The Oser View: July 2008

Much to nobody’s surprise, the Bureau of Labor Statistics announced a substantial increase in the Consumer Price Index for June. The 1.1% monthly increase was the biggest jump since 2005, while the 5.0% year-over-year increase was the biggest since 1991. The annualized increase in CPI for 2008 is even higher at 5.5%, driven by a 29.1% rise in energy costs and 6.8% jump in food prices. Gasoline prices rose 10.1% in June alone, accounting for half the total increase in CPI. Housing costs, which represent 42% of the total weight of prices measured in the CPI, rose 0.5% for the second consecutive month. The biggest component of housing costs is “owners’ equivalent rent.” The term means the amount homeowners could expect to receive in rent for their houses or condos. Since most people don’t have any idea of what this sum might be, the BLS uses actual rental costs as a proxy. This tends to understate actual inflation when times are good, since more people are able to buy homes, and to overstate inflation when times are bad, as more people are forced to rent. Today, however, actual rental costs are being pushed higher not only by increased demand but by the rising costs of property maintenance, especially utilities and real estate taxes.

As Fed Chairman Bernanke warned Congress yesterday, “inflation remains elevated,” but there’s not much the Fed can do about it. The economy is too weak to absorb sharply higher borrowing costs. It’s unclear anyway how much higher rates would dent US inflation, since the major cause of higher oil prices is demand outside the US, especially in China. The one benefit of higher rates would be to raise the purchasing power of the dollar, which is hovering near an all-time low versus the euro. A stronger dollar, however, would hurt the exports of US-based manufacturing companies, currently one of our economy’s few bright spots.

As I write on a quiet Sunday afternoon, momentous decisions about the future of mortgage giants, Fannie Mae and Freddie Mac are being considered in Washington. Treasury Secretary Paulson has announced a three-pronged plan to provide liquidity and capital (up to $15 billion according to "The Sunday Times") in concert with a more stringent regulatory framework for the two companies. In recent days, Mr Paulson, President Bush, Fed Chairman Bernanke, both major Presidential candidates, and many other members of Congress have advocated the critical necessity of ensuring Fannie and Freddie’s survival. On Friday, Mr Paulson stated, "Today our primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission." The key words are "in their current form," and Mr Paulson repeated them today. An outright government takeover or some more indirect form of nationalization is, at least for now, off the table.

The impetus for Mr Paulson’s weekend duty is the huge slide in Fannie and Freddie’s share prices in an avalanche of selling. The media has had a field day with the story, tearing into what "The Wall Street Journal" calls "these financial beasts," 1 and gloating over the evaporation of "profits [that] enriched Fannie and Freddie shareholders over the years and bestowed significant wealth on the companies’ executives." 2 Most disturbing of all was an outburst, last Wednesday by former St Louis Federal Reserve Bank President William Poole. "Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer," Poole told Bloomberg News. The final downward spasm in Fannie and Freddie’s share prices was a panic response to Poole’s comments. By Friday, even Poole was singing a different tune. "Clearly they must be supported. They (the U.S. government) cannot allow that amount of assets ... to go into limbo. It would produce a worldwide financial crisis of unspeakable magnitude if they were allowed to default," Poole told Reuters in an interview.

"A worldwide financial crisis of unspeakable magnitude." That, to state the obvious, is serious. It’s also true. Here’s just one of the reasons:

"Fannie and Freddie are crucial to the smooth flow of everyday American life. They are the cement that holds the nation's housing markets together. The companies buy home loans from banks that issue them, repackage those loans as bonds, and either hold them as assets or sell them to the public. Roughly 70% of U.S. home mortgages pass through the hands of Fannie and Freddie. Together, they own or guarantee $5.2 trillion in mortgages. Without Fannie and Freddie, it could soon become all but impossible to buy or sell a home." 3

Here’s another reason, one which has received almost no media attention, but which Mr Paulson alluded to today. As of March 31, the 7,240 commercial banks in the United States held $11.5 trillion in total assets, of which $1.6 trillion were bonds. FDIC data doesn’t break out precisely how much of the total are either direct obligations of Fannie and Freddie or mortgage-backed securities they guarantee, but a safe estimate is about half or $800 billion. Total equity capital held by US banks was $1.16 trillion, so if Fannie and Freddie debt were suddenly worthless, there goes 70% of all the capital in the US banking system.

Total default is extreme, but even a much less drastic change in Fannie and Freddie’s status would be crippling to the banking system. In 1946, when interest rates were still regulated, well over half of all banking assets were held in direct US Treasury obligations—that is, bills, notes and bonds. The percentage today is 0.20%. It’s not that banks don’t want to own Treasuries; it’s that Treasuries are unprofitable. The rate of interest they pay is lower than most banks’ own cost for deposits and other funding. Fannie Mae and Freddie Mac (along with the other primary Government-Sponsored Enterprise (GSE), the Federal Home Loan Bank system) have filled the breach. The GSEs issue a constant stream of bonds and mortgage-backed securities with innovative features that allow banks to own them profitably. What’s more, banking regulations do not restrict the amount of GSE debt a bank can own, and the debt requires less capital. 4 And banks can use GSE debt as collateral to acquire additional funding. A change to any or all of these benefits would force banks to raise more capital (at the worst possible time) and curtail lending even further.

