2 things: Greed and no Risk Management.
In the past few days Hank Greenberg, the former CEO of AIG, has admitted that the finance part of AIG hurt the business as well as the "dissapearance of Risk Management."
The two are related to the company's over use of credit in the early part of this decade. At the time of failure, AIG's leverage was 60 to 1. There was definetly no risk management oversite to the finance area. This overleveraging was due in part to AIG's issuance of over $440 Billion in Credit Default Swaps. These financial instruments are used to create an insurance policy against bonds for a fee. Issuing $44o Billion in CDS meant quite a bit of revenue for AIG. (If there was any question of how AIG made huge profits year after year in the early part of this century, as it was to many in the industry, including regulators, we now know the answer.) And since now asset backed securities, derivatives, and bonds are all becoming worthless, AIG is responsible for all payments on their CDS. They cannot fulfill these obligations and, in turn, have become insolvent. This means that all the institutions that they sold these obligations to are losing their insurance. If this is allowed to happen it would trigger the end of our financial system as we know it because if AIG fails, many institutions would soon follow. The result was a hesitant government bailout merely to prevent the fallout of such events.
Thursday, September 25, 2008
Monday, September 15, 2008
Implications of an AIG Failure
Lehman brothers was allowed to fail today without a government bailout, and without a buy out (although there was opportunity for the latter by the Korean Bank KDB as I discussed in a previous post.) It could be assumed that the failure of this bank was a risk the government was willing to take in its strategy of picking and choosing companies in order avoid a complete collapse of the U.S. banking system. AIG, however, with its balance sheet worth over a trillion dollars, does not appear on the list of companies that will be allowed to fail and shouldn't. The implications of AIG failing are much greater than Lehman Brothers. AIG faces the threat of a credit downgrade from the rating agencies if the company is not able to sell its assets and raise capital. Personal insurance under the insurer would not be affected but commercial insurance would. If AIG was to receive a downgrade commercial interests across the world would not meet its obligations of having high grade insurance and would be forced to find insurance elsewhere. This would create opportunity for companies such as Metlife, Allstate, Prudential, Chubb, and The Travelers as AIG would lose a substantial portion of this market share. This is needless being that a substantial portion of AIG's woes come from its risky backing of complex derivative securities. AIG spans 130 countries with assets so large in number it would be impossible to quantify. It's failure would be incredible.
My contention on action must be weighed against it's ultimate benefit to society. You can say that all of these delicate actions to keep the country's economy afloat is ultimately beneficial in that it is preventing another great depression. You can also say that we are merely propping up the dead in the name of preventing a collapse - this having great social risks in itself through moral hazard. AIG was given a 20 Billion loan from the state of New York to create a bridge to sell more of its assets. Another 20 Billion is still needed which will presumably come from the federal government. If AIG can overlook its pride, the best course of action would be to sell all of its assets as cheap as they can and divide up what has become too large to quantify and too risky to manage. Merrill did this very intelligently. Bank of America bought the company cheap which at least keeps the company alive. I am personally impressed with the CEO of that company, John Thaine, for his diligent, selfless actions to save that company from collapse. AIG needs to do the same, as do all other companies in danger of collapsing in order to prevent a financial calamity with far reaching social consequences.
My contention on action must be weighed against it's ultimate benefit to society. You can say that all of these delicate actions to keep the country's economy afloat is ultimately beneficial in that it is preventing another great depression. You can also say that we are merely propping up the dead in the name of preventing a collapse - this having great social risks in itself through moral hazard. AIG was given a 20 Billion loan from the state of New York to create a bridge to sell more of its assets. Another 20 Billion is still needed which will presumably come from the federal government. If AIG can overlook its pride, the best course of action would be to sell all of its assets as cheap as they can and divide up what has become too large to quantify and too risky to manage. Merrill did this very intelligently. Bank of America bought the company cheap which at least keeps the company alive. I am personally impressed with the CEO of that company, John Thaine, for his diligent, selfless actions to save that company from collapse. AIG needs to do the same, as do all other companies in danger of collapsing in order to prevent a financial calamity with far reaching social consequences.
