Sense on Cents

I am happy to provide you with a full accounting of what occurred from the late ’90s to the present.

–The repeal of Glass-Stegall (GLBA) is a total non-event in the midst of the current economic turmoil. What this repeal did was allow commercial banks to get more deeply involved with investment banking activities. Thus, JP Morgan, Citigroup, Bank of America were able to utilize their significant balance sheets and capital bases to become a force on Wall Street. Fast forward ten years and it is those institutions that are now thankfully supporting and bailing out our system.

–Throughout the 90s and into the early part of this century, Freddie Mac and Fannie Mae were utilizing their significant lobbying power to gain an ever increasing portion of the overall U.S. mortgage market. They had the enormous advantage of being able to borrow at just marginally over U.S, government rates given the “implied” but not explicit backing of Uncle Sam. I mean, come on. That worst case scenario could never come to pass!!

While Freddie and Fannie were designed to provide liquidity to the market in the form of bundling mortgages into securities, charging a guarantee fee for return of principal to the investors in these MBS, and then selling the MBS into the private market, they decided to “grow their business”. Just how did they grow? Given their ability to borrow at very cheap rates they decided to effectively grow their own internal portfolios. This business model was nothing more than a massively levered hedge fund under the guise of “helping the homowner”. In order to grow these portfolios, though, they needed more mortgages. Thus they went directly to the mortgage originators and worked with them to increase the mortgage terms and types that they would buy.

–As Freddie and Fannie were executing this strategy, there were 3 groups that stood up and said that this activity was getting out of control. Who were they?? On Capitol Hill, Senator Richard Baker (R-LA) carried the torch. There were actually a number of large banks including Chase and Citi that formed a group called FM Watch that complained that Freddie and Fannie were taking market share from them in their own mortgage origination business. This group was conflicted because the investment banking arms of these institutions were pressured by Freddie and Fannie to quell their complaints or they would refrain from doing business with them. Lastly, the Wall St. Journal was vociferous in their complaints that these entities were getting out of control. Freddie and Fannie responded that they were merely trying to fulfill their mission of providing affordable rates to potential homeowners.

–Well how was the impact of Freddie and Fannie on the overall mortgage rates that passed through to the consumer. A number of private studies put the “benefit” of Freddie and Fannie to the American homeowner at between 2 and 4 basis points, In layman’s terms, if a homeowner would have gotten a 6.75% rate then having F/F on the scene helped them get a 6.72% rate. Now wait a minute, you mean the system was taking all that risk and F/F grew their internal “hedge fund” portfolios to north of 1.5 trillion for a benefit of 3bps. How does that work? Well, the benefits accrued to the shareholders and the executives including Franklin Raines and Jim Johnson, who took out multiple millions. (Raines specifically took out 90mil)

–As this scenario played out, Senator Baker and then Senator McCain and other Republicans started to get up in arms about the enormous “systemic” risk that was developing. To be fair, Freddie Mac did work to root out the most egregious “predatory lending” that had been undertaken. That said, Freddie was the buyer of the bulk of sub-prime product in the market and without their bid the “overly aggressive” lending would not have taken place to the extent that it did. Fannie was the buyer primarily of Alt-A product which included a lot of the loans without full documentation.

–Both F/F were effectively cooking their books. Freddie actually made more money than they were reporting (putting revenue away for future years) while Fannie had truly pathetic risk management and grossly overstated earnings. Both firms reporting of earnings were totally driven by “maximizing” executive bonus packages. Very simply, heads I win, tails you (meaning Uncle Sam and taxpayers) LOSE!!

–Even in the midst of this while Baker, McCain, the WSJ and others were railing on how these agencies were managed, regrettably the necessary regulations and oversights never got out of committee because the Democrats, primarily Dodd, Schumer, and Frank crushed it. At this juncture, Barack Obama votes present. He was not willing to stand up to his party because he was in bed with F/F and was well on his way to being the second greatest beneficiary of their largesee only after Chris Dodd. To think that this crowd is now going to hold hearings to “review” this crisis is akin to the “inmates running the asylum!!

–While Franklin Raines, Jim Johnson, and Tim Howard were ushered out at Fannie, and Leland Brendsel was pushed out at Freddie there were no real dramatic changes. Their regulator OFHEO was given some greater oversights but F/F knew that they had their “friends on the Hill” in their back pocket to stymie real regulation.

–Well, American homeowners got their 3bps but are now stuck with a multiple hundred billion dollar price tag along with the price of the systemic risk that went along with it.

–One may ask, why did this happen at F/F and not Ginnie Mae? Well, Ginnie does not run a big internal hedge fund and merely bundles FHA- and VA-insured mortgages, takes a guarantee fee for return of principal to the investor and then lets the securities go into the private market. It works just fine.

LD

This entry was posted on Thursday, October 16th, 2008 at 6:00 AM and is filed under American Consumers, Bank of America, Christopher Dodd, Current Affairs, Economy, Fannie Mae, Freddie Mac, Ginnie mae, Home Loan, Housing Crisis, JP Morgan. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.