This post is a reply to a specific news story appearing a week and a half ago in the New York Times, "Obama Outlines Plans for Fannie Mae and Freddie Mac," by Jackie Calmes (at: http://www.nytimes.com/2013/08/07/us/politics/obama-fannie-mae-freddie-mac.html?_r=0). In some respect, my comments here need to be read partly in conjunction with and partly in divergence from the other posts that I have included in this series. The larger conclusion that I have attempted to convey in this series of posts on the foreclosure crisis has been that, while we need to reconsider the institution of home ownership as a component of the "American dream," in the name of stabilizing communities and restoring housing values after the deflation of the housing price bubble, we need organizations that will fight foreclosure, actively (and, if necessary, physically) contest eviction of foreclosed mortgagors, promote renegotiation of principle by lenders to reflect diminution of housing values, and demand the support of governments in developing statutory restrictions on the actions of lenders to execute foreclosure. In line with this ultimate conclusion, it has not been my contention that irresponsible borrowers, who had no business being in markets for the purchase of residential real estate, deserve to be absolved of culpability for their actions and, as such, be granted free property at the expense of lenders. Rather, for reasons that I will elaborate, I think we need to deal with the facts on the ground concerning the health of local real estate markets and the effects of diminishing home values on the fiscal health of local governments and, in so doing, develop public policies that will address the culpability of all parties in relation to the mortgage market meltdown.
The particular direction being taken presently by the Obama administration appears to proceed on a tangent from my perspective on the foreclosure crisis and its effects on housing markets. Emphatically, the views expressed by President Obama in the above article lay the groundwork for a larger reconsideration of expanded home ownership as a goal in federal housing policy. To the extent that it does so, there may be merit to what the administration is seeking to do in "winding down" the government sponsored secondary mortgage market enterprises, Fannie Mae and Freddie Mac, institutions that are ultimately unnecessary if we are assuming that the majority of U.S. households should continuously reside in rental housing that conforms to their ability to make rental payments. If the promotion of affordable rental housing becomes a goal of federal housing policy, it further raises questions about how we will have to alter our conception of the U.S. economy as consumption driven, insofar as the vast majority of Americans would be incapable of marshaling home equity as a source of collateral in borrowing to finance big ticket consumption. I want to consider these questions as a larger part of what I consider to be a politically controversial but logical and, perhaps, sensible conclusion to be derived from President Obama's enunciation of the new direction in U.S. housing policy.
If, on the other hand, as it seems here, the ostensible goal of the administration is to continue, like the Bush administration before it, to promote an "Ownership society," in which the expansion of home ownership to lower income groups is the declared goal of the federal government, then the policies contemplated by the Obama administration appear singularly unsuited to the goals that it seeks to pursue. Rather, the administration is proceeding from false premises in concluding that, on the one hand, irresponsible portfolio management practices by managers at Fannie Mae and Freddie Mac, emanating from moral hazard constituted by the implicit guarantee of the federal government to insure financial losses by the institutions, were primarily to blame for the mortgage market meltdown, and that, on the other hand, secondary mortgage markets consigned wholly to private sector investors will generate a robust environment within which the majority of Americans will be able to secure affordable financing for purchases of residential real estate. Instead of developing housing policies sensibly relate to ensuring liquidity in primary mortgage markets and, thus, lowering borrowing costs on 30 year fixed rate mortgages in relation to other credit instruments, the administration is borrowing a page from traditional right wing critics of the New Deal to blame the government sponsored secondary mortgage market agents for a crisis that was not entirely of their making.
