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07/11/2008

Fannie Mae's Golden Goose: A Lesson In Moral Hazard

In the mid 1990’s I spent over a year as part of a team consulting to Fannie Mae. Given that they have been in the news a bit over the last few days, I thought it might be interesting to pass along a few observations that initially crystallized during my time there.

The World’s Biggest Mortgage Bank

For those of you that don’t know Fannie Mae, it is one of the largest financial institutions in the county with over $880BN in assets. It is almost exclusively focused on buying, selling, and guaranteeing single family residential mortgages. Fannie Mae was originally a US government agency, but became a public company in the 1970s. Despite being a public company, Fannie Mae has remained a quasi-government agency subject to federal oversight and regulation. This government regulation, combined with a few perks such a direct credit line from the US Treasury as well as its overwhelming size and importance to the US housing market has resulted in what amounts to an implicit US government guarantee that Fannie Mae (and its cousin brother Freddie Mac) will never default on their debt. There is no law or regulation to that effect, just an assumption by the market that Fannie Mae is too big, too close and too important to the government for the government to ever let Fannie Mae fail. With the mortgage market in massive turmoil and Fannie Mae’s stock down 85% in the last year, that assumption is currently being heavily tested.

I don’t know exactly what the future holds for Fannie Mae, but I think I can shed some light on how it got in this position in the first place. The seeds of Fannie Mae’s current crisis were actually sown in the recovery from its last crisis. In the mid-1980s Fannie Mae almost went out of business thanks in large part to some very poor and rather unsophisticated asset and liability management practices. What basically happened is that the aggregate cost of Fannie Mae’s debt exceeded the income it was deriving from its (then relatively modest) mortgage portfolio. This never should have happened given the instruments and strategies available to Fannie Mae’s finance team, but they had become somewhat complacent and had failed to keep up with the state of the art in portfolio and treasury management.

Creating the Golden Goose

A new team of people took over the finance side of Fannie Mae and implemented a series a relatively sophisticated and ultimately incredibly profitable Asset and Liability Management (ALM) strategies. One of the key innovations was issuing debt instruments, specifically callable debt instruments, that enabled Fannie Mae to much more closely match both the duration and pre-payment characteristics of its Assets (primary residential mortgage securities) with its debt (primarily Fannie Mae corporate debt). Normally, callable debt is quite expensive (much more expensive than residential mortgage debt), because bond holders want to be compensated for selling the call option to the issuer, but thanks to Fannie Mae’s quasi-government status it was able to issue this callable debt at yields that were only marginally above straight treasury yields. This debt combined with a more sophisticated overall ALM approach, not only reduced Fannie Mae’s borrowing costs significantly, but enabled it to very quickly adjust its portfolio in the event of rapid changes in pre-payments.

With this strategy in hand, not only could Fannie Mae buy mortgage securities for less than the cost of its debt (and thus earn a nice spread), but it could almost entirely contain pre-payment risk effectively making the purchase of mortgage securities “risk free” except for credit risk, which itself was very low thanks to Fannie Mae’s strong underwriting guidelines. Fannie Mae had discovered the equivalent of a financial golden goose.

Let’s Get This Party Started

With its golden goose in hand, Fannie Mae almost immediately began buying a lot more mortgage securities. Who did it buy these securities from? Why none other than Fannie Mae itself. You see Fannie Mae’s original role was to buy mortgages from individual banks, package them up into securities, guarantee those securities against loss, and then sell them to other financial institutions. However once Fannie Mae realized that the “golden goose” allowed them to buy those same securities for its own portfolio and lock-in “risk free” profits, Fannie became a major buyer of its own securities. Fannie Mae was thus in the rather bizarre position of guaranteeing an ever increasing portion of its own assets against default.

By the time I showed up in the mid-1990’s, Fannie Mae had become one of the largest buyers of its own securities. Its stock was up over 40X from it’s 1980s nadir and it seemed as though the single biggest problem it had was deciding on how much money it wanted to make. This was a bigger problem than you might imagine because as a quasi-government agency, and a constant political football, Fannie Mae realized it couldn’t be seen to be abusing its market position. So rather than go crazy and buy every mortgage security in sight, Fannie Mae just settled on charting a nice predictable upward growth in earnings fueled largely by buying an ever increasing share of its own securities.

Now a normal private company could not pursue this strategy because as it issued more and more debt to fund the golden goose, the yields on the incremental debt would start to increase to the point where the strategy no longer made sense. But Fannie Mae was different. Because of the implicit government guarantee of its debt, Fannie could issue incremental debt with little or no regard to its existing debt load because everyone assumed the federal government would backstop the debt.

Fannie Mae’s only significant problem thus became that the supply of mortgage securities would prove insufficient to fund its projected earnings growth (which was well above the projected growth in mortgage debt). As a result Fannie began a series of largely successful political campaigns to increase the volume of mortgage securities available to fund their habit. Theoretically, the easiest way to increase the supply of mortgage securities was to get the federal government to increase the size limit of mortgages that Fannie could buy and guarantee, but this was a very difficult political fight for Fannie to win because commercial and investment banks dominated the so-called “jumbo” mortgage market and, already smarting from Fannie’s dominance of the so-called “conforming” market, they had drawn a line in the sand in the jumbo market and committed most their lobbying resources to keeping Fannie’s size limit as low as possible.