Wednesday, September 10, 2008
Privately Sponsored Public Security
When reading Professor Klein's post, "Public Goods and Risk Management", I was reminded of an anecdote I had heard on a radio show about privately sponsored militarys hired after Hurricane Katrina. The story alarmed me in its descriptions of obvious conflicts of interest. The caller on the radio show spoke about a special police force he had encountered in the wake of Katrina which didn't appear to be U.S. military. It wasn't in fact, it was a private company hired by the U.S. government to protect special interests in the area. The caller described how he went up to the men asking for assistance and receieved a response indicating lack of care or concern. The caller described their snide comments about the situation and how they were saying they were being paid so much for doing nothing.
In researching more about companies offering these services, I found information on a few. I found companies offering "risk advisory services" like Kroll, Inc., CRG, and Global Options, Inc. Global Option's company profile described itself as "a multi-disciplinary, international, risk management and business intelligence company."..."the staff of professionals includes former intelligence and law enforcement officers, veterans of America's elite military units, and legal and crisis communication specialists."
Kroll has a security service and describes itself here:
"Global threats are forcing companies to take a harder look at their security programs.
Kroll’s experts in security, protection, engineering, business continuity and emergency management help clients prevent, prepare for and respond to the many threats they face at home and abroad.
From assessment to implementation, clients benefit from Kroll's seamless integration of services, resulting in a more efficient, cost-effective security program. Our experts develop proactive, tiered approaches that can respond quickly to changing threat conditions and help ensure operational continuity in the wake of a crisis."
Here is a description of some of the activities of private militarys and their involvement with the U.S. Department of Defense:
The laws surrounding hired soldiers and civilian contractors is not clear and not well defined under international agreements. This is a reason why increasingly the focus is regulation at the national level; e.g. as the licensing mechanisms used by the United States and South Africa demonstrate. Yet many of the hired soldiers are not American; they could be from the country of conflict, or flown in from Chile, El Salvador, or South Africa. Exactly what jurisdiction, aside from their employer, they are under is, according to some commentators, uncertain. [1]
This is true for American contractors as well. Civilian contractors working for Dyncorp in the Balkan wars were implicated by a fellow employee for indulging in a child prostitution and sale ring in the war torn country. [2] Those who turned in the employees were fired, and later the offending employees were fired , however not charged with anything. [3]
Some of the interrogators in the Abu Ghraib crimes were civilian contractors provided by Titan and CACI. They have yet to be charged for any crimes, however they are being sued as are the two companies. [4][5][6] All three companies have continued to receive large wartime contracts from the US government.
In 2006, the US Congress published an official report on US enterprises that had signed contracts with the State Department or the Defense Department so as to carry out anti-narcotics activities as a part of Plan Colombia. Most the private contract enterprises are under the responsibility of the Defense Department, but the largest contract (DynCorp) is in the hands of the State Department.
I believe it is dangerous for the public to have privately funded public services as the services are more likely to be bent to serve the interests of the ones writing the checks.
“The mercenaries and auxiliaries are useless and dangerous, and if anyone supports his state by the arms of mercenaries, he will never stand firm or sure, as they are disunited, ambitious, without discipline, faithless, bold amongst friends, cowardly amongst enemies, they have no fear of God, and keep no faith with men,” wrote Machiavelli in The Prince.
http://www.sourcewatch.org/index.php?title=Global_Options%2C_Inc.
http://www.kroll.com/services/security/
http://www.sourcewatch.org/index.php?title=PMC
In researching more about companies offering these services, I found information on a few. I found companies offering "risk advisory services" like Kroll, Inc., CRG, and Global Options, Inc. Global Option's company profile described itself as "a multi-disciplinary, international, risk management and business intelligence company."..."the staff of professionals includes former intelligence and law enforcement officers, veterans of America's elite military units, and legal and crisis communication specialists."
Kroll has a security service and describes itself here:
"Global threats are forcing companies to take a harder look at their security programs.
Kroll’s experts in security, protection, engineering, business continuity and emergency management help clients prevent, prepare for and respond to the many threats they face at home and abroad.
From assessment to implementation, clients benefit from Kroll's seamless integration of services, resulting in a more efficient, cost-effective security program. Our experts develop proactive, tiered approaches that can respond quickly to changing threat conditions and help ensure operational continuity in the wake of a crisis."
