A puzzle with no solution?
With its recent $9 billion earnings writedown, Fannie Mae has made immediate moves to raise new capital starting with 5 billion in preferred stock:
[To] cure Fannie’s immediate problem of being “significantly under-capitalized” for regulatory purposes, a designation given to Fannie last week after the Securities and Exchange Commission’s chief accountant told the company to restate its financial results.
GSE soundness and activity is critical to the US affordable housing ecosystem, in which they play an essential and enormous role:
Assisted by the implied federal guarantee, the housing GSEs have grown into some of the largest financial institutions in the world. Their outstanding securities now exceed $4 trillion–or more than the entire U.S. public debt. In the process, Fannie Mae and Freddie Mac have come to dominate the U.S. residential mortgage market, accounting for almost 57 percent of residential mortgage debt.
Anything that large, and that important, may literally be too big to fail, even if Congress never explicitly says so:
Some observers claim that the government’s commitment is only conjectural and therefore potentially illusory. However, when another GSE, the Farm Credit System, suffered threatening losses in the 1980s, the Congress authorized up to $4 billion in federal financial assistance to avoid a default on bonds that carried a similar guarantee. In that case, at least, the implied federal guarantee became real. In the event of future losses by the housing GSEs in excess of their private capital, the government would face a choice between ignoring a financial shock of unknown magnitude or confirming that its guarantee would be honored. The significant difference in the expected short-term costs of those alternatives suggests that the capital markets are likely to be correct in supposing that the government will not walk away from its implied guarantee when the need for federal support arises.
Triggering government response does not need a crisis as large as the 1987 multi-billion-dollar S&L bailout; it need not even require the wounded company to have a a public purpose, as we learned less than a decade ago with the collapse of Long-Term Capital Management, which until its sudden implosion looked to be a wildly successful derivatives specialist hedge fund:
In 1996, Long-Term’s profits of $2.1 billion overshadowed those of the most successful corporations.
LTCM’s profits were magnified by its use of very high leverage, 30 to 1 or more:
Actually a little more, 33 to 1 was a typical figure…. For every $100 you’re playing with only $3 of them are yours. If those $100 of assets should shrink only by 3% to $97 … you’re wiped out…. That’s a lot of confidence, bordering on hubris. Actually, their leverage was worse, because that 33 to 1 is only the leverage that’s showed on their books, only the balance sheet debt. Long-Term was also very exposed, a very big player in these newer securities, newer instruments called derivatives, which are basically just bets on which way market prices will go. Their effective leverage was something in the order of 50 to 60 to 1.
If you’re going to use very high leverage with volatile assets, you want smart people on board:
The founders included two Nobel Prize-winning economists, Myron Scholes and Robert C. Merton. Scholes and Merton, among other things, developed along with the late Fischer Black, the Black-Scholes formula for option pricing. LTCM also included as guiding spirit John Meriwether, a former vice chairman of Salomon Brothers and famous bond trader. David Mullins, a former vice chairman of the Board of Governors of the Federal Reserve System was also part of the LTCM team. Also several important arbitrage analysts from Salomon Brothers joined LTCM. Eric Rosenfeld left Harvard University to join LTCM. It was a very elite group.
So when LTCM lost 77% of its capital, the potential impact on the financial markets was so great that:
In the fall of 1998 when LTCM was on the brink of failure the Federal Reserve Bank of New York brought the lenders together and brokered a bailout. Some fourteen or so banks contributed about $300 million each to raise a $3.65 billion loan fund.
How does this compare with the GSEs? To start with, they use complex financial instruments:
As a practical matter, however, the enterprises’ risks cannot be eliminated, nor would doing so be in the interests of equity investors. The risks of financing and holding a portfolio of mortgages are simply too varied and complex to permit management to identify them all and to find another party willing to accept them at a reasonable cost. The more feasible objective of holding interest rate and prepayment risks within acceptable bounds is among the most complex and difficult tasks facing the managers of mortgage portfolios.
The GSEs also have leverage higher than Long-Term Capital’s: Fannie Mae’s is an impressive 78 to 1. And though there is a lot of public research available, some in the business admit bewilderment:
In fact, I’m willing to say something that analysts will likely find scandalous: I believe that Fannie Mae is unanalyzable. Fannie Mae, like its sister company, Freddie Mac (NYSE: FRE), uses extraordinarily complex financial statements, layers of derivatives, and has enjoyed years of poor regulatory oversight. Even before Fannie received a stunning and long overdue rebuke from its governmental overseers, it took a Herculean effort to be able to determine how much actual cash flow the company made in a given year.
Analytically inscrutable or not, today Fannie Mae’s financial soundness is regulated by OFHEO, whom many critics have suggested is not up to the task, recommending OFHEO be replaced by a single consolidated GSE regulator, a move Treasury generally endorses:
The Administration recommends that Congress enact legislation to create a new Federal agency to regulate and supervise the financial activities of our housing-related government sponsored enterprises. This new agency’s powers should be comparable in scope and force to those of other world-class financial supervisors, fully sufficient to carry out the agency’s mandate. This means that the agency should have general regulatory, supervisory, and enforcement powers with respect to the enterprises, including responsibility for ongoing prudential review of GSE activities in keeping with the terms of their charter, with the evaluation of new activities being made in consultation with the Secretary of Housing and Urban Development. With respect to conservatorship/ receivership powers, the new agency should have all of the authority necessary to direct the liquidation of assets and otherwise to direct an orderly wind down.
These issues will heat up as soon as the new 109th Congress convenes.
