Friday, 15 August 2008

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

The lucrative business of Fannie Mae and Freddie Mac had attracted the attention of the private financial firms. They had created Structured Investment Vehicles (SIVs) that approximately mimicked the business model of the GSEs. The SIVs borrowed at the lower rates in the commercial paper market and purchased higher yielding assets, mostly mortgage-based CDOs. Between 1998 and 2001, the CDO assets of the SIVs more than doubled to $85 billion.

Rising home prices and low interest rates had kept the mortgage supply line going. Naturally, Fannie Mae and Freddie Mac also benefited from this market. Their balance sheets, too, expanded as they kept issuing bonds and purchasing mortgages.

But while the demand continued to grow, the supply began to flatten; even in a strong housing market there were only so many qualified buyers. “Qualified” is the key. Because Fannie and Freddie guaranteed the mortgages, they naturally wanted to limit their exposure to potential default. So they had put in place strict requirements in terms of the borrowers' income and the “loan to value” ratios. Only such loans that met the established criteria were “agency eligible” – fit to be purchased by Fannie and Freddie.

To SIV’s, this constraint was a choke point. Their CP-CDO arbitrage machine needed the constant flow of mortgages. As the mortgage lenders ran out of qualified borrowers, the CDO supply line was affected. One obvious way – the only way, really – of maintaining the production line was loosening the lending standards. But the Fannie-Freddie requirements stood in the way.

So it was that in a late February ’01 meeting of the chief executives of some of the largest financial institutions in the U.S., a plot was hatched to finally take out the two agencies. The previous, less coordinated attacks on Fannie and Freddie had failed due to the strong support the agencies enjoyed in Congress and among the advocacy groups. Now, it was time to get serious. Under the heading “Finance CEOs to Press for Overhaul of Fannie, Freddie” the Wall Street Journal reported the plot on March 9, 2001:
A coalition of chief executives from more than a dozen large financial institutions has decided to press for reform of Fannie Mae and Freddie Mac … The decision to seek a review of the way the government-sponsored mortgage giants conduct their business was made two weeks ago at a meeting in Amelia Island, Fla., of the Financial Services Forum … The group, an intentionally low-profile organization of chief executives from the country’s biggest financial companies, backed the successful effort to repeal laws separating the banking and securities industries … Tensions have risen in recent years between the mortgage companies and other financial-service concerns amid fears that rapidly growing Fannie and Freddie would diversify and take business away from other companies.
What followed is a fascinating tale of media and perception control that touched upon the epistemological issue of the relation between the narrative and truth. In Vols. 4 and 5 of Speculative Capital I will at look at them in some detail. Suffice it to say that the whole affair was a stunning display of the falling-into-the-line of the media, academia and the regulatory agency in charge the moment the marching order was given. No dissent was allowed. Certainly no dissent was given any “air time”. The conformity that was initially forced and then internalized and “freely” expressed would make any commissar green with envy.

Three weeks after the fateful meeting, the Wall Street Journal led the charge with an editorial calling for the “investigation” of Fannie and Freddie for “threatening” their opponents. This was a reference to the agencies’ spirited resistance to previous attacks.
Perhaps the allegations of threats against political opponents will be investigated by Congress, and, if found to be true, will change the equation in Washington. Perhaps responsible members of Congress will realize that GSEs (government sponsored enterprises) – and Fannie and Freddie in particular – are uniquely problematic institutions that can do great harm to a market economy.
Why and how Fannie and Freddie “can do great harm to a market economy” was left unsaid. The smear campaign had begun.

A few months later, when a planted question raised the issue of Fannie and Freddie, the plainspoken Treasury secretary Paul O’Neill hinted at the plot (WSJ, July 5, 2001):
In a recent appearance, Mr. O’Neill fielded a question about the companies [Fannie Mae and Freddie Mac]. There were people who “in good faith” wanted to curb Fannie and Freddie’s privileges, he responded. But “most of them,” he added, “would not want to walk out here and stand with me and say that.”
The baton was then passed on to the executive branch which added a new warning about the dangers of Fannie and Freddie. The Wall Street Journal reported (February 5, '02):
The Bush Administration said Fannie Mae and Freddie Mac have funded their rapidly growing asset portfolios by increasing their debt outstanding and warned that the two companies may be taking on more risk with subprime loans.”
This was a curious criticism. Buying mortgages with the money borrowed on the strength of their credit rating was the very business model of Fannie Mae and Freddie Mac. True to the plot line, their raison d’etre was now being questioned.