Here is a description of some of the activities of private militarys and their involvement with the U.S. Department of Defense:
The laws surrounding hired soldiers and civilian contractors is not clear and not well defined under international agreements. This is a reason why increasingly the focus is regulation at the national level; e.g. as the licensing mechanisms used by the United States and South Africa demonstrate. Yet many of the hired soldiers are not American; they could be from the country of conflict, or flown in from Chile, El Salvador, or South Africa. Exactly what jurisdiction, aside from their employer, they are under is, according to some commentators, uncertain. [1]
This is true for American contractors as well. Civilian contractors working for Dyncorp in the Balkan wars were implicated by a fellow employee for indulging in a child prostitution and sale ring in the war torn country. [2] Those who turned in the employees were fired, and later the offending employees were fired , however not charged with anything. [3]
Some of the interrogators in the Abu Ghraib crimes were civilian contractors provided by Titan and CACI. They have yet to be charged for any crimes, however they are being sued as are the two companies. [4][5][6] All three companies have continued to receive large wartime contracts from the US government.
In 2006, the US Congress published an official report on US enterprises that had signed contracts with the State Department or the Defense Department so as to carry out anti-narcotics activities as a part of Plan Colombia. Most the private contract enterprises are under the responsibility of the Defense Department, but the largest contract (DynCorp) is in the hands of the State Department.
I believe it is dangerous for the public to have privately funded public services as the services are more likely to be bent to serve the interests of the ones writing the checks.
“The mercenaries and auxiliaries are useless and dangerous, and if anyone supports his state by the arms of mercenaries, he will never stand firm or sure, as they are disunited, ambitious, without discipline, faithless, bold amongst friends, cowardly amongst enemies, they have no fear of God, and keep no faith with men,” wrote Machiavelli in The Prince.
http://www.sourcewatch.org/index.php?title=Global_Options%2C_Inc.
http://www.kroll.com/services/security/
http://www.sourcewatch.org/index.php?title=PMC
Thursday, September 4, 2008
Lehman Brothers and Merrill Lynch
With the fall of Bear Stearns in March other major investment bank names began popping up in speculation over their possible failure. Lehman Brothers, Merrill Lynch, and Morgan Stanley were said to have high counterparty exposures to the failed bank and would have followed suit had Bear not been bailed. We discussed the sale of assets by failing companys to capture some equity before an ultimate collapse. This would almost seem the case with Lehman and Merrill. Lehman and Merrill have both been putting up pieces of it's companies for sale in the past couple months which would, if today's discussion can be applied, indicate an imminant failure or atleast a slow unraveling of a doomed enterprise. Because it is against the law to start rumors and short big banks on Wall Street now-a-days, and because of these increasingly large sales of assets, especially with a bid to buy 25-50% of Lehman by Korean Bank KDB, I would be willing to bet (not on the open market) that Lehman Brothers and Merrill Lynch are failing.
http://ap.google.com/article/ALeqM5gdhcgQsMtGn3t44cuC8W6GaVJxcQD92V73UO0
http://www.cnbc.com/id/26546070
http://ap.google.com/article/ALeqM5gdhcgQsMtGn3t44cuC8W6GaVJxcQD92V73UO0
http://www.cnbc.com/id/26546070
Monday, September 1, 2008
Moral Hazard in Fannie Mae and Freddie Mac
Dr. Bob mentioned controlling moral hazard in his last post. The following blog describes the highest height of moral hazard currently facing the U.S. It describes the actions of Fannie Mae and Freddie Mac as it used government subsidized guarantees to essentially create "risk free" securities. These securities created an insatiable appetite for Freddie and Fannie to purchase their own products. Restricted only by strict underwriting standards, the corporations grew their "golden goose" by easeing those credit standards. These actions, based in moral hazards are, in large part, responsible for the creation of the U.S. credit crisis. As the end of the blog implies, the moral hazard created in the 80s and 90s is seemingly only fixed by more of the same moral hazards.
There are two stocks now in the stock market which are not capable of ever reaching zero because they are backed by the U.S. government. How is this possible? What are the implications for capitalism in such a case?
