A GSE Perspective

Doug Noland, Credit Bubble Bulletin, www.prudentbear.com  07/25/08

           ...[W]ithout the GSEs as buyers eager to pay top dollar for mortgages and MBS – especially in the event of marketplace disruption – the hedge funds, Wall Street proprietary trading desks, and others would never have had the gumption to accumulate highly leveraged positions throughout the mortgage and debt securities marketplace. Today’s massive and destabilizing Global Pool of Speculative Finance owes its existence to the GSEs.

           ...[T]he reality of the situation is that GSE “Books of Business” must expand at least $600bn this year and then as much next year and the year after that… or very serious problems will unfold throughout the conventional mortgage marketplace.

           The GSEs are now trapped in a precarious riptide where they must swim incredibly hard to barely tread water. This is an extremely tenuous position for the conventional mortgage marketplace, not to mention the increasingly credit-starved U.S. Bubble economy.

On more than a few occasions over the years I’ve been accused of having an obsession with the GSEs. For some time I’ve viewed these institutions as the key linchpins for a historic Credit Bubble along the lines of John Law’s eighteenth-century Mississippi Bubble. The GSEs, with their implied government backing, forged a fundamental – and momentous - change in the nature of contemporary “money” and Credit. Their financial and economic impact has expanded exponentially since their initial foray into system liquidity backstop operations back with their 1994 bond market/hedge fund “bailout.” I am left to scoff at the CBO’s $25bn estimate for the likely eventual cost to the American taxpayer.

Fannie’s and Freddie’s combined Total Assets ended 1991 at $194bn, only to about double in four years before ending the nineties at $962bn. After several years of aggressive growth, Fannie’s and Freddie’s combined Books of Business (retained holdings and MBS guarantees) began 1999 at about $1.60 TN. In May of this year they exceeded an incredible $5.20 TN and have so far this year expanded at near y-t-d double-digit rates. Over the past 12 months (through May), Fannie and Freddie’s combined Book of Business had expanded $627bn, or 13.7%.

When I read the various estimates of the GSEs’ additional capital requirements, I again reflect back to one of the great flaws in economic historical revisionism with respect to the Great Depression. Conventional (“revisionist”) thinking today has it that if the Fed had simply “printed” $5bn and replenished lost banking system capital in the early thirties, the worst effects of the depression would have been avoided. But then, as is the case today, the size of lost financial sector “capital” was not the critical issue. Instead, financial sector losses pale in comparison to the huge scope of additional Credit creation necessary to sustain deeply maladjusted financial and economic structures – and the impossibility of sustaining Credit Bubble excess in the face of escalating risk intermediation losses and resulting tightened financial conditions, sinking asset prices, acute financial system impairment, investor and speculator revulsion, de-leveraging, major changes from boom-time spending patterns and economic downturn.

Treasury and the Fed could today easily “cut” Fannie and Freddie (and the FHLB!) a $20bn check or, ok, $50bn. Yet the reality of the situation is that GSE “Books of Business” must expand at least $600bn this year and then as much next year and the year after that… or very serious problems will unfold throughout the conventional mortgage marketplace. There are Minskian “Ponzi Finance” dynamics at work here, as there were in subprime, “private-label” MBS, CDO, auction-rate and other markets. Only the stakes of a conventional mortgage bust are much greater.

Without the GSEs, there is no way Total U.S. Mortgage Debt would have doubled in the six years 2001-2006. Without the GSEs, it would have been impossible for broker/dealer assets to have ballooned from $455bn to begin 1995 to $3.10 TN to end 2007. And I believe very strongly that without the GSEs the leveraged speculating community would be but a fraction of its current unfathomable size.

Many view the GSEs in an ideological context. To me, it’s always been at its core a financial, economic and political issue – one of the most important issues of our day that Washington and the Fed have left in complete shambles. With the GSEs’ quasi-governmental status, the markets have merrily assumed GSE obligations would be, if necessary, backed by the full faith and Credit of the U.S. government. It remains an irrepressible Bubble.

Washington (democratic and republican administrations, congress, and the Federal Reserve) and Wall Street were happy to live/thrive with the grey area of the markets’ acceptance of implied government backing. Importantly, this market perception granted the GSEs the extraordinary capacity to create at will contemporary “money” (financial instruments perceived as being safe and liquid) and (extraordinarily appealing) Credit. This “moneyness” of GSE obligations played an instrumental role in profound changes experienced throughout the financial and economic world over the past 15 years. Never in history has an inflationary mechanism enjoyed such capacity to issue endless quantities of “money-like” instruments with nary a public protest or market backlash (at least as long as asset prices were inflating). And even recently, despite heightened market concerns, Freddie was not impeded from expanding its retained portfolio $21bn during June, or 33% annualized.

The markets’ enthusiastic embrace of massive issuance during bouts of financial market tumult encompassed the greatest danger inherent in GSE obligation “moneyness”. GSE assets expanded 15% ($115bn) during the 1994 crisis, 28% ($305bn) during tumultuous 1998, 23% ($317bn) during 1999, and another 18% ($344bn) during the corporate Credit crisis of 2001. And keep in mind that Fannie’s and Freddie’s combined Books of Business have ballooned more than $3.1 TN so far this decade.

