FHLMC, FNMA, Credit Derivatives

There has been and - for jumbo mortgages - continues to be a problem with lack of liquidity. This week we saw heavier than ever talk from Congress about what the GSEs (FHLMC & FNMA) should do. The Fed Chairman countered that.

I find myself is the uncomfortable position is disagreeing with them all.

Let's take a step outside the previous discussion first and let me tell you one of the great secrets of the mortgage industry. The most profitable segments (for loan officers, banks and everyone other than the borrower and the investor) have always been 1) subprime and 2) jumbo. The profits on conforming loans have always been less both in terms of points and absolute dollars than Jumbo. Remember that.

Now let's go to my previous suggestion about what the GSEs should do. The thesis here is that FHLMC & FNMA have displayed that they understand how to underwrite mortgages and to sell their product in the secondary market. Their risks (and this is something which simply does not get talked about) are largely hedging risks. They need to be covered for rate movements from the time they buy the loans until the time they sell the loans.

FHLMC & FNMA have caps on how large a portfolio they can hold. How that came to pass is really a twofold story. Part of it is that there has been pressure on the part of banks and Wall Street firms to keep the GSEs from expanding because the banks and Wall Street firms are the GSEs competition. Part of the problem was generated by the GSEs themselves as they incorrectly reported their quarterlies in an attempt to obfuscate the real variations in their income and the risks that they were taking.

I believe that FHLMC & FNMA have shown that they can create artificial intelligence underwriting systems which reduce the cost of generating loans without adding undue risks. We have been using these tools for years.

I would suggest that pressure should be applied to the mortgage industry to essentially say, "Fix the liquidity problem on Jumbo mortgages or we will have the GSEs do it for you." That is why I believe that the Fed Chairman is making a mistake at present. The mere threat to have GSEs "take over" a good chunk of the Jumbo market may well induce the banks which buy these loans and the Wall Street firms which make them into MBS and sell them to act. If they refuse then the GSEs should start taking over the Jumbo market.

This brings us to another problem. It really may not make a difference if FHLMC/FNMA start securitizing Jumbos or if the commercial bank/Wall Street model continues. Either requires the presence of credit derivatives to be able to offer the kinds of low rates which we have gotten used to. Let's try looking at that.

The Liquidity Thing From a Different Perspective

I have been writing that the mortgage business can be fixed by making some changes (no stated B-paper, higher adds for Jumbo stated) but my assumption is that the system which has fed this - the system of derivative risk being spread far away from the original lender can and will be fixed. For an entirely different and more doomsday perspective see this article from MSN this week. This is by an expert on credit derivatives.

Remember that Warren Buffet referred to derivatives as "financial weapons of mass destruction" and Greenspan defended them. To quote the Chairman: “By far the most significant event of finance during the past decade has been the extraordinary development and expansion of financial derivatives….. As we approach the twenty-first century, both banks and non-banks will continually reassess whether their own risk management practices have kept pace with their own evolving activities and with changes in financial market dynamics and readjust accordingly. Should they succeed I am quite confident that market participants will continue to increase their reliance on derivatives to unbundle risks and thereby enhance the process of wealth creation.” Remarks at the Futures Industry Association, Boca Raton, Florida (19 March 1999).

Until the recent mortgage liquidity mess credit derivatives were seen as big-profit makers by the folks who sold them and the folks who bought them. Perhaps we are at at sort of post-Katrina for the insurance industry moment and the derivatives industry needs to decide if it want to go ahead based on the knowledge gained by this or if the investors want to pack it up and try some new adventure.

I do want to offer one comment to offset some of the concern that can arise when you read "popular" articles about something as complex as derivatives. While it is noted that the outstanding value of derivatives is some staggering amount like 8 times GDP one must recognize that is a notional amount. A much smaller number than that is "at risk." One could look at all on the money bet on individual craps rolls on the Las Vegas strip each year and conclude that it could bust the economy. The fact is that I might go there with a $1,000 bankroll and bet $100,000 in the course of a few hours. It is the $1,000 that is at risk not the $100,000. And the $1,000 is not destroyed. The casino now has my money. I may have lost some money but the economy lost nothing.

Dick Lepre

Comments

[Heymull]

I read the article in MSN you referred to by Das, a derivatives guru who has seen the light. He ended his article by mentioning Michael Milken. It was a very sobering read.

Your assurance that "$1000 is at risk not $100,000" using a Las Vegas casino example, is flawed. Derivatives are used all around the world without regulation, so it would seem that all the world's funds are at risk. Getting back to your casino: it is as though the house was in collusion with the individual better, and let betters spend the $100,000 *while keeping it in the game*. It can work for a while if you are all lucky and no one is checking the books. But if all casinos did this and people started losing "their money" (the casino's $100,000), how long could the casinos stay in business?

[Dick Lepre]

My point was only that a small percentage of the total outstanding "bet" was in danger of being lost. Read this piece by FDIC for a more detailed explanation:
http://www.fdic.gov/bank/analytical/fyi/2003/032603fyi.html