GSEs Still A Good Thing, Ranieri Says
Government-guaranteed giants would be a solid backstop for fragile financial markets
October 6, 2008
Like it or not, US housing agencies Fannie Mae and Freddie Mac are a key to bringing back to life US housing finance, according to Lewis Ranieri, one of the earliest pioneers of mortgage securitization.
"The biggest and most necessary challenge will be rebuilding Fannie and Freddie. We are not going to have a market unless we have a deep, stable institution or institutions willing to take appropriate risk and carry it into the future," Ranieri told a group of senior home builder executives Wednesday. "A properly reconfigured Fannie and Freddie is the most important thing we can do."
Ranieri was the guest speaker at Harvard University's Joint Center for Housing Research. He is best known for his work on the Salomon Brothers mortgage bond trading desk, which led much of the innovation in US mortgage housing finance, creating products such as the first collateralized mortgage obligation. His work at Salomon was chronicled in Michael Lewis' Liar's Poker and has earned him the title of "godfather of mortgage finance." (To read IDD's interview with Ranieri from last year, click here.)
Lewis Ranieri
"Some [people] want the GSEs to be wholly government-owned and others want them to be private. I don't think either of these extremes works well," he said. "During the takeover of Fannie Mae and Freddie Mac, [Treasury] Secretary [Henry] Paulson made it clear that the quasi-government nature of these two giants had to change. I think he is right but I think the trick is in creating a more responsible structure that will make them relevant and effective while also providing the explicit guarantee."
That explicit guarantee has been the center of much discussion for close to a decade. But, the debate over the guarantee has been more fevered in the years after accounting scandals at both of the housing agencies forced a series of changes in the ranks of senior managers and put both agencies under greater regulatory scrutiny.
The explicit guarantee has allowed the agencies to borrow from a wide range of investors worldwide, including foreign central banks, at a low cost. The borrowed money was typically put to work in the US mortgage market, either through purchases of mortgage-backed securities or mortgage loans with an agency guarantee.
"What value would a totally privatized Fannie Mae and Freddie Mac bring to this uncertain market and carry it forward ... if they can no longer provide government guarantees?" Ranieri asked. "It is hard to see them being effective under any of those circumstances. The guarantee function always sets them apart. It's been their true value whether it was implicit or, now, explicit."
Ranieri said he believes that the housing agencies would lose their value as private entities without the guarantee of the US government. But, he also noted that complete government ownership of the housing agencies is not, in his eyes, palatable. "Do we really want the government on the hook for all of the risk? I don't think so."
One alternative to the current housing agency structure is a system akin to the Federal Home Loan Bank system, according to Ranieri, who describes such an alternative agency structure as a "sort of a co-op." Lenders would "buy into" Fannie and Freddie and the federal government would guarantee MBS for a fee. "Some kind of co-op is a viable idea. It worked for the (Federal) Home Loan Bank system and I don't see why it can't work that the users have to buy in," Ranieri said.
To illustrate his point of how housing agencies have, in the past, provided a backstop to the mortgage finance market, Ranieri recalled that the two government-sponsored enterprises helped provide liquidity when finance markets were tripped up by the collapse of Long-Term Capital Management. That collapse, which came in the wake of the Russian debt default in August 1998, nearly brought US credit markets to a standstill in September and October 1998. Yield premiums on a wide range of bonds widened dramatically and liquidity in a variety of markets was hobbled. Within the US conforming mortgage market, though, liquidity was shored up by large purchases of mortgage debt by Fannie Mae and Freddie Mac. While it is generally believed that both agencies profited immensely by purchasing mortgage debt when it was inexpensive, their entrance in the market ensured that home loans were being made to consumers without a spike in borrowing costs.
"When the [John] Meriwether crisis hit, the only market that continued to function was the housing market because Fannie Mae and Freddie Mac stepped in. Using the portfolio in that regard is fine," said Ranieri. He added, though, that "using a portfolio to generate income for shareholders so that shareholders and managers get it when times are good and taxpayers get it when times are bad doesn't work."
In recent months, a wide range of mortgage finance professionals have embraced the idea of raising money for home loans through covered bond structures, an idea that has long been used by European lenders. Bank of America and Washington Mutual had covered bond programs and, recently, CIBC introduced its own covered bond program.
According to Ranieri, US housing finance could benefit from using elements of the covered bond mechanism.
"If we can develop covered bond structures that look like the underlying term of housing, 30 years as an example, [so] we're not simply trying to match a 30-year loan to a three-year liability, it would become a very viable tool," according to Ranieri. "Covered bonds are an interesting idea and as a liability tool for the Bank of America it is interesting because covered bonds give them one more quiver to get money."
In his address to housing professionals and academics, the chairman of Hyperion also suggested changing the risk-based capital requirements on agency debt. By doing so, he said, "you would free up a ton of capital in the banking system."
Government National Mortgage Association, or Ginnie Mae, mortgage debt has a zero percent risk weighting because there is an explicit guarantee for Ginnie Mae debt. Ginnie Mae is a corporation within the US Department of Housing and Urban Development.
At the same time, the risk weighting for Fannie Mae and Freddie Mac debt is 20%, which means that the risk based capital required is 1.6% of the amount of assets.
So, for example, if you buy $1 billion worth of Fannie and Freddie debt, you need to set aside $16 million in capital.
Additionally, Ranieri called on the Securities and Exchange Commission to reimpose its uptick rule. The Hyperion executive said "taking out the uptick rule was, in retrospect, a major policy error. Most of what has been going on could have been prevented if the uptick rule were in place."
Ranieri also called for greater regulation of the credit default swaps market. "Somehow it needs to be regulated. We need disclosure and we need transparency or we are going to keep wiping out big institutions."
According to the International Swaps and Derivatives Association, the notional amount outstanding of credit default swaps grew 37% to $62.2 trillion in the second half of 2007. CDS notional growth was 81%for all of 2007.
The CDS market effectively allows investors to buy insurance against a coporation's default. But not all investors have used the CDS market to buy protection and many have used CDS as a way to bet against the credit-worthiness of a corporation.
"CDS have doubled in the last two and half years ... and they are completely invisible. There is no oversight ... and everybody's got them," said Ranieri, adding, "There is virtually no bank, no insurance company, no pension fund that is not in some way touching credit default swaps. And, the leverage is extraordinary."
Likening the CDS markets to an 800-pound gorrilla in the room that few have acknowledged until recently, Ranieri noted that "when the SEC basically imposed rules that prevented hedge funds from shorting financial institutions all the action went from shorting the stock to playing around with credit default swaps."
In the meantime, Ranieri warned that the US financial system's livelihood is being threatened by an upwelling in the money markets. "The real crisis is going on in the money markets. The most immediate [response to the crisis] is the stabilize the short end. Because if you don't stabilize the short end you wont have to worry about the long end."
The money markets--debt for 12 months or less--have been under pressure in recent weeks after the demise of Lehman Brothers. Few lenders are willing to stake money for the short term because of concerns about the condition of the financial markets. For example, the Libor rate has risen sharply as banks are less willing to lend to each other because they have lost faith in each other's ability to pay back loans.
Much of the concern also stems from the recent FDIC-orchestrated sales of what was once the largest US thrift, Washington Mutual, and Wachovia.
Additionally, Ranieri said that the limit on FDIC-insured deposits should be lifted, but the maximum insured amount ought not to have a cap. Legislators have floated the idea of raising the limit from $100,000 to $250,000.
"Why only $250,000? Why not just guarantee unlimited [amounts] in the same way mutual funds" guarantees are unlimited, said Ranieri.
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