Wednesday, December 30, 2009

The Sky is Falling! -- Maybe Not.....

On Christmas Eve, the Treasury announced that they were changing the funding situaition for Fannie and Freddie. The blogs erupted in unison -- there was a conspiracy! We're all going to hell! The sky is falling.

As usual, the blogs, well, overreacted:

Let’s start with “uncapping” Treasury support under the Preferred Stock Purchase Agreements (PSPAs) authorized by the Housing and Economic Recovery Act (HERA) of 2008. Under the new calculation the maximum amount either enterprise may draw is the greater of $200 billion, or $200 billion plus the cumulative amount of deficiency amounts covered by Treasury preferred purchases as of December 31, 2012, less any surplus at December 31, 2012.

Deficiencies are negative net worth measured in any quarter; these require the enterprise to sell preferred stock to the Treasury to maintain net worth at zero. Surpluses are positive net worth. Please notice that the new calculation provides for the possibility that the enterprises will not continuously run in the red. The mechanics are a little vague - suppose an enterprise draws $210bn through Q111 but emerges with a $20bn surplus at December 31, 2012. Does the Treasury claim the surplus at that time?

Nonetheless, including surpluses in the cap formula is an important and appropriate adjustment. Freddie Mac did draw a total of $51bn over the first three quarters the agreements were in place (Q3 and Q4 of 2008, Q109), but it finished Q2 and Q3 with positive net worth ($8.2bn and $10.2bn respectively). It had no need to draw on Treasury for funding.

More fundamentally, the game has radically changed since Congress (spurred on by a strong scapegoating and retribution-mongering spirit) and the Paulson Treasury wrote the rules for GSE support. Private lenders (including the biggest ones paying back their TARP money, Ms. Story) are making few residential mortgages for their own books, and there is NO investor appetite for privately securitized mortgages. And furthermore, between FAS 166/167 and proposed requirements that securitizers retain significant risk, prospects are not bright for a renewal of private securitization.

Like it or not, at present home sales and refinancings are overwhelmingly supported by FHA/Ginnie Mae, Fannie and Freddie. Equally significant, and completely unforeseen by the Congress and Administration that authored HERA, Fannie and Freddie are bearing a disproportionate share of the burden for mortgage modifications. Although there is much that can be written on this issue, Credit Suisse mortgage analysts Mahesh Swaminathan and Qumber Hassan put it succinctly in a report published last November on the expected impact of HAMP modifications on prepayments:

The GSEs have a much higher share of HAMP trial mods compared with their share of overall delinquencies for the mortgage universe. No PSA constraints and relaxed NPV requirements for mods make it easier for servicers to initiate trial mods on GSE-backed loans.

(Translation: PSAs are the pooling and servicing agreements that govern, among other things, what modifications of securitized private mortgages. Although mass reviews of PSAs and the creation of a legal safe harbor should give servicers sufficient latitude to modify much larger numbers of loans, the possibility of law suit remains as the interests of different classes of investors in a deal are often not aligned and decision-making responsibility appears divided between servicers and trustees.)

Also, thanks to high unemployment and the precipitous decline in home values, the delinquency and foreclosure crisis has spread to loans underwritten to traditional credit standards - the bulk of Fannie and Freddie’s books of business. Official estimates from Treasury and the Congressional Budget Office indicate the caps are sufficient, but some analysts have been arguing for more headroom. In a December 11, 2009 piece, Barclays Capital analysts led by Rajiv Setia published a lengthy examination of the GSE’s current condition and the future of government involvement in US housing finance. Noting that serious delinquencies continue to rise, they tested the original caps under a base and stress-case scenario. In both cases they found that $200bn was more than sufficient for Freddie. However, given that Fannie’s credit book is 50% larger, they questioned the wisdom of providing the same level of support to both enterprises. Under the stress scenario, “the $200bn backstop may prove too close for comfort, especially in a double-dip recession.”

Swaminathan at Credit Suisse, in a note written over Christmas weekend, similarly saw the risk as small: “The only way GSEs would need to tap more than the $400bn capital line previously provided is if there is a housing double dip that causes losses on GSE credit books to exceed 8%.”

This plays directly into an article I wrote on the economic blogs, especially this point:

Third, there is the simple fact that people who write about the economy don't understand the economy.

Once again, writers have demonstrated they know squat about how finance works.