fundamentals. Let us say the marginal tax rate of the typical buyer is 25 percent, that property taxes (which are deductible for most people) are at 1.5 percent, that maintenance costs about 2 percent, and that expect rent growth is 2.5 percent (i.e., a little less than recent CPI growth). Then the user cost of owning would be
410,000*(.065*.75 + .015*.75+ .02 -.025) = 22,550, or a little less than the $24,000 you are paying in rent right now.
Two financial advantages of owning that you are not considering are the tax benefit and the immunization from future rent increases. Of course, should interest rates rise to 8 percent, or tax policy change, these calculations change.

OFHEO HPI and long term trends.

The new OFHEO house price index came out yesterday. At the moment, I like OFHEO better than Case-Shiller (I worry that Case-Shiller is now giving too much weight to REO properties in its index). In any event, it is fun to play with some long term trends.

According to yesterday's OFHEO press release, since 1991, house prices have risen about 4.5 percent per year; since 2000, they have risen by 5.5 percent per year, even taking into account the recent decline. This means that between 1991-2000, prices rose about 3.6 percent per year (take (1.045^17/1.055^8)^(1/9)-1).

Suppose that 3.6 percent is the long-term nominal house price growth trend. By how much are house prices overvalued? The answer is (1.045^17)/(1.036^17)-1= .158. So house prices would have to fall by about another 13.6 percent immediately to stay in line with the long term nominal trend, after which they should rise by 3.6 percent per year.

Alternatively, if house prices just stayed flat for four more years, they would return to their long-term trajectory--assuming that the trajectory before the year 2000 was the long-term trajectory.

Tuesday, July 22, 2008

What does it mean?

Obama has 1.1 million fans on facebook.

McCain has 170,000 fans on facebook.

Of course, McCain doesn't know what facebook is.

Monday, July 21, 2008

Perspective on Fannie and Freddie (update)

I should have looked at the 10Qs (duh) for the first quarter. Credit losses for both companies were around 12bp (although survivable), which is high by historical standards (see below). Still, the first quarter financial statements came out in May, so it is hard to understand exactly what happened a couple of weeks ago.

Perhaps we can start looking for a bottom

I have long said that so long as the months supply of housing available for sale is rising, it is not possible to know then the housing market will reach bottom (in terms of price). But the months supply measure has fallen pretty substantially since this winter, from a peak of 11.4 months to a current rate of 9.4 months. The inventory needs to get down to 5-6 months before inflation adjusted prices become stable. But the derivative finally has the right sign.

Saturday, July 19, 2008

A little perspective on Fannie and Freddie

Above are charts of 90-day delinquencies (based on the Monthly Volume Summaries and the OFHEO Report to Congress) through the first quarter of this year and credit losses through 2007 (these are the most recent public data that I can find).

Like many others, I eagerly await the companies' first quarter financial statements. But what do
others know that we don't?

Friday, July 18, 2008

Inflation and the Development of Mortgage Markets in Emerging Economies

Rising commodity prices have not just placed upward pressure on inflation in the US. In emerging markets, the impact is, in many cases, larger, with double digit inflation returning to places such as South Africa and Russia.

Inflation harms mortgage markets. Because nominal interest rates are high during periods of high inflation, payment-to-income ratios for even modest houses move beyond the means of what households can afford (and what lenders are willing to lend) in the short run. This problem is known as mortgage "tilt."

There are workarounds--for instance, price level adjustable mortgages (or PLAMS) charge real interest rates and then adjust the loan balance each period to reflect inflation. Unless these mortgages are carefully constructed, however, and unless the "correct" price index is known (and it rarely is), they are highly risky, because they have a negative amortization feature by construction. They are particularly problematic when house prices do not rise as rapidly as the general price level. The current US experience (as well as the 1980s) show that gaps between consumer prices and house prices can at times be large.

So the mortgage market is a case where nominal price changes can have real effects. It is no accident that the American mortgage market nearly disappeared during the late 1970s--a period of double digit inflation in the US.

Unhappiness (again)

From Greg Ip:

For decades, the typical college graduate's wage rose well above inflation. But no longer. In the economic expansion that began in 2001 and now appears to be ending, the inflation-adjusted wages of the majority of U.S. workers didn't grow, even among those who went to college. The government's statistical snapshots show the typical weekly salary of a worker with a bachelor's degree, adjusted for inflation, didn't rise last year from 2006 and was 1.7% below the 2001 level.

Tuesday, July 15, 2008

Greg Mankiw's Economics Platform

He tries to list the things for which there is a consensus among economists. It is actually quite good.

I have two problems with the list. First, raising the retirement age for people like me (i.e., those who have cushy jobs) makes a lot of sense. But I think we need to treat truck drivers, miners, linemen, etc. differently. They are often physically incapable of continuing work until an old age. And to ask a 60 year old to retrain is, I think, naive.

