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Monday, July 14, 2008

The Fannie/Freddie Bailout and Crack Addicts

To no one's surprise, the Federal Government stepped in quickly and bailed out both Fannie Mae and Freddie Mac over the weekend. As I pointed out over the weekend, the government had no choice because both are vital to the mortgage market and without them there is no mortgage market. Unfortunately, the system is set up so that these two are Socialistic Monopolies. Because they securitize nearly all mortgages funded, they in effect also control the entire system. Without them, there is no system. This piece provides an excellent analysis of what brought us here.

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 StartedWith 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.

This piece is spot on as far as what brought this specific situation on and the moral hazard the two created for themselves. What the piece doesn't mention is the moral hazard the government created for the two. By turning these two giants into the only game in town when it comes to mortgage securitization for loans for good borrowers, and making them an extension of the government, they created their own terrible moral hazard. These companies can't fail, and thus, they take extra risks knowing this.

This bailout is no surprise, but furthermore, it is the equivalent of giving a crackhead more crack. These two engaged in terribly risky behavior. It was behavior they never would have engaged in if they didn't know they would be bailed out if that behavior didn't work out.

That's exactly what happened. So, what is the lesson for both here? Engage in risky behavior. If it works out your bottom line is padded tremendously. If it doesn't you know the government will have to bail you out because you are each too important to fail.

Not only has the federal government done nothing to fix the extreme moral hazard the two have, but in fact, they have only fed it. Just like giving a crackhead more crack, the government just gave these two a parachute following their risky behavior. Microsoft would never get such a parachute if they exhibited similar risky behavior and gambled wrong. Yet, these two not only get their parachute, but the government has done absolutely nothing to make sure they don't continue to exhibit such risky behavior in the future. Will anyone really be surprised if we are facing a similar situation a few years down the road?

Here is my solution for fixing this fiasco.

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