Greenspan Mortgage Rant Hits Home
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Imagine a country where the most powerful bank regulator in the land repeatedly voices deep concerns about two of the country's largest financial institutions -- but is powerless to rein them in.
That could never happen in America, right? Wrong. Take a look at
Federal Reserve
Chairman Alan Greenspan's testimony Tuesday before the Senate Banking Committee on government-sponsored mortgage giants,
Fannie Mae
(FNM)
and
Freddie Mac
(FRE)
.
In what is shaping up to be one of the most highly charged conflicts in American financial history, Greenspan Tuesday stepped up his campaign to bring deep reforms to Fannie and Freddie by advocating limits to their debt and the establishment of a regulator that has a free hand to set capital requirements. Currently, Fannie and Freddie, known as government-sponsored entities, or GSEs, are regulated by a small, relatively feeble body called the Office of Federal Housing Enterprise Oversight, while one of their key capital measures was set by congressional statute.
Under OFHEO's weak watch, losses due to big interest rate moves have crushed Fannie Mae's equity. Also, Freddie Mac has been through a bruising accounting scandal, while Fannie's accounting
has plenty of blemishes. Greenspan's Senate testimony makes it clear that he has contemplated the many risks involved in the GSEs' business. Managing the balance sheet against big swings in interest rates is difficult, and Fannie
dramatically failed to protect itself during the steep drop in rates in 2002, when lower rates led to a tsunami of mortgage prepayments. (Prepayments are troublesome for GSEs because old, higher-yielding assets get paid off and replaced with lower-yielding ones, hurting profits.)
Despite Freddie's accounting missteps, and much evidence of poor risk management at Fannie, there are many forces -- including large construction companies and politicians who favor government intervention in the economy -- who dispute Greenspan's concerns. But after Tuesday, investors cannot ignore what Washington's most powerful financial player has to say about the GSEs.
If, as Greenspan advocates, debt ceilings and a more powerful regulator were introduced, Fannie and Freddie's balance-sheet growth would have to slow and earnings could be smashed. While the legislation in Congress aimed at reforming Fannie and Freddie does not contain provisions to limit debt, it does advocate transferring regulation of the two GSEs to an entity that has more powers than OFHEO.
The enactment of a GSE reform bill is possible this year, but high odds cannot be attached to legislation passing in an election year. Moreover, Fannie and Freddie, whose main business is to borrow money in the market and use it to buy higher-yielding mortgages, have a wide array of supporters in Congress who can be relied upon to vote against any effort to tighten their regulation.
Greenspan has long raised questions about the long-term viability of the GSEs, but his Tuesday testimony is the fullest exposition yet of his thinking. In his testimony, Greenspan said that he believes that the government-sponsored status of Fannie and Freddie gives them an implicit government guarantee that allows them to borrow at cheaper rates than banks. This subsidized funding has allowed Fannie and Freddie to load up their balance sheets with a combined $1.6 trillion in mortgages. The income from the mortgages now dwarfs the income from guaranteeing mortgage-backed bonds held by other investors.
Greenspan made two very important assertions Tuesday that will color the debate over Fannie and Freddie, and may even influence the content of the legislation at hand. Most important was his argument -- apparently made in public for the first time Tuesday -- that actual steps should be taken to curtail the GSEs' biggest business, which is buying and owning mortgages. "GSEs need to be limited in the issuance of GSE debt and in the purchase of assets, both mortgages and nonmortgages, that they hold," Greenspan said in prepared testimony.
If this was ever made policy, Fannie and Freddie's earnings power would be much depleted, because they get far more of their revenue from the interest payments on the mortgages they own than from the fees earned by guaranteeing mortgages that other investors hold. For example, in 2003 Fannie Mae had revenue of nearly $16 billion, 85% of which came from net interest income from its assets, chiefly mortgages.
The second, and apparently new, argument from Greenspan had to do with the implied government guarantee on GSE debt. There is no explicit guarantee on GSE debt, but the market prices it as if there is one because the GSEs could have access to a line of credit from the Treasury and because it is widely believed that, in the event of insolvency, the government would step in to prevent a collapse of the housing market.
The big challenge for GSE reformers is finding a way of getting the market to believe that there really is no guarantee. To that end, Greenspan Tuesday suggested that Congress, in setting up a new GSE regulator, "needs to clarify the circumstances under which a GSE can become insolvent and, in particular, the resultant position -- both during and after insolvency -- of the investors who hold GSE debt."
In other words, Greenspan is saying that a new regulator must have some sort of prepared, codified procedure for treating the GSEs' creditors in the event of insolvency. Presumably, if that protocol makes it clear those creditors could actually lose money in insolvency, the belief in a government guarantee would weaken. The only problem is that investors would just assume that the government could always choose to overrule this protocol in a crisis, thus leaving the implied subsidy on GSE debt intact. Even so, Greenspan's measure is not without merit, because it would make a government rescue incrementally harder and perhaps shave a small amount off the subsidy.
If it is impossible to do away with the perceived government guarantee on the GSEs, policymakers have to tackle the GSE problem by imposing limits on their growth. They can do this by giving the new regulator more sway over capital requirements and imposing a growth limit. At the moment, OFHEO sets its own
flawed capital requirement called risk-based capital. The new regulator, according to Greenspan, should set the risk-based capital
and
the minimum capital requirement, currently fixed by Congress.
"In the Federal Reserve's judgment, a regulator should have a free hand in determining the minimum and risk-based capital standards for these institutions," Greenspan's prepared testimony said.
Compared with banks like
Citigroup
(C) - Get Report
and
J.P. Morgan
(JPM) - Get Report
, equity at Freddie, and particularly Fannie, is a very small percentage of assets. Because of that, it is not beyond the realm of possibility that a new regulator could be expected to ask Fannie to issue billions of dollars of stock to raise its minimum capital requirement closer to the market norm.
Finally, did Greenspan make a veiled reference Tuesday to the massive realized losses that Fannie has stored up in its equity, a subject first reported by this column?
In his testimony, he said: "The difficulties of creating transparent accounting standards to reflect the gains and losses associated with hedging mortgage-prepayment risk highlight that the business of taking on prepayment risk is far from simple and is difficult to communicate to outside investors."
In the second half of 2002, Fannie suffered massive losses on closed-out derivatives that arose due to its devil-may-care attitude toward prepayment risk. The company
refuses to disclose the size of these losses, but some financial sleuthing indicates that they are huge. Before its accounting scandal, Freddie openly reported closed-out derivative losses. If Freddie can post these losses, Fannie is also able to, but refuses, almost certainly to protect the position of Fannie CEO, Franklin Raines.
The Fannie losses are key to understanding Greenspan's testimony. If interest rates had dropped just a little bit further than they did in 2002, Fannie's equity would've been wiped out.
Think Detox is exaggerating?
Well, as rates fell, Fannie's equity plunged by $10 billion, or 50%, to $11 billion (excluding a gain from a change in accounting) in just two quarters in 2002. Recent numbers
indicate that the company is still taking huge bets on rates that could blow up in its face. But the nation's premier bank regulator can do nothing. Except complain, which he did very eloquently Tuesday.
In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to
peter.eavis@thestreet.com.