Sir Alan’s Big Mistake

I’ve heard that blogs do well when they deal with controversy, and few things stir up more controversy that looking at the reasons behind the meltdown.  I’ve even had some politically-driven comments here in my first week of blogging, and I imagine this post will cause even more.

A friend made a comment on a post I made on a pay-to-play discussion board,  and the ensuing remarks should stir up some interest among those that read here.

For those who haven’t viewed the Frontline special entitled The Warning, you could do worse things with 52 minutes than watching it.  For me, the highlights were Arthur Levitt and Alan Greenspan admitting they were wrong.

My web buddy’s comment was as follows:

Howard What effect did the Gramm deregulation’s have on Fannie and Freddie? I see they try and blame this all on Barney Frank and I don’t know enough to comment. Bu I do know I couldn’t sell my company back in the 80’s to A&P, or they would own to big a share of the super market business. Then I sold and deregulation’s came about.Cost me a lot of money.

He really crammed a lot into that one comment, so I’ll deal with the issues in two posts.  Besides, anyone that doesn’t get mad reading the first one will probably get their chance when they see how I address the anti-trust issues.

To directly answer the question about derivative de-regulation’s effect on Fannie and Freddie, I have to say that they probably saved some money, since compliance with a derivatives regulatory scheme would have forced them to take on additional overhead disclosing and justifying their interest rate hedging programs. This would probably not have affected them too much, however, since they had OFHEO (now FHFA) and their auditors poking around all the time, anyway.

As far as I know, they weren’t users, to any meaningful degree, of the credit derivatives (CDS) market.  They were huge users of interest rate swaps, however.  We have to remember that they weren’t just in the business of guaranteeing (“wrapping”) MBS in exchange for a fee.  They also held large portfolios of MBS themselves, and they funded those holdings by issuing debentures (bonds).

The bonds they issued were often callable, a feature that gave them flexibility to offset the inherent call in a mortgage (the right of the borrower to pay off their loan early).  Still, just issuing callable bonds didn’t deal with all the vagaries of the rates market, so Fannie and Freddie spent considerable time and effort managing their interest rate risk.  Hence, the big-time use of interest rate swaps, swaptions, caps, etc.

I’ll start with the post to which he appended the question.  It was in the middle of a larger discussion about government “interference” with markets, a role most of us naturally distrust.

A poster had just brought up the issue of Fannie, Freddie and them guaranteeing subprime loans, and I questioned what he was referring to:

Since they were both constrained by their charters, I’m wondering what you’re referring to.

If you mean the exceedingly small program from Fannie Mae to “wrap” CRA loans, it only totaled $10 billion over a five year period. I’m quite sure those CRA loans were “purchased” by the issuance of MBS, which were immediately returned to the “selling” institution. What the banks did was get some capital relief by holding FNMA paper instead of whole loans, and it cost them a guarantee fee, probably in the 40 to 60 basis point neighborhood. For large enough banks with enough CRA loans on their books that satisfied other FNMA requirements (full documentation, 80% LTV cap), it was a good trade. I believe it to be similar to the Freddie Mac PC (Participation Certificate) program rolled out during the Reagan Administration as the second major attempt to fix the S&L crisis.

When you look at a $10 billion number over five years, you have to compare it to the $600+ billion per year subprime lending going on from purely non-Agency, non-bank issuers that was sold into the market as private label MBS. Over 60% of that came from Wall Street owned non-bank finance companies. Look also at the $400 billion per year of alt-A, and twice that amount of “prime jumbo” non-Agency MBS.

I do agree that Fannie and Freddie were accorded special status that pushed yield spreads down too far on their MBS, which forced investors to have an appetite for the mortgage equivalent of junk bonds, as well as enormous tolerance for leverage (outright sought after in things like CDO’s and SIV’s that held ABS…

You are dead wrong blaming the CRA program for any of this, however, since those loans, on a relative basis, held up far better than any other mortgage subsector, including (especially) the super-prime jumbos and the alt-A loans made only to high-FICO borrowers.

You should at least consider the fact that those two worst performing sectors (alt-A and jumbo private label MBS) were not subject to Federal regulation, nor to Agency guarantees, when you try to blame government interference.

I believe very strongly that the entire problem would have been manageable if it were not for the CDS issued without regulation or disclosure or capital reserve requirements. Those grew to roughly twice the size of the world debt markets ($60 trillion), and were highly concentrated into a few names and sectors. Blame the Commodity Futures Modernization Act, if you want to blame any government action. Check it out, and tell me whether you disagree.

When the truth is known, if it ever is, I believe we will find out that CDS amounting to 100 to 1,000 times the face amount of the below-AAA MBS were issued by unregulated, non-reporting issuers like AIGFP. By definition, Fannie and Freddie never issued below-AAA securities. We can argue about whether they deserved their rating, but the CDS that started with a conventional explosion and made it nuclear were using non-Agency MBS paper as their reference securities.

As is usually the case, the discussion continued.  I can only present here the parts of it that I contributed.  Following on in the thread, I replied further to my friend:

There wasn’t much effect on Fannie and Freddie directly, other than the enormous leverage available for purchasers of CDS on their corporate name. When the Fannie CDS settlement (corporate bond version) was publicized, the cash payment was over $360 billion from writers of that insurance to the purchasers, most of whom were hedge funds and/or Wall Street dealers. They only paid 10 to 20 basis points per annum for that insurance, so a five year contract cost less than 1%. For a buyer that had only paid a couple of years of insurance premium on the Fannie corporate CDS, they got a 91 cents on the dollar payoff from an investment of less than half a cent on the dollar.

I bring up the sheer size of the money changing hands on the Fannie CDS settlement ($365 billion, if memory serves), because the total amount lost there was roughly equal to the total amount lost in all subprime mortgages, combined. And the subprime losses were spread over thousands of investors over a period of years, while the entire Fannie Mae corporate collapse happened over a period of months, culminating in a single day for loss recognition.

While we may never know the total extent of the loss transfers related to mortgages and mortgage lenders in the synthetic (CDS) market because of Gramm’s CFMA, it is easily trillions of dollars, and dwarfs what happened in the cash markets.

That Frontline special on Brooksley Born’s warning had two especially unusual clips, where Arthur Levitt and Alan Greenspan admitted they were wrong in their fundamental belief in capitalism’s ability to self-regulate.

They essentially failed to understand that a web of interrelated obligations that is NOT regulated is, by definition, subject to systemic failure if just one link between two counterparties breaks. It has a name every market historian knows — the Herstatt Effect, named after a small German bank that failed and almost destroyed the world banking system’s mechanism of currency exchange.

They (Clinton, Rubin, Gramm, Greenspan, Levitt et al) let their ideological bias hide from them the reality that any economic system subject to self-reinforcing behavior (feedback loops) will follow its trend until the system oscillates out of control. They’d like to believe that there is some magical self-regulating mechanism. The history of booms and busts and bubbles going back for centuries is proof that no such mechanism exists.

While Greenspan is correct that sophisticated institutional investors will try to require their counterparty to be able to perform in their private contracts, he was completely out to lunch to extend that to a belief that every counterparty in the system will get it right every time.

OK. Time to let this one fly. More later on the anti-trust issues brought up by my friend being stopped from selling his supermarkets to A&P because it would create a local monopoly.

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One Response to Sir Alan’s Big Mistake

  1. Eric iousa says:

    I saw your post on valueforum and read your blog. You are an amazing guy and look forward to reading your blog. Good luck in all you do.

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