March 11, 2007
Fannie, Freddie, and Ben
Bernanke began with a nice summary of what we're talking about:
The subject of my remarks today is the regulation and supervision of two large financial companies: the Federal National Mortgage Association (known familiarly as Fannie Mae) and the Federal Home Loan Mortgage Corporation (or Freddie Mac). Fannie Mae and Freddie Mac were created by acts of the Congress and are thus known as government-sponsored enterprises, or GSEs. The Congress chartered these two companies with the goal of expanding the amount of capital available to the residential mortgage market, thereby promoting homeownership, particularly among low- and middle-income households. Although they retain their government charters, Fannie and Freddie were converted (in 1968 and 1989, respectively) to private, publicly traded, for-profit companies....
Fannie Mae and Freddie Mac each run two lines of business. Their first line of business involves purchasing mortgages from primary mortgage originators, such as community bankers; packaging them into securities known as mortgage-backed securities (MBS); enhancing these MBS with credit guarantees; and then selling the guaranteed securities....
The GSEs' second line of business is the main focus of my remarks today. It involves the purchase of mortgage-backed securities and other types of assets for their own investment portfolios....Beginning in the mid-1990s, the GSEs began to rapidly increase the quantity of mortgages and other assets that they purchased and retained in their portfolios. From the end of 1990 until the end of 2003, the combined portfolios of Fannie Mae and Freddie Mac grew more than tenfold, from $135 billion to $1.56 trillion, and the share they hold of outstanding residential mortgages increased from less than 5 percent to more than 20 percent. Moreover, to finance their own holdings of MBS and other assets, in 2005 the two GSEs together issued almost $3 trillion in debt. Today, the two companies have $5.2 trillion of debt and MBS obligations outstanding, exceeding the $4.9 trillion of publicly held debt of the U.S. government.
If you want to find out more about Fannie Mae, don't bother trying to find their annual reports. The most recent one available from their webpage is for 2003, accompanied by the following cautionary information:
On December 6, 2006, Fannie Mae filed its 2004 Form 10-K with the SEC. The filing provides consolidated financial statements for 2004, and a restatement of previously issued financial information for 2002 and 2003 and the first two quarters of 2004. As a result, investors and others should not rely on Fannie Mae's annual and quarterly financial statements issued prior to December 2004 nor should they rely on financial information issued prior to December 2004 that may be contained in Fannie Mae's earnings releases, Annual Reports, Form 10-Ks, Form 10-Qs, Information Statements and Quarterly Supplements, Form 8-Ks, Form 12b-25s , Monthly Summaries, and Business Activity Supplements.
That a publicly traded company is unable to provide accurate and up-to-date annual reports for shareholders is to me astonishing. Usually, a company that is more than a year delinquent in filing its annual report would be delisted from the New York Stock Exchange. That we are in this situation for an institution with such a huge financial footprint is quite alarming. These problems, however, are not those addressed by Bernanke, who instead raised the following issue:
This line of business has raised public concern because its fundamental source of profitability is the widespread perception by investors that the U.S. government would not allow a GSE to fail, notwithstanding the fact that-- as numerous government officials have asserted-- the government has given no such guarantees. The perception of government backing allows Fannie and Freddie to borrow in open capital markets at an interest rate only slightly above that paid by the U.S. Treasury and below that paid by other private participants in mortgage markets. By borrowing at this preferential rate and purchasing assets (including MBS) that pay returns considerably greater than the Treasury rate, the GSEs can enjoy profits of an effectively unlimited scale. Consequently, the GSEs' ability to borrow at a preferential rate provides them with strong incentives both to expand the range of assets that they acquire and to increase the size of their portfolios to the greatest extent possible.
