Tuesday, December 8, 2009

The Steering Wheel: Government Housing Policy

In 1999, the New York Times stated: "In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae corporation is easing the credit requirements on loans that it will purchase from banks and other lenders...Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stockholders to maintain its phenomenal growth in profits."

I submit that the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), acting under relentless political pressure to execute a popular, bipartisan affordable-housing mandate, played a significant role in directing the excess liquidity generated by the Fed towards a particular dangerous section of the housing market (a general housing bubble would probably have formed, regardless, but the special toxicity of this particular situation was created by government policy). Thus, government policy was the "steering wheel" that drove the car into the wall, or crowd of innocent people, or whatever disaster metaphor is most appropriate.

Let's start with a brief overview of what Fannie and Freddie do. The two for-profit companies are simultaneously also "Government-Sponsored Enterprises" (GSEs), meaning that they fall under the authority of the Department of Housing and Urban Development (HUD) and enjoyed implicit---now, in the wake of their failures, explicit---government protection. Fannie Mae and Freddie Mac do not originate mortgages; rather, they purchase them from originating banks, and this allows the banks to avoid having 30-year or so commitments to service the mortgages. Instead, the banks get to take a lot of the money now, and are then free to originate more mortgages and to collect the origination fees (which is what many local branches would prefer to specialize in because they allow managers to show near-term performance). The effect on the housing market is to increase liquidity and mortgage access.

In the traditional "originate and distribute" model, the mortgages would be purchased by Fannie and Freddie, securitized, and sold on to other investors with guarantees attached. In fact, as time went on, the GSEs were primarily using their implicit government-protected status to borrow at low rates and then use the cash to repurchase mortgage-backed securities and house them on their own books. The firms became enormously leveraged. As a result of the exposure to interest-rate risks, they also began carrying out dynamic interest-rate hedging operations.

Because they are the giants in the industry and enjoy special privileges, Fannie and Freddie have great power over the origination channel and the standards employed at that initial phase. A local bank has little incentive to be particularly careful with screening mortgage applicants if it knows that the mortgage is going to be turned around and sold to Fannie Mae, and that Fannie Mae not only does not care about the screening process, but also wants screening standards to be lowered.

By creating a voracious appetite for subprime and Alt-A mortgages, Fannie and Freddie transmitted a "demand" signal to the banks. The incentives for the banks were to satisfy this demand; indeed, it would be irrational for them to have not done so, particularly given the implicit government backing of the two mortgage GSEs.

It is not that there was a complete absence of concern among politicians regarding the expansion of Fannie and Freddie. For example, Congressman Ron Paul of Texas said in Congressional testimony in 2003 that "the special privileges granted to Fannie and Freddie have distorted the housing markets by allowing them to attract capital they could not attract under pure market conditions. As a result, capital is diverted from its most productive use into housing. This reduces the efficacy of the entire market and thus reduces the standard of living of all Americans...Despite long-term damage to the economy inflicted by the government's interference in the housing market, the government's policy of diverting capital...creates a short-term boom in housing. Like all artificially created bubbles, the boom in housing prices cannot last forever. When housing prices fall, homeowners will experience difficult as their equity will be wiped out. Furthermore, the holders of the mortgage debt will also have a loss. These losses will be greater than they would have otherwise been had government policy not actively encouraged overinvestment in housing."

Even Alan Greenspan, whose previously-discussed departures from the Taylor Rule fueled the massive credit expansion that made so much of this possible, testified in 2005 that Fannie and Freddie were becoming dangerous, almost to the point of becoming doomsday machines: "The Federal Reserve has been unable to find any credible purpose for the huge balance sheets built by Fannie and Freddie other than the creation of profit through the exploitation of the market-granted subsidy...(if they) continue to grow, continue to have the low capital that they have (my note: $30 billion in capital to finance an estimated $2 trillion in mortgages!)...they potentially create ever-growing systemic risks down the road...by enabling these institutions to increase in size...we are placing the total financial system of the future at risk."

