The Curious Greenspan and the GSEs
Doug Noland
February 27, 2004
prudentbear.com
Credit Bubble Bulletin
The Curious Greenspan and the GSEs
Chairman Greenspan’s busy schedule this week provided much to keep analysts’ minds busy. Monday he spoke before the Credit Union National Association, with an intriguing speech, Understanding household debt obligations. Tuesday he provided fascinating testimony on the government-sponsored enterprises before the Senate Committee on Banking, Housing, and Urban Affairs. Then on Wednesday, he was before the House Committee on the Budget, offering strong arguments why our government’s long-term fiscal situation is untenable.
As with many of his recent speeches, there is a clear effort by Dr. Greenspan to craft his legacy in a most positive light, as well as attempt to distance the Fed from future crises. Congress must cut spending, rein in social security, deal with the unwieldy GSEs they created, and so forth; the Fed has done a truly exemplary job and Congress needs to get with the program or there will be problems. Our Fed chairman made for some good sound bites and most of what he said seems reasonable, if not genuine. But I also get the sense something more significant may be at play. Is Greenspan quietly crafting some major developments for the financial system?
The first sign that something was up came with Monday’s Curious comments.
“One way homeowners attempt to manage their payment risk is to use fixed-rate mortgages, which typically allow homeowners to prepay their debt when interest rates fall but do not involve an increase in payments when interest rates rise. Homeowners pay a lot of money for the right to refinance and for the insurance against increasing mortgage payments. Calculations by market analysts of the ‘option adjusted spread’ on mortgages suggest that the cost of these benefits conferred by fixed-rate mortgages can range from 0.5 percent to 1.2 percent, raising homeowners’ annual after-tax mortgage payments by several thousand dollars. Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade… American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.”
What? How could chairman Greenspan endorse adjustable-rate mortgages for our aggressively borrowing household sector at this stage of the interest rate cycle? This borders on the absurd, or so I thought initially. But things began to make more sense after his Curious testimony on the GSEs.
“The Federal Reserve is concerned about the growth and the scale of the GSEs’ mortgage portfolios, which concentrate interest rate and prepayment risks at these two institutions. Unlike many well-capitalized savings and loans and commercial banks, Fannie and Freddie have chosen not to manage that risk by holding greater capital. Instead, they have chosen heightened leverage, which raises interest rate risk but enables them to multiply the profitability of subsidized debt in direct proportion to their degree of leverage. Without the expectation of government support in a crisis, such leverage would not be possible without a significantly higher cost of debt.”
“In general, interest rate risk is readily handled by adjusting maturities of assets and liabilities. But hedging prepayment risk is more complex. To manage this risk with little capital requires a conceptually sophisticated hedging framework. In essence, the current system depends on the risk managers at Fannie and Freddie, as good as they are, to do everything just right, rather than depending on a market-based system supported by the risk assessments and management capabilities of many participants with different views and different strategies for hedging risks. Our financial system would be more robust if we relied on a market-based system that spreads interest rate risks, rather than on the current system, which concentrates such risk with these two GSEs…”
“But to fend off possible future systemic difficulties, which we assess as likely if GSE expansion continues unabated, preventive actions are required sooner rather than later. As a general matter, we rely in a market economy upon market discipline to constrain the leverage of firms, including financial institutions. However, the existence, or even the perception, of government backing undermines the effectiveness of market discipline. A market system relies on the vigilance of lenders and investors in market transactions to assure themselves of their counterparties’ strength. However, many counterparties in GSE transactions, when assessing their risk, clearly rely instead on the GSEs’ perceived special relationship to the government.”
Well, isn’t this interesting. After a decade of explosive GSE growth, our Fed chairman has found religion. These institutions abrogate market discipline and are a risk to future stability. And now Dr. Greenspan would like to halt their balance sheet expansion. This is big. But why today?
Chairman Greenspan: “And I would say one of the reasons why the issue of Fannie and Freddie didn’t arise earlier is they weren’t large enough and they didn’t create a potential significant problem for the overall financial system that -- not that they do today, as I point out, but they will almost surely do in years ahead unless some changes are made in the structure of how these organizations function.”