So far, the bond markets have not joined in stock market hysteria. Prices of Fannie and Freddie bonds and mortgage securities have fallen compared to Treasuries, but the damage has been slight. This is also good for banks and other entities that use "mark to market" accounting, which requires that changes in the market values of certain assets and other items be recorded through a company’s capital accounts. Had Fannie and Freddie’s bonds lost market value even approximating the extent of their stocks’ loss, banks’ capital would be reduced just as surely as if the bonds were in default.

Mark to market is a controversial—and not at all obvious—accounting technique that has only recently come into wide use. Every asset, as E-Bay has definitively proven, has a market value. If I advertise my four-year old refrigerator, surely someone will pay me a couple of hundred dollars and take it away. But the value to me of my refrigerator is not what I could sell it for; its value is what it does. In fact, its market value is irrelevant as long as I am not in desperate need of cash. Bonds have readily observable market values and, in the US and other developed countries, trade freely in deep and liquid markets. If, however, a holder of a bond has the capacity and intent to retain it until maturity, the market value at any given time may be as irrelevant as my refrigerator’s monetary value. Derivatives—that is, financial instruments such as interest rate swaps that are used to mitigate market risks—also have market values, although they may not be quite as observable. New and complex accounting rules require that they too be marked to market.

Many of Fannie and Freddie’s recent problems center on accounting for derivatives. Both companies had to restate years of earnings because their interpretations of the derivative accounting rules did not pass muster. In the first quarter this year, Fannie Mae, now following the new rules, announced a loss of $2.5 billion even though income from operations was nearly $1.9 billion. What sunk quarterly earnings was a charge of $4.4 billion for "fair value losses." Three billion dollars of this loss was caused by marking to market the value of derivatives that Fannie used to hedge its interest rate risk. In other words, Fannie Mae booked a huge paper loss that it will ultimately reverse, to prevent a permanent economic loss. Prior to the recent accounting standards taking effect, this was called prudent risk management.

Not that the housing crisis has left Fannie and Freddie unscathed. Far from it. In the first quarter Fannie Mae set aside $2.3 billion for potential credit losses compared to $180 million a year earlier. It charged off 0.126% of its loans compared to 0.034% in the first quarter of 2007. In its published outlook, the company stated, "We expect significant increases in our credit-related expenses and credit loss ratio in 2008 relative to 2007. We also believe that our credit losses will increase in 2009 relative to 2008." Hardly good news, but not catastrophic either and certainly not enough to torpedo the two companies that keep the US mortgage industry—and thus the US economy—afloat.

That’s the heart of the issue. Commercial banks are struggling for capital. They can hold few mortgages on their books. Mortgage bankers and brokers, by definition, sell all the mortgages they originate. The markets for privately securitized mortgages—whether subprime or loans for amounts above the limits imposed by Congress on Fannie and Freddie—have evaporated. All but a tiny fraction of mortgages being sold and securitized today are guaranteed by Fannie Mae or Freddie Mac. 5 In June alone Fannie and Freddie securitized $39.6 billion of 30-year single family mortgages. It’s impossible to say exactly how many of those mortgages would have been made without Fannie and Freddie, but the total amount is closer to the .6 than the 39.

If it isn’t obvious, it should be. Fannie and Freddie are a big part of the solution, not the problem. It is not an exaggeration to say that if all single-family mortgages originated between 2003 and 2007 had been underwritten to Fannie and Freddie’s standards, we would not have a housing crisis today.

Fannie Mae describes itself as supporting "liquidity and stability in the secondary mortgage market." Its mission objectives are "helping to increase the total amount of funds available to finance housing in the United States and to make homeownership more available and affordable for low-, moderate- and middle-income Americans." That’s really what Fannie Mae and Freddie Mac do. At this moment, it doesn’t really matter whether Fannie and Freddie have gotten too big or too arrogant. It doesn’t matter whether their lobbyists are too aggressive or their top executives are over-paid. It doesn’t matter if their regulator is too weak or Congressional oversight is too lax. Fannie and Freddie evolved into their present shape for all sorts of reasons, many of which will be addressed in the months and years ahead. What matters now is that Fannie and Freddie be allowed to continue their indispensable roles in the American financial system. I think that’s obvious.

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1 "Fannie Mae Ugly." Editorial, July 12, 2008

2 "The Fannie and Freddie Fallout" Gretchen Morgenson, "The New York Times, July 13, 2008

3 Fred W. Frailey, , July 11, 2008, Kiplinger.com

4 Banks are required to maintain levels of capital based on their assets. One key measure of capital is "risk-based capital." Put simply, if a bank makes me a $10,000 car loan, it must hold $1,000 of risk-based capital to support the loan. If it buys a $10,000 Fannie Mae bond instead, it need only hold $200 of risk-based capital, and if it buys a $10,000 US Treasury note, it needs no risk-based capital at all.

5 There is an exception to this broad statement. Loans made under FHA and VA programs are sold to and securitized by Ginnie Mae, which is a direct US Government instrumentality.