Thursday, August 21, 2008

About Those GSEs: Fannie & Freddie

There's been quite a bit of ink spilled recently over Fannie Mae and Freddie Mac, the GSEs for mortgage finance. I haven't directly addressed their plight since I wrote this post a little over a month ago.

Now, with both of them near financial death, it's appropriate to revisit the topic. I wrote in that piece,

"My overall view of the situation is that it is a mistake to give more capital access to the same crew that got into this mess.

The implicit Federal Government guarantee clearly led to an imbalanced strategy over the last decade. Both institutions enriched employees, especially senior management, while failing to pay careful attention to the growing risks on their own balance sheets.

For this, we have Congress to thank, since it tends to view Fannie and Freddie as a large real estate finance cookie jar for their own pet agendas.

Of the choices which the Journal's article suggests, I think I would go with the Bush administration's desire to replace the current boards with members whose stated objective would be to clean up the balance sheets of the two firms and gradually shrink their role in the housing markets.

In this day and age, if a government-affiliated lender can't do a decent job securitizing housing loans, why allow it to exist?

We'll always get better performance from the private sector, assuming adequate regulation.

Now, we have the worst of both worlds- shareholders losing value due to entrenched, incompetent management, and the Federal Government picking up the tab.Shareholders chose to own the companies' stocks (I have owned equity in both firms in the past), so they deserve to lose their capital.

But to prevent a replay of this fiasco, I think it's time to remove the governmental connection to the two mortgage securitization firms as soon as it is possible."

Yesterday, over lunch, my partner and I discussed how the situation could best be resolved now. Everyone seems to fear a 'market collapse' in Fannie- and Freddie-issued mortgage-backed securities.

But as I see it, there are actually two distinct problems to be solved.

The first problem involves the treatment of outstanding GSE-issued mortgage-backed securities. These pretty much have to be backed by the US Treasury. To fail in this regard would be to, as my friend B, whose opinions I published in this post, cause large-scale losses in virtually every pension and retirement fund in the nation.

It's instructive to consider that what is involved here is only making up the losses from defaulted mortgages in these securities. If Fannie and Freddie were actually providing a value-adding service, including effective risk management, this wouldn't be a big problem. The expected value of losses from defaults would be low.

If, on the other hand, that expected value is high, then this alone argues for simply shutting the two GSEs down. Service their issued securities, but liquidate the companies.

The second problem is the role of the two GSEs in ongoing US housing finance. Here, articles discuss the new difficulties the two companies have in rolling over their longer-term debt.

To me, the solution here is simple, as I just stated two paragraphs above. Terminate the organizations.

Don't roll the debt over. Liquidate the companies' assets, and use remaining shareholder equity to satisfy any debts. Place what's left into receivership to work out any remaining unpaid creditors.

But, you ask, what about the mortgage finance industry? Won't this, as one Wall Street Journal op-ed cried, bring US housing finance markets to a standstill?

No. Of course not.

In our economy, absent unwise governmental interference or regulation, something worth doing will be done by someone, at a profit.

So, too, will that occur in this case. By killing the GSEs, room will be made for private mortgage conduit companies to do the work, if it's valuable and profitable, of mortgage securitization.

I suppose it's possible that investors might not currently trust any securities backed by mortgages, for fear of experiencing more of the same they have gotten from Fannie's and Freddie's poor underwriting standards and unwise programs requiring too little equity from borrowers.

In time, a well-run portfolio lender could easily begin to liquify their balance sheet via securitization. There's nothing magical about it. A few well-run mortgage banks and a few investment banks could fill investor demand for mortgage-backed securities left by the GSEs.

In time, the better home finance lenders with lower delinquency and default rates would command higher prices, and lower yields, for both their securitized mortgage notes and their debt. And equity.

Simply put, if there's a need for the functions which the GSEs performed, won't we see sufficient capacity, and better performance, from private-sector firms doing the same thing?

Well, we know one thing. We won't see worse underwriting practices in these securities. The very worst system you could possibly design is to pay government-backed entities private-sector-style compensation. Risk is transferred to the government, while rewards accrue, unfairly, to the equity holders and management.

With private-sector players doing this work, risk and reward would be appropriately put back together, where they belong. But, most importantly, Fannie and Freddie should be prevented from doing anymore ongoing mortgage finance securitization. With their track record, whether taken over by Treasury, or not, they simply have to be shut down, so room can be made for more effective firms with better risk management to replace their shoddy underwriting practices.

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