In this post, I plan to address each of these fallacious conclusions in order to argue why the "winding down" of Fannie Mae and Freddie Mac, absent a substantial expansion of explicitly guaranteed FHA mortgages (that neither seems to be part of Obama's agenda nor seems likely to emerge from this Congress), must, invariably, reduce liquidity in primary mortgage markets and, thus, produce a severely constricted institution of home ownership in the U.S. In this regard, I want to evaluate the record of Fannie Mae and Freddie Mac relative to housing markets since the 1970s, reiterate why the critical source of the mortgage market meltdown derives from private securitization of mortgage assets, and argue why elimination of the government sponsored secondary market enterprises will both substantially increase volatility in secondary mortgage markets and differentially truncate the eligibility large segments of the U.S. population for mortgage financing based on the availability of highly mobile investment capital, seeking the highest possible rate of return across the global macroeconomy.
The Secondary Mortgage Market and the Structural Role of the GSEs
From its inception in 1938, the Federal National Mortgage Association/Fannie Mae possessed a Congressional mandate to generate a secondary market for home mortgages by purchasing mortgages from primary market issuers (e.g. savings-and-loan associations, savings banks, etc.). Emerging from the broader project of the New Deal, the idea of generating a secondary market for mortgages enacts a critical postulate of Keynesian economic theory - that financial lending, as a linchpin in generating economic growth, will only occur if the financial instruments issued satisfy the demands of lenders for liquidity (i.e. liquidity preferences). The business of Fannie Mae was initially to inject federal money into primary mortgage markets by purchasing mortgages directly from issuers to clear their balance sheets of assets with extended turnover times on investments (i.e. to purchase mortgages that would completely realize their values in 15, 20, or 30 years, compensating banks with an estimated present value of the assets). The presence of a secondary market for mortgages transforms a 15 or 30 year mortgage, especially fixed rate mortgages, into relatively liquid assets, capable of being transformed at will by a mortgage lender into new capital to issue new mortgages.
Importantly, by increasing the liquidity of a mortgage asset, the secondary market gives lenders an incentive to issue more mortgages at lower rates of interest to borrowers because the existence of an entity purchasing mortgages, in effect, insures the lending process against the risks of default. In exchange for the enhanced liquidity, primary mortgage issuers were compelled to meet a set of "conformity" standards in the issuance of mortgages, concerning the overall size of a loan and threshold loan-to-value ratios/down-payment requirements or purchase of mortgage insurance by borrowers. The presence of these standards served both a strategy of risk management by Fannie Mae and a regulatory mechanism for lenders to firmly define limitations on the liquidity of the mortgages they issued. Beyond this, the mechanism of establishing and altering conformity standards by the Government Sponsored Enterprises (GSEs) (i.e. Fannie Mae and the Federal Home-Loan Mortgage Corporation/Freddie Mac) constitutes a policy tool with regard to the housing sector. If standards on loan conformity are loosened, the change in policy must necessarily generate a expansion in home-loan activity to the extent that mortgages beyond the margin of conformity become conforming and, hence, become relatively liquid assets for lenders.
At its inception, Fannie Mae's primary funding source is the federal government. In the 1950s, however, it gains the ability to market common equities in financial exchanges to raise capital. In 1968, the enterprise is split, with Fannie Mae spun off as a fully private corporation marketing prefered and common equities to private financial market shareholders and the Government National Mortgage Association/Ginnie Mae remaining under full ownership of the federal government to repurchase Federal Housing Administration (FHA) insured mortgages and rebundle them into mortgage backed securities (MBSs), backed by the full-faith and credit of the federal government. Both enterprises were empowered to fund their mortgage repurchases by issuing MBSs for sale by private investors. In 1970, Congress establishes Freddie Mac to actively compete with Fannie Mae for secondary market purchases and, thus, increase the sale prices of mortgage assets received by primary market lenders. Both GSEs are constrained by Congress to limit their purchases to mortgages conforming to defined conformity standards, and, until the 1990s, the GSEs jointly devise these standards. Given the relatively conservative character of GSE conformity standards, an implicit guarantee exists for purchasers of GSE securities that the federal government will back GSE-issued MBSs against default by underlying borrowers.
