Friday, July 11, 2008

Fannie & Freddie: Affirmative Action for the Rich and Stupid

Recent responses by policymakers to insolvency risk at Fannie Mae (FNM) and Freddie Mac (FRE) are entirely wrongheaded.  Not only do financial markets realize that credit protection supplied by Fannie Mae and Freddie Mac might be fictional in a full-blown mortgage crisis, but also that their guarantees of mortgage-backed securities create distortions in interest rates which destabilize markets. Even worse, logic suggests that these GSEs are making real estate more expensive,  not more affordable, to American homeowners. Fannie Mae and Freddie Mac are prominent causes of the current financial crisis, not part of the solution. 

The market has clearly come to terms with the fact that since Fannie Mae and Freddie Mac are not government backed, but government sponsored, that their historically lower cost of capital is not warranted. The collapse in their stock prices and the rise in their borrowing costs is evidence of this.

As Fannie Mae’s annual report states:

Although we are a corporation chartered by the U.S. Congress, the U.S. government does not guarantee,  directly or indirectly, our securities or other obligations.

This wouldn’t be particularly relevant except for the fact that Fannie Mae and Freddie Mac then turn around and, in the words of Fannie’s Annual Report:

...issu[e] and guarant[ee] mortgage-related securities that facilitate the flow of additional funds into the mortgage market.

Yes, you read correctly—guarantee.  With highly leveraged balance sheets, these guarantees are clearly at risk without government intervention.

But why are such promises dangerous? 

It is incredibly illogical for a society to encourage any concept of credit insurance by any entity,  since it encourages the charging of relatively lower interest rates which do not reflect the true probability of default.

Therefore, the solution is for mortgage-backed securities issued by Fannie Mae and Freddie Mac to carry interest rates denoted by the risk, not an interest rate which partially reflects the credit risk and partially reflects an almost meaningless promise to pay in the event of widespread defaults on the underlying mortgages, sans government intervention. It is precisely at the point when one would need such credit insurance, a crisis, at which the insurer would be least able to pay, since homeowners tend to default in a highly correlated fashion.  

Therefore, since the promise of credit protection may be illusory in times of crisis, it heightens distortions in interest rates and creates credit shocks rather than dampening shocks to the financial system. When optimism abounds, market participants overestimate the true credit protection that Fannie Mae and Freddie Mac are able to provide with their leveraged balance sheets.  They bid up mortgage-backed securities bundled by these firms to unrealistic levels, do not correctly discount the risk that the GSEs might not make good on their promises of credit protection, and narrow credit spreads.  This creates a debt bubble, as we have seen, and heightens market instability.

In contrast, the former unquestioning confidence in such credit protection has been replaced by a view that it could be meaningless without explicit government guarantees. Rather than increasing market efficiency, the real possibility of meaningless promises is destabilizing and inefficient.  

Policy makers forget that in today’s world, capital is everywhere to be found. Investors do not need highly leveraged institutions to provide the shabby semblance of credit protection. Investors crave more information in tandem with more simplicity in order to decrease uncertainty and to better evaluate credit risk. Risk is not the issue. Uncertainty is the issue.  

The logical solution is for investors to bear the full credit risk without any semblance of credit protection (after all, isn’t that what investment means, bearing the risk of loss?!) and to charge an interest rate which is compensation for the risk assumed. This spoiled, ridiculous concept that we can eliminate risk by having it born by financial institutions which are themselves highly leveraged is the adult version of the tooth fairy.

If the GSEs are allowed to collapse, interest rates will immediately adjust, as they have started to, to account for the real credit risk of the underlying mortgages. These higher interest rates, in the longer term, will drive investment in residential mortgages better than any GSE. Such a free market solution would make mortgage securities easier to value, free from the uncertainty that leveraged GSEs introduce into the financial system. 

Anyone who argues that we have insurance in the physical world, which generally works quite well, and that therefore insurance in the financial world is no different, is living on fantasy island. Despite the musings of the chaos theorists,  there is absolutely no correlation for an insurer between snow damage in Alaska and between car accidents in Florida. In the financial markets,  the effect of leverage creates correlations between totally divergent assets and geographies. Real estate may be local in nature, but because mortgages are usually handled by large national financial institutions (whose bankers, like lemmings, seem to get the same dumb ideas all at once when they do something dangerous like talk to each other on the phone, or golf at the country club), correlations become national and potentially international in scope. 

Humans, unlike weather systems, behave like sheep. And there is nothing real about real estate in any country in which it’s financed primarily be debt. As we have seen, it is then a financial asset which derives a large part of its value from the cost of financing. And if the cost of financing is distorted by promises to pay which may not be kept,  the reliance on such unkeepable promises should not be encouraged in the financial system.  

Furthermore, it unintentionally acts against the original purpose of the GSEs, which is to make housing more affordable. Even if the government decides, as recently suggested in the media, to explicitly back Fannie Mae and Freddie Mac’s obligations,  this will perpetuate the very distortions in the bond and real estate markets which have lead to the current subprime crisis.

By distorting interest rates downward, it makes the price of real estate more expensive—and accomplishes exactly the opposite of the GSEs original purpose,  by making real estate less affordable to the very people GSEs are meant to help. Politicians are behaving disingenuously when they claim that propping up the GSEs helps potential homeowners. The subprime crisis has done more to make real estate cheaper in this country than any government program.

Any bailout of the GSEs would not be about homeowners. It would be about charity to financial institutions and investors who have not behaved logically and stand to lose terribly due to sloppy decision making. I like to call it affirmative action for the rich and stupid. 

Disclosures: Harry Long does not currently have long or short positions in FNM or FRE. This could change at any time.