"Guaranteeing oneself against risk is not insurance, its an exercise in futility."
http://billburnham.blogs.com/burnhamsbeat/2008/07/fannie-maes-gol.html
07/11/2008
Fannie Mae's Golden Goose: A Lesson In Moral Hazard
In the mid 1990’s I spent over a year as part of a team consulting to Fannie Mae. Given that they have been in the news a bit over the last few days, I thought it might be interesting to pass along a few observations that initially crystallized during my time there.
The World’s Biggest Mortgage Bank:
For those of you that don’t know Fannie Mae, it is one of the largest financial institutions in the county with over $880BN in assets. It is almost exclusively focused on buying, selling, and guaranteeing single family residential mortgages. Fannie Mae was originally a US government agency, but became a public company in the 1970s. Despite being a public company, Fannie Mae has remained a quasi-government agency subject to federal oversight and regulation. This government regulation, combined with a few perks such a direct credit line from the US Treasury as well as its overwhelming size and importance to the US housing market has resulted in what amounts to an implicit US government guarantee that Fannie Mae (and its cousin brother Freddie Mac) will never default on their debt. There is no law or regulation to that effect, just an assumption by the market that Fannie Mae is too big, too close and too important to the government for the government to ever let Fannie Mae fail. With the mortgage market in massive turmoil and Fannie Mae’s stock down 85% in the last year, that assumption is currently being heavily tested.
I don’t know exactly what the future holds for Fannie Mae, but I think I can shed some light on how it got in this position in the first place. The seeds of Fannie Mae’s current crisis were actually sown in the recovery from its last crisis. In the mid-1980s Fannie Mae almost went out of business thanks in large part to some very poor and rather unsophisticated asset and liability management practices. What basically happened is that the aggregate cost of Fannie Mae’s debt exceeded the income it was deriving from its (then relatively modest) mortgage portfolio. This never should have happened given the instruments and strategies available to Fannie Mae’s finance team, but they had become somewhat complacent and had failed to keep up with the state of the art in portfolio and treasury management.
Creating the Golden Goose:
A new team of people took over the finance side of Fannie Mae and implemented a series a relatively sophisticated and ultimately incredibly profitable Asset and Liability Management (ALM) strategies. One of the key innovations was issuing debt instruments, specifically callable debt instruments, that enabled Fannie Mae to much more closely match both the duration and pre-payment characteristics of its Assets (primary residential mortgage securities) with its debt (primarily Fannie Mae corporate debt). Normally, callable debt is quite expensive (much more expensive than residential mortgage debt), because bond holders want to be compensated for selling the call option to the issuer, but thanks to Fannie Mae’s quasi-government status it was able to issue this callable debt at yields that were only marginally above straight treasury yields. This debt combined with a more sophisticated overall ALM approach, not only reduced Fannie Mae’s borrowing costs significantly, but enabled it to very quickly adjust its portfolio in the event of rapid changes in pre-payments.
With this strategy in hand, not only could Fannie Mae buy mortgage securities for less than the cost of its debt (and thus earn a nice spread), but it could almost entirely contain pre-payment risk effectively making the purchase of mortgage securities “risk free” except for credit risk, which itself was very low thanks to Fannie Mae’s strong underwriting guidelines. Fannie Mae had discovered the equivalent of a financial golden goose.
Let’s Get This Party Started:
With its golden goose in hand, Fannie Mae almost immediately began buying a lot more mortgage securities. Who did it buy these securities from? Why none other than Fannie Mae itself. You see Fannie Mae’s original role was to buy mortgages from individual banks, package them up into securities, guarantee those securities against loss, and then sell them to other financial institutions. However once Fannie Mae realized that the “golden goose” allowed them to buy those same securities for its own portfolio and lock-in “risk free” profits, Fannie became a major buyer of its own securities. Fannie Mae was thus in the rather bizarre position of guaranteeing an ever increasing portion of its own assets against default.
By the time I showed up in the mid-1990’s, Fannie Mae had become one of the largest buyers of its own securities. Its stock was up over 40X from it’s 1980s nadir and it seemed as though the single biggest problem it had was deciding on how much money it wanted to make. This was a bigger problem than you might imagine because as a quasi-government agency, and a constant political football, Fannie Mae realized it couldn’t be seen to be abusing its market position. So rather than go crazy and buy every mortgage security in sight, Fannie Mae just settled on charting a nice predictable upward growth in earnings fueled largely by buying an ever increasing share of its own securities.
