If you’ve been following Rafferty Capital Markets VP Richard Bove’s commentary on Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC), you know that he considers the GSEs to be essential parts of the US economy that the government liquidates at all of our peril. In light of the recent setback to GSE shareholders, he’s decided to take another shot at explaining the theory and brought in another banking expert to back him up for good measure.
Solutions to the wrong problems put in place, says Bove
Bove’s version of what happened during the financial crisis focuses a lot more on global macro trends and less on moral hazard than the typical rendition. The sequence of events that he sees is the population growth ‘outside the North Atlantic communities’ (eg India and China, as opposed to the UK and US) meant that there was an abundance of cheap labor to produce goods for consumption in the West, causing huge flows of capital to these developing economies. Since those countries couldn’t absorb so much capital so quickly, investors sent that money back to the West where it quickly outpaced the amount of responsible investment opportunities and new assets were created to meet the rising demand, resulting in a lot weaker loans being issued and new investment products being created.
“The shortsighted view that greedy bankers created the financial crisis has done this nation incredible harm. This is because solutions have been put in place to solve the wrong problem,” writes Bove. In particular, he has argued repeatedly that Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) have been a backbone of the economy and that, far from putting us in more danger, they played the safety valve role that they were intended to play during a crisis.
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“The failure to understand the importance of the 30-year fixed-rate, self-amortizing mortgage; what is needed to create it; and why it cannot be lost is going to lead the people of this country into massive losses in wealth that no one seems to remotely understand,” he writes.
Fannie Mae, Freddie Mac: Bove gets support from fellow bull Fiderer
“Whenever the private market failed–as it did with the S&L crises of the early 1980s and early 1990s, and in the aftermath of the collapse of the private securities market in 2007 onward–the GSEs have stepped in to staunch a market collapse that would have been much worse,” writes journalist and GSE bull David Fiderer in an open letter to Bove.
Fiderer argues that if other lenders had followed Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC)’s lead in sticking to higher credit standards thirty-year fixed-rate mortgages instead of fighting for market share with risk layering and sub-prime mortgages, there never would have been a crisis in the first place.
Below is the full letter from David Fiderer
I take a less all-encompassing macro view of things. In a nutshell, I believe that a New Deal innovation, the fixed-rate self-amortizing mortgage loan (which initially began with a 15-year tenor and, beginning in 1948 was increased to 30-years), brought about stability in housing finance.
It all worked just fine until the dismantling of Bretton Woods and the inevitable deregulation of interest rates. More specifically, FRMs became imperiled by Paul Volker’s anti-inflation medicine, which caused the thrifts to become insolvent. The only way that 30-year FRMs could be maintained, during and after Volker’s tenure at the Fed, was through Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC), which, until the 1990s, were the only balance sheet lenders with nationwide footprints.
The GSEs’ ability to diversify risks, with regard to location and market timing, could not be matched, then or now. This broad diversification, plus economies of scale, enabled the GSEs to effectively manage the interest rate risk on their balance sheets through interest rate derivatives.
Similarly, only Fannie Mae and Freddie Mac could issue mortgage backed securities that transferred interest rate risk but not credit risk. (All GSE MBS benefitted from corporate guarantees.) The risk profile of private label securities–static portfolios of same-vintage loans in liquidation–can never match the risk diversification of GSE mortgage securities.
Whenever the private market failed–as it did with the S&L crises of the early 1980s and early 1990s, and in the aftermath of the collapse of the private securities market in 2007 onward–Fannie Mae and Freddie Mac have stepped in to staunch a market collapse that would have been much worse.
The common trop, that Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) were only successful because of implicit government backing, is belied by their unmatched loan performance, and, by their consistent profitability.
As a bank analyst, you certainly understand the difference between a liquidity crisis and insolvency, which is based on a number of GAAP timing differences. The GSEs became “insolvent” because of the loss of deferred tax assets and excessively pessimistic loan loss provisions, which were both reversed last year. Unlike all the other 2008 bailouts, the drawdowns of government funds were never needed to support day-to-day operations or any current debt obligations. Of course the government’s unfunded commitment gave Fannie Mae and Freddie Mac the ability to stabilize the mortgage markets when all other players had exited. But that government backstop benefitted all mortgage creditors, not just Fannie Mae and Freddie Mac.
The way I see it, Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) business model has been an extraordinary success. There never would have been any kind of mortgage crisis if all lenders issued FRMs and followed the GSEs credit standards.