The Federal Reserve's Exit Strategy: Unlegislated Bailout of Fannie and Freddie
John P. Hussman, Ph.D.
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?n June 2009, the Financial Accounting Standards Board issued an amendment to the accounting standards for transfers of financial assets (SFAS 166) and an amendment to the accounting standards on consolidation of variable interest entities (SFAS 167). Both amendments are effective and will be applied prospectively by the company on January 1, 2010 ·Under these accounting standards, the company will record the underlying mortgage loans in these single-family PC trusts and some of its Structured Transactions on its balance sheet. These mortgage loans have an outstanding unpaid principal balance of approximately $1.8 trillion as of September 30, 2009·While Freddie Mac continues to evaluate the impacts of adoption, the company expects that the adoption could have a significant negative impact on its net worth.·
- Freddie Mac, September 30, 2009 Quarterly 10Q Report
"We do not expect to operate profitably in the foreseeable future"
- Fannie Mae, September 30, 2009 Quarterly 10Q Report
?t the time the Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservatorship in September 2008, Treasury established Preferred Stock Purchase Agreements (PSPAs) to ensure that each firm maintained a positive net worth. Treasury is now amending the PSPAs to allow the cap on Treasury's funding commitment under these agreements to increase as necessary to accommodate any cumulative reduction in net worth over the next three years.·br>
Treasury Update on Status of Support for Housing Programs, December 24, 2009
"All told, the Federal Reserve purchased $300 billion of Treasury securities and currently anticipates concluding purchases of $1.25 trillion of agency MBS and about $175 billion of agency debt securities at the end of March. I currently do not anticipate that the Federal Reserve will sell any of its security holdings in the near term. However, to help reduce the size of our balance sheet and the quantity of reserves, we are allowing agency debt and MBS to run off as they mature or are prepaid. In the long run, the Federal Reserve anticipates that its balance sheet will shrink toward more historically normal levels and that most or all of its security holdings will be Treasury securities."
- Federal Reserve Chairman Ben Bernanke, "Federal Reserve's Exit Strategy"
Testimony to House Financial Services Committee, February 10, 2010
Let's put two and two together here. Fannie Mae and Freddie Mac are already insolvent, and face "significant negative impact" on their net worth resulting from the required consolidation of "off balance sheet" loans into their financial reporting, which will take effect in financial statements for periods beginning January 1, 2010. Over 60% of the U.S. foreclosure market now falls under the umbrella of these two entities.
Under the Housing and Economic Recovery Act of 2008 (HERA), Congress authorized the Treasury to provide sufficient funding to insure up to $300 billion dollars of original principal. Yet in a move that was clearly no part of Congressional intent, the Treasury has announced that it will allow this commitment to "increase as necessary to accommodate any cumulative reduction in net worth over the next three years." Coincident with this, the Federal Reserve has accumulated nearly $1.5 trillion of Fannie Mae and Freddie Mac securities (MBS and agency debt), which is has no plan to liquidate other than lip service. Rather, it is allowing these securities to run off through maturity and pre-payment. Of course, the funds to pay off those maturing securities will largely come from the Treasury. Meanwhile, Bernanke has made it clear that the most important tool of the Fed during the interim will not be liquidation of these securities, but instead the payment of interest on bank reserves.
If one is alert, it is evident that the Federal Reserve and the U.S. Treasury have disposed of the need for Congressional approval, and have engineered a de facto bailout of Fannie Mae and Freddie Mac, at public expense.
Below is a chart of the composition of the Federal Reserve's balance sheet, in billions of dollars. Against these assets, the Fed creates currency and bank reserves, which comprise the "monetary base." Clearly, the volume of Fed-supplied stabilization funding in the system is still enormous. As James Hamilton has observed, "it seems not coincidental that, when you look at the total of all the assets the Fed is holding, the expansion of MBS purchases exactly offsets the declines from phasing out the short-term lending facilities. As a result of the MBS and agency purchases, the total assets of the Federal Reserve today exceed the total reached at the peak level of activity for the lending facilities in December 2008."
fed_assets_feb_10.gif
How will the Fed "unwind" this position? Given the additional information of the past few weeks, we can update the steps that I suggested in A Blueprint for Financial Reform
How to spend (up to) $1.5 trillion without Congressional approval (updated)
Step 1: Federal Reserve purchases $1.5 trillion in Fannie Mae and Freddie Mac securities, creating $1.5 trillion of monetary base to pay for these purchases.
Step 2: U.S. Treasury quietly announces unlimited 3-year support for Fannie Mae and Freddie Mac on December 24, 2009, indicating that it is acting under the authority of a 2008 law (HERA) that was originally written to insure a maximum of $300 billion in total mortgage principal (not losses, but principal).
Step 3: Fed Chairman Ben Bernanke testifies to the House Financial Services Committee on February 10, 2010 that "I currently do not anticipate that the Federal Reserve will sell any of its security holdings in the near term. However, to help reduce the size of our balance sheet and the quantity of reserves, we are allowing agency debt and MBS to run off as they mature or are prepaid. In the long run, the Federal Reserve anticipates that its balance sheet will shrink toward more historically normal levels and that most or all of its security holdings will be Treasury securities." During the interim, the Federal Reserve indicates that it expects to limit the extent to which banks lend out the base money created in Step 1, through a policy of paying interest on bank reserve balances.
Step 4: On February 11, 2010, with Treasury backing in place, Fannie Mae and Freddie Mac (whose delinquency rates have more than doubled over the past year) announce the purchase of $200 billion in delinquent mortgages that they had previously guaranteed. The entire remaining principal balance will be paid to investors at face value. This action provides a glimpse into the future: Fannie and Freddie take bad mortgages onto their balance sheets, extinguish the MBS securities at face value, and rely on Treasury funding to fill the gap.
Step 5: In the next few years, the U.S. Treasury can be expected to issue up to $1.5 trillion in new Treasury debt to the public, taking in much of the $1.5 trillion in base money created by the Fed in Step 1.
Step 6: Proceeds (base money) received from new Treasury debt issuance are periodically transferred to Fannie Mae and Freddie Mac in order to cover cumulative balance sheet losses.
Step 7: Over a period of years, Fannie Mae and Freddie Mac use the proceeds to redeem mortgage securities held by the Fed, thus reversing the Fed's transactions in Step 1, without the need for liquidation or any other "unwinding" transactions. If the MBS securities extinguished in Step 4 are not directly held by the Fed, the Fed can be expected to simultaneously sell an equivalent amount of its own holdings out to the public, so that the publicly held stock of MBS remains constant. In any event, the base money created by the Fed ultimately comes back to the Fed, and the mortgage securities purchased by the Fed disappear, by burdening the American public with a new, equivalent obligation in the form of U.S. government debt.
Outcome: The Federal Reserve closes its positions in Fannie Mae and Freddie Mac securities, the quantity of outstanding Fannie Mae and Freddie Mac liabilities declines by as much as $1.5 trillion, thus allowing their remaining assets repay the remaining liabilities despite insolvency, and the outstanding quantity of U.S. Treasury debt expands by as much as $1.5 trillion in order to protect the lenders, while ordinary Americans continue to lose their homes and jobs.
This would all be really clever if it weren't so insidious. |