Now a normal private company could not pursue this strategy because as it issued more and more debt to fund the golden goose, the yields on the incremental debt would start to increase to the point where the strategy no longer made sense. But Fannie Mae was different. Because of the implicit government guarantee of its debt, Fannie could issue incremental debt with little or no regard to its existing debt load because everyone assumed the federal government would backstop the debt.
Fannie Mae’s only significant problem thus became that the supply of mortgage securities would prove insufficient to fund its projected earnings growth (which was well above the projected growth in mortgage debt). As a result Fannie began a series of largely successful political campaigns to increase the volume of mortgage securities available to fund their habit. Theoretically, the easiest way to increase the supply of mortgage securities was to get the federal government to increase the size limit of mortgages that Fannie could buy and guarantee, but this was a very difficult political fight for Fannie to win because commercial and investment banks dominated the so-called “jumbo” mortgage market and, already smarting from Fannie’s dominance of the so-called “conforming” market, they had drawn a line in the sand in the jumbo market and committed most their lobbying resources to keeping Fannie’s size limit as low as possible.
Moral Hazard vs. Mo’ Money:
While Fannie still fought to increase its size limits, it quickly found another, much more politically palatable, way to increase the pool of mortgages it could buy: it dropped underwriting standards under the guise of increasing “home ownership” and “affordability”. Traditionally, Fannie had required the mortgages it purchased to be so-called 80/20 mortgages wherein the borrower puts at least a 20% down payment on the mortgage. This was a requirement because residential mortgages in the US are a “no-recourse” loan in which the borrow can generally “walk away” from the loan with no recourse to the lender other than seizing the house and reporting the default to a credit agency. A 20% down payment was generally thought to be enough to dramatically limit the moral hazard of borrowers “walking away” because housing values would have to decline 20%+ for the borrower to be underwater and even then the borrower would still face the prospect of losing their own sunk capital which makes walking away even more difficult from a psychological perspective
The problem with a 20% down payment is for many people it was very hard to come up with that big a down payment and thus it limited the total size of the mortgage market which in turn limited the volume of mortgage securities that Fannie Mae could purchase for its golden goose. While the obvious solution to this problem is just to lower the down payment requirement, Fannie couldn’t do this unilaterally because the government unit that regulated it would see such cuts as needlessly raising Fannie Mae’s risk profile. Far more politically astute that that, Fannie Mae began a campaign to increase “home ownership” and “affordability”. It created a home ownership “foundation” which opened offices in almost every congressional district and promptly set about mobilizing all the local advocates for “affordable” housing to put pressure on their elected representatives to let Fannie Mae offer “affordable housing programs”. Of course, “affordable housing problems” was just a euphemism for allowing Fannie Mae to lower its underwriting standards so that more mortgages could be created and the golden goose could thus kick out more golden eggs.
This proved to be a highly effective political coalition for Fannie Mae. Not only did they build a huge network of grass roots political supporters through their “foundation”, but politicians saw political advantages in supporting the programs because it cast them in the role of trying to help families buy a new home (as opposed to lowering underwriting standards to help a giant corporation keep up its earnings growth by taking a free ride on the US government’s guarantee). Even commercial banks and investment banks signed on to the program because it at least resulted in higher origination fees and an expanded credit market, even if most of the assets ultimately went to Fannie Mae and Freddie Mac.
A Victim of Its Own Success:
Fast forward to the mid-2000’s and Fannie Mae’s financial and political strategy was largely a resounding success. Fannie was now offering a wide range of mortgages that required less than a 20% down payment including even some that required no down payment at all! These products had dramatically increased the addressable size of the mortgage market. The increased size of the mortgage market enabled Fannie to purchase a massive amount of its own mortgage securities. In fact by this point Fannie Mae had become the single largest purchaser of its own securities. These newly purchased assets in turn enabled Fannie to continue to grow earnings which in turn supported a stock price that continued to trend nicely upward (though at a much more modest rate).
