Friday, April 13, 2007

The Fed, Mortgage Credit, and the GSEs

Where does all of the conflict come from, between the Fed, Fannie Mae, Freddie Mac, and the incredibly efficient secondary mortgage market system?

Simply, the Fed has little respect for financial institutions created by Congress for specialty lending, i.e. thrifts for housing, Fannie and Freddie for the same, formerly Sallie Mae for college loans, and Farmer Mac for agriculture lending. The Fed believes that these institutions are “artificial” and create credit demand far larger than what would be, if they didn’t exist. Lastly, the Fed believes that a commercial banking system, with the Fed in the lead, is all that the nation needs for credit to go to the most rational needs, based on market demands, not because Congress “tilts” the playing field and creates credit incentives for housing, student loans, agriculture loans, et al.

The Board of Governors of the Federal Reserve System has a priority list. It is fanatic about its role and independence in setting monetary policy and its control over the payments system. It wants no interference, from any source. It wants no financial rivals, either inside or outside the Beltway, generating positive influence or national attention.

The Fed may have a seven member board, but—traditionally--the Chairman controls the Board of Governors. His priorities and his dictates becomes the Board’s. The Board’s Vice Chairman and other Governors, as they are known, and the Fed’s senior staff always fall in line with the Chairman’s thinking, even though there might be some disagreement behind the scenes.

So, why is the Fed viewed as “anti-housing” and why is it said by many that the “Fed dislikes the GSEs?”

When I first joined the Fed, in 1981, as a congressional liaison officer, coming from a senior post at the Federal Home Loan Bank Board, I found myself explaining the thrift industry and their lending habits and practices to a the Fed professionals. The central bankers didn’t really know and didn’t care to know about the “housers.”

They viewed the savings and loan institutions and their executives, almost as jokes, their officers like kids playing financial games. Housing lenders, because of their generally small size and specific housing lending, weren’t viewed as real lending institutions, with the Fed disdaining for years to include their business activities in national lending data.

While everyone professed to love housing and the thrift institutions which exclusively lent for home mortgages, the Fed thought the industry and their work was unnecessary and propped up solely by an adoring Congress, which viewed thrifts as serving the “little guy,”

The Fed’s credo was/is that commercial banks could do everything that these “creatures of Congress” could do and more efficiently.

The “thrift crisis,” which ended up costing the nation over $250 billion, seemed to buttress the Fed’s predilection about excessive mortgage credit and dedicated housing lenders.

Fannie Mae and Freddie Mac just naturally got into the Fed’s crosshairs, for policy reasons and some ego driven.

First and foremost, as Fannie and Freddie grew out of the thrift debacle, the Fed just viewed them as part and parcel of the same problem and gritted its institutional teeth, as the GSEs create large and seamless international mortgage markets, with huge access to international money benefiting homebuyers.

The GSEs were great for consumers and for many lenders, including big banks, but the Fed didn’t want to acknowledge the plus, for many of the old reasons, i.e. too much money going into housing and the fact that the Fed did not directly control the GSEs.

GSE financial power was being enhanced by their growing political growing influence in Washington. Starting in the late 1990’s, Congress and others wanted Fannie’s opinion on housing as well as a variety of other financial services matters. “If they could do so well with home financing, why not try them….”

To the Fed and Alan Greenspan, Fannie Mae was becoming a scary juggernaut, big business and big politics, neither of which the Fed could countenance.

The central bank got some added incentive to combat the GSEs, when the major regional and money center banks started to complain that Fannie and Freddie were getting too large, too efficient, and reducing profits for the banks, which by now had acquired control of the “primary mortgage market” from the thrifts and the mortgage bankers. The large banks facilitated this latter development by rapidly buying up the previously “independent” mortgage companies.

Targeting the GSEs gave the Fed a veritable bonanza: it could pontificate about excessive housing credit, blow hard about systemic risk, and help the banks, the institutions they really cared about the most.