With these considerations in mind, the GSEs jointly monopolize the secondary market for conforming mortgages until the passage of the Gramm-Leach-Bliley Act in 1999. A secondary market certainly exists for non-conforming mortgages and, within this market, subprime loans make up a small part, but this segment remains at the underserved margins of mortgage issuance. Over this period, the secondary market for conforming loans remains a bland and boring place, where low risk assets, supported by tangible borrower down payments and by rigorous credit investigations, are issued largely by well regulated primary mortgage market enterprises (e.g. savings banks, commercial banks), purchased by Fannie or Freddie, and rebundled for sale to investors interested in low risk, long term steady-return assets as MBSs. The only significant alternative model in funding for home financing, involving strict reliance on depositors to savings institutions (i.e. savings banks or thrifts/savings-and-loan (S&L) associations), was largely undermined during the 1970s as simultaneous inflation and elevated interest rates created insurmountable negative rifts between deposit liabilities and mortgage revenues for savings institutions (a major cause of the S&L crisis of the mid-1980s - due to the fixed rates on mortgages and variable rates on savings accounts, the S&Ls frequently found themselves owing more in interest to depositors than they were being paid back by borrowers). Thus, secondary mortgage markets continued to enjoy greater and greater prominence in assembling the capital necessary to fund home financing. After a short term decline in the mid-1980s around the time of the S&L crisis, home ownership rates (as a portion of total U.S. housing stock) remained relatively steady through the 1990s, around 64 percent increasing to 65 percent through the mid-1990s.
All the while, Fannie and Freddie acted like any other publicly traded major U.S. financial corporation - it hired executive officers at modest salaries and compensated them with exorbitant bonuses for financial performance, creating adverse incentives for cost accounting and reported revenues, raising the eyebrows of the Securities and Exchange Commission and Congressional critics, many of whom never fancied either the government's role in establishing the secondary market in the first place or the prospect that Fannie and Freddie enjoyed an implicit guarantee by the U.S. Treasury to fund outstanding mortgage backed liabilities to investors in case of insolvency. On the other hand, the latter prospect was, in some measure, warranted in view of the burdens of federal regulatory oversight and restrictions placed by Congress on the composition of Fannie and Freddie's asset portfolios. They were restricted to investing in secondary mortgage markets. Their loan purchase activities were restricted to conforming mortgages. In 1992, Congress established the Office of Federal Housing Enterprise Oversight (OFHEO) within the Department of Housing and Urban Development (HUD) to set standards for conforming loans for Fannie and Freddie, thus (theoretically) tying the hands of each enterprise on setting criteria for mortgage purchases. The same legislation allowed HUD to regulate goals for Fannie and Freddie to invest in underserved Census tracts, purchasing mortgages in low-income, often urban communities with high minority populations, originally setting a requirement that 33 percent of the portfolios for each of the enterprises should be composed of mortgages from such communities. Insofar as Fannie and Freddie were legally prohibited from diversifying their asset portfolios with assets from outside of the housing sector, the solvency of each enterprise relied critically on the larger health of housing markets and in the quality of the conforming mortgages that they were mandated to purchase.
The Problem of Secondary Market Deregulation
As I have argued consistently in this set of posts, the real problem with mortgage markets in the U.S. comes with the elimination of restrictions on who can invest in mortgage markets and how mortgage lenders can finance their activities. By removing the Glass-Steagall firewall between the commercial banking and investment banking sectors, the Gramm-Leach-Bliley Act allowed for a significant inflow of capital into secondary mortgage markets, seeking high-risk, high-profit opportunities. From being a bland and boring market, dominated by bundled conforming loans securitized as MBSs by Fannie and Freddie, with relatively low, fixed-rate returns, secondary markets were, within five years of the law's passage, awash with high-return, high-risk MBSs and collateralized debt obligations (CDOs) (in many cases, mysteriously rated AAA (extremely low risk) by bond rating agencies, when they were loaded with B or CCC (high or extremely high risk) rated mortgage loans!), produced through confusing bundling and "tranche"-ing practices (i.e. separating "tranches"/slices of mortgage assets by diverse levels of risk). As new private sources of mortgage capital began to crowd Fannie and Freddie out a secondary market that they had virtually monopolized for three decades, issuance of non-conforming mortgages in primary markets, especially subprime and Alt-A mortgages, boomed, further driving the inflation of housing prices up to 2006.
