Someone correct me, but most of the retained portfolio consists of fixed rate mortgages, pooled as their own MBS. So ignore ARMs. Suppose you have $10 in fixed rate mortgages, with a WAC of 10%. They're typically 30year, ie a duration around 6-10 yrs. You issue 1 year debt at 9%, and add 25c of your own capital. 1st year, net income is 12.25c. Year 2, oh horror, 1- through 10-year agency rates don't change adiabatically, but jump to 11% before you can say "buy more swaps." (or market says "sorry no swaps available today") Loss that year: 7.25c. By about year 6 or 7 your book equity is gone and you're insolvent. Simplistic, but that's what being short funded means. Happened to FNM in early 80's I believe. "Bankruptcy" is much more difficult, as it is more idiosyncratic. M-KMV build some (proprietary) trigger that's like "MV of assets 10% below book value of debt." Forbearance by the "regulator" (OFHEO) comes into play.
When the sky falls, no one wants to pay and its a race to keep the money. So when the bank makes these "GOVERNMENT BACKED" loans and that branch of the gov't goes insolvent...who is the Gov't then? I know, the Federal BK courts.... It's really good that someone is looking ahead and bringing this out...now will they go hide in their holes and wait for it to happen or will they act on this? Henry noted that the markets continue to hold the "false belief" that the U.S. government guarantees GSE debt, which has led to preferential funding rates and the expansion of GSE portfolios.
Frankly, I don't believe Franklin Raines, Jaimie Gorelick and the other political hacks who were running FNM had the background to understand even vaguely what the hedging was all about. When the shyt hit the fan, they would have used the Ken Lay defense:" Well, my job was to collect stock options, I relied on those experts to do the actual work." Bottom line is the U.S. housing finance market is now sufficiently mature that we do not need the moral hazard implied by too big to fail GSE's. If we are going to have socialism, I'd rather get it full strength. Socialized risk and private profit, albeit rewarded due to political connections, is the worst mixture.
Agree on the first para, but also add that I think most guys below the very top are very very good and very very honest. Also, the shenanigans *were* "caught" - kudos. ceo's at fully private cos pull this stuff, too. Second para - don't you think are more gentle approach (for now?) might be better? Cap portfolios, perhaps slowly? I agree that financial markets have come a long way since 1938 (Reg Q, for heaven's sake!), and perhaps liquidity is not much threatened if you take away Fannie and Freddie - but who likes such abrupt changes (esp right now with the housing market already a little stretched)? The credit guarantee is prob instrumental in convincing the cap markets to hold more rather than less MBS.
I agree. I'm not suggesting disbanding the GSE's, only making it clear that they are private entities, plus giving their regulator the teeth that federal bank regulators have. As for Raines and his crowd, I think it is fair, if perhaps unrealistic, to expect a higher level of ethics from political appointees, which they were. Also, taxpayers would likely pay to clean up their mess.
Cutting ties completely also means you can no longer force them to confine business to residential mortgages, etc. Eventually they'll just be another Citibank, right? And they can decide to get out of the MBS-guarantee business alltogether. Big bonus for other banks, but home owners will lose (for a change!). Perhaps this is the way to start weening owners from government largess. Interest tax deduction next, though that one most voters will get! I think the problem is not so much that the subsidy bucket is leaky (just go buy FNM or FRE if it bothers you), but those retained portfolios' size. Also, the government need not step in any more than it would (or should) if a Citi were to go down (or an LTCM...). So cutting ties will not remove the taxpayers "obligation" to step in, it's not spelt out anyway (2.25bn each is a drop, and that's up to the Treasury, I think). Right now, FNM and FRE (and homeowners) benefit from the ambiguity of their status in the market's mind. Let the capital markets subsidize social stabilty ! Just tap the brakes on portfolio size (and growth), with some flexibilty for economic conditions (devil in the details: Bernanke could decide size limits from FOMC to FOMC ) Another solution would be to improve the Federal Housing Enterprises Financial Safety and Soundness Act...not as easy as it sounds, though.