However beneath the seeming calm, the seeds for Fannie’s distress were now firmly planted. Fannie’s drive to lower underwriting standards had created a pool of mortgage debt with a much higher level of embedded moral hazard risk as well as good old fashioned credit risk. Fannie’s purchases of mortgage securities were so large that it was getting increasingly difficult to feed the golden goose enough food. On top of all that, with hundreds of billions of dollars of assets and liabilities to manage, Fannie's ALM strategies had become more and more complex and some of its bread and butter strategies started to become less profitable as the sheer weight of over half a trillion dollars of debt started to compress spreads (it would seem that even an implicit government guarantee has its limits).
It is no coincidence that the current mortgage crisis started in the so-called sub-prime market as that’s the mortgage market with the lowest credit quality and underwriting standards, however as the mortgage crisis has spread it has become increasingly clear that the traditional conventional, conforming mortgage market, long the domain of Fannie Mae and Freddie Mac, shares many more similarities with the sub-prime market than it would like to admit. While credit and underwriting standards are clearly much higher in the conforming market, they are also undoubtedly much lower than they were 10 or 20 years ago. What’s more the two biggest insurers against loss in that market now happen to also be the biggest owners in that market thanks to 20 years of purchasing mortgages to fund their government subsidized golden gooses. Guaranteeing oneself against risk is not insurance, its an exercise in futility.
The Goose Is Not Dead Yet:
Despite all of this, I personally don’t expect either company to go out of business. If recent comments from a slew of politicians are any indication, they are indeed “too big to fail”.
What I find most ironic in all of the current commotion is that rather than trying to address the root causes of Fannie Mae’s precarious state: dramatically lower underwriting standards and a massively levered balance sheet taking a free ride on the government’s back, politicians are doing the exact opposite: they are dramatically increasing the size of the mortgages that Fannie and Freddie can buy and pressuring them to maintain and even further lower their already un-sustainably low underwriting standards. I don’t know where this ends, but reinforcing the bad behavior that led to the crisis in the first place can’t end well
There are two stocks now in the stock market which are not capable of ever reaching zero because they are backed by the U.S. government. How is this possible? What are the implications for capitalism in such a case?
"Guaranteeing oneself against risk is not insurance, its an exercise in futility."
http://billburnham.blogs.com/burnhamsbeat/2008/07/fannie-maes-gol.html
07/11/2008
Fannie Mae's Golden Goose: A Lesson In Moral Hazard
In the mid 1990’s I spent over a year as part of a team consulting to Fannie Mae. Given that they have been in the news a bit over the last few days, I thought it might be interesting to pass along a few observations that initially crystallized during my time there.
The World’s Biggest Mortgage Bank:
For those of you that don’t know Fannie Mae, it is one of the largest financial institutions in the county with over $880BN in assets. It is almost exclusively focused on buying, selling, and guaranteeing single family residential mortgages. Fannie Mae was originally a US government agency, but became a public company in the 1970s. Despite being a public company, Fannie Mae has remained a quasi-government agency subject to federal oversight and regulation. This government regulation, combined with a few perks such a direct credit line from the US Treasury as well as its overwhelming size and importance to the US housing market has resulted in what amounts to an implicit US government guarantee that Fannie Mae (and its cousin brother Freddie Mac) will never default on their debt. There is no law or regulation to that effect, just an assumption by the market that Fannie Mae is too big, too close and too important to the government for the government to ever let Fannie Mae fail. With the mortgage market in massive turmoil and Fannie Mae’s stock down 85% in the last year, that assumption is currently being heavily tested.
I don’t know exactly what the future holds for Fannie Mae, but I think I can shed some light on how it got in this position in the first place. The seeds of Fannie Mae’s current crisis were actually sown in the recovery from its last crisis. In the mid-1980s Fannie Mae almost went out of business thanks in large part to some very poor and rather unsophisticated asset and liability management practices. What basically happened is that the aggregate cost of Fannie Mae’s debt exceeded the income it was deriving from its (then relatively modest) mortgage portfolio. This never should have happened given the instruments and strategies available to Fannie Mae’s finance team, but they had become somewhat complacent and had failed to keep up with the state of the art in portfolio and treasury management.
