Sunday, 27 July 2008

Mission Accomplished: The Destruction of Fannie Mae and Freddie Mac (Part 1 of 2)

Speculative capital is inherently self destructive; it eliminates the opportunities that give rise to it. What is the real life manifestation of this characteristic? In other words, how does the self-destructive tendency manifest itself in practice?

On example I used in Speculative Capital and the Credit Woes series was the shrinkage of spreads. Speculative capital is capital engaged in arbitrage. Arbitrage, by definition, tends to bring the price of two arbitraged positions together, eventually making them equal. In such a state of equality, the arbitrage possibility vanishes, and with it, the condition for the existence of speculative capital.

Shrinkage of spreads is a technical example. As the influence of speculative capital permeates beyond the markets to the various segments of social life, does this self-destructive tendency manifest itself in a larger context with more far-reaching social ramifications? The answer is yes. One outstanding example in that regard is the premeditated destruction of Fannie Mae and Freddie Mac.

In the past couple of weeks, the distress at Fannie Mae and Freddie Mac has dominated the business headlines. True to norm, the extensive coverage has left the readers in a state of utter ignorance. What a bond trader, a finance professor or a corporate treasurer knows from reading the New York Times or Wall Street Journal is that two somehow government related mortgage companies are going to lose billions of dollars and need be rescued by the government. That is how the story is framed, confirming the prejudices of the run-of-the-mill consumer of the news, built over the years by equally one-sided reporting, that the government “cannot do anything right” and the politicians “screw up” every time and big government is bad, and so on.

In reality, what we are witnessing is coming to fruition of a deliberate plan – a conspiracy, really – by a group of men in power to destroy Fannie Mae and Freddie Mac so that their institutions could reap larger profits. The success of the plan and the consequences of that success is the subject of today’s posting that will appear in two parts. Part I deals with the details of the operation of the two agencies and is at times slightly technical. So, pay attention!

The Role and Function of Fannie and Freddie

Fannie Mae and Freddie Mac were created by the US Congress to facilitate home ownership in the US. They were to do that by purchasing mortgages from banks.

For reasons that do no concern us here, the price of a house in general is many times above the average yearly income of a worker. The median home price in the US, for example, is about $200,000, while the median household income is about $50,000. If homes were bought and sold for cash only, as they are in many counties around the world, it would require years of saving – well into the middle age – for the average working person to save enough to purchase a house.

Credit circumvents that need. (I discuss the subject of credit – vulgarized beyond recognition to “trust” and “credit worthiness” – in Vol. 4 of Speculative Capital.) Our average worker could borrow the $200,000 asking price of the house from a bank and make only small monthly payments – small because the payment is stretched over 30 years. With 6% interest rate, for example, the monthly principal and interest payment on a $200,000, 30-year loan would be about $1200. (By virtue of this extension, the borrower would pay more in interest than the original sum, but that is the nature of the beast in the system we are investigating.)

Historically, this extension of credit has had two constraints, one at the borrower’s end, the other, at the lender’s.

The constraint on the borrower’s end was his wherewithal; he had to demonstrate his ability to make the monthly mortgage payments. The house that was being purchased was pledged as the collateral for the loan, so in the case of the borrower’s default the bank would repossess the house and sell it to recover the loan. To protect itself further, the bank demanded an initial payment, equal to 20% of the purchase price. This forced the borrower to have a “skin in the game”, which acted as a disincentive for him to walk away from his obligation in the case of a drop in property values. These requirements limited the universe of qualified home buyers.

The second constraint was the banks’ lending capacity. After setting aside 10% for the regulatory capital with Federal Reserve, a bank with $100 million in deposits would only have $90 million to lend. Assuming $200,000 for the average loan, that would translate to 45 mortgages. To lend to the 46th applicant, the bank would have to grow its deposits, a slow process that remains vulnerable to many parameters including the state of local economy.
Fannie Mae and Freddie Mac were created to eliminate this latter constraint. They did it by offering to buy all the banks’ mortgages. In our example, they offered to buy 45 mortgages for, say, $91 million.

The bank happily accepted the offer. By receiving $91 million, it: i) realized a profit of $1 million immediately; and ii) had its $90 million returned to it which it could lend to the second batch, another 45 qualified applicants.

That was the sole function of Fannie Mae and Freddie Mac: to make it possible for banks to lend to more home buyers. They did not lend to individuals or otherwise engaged in banking activities.

What about Fannie Mae and Freddie Mac, how did they get $90 million to buy the mortgages? They borrowed the money in the capital markets. Both entities were created as “government sponsored enterprises” or GSEs, meaning that the US government implicitly guaranteed their debt. As a result, they could borrow at very low rates, almost comparable to the US treasuries. As the mortgage rates were about 2% above the yield of the treasuries, it is easy to see how the two GSE’s made money: they borrowed at 4% and earned 6% on the newly acquired mortgage asset. On a $90 million pool of mortgage, that would translate to $1.8 million annual revenue.

This method of financing, however, ran against the same constraint that had limited the banks’ mortgage lending. The two agencies could not, ad infinitum, borrow in capital markets and buy mortgages because they also had regulatory capital constraints. So they came upon the idea of creating mortgage-backed securities (MBS), a landmark event in capital markets.

The idea behind MBS is a simple one. Pool a group of mortgages and, on the strength of the pool and its monthly payment, issue fixed income securities whose coupon would be paid by the home owners. An MBS is a bond whose coupon, instead of being paid by one borrower, is paid by many borrowers.

Suppose in our example Fannie Mae purchased mortgages from two banks, one for $90 million that we saw and the other for $110 million. The combined mortgage pool would then be $200 million. The agency could issue – sell to capital market investors – 200 thousand MBSs, each with the face value of $1000. (The structure of MBS is more complex than in this example. It involves “tranches” with different loss exposure and credit ratings. That technicality does not concern us here.)

The mortgage pool was vulnerable to the borrowers’ default. If a few borrowers defaulted, the monthly payment to the pool, and thus, the amount of money available to the MBS holders would be reduced. To address this eventuality, Fannie Mae and Freddie Mac guaranteed the payment of MBSs.

That guarantee, offered by two GSEs whose obligations were in turn implicitly guaranteed by the US government, made MBSs tremendously valuable. Note that in our example the yield of US treasuries is assumed to be 4%. A purchaser of a MBS would receive 6% annual coupon. That yield was 2% above the yield of the treasuries but for all intents and purposes, the MBS had the default protection of the treasuries.

Little wonder then, that Fannie Mae and Freddie Mac became tremendously successful. Their asset size, the amount of mortgages they purchased and kept on their balance sheet, the amount of MBS they issued, together with the home ownership, grew tremendously. It was the proverbial American success story.