Fannie Mae Bethany McLean

Why Fannie Mae And Freddie Mac Remain Frightening

Karen Shaw Petrou memorandum to the Federal Financial Analytics Clients on why Fannie Mae and Freddie Mac remain frightening.

TO: Federal Financial Analytics Clients

FROM: Karen Shaw Petrou

DATE: October 23, 2015

Earlier this week, Fannie Mae told mortgage bankers that it’s now a “holder and mover” – not a warehouse – of mortgage credit risk. Freddie has previously described itself as a “buyer and seller,” also taking itself out of the GSEs’ bread-and-butter guarantee business. With this transformation, the GSEs are complying with the Administration’s demands and sharing what was once their wealth. However, it’s not that easy. Fannie and Freddie can shed credit risk while the market is devouring high-yield deals with an “effective” USG guarantee. At any point at which the music stops, the GSEs may well find themselves stuck with a big pile of non-transferable credit risk and a portfolio they cannot fund unless Treasury bails them out again or the market absorbs a huge, sudden issue of GSE debt backed by an “effective” USG guarantee. In short, we can pretend we’re making Fannie Mae and Freddie Mac disappear, but we’re actually turning the GSEs into still bigger simulacrums of their old, risky selves.
I don’t blame the GSEs for coming up with their new gig. They didn’t. While the Obama Administration can’t get Congress off the GSE dime, it can and, through FHFA, has done as much as it can to restructure Fannie Mae and Freddie Mac into entities that serve national need without posing systemic risk. A sweet thought, but there’s flat-out no way for Fannie and Freddie to do their master’s bidding and support the entire U.S. residential-mortgage market without being way big and, thus, ultra-systemic.

To be sure, the White House, Treasury, and FHFA have done a lot to the GSEs’ on- and off-balance sheet books. Through stringent portfolio restrictions, they’ve whittled away the big on-balance sheet portfolios of all sorts of stuff that long supported GSE earnings as well as, some say, sparking the financial crisis. To shrink the GSEs even more, policy-makers have now also gone after the still more-intransigent part of the book – guarantees – not by hiking g-fees in ways that would allow private competition (maybe), but rather by forcing Fannie Mae and Freddie Mac to hive off their guarantee risk after taking it on. A growing series of risk-share transactions is thus establishing just how the GSEs can do this, who will take the risk, and how much it costs to execute this complex risk shuffle.

So far, the deals are moving well and FHFA and the GSEs have thus decided to do more – hence the new GSE mission statements. It seems like the perfect no-action sort-of solution – Washington’s favorite kind. In it, Congress and the Administration do nothing, while seeming to do something because Fannie Mae and Freddie Mac’s on- and off-balance sheet books dwindle without any decrease in originations of the thirty-year, fixed-rate mortgages so beloved of constituents and, thus, also of policy-makers regardless of party.

The only problem is that this solution only works for as long as interest rates are low, macroeconomic growth is positive, and no one rattles the cage. Despite the good times, private investors now gobbling up GSE risk-shares could decide not to play. This decision could be made gradually as rates rise and deals better pair risk and reward, especially if risk perceptions discount the GSEs’ federal backstop as any real reform demands. Or, far worse, the market could snap shut because hedge funds, insurance companies, pension funds, and the others bellying up to the risk-share bar come under acute market stress – the 2007-08 scenario that shut down bank mortgage securitization at terrific cost to their liquidity and, then, the financial market.

Fannie Mae and Freddie Mac have no capital against their credit risk because of the USG’s backstop. The holder/mover and buyer/seller plan is designed to self-privatize the GSEs by substituting private capital for the GSEs as credit risk changes hands. However, it’s not just credit risk that sparks systemic debacles – liquidity risk is even more pernicious.

It was liquidity risk that created solvency risk, although admittedly highly-leveraged companies like AIG and Lehman were sitting ducks. Maybe they could have made it out of their credit-risk holes given time and access to the federal liquidity support that buttressed banks until the storm grew too ferocious. But, without liquidity or Federal Reserve access, non-bank risk – including that at Fannie Mae and Freddie Mac – went from bad to really worse with breath-taking speed.

The real road to GSE reform requires a comprehensive prudential framework that recognizes what sparks risk across an on- and off-balance sheet book of business, builds in protections at shareholder cost, backs them with federal facilities for public policy purposes, and ensures orderly resolution if all else fails. Covering up GSE solvency problems with risk transfers only makes Fannie Mae and Freddie Mac still more vulnerable to liquidity risk –in short, it’s no way out.

Fannie Mae Bethany McLean

Fannie Mae

Comments (4)

  • Goforfreedom

    Fannie and Freddie did not share their profits. Mr. Lew is stealing them. People forget that this is a public company with shareholders who are being robbed. Last I saw Fannie and Freddie made billions in profits last quarter and mr Lew stole it all. Maybe you should be writing articles on how the govt is breaking laws. The goal now is for the govt to bash and take their billions each quarter. This is the biggest heist in AMERICAN history

    October 23, 2015 at 4:07 pm
  • Anthony Ellis

    The big banks got America and the GSE’s into trouble, yet government didn’t high-jack them like they did Fannie and Freddie.

    October 23, 2015 at 4:12 pm
  • chiefSeattle

    This article is overthinking. Systemic risk pervades so many aspects of our economy besides Fannie & Freddie. It cannot be eliminated. Also, you cannot steal something and THEN reform them, for they are not the governments to reform. Weren’t you aware of that?

    But a nation without LAWS cannot function, or reform anything at all. The best advice is: Follow the law first! There is nothing wrong with the law. We are a nation of laws, in fact. We don’t steal and then reinvent things to our liking. Create your fantasy Utopia AFTER laws are in place and followed. I invite you to read the law before disregarding it.

    October 23, 2015 at 11:21 pm
  • chiefSeattle

    Oh by the way. The GSE’s were never in solvent. Who told you that?

    October 23, 2015 at 11:25 pm

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