Two days later, the Journal opened a new front, questioning the strength and reliability of the agencies’ earnings:
An accounting rule implemented by the companies last year has highlighted a highly volatile aspect of their business. … Companies must [now] record quarterly changes in the value of their derivatives. At Fannie Mae and Freddie Mac, the value of those derivatives has swung, and, as a result, they have reported unprecedented volatility in earnings and shareholder equity.
The new accounting rule and the “unprecedented volatility in earnings” that resulted were going to play a critical role in bringing down the agencies.

Meanwhile, the incessant negative coverage continued. The New York Times seized upon the collapse of Enron to make some not-so-subtle associations and level new charges:
Now, in the wake of Enron collapse, the argument over the companies has taken a new turn. Instead of taking on Fannie and Freddie over subsidies, their critics are arguing that the companies ... do not give enough information to regulators or investors ... Alan Greenspan, the Federal Reserve Chairman, expressed related concern in a speech ... “The broader risk for financial markets and economy result from the perception of government support for these corporations,” Mr. Greenspan said. ... Fannie Mae and Freddie Mac respond that they already disclose huge amounts of information about their portfolios and derivatives exposure, and that the fuss over the implicit government support and the companies’ used of derivatives is a red herring.
Note how Fannie and Freddie are hopelessly outmatched. Their defense sounds like the ridiculous denial of someone caught in the act. Who would you believe, after all, a functionary at a quasi-government enterprise or the Chairman of the Board of the Federal Reserve?

The “Maestro”, by the way, dishonored himself by being the most persistent besmearer of the agencies. His attacks carried extra weight because his utterances were given wide coverage, even when, as generally was the case, he uttered drivel. In the above paragraph, for example, he is saying that the “broader risk” – the more serious risk – facing the U.S. economy and the U.S. financial markets is that people believe Fannie and Freddie are safe and sound! Private finance never had a more mindlessly destructive errand boy.

Not that his intentions and actions were difficult to read. Here is the enfant terrible of the mortgage market, Angelo Mozilo, the CEO of Counterywide, in an interview with the New York Times:
Particularly irksome to [Angelo R. Mozilo] are calls by Alan Greenspan, the Federal Reserve Chairman, to shrink Fannie Mae ... “Fannie and Freddie are threats to his banks,” Mr. Mozilo said of Mr. Greenspan, whose agency regulates big bank holding companies. By buying his mortgages and thus freeing up his capital to solicit even more business, Fannie and Freddie are a big reason Mr. Mozilo has driven Countrywide past the Citigroups and Wells Fargos to the top of the mortgage heap. “If it wasn’t for them,” he said of Fannie and Freddie, “Wells knows they’d have us.”
Then in 2004 came the “accounting scandal”.

Fannie and Freddie were regulated by The Office of Federal Housing Enterprise Oversight (Ofheo), a regulatory backwater par excellence, if there ever was one. A regulatory body could be useful in attacking the GSEs. As luck would have it, in the person of Ofheo’s managers, the plotters found natural-born weathermen who knew which way the wind was blowing. So, starting with 2001, when it forced Fannie and Freddie to adopt fair value accounting as a prelude to what was to come, this cream puff of a regulatory agency was gradually transformed into a Rottweiler.

In 2004, Ofheo issued a strongly worded report criticizing Fannie Mae for using improper accounting methods. It further accused the agency of fostering a “culture” that had allowed the accounting and risk management system to deteriorate and become dysfunctional.

The details of the accusations are too technical to discuss here. More to the point, they are irrelevant; spending any time on them would be missing the main point. Floyd Norris, an old hand in business reporting in the New York Times, came closest to describing it fairly:
The accounting issues confronting Fannie Mae concerned two accounting rules. Neither is simple, and results from both can be changed if the company changes its assumptions. But the fact that a range of numbers might be appropriate did not give the company the right to pick numbers based on what figure would look best on its financial statements. Still, that is what the Ofheo report concluded happened.
The report got extensive coverage, especially because it charged that the earnings were “manipulated” to boost the bonuses of Fannie’s CEO and other executives. Franklin Raines, the CEO, was savaged in business talk shows and newspaper commentaries.