The GSEs ended 1998 with outstanding debt approaching $1.3 Trillion, so it is not credible to argue that they until recently “weren’t large enough and they didn’t create a potential significant problem.” The GSEs have played such prominent roles in a series of Fed-orchestrated “reliquefications” that they have operated as virtual central banking partners. For years, the Greenspan Fed has acquiesced to risky GSE expansion, and, for years, GSE and Fed interests have been in harmony. Perhaps Dr. Greenspan’s newfound resolve is related to ECB and foreign central bank demure. It would, after all, be reasonable that some might appreciate that the GSEs are the fountainhead for much of the destabilizing dollar liquidity inundating the global financial system. I can imagine the ECB’s Dr. Issing protesting that the explosion in GSE borrowings was a leading source of unsound money and Credit – fostering financial and economic imbalances.
I will further conjecture that the true scope of the GSE problem became apparent to the Fed (and others) this past summer and fall. A strengthening economy set the stage for what would typically be an imminent tightening by the Federal Reserve. Between July and August, 10-year interest rate futures yields surged 120 basis points, while measures of bond market volatility exploded. The MBS market was being pummeled, the cost of hedging was skyrocketing, interest-rate markets were rapidly moving toward dislocation and the fledgling reflation/recovery was in serious jeopardy. The GSEs had relied on interest rate derivatives to hedge their ballooning balance sheets, but they had effectively become too large to hedge (the market can’t hedge itself!). And much complicating matters, the leveraged speculator community was heavily exposed, also seeking to reduce exposure to rising rates.
Everyone was on the same side of the boat, and the commencing of interest rate risk off-loading (including the self-reinforcing trading by dynamic/“delta” hedging strategies - by GSE counterparties and others) was quickly exposing the untenable nature of systemic interest rate hedging. The interest rate derivatives market – one chairman Greenspan has so trumpeted as a modern marvel with myriad benefits to financial stability and economic prosperity – was faltering. Moreover, Federal Reserve interest rate policy was hamstrung by the risk of financial dislocation.
But things were brought back to calm. The Fed assured the marketplace that rates would not be rising for a considerable period, while the GSEs ballooned their balance sheets with securities liquidated by the fearful speculators and hedgers. Between July and September, Fannie and Freddie Retained Portfolios expanded by an unprecedented $160 billion. This major operation worked its magic by injecting massive new liquidity, thereby lowering interest rates, fueling stock market gains, and stimulating the U.S. Bubble economy. Stock market speculation intensified and speculative excess fanned out across markets at home and abroad. And it is certainly no accident that this wild inflation also coincided with the arrival of a new leg down in the dollar bear market. This, then, set in motion greater foreign central bank dollar support, ushering in unparalleled global liquidity excess and heightened inflation throughout Asia. Never before had GSE power been as impressive or global in nature. It was also destabilizing.
And while GSE and interest-rate derivative issues were anything but resolved, their resolutions were at least delayed for the Fed’s discretionary “considerable period.” It is my view that Dr. Greenspan would now like to take this opportunity and attempt a change in course -- rein in GSE balance sheet expansion and hedging operations, and get interest rate risk rebalanced away from the financial sector.
But our Fed chairman has a number of dilemmas. For one, any admission that these institutions’ balance sheet operations have played critical roles in reliquefying the system during periods of heightened stress would surely lend congressional support to the GSEs. What’s a politician not to love about that? So Greenspan contrives a circumstance where the GSE business of insuring MBS functions just wonderfully and poses little systemic risk. Balance sheet operations, on the other hand, offer little positive impact (outside of boosting GSE profits), while posing considerable systemic risk. Here’s how Dr. Greenspan explains it:
“There is another business (other than insuring MBS), which relates to the issue of taking part of the mortgages, which are purchased, and hold them on the balance sheets of the GSEs. These mortgages are selling at market interest rates, but if you have a subsidy in issuing debt, you are picking up an abnormal profit, which is the normal profit in the spreads plus the size of the subsidy so that the incentive to put assets on the balance sheet, whether or not they are mortgages, corporate bonds, or other things, which are on the GSE balance sheets; that, in effect, harvests the subsidy which, remember, because it is not restricted by the Congress, can be expanded at will by the GSE. And so what we have is a structure here, in which a very rapidly growing organization holding assets and financing them by subsidized debt is growing in a manner, which really does not, in and of itself, contribute to either home ownership or necessarily liquidity or other aspects of the financial markets.”
