Rate Watch #632 Treasury Should Take Over FHLMC & FNMA

August 22, 2008
by Dick Lepre
dicklepre@rpm-mortgage.com
www.loanmine.com

What to Do with FHLMC & FNMA

It has become a bit silly to forecast mortgage rates when 1) Jumbo securitization became impossible a year ago 2) Congress increased FHLMC & FNMA loan limits to help the housing market and 3) the only people other than FHA who buy mortgages are those two agencies and their equity value has declined to something approaching zero. It is not time to bail these entities out. It is time to wipe them out.

These two agencies have $5.2 trillion in outstanding bonds that they have guaranteed and they are, in reality, broke. This is a problem because there is no way that the U.S. Government can allow that debt to default. This is not debt which the Treasury department has guaranteed but it has no choice. Not stepping up and taking over these agencies and the guarantee of that debt would devastate the economy, retirement funds, the banking system, the housing market and... did I leave anything out?

Congress recently enacted legislation allowing the Treasury Department to take over the GSEs. Barrons had a recent article which suggested that the end is near for the GSEs and that article has help smash their equity values. In addition it has gotten increasingly expensive for the GSEs to borrow money. This past Tuesday FHLMC paid the highest in its history spread over Treasury debt. On top of that they are no longer properly hedging their rate risk. This head in the sand, hoping things will get better approach is doomed to fail. The GSEs have $223 billion in debt to refinance this quarter. Good luck, guys.

I believe that it is time to get this over with and suggest here a course of action. The plan below should be executed as soon as possible. Preferably within the next couple of weeks.

Let's step back and look at some numbers. If one looked at the balance sheets of these entities and marked the assets at present market value FHLMC would have a net worth of negative $5.6 billion and FNMA would have a positive worth of $12 billion representing a 2/3'rds loss from the start of the calendar year. But that accounting is largely a joke. Each of these entities has a large asset which is solely tax credit. This is not real money but only an imaginary item to offset potential future taxes from profits. Those assets (tax credits) cannot be sold. They are, at present, illusory. Eliminating those assets would chip $36 billion from FNMA's net worth and $29 billion from FHLMC's worth.

In other words: what are we waiting for?

The Plan

The Treasury Department should walk into these GSEs some weekend real soon and literally take them over in the manner in which the FDIC seizes a bank.

This should be accompanied by a press conference at which the President, The Secretary of the Treasury, the Chairman of the Federal Reserve and whoever will head the new entity appear and give public reassurance and answer stupid questions from clueless reporters.

Treasury must set up a receiver for the assets of the 2 GSEs and seize the GSEs and turn over the assets to the new entity. Treasury can capitalize this receiver under the just passed legislation. This entity should merge the 2 GSEs into one new entity preserving the IT systems and the relationships that the GSEs have with the folks who sell them mortgages. A massive management rework must be done. The equity holders of the present GSEs will be wiped out. If Treasury wants to placate FNMA by paying its stockholders some chump change amount like $10 billion to shut them up and make this transition less objectionable let them do so. FHLMC shareholders have no case because they are indisputably broke.

These two agencies would cease to exist. Most of their employees would work for the new entity created as the receiver.

Treasury would now be explicitly responsible for all FHLMC/FNMA debt and Congress must authorize Treasury to issue debt to cover real losses on the old paper. Treasury debt would replace the GSE losses but not actual GSE debt.

The new entity should have a new class of Treasury backed mortgage debt that can be monetized in the same manner in which the Fed deals with existing Treasury debt. Congress should also create explicit authorization of new Treasury debt to guarantee any shortfalls that come to pass from this new class of debt. The new mortgage debt is "off sheet". This does not increase the size of the National Debt because, unlike other Treasury debt, this has assets which offset it. Treasury debt issued to cover shortfall is "on sheet". Treasury could also do what HUD does for FHA loans and collect a fee on each loan up front which becomes part of a reserve for future losses.

Treasury could simply hold the securities and make money on the interest rate differential or it could sell them in the same manner as the GSEs presently do or it could do a combination of the two. The advantage of selling them would be that this debt was always priced to the market rather than subject to political pressures or the effects of inattention. Perhaps there would be times when it was best for this entity to not price to the market but to deliberately price counter to the market in order provide, for example, stability to housing prices as a more general support to the entire U.S. economy.

Also, this entity could forego the expense of interest rate hedging because it can self-insure the rate risk. I am not necessarily saying that self-insurance is best I am only saying that it is viable.

Let me be clear. This is a radical plan. It is the nationalization of GSE debt. The plan I suggest is radical but incredibly simple and straightforward. Mortgage securitization of existing pipelines of FHLMC and FNMA commitments would remain in place and the new entity would have to begin taking commitments for new mortgage debt immediately or with a delay of no more than a couple of days. The existing software support on the front-end that enables folks like me to insure that I can get you a FNMA loan must remain operational and the back-end software which distributes the proceeds to the investors must remain in place.

There is a less aggressive alternative which is to keep the 2 GSEs intact (more or less) and have Treasury issue preferred sock (or some such thing) and have Treasury own the 2 GSEs. The effect would be much the same as what I presented above but I like the utter clarity of my suggestions.

Let's look at some of the nuances here. These agencies have a lot of political clout. They are not likely to go quietly. That will create reticence to execute this plan and post facto grousing. So what?

The notion that I am sitting here typing a suggested plan for the nationalization (see, I did not say "socialization") of what are today 2 corporations is something which I find disturbing. It grates my capitalistic predisposition. But the fact is that there is no alternative. It is necessary for the good of all citizens that the federal government step up and assume this liability. In short, it is in our collective best interests to assume into our national debt when it is all over several hundred billion dollars of loss associated with the obligations of FHLMC & FNMA.

An interesting notion is this: what will happen after this is done? Let's assume that uncertainty about housing values and the real value of this debt will last for at very most two years. At that point the government will likely be pressured to turn this back into a private entity. My own initial look was that this would function best as one single entity. I had a conversation yesterday with Rob Hirt, the owner of RPM, who said that his conversations with folks in the industry saw this as something that would split into as many as 10 different entities. Whatever may be the case, it is certainly not my belief that this is best left in the hands of the government on a permanent basis. That statement is based on the belief that capitalism furnishes a better model for business activity. Its recent performance in everything related to mortgages has displayed a shining example of capitalism at its worse and it is necessary that we legislate and regulate the misdeeds out of any such future activity. We should learn from out mistakes and protect ourselves from making those mistakes again.

If you have something to add to this discussion please post a comment on the blog.

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Dick Lepre
RPM - SF

Comments

[greg nowell]

It isn't that radical to note that socialization of losses is sometimes necessary, Dick! Lenin criticized Bismarck's Germany for doing the same thing with failing railroads. In any case failed debt gets socialized one way or another: either through an increased tax burden or through unemployment and deflation. The measures you recommend are sane in the sense that they will keep a bad situation bad, rather than letting it deteriorate to catastrophic.

The people who think that such bailouts deprive the markets of the discipline of "moral hazard" miss the point. We could create a good deal of moral hazard simply by putting imprudent banking wheelers and dealers in jail. No reason to have a Great Depression just because they wrote some bad paper.

[Dick Lepre]

Greg,

I was more making the comment that things have gotten radical if I am suggesting socialization of mortgage debt but clearly this is the only solution.

The "moral hazard" issue is, for me, a red herring. Banks, Wall Street firms, mortgage companies, and investors have been savaged. They are hardly getting a free ride. The only bone I threw was potentially to FNMA shareholders if they really have some net worth.