Others clearly disagreed. The same year, Congressman Barney Frank, the ranking member of the House Committee on Financial Services (later to become its chairman) and a key architect of the affordable housing push, argued that Fannie and Freddie were "not facing any kind of financial crisis...The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing...(critics of the GSEs) conjure up the possibility of serious financial losses to the Treasury...I believe that we, as the Federal Government, have probably done too little rather than too much to push them to meet the goals of affordable housing and to set reasonable goals. I would like to get Fannie and Freddie more deeply into helping low-income housing and possibly into something that is more explicitly a subsidy. I want to roll the dice a little in this situation...". Of course, Frank had been blocking attempts to control Fannie and Freddie since the early 1990s.

Fannie's top client was Countrywide Financial Corporation, the wild subprime enthusiast that blew up in 2008. Countrywide gave special below-market "VIP loans" to various targeted individuals (including, brazenly, the HUD Secretary, CEO of Fannie Mae, and the Chairman of the Senate Committee on Banking, Housing, and Urban Affairs) as part of its "Friends of Angelo" program (named for Countrywide CEO Angelo Mozilo). When we get to political contributions and attractive private arrangements involving Fannie and Freddie themselves, the story becomes even more interesting.

The GSEs spent millions in campaign contributions and were seen as a sort of political warchest/piggybank for the Democratic party (although support was often non-partisan). In 2004, when Bush expressed concerns about the riskiness of the GSEs, 76 Congressional Democrats---including Frank, Nancy Pelosi, Maxine Waters, and Charley Rangel---sent him a joint letter making the case that "an exclusive focus on safety and standards is likely to come, in practice, at the expense of affordable housing." Many of the letter-writers would later blame Wall Street excess and "deregulated markets" for the housing crisis and debt-deflation, and would call for greater government controls and more central planning. Even well into 2008, Senator Christopher Dodd (himself a recipient of a "Friends of Angelo" VIP loan), incredibly, continued to report that Fannie and Freddie were "on a sound footing."

The Office of Federal Housing Enterprise Oversight---the regulatory agency overseeing the two GSEs---issued a very critical report of Fannie Mae after finding numerous accounting irregularities at the firm. In response, Senator Kit Bond (a Republican) sought to have the OFHEO's leadership culled and budget frozen pending an investigation. Barney Frank concurred, stating that "it is clear that a leadership change at OFHEO is overdue."

While deeply complicit at other times, Republican Senators of the Banking Committee did ultimately make a (futile) attempt at substantive GSE reform in 2005. All Democrat members opposed the bill. A group of Republicans attempted to gather support for a full Senate vote, saying, "If effective regulatory reform legislation ... is not enacted this year, American taxpayers will continue to be exposed to the enormous risk that Fannie Mae and Freddie Mac pose to the housing market, the overall financial system and the economy as a whole." The vote was not called after extensive anti-reform lobbying by Fannie Mae.

It is still difficult to determine the size of the exposures that Fannie and Freddie ultimately had to subprime mortgages. They were clearly monstrous---the direct taxpayer-driven bailout stands at around $350 billion, while the Fed is holding at least $1 trillion of toxic paper, housed in non-mark-to-market darkness, that was purchased from them. Bernanke is apparently going to try to unwind the paper through complex, opaque reverse-repurchase agreements in which market players will purchase the paper but the Fed will retain all of the credit risk. God only knows how that one is going to work out. The opacity extends to Fannie and Freddie because neither were exactly known for accounting transparency---even prior to the crisis, they were rocked by accounting scandals totaling $11 billion (the errors were related to how hedging activities were accounted for and led to senior executives receiving far more generous bonuses than they otherwise would have). I have heard estimates that the two GSEs had exposures totaling at least $1.5 trillion, possibly over $2 trillion.

