The Mortgage GSEs Should Be Broken Up - Before It’s Too Late

Tuesday’s NY Times ran a great article discussing the financial health of the Mortgage GSEs and the possible negative impact to the economy if either one needs a rescue.

The overall situation can be summed up as follows: two companies that are losing money, are on somewhat shaky financial ground and potentially have unreported losses, bought 80% of all mortgages sold to investors last quarter. Furthermore congress has lifted their restrictions on investing in mortgages, during a time when it would’ve made more sense to rein in their investments, especially with respect to riskier non-prime mortgages and jumbo mortgages. Finally if either (or both) mortgage GSEs were to need a rescue of some sort, not only would the tax payer be on the hook for trillions but it could cause the credit markets to completely freeze-up.

To help illustrate the primary issue around capital requirements, take a look at a graphic below, which depicts the relative ratio of capital to assets and debt to guaranteed mortgages, as well as the scenarios under which the tax payer is on the hook for their liabilities.

Graphic courtesy of the NY Times

It’s worth noting that Fannie Mae (FNM) reported a loss of $2.2 billion for Q1 and analysts expect the losses to continue for the next 2-3 quarters.

Per the article, the mortgage GSEs are exceeding their minimum capital requirements by approximately $7 billion, and while the GSEs believe that new revenue and investment dollars will offset any future losses can we afford to risk them being wrong? I contend that the country simply can’t afford to have any two companies in a position to cause such a large negative impact on the economy. From my perspective, the mere fact that a significant risk exists is enough for immediate (and potentially drastic) measures to be taken, in order to protect the mortgage market and the larger economy.

From the NY Times:

…But with mortgage defaults and foreclosures rising, Bush administration officials, regulators and lawmakers are nervously asking whether these two companies, would-be saviors of the housing market, will soon need saving themselves…

…as Wall Street all but abandons the mortgage business, Fannie Mae and Freddie Mac now overwhelmingly dominate it, handling more than 80 percent of all mortgages bought by investors in the first quarter of this year. That is more than double their market share in 2006.

But some financial experts worry that the companies are dangerously close to the edge, especially if home prices go through another steep decline. Their combined cushion of $83 billion — the capital that their regulator requires them to hold — underpins a colossal $5 trillion in debt and other financial commitments.

… The companies, which were created by Congress but are owned by investors, suffered more than $9 billion in mortgage-related losses last year, and analysts expect those losses to grow this year. Fannie Mae is to release its latest financial results on Tuesday and Freddie Mac is to report earnings next week.

The companies are sitting on as much as $19 billion in additional losses that they have not yet fully acknowledged, analysts say. If either company stumbled, the mortgage business could lose its only lubricant, potentially causing the housing market to plummet and the credit markets to freeze up completely.

And if Fannie or Freddie fail, taxpayers would probably have to bail them out at a staggering cost.

“We’ve taken tremendous risks by loosening these companies’ purse strings,” said Senator Mel Martinez, Republican of Florida and a former secretary of housing and urban development. “They could cause an economy wide meltdown if they got into real trouble and leave the public on the hook for billions.”

If the last 12-15 months have taught us anything, it is that companies that “claim” to be perfectly all right can fall apart rather rapidly if a few things go wrong. Even though the GSEs are theoretically more stable than a typical bank or lender, their investments need to be reined in as a safety measure against a larger financial crisis. The economy shouldn’t be put at risk because two companies bit off more than they could chew under orders from congress, nor should any two companies be in a position to cause that much economic damage if their management teams make a series of bad decisions.

It would be better for the mortgage GSEs to negatively impact the housing market by sharply reducing their investments, than it would be to have them cause the credit markets to freeze-up by needing a rescue. A conservative approach (even if it’s painful) is what is required right now.

Finally, there needs to be a complete top to bottom overhaul of the role of the GSEs and how they’re allowed to operate. Having a situation where the economy is overly dependent on the financial health of two companies is patently absurd. The mortgage GSEs should be broken up into several smaller companies, with restrictions placed on how large they’re allowed to grow and on their investment activities. It makes more sense to have to spin-off a Freddie (FRE) Jr. or three and spread the economy risk around, than it does to have two companies in a position where they control such a large swath of the mortgage market.

Acknowledgments: a thank you to my friend “Jest” for bringing this article my attention.

Sources:

The NY Times: “Doubts Raised on Big Backers of Mortgages” – Charles Duhig, May 6, 2008.

Disclosure: as of the time of publishing the author didn’t own a position in either Fannie Mae or Freddie Mac, but as a U.S. tax payer I suppose that distinction is moot if I wind up on the hook for my slice of their financial obligations.

Comments

[Malkiel]

"It would be better for the mortgage GSEs to negatively impact the housing market by sharply reducing their investments, than it would be to have them cause the credit markets to freeze-up by needing a rescue"

Okay, so what's your objective evidence for that? Or is that statement some blind article of faith? If I get to make statements on faith rather than evidence like you, my guess would be that an actual bailout would send the signal to the lending market that the government is willing to do what it takes to keep the market liquid and that may break the crisis. I'm not preferring that scenario, but it seems to be what the market is looking for...

[Markham]

Bailing out the mortgage GSEs could potentially cost 100s of billions if not trillions, if such an event were to occur it would NOT investors more faith in the market because it would evidence that conditions must be beyond abysmal for such a thing to happen.

Furthermore the mortgage GSEs purchased 80% of the total mortgages sold to investors last quarter, without the participation of the mortgage GSEs other investors would lose confidence and there would be very liquidity in the mortgage market.

If liquidity in the mortgage market dries up, the housing crisis would undoubtedly get much, much worse.

Considering the role of the housing crisis in the credit crunch, it's absurd to think that a government bailout of the mortgage GSEs would end the credit crisis.

-M

[jimmy46]

you fail to mention that both have instituted new fees and raises old fees.
These will generate a large stream of cash every quarter from now on