Second, I would like to see something about fiscal responsibility. Deficit spending during recessions is fine. But it would be nice to go back to the good old days of the late '90s and run surpluses when the economy is surging.

Monday, July 14, 2008

A Modest Proposal for Richard Syron and Dan Mudd

The two CEOs would take compensation of $1 per year plus restricted stock that doesn't vest for, say, two years. By doing this, whey would show that they have confidence in the long term futures of their companies, and that they are willing to risk-share with taxpayers.

Mark Zandi says the Price-Rent ratio is returning to the fundamentally correct level

He is quoted in today's WSJ.

Also coming into balance, though not there quite yet, is the ratio of home prices to rents. The lower the ratio, the more people are likely to buy a home than rent one. Mr. Zandi estimates that this ratio dropped to 20.02 in the second quarter from a high of 24.90 during the boom. The average ratio from 1985 to 2002 was 14.44. "If you just look at affordability indices, we would say we are probably close to a bottom," says Ivy Zelman, a housing and homebuilding analyst. "But these are not normal times."

FWIW, I am in the middle of buying a house in Pasadena (when it is a done deal, I will write a little history of the transaction). It is because owning looks like a very fair deal relative to renting; also, LA is likely the place we will live for the next 20+ years, so short term house price fluctuations don't mean much to us.

Now that I will be driving to work most days

I will swap my minivan for a Toyota Corolla. I love the Prius, but the price premium in California is too high--assuming you can even get one.

It does bring to mind my first car that was not a hand-me-down from my parents--a Honda Civic that my wife and I bought in 1985. It had a 76 hp engine mated to a 5-speed manual transmission. It seemed adequately fast to me. It had no gadgets on it--riders rolled up the windows by hand, and I had to install the radio by myself. It got 30 mpg around town, and between 35 and 40 on the highway.

Here's the thing--it was not a "sacrifice:" I loved the car. It was fun to drive, and pretty much flawless--we spent very little on maintaining the car. We kept it for 12 years, and only then replaced it because Wisconsin winters took their toll on its body (and Hondas tended to rust back then). But the engine and drive train still ran beautifully.

So my question is--why is it not easy to buy cars like the middle-80s vintage Civic anymore? It seems like a great solution for reducing emissions and congestion. And no new technology is necessary.

Paul Krugman on the GSEs

He writes:

But here’s the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago, an explosion that dwarfed the S.& L. fiasco. In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.

Partly that’s because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn’t do any subprime lending, because they can’t: the definition of a subprime loan is precisely a loan that doesn’t meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.

So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works.

In that case, however, how did they end up in trouble?

Part of the answer is the sheer scale of the housing bubble, and the size of the price declines taking place now that the bubble has burst. In Los Angeles, Miami and other places, anyone who borrowed to buy a house at the peak of the market probably has negative equity at this point, even if he or she originally put 20 percent down. The result is a rising rate of delinquency even on loans that meet Fannie-Freddie guidelines.

Also, Fannie and Freddie, while tightly regulated in terms of their lending, haven’t been required to put up enough capital — that is, money raised by selling stock rather than borrowing. This means that even a small decline in the value of their assets can leave them underwater, owing more than they own.

Ex post it would appear that Fannie-Freddie should have had higher capital requirements, if for no other reason than to bolster confidence during periods of stress. But ex ante, stress-testing models showed that Fannie was well capitalized and that Freddie was very well capitalized. Ironically, most of us who followed the companies worried a lot more about interest rate/prepayment risk than default risk.

This is not to say that past Fannie/Freddie senior management did not behave badly with respect to financial reporting, and I find it maddening that some of the worst actors wound up walking away with millions of dollars. While I made good friends at Freddie and learned a lot, the moral obtuseness of company leaders at the time (2002-03) made me very uncomfortable and I looked for a way out (I also discovered within about a week of being there that I really missed being a professor). Daniel Mudd's current silence also makes me wonder if there is a shoe to drop that has not yet appeared in the monthly volume summaries.

But for the reasons Krugman gave, moral hazard did not produce lax underwriting at Fannie-Freddie--regulation (and to be fair, I think corporate culture at Freddie) prevented that from happening. To the extent they are in trouble, it is because of market conditions outside the realm of historical experience. It is, after all, their job to be in the market at all times--no matter what. They is why they have their charters. A government backstop will not it their cases reward bad behavior; it will assure that they can do a job that purely private participants are unwilling to do at the moment.

Sunday, July 13, 2008

I spent the afternoon flying back to DC from California

I just read the Paulson press release. Tomorrow will be an interesting day. I'll be watching the repo market.

Saturday, July 12, 2008

I was going to say this, but...