This kind of problem and its solution are very well understood by economists. There are strong incentives to gamble whenever you're playing with somebody else's money. The way to solve this problem is to raise capital requirements. If you have none of your personal money at risk, then the upside when you gamble with somebody else's capital is all yours, and the downside is none of your concern. But if the GSE's equity were 10% of its mortgage portfolio, then when there is a 10% loss on the mortgage portfolio, the loss is entirely borne, as it should be, by GSE's stockholders, who could then be relied on to pressure management to minimize the risk of such an outcome. To meet toughened capital requirements, Fannie and Freddie would have to use some combination of raising more equity from new share offerings and selling off existing mortgage holdings. The latter would perhaps also involve narrowing the mission of the GSEs to target a specific policy objective, such as helping low-income households achieve affordable housing. Any such changes would significantly reduce the GSEs' contribution to systemic financial risk. Hence Bernanke's recommendations:
First, the GSE regulator should have the broad authority necessary to set and adjust GSE capital requirements in line with the risks posed by the GSEs. Second, the GSEs should be subject to a clear and credible receivership process, a process that would establish that both shareholders and debt holders of a failed GSE would suffer financial losses. Third, the GSEs' portfolios should be anchored firmly to a well-understood public purpose approved by the Congress.
Very sensible suggestions from the Federal Reserve Chair. Let's hope that Congress has enough sense to adopt them.
Posted by James Hamilton at March 11, 2007 12:41 PMdigg this | reddit
Listed below are links to weblogs that reference Fannie, Freddie, and Ben:
» Fannie Mae and Freddie Mac from TruePress
Econbrowser on Fannie Mae, Freddie Mac and Ben Bernanke suggestions for reducing these entities contributions to systemic risk. What I didn’t realize was that these two entities have more debt outstanding than the US Government ($5.2t vs $4.9t... [Read More]
Tracked on March 12, 2007 04:40 AM
To what extent is the supposedly assumed guarantee stronger than that given to Citibank or sufficiently large hedge funds by virtue of their size? I seem to remember Citi's early 90s travails impacting monetary policy for example and it was much smaller then.
Has anyone calculated the benefit to Fannie mae in spread terms?
Posted by: Jack at March 11, 2007 01:44 PM
So do we have any idea of the debt to equity ratio of these beasts?
I still haven't managed to get my jaw off the floor after reading $5.2 trillion...
Posted by: Stuart Staniford at March 11, 2007 11:45 PM
Third, the GSEs' portfolios should be anchored firmly to a well-understood public purpose approved by the Congress.
Was the original purpose of the GSEs not "well-understood?"
It is important to thank BB for addressing the problem but political correctness let's congress off the hook. They created beasts with enormous moral hazard. Now, as painful as it will be, they must kill the beasts.
Posted by: Anonymous at March 12, 2007 04:19 AM
Another great post.
Of course, the problem is that the stock's FRE and FNM would drop by quite a bit if a big jump in capital ratios were seen. I haven't done the math, but FNM and FRE capital ratios are nowhere near 10% of its assets-the resulting drop in ROE would be huge if FNM and FRE moved to this type of capital ratio. As one might expect, FNM/FRE have long argued that their capital ratios need not be high since history has shown that conforming mortgages are relatively safe. FRE/FNM interest rate risk has always been a bit of black box.
A "Long-Term Capital" problem might be brewing here. History may be reliable as long as you are not a large part of the history. FNM and FRE's investment spreads have been dropping for some time-bulls have argued that FNM and FRE have figured out to lower their risk with issues of put-bonds etc. that lower the risk.
I think that FNM and FRE are just too big. The graph above shows the huge growth in retained portfolios. When they buy and sell mortgages, they affect the spreads by their own behavior.
Again, I haven't done the math, but I have heard bulls argue that FRE and FNM are still only 10-20% of all retained mortgages. I think this misses the point. First, 10-20% is large. Second, it is the behavior of marginal buyers and sellers that effect the markets, and I expect FRE and FNM to be large marginal players.
Since I am a small cap investor, I long ago I stopped looking at FRE and FNM. But as a first look, FRE's capital ratio appears to be
Another big meltdown/ moral hazard potential problem deals with the PBGC. I would be interested in the Professor's thoughts here!
