The Insatiable Bill Gross Challenges Geithner on Housing Finance

Includes: FMCC, FNMA
by: Michael Steinberg

Treasury Secretary Geithner and HUD Secretary Donovan hosted the Conference on the Future of Housing Finance Tuesday, August 17, 2010. Among the esteemed panelists were PIMCO’s Bill Gross, Bank of America’s Barbara J. Desoer, Wells Fargo’s Mike Heid and the stellar brand builder from Moody's Analytics Mark Zandi. Geithner’s keynote was that the only known fact is that the future of residential mortgage finance must change. But as each party spoke it became clearer that change was the last thing anyone wanted.

Some of the academics talked about counter cyclic mortgage structures such as increasing down payments during boom times and reducing down payments during economic stress. Others countered that affordability would prevent larger down payments when house prices were rising. Many gave lip service to affordability being limited to rental units. But, supporting or constraining the growth of bubbles and the economy in general was not the purpose for most of the attendees.

Gross and Desoer carried the tail end of the first panel. Both wanted an explicit 100% guarantee on mortgage securities, but Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC) and Ginnie Mae should not hold any mortgages. Geithner said the GSE portfolios should be liquidated slowly. When other panelists spoke about shared risk, such as private investors absorbing first losses, The Professionals were not interested. Heid said it has to be private capital, public guarantee. How does this differ from the private profit, public risk that had been the outcry against current Fannie and Freddie?

Geithner stated that government must be adequately compensated for any risks it takes so that it does not lose money on its guarantees. The panelists had no interest in seeing that government was adequately compensated or not over extended. The private sector should not be encumbered in trying to protect the government.

Gross was not shy about selling his opinion. He started out saying that today I represent the good of the nation, which might be in conflict with the good of PIMCO investors. Then he blatantly said if the government did not fully guarantee residential mortgage paper, PIMCO would require a 7% to 8% interest rate. Given the importance that Geithner placed on mortgage securitizations in his opening remarks, Gross appeared to be threatening.

Next Gross weighed in on using mortgage finance to boost the economy and not so subtlety his own book. Fannie, Freddie and Ginnie should be rolled into one government owned entity. There should be no public/private insurance like the current GSEs. Private mortgage insurance to support low down payments would also be eliminated. The government guarantees everything.

Then Gross gave more substance to the rumors circulated by Wall Street, calling for the Treasury to allow all mortgages in the GSE portfolios to be refinanced down to about 4% as an economic stimulus. No consideration should be given to loan to value, credit score, second liens or the borrower’s ability to pay. Gross believes this would raise housing prices by 10%. So the government takes on the same risk for lower compensation; the direction opposite of Geithner’s objective of the government being adequately compensated for risk. Gross is asking the government to do something PIMCO flat out refuses to do.

Lastly, Gross want investors in GSE mortgage securities to lose their premiums on higher interest mortgages. The refinancing risk is already present, but a government induced mass refinancing is a black swan for mortgage investors and causes a higher spread over Treasuries in the future. Gross concluded by asking the Fed to retain a massive balance sheet. There’s no end to what Gross wants.

Note: In his book “The Big Short,” Michael Lewis cites short CDS investors worst fear was that the government would bailout the subprime market making their bets worthless. An intervention on the scale Gross is requesting could wipe out highly leveraged mortgage investors.

Disclosure: Author is long BAC, FMCC.OB, FNMA .OBand WFC.