Creating the Golden Goose:
A new team of people took over the finance side of Fannie Mae and implemented a series a relatively sophisticated and ultimately incredibly profitable Asset and Liability Management (ALM) strategies. One of the key innovations was issuing debt instruments, specifically callable debt instruments, that enabled Fannie Mae to much more closely match both the duration and pre-payment characteristics of its Assets (primary residential mortgage securities) with its debt (primarily Fannie Mae corporate debt). Normally, callable debt is quite expensive (much more expensive than residential mortgage debt), because bond holders want to be compensated for selling the call option to the issuer, but thanks to Fannie Mae’s quasi-government status it was able to issue this callable debt at yields that were only marginally above straight treasury yields. This debt combined with a more sophisticated overall ALM approach, not only reduced Fannie Mae’s borrowing costs significantly, but enabled it to very quickly adjust its portfolio in the event of rapid changes in pre-payments.
With this strategy in hand, not only could Fannie Mae buy mortgage securities for less than the cost of its debt (and thus earn a nice spread), but it could almost entirely contain pre-payment risk effectively making the purchase of mortgage securities “risk free” except for credit risk, which itself was very low thanks to Fannie Mae’s strong underwriting guidelines. Fannie Mae had discovered the equivalent of a financial golden goose.
Let’s Get This Party Started:
With its golden goose in hand, Fannie Mae almost immediately began buying a lot more mortgage securities. Who did it buy these securities from? Why none other than Fannie Mae itself. You see Fannie Mae’s original role was to buy mortgages from individual banks, package them up into securities, guarantee those securities against loss, and then sell them to other financial institutions. However once Fannie Mae realized that the “golden goose” allowed them to buy those same securities for its own portfolio and lock-in “risk free” profits, Fannie became a major buyer of its own securities. Fannie Mae was thus in the rather bizarre position of guaranteeing an ever increasing portion of its own assets against default.
By the time I showed up in the mid-1990’s, Fannie Mae had become one of the largest buyers of its own securities. Its stock was up over 40X from it’s 1980s nadir and it seemed as though the single biggest problem it had was deciding on how much money it wanted to make. This was a bigger problem than you might imagine because as a quasi-government agency, and a constant political football, Fannie Mae realized it couldn’t be seen to be abusing its market position. So rather than go crazy and buy every mortgage security in sight, Fannie Mae just settled on charting a nice predictable upward growth in earnings fueled largely by buying an ever increasing share of its own securities.
Now a normal private company could not pursue this strategy because as it issued more and more debt to fund the golden goose, the yields on the incremental debt would start to increase to the point where the strategy no longer made sense. But Fannie Mae was different. Because of the implicit government guarantee of its debt, Fannie could issue incremental debt with little or no regard to its existing debt load because everyone assumed the federal government would backstop the debt.
Fannie Mae’s only significant problem thus became that the supply of mortgage securities would prove insufficient to fund its projected earnings growth (which was well above the projected growth in mortgage debt). As a result Fannie began a series of largely successful political campaigns to increase the volume of mortgage securities available to fund their habit. Theoretically, the easiest way to increase the supply of mortgage securities was to get the federal government to increase the size limit of mortgages that Fannie could buy and guarantee, but this was a very difficult political fight for Fannie to win because commercial and investment banks dominated the so-called “jumbo” mortgage market and, already smarting from Fannie’s dominance of the so-called “conforming” market, they had drawn a line in the sand in the jumbo market and committed most their lobbying resources to keeping Fannie’s size limit as low as possible.