Posted by: toddleem at March 12, 2007 08:05 AM
I'm not sure who is writing this blog, but they should definitely learn how to 1) find a financial statement and 2) read a financial statement.
Fannie Mae has a link on its website to its most recently released annual report (2004) which was issued on 12/6/06.
The total obligation of a company can be defined by the debt it issues and the fair value of other contractual obligations. Freddie and Fannie engage in the business of guarantees. The guarantee of another's obligation is not regarded by ANY financial institution as proximate indebtedness. Nor should it. This blogger appears to be haphazardly adding various figures for shock value (e.g. more debt that the US gov't). The combined value of the two company's debt and obligations is not $5.2 trillion.
Posted by: john at March 12, 2007 11:49 AM
John, perhaps I should "learn how to find an annual report", and perhaps you can help me. Here's how I thought I'd be able to do it:
(1) From the Fannie Mae homepage try investor relations. That page begins with the "cautionary note" which I quoted verbatim above. If you follow the link on that page to Annual Reports and Proxy Statements, you're led to a menu that allows you to choose an annual report for any year between 1998 and 2003. And even a 2004 report at this point is seriously out of date and grounds for delisting.
(2) Again from the Fannie Mae homepage try "annual report" in their search box. Of the first 20 hits, not one refers to anything more recent than 2003.
Next for your statement, "This blogger appears to be haphazardly adding various figures for shock value (e.g. more debt that the US gov't). The combined value of the two company's debt and obligations is not $5.2 trillion." The statement you refer to is not from me, but rather is a direct quote from Federal Reserve Chair Ben Bernanke. However, I completely agree with everything Bernanke said, and am willing to take responsibility for defending the accuracy and appropriateness of all of his words. In particular, a guarantee is a potential liability, and it's fully appropriate to consider it as such.
Now, as for your statement, "I am not sure who is writing this blog," let me help you find that information. My name and link to my biographical information are in the upper right corner of our main page. In case that's tricky for you to find, I'll repeat it here: I'm James D. Hamilton, Professor of Economics at the University of California, San Diego.
And, out of curiosity, who are you, John?
Posted by: JDH at March 12, 2007 12:41 PM
The Bank for International Settlements is a reasonably well known institution. Some rules regarding the translation of guarantees into proximate indebtedness (or, as the bank puts it, "Off-balance-sheet items under the standardised approach will be converted into credit exposure equivalents through the use of credit conversion factors (CCF).") can be found here, on page 15 of the PDF.
I would be most interested in knowing what the Tier 1 Capital Ratios of Freddie Mac and Fannie Mae might be, should they be analyzed as stand-alone banks.
Posted by: James I. Hymas at March 12, 2007 01:31 PM
Hurrah, I was able to answer my own question!
High leverage is a key source of systemic risk for the Enterprises. Enterprise core capital ratios are lower than the Tier 1 capital ratios of the largest banks. The top five banks are about 6.4 percent, while the Enterprises are 4.6 percent. When the Enterprises? very substantial off-balance sheet obligations are recognized, the difference in leverage is much more pronounced, with their capital to assets ratio falling to 3.5 percent.
3.5% is an appallingly small number. I have noted in my own Blog that at least one sample issue of Innovative Tier One Capital (RBC TruCS - Series 2015) converts to preferred shares if
the Superintendent advises the Bank in writing that the Superintendent is of the opinion that the Bank has a riskbased Tier 1 Capital ratio of less than 5.0% or a risk-based Total Capital Ratio of less than 8.0%;
... and judging by market spreads, this is not an eventuality that is considered at all likely by the market.
"Jack", in the first comment on this thread, asked if anybody had calculated the benefit (of the supposedly assumed guarantee) to Fannie Mae in spread terms. I suspect - though I will defer to those with a greater knowledge of the US Market - that a bank with such capital ratios would not be able to conduct business and that the only way to phrase the question in a meaningful way would be "How much Tier 1 Capital would need to be injected into the companies to make doing business at commercial spreads commercially possible?" Only then could we compare commercial spreads to actual spreads.
