The Mortgage Market
Alan Greenspan was in the headlines frequently in February. Starting with the semi-annual Humphrey-Hawkins testimony to both
houses of Congress early in the month, followed by several speeches and additional testimony in front of the Senate and the House,
Chairman Greenspan voiced his opinions on such issues as globalization, household debt, the current account and budget deficits, taxes
and the status of the Government Sponsored Enterprises. We pay attention to all of these topics, for the discussion of interest rates
cuts across all macroeconomic boundaries, but the issue most immediately relevant to our business is the Chairman’s GSE testimony
on February 24 before the Senate Committee on Banking, Housing and Urban Affairs. “Fannie Mae, Freddie Mac and the Federal
Home Loan Banks,” he began, “collectively dominate the financing of residential housing in the United States. Indeed these entities
have grown to be among the largest financial institutions in the United States, and they now stand behind more than $4 trillion of
mortgages-or more than three-quarters of the single-family mortgages in the United States-either by holding the mortgage-related
assets directly or assuming their credit risk. Given their ties to the government and the consequent private market subsidized debt that
they issue, it is little wonder that these GSEs have come under increased scrutiny as their competitive presence in the marketplace has
increased.”
Chairman Greenspan’s criticisms of the GSEs (he spent the rest of his testimony solely discussing Fannie Mae and Freddie Mac) can be summarized as follows:
The last point is the one most concerning to Chairman Greenspan, as he says, “The Federal Reserve is concerned about the growth and the scale of the GSEs’ mortgage portfolios, which concentrate interest rate and prepayment risks at these two institutions. Unlike many well-capitalized savings and loans and commercial banks, Fannie and Freddie have chosen not to manage that risk by holding greater capital. Instead, they have chosen heightened leverage, which raises interest rate risk but enables them to multiply profitability of subsidized debt in direct proportion to their degree of leverage. Without expectation of government support in a crisis, such leverage would not be possible without a significantly higher cost of debt.”
These are not new issues in the marketplace, nor are they new issues to us. In a piece posted to our website almost two years ago (“A Discussion of Risk at Fannie Mae and Freddie Mac,” June 21, 2002), we identified Fannie Mae and Freddie Mac as big, leveraged bond funds sitting on top of a guarantee business, and listed many of the same concerns that Chairman Greenspan addressed. Of all the risks we enumerated, there was one that the Chairman overlooked, namely headline or political risk: “Fannie and Freddie serve two masters with different objectives,” we said, “the federal government that chartered and regulates them, and the stock market that looks for growth.” The last five years of financial results would lead any observer to conclude that management of these two entities has been listening more to the stock market, possibly to the detriment of the government regulator. As we said back then, the bigger, more leveraged and more complex Fannie and Freddie become, the more the government will take notice and take action. In a sense, the current debate over the GSEs boils down to this prediction coming true-this is nothing more than headline risk because the rest of the discussion holds no new information for the marketplace.
Before we get too alarmist in this discussion, we need to remind ourselves of a few facts. As Chairman Greenspan said, “I should emphasize that Fannie and Freddie, to date, appear to have managed these risks well and that we see nothing on the immediate horizon that is likely to create a systemic problem.” Franklin Raines, chairman of Fannie Mae, writing in the Financial Times, reminded the market that the GSEs shouldn’t be compared to a bank because the assets that are being hedged are different. “In the end,” he said, “because Fannie Mae specializes in home mortgages, a mortgage-and the financial system-is safer with our stabilizing presence than without us.” We would also emphasize a few more points: First, not once have Fannie Mae or Freddie Mac failed to honor the guarantee on their mortgage-backed securities. Second, not once have they needed the assistance of the US government to do so. Third, the MBS holder has multiple levels of protection. Besides the implied guarantee of Treasury, the MBS holder is secured-protected by the actual loan-to-value rating of the home, mortgage insurance, the income verification and maintenance of the homeowner, property/casualty and life insurance, the rights of foreclosure and the settlement process, and the reduction in principal amount from monthly amortization. Fourth, as the graph below shows, through all of the headlines and editorials and sound bytes, the spreads of Agency MBS have barely budged. Since 1998, the spread between the current coupon and the 10-year yield has been as wide as 200 basis points and as narrow as 94 basis points, with the average spread being 140. Currently, the spread is 104.
The object of all of the current discussion is to frame the debate over the regulation of the GSEs. Congress is currently working on legislation that would change the current regime in which the Agencies are regulated by the Office of Federal Housing Enterprise Oversight (OFHEO), which is situated in the Department of Housing and Urban Development. The Bush Administration position has been clearly laid out in several places, most recently in a February 24 Financial Times op-ed piece by Gregory Mankiw, chairman of President Bush’s Council of Economic Advisors. “Although there is no way to eliminate the underlying risk,” he wrote, “it is possible to reduce it by ensuring that the housing GSEs are overseen by an effective regulator with appropriate tools and resources. In particular, it should have broad authority to set both risk-based and minimum capital standards for GSEs; to review and, if appropriate, reject new GSE activities; and to wind down the affaris of a troubled GSE through receivership.” Mankiw also called for the new regulator to be granted permanent funding.
The Senate may deliver its draft legislation before Congress’ Spring break in mid-March, but the timing of any change is unclear. The House would not even begin its debate until the Senate is done with its deliberations. If the current view of the Administration serves as the guideline for the legislation, then the new regulatory regime will likely be favorable to the GSEs. “A regulator with credibility will actually enhance the attractiveness of Freddie and Fannie to both bondholders and stockholders,” said the UBS mortgage strategy group in a recent write-up. If, at the end of this debate, GSE regulatory reform is viewed negatively by the market, then the question that will be asked by the markets is what would the effect be on the value of the MBS guaranteed by Fannie Mae and Freddie Mac. While this is not a question that can be answered with any certainty, we believe that lawmakers are well aware of the risks-economic and political-to the financial markets and to the housing market of any change in the creditworthiness of the GSEs. To us, the promises of the GSEs to their debt-holders and their MBS holders were made in the full realization that the implicit guarantee of the Federal Government was part of the sale. Any outcome to the contrary would expose the Federal Government to unintended consequences that could, ironically, destabilize the very same financial system Congress is trying to make safer. Regardless of the outcome, we must remember that this debate is over regulation, not crediworthiness, and we believe that the secured nature of the Agency MBS, the quality of the collateral and the demonstrated ability of Fannie Mae and Freddie Mac to honor their guarantees will serve to support the value of our portfolios.
The Markets
In February, the bond market was volatile but drifted down in yield. US stocks were mixed, and oil got tighter.
