Wednesday, November 18, 2015

Shaky Ground: The Strange Saga of the U.S. Mortgage Giants by Bethany McLean

Bethany McLean’s new book, Shaky Ground: The Strange Saga of the U.S. Mortgage Giants, is short (about 150 pages) but filled with useful information and analysis concerning the two biggest government-sponsored enterprises (“GSEs”), Fannie Mae and Freddie Mac. I recommend this book for anyone wondering about these entities and why they are still in conservatorship.

I should point out at the outset that I spent most of my career in the Domestic Finance section of Treasury, and the Treasury, no matter the political complexion of the Administration, took a dim view of Fannie and Freddie. The career Treasury official I worked for in the first half of the 1980s summed up the attitude succinctly by remarking that Fannie Mae and Freddie Mac officials paid themselves private sector salaries without taking private sector risks. While Treasury would take every opportunity to say that GSE debt was not guaranteed by the U.S. government, the market assumed, rightly as it turned out, that if the GSEs ever got into trouble, the U.S. government would make good on the debt. In other words, Treasury was correct as a legal matter in saying that the debt was not guaranteed, but most, if not all, Treasury officials knew that the Treasury would have to do something if they got into financial trouble because of the implicit government guarantee. The shock to the financial system of a Fannie or Freddie default would be too great.

In fact, it was the implicit government guarantee that effectively saved Fannie Mae in the 1980s. Fannie Mae was then faced with the same problem as the savings and loans in a rising interest rate environment. Both Fannie and the S&Ls were financing long-term assets (home mortgages) with shorter term financing. When the cost of financing became much higher than the return on their assets, this proved to be a big problem. Fannie solved this by resorting to issuing mortgage-backed securities, on which Fannie bore credit but not interest rate risk, and by changing its financing strategy so that the duration of its liabilities more nearly matched the duration of its assets, thus reducing its interest rate risk. (I am using the term “duration” in its technical sense, which is related to but not the same as maturity, but you can probably follow what I am saying even if you do not how to calculate duration.) Fannie would not have been able to do this and effectively grow out of its problem without the implicit government guarantee that afforded it continued access to the credit market. Real private companies would have faced downgrades on their debt and eventual failure.

Another reason for Treasury resentment of the GSEs is that, when it came to policy issues that affected them, the GSEs would either argue as if they were  private corporations or as if they were government entities, depending on the particular issue. Fannie Mae, in its publicity, stated that this mixture of public and private worked for the benefit of housing and the U.S. economy. From the Treasury perspective, Fannie and Freddie did just enough for low income housing in order to form a formidable political coalition including the housing finance industry, real estate brokers, and advocates for low income housing.

Further, Treasury was keenly aware that Fannie and Freddie were thinly capitalized. Officials from both companies would argue that they had a good handle on their risk, and that the only thing that could bring them down was a housing bust all over the United States, rather than in  particular regions. Treasury was resigned to appreciating that nothing really could be done about them unless they got into real trouble. In the event, there was a housing bust, and the U.S. government took them over.

Nevertheless, I do not subscribe to the view that the activities of Fannie and Freddie were major causes of the financial crisis. The person most associated with pushing this view is Peter Wallison, a former General Counsel of the Treasury Department during the Reagan Administration and currently co-director of financial policy studies at the American Enterprise Institute, a conservative think tank in Washington, D.C. He was also a member of the Financial Crisis Inquiry Commission and wrote a dissent from the Commission’s report. In his dissent, he argued that a prime cause of the crisis was the affordable housing goals of Fannie and Freddie. This was too much for his fellow Republican commissioners, and they jointly filed a different dissent, which, as I have previously commented, made reasonable arguments.

Bethany McLean easily demolishes Wallison’s argument by pointing out, among other things, that the mortgages Fannie and Freddie bought or securitized were not as risky as Wallison claimed and the two institutions were latecomers to the subprime party. As for the more sophisticated argument that Fannie and Freddie took all the good loans, leaving only bad loans for the private sector, McLean writes that “this leaves a lot of other factors unexplained. Among them: Why was there so much money, for a period of time, to be made on these fringes? Why didn’t the private sector do what it was supposed to do best, namely manage risk?” (p. 55)

It is unclear why Wallison has been obsessed with Fannie and Freddie. He may be trying to make a political case that stricter regulation of the private financial sector is unnecessary because the financial crisis, in his view, is the result of government policies. As I have indicated, I am not a fan of these companies and their activities were part of the myriad of causes for the financial crisis, but focusing on these companies and leaving out other actors, which had much more to do with the crisis, is a mistake. There is plenty of reason to question whether initially privatizing Fannie and Freddie (their respective histories, incidentally, are different) were good ideas, and, as McLean points out, the political process has not produced any consensus about what to do with these entities.

Fannie and Freddie are currently profitable, but the profits are flowing to the U.S. government, which I suppose should please deficit hawks. For example, in calendar year 2014, Fannie paid the Treasury $20.1 billion in dividends and Freddie paid $19.6 billion. However, when the government put the two GSEs into conservatorship, it left 20.1% of the common stock in private hands in order not to include the two companies’ debts on the U.S. balance sheet. Now the holders of the common stock and preferred stock have gone to court because they believe that they have a right to some of the profits the GSEs are generating. Whether or not they do has not been finally decided by the courts.

Fannie and Freddie are providing significant financial support to the housing market. Left undecided is what role the government should play in housing. The 30-year fixed rate mortgage is possible because of Fannie and Freddie, and U.S. homebuyers have become accustomed to the availability of this type of loan. On the other hand, government subsidies to housing – and Fannie and Freddie are only part of that – arguably distort markets and encourages more resources to be devoted to housing at the expense of other sectors of the economy and encourages families and individuals to buy larger houses than they really need or would otherwise buy. Since there is no consensus on what to do with the GSEs, they continue in conservatorship and, at least until the courts have finally spoken, providing their profits to the U.S. government, which also effectively bears the risks from their operations.

There is much more to the book, including discussion of Ed DeMarco, who was acting head of the regulator of  Fannie and Freddie, defying enormous pressure to have them provide relief to borrowers. There are also some errors and oversights in the book, though none are critical. I will single out two here. The author uses the term government-sponsored enterprise to refer to only Fannie and Freddie. In fact, there are other GSEs, such as the problematical Farm Credit System. (The GSE that has been successfully spun off from the government is Sallie Mae, which is active in the student loan market.)

Also, the author quotes former Treasury Secretary Tim Geithner saying “how little authority we had over Fannie and Freddie” without mentioning that Treasury had the authority to approve (or disapprove) their debt issuances. Treasury had used that authority mainly as a traffic cop, that is, to make sure that the Treasury and the GSEs were not all issuing debt at the same time. Treasury stopped acting as a traffic cop during the Clinton Administration. However, in the early 1980s, Treasury used the authority to stop Fannie Mae from issuing debt in a manner motivated by questionable tax strategies. In one instance, it stopped Fannie from setting up a Netherlands Antilles financial subsidiary as a way to issue bonds in Europe without imposing a 30% foreign withholding tax. (Tax law regarding the 30% foreign withholding tax was subsequently changed to exempt “portfolio interest income.”) The Treasury could likely have been more aggressive in using the debt approval authority, as Fannie and Freddie grew their mortgage portfolios, on which they bore both interest and credit risk, in the decade leading up to the financial crisis, but shied away from doing that.
Fannie and Freddie have long been absent from the headlines, but what ultimately to do about them is important. They should not be in conservatorship forever. Despite my quibbles, I recommend this book is for those interested in the subject, whether or not they are previously familiar with these two companies.