Posted by: James I. Hymas at March 12, 2007 01:54 PM
I don't dispute the validity of Bernanke's comments or the opionion of Dr. Hamilton. I would only say that this might not be the best time in history to be messing with the "Enterprises."
To withdraw or limit liquidity from the mortgage market right at this instant would probably lead to further slowing in a real estate market that is slowing quite well on its own.
Just sayin' ...
Posted by: gab at March 12, 2007 02:31 PM
I understand that at one point there was a perceived need for these Freddies. But with the huge expansion in capital markets both in the US and globally, why do we need them today?
Posted by: Allen at March 12, 2007 02:51 PM
Given a 3.5% capital ratio, and looking at
it looks to me like, for example, that about $235 billion, 7%, of the $3.4 trillion mortage portfolio is interest only loans, which I imagine might be interesting to refinance in the new environment. $351 billion, around 10%, are ARMS of some kind. I wonder how many of them are on their teaser rate and have a reset that the borrower would not qualify for if they were doing it today.
The overall question is how much worse would the current mortgage finance meltdown have to get before the GSE's were insolvent?
Posted by: Stuart Staniford at March 12, 2007 02:53 PM
The fact that BB is urging a downsizing on Fannie and Freddie (done already once with a 30% cap requirement, no?) suggests to me (proud and mighty recreational economist of no fixed address) that the risk assessment of GSEs just went up. But we recreational economists are sometimes misled (not only by our peers but more practiced participants) being the impressionable folk that is our trademark.
Barney Frank asked BB to "keep in touch". He may have received something a little more private...that is my hope.
Posted by: calmo at March 12, 2007 03:23 PM
Gab, Toddleem, and others, I was using the 10% figure just for illustration, not as a recommendation for a standard that had to be immediately slapped down. My specific recommendation is the same as Bernanke's, to wit, "the GSE regulator should have the broad authority necessary to set and adjust GSE capital requirements in line with the risks posed by the GSEs".
Posted by: JDH at March 12, 2007 04:21 PM
My specific recommendation is the same as Bernanke's, to wit, "the GSE regulator should have the broad authority necessary to set and adjust GSE capital requirements in line with the risks posed by the GSEs".
Here I have to disagree with you, Dr. Hamilton and, as seems to be my habit in your comment pages, argue for a more "principles based" approach.
As Allen said above:
I understand that at one point there was a perceived need for these Freddies. But with the huge expansion in capital markets both in the US and globally, why do we need them today?
Yes, why? These structures are popular with politicians because they allow government to 'support home ownership' with a mere guarantee, which doesn't cost anything (at least ... they hope not!). Ultimately and inevitably, it leads to a distortion in the capital markets.
Which is not, in and of itself, a bad thing. I can't buy a chocolate bar without distorting the capital markets to some small extent. But is such a guarantee - and a separate regulatory system and heaven only knows how many extra regulatory bureaucrats - the best way to accomplish whatever social goals are at stake here?
Repeal the legislation! Bring the agencies into the regular banking system, under common oversight with all the other banks! If the government wants to subsidize the mortgage market, let it do so directly - a partial guarantee on all Mortgage Backed Securities? A tax-credit for MBS holders (look at what special tax treatement has done for municipal bonds!)? Some kind of funding whereby, for instance, an agency would buy Tier 1 Capital Preferreds at the Fed Funds rate from qualifying institutions (which gets a little tricky at the point where the bank is no longer deemed to qualify for such largesse, but that part's open for discussion)?
Any of the above suggestions would come with a definite price tag, subject to scrutiny - and perhaps that's why none of them will ever happen. A parallel structure to the regulation of banks, as is implied by Bernanke's suggestion, is perhaps the only politically possible method of making progress. But that doesn't mean it's the best possible method.