Moral Hazard vs. Mo’ Money:
While Fannie still fought to increase its size limits, it quickly found another, much more politically palatable, way to increase the pool of mortgages it could buy: it dropped underwriting standards under the guise of increasing “home ownership” and “affordability”. Traditionally, Fannie had required the mortgages it purchased to be so-called 80/20 mortgages wherein the borrower puts at least a 20% down payment on the mortgage. This was a requirement because residential mortgages in the US are a “no-recourse” loan in which the borrow can generally “walk away” from the loan with no recourse to the lender other than seizing the house and reporting the default to a credit agency. A 20% down payment was generally thought to be enough to dramatically limit the moral hazard of borrowers “walking away” because housing values would have to decline 20%+ for the borrower to be underwater and even then the borrower would still face the prospect of losing their own sunk capital which makes walking away even more difficult from a psychological perspective
The problem with a 20% down payment is for many people it was very hard to come up with that big a down payment and thus it limited the total size of the mortgage market which in turn limited the volume of mortgage securities that Fannie Mae could purchase for its golden goose. While the obvious solution to this problem is just to lower the down payment requirement, Fannie couldn’t do this unilaterally because the government unit that regulated it would see such cuts as needlessly raising Fannie Mae’s risk profile. Far more politically astute that that, Fannie Mae began a campaign to increase “home ownership” and “affordability”. It created a home ownership “foundation” which opened offices in almost every congressional district and promptly set about mobilizing all the local advocates for “affordable” housing to put pressure on their elected representatives to let Fannie Mae offer “affordable housing programs”. Of course, “affordable housing problems” was just a euphemism for allowing Fannie Mae to lower its underwriting standards so that more mortgages could be created and the golden goose could thus kick out more golden eggs.
This proved to be a highly effective political coalition for Fannie Mae. Not only did they build a huge network of grass roots political supporters through their “foundation”, but politicians saw political advantages in supporting the programs because it cast them in the role of trying to help families buy a new home (as opposed to lowering underwriting standards to help a giant corporation keep up its earnings growth by taking a free ride on the US government’s guarantee). Even commercial banks and investment banks signed on to the program because it at least resulted in higher origination fees and an expanded credit market, even if most of the assets ultimately went to Fannie Mae and Freddie Mac.
A Victim of Its Own Success:
Fast forward to the mid-2000’s and Fannie Mae’s financial and political strategy was largely a resounding success. Fannie was now offering a wide range of mortgages that required less than a 20% down payment including even some that required no down payment at all! These products had dramatically increased the addressable size of the mortgage market. The increased size of the mortgage market enabled Fannie to purchase a massive amount of its own mortgage securities. In fact by this point Fannie Mae had become the single largest purchaser of its own securities. These newly purchased assets in turn enabled Fannie to continue to grow earnings which in turn supported a stock price that continued to trend nicely upward (though at a much more modest rate).
However beneath the seeming calm, the seeds for Fannie’s distress were now firmly planted. Fannie’s drive to lower underwriting standards had created a pool of mortgage debt with a much higher level of embedded moral hazard risk as well as good old fashioned credit risk. Fannie’s purchases of mortgage securities were so large that it was getting increasingly difficult to feed the golden goose enough food. On top of all that, with hundreds of billions of dollars of assets and liabilities to manage, Fannie's ALM strategies had become more and more complex and some of its bread and butter strategies started to become less profitable as the sheer weight of over half a trillion dollars of debt started to compress spreads (it would seem that even an implicit government guarantee has its limits).
It is no coincidence that the current mortgage crisis started in the so-called sub-prime market as that’s the mortgage market with the lowest credit quality and underwriting standards, however as the mortgage crisis has spread it has become increasingly clear that the traditional conventional, conforming mortgage market, long the domain of Fannie Mae and Freddie Mac, shares many more similarities with the sub-prime market than it would like to admit. While credit and underwriting standards are clearly much higher in the conforming market, they are also undoubtedly much lower than they were 10 or 20 years ago. What’s more the two biggest insurers against loss in that market now happen to also be the biggest owners in that market thanks to 20 years of purchasing mortgages to fund their government subsidized golden gooses. Guaranteeing oneself against risk is not insurance, its an exercise in futility.
The Goose Is Not Dead Yet:
Despite all of this, I personally don’t expect either company to go out of business. If recent comments from a slew of politicians are any indication, they are indeed “too big to fail”.
What I find most ironic in all of the current commotion is that rather than trying to address the root causes of Fannie Mae’s precarious state: dramatically lower underwriting standards and a massively levered balance sheet taking a free ride on the government’s back, politicians are doing the exact opposite: they are dramatically increasing the size of the mortgages that Fannie and Freddie can buy and pressuring them to maintain and even further lower their already un-sustainably low underwriting standards. I don’t know where this ends, but reinforcing the bad behavior that led to the crisis in the first place can’t end well
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