Brad Delong said it first:

The chance that American taxpayers will actually lose any money if Ben Bernanke and Henry Paulson decide that Fannie and Freddie need government support is very low:

* The interest payments they have coming in are greater than the interest payments they have going out.
* Their government guarantee is itself a very valuable asset that they have made a lot of money off of in the past and will make more off of in the future.
* They are not even in liquidity trouble--unless they begin to have problems rolling over their discount notes...
* As long as it is generally understood that they are too big to fail, they should not even have liquidity problems--absent a depression that bankrupts many currently-solvent homeowners, that is.

I would like to mention three other things based on the 15 months or so that I worked at Freddie.

(1) One reason Freddie got in trouble about how it reported its earnings is that Senior Management did not believe that GAAP treatments of earnings reflected the economics of the company, and so it needed to fudge (the company's self-investigation, called the Baker-Botts report, made this quite clear). This does not excuse its behavior--publicly traded companies must comply with GAAP. The correct thing would have been for management to explain the problems with GAAP in the MD&A Statement.

But Senior Management was correct that GAAP earnings did not (and does not) give meaningful metrics of GSE corporate performance.

(2) Just my two cents, but I don't think the company's mortgage underwriting could be characterized as reflecting moral hazard. The company was quite conservative about loans that qualified for purchase, and perhaps would have been more conservative were it not for the Affordable Housing Goals (and BTW, there is no evidence that the Affordable Housing Goals in any way helped channel mortgage credit to underserved communities or families). In any event, the people running Freddie were not the Savings and Loan cowboys who would lend to anyone for anything.

(3) It is very hard to measure corporate cash flow at Fannie-Freddie, because funding and amortization are both happening constantly.

One other disclosure, I own something like 300 shares of Freddie stock that I received as compensation when I worked there. Feel free to discount anything I say about these matters as a result of this.

Friday, July 11, 2008

I don't get it

The last real "news" about Freddie Mac is the May Monthly Volume Summary, which came out more than 2 weeks ago. Delinquencies on their book have been rising, but at .81 percent are not at anything like an alarming level.

Could the word of a former Federal Reserve Bank President really have such a strong impact on the market?

Thursday, July 03, 2008

Christopher Mayer, Tomasz Piskorski and Alexei Tchistyi Show that Prepayment Penalties Benefit Borrowers with Poor Credit Histories

Their paper find there is a separating equilibrium under which borrowers with blemished credit want prepayment penalties, while those with perfect credit do not. More particularly, they show:

Subprime borrowers with FICO scores below 620 obtain rates as much as 0.7%
lower than similar borrowers with fully prepayable mortgages and default at a lower rate (13% default rate) than comparable borrowers with no prepayment penalties (18% default rate). Our …findings suggest that regulations banning re…financing penalties might have the unintended consequence of raising interest rates, increasing mortgage default, and limiting available credit for the riskiest borrowers.

The paper does only look at fixed rate mortgages, and so it is not clear whether the argument applies to 2-28s. But the finding is well worth considering in light of the current policy debate.

Shopping for Mortgages

I am currently shopping for a California Mortgage. It is a little weird--the best pricing relative to the yield curve seems to be a 5-1 ARM. 30-year fixed rates are absurd--around 350 bp above 30 year CMT. While part of this is pricing the prepayment option, it also implies a truly implausible default probability for a prime mortgage.

One would think five-year ARMS would have higher default risks, so it must be about interest rate risk--perhaps buyers of 30-year Treasuries are not so worried about duration matching as buyers of 30-year mortgages? Anyway, the mortgage market in California currently strongly resembles the Canadian Mortgage market.

Jefferson had his problems, but boy could he write

When in the Course of human events, it becomes necessary for one people to dissolve the political bands which have connected them with another, and to assume among the powers of the earth, the separate and equal station to which the Laws of Nature and of Nature's God entitle them, a decent respect to the opinions of mankind requires that they should declare the causes which impel them to the separation.

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness. --That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed, --That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness. Prudence, indeed, will dictate that Governments long established should not be changed for light and transient causes; and accordingly all experience hath shewn, that mankind are more disposed to suffer, while evils are sufferable, than to right themselves by abolishing the forms to which they are accustomed. But when a long train of abuses and usurpations, pursuing invariably the same Object evinces a design to reduce them under absolute Despotism, it is their right, it is their duty, to throw off such Government, and to provide new Guards for their future security. —Such has been the patient sufferance of these Colonies; and such is now the necessity which constrains them to alter their former Systems of Government. The history of the present King of Great Britain [George III] is a history of repeated injuries and usurpations, all having in direct object the establishment of an absolute Tyranny over these States. To prove this, let Facts be submitted to a candid world.

He has refused his Assent to Laws, the most wholesome and necessary for the public good.