Posted by: James I. Hymas at March 12, 2007 10:07 PM
After my home burned down my insurance company advanced me a check for the nominal amount of the policy. Since I had guaranteed replacement value insurance this was simply a first installment. The original lender had sold my mortgage to Freddie and the check was made out to both Freddie and me. Freddie wanted to collect and hold the amount of the check without paying me any interest. They also wanted me to continue to make mortgage payments. They said the amount of the check would be held in a non-interesting bearing account. Of course I needed that money to rebuild, and I found their position on this matter to be unreasonable. Freddie said they were required to do this because of certain rules, which they refused to disclose. I asked the person on the phone which federal agency regulated them (it was HUD) and she said, "I don't know." It felt like I was dealing with the Mafia. I solved the problem by paying off the loan using that check and supplementary funds. The whole experience with them was bizarre. I found other people had the same problem with them, but were afraid to pay off their loans because they feared interest rates would go up (they went down).
Posted by: A. Zarkov at March 13, 2007 02:58 AM
I came across this blog through another website and am not a regular reader of Econobrowser nor had I ever posted to a blog. Inaccurate information disseminated by semi-informed professionals is one of my greatest pet peeves. When I saw today another link to this blog from a large media conglomerate, I thought I'd check it out to see if someone read my posting. To my surprise, the author did. And so I?m now posting for a second time. I?ll try to be brief as I have usually find blogs to be a bore.
Although Fannie Mae?s financial statement are on its website, I will not comment on the adequacy of Fannie Mae's search engine. I don?t care that much about search engines. I would agree, however, with Dr. Hamilton. All companies should be obligated to follow the listing regulations. The exceptions provided to Fannie Mae do not appear justified. Could the NYSE board have been more concerned about the interests of investments banks and fixed income specialists like JPMorgan? The delisting of these GSEs would surely devalue the guarantee of a Fannie/Freddie MBS held by the investment bank.
The latter point of guarantees vs. obligations may boil down to semantics. However, myself and many other investment professionals would disagree with Mr. Bernanke. It is somewhat naive to believe that Freddie and Fannie must at some point in time assume ALL of the debt obligations incurred by homeowners. It would be equally naive to believe that the two companies have no legal recourse to collect on unpaid mortgages. There are thousands of investment professionals that collectively analyze the mortgage default rates. Many of them have assisted Freddie and Fannie in estimating an expected guarantee obligation (as noted on their financial statements). This guarantee obligation is SUBSTANTIALLY smaller than what our friend at the Federal Reserve would have us believe. (Financial statements reveal a lot more information than some would like to admit.) Could Mr. Bernanke could he have a political bent? Maybe his job of managing monetary policy is too hard when he has to compete with Freddie and Fannie securities? The attractiveness of mortgage-backed securities to investors may be greater than Treasury securities given the fiscal responsibility of our current administration.
As to my identity, my name is John. Although it has been to my advantage at times, I never have been a fan of letters following/preceding my name. Suffice it to say, I have somewhat intimate insight into these companies.
Posted by: john at March 13, 2007 11:40 AM
This discussion is way over my pay grade, but as someone who has to look at company filings on a very regular basis, I do have some insight on the topic of finding filings. I never trust the company's website. They aren't updated enough.
Very trustworthy method EDGAR, it is an excellent tool:
Go to the SEC website.
Click on the link entitled "Search for Company Filings" under the "Filings & Forms (EDGAR)" heading.
Click on "Companies and other Filers".
The easiest way to get to the right filer is by knowing its stock ticker symbol. In this case it is "FNM"
Plug that in to the "CIK or Stock Ticker Symbol" section and you'll have it.
Edgar updates these almost instantly (when I've made a submission to the SEC it appears within minutes).
For Fannie Mae I see a disturbing "Notification of Inability to Timely File 10-K". The most recent 10-K appears to be for the year ending Dec 31, 2004--which is totally unacceptable. Their lack of 10-Qs is equally disturbing.