We do know that, by mid-2006, the ratings agencies were voicing their concerns that the default rate assumptions used in packaging and selling various MBS (mortgage-backed securities---to be discussed in a different post) had been too conservative and the models used had been optimistic. At this point, JP Morgan Chase had never really entered the game in a big way, Deutschebank had also been wary, and Goldman, clearly scared, had purchased protection through both credit default swaps sold by AIG (more on that firm later) and, at least as has been related to me by an insider, a large in-house "Black Swan" bet that the housing market would collapse. The ratings agencies had issued warnings and would begin downgrading ratings in about a year, yet UBS, CITI, Bear Sterns, Lehman, Merrill Lynch, and, most importantly, the GSEs continued to aggressively push subprime-based products. Credit risk analysts at Fannie had voiced their concerns back when senior executives at the firm had started demanding to "make markets" in the subprime space; the most vocal of them was apparently fired as an example, the others effectively muzzled.

There were other programs and policies that encouraged subprime lending, including the Carter-era Community Reinvestment Act (CRA) that was given new life during the Clinton Administration and used as a hammer by prominent community organizers/activists. If the Fannie and Freddie purchases represented the "carrot" side of the game, the CRA represented the "stick"---it opened banks up to crushing lawsuits if they failed to meet the goals of various subprime-biased lending initiatives.

While clearly not without blame, Fannie and Freddie were essentially doing what they were told. The most troubling part is the incestuous feedback loop of lavish campaign contributions, special private loan arrangements (laundered through the Countrywide "Friends of Angelo" program), and even post-political life private-sector job opportunities that existed between key political supporters and the mortgage giants. As GSEs, they were inescapably political organizations and their abilities to attract capital at very attractive rates depended on their special, guaranteed status. In terms of our public servants, one may ask why, naked political ambitions, economic self-interest, and "community leadership" narcissism/messianic complexes aside, government officials at least notionally representing the public good would have pushed for NINJA-type loans and other forms of extremely relaxed lending standards, especially magnified to the level of the Fannie Mae and Freddie Mac exposures.

Perhaps I am naive, but I think that many of the politicians involved were probably acting from good---if somewhat vague---intentions, and saw affordable housing as a legitimately noble policy goal. This is anecdotal, but I know Mel Martinez, former HUD Secretary under Bush and now Senator, and his wife personally. My parents were involved in his election to Orange County Chairman back in the late 90s, and his mother-in-law worked with my dad at the Florida Audubon Society many years ago. He has always seemed like an affable, genuinely concerned individual---why wouldn't he have done more to discipline the mortgage GSEs?

My personal belief is that there were the obvious reasons for the affordable housing push ("homeownership is part of the American Dream") and the attractiveness of housing in terms of bringing home tangible results to one's political constituents, but there was also a more subtle effect at work: by operating through the GSEs and then through the private banks, it appeared that a quasi-"market solution" for the affordable housing issue was being applied. Rather than an outwardly foolhardy, directly Socialist effort such as some kind of nationwide home-price controls policy, politicians could feel that they were simply applying a humanistic incentive package to the market and then allowing it to work out the details in its own, efficient way. As we found in the case of the Federal Reserve and as George Cooper argued in his book, the most dangerous modern threat may be the attempt to have our cake and eat it, too, by trying to combine incompatible free market, decentralized price discovery mechanisms and centrally planned social engineering programs. What makes this so sinister is that the central planners may get a free "put option" to blame the free market and deregulation when things don't work out as planned.

The next blog entry will discuss structured financial products, particularly credit derivatives, that became "weapons of mass destruction" during the crisis. The techniques of structured finance, particularly a seemingly-benign mathematical theorem called the Gaussian copula, were perhaps inadvertently used to make subprime-based securities seem far less dangerous than they turned out to be.

For Further Reading: The great Thomas Sowell's "The Housing Boom and Bust" is a wonderfully witty and erudite account of the politics of affordable housing.

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