Part of the Fed campaign involved saying/testifying that the GSEs were “undercapitalized,” despite the fact that the GSEs have statutory risk based capital tests—which no other financial institutions have—that, in part, were designed in collaboration with Paul Volcker, after he retired from the Federal Reserve.

Because the Fed is the nation’s “lender of last resort” and has explicit and implicit authority—working with the Treasury and others—to do whatever is necessary to make sure a commercial failure doesn’t bring down the entire payments system, it began to suggest that the GSEs “could/might/potentially” be a problem source of problem and needed more capital and control.

The “systemic risk” phrase, encouraged by the Fed and jumped on by the GSEs opponents, who included the aforementioned banks, larges elements of the GOP, the conservative thinks tanks and media, started to get used against Fannie Mae and Freddie Mac, in an effective—but not accurate—campaign.

The GES accounting fiascos, for which the companies themselves are exclusively to blame exclusively, should never have caused the blowback they did, if for no other reasons than the mammoth remedial efforts both Fannie Mae and Freddie Mac took, after acknowledging the errors.

But, if an allegation is repeated frequently enough, especially by those in a position of respect, the potential to accept it as “truth” grows. After all, who has enough swack to challenge the Fed?

My final observation about the Fed’s hostility to housing and the GSEs, and especially Fannie Mae, is one that I cannot prove. Yet, I strongly believe it to be fact.

I think the Fed’s anti-GSE vendetta got a steroid injection from Alan Greenspan, who took personal umbrage at senior Fannie Mae officials. He had all of the aforementioned institutional cover he needed to go after Fannie and Freddie, but the growing “cult of GSE personalities,” giving and receiving major awards and media attention, association with other prominent DC institutions, plus getting lots of positive reviews on the important “Georgetown cocktail train” etc. irritated Greenspan—no shrinking social violet, himself--and allowed him to give Fed staff the green light to torch the companies, using the Fed’s famous “on the one hand and on the other,” where much was negatively implied, but little substantiated.

Would the Fed ever carry out a destructive GSE campaign because of institutional pique or the Chairman’s anxieties?

The Washington Post’s excellent financial writer nailed the answer to both question, writing on May 25, 2005.

Pearlstein had gotten his hands on a Fed staff report which dramatically downplayed the risks the GSEs represented to the financial system (the Fed’s catchy “systemic risk” allegation), because the companies employed “derivative securities,” commonly used to hedge against interest rate movements.

The Fed staff concluded that the GSE risk was far less than “most of us thought” and that, “If either Fannie or Freddie were to fail, the(se) derivative markets would not melt down.”

According to Pearlstein, Greenspan—shortly after the report was produced—delivered a speech to a Chicago banking conference, via satellite, and summarized the report, “at times tracking the report line by line, while carefully skipping over other portions that might have given comfort to Fannie and Freddie and their supporters.”

“And then, at a crucial moment, he (Greenspan) departed from the staff’s conclusions to add one of his own, albeit, without attribution”

Pearlstein wrote that AG freelanced and declared, “Nonetheless, concerns about potential disruptions to swaps market liquidity will remain valid until the vast leveraged portfolios of mortgage assets held by Fannie and Freddie are reduced.”


Here’s hoping that Mr. Bernanke can rise above recent history—and his predecessor--and see the value to the nation’s mortgage finance system in strongly regulated GSEs, controlled by their own business managers.

(Writer’s note: This piece was boiled down, from one that was nearly 3000 words, but which I wanted people to read, not sleep through. The balance will lend itself to more blog stuff about the banks, their large DC associations, and why an industry that benefits from huge and explicit federal deposit insurance subsidies, is the proverbial “pot” calling the GSEs “kettles” black. Worrisome addendum: Pearlstein did a recent piece on Bernanke calling for more GSE controls and speaking to “subprime” problems, yet never mentioning that the GSEs had no role in creating that mess.)

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