“There are disputes, I must tell you, that people -- there are some people who do believe that (GSE balance sheet expansion) has some effect on securities markets. I think the evidence here is very murky and, clearly, in any event, more of a secondary issue than anything else. The crucial question are there -- these are two businesses. They are both subsidized. They both have a high rate of return on equity; indeed, the rate of return on equity on the part of the GSEs is significantly above those of, say, large commercial banks, which is an indication that they have a special advantage. And I’m saying that there is one vehicle or, I should say, one part of this business, which we should be endeavoring to get them to expand, because that’s the base on which the secondary mortgage market functions.”
“The ownership of assets on the balance sheet is a very seriously lesser -- a lesser force. My own judgment is it has very little to do with either home ownership, home construction, or even -- has a -- having a very significant impact at all on interest rates. The real issue is the securitization, which is what Fannie and Freddie originated, they do an exceptionally good job technically, and my own view and why I think privatization would be the thing for them to want to do is I basically believe that if they were to fully privatize, they would be smaller organizations, their profit levels would be somewhat less, their price earnings ratios would be much higher and, in all likelihood, they may even have greater market value from a privatized organization largely because they do things so well.”
Wow! This is fascinating subject matter, as it broaches the key issue of GSE growth: Does their balance sheet expansion create liquidity, thus impacting interest-rate and financial markets generally? Chairman Greenspan is arguing that they do not, and that such potentially risky operations should be limited by congress. He also conveniently avoids the critical issue of the GSEs as “Buyers of First and Last Resort for the Leveraged Speculating Community.” The capacity for basically unlimited GSE balance sheet expansion – especially in a time of heightened systemic stress - provides a momentous incentive for leveraged speculation in MBS and throughout the U.S. Credit market. To downplay the importance of GSE balance sheet expansion is Curious but not all too credible.
Not surprisingly, Mr. Greenspan’s testimony elicited immediate responses from both Fannie and Freddie. From Fannie’s Franklin Raines: “By purchasing mortgages for its portfolio, Fannie Mae has been able to move independently to stabilize the mortgage market during a crisis. In so doing, it has provided an important source of stability to the market. This was clearly evident during the global financial market turmoil in the fall of 1998… Fannie Mae repeated this role of market stabilizer following the events of September 11.” Fannie and Freddie CEOs both testified before congress on Wednesday, stating (the obvious) that GSE purchases lower mortgage rates and, at crucial times, have stabilized the markets.
Richard Syron, Freddie’s new CEO and former Fed bank President, wrote, “It is unfortunate that the debate has moved from a discussion of the importance of legislation to strengthen the regulatory structure of the housing GSEs to a more theoretical discussion.” Well, for too long the critical “theoretical discussion” of the GSE’s instrumental role in contemporary money, Credit, marketplace liquidity, speculative excess and economic activity has been dismissed and disregarded.
Chairman Greenspan would, of course, never admit that the GSEs – in the age of unconstrained Wildcat Finance - operate as quasi central banks and nurture leveraged speculation. He’ll gladly stick with the conventional view that these institutions are incapable of creating liquidity and are far removed from markeplace speculation. And Dr. Greenspan points the finger of responsibility at congress, instructing them to attempt to resolve the issue of the markets assuming government backing of GSE debt. But surely he appreciates that the “implicit guarantee” is much more of a creature of the Greenspan Fed than it is of our Washington politicians.
The Fed cannot speak of helicopter money, “unconventional methods,” and fighting deflationary forces at all cost and not have the markets absolutely convinced that the Fed would move aggressively at any indication of problems at the GSEs. Holders of GSE debt have understandable confidence that the Fed would respond to any systemic crisis by inflating the value of their holdings – they’ve done it repeatedly. Indeed, the GSEs powerful unlimited capacity to issue securities and create marketplace liquidity rests squarely with the Fed’s guarantee of marketplace liquidity and repeated market bailouts. The GSEs are the ultimate Too Big Too Fail – the ultimate Moral Hazard and no amount of legislation will alter this reality.