Moral Hazard vs. Mo’ Money

While Fannie still fought to increase its size limits, it quickly found another, much more politically palatable, way to increase the pool of mortgages it could buy: it dropped underwriting standards under the guise of increasing “home ownership” and “affordability”. Traditionally, Fannie had required the mortgages it purchased to be so-called 80/20 mortgages wherein the borrower puts at least a 20% down payment on the mortgage. This was a requirement because residential mortgages in the US are a “no-recourse” loan in which the borrow can generally “walk away” from the loan with no recourse to the lender other than seizing the house and reporting the default to a credit agency. A 20% down payment was generally thought to be enough to dramatically limit the moral hazard of borrowers “walking away” because housing values would have to decline 20%+ for the borrower to be underwater and even then the borrower would still face the prospect of losing their own sunk capital which makes walking away even more difficult from a psychological perspective

The problem with a 20% down payment is for many people it was very hard to come up with that big a down payment and thus it limited the total size of the mortgage market which in turn limited the volume of mortgage securities that Fannie Mae could purchase for its golden goose. While the obvious solution to this problem is just to lower the down payment requirement, Fannie couldn’t do this unilaterally because the government unit that regulated it would see such cuts as needlessly raising Fannie Mae’s risk profile. Far more politically astute that that, Fannie Mae began a campaign to increase “home ownership” and “affordability”. It created a home ownership “foundation” which opened offices in almost every congressional district and promptly set about mobilizing all the local advocates for “affordable” housing to put pressure on their elected representatives to let Fannie Mae offer “affordable housing programs”. Of course, “affordable housing problems” was just a euphemism for allowing Fannie Mae to lower its underwriting standards so that more mortgages could be created and the golden goose could thus kick out more golden eggs.

This proved to be a highly effective political coalition for Fannie Mae. Not only did they build a huge network of grass roots political supporters through their “foundation”, but politicians saw political advantages in supporting the programs because it cast them in the role of trying to help families buy a new home (as opposed to lowering underwriting standards to help a giant corporation keep up its earnings growth by taking a free ride on the US government’s guarantee). Even commercial banks and investment banks signed on to the program because it at least resulted in higher origination fees and an expanded credit market, even if most of the assets ultimately went to Fannie Mae and Freddie Mac.

A Victim of Its Own Success

Fast forward to the mid-2000’s and Fannie Mae’s financial and political strategy was largely a resounding success. Fannie was now offering a wide range of mortgages that required less than a 20% down payment including even some that required no down payment at all! These products had dramatically increased the addressable size of the mortgage market. The increased size of the mortgage market enabled Fannie to purchase a massive amount of its own mortgage securities. In fact by this point Fannie Mae had become the single largest purchaser of its own securities. These newly purchased assets in turn enabled Fannie to continue to grow earnings which in turn supported a stock price that continued to trend nicely upward (though at a much more modest rate).

However beneath the seeming calm, the seeds for Fannie’s distress were now firmly planted. Fannie’s drive to lower underwriting standards had created a pool of mortgage debt with a much higher level of embedded moral hazard risk as well as good old fashioned credit risk. Fannie’s purchases of mortgage securities were so large that it was getting increasingly difficult to feed the golden goose enough food. On top of all that, with hundreds of billions of dollars of assets and liabilities to manage, Fannie's ALM strategies had become more and more complex and some of its bread and butter strategies started to become less profitable as the sheer weight of over half a trillion dollars of debt started to compress spreads (it would seem that even an implicit government guarantee has its limits).

It is no coincidence that the current mortgage crisis started in the so-called sub-prime market as that’s the mortgage market with the lowest credit quality and underwriting standards, however as the mortgage crisis has spread it has become increasingly clear that the traditional conventional, conforming mortgage market, long the domain of Fannie Mae and Freddie Mac, shares many more similarities with the sub-prime market than it would like to admit. While credit and underwriting standards are clearly much higher in the conforming market, they are also undoubtedly much lower than they were 10 or 20 years ago. What’s more the two biggest insurers against loss in that market now happen to also be the biggest owners in that market thanks to 20 years of purchasing mortgages to fund their government subsidized golden gooses. Guaranteeing oneself against risk is not insurance, its an exercise in futility.

The Goose Is Not Dead Yet

Despite all of this, I personally don’t expect either company to go out of business. If recent comments from a slew of politicians are any indication, they are indeed “too big to fail”.

What I find most ironic in all of the current commotion is that rather than trying to address the root causes of Fannie Mae’s precarious state: dramatically lower underwriting standards and a massively levered balance sheet taking a free ride on the government’s back, politicians are doing the exact opposite: they are dramatically increasing the size of the mortgages that Fannie and Freddie can buy and pressuring them to maintain and even further lower their already un-sustainably low underwriting standards. I don’t know where this ends, but reinforcing the bad behavior that led to the crisis in the first place can’t end well

UPDATE: See my latest post if you are interested in my take on the Fed/Treasury's recently announced strategies for helping Fannie/Freddie.

I currently have no investment position, long or short, in Fannie Mae or Freddie Mac. This is not investment advice. Please see my disclaimer at the bottom of this page for further details.

July 11, 2008 in Wall Street | Permalink

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The thoughts and opinions on this blog are mine and mine alone and not affiliated in any way with Inductive Capital LP, San Andreas Capital LLC, or any other company I am involved with. Nothing written in this blog should be considered investment, tax, legal,financial or any other kind of advice. These writings, misinformed as they may be, are just my personal opinions.