Again, taking this context as the point of reference, it is disingenuous to argue that Fannie Mae and Freddie Mac were, somehow, paragons of irresponsible profiteering in the face of an impending crash of high-risk investments. Moreover, leveling such charges omits any consideration of the role of the federal government, through HUD and OFHEO, in managing the engagement of Fannie Mae and Freddie Mac relative to the purchase of high-risk assets. At a minimum, OFHEO regulators were negligent at ensuring that Fannie and Freddie maintained adequate market capitalization through equity to support the purchase of their asset portfolio (i.e. that they did not over-leverage their purchase of assets through the marketing of debts instruments, predominantly MBSs, that they would be left on the hook to pay if the mortgage market collapsed). Worse, HUD pushed Fannie and Freddie to increase their exposure to assets issued in underserved tracts, to 56 percent in 2005, in the process necessitating a watering down of conformity standards (these "underserved" tracts were typically in poorer, urban, minority neighborhoods, where borrowers might be expected to rely on subprime or Alt-A financing terms, often with hybrid adjustable rate mortgages, the signature creation characterizing the subprime meltdown).
For an alternative reading, stressing the significant political clout of Fannie and Freddie, and their consequent capacity to manipulate Washington policy makers and overwhelm powerless regulators, see Appelbaum et al. ("How Washington Failed to Rein in Fannie, Freddie," Washington Post, Sept. 14, 2008, at: http://articles.washingtonpost.com/2008-09-14/business/36771321_1_new-regulator-fannie-mae-freddie-mac). I discount this perspective simply because it does not take into account changes in the regulatory environment of secondary mortgage markets and the participation of private, non-agent (i.e. non-GSE) issuers of MBSs in the aftermath of Gramm-Leach-Bliley. Still, there must be some grain of truth here, insofar as the GSEs did, in fact, lower their standards for conforming mortgage purchases in or around 2004, and there is no tangible evidence that I can find that OFHEO had any meaningful influence in constraining their actions in the public interest, much less a stamp of approval. My own position in this post seeks, in part, to defend the roles of Fannie Mae and Freddie Mac in the larger goal of expanding home ownership, but it should not be construed as suggesting that the GSEs were not, in some way, culpable in the mortgage market meltdown or that their political influence in Washington, on both major parties, in the years leading up to the meltdown did not have corrosive aspects!
The roles of Fannie Mae and Freddie Mac in the mortgage market meltdown, like those of all other relevant players, must be understood in their proper contexts. They were active participants in the expansion of subprime mortgage markets as much as they were victims of this expansion. They purposefully responded to the pressures of changing secondary mortgage markets the only way that they possibly could - by watering down their purchasing guidelines to accumulate the high-risk assets that their equity shareholders wanted and that HUD wanted them to invest in, as a political prerogative in line with the goals of the Community Reinvestment Act (CRA). It is easy for critics of Fannie and Freddie, or, for that matter, for critics of the larger New Deal-inspired project of expanding home ownership opportunities, to situate the insolvency of these institutions in 2007/2008 within a temporal framework in which they acted as irresponsible oligopolists, operating under moral hazard arising from the implicit guarantee of their MBSs by the U.S. Treasury. Such an interpretation omits the specificity of the short span of time (less than one decade from the passage of Gramm-Leach-Bliley in 1999), when their circumscribed market niches were compromised by the infiltration of Wall Street actors seeking high-profit opportunities at the expense of inflicting extreme market volatility and unmanageable risk. Moreover, both of these relatively short term interpretations ignore the larger place of the GSEs in housing markets in the period since the initial inception of federal housing policy during the New Deal.
No comments:
Post a Comment