Dr. Greenspan recognizes he has a major problem, and he is surely anxiously aware that he must attempt to rein in GSE debt growth. They have become too powerful, they now dominate (unsound) “Money & Credit,” and, importantly, GSE and Fed interests are no longer necessarily in accord. Of immediate concern, Greenspan faces an interest rate hedging nightmare. But he also fully appreciates that he cannot risk any reduction in mortgage finance Credit Availability. This leads Greenspan to become a strong advocate of GSE guarantees, ensuring the continuation of enormous Credit growth through the MBS market. But he also fully appreciates that aggressive banking system asset growth will be required to compensate for restrained GSE portfolio expansion. Yet such expansion would be especially dangerous at this stage in the interest rate cycle (not to mention the terminal phase of the Mortgage Finance Bubble). The interest rate derivative market is today untenable, and he would be adamant to minimize the banking system’s exposure to excessive interest rate risk.
So a crucial aspect of his plan is to have households shoulder much more of the risk burden – Adjustable-rate Mortgages for the Masses. And with today’s active purchase and refi mortgage markets, in not all too long of a period a considerable amount of interest-rate risk can be shifted to homeowners enticed by low payments. This process is certainly supported by the myriad of alluring new ARM (and interest-only) products coming to market, which Greenspan went out of his way to trumpet Monday. The Fed can do its part by keeping interest rates artificially low. And as crazy and reckless as all of this is, it suits Dr. Greenspan just fine. Sustain the Great Credit Bubble and transfer even more risk to unsuspecting homeowners. The banks win, as they gain back market share in mortgage lending. The GSEs do fine as they insure only larger amounts of MBS. And the financial system wins generally as it earns strong profits while transferring interest rate risk to the household sector. And, as we all know by now, What’s Good for the Financial Sector, is Good For America.
All I can say is the Dr. Greenspan is truly The Wizard. He is the financial genius, the artful politician, the brilliant scientist. But his experiment has “gone mad.” To proceed with his endeavor – to sustain the Great U.S. Credit Bubble - requires larger quantities of debt of increasingly risky debt. And he clearly has every intention of burdening households with unprecedented risk. He makes the ridiculous claim that household finances are in good shape, but this is only to rationalize his plan. He is in the process of thoroughly burying Americans in debt. Greenspan imparts a terrible injustice.
I will stick with my view that this is despicable central banking at its absolute worst. I will again protest that Dr. Greenspan is deceitful and dishonorable. And I will protest that a reckless U.S. financial sector is more than willingly complicit in the rape and pillage of American finance. But placing all this aside, we must be especially vigilant analysts. There are potentially major financial developments afoot. And in the unfolding battle between Alan Greenspan and the government-sponsored enterprises, I would not underestimate The Enormous Power of Franklin Raines & The GSE Lobby.
Maryland Senator Paul Sarbanes: “Let me just follow up on the question that the chairman just put, because I think it’s interesting. Some have argued that the GSEs provide important stability in the mortgage markets during periods of economic instability, and they site, for example, the Asian debt crisis in ‘98, or the business and bank recession of ‘90, ‘92, and argue that the mortgage rates would have increased dramatically at that time as, in fact, they did in the Jumbo mortgage market and in other credit markets, but that the GSEs’ ability to continue buying mortgages and mortgage-backed securities made a difference so that they had played an important stabilizing role. What’s your response to that?”
Chairman Greenspan: “First of all, the reason that there were fairly significant purchases at that time is that, remember, during that crisis you had a flight to quality, which pushed long-term Treasury rates down. And because the presumption was that the GSE debt was comparable to Treasury, its rates went down. And, as a consequence of that, the margins opened up, and it became quite profitable to go in and purchase mortgages and mortgage-backed securities so that the issue was not an endeavor to do something for the markets, per se, it was a very sensible decision.”
Senator Sarbanes: “But did that endeavor contribute to stability?”
Chairman Greenspan: “I think it did, in part, yes.”
Senator Sarbanes: “In part?”
Chairman Greenspan: “I said I think it did, in part.” |