Enjoying unlimited access to borrowings during periods of systemic stress, the GSEs evolved into the powerful liquidity backstop for the leveraged speculating community and the securities markets generally. Like clockwork, the Greenspan Fed would aggressively cut rates and the GSEs would aggressively expand Credit. And without the GSEs as buyers eager to pay top dollar for mortgages and MBS – especially in the event of marketplace disruption – the hedge funds, Wall Street proprietary trading desks, and others would never have had the gumption to accumulate highly leveraged positions throughout the mortgage and debt securities marketplace. Speculator profits would not have been as spectacular and certainly not consistently so; the unrelenting fund flows feeding the speculator community Bubble would have been a trickle or perhaps a stream as opposed to what evolved into a historic flood. Today’s massive and destabilizing Global Pool of Speculative Finance owes its existence to the GSEs.

If it weren’t for the GSE’s, the 1998 LTCM crisis would have burst a number of fledgling Bubbles, certainly those gaining momentum in technology stocks and telecom debt and most likely in securitizations more generally. The year 1999 would have been a recession year, rather than one noted for spectacular stock market gains. The GSEs again played a major role in ensuring that the 2001/02 recession was short and shallow – that unfolding excesses and imbalances were validated rather than corrected. The GSEs, along with their Wall Street comrades, ensured that each year would bring only greater amounts of system Credit and resulting higher asset prices higher than the year before. Resulting economic and asset market “resiliency” spurred an increasing variety of Credit instruments and channels – mostly “AAA” – that provided more than sufficient fuel for the U.S. Bubble economy.

I have repeatedly expounded the view that the most problematic systemic damage over this protracted Credit boom has been inflicted upon the underlying structure of the U.S. economy. It is my view that only through the interplay of GSE and Wall Street “structured finance” Bubble dynamics has our massive Current Account Deficit been sustainable. It was this Credit apparatus that created much of the “money-like” financial claims that our economy has for too long traded for imported energy and goods. And each year that foreigners eagerly accepted these claims brought deeper mal-investment and structural impairment. The GSEs provided a “backstop bid” to the speculators, and foreign central banks provided a “backstop bid” for the Trillions of agency instruments and dollar financial claims more generally. U.S. and global imbalances went to unprecedented extremes. Most regrettably, the evolution to our finance-driven, “services,” asset and consumption-based economy has been a direct byproduct of the GSE/Wall Street Credit boom.

As the Credit Bust has broadened and worsened, GSE solvency has become a critical marketplace issue. Today, with the specter of acute GSE financial fragility, the “moneyness” of GSE obligations now rests 100% with unlimited federal government backing. Treasury has few options than the game it’s playing (Bill Gross used “sham”). The hope is that with Congress providing Treasury with blank check discretion to recapitalize the GSEs, agency obligations will retain the confidence of the marketplace. It worked somewhat this week, as agency debt spreads narrowed significantly. But why, then, are agency MBS spreads remaining so wide?

Mortgages have traditionally been a rather unattractive investment instrument. Real estate markets are traditionally highly cyclical, with risk under-pricing during the boom and Credit losses exploding in subsequent downturns. Moreover, there’s major interest rate risk. When rates decline, homeowners rush to refinance and the holders of these mortgages suffer prepayment risk (must reinvest proceeds at lower rates). When interest rates rise, homeowners hold onto their attractive mortgages longer – and the holder gets stuck with longer duration.

Yet despite these less than enticing attributes, mortgages became only more coveted during each year throughout the life of the Credit Bubble – with, of course, the booms in the GSE and Wall Street finance playing an instrumental role in the newfound status of this asset class. A strong case can be made today that the dynamics of this asset class have changed once again – and profoundly. Mortgages are poised to be unappealing for years to come.

Capital raising notwithstanding, the GSEs will now be indefinitely and severely equity capital constrained (at best). Their days of mortgage/MBS “buyers of first and last resort” will be drawing to a conclusion. Capital requirements for guaranteeing MBS are significantly less onerous, so Fannie and Freddie will have little alternative than to rein in balance sheet growth (MBS retention) while continuing to guarantee massive agency MBS issuance (“insurer of last resort”). This cannot be a comforting dynamic for those that have had been making a nice living leveraging in MBS. Meanwhile, the “private-label” MBS market is an unmitigated bust and even bank “prime” mortgage lending appears to have tightened meaningfully, further restraining mortgage Credit growth and placing ongoing downward pressure on home prices and the general economy. This Credit bust dynamic greatly exacerbates GSE portfolio Credit risk, while leaving them with no alternative than to continue to aggressively expand their MBS guarantee business (to the tune of $600bn plus annually in the face of an escalating housing and economic bust).

The GSEs are now trapped in a precarious riptide where they must swim incredibly hard to barely tread water. This is an extremely tenuous position for the conventional mortgage marketplace, not to mention the increasingly credit-starved U.S. Bubble economy.