He has forbidden his Governors to pass Laws of immediate and pressing importance, unless suspended in their operation till his Assent should be obtained; and when so suspended, he has utterly neglected to attend to them.

He has refused to pass other Laws for the accommodation of large districts of people, unless those people would relinquish the right of Representation in the Legislature, a right inestimable to them and formidable to tyrants only.

He has called together legislative bodies at places unusual, uncomfortable, and distant from the depository of their public Records, for the sole purpose of fatiguing them into compliance with his measures.

He has dissolved Representative Houses repeatedly, for opposing with manly firmness his invasions on the rights of the people.

He has refused for a long time, after such dissolutions, to cause others to be elected; whereby the Legislative powers, incapable of Annihilation, have returned to the People at large for their exercise; the State remaining in the mean time exposed to all the dangers of invasion from without, and convulsions within.

He has endeavoured to prevent the population of these States; for that purpose obstructing the Laws for Naturalization of Foreigners; refusing to pass others to encourage their migrations hither, and raising the conditions of new Appropriations of Lands.

He has obstructed the Administration of Justice, by refusing his Assent to Laws for establishing Judiciary powers.

He has made Judges dependent on his Will alone, for the tenure of their offices, and the amount and payment of their salaries.

He has erected a multitude of New Offices, and sent hither swarms of Officers to harass our people, and eat out their substance.

He has kept among us, in times of peace, Standing Armies without the consent of our legislatures.

He has affected to render the Military independent of and superior to the Civil power.

He has combined with others to subject us to a jurisdiction foreign to our constitution and unacknowledged by our laws; giving his Assent to their Acts of pretended Legislation:

For Quartering large bodies of armed troops among us:

For protecting them, by a mock Trial, from punishment for any Murders which they should commit on the Inhabitants of these States:

For cutting off our Trade with all parts of the world:

For imposing Taxes on us without our Consent:

For depriving us, in many cases, of the benefits of Trial by Jury:

For transporting us beyond Seas to be tried for pretended offences:

For abolishing the free System of English Laws in a neighbouring Province, establishing therein an Arbitrary government, and enlarging its Boundaries so as to render it at once an example and fit instrument for introducing the same absolute rule into these Colonies:

For taking away our Charters, abolishing our most valuable Laws, and altering fundamentally the Forms of our Governments:

For suspending our own Legislatures, and declaring themselves invested with power to legislate for us in all cases whatsoever.

He has abdicated Government here, by declaring us out of his Protection and waging War against us.

He has plundered our seas, ravaged our Coasts, burnt our towns, and destroyed the lives of our people.

He is at this time transporting large Armies of foreign Mercenaries to compleat the works of death, desolation and tyranny, already begun with circumstances of Cruelty and perfidy scarcely paralleled in the most barbarous ages, and totally unworthy the Head of a civilized nation.

He has constrained our fellow Citizens taken Captive on the high Seas to bear Arms against their Country, to become the executioners of their friends and Brethren, or to fall themselves by their Hands.

He has excited domestic insurrections amongst us, and has endeavoured to bring on the inhabitants of our frontiers, the merciless Indian Savages, whose known rule of warfare, is an undistinguished destruction of all ages, sexes and conditions.

In every stage of these Oppressions We have Petitioned for Redress in the most humble terms: Our repeated Petitions have been answered only by repeated injury. A Prince whose character is thus marked by every act which may define a Tyrant, is unfit to be the ruler of a free people.

Nor have We been wanting in attentions to our British brethren. We have warned them from time to time of attempts by their legislature to extend an unwarrantable jurisdiction over us. We have reminded them of the circumstances of our emigration and settlement here. We have appealed to their native justice and magnanimity, and we have conjured them by the ties of our common kindred to disavow these usurpations, which, would inevitably interrupt our connections and correspondence. They too have been deaf to the voice of justice and of consanguinity. We must, therefore, acquiesce in the necessity, which denounces our Separation, and hold them, as we hold the rest of mankind, Enemies in War, in Peace Friends.

We, therefore, the Representatives of the united States of America, in General Congress, Assembled, appealing to the Supreme Judge of the world for the rectitude of our intentions, do, in the Name, and by the Authority of the good People of these Colonies, solemnly publish and declare, That these United Colonies are, and of Right ought to be Free and Independent States; that they are Absolved from all Allegiance to the British Crown, and that all political connection between them and the State of Great Britain, is and ought to be totally dissolved; and that as Free and Independent States, they have full Power to levy War, conclude Peace, contract Alliances, establish Commerce, and to do all other Acts and Things which Independent States may of right do. And for the support of this Declaration, with a firm reliance on the protection of divine Providence, we mutually pledge to each other our Lives, our Fortunes and our sacred Honor.