Posted by: Sebastian Holsclaw at March 13, 2007 12:02 PM
John, you've now twice seemed to suggest that the 2004 annual report can be found from the Fannie Mae webpage, and twice failed to provide us with the URL.
Posted by: JDH at March 13, 2007 12:32 PM
He should let OFHEO know the URL as well - the most recent 10K on their site is for the year ended Dec 31/04.
Doc. Hamilton, "John" shows every indication of being just another trolling high-school student ... or perhaps a student who failed one of your courses. Don't let poison pen letters get under your skin.
Posted by: James I. Hymas at March 13, 2007 01:56 PM
Oooh, ooh, ooh! I've got it! On the Fannie Mae Annual Reports & Proxy Statements page, the sentence For more information, please see the Form 10-K we filed with the SEC on December 6, 2006 is the last in the italicized introductory paragraph. In this sentence, the phrase "Form 10-K" is a link to the SEC record of the 2004 10-K.
I have no idea how long that link has been there. Do I win a kewpie doll?
Posted by: James I. Hymas at March 13, 2007 02:10 PM
That's the 10-K, but where's the annual report to shareholders?
Posted by: JDH at March 13, 2007 02:22 PM
And even John seems to agree there's nothing at all for 2005 or 2006.
Posted by: JDH at March 13, 2007 02:26 PM
John - to suggest that Bernanke's issue with the GSE's is "Maybe his job of managing monetary policy is too hard when he has to compete with Freddie and Fannie securities? The attractiveness of mortgage-backed securities to investors may be greater than Treasury securities given the fiscal responsibility of our current administration" is, how should I phrase this politely? Ah yes, it's idiotic.
The Central Bank doesn't compete with mortgage backed secuirities. It doesn't compete with anyone. It doesn't issue Treasury debt - that's the Treasury's job. The Fed can use any security (or anything else for that matter) to conduct monetary policy. You are talking out your elbow with that suggestion.
Posted by: gab at March 13, 2007 02:27 PM
More on this from Treasury Under Secretary Robert K. Steel, including:
For example, in terms of specific benefits the housing GSEs are not subject to state or local taxation and they have access to a line of credit with the Treasury Department ($2.25 billion each for Fannie Mae and Freddie Mac and $4 billion for the FHLBank System, which pales in comparison to the size of their debt obligations). The GSEs also greatly benefit from the market's perception that the U.S. government guarantees or stands behind GSE obligations, which results in preferential funding rates being provided to the GSEs. On behalf of Treasury, I want to reiterate that the GSEs' debt and other financial obligations are not backed by the federal government.
I will hazard a guess that for as long as the US Gov't gives the GSEs special status of any nature, the market will presume a guarantee.
Posted by: James I. Hymas at March 16, 2007 01:46 PM
John says "Could Mr. Bernanke could he have a political bent? Maybe his job of managing monetary policy is too hard when he has to compete with Freddie and Fannie securities? The attractiveness of mortgage-backed securities to investors may be greater than Treasury securities given the fiscal responsibility of our current administration."
I think that the relevant issue is whether two privately owned firms in the mortgage market deserve an implicit govt subsidy. Without this implicit taxpayer-financed subsidy, Fannie and Freddie would not have such a dominant market share, and certain financial risks would not be so heavily concentrated with the activities of these two firms.
One very significant concern has been the potential for a failure in their (massive) derivatives hedging programs to cascade through financial markets. One of the primary reasons these firms have not been able to provide timely financial reports relates to their accounting for such derivatives positions (e.g., FAS 133).
Posted by: John Elder at March 19, 2007 03:36 PM
I have a small investment in Fannie Mae bonds and I was wondering in the face of the subprime scandal how safe it might be. I am happy to hear that Fannie and Freddie reformed their policies to emphasize quality mortgage holdings but with such a large amount of debt on the liability side, I still worry about their strength or even their solvency.
Posted by: Ralph at March 26, 2007 06:30 PM