The proof is in the pudding. If there were any merits to the charges, Raines would be hung from the nearest tree. He was never charged, merely forced to resign retroactively – a puzzling concept until you realized that he was forced to return $50 million bonus he had received in the previous 5 years. That was a payback for the “arrogance” of the uppity black man who had ticked off his detractors by fighting back.

After the report, the Ofeho increased the regulatory capital on the agencies by an unheard-of 30 percent, the financial equivalent of a military blockade. That effectively ended the agencies’ active participation in the markets.

With Fannie and Freddie thus sidelined, mortgage underwriters had the field to themselves. The halcyon, anything goes days of mortgage lending began. Every day a new word entered into the lexicon of mortgage lending: alt A loans, no-doc loans, stated-income loans and “ninja” loans. What all these loans had in common was the suspect capacity of the borrower to pay back. A New York Times story described the frenzy::
[William D. Dallas, the founder of a mortgage brokerage] recalls being asked to make more “stated income” loans, in which lender do not verify the information provided by borrowers and brokers with tax returns, pay stubs or other documentations. The message, he said, was simple: You are leaving money on the table – do more of them.
In the summer ‘07, the value of mortgages in the U.S reached $12 trillion, a large portion of which had found their way into the CDOs. In the latter category, the ’05, ’06 and ’07 vintages stood out.

The rest, as they say, is history. The signs of the trouble appeared early in the ’07 as the indexes corresponding to mortgages fell. In April '07, a Fitch report sounded the alarm, highlighting the troubles of ‘05 and ’06 CDO vintages:
As the U.S. subprime market stresses continue to materialize, 2005 and 2006 vintage structured finance (SF) CDOs will be under greater ratings pressure as they have substantially larger concentrations of subprime RMBS, according to Fitch analysts.
In June ‘07, two mortgage funds managed by Bear Stearns folded. By late August, the hopes for a quick market rebound had faded.

Could Freddie and Fannie help stabilize the market by large scale purchasing of mortgages?

We will never know. The idea was proposed but rejected :
As the ominous drumbeat of bad news in the US subprime mortgage market continues, investors and politicians this week pinned hopes on government-sponsored mortgage groups Fannie Mae and Freddie Mac to come to the market’s rescue. Word that the US housing agencies had asked their regulator to raise caps on the size of their mortgage portfolios helped lift bond and equity markets on Monday as investors bet that the agencies could provide relief. But some analysts and Bush administration officials questioned the value of that relief in spite of support for action on Capitol Hill.
Losses mounted. The crisis intensified. Now even the good quality mortgages were affected. In November ‘07, Freddie Mac reported 3rd quarter losses of about $2 billion, mostly due to the deterioration in the mortgage market. Freddie’s CEO used the occasion to appeal for a sympathetic hearing:
Mr Syron [Freddie Mac’s CEO] tacitly blames US regulators for Freddie’s problems, highlighting the complex politics when troubles hit Freddie and its larger rival, Fannie Mae. …“We have the opportunity to put profitable business on the book but we are constrained by capital requirements. That is a major factor,” Mr Syron said.
The Financial Times begged to differ. It said that the loss showed that “ “tough stance on Freddie and Fannie was vindicated” ” and made its pages available to Ofheo to say just that. The agencies were not to be given a break.
James Lockhart, Ofheo director … takes issue with some analysts’ belief that by being capital-constrained, the GSEs might no longer provide the financial lifeline to private-sector mortgage lenders such as Countrywide. He says: “They have a lot of flexibility. That’s why I think some of the market has overreacted, if I may say that.” … He rejects suggestions that the GSEs should be temporarily allowed to securitize loans of more than $417,000. He says … they don’t have the risk management system.
All this meant that the tough stance on Freddie and Fannie was vindicated!

As John Wayne would say, like hell it was.

By early ‘08, a full blow crisis was at hand. A January ‘08 report by the S&P pointed to the vulnerable areas.
We believe U.S. RMBS transactions backed by subprime loan collateral of all vintages could be adversely affected by our pending assumption changes, especially those transactions issued in 2005, 2006, and 2007.
Still, Fannie and Freddie remained in shackles.

On the evening of Friday, March 14, Bear Stearns employees went home. Someone should have warned them of Ides of March. On Monday, March 17, they returned to the news that their firm was gone, given away to JPMC at $2 per share. This was a financial 2x4 that hit the collective head of all “participants in the financial markets”. Even the thickest of the thick got the message: things were spinning out of control.

Three days later, came a U-turn, presented as a “break for Freddie and Fannie
With the blessing of Bush administration, the regulator of Fannie Mae and Freddie Mac, the nation’s two largest mortgage finance companies, eased a major restriction on the companies on Wednesday in an effort to unfreeze credit markets and stabilize housing prices. By reducing the extra cushion of capital the two companies have been required to hold since 2004, the regulator, the Office of Federal Housing Enterprise Oversight, is enabling the companies to invest $200 billion more in home loans.
The risk management systems were now fine.

But it was too late; the meltdown was already under way. Fannie and Freddie’s shares kept drifting downward until in July they collapsed. The end of the mission was in sight.

Now it was time to save the agencies!

But how and why would you save entities that you sought to destroy?

Fannie and Freddie have upwards of $5 trillion mortgage-related exposure either in the form of straight agency bonds or the MBSs. Their bonds, especially, are held by virtually every financial institution in the U.S. and many others concerns around the world. So there never was – simply could not have been – a question of allowing them to fail. The seemingly frantic “rescue” efforts that involved the Treasury Department, Federal Reserve and Congress were mere theatrics. The end result, which was a blank Treasury check to Fannie and Freddie, was a foregone conclusion from the start, palm-on-forehead and head-in-hands poses of grave looking officials notwithstanding.

“Saving” meant bailing out the bondholders only. Now it also had to include a “regime change” of sort in Fannie and Freddie – ensuring that they would never regain their previous position.

The Wall Street Journal, which had fired the opening salvo against Fannie and Freddie in ’01, led the way in calls to dismantle them. In a July 10 editorial, it called for shrinking “these monsters to a less dangerous size,” and went on to say:
These columns have warned about Fannie Mae and Freddie going back to 2002, and our fate has been to climb a wall of denial and hostility.
Observe the journalistic standards. First, there is the claim of climbing “a wall of denial and hostility” while the truth is exactly the opposite: one way, coordinated assault on Fannie and Freddie without any response, a public relations version of shooting fish in a barrel. Also note the reference to 2002 instead of 2001, which is probably intended to hide any potential link with the Financial Services Forum.

At this point, though, it did not matter. Unless you had been paying very close attention – and I am not aware if anyone outside the maligned management at Fannie and Freddie did – it was impossible to make heads and tail of the situation. The failure and dangers of Fannie and Freddie were established as historical facts, beyond doubt and dispute. Scripta manent.

Naturally, the grand names of economics and finance were heard from: Joseph Stigler, the people’s economist, Larry Summers, the ex wunderkind, El-Erian, the all purpose commentator and, of course, George Soros, all wrote on their volition and with free will to say the same exact things about Fannie and Freddie. Soros, writing in the Financial Times, typified them:
The companies have been plagued by accounting problems and other irregularities; their management have spent enormous sums lobbying Capitol Hill. This is not a business model that deserves to be perpetuated.
The philosophical-intellectual trader had swallowed the bait, hook, line, reel and rod.

The game was over. One half trillion dollar losses later, the mission was accomplished. The New York Times spelled out what had to be done now – what was expected.
The government would have to take control of Fannie and Freddie until the housing crisis passed, and then debate how best to sever the links between the government and the companies.
That was the plan all along: for the government to cut loose Fannie and Freddie and turned them into private enterprise. Their success, like Medicare, might have given people ideas.

Still, like a B-movie monster that refuses to die, there were concerns that Fannie and Freddie might not be completely out of the picture. So the Times ended the editorial with a statement that had the elements of threat, wish, prophecy and promise. It said:
Fannie and Freddie may yet muddle through without an explicit bailout … But there is no return to the old normal. The future of Fannie and Freddie will be different from their past.

I will return shortly with the